Recent US growth figures seem to have re-energised naive Keynesians who, lacking any real evidence or credible prior theory for their case, leap upon anything that can justify policies that involve increasing government borrowing further. More sophisticated Keynesians have something to offer to the debate about how we can deal with sticky prices during a recession, but their voices are drowned out by their naive Keynesian allies.
There are three arguments that are worth examining here, two of which come from one of Larry Summers’ 2012 Davos speeches.
He suggested that an expansionary fiscal contraction was a moronic idea. This is not true. A country that borrows more money has to fund that borrowing. One would expect from prior theory that a country with well developed capital markets, an open economy and floating exchange rates would not have a significant positive fiscal multiplier. If a government borrows more, that borrowing has to be funded. Capital is attracted from other parts of the capital market, thus making it more difficult for business to fund its borrowing. Alternatively, capital is sucked in from overseas and the real exchange rate rises. This is not a moronic argument: it is borne out by the empirical evidence. For countries that are already highly indebted, the situation is worse. The more indebted a country is, the more likely it is that people will rein in their consumer spending if government spending increases because it will be known that the so-called fiscal expansion will have to be reversed rapidly with an increase in taxes. The best that can happen from a so-called fiscal expansion in current circumstances is a very temporary boost to growth, followed by a rapid slowdown as the brakes are put on just as we start crawling out of recession. Perhaps 2011 is the price we are paying for 2009.
Summers also suggested that no country had pulled out of the Great Depression except through leaving the Gold Standard or through rearmament. Leaving the Gold Standard involved loosening monetary policy – it had nothing to do with fiscal expansion. Indeed, the one country that tried a fiscal expansion to pull itself out of the Great Depression – albeit very erratically – had the longest Great Depression of any developed country. That country was the US. The UK, on the other hand, grew rapidly just after leaving the Gold Standard whilst never having a budget deficit of more than one per cent of national income. Fiscal policy simply did not enter into the equation. In the UK, the Great Depression was finished before Keynes published General Theory.
Thirdly, naive Keynesians are pointing to the relative performance of the US and UK economies – the former has been following the approved policies and the latter has not, according to them. Why do they not examine Germany, one wonders? Let’s come to Germany in a moment. UK and US unemployment rates are more-or-less identical – and this is quite unusual, the US rate is normally lower. So, certainly, the two unemployment rates do not point to the success of ‘fiscal expansion’. The US economy has grown more rapidly and is four per cent bigger relative to the ‘crash position’ of four years ago compared with the UK economy. However, US government spending is about ten per cent of GDP lower as we have imitated the sluggish continental countries by raising government spending to 50 per cent of national income. Most studies suggest that a one percentage point of GDP increase in government spending reduces growth by 0.1 per cent. The differences in government spending levels alone would therefore explain the relative differences in performance between the UK and US economies. Indeed, a difference in growth rates of one per cent per annum between the US and the EU is fairly typical and certainly not explained by the former's attachment to Keynesian policies. Also, the eurozone crisis is not irrelevant to this debate – the crisis has affected UK growth to a far greater extent than US growth.
But, let’s put all this to one side and assume that the growth can only be explained by differences in fiscal policy. What are those differences? There aren’t any! US and UK government borrowing are more or less identical. And, as Jeremy Warner pointed out in the Telegraph on Saturday, the change in the government fiscal position has also been more-or-less identical after you take into account the spending behaviour of the states in the US. The argument that identical rates of unemployment, differing growth rates and identical fiscal balances and changes in those fiscal balances in two countries clearly demonstrate that higher government borrowing leads to higher growth is just silly. Oddly enough, of course, Germany seems to be booming with much lower government borrowing and, for the first time in a generation, has lower unemployment than either the UK or the US. None of this proves that government borrowing does not lead to higher growth but, it has to be said that our opponents in the economics profession are not running very sophisticated arguments.
Interestingly, though, Ed Balls does try to run a more sophisticated version of the Keynesian position – or rather a version laden with more sophistry. He argues that the economy is slowing in the UK ahead of the proposed fiscal retrenchment because people are preparing for it by reining in spending. If this argument is true, however, it suggests highly sophisticated behaviour on the part of households – exactly the sort of highly sophisticated behaviour that naive Keynesians assume away in their models in general and which would make Keynesian solutions irrelevant. Surely, if people are reducing spending today because they expect a fiscal retrenchment tomorrow, they would rein in their spending today if there were an unsustainable fiscal expansion today - in anticipation of the inevitable rise in taxes to pay for the borrowing. Balls is just running a version of Ricardian equivalence for when it suits him.
Of course, Keynesian economics is all about having your cake and eating it – but Ed Balls’ position certainly takes the biscuit.
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