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Letter from an Economist
John Birchall
02 Nov 2008
UK economist John Birchall looks at the work of John Keynes against the backdrop of the current financial crisis in world markets.
In his seminal work ‘The General Theory of Employment, Interest and Money’ published in 1936 John Maynard Keynes wrote that economic downturns are not necessarily self-correcting. Classical economics held that business cycles were unavoidable and that peaks and troughs would pass.
Economies get stuck
Keynes contended that in certain circumstances economies could get stuck. If individuals and businesses try to save more, they will cut the incomes of other individuals and businesses, which will in turn cut their spending. The result can be a downward spiral that will not turn up again without outside intervention.
That is where government comes in: to pump money into the economy by some means, such as spending on public works, to persuade individuals and businesses to save less and spend more themselves.
Keynes wrote to George Bernard Shaw that he expected the General Theory to “largely revolutionise ... the way the world thinks about economic problems”, and so it proved. Economists such as Paul Samuelson and James Tobin systematised Keynes’ ideas, using them as the foundations of what became orthodox thought and economic policy for more than two decades after the Second World War.
Fiscal policy
After crude applications of monetarism also foundered in the 1980s, modern macroeconomic orthodoxy blended ideas from both, reflecting a belief in the ability of monetary and fiscal policy to affect employment and growth, but also concern for inflation and budget deficits.
As the financial crisis has deepened, so that orthodoxy has been shaken. The problems Keynes faced in the 1930s, such as the ineffectiveness of monetary policy and banking failures triggered by falling asset prices, again seem the most pressing.
Keynes’ solutions, including greater public spending funded by borrowing, are becoming popular – though Messrs Cameron and Osborne are less attracted to such a route out of trouble. The criticisms that this will fuel inflation and raise budget deficits are still heard but are increasingly seen as irrelevant.
Great Depression
Robert Skidelsky wrote at the end of his definitive three-volume biography that Keynes’ ideas “will live so long as the world has need of them”. Keynes was scathing about the view that the Great
Depression was a return to normality, a necessary correction after the unsustainable excesses of the 1920s. It was expectations that he felt needed to addressed and upper most amongst those was consumer confidence.
It is therefore all the more worrying that across the Atlantic, where eyes have tended to wander to things "political" the average "Joe plumber" is now spending less.
According to the most recent GDP report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods, cars and TV fell at an annual rate of 14 percent.
Americans spend
American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasn't been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation.
As the current numbers refer to the summer the data is basically telling us what happened before confidence collapsed after the fall of Lehman Brothers in mid-September, not to mention before the Dow plunged below 10,000. The data does show the full effects of the sharp cutback in the availability of consumer credit, which is still under way.
To be brutally honest the American consumer has been living beyond its means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent - sometimes it has even been negative - and consumer debt has risen to 98 percent of GDP, twice its level a quarter-century ago.
Growing debt
For some these worrying numbers could be offset by looking at growing debt with the ever-rising values of their homes and stock portfolios. Alas, just as the economy needed to US consumer to remain confident and as the largest economy on earth we all need them to continue spending most US consumers have tightened their belts.
Such a situation allows the teacher of economics to note that by dropping consumer spending so the economy contracts and may lead to an increase in unemployment and a fall in economic growth. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income.
In fact, consumers' income may actually fall more than their spending, so that their attempt to save more backfires - a possibility known as the paradox of thrift.
Avoid recession
To offset this the Central Bank may respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment.
Now here comes another paradox – as interest rates are already low the central bank is restricted in what it can do and the "banks" are not passing on interest cuts to hard pressed mortgage holders and others who want to borrow money. This results in the already rather depressed consumer becoming even more suicidal and economic terms that means that they will resort almost no spending and will probably save – including any tax cuts they may be offered – something the Liberal Democrats in the United Kingdom seem reluctant to accept.
Perhaps what the economy needs now is a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate cheques that consumers probably wouldn't spend.
For Keynes this would be the obvious route out of a potential depression. Yes, we pass on debt to a future generation but is better that giving them the consequences of a prolonged depression and all the problems that would bring.
We will have to wait and see if JMK is to make a posthumous return and finally cast the monetarists and their acolytes into the dusty pages of history books yet to be written.
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