This essay, published in the New Statesman, is based on a lecture hosted on 19th September by the Progressive Economy Forum, of which Lord Skidelsky is a Council member.
Labour has always been set a higher standard on the economy than the Conservatives: it had to be more orthodox, more competent, more successful to win equal praise or escape equal blame. The reason is not hard to find: created and financed by the trade unions, and committed to the abolition of capitalism, the Labour Party faced obvious difficulties in guaranteeing what John Maynard Keynes called a “political and social atmosphere congenial to the average business man”. Not that it necessarily wanted to: it was torn between wanting to “manage capitalism” better than the Conservatives and the desire to achieve socialism.
Between 1945 and 1975 Keynes solved the problem. Keynes offered a middle way between capitalism and socialism. Macro-economic policy would secure growth and full employment. Sufficiently strong trade unions and redistributive taxation would ensure that the fruits of growth were fairly shared. Under Keynesian social democracy, the “average business man” would no longer call the shots.
A key text of this period is Anthony Crosland’s The Future of Socialism (1956). Socialism, he said, was not about public ownership, it was about equality and fraternity. Public ownership was no longer an important means for achieving socialism’s goals. This was because the old capitalist economy had been replaced by a mixed economy of public and private sectors. The significant players in the private sector were managers, not owners, and their aim was survival not profit maximisation. Capitalists had become pussycats.
I am caricaturing, but not by much. The idea that a combination of Keynesian government, the managerial revolution, and strong trade unions had modified the nature of capitalism was common on both sides of the Atlantic.
We need to add one further modification, not much mentioned at the time: there was a high level of tariffs, which shielded both employers and employees from international competition, and capital controls. Globalisation was still far in the future.
The former Labour leader Hugh Gaitskell failed in his attempt to implement Crosland’s message by abolishing Clause IV of the Labour Party’s constitution, which pledged it to the common ownership of the means of production, distribution, and exchange. But Gaitskell’s successor, Harold Wilson, brilliantly repositioned Labour as the party of economic growth, of science and of the upwardly-mobile professionals, as against the Conservatives who had produced “13 wasted years”.
“Economic growth,” Wilson said in 1963, “sets the pace at which Labour can build the fair and just society which we want to see.” Economic growth would be achieved by Keynesian demand management in the context of a medium-term plan for growth.
However, Labour desire to make itself seem more orthodox than the Conservatives led to the biggest mistake of Wilson’s premiership, the failure to devalue the pound in 1964. In a remarkable pre-run of George Osborne’s austerity, it caused three years of stagnation and a lower growth rate over the six years of Labour government, from 1964 to 1970, than that achieved by the Conservatives. Labour was then left to pick up the pieces of the Conservatives’ mismanagement of the economy between 1970 and 1974, before being swept away by Margaret Thatcher and her revolution. James Callaghan sounded the funeral note of the social democratic era when he declared in 1976: “We used to think that you can spend your way out of recession… I tell you in all candour that that option no longer exists, and that insofar as it ever did exist, it only worked on each occasion by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment.”
A new story had taken hold. The narrator was Milton Friedman, and it frustrated the left’s hopes of “building the fair and just society which we want to see”.
To get a sense of the constraints facing the Blair-Brown governments of 1997-2010, we must grasp the momentous shifts in the climate of opinion in the 1980s and 1990s. These resulted in the dismantling of the intellectual and institutional structure on which the left relied to achieve its goals. (They also destroyed the basis of Harold Macmillan’s Tory paternalism.)
The main signposts on the road were: first, Milton Friedman’s assault on Keynes and the rise of monetarism. Friedman claimed not only that Keynesian policies of full employment led to inflation, but that, provided inflation was controlled, the economy would be cyclically stable at its natural rate of unemployment. That is to say, uncontrolled money was the one flaw in an otherwise optimally self-regulating market system. Friedman’s further claim that inflation was a purely monetary phenomenon also ruled out as futile Keynesian attempts to restrain the rise in prices by trying to limit the rise in costs (“incomes policy”).
In the British version of monetarism, the source of inflation was budget deficits: hence the demand for balanced budgets. Since voters were opposed to higher taxes, budget balance implied cutting down on public services.
Second, and parallel to this, was the rise of “public choice theory”, or the “economics of politics”. This claimed that politicians and civil servants were mainly motivated by self-interest rather than by any concern for the public good. Bureaucrats aimed to line their departmental pockets; politicians to maximise their votes. It would be best to avoid discretionary policies altogether. This theory of “government failure” provided a powerful argument for a limited state, in which politicians were restrained by fiscal rules, and policy placed in the hands of independent central banks. A third influence was “supply-side economics”, sometimes called Reaganomics. Its aim was to remove high marginal tax rates in order to improve the incentives to work and save; and to remove labour market rigidities in order to lower the natural rate of unemployment. Increased inequality and curtailment of welfare entitlements were necessary consequences of both, but by raising the growth rate such policies would improve the lot of all.
Fourth, people started reading Friedrich Hayek again. In The Road to Serfdom (1944) Hayek had claimed that Keynesian social democracy was the slippery road to totalitarianism. The rapid growth of the state from the 1960s suggested that Britain and other Western democracies were well along this path.
Finally, the collapse of communism in the late 1980s opened the road to globalisation.
Changes in the structure of the British economy, partly inevitable, partly contrived, weakened the institutional bases of Keynesian social democracy. The decline of the white working class eroded Labour’s traditional class base. The replacement of a manufacturing-based economy by a service-based one led to a deunionisation of the British labour market. And then there were Margaret Thatcher’s labour market laws, sale of council houses, privatisation policies and the liberation of finance.
We need an urgent analysis of the reasons for the overthrow of Keynesian social democracy. I reject the simple Friedman story that it was because it was inherently inflationary. There was a strong input of anti- state ideology. Nevertheless, the Friedman story became the accepted version.
The new orthodoxy was given classic expression in Nigel Lawson’s Mais Lecture of 1984: “It is the conquest of inflation, and not the pursuit of growth and employment, which… should be the objective of macroeconomic policy. And it is the creations of conditions conducive to growth and employment, and not the suppression of [inflation], which should be the objective of microeconomic policy.”
This amounted to the theoretical abolition of the Keynesian revolution.
Labour’s macroeconomic framework 1997-2007
Faced with an intellectual climate and economic structure hostile to the left’s political project, Blair and Brown – after having finally got rid of Clause IV in 1995 – endorsed and to a large extent devised a macroeconomic framework which aimed to portray the economy as being “safe” in Labour’s hands. This built on the new orthodoxy. The Bank of England Act of 1998 mandated the bank to “maintain price stability” and empowered it to set the level of official interest rates independently of government.
For fiscal policy, Gordon Brown’s “golden rule”, announced in 1997, was that “over the economic cycle, we will borrow only to invest and not to fund current spending”. To this was added a “sustainable investment” rule: “public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.” These were tougher than any rules the Conservatives had set for themselves.
Labour also adopted an “active” version of “supply-side” policy. It aimed not to de-regulate labour markets but to equip workers with higher skills through government training and work programmes. The traditional left-wing goal of reducing inequality was replaced by a pledge to end absolute poverty.
Over the ten years from 1997 to 2007 the new macroeconomic dispensation seemed to work reasonably well. Labour stuck to its fiscal rules. Unemployment and interest rates fell, growth was reasonable. Inflation was subdued. However, this good record masked three troubling weaknesses, and left one important question unanswered.
First, balance on the budget’s current spending was achieved by redefining when cycles started and ended, and by balancing early surpluses against later deficits.
Second, capital spending was kept within the prudent 40 per cent debt/GDP ratio by extensive use of the Private Finance Initiative (PFI) to build hospitals, schools and some extensive transport projects. PFI replaced spending financed by issues of public debt with spending undertaken by private firms, for which they were repaid by leasing agreements with the government over a period of up to 30 years. PFI added nothing to current public debt, but enlarged future public debt.
Finally, the government relied unduly on the inflated profits from the property boom and financial sector to balance its books. When tax receipts from these sources fell sharply during the crisis of 2008, the public sector was revealed as having lived beyond its means. New Labour’s pact with the Mephistopheles of high finance ruined it in the end. In practice, the maintenance of full employment over the Blair-Brown years depended on sleight of hand; publicly subscribing to the new orthodoxy, but trying to get a bit of Keynes through the back door.
The unanswered question is whether monetary policy actually worked. Mervyn King, governor from 2003 to 2013, conceded that the Bank of England had benefited from a “nice environment”. Most economists now think that inflation was kept low not by central bank policy but by the entry of billions of low-wage east Asian, mainly Chinese, workers into the global labour market. These, together with Thatcher’s trade union reforms, subdued wage, and consequently price, pressure.
The failure of prevention and cure
It’s pretty obvious in retrospect that the requirements for maintaining economic stability were grossly underestimated. Friedman’s doctrine that if inflation was controlled, the macroeconomy would be stable ignored Keynes’s crucial insight that investment prospects are inherently uncertain. Macroeconomic policy, he said, therefore, had a decisive role to play in maintaining growth and employment.
Further, he argued that monetary policy on its own was too weak either to prevent a collapse or produce a recovery. So fiscal and monetary policy had to be coordinated. The new orthodoxy discarded these insights.
Pre-crash fiscal policy deprived the budget of any active role in demand management. Once the economy collapsed in 2008, fiscal policy was briefly brought out of retirement, but soon put back in its box. The reason is that in rescuing banks from disaster in 2008-09, the government transformed a great deal of private debt into public debt. Conservative rhetoric was then able to reverse the causation: the crisis was caused by the build-up of public debt under Labour, and could only be resolved by cutting the deficit to zero as quickly as possible.
Of all the arguments supporting the Cameron and Osborne austerity policy (backed by the Liberal Democrats in government), the one that resonated most was that the government was like a private household. Everyone knows, so ran the argument, that if a household’s income falls it has to reduce its consumption. It can borrow temporarily, but the loan must be paid back by saving even more. The same was true for a government. If its revenue falls, as a result of the slump, it needs to cut its own consumption. Any temporary borrowing should be repaid as quickly as possible. This was the logic of Osborne’s austerity programme.
The obvious reply is that the government is not like a household. If a single household cuts its spending this will affect only itself. If the government – which spends 40 per cent of the national income – cuts its spending, it affects everyone else’s spending, because the government’s spending is part of almost everyone else’s income. Therefore, the correct policy in a slump is for the government to increase its deficit not reduce it.
Given the political difficulty of putting this message across, one would think that the economics profession would have been shouting it from the rooftops. But this was no longer the Keynesian economics profession. The economists were hopelessly entangled in doctrines that either stated that the economy was always at full employment – and therefore extra government spending would simply be taking away money already being used by the private sector – or that failure to slash the deficit would lead to a flight of money from the country, leading to a rise in all interest rates, including the government’s. The claim that the national debt was a burden on future generations was allowed to run unchallenged, despite the fact that government borrowing that prevents lost growth benefits future generations.
Conversely, the Italian economist Alberto Alesina, of Harvard and Bocconi universities, achieved instant fame in 2010 by promising European finance ministers that a “credible programme of deficit reduction”, particularly cutting spending on the poor, would soon reverse the slump as private business regained the “confidence” to invest.
The consensus today is that Osborne’s “expansionary fiscal contraction” delayed recovery by at least two years. Its cumulative effect over six years was to destroy productive capacity and leave households £4,000 to £13,000 poorer than they would have been had the government properly stepped into the breach. Theresa May says austerity is over. This is welcome news. But a decade of cuts has eaten away at social and capital spending, and soured the public realm.
Only a tiny minority of economic commentators in the UK stood out against the gadarene rush to austerity: Martin Wolf of the Financial Times, Larry Elliott of the Guardian, William Keegan of the Observer, and David Blanchflower of the New Statesman. I also attacked Osbornism from the start, sometimes in these pages. I remember during a dinner with the American economist Paul Krugman in 2012, he asked, “What’s wrong with your economists?” It is a dismal episode.
The failure of monetary policy was equally palpable. The pre-crash story is quite simple. Prices were stable, but money was set free to wreak havoc in the financial system. Why was this?
Extraordinary as it now seems, the Bank of England’s main macroeconomic model between 2004 and 2010 omitted banks from its grouping of key economic agents. This was the result of treating banks as mere intermediaries between utility-maximising households and profit-maximising firms. Captivated by the idea that money plays only the part allotted to it by the monetary authority, central banks failed to identify the build-up of debt in the financial sector, a fragility made worse by the octopus-like spread of derivative instruments.
The lack of special attention to the financial sector had a specific basis in Eugene Fama’s efficient market theory. According to Fama, all the risks run by banks are calculable, and therefore all the loans they make will be accurately priced on average: any mistakes would cancel each other out. Banks could thus be safely left free to roam the world, placing their bets where they wanted. Little wonder that Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006, later admitted that the “under-pricing of risk world-wide” had destroyed his intellectual system. The reason is that his intellectual system had never distinguished between risk and uncertainty.
After the crash, quantitative easing (QE) was designed to offset fiscal contraction. The central banks of the world, led by the Fed and the Bank of England, started buying up government debt on a huge scale. Their purpose was so to enrich the holders of government bonds that they would start lending or spending to the extent needed to restore full employment. Here too they ignored Keynes’s warning that “money plays a part of its own”. He wrote in 1936: “If 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.” In other words, central banks ignored the existence of “liquidity preference”, the preference for holding assets in liquid form, rather than buying current goods and services.
Though some of the new money trickled into the economy, much of it went into cash reserves or purchasing liquid assets. Today we are left with a whole lot of speculative cash sloshing round the global financial system, setting the scene for the next crash.
The macroeconomic consequences of rising inequality
Was the financial crisis structurally determined? It was too extreme to be a random shock. As with many forms of cancer, one can detect predisposing factors. The one I would single out for economic diagnostics is rising inequality. This was partly the result of supply-side economics, whose aim was to lift the growth rate by redistributing wealth and income from the poor to the rich.
The flaw in this strategy should have been obvious. The rich save a higher fraction of their incomes than the poor. Growing inequality thus creates a contradiction. The more unequal the society, the greater the investment needed to keep the economic machine going; yet the smaller are the earnings available to buy the increased output from the investment. Hence, barring steps to reduce inequality, consumption will become increasingly dependent on debt; and the savings of the rich will be increasingly employed in speculation rather than in expanding the output of consumer goods.
Something like this happened in the run-up to 2008, exacerbated after by the lopsided nature of quantitative easing. Advanced country data show a sharp rise in the share of the post-tax income going to the top 1 per cent; real hourly earnings lagging well behind the growth in labour productivity; a fall in the share of median, or typical, family income as a percentage of average family income; and a fall in the share of wage income in GDP.
Thus, the main effect of the Reagan-Thatcher supply-side reforms was not to speed up the rate of growth, but to speed up the growth of private debt. In the UK, household debt (consumer debt plus mortgages) rose from 70 per cent of GDP in the 1980s to 148 per cent in 2008. Financialisation – a measure of the ratio of financial transactions to total economic transactions – rose from 70 per cent of GDP in advanced economies in 1980 to over 450 per cent in 2011. With huge inflows of Chinese money keeping interest rates low, cheap access to credit became the new form of the social contract.
Thus the excess credit creation, which Hayekians see as the cause of the financial collapse of 2007-08, can, on further reflection, be seen to be rooted in the stagnation or decline in consumption from earnings. Consumption smoothing – consuming expected future wealth today – produced its nemesis in 2008.
What needs to be done
The failure of post-Thatcherite economic orthodoxy impels the left to rethink its economic strategy. At the centre of this rethink should be the reinstatement of Keynesian social democracy. This cannot be identical to the policies of the 1960s. Globalisation has changed the structure of the world economy. New problems have emerged – especially global warming, population ageing, and the replacement of human labour by machines. Nevertheless, certain principles of the old policy remain as relevant as ever.
The most important is that prevention is better than cure. Once a downturn gathers momentum, the scale of intervention needed to reverse it becomes frighteningly large. Budget deficits balloon, public debts soar, governments take over banks – all conjuring up visions of looming state bankruptcy, or worse, state control over the economy. So the most important question is: how can such catastrophes be stopped from happening?
By prevention, I do not mean trying to stop the semi-regular fluctuation of 1 per cent to 2 per cent of nominal income over, say, a ten-year business cycle. There is no point in trying to “fine tune” the cycle: one never knows exactly where one is within it, or how long it will last.
I mean preventing economic collapses in the order of 5 to 10 per cent of GDP and an unemployment rate double or treble that of “normal” times. These can happen at any time, because, as Keynes taught, the future is uncertain, and any number of unanticipated small events can have large effects. Moreover, these effects linger on for years, diminishing growth and souring politics.
It was the rapid spread of contagion through the banking system that brought the world economy low in 2008. So the question is: has the banking system been made less risky?
To some extent: capital and reserve requirements have been beefed up, big banks are now subjected to stress tests and the downside of financial innovation is increasingly recognised. But the big reform has not happened: which is to cut the international links between the banks. This is the only way to stop contagion from spreading worldwide.
We need to get back to the idea that deposit-taking, or “high street”, banks should be public utilities, doing mainly domestic business, not parts of global financial supply chains. For example, the Bank of England should limit their exposure to foreign risks. By contrast, investment banks should be left free to place their bets wherever they want, but they should not be bailed out by the taxpayer if they fail. Securitisation – the process of selling the cash-flow from, for example, mortgage loans to third parties – should be reined in. The aim should be to make the banking system less inventive, but safer.
There is a case for looking again at capital controls. A Labour government, elected on a radical programme, is likely to face a flight of capital. Is it right for the financial sector to have a veto over policies they dislike? A balance needs to be struck between the freedom of people to take their money out of the country and the right of a government to implement the programme on which it was elected.
More fundamentally, the task of making banks “resilient to shocks” depends on making economies resilient to shocks. The healthier the lifestyle of an economy, the less likely it is to have a diseased banking system. An economy that can only be kept going by accumulating private debt cannot enjoy a healthy banking system.
I would reverse the Nigel Lawson dictum. The aim of macroeconomic policy should be the pursuit of growth and employment. It should do this by keeping market economies continually closer to their production and employment frontiers than they would achieve on their own.
This requires reinserting the state into the management of the economy in two ways: by expanding the source of investment funds and by making strategic changes to the distribution of income: the twin components of Keynesian social democracy.
Governments should, through means of a Public Investment Bank, and their own capital budget, guarantee the economy a sufficient stream of new capital construction to offset the speculative character of much private investment, and not be put off by the spurious argument that public authorities are bound to “pick losers”. They sometimes do – and so does the private sector. The European Investment Bank is a model of what a competently run public investment bank can achieve.
The central bank mandate should simply be to support the economic policy of the government. It is for democratically accountable government to balance total demand and supply in the economy. The central bank’s distinctive function should be to ensure financial stability.
Governments must also take much bolder steps than any yet contemplated to reverse the concentration of wealth and income, and not be put off by spurious arguments about reducing the incentives to save and work. In other words, we should set about restoring an economy whose people can “pay their way” without having to take on more and more debt.
Other reforms are needed beyond the scope of any national authority. But the British government should at least press for the reform of the international payments system to bring pressure on trading partners to balance their current accounts, as Keynes proposed in 1941. Balanced international accounts will make exchange rates more stable and reduce the flow of speculative funds. Without such a reform, trade and currency wars will become almost inevitable.
Today especially, it is necessary to repeat Keynes’s warning that bad economics produces political extremism. By bad economics I mean allowing financial markets to dictate what happens to economies. By good economics I mean recognising the duty of governments to protect their people – even the inefficient ones – against misfortune, insecurity and calamity.
If good politics neglects these matters, then bad politics will step in to provide its own answers.
Robert Skidelsky’s “Money and Government: A Challenge to Mainstream Economics” (Allen Lane) has just been published