The first article below, from The Economist, examines likely macroeconomic policy under Donald Trump. He has stated that he plans to cut taxes, including reducing the top rates of income tax and reducing taxes on corporate income and capital gains. At the same time he has pledged to increase infrastructure spending.
This expansionary fiscal policy is unlikely to be accompanied by accommodating monetary policy. Interest rates would therefore rise to tackle the inflationary pressures from the fiscal policy. One effect of this would be to drive up the dollar and therein lies significant risks.
The first is that the value of dollar-denominated debt would rise in foreign currency terms, thereby making it difficult for countries with high levels of dollar debt to service those debts, possibly leading to default and resulting international instability. At the same time, a rising dollar may encourage capital flight from weaker countries to the US (see The Economist article, ‘Emerging markets: Reversal of fortune’).
The second risk is that a rising dollar would worsen the US balance of trade account as US exports became less competitive and imports became more so. This may encourage Donald Trump to impose tariffs on various imports – something alluded to in campaign speeches. But, as we saw in the blog, Trump and Trade, “With complex modern supply chains, many products use components and services, such as design and logistics, from many different countries. Imposing restrictions on imports may lead to damage to products which are seen as US products”.
The third risk is that the main beneficiaries of Trump’s likely fiscal measures will be the rich, who would end up paying significantly less tax. With all the concerns from poor Americans, including people who voted for Trump, about growing inequality, measures that increase this inequality are unlikely to prove popular.
That Eighties show The Economist, Free Exchange (19/11/16)
The unbearable lightness of a stronger dollar Financial Times (18/11/16)
- What should the Fed’s response be to an expansionary fiscal policy?
- Which is likely to have the larger multiplier effect: (a) tax revenue reductions from cuts in the top rates of income; (b) increased government spending on infrastructure projects? Explain your answer.
- Could Donald Trump’s proposed fiscal policy lead to crowding out? Explain.
- What would protectionist policies do to (a) the US current account and (b) dollar exchange rates?
- Why might trying to protect US industries from imports prove difficult?
- Why might Trump’s proposed fiscal policy lead to capital flight from certain developing countries? Which types of country are most likely to lose from this process?
- Go though each of the three risks referred to in The Economist article and identify things that the US administration could do to mitigate these risks.
- Why may the rise in the US currency since the election be reversed?
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)
- Explain what is meant by Say’s Law and its implication for macroeconomic policy.
- Why have many governments, including the UK government, been reluctant to pursue expansionary fiscal policies?
- What is meant by the liquidity trap? What is the way out of this trap?
- In the first article above, Eduardo Porter argues that ‘moral views are getting in the way of reason’. What does he mean by this?
- 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?
- What are the dangers in pursuing aggressive Keynesian policies?
- What are the dangers in not pursuing aggressive Keynesian policies?
Here’s an excellent article (the first link below) for giving an overview of macroeconomic thinking and policy since the start of the financial crisis in 2007. It looks at how a Keynesian consensus emerged in 2008–9, culminating in policies of fiscal and monetary stimulus being adopted in most major economies.
It also looks at how this consensus broke down from 2010 with the subsequent problem of rising public-sector deficits and debt, and was replaced by a new, although less widespread, consensus of fiscal restraint.
The article is not just about economic theory and policy, but also about the process and politics of how consensus and ‘dissensus’ emerge. It looks at the spread of ideas as a process of ‘contagion’ and how dissent may reflect the view of different defined groups, such as political parties or schools of economic thought.
Consensus, Dissensus and Economic Ideas: The Rise and Fall of Keynesianism During the Economic Crisis, Henry Farrell (George Washington University) and John Quiggin (University of Queensland) (9/3/12)
Keynesianism in the Great Recession Out of the Crooked Timber, Henry Farrell (9/3/12)
Economics in the Crisis (see also) The Conscience of a Liberal, Paul Krugman (5/3/12)
- What were the features of the Keynesian consensus in 2008–9?
- To what extent can the consensus of that period be described as the result of ‘contagion’?
- Why did consensus break down in 2010?
- How do economic experts play a political role in economic crises?
- To what extent does a lack of consensus benefit politicians?
- Why may the appearance of a consensus be more important in driving policy than actual consensus?
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.
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)
- 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?
Should economists have foreseen the credit crunch? A few were warning of an overheated world economy with excessive credit and risk taking. Most economists prior to 2007/8, however, were predicting a continuation of steady economic growth. Inflation targeting, fiscal rules and increasingly flexible markets were the ingredients of this continuing prosperity. And then the crash happened!
So why did so few people see the downturn coming? Were the models used by economists fundamentally flawed, or was it simply a question of poor assumptions or poor data? Do we need a new way of modelling the economy, or is it simply a question of updating theories from the past? Should, for example, models become much more Keynesian? Should we abandon the new classical approach of assuming that markets are essentially good at pricing in risk and that herd behaviour will not be seriously destabilising?
The following podcast looks at these issues. “Aditya Chakrabortty’s joined in the studio by the Guardian’s economics editor Larry Elliott, as well as Roger Bootle, the managing director of Capital Economics, and political economist and John Maynard Keynes biographer Robert Skidelsky. Also in the podcast, we hear from Nobel prize-winning economist, Elinor Ostrom, Freakonomics author Steven Levitt, and UN advisor and developmental economist Daniel Gay.”
The Business: A crisis of economics Guardian podcast (25/11/09)
See also the following news items from the Sloman Economics news site:
Keynes is dead; long live Keynes (3/10/09)
Learning from history (3/10/09)
Macroeconomics – Crisis or what? (6/8/09)
The changing battle grounds of economics (27/7/09)
Repeat of the Great Depression – or learning the lessons from the past? (23/6/09)
Animal spirits (30/4/09)
Keynes – do we need him more than ever? (26/10/08)
- Why did most economists fail to predict the credit crunch and subsequent recession? Was it a problem with the models that were used or the data that was put into these models, or both?
- What was the Washington consensus? To what extent did this consensus contribute to the current recession?
- What is meant by systemic risk? How does this influence the usefulness of ‘micro’ financial models?
- What particular market failures were responsible for the credit crunch?
- What is meant by ‘rational behaviour’? Is it reasonable to assume that people are rational?
- Is macroeconomics too theoretical or too mathematical (or both)? If you think it is, how can macroeconomics be reformed to improve its explanatory and predictive power?
- Does a ‘really good economist’ need to have a good grounding in a range of social sciences and in economic history?