Fiscal activism makes a comeback. But it won’t help savers

Even the Prime Minister Theresa May is saying it. Low interest rates are not lifting the economy in the right way. So time for government spending and tax cuts to take over? Or, as economists call it, active fiscal policy. She joins a chorus of academic economists and newspaper commentators.

The story goes back to the 1930s when the Depression was rampant. This hit government tax revenues and the conventional wisdom was that government spending had to be cut to balance the budget. Enter the great economist Maynard Keynes.

Keynes pointed out that the problem with the economy was a shortage of demand – not enough people buying things to pay for the people in jobs. Or to put it another way, there was excess saving. If people are saving, they are spending less than they earn. That means that there isn’t enough spending across the economy to pay everybody’s wages, so the economy sinks. Or it will sink if the savings are not spent on investment, which is another type of spending. Stuffing cash into mattresses is not investment. Neither is putting the money into a bank account unless the bank lends it to somebody who in their turn pays somebody to do something. In a depression people are unwilling to invest, and so saving tends to be higher than investment. And so the economy enters a doom-loop. Before the 1930s economies were marked by severe boom and bust cycles.

Keynes pointed to a way through. If government increased its spending or cut taxes, they would put money in people’s pockets, which would be spent, neutralise the excess saving and bring the economy back to life again. Slowly governments followed his advice, most famously US President Franklin Roosevelt with his New Deal.  The most spectacular success came in Hitler’s Germany, which spent freely on infrastructure (think of the autobahns) and armaments. Keynes pointed out that it did not matter what the spending was on provided it was spent at home, or at any rate it didn’t matter at first. As the economy approaches capacity wasteful government spending is a problem, but not before then. The rapid expansion of the US economy as it was placed onto a war footing in the 1940s proved Keynes right beyond doubt. Thus was born fiscal policy as an instrument of economic management, and economics as a discipline entered a golden age. The swings from boom to bust were notably reduced in the 1950s and 1960s.

Then it came off the rails. In the 1970s things changed. The first shock was the breakdown of the Bretton Woods system of managed exchange rates – it could not handle the excess of US spending on the Vietnam war. This destabilised the international financial system. Then came the oil shock in 1973, as OPEC ramped up oil prices massively. The governments that tried to spend their way out of the subsequent recession merely created inflation and not jobs. The governments that applied stricter fiscal policy, West Germany and Japan in particular, suffered much lower inflation. Enter another economist: Milton Freidman.

Freidman suggested that Keynes had it all wrong. The issue was not managing government spending and taxes, it was managing the money supply. The Depression was severe because the banking system collapsed, and people couldn’t borrow money. A lot of what Freidman said turned out to be nonsense, but what evolved was the neo-Keynesian consensus. This relegated fiscal policy to a relatively minor role. In the conventional wisdom of the time (often referred to nowadays as “neoliberalism”), government spending could easily get out of hand, destroy inventives and make economies less efficient. Instead the main responsibility for managing the business cycle came to something referred to as “monetary policy”, run by  central banks.

Monetary policy is a bit of misnomer, a hangover from Freidman’s emphasis on money supply. To this day people often explain monetary policy as if people paid for things in banknotes, which are printed at will by the central bank. In fact money has moved almost entirely to accounting systems of debtors and creditors, with banknotes relegated to a very minor role. The economic implications of a bank account are utterly different from those of a pile of banknotes. The idea of money supply is nearly meaningless. Instead of that, as regular commenter to my blog Peter Martin put it in a post to Lib Dem Voice, what we have is interest rate policy. Money supply in the economic models taught to students has become a completely theoretical concept that cannot actually be measured . If demand is falling in an economy, this is corrected by reducing interest rates, which should encourage people to spend more. If things look like getting out of hand, then interest rates are raised.

Through the 1990s and early 2000s this system seemed to be working, but it came under increasing criticism. Central banks used inflation targets to judge whether the level of demand was too high or too low. But this measure excluded asset prices, which were directly influenced by interest rates. Asset bubbles were allowed to develop. Then they popped in 2007 to 2009, in the financial crash and the big recession that ensued, which interest rate policy proved unable to correct.

Fiscal policy made a return. But it was tentative. As soon as the worst of the recession was over, governments cut back (widely referred to as “austerity”). Critics argued that this was stalling any recovery. Then the victims of low interest rates, those saving for pensions in particular, started to get agitated. This is most evident in Germany – but Mrs May was voicing concerns amongst her constituents in the UK.

So can fiscal policy help lift economic growth, in place of low interest rates? There is a strong case for this, but caution is warranted. Most economic commentators hedge their bets by recommending that extra spending is on infrastructure projects, that will yield economic returns in their own right.

This hints at the first of three reasons for caution. What if the reasons for slow growth are structural and not to do with low aggregate demand? Are we making the same mistake as the mid 1970s, when economists saw high unemployment and low growth and assumed that this meant lots of spare capacity? In fact economies then had suffered a major dislocation from the oil shock, and were slow to adapt because of excessively unionised and corporatist economic management. That was then, but there are plenty of suggestions as to what the capacity restraints might be now, starting with demographics. Investing in infrastructure should help overcome these constraints, killing two birds with one stone.

The second reason for caution is that economies have internationalised. A lot of the benefit of fiscal stimulus can leak abroad, especially if other countries have a deficiency of demand too. Fiscal stimulus might simply drag in imports from countries eager for export-led growth. Globally coordinated fiscal policy works much better. This was achieved in 2009, but consensus has broken down since. The risk of stimulating other people’s economies can be reduced if the stimulus programme is carefully designed. But it can be quite hard to tell where best to direct spending or tax cuts.

And the third reason for caution is the difficulty in understanding when to turn the tap off and tighten policy. Politicians are prone to fiddling the figures to put the evil day off. British Chancellor Gordon Brown was notorious for this in the mid-2000s, contributing, in my view anyway, to the severity of the financial crash in 2007-09. Anti-austerity has become a political totem on the left – and yet there must come a point in any business cycle when austerity is required. This is also a problem with using infrastructure investment as the prime instrument of fiscal policy – it is not so easy to manage according to the business cycle. Lead times can be long and if an investment project is worth doing, it is probably worth doing at all points in the cycle.

And a final point. looser fiscal policy is unlikely to help savers with raising interest rates. Interest rate policy and fiscal policy should not be working against each other. To raise interest rates we need to see a healthier British and world economy. That looks some way off.

 

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43 thoughts on “Fiscal activism makes a comeback. But it won’t help savers”

  1. Fiscal stimulus might simply drag in imports from countries eager for export-led growth.

    That’s true but what are the implications of that? Let’s consider a hypothetical economy which is running along under a condition of balanced trade. Ie Exports = Imports. The Domestic sector neither saves nor de-saves and so, according to the theory of sectoral balances, the government must run a balanced budget too. The Government decides that the economy needs a stimulus and chooses spend more and tax less.

    The stimulus can only work if the other players in the economy choose not to save more. If only overseas sector chooses to save more a trade gap will open up and the government will run a budget deficit. If only the domestic sector chooses to save more, the trade gap will remain the same but the government will start to run a budget deficit.

    So an increased trade gap can be taken as evidence that the stimulus isn’t working. Except for that – it’s probably nothing much to worry about at all. It’s just a sign that our overseas partners are wanting to save more.

    But, a sign that it is working would be a falling level of unemployment, possibly a falling exchange rate and an upward pressure on prices. The trick is to steer a sensible middle course between having too much of one or the other.

    1. I have in mind the classic IS-LM model for small open economies that I was taught at UCL. In this fiscal stimulus will raise the demand for money, causing the exchange rate to rise and leading to an increased trade deficit with little effect on domestic demand. Unless you operate a fixed exchange rate regime, which amplifies the effect of fiscal policy on the domestic market. It was a neat model, which does not make it realistic of course! The point is that it is not a given that fiscal stimulus will necessarily affect the domestic economy. But I agree with you (I think) that the key thing is to design it intelligently.

      1. I’m not sure the IS-LM model is that neat. Correct me if I’m wrong but, according to the model, the fiscal stimulus will require more borrowing which then causes interest rates to rise which in turn raises the exchange rate? The rising interest rate then negates the stimulus?

        If I’ve got that right then I have to say that this is an incorrect model. If there’s one thing we all will have noticed recently it is that interest rates are determined almost entirely by Government / Central Bank policy. The overnight or short term rate has recently been reduced from 0.5% to 0.25%. This is just the decision of a few people or a committee.

        The longer term interest is a little harder for Government but, essemtially, if it wants a lower longer term rate it has more QE , or open market operations. If it wants a higher rate it restricts the sale of bonds so they fetch a higher price at auction.

        In other words the Government can have any level of interest rates it chooses -both for the short and longer term.

        https://en.wikipedia.org/wiki/IS%E2%80%93LM_model

        1. Correction: I’ve just realised I should have written:

          “If it wants a higher rate it increases the sale of bonds so they fetch a lower price at auction. The lower the price the higher the yield and therefore the higher the effective interest rate”

          1. No model is going to reflect the world as we find it fully. They are somewhere to start, though, so that we can explore second order effects of policy changes. This particular bit of the model is based on work by Mundell-Fleming – famous for developing thinking on exchange rates. What you are suggesting, I think, is that you can offset the neutralising effects of fiscal policy by loosening monetary policy – and that is perfectly consistent with ISLM. By itself (in this theoretical small open economy) fiscal policy is neutral – but monetary policy is effective. That’s not so dissimilar to saying the two have to work together. But that, the theorists would probably riposte, is not so dissimilar from a managed exchange rate policy.

            I must admit the more I think about it, the more I see the barriers between monetary and fiscal policy as being arbitrary. Perhaps one of the most effective models of monetary expansion is “helicopter money” – “printing” money and giving it to people. Surely that’s the same as giving people a tax cut and funding it through QE.

          2. The reason for any model isn’t “to reflect the world as we find it fully”. The model gives us the basis for understanding something that might be too difficult otherwise. They do need to be tested out to ensure they are correct and aren’t making that understanding even more difficult than it was.

            There is a fair bit of criticism on the net of the IS-LM model, and which is probably to abstruse for this discussion. See for example here:

            http://nakedkeynesianism.blogspot.co.uk/2013/03/is-lm-is-bad-economics-no-matter-what.html

            It looks to me that the assumption, in the model, is that all government money has to be borrowed and ignores the question of where it comes from in the first instance. I don’t mean from taxation. I mean how these things we call pounds and dollars were created in the first instance.

            So there seems to be no theoretical reason why Government can’t use fiscal measures to regulate aggregate demand -irrespective of whether the currency is fixed or floating. It’s probably easier if it is allowed to float. If interest rates are too high Govt can lower them. If the exchange rate of the currency is too high it can lower that too. That’s a lot easier than propping up a currency at higher than its market value.

          3. To my mind the problem with IS-LM is that it is a bit like what the first law of thermodynamics is to chemistry. All very elegant, but the really useful stuff comes in the much messier bit of kinetics. You need to move on from general rules to understand specific problems. It was understanding this in chemistry (in my A-levels) that was one of my big intellectual breakthrough moments. The blog post you linked to sort of makes this point by referring to the limitations of equilibrium analysis. But I really worry when people start to base arguments on getting to a true understanding of the thoughts of a great master. Shades of Marxism. IS-LM, properly understood, has its uses – as indeed Paul Krugman continues to show.

            I am still trying to get my head round what money is. But the more I think about it the more I see modern money as being essentially bookkeeping, and it is not helpful to think of it in terms of piles of banknote. It is a form of debt.

            And yes if the government takes direct control of monetary policy rather than working with an independent central bank, there are all sorts of things it can do. The fear is that short-term political objectives would trump sensible economic management. It’s an old argument about absolute power.

            I think your vision

          4. It’s interesting to read that “you are still trying to get your head around what money really is” !

            I would have thought that should be level 101 in an economics course. But some of the economists I read, and am influenced by, have made the accusation that the mainstream tends to mainly ignore the question, and even when they don’t, tend to misunderstand what money really is.

            So their objection to the IS-LM model would be largely over its treatment of the money markets. The idea that money is borrowed by person B from person A in the financial system, albeit with the banks as an intermediary, is how we might think it works, and that also seems to be the assumption in the LM part of the model, but really doesn’t work that way.

            The thinking is that any bank with sufficient capital can, in effect, create money when it issues a loan.
            Have you read this article which has come from the BoE and which has attracted quite a bit of approval from the PK fraternity?
            http://www.monetary.org/wp-content/uploads/2016/03/money-creation-in-the-modern-economy.pdf

            A central bank can issue money when it makes loans too. This means that, contrary to what many might assume, increased government debt tends to force down interest rates as new money is issued. This would explain why interest rates are now very low at the same time as Govt debt is relatively high both in the USA and UK.

            PS I agree that we shouldn’t attribute infallibility to Keynes or anyone else. We should be scientific and always look for ways of proving them wrong.

          5. Economics 101 is not the place to acquire deep understanding. I do remember my Year 1 macroeconomics lecturer at the end of the course musing that electronic money was changing everything because it was bypassing the central bank management systems.

            And yes I certainly do remember the kerfuffle when that article from BoE came out. But Paul Krugman asked, so what? This has been known for decades. He referenced this article by James Tobin from 1963. At the same times as banks “create” money they also create loan debt, which has th effect of neutralising the wider macroeconomic consequences. And the process is dynamic and reversible – they are withdrawing money almost as fast as they are creating it. All which left me wondering what on earth “money” actually is.

          6. But does the creation of private sector debt neutralise the wider economic consequences? This is a point that Steve Keen has been harping on about for a while now. ie The theory of Debt Deflation. First proposed by Irving Fisher, I believe.

            If banks lend money the lenders have a financial asset in the loan (assuming it doesn’t go sour) plus the liability of their created money and the borrowers initially have the asset of the money borrowed plus the liability of the loan. So it’s all square in double entry bookkeeping terms.

            But there’s usually no point in borrowing money unless it is for spending so that initial picture changes very rapidly. There’s an initial stimulus to the economy with the extra spending generated. The Government’s taxation net picks up the created money as its spent, which is why there can be a Govt surplus during a credit boom. But then the debt remains and the economy slumps as a result. So the Govt, or the central bank, then has to lower interest rates to create another stimulus which builds up more private sector debt. That’s why interest rates are now so low and everyone is scratching their heads wondering what to do next.

          7. I haven’t gone back to work through James Tobin’s logic, but I guess the extra spending is offset by extra saving from loan repayments from earlier borrowing. But, I guess you would say that if debt is expanding, then new loans are outstripping repayments, so you get a net expansionary effect. And certainly rapidly expanding credit seems good for tax receipts – one of the things that led Gordon Brown into a false sense of security in the years before the crash, including his mad cut to the basic rate of income tax. But a lot of that was capital taxes generated by the asset price bubble – one of the reasons tax revenues collapsed so drastically after the crash.

            The more I reflect on this, the more I feel that the quantum of debt or money is not the real point, but how the money is spent (or not). We are in danger of confusing the medium with the message, or symptom with the disease. The malign element of private sector debt expansion was that so much of it was leverage (i.e. used to finance financial assets or property) promoted by a finance sector with distorted incentives from an agent-principal problem. Trying to limit borrowing may simply have squeezed constructive, productivity-improving investment while leaving leverage relatively untouched.

          8. Paul Krugman is being slightly disingenuous when he makes the “so-what” argument. True, a lot of the criticisms of mainstream economics are based on theories that have been around for 70 years or more.

            But the point is that they seem to have been discarded by the mainstream. Steve Keen makes the point that he’s struggled for years to convince the mainstream that the build up of private sector debt has been the real problem in the economy, rather than public sector debt which is all politicians and the economic mainstream seems to care about.

            It’s only now that he’s claiming some success. And yet the theory of Debt Deflation is “nothing new.” That’s been around since the mid 30’s.

            So if it’s “nothing new” why have Govts allowed such a dangerous situation to develop?

          9. Certainly mainstream economics has its blind spots, and these contributed to the crash. But to be fair on Krugman, he was highly critical of the financial regime before the crash, and came close to predicting it (I was an avid reader of his New York Times column at the time). I think the reason why the “old masters” were discarded was that modern economists found it hard to quantify their ideas in their models. Of course they also had a strong incentive not to rock the boat – a lot of the economists were being paid by banks who weren’t interested in disruptive thinking.

            Why did governments let such a dangerous situation develop? They had far too much confidence that bankers were managing risk rigorously. And they did not have the political power to push back and pop the bubble. There were plenty of people suggesting that something should be done, including Paul Krugman.

  2. “And a final point. looser fiscal policy is unlikely to help savers with raising interest rates. Interest rate policy and fiscal policy should not be working against each other. ”

    But they have been working against each other for quite a while now. Central banks have been charged with setting interest rates and have been given a inflation target. It is also part of their remit to aim for a certain level of growth with not too much unemployment.

    Meanwhile the government sits back and makes promises about how its going to balance the budget. The end result is that central banks have pushed down interest rates to almost zero in an attempt to achieve the impossible.

    So whether we need higher interest rates is a matter of some debate. But we’ve had higher interest rates before even though the economy hasn’t been in fantastic shape and we could again – if we wanted to. But if we knew what we were doing, of course we’d have a better chance of it being in good shape.

    1. Yes, my argument does need to be developed properly – fiscal and monetary policy have often been conducted in opposition. Including, as you say, in the austerity years. That probably wasn’t very sensible.

  3. “British Chancellor Gordon Brown was notorious for this [too much public borrwoing] in the mid-2000s, contributing, in my view anyway, to the severity of the financial crash in 2007-09.”

    This has become the conventional (maybe right wing?) view. Also part of the conventional view is that there was too much private borrowing in the economy in the mid 2000’s. I seem to remember that banks were going out of their way at the time to encourage their customers to borrow to have new fitted kitchens and bathrooms. I must admit I did just that.

    But lets take a look at the actual figures:

    http://www.3spoken.co.uk/2016/04/uk-sectoral-balances-q4-2015.html

    The government deficit at the time of the crash was about 4% of GDP. The overseas deficit was 3% and the private sector was net saving about 1% of GDP.

    So 4=3+1 (as it should be)

    So the conventional wisdom is that 4 was too high. OK so lets make it 2. We now have

    2= Overseas Deficit + Private Sector Net Savings.

    So we do have to now say how we make this equation balance. We could have had a lower overseas deficit. How should Gordon Brown have achieved this? By Devaluing the Pound?

    Or he could have encouraged more private borrowing which would have made this negative as it was at the turn of the millenium.

    So I just wonder if those who do criticise Gordon Brown understand the nature of their criticisms? They are effectively saying he should have either devalued the pound or encouraged even more private sector borrowing that we actually had.

    1. If you have been following my logic, you will remember that I have been arguing precisely that the pound in the early to mid noughties was too high, and that excess government spending was one of the things keeping it there. The aim for the UK economy at the time should have been a current account balance (though I would be interested in arguments otherwise – usually developed economies should be in balance or even surplus because they have fewer investment needs). If that meant a budget surplus, then so be it. It would have been a tough call though, I admit. Better to have a close look at the dynamics of the British economy to figure out how to push it in a more sustainable direction. I think Gordon Brown did worry about this, but was taken in by his own hubris into thinking the was less urgent than it really was.

      1. Also I am making specific reference to Brown effectively suspending his “Golden Rule” by fiddling the statistics to come the politically correct answer. If I’m being a tad unfair on the man, that was certainly how it was seen att he time. He lost a lot of credibility. It was not the stern chancellor of 1997.

      2. I’m somewhat intrigued by your argument that excess Government spending can be a factor in keeping the pound high. So you’d suggest that one possible remedy for the currently falling pound is for Government to spend more?

        Or is your argument based on interest rates? If interest rates are high then sales of gilts do become more attractive to overseas buyers. This could push up the pound’s value. But is the level of interest rates dependent on the level of government borrowing? This suggest a possible ‘crowding out mechanism’ whereby government competes for available funds with the private sector.

        But surely the experience of the developed economies should show that it doesn’t work like this at all. As deficits rose after the 2008 crash, interest rates fell sharply. So, I’d suggest economists should work on a more scientific basis. Make the observation first. Note that falling interest rates have coincided with increased deficit spending and then devise a theory to fit the facts.

        Finally, on the question of current account deficits, I think we need to look at the international picture. There are many countries, which, by hook or by crook, do whatever it takes to ensure they have a surplus in their trade. It isn’t at all difficult to suppress an exchange rate by simply offering to sell as much currency as anyone wants to buy at lower than a market rate. Or, like Germany, use someone else’s currency which is weaker than its own currency would be, if left to market forces.

        So what to do about this? Have currency wars and fight it out? This used to happen and it led to international tensions too. Those tensions could even erupt into real wars. We don’t really want that again. So the alternative has to be for countries like the USA and UK to run deficits to allow others to acquire financial assets in dollars and pounds.

        1. I find you so full of contradictions Peter! In a recent post you rounded on economists for apparently believing that only public sector borrowing mattered, and yet isn’t that just what you are suggesting in this post? After the 2008 crash private sector borrowing crashed – “deleveraging” was the word. For the man in the street interest rates went up rather than down as cheap credit became impossible to find. The public sector rushed in to fill the gap. The public sector is only one actor in the overall market for money. Roll back to before the crash, and private sector demand for money was high. Add into that additional public sector borrowing and you find excess demand for sterling. This might express itself in higher interest rates; or it could express itself in a higher price for sterling in capital markets. In fact the way capital markets tend to work in the world of free capital markets is for interest rates to converge and for the exchange rate to reflect market demand.

          Or look at it in terms of sectoral balances. If private sector net saving is fixed, then if the government want to increase the budget deficit, the current account deficit must increase. The market based mechanism for that is for an appreciating exchange rate, so that imports are encouraged and exports discouraged. But the private sector balance is not fixed, and in 2008 it shot into surplus. The public sector deficit shot up too, while the current account stayed in deficit. The pound fell because private sector demand for sterling fell – but this did not have the expected effect on the current account, and it crept back up again.

          And yes, you can make a cogent case that the UK could afford to run a current account deficit in 2005 because so many global players were insisting on running surpluses. That’s a bit of a free lunch up for grabs. The answer, as always in economic policy, is to look behind the macroeconomics at what is happening in the “real” world. In Britain we had an unbalanced economy, with SE England and Scotland doing quite nicely but other parts of the country increasingly dependent on the generosity of the state. In Wales or Tyneside had their own exchange rates, they would have been much lower than the pound. There were good reasons to think that a cheap imports strategy was not so benign for the UK. There was good reason to think that by the mid-2000s the UK economy was overheating, and that fiscal adjustment was the best way to address it.

          Should the government spend more to shore up the pound? No because I don’t think the pound is undervalued.

          “Make the observation first…and then devise a theory to fit the facts.” I if saw more evidence that you developed your thinking this way, I would be more impressed. Make the observations. Analyse. Produce different hypotheses that fit the observations. Test the hypotheses. I thought that was how scientists were meant to proceed? And see quite a bit of this amongst more academically-minded economists. But these are complex issues, and we cannot run experiments to verify hypotheses so I think we need to be constantly mindful of alternative explanations.

          1. OK First a point where we might agree. You say “. If Wales or Tyneside had their own exchange rates, they would have been much lower than the pound. ”

            Well that’s true. And we could say the same about Greece and Spain with the euro. Or Mississippi and the dollar. But the duty of any sovereign government is to ensure a certain balance by providing the right fiscal transfers between wealthy and poorer regions. We shouldn’t view that as “generousity”. It’s what has to happen to make a currency zone work effectively. If London and the SE wants to go it alone it should move to establishing an independent state!

            And how do we ascertain whether we have the correct level of fiscal transfers? The answer has to be that we look at parameters such as unemployment rates, wage levels, house prices etc in the poorer parts of the currency zone and compare them to the wealthier parts. I’d argue that we should be aiming for equality. Maybe that is being too idealistic but the differences certainly shouldn’t be as high as they are in the EZ. The difference between London and the regions is too high too. Therefore we need larger fiscal transfers.

            Another way to look at the problem is to say that the government can safely spend money in Derry without causing inflation but that same money spent in the SE of England would be inflationary.

            An overheating economy can be the result of too much private borrowing. It doesn’t have to be too much public borrowing. I’m not sure why you can’t see the logic of the argument that if public borrowing is to be reduced then either private borrowing has to be increased or the currency devalued. So why not just let public borrowing be what it needs to be to keep the economy moving? Why worry about it quite so much?

            Of course if Govt is sufficiently determined it can reduced its deficit by cutting spending and raising taxes. But what else is going to happen? The economy will be plunged into depression. The population simply won’t be able to afford to save or buy more imports than they have money from exports. The sector balances always have, by definition, to balance whether we have a successful economy or a Greek style basket case.

          2. There is no free lunch with currency areas. There are valid arguments for large ones, like the US or the Euro, and also for smaller ones like Iceland. Each way brings big management problems – though I would admit that the way the Euro is currently designed it is dysfunctional. Its problems may be down to weak governance in the south of the zone – but blaming people doesn’t get you anywhere. I think the floating rate served Britain badly in the period 1995 to 2008 and was partly responsible for tipping the balance of the economy to the southeast and hollowing out other areas. Germany and France did better by pegging their currencies – though I’m sure their regional policies were better too. But pegging the pound would have brought its own problems, and it was already too late by the time the Euro got going. We’d have gone in at the wrong rate, which would have been a disaster.

            Fiscal transfers often don’t work. In the UK they have a habit of being funnelled right back to the southeast through the profit margins of Serco, Tesco et al. And they also create dependency and political resentment. They are no substitute for getting a healthy private sector economy going. The right sort of fiscal transfers (especially education and training) will help though – though the beneficiaries have the habit of then migrating to the SE to make their fortunes. Free movement of capital makes it very hard to secure regional balance – something we are finding internationally too.

            “if public borrowing is to be reduced then either private borrowing has to be increased or the currency devalued.” Eureka! You seem to have understood my logic at last. I’ve just being stating this in inverse. If public borrowing is increased then either private borrowing reduces or the exchange rate appreciates. That is precisely my line of critique of Gordon Brown that you have queried at every turn.

            I’ve never challenged your logic about public borrowing in a recession. I pressed you on the logic that public borrowing should by the same token decrease when the economy picks up (like 2005), but you seem very unwilling to allow that this is more than a theoretical possibility. Which reinforces my worry that it is politically impossible for governments to rein in fiscal policy when the macro economy demands – they will always be like Gordon Brown and find a thousand reasons why it should be later. Actually a bit like Greenspan and interest rates in the US.

  4. To my comment “if public borrowing is to be reduced then either private borrowing has to be increased or the currency devalued.”

    You’ve replied “Eureka! You seem to have understood my logic at last. I’ve just being stating this in inverse”

    But hang on a second! Maybe it doesn’t work in the inverse?

    Have we ever seen it happen this way around? I don’t think we have. What we’ve seen is a reduction in economic activity or
    a tendency to recession. Or maybe you can provide an example to show otherwise?

    But we have seen that increased private borrowing has led to lower public sector borrowing. The only time Mrs T’s govt had a surplus was in the Lawson boom.

    It may be more contentious that we’ve seen a devaluation lead to lower public sector borrowing, but my prediction is that the recent fall in the pounds value will have just that effect.

    1. And why wouldn’t it work in the inverse? My economic lecturer in 2007/08 thought that was exactly what was happening to the UK government at the time. Before the crash. Evidence that you have repeatedly ignored for reasons that I suspect are political at root. You really don’t want to admit that Gordon Brown overdid the budget deficit. For other examples I would have to go to other open economies – but actually I think it is quite rare because in most cases markets start to worry about creditworthiness or inflation before the currency has much chance appreciate. Austerity is then forced by the markets. Britain in the 2000s was exempt from that source of discipline.

      I think that govt borrowing is set to go up – but that would be mainly to do with the private sector increasing saving in the Brexit chaos.

      1. I can assure you it’s not political to that extent that I would support Gordon Brown even when I thought he was in the wrong. He certainly was wrong to claim he’d abolished boom and bust for example. Would it be unscientific to suggest he might have a had a few ‘rocks in his head’ at the time? 🙂

        I’d make, indeed I have made, the same defence of George Osborne too. I’ve argued that those of us on the left shouldn’t criticise him for failing to meet his budget deficit targets, tempting as it might be to make political capital from his discomfort.

        What we should do, of course, is try to explain why those deficits are necessary and why the Government was wrong to make promises which couldn’t be kept in the first place.

        1. PS You ask “And why wouldn’t it work in the inverse?”

          The point is that it just doesn’t. We can see from our own observations that it doesn’t. In my day job as an electronics engineer, I used to have to design things that worked. But sometimes I’d build something, or write a computer program or , whatever and it didn’t! It really wasn’t any good making the argument that it should have worked.

          My opinion would have counted for nothing in any case. So I just had to try to understand where I’d gone wrong and fix the problem from there.

          1. “The point is that it just doesn’t. We can see from our own observations that it doesn’t.” we’ll just have to agree to disagree on that. I’m not sure it matters that much though, beyond a critique of Gordon Brown’s economic stewardship.

  5. “I think the floating rate served Britain badly in the period 1995 to 2008 and was partly responsible for tipping the balance of the economy to the southeast and hollowing out other areas. “

    You’re mixing two separate issues. The experience during my lifetime is that it’s always been better for the pound to freely float. Whenever the Govt has got its knickers in a twist about what it thinks the value of the pound should be, there’s been trouble. The Labour Govt in the 60’s was always hamstrung by the peg that was required to be kept to the dollar.

    When the pound fell below $2 in 1976 the Govt panicked and called in the IMF quite unnecessarily. Then there was Black Wednesday in 1991. There really was no need to peg the pound to the Deutschmark. Speculators the world over were queuing up to line their pockets at the UK’s expense. It was the silliest thing anyone could do short of actually sharing a currency with the Germans!

    Anyone wanting to do that must have rocks in their heads!

    There’s no connection with a floating currency and the tendency of the economy to gravitate to the SE. The Govt has all the policy space it needs to redirect its spending towards the regions. Obviously it makes sense to have the DVLA in Swansea rather than London. But why not go much further? I’d move Parliament out of London for a start!

    We could make a long list of publicly funded organisations which could be moved out of the SE England. It makes perfect sense for the private sector in the regions too.

    1. A fixed or floating rate won’t save you from bad policy and even if you are right that Britain has ben better off when the exchange rate has floated, it would prove nothing whatsoever. It all depends on what happened and why they happened. I find that for somebody that likes to claim a scientific outlook the certainty with which you pronounce opinions on economic history to be quite astonishing! You are trying to provoke, I suppose. But it really comes across that you have read a bunch of books and blogs that you find politically congenial and are using basing your facts on these. Well I do that too, but I do try to apply a bit of curiosity. Amongst my varied academic career (I’m not an academic, of course) I have taken in science, history and economics I have learnt that there is reason for everything. The most usual explanation offered for things going wrong is stupidity, but it never is. Expressions like “anyone wanting to do that must have rocks in their heads!” must be fun to write but to me show particular shallowness of analysis. Just ask yourself why any intelligent person would want to do that, and keep asking until you find an answer. Then consider exactly where they went wrong. That way real insight lies.

      “When the pound fell below $2 in 1976 the Govt panicked and called in the IMF quite unnecessarily”. Hmmm. I’ll believe that only after I done a bit of research myself, but I am very sceptical.

  6. In a previous blog you suggested that the question of just what money might be was way too difficult for Economics 101. But I’d argue we need some idea of what it is to do any sort of meaningful economic analysis. Just as we need to know what atoms and molecules are, at least to some extent, to do any meaningful Chemistry.

    At one time, the answer was that usually money was just a more convenient way of expressing a commodity’s value in terms of an amount of gold. That was the conventional thinking. But when we had wars and governments removed the convertibility of their currency into gold, the economy carried on pretty much as normal. So that couldn’t have been the real answer to how money operated. I suppose economists must have noticed that.

    Then in the early 70’s the final link to gold was removed as the US$ came off the gold standard. The thinking previously was that currencies still needed to be tethered to gold albeit indirectly through a tether to the US$. But when the US$ was itself not tethered to gold, what was the point? So rapidly other countries removed the link and we entered into the modern period of fully floating non convertible currencies. So what makes them worth anything?

    Your presumption is that it is unscientific to argue that we should have non-convertible currencies but why? That’s what we have worldwide. It’s just a statement of the obvious. Yes, countries like NZ, Canada and Australia could choose to tether their dollars to the the US$ but they choose not too.

    And they are quite right to do that in my opinion. They’d be unnecessarily limiting their ability to use the movement of their dollars to cushion the effects of relative changes of their economy with the US economy.

    So why is it any different for the UK wrt to Germany and their DM or the euro? Why impose unnecessary restrictions? If there is a good reason for it, then fine, but the evidence shows there really isn’t any good reason for the UK government to want to restrict its own freedom of movement. That’s why I do argue the decision of the Thatcher government to peg the currency to the DM in the late 80’s and early 90’s was little short of crazy. ie doing things for no good reason.

    1. The interesting thing about much of economics is that it tries to address “real” things, like labour, consumption, production and such, and simply uses money as a measuring device. That is a very powerful analytical idea, which cuts through many fallacies, but it leaves a bit of a blind spot on how the financial system interacts with the real economy.

      “Your presumption is that it is unscientific to argue that we should have non-convertible currencies but why?” I have a presumption against presumptions, Peter. That leads me to being a bit of a devil’s advocate against floating currencies (if that’s what you are referring to), but I get tired of the lazy assumption that it is a free lunch, when in so many contexts they have failed. Why else could a mad-cap project such as the Euro have got traction? The Greek public still want to keep it! Even after all they’ve been through.

      Anyway you aren’t addressing the issue that is puzzling me. I’m not bothered by valuation particularly, or the link to precious metals. In the days of notes and coins money could be described as a thing in itself that you could measure. It was produced by the state and could only be withdrawn by the state. And it wasn’t practical to stare it in very large quantities. Now we can run an economy without notes and coins at all. Banks accounts are only needed to process transactions and the aggregate balance of current accounts means very little. Does the idea of a money as a thing in itself mean anything at all? But then clearly you can have inflation – something that is often attributed to have “too much” money.

      1. Matthew,

        Yes, you’re right when you say that economics should be about real things such as “labour, consumption, production and such”. Let’s call all that the productive capacity of the economy.

        But. can money in itself be regarded as a “measuring device”? Well, possibly, but we can’t just assume that prices and wages will automatically vary so that every financial transaction will occur at its optimum level. Businesses and individuals seem to cope with rising wages and prices, providing that they aren’t rising too quickly, but there is an inbuilt aversion to having falling prices and wages.

        From the POV of the worker a reduction in wages is a hostile act from his employer and can provoke conflict. The General Strike of 1926 was over the issue of wage cuts. However, a classical economist would argue that if prices are falling, then there is no reason that wages shouldn’t fall too.

        From the POV of an industrialist falling prices could well mean that by the time a product is made the sale price will be insufficient to cover the costs of production. Or, at least cut into his profit margin, so that it is much less worthwhile to manufacture than it might have been.

        A classical economist would argue that the money itself will have increased in value so his real profit margin is unaffected. But the industrialist will be thinking “so what?” If that’s the case I might just as well keep the money in the bank.

        So money can’t be ignored. It just doesn’t automatically change in value to accommodate all financial transactions. Aggregate demand has to be managed, otherwise we have too much inflation on the one hand, or too much recession on the other. Too much recession means that the productive capacity of the economy is being wasted.

        And, as we are both saying, economics should be about our productive capacity, rather than money, and so wasting that must be the worst of all possible economic failures.

      2. Does the idea of a money as a thing in itself mean anything at all?

        Of course it does. Those on the right might rail on about “worthless fiat money” but they still want to hang on to, and accumulate, as much as possible.

        The dollars, euros and pounds we call money are IOUs of the State. Banks, and even you or I, can create their own IOUs which is money too, in whatever currency we like. So, we can think of dollars and pounds, at any one instant, as just another unit like an inch or a foot. That’s where the unit of account comes into it.

        Each unit of account is a record of debt. And that debt is transferable and storable. That’s where the medium of exchange and store of value comes into it.

        It’s all underpinned by the power of the State to impose taxes which creates a demand for issued IOUs. Take that away and the currency becomes worthless.

  7. “I get tired of the lazy assumption that it is a free lunch”

    I do see this kind of comment a lot. It is a typical response to someone who might be arguing for increased fiscal intervention. Where’s the money going to come from? Who’s going to pay etc are other typical comments.

    They are all examples of applying micro-economic concepts to macro-economic problems. So although you might complain if I said you were treating the National economy like a household economy, that is what you are effectively doing.

    The key balance to achieve, although it’s easier said than done, is to keep the economy moving at close to full capacity without having too much inflation. Really nothing else matters. Deficits and exchange rates will always take care of themselves.

    In other words, we aren’t looking for free lunches but we don’t want a sluggish economy where we have unemployed and underemployed workers who would otherwise be capable of creating those lunches.

    1. Good point. Aggregate demand management can be something of a free lunch – though it carries risks. In the current context, those risks are lower than normal though. And ultimately the productive capacity of the economy is not about macroeconomics – it gets back to weeding out the inefficiencies – which is microeconomics. Which is why infrastructure investment is so popular with theoretical economists – it should work on both levels.
      My comments about free lunches apply to the consistent advocacy of floating exchange rates by neoliberal anglo-saxon economic commentators. Floating rates have clear advantages over managed or fixed rates. But at a cost. Is it a coincidence that the countries that are keenest on floating currencies also have the worst inequality problems? (Well not Japan!).

  8. it gets back to weeding out the inefficiencies – which is microeconomics.

    Is it? What’s so efficient about having unemployed workers or workers in poorly paid /Zero hour contract type employment? If we look at the growth of GDP in the UK since the sixties there is simply no evidence that microeconomic considerations are dominant.

    That’s not to say they aren’t important but one incentive for employers to increase inefficiencies has to be the relative cost of labour. If labour is too cheap then there is much less incentive.

    1. It’s a very striking graph. I think it’s why so many economists, like Martin Wolf, felt that the problem since 2008 has been a chronic lack of demand. They seem to think that the trend line in GDP growth before then is a given. This is not a view that I share at all – not even back in 2006. At the time I likened the UK economy’s advance to James Bond crossing a pool by leaping from the back of one crocodile to another (the high tech boom 97-00, fiscal stimulus 01-03, east European immigration 03-07). In 2007 they ran out of crocodiles! I think that the slowing of growth since 2007 has been so persistent in so many developed economies that even Mr Wolf is suspecting there is more to it than poor management of aggregate demand. There are lots of potential culprits, starting with changed demographics.

      “If we look at the growth of GDP in the UK since the sixties there is simply no evidence that microeconomic considerations are dominant.” I would turn that around, and suggest that the evidence does not show that microeconomics was not dominant either. You have to probe the data much deeper. I think there is much of what I would call “macro blindness” – that is assuming that macroeconomic aggregate statistics (income, growth, inflation, etc) are real things in themselves, rather than simply statistics imperfectly representing what is happening in people’s lives. Accepting the trend growth rate without picking it apart is a classic case of such blindness.

  9. I just noticed that I said “increase inefficiencies” when I meant increase efficiencies! I’m not really a Luddite!

    I agree to some extent with your crocodile analogy but the relative prosperity up to 2007 was built on the accumulation of too much private debt. It was the same story in much of the Anglo world ie Australia, NZ, Canada, NZ , the USA of course which all have similar open economies. They don’t follow the German, Singaporean, HK, Chinese models of suppressing their own currencies to achieve perpetual export surpluses.

    So when you’re looking for an explanation of what has happened you really need to take a wider view than just what goes on in the UK. I find that quite annoying actually. We see exactly the same things happen in the USA and the UK and yet many theories and explanations are almost entire in terms of the local UK scene. I’ve spent quite a number of years working in Australia and the same thing happens there too.

    This graph shows my point that there is a definite correlation between economic growth and liking for Keynesian economics!

    I don’t suppose George Osborne will ever admit it but he started to learn from his previous mistakes sometime around 2012 . The realisation set in that he did need to win an election in 2015. That must be more important than a futile quest to balance the budget.

    I hope we don’t have to go through a similar process with Philip Hammond.

  10. Does the idea of a money as a thing in itself mean anything at all?

    Another answer to this question is that money is effectively just a tax voucher. If the UK government were to actually print £ 10 vouchers which entitled the holder to use them to settle a tax bill they’d be worth exactly £10. They’d be functionally equivalent to £10 notes. They’d be an IOU of the Treasury just like the old Bradbury notes from WW1.

    When the Greeks had trouble last year there were several suggestions that they could effectively create euros this way and by-pass the influence exerted by the ECB. The Germans wouldn’t have liked it, though!

    1. “Render unto Caesar that which is Caesar’s” You have biblical support for that view! But it still goes back to the idea that money is something written down on a piece of paper, where a relatively fixed quantity remains in circulation. That seems to be as out of date as the idea that paper money represents quantities of precious metals in a vault somewhere – even if that is how it started.

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