UK: Mr Keynes' Quiet Comeback

Last Updated: 5 October 2016
Article by Ian Stewart

For much of the post-war period, the ideas of British economist John Maynard Keynes held sway in Western Finance Ministries and Central Banks. Keynes believed that government should manage the economy using fiscal policy – public borrowing, spending and taxation.

High inflation and weak growth in the 1970s undermined faith in fiscal policy. The Reagan/Thatcher revolution of the 1980s emphasised small government and put monetary policy at the heart of economic management. Since then monetary policy has largely ruled the policy roost.

Keynesianism saw a brief revival in 2009, in the midst of the global financial crisis. Shocked by the severity of the downturn, many governments reached for Keynesian programmes of public spending. The boost to growth in 2009 amounted to an average of 2% of GDP for the world's twenty largest economies. In the US a newly elected President Obama enacted the American Recovery and Reinvestment Act in which pumped the equivalent of 6% of US GDP into the economy.

The global recovery has been patchy, but sufficient for most governments to jettison Keynesian fiscal activism. Instead the focus has been on cutting public sector borrowing through tax rises and spending cuts. In recent years the austerity needed to reduce public sector borrowing has acted as a drag on activity. Monetary policy, in the form of ultra-low interest rates and Quantitative Easing, have been left to do the heavy lifting of supporting growth.

But today Mr Keynes is making a quiet comeback. This partly reflects a growing belief that monetary policy is "running out of juice".

The ability of central banks to boost growth increasingly means pushing interest rates into negative territory. In an inversion of normal relationships central banks in the euro area, Japan, Switzerland and Sweden already charge commercial banks to deposit funds with them. Policymakers worry about the declining effectiveness of monetary policy and the side effects – pressure on savers, money flowing into high risk assets, such as real estate, and the risks for banks (Negative interest rates encourage businesses and households to hang on to cash, undermining banks' ability to raise funds).

Fiscal policy offers an alternative way of boosting growth, and with financing costs that are lower than for centuries. The private sector pays the German and Japanese governments for the privilege of lending them money for ten years. The UK, despite slow progress in cutting borrowing and a post-referendum credit downgrade, can raise money at the lowest rates in history, at a cost of just 0.8% a year.

Surely, the argument runs, governments can find public sector projects – such as infrastructure or education - which will give society a higher return than the vanishingly low cost of capital and, at the same time, will boost demand?

For all the talk of austerity most governments have been trying to reduce the amount they borrow each year, not to reduce their overall levels of borrowing. Outside a small group of countries, including Germany and Canada, government debt has continued to rise. Despite this, the private sector has become ever more enthusiastic about lending to governments, and the cost of borrowing has declined.

To a Keynesian all of this suggests that the problem is not too much government borrowing or excessively high interest rates, but a lack of demand. Uncertainty and weak demand discourage investment and push money into the supposed safety of government bonds. Correcting this requires more government spending.

These arguments seem to be gaining traction in unlikely quarters. Donald Trump has outlined spending plans worth a whopping 2.5% of GDP. In a reversal of roles the Democratic candidate, Hillary Clinton, is the voice of fiscal conservatism by offering fiscal stimulus worth "only" 1.5% of GDP. The rhetoric of austerity is out under the UK's new Chancellor, Philip Hammond who seems likely to abandon his predecessor's plan to balance the budget by 2020. And the Japanese government recently launched a fiscal stimulus worth 1.3% of GDP.

Policymakers haven't given up on monetary stimulus, nor are they placing all their bets on fiscal policy. But after several years of tightening fiscal policy in the developed world is likely to be slightly expansionary this year and next. The guardians of the global economic order – the IMF and the OECD – argue that countries with low borrowing costs should borrow to invest. And politicians seem more receptive to spending, especially for growth-enhancing projects such as infrastructure.

This is not so much a revolution as a tilt to easier fiscal policy. It's a quiet comeback for Mr Keynes, but one that opens up the possibility of more significant fiscal stimulus to come.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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