Keynes would be on our side
Vince Cable argues that although everyone claims to be a Keynesian, the coalition’s strategy of libe
If anyone doubted it before, recent months have proved decisively that coalitions are quite consistent with radical policy change. What matters now for British politics is whether the coalition government's economic policies deliver a sustainable recovery.
The most controversial part of the debate relates to the speed at which the fiscal deficit should be corrected. It is not, however, a controversy within the coalition. The structural deficit is over 6 per cent of GDP - meaning that, even once the economy has recovered fully, the government would still be borrowing almost £100bn a year. In September 2009, I argued in a Reform pamphlet that, in balancing the risks of too rapid adjustment (threatening recovery) or delaying it (precipitating a deficit funding crisis), the next government should try to eliminate this deficit over five years. Now we are in government, that is exactly what we plan to do.
Despite all the controversy, the boundaries that define this debate are relatively narrow. The outgoing Labour government was already planning a fiscal tightening of 1.5 per cent of GDP in 2010/2011. The difference between its deficit reduction plan beyond 2010/2011 and that of the coalition amounts to roughly half a per cent of GDP per annum: well within the forecasting error. Such differences, though not trivial, hardly justify the titanic clash of economic ideas advertised in the commentaries or a threatened mobilisation of opposition comparable to the General Strike. For all the protesters shouting "No to cuts", this electoral term would always have been about public-sector austerity, no matter who won the election.
As in many economic policy disputes, much of the ideological rhetoric conceals different forecasting assumptions - in respect of the cyclical, as opposed to structural, deficit; the influence of asset prices on consumer behaviour; the impact of the unorthodox monetary policy of quantitative easing (QE) and its interaction with the velocity of circulation of money; and the weight to be attached to business confidence and sentiment in financial markets. Amid such uncertainty, economic policymaking is like driving a car with an opaque windscreen, a large rear-view mirror and poor brakes. To avoid the trap of self-justifying, competitive forecasting, the government has subcontracted its forecasts to an independent body, the Office for Budget Responsibility (OBR). As it happens, the OBR has produced the reassuring estimate that, on plausible assumptions, growth should improve, unemployment should fall and fiscal consolidation should ease to safe levels over the five-year life of this parliament. But even such an independent body can only point to a range of probabilities.
This lack of solid ground has failed to discourage serious people from invoking different economic philosophies to justify polarised positions. Increasingly, the debate is characterised in terms of John Maynard Keynes (in the "left" corner) v the reincarnations of his 1930s critics (in the "right" corner). Whatever their motivations, Nobel prizewinners and other economists are lining up with party politicians to re-enact the dramas of 80 years ago, like history buffs dressing up in armour to relive the battles of the English civil war.
This politicisation is odd, because Keynes was a liberal, not a socialist (nor even a social democrat). He showed no fundamental discomfort with the then modest levels of state spending in the economy, which amounted to half of today's level as a share of GDP. Keynes's policies were intended not to overthrow capitalism but to save it from a systemic malfunction - the problem of insufficient aggregate demand.
Despite the mischaracterisation of Keynes as a friend of socialism, the ongoing debates are valuable insofar as they illuminate vital bits of theory and evidence. In a recent New Statesman essay (25 October 2010), Robert Skidelsky provides a very good exposition of the Keynesian interpretation of current problems and solutions. I would like to continue the debate but argue that Keynes would be on my side, not his.
The main theoretical issue is what determines investment. As illustrated in the OBR's forecasts, growth is expected to come from a large increase in private-sector investment, after decades in which ever-increasing consumption has borne too much of the burden of fuelling growth. Keynes, too, was consistently preoccupied with how to sustain investment as the motor of economic growth and employment. The specific problem he grappled with was what happens during a slump, when intended saving seriously diverges from intended investment, such that there is a pool of excessive savings, which, in turn, depresses spending and the willingness of business to produce and employ workers.
The orthodox response was that interest rates would fall, increasing investment and reducing savings, thus restoring balance. Flexible wages would operate to restore full employment. Keynes showed that, sometimes, this equilibrating mechanism may not work without government intervention to support demand, particularly when deflationary conditions pertain. During periods of weak expected demand, consumers and businessmen hold back from spending and reinforce the deflationary trend. This is the mistake that governments of the interwar period perpetrated.
Few would now deny that Keynes's insight was correct, and it was put to good use in the co-ordinated global response to the financial crisis two years ago. This response reflected an understanding that, while Keynes's original analysis was based on a model of a closed economy, today's investment/savings imbalances manifest themselves at a global level (with the UK, like the US, importing savings). Nonetheless, modern Keynesians claim to hear the echo of a long-dead 1930s controversy in the coalition government's policy of seeking an investment-led recovery and at the same time reducing state-financed demand, through cutting the government's current spending and increasing tax receipts.
Skidelsky concludes his essay by quoting Keynes, writing on investment in 1932, in the depths of the Great Depression: "It may still be the case that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn . . . There will be no means of escape from prolonged and, perhaps, interminable depression except by direct state intervention to promote and subsidise new investment."
In other words, there are times when only through government spending will the economy gain the growth in expected demand necessary to drag it out of a slump. The deflationary 1930s were certainly one such time. The question, however, is what relevance that insight has today.
Decision-making has to be evidence-based rather than dogmatic. At a macroeconomic level, there is now a wealth of experience of postwar fiscal adjustment in developed-market economies - more than 40 examples since the mid-1970s. This experience provides strong empirical support for the view that decisive rather than gradual budgetary adjustments, focusing on spending cuts, have been successful in correcting fiscal imbalances and have, in general, boosted rather than suppressed growth - the experience in Denmark in the 1980s, for example, as Francesco Giavazzi and Marco Pagano argued in 1990. A recent study by the International Monetary Fund determines that fiscal consolidation does, indeed, boost growth and employment but only in the long term (five years or more) and may have negative effects in the short run.
The overall conclusions are non-Keynesian. What explains this? One plausible explanation, from Olivier Blanchard of the IMF, is that the Keynesian model of fiscal policy works well enough in most conditions, but not when there is a fiscal crisis. In those circumstances, households and businesses react to increased deficits by saving more, because they expect spending cuts and tax increases in the future. At a time like this, fiscal multipliers decline and turn negative. Conversely, firm action to reduce deficits provides reassurance to spend and invest. Such arguments are sometimes described as "Ricardian equivalence" - that deficits cannot stimulate demand because of expected future tax increases. While David Ricardo's name may have been misused to perpetuate an economic dogma - one popular in Germany - his mechanism could well explain behaviour in fiscal-crisis economies.
The Keynesian counteroffensive consists of several arguments. First, it is argued that "the myth of expansionary fiscal austerity" (Dean Baker, Centre for Economic Policy Research, October 2010) is based on extrapolating from the results of adjustment in boom conditions, or at least relatively favourable international conditions. As Keynes put it: "The boom, not the slump, is the right time for austerity at the Treasury."
Skidelsky rightly cites the "Geddes Axe" in 1921-22 and the Snowden cuts of 1931 as examples of badly timed austerity. However, Britain today cannot be said to be in a deflationary slump. There is annual growth of 2 to 2.5 per cent. Added to inflation of 3 to 3.5 per cent, the UK now has growth in the cash economy of over 6 per cent per annum - nothing like the conditions needed for a liquidity trap. Tradables, including the manufacturing sector, are growing in response to a 25 per cent devaluation and strong growth in Asia and parts of the EU. Private, non-financial companies are expected to achieve 10 per cent growth in capital spending in 2011/2012, based on CBI surveys. Unemployment is 7.9 per cent on the International Labour Organisation measure and 4.6 per cent on the claimant count, hardly comparable to the 20 per cent suffered in 1931.
It is true that the economy is still recovering from the economic equivalent of a heart attack, which took place two years ago. But the intensive-care phase has passed. Current conditions in the economy are far closer to recovery than to slump, with manufacturing, in particular, enjoying robust growth and survey after survey of business leaders indicating that they are planning for expansion.
Second, Keynesian critics are overly dismissive of the importance of keeping down the cost of capital (by maintaining the confidence of lenders). Skidelsky wrote in his essay that "even large reductions in interest rates might have quite small effects on activity". Yet this was not Keynes's view at all. In his open letter to Franklin D Roosevelt in 1933, he argues: "I put in second place [after accelerated capital spending] the maintenance of cheap and abundant credit and, in particular, the reduction of long-term rates of interest . . . Such a policy might become effective in the course of a few months and I attach great importance to it."
The coalition has had demonstrable success in this area. As the perceived risks of a fiscal crisis have receded, ten-year-term government bond yields in the UK have fallen from 3.7 per cent in May to around 3.3 per cent and are now closer to those in Germany and France than those in the troubled southern periphery of the EU. To see what the alternative might have been, you need only look at other European countries where yields have risen by 2 per cent or more. Had this happened in Britain, with its eye-watering levels of private debt, the risk of a second dip into recession would have been very real.
A third and related point is that Skidelsky and others are inclined to dismiss arguments that rest on "matters of psychology" or "fatuous expressions of confidence". This is an odd criticism, as Keynes also relies heavily on the mass psychology of confidence induced by expansionary policies and on stimulating the "animal spirits" of entrepreneurs. It is especially odd in the wake of the global financial crisis, when loss of confidence in highly leveraged financial institutions caused widespread economic damage and at a point where highly leveraged governments are being subjected to the same degree of critical scrutiny.
One of the more worrying reactions of the Keynesian critics is their belief that Britain, in some undefined way, is immune from the kind of financial firestorm that occurred in the eurozone in April and May, or the repeated flare-ups from Greece through Spain and Portugal to Ireland since. Even some distinguished academic economists don't understand how volatile and vulnerable to speculative attack the capital markets have become. The cardinal error of the boom years was to assume that low, stable interest rates were a fact of life, when such conditions could vanish overnight. An important justification for our early action on the deficit was to remove any risk of a sterling debt crisis.
The fourth and final element of the Keynesian counteroffensive might be called the "plan B" problem: what if rapid cuts do have gravely depressive effects on economic activity and investment? Can a government, using fiscal discipline as a means of restoring confidence, produce an alternative plan?
There are several answers to this. The most important is that, while all sensible governments plan for contingencies, there is no reason to assume the need for a plan B or a plan C, because there is a credible plan A and every sign is that it is working.
Another observation is that tight fiscal policy can be expected to be offset by loose monetary policy. As Mervyn King said last June: "If prospects for growth were to weaken, the outlook for inflation would probably be lower and monetary policy could then respond." Indeed, our early recovery during the Depression is generally linked to leaving the gold standard in 1931 and enabling looser money. Though the effects of QE are not fully understood, it should be clear that it is effective - the fast growth of the cash economy since the easing began is evidence.
Furthermore, it is only through having a clear plan A that the government can claim to be well prepared if the economy takes an unexpected dip. As we have seen elsewhere in the world, the only countries that are capable of supporting their economies in a crisis are those that have the confidence of the bond market. Britain's credit is as good as it can be. Contrast this with our position going into the 2008-2009 recession: with a huge structural deficit and demonstrating no willingness to address it, the Labour government could afford very little stimulus (another point made both by me and by George Osborne in 2009).
It would be foolish to be complacent, however. I worry that the modern Keynesians are not bold enough and that the rather contrived indignation over the speed of deficit reduction distracts attention from more critical problems. We have, after all, just experienced the near collapse of the banking sector, the freezing of credit systems and the subsequent need to recapitalise banks leading to further credit restriction. The crisis was global but Britain's exceptional exposure to the global banks has left us disproportionately affected - if not quite as severely as Iceland or Ireland.
The economics of banking and credit crises was first explained properly by John Stuart Mill nearly 200 years ago. In modern times, the best analysis has come from Friedrich Hayek. As Meghnad Desai has put it: "The current crisis is very much a Hayekian crisis" - caused by excess credit, leading to bad investments that eventually collapsed. That is not to say Keynes was "wrong"; that would be as absurd as saying that Newton was "wrong" because he did not explain quantum phenomena. But we should be sceptical about Keynesian economists, however distinguished, who conspicuously failed to anticipate the financial crisis and now blithely ignore its consequences. Skidelsky's essay does not even make passing reference to the banking crisis, like someone dispensing advice on earthquake relief and reconstruction without any reference to past or future earthquakes.
We cannot ignore the causes of the crisis. That is why the government's deficit reduction programme, though necessary, is not sufficient. We still need to address the question of how to generate investment and sustainable growth. It will not happen automatically. Supply-side reforms will help: attracting inward investment; shifting taxation away from profitable, productive investment (as opposed to unproductive asset accumulation, as with property); reducing obstacles to productive activity; reforming corporate governance and takeover rules to encourage long-term - rather than speculative - investment; helping workers to adjust through training, retraining and a safety net of benefits.
But a central issue remains the high cost and low availability of capital in a low-interest environment. Real short-term interest rates are negative and real long-term rates close to zero. Capital is, in theory, cheap - and for those large companies that have access to capital markets or the confidence of the banks, borrowing has never been cheaper. But for smaller business borrowers that rely on the banking system, there is a continuing credit crunch, with high (often double-digit) interest rates, new charges or conditions, sometimes a blank refusal to offer any finance at all. Small companies are the backbone of our economy and, in their eagerness to deleverage, banks may squeeze the life out of productive enterprise. To remedy this problem requires an early move to counter the cyclical regulation of the banks and, in the wake of the Banking Commission, now sitting, structural reform of the banking sector.
The problem - of available capital failing to find its way into economic activity - goes wider than banking. Dieter Helm has described how there is huge, pent-up demand for infrastructure investment and abundant available savings, but the regulatory environment needs reform to reduce the cost of capital. There is what Keynes described as a problem of "liquidity preference", but it is not caused by lack of demand. Put simply, investors need reasonable reassurance that they will get their money back with decent, long-term rates of return and the ability to buy and sell theirinvestment cheaply.
Keynes was right to argue that the state has a critical role to play in facilitating investment. Banking reform is one requirement, as is reform of the regulatory system to encourage private investment in public goods. Other innovations such as local tax increments and tolling can free up investment without undermining fiscal credibility. The government is already relaxing a little the deep cuts inherited from the Labour government in capital spending.
The serious debate for progressives should not centre on denying the need for discipline over public spending. If the British left follows Bob Crow and the National Union of Students to the promised land of the big spenders, it will enjoy short-term popularity at the expense of the coalition but it will also enter an intellectual and political blind alley. We need instead to reform the British state to create a banking system, incentives and institutions that will put safety first, not speculation, and will liberate new and sustainable investment. That is the challenge Keynes would have relished.
Vince Cable is Secretary of State for Business, Innovation and Skills
Next week: Robert Skidelsky and our economics editor David Blanchflower respond
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