Friday 27 January 2012

Fiscal policy: what does "Keynesian" mean?

On Sunday, David Smith described me as “a former Cabinet Office economist who has taken the institute [NIESR] back to its Keynesian roots”.  Then on Wednesday, Nadhim Zahawi MP talked of “Keynesians such as [Ed Balls] and bodies such as the NIESR”. This prompted a couple of thoughts. What do they mean?  And am I, in fact, a Keynesian? 

So I emailed David Smith to ask.  He hasn’t replied yet, but, as I pointed out here, in fact on the point he was disputing with me (why are UK long-term interest rates so low) my views are clearly simply the standard (pre-Keynes) rational model of interest rate determination.   Mr Zahawi's statement is in reference to a quote  (also cited in my blog here of the same day) from the IMF World Economic Outlook update: 
Among those countries, those with very low interest rates, or other factors that create adequate fiscal space, should reconsider the pace of near term fiscal consolidation.” 
So presumably he thinks that those of us who agree with the IMF on this are "Keynesians".  More of that later.

But first, since this is to some extent personal, some autobiography. I joined the Treasury in 1987 – as a generalist, with a Maths degree, not an economist – and learned my economics, both macro and micro, on the job, culminating in a stint in the Chancellor’s (Norman Lamont’s) office.  I worked both for Nick Macpherson, now the Permanent Secretary of the Treasury, and Jeremy Heywood, the new Cabinet Secretary. 

Then in 1992 I decided I did in fact need some formal training in economics, and I went to Princeton, where I studied macroeconomics first with John Campbell (primarily a financial economist) and then Ken Rogoff, who went on to become Chief Economist at the IMF. Both were very much in the mainstream of modern macroeconomic thinking.  After that, I had a varied career, but didn’t really do much macroeconomics until I ended up in the Cabinet Office on the eve of the financial crisis.

At no point in this period did I think of myself as a “Keynesian”. Nor was it really a meaningful question. You might as well have asked a physicist if he was a “Newtonian”. Keynes was a great figure (indeed, one of the greatest Britons of the 20th century) and you had to understand his insights to understand macroeconomics; but the debate had moved on. The Treasury approach to macroeconomic management throughout this period was that while fiscal policy mattered, it wasn't - for largely pragmatic reasons - sensible to adjust policy in order to manage demand; monetary policy was quicker, more transparent, and less subject to political distortion. And I fully subscribed to this view.

Of course, post-2008, things are rather more complicated.  So what could it mean to be  a “Keynesian”? I can think of a number of possible definitions.

1.  Going back to the 1930s, Keynes himself obviously defined himself in opposition to the "Treasury View" [sometimes also described, somewhat unfairly, as "Say's Law", that supply creates its own demand], that fiscal policy cannot, as an accounting identity, impact aggregate demand, because the government needs to get the extra money from somewhere, whether through taxes or borrowing.  So a Keynesian is anyone who doesn't believe this identity means that fiscal policy can't impact demand. 

This appears to be the definition espoused at one point by John Cochrane at the University of Chicago, who wrote:  
"First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both . This form of “crowding out” is just accounting, and doesn't rest on any perceptions or behavioral assumptions."
This became the subject of a furious row in the econo-blogosphere, with Paul Krugman, Brad Delong and Simon Wren-Lewis accusing Cochrane of "undergraduate errors".  Cochrane himself seems to have retreated from this position, as Delong and others have pointed out.  But leaving US academic disputes aside, obviously in this sense I am a Keynesian - hence the title of this blog!  But then so is everybody else, including today's Treasury. Nobody, and I mean nobody, really believes that it is impossible by definition for fiscal policy to affect aggregate demand.

2.  A more plausible, and traditional, definition is to say that a Keynesian is someone who believes that as an empirical matter, fiscal policy does have a substantial impact on aggregate demand; in contrast to those who believe that "Ricardian equivalence" means that changes to government spending and borrowing will be substantially or wholly offset by changes to private sector spending and saving.  More recently, the doctrine of "expansionary fiscal contraction" went even further, and argued that tightening fiscal policy could, through exchange rate and confidence effects, actually increase demand and growth; a paper by Alesina and Ardagna was particularly influential in this respect, and even (tentatively and briefly) influenced the Treasury here, who argued in the 2010 Emergency Budget that 
" These [the wider effects of fiscal consolidation] will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects".
The Treasury has not as far as I am aware repeated this argument, although Mr Zahawi apparently still believes it, arguing
" I am well aware of the fiscal multiplier effect of such strategies, but there is growing evidence that in a debt crisis it is less effective or simply doesn’t work."
But he is rather behind the curve on this, since the evidence shows precisely the opposite. The original paper has been widely questioned, debunked by further IMF research, and (more importantly) experience has hardly verified its claims.  The conventional wisdom now is very much that of the IMF, which by October 2010 had already concluded that:
"Fiscal consolidation typically lowers growth in the short term. Using a new data set, we find that after two years, a budget deficit cut of 1 percent of GDP tends to lower output by about ½ percent and raise the unemployment rate by ⅓ percentage point." 
Coincidentally, these results are quite similar to those given by NIESR's model for the UK.  The IMF has if anything strengthened its views since, with the current Chief Economist saying recently:
"[fiscal consoliation] is clearly a drag on demand, it is a drag on growth."
So I'm a Keynesian on this definition, but then so too are the Managing Director and  Chief Economist of the IMF.  And so indeed too are the Treasury, Bank of England, and the Office of Budget  Responsibility.  Like the NIESR model, their models too incorporate a fiscal multiplier; and I do not think that senior officials at any of these institutions would deny for a minute that fiscal consolidation has, in practice, had a negative impact on growth in the UK.  For example, the Monetary Policy Committee said in November 2011:  
"Growth had been weak throughout the past year, reflecting a fall in real household incomes, persistently tight credit conditions and the effects of the continuing fiscal consolidation. " 
This is no longer a contentious proposition, Mr Zahawi notwithstanding.

3.  So under definitions 1 and 2 I'm a Keynesian, but then so is pretty much everyone else who one would take seriously.  The final definition, then, of a Keynesian, appears to be a much more "political" one - someone who thinks that slowing fiscal consolidation would be a sensible policy decision in the current UK economic context. This does at least make David Smith's and Mr Zahawi's comments meaningful, since clearly I do fall into that category and those currently responsible for UK fiscal policy don't.

But this definition seems to me to be misconceived, for two reasons.  First, if "Keynesian" means anything, it must surely have a more general significance than indicating one's position on a particular policy choice in a particular country at a particular time. Surely it should  indicate a philosophy, a theoretical view, or at least a view of what the empirical evidence means?

Second, and perhaps more importantly, it is quite clear that - now that the "expansionary fiscal contraction" hypothesis has been discredited - the main argument between those of us who favour slowing fiscal consolidation in the UK and those who think that this would be a dangerous mistake is not about whether the direct impact would be positive. It is whether the price of this direct positive impact would be "credibility" with financial markets, and hence a damaging rise in long-term interest rates that would more than offset the gains.  

I think this risk is hugely exaggerated, while the damaging social and economic consequences of inaction are correspondingly not recognised (see here and here), but the point here is not who's right, but that this debate really has nothing to do with Keynes at all. It's about a lot of things - how policymakers should deal with potential market irrationality, the role of the credit rating agencies, multiple equilibria, etc. But I don't see that taking one side or the other of these arguments makes you a Keynesian (or not). 

Finally, and returning to what I originally learned at the Treasury, there still remains the view that if we think demand is too low, then the right response is always through monetary rather than fiscal policy. Again, there is a vigorous debate among blogging economists on this topic (see here for an introduction to the debate). And here my perspective has indeed changed; I no longer subscribe to the Treasury view of the last two decades, described above, that fiscal policy never has any role to play in demand management, even though I don't think it should be the tool of first resort.  (See Simon Wren-Lewis' excellent discussion here, especially the penultimate paragraph).  

But just as this approach was motivated by pragmatism more than theory - monetary policy was better suited to this task - my change of mind is similarly motivated. If monetary policy alone was indeed enough in practice, we wouldn't be where we are now, with unemployment a million higher than the OBR's estimate of the natural rate, and no prospect of it coming down in the immediate future. Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate.

So my views have indeed changed; not, I would argue, ideologically, but in recognition of the fact that life, and macroeconomics, is considerably more complicated than we thought.  Again, this view is shared by the Chief Economist of the IMF, who argues:
"We’ve entered a brave new world in the wake of the crisis; a very different world in terms of policy making and we just have to accept it....Macroeconomic policy [specifically fiscal and monetary policy] has many targets and many instruments."
This pragmatic and questioning - but evidence-based - approach to macroeconomic policy is one I share.  If he were here, I imagine Keynes would too.

Want more?  Further reading: a more academic, but complementary, analysis from Simon Wren-Lewis.


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