In 2008 and 2009, as the global recession deepened, so governments around the world turned to Keynesian policies. Aggregate demand had to be boosted. This meant a combination of fiscal and monetary policies. Fiscal stimulus packages were adopted, combining increased government expenditure and cuts in taxes. On the monetary policy front, central banks cut interest rates to virtually zero and expanded the money supply in bouts of quantitative easing.
The global recession turned out not to be a deep as many had feared and the Keynesian policies were hailed by many as a success.
But how the tide is turning! The combination of the recession (which reduced tax revenues and increased welfare spending) and the stimulus packages played havoc with public finances. Deficits soared. These deficits had to be financed, and increasingly credit agencies and others were asking how sustainable such deficits were over the longer term. These worries have been compounded by the perilous state of the public finances in countries such as Greece, Portugal, Ireland and Hungary. The focus has thus turned to cuts. In fact there is now an international ‘competition’ as to which country can wear the hairiest hair shirt. The new Coalition government in the UK, for example, is busy preparing the general public for deep cuts to come.
We are now seeing a re-emergence of new classical views that increased deficits, far from stimulating the economy and resulting in faster growth, largely crowd out private expenditure. To prevent this crowding out and restore confidence in financial markets, deficits must be rapidly cut, thereby allowing finance to be diverted to the private sector.
But if the contribution to aggregate demand of the public sector is to be reduced, and if consumption, the largest component of aggregate demand, is also reduced as households try to reduce their reliance on borrowing, where is the necessary rise in aggregate demand to come from? We are left with investment and net exports – the remaining two components of aggregate demand, where AD = C + G + I + (X – M).
But will firms want to invest if deficit reduction results in higher taxes, higher unemployment and less spending by the government on construction, equipment and many other private-sector goods and services. Won’t firms, fearing a decline in consumer demand, and possibly a ‘double-dip recession’, hold off from investing? As for export growth, this depends very much on growth in the rest of the world. If the rest of the world is busy making cuts too, then export growth may be very limited.
The G20, meeting in Korea on 4 June, wrestled with this problem. But the mood had definitely turned. Leaders seemed much more concerned about deficit reduction than maintaining the fiscal stimulus.
The following articles look at the arguments between Keynesians and new classicists. The disagreements between their authors reflect the disagreements between economists and between politicians about the timing and extent of cuts.
Articles
Time to plan for post-Keynesian era Financial Times, Jeffrey Sachs (7/6/10)
The Keynesian Endpoint CNBC Guest Blog, Tony Crescenzi (7/6/10)
Keynes, Recovered Boston Review, Jonathan Kirshner (May/June 2010)
How Keynes, not mining, saved us from recession Sydney Morning Herald, Ross Gittins (7/6/10)
The verdict on Keynes Asia Times, Martin Hutchinson (2/6/10)
The G20 Has Officially Voted For Global Depression Business Insider, Marshall Auerback (7/6/10)
Deficit disorder: the Keynes solution New Statesman, Robert Skidelsky (17/5/10)
Hawks v doves: economists square up over Osborne’s cuts Guardian, Phillip Inman (14/6/10)
Reports and data
OECD Economic Outlook No. 87, May 2010 (see)
Economics: Growth rising faster than expected but risks increasing too, says OECD Economic Outlook OECD (26/5/10)
Economy: responses must reflect governments’ views of national situations OECD (26/5/10)
Editorial and summary of projections OECD (26/5/10)
General assessment of the macroeconomic situation OECD (26/5/10)
Statistical Annex to OECD Economic Outlook No. 87 OECD (10/6/10)
Communiqué, Meeting of Finance Ministers and Central Bank Governors, Busan, Republic of Korea G20 (5/6/10)
Questions
- Summarise the arguments for and against making rapid cuts in public-sector deficits.
- What forms can crowding out take? Under what circumstances will a rise in public-sector deficits (a) cause and (b) not cause crowding out?
- Assess the policy measures being proposed by the G20.
- How important is confidence for the success of (a) fiscal stimulus packages and (b) deficit reduction policies in boosting economic growth?
With the Conservatives and Liberal Democrats now in power in the UK and with the Labour Party, having lost the election, being now in the midst of a leadership campaign, politicians from across the political spectrum are balming Gordon Brown for the ‘mess the country’s in’. The UK has a record budget deficit and debt, and is just emerging from a deep recession, when only a few years ago, Gordon Brown was claiming the end of boom and bust. But is the condition of the UK economy Mr Brown’s fault? Would it have been any better if others had been in charge, or if there had been even greater independence for the Bank of England of if there had been an Office of Budget Responsibility (see)?
The following podcast by Martin Wolf, chief economics commentator of the Financial Times, considers this question. He argues that:
Everybody would like to blame Gordon Brown for the financial crisis. But he was only acting in line with the national consensus on economic policy.
The economic legacy of Mr Brown FT podcasts, Martin Wolf (13/5/10)
The economic legacy of Mr Brown Financial Times, Martin Wolf (13/5/10)
Questions
- Explain what is meant by ‘the great moderation’.
- Should regulation of the banks be handed back to the Bank of England?
- Why may controlling inflation not necessarily result in stable economic growth? Is this a case of Goodhart’s Law?
- Why was the UK economy especially fragile during the banking crisis and its aftermath?
- What, according to Martin Wolf, was Mr Brown’s biggest mistake?
- Could a mistake be now being made by following the conventional wisdom that cutting the deficit is the solution to achieving sustained recovery?
On the 14th May the IMF published its latest Fiscal Monitor. The key message coming out of this was the need for countries to reduce their public debt ratios, i.e. public debt relative to GDP. Specifically, the IMF is arguing that public debt ratios should be reduced to their ‘post-crisis levels’. In effect, this means countries need to undertake fiscal consolidation. The IMF recognises that the pace of fiscal consolidation should reflect underlying fiscal and macroeconomic conditions, but warns of the dangers of not doing so especially in those countries where the credibility of the current and medium-term fiscal position is weakest.
Underpinning the IMF’s argument for fiscal consolidation is their concern that higher public debt ratios necessitate higher interest rates in order to entice investors to purchase government debt. In those countries with weak fiscal credibility, a sizeable interest rate premium may be needed to entice investors to hold government debt over other types of investments. For instance, we have seen how the markets reacted to the perceived lack of fiscal credibility in Greece and how a series of measures, as discussed in Fixing the Euro: a long term solution or mere sticking plaster were needed to both restore normality to debt markets and to prevent contagion in markets for other country’s public debt.
The IMF argues that the impact of higher interest rates from high public debt-to-GDP ratios would be to reduce an economy’s potential growth. The mechanism by which this would happen would primarily be a reduction of labour productivity growth resulting from lower levels of investment and, hence, from slower growth in the country’s capital stock.
In short, the IMF is arguing that without credible fiscal consolidation plans, countries – particularly advanced economies – run a real risk of restricting their rate of economic growth over the longer-term. Of course, the challenge is to implement fiscal consolidation plans that protect short-term growth by cementing the current economic recovery but do not hinder longer-term growth. Now that is a real challenge!
Report
Fiscal Monitor, May 14 2010 IMF
Articles
IMF Says Rising Public Debt Risk ‘Cannot Be Ignored’ Bloomberg Businessweek, Sandrine Rastello (14/5/10)
US faces one of the biggest crunches in the world – IMF Telegraph, Edmund Conway (14/5/10)
IMF says that developed countries must curb their deficits BBC News (14/5/10)
Outlook for rich economies worsening – IMF Eurasia Review (14/5/10)
Britain’s public debt falls under IMF focus Financial Times, Alan Beattie (15/5/10)
Advanced Economies Face Tougher, Not Impossible, Fiscal Adjustment MarketNews.com, Heather Scott (14/5/10)
A good squeeze The Economist (31/3/10)
Data
IMF Data and Statistic Portal IMF
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission
Questions
- Evaluate the argument put forward by the IMF that fiscal consolidation is necessary to prevent harming long-term economic growth.
- What are the economic dangers of consolidating a country’s fiscal position too quickly?
- What do you understand by short-run and long-term economic growth?
- What do you understand by potential growth?
- What could a government do to increase the perceived credibility of its fiscal position?
The incoming coalition government in the UK has been spelling out its fiscal policy. It is sticking to the Conservative pledge of cutting £6bn from government spending this fiscal year (6 April 2010 to 5 April 2011). It hopes to make most of these by ‘efficiency savings’ – in other words, providing the same level of service for less money. It has, however, said that it will take advice from the Treasury and the Bank of England as to whether the cuts need to be delayed if the economy weakens substantially.
But the Bank of England is forecasting a continuation of the recovery (see its latest Inflation Report below), even assuming no further quantitative easing beyond the £200bn of assets purchased by the Bank. The Governor, Mervyn King, feels that the economy can indeed bear the proposed £6bn cut in government spending and that this will also send an important signal to the market that the government is committed to reducing the deficit.
The new government has also said that it will honour the Liberal Democrat pledge to raise the personal tax free allowance on income tax to £10,000. It has also backtracked somewhat on the Conservative pledge not to raise national insurance. Only employers will be spared the rise; employees will have to pay it.
So has there been a major change in fiscal policy? Has the focus moved from one of maintaining aggregate demand in order to avoid falling back into recession to one of making a start on tackling the deficit straight away? Or is the change in emphasis more one of presentation than substance? The following webcasts looks at the new fiscal policy emerging from number 11 and at the latest forecasts for growth and inflation.
Webcasts
What kind of medicine is the economy going to be fed? BBC Newsnight, Paul Mason (13/5/10)
Policy breakdown for Lib Dem-Conservative coalition BBC News, James Landale (12/5/10)
Savings cuts to ‘hit middle class families’ BBC News, Keith Doyle (15/5/10)
Inflation Report, May 2010 Bank of England (click on Watch Webcast) (12/5/10)
Documents and data
Coalition Agreement published (see here for text of agreement) Conservative Party (11/5/10)
Conservative – Liberal Democrat coalition negotiations agreements Liberal Democrats (11/5/10)
Inflation Report, May 2010 (portal) Bank of England, see in particular:
Articles
Department by department, what the new Government plans to do Independent (13/5/10)
VAT rise looms as coalition deal adds estimated £10bn to debt Guardian, Katie Allen and Julia Kollewe (13/5/10)
Some initial reaction to the Tory / Lib Dem coalition agreement Institute for Fiscal Studies Press Release, Robert Chote and Mike Brewery (12/5/10)
Tax rises likely under coalition government, says Institute for Fiscal Studies Telegraph, Edmund Conway (13/5/10)
Give and take BBC News blogs, Stephanomics, Stephanie Flanders (12/5/10)
Questions
- What ground has been given by (a) the Conservatives; (b) the Liberal Democrats in terms of their proposed economic policies (see Looking at the manifestos for details of their proposed policies).
- What will be the implications of a £6bn cut in government spending on aggregate demand? What other determinants of aggregate demand need to be taken into account in order to assess the likely growth in GDP over the coming months?
- What are the distributional consequences of (a) a rise in the personal income tax allowance to £10,000; (b) a rise in VAT?
- Has there been a major change in fiscal policy?
With an election approaching, there is much debate about recovery and cuts and about the relationships between the two. Will rapid cuts stimulate confidence in the UK by business and bankers and thereby stimulate investment and recovery, or will they drive the economy back into recession? The debate is not just between politicians vying for your vote; economists too are debating the issue. Many are taking to letter writing.
In the February 2010 news blog, A clash of ideas – what to do about the deficit, we considered three letters written by economists (linked to again below). There has now been a fourth – and doubtless not the last. This latest letter, in the wake of the Budget and the debates about the speed of the cuts, takes a Keynesian line and looks at the sustainability of the recovery – including social and environmental sustainability. It is signed by 34 people, mainly economists.
Letter: Better routes to economic recovery Guardian (27/3/10)
Letter: UK economy cries out for credible rescue plan Sunday Times, 20 economists (14/2/10)
Letter: First priority must be to restore robust growth Financial Times, Lord Skidelsky and others (18/2/10)
Letter: Sharp shock now would be dangerous Financial Times, Lord Layard and others (18/2/10)
Questions
- Summarise the arguments for making rapid cuts in the deficit.
- Summarise the arguments for making gradual cuts in the deficit in line with the recovery in private-sector demand.
- Under what conditions would the current high deficit crowd out private expenditure?
- What do you understand by a ‘Green New Deal’? How realistic is such a New Deal and would there be any downsides?
- Is the disagreement between the economists the result of (a) different analysis, (b) different objectives or (c) different interpretation of forecasts of the robustness of the recovery and how markets are likely to respond to alternative policies? Or is it a combination of two of them or all three? Explain your answer.
- Why is the effect of the recession on the supply-side of the economy crucial in determining the sustainability of a demand-led recovery?