In today’s FT the economists Paul Krugman and Richard Layard (of the LSE, famous for his work on the economics of happiness) publish an article A manifesto for economic sense calling for looser fiscal policy around the world. Being in the FT it’s behind a paywall (though I have shared the article on Facebook). But the simplicity and clarity of their argument make it a particularly good pace to discuss the difficult issues of economic policy as the economic crisis rumbles on.
Back in 2005 I was contemplating taking an Economics degree, with little formal background in the subject. I asked a tutor at the university (UCL) on their advice for background reading and he said “Anything by Paul Krugman”. The Professor at Princeton, who subsequently won the Nobel Prize, was famous for the clarity of his writing on economics. I also discovered, as I devoured anything by him I could find, that he was not a shrinking violet on the subject of US politics – passionately attacking the Republican regime of George Bush. Now he is a crusader against “austerity” – the focus of governments on healthy finances even as recession stalks the world. He recently visited London, and appeared on Newsnight. I didn’t see him, but I am told he made mincemeat of his opponents – and I’m not surprised.
As I took my degree at UCL I read more of Professor Krugman’s work, now in academic papers and discussions, rather than the more accessible stuff I read read before. The clarity remained – but he came over as a bit wild. I remember in particular one discussion where he became obsessed with the idea that Japan needed to stoke up inflation to get its economy out of the doldrums. His wild suggestions for doing so seemed to leave his fellow economists quite exasperated. Ever since I have viewed his opinions as entertaining, but liable to be impractical, and in the end very unhelpful. So it is this time.
The article (not very long) starts its main line of argument by talking about the causes of the crisis:
The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions – such as Greece – this is false. Instead, the conditions for the crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The bursting of this bubble led to large falls in output and thus in tax revenue. Today’s government deficits are a consequence of the crisis, not a cause.
I think it is highly significant that the authors throw this in so early. It implies, without actually saying so, that pre-crisis government expenditure in most developed economies was perfectly sustainable, if that pesky crisis hadn’t caused a dip in tax revenues. It is perfectly true that government debt was not a major problem before the crisis, which was caused by excessive private sector debt. The trouble is that the boom years gave us false expectations as to what the sustainable levels of tax revenues were. A large part of the dip is permanent, not temporary. So substantial cuts will have to be made at some point to bring government debt under control. It isn’t just a question of waiting for the economy to bounce back (in the UK, US and southern Europe, anyway).
The authors then point out that the crisis is caused by a collapse in private demand – and that it makes sense to make up the shortfall in demand by extra government expenditure until private sector confidence returns. A failure to act means that unemployment becomes endemic and difficult to put right later. They point out that monetary policy cannot take up the strain. They say that there must be a medium term plan to bring government deficits under control – but that it must not be front-loaded. I have no disagreement with any of this. Quite a few people think that looser monetary policy would help – but I agree with the authors on this (which I will say more on in a future post).
Where I differ is that I think what they suggest is exactly what governments are now doing, in the UK and US anyway. In nominal terms government expenditure has not been cut. The private sector is slowly taking up the slack. Governments may be talking austerity, to prepare the ground for the real cuts that are absolutely necessary in the medium term, but they are not practising what they preach.
The article concludes by trying to debunk two typical counterarguments to further stimulus. First is that financial markets would lose confidence and refuse to keep funding government debt. They point out that there is no sign of this in the UK or the US, where government bonds are at record low yields. They also say that there is no actual evidence that budget cuts can generate growth. On the contrary, they suggest (though don’t quite spell out) that looser fiscal policy will help restore confidence and get the private sector moving again, which would allow the deficits to be brought under control. The trouble, of course, with using past evidence to prove a point is that the current situation is unprecedented. And the global financial markets are quite unstable; who is to say that UK and US bond markets aren’t in their very own bubble that could burst very suddenly. The absolute levels of deficit, and, increasingly, overall debt are becoming so alarming that anything is possible. And what if the private sector remained sceptical in face of government stimulus?
Finally they tackle the argument that stimulus cannot work because there are structural constraints. In other words, the pre crisis economy was so unbalanced that there is in fact little spare capacity – so that a stimulus would run into trouble very quickly, leading to inflation or a currency crisis. If this were so, they say, we would see more parts of the economy at full strength. Here there may be a difference between the UK and the US. In the UK there are indeed a few signs of trouble. Inflation has been much more persistent than predicted, though admittedly not through wage rises. Export businesses complain of a lack of suitably skilled staff.
Straws in the wind perhaps. But the pre-crisis economy clearly was unbalanced, especially in the UK. Public service employment was clearly too high, and cannot be afforded at its current strength on any realistic level of taxation. Also too much of the economy is spent taking care of ultra-rich bankers and foreign exiles – whose numbers and wealth we cannot or should not expect to grow. And we still need to adapt to a lower energy economy. I can’t prove that the authors are wrong – but there is enough reason for caution.
The authors make much of not repeating the mistakes of the 1930s. But that was a very different world for two important, and related, reasons. First there was a ready solution at hand: the expansion of manufacturing industry with an abundance of good low skilled jobs. It took the war to unlock this, with the manufacture of armaments and transport, but war production could be converted to civilian use with surprising ease – as there was massive untapped demand for cars, fridges and other manufactured goods. Second we were much poorer then. Starvation was a real problem for the unemployed and poor, and the destruction of wellbeing flowing from depression was horrific. Now we define poverty as lack of access to television and mobile phones. The hardship is much less – and there is less untapped demand. Technology has put paid to the number and quality of unskilled jobs.
That bespeaks caution – something that the manifesto economic sense disregards. There is a case for some sensible investment projects – including the right sort of housing in the UK. But temporary tax cuts would be reckless, and stopping public sector cuts irresponsible.