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A brief guide to Keynesianism and the economic crisis

Hardly a day goes by without the dead British economist John Maynard Keynes being invoked, such as this article from this morning’s Independent.  Generally it is the critics of austerity that use his name, although this article is more nuanced, blaming George Bush and Gordon Brown for getting us into this mess by ignoring Keynes’s prescriptions.  And many more economists, including big names like Paul Krugman, use ideas that most people understand as “Keynesianism” even if they do not evoke the great man directly, rightly thinking it is better to appeal to logic and evidence rather than dead men, however great.  Inevitably a lot get taken for granted in these arguments.  For the benefit of amateur economists like me, in this long posting I want to explain and re-examine Keynesianism, in order to assess its relevance to the current crisis, especially here in the UK.

What do we mean by “Keynesianism”?  It is the idea that government fiscal policy, public expenditure and taxes, should be used to counteract a deficiency in demand in the total economy.   It originated with the insights of the great economist, and his reflections on the Great Depression of the 1930s.  Its starting point is that a whole economy does not work like a household budget.  It may be very sensible for a household to choose to spend less than it earns, but a whole economy cannot do this.  Supply must equal demand; you cannot store more than a trivial amount of production from one period to the next.  If across a whole economy more people want to spend less than they earn, in other words to save, then there isn’t enough demand to meet supply and the economy must shrink; people are put out of jobs and so on.

Not so fast.  Things balance out of the net saving can be channelled into investment.  Investment, in economics, refers to production for future benefit.  This usually refers to business investment (machines to make future production more efficient) but can also refer things like building houses which are “consumed” over a long time period .  But if savings are not matched by investment there is trouble.

The possibility of trading with another economy complicates the picture, of course.  Net saving can be balanced out by net exports.  But net exports across the world economy are zero, so this option isn’t available to everybody.

In classical economics there is no lasting mismatch between savings and investment, because markets balance the two out.  If there is too much saving, then this stimulates the supply of investment opportunities, for example by reducing the rate of interest.  Keynes’s great insight was to see that often this market mechanism doesn’t function properly, leading to prolonged unemployment.  And unemployment is a waste; production lost forever.  Much better to use this surplus labour inefficiently than not at all.

Extra spice is added to this logic by the idea of the multiplier effect.  If, for example, you stimulated the economy by paying extra benefits, then the recipients of the benefit would go out and spend them, and the people receiving this spending will spend more in turn, creating further demand and so creating more work.  The same logic applies in reverse; austerity tends to multiply itself too.  This effect is probably what students remember best about Keynesianism.  It gives the idea of Keynesian stimulus gravity defying properties – so that government spending on stimulus can pay for itself in extra taxes generated by multiplied demand (and the reverse, of course, with cuts being self-defeating).

Keynesians point to the Great Depression as an example of how things can go wrong, where excessive austerity turned a setback into a disaster, only rescued by the War (and what could be more wasteful than fighting a war?).  Critics of this view, incidentally, point out that the primitive state of the world’s banking systems had a lot to with this disaster, and so you can’t really compare it to now.

After the war, demand management by governments using fiscal policy became pretty much the orthodoxy.  But this went wrong in the 1970s, when a Keynesian response to the oil crisis simply led to rampant inflation, rather than reduced unemployment.  What are the problems?

First of all, Keynesian stimulus can’t push an economy beyond the limits of its economic infrastructure. To do so simply creates inflation.  After the oil crisis disaster, economists modified their ideas to take account of this, bringing in such ideas a as a “natural” level of unemployment, and giving a major role to monetary policy alongside fiscal policy.  This set of ideas became “neo-Keynesianism” and the orthodoxy of the 2000s.  It was what I was taught in my macro-economics course in 2005-08 at UCL.

A more subtle criticism is that fiscal stimulus is undermined by human behaviour.  If people respond to extra money in their pockets by saving more, the stimulus effect evaporates.  An idea of “Ricardian equivalence” has been developed to postulate that extra government spending would always be offset by extra saving, because people know it would lead to more tax, for which they must save.  Responding to this, proponents tend to suggest stimulus to areas where this is less of a risk.  For example, benefits to the hard up, rather than tax-breaks for the rich.

Another idea, in floating exchange rate economies like Britain’s, is known as the Mundell-Fleming effect, which predicts that fiscal stimulus simply causes the exchange rate to appreciate and crowds out exports (or is lost in imports).  This idea is quite difficult to get a grip on, and anything to do with predicting exchange rates turns out to be impossible to prove.  But it does offer an explanation of why the pound appreciated after British government’s stimulus programme following 2001.  And the basic idea that fixed exchange rates undermine monetary policy while floating ones undermine fiscal policy has the undoubted merit of symmetry.  So British austerity should be offset by a lower pound which stimulates exports.  The first part of this prediction seems to be working, but the second is slow to come about, not least because so many of our usual trading partners are in crisis too.

But the strongest objections to Keynesians come from the so-called “Austrian” school, because its more famous advocates (Schumpeter and Hayek in particular) were born in Austria.  This sees unemployment as a essential to a process of creative destruction, as inefficient and unwanted businesses go to the wall, to be replaced by better ones.  Keynesian stimulus interferes with this process, in particular by leading to wasteful investment; any temporary relief is offset by longer term problems.

From within the neo-Keynesian camp there are also those who advocate the use of monetary policy to manage the business cycle, as being much more efficient and effective that fiscal policy.  These seem to include the British Chancellor of the Exchequer, George Osborne.

So how to apply to the current economic crisis, and in particular to Britain?  The first point is that the pre-crisis economy was built on false premises, with unsustainable borrowing and a property boom.  It cannot be recreated by applying stimulus.  Not everybody accepts this, but almost everybody without a political axe to grind does.  The serious Keynesian argument is not about stimulus, but about the effects of austerity.  Austerity policies are reducing demand, setting up a multiplier effect and causing pointless unemployment before the replacement jobs can be created.

It helps the Keynesians that there does not seem to be a big risk of inflation – or not wage inflation, anyway, which is the critical issue.  This seems to be held in check by strong market forces, in the developed world at least.  High price inflation in Britain is not matched by pay inflation, and it is much more about forcing Britons to accept a lower standard of living as a result of a lower pound and shortages of key raw materials.

Advocates of monetary policy are also in a weak position.  It simply does not seem to be all that effective.  Interest rates are rock bottom, and all quantitative easing seems to do is to keep asset prices at unrealistic levels.

Would extra saving undermine a looser fiscal policy?  Britons are heavily indebted, after the borrowing binge.  That might encourage them to save any stimulus money – but it also suggests that they can’t respond to lower income by borrowing more.  Since we are talking about simply slowing a downward trajectory, the latter is the more relevant argument.

For me the most persuasive case for some kind of Keynesian influence on policy is made by the Financial Times’s Martin Wolf (behind the FT paywall).  This goes back to first principles.  Consumers are over indebted and need to spend more than they consume.  Business confidence is low, which means that it is difficult to persuade businesses to invest.  The potential for more exports (or less imports) is certainly there, but is limited because to many other economies are trying to play the same game.  So we are exactly in danger of the doom loop of excess saving that Keynes worried about.  The government’s massive deficit offsets these problems to a great extent, but reducing it too fast could well lead to excess unemployment.

But we don’t know.  Austerity policies are stronger in rhetoric than practice.  We can’t avoid major cuts to government services, so there is something to be said for getting them over with as quickly as practical.  But there is also something to be said for having a “plan B” should unemployment start to escalate.  But if the government had one, they wouldn’t tell us.

Cutting VAT is one idea, advocated by Labour Shadow Chancellor Ed Balls, since it is quite likely that it will stimulate some extra expenditure – though it is very unclear by how much.  That is probably too much of a humiliating U-turn for the government.  But it is a better idea than cutting the top rate of tax, advocated by some Conservatives, since that is unlikely to have much immediate effect on demand, even if it does have longer term benefits.  Another idea is to ramp up investment projects – but it is very difficult to do this efficiently in the sort of quantities that would have a major impact on the overall economy.  Personally I would favour a go-slow on benefit reform, which is where a lot of the cuts are focused, since mostly benefits get spent.  Given how tricky this programme is already, it might happen anyway.

It would not be surprising if the government missed its deficit reduction target over the five year term.  What will not be clear is whether this happens because Keynesian policies were applied (i.e. by slowing the pace of austerity) or because they weren’t (i.e. austerity strangling the economy at large).  That won’t stop people being firmly on one side of the argument or the other.

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