A friend has sent me a couple of interesting papers on the possibility of ‘non-Keynesian’ effects from extra government consumption.  Here is the first.  Its thesis is simple, and also important: that in certain circumstances, lower government consumption, far from causing economic contraction, makes private consumption rise.  As a result, there is less to fear from cutting down a large deficit.

What are these conditions? One is when the public is sufficiently forward-looking that it believes a credible fiscal contraction may produce lower taxes in future.  Anticipating higher future prosperity, the private sector boosts consumption now.

Another, obvious mechanism is when the government’s borrowing is at such a high level that it is making interest rates rise. Private investment might be ‘crowded in’ by sensible government behaviour.

Interestingly, the paper even allows for tax raises now to boost private consumption, via a similar process of logic. It is not all about government-hatred….

Now I am aware that you are aware that I was aware of all this before: after all, in A Balancing Act I wrote about 1981*, and conceded that Mrs T and her Chancellor Howe were right to continue with fiscal consolidation. My view about the difference between then and now was summarised in the headline: “The facts have changed, not the thinking”.  And I thought the objective conditions under which Keynesian and non-Keynesian effects pertained were reasonably easy to grasp, at least in extreme circumstances.

How expensive is government borrowing?  What is inflation like?  are two of the obvious ones.

What is the private sector worried about? is a more nebulous one – but easy to answer in 2008-9 – and it was not the government (despite what John Cochrane says). However that is now the past.  And the second paper brought me up short when it found from empirical regressions that a fiscal consolidation was often expansionary without the need for monetary looseness, or depreciating currency.  It did find that a looser monetary stance helped, but it also found other ways in which investment might be encouraged by a shrinking government, in particular the idea that such shrinking lessens the pressure for higher wages (see p4).

This takes the rug from beneath the feet of those who think that zero rates change everything – for further discussion of this, see my paper on QE.

There needs to be a few caveats, of course, before we all start merrily cutting.  An obvious one is that the improved conditions are often only apparent in the medium term (3 years or so).   For those hoping for a better 2011, the papers give little encouragement.  Also, the subject matter is European nations, over 1970-2005.  This was a period when many European states would have gradually liberalised and privatised – a one-off period which may make them unsuitable for straightforward extrapolation.  A crude example: Maggie privatised a lot.  This will have lowered government consumption and lifted private consumption in a mechanical way.

But these papers hold lessons that we might wish the British understood 30+ years ago.  My continued enjoyment of “Goodbye Great Britain“, about the IMF crisis of 1976, is punctuated by moments of astonishment about the difference in thinking back then.  It was very ‘hydraulic’ and Keynesian.  When the IMF mildly suggests that the government getting a grip might actually be good for sentiment, the suggestion went nowhere.  Instead, the Lefties assumed that austerity would follow – and must have been surprised by the quite reasonable growth in 1977-8.

I am tired of reiterating how much different I find 2009 to 1976 or 1981. Lord Skidelsky attacks the ‘non-Keynesian’ view in today’s FT, taking the NK as George Osborne, whose recent Mais lecture distilled the arguments above into:

(paraphrasing) ‘without early fiscal action, private expectations and confidence may take a hit’.**

Skidelsky’s response is robust – read it.

BUT. Let us leave timing aside for now.  These papers are still important, because, a fiscal consolidation IS coming, and very soon conditions will mean such a consolidation is the right thing to do.  The most popular trigger point is meant to be the debt markets – though see Wadwhani’s letter today on this. The private sector has been deleveraging pretty fast (front page), and the day when it can take over may be sooner than people think.  Certainly sooner than people like my friends here.

Keynes may have made a resurgence, but that does not mean thinking like Tony Benn in his pomp is suddenly sensible. Extra government spending is not everywhere and any time a boost for growth. However I would caution taking anything as crude as a set of macroeconomic regressions from a specific and rather special period of history as proof that a general rule always applies.  The next Chancellor would do well to be pragmatic – look at the actual economic conditions on the ground, rather than apply dogma.  Sometimes, the government crowds out wages, forces up rates, taxes the hell out of all of us.  Right now wages are growing at 1%, rates are 4% for 10 years, and taxation is about 36% of GDP.  I would still say: not there yet ….

*In fact, I conceived of the paper when greatly enjoying Nigel Lawson’s “The View from Number 11”, and the original title for the paper was “This isn’t 1981”.
** Skidelsky also takes quite welcome aim at the Office for Budget Responsibility in a manner that resembles our scepticism:

“[An OBR] has its attractions: governments can too easily become addicted to deficit finance. But it is no use having Three Wise Men monitoring the Treasury’s adherence to its fiscal rules until one knows what the fiscal rules will be. In the present circumstances, the risk is that these rules might be designed to reincarnate and reinforce the “Treasury view” of balanced budgets as it operated at the time of the Great Depression.

This is welcome because everyone seems to think the OBR is a great idea.

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13 thoughts on “Non-Keynesian effects: or, how cutting the government can boost the economy

  1. Cutting spending & putting the savings into cutting corporation tax, or other taxes, would produce the confidence for spending growth without cutting this beloved deficit.

    All parties know perfectly well how to get out of recession but they have no intention of doing it because it would reduce their power.

    1. It’s such a relief to read that the solution to such intractable problems is so obvious.

      But such a worry to read about what Machiavellan and perversely motivated villains our political leaders are. Perhaps Labour and Conservatives are in cahoots?

      Now I don’t know whether to be optimistic or miserable ;-).

  2. The authors of the second paper have (I think) a follow up. Similar results.

    http://www.springerlink.com/content/3r54828624lt2785/

    It was a contributing part of a post I did a while back hauling out papers just to remind lefty readers that not every economist published in respectable journals is a neo-Keynesian. I got fed up of the ‘Paul Krugman says deficits are necessary, so what have you got to say to that, eh? Eh? EH?’ line of so-called argument.

    1. Oh no, sorry, scratch that. I think it might be the same paper, but moderately edited for publication in Open Ec. Rev. after appearing in the EC in-house journal you linked.

      Why can’t economists be more like mathematicians? 😉

      1. that question is very provoking. I did a year of maths at Oxford and changed into PPE ….

  3. Dr Sushil Wadhwani is correct. What markets expect, want are saying is becoming so political. What people mean when they appeal to the higher authority of the ‘ voice of the ‘market ‘ is the interpretation they place on variables. There are legitimate debates about what is the optimal approach to the macro economy. However, if the concern is the government debt markets the only legitimate voice of the market is the bid-to-cover ratios and the length of the tails at the debt auctions. A bid-to-cover of 2.5 a few days ago is a reasonable ratio.

    Amidst the noise it should not be ignored that we are now in March and the 10-year benchmark gilt is yielding less than it did January 1st. However, that fact sits awkwardly with the media narrative. Moreover, consensus opinion at the end of last year was that after QE ended yields would be a minimum of 50 basis points higher by now. Yields fell and the first auction after QE ended had the highest bid-to-cover ratio for eight years. We certainly should watch the markets but also should ignore 99% of the noise. We are a million miles away from a debt crisis. However, who knows what the future holds.

    1. I was in a quite high level seminar in Whitehall where that ‘fact’ about the end of QE was utterly unchallenged. I wanted to say ‘er…. efficient markets? Surely it would be sold down already?’ They wrongly expect the shock and awe of its entry to be replicated in the exit. I’m not sure.

      Then again, it maybe ain’t over.

  4. “One is when the public is sufficiently forward-looking that it believes a credible fiscal contraction may produce lower taxes in future. Anticipating higher future prosperity, the private sector boosts consumption now.”

    That’s cute, running Ricardian Equivalence in reverse…..

    1. Yeah – very imaginative. ALthough I am not sure from a macro-regression they managed to get a handle on what people actually thought about future taxes… it is too government-centric. Most people don’t know the first thing about 10 years’ time tax rates. Including me.

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