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Articles for the ‘Economics 9e: Ch 16’ Category

A fall in the UK natural rate of unemployment?

When UK unemployment was 7.7% in July 2013, Mark Carney, the newly arrived governor of the Bank of England, said that the Bank would probably have to rise interest rates when the unemployment rate dropped below 7%. Below that rate, it was expected that inflation would rise. In other words, 7% was the NAIRU – the non-accelerating rate of inflation. The most recent figure for the unemployment rate is 4.8% and yet the Bank of England has not raised interest rates. In fact, in response to the Brexit vote, it cut Bank Rate from 0.5% to 0.25% in August last year. (Click here for a PowerPoint of the chart below.)

The NAIRU is a similar, although not identical, concept to the natural rate of unemployment. The natural rate is the equilibrium rate consistent with an overall long-term balance of aggregate labour demand and supply: i.e. the rate after short-term cyclical movements in unemployment have been discounted. It is thus a long-term concept.

The NAIRU, although similar, focuses on the relationship between inflation and unemployment. With inflation caused solely by demand-side factors, the natural rate and the NAIRU will be similar if not identical. However, if cost-push factors change – say there is a poor harvest, which pushes up food prices and inflation (temporarily), or a substantial depreciation of the exchange rate caused by political factors (such as Brexit) – the NAIRU would increase, at least in the short term, as a higher rate of unemployment would be necessary to stop inflation rising. In the long term, although being defined differently, the NAIRU and the natural rate will be the same.

In practice, because the Bank of England is targeting inflation at a 24-month time horizon, the NAIRU for the UK at that point could also be seen as the natural rate.

So with the Bank of England not raising interest rates despite the considerable fall in the unemployment rate, does this imply a fall in the natural rate of unemployment? The answer is yes. The reason has to do with changes in the structure of the labour market.

The proportion of young people and women with children returning to the labour market has fallen. Such people have a higher-than-average rate of unemployment since they typically spend a period of time searching for a job.

Tax and benefit reforms over the years have increased the incentive for the unemployed to take work.

Perhaps the biggest factor is a greater flexibility in the labour market. As union power has waned and as people are increasingly working on flexible contracts, including zero-hour contracts, so this has moderated wage increases. At the same time, many firms are facing increased competition both from abroad and domestically via the Internet. This has put downward pressure on prices and hence on the wages firms are willing to pay.

The effect has been a fall in the NAIRU and probably the natural rate. Frictions in the labour market have reduced and people losing their jobs because of changes in industrial structure find it easier to get jobs in low-skilled service industries, where employers’ risks of taking on such workers have fallen because of the loss of rights for such workers.

So what is the natural rate of unemployment today? It is certainly much lower than 7%; the consensus is that it is probably below 5%. As Kristin Forbes, External MPC Member of the Bank of England stated in a recent speech:

[Unemployment] is forecast to increase gradually from its current 4.8% to a high of 5.0% in the second half of 2017, before falling back to its current rate by the end of 2019. To put this in context, 5.0% was previously believed to be around the UK’s natural rate of unemployment – the rate below which unemployment could not fall without wages picking up to levels inconsistent with sustaining inflation around the 2% target. Unemployment at 5.0% is also below the average unemployment rate for the UK over the pre-crisis period from 1997 to 2007 (when it was 5.5%).

She went on to discuss just what the figure is for the natural, or ‘equilibrium’, rate of unemployment (U*). One problem here is that there is considerable uncertainty over the figure in the current forecast made by the Bank.

[An] assumption in the forecast about which there is substantial uncertainty is of the equilibrium unemployment rate – or U* for short. Since I have been on the MPC, the Committee has assumed that U* was around 5%. This implied that the more by which unemployment exceeded 5%, the more slack existed in the economy, and the less upward momentum would be expected in wages (controlling for other factors, such as productivity growth).

As part of our annual assessment of regular supply-side conditions this January, Bank staff presented several pieces of analysis that suggested U* may be lower than 5% today [see, for example]. The majority of the MPC voted to lower our estimate of U* to 4.5%, based partly on the persistent weakness of wage growth over the past few years after accounting for other factors in our models. [See page 20 of the February 2017 Inflation Report.]

My own assessment, however, suggested that although U* was likely lower than 5% today, it is likely not as low as 4.5%. If true, this would suggest that there is less slack in the economy than in the MPC’s central forecast, and wage growth and inflation could pick up faster than expected.

Against that, however, uncertainty related to Brexit negotiations could make firms more cautious about raising wages, thereby dampening wage growth no matter where unemployment is relative to its equilibrium. Moreover, even if we could accurately measure the level of U* in the economy today, it could easily change over the next few years as the labour force adjusts to any changes in the movement of labour between the UK and European Union.

Determining the precise figure of the current natural rate of unemployment, and predicting it for the medium term, is very difficult. It involves separating out demand-side factors, which are heavily dependent on expectations. It also involves understanding the wage elasticity of labour supply in various markets and how this has been affected by the increased flexibility of these markets.

When will Britons get a pay rise? The Guardian, Phillip Inman (26/2/17)
BoE decision, Inflation Report – Analysts react DigitalLook, Alexander Bueso (2/2/17)
Bank of England hikes UK economic growth forecasts but warns of rising inflation The Telegraph, Szu Ping Chan (2/2/17)

Bank of England publications
Inflation Report Bank of England (February 2017)
A MONIAC (not manic) economy Bank of England Speeches, Kristin Forbes (8/2/17)
The labour market Bank of England Speeches, Michael Saunders (31/1/17)


  1. Distinguish between the following terms: natural rate of unemployment, NAIRU, equilibrium rate of unemployment, disequilibrium rate of unemployment.
  2. For what reasons did the Monetary Policy Committee members feel that the equilibrium rate of unemployment might be as low as 4.25%?
  3. Why might it be as high as 5%?
  4. How are changes in migration trends likely to affect (a) wage growth and (b) unemployment?
  5. How is the amount of slack in an economy measured? What impact does the degree of slack have on wage growth and inflation?
  6. What is meant by the ‘gig’ economy? How has the development of the gig economy impacted on unemployment and wages?
  7. Why has there been a considerable rise in self employment?
  8. How may questions of life style choice and control over the hours people wish to work impact on the labour market?
  9. If people are moving jobs less frequently, does this imply that the labour market is becoming less flexible?
  10. Why may firms in the current climate be cautious about raising wages even if aggregate demand picks up?
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What would Keynes say if he were alive today?

We’ve considered Keynesian economics and policy in several blogs. For example, a year ago in the post, What would Keynes say?, we looked at two articles arguing for Keynesian expansionary polices. More recently, in the blogs, End of the era of liquidity traps? and A risky dose of Keynesianism at the heart of Trumponomics, we looked at whether Donald Trump’s proposed policies are more Keynesian than his predecessor’s and at the opportunities and risks of such policies.

The article below, Larry Elliott updates the story by asking what Keynes would recommend today if he were alive. It also links to two other articles which add to the story.

Elliott asks his imaginary Keynes, for his analysis of the financial crisis of 2008 and of what has happened since. Keynes, he argues, would explain the crisis in terms of excessive borrowing, both private and public, and asset price bubbles. The bubbles then burst and people cut back on spending to claw down their debts.

Keynes, says Elliott, would approve of the initial response to the crisis: expansionary monetary policy (both lower interest rates and then quantitative easing) backed up by expansionary fiscal policy in 2009. But expansionary fiscal policies were short lived. Instead, austerity fiscal policies were adopted in an attempt to reduce public-sector deficits and, ultimately, public-sector debt. This slowed down the recovery and meant that much of the monetary expansion went into inflating the prices of assets, such as housing and shares, rather than in financing higher investment.

He also asks his imaginary Keynes what he’d recommend as the way forward today. Keynes outlines three alternatives to the current austerity policies, each involving expansionary fiscal policy:

•  Trump’s policies of tax cuts combined with some increase in infrastructure spending. The problems with this are that there would be too little of the public infrastructure spending that the US economy needs and that the stimulus would be poorly focused.
•  Government taking advantage of exceptionally low interest rates to borrow to invest in infrastructure. “Governments could do this without alarming the markets, Keynes says, if they followed his teachings and borrowed solely to invest.”
•  Use money created through quantitative easing to finance public-sector investment in infrastructure and housing. “Building homes with QE makes sense; inflating house prices with QE does not.” (See the blogs, A flawed model of monetary policy and Global warning).

Increased government spending on infrastructure has been recommended by international organisations, such as the OECD and the IMF (see OECD goes public and The world economic outlook – as seen by the IMF). With the rise in populism and worries about low economic growth throughout much of the developed world, perhaps Keynesian fiscal policy will become more popular with governments.

Keynesian economics: is it time for the theory to rise from the dead?, The Guardian, Larry Elliott (11/12/16)


  1. What are the main factors determining a country’s long-term rate of economic growth?
  2. What are the benefits and limitations of using fiscal policy to raise global economic growth?
  3. What are the benefits and limitations of using new money created by the central bank to fund infrastructure spending?
  4. Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
  5. Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
  6. Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all countries rather than being the only country to pursue such a policy?
  7. Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
  8. What determines the size of the multiplier effect of such policies?
  9. What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
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The future of capitalism

Some commentators have seen the victory of Donald Trump and, prior to that, the Brexit vote as symptoms of a crisis in capitalism. Much of the campaigning in the US election, both by Donald Trump on the right and Bernie Sanders on the left focused on the plight of the poor. Whether the blame was put on immigration, big government, international organisations, the banks, cheap imports undercutting jobs or a lack of social protection, the message was clear: capitalism is failing to improve the lot of the majority. A small elite is getting significantly richer while the majority sees little or no gain in their living standards and a rise in uncertainty.

The articles below look at this crisis. They examine the causes, which they agree go back many years as capitalism has evolved. The financial crash of 2008 and the slow recovery since are symptomatic of the underlying changes in capitalism.

The Friedman article focuses on the slowing growth in technological advance and the problem of aging populations. What technological progress there is is not raising incomes generally, but is benefiting a few entrepreneurs and financiers. General rises in income may eventually come, but it may take decades before robotics, biotechnological advances, e-commerce and other breakthrough technologies filter through to higher incomes for everyone. In the meantime, increased competition through globalisation is depressing the incomes of the poor and economically immobile.

All the articles look at the rise of the rich. The difference with the past is that the people who are gaining the most are not doing so from production but from financial dealing or rental income; they have gained while the real economy has stagnated.

The gains to the rich have come from the rise in the value of assets, such as equities (shares) and property, and from the growth in rental incomes. Only a small fraction of finance is used to fund business investment; the majority is used for lending against existing assets, which then inflates their prices and makes their owners richer. In other words, the capitalist system is moving from driving growth in production to driving the inflation of asset prices and rental incomes.

The process whereby financial markets grow and in turn drive up asset prices is known as ‘financialisation’. Not only is the process moving away from funding productive investment and towards speculative activity, it is leading to a growth in ‘short-termism’. The rewards of senior managers often depend on the price of their companies’ shares. This leads to a focus on short-term profit and a neglect of long-term growth and profitability – to a neglect of investment in R&D and physical capital.

The process of financialisation has been driven by deregulation, financial innovation, the growth in international financial flows and, more recently, by quantitative easing and low interest rates. It has led to a growth in private debt which, in turn, creates more financial instability. The finance industry has become so profitable that even manufacturing companies are moving into the business of finance themselves – often finding it more profitable than their core business. As the Foroohar article states, “the biggest unexplored reason for long-term slower growth is that the financial system has stopped serving the real economy and now serves mainly itself.”

So will the election of Donald Trump, and pressure from populism in other countries too, mean that governments will focus more on production, job creation and poverty reduction? Will there be a movement towards fiscal policy to drive infrastructure spending? Will there be a reining in of loose monetary policy and easy credit?

Or will addressing the problem of financialisation and the crisis of capitalism result in the rich continuing to get richer at the expense of the poor, but this time through more conventional channels, such as increased production and monopoly profits and tax cuts for the rich? Trump supporters from among the poor hope the answer is no. Those who supported Bernie Sanders in the Democratic primaries think the answer will be yes and that the solution to over financialisation requires more, not less, regulation, a rise in minimum wages and fiscal policies aimed specifically at the poor.

Can Global Capitalism Be Saved? Project Syndicate, Alexander Friedman (11/11/16)
American Capitalism’s Great Crisis Time, Rana Foroohar (12/5/16)
The Corruption of Capitalism by Guy Standing review – work matters less than what you own The Guardian, Katrina Forrester (26/10/16)


  1. Do you agree that capitalism is in crisis? Explain.
  2. What is meant by financialisation? Why has it grown?
  3. Will the policies espoused by Donald Trump help to address the problems caused by financialisation?
  4. What alternative policies are there to those of Trump for addressing the crisis of capitalism?
  5. Explain Schumpeter’s analysis of creative destruction.
  6. What technological innovations that are currently taking place could eventually benefit the poor as well as the rich?
  7. What disincentives are there for companies investing in R&D and new equipment?
  8. What are the arguments for and against a substantial rise in the minimum wage?
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Brazil: suffering from an old economic problem in the new world

The article below looks at the economy of Brazil. The statistics do not look good. Real output fell last year by 3.8% and this year it is expected to fall by another 3.3%. Inflation this year is expected to be 9.0% and unemployment 11.2%, with the government deficit expected to be 10.4% of GDP.

The article considers Keynesian economics in the light of the case of Brazil, which is suffering from declining potential supply, but excess demand. It compares Brazil with the case of most developed countries in the aftermath of the financial crisis. Here countries have suffered from a lack of demand, made worse by austerity policies, and only helped by expansionary monetary policy. But the effect of the monetary policy has generally been weak, as much of the extra money has been used to purchase assets rather than funding a growth in aggregate demand.

Different policy prescriptions are proposed in the article. For developed countries struggling to grow, the solution would seem to be expansionary fiscal policy, made easy to fund by lower interest rates. For Brazil, by contrast, the solution proposed is one of austerity. Fiscal policy should be tightened. As the article states:

Spending restraint might well prove painful for some members of Brazilian society. But hyperinflation and default are hardly a walk in the park for those struggling to get by. Generally speaking, austerity has been a misguided policy approach in recent years. But Brazil is a special case. For now, anyway.

The tight fiscal policies could be accompanied by supply-side policies aimed at reducing bureaucracy and inefficiency.

Brazil and the new old normal: There is more than one kind of economic mess to be in The Economist, Free Exchange Economics (12/10/16)


  1. Explain what is meant by ‘crowding out’.
  2. What is meant by the ‘liquidity trap’? Why are many countries in the developed world currently in a liquidity trap?
  3. Why have central banks in the developed world found it difficult to stimulate growth with policies of quantitative easing?
  4. Under what circumstances would austerity policies be valuable in the developed world?
  5. Why is crowding out of fiscal policy unlikely to occur to any great extent in Europe, but is highly likely to occur in Brazil?
  6. What has happened to potential GDP in Brazil in the past couple of years?
  7. What is meant by the ‘terms of trade’? Why have Brazil’s terms of trade deteriorated?
  8. What sort of policies could the Brazilian government pursue to raise growth rates? Are these demand-side or supply-side policies?
  9. Should Brazil pursue austerity policies and, if so, what form should they take?
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Economists: have we failed to communicate to the general public?

Before the referendum, economists overwhelmingly argued that the economic case for the UK remaining in the EU was much stronger than that for leaving. They warned of serious economic consequences, both short term and long term, of a Brexit vote. And yet, by a majority of 51.9% to 48.1% of the 72.1% of the electorate who voted, the UK voted to leave the EU.

Does this mean that economists failed to communicate to the electorate? Were the arguments presented poorly or in too academic a way?

Or did people simply not believe the economists’ forecasts, being cynical about the ability of economists to forecast? During the campaign, on several occasions I heard people repeating the joke that economists had successfully predicted five out of the last two recessions!

Did they not believe the data that immigrants from other EU countries to the UK contribute more in taxes they draw in benefits and that overall they make a net positive contribution to output per head? Or perhaps they believed the claims that immigrants imposed a net cost on the economy.

Or were there ‘non-economic’ issues that people found more persuasive, such as questions of sovereignty or national identity? Or was the strain on local resources, such as health services, schools and housing, blamed on immigration itself rather than on a lack of spending on additional resources – the funding for which could have come from the extra GDP generated by the immigration?

Or were there so many lies told by politicians and those with vested interests that people simply didn’t know whom to believe?

Economists will, no doubt, do a lot of soul searching over the coming months. One such economist is Paul Johnson, Director of the Institute for Fiscal Studies, whose article is linked below.

We economists must face the plain truth that the referendum showed our failings Institute for Fiscal Studies newspaper articles. Paul Johnson (28/6/16)


  1. In what ways could economists have communicated better to the general public during the referendum campaign?
  2. For what reasons may people distrust economists?
  3. Were economists hampered in delivering their message by ‘balanced reporting’?
  4. Comment on Paul Johnson’s statement that, ‘The most politically engaged of us spend decades working out how to tweak tax policy, or labour market policy, or competition policy to deliver small benefits. How many times over would our work have been repaid if we had simply convinced a few more people of the basics?’
  5. Do economists, or at least some of them, need to become more ‘media savvy’?
  6. How could institutions, such as the Royal Economic Society and the Society of Business Economists, do more to help economists collectively to communicate with the general public?
  7. Give some examples of the terminology/jargon we use which might be inappropriate for communicating with the general public. Suggest some alternative terms to the examples you’ve given.
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Global warning

Project Syndicate is an organisation which produces articles on a range of economic, political and social topics written by eminent scholars, political and business leaders, policymakers and civic activists. It then makes these available to news media in more than 150 countries. Here we look at four such articles which assess the outlook for the European and global economies and even that of capitalism itself.

The general tone is one of pessimism. Despite unconventional monetary policies, such as quantitative easing (QE) and negative nominal interest rates, the global recovery is anaemic. As the Nouriel Roubini articles states:

Unconventional monetary policies – entrenched now for almost a decade – have themselves become conventional. And, in view of persistent lacklustre growth and deflation risk in most advanced economies, monetary policymakers will have to continue their lonely fight with a new set of ‘unconventional unconventional’ monetary policies.

Perhaps this will involve supplying additional money directly to consumers and/or business in a so-called ‘helicopter drop’ of money. Perhaps it will be supplying money directly to governments to finance infrastructure projects – a policy dubbed ‘people’s quantitative easing‘. Perhaps it will involve taxing the holding of cash by banks to encourage them to lend.

The Hans-Werner Sinn article looks at some of the consequences of the huge amount of money created through QE and continuing to be created in the eurozone. Although it has not boosted consumption and investment nearly as much as desired, it has caused bubbles in various asset markets. For example, the property market has soared in many countries:

Property markets in Austria, Germany, and Luxembourg have practically exploded throughout the crisis, as a result of banks chasing borrowers with offers of loans at near-zero interest rates, regardless of their creditworthiness.

The German property boom could be reined in with an appropriate jump in interest rates. But, given the ECB’s apparent determination to head in the opposite direction, the bubble will only grow. If it bursts, the effects could be dire for the euro.

The Jean Pisani-Ferry article widens the analysis of the eurozone’s problems. Like Roubini, he considers the possibility of a helicopter drop of money, which “would be functionally equivalent to a direct government transfer to households, financed by central banks’ permanent issuance of money”.

Without such drastic measures he sees consumer and business pessimism (see chart) undermining recovery and making the eurozone vulnerable to global shocks, such as further weakening in China. (Click here for a PowerPoint of the chart.)

Finally, Anatole Kaletsky takes a broad historical view. He starts by saying that “All over the world today, there is a sense of the end of an era, a deep foreboding about the disintegration of previously stable societies.” He argues that the era of ‘leaving things to the market’ is coming to an end. This was an era inspired by the monetarist and supply-side revolutions of the 1960s and 1970s that led to the privatisation and deregulation policies of Reagan, Thatcher and other world leaders.

But if the market cannot cope with the complexities of today’s world, neither can governments.

If the world is too complex and unpredictable for either markets or governments to achieve social objectives, then new systems of checks and balances must be designed so that political decision-making can constrain economic incentives and vice versa. If the world is characterized by ambiguity and unpredictability, then the economic theories of the pre-crisis period – rational expectations, efficient markets, and the neutrality of money – must be revised.

… It is obvious that new technology and the integration of billions of additional workers into global markets have created opportunities that should mean greater prosperity in the decades ahead than before the crisis. Yet ‘responsible’ politicians everywhere warn citizens about a ‘new normal’ of stagnant growth. No wonder voters are up in arms.

His solution has much in common with that of Roubini and Pisani-Ferry. “Money could be printed and distributed directly to citizens. Minimum wages could be raised to reduce inequality. Governments could invest much more in infrastructure and innovation at zero cost. Bank regulation could encourage lending, instead of restricting it.”

So will there be a new era of even more unconventional monetary policy and greater regulation that encourages rather than restricts investment? Read the articles and try answering the questions.

Unconventional Monetary Policy on Stilts Project Syndicate, Nouriel Roubini (1/4/16)
Europe’s Emerging Bubbles Project Syndicate, Hans-Werner Sinn (28/3/16)
Preparing for Europe’s Next Recession Project Syndicate, Jean Pisani-Ferry (31/3/16)
When Things Fall Apart Project Syndicate, Anatole Kaletsky (31/3/16)


  1. Explain how a ‘helicopter drop’ of money would work in practice.
  2. Why has growth in the eurozone been so anaemic since the recession of 2009/10?
  3. What is the relationship between tightening the regulations about capital and liquidity requirements of banks and bank lending?
  4. Explain the policies of the different eras identified by Anatole Kaletsky.
  5. Would it be fair to describe the proposals for more unconventional monetary policies as ‘Keynesian’?
  6. If quantitative easing was used to finance government infrastructure investment, what would be the effect on the public-sector deficit and debt?
  7. If the inflation of asset prices is a bubble, what could cause the bubble to burst and what would be the effect on the wider economy?
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When the light at the end of the tunnel is yet another oncoming train: Greece’s woes set to continue

As we saw in several posts on this site, last year was a tumultuous one for the Greek people and their economy. The economy was on the verge of bankruptcy; the Greek people rejected the terms of a bailout in a referendum; exit from the eurozone and having to return to the drachma seemed likely; banks were forced to closed at the height of the crisis; capital controls were imposed, with people restricted to drawing €60 a day or €420 a week – a policy still in force today; unemployment soared and many people suffered severe hardship.

To achieve the bailout, the Syriza government had to ignore the results of the referendum and agree to harsh austerity policies and sweeping market-orientated supply-side policies. This, at least, allowed Greece to stay in the eurozone. It held, and won, another election to seek a further mandate for these policies.

But what are the prospects for 2016? Will it be a year of recovery and growth, with market forces working to increase productivity? Does 2016 mark the beginning of the end and, as prime minister Alexis Tsipras put it, “a final exit from economic crisis”?

Or will the continuing cuts simply push the economy deeper into recession, with further rises in unemployment and more and more cases of real human hardship? Is there a hysteresis effect here, with the past six years having created a demoralised and deskilled people, with cautious investors unable and/or unwilling to rebuild the economy?

The article below looks at the rather gloomy prospects for Greece and at whether there are any encouraging signs. It also looks at the further demands of the troika of creditors – the IMF, the ECB and the European Commission’s European Stability Mechanism (ESM) – and at what the political and economic impact of these might be.

Greece’s economic crisis goes on, like an odyssey without end The Guardian, Helena Smith (4/1/16)


  1. Construct a timeline of Greece’s debt repayments, both past and scheduled, and of the bailouts given by the troika to prevent Greece defaulting.
  2. What supply-side reforms are being demanded by Greece’s creditors?
  3. What will be the effect of these supply-side reforms in (a) the short run; (b) the long run?
  4. Explain the meaning of hysteresis as it applies to an economy in the aftermath of a recession. How does the concept apply in the Greek situation?
  5. Discuss the alternative policy options open to the Greek government for tackling the persistent recession.
  6. Would it be better for Greece to leave the euro? Explain your arguments.
  7. “I cannot see how this government can survive the reforms. And I cannot see how it can avoid these reforms.” Is there any way out of this apparent impasse for the Greek government?
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What would Keynes say?

Here are two thought-provoking articles from The Guardian. They look at macroeconomic policy failures and at the likely consequences.

In first article, Larry Elliott, the Guardian’s Economics Editor, argues that Keynesian expansionary fiscal and monetary policy by the USA has allowed it to achieve much more rapid recovery than Europe, which, by contrast, has chosen to follow fiscal austerity policies and only recently mildly expansionary monetary policy through a belated QE programme.

In the UK, the recovery has been more significant than in the eurozone because of the expansionary monetary policies pursued by the Bank of England in its quantitative easing programme. ‘And when it came to fiscal policy, George Osborne quietly abandoned his original deficit reduction targets when the deleterious impact of an over-aggressive austerity strategy became apparent.’

So, according to Larry Elliott, Europe should ease up on austerity and governments should invest more though increased borrowing.

‘This is textbook Keynesian stuff. Unemployment is high, which means businesses are reluctant to invest. The lack of investment means that demand for new loans is weak. The weakness of demand for loans means that driving down the cost of borrowing through QE will have little impact. Therefore, it is up to the state to break into the vicious circle by investing itself, something it can do cheaply and – because there are so many people unemployed and businesses working well below full capacity – without the risk of inflation.’

In the second article, Paul Mason, the Economics Editor at Channel 4 News, points to the large increases in both public- and private- sector debt since 2007, despite the recession. Such debt, he argues, is becoming unsustainable and hence the world could be on the cusp of another crash.

Mason quotes from the Bank for International Settlements Quarterly Review September 2015 – media briefing. In this briefing, Claudio Borio,
Head of the Monetary & Economic Department, argues that:

‘Since at least 2009, domestic vulnerabilities have developed in several emerging market economies (EMEs), including some of the largest, and to a lesser extent even in some advanced economies, notably commodity exporters. In particular, these countries have exhibited signs of a build-up of financial imbalances, in the form of outsize credit booms alongside strong increases in asset prices, especially property prices, supported by unusually easy global liquidity conditions. It is the coincidence of the reversal of these booms with external vulnerabilities that should be watched most closely.’

We have already seen a fall in commodity prices, reflecting the underlying lack of demand, and large fluctuations in stock markets. The Chinese economy is slowing markedly, as are several other EMEs, and Europe and Japan are struggling to recover, despite their QE programmes. The USA is no longer engaging in QE and there are growing worries about a US slowdown as growth in the rest of the world slows. Mason, quoting the BIS briefing, states that:

‘In short, as the BIS economists put it, this is “a world in which debt levels are too high, productivity growth too weak and financial risks too threatening”. It’s impossible to extrapolate from all this the date the crash will happen, or the form it will take. All we know is there is a mismatch between rising credit, falling growth, trade and prices, and a febrile financial market, which, at present, keeps switchback riding as money flows from one sector, or geographic region, to another.’

So should there be more expansionary policy, or should rising debt levels be reduced by tighter monetary policy? Read the articles and then consider the questions.

I told you so. Obama right and Europe wrong about way out of Great Recession The Guardian, Larry Elliott (1/11/15)
Apocalypse now: has the next giant financial crash already begun? The Guardian, Paul Mason (1/11/15)


  1. To what extent do the two articles (a) agree and (b) disagree?
  2. How might a neo-liberal economist reply to the argument that what is needed is more expansionary fiscal and monetary policies?
  3. What is the transmission mechanism whereby quantitative easing affects real output? Is it a reliable mechanism for policymakers?
  4. What would make a financial crash less likely? Is this something that governments or central banks can influence?
  5. Why has productivity growth been so low in many countries? What would increase it?
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Keynes versus the Classics: a new version of an old story

The ‘Classical’ Treasury view of the 1920s and 30s was that extra government spending or tax cuts were not the solution to depression and mass unemployment. Instead, it would crowd out private expenditure if the money supply were not allowed to rise as it would drive up interest rates. But if money supply were allowed to rise, this would be inflationary. The solution was to reduce budget deficits to increase confidence in public finances and to encourage private investment. Greater price and wage flexibility were the answer to markets not clearing.

Keynes countered these arguments by arguing that the economy could settle in a state of mass unemployment, with low confidence leading to lower consumer expenditure, lower investment, lower incomes and lower employment. The situation would be made worse, not better, by cuts in public expenditure or tax rises in an attempt to reduce the budget deficit. The solution was higher public expenditure to stimulate aggregate demand. This could be achieved by fiscal and monetary policies. Monetary policy alone could, however, be made ineffective by the liquidity trap. Extra money might simply be held rather than spent.

This old debate has been reborn since the financial crisis of 2007/8 and the subsequent deep recession and, more recently, the lack of recovery. (Click here for a PowerPoint of the chart.)

The articles below consider the current situation. Many economists, but certainly not all, take a Keynesian line that austerity policies to reduce public-sector deficits have been counter-productive. By dampening demand, such policies have reduced national income and slowed the recovery in both investment and consumer demand. This has at best slowed the rate of deficit reduction or at worst even increased the deficit, with lower GDP leading to a reduction in tax receipts and higher unemployment leading to higher government social security expenditure.

Although monetary policy has been very loose, measures such as record low interest rates and quantitative easing have been largely ineffective in stimulating demand. Economies are stuck in a liquidity trap, with banks preferring to build their reserves rather than to increase lending. This is the result partly of a lack of confidence and partly of pressure on them to meet Basel II and III requirements of reducing their leverage.

But despite the call from many economists to use fiscal policy and more radical monetary policy to stimulate demand, most governments have been pre-occupied with reducing their deficits and ultimately their debt. Their fear is that rising deficits undermine growth – a fear that was given weight by, amongst others, the work of Reinhart and Rogoff (see the blog posts Reinhart and Rogoff: debt and growth and It could be you and see also Light at the end of the tunnel – or an oncoming train?.

But there is some movement by governments. The new Japanese government under Shinzo Abe is following an aggressive monetary policy to drive down the exchange rate and boost aggregate demand (see A J-curve for Japan?) and, more recently, the European Commission has agreed to slow the pace of austerity by giving the Netherlands, France, Spain, Poland, Portugal and Slovenia more time to bring their budget deficits below the 3% of GDP target.

Of course, whether or not expansionary fiscal and/or monetary policies should be used to tackle a lack of growth does not alter the argument that supply-side policies are also required in order to increase potential economic growth.

A Keynesian Victory, but Austerity Stands Firm The New York Times, Business Day, Eduardo Porter (21/5/13)
With Austerity Under Fire, Countries Seek a More Balanced Solution Knowledge@Wharton (22/5/13)
Keynes, Say’s Law and the Theory of the Business Cycle History of Economics Review 25.1-2, Steven Kates (1996)
Is Lord Keynes back in Brussels? The Conversation, Fabrizio Carmignani (31/5/13)
Keynes’s Biggest Mistake The New York Times, Business Day, Bruce Bartlett (7/5/13)
Keynes’s Not So Big Mistake The New York Times, The Conscience of a Liberal blog, Paul Krugman (7/5/13)
The Chutzpah Caucus The New York Times, The Conscience of a Liberal blog, Paul Krugman (5/5/13)
Keynes and Keynesianism The New York Times, Business Day, Bruce Bartlett (14/5/13)
Japan Is About To Prove Keynesian Economics Entirely Wrong Forbes, Tim Worstall (11/5/13)
The poverty of austerity exposed Aljazeera, Paul Rosenberg (24/5/13)
Britain is a lab rat for George Osborne’s austerity programme experiment The Guardian, Larry Elliott (26/5/13)
Eurozone retreats from austerity – but only as far as ‘austerity lite’ The Guardian, Larry Elliott (30/5/13)
Europe’s long night of uncertainty Daily Times (Pakistan), S P Seth (29/5/13)
Abenomics vs. bad economics The Japan Times Gregory Clark (29/5/13)
European countries to be allowed to ease austerity BBC News (29/5/13)
U.K. Should Restore Growth, Rebalance Economy IMF Survey (22/5/13)
Now everyone is a Keynesian again – except George Osborne The Observer, William Keegan (2/6/13)
Austerity Versus Growth (III): Fiscal Policy And Debt Sustainability Social Europe Journal, Stefan Collignon (30/5/13)


  1. Explain what is meant by Say’s Law and its implication for macroeconomic policy.
  2. Why have many governments, including the UK government, been reluctant to pursue expansionary fiscal policies?
  3. What is meant by the liquidity trap? What is the way out of this trap?
  4. In the first article above, Eduardo Porter argues that ‘moral views are getting in the way of reason’. What does he mean by this?
  5. Explain what are meant by the ‘paradox of thrift’ and the ‘fallacy of composition’. How are these two concepts relevant to the debate over austerity policies?
  6. What are the dangers in pursuing aggressive Keynesian policies?
  7. What are the dangers in not pursuing aggressive Keynesian policies?
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Margaret Thatcher: seeking a calm assessment

Much has been written on Margaret Thatcher following her death at the age of 87 on April 8. But getting a calm assessment of both her time in office and her legacy is not easy. And it’s clear why: she created both stronger loyalty and stronger opposition than any other UK Prime Minister.

As economists, however, we should try to be as dispassionate as possible in assessing the effects of policies. There is always a normative question of the relative desirability of different economic outcomes – and you will have your own views on the relative importance of objectives such as economic growth, greater equality and greater social cohesion – but to determine cause and effect, or at least correlation, requires a careful examination of the evidence. Also, drawing lessons for future policy requires a careful modelling of the economy and the effects of changing economic variables.

The following articles have been selected from the hundreds that have appeared in the press in the past few days. Whilst they cannot be claimed to be totally ‘objective’, taken together they give a good overview of her economic policies and her economic legacy.

You may well have been surprised by the amount of coverage of her death and at the fervour of her supporters and critics. But this bears witness to the huge effect she had on both the political scene and on the UK economy – for good or bad.

Margaret Thatcher’s timeline: From Grantham to the House of Lords, via Arthur Scargill and the Falklands War Independent (8/4/13)
Overhauls Are Still Felt, Debated Decades Later Wall Street Journal, Charles Forelle (9/4/13)
Margaret Thatcher’s Four Ages of Monetary Policy EconoMonitor, David Smith (10/4/13)
How Mrs Thatcher smashed the Keynesian consensus The Economist (9/4/13)
Margaret Thatcher: The economy now and then BBC News, Stephanie Flanders (10/4/13)
Did Margaret Thatcher transform Britain’s economy for better or worse? The Guardian, Larry Elliott (8/4/13)
A look back at Margaret Thatcher’s economic record Washington Post, Dylan Matthews (8/4/13)
Margaret Thatcher’s legacy for business and economics—the world weighs in Quartz, Gwynn Guilford (8/4/13)

Economic Data freely available online The Economics Network, see especially sites 1, 2, 3, 6 and 9


  1. Summarise the macroeconomic policies followed by the Thatcher government from 1979 to 1990.
  2. Chart economic growth, unemployment and inflation over Margaret Thatcher’s time in office. How does the performance of each of these indicators compare with the period from 1990 to 2007 and from 2008 to the present day?
  3. What is meant by ‘monetarism’? Did the Thatcher government follow pure monetarist policies?
  4. What is meant by the ‘Big Bang’ as applied to the financial sector in 1986? Assess the long-term consequences of the Big Bang.
  5. What elements of ‘Thatcherism’ were retained by the Labour government from 1997 to 2010?
  6. To what extent can the current Coalition government be described as ‘Thatcherite’?
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