On Wednesday in his Autumn Statement George Osborne, the chancellor, is expected to admit that it will take three more years of austerity than originally planned to bring borrowing under control. Extravagant hopes are being placed on Mark Carney, the newly appointed Bank of England governor. There will be talk of an incipient recovery meeting “headwinds from the eurozone” and comfort will be taken from the thought that things could be a lot worse.
Of course, the crises in Europe and elsewhere have not helped. But the reasons for the failure of austerity and of quantitative easing to revive the economy lie deeper than headwinds. The chancellor’s policy is based on the wrong theory of the economy; the BoE’s on the wrong theory of money. Failure was predictable. This is not retrospective. A few of us who are proud to be Keynesians have been predicting failure for two years and more, before these headwinds appeared.
The Osborne recipe for recovery was based on the Treasury View, which Keynes confronted when arguing for public works during the Great Depression. The Treasury then argued that extra government spending would take away resources from the private sector; and even if there were spare resources, the loss of confidence and associated rise in long-term interest rates would far outweigh any stimulative effect of the extra spending.
Continuing the same line of thought, Mr Osborne’s Treasury has argued that reduction in the deficit would “crowd in” the private sector by freeing up the capital and labour appropriated by the public sector and by “restoring confidence”, so reducing long-term interest rates.
Keynes would have claimed otherwise: that cuts would reduce the level of total spending in the economy and thus perpetuate the slump. This has happened: the economy has been flat for two years and large parts of it outside London and the southeast are sinking.
The BoE’s mistake has been to believe it is the supply of money that is critical for economic recovery; Keynes said it was the demand for money. In 1936 he wrote: “If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip.” These slips have been much in evidence. By printing money, the BoE aimed to increase spending through various channels: portfolio rebalancing, increased bank lending and, more vaguely, “confidence” that the BoE would not let the money supply collapse. But the money supply did collapse; some of the money has been invested in speculative assets; most of it remains stuck in banks and companies.
This does not come as a surprise to Keynesians. We have argued that banks create deposits in response to the demand for loans. The demand for loans depends on market expectations. If businesses see no market for their products, they will not borrow whatever the interest rate and the BoE cannot force them.
Unfortunately, both the Treasury and BoE are running out of ammunition. Mr Osborne has staked his credibility on the success of his deficit reduction programme. He has to go on pretending that foul is fair.
The BoE is fettered by its inflation target. The appointment of Mr Carney may be a masterstroke, however what the BoE needs is not a magician but a new mandate.
So where does that leave the economy? Without a change of policy it will not grow. And this is not just a temporary interruption of progress. The longer the economy remains stuck in semi-recession the weaker it becomes. Labour skills rust; the capital stock is not renewed. Each extra month the economy remains flat, its output potential is weakened.
What is to be done? If I were chancellor of the exchequer, I would immediately restore the programmes of capital investment cancelled by Mr Osborne and his predecessor Alistair Darling, accelerate infrastructure projects now in the pipeline and expand the programme of the Green Investment Bank. This would add about £100bn to aggregate demand, galvanising industrial supply chains.
The programme could be financed in various ways. I would borrow directly from the BoE for the government’s own capital programmes. To allow for their monetary financing I would give the bank a new nominal income target of (say) 5 per cent to replace the existing target of 2 per cent inflation.
I would also set up a National Investment Bank, whose mandate would be to borrow from the pension and insurance funds for revenue-generating infrastructure projects, and which could offer a higher rate of return than obtainable from gilts.
Of course there are risks. These would be mitigated if the expansionary impulse could be co-ordinated with other countries. I would go to Brussels and seek agreement to a Europe-wide reversal of the austerity policy. But I would judge the risks of reversing austerity less than the risk of continuing policies that are slowly strangling our economic life.