LONDON - All economies recover in the end. The question is how fast and how far. When Keynes talked of persisting ‘under-employment’he did not mean that, following a big shock, economies stay frozen at one unchanging level of under-activity. But he did think that, without an external stimulus, recovery from the lowest point would be slow, uncertain, weak, and liable to relapse. In short, his ‘under-employment equilibrium’ is a gravitational pull rather than a fixed condition. This is a situation which Alan Greenspan has aptly described as a ‘quasi-recession’, a better phrase than ‘double-dip recession’.It is a situation of anaemic recovery, with bursts of excitement punctuated by collapses. It is the situation we are in today.

 

 

Contrary to Keynes, orthodox economics believes that, after a big shock, economies will ‘naturally’ return to their previous trend rate of growth, provided that governments balance their budgets and stop stealing resources from the private sector. The theory underlyingit has been explained in the July Bulletin of the European Central Bank. Debt-financed public spending will ‘crowd out’ private spending either if it causes a rise in real interest rates or if it leads households to increase their saving because they expect to pay higher taxes later. In these cases a fiscal stimulus will not only have no effect; the economy will be worse off because public spending is inherently less efficient than private spending.

 

The Bulletin’s authors do not believe that such complete ‘crowding out’ actually happened in the last two years. They explain why.If there are unemployed resources, extra government spending can ‘crowd in’ in private spending by creating additional demand in the economy which would otherwise not be there. Summarizing the evidence, the Bulletin finds that fiscal stimuli in the Eurozone have caused Eurozone GDP to be 1.3% higher over the period 2009-2010 than it would otherwise have been.

 

The evidence of a positive effect is even stronger for the United States. In a recent paper, economists Alan Blinder and Mark Zandl find that the total stimulus policy adopted in 2009-2010 (including TARP) averted another Great Depression. Fiscal expansion alone (to make the direct comparison with the ECB Bulletin) caused US GDP to be 3.4% higher over 2009-2010 than it would otherwise have been.

However the cutters have a fall-back position. The problem with fiscal stimuli, they say, is that they destroy confidence in the finances of the governments undertaking them, and this lack of confidence impedes recovery. So a credibledeficit reductionprogramme is now needed to ‘consolidate’ recovery’.

 

What is it about cutting the deficit which is supposed to ‘restore confidence’. Well, it‘may’ lead consumers to believe that a permanent tax reduction will also take place in the near future. This will have a positive wealth effect and increase private consumption.(This is known as the expansionary fiscal contraction hypothesis.)But why on earth should consumers believe that cutting a deficit, and raisng taxes now, will lead to tax cuts later on?

One implausible hypothesis follows another. Fiscal consolidation, the Bulletin says, ‘might’ lead investors to expect an improvement in the supply-side of the economy. But It is unemployment, loss of skills and human self-confidence, and investment cancellations that hit the supply side.

 

We are told that the ‘credible announcement and implementation’ of afiscal consolidation strategy‘may’ diminish the risk premium associated with government debt issuance. This will reduce real interest rates and make the ‘crowding-in’ of private spending more likely. But real interest rates on long-term government debt in the USA, Japan, Germany, and the UK are already close to zero. Not only do investors view the risks of depression and deflation as greater than those of default, but bonds are being preferred to equities for the same reason.Finally, the reduction of government borrowing requirements ‘might’ benefit output in the long-run from lower long-term interest rates. Of course, low long term interest rates are necessary for recovery. But so are profit expectations, and these depend on buoyant demand. However cheap it is for businessmen to borrow, they will not do so if they see no demand for their products.

 

These Bulletin arguments look to me like scraping the bottom of the intellectual barrel. The truth is that it’s not the fear ofgovernment bankruptcy but governments’ determination to balance their books which lowers business confidence, by reducing expectations of employment, incomes, and orders. It’s not the hole in the budget but the hole in the economy which is the problem.

Let us assume, though, that the ECB is right and that fears of ‘unsound finance’ are holding back the recovery of the economy. The question still needs to be asked: are such fears rational? Are they not grossly exaggerated in the existing circumstances (except, possibly in countries like Greece)? If so, is it not the duty of official bodies like the European Central Bank tochallenge irrational beliefs about the economy rather than pander to them?

The trouble is that the present crisis finds governments intellectually disabled, because their theory of the economy is in a mess. Events and common sense drove them to deficit finance in2009-2010, but they have not abandoned the theory which tells them that that depressions cannot happen, and that deficits are therefore always harmful (except in war!). So now they vie with each other in their haste to cut off the life-line which they themselves created. Policy-makers need to re-learn their Keynes, explain him clearly, and apply him, not invent pseudo-rational arguments for prolonging the recession.

 

In 1937 Keynes wrote: “The boom, not the slump, is the right time for austerity at the Treasury.” Jean-Claude Trichet, president of the European Central Bank, disagrees. Stripped of its jargon, his argument last Friday in the Financial Times is that fiscal retrenchment is needed to “consolidate recovery”. This has become the standard European – though not American – line. “Failure to address the deficit is the greatest danger we face,” said UK Treasury minister Lord Sassoon in the House of Lords on Monday, faithfully echoing the words of his master, chancellor George Osborne. But beyond vaguely referring to the need to restore “confidence”, none of the cutters can explain how reducing public spending when private spending is already depressed will “consolidate recovery”.

 

 

By contrast, Keynesian theory can readily explain why it will not. The government, Keynes argued, is the only agency that can prevent total spending in the economy from falling below a full or acceptable employment level. If private spending is depressed, it can restore total spending to a reasonable level by adding to its own spending or reducing taxes.

 

In doing so it will be adding to a deficit that is already the result of falling tax revenues and rising benefits due to the recession. The deficit, though, has the function of sustaining the level of total spending and output in the economy.

 

Any attempt to reduce it before a strong momentum to private sector recovery is established will make matters worse. Once the economy has started to grow, the deficit incurred during the recession will automatically shrink to a pre-recession level. Deliberate steps to eliminate the “structural” (ie non-recession induced) deficit should be postponed until the recovery is firmly entrenched. With the budget balanced, or even in surplus, at high employment, continued growth will steadily reduce the national debt as a percentage of gross domestic product. This is what happened after the second world war.

In Keynesian theory, monetary and fiscal policy are parts of a single process, not alternatives. In the early stages, money may have to be created to finance the deficit; the spending of this money generates the extra saving needed to “pay for” the investment; the rise in national income improves public revenues, thus helping the deficit to fall.

 

Contrary to a widespread view, the deficit does not impose a burden on future generations. There is no repayment burden because the government, unlike private individuals, can and normally does repay its maturing debts by borrowing again. (In the last resort, it can print money).

 

As for the interest burden that is said to arise when the interest is paid by taxation rather than by fresh borrowing, it is merely a transfer payment. Income is transferred from taxpayers to bond-holders. In the case of the UK, most of these bond-holders are domestic. The transfer is therefore a redistribution rather than a loss of income.

 

If, however, the public deficit is cut now, there will undoubtedly be a burden on both present and future generations. Income and profits will be lowered straight away; profits will fall, pension funds will be diminished, investment projects cancelled or postponed, schools not rebuilt – with the result that future generations will be worse off, having been deprived of assets they might otherwise have had.

 

The Keynesian theory contradicts the Osborne-Trichet doctrine that private spending is depressed because of fears about the sustainability or future cost of the deficit. The correct causal explanation is that private spending is depressed because total demand in the economy is depressed. The deficit is the consequence, not the cause, of depressed business expectations. It is “nature’s way” of sustaining economic activity in the face of a collapse of business confidence.

 

Nevertheless, confidence is a psychological phenomenon. Irrational though the fear of a recession-induced deficit may be, it is a fact that governments have to face. So they should aim to maintain total spending in a way that reinforces rather than diminishes business confidence.

 

One way would be to cut taxes by the same amount as they cut their own spending. This would imply a reduction of taxes by about £100bn over five years. This might appeal to the right, as over a period of years it would reduce the size of the state. But the effect of tax-cutting on economic activity is uncertain. A better way would be to offset any market-appeasing cuts in current spending by an increase in capital spending. A recession is an ideal time to “bring the country up to date”, since labour and capital will both be cheaper than in boom times.

 

The £38bn high-speed rail link from London to Birmingham and beyond, unveiled in March by Lord Adonis, the former transport secretary, is a perfect example. Like the smaller rail electrification schemes, it is not “shovel ready”, but a determined government could get it going long before the planned start in 2017. It would set up an immediate demand on the construction industries while also offering returns in the long run.

Former chancellor Alistair Darling’s scheme for a Green Investment Bank to invest in renewable energy and energy efficiency is another example. Industry experts predict that up to £37.5bn will be needed each year to upgrade or replace our old power plants over the next decade. Mr Darling’s £2bn plan was a step in the right direction – a step that was then retracted in Mr Osborne’s Budget.

 

A government whose animating spirit was Lloyd George rather than George Osborne would ask the public to subscribe to a National Recovery Loan of £100bn, to be spent over five years, to equip the UK with a modern transport system, energy-efficient housing and new power plants, and up-to-date schools. Austerity in the capital budget is the worst possible remedy for a slump.

 

Michael Kennedy is a former economic adviser at the Treasury. Lord Skidelsky is professor emeritus at Warwick University

 

 

 

In the debate on the Address, I asked the noble Lord, Lord Henley, this question. By what mechanism do the Government believe that fiscal tightening will promote recovery? The noble Lord, Lord Henley, was good enough to write to me, making three points. His first was that public borrowing is only taxation-deferred. The idea is that the public, knowing that they will have to pay for the deficit with higher taxes, increase their saving by the amount of the higher taxes they expect to have to pay. Thus the deficit not only fails to stimulate the economy, it crowds out more efficient private spending. As stated, the argument is simply false. That part of the deficit which brings into employment resources which would otherwise stand idle will be paid off without any need to increase taxes, simply by the growth of public revenue which the rise in national income brings about. I do not know that any serious economist believes this Ricardian equivalence argument and yet it is one of the justifications for the Government's deficit-cutting programme. So where is the Treasury getting its wisdom from?

 

The second point the noble Lord, Lord Henley, made was that it would be irresponsible to accumulate substantial debts that would have to be paid off by subsequent generations in the decades to come. The reply to this is that a deficit does not impose a burden on future generations. There is no repayment burden because the Government, unlike private individuals, can and normally do repay their maturing debts by continuing to borrow. As for the interest burden which is said to arise when interest is paid by taxation rather than by fresh borrowing or printing money, it is merely a transfer payment. Income is transferred from taxpayers to bond holders. Since most of the transfer of income is within the United Kingdom, it is therefore a redistribution rather than a loss of income for future generations. Again, these are quite straightforward points once one grasps them, but the Government and many of the fiscal consolidators have gone on and on about the burden which would be faced by future generations, as though there was a net loss to them from an increase in the national debt.

 

If, however, the public deficit is cut now, there will undoubtedly be a burden on both present and future generations. Income and profits will be lowered straightaway; profits will fall over the medium term; pension funds will be diminished; investment projects will be cancelled or postponed; and schools will not be rebuilt, with the result that future generations will be worse off, having been deprived of assets that they might otherwise have had.

 

I go back to the letter of the noble Lord, Lord Henley. Of course, this is not a personal attack on the noble Lord, whom I greatly like and admire. He is just acting, as is the noble Lord, Lord Sassoon today, as the unfortunate fugleman of the Treasury. His third point was:

"The higher the level of debt, the higher the interest rate that markets will demand to compensate them for holding that debt. Failure to tackle Britain's deficit would therefore push up the costs of debt service and risk higher long-term interest, not just for the Government, but also for families and businesses through the higher costs of loans and mortgages".

Every proposition in that short paragraph is false in the present situation. If the economy were fully employed, it is true that the higher the level of public debt, the more the Government would have to pay for it, which could cause the whole structure of interest rates to rise. But if the private economy is depressed, interest rates on government debt do not have to rise; indeed, they have not risen over the whole of this recession, even though the Government are borrowing almost three times as much as before. Why? It is surely not because of the resolute steps which the Chancellor has taken to reduce the deficit and thus restore confidence, since the Treasury is able to borrow just as cheaply and with the same long maturities as under the previous Government.

The reason that all Treasuries, except the most profligate ones such as the Greek treasury, can get their money so cheaply is that investors demand safety-first investment strategies, or, as Keynes would have said, there has been a massive flight to liquidity. Even as government debt mounts, low yielding bonds are still considered better-because they are safer-than equities.

 

Or, put another way, when there is a dearth of private sector investment opportunities, government borrowing does not "crowd out" private sector investment; it adds to it.

The reason that private sector investment is depressed is not fears about the cost or sustainability of the deficit. Do businessmen wake up in the night, thinking, "God, how large the deficit is! I really can't do any business now because of the increase in the deficit"? I do not believe that that is the way in which businessmen think about it. They do not invest because they do not see the orders, not because they think that the deficit is running out of control. It is the same with the commercial banks, which still cannot accurately price their assets. It is because they have troubles with their balance sheets and because businesses cannot see where the orders are coming from that there is too little investing and borrowing going on in the private sector.

This explains-I go to a point made by the noble Lord, Lord Higgins-why quantitative easing is not the automatic offset to fiscal tightening that some noble Lords, especially the noble Lord, Lord Barnett, assumed it to be. It is not the printing of money but the spending of money which is important. Quantitative easing, unless it is done in particular ways-that is a subject on its own-is not a guarantee of the spending of money. So how does the noble Lord, Lord Higgins, propose to get a monetary policy consistent with a reasonable level of demand through quantitative easing? That was a missing part of an otherwise very interesting speech. In short, contrary to what the deficit vigilantes say, the deficit is the consequence and not the cause of depressed business conditions.

I believe that a Government who had the courage and intelligence to explain all this properly to the public would have a much better chance of calming jittery markets than the grotesque exaggeration of the dangers of debts and deficits which is now going on.

I agree thus far with the noble Lord, Lord Desai. There is not going to be a repeat of the 1929-31 depression. We have done enough to cut off the slide. There is an anaemic recovery going on. The UK may grow by 2 per cent this year, though I would be surprised if it did. If we look beyond a single quarter's figures, to the forces of demand in the world, especially as they will be impacted by the rolling out of the cuts in Europe and elsewhere over the next few years, it is hard to see where the sources of robust growth are coming from. In that sense I disagree with the noble Lord, Lord Desai, who made a constructive and well-thought-out speech. I agree with him when he argues that the extra cuts this year are too slight to have any really depressive macro-economic consequences.

The point is that the Government have said that they are deliberately going to take £100 billion of spending out of the economy over the next four or five years, and it is the effect of that determination to do that on business confidence which seems the relevant factor, not the very small amount of cuts that are going to take place this year.

So what would my alternative policy be? One confidence-boosting policy would be for the Government to cut taxes by the same amount as they cut their own spending. This would imply a reduction of taxes by about £100 billion over five years. There is a nod to tax cutting in the Budget in the proposals to reduce corporation tax, but the net effect of the tax policies is to raise taxes and therefore will be deflationary. Also, the effect of tax cutting on demand is subject to quite large uncertainties: how much will be saved, how much will be spent and so on. A far better way would be to offset any cuts in current spending by an increase and acceleration in capital spending. A recession is an ideal time to bring a country up to date, since labour and capital will be cheaper than in boom times.

The £38 billion high-speed rail link from London to Birmingham and beyond, unveiled in March by the noble Lord, Lord Adonis, who I see is in his place, is a perfect example of such a programme, as is the smaller railway electrification programme announced at the same time. This is not all shovel-ready stuff, but a determined Government could get the high-speed scheme going long before the business-as-usual start planned for 2017. It would set up an immediate demand on the construction industries while also offering long-run returns. Former Chancellor Alistair Darling's scheme for a green investment bank to invest in renewable energy and energy efficiency, is another example. Industry experts predict that up to £37.5 billion will be needed each year for the next 10 years to upgrade or replace our old power plants.

These are examples to develop the capital of this country for its long-term benefit which should certainly be part of any fiscal plan for both the immediate and the medium-term future. Of course it would be better if a large programme of capital spending could be agreed with other governments. But we could still do a lot of it on our own. A Government whose animating spirit was Lloyd George rather than Boy George would ask the public to subscribe to a national recovery loan of £100 billion, to be spent over five years to equip the UK with a modern transport system, an efficient energy system and a modern school system. To advocate capital cutting at a time of recession is the worst remedy that one could possibly have. It is an insane policy and it will not only destroy the coalition, but it will do enormous damage to the country.

 

 

 

At a time when the UK economy has an estimated "output gap" – the gap between what the economy is producing and what it has the potential to produce – of between 4 and 6 per cent (the Government's figures), I do not believe the Government take money out of the economy; it should pump it in. I don't understand how you help growth by reducing spending. But let's start on the macroeconomic analysis.

 

First, a short lesson in Keynesian macroeconomics. I make no apology for starting here, because what is at issue are two opposing theories, or "models" of the macroeconomy. The message of John Maynard Keynes's General Theory of Employment, Interest and Money (1936) comes in three parts. First, the community's level of income and output is determined by the level of aggregate demand, or purchasing power. Second, consumer demand, especially investment demand, can fall short of the supply of goods, so that the community's available stock of labour and plant can exceed the demand for their services. Third, this situation can continue indefinitely, in the absence of an outside stimulus to replace the missing private sector demand.

 

Now compare what happened in 1929-1932 (the Great Depression) and what has happened since 2008 (the Great Recession). In both periods the world economy declined at the same rate for five quarters. But whereas the Great Depression economy went on declining for another seven quarters, the Great Recession economy's decline stopped after five quarters, and there has been a very modest recovery. Almost all analysts agree this was because this time, unlike in the earlier period, governments all over the world poured a huge amount of extra money into their shrinking economies. Many allowed their deficits to expand from about 2 per cent of GDP to 10 per cent; and their central banks flooded the banks with new money.

 

This was good old fashioned Keynesianism. In a slump, Keynes said, governments should increase, not reduce, their deficits to make up for the fall in private spending. Any attempt by government to balance its budget in a slump would only worsen the slump.

 

Compare this to the key sentence on the first page of HM Treasury's Budget 2010: "Reducing the deficit is a necessary precondition for sustained economic growth" – an almost exact reversal of Keynes's theory. We have to understand that the Treasury is under new management and what it believed three months ago is not necessarily what it believes today. What we do know is that its new master, George Osborne, never believed in the stimulus. On 30 October 2008, six weeks after the collapse of Lehman Brothers, he compared a fiscal stimulus to "a cruise missile aimed at the heart of the economy". For the last two years he has been calling for the elimination of the stimulus as quickly as possible.

 

What theory of the economy makes sense of Osborne's attitude? He has never allowed himself the luxury of explicitly offering a theory. But his "model" can be inferred from his pronouncements. It can be boiled down to three propositions of expanding generality: (1) in the absence of the fiscal stimulus, the economy would have rapidly recovered to full employment; (2) following a shock, economies quickly self-adjust back to full employment in the absence of counter-productive government efforts to revive them; (3) markets are optimally self-regulating in the absence of government interference. Osborne has never said any of this precisely, but his pronouncements make no sense unless he believes this. So it is between these two views – Keynes's and Osborne's – that we are invited to choose. Let's see how far the new Treasury view endorses the Osborne view.

 

What the Government aims to do is to add an extra £40bn to Labour's deficit reduction plan, both by starting earlier and by cutting faster. That is, it aims to have removed, by 2014-15, £40bn a year from the private sector in addition to the £73bn which Labour had wanted to remove by then: a total fiscal tightening of £113bn, or two-thirds of the current deficit. This augmented degree of fiscal tightening should eliminate entirely the "structural" deficit by 2014-15, leaving only a vestigial public sector net borrowing requirement of 1.1 per cent by 2015-16; it will also cause the decline of public sector net debt from a peak of 70.3 per cent of GDP in 2013-14 to 67.4 per cent of GDP in 2015-16. In a nutshell, Osborne aims to balance the Budget by 2014-15.

 

Two questions arise: why does the Osborne Treasury suppose that the UK Government's deficit had reached £155bn, or 11 per cent of GDP by 2010? And by what mechanisms does it suppose that removing increasing amounts of money from the economy will help the recovery.

 

To answer the first, let's look at some more figures: between 2002-3 and 2007-8 the Government's annual deficit averaged 2.5 per cent of GDP. In 2008-9 it shot up to 6 per cent and in 2009-10 to 11 per cent. Between 2002-3 and 2007-8 the national debt rose from 32 per cent of GDP to 36 per cent, still well below 40 per cent, which Gordon Brown had laid down as the "prudent" maximum, before rising to 44 per cent in 2008-9 and 62 per cent in 2008-10. This deterioration in the national finances has been mainly caused by the decline in the economy, so the Government has been getting less revenue and is having to spend more on social benefits. One might suppose that most of it would be reversed as the economy recovers, without any change of policy.

 

But this is apparently not so. The Treasury now argues that its Comprehensive Spending Review of 2007 assumed "unsustainable revenue streams" based on a property boom and excess profits in the financial sector. Worse, for years, the Treasury had been overestimating the sustainability of its revenues and therefore of its spending. Or, put another way, the Treasury's pre-recession projections of taxes and spending assumed an inflation rate of 2 per cent, or nominal GDP growth of between 4 and 5 per cent. Once the recession hit and inflation started falling, nominal GDP fell faster than real GDP, leaving a larger than expected gap between revenue and spending.

 

What the recession did was "reveal that the public sector was living beyond its means". This is an odd way of putting it. Whenever you have an economic collapse, you are "revealed" to be living beyond your means, as the revenue side of your balance sheet falls. But does that mean you had previously been living beyond your means? Surely not. That you can't support yesterday's spending with today's income does not mean you could not do so yesterday. The only thing the slump reveals is that some event has cut your income and you need to adjust your spending. Moreover, the private sector was just as guilty of "living beyond its means", a fact conservative commentators prefer to avoid. Both levels of indebtedness was about 100 per cent of income.

 

Was the boom the fantasy, the slump the reappearance of reality? The answer is that the boom was neither more nor less real than the slump. The idea that asset prices in the boom were too "high" presupposes that there existed a set of objectively correct prices from which boom prices deviated. But where do such objectively correct prices come from and why are they more correct in a slump than in a boom? Expectations are only wrong in retrospect. Assets are worth no more and no less than buyers are willing to pay for them – regardless of whether we are in a slump or a boom.

 

My second question is: how does the Government suppose that taking money out of the economy is going to help recovery? We get an initial answer on page nine of the Budget statement: the deficit reduction plan "should underpin household, business, and market confidence". Notice the "should" here. The Treasury, unlike the Chancellor, is hedging its bets.

 

In the "medium term", ie over five years, deficit reduction will: "reduce competition for funds for private sector investment..." thus lowering long-term interest rates and boosting private sector investment. This has long been the Chancellor's main argument. It is loaded with fallacies. First, it assumes there is a fixed supply of saving, so that the more saving borrowed by the Government, the less will be available to be borrowed by the private sector. This is true at full employment, but untrue when there are unemployed resources. If the economy is underemployed, an increase in the government deficit does not encroach on existing saving; it creates additional saving by raising the national above what it would have been. This additional saving helps finance the increased borrowing.

 

Secondly, the "crowding out" argument assumes that interest rates adjust the supply of saving to the demand for investment: the more saving "released" for private investment, the lower long-term interest rates will be. Keynes denied that interest rates adjusted the supply of saving to the demand for investment. Rather, interest rates adjusted the supply of money to the demand for money. If the demand for money, or more generally liquidity, is going up as a result of increased uncertainty, then the interest rate will go up, whatever is happening to saving. It may even resist attempts by the Government to lower it by flooding the banks with money. This is what has been happening: banks and money markets are awash with cash, but little of it has been trickling through to the business sector. Investment has fallen by 20 per cent since the start of the recession.

 

The Treasury's "crowding-out" argument is bogus. Its argument about the beneficial effect of accelerated deficit reduction hinges on its effect on confidence. The proposition is that it will reduce the perceived risk of investing in Britain. This psychological boost will be sufficient to offset any negative effect of accelerated retrenchment on demand.

 

I would not for a moment decry the importance of psychology. We live in an uncertain world in which decisions to invest depend on subjective estimates of risk. Osborne's argument is that deficits do positive harm by destroying business confidence. This may come in several forms – fear of higher taxes, fear of default, fear of inflation. Deficits thus delay the natural (and rapid) recovery of the economy from an unexpected "shock".

 

However, this view has an unpalatable corollary. It implies that markets must always be appeased, even if they are wrong. What market participants believe to be the case becomes the case, not because their beliefs are true, but because they act on their beliefs. In short, it may not be the case that government borrowing crowds out an equal amount of private investment. But if markets believe it does, then government borrowing should be curtailed. This is equivalent to demanding a capitulation of governments to market ideology.

 

How far does Osborne's Treasury buy the Chancellor's argument? The answer is: by no means completely. The basis of its scepticism is reinforced by a body which Osborne set up to monitor the Treasury's projections: an independent Office for Budgetary Responsibility (OBR) chaired by former Treasury official, Sir Alan Budd.

 

The OBR's central economic forecast is for "the economy to rebalance, with net exports and business investment making a greater contribution to growth than in the recent past, and government spending making a negative contribution to growth as fiscal consolidation is implemented". To translate into English: tax rises and spending cuts will tend to reduce growth in the near future by reducing consumer demand, but this may be offset and even outweighed in the medium term by increased confidence. Specifically "reassuring the private sector that concrete measures have been put in place to limit the rise in government debt could prompt households and companies to reduce precautionary saving, increasing consumption and investment relative to what they would have been otherwise". The bottom line here is the conclusion that "fiscal consolidation will negatively effect the economy in the short term", but this could be offset by favourable effects on business confidence. The blow to demand is definite; the psychological offsets are hypothetical.

 

But the Treasury does not rely on "confidence" alone. It is also placing its hopes on the supply-side reforms of the Budget. "Measures to promote enterprise will reduce regulation and tax rates and refocus support towards infrastructure, the low carbon economy and regional development. Measures to create a fair tax system will reward work and promote economic competitiveness." These measures will promote "sustainable" growth, not the "artificial", deficit-created growth. And so they may. But they do not address what happens in the short term.

 

And, finally, if confidence doesn't do the trick, the Treasury looks to monetary easing to offset the effects of fiscal austerity, even though the policy of "quantitative easing" has failed so far to bring down long-term interest rates enough to stimulate private sector borrowing.

 

So that's the gamble on which the coalition has staked its fate, and that of the British economy. An important footnote is an exchange between President Roosevelt and Keynes in 1938. From 1933 to 1937, America had experienced four years of recovery since the Depression, with unemployment falling from 25 per cent to 14 per cent. Keynes attributed this recovery to the solution of the credit and insolvency problems and establishment of easy short term money; establishment of adequate relief for the unemployed; public works and other investment programmes helped by government funds or guarantees; the surge in private investment, and the momentum of the recovery. By the time of Keynes's letter to Roosevelt on 1 February 1938, however, the American economy was experiencing a "double dip" recession: unemployment had gone up from 14 per cent to 18 per cent, industrial production had fallen by 21 per cent and real GDP by 3.5 per cent. Keynes attributed this to the premature curtailment of the public works programme, as Roosevelt tried to "balance the budget" in 1936-37. Keynes's letter marks the start of the "Keynesian" phase of the New Deal which, by 1941 had reduced unemployment by 8 percentage points.

 

Whose judgement – or ideology – do we trust, Keynes's or Osborne's?

 

 

 

 

 

 

In one sense, next week’s emergency Budget is simply the logical working out of an intellectual theorem. The implicit premise of the coming retrenchment is that market economies are always at, or rapidly return to, full employment. It follows that a stimulus, whether fiscal or monetary, cannot improve on the existing situation. All that increased government spending does is to withdraw money from the private sector; all that printing money does is to cause inflation.

 

These propositions are a re-run of the famous “Treasury view” of 1929. By contrast, Keynes argued that demand can fall short of supply, and that when this happened, government vice turned into virtue. In a slump, governments should increase, not reduce, their deficits to make up for the deficit in private spending. Any attempt by government to increase its saving (in other words, to balance its budget) would only worsen the slump. This was his “paradox of thrift”. The current stampede to thrift shows that the re-conversion to Keynes in the wake of the financial collapse of 2008 was only skin-deep: the first story remains deeply lodged in the minds of economists and politicians.

 

But this story alone does not explain the conversion to austerity. Politicians clamouring for cuts in public spending do not cite Chicago University economists. They talk about the need to restore “confidence in the markets”. The argument here is that deficits do positive harm by destroying business confidence. This collapse of confidence may come in several forms – fear of higher taxes, fear of default, fear of inflation. Deficits thus delay the natural (and rapid) recovery of the economy. If markets have come to the view that deficits are harmful, they must be appeased, even if they are wrong. What market participants believe to be the case becomes the case, not because their beliefs are true, but because they act on their beliefs, true or false.

 

The parallel with what happened in 1931 is irresistible. In February of that year, Philip Snowden, the Labour government’s chancellor of the exchequer, set up the May Committee to recommend cuts in public spending. The committee projected a budget deficit of £120m, later raised to £170m, the latter figure amounting to about 5 per cent of gross domestic product, and proposed raising taxes and reducing spending to “balance the budget”. The international financial crisis caused by the collapse of the Austrian Credit-Anstalt bank in July 1931 brought huge pressure on the government to act on the May Report. In a notable display of patriotic fervour, the financial and political establishment united to demand cuts in unemployment benefits to “save the pound”.

 

Keynes was one of the very few who stood out against the herd. Of the May Report’s authors, he wrote: “I suppose that they are such very plain men that the advantages of not spending money seem obvious to them.” They had ignored the fact that their proposed cuts would add 250,000-400,000 to the unemployed and diminish tax receipts. “At the present time,” Keynes continued, “all governments have large deficits. They are nature’s remedy for preventing business losses from being ... so great as to bring production altogether to a standstill.”

 

When the Conservative-Liberal coalition that had succeeded the Labour government introduced an emergency budget in September 1931, Keynes again stood out against the chorus of approval. The budget was, he wrote, “replete with folly and injustice”. He explained to an American correspondent that “every person in this country of super-asinine propensities, everyone who hates social progress and loves deflation, feels that his hour has come and triumphantly announces how, by refraining from every form of economic activity, we can all become prosperous again.”

 

Conservative spokesmen often claim that fiscal consolidation causes economies to recover. If so, the effect of the outbreak of public frugality in 1931 was curiously roundabout. Cuts in salaries produced a “mutiny” of naval ratings at Invergordon, suggesting that the empire was crumbling. This was enough to force Britain off the gold standard. A combination of sterling depreciation and lower interest rates revived exports and started a housing boom. But there was never a complete recovery until the war. Such evidence for the success of the cuts is the stuff of castles in the sky.

 

We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all. If however, the financial markets and their political fuglemen turn out to be as “super-asinine” as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.

 

 In the Crimean War, it is said that Lord Raglan, a veteran of the Peninsular War, announced his plan of campaign to the assembled commanders by pointing to the map and saying, "We attack the French here", at which point an aide whispered to him, "Sir, the French are our allies". I trust that members of the coalition will not be afflicted by a similar cognitive dissonance.

 

The Government have already announced £6.2 billion of cuts, and further cost-cutting is promised in the emergency Budget of 25 June. Contrary to the noble Lord, Lord Desai, I believe that these will be real cuts if growth does not take place. That is why I would not make them until we have much firmer evidence of recovery than we have at the moment.

 

Why this stampede to austerity? The basic reason is a visceral, if vestigial, puritanism. We feel that more spending cannot be the answer to having spent too much already. Peter Oborne summed this up well in the Daily Mail. He said: "Borrowing to save the economy is like trying to sober up a drunk by giving him a large whisky".

 

The Chancellor said much the same some six weeks after the collapse of Lehman Brothers. He said:  "Even a modest dose of Keynesian spending", is, "a cruise missile aimed at the heart of the recovery". That was in October 2008.

 

I have long argued that such propositions would be true if the economy was at full capacity. The boom is the time for belt-tightening. However, these propositions are not true for today. Everyone knows that output and employment are severely depressed. The OECD has calculated that the UK's output gap is 5 per cent. Does the noble Lord, Lord Henley, agree or not agree with that estimate?

 

In my judgment, we are experiencing a good, old-fashioned Keynesian demand-led recession, which requires a good, old-fashioned Keynesian response. As Nobel laureate Paul Krugman writes:

 

"Both textbook economics and experience say that slashing spending when you're still suffering from high unemployment is a really bad idea. Not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts".

 

By what mechanism do the Government believe that cutting the deficit will promote recovery? The usual argument is that it will restore business confidence. Surely the best way to do that and to reduce the deficit is to increase total spending from the low level to which it has fallen. The projected deficit has already shrunk from £176 billion to £156 billion without any change of policy. It will continue decreasing gradually as the economy recovers, unemployment shrinks and revenues grow.

 

The way in which the stampede for austerity has built up is frightening. I have yet to find a single solid reason for cutting the deficit now, especially in view of the disaster threatening to overwhelm the eurozone. People talk about the need to pay attention to the psychology of the markets. However, no one who has made any money on the market believes for a moment that financial markets are capable of judging risk accurately. As Warren Buffett said:

 

"A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth".

 

That is why politicians and public officials have a particular responsibility not to try to second-guess the financial markets by threatening disaster if certain policies are not followed. They do not know what the financial markets will think and, by playing up the risk of default or inflation, they can create a dangerous self-fulfilling prophesy-exactly the type of momentum that they do not want. If the markets believe what the Chancellor has been saying for the past year or so, they might make it impossible for him to eat his own words.

 

It is a tragedy that the very financial system that has recently been bailed out by the taxpayer is treated as the arbiter of fiscal policy-using the very deficits and debt that they have foisted on us as the pretext for savage fiscal cuts in recession. Regrettably, I do not agree with the noble Lord, Lord Lawson, that deficit reduction should take precedence over any other policies, but I agree with a famous predecessor of his, Winston Churchill, who, as Chancellor of the Exchequer, said:

 

"I would rather see finance less proud and industry more content".

 

 

 

 

The recent economic meltdown was at root not a failure of character or competence, but a failure of ideas.

 

Behind the cupidity of bankers, the weakness of regulators and the myopia of macro-policy stood a set of dominant ideas about the proper relationship between the state and the market. This amounted to two propositions: that markets–and in this context financial markets–were efficiently self-regulating, and that government intervention in the macro-economy should be confined to the single point of maintaining the value of money. Provided these two conditions were satisfied, a market economy would be cyclically stable and stay close to its production frontier. Collapses of the kind we have just experienced were off the radar screen. Not surprisingly, the chief intellectual casualty of the Great Recession has been this benign view of markets. As George Soros put it, “The crisis was generated by the system itself” (New York Review of Books, 4 December 2008). The economic crisis was thus also a crisis in economics. Soros has endowed a new foundation, the Institute for New Economic Thinking (INET), which held its inaugural meeting at King’s College, Cambridge, in early April.

 

Notable by their absence were representatives of the “new classical economics”, centred on the universities of Chicago and Minnesota, because theirs was the paradigm that was being attacked as the explanation of our economic woes. Since the 1980s Chicago economics has been the dominant influence on the way economics is done and taught throughout the world. At its heart is the rational expectations hypothesis (REH). In its hardline version, this holds that economic agents have perfect information about all possible future states of the world, so that expectations are always fulfilled on average. A direct application of hardline REH is the efficient market hypothesis (EMH). This claims that risks are always correctly priced and that therefore financial markets need little or no regulation. Chicago economics excludes the possibility of large-scale collapses. Chicago economists have been relatively silent in the last two years, since their theories have robbed them of plausible explanations of what went wrong. Professor Robert Lucas did indeed remark that “everyone is a Keynesian in the foxhole”, without explaining that his model had no foxholes in it. The INET conference brought together the dissenting schools, of which three may be picked out.

 

1. The New Keynesians, sometimes known as “sticky price” Keynesians from their early work on labour markets. New Keynesian economists accept rational expectations, but drop the assumption of perfect information. At the INET conference, New Keynesian Nobel Laureate Joseph Stiglitz explained that you can have rational expectations without common knowledge. Markets are not in general efficient even when all market participants have rational expectations and all markets are competitive. Whenever risk markets are incomplete and information is imperfect, or asymmetrical, threats from so-called externalities become pervasive. Whenever there are externalities there is a scope for government intervention. Professor Mark Brunnenmeier of Princeton explained that if it’s commonly known that a bubble will burst on a certain day, the bubble will never get off the ground. But we don’t know that everyone knows. You can have a “rational” bubble if everyone knows that the price is too high, but no one knows that everyone knows that either. New Keynesians are not in general committed to “new economic thinking”, they just want their thinking to become the mainstream once more, as it was in the 1950s and 1960s.

 

2. The post-Keynesians drop the rational expectations hypothesis completely. They believe that uncertainty– symmetric ignorance, not asymmetric information–is what explains why markets fail. At the INET event, George Soros outlined his theory of reflexivity. There are two elements. We are fallible in our understanding of reality, and our thinking about reality changes it. His first fallibility may be called “epistemological uncertainty”, the second “ontological indeterminacy”. In the first case, the future is in principle knowable, but unknown. In the second, it is genuinely unknowable, because we create it each time we act. As a result of this double fallibility we may easily get “super bubbles”. Soros believes the one which collapsed in 2007 may have been germinating since the mid 1990s, with each rescue operation confirming a false trend.

 

Professors Roman Frydman and Michael Goldberg put forward their Imperfect Knowledge Economics, which enables qualitative, rather than quantitative, predictions by developing a “non standard probabilistic formalism”. As an alternative to efficient market hypothesis, Goldberg suggested a contingent market hypothesis, which recognises that change is affected by unforeseen causes and conditions. The causal processes underpinning price movements can’t be specified by any over-arching model.

 

A third post-Keynesian contribution came from Tony Lawson. His central point was that you need to use different kinds of models for different situations. Maths isn’t neutral: it is a particular way of structuring reality. It requires what Lawson called “event regularity”. But social reality is not typically like that. It is open, not closed, it is emergent, it is meaningful, it is “valuey”. Economics should not give up maths, but should understand the limits of its applicability to economic problems.

 

3. Behavioural Economics was represented at the INET conference by Nobel Laureate George Akerlof. Best known for his 1970 article, “The Market for Lemons”, a pioneering study in asymmetric information, he and coauthor Robert Shiller have dropped rational in favour of psychological (i.e. “irrational”) explanations of behaviour in their recent book, Animal Spirits. Economic agents rely not on rational calculation but on confidence, snake oil and stories to motivate their actions. Economics as a system of story-telling is common ground to the Post-Keynesians and the behaviourists. But whereas Post-Keynesians explain conventional behaviour as a rational, or at least reasonable, response to the existence of uncertainty, behaviourists argue that it is an ingrained aspect of human psychology. Behavioural economists expect that in time neuro-analysis will discover behavioural patterns as predictable as those assumed by the rational expectations hypothesis, thus confirming the scientific status of economics.

 

Practical people may wonder what all these professors have to tell them. The answer is: quite a lot. The common conclusion of the INET weekend was that the self-regulating market is a myth, and that various forms of government intervention are required to make the market system stable and efficient. There is as yet no agreed “new paradigm”, perhaps there will never be. But from the ferment of ideas produced by the crisis is sure to come the next generation of regulation and policy.

 

*Lord Skidelsky is author of a prize-winning biography of John Maynard Keynes.

 

References Financial Services Authority (2009), The Turner Review: A regulatory response to the crisis in global banking, available at http://www.fsa.gov.uk

 

Skidelsky, Robert (2009), Keynes: The Return of the Master, Penguin Books, Ltd., UK. Smithers, Andrew (2009), Wall Street: Imperfect Markets and Inept Central Bankers, John Wiley & Sons, Ltd, UK.

 

©OECD Observer No 279 May 2010

 

 

 

But was Swift right to see knavery as the main motive for unintelligibility? Obviously, it is a very powerful motive, in politics no less than in finance. The less people understand about something, the easier it is to fool them. There has never been a shortage of snake-oil merchants: Donizetti wrote an opera, L’Elisir D’Amore, about one of them advertising a love potion in a nonsensical patter. But the intention to deceive, or even to make money, is not necessarily what has driven the recent explosion of financial innovation.

 

Consider the US Securities and Exchange Commission’ current civil suit against Goldman Sachs. Goldman whiz-kid Fabrice Tourre is charged with having deliberately designed a complicated security that was designed to fail. Was his intention to deceive? Or was it the intellectual pleasure he got from creating a “Frankenstein monster” (as one of his e-mails described it), regardless of the consequences?

 

The latter seems the dominant motive. As another of his e-mails put it: “The entire system is about to crumble any moment...the only potential survivor the fabulous Fab...standing in the middle of all these complex, highly levered, exotic trades he created.” To be cleverer than the pack (and of course making money by his cleverness) seems to have been Tourre’s driving passion.

 

Finance has always been opaque, quite apart from the motive of swindling the investing public. “Double-entry bookkeeping” is one of the great discoveries of European civilization, but five centuries later most people are still muddled about assets and liabilities. Without such knowledge, technical terms like “balance-sheet recession” and “rebuilding balance sheets” are meaningless.

 

Opacity has grown with complexity. The explosion of derivative instruments has demanded such an effort at understanding that metaphorical language is needed. Think of collateral debt obligations (CDOs) as poisoned sausages, says the economist Nouriel Roubini, with sub-prime mortgages as the rat meat in them. With a mental effort, the layperson can then imagine these poisonous sausages, otherwise known as “toxic assets,” spreading through the world’s banks, ruining their digestions and crippling the economies they are meant to serve.

 

But complexity is not the only reason for obscurity. In his famous essay “Politics and the English Language,” George Orwell pointed to the widespread use of euphemism, which means not calling a spade a spade. This, he thought, was due to too many facts in the modern world having become too horrible, or unpalatable, to be stated clearly. One of his examples was the phrase “rectification of frontiers” to sugar-coat forced population movements.

 

Political correctness is another aspect of this: calling disabled people “differently abled,” for example. As the historian Tony Judt points out: “It’s not a ‘different’ ability, it’s no ability. Lousy language...conceals the effects of real power and capacity, real wealth and influences.” It enables deep inequality to happen more easily.

 

As important is a straightforward decline in literacy. Orwell talked of officials putting together blocks of words like “prefabricated hen houses.” This quality is much in evidence in a recent IMF report:

 

“Risks to global financial stability have eased as the economic recovery has gained steam, but concerns about advanced country sovereign risks could undermine gains and prolong the collapse of credit. Without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking system or across borders. Hence, policies are needed to (1) reduce sovereign vulnerabilities, including through communicating credible medium-term fiscal consolidation plans; (2) ensure that the ongoing deleveraging process unfolds smoothly; and (3) decisively move forward to complete the regulatory agenda so as to move to a safer, more resilient, and dynamic global financial system. For emerging market countries, where the surge in capital inflows has led to fears of inflation and asset price bubbles, a pragmatic approach using a combination of macroeconomic and prudential financial policies is available.”

 

Ironically, the same document is full of demands for greater “transparency.” So let us translate that IMF passage into transparent English:

 

“The world economy has become less risky as it has recovered from recession, and as banks and households have reduced their debts. But fears of government default in rich countries could threaten the recovery by causing interest rates to rise and exchange rates to fall. So three things are needed: governments must (1) cut their deficits gradually in a believable way, (2) keep enough spending going to compensate for increased saving in the private sector, and (3) press on with bank regulation. For developing countries, economic policy and bank regulation should be used together to stop inflation and asset bubbles.”

 

The greater the distance between the language of elites and ordinary people, the greater the risk of revolt. To the extent that complexity in finance or politics creates new opportunities to deceive, impedes understanding, or blurs lines of accountability, we should aim to reduce it. To the extent that such problems reflect decreased ability to express oneself clearly, the remedy is to improve education. The price of clarity, like the price of liberty, is eternal vigilance, and the two are connected.

 

 

Once a new government is in place, the chancellor will have to face the situation as it is, not as his party claimed it would have been had it been in power. The government's finances are dire. The £163.4bn that the Labour government borrowed in the fiscal year 2009-2010, representing 11.6 per cent of GDP, is the biggest deficit in the postwar period. Public-sector net debt at the end of March was at £890bn, or 62 per cent of GDP - an increase of almost 10 percentage points over last year.

 

The worsening of the public finances is mainly the result of the deterioration in the economy. This has two aspects. The British economy is 5.4 per cent smaller than it was two years ago. But in addition, the fiscal forecasts at that time assumed that the economy would continue to grow to trend, reckoned to be 2.5 per cent a year - a growth that failed to occur. As a result, the British economy is 8.2 per cent smaller than it would have been had it continued to grow at that trend over the past two years. This, and not the actual shrinkage of the economy, measures the true deterioration in economic performance and the resulting deterioration in the public finances. Perhaps the forecasts were over-optimistic. But hindsight is the easiest form of virtue.

 

Such poor private-sector performance has inevitably had severe effects on the public finances. Tax revenues dwindle and social expenditure goes up. Of the total deficit of 11.6 per cent of GDP, 70 per cent is "structural", representing a continuation of pre-recession spending. The £14.4bn tab for the fiscal stimulus in 2009-2010, plus the "automatic stabilisers" representing increased spending on the un­employed, amount to almost 5 per cent. This spending will shrink automatically as the economy recovers: the government saves £1bn a year until 2012 for every 200,000 people who leave claimant count unemployment. The most recent projections for this year's deficit are already £13bn, lower than projections for the same period made 18 months ago.

 

However, even if the economy now resumes "growing to trend" - the 2010 Budget projects steady GDP growth in the next few years reaching between 3.25 per cent and 3.75 per cent in 2012, while inflation is expected to converge on the target rate of 2 per cent - there will remain a "structural" deficit of between 7 per cent and 8 per cent of GDP, which will have to be filled by increases in taxes and cuts in expenditure. The Labour government promised to launch a programme next April aimed at cutting the deficit to £74bn or 4 per cent of GDP by fiscal year 2014-2015. The Tories promised to start cutting sooner and more, but how much sooner and how much more would depend on George Osborne's promised emergency Budget.

 

If the recovery falters, even this drastic fiscal consolidation plan will seem inadequate. Although the stock market has recovered, the "real" economy is still struggling. In the first quarter of this year, GDP increased by only 0.2 per cent (half the figure in the last quarter of 2009), hardly the catch-up recovery some were hoping for. In February, unemployment figures rose by 43,000 to 2.5 million in total - or 8 per cent of the workforce. The US has started to grow more strongly, but Europe is flat. And, as already remarked, there is a not negligible risk of a double-dip recession.

 

 

In the pre-election period, there was a "war of economists", in which I myself took part. To the outsider, the engagement might have seemed to be on too narrow a front to be interesting. It was about how soon fiscal consolidation should start. However, behind this technical issue lay two contrasting theories, or models, of the economy. The first, which we may call "classical", is highly sceptical about fiscal stimulus under any conditions. The argument is that when the government issues bonds or debt to pay for its spending, this is bound to be at the expense of private lending and borrowing. The stimulatory effect of a government deficit is therefore bound to be zero, or very small.

 

The second, or Keynesian, view is that this is not true when there is a lot of slack in the economy. The reason for the slack is that the private sector is not spending enough to employ all those seeking work - whether because investment prospects are too uncertain, or because it is paying off debt. In these circumstances government spending is not at the expense of private spending: it compensates for its absence. If the government were to economise on its own spending at the same time as the private sector was spending less, the result would be a slide into even greater recession. Keynes called this the "paradox of thrift".

 

Those in the first camp do not deny the need for some stimulus when the economy is depressed, but they think this should not be at the expense of existing private spending. The only type of stimulus that meets this requirement is printing extra money. "Monetarists" put their faith in so-called quantitative easing (QE); Keynesians are happy with printing money, but deny that it is enough. The extra money has to be spent, and only the government can ensure that it is. (There is another way: the government can give all households time-limited spending vouchers - that is, special pounds, perhaps printed red, valid only for three months, and to be spent on buying British goods - and could issue successive tranches of these until the economy revives. This move would bypass the frozen banking system, but no political party has advocated it, and we can be sure that the incoming chancellor will put the horrendous thought to one side.)

 

The monetarists believe that the level of aggregate income is directly proportional to the amount of money in the economy. If the money supply goes up by 10 per cent, money income will go up by the same amount, and aggregate spending by the same amount. As the British monetarist Tim Congdon explains (using a more carefully defined notion of money): "large-scale creation of new bank deposits by the state can stop any recession".

 

Printing money has an additional advantage. As the Chicago economist Robert Lucas remarked, monetary expansion "entails no new government enterprises . . . and no government role in the allocation of capital . . . These seem to me important virtues." Except for one thing: it doesn't do the job.

 

Keynesians argue that the demand for real cash balances (the amount of "ready command" or liquidity that people want) varies with the state of confidence. In the old days people would start hoarding gold when confidence fell. Now they add to their cash reserves or buy liquid securities. Building up cash or liquidity buffers, however, means that the new QE money is not spent, and therefore does not contribute to increasing output. While the Keynesians accept that an increase in the money supply is a necessary condition for an increase in national income, they deny that it is a sufficient condition. With increased preference for liquidity, the injection of cash into the banking system by the Bank of England may not lower the rate of interest sufficiently to restore a full-employment level of aggregate spending. As Keynes put it, if money is the drink that stimulates the system to activity, "there may be several slips between the cup and the lip".

 

The numbers bear this out. From early 2009, the Bank of England started printing money with which to buy back government debt (as well as some high-grade corporate bonds) from the public. Over the year, roughly £200bn - or 15 per cent of GDP - worth of gilts and bonds was exchanged for cash. The monetarists expected a cash injection of that size would allow Britain to leave the recession with a bang.

 

Yet, as the 0.2 per cent GDP growth in the first quarter of this year is telling us, there was very little bang for quite a lot of buck. So what happened? Already at the first evaluation of the QE policy in August, six months into the programme, the Treasury and the Bank had noticed that something was not working. By then £144bn had been injected, yet UK bank lending had not picked up. Money from bond sales remained stuck in the banking system. The commercial banks held on to the cash, either in the form of reserves at the Bank of England or by buying new gilts or corporate bonds for the cash. Overall, in the 11 months between the launch of quantitative easing and its suspension, broad money supply (which includes bank deposits) actually fell by almost 10 per cent. And if we consider what John Slater calls "effective money" - a measure that, by including credit in the shad­ow banking system, is broader still - this fall is likely to have been even steeper.

 

The injection of money may have caused a stock-market boom in the financial economy, but on the real economy - the target of the policy - it had little effect. In short, damaged expectations may cause the credit crunch to outlast the circumstances that gave rise to it. In such circumstances government spending needs to be the main agent of recovery - and that means fiscal policy, however it is financed. We learn from experience nonetheless. If flooding the banking system with money doesn't do the trick, there is a big problem with fiscal policy as well. The nature of this first emerged in an enthralling exchange between Keynes and the Treasury official Richard Hopkins before the Macmillan committee on finance and industry in 1930. Keynes was arguing for a big expansion of the public works programme; Hopkins countered that the effects of any government programme would depend on its effects on business confidence.

 

 

Hopkins did not disagree that government work programmes could, in principle, cure unemployment, but went on, "if you had to get [the loan] taken up at a very high rate of interest and accompanied by an adverse public sentiment you would very quickly lose what you gained by that from the number of people who would think it better to invest the next lot of money they had in America". In other words, "psychological crowding-out" would cause the government to have to pay more for its debt. Extra government spending would cure unemployment only if it did not spook the markets.

 

Keynes himself was fully alert to the im­portance of confidence. He acknowledged that "economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average businessman. If the fear of a Labour government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; it is the mere consequence of upsetting the delicate balance of spontaneous optimism." He would even accept a "conservative Budget . . . if this would be helpful as a transitional measure".

 

Keynes wrote his General Theory of Employment, Interest and Money (1936) not just to change the minds of economists, but to persuade the business world that government intervention to rescue failing economies would be in its interest. But he tended to the view that the root of "lack of confidence" was lack of demand for goods and services and that confidence would automatically revive with the revival of spending, however engineered. In all this, he underestimated the visceral business hatred of big government. By 1939, however, even he had come to doubt whether a "democracy would ever have the courage to make the grand experiment necessary to prove my case outside the conditions of war".

 

In fact, that grand experiment has never been made outside war or other than under a totalitarian state, in the sense of Keynesian policy being used to rescue an economy from a slump. Franklin D Roosevelt's "New Deal" gave Americans hope and important reforms, but achieved only a modest recovery from the Depression - largely, Keynes thought, because the scale of government spending was in­sufficient. Full employment in democracies was restored only in the Second World War, when the government started spending 70 per cent of the national income, with the national debt rising above 200 per cent.

 

The one experiment that did prove Keynes's case was undertaken in Hitler's Germany, under the aegis of the Führer's economics minister Hjalmar Schacht, though not in conditions that encouraged democratic emulation. The Schachtian system consisted of three main elements: a) controls on capital exports, b) bilateral payments agreements, whereby Germany's trading partners were only allowed to sell as much to Germany as they brought from Germany, and c) huge state credits to German industry ("printing money"), which over four years reduced unemployment from six million to near zero, with inflationary pressure being repressed by wage and price controls.

 

 

Given the potentially conflicting requirements of "confidence" that he will face, what should the incoming chancellor do? He should choose the path dictated by economic reason, refuse to be spooked by what Samuel Brittan calls the "teenage scribblers", and continue to pump money into the economy, counting on this advantage: that the markets do not expect the UK government to go bankrupt.

 

While Greece is paying close to 11 per cent for its ten-year bonds, the UK Treasury is still paying less than 4 per cent, and the UK coupon is not even 100 basis points higher than the German. In fact, the bid yield on the ten-year gilt is roughly 50 basis points lower now than at the start of September 2008. Unless and until confidence runs out, running a Budget deficit is far less costly than a return to recession. If we fear market reactions to sluggish growth and large deficits, imagine market reactions to no growth and much larger deficits.

 

To ensure that the policy of continued macroeconomic stimulus does not lead to the capital strike that Richard Hopkins feared and his modern successors predict, the chancellor should make a few simple promises. He should promise (and prepare) sharp fiscal cuts the day the government's credit rating comes into serious doubt; he should promise to withdraw support for QE in the quarter that annualised inflation exceeds, say, 3 per cent; and he should promise to reconsider any type of stimulus measure once annualised GDP growth exceeds, say, 2.5 per cent for two quarters in a row. These promises could be part of a new fiscal constitution, adherence to which would be independently monitored. Spelling out precise conditions for the continuation of the fiscal stimulus would reassure the markets and shorten the period necessary to have one.

 

Beyond this, we cannot continue to run an economic system in which there is such a large gap between the beliefs of ordinary people and the beliefs of the business and financial worlds about the properties of the economy and the requirements of a decent economic life. Keynes rightly thought that ordinary people are instinctively more reasonable economists than economists and financiers. It is to them that the chancellor is ultimately responsible.

 

 

Once a new government is in place, the chancellor will have to face the situation as it is, not as his party claimed it would have been had it been in power. The government's finances are dire. The £163.4bn that the Labour government borrowed in the fiscal year 2009-2010, representing 11.6 per cent of GDP, is the biggest deficit in the postwar period. Public-sector net debt at the end of March was at £890bn, or 62 per cent of GDP - an increase of almost 10 percentage points over last year.

 

The worsening of the public finances is mainly the result of the deterioration in the economy. This has two aspects. The British economy is 5.4 per cent smaller than it was two years ago. But in addition, the fiscal forecasts at that time assumed that the economy would continue to grow to trend, reckoned to be 2.5 per cent a year - a growth that failed to occur. As a result, the British economy is 8.2 per cent smaller than it would have been had it continued to grow at that trend over the past two years. This, and not the actual shrinkage of the economy, measures the true deterioration in economic performance and the resulting deterioration in the public finances. Perhaps the forecasts were over-optimistic. But hindsight is the easiest form of virtue.

 

Such poor private-sector performance has inevitably had severe effects on the public finances. Tax revenues dwindle and social expenditure goes up. Of the total deficit of 11.6 per cent of GDP, 70 per cent is "structural", representing a continuation of pre-recession spending. The £14.4bn tab for the fiscal stimulus in 2009-2010, plus the "automatic stabilisers" representing increased spending on the un­employed, amount to almost 5 per cent. This spending will shrink automatically as the economy recovers: the government saves £1bn a year until 2012 for every 200,000 people who leave claimant count unemployment. The most recent projections for this year's deficit are already £13bn, lower than projections for the same period made 18 months ago.

 

However, even if the economy now resumes "growing to trend" - the 2010 Budget projects steady GDP growth in the next few years reaching between 3.25 per cent and 3.75 per cent in 2012, while inflation is expected to converge on the target rate of 2 per cent - there will remain

a "structural" deficit of between 7 per cent and 8 per cent of GDP, which will have to be filled by increases in taxes and cuts in expenditure. The Labour government promised to launch a programme next April aimed at cutting the deficit to £74bn or 4 per cent of GDP by fiscal year 2014-2015. The Tories promised to start cutting sooner and more, but how much sooner and how much more would depend on George Osborne's promised emergency Budget.

 

If the recovery falters, even this drastic fiscal consolidation plan will seem inadequate. Although the stock market has recovered, the "real" economy is still struggling. In the first quarter of this year, GDP increased by only 0.2 per cent (half the figure in the last quarter of 2009), hardly the catch-up recovery some were hoping for. In February, unemployment figures rose by 43,000 to 2.5 million in total - or 8 per cent of the workforce. The US has started to grow more strongly, but Europe is flat. And, as already remarked, there is a not negligible risk of a double-dip recession.

 

Stimulating facts

In the pre-election period, there was a "war of economists", in which I myself took part.

To the outsider, the engagement might have seemed to be on too narrow a front to be interesting. It was about how soon fiscal consolidation should start. However, behind this technical issue lay two contrasting theories, or models, of the economy. The first, which we may call "classical", is highly sceptical about fiscal stimulus under any conditions. The argument is that when the government issues bonds or debt to pay for its spending, this is bound to be at the expense of private lending and borrowing. The stimulatory effect of a government deficit is therefore bound to be zero, or very small.

 

The second, or Keynesian, view is that this is not true when there is a lot of slack in the economy. The reason for the slack is that the private sector is not spending enough to employ all those seeking work - whether because investment prospects are too uncertain, or because

it is paying off debt. In these circumstances government spending is not at the expense of private spending: it compensates for its absence. If the government were to economise on its own spending at the same time as the private sector was spending less, the result would be a slide into even greater recession. Keynes called this the "paradox of thrift".

 

Those in the first camp do not deny the need for some stimulus when the economy is depressed, but they think this should not be at the expense of existing private spending. The only type of stimulus that meets this requirement is printing extra money. "Monetarists" put their faith in so-called quantitative easing (QE); Keynesians are happy with printing money, but deny that it is enough. The extra money has to be spent, and only the government can ensure that it is. (There is another way: the government can give all households time-limited spending vouchers - that is, special pounds, perhaps printed red, valid only for three months, and to be spent on buying British goods - and could issue successive tranches of these until the economy revives. This move would bypass the frozen banking system, but no political party has advocated it, and we can be sure that the incoming chancellor will put the horrendous thought to one side.)

 

The monetarists believe that the level of aggregate income is directly proportional to the amount of money in the economy. If the money supply goes up by 10 per cent, money income will go up by the same amount, and aggregate spending by the same amount. As the British monetarist Tim Congdon explains (using a more carefully defined notion of money): "large-scale creation of new bank deposits by the state can stop any recession".

 

Printing money has an additional advantage. As the Chicago economist Robert Lucas remarked, monetary expansion "entails no new government enterprises . . . and no government role in the allocation of capital . . . These seem to me important virtues." Except for one thing: it doesn't do the job.

 

Keynesians argue that the demand for real cash balances (the amount of "ready command" or liquidity that people want) varies with the state of confidence. In the old days people would start hoarding gold when confidence fell. Now they add to their cash reserves or buy liquid securities. Building up cash or liquidity buffers, however, means that the new QE money is not spent, and therefore does not contribute to increasing output. While the Keynesians accept that an increase in the money supply is a necessary condition for an increase in national income, they deny that it is a sufficient condition. With increased preference for liquidity, the injection of cash into the banking system by the Bank of England may not lower the rate of interest sufficiently to restore a full-employment level of aggregate spending. As Keynes put it, if money is the drink that stimulates the system to activity, "there may be several slips between the cup and the lip".

 

The numbers bear this out. From early 2009, the Bank of England started printing money with which to buy back government debt (as well as some high-grade corporate bonds) from the public. Over the year, roughly £200bn - or 15 per cent of GDP - worth of gilts and bonds was exchanged for cash. The monetarists expected a cash injection of that size would allow Britain to leave the recession with a bang.

Yet, as the 0.2 per cent GDP growth in the first quarter of this year is telling us, there was very little bang for quite a lot of buck. So what happened? Already at the first evaluation of the QE policy in August, six months into the programme, the Treasury and the Bank had noticed that something was not working. By then £144bn had been injected, yet UK bank lending had not picked up. Money from bond sales remained stuck in the banking system. The commercial banks held on to the cash, either in the form of reserves at the Bank of England or by buying new gilts or corporate bonds for the cash. Overall, in the 11 months between the launch of quantitative easing and its suspension, broad money supply (which includes bank deposits) actually fell by almost 10 per cent. And if we consider what John Slater calls "effective money" - a measure that, by including credit in the shad­ow banking system, is broader still - this fall is likely to have been even steeper.

 

The injection of money may have caused a stock-market boom in the financial economy, but on the real economy - the target of the

policy - it had little effect. In short, damaged expectations may cause the credit crunch to outlast the circumstances that gave rise to it.

In such circumstances government spending needs to be the main agent of recovery - and that means fiscal policy, however it is financed.

We learn from experience nonetheless. If flooding the banking system with money doesn't do the trick, there is a big problem with fiscal policy as well. The nature of this first emerged in an enthralling exchange between Keynes and the Treasury official Richard Hopkins

before the Macmillan committee on finance and industry in 1930. Keynes was arguing for a big expansion of the public works programme; Hopkins countered that the effects of any government programme would depend on its effects on business confidence.

 

Fear of Labour

Hopkins did not disagree that government work programmes could, in principle, cure unemployment, but went on, "if you had to get [the loan] taken up at a very high rate of interest and accompanied by an adverse public sentiment you would very quickly lose what you gained by that from the number of people who would think it better to invest the next lot of money they had in America". In other words, "psychological crowding-out" would cause the government to have to pay more for its debt. Extra government spending would cure unemployment only if it did not spook the markets.

 

Keynes himself was fully alert to the im­portance of confidence. He acknowledged that "economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average businessman. If the fear of a Labour government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; it is the mere consequence of upsetting the delicate balance of spontaneous optimism." He would even accept a "conservative Budget . . . if this would be helpful as a transitional measure".

 

Keynes wrote his General Theory of Employment, Interest and Money (1936) not just to change the minds of economists, but to persuade the business world that government intervention to rescue failing economies would be in its interest. But he tended to the view that the root of "lack of confidence" was lack of demand for goods and services and that confidence would automatically revive with the revival of spending, however engineered. In all this, he underestimated the visceral business hatred of big government. By 1939, however, even he had come to doubt whether a "democracy would ever have the courage to make the grand experiment necessary to prove my case outside the conditions of war".

In fact, that grand experiment has never been made outside war or other than under a totalitarian state, in the sense of Keynesian policy being used to rescue an economy from a slump. Franklin D Roosevelt's "New Deal" gave Americans hope and important reforms, but achieved only a modest recovery from the Depression - largely, Keynes thought, because the scale of government spending was in­sufficient. Full employment in democracies was restored only in the Second World War, when the government started spending 70 per cent of the national income, with the national debt rising above 200 per cent.

 

The one experiment that did prove Keynes's case was undertaken in Hitler's Germany,

under the aegis of the Führer's economics minister Hjalmar Schacht, though not in conditions that encouraged democratic emulation. The Schachtian system consisted of three main elements: a) controls on capital exports, b) bilateral payments agreements, whereby Germany's trading partners were only allowed to sell as much to Germany as they brought from Germany, and c) huge state credits to German

industry ("printing money"), which over four years reduced unemployment from six million to near zero, with inflationary pressure being repressed by wage and price controls.

 

Gilt trip

Given the potentially conflicting requirements of "confidence" that he will face, what should the incoming chancellor do? He should choose the path dictated by economic reason, refuse to be spooked by what Samuel Brittan calls the "teenage scribblers", and continue to pump

money into the economy, counting on this advantage: that the markets do not expect the UK government to go bankrupt.

 

While Greece is paying close to 11 per cent for its ten-year bonds, the UK Treasury is still paying less than 4 per cent, and the UK coupon is not even 100 basis points higher than the German. In fact, the bid yield on the ten-year gilt

is roughly 50 basis points lower now than at the start of September 2008. Unless and until confidence runs out, running a Budget deficit is far less costly than a return to recession. If we fear market reactions to sluggish growth and large deficits, imagine market reactions to no growth and much larger deficits.

 

To ensure that the policy of continued macroeconomic stimulus does not lead to the capital strike that Richard Hopkins feared and his modern successors predict, the chancellor should make a few simple promises. He should promise (and prepare) sharp fiscal cuts the day the government's credit rating comes into serious doubt; he should promise to withdraw support for QE in the quarter that annualised inflation exceeds, say, 3 per cent; and he should promise to reconsider any type of stimulus measure once annualised GDP growth exceeds, say, 2.5 per cent for two quarters in a row. These promises could be part of a new fiscal constitution, adherence to which would be independently monitored. Spelling out precise conditions for the continuation of the fiscal stimulus would reassure the markets and shorten the period necessary to have one.

 

Beyond this, we cannot continue to run an economic system in which there is such a large gap between the beliefs of ordinary people and the beliefs of the business and financial worlds about the properties of the economy and the requirements of a decent economic life. Keynes rightly thought that ordinary people are instinctively more reasonable economists than economists and financiers. It is to them that the chancellor is ultimately responsible.

 

The most politically challenging is Tony Judt's Ill Fares the Land. Judt invites us to rethink the role of the state. Socialism is dead – too contaminated with the crimes of Stalinism. But the Reagan/Thatcher revolution was no answer. In the name of self-enrichment it allowed inequality to rip; and is now discredited by economic failure. Judt wants to reclaim the middle ground of social democracy. As a historian, he argues that the conservation of the 20th century's social achievements may be the most important political task today, warning that the "heedless rush" to dismember social protection threatens a destructive political backlash.

 

In Crisis Economics the economist Nouriel Roubini offers a crash course in financial reform. Politicians, he says, have been much too deferential to the myths and powers of the financial system. Roubini proposes extensive regulation of asset-backed securities – and a possible banning of the more complex derivatives – as well as separating retail from investment banking. In the UK this would mean a partial reversal of Thatcher's "big bang" of the 1980s, which set the City free from previous financial controls. Roubini's tract recognises that the state is not always the problem; it can also be the solution.

 

Politicians who are curious to understand why markets fail might do worse than skim the burgeoning literature of "behavioural economics". This branch of economics aims to understand how people actually behave, as against the idealised view of "rational" behaviour which has dominated mainstream economics. Highly recommended for those tedious train journeys our politicians have to make between the centre of power and the source of their mandates is James Montier's The Little Book of Behavioral Investing. This slim volume offers several entertaining tests to check the reader's grasp of reality, a useful service for a politician.

 

There are facts galore in Carmen Reinhart and Kenneth Rogoff's This Time is Different, a wonderful book to dip into for those statespersons interested in both finance and folly. Chapter 14 makes sombre reading for any who expect a rapid recovery to lighten the burden of painful retrenchment. The Reinhart-Rogoff conclusion is that, once economies have fallen into a hole, it is an exceedingly hard and lengthy business for them to clamber out of it. This reinforces the lesson of Judt and Roubini: it is much less costly in the end to have a mixed system of state and markets than to put all one's trust in markets. There is a fascinating table which shows that Greece has been in default on its sovereign debt every other year on average since its independence in 1823. The UK has never defaulted.

 

 

 

 

The surprise is that the Conservatives are not polling far ahead of Labour. After 13 years in power, Labour started the election with a huge disadvantage: the legacy of Tony Blair. From being Labour’s most potent asset in 1997, Blair turned into the party’s greatest liability after the Iraq war, and had to be practically forced out in 2006.

 

His successor, Chancellor of the Exchequer (finance minister) Gordon Brown, was well described by Blair as “clunking.” A man of charm and humor in private life, he is relentlessly dour in public. In Britain’s first ever “presidential” television debate the youthful Nick Clegg stole the show for the Liberal Democrats with his freshness and directness. David Cameron was polished but vague, and the jowly Brown came across as gun loaded with statistics.

 

But the statistics were not as good as they should have been. Brown’s reputation for fiscal prudence evaporated with the Great Recession.

 

Nevertheless, it is the Great Recession that keeps Labour in contention, particularly in the light of the Conservatives’ pledge to start cutting public spending the moment they take power.

 

This makes people anxious for their jobs. Most people – bankers and many “experts” excepted – are instinctive Keynesians, even if they have never heard of John Maynard Keynes. At some level, they understand what Keynes called the “paradox of thrift”: if households and firms are forced to reduce their expenses, and the government simultaneously cuts spending, unemployment will rise, because one person’s spending is another’s income, and the outcome will be less spending and less income all around.

 

Moreover, now is not the time for a political party to be seen to be in cahoots with the bankers. Although there is no real British equivalent of the American revolving door between Washington and Wall Street, the Conservatives are widely considered to be friends of the City of London and soft on rich tax evaders like Lord Ashcroft and Zak Goldsmith. Although the MPs’ expenses scandal – parliamentarians claiming reimbursement for dubious expenses – hit both main parties, the most egregious cases involved wealthy Conservative MPs.

 

And even though inequality of wealth and income in Britain increased in the 13 years Labour has been in power, this is thought to be something that a left-wing party might seek to correct, whereas there is no similar expectation for a party of the right. In short, when the power of money is under attack, a party that represents money will have a harder time.

 

Labour has an obvious interest in fighting the election on their handling of the economic crisis. The Conservatives would have done better to support them on this, while focusing their attack on the government’s economic record as a whole –especially Labour’s addiction to centralization and over-regulation. But this is going to be difficult to do because their naïve Shadow Chancellor, George Osborne, seems determined to put “cutting the deficit” at the heart of the Conservative program.

 

Spending cuts, he argues, would restore credibility to Britain’s public finances, thereby quelling the anxieties of businesses, investors, and consumers about future tax increases and inflation. A more certain future would restore confidence, boosting private investment and ensuring a robust recovery.

 

Public spending cuts come more naturally to Conservatives, and they have – despite their lack of candor – attempted to make a virtue out of this necessity. The Conservative manifesto ‘An Invitation to Join the Government of Britain’ is merely a grandiloquent way of saying that under a Conservative government the people will have to look after themselves.

 

Labour, by contrast, argues that immediate spending cuts would wreck the recovery – that the hole in the economy, not the government budget deficit, is the problem needing most attention.

 

In practice, both parties are afraid of their convictions. The Conservatives’ pledge to start cutting the deficit immediately amounts to only a 1% reduction in the coming year. Any promise of deeper cuts would, they feel, be electoral suicide, even though their model of the economy tells them that the government should be smaller, and that the deficit is unnecessary and even damaging.

 

Labour’s model of the economy implies maintaining the deficit for as long as needed, and even increasing government spending if the recovery appears to be flagging. But Labour is too afraid of the markets to say so openly. So, like St. Augustine, they promise virtue, but not until next year.

 

In other words, neither major party can afford to blurt out the awkward truth: how much deficit reduction any government can achieve will depend on what happens to the economy over the next five years, and no one can say anything for certain about that.

 

So the main parties vie with each other in their promises not to cut public services. Labour will not cut spending on unspecified “front-line services.” The Conservatives will not cut spending on health, international aid, and defense, similarly leaving unclear just where the cuts will be made. Only the Liberal Democrats are committed to a big cut: scrapping Britain’s nuclear submarines.

 

Finally, all the parties promise big constitutional changes. The Conservatives want to reduce the size of the House of Commons by 10%. Labour wants to reduce the House of Lords’ membership by half and hold referenda on making it wholly elected and on changing the voting system. The Liberal Democrats want MPs to be elected by proportional representation.

 

In a hung parliament, Britain’s ancient constitution would become a pawn among the parties as they haggle for a share of power. In that case, voters would get both more and less than they bargained for.

 

 

 

The 1958 Treaty of Rome, which established the European Economic Community, was Europe’s great leap forward. But the decision to create a common market without a common government was simply storing up trouble for the future. Everything since – enlargement to 27 member states and the creation of the 16-member euro-zone – has widened the gap between rhetoric and reality. Euroland has gone on promising far more than its history enables it to deliver.

 

The Greek financial crisis is the latest example of the gap between reality and rhetoric. At root, it is a crisis of “enlargement,” in this case enlargement of the euro-zone. Unprecedented effort at fiscal discipline in the 1990’s – helped in Greece by creative accounting – enabled Portugal, Italy, Greece, and Spain (disobligingly known as the PIGS) to meet the entry criteria in 2002. But once in, the pressure was off. Most of the Mediterranean countries continued on their spendthrift ways, confident that the markets would not call them to account.

 

Now Wolfgang Schauble, Germany’s Finance Minister, has said enough is enough. He advocates setting up a European Monetary Fund (EMF) to provide emergency lending to countries at risk of default on their sovereign debt. Emergency lending would come with a “prohibitive price tag,” “strict conditions,” and “mandatory penalties” in the event of non-compliance.

 

Translated into ordinary language, this means that the state finances of a country that was granted help from the EMF would be outsourced, for a time, to external commissioners, much as happened in the nineteenth century to Latin American states that wanted their debts re-financed.

 

Milton Friedman predicted the single currency would fall apart after a decade or two; this has now become more likely than not. After all, Schauble knows that the conditions he proposes would be politically unacceptable, so he says that any country unable to meet them “should, as a last resort, exit the monetary union, while being able to remain a member of the EU.” Germany might even exit itself, if it cannot bring its weaker partners to heel.

 

The Mediterranean crisis has exposed the euro-zone’s long-standing flaw: the absence of a single government. Because the euro-zone is not an “optimal currency area,” it needs tools to deal with so-called “asymmetric shocks” – shocks that affect some members more than others. But it lacks those tools, especially a Treasury with powers to tax and borrow, and a central bank that can act as lender of last resort to its member banks.

 

Schauble’s proposal has both an economic and a geopolitical dimension. Economically, it exposes the deep divide between those who believe that external imbalances are the fault of those who spend too little and those who believe that they are the fault of those who spend too much.

 

John Maynard Keynes wanted to force surplus countries to either spend or lend. But the older doctrine that it was a deficit country’s duty to “put its house in order” survived. The one concession to Keynes was the creation of the International Monetary Fund in 1944 in order to provide short-term assistance to deficit countries under strict conditions. This, in essence, is the German proposal today in the narrower context of the euro-zone.

 

Schauble’s view is an expression of Germany’s long-standing deflationary outlook. Germany’s fiscally conservative establishment would like other EU countries with large budget deficits to return to economic health through fiscal discipline, reduced domestic demand, and high export growth. The problem, German leaders believe, is not their country’s high saving rate, but other euro-zone members’ excessive spending.

 

Martin Wolf of The Financial Times disagrees. He also points the finger at China. Both countries have massive surpluses of savings over investment and huge trade surpluses. Both parade their fiscal virtue and insist that deficit countries stop their irresponsible spending.

 

Wolf rightly calls this argument economically incoherent. Piling up savings in one place imposes unemployment on the rest. High savers should consume more, allowing the big spenders to export more and start living within their means without dooming them to hair-shirted stagnation. Frugality is no virtue if no one is willing to spend.

 

But the main impact of Schauble’s bombshell is on the geopolitics of the EU. Europe’s political elite view the Union as one of the poles in a multi-polar world. But what is Europe? Less than a federation, more than a confederation, it lacks any center of gravity, any fixed frontiers. When an American, Chinese, or Russian leader wants to speak to Europe, whom does he call? Without internal coherence or external shape, Europe is little more than a geographical expression.

 

The implication of Schauble’s proposition, therefore, is that Euroland should shrink to a governable dimension. In essence, it recapitulates the contrast between the Greater Germany dreamed of by idealists in 1848 and the Smaller Germany created by Bismarck in 1871.

 

Like the little boy who was unafraid to declare the emperor naked, Schauble has pointed the finger of realism at the aspirational rhetoric in which all European leaders are still compelled to clothe their utterances. He has broken with the taboo against calling into doubt any aspect of the European project. For those who prefer solid construction to wishful thinking, his words are to be welcomed.

 

 

The fragility of the British economy in face of the Great Recession demands a rethinking not just of macroeconomic policy, but of the balance between consumption and investment, between finance and industry. In response to this challenge, George Osborne, the shadow chancellor, set out a “new economic model” in the annual Mais lecture last week. But there is little evidence of new thinking. There is no reference, for example, to what one might learn from the experience of Japan, which faced a similar “balance sheet recession” in the 1990s. Mr Osborne harks back to the old view that government is the problem not the solution – a philosophy that led to widespread financial deregulation and the current crisis.

 

Leaving aside the party-political stock-in-trade, the intellectual issue raised by the lecture concerns the relationship between government finance and the economy, and how this should respond to “the slings and arrows of outrageous fortune”. Mr Osborne quotes from a Bank of International Settlements report that “persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term growth potential”. This is true, provided the economy is running at or near full capacity. In such a situation, a high and persistent level of public debt would “crowd out” more profitable private investment. But this is not our situation.

 

Our public debt – unlike, perhaps, that of Greece – is not “persistently high”. It has gone up from a low of 36 per cent to 62 per cent in 2009 to cope with an unprecedented emergency. Moreover, when national output is 6 per cent – possibly more – below potential, as measured by prior trend, an increase in the public debt does not come at the expense of capital accumulation. It replaces the investment that is not taking place because the economy has shrunk. The government is spending so much because the private sector is investing so little: figures show that private investment has declined by a quarter since 2008.

 

Mr Osborne asks: why is private demand so weak? His answer is that private demand depends on “expectations and confidence”, and that immediate fiscal consolidation will be good for confidence. But an IMF paper last month warned that premature cuts in public spending could lead to a sterling crisis. The truth is that we do not know how the markets will assess the balance of risk between cutting off the life-support system and the government defaulting on its debt.

 

In any case, Mr Osborne is ignoring the pressure to rebuild private sector balance sheets, which has pushed the household savings ratio up from about 1 per cent at the start of 2008 to about 9 per cent in the third quarter of 2009. Experience of Japan’s recession of the 1990s will confirm that if the private sector is de-leveraging – reducing spending to reduce its debts – then public sector de-leveraging – cutting its deficit – will deepen, not lighten, recession. This is what Keynes dubbed the “paradox of thrift”.

 

Mr Osborne recommends an independent Office for Budget Responsibility to oversee the public finances. This 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.

 

The shadow chancellor sets out the argument for the Bank of England to re-absorb the responsibilities of the Financial Services Authority. This proposal deserves to be considered on its merits. But the focus on “institutional design” of the regulatory framework risks masking the flaws in regulatory philosophy that stemmed from the belief that the banks could safely be left to regulate their own risks.

 

Now is not the time to be scoring party-political points on the conduct of economic policy. It is a time for a radical reappraisal of the regulation of finance, so that the creativity of the industry can be harnessed to serve the needs of society, and not to generate transfers to those who can gamble with the nation’s resources. It is a time to design an “exit strategy” that allows the public sector – and the Bank – safely to remove the life support that was extended to the private capital markets in their hour of need.

 

We cannot return to the status quo ante. Get the reforms right and the private sector can get back on its feet without the crutch of public sector support and wholesale guarantees. Get them wrong and the present recession, for which Mr Osborne so castigates the government, could look like a success story.

 

Lord Skidelsky is emeritus professor of political economy and Marcus Miller professor of economics at the University of Warwick

 

 

Lord Skidelsky was awarded an honorary degree from the University of Rome Tre, in the presence of the President of Italy, Giorgio Napolitano. At the same ceremony, he was also appointed a Knight of the Grand Cross ( Cavaliere di gran Croce), which is the highest decoration within the President’s gift.

 

Lord Skidelsky has recently been at the heart of a lively debate in the UK's national media among economists, discussing the best way to tackle the national deficit, which has ballooned. The debate has created a schism in the profession, with some economists backing the Conservative Party’s view that fiscal tightening should begin this year, and others lending their support to Alistair Darling’s decision to delay spending cuts until 2011. Lord Skidelsky’s letter to the Financial Times on 18th February, co-signed by a further 57 leading economists, warned against a premature programme of deficit reduction, following a letter setting out the opposite view from leading economists from across the political spectrum to The Sunday Times on 14th February.

 

In banking, the trust-busters won the day with the Glass-Steagall Act of 1933, which divorced commercial banking from investment banking and guaranteed bank deposits. With the gradual dismantling of Glass-Steagall, and its final repeal in 1999, bankers triumphed over both the busters and the regulators, while maintaining deposit insurance for the commercial banks. It was this largely unregulated system that came crashing down in 2008, with global repercussions.

 

At the core of preventing another banking crash is solving the problem of moral hazard – the likelihood that a risk-taker who is insured against loss will take more risks. In most countries, if a bank in which I place my money goes bust, the government, not the bank, compensates me. Additionally, the central bank acts as “lender of last resort” to commercial banks considered “too big to fail.” As a result, banks enjoying deposit insurance and access to central bank funds are free to gamble with their depositors’ money; they are “banks with casinos attached to them” in the words of John Kay.

 

The danger unleashed by sweeping away the Glass-Steagall barrier to moral hazard became clear after Lehman Brothers was allowed to fail in September 2008. Bail-out facilities were then extended ad hoc to investment banks, mortgage providers, and big insurers like AIG, protecting managers, creditors, and stock-holders against loss. (Goldman Sachs became eligible for subsidized Fed loans by turning itself into a holding company). The main part of the banking system was able to take risks without having to foot the bill for failure. Public anger apart, such a system is untenable.

 

Premature rejection of bank nationalization has left us with the same two alternatives as in 1933: break-up or regulation. Taking his cue from Paul Volcker, a former chairman of the US Federal Reserve, President Barack Obama has proposed a modern form of Glass-Steagall.

 

Under the Obama-Volcker proposals, commercial banks would be forbidden to engage in proprietary trading – trading on their own account – and from owning hedge funds and private-equity firms. Moreover, they would be limited in their holding of derivative instruments, and Obama has suggested that no commercial bank should hold more than 10% of national deposits. The main idea is to reduce the risks that can be taken by any financial institution that is backed by the federal government.

 

The alternative regulatory approach, promoted by Nobel Laureate Paul Krugman and the chairman of Britain’s Financial Service Authority, Adair Turner, seeks to use regulation to limit risk-taking without changing the structure of the banking system. A new portfolio of regulations would increase banks’ capital requirements, limit the debt that they could take on, and establish a Consumer Financial Protection Agency to protect naïve borrowers against predatory lending.

 

This is not an either-or matter. In testimony to the Senate Banking Committee in early February, MIT’s Simon Johnson endorsed the Volcker approach, but also favored strengthening commercial banks’ capital ratios “dramatically” – from about 7% to 25% – and improving bankruptcy procedures through a “living will,” which would freeze some assets, but not others.

 

Many details of the Obama package are unlikely to survive (if, indeed, the plan itself does). But there are powerful arguments against the principles of his approach. Critics point out that “plain old bad lending” by the commercial banks accounted for 90% of banks’ losses. The classic case is Britain’s Royal Bank of Scotland, which is not an investment bank.

 

The commercial banks’ main losses were incurred in the residential and commercial housing market. The remedy here is not to break up the banks, but to limit bank loans to this sector – say, by forcing them to hold a certain proportion of mortgages on their books, and by increasing the capital that needs to be held against loans for commercial real estate.

 

Moreover, many countries with integrated banking systems did not have to bail out any of their financial institutions. Canada’s banks were not too big to fail – just too boring to fail. There is nothing in Canada to rival the power of Wall Street or the City of London. This enabled the government to swim against the tide of financial innovation and de-regulation. It is countries like the US and Britain, with politically dominant financial sectors competing to take over financial leadership of the world, that suffered the heaviest losses.

 

This is the point that the well-intentioned regulators miss. At root, the battle between the two approaches is a question of power, not of technical financial economics. As Johnson pointed out in his Congressional testimony, “solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraint on regulation and the political power of big banks.”

 

Such proposed solutions assume that regulators will be able to identify excess risks, prevent banks from manipulating the regulations, resist political pressure to leave the banks alone, and impose controversial corrective measures “that will be too complicated to defend in public.” They also assume that governments will have to the courage to back them as their opponents accuse them of socialism and crimes against freedom, innovation, dynamism, and so on. In fact, this chorus of abuse has already started, led by Goldman Sachs Chairman Lloyd Blankfein.

 

There is another interesting parallel with the New Deal. Roosevelt got the Glass-Steagall Act through Congress within a hundred days of his inauguration. Obama has waited over a year to suggest his bank reform, and it is unlikely to pass. This is not just because the banking crisis in 1933 was greater than today’s crisis; it is because much more powerful financial lobbies now stand between pen and policy. If reformers are to win, they must be prepared to fight the world’s most powerful vested interest.

 

 

Sir, In their letter to The Sunday Times of February 14, Professor Tim Besley and 19 co-signatories called for an accelerated programme of fiscal consolidation. We believe they are wrong.

 

There is no disagreement that fiscal consolidation will be necessary to put UK public finances back on a sustainable basis. But the timing of the measures should depend on the strength of the recovery. The Treasury has committed itself to more than halving the budget deficit by 2013-14, with most of the consolidation taking place when recovery is firmly established. In urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!

 

They seek to frighten us with the present level of the deficit but mention neither the automatic reduction that will be achieved as and when growth is resumed nor the effects of growth on investor confidence. How do the letter’s signatories imagine foreign creditors will react if implementing fierce spending cuts tips the economy back into recession? To ask – as they do – for independent appraisal of fiscal policy forecasts is sensible. But for the good of the British people – and for fiscal sustainability – the first priority must be to restore robust economic growth. The wealth of the nation lies in what its citizens can produce.

 

Lord Skidelsky,

Emeritus Professor of Political Economy, University of Warwick, UK

 

Marcus Miller,

Professor of Economics, University of Warwick, UK

 

David Blanchflower,

Bruce V. Rauner Professor of Economics, Dartmouth College, US and University of Stirling, UK

 

Kern Alexander,

Professor of Law and Economics, University of Zurich, Switzerland

 

Martyn Andrews,

Professor of Econometrics, University of Manchester, UK

 

David Bell,

Professor of Economics, University of Stirling, UK

 

William Brown,

Montague Burton Professor of Industrial Relations, University of Cambridge, UK

 

Mustafa Caglayan,

Professor of Economics, University of Sheffield, UK

 

Victoria Chick,

Emeritus Professor of Economics, University College London, UK

 

Christopher Cramer,

Professor of Economics, SOAS, London, UK

 

Paul De Grauwe,

Professor of Economics, K. U. Leuven, Belgium

 

Brad DeLong,

Professor of Economics, U.C. Berkeley, US

 

Marina Della Giusta,

Senior Lecturer in Economics, University of Reading, UK

 

Andy Dickerson,

Professor in Economics, University of Sheffield, UK

 

John Driffill,

Professor of Economics, Birkbeck College London, UK

 

Ciaran Driver,

Professor of Economics, Imperial College London, UK

 

Sheila Dow,

Emeritus Professor of Economics, University of Stirling, UK

 

Chris Edwards,

Senior Fellow, Economics, University of East Anglia, UK

 

Peter Elias,

Professor of Economics, University of Warwick, UK

 

Bob Elliot,

Professor of Economics, University of Aberdeen, UK

 

Jean-Paul Fitoussi,

Professor of Economics, Sciences-po, Paris, France

 

Giuseppe Fontana,

Professor of Monetary Economics, University of Leeds, UK

 

Richard Freeman,

Herbert Ascherman Chair in Economics, Harvard University, US

 

Francis Green,

Professor of Economics, University of Kent, UK

 

G.C. Harcourt,

Emeritus Reader, University of Cambridge, and Professor Emeritus, University of Adelaide, Australia

 

Peter Hammond,

Marie Curie Professor, Department of Economics, University of Warwick, UK

 

Mark Hayes,

Fellow in Economics, University of Cambridge, UK

 

David Held,

Graham Wallas Professor of Political Science, LSE, UK

 

Jerome de Henau,

Lecturer in Economics, Open University, UK

 

Susan Himmelweit,

Professor of Economics, Open University, UK

 

Geoffrey Hodgson,

Research Professor of Business Studies, University of Hertfordshire, UK

 

Jane Humphries,

Professor of Economic History, University of Oxford, UK

 

Grazia Ietto-Gillies,

Emeritus Professor of Economics, London South Bank University, UK

 

George Irvin,

Professor of Economics, SOAS London, UK

 

Geraint Johnes,

Professor of Economics and Dean of Graduate Studies, Lancaster University, UK

 

Mary Kaldor,

Professor of Global Governance, LSE, UK

 

Alan Kirman,

Professor Emeritus Universite Paul Cezanne, Ecole des Hautes Etudes en Sciences Sociales, Institut Universitaire de France

 

Dennis Leech,

Professor of Economics, Warwick University, UK

 

Robert MacCulloch,

Professor of Economics, Imperial College London, UK

 

Stephen Machin,

Professor of Economics, University College London, UK

 

George Magnus,

Senior Economic Adviser to UBS Investment Bank

 

Alan Manning,

Professor of Economics, LSE, UK

 

Ron Martin,

Professor of Economic Geography, University of Cambridge, UK

 

Simon Mohun,

Professor of Political Economy, QML, UK

 

Phil Murphy,

Professor of Economics, University of Swansea, UK

 

Robin Naylor,

Professor of Economics, University of Warwick, UK

 

Alberto Paloni,

Senior Lecturer in Economics, University of Glasgow, UK

 

Rick van der Ploeg,

Professor of Economics, University of Oxford, UK

 

Lord Peston,

Emeritus Professor of Economics, QML, London, UK

 

Robert Rowthorn,

Emeritus Professor of Economics, University of Cambridge, UK

 

Malcolm Sawyer,

Professor of Economics, University of Leeds, UK

 

Richard Smith,

Professor of Econometric Theory and Economic Statistics, University of Cambridge, UK

 

Frances Stewart,

Professor of Development Economics, University of Oxford, UK

 

Joseph Stiglitz,

University Professor, Columbia University, US

 

Andrew Trigg,

Senior Lecturer in Economics, Open University, UK

 

John Van Reenen,

Professor of Economics, LSE, UK

 

Roberto Veneziani,

Senior Lecturer in Economics, QML, UK

 

John Weeks,

Professor Emeritus Professor of Economics, SOAS, London, UK

 

My Lords, as this is a money Bill, this House cannot amend it, but I shall discuss the motives and principles underlying it. My speech will not give satisfaction to the two opposing parties, but I hope that, for that reason, it may gain in coherence. As the noble Lord said, we shall see.

 

The Government are in a bind. The markets are clamouring for retrenchment. On the other hand, the Government know that retrenchment now would be fatal for recovery. This rather feeble measure is the result. It reminds me of nothing so much as the optimistic promises that I used to make to my bank manager when he called me to ask what I intended to do about my overdraft. This, of course, was in the days when I knew who my bank manager was. He was called Mr Gay and was a delightful man.

 

Deficit reduction will start in 2011 and proceed steadily year by year until 2015. By 2014, at least half of this year's deficit will have gone. By 2016, the national debt as a proportion of GDP will be lower than in 2015 and, after that, we are promised an era of sound public finances. It would be interesting to know the economic analysis underlying this rather random collection of figures and dates, because I have not found it. However, one thing is clear: as for St Augustine, virtue is for the future.

 

An interesting feature of the Bill is that these promises are set forth as duties. The Government seek to bind themselves to what they promise to perform, but these are not hoops of steel but hoops of elastic. As has been pointed out by other noble Lords, there are no sanctions for non-fulfilment of the duties; there is simply an extra duty to report to Parliament on progress towards and compliance with the other duties, or non-progress and non-compliance, as the case may be. The programme seems rule-bound, but it is at the discretion of the Treasury to be bound by the rules that it lays down. This ample escape clause is no doubt wise, given the fact that neither the Government nor anyone else can know whether they will be in a position to fulfil their duties. That depends entirely on what happens to the economy, and no one knows for how long it will have to be on a life-support system.

 

This being so, I would rather there had been no Bill at all than one that makes a mockery of the concept of duty. However, given that it may have been politically necessary to have some statement of future intentions with a law-like look about it, I would have liked to have seen an independent fiscal policy committee set up as part of the machinery of the Bill and charged with the duty of reporting to Parliament on the validity of any reasons that the Government might give for non-fulfilment of their statutory duties as laid down in Clause 1. Such a committee, I suggest, should become a permanent part of our fiscal system. Talk about primary legislation and strengthened accountability to Parliament seems to me to be largely eyewash. This Government know that any Government with a reliable majority can always get their money Bills through Parliament.

 

I want to make a few more general observations. I notice that there is no duty laid on the Treasury to restore the much vaunted fiscal rules that were suspended in 2008. This interim period affords us an opportunity to rethink the content of these rules. The rules state that, over the cycle, the Government should borrow only to invest and that investment should not add to the national debt. In fact, these rules were being broken before the present downturn. Everyone knows that. I am surprised that the Minister said otherwise when he introduced the debate. Part of the doubts about the solvency of government finances today is due to previous cheating on the rules.

 

By 2007, after five years of GDP growth of 2.7 per cent per annum on average, which was widely accepted as the trend rate, or even above trend, there was no excuse for a deficit in 2007-08 of 2.6 per cent of GDP. Over the period, the Budget should have been balanced on the Chancellor's rules or even been in slight surplus. In fact, there have been only three years of surpluses-1999, 2000 and 2001-over 17 years of positive growth.

 

The so-called rules lent themselves to manipulation for two reasons. First, no one really knows when cycles start or how regular they are. One can only know for sure in retrospect. Secondly, and possibly more important, public sector investment is an inherently vague term, as the noble Lord, Lord Lawson, pointed out with his usual clarity in his book View from No. 11. His words are worth repeating:

 

"The current/capital distinction does not have the same meaning in the public as in the private sector. School buildings, for example-however desirable and productive in the larger sense-do not produce a cash return which will service debt interest. Nor are outlays on them inherently more productive than, say, expenditure on better teachers, which counts as current".

 

Therefore, I have considerable sympathy with his conclusion that,

 

"those who seek to assimilate the system of public expenditure control to the conventions and methods used in the private sector always remind me of small children playing at shops. It has little relationship to the real thing".

 

One could argue that we need fiscal rules, and I would agree, but if we are to have them I would prefer the following rule: that the Government should set taxes to balance the Budget when the economy is growing to trend, as measured by a moving average of outcomes over the previous five years, with a surplus accruing when the economy is growing above trend and a deficit when it is growing below. Of course, if a black swan, such as the meltdown of 2008, happens, all bets are off. The rules have to be suspended. There always have to be escape clauses in any financial rules, but that does not seem to be a sufficient reason for not having any.

 

My final point concerns a matter of economic theory. John Redwood remarked in the other place that,

 

"we cannot solve a crisis of over-borrowing by borrowing too much in the state sector".-[Official Report, Commons, 5/1/10; col. 97.].

That is definitely wrong. If every bank had started to deleverage simultaneously without any increase in public borrowing, the collapse in aggregate spending would have made the great depression look like a vicar's tea party. Keynes pointed this out years ago in his famous paradox of thrift. The Government are a qualitatively different borrower from a private sector borrower; to treat the private and public borrower as equivalent is like children playing at shops, to use the words of the noble Lord, Lord Lawson. Mr Redwood and most of his colleagues should go back to school.

 

One may argue about how big the output gap was and is and about whether the stimulus policies have been enough, too much, or well or ill designed, but I am absolutely sure that some stimulus was and remains necessary. The Government are therefore absolutely right to resist the austere spirits who are calling for draconian spending cuts and tax increases now. If this Bill, full of mirrors, is the price that needs to be paid for pretending to listen to them, I am content to support it.