A Keynsian case for cutting the deficit
Civitas, 21 September 2010
Several commentators have been raking Nick Clegg over hot coals for his supposed conversion from Keynsian economics to becoming a ‘deficit hawk’. They argue that Keynsian policies, still dominant in economic thought, require more deficit spending in order to stimulate the economy during a fragile recovery, or else risk a double-dip recession. However, as Prof. Scott Sumner argues, even on robust Keynsian assumptions, additional Government spending is unlikely to work as stimulus right now.
The global financial crisis probably had two main components. The first was a real destruction of wealth through malinvestment in various sectors (especially housing in parts of the United States). Too much wealth was sunk into economic activity that turned out not to be anywhere near as useful or as safe as expected. The second component was nominal. When these investments went pop, an awful lot of credit went with it, reducing liquidity. This caused banks to hoard cash rather than continue lending. In essence, there was suddenly much less money (or at least credit that people treated exactly the same as money) flowing around the financial system: a nominal shock.
This is where the Government comes in. It cannot do all that much about the first component of the crisis. The wealth has already been destroyed through bad investments, and we have little choice but to try to generate fresh economic growth. However, the nominal problem might be amenable to Government intervention. Before the crisis, businesses and individuals were making contracts and agreeing wages with certain expectations about the future availability of money, interest rates and inflation. Many of these decisions took place in sectors that had little or nothing to do with the malinvestment. However, when the crisis hit, their plans were thrown into disarray. Borrowing became more difficult, and the value of money even started to increase (deflation), because of this sudden lack of liquidity. These purely nominal changes threaten the viability of otherwise perfectly well-functioning businesses.
Facing this problem, the Government has two main types of response: fiscal policy (public spending) and monetary policy which is currently handled in the UK by the formally independent Bank of England. The standard lever of monetary policy is to lower interest rates to encourage lending. However, when that isn’t enough, it can engage in so-called ‘unconventional monetary policy’, like quantitative easing (increasing funds available to banks). In doing so, the Bank of England could aim at a particular target such as a steady inflation rate, or rate of Nominal GDP growth. This helps to re-establish expectations allowing the economy to recover.
Of course, a Government can use fiscal policy (borrowing and spending) instead of or alongside a pro-active monetary policy to improve nominal GDP. But this has disadvantages. It means that Government runs up debts which eventually have to be paid off, leading businesses and individuals to expect punitive future tax rises, higher inflation or even a sovereign debt crisis. This reduces their eagerness to re-invest. In addition, it doesn’t target the central problem of bank lending as effectively as quantitative easing. Once the Government has spent the money, it can still end up being hoarded by banks. This means that if you have a monetary policy that is tackling the problem of liquidity already (which the Bank of England has been more than willing to enact), then deficit spending isn’t doing much to improve the economic outlook. Instead it could be generating problems for the future.
As Scott Sumner explains, this is what ‘Keynsian’ economics text-books have been saying for sometime now. It is also why Mervyn King, Governor of the Bank of England, seems untroubled by news of the Coalition’s planned cuts. Monetary policy can make up for any drop in nominal output that a more austere fiscal policy may produce.