Co-authored with Michael Kennedy
In 1937 Keynes wrote: “The boom, not the slump, is the right time for austerity at the Treasury.” Jean-Claude Trichet, president of the European Central Bank, disagrees. Stripped of its jargon, his argument last Friday in the Financial Times is that fiscal retrenchment is needed to “consolidate recovery”. This has become the standard European – though not American – line. “Failure to address the deficit is the greatest danger we face,” said UK Treasury minister Lord Sassoon in the House of Lords on Monday, faithfully echoing the words of his master, chancellor George Osborne. But beyond vaguely referring to the need to restore “confidence”, none of the cutters can explain how reducing public spending when private spending is already depressed will “consolidate recovery”.
By contrast, Keynesian theory can readily explain why it will not. The government, Keynes argued, is the only agency that can prevent total spending in the economy from falling below a full or acceptable employment level. If private spending is depressed, it can restore total spending to a reasonable level by adding to its own spending or reducing taxes.
In doing so it will be adding to a deficit that is already the result of falling tax revenues and rising benefits due to the recession. The deficit, though, has the function of sustaining the level of total spending and output in the economy.
Any attempt to reduce it before a strong momentum to private sector recovery is established will make matters worse. Once the economy has started to grow, the deficit incurred during the recession will automatically shrink to a pre-recession level. Deliberate steps to eliminate the “structural” (ie non-recession induced) deficit should be postponed until the recovery is firmly entrenched. With the budget balanced, or even in surplus, at high employment, continued growth will steadily reduce the national debt as a percentage of gross domestic product. This is what happened after the second world war.
In Keynesian theory, monetary and fiscal policy are parts of a single process, not alternatives. In the early stages, money may have to be created to finance the deficit; the spending of this money generates the extra saving needed to “pay for” the investment; the rise in national income improves public revenues, thus helping the deficit to fall.
Contrary to a widespread view, the deficit does not impose a burden on future generations. There is no repayment burden because the government, unlike private individuals, can and normally does repay its maturing debts by borrowing again. (In the last resort, it can print money).
As for the interest burden that is said to arise when the interest is paid by taxation rather than by fresh borrowing, it is merely a transfer payment. Income is transferred from taxpayers to bond-holders. In the case of the UK, most of these bond-holders are domestic. The transfer is therefore a redistribution rather than a loss of income.
If, however, the public deficit is cut now, there will undoubtedly be a burden on both present and future generations. Income and profits will be lowered straight away; profits will fall, pension funds will be diminished, investment projects cancelled or postponed, schools not rebuilt – with the result that future generations will be worse off, having been deprived of assets they might otherwise have had.
The Keynesian theory contradicts the Osborne-Trichet doctrine that private spending is depressed because of fears about the sustainability or future cost of the deficit. The correct causal explanation is that private spending is depressed because total demand in the economy is depressed. The deficit is the consequence, not the cause, of depressed business expectations. It is “nature’s way” of sustaining economic activity in the face of a collapse of business confidence.
Nevertheless, confidence is a psychological phenomenon. Irrational though the fear of a recession-induced deficit may be, it is a fact that governments have to face. So they should aim to maintain total spending in a way that reinforces rather than diminishes business confidence.
One way would be to cut taxes by the same amount as they cut their own spending. This would imply a reduction of taxes by about £100bn over five years. This might appeal to the right, as over a period of years it would reduce the size of the state. But the effect of tax-cutting on economic activity is uncertain. A better way would be to offset any market-appeasing cuts in current spending by an increase in capital spending. A recession is an ideal time to “bring the country up to date”, since labour and capital will both be cheaper than in boom times.
The £38bn high-speed rail link from London to Birmingham and beyond, unveiled in March by Lord Adonis, the former transport secretary, is a perfect example. Like the smaller rail electrification schemes, it is not “shovel ready”, but a determined government could get it going long before the planned start in 2017. It would set up an immediate demand on the construction industries while also offering returns in the long run.
Former chancellor Alistair Darling’s scheme for a Green Investment Bank to invest in renewable energy and energy efficiency is another example. Industry experts predict that up to £37.5bn will be needed each year to upgrade or replace our old power plants over the next decade. Mr Darling’s £2bn plan was a step in the right direction – a step that was then retracted in Mr Osborne’s Budget.
A government whose animating spirit was Lloyd George rather than George Osborne would ask the public to subscribe to a National Recovery Loan of £100bn, to be spent over five years, to equip the UK with a modern transport system, energy-efficient housing and new power plants, and up-to-date schools. Austerity in the capital budget is the worst possible remedy for a slump.
Michael Kennedy is a former economic adviser at the Treasury. Lord Skidelsky is professor emeritus at Warwick University