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
- What factors in the current economic environment affect the level of consumer confidence?
- What are the most important factors that will determine whether or not a policy of fiscal consolidation will drive the economy back into recession?
- How expansionary is monetary policy at the moment? Is it enough simply to answer this question by reference to central bank repo rates?
- 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?
- Why may fiscal multipliers have ‘turned negative’?
- For what reasons might a tight fiscal policy lead to an increase in aggregate demand?
- Your turn: what would Keynes have done in the current macroeconomic environment?
The government’s plan for the UK economy is well known. Reduce the public-sector deficit to restore confidence and get the economy going again. The deficit will be reduced mainly by government spending cuts but also by tax increases, including a rise in VAT from 17.5% to 20% on 1 January 2011. Reductions in public-sector demand will be more than offset by a rise in private-sector demand.
But what if private-sector demand does not increase sufficiently? With a fall in government expenditure, reduced public-sector employment and higher taxes, the danger is that demand for private-sector output may actually fall. And this is not helped by a decline in both consumer and business confidence (see, for example, Nationwide Consumer Confidence Index). What is more, consumer borrowing has been falling (see Consumer borrowing falls again) as people seek to reduce their debt, fearing an uncertain future.
So does the government have a ‘Plan B’ to stimulate the economy if it seems to be moving back into recession? Or will it be ‘cuts, come what may’? The Financial Times (see link below) has revealed that senior civil servants have indeed been considering possible stimulus measures if a return to recession seems likely.
Over in Threadneedle Street, there has been a debate in the Bank of England’s Monetary Policy Committee over whether an additional round of quantitative easing may be necessary. So far, the MPC has rejected this approach, but one member, Adam Posen, has strongly advocated stimulating demand (see The UK inflation outlook if this time isn’t different, arguing that the current high inflation is the result of temporary cost-push factors and is not indicative of excessively strong demand.
So should there be a Plan B? And if so, what should it look like?
Articles
Gus O’Donnell’s economic ‘Plan B’ emerges BBC News, Nick Robinson (14/12/10)
Sir Gus O’Donnell asks ministers to consider possible stimulus measures Financial Times, Jim Pickard (14/12/10) (includes link to article by Philip Stephens)
Gus O’Donnell urges Treasury to prepare ‘Plan B’ for economy Guardian, Patrick Wintour and Nicholas Watt (14/12/10)
Unemployment, and that ‘Plan B’ BBC News blogs, Stephanomics, Stephanie Flanders (15/12/10)
Inflation wars (cont’d) BBC News blogs, Stephanomics, Stephanie Flanders (16/12/10)
Don’t overreact to UK inflation – Bank’s Posen Reuters, Patrick Graham (16/12/10)
Bank of England’s Adam Posen calls for more quantitative easing The Telegraph, Philip Aldrick and Emma Rowley (29/9/10)
Don’t overreact to above-target UK inflation rate, cautions Posen Herald Scotland, Ian McConnell (17/12/10)
Posen calls for calm as inflation fears rise Independent, Sean O’Grady (17/12/10)
Data
OECD Economic Outlook OECD (see, in particular, Tables 1, 18, 27, 28 and 32)
Forecasts for the UK economy HM Treasury
UK Economic Outlook PricewaterhouseCoopers
Employment and Unemployment ONS
Inflation Report Bank of England
Questions
- What are likely to be the most important factors in determining the level of aggregate demand in the coming months?
- What are the dangers of (a) not having a Plan B and (b) having and publishing a Plan B?
- Why is inflation currently above target? What is likely to happen to inflation over the coming months?
- What are the arguments for and against having another round of quantitative easing?
- What else could the Bank of England do to stimulate a flagging economy?
Towards the end of each month the European Commission for Economic and Financial Affairs publishes its economic sentiment index for each EU country, including the UK, along with average scores for the EU and for the countries using the euro. September’s release showed sentiment in the UK amongst consumers and businesses to have weakened more than in any other EU country. The index fell from a score of 102.3 to 100.2, where 100 represents an equal number of optimistic and pessimistic responses.
In itself the score seems to suggest that there remains some degree of economic confidence here in the UK. So should we be concerned? Well, the direction of the sentiment index is very likely to be of some concern and something that policy-makers will be keeping a keen eye on. Furthemore, the direction of sentiment in the UK is contrary, perhaps surprisingly so you might think, to that in most EU countries. The EU-average score, for instance, rose from 103.1 to 103.4, its highest since March 2008. From this we can infer not only that more people in the survey are optimistic than pessimistic but also that sentiment is becoming more positive (slightly). In Germany the economic sentiment index rose between August and September from 111.2 to 113.2, its highest since February 1991, with sentiment rising across consumers and all sectors of business.
If we delve a little deeper into the UK sentiment figures we see that the weakening of economic confidence is greatest amongst retailers. To a large extent this reflects an erosion of the significant increase in sentiment reported by retailers in the summer months. It also appears to reflect something of a lagged response to the waning sentiment amongst consumers. The figures for consumer confidence showed a ‘bounce’ in confidence during the spring, but September’s consumer confidence level was the lowest since June 2009 when the economy was still in recession.
One of the tasks facing policy-makers and economists is to try to predict what these economic sentiment figures might mean for economic activity. In particular, to what extent do these figures have significance for the future decisions made by households and businesses? Surprisingly, relatively little column space is given to measures of confidence and to the EU’s Economic Sentiment Index in particular.
It’s probably fair to say too that, as economists, we are a long way from fully understanding the role that confidence plays in affecting individual behaviour or indeed the variables that impact on confidence. It was once suggested to me (Dean), for instance, that changes in UK consumer confidence might be closely related to changes in housing wealth. Further, we economists struggle to understand what these survey measures of economic confidence are actually capturing, since the surveys comprise a multitude of questions, which, in the case of consumers for instance, ask them to compare their current financial situation with that in the past as well as to predict how it will evolve over the coming months.
Despite our imperfect understanding of the role played by confidence and how we can measure it, there is considerable interest amongst policy-makers, economic think-tanks and economic forecasters. For example, earlier this week a statement following an IMF Mission to the UK indentified ‘sizeable’ downside risks to the UK economy’s recovery, including what it termed ‘the continued fragility of confidence’. Could the release just a few days later from the EU reporting a decline in economic sentiment in the UK be timely?
Articles
Eurozone optimism nears three-year high Financial Times, Ralph Atkins and David Oakley (29/9/10)
EU economic, business indicators improve again The Sofia Echo (29/9/10)
Eurozone Sept. economic sentiment strongest since 2008 RTT News (29/9/10)
EU September economic morale unexpectedly improves MarketNews.com (29/9/10)
Data
Business and Consumer Surveys The Directorate General for Economics and Financial Affairs, European Commission
Consumer Confidence Nationwide Building Society
Questions
- Do you think economic sentiment or economic confidence is a worthwhile concept for economists and policy-makers to analyse?
- Draw up a series of factors that you think might affect the economic sentiment amongst consumers. Are there any factors that might be peculiar to the UK? Then repeat the exercise for businesses.
- Why do you think there is a ‘fragility of confidence’ in the UK? What might explain the stronger confidence levels in other EU countries, such as Germany?
Economists are famous for disagreeing – as, of course, are politicians. And there is a lot of disagreement around at the moment. George Osborne is determined to cut Britain’s large public-sector deficit, and cut it quickly. This, argues the Coalition government and many economists, is necessary to maintain the UK’s AAA sovereign credit rating. This, in turn, will allow interest rates to be kept down and the international confidence will encourage investment. In short, the cut in aggregate demand by government would be more than compensated by a rise in aggregate demand elsewhere in the economy, and especially from investment and exports. By contrast, not cutting the deficit rapidly would undermine confidence. This would make it more expensive to borrow and would discourage inward investment.
Not so, say the opposition and many other economists. A contractionary fiscal policy will achieve just that – an economic contraction. In other words, there is a real danger of a double-dip recession. Far from encouraging investment, it will do just the opposite. Consumers, fearing falling incomes and rising unemployment, will cut back on spending. Businesses, fearing a fall in sales, will cut back on investment. Economic pessimism, and hence caution, will feed on themselves.
So who are right? The first two blogs by Stephanie Flanders, the BBC’s Economics Editor, look at the arguments on both sides. The third attempts to sum up. The other articles continue the debate. For example, the link to The Economist contains several contributions from commentators on either side of the debate. See also the earlier posting on this site, The ‘paradox of cuts’.
Articles
The case for Mr Osborne’s austerity BBC News Blogs, Stephanomics, Stephanie Flanders (7/9/10)
The case against Mr Osborne’s austerity BBC News Blogs, Stephanomics, Stephanie Flanders (8/9/10)
Austerity plans: Where do you stand? BBC News Blogs, Stephanomics, Stephanie Flanders (10/9/10)
Are current deficit reduction plans likely to boost growth? The Economist debates, various invited guests
Debt and growth revisited Vox, Carmen M. Reinhart and Kenneth Rogoff (11/8/10)
Leading article: Mr Osborne should prepare a Plan B Independent (13/9/10)
Shock fall in UK retail sales adds to fears of double-dip recession Guardian, Larry Elliott (16/9/10)
Chancellor accused of £100bn economic growth gamble by Compass Guardian, Larry Elliott (18/9/10)
Double-dip recession: bulls and bears diverge over future economic prospects Guardian, Phillip Inman (16/9/10)
Speech by Mervyn King to TUC Congress TUC (15/9/10)
Barber, Blanchflower and the fake debate on double dip The Spectator, Ed Howker (14/9/10)
Confidence data
Consumer confidence Nationwide
ICAEW / Grant Thornton UK Business Confidence Monitor (BCM) ICAEW
Business and Consumer Surveys Economic and Financial Affairs, European Commission
Questions
- Summarise the arguments for the Coalition government’s programme of rapidly reducing the public-sector deficit.
- Summarise the arguments against the Coalition government’s programme of rapidly reducing the public-sector deficit.
- What factors are likely to determine whether there will be a double-dip recession as a result of the austerity programme?
- Why is it very hard to predict the effects of the austerity programme?
- How effective is an expansionary monetary policy likely to be in the context of a tightening fiscal policy?
- How important are other countries’ macroeconomic policies in determining the success of George Osborne’s policies?
- How similar to or different from other recessions has the recent one been? What are the policy implications of these similarities/differences?
The sun may have been shining of late across the UK, but there are increasing signs that economic sentiment is deteriorating, more especially amongst consumers. The EU’s economic sentiment index for the UK fell for the first time since November of last year and is now just a little below its long-run average.
The EU’s economic sentiment index is a composite indicator of confidence in that it captures confidence levels amongst both consumers and businesses. While overall sentiment actually increased in each month from December of last year through to this May, the decline in consumer confidence in the UK is now well established having fallen each month since March.
We might expect the falls in consumer confidence to be reflecting the prevailing economic environment and, in particular, the increasing number of people unemployed. However, since the sentiment survey contains forward-looking questions too, it may be that declining consumer sentiment reflects concerns amongst households about the impact of fiscal consolidation measures. These consumer expectations could be important in affecting consumer behaviour today. It could be very important to track consumer confidence in the coming months, especially in light of the measures announced in the Budget of 22 June (which occurred after June’s polling of consumers) and subsequent announcements too.
Interestingly, declining levels of consumer confidence in the UK had until June been offset by rising confidence amongst businesses. However, confidence across most sectors of industry deteriorated in June. In particular, confidence amongst manufacturers fell back very sharply. Bucking the trend were businesses in the service sector who reported feeling more confident than at any time since March 2008. However, given waning sentiment elsewhere, one would expect this to be relatively short-lived.
The profile of the average economic sentiment indicator across all 27 member states of the EU is broadly similar to that for the UK. It exhibits a sharp and continuous rise from the historic lows of the indicator recorded in March 2009, but fell back, although very slightly, in June. The improvement in sentiment amongst business has been especially marked. Sentiment too had been improving amongst consumers, but recent evidence points to consumer confidence easing, although not quite to the extent seen here in the UK.
There are, of course, some notable national trends in sentiment across EU countries. It will come as little surprise to know that in Greece the economic sentiment indicator has, in recent months, been at historic lows. If you are looking for countries where sentiment is above average, then perhaps try, amongst others, Austria, Denmark, Finland and Germany!
Articles
Euro economic sentiment near-static RTE (29/6/10)
Eurozone confidence unchanged Bloomberg Business Week, Associated Press (29/6/10)
Eurozone economic sentiment picks up Financial Times, Stanley Pignal (29/6/10)
FTSE loses more than 3% as Wall Street slides on confidence data Guardian (Market Forces Blog) (29/6/10)
How long can the housing market avoid a crash? Independent, Sean O’Grady (30/6/10) (Article stresses link between confidence and the housing market)
Data
Business and Consumer Surveys The Directorate General for Economics and Financial Affairs, European Commission
Consumer Confidence Nationwide Building Society
Questions
- Think about your confidence in your own financial situation. Draw up a list of those factors that might affect this confidence. How might this list change if you were thinking about the level of confidence across all consumers?
- Why might confidence amongst UK consumers have been falling well before that amongst businesses? Do you think such divergences can persist for any length of time?
- What factors do you think might be particularly important in affecting the sentiment amongst consumers and businesses in the weeks and months ahead?
- Imagine that you are given a choice of plotting a chart over time of the economic sentiment indicator and either the level of real GDP or the rate of growth in real GDP. Which plot would you go for and why?
- Perhaps the key question of all! Do you think economists can learn anything from tracking the patterns in economic sentiment?