The takeaway from six years of economic troubles? Keynes was right.

October 31, 2014

Protesters clash with police during an anti-austerity rally in Athens

Now that the Federal Reserve has brought its program of quantitative easing to a successful conclusion, while the French and German governments have ended their shadow-boxing over European budget “rules,” macroeconomic policy all over the world is entering a period of unusual stability and predictability. Rightly or wrongly, the main advanced economies have reached a settled view on their economic policy choices and are very unlikely to change these in the year or two ahead, whether they succeed or fail. It therefore seems appropriate to consider what we can learn from all the policy experiments conducted around the world since the 2008 crisis.

The main lesson is that government decisions on taxes and public spending have turned out to be more important as drivers of economic activity than the monetary experiments with zero interest rates and quantitative easing that have dominated media and market attention. Fiscal decisions on budget deficits, taxes and public spending have mostly been debated as if they were largely political choices, with much less influence than monetary policy on macroeconomic outcomes such as inflation, growth and employment. Yet the reality has turned out to be the opposite. While every major economy in the world has followed essentially the same monetary policy since 2008, their fiscal policies have been very different and the divergence in outcomes, especially when we compare the United States and Europe, has been exactly the opposite to what was implied by the rhetoric of most politicians and central banks.

Countries that took emergency measures to reduce public borrowing have mostly suffered weaker growth, as in the case of Britain from 2010 to 2012, Japan this year and the United States after the 2013 “sequester” and fiscal cliff deal. In more extreme cases, such as Italy and Spain, fiscal tightening has plunged them back into deep recession and aggravated financial crises. Meanwhile countries that ignored their deficit problems, as in the United States for most of the post-crisis period, or where governments decided to downplay their fiscal tightening plans, as in Britain this year or Japan in 2013, have generally done better, both in terms of economics and finance. The one major exception has been Germany, where budgetary consolidation has managed to coexist with decent growth, largely because of a boom in machinery exports to Russia and China that is now over, pushing Germany back into the recession its stringent fiscal policy suggested all along.

Thus the six years since 2008 have provided strong empirical support for the supposedly outmoded Keynesian view that government borrowing is more powerful than monetary policy in stimulating severely depressed economies and pulling them out of recession. In a sense, it is odd that the power of fiscal policy has come as a surprise – or that it continues to be categorically denied by the German government and the U.S. Tea Party. The underlying reason why fiscal policy is so important in recessions, and has now come to dominate over monetary policy, is a matter of simple arithmetic that should not be open to debate.

Recessions generally occur when private business and households decide to spend less than their incomes in order to reduce their debts or increase their savings. If this process of “deleveraging” is happening in the private sector, which it clearly has been, then simple arithmetic shows that economic balance can only be restored if some other sector of the economy spends more than its income – and such excess spending is only possible if that “other sector” is willing to increase its debts. Disregarding the role of exports and imports, which must sum to zero for the world as a whole, the government is the only possible candidate to play the crucial balancing role as the “other sector.” It is therefore a mathematical certainty that governments must increase their borrowing whenever businesses and households decide to boost their savings by spending less than they earn.

Despite this indisputable arithmetic, there has been surprisingly little interest in the macroeconomic impact of budgetary policies in contrast to the endless debates about every twist and turn of monetary policy. The explanation lies in the monetarist theories that came to dominate standard economic models of the pre-crisis period – and the related institutional changes that elevated central bankers above finance ministers as the supreme arbiters of economic policy.

Monetarism overturned the Keynesian fiscal consensus that prevailed from the 1930s to the 1970s, by introducing one simple assumption into the models that guided governments and central banks. The case for Keynesian fiscal stimulus in deep recessions was simply assumed away by asserting that interest rates could always be reduced sufficiently to stimulate private investment, discourage private savings and so restore growth. As a result, the private sector as a whole would never suffer for long from a shortfall in spending. Therefore government borrowing would never be needed to balance inadequate private demand.

As a result of these assumptions, interest rate decisions by central banks came to be seen as the only effective tool of macroeconomic management, while fiscal policy was relegated to a microeconomic supporting role. Tax structures and public spending levels were seen as supply-side issues influencing incentives and resource allocation, but the demand impact of government borrowing was largely ignored. Whether government borrowing expanded or contracted, interest rates would rise or fall to offset the Keynesian demand effects. Independent central bankers would manage macroeconomic demand with monetary policy, leaving governments to set taxes and spending plans to achieve political or supply-side objectives.

In the era of high inflation when monetarism was introduced, the idea that interest rates could always be cut by enough to revive private economic activity was reasonable enough. After all, when inflation is running at 5 percent, an interest rate of 1 percent is equivalent to minus 4 percent in real terms, imposing a massive tax on savers and offering a big subsidy to private investors. But this argument fails completely when inflation falls to negligible levels or disappears completely, as in the euro-zone and Japan.

Ironically, therefore, the very success of monetarism and central banking in conquering inflation now means that the era of monetary dominance is over. Keynesian fiscal thinking has triumphed and finance ministers are again more important than central bankers, even though most of them have not yet noticed. Once interest rates fell to zero, traditional monetary management lost its ability to provide further stimulus. And now that central banks are providing “forward guidance” which commits them to very low interest rates for years ahead, monetary policy has also lost its ability to offset fiscal easing and restrain demand.

As monetary policy has lost traction, fiscal policy has automatically gained power. With interest rates at or near zero, private demand cannot be simulated with further rate cuts and this means that monetary easing can no longer offset fiscal tightening. As a result, any reduction in budget deficits becomes unambiguously deflationary, which is why the French and Italian governments were right to resist enforcement of the German-inspired fiscal compact in the euro-zone. Conversely, fiscal expansion now provides an unqualified economic stimulus because there is no risk of interest rates rising significantly in the next year or two – and perhaps not until the end of the decade. In short, the world has returned to a period of fiscal dominance, as in the 1950s and 1960s.

 

PHOTO: Protesters clash with police during an anti-austerity rally in Athens April 1, 2014. Protesters marched through the streets of the capital to protest austerity measures as European Union Finance Ministers meet in Athens. REUTERS/Alkis Konstantinidis

29 comments

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Boring writer pushing her faith system. This writer “believe” in Keynes formula…. well, inflation works for business owners, yet since it never workers & causes this huge wealth gap- time for modern economics — sustainability w/ very low employment.

Posted by TigerFalls | Report as abusive

Confirmation bias much? No, Keynes was wrong and Monetarism was *also* wrong, the Austrian School are the ones who actually seem to be correct.

Posted by evilhippo | Report as abusive

Confirmation bias is bad, but completely ignoring all empirical evidence is worse.

Posted by QuietThinker | Report as abusive

I’m having a hard time getting past the first sentence “Now that the Federal Reserve has brought its program of quantitative easing to a successful conclusion”. Are we hanging up the ‘mission accomplished’ banner a little too soon given that we haven’t even started the process of unwinding the massive growth of the Fed’s balance sheet?

Posted by jambrytay | Report as abusive

Of course to really believe in the accuracy of this op-ed you have to forget the fact that the nations that took on more debt to add money into the economy now will need to remove money from their economies later to pay for the debt. This is just another case of the generation in charge not wanting to do what they need to and kicking their messes down the road for the following generations to clean up, and using op-eds like this to justify it.

Posted by Abauerfeld | Report as abusive

Self-congratulatory claptrap – a Hayekian reorganisation with losses being taken by the status quo would have been much better for the vast majority of the population. Instead of paying once for the recklessness of others, we are forced to keep on paying many times over what we would have to maintain failed insttution and a crony capitalist status quo.

Keynesian stimulus is a pointless exercise when the stimulating country has borders porous to capital and is a client of multinationals – Keynes would have been the first to point this out.

Posted by Andy_Redman | Report as abusive

The countries that tried to cut their deficits the most still ran massive deficits. This should have been very stimulative according to Keynesian theory, and yet the countries contracted anyway.

The great thing about believing in Keynesian economic policies is that you can never be wrong. Massive deficits didn’t work? Then they weren’t massive enough.

If Keynesian policy fails, you can *always* claim that not enough was done to stimulate the economy, even if relatively heroic efforts were taken and failed.

Posted by MarkCancellieri | Report as abusive

Please explain why Austrian school is right and why the fed ever has to unwind its positions from QE.

Posted by edreh | Report as abusive

agree about confirmation bias in this ridiculous article.

Posted by thoreaupoe | Report as abusive

An understanding of sectoral balances is critical to understanding monetary economics at a macroeconomic level, so it’s good to see Mr. Kaletsky writing an article which places what Godley called “sector analysis” at the fore of good policy. The failure of monetarism and other schools of thought (including austrianism) to face reality has made them an impediment to recovery.

Posted by BenJohannson | Report as abusive

An understanding of sectoral balances is critical to understanding monetary economics at a macroeconomic level, so it’s good to see Mr. Kaletsky writing an article which places what Godley called “sector analysis” at the fore of good policy. The failure of monetarism and other schools of thought (including austrianism) to face reality has made them an impediment to recovery.

Posted by BenJohannson | Report as abusive

Great article, Anatole. I learned from it. Always trying to understand.

Posted by SaveRMiddle | Report as abusive

Quantitative easing in the US has dwarfed the fiscal side of the equation.

Wouldn’t QE be called a “monetarist” tool?

Posted by LoveJoyOne | Report as abusive

Dear Author, could you explain why microeconomic issues (such as german exports do China and Russia) can be used to support your view, whereas microeconomic issues (like the energy boom in the US, nuclear energy restraint in Japan, or even the Ukrainian crisis) that could weaken your argument are totally ignored ?

Posted by JoseRobazzi | Report as abusive

“Now that the Federal Reserve has brought its program of quantitative easing to a successful conclusion…”
Starting off an opinion piece with this assertion is problematic on a number of levels, not least of which is that the monetary experiment that is quantitative easing has not concluded. The economy is a dynamic complex system with extensive feedback loops whose impact takes time and whose far flung consequences will be felt for some time to come.
Trying to derive lessons from the monetary policies used over the years is more an exercise in confirmation bias, as other commenters have suggested, than anything else.
One thing is certain, however, exponential growth of anything on a finite planet is impossible to sustain; that’s mathematics, not opinion.
The-powers-that-be, including the central banks and corporate media–and its yellow journalists–will likely continue to argue that their way is the right way and push on the string that is quantitative easing (look how the Bank of Japan upped the ante immediately upon conclusion of the Fed’s bet), but this does not mean it is right or correct; except for perhaps the 1% who are benefitting and who own/run the propaganda machines that is today’s mass media.
This is an experiment whose conclusion has yet to surface. Previous experiments in this vein, however, have not ended well and that is what has been ignored in this opinion piece…

http://olduvai.ca

Posted by OlduvaiNovel | Report as abusive

Anatole says:

“Recessions generally occur when private business and households decide to spend less than their incomes in order to reduce their debts or increase their savings.” Fair enough.

There is one huge assumption here. Private business and households have the income to pay down debt and/or increase savings. Looking at BLS data it would seem that for households at least, spending is sluggish because generally they just don’t have the money. Going forward this looks to get worse as the boomer generation ages with (again) generally no appreciable savings.

I’d argue that an economy that relies on ever increasing debt to flourish is doomed to failure. No one likes “austerity”. No one likes to say no. Sometimes though no is the only sustainable answer.

Posted by Missinginaction | Report as abusive

You would think that if government spending was so important to economic recovery that governments like the one in Argentina would not have been forced into default by Wall Street “vulture fund” speculators.

Posted by nose2066 | Report as abusive

“Now that the Federal Reserve has brought its program of quantitative easing to a successful conclusion…”
Starting off an opinion piece with this assertion is problematic on a number of levels, not least of which is that the monetary experiment that is quantitative easing has not concluded. The economy is a dynamic complex system with extensive feedback loops whose impact takes time and whose far flung consequences will be felt for some time to come.
Trying to derive lessons from the monetary policies used over the years is more an exercise in confirmation bias, as other commenters have suggested, than anything else.
One thing is certain, however, exponential growth of anything on a finite planet is impossible to sustain; that’s mathematics, not opinion.
The-powers-that-be, including the central banks and corporate media–and its yellow journalists–will likely continue to argue that their way is the right way and push on the string that is quantitative easing (look how the Bank of Japan upped the ante immediately upon conclusion of the Fed’s bet), but this does not mean it is right or correct; except for perhaps the 1% who are benefitting and who own/run the propaganda machines that is today’s mass media.
This is an experiment whose conclusion has yet to surface. Previous experiments in this vein, however, have not ended well and that is what has been ignored in this opinion piece…

Posted by OlduvaiNovel | Report as abusive

As one commenter says, QE is not over. The assumption has always been that QE “unwinding” would involve the Fed’s selling all those billions of Treasury securities and MBOs acquired during QE1, QE1 and QE3. Now apparently “unwinding” is simply defined as no more Fed bond buying. Is the Fed’s balance sheet to remain bloated indefinitely into the future?

Posted by janejohn | Report as abusive

It still depends whether or not the central government is using fiscal policy efficiently. The US weathered the recession due to a focus on pouring money into domestic industry and loosening restrictions on investments. Germany and China increased their industrial capacity as well, allowing for an increase in GDP to offset the increases in spending. France, Spain, and Italy however have cut spending on their industrial sectors and even tightened restrictions on investment. Their key spending focus is still on Social Services, which means that as those countries spending increases, their actual production relative to the rest of the world is decreasing.

Posted by leumasmc | Report as abusive

Let’s be clear about this…macro-economic tools such as lower interest rates and QE have had an enormous negative effect on the global economy.

It started under Alan Greenspan in 1989 when a huge fall in the stock market was miraculously averted by juicing the money supply. During the next decade, a variety of monetary shocks were solved using similar methods–with apparent success. (Mexican Peso crisis, Russian Ruble crisis, Asian crisis etc.) This culminated in the ‘irrational exuberance’ of the Dot.com crisis.

For years, the price of gold was used as an impartial proxy for measuring global inflation. Then, for some strange reason, the price of gold shot up, yet, local national measures of inflation seemed stable? What was happening? The cost of food, fuel and many other essential parts of the CPI index increased, yet salaries/wages froze in place in the late 1990’s.

The next warning sign after the jump in the gold price was the interesting lack of economic effect lower interest rates had on the economy. The interest rates kept falling without any noticeable economic effect–when only a few years earlier, such economic stimulus would have fueled the economy to a roaring fast pace.

Since then, despite good economic news, growth has been fitful and tepid at best. Entire generations have been underemployed or unemployed globally, thanks to this pervasive economic malaise.

There was one huge effect which monetary stimulus had. All that extra money injected into the economy needed to find a home–thus a multitude of bubbles were formed, notably, one large bubble in real estate. Money became so cheap–anyone could buy a home. But this easy money created what economists call ‘moral hazard’. Bankers and lenders were encouraged to lend even to bad risks.

I have no time for a dissertation, but essentially, the world has become hooked on the economic heroin of easy stimulus and the use of money printing to forestall immediate economic shocks–deferring the consequences to a later date. When does the borrowing stop if Keynes was the correct answer?

The article above appears to justify further government borrowing as the only answer to temporary economic downturns–but that is what got us into trouble in the first place. The article misses the point entirely–and I find it frightening in its lack of depth and insight as to the root causes of the current long-standing global economic malaise.

Posted by MaskOfZero | Report as abusive

Excellent article. nose2066: The Keynesian argument is that govts should run budget deficits IN A RECESSION when interest rates have fallen to their lower bound. Its not an argument for running budget deficits continuously, or issuing debt in a foreign currency. As a result Argentina is a poor counter-example.

Posted by EcoHistorian | Report as abusive

Claptrap

Posted by XiolingVonNof | Report as abusive

None is so blind as he who will not see. The Fed has been quite clear: they would do what they could, but a completely successful policy would include a fiscal stimulus. The Fed set conditions for ending their monetary policy when it became clear the economy was not only “recovering”, but actually growing. Indications of this would be not only low unemployment figures, but rising incomes, as well as rising pressure (in the private sector) on interest rates, in part as a response to more inflationary environment. We are very far from such an environment. If you include our global partners, which must be done in this day and age, the deflationary pressures in Europe are already evident, Japan has had trouble creating inflation, and China is having to come to terms with the consequences of low growth and at least a decade of malinvestment. To worry about the Fed “unwinding” in this environment is very misplaced. The Fed has stated it may sell the Treasuries and MBS, or it may not, holding them until maturity. Unwinding is not the main problem. Hyperinflation is not in the cards. Weak worldwide demand is the issue. Slow or no growth is the issue.

Posted by mlnberger | Report as abusive

QE is like keeping a ripped hot air balloon in the air by keeping the flame on full blast. Works great! Well, at least until you run out of fuel.

Posted by TBorNot | Report as abusive

Oh just hilarious, pretending that QE is over, and pretending that things go fixed!

Things are far worse than 6 years ago, and all of the problems are still there, albeit covered up with lies and distraction. Not to mention the contiuous ongoing wars.

my my my

Posted by blackout888 | Report as abusive

This article is ridiculous and only displays the author’s lack of understanding of even basic economics.

My earlier, more detailed response was deleted by the Reuter’s censor.

Posted by MaskOfZero | Report as abusive

So very valid for developed economies. Watch out on emerging markets though, with very high inflation rates and interest rates still those days… On this part of the world working as a good portion of global macroeconomic outlook, central bankers are still of the utmost importance.

Posted by VitorPC | Report as abusive

Works for developed with inflation and rates close to zero. Doesn’t work for emerging where inflation and rates are significant. As emerging plays an important role in world GDP, one just can’t say Keynes was right or won anything over monetarists…

Posted by VitorPC | Report as abusive