One might almost say that economics is too important to be left to economists. Keynes, as his wife put it, was “more than an economist”. Here are three things he believed:
1. The future is radically uncertain. To talk of risks being “correctly priced” is a nonsense term. Risks are conventionally priced, but because there is no firm basis of knowledge to hold their prices steady they are subject to “sudden and violent changes”. This makes investment very volatile.
2. Holding money is a hedge against uncertainty. When confidence falls there is a flight into cash. This means that economies can run down, with people curtailing their spending.
3. Economies can stay depressed a long time unless government increases its own spending to offset the fall in private spending. This justifies “stimulus” policies.
Contrast this with the most influential macroeconomics taught today:
1. The future is known. We either know what is going to happen for certain, or we have mathematical probabilities about future events.
2. Markets continuously, or almost continuously, clear.
3. Shares are correctly priced on average.
These propositions amount to saying that a market system is almost always at full employment. If this is so, then stimulus policies will have no stimulating effect – they will only divert spending from the private to the public sector.
Obviously policy and regulation will be different depending which story one buys. In the last 30 years, governments and regulators have bought the second story, with the results we now see.
We are now coming out of a very severe recession. This is largely due to the stimulus policies adopted under the influence of Keynes. Hundreds of billions of dollars have been pumped into leaking economies all round the world.
Just compare this with the Great Depression of the early 1930s. Then, the world economy contracted for 12 quarters in a row. Now, it looks as if the contraction will be limited to four quarters. The difference is that then governments cut their own spending. This time they have done exactly the opposite. They have pumped money into the economy, either by expanding their own deficits or by getting central banks to print money.
Keynes showed that trying to balance the budget, which was correct at full employment, was radically unsound when the economy was contracting. In such a situation, the government’s revenue base would contract, and raising taxes or cutting spending would only cause it to contract more.
Conversely, any stimulus which revived the economy would largely pay for itself by automatically increasing the government’s revenues.
Yes, there would be a legacy of a higher debt. But this could be reduced gradually. After all, it took almost 100 years to pay off the debt incurred by the British government in the Napoleonic wars, during which time the British economy flourished mightily.
So, those economists and politicians who argue that the stimulus will bankrupt governments or raise the cost of future borrowing to astronomical heights are talking nonsense. This doesn’t mean that budgets should not be restored to balance and the national debt gradually reduced.
The most important thing to do in the recovery phase is to set up a system which guards against severe future downturns. We shouldn’t just rely on government stimulants. We should aim to give economies healthy lifestyles, so they don’t depend on constant blowing up to keep them vigorous.
The starting point of reform is the recognition that economies can crash. So they need to be weaned off activities which are liable to make them crash. I would pick out three topics for reform.
Banks taking deposits should be forbidden from speculating with their depositors’ money. There are different ways for achieving this. One could separate retail from investment banking. In the British context this would mean stopping high street banks giving mortgages. Less radically, one could stop banks securitising mortgages; or one could tighten up the conditions for mortgage lending. Another way of making banks “safer” for depositors (and for the economy) is to force them to hold more capital against their liabilities or more reserves against their deposits.
However, if retail is to be separated from investment banking, it is important to ensure that investment banks are not allowed to become “too big to fail”. Governments (for which read taxpayers) should never be in the position of having to bail out banks in order to prevent the economy from collapsing.
Secondly, price stability is not enough. Macroeconomic policy should aim to preserve financial stability as well. That means preventing asset bubbles. Current proposals aim to vary bank capital adequacy requirements contra-cyclically. However, this approach presupposes both the existence of regular economic cycles and ability to judge where we are in the cycle. I doubt if either proposition is true.
A more durable way of preventing asset bubbles would be to reverse the trend to inequality. This has resulted in wealth being piled up in ever fewer hands, and poorer people becoming over-borrowed. The combination of concentrated wealth and stagnant median incomes is calculated to turn investment into speculation. How to reverse the trend to increasing inequality is the main unsolved question of political economy today.
Finally, we must correct the huge global imbalances which have enabled some parts of the world, notably China and East Asia, to pile up huge current account surpluses against the rest of the world. This has left much too large a part of our own economic activity dependent on foreign loans. It is one thing to borrow from abroad for investment, a different matter to borrow for consumption, since this does not create assets which can service the debt. The global imbalances helped pump up the inverted debt pyramid that brought the system crashing down.
These would be the lines of reform for a Keynesian Chancellor. It is not enough to say, with the economist Robert Lucas, “I guess, we are all Keynesians in the foxhole”. We must stop falling into foxholes.
Robert Skidelsky 