July 26, 2009
Keynes, Cuts and Conservatives
Tory MP and shadow Treasury secretary Phillip Hammond yesterday declared that if the Tories win power, he will become a hate-figure. The reason? He plans to slash public spending.
Hammond, however, is claiming this as a virtue, not a vice. This is because he reckons public spending cuts will result in a short unpleasant period of belt-tightening, before leading to economic recovery. He’s thus presenting himself as a hard man for hard times, declaring that he doesn’t mind being unpopular because he’ll do what’s right.
It’s a clever political move, and likely to pay-off given how evasive, dishonest and useless Gordon Brown is now perceived to be by the electorate. But it’s a worrying one, because Hammond advocates a macro-economic model that may well make the dire economic situation worse. To see why this is so, some careful thought will be required. Hence today’s blog – answering a call from The Other Taxpayer’s Alliance – is not for those unwilling to spend 15 minutes having a good careful think.
Here we go.
The model Hammond advocates can be dubbed the “grocer’s shop” approach. It treats the national economy as though it were a corner shop, with the government being the grocer. It goes roughly like this:
Books should be balanced, and spending should be tightly related to incomings. If the shop’s income falls, then its outgoings should fall too. This is because it is only prudent to spend what one has, or else one over-reaches the business, leaves it exposed and reaps economic ruin. Expenditure should be cut as income falls, and should remain cut until better times increase demand, and in turn, income.
Thus the grocer’s model is very simple: it advocates familiar and safe-sounding ideas like “only spending what you’ve got” and “balancing the books”. But it’s also a very passive approach: the shopkeeper simply sits back and waits for the bad times to pass.
Now, critics of the grocer’s model may raise the following worries. Firstly, they might point out that the grocer, in making cuts, is likely to impact heavily upon people’s lives. After all, one way to make cuts at the grocery store is to sack the employees. To simply sack the employees and say “toodle-pip, we’ll see you again when the good times return (whenever that may be)” may seem more than a little callous…especially if the employees elected the grocer to run the shop in their interests, say, rather than just to make personal profit.
Furthermore, the grocer’s attitude to increasing income – i.e. getting people to spend in her shop – may leave something to be desired. For the “grocer’s model” only really has room for the grocer to do things like offer discounts on what’s being sold [you might like to think of this as analogous to a tax cut] or increase advertising of what’s on sale, hoping this will boost demand and increase income, speeding-up recovery. Yet because the grocer is fundamentally separate from her customers, there’s not much she can do. For surely it would be madness for the Grocer to kick-start her shop’s recovery by, say, generating increased income for the customers. Wouldn’t it? Right?
Well perhaps not. Indeed this is where we might start to question whether a national economy really is like a grocer’s shop, and whether the government is helpfully thought of as a grocer.
To understand this alternative to the grocer’s shop approach, it’s useful to consider an idea from John Maynard Keynes which sounds complicated but really isn’t. The very important idea is called “the paradox of thrift”, and it goes like this:
In a recession, people are worried about job security, interest payments on their debts, inflation and all the other nasty things that people worry about in recessions. These worries cause people to lose confidence. When people lose confidence, they decide not to spend but to save. This is because saving feels safe: it’s money in the bank for a rainy day, which everyone expects to be tomorrow.
The problem is that this creates “multiplier effects” in the economy as a whole. Instead of consuming goods and services and stimulating demand, which would in turn lead to job-creation and economic growth, when people save it suppresses economic growth because their money sits in a bank (or under a mattress) instead of creating the demand necessary for growth by being spent.
Thus we have a paradox: in a recession people save because they feel insecure and lack confidence, and so saving seems like a very sensible idea…but the aggregate effect of many people saving at high levels is actually to prolong the recession, because it dampens the stimuli to growth.
So why does this paradox matter?
Well, it illustrates that the government’s job in a recession is to be far more than just a grocer. In a recession, people are saving because they lack confidence, but paradoxically this is causing economic stagnation. What is required is for an external agent to come along and kick-start the whole shebang: to encourage the savers to save less and to spend more. This will create demand in the economy, and lead to job creation and further growth.
The only external agent capable of doing this at the concerted national level required to be effective is a government. There are multiple ways it can be achieved, but for example in 1930s America it was often done by spending money on huge civic projects like the Hoover damn. By undertaking large infrastructure projects, the Government demanded resources and services from companies that could help build the projects. This stimulated demand from those companies, who in turn bought goods and services from other companies, all of whom increased their output and in turn employed more workers. Alongside this, the Government also employed people to work on its infrastructure projects. These workers, having jobs, went out and spent more money, thus creating more demand, and so on. Economic growth was kick-started. (Of course, governments will have problems here if the workers simply save all their wages instead of spending, say because they still lack confidence and hence would rather save. This factor helps explain why recessions can be long-lasting, though of course there are many other factors in play).
The point is, to beat the paradox of thrift created by spending, Governments must do something. Simply cutting spending is likely to be counter-productive because it will reduce demand in the economy (remember that the Government is a big consumer of non-Governmental goods and services, so if it stops spending this has big knock-on effects). Here we actually have another paradox: if a Government cuts spending and says “we’re just waiting for the storm to pass”, they may actually be prolonging the storm.
Indeed my colleague Richard Murphy has explored such thoughts already and in great depth. He’s a trained accountant, so you can read the well-explained maths here. But to simplify his thinking very quickly, consider it as follows.
If the Government cuts spending, this decreases demand in the economy as a whole. This leads firms to cut back their production and to shed workers. Unemployment as a whole rises. This is a real problem, not just because unemployment is an evil that ruins families and lives, but because it makes recessions worse. For consider, if people are unemployed they have significantly lower incomes, thus they have less money to spend, thus demand is lower…which means lower output, lower investment and lower growth in the economy. Furthermore, unemployment has further adverse affects on Government: when unemployment rises the Government sees its tax receipts fall, and must pay-out more in social security payments. This in turn means the Government has less money to spend in ways which could stimulate demand in the economy, and which would help to reduce unemployment.
So cutting spending in a recession is a very risky thing to do. It threatens to make the recession worse. This is because the Government is not a mere grocer whose job is simply to make cuts, sit back and wait for recovery. Such behaviour is likely to make recovery a more distant prospect. The Government is the agent that can kick-start recovery itself by spending.
Now, behind all of this is a lurking problem which threatens to throw a spanner into the works. At the outset of a recession a Government may be constrained in its ability to spend because it may have run up debts in the good times. As those debts require servicing (i.e. the interest on them needs paying), the Government must be committed to making sure it can meet its obligations. This is pretty important: if international lenders judge a Government unable to meet its financial commitments, then the nation in question could be blackballed by international lending markets and the consequences would be pretty dire (all modern macroeconomics depends upon a “rolling-ball” of controlled government debt, chunks of which are owed to international financiers as well as domestic citizens holding government gilts and bonds).
However, when a recession gets under way Government coffers suffer because tax receipts decrease and social security out-goings increase. The Government has less money to play with, so it must make servicing its debt a priority for the sake of the nation’s fiscal integrity. This is just a brute fact of life, and it explains why some cuts may be needed in a recession: if the Government must service its debt, and can only afford to do so by cutting some public spending, then it will have to face up to this and make the necessary cuts.
But it’s important to understand what’s going on here: the Government is under an unfortunate constraint, stuck between a rock and a hard place. It must service the debt for the sake of national financial integrity, but doing so through spending cuts is likely to make the recession worse. This may be the bullet which has to be bitten; the lesser of two evils. Yet it should be recognised as such. What it should not be seen as is an invitation to make any more cuts than are absolutely necessary. Making increased cuts will lead to further economic stagnation and delay recovery.
Yet Tories like Hammond have interpreted the unfortunate need for some spending cuts in a recession (a necessary evil arising due to national debt levels) as an opportunity to make more, counter-productive cuts than are called for (a decidedly unnecessary evil arising, often, from an ideological desire to slash state services).
Thus Hammond should well deserve to become a hate figure. He plans to implement economic policies that will prolong the recession, increase unemployment and make the pain of recession worse for millions. And all because he’s forgotten the paradox of thrift, and fallen into the trap of thinking the Government is a simple grocer when it should and must be so much more than that.
richardjmurphy said,
July 26, 2009 at 1:36 pm
Paul
The reality is that in recession borrowing creates enough growth to pay for itself – as was proven in the 1930s. As the New Deal borrowed more government net borrowing fell – tax revenues rising faster than borrowing tom allow net repayment as a result of the multiplier effect – that government spending stimulates much more economic activity in a recession than it costs in borrowing terms – generating revenues in excess of that cost of borrowing.
The argument that there is need for any cuts is wrong – and the markets are wrong to demand it. In the current situation the best hope they have of repayment is to lend more
If that reality is ignored then we have to assume a) ignorance of b) political desire to control the size of the state as their motivation for action
Richard
Tax Research UK » What are you going to do about unemployment? said,
July 26, 2009 at 1:58 pm
[...] Which I said, in more words, here. And Paul Sagar says, here. [...]
Ste For Sure said,
July 26, 2009 at 3:43 pm
great post.
Tom said,
July 26, 2009 at 4:13 pm
yeah Richard, the growth made from spending usually will account for the borrowing. But, is that the case with Britain’s current position? the debt that GBR is in is so huge that its a bit of an exception. Its so large that some cuts must be made. I agree with Paul there. I’m not sure what USA’s financial position was during the early 1930′s, but i think – i could be wrong – that it wasn’t as bad as GBR’s now so tax and spend was a good idea, and cuts not a necessity. GBR can’t carry on spending for years to come though, surely. Of course, it depends where the cuts are…
Dan said,
July 26, 2009 at 5:32 pm
The paradox of thrift only arises if you take a (fallacious) static view of the economy, as Keynesians tend to do. Once you start to take dynamic effects and capital theory seriously, the paradox essentially disappears – here (http://mises.org/story/2804/preview) is a outline of Hayek’s refutation of it when it was originally proposed, and here (http://www.econlib.org/library/Columns/y2009/Murphythrift.html) is Bob Murphy attacking some more modern proponents
A final point is that if Keynesianism was to be taken seriously, the government should have taxed more and spent less during the boom of the last decade and a half. The fact that the same people calling for more government spending now are the same ones who called for more government spending then does not fill me with confidence that their Keynesianism is being scientifically rather than opportunistically employed.
Paul said,
July 26, 2009 at 6:04 pm
Dan,
Well I’m not covninced, at all. For all your adoration of Hayek, I think you have to admit that Keynes has stood the test of time as the stronger and more insightful economist. I’ll try and read those links when I get a minute, but i’m dubious that Keynes was disproved by Hayek of all people.
As for “if Keynesianism was to be taken seriously, the government should have taxed more and spent less during the boom of the last decade and a half.”
Yes, agreed. But all this proves is that Keynesianism hasn’t been taken seriously. But then, if you’re going to blame this recession on Keynes that’s going to be rather hard to maintain. The Friedmanite reforms of the 1980s are surely our main root cause?
“The fact that the same people calling for more government spending now are the same ones who called for more government spending then does not fill me with confidence that their Keynesianism is being scientifically rather than opportunistically employed.”
What? Have you been paying any attention to the last 30 years of economic history? Keynes has been out of fashion (well, until September 2008) for rather a long time. If you think the economy has been run on Keynesian lines since 1979…well I have no idea what to say, really.
What are you going to do about unemployment? | called2account said,
July 26, 2009 at 7:20 pm
[...] Which I said, in more words, here. And Paul Sagar says, here. [...]
Dan said,
July 26, 2009 at 10:07 pm
Paul,
I’m afraid (as you might imagine!) that I don’t agree; as far as I’m concerned, Hayek has a good claim to being the greatest economist of the 20th century, and certainly one of the most prescient. As for his debate with Keynes, there’s a short article here (http://thinkmarkets.wordpress.com/2009/06/17/keynes-versus-hayek-a-rerun-of-the-1930s/) which sums it up but the upshot is that Keynes was wrong and Hayek was right – I’m sure you will disagree but at least you and the readers of your blog know where I stand.
Yes, agreed. But all this proves is that Keynesianism hasn’t been taken seriously. But then, if you’re going to blame this recession on Keynes that’s going to be rather hard to maintain. The Friedmanite reforms of the 1980s are surely our main root cause?
The main cause, if you ask me (and you apparently are) ,is the government sponsored manipulation of the money supply by central banks; I suspect that something very much along the lines of the modern day Austrian economists is the right analysis of what went wrong, and I think their position is made much more credible by the fact that they predicted the trouble long before anything kicked off. It’s hard to look at the bailout reader at mises.org (here: http://mises.org/story/3128) – with articles as far back as 2002 predicting the whole mess – and not think that they have a better idea than the vast majority of economists who were apparently blind-sided by one of the biggest bubbles in history.
The last point I made was not supposed to imply that the economy had been run along Keynesian lines (although it sure as hell wasn’t run along free market lines), but just to note that Keynesianism has far more friends among the left now, when it would apparently be advocating higher government spending, than it did during the boom years, when it would apparently be advocating lower spending. All of which gives me the impression that the motivation behind a lot of the renewed interest is not because of a new appreciation of Keynes’ economics, but because of a political belief in higher government spending; that’s all.
Paul said,
July 26, 2009 at 10:14 pm
“All of which gives me the impression that the motivation behind a lot of the renewed interest is not because of a new appreciation of Keynes’ economics, but because of a political belief in higher government spending; that’s all.”
Prossibly right about that, to an extent. Most “Keynesians” were no such thing, from 1945-79, or from 1979 onwards, as Will Hutton has pointed out umpteen times. However it’s probably fair to say that much of the renewed interest in Keynes stems from wanting to get out of the hole, and looking to him as a way of achieving that. That’s something that could motivate even those who have no particular love of public spending.
And yes, we’re going to disagree about Hayek vs. Keynes.
Peter said,
July 26, 2009 at 11:02 pm
Dan,
Here’s something I’ve been meaning to ask you for a while. If Austrian economics is true (or closest to the truth), how come it’s not taken that seriously by academic economists, as compared to neo-classical etc? I’m not trying to be smarmy or anything (though my question reads that way), I’m genuinely curious. I mean … Nozick has his own sort of theory as to why academics are typically left-liberals, do you have a similar one for why the mainstream views in economics don’t really take the Austrian view seriously?
Dan said,
July 27, 2009 at 11:14 am
Peter,
It’s a good question, and in my more reflective moments I wonder whether I’m crazy for being sympathetic to it – surely the whole of the economics profession can’t be wrong? But then I realize that yes, the whole of the economics profession can and indeed is often that wrong, which gives me more confidence. Your question is a sociological one as much as an economic one, and so I’ll say right now that I’m no expert on the history of the economics profession in the 20th century. With that caveat here’s my theory: since WW2 economics as studied in the big departments became more and more mathematical; and, of course, the Austrians reject, for the most part, the use of mathematics in economics. Not because they are ignorant or frightened of maths, but because they think (and I agree) that economic phenomena do not lend themselves to mathematical treatment in the way that, say, physical phenomena do (and I hope I can avoid charges that I have an irrational hatred/ignorance of maths given that I’ve just finished my 3rd year studying it). For instance mainstream economics is heavily dependent on the modelling of static equilibria; Austrians argue that markets are actually dynamic processes which take place through time – the upshot being that neoclassical econ neglects a fundamental and pervasive part of economic life, namely, entrepreneurship. Now once you realize that the Austrian critique of mathematical methods, if correct, implies that the vast majority of economic research is worthless (look in any modern economics journal – you’ll see how common these methods are), and you realize that learning the amount of maths that most economists know is very costly, you see that there are reasonably good incentives for the mainstream to denigrate Austrians. If you are a respected member of a prestigious field and some people come along and criticize the fundamental methodology of your field, what is your reaction going to be? Will you admit that all of the stuff you spent years learning in grad school is useless for the purposes you put it to, or are you going to ignore the criticism? As far as I can see it there is no mechanism by which economic theories are forced to track the truth – for instance, the supposedly scientific economics profession (except for the Austrians and a handful of other stragglers) failed catastrophically in predicting the credit crisis, and yet it is business as usual. Will the best chairs at Oxford or Harvard all of a sudden go to those who came out with accurate predictions? I’m not holding my breath.
So in a few words, my answer is: institutional inertia, incentive problems, and scientism/physics envy.
Grace said,
July 28, 2009 at 2:06 pm
There’s an interesting chapter in a book i’m reading called “Keynes versus the Keynesians”, which questions the extent to which Keynes would actually have supported the kind of “Keynesian” analysis and policies recommended in this post. He wasn’t an unrestrained advocate of expansionary fiscal/monetary policy to reduce unemployment – in fact in 1937, when unemployment was still 12%, he insisted that it be dealt with not by the general expansion of aggregate demand by government. because “the economic structure is unfortunately rigid” the extra demand would probably not reach the right areas.
Letting the Tories Win « Bad Conscience said,
July 29, 2009 at 6:23 pm
[...] better strategy would be to argue that Tory cuts will make the recession worse. This, as it happens, is stock Keynesian thinking and is (finally) starting to get an airing (and [...]
Is high unemployment a policy choice? « Bad Conscience said,
August 19, 2009 at 3:36 pm
[...] don’t know enough about it to say. But I have written beforethat there seems, prima facie, to be a strong case for increasing spending during a recession, [...]