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The takeaway from six years of economic troubles? Keynes was right.

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Now that the Federal Reserve has brought its program of quantitative easing to a successful conclusion, while the French and German governments have ended their shadow-boxing over European budget "rules," macroeconomic policy all over the world is entering a period of unusual stability and predictability. Rightly or wrongly, the main advanced economies have reached a settled view on their economic policy choices and are very unlikely to change these in the year or two ahead, whether they succeed or fail. It therefore seems appropriate to consider what we can learn from all the policy experiments conducted around the world since the 2008 crisis.

The main lesson is that government decisions on taxes and public spending have turned out to be more important as drivers of economic activity than the monetary experiments with zero interest rates and quantitative easing that have dominated media and market attention. Fiscal decisions on budget deficits, taxes and public spending have mostly been debated as if they were largely political choices, with much less influence than monetary policy on macroeconomic outcomes such as inflation, growth and employment.

Yet the reality has turned out to be the opposite. While every major economy in the world has followed essentially the same monetary policy since 2008, their fiscal policies have been very different and the divergence in outcomes, especially when we compare the United States and Europe, has been exactly the opposite to what was implied by the rhetoric of most politicians and central banks.

Countries that took emergency measures to reduce public borrowing have mostly suffered weaker growth, as in the case of Britain from 2010 to 2012, Japan this year and the United States after the 2013 "sequester" and fiscal cliff deal. In more extreme cases, such as Italy and Spain, fiscal tightening has plunged them back into deep recession and aggravated financial crises.

Meanwhile countries that ignored their deficit problems, as in the United States for most of the post-crisis period, or where governments decided to downplay their fiscal tightening plans, as in Britain this year or Japan in 2013, have generally done better, both in terms of economics and finance. The one major exception has been Germany, where budgetary consolidation has managed to coexist with decent growth, largely because of a boom in machinery exports to Russia and China that is now over, pushing Germany back into the recession its stringent fiscal policy suggested all along.

Thus the six years since 2008 have provided strong empirical support for the supposedly outmoded Keynesian view that government borrowing is more powerful than monetary policy in stimulating severely depressed economies and pulling them out of recession. In a sense, it is odd that the power of fiscal policy has come as a surprise - or that it continues to be categorically denied by the German government and the U.S. Tea Party. The underlying reason why fiscal policy is so important in recessions, and has now come to dominate over monetary policy, is a matter of simple arithmetic that should not be open to debate.

Recessions generally occur when private business and households decide to spend less than their incomes in order to reduce their debts or increase their savings. If this process of "deleveraging" is happening in the private sector, which it clearly has been, then simple arithmetic shows that economic balance can only be restored if some other sector of the economy spends more than its income - and such excess spending is only possible if that "other sector" is willing to increase its debts.

Disregarding the role of exports and imports, which must sum to zero for the world as a whole, the government is the only possible candidate to play the crucial balancing role as the "other sector." It is therefore a mathematical certainty that governments must increase their borrowing whenever businesses and households decide to boost their savings by spending less than they earn.

Despite this indisputable arithmetic, there has been surprisingly little interest in the macroeconomic impact of budgetary policies in contrast to the endless debates about every twist and turn of monetary policy. The explanation lies in the monetarist theories that came to dominate standard economic models of the pre-crisis period - and the related institutional changes that elevated central bankers above finance ministers as the supreme arbiters of economic policy.

Monetarism overturned the Keynesian fiscal consensus that prevailed from the 1930s to the 1970s, by introducing one simple assumption into the models that guided governments and central banks. The case for Keynesian fiscal stimulus in deep recessions was simply assumed away by asserting that interest rates could always be reduced sufficiently to stimulate private investment, discourage private savings and so restore growth. As a result, the private sector as a whole would never suffer for long from a shortfall in spending. Therefore government borrowing would never be needed to balance inadequate private demand.

As a result of these assumptions, interest rate decisions by central banks came to be seen as the only effective tool of macroeconomic management, while fiscal policy was relegated to a microeconomic supporting role. Tax structures and public spending levels were seen as supply-side issues influencing incentives and resource allocation, but the demand impact of government borrowing was largely ignored. Whether government borrowing expanded or contracted, interest rates would rise or fall to offset the Keynesian demand effects. Independent central bankers would manage macroeconomic demand with monetary policy, leaving governments to set taxes and spending plans to achieve political or supply-side objectives.

In the era of high inflation when monetarism was introduced, the idea that interest rates could always be cut by enough to revive private economic activity was reasonable enough. After all, when inflation is running at 5 percent, an interest rate of 1 percent is equivalent to minus 4 percent in real terms, imposing a massive tax on savers and offering a big subsidy to private investors. But this argument fails completely when inflation falls to negligible levels or disappears completely, as in the euro-zone and Japan.

Ironically, therefore, the very success of monetarism and central banking in conquering inflation now means that the era of monetary dominance is over. Keynesian fiscal thinking has triumphed and finance ministers are again more important than central bankers, even though most of them have not yet noticed. Once interest rates fell to zero, traditional monetary management lost its ability to provide further stimulus. And now that central banks are providing "forward guidance" which commits them to very low interest rates for years ahead, monetary policy has also lost its ability to offset fiscal easing and restrain demand.

As monetary policy has lost traction, fiscal policy has automatically gained power. With interest rates at or near zero, private demand cannot be simulated with further rate cuts and this means that monetary easing can no longer offset fiscal tightening. As a result, any reduction in budget deficits becomes unambiguously deflationary, which is why the French and Italian governments were right to resist enforcement of the German-inspired fiscal compact in the euro-zone.

Conversely, fiscal expansion now provides an unqualified economic stimulus because there is no risk of interest rates rising significantly in the next year or two - and perhaps not until the end of the decade. In short, the world has returned to a period of fiscal dominance, as in the 1950s and 1960s.

© (c) Copyright Thomson Reuters 2014.

©2024 GPlusMedia Inc.

12 Comments
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Hahaha some on here gonna hate this, those who printed are doing better than those who used austerity.

1 ( +4 / -3 )

Darn right Keynes was right. Some still subscribe to the trickled on school of economics, though.

0 ( +4 / -4 )

Really? Keynes was right? How so?

Let`s see, "official" unemployment is down to 5.9%, but the labor participation rate is the lowest in 40 years. That means that fewer people are participating in the workforce than at any time since the bad old days of Jimmy Carter. Anyone remember those days? Double-digit inflation? Lines at the gas pumps? Companies posting signs in bold letters saying "NOT HIRING"?

The stock market is now at record levels, but so what? The "liquidity" added to market when the Fed quadrupled the money supply has borrowed at low interest by big businesses and corporations, and they have used this money to buy their own stocks to drive up the prices. SInce executive pay is tied to stock value, and not the actual sales performance of the company, executives have found a way to pad their salaries while the rest of the workers are seeing their pay at best, remain the same, and in most cases, fall.

Keyne's economic theories (and they are theories, not proven science) were developed at a time when the world's populations and industries were exploding. This was a time of great fluctuations in the world economy, as countries switched from money to currency, and international exchanges had not yet been fully worked out. Keyne's theories provided a means for central banks to smooth out the bumps. These theories were workable when there was a strong underlying environment for growth. You can easily borrow and spend the taxpayer's money when government makes up less that 15% of GDP, and when growth and demand-driven inflation are strong.

But the situation today is different, population growth has slowed in most developed countries, and is declining in others. Industry has matured, and industrial growth is stagnant. You cannot increase national debts by 20% per year in order to achieve annual growth rates of less than 2%, it is economic suicide. Added to all of this is the rise in competition from developing countries, whose populations are still growing strongly, and whose levels of industrial production are far from mature.

Keyne's policies are 20th century science for developed countries, and are not workable in the 21st century.

-2 ( +3 / -5 )

Kind of irrelevant whether Keynes was right or wrong. Fact is that the global economy has run up unsustainable amounts of debt that will either have to be repaid or defaulted on at some stage in the future. and no-one can credibly say that living standards or economic activity are in any way improved over the last 5 to 20 years in many developed economies.

1 ( +5 / -4 )

@sangetsu03 Keynes simply observed that in the short term the government has the ability to stimulate the economy with multiplier, thank you very much. The time for that stimulus now has sadly passed, but the wreckage across Europe surely shows that even the tiny stimulus in the US was better than austerity.

3 ( +4 / -1 )

even keynes acknowledged "I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking twenty years ago."

government debt chokes out private investment which is needed for growth and at some point, when the government are taxing them to death in order pay their salaries, people will wake up and realize the governments are never going to be able to repay the debt.

-2 ( +2 / -4 )

The proof is in the pudding, but some people refuse to eat.

1 ( +3 / -2 )

Fact is that the global economy has run up unsustainable amounts of debt that will either have to be repaid or defaulted on at some stage in the future.

Actually what's being played out now is called "Financial Repression." It's when they keep interest rates below the REAL rates of inflation. This results in negative interest rates, or having to pay your bank to keep your money.

It happens slowly so few notice it. The intention is to slowly make the currency worthless, so the debt is worthless.

2 ( +2 / -0 )

Keynes was right. When Keynesian policies were in vogue, we had growing middle class, job security, high GDP growth, and a rock-solid financial system.

It all went out of control after neo-classical and free-trade policies started to take root from the 80s. Since then, we've had falling real wages and economic uncertainty and instability the likes of which haven't been seen since the 1930s.

"The global economy has run up unsustainable amounts of debt"

Prove it. Japan's fiscal debt continues to expand, beyond the point where many people a collapse would be inevitable. Where's the evidence that it's "unsustainable"?

1 ( +1 / -0 )

In other words Globalisation has screwed the citizens of the mature economies as jobs have moved to lower wage countries. The big companies keep profitability by constantly moving to areas where labor costs are lower. The current system of endless growth and it's sustainability is an illusion as we live on an earth with finite resources with an ever expanding population. In time something will break......

2 ( +2 / -0 )

Conservatives hate Keynes for being correct. Austerity has been a negative factor in the economy.

2 ( +2 / -0 )

Jeff.

just because Japan has managed to maintain ridiculous levels of debt with interest rates at zero for a while doesn't mean those levels are sustainable. someday the debt will need to be repaid or defaulted on.....

0 ( +0 / -0 )

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