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Posts Tagged ‘Ricardian equivalence’

What would Keynes do?

The debate about how much and how fast to cut the deficit has often been presented as a replaying of the debates of the 1920s and 30s between Keynes and the Treasury.

The justification for fiscal expansion to tackle the recession in 2008/9 was portrayed as classic Keynesianism. The problem was seen as a short-term one of a lack of spending. The solution was seen as one of expansionary fiscal and monetary policies. There was relatively little resistance to such stimulus packages at the time, although some warned against the inevitable growth in public-sector debt.

But now that the world economy is in recovery mode – albeit a highly faltering one in many countries – and given the huge overhang of government deficits and debts, what would Keynes advocate now? Here there is considerable disagreement.

Vince Cable, the UK Business Secretary, argues that Keynes would have supported the deficit reduction plans of the Coalition government. He would still have stressed the importance of aggregate demand, but would have argued that investor and consumer confidence, which are vital preconditions for maintaining private-sector demand, are best maintained by a credible plan to reduce the deficit. What is more, inflows of capital are again best encouraged by fiscal rectitude. As he argued in the New Statesman article below

One plausible explanation, from Olivier Blanchard of the IMF, is that the Keynesian model of fiscal policy works well enough in most conditions, but not when there is a fiscal crisis. In those circumstances, households and businesses react to increased deficits by saving more, because they expect spending cuts and tax increases in the future. At a time like this, fiscal multipliers decline and turn negative. Conversely, firm action to reduce deficits provides reassurance to spend and invest. Such arguments are sometimes described as “Ricardian equivalence” – that deficits cannot stimulate demand because of expected future tax increases.

Those on the other side are not arguing against a long-term reduction in government deficits, but rather that the speed and magnitude of cuts should depend on the state of the economy. Too much cutting and too fast would cause a reduction in aggregate demand and a consequent reduction in output. This would undermine confidence, not strengthen it. Critics of the Coalition government’s policy point to the fragile nature of the recovery and the historically low levels of consumer confidence

The following articles provide some of the more recent contributions to the debate.

Keynes would be on our side New Statesman, Vince Cable (12/1/11)
Cable’s attempt to claim Keynes is well argued — but unconvincing New Statesman, David Blanchflower and Robert Skidelsky (27/1/11)
Growth or cuts? Keynes would not back the coalition – especially over jobs Guardian, Larry Elliott (17/1/11)
People do not understand how bad the economy is Guardian, Vince Cable (20/5/11)
The Budget Battle: WWHD? (What Would Hayek Do?) AK? (And Keynes?) PBS Newshour, Paul Solman (29/4/11)
Keynes vs. Hayek, the Rematch: Keynes Responds PBS Newshour, Paul Solman (2/5/11)
On Not Reading Keynes New York Times, Paul Krugman (1/5/11)
Would a More Expansionary Fiscal Policy Be Effective Right Now? Yes: On the Invisible Bond Market and Inflation Vigilantes Once Again Blog: Grasping Reality with a Prehensile Tail, Brad DeLong (12/5/11)
Keynes, Crisis and Monopoly Capitalism The Real News, Robert Skidelsky and Paul Jay (29/4/11)

Questions

  1. What factors in the current economic environment affect the level of consumer confidence?
  2. What are the most important factors that will determine whether or not a policy of fiscal consolidation will drive the economy back into recession?
  3. How expansionary is monetary policy at the moment? Is it enough simply to answer this question by reference to central bank repo rates?
  4. What degree of crowding out would be likely to result from an expansionary fiscal policy in the current economic environment? If confidence is adversely affected by expansionary fiscal policy, would this represent a form of crowding out?
  5. Why may fiscal multipliers have ‘turned negative’?
  6. For what reasons might a tight fiscal policy lead to an increase in aggregate demand?
  7. Your turn: what would Keynes have done in the current macroeconomic environment?
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