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:
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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. |
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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.” |
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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.
Article
Keynesian economics: is it time for the theory to rise from the dead?, The Guardian, Larry Elliott (11/12/16)
Questions
- What are the main factors determining a country’s long-term rate of economic growth?
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the benefits and limitations of using new money created by the central bank to fund infrastructure spending?
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- 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?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- What determines the size of the multiplier effect of such policies?
- 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’?
The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.
According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.
Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.
With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.
With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.
Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).
Article
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)
Questions
- Explain what is meant by ‘the liquidity trap’.
- Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
- Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
- Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
- In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
- Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
- Why may a political upheaval be necessary for a country to escape the liquidity trap?
The Bank of England has responded to forecasts of a dramatic slowdown in the UK economy in the wake of the Brexit vote. On 4th August, it announced a substantial easing of monetary policy, but still left room for further easing later.
Its new measures are based on the forecasts in its latest 3-monthly Inflation Report. Compared with the May forecasts, the Report predicts that, even with the new measures, aggregate demand growth will slow dramatically. As a result, over the next two years cumulative GDP growth will be 2.5% lower than it would have been with a Remain vote and unemployment will rise from 4.9% to around 5.5%.
What is more, the slower growth in aggregate demand will impact on aggregate supply. As the Governor said in his 
opening remarks at the Inflation Report press conference:
“The weakness in demand will itself weigh on supply as a period of low investment restrains growth in the capital stock and productivity.
There could also be more direct implications for supply from the decision to leave the European Union. The UK’s trading relationships are likely to change, but precisely how will be unclear for some time. If companies are uncertain about the future impact of this on their businesses, they could delay decisions about building supply capacity or entering new markets.”
Three main measures were announced.
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A cut in Bank Rate from 0.5% to 0.25%. This is the first time Bank Rate has been changed since March 2009. The Bank hopes that banks will pass this on to customers in terms of lower borrowing rates. |
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A new ‘Term Funding Scheme (TFS)’. “Compared to the old Funding for Lending Scheme, the TFS is a pure monetary policy instrument that is likely to be more stimulative pound-for-pound.” The scheme makes £100bn of central bank reserves available as loans to banks and building societies. These will be at ultra-low interest rates to enable banks to pass on the new lower Bank Rate to customers in all forms of lending. What is more, banks will be charged a penalty if they do not lend this money. |
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An expansion of the quantitative easing programme beyond the previous £375 billion of gilt (government bond) purchases. This will consist of an extra £60bn of gilt purchases and the purchase of up to £10bn of UK corporate bonds. |
The Bank recognises that there is a limit to what monetary policy can do and that there is also a role to play for fiscal policy. The new Chancellor, Philip Hammond, is considering what fiscal measures can be taken, including spending on infrastructure projects. These are likely to have relative high multiplier effects and would also increase aggregate supply at the same time. But we will have to wait for the Autumn Statement to see what measures will be taken.
But despite the limits to monetary policy, there is more the Bank of England could do. It already recognises that there may have to be a further cut in Bank Rate, perhaps to 0.1% or even to 0% (the ECB has a 0% rate). There could also be additional quantitative easing or additional term funding to banks.
Some economists argue that the Bank should go further still and, in conjunction with the Treasury, provide new money directly to fund infrastructure spending or tax cuts, or even as cash handouts to households. This extra money provided to the government would not increase government borrowing.
We discussed the use of this version of ‘helicopter money’ in the blogs, A flawed model of monetary policy, Global warning and People’s quantitative easing. Some of the articles below also consider the potential for this type of monetary policy. In a letter to The Guardian 35 economists advocate:
A fiscal stimulus financed by central bank money creation [which] could be used to fund essential investment in infrastructure projects – boosting the incomes of businesses and households, and increasing the public sector’s productive assets in the process. Alternatively, the money could be used to fund either a tax cut or direct cash transfers to households, resulting in an immediate increase of household disposable incomes.
Webcasts and podcasts
Inflation Report Press Conference Bank of England, Mark Carney (4/8/16)
Bank spells out chance of further rate cut this year BBC Radio 4 Today Programme, Ben Broadbent, Deputy Governor of the Bank of England (5/8/16)
Broadbent Ready to Back Another BOE Rate Cut Amid Slowdown Bloomberg, Chris Wyllie (5/8/16)
What’s Top of Mind? ‘Helicopter Money’ Goldman Sachs Macroeconomic Insights, Allison Nathan (April 2016)
Articles
Bank of England measures
Interest rate cut: What did the Bank of England announce today and how will it affect you? Independent, Ben Chu (5/8/16)
This is the Bank of England’s all-action response to Brexit The Guardian, Larry Elliott (4/8/16)
Bank of England unveils four-pronged stimulus package in bid to avoid Brexit recession The Telegraph, Szu Ping Chan (4/8/16)
Record-breaking Bank of England Financial Times, Robin Wigglesworth (4/8/16)
The Bank of England has delivered – now for a fiscal response Financial Times (4/8/16)
Bank of England Cuts Interest Rate to Historic Low, Citing Economic Pressures New York Times, Chad Bray (4/8/16)
Sledgehammer? This is more like the small tool to fix a fence The Telegraph, Andrew Sentance (5/8/16)
All eyes are on Hammond as Bank runs low on options The Telegraph, Tom Stevenson (6/8/16)
Bank of England’s stimulus package has bought the chancellor some time The Guardian, Larry Elliott (7/8/16)
Helicopter money
A post-Brexit economic policy reset for the UK is essential Guardian letters, 35 economists (3/8/16)
Cash handouts are best way to boost British growth, say economists The Guardian, Larry Elliott (4/8/16)
Helicopter money: if not now, when? Financial Times, Martin Sandbu (2/8/16)
The helicopters fly on for now, but one day they will crash The Telegraph, Tom Stevenson (23/7/16)
Is the concept of ‘helicopter money’ set for a resurgence? The Conversation, Phil Lewis (2/8/16)
Helicopter money talk takes flight as Bank of Japan runs out of runway Reuters, Stanley White (30/7/16)
Helicopters 101: your guide to monetary financing Deutsche Bank Research, George Saravelos, Daniel Brehon and Robin Winkler (15/4/16)
Helicopter money is back in the air The Guardian, Robert Skidelsky (22/9/16)
Bank of England publications
Inflation Report, August 2016 Bank of England (4/8/16)
Inflation Report Press Conference: Opening Remarks by the Governor Bank of England, Mark Carney (4/8/16)
Inflation Report Q&A Bank of England Press Conference (4/8/16)
Inflation Report, August 2016: Landing page Bank of England (4/8/16)
Questions
- Find out the details of the previous Funding for Lending (FLS) scheme. How does the new Term Funding Scheme (TFS) differ from it? Why does the Bank of England feel that TFS is likely to be more effective than FLS in expanding lending?
- What is the transmission mechanism between asset purchases and real aggregate demand?
- What factors determine the level of borrowing in the economy? How is cutting Bank Rate from 0.5% to 0.25% likely to affect borrowing?
- If the Bank of England’s latest forecast is for a significant reduction in economic growth from its previous forecast, why did the Bank not introduce stronger measures, such as larger asset purchases or a cut in Bank Rate to 0.1%?
- What are the advantages and disadvantages of helicopter money in the current circumstances? If helicopter money were used, would it be better to use it for funding public-sector infrastructure projects or for cash handouts to households, either directly or in the form of tax cuts?
- How does the Bank of England’s measures of 4 August compare with those announced by the Japanese central bank on 29 July?
- What effects can changes in aggregate demand have on aggregate supply?
- 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’?
In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.
The two articles below argue that the failure has been due to a flawed model of monetary policy: one that takes too little account of the behaviour of banks and the drivers of consumption and of physical investment. Negative interest rates on banks’ holdings of reserves in central banks are hardly likely to push down lending rates to businesses sufficiently to stimulate investment in new plant and machinery if firms already have overcapacity. And consumers are unlikely to borrow more for consumption if their wages are barely rising and they already have debts that they fear will be difficulty to pay off.
As Joseph Stiglitz points out:
As real interest rates have fallen, business investment has stagnated. According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in both Europe and the US in recent years. (In the US, it fell from 8.4% in 2000 to 6.8% in 2014; in the EU, it fell from 7.5% to 5.7% over the same period.) Other data provide a similar picture.
And the unwillingness of many firms and individuals to borrow is matched by banks’ caution about lending in an uncertain economic environment. Many are more concerned about building their capital and liquidity ratios to protect themselves.
In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less
What central banks should be doing, argue both Stiglitz and Elliott, is finding ways of directly stimulating consumption and investment. Perhaps this will involve central banks “focusing on the flow of credit, which means restoring and maintaining local banks’ ability and willingness to lend to SMEs.” Perhaps it will mean using helicopter money, as we examined in the previous blog. As Larry Elliott points out:
The fact that economists at Deutsche Bank published a helpful cut-out-and-keep guide to helicopter money last week is a straw in the wind.
As the Deutsche research makes clear, the most basic variant of helicopter money involves a central bank creating money so that it can be handed to the finance ministry to spend on tax cuts or higher public spending. There are two differences with QE. The cash goes directly to firms and individuals rather than being channelled through banks, and there is no intention of the central bank ever getting it back.
So if the model of monetary policy is indeed flawed, prepare for more unconventional measures
Articles
What’s Wrong With Negative Rates?, Project Syndicate, Joseph Stiglitz (13/4/16)
The bad smell hovering over the global economy The Guardian, Larry Elliott (17/4/16)
Questions
- What arguments does Stiglitz use to support his claim that the model of monetary policy currently being used is flawed?
- In what ways has monetary policy hurt older people and what has been the effect on their spending and on aggregate demand in general?
- Why has monetary policy encouraged investors to shift their portfolios toward riskier assets?
- Examine the argument that ultra-low interest rates may result in a rise in unemployment in the long term by affecting the relative prices of capital and labour.
- What forms might helicopter money take?
- Would the use of helicopter money necessarily result in an increase in aggregate demand? What would determine the size of any such increase?
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.
Articles
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)
Questions
- Explain how a ‘helicopter drop’ of money would work in practice.
- Why has growth in the eurozone been so anaemic since the recession of 2009/10?
- What is the relationship between tightening the regulations about capital and liquidity requirements of banks and bank lending?
- Explain the policies of the different eras identified by Anatole Kaletsky.
- Would it be fair to describe the proposals for more unconventional monetary policies as ‘Keynesian’?
- If quantitative easing was used to finance government infrastructure investment, what would be the effect on the public-sector deficit and debt?
- 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?
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.
