The massively overdue return of economic recovery now means Keynesian approaches to economics should lead to support for deficit reduction
Since 2008, news about the UK economy has ranged from the modestly encouraging to the truly terrifying via the generally depressing. So yesterday’s staggering drop in unemployment – alongside the IMF upgrading its growth forecast for the UK – feels quite a novelty.
It should also have large ramifications for the debate on economic policy. Ever since the crash, there has been a sharp divide over the merits of deficit spending has been fiercely debated. Keynesians including Ed Balls advocated government borrowing. This would create demand at a time it was lacking. Proponents of austerity such as George Osborne retorted that this extra borrowing would not actually serve as a stimulus. The extra debt governments were taking on would raise doubts about their creditworthiness. It would also mean individuals and companies would anticipate future tax rises to help pay for that debt. This would lead them to hold onto cash to pay these prospective new taxes. For as long as the economy faltered both of these arguments were prima facia plausible.
However, recovery changes this. Following yesterday’s news, unemployment now stands at 7.1%. That’s just above the 7% level at the Bank of England stops promising not to raise interest rates. The argument for deficit spending as a way to stimulate the economy pre-supposes that interest rates are as low as they will go. Otherwise, the Bank of England can make up a shortfall in demand by cutting rates without the need for the government to use fiscal policy. In fact, if governments create demand themselves the Bank is likely to feel the need to offset that extra demand when it sets interest rates. Otherwise it may worry that demand from the government will have an inflationary impact.
We think of Keynes as an advocate of an active fiscal policy because he wrote his most famous work during the Great Depression. Under different circumstances, he took a different view. Most notably in How to Pay for War, he warned against using deficit spending to fund Britain’s involvement in WWII less this cause inflation. We can also find plenty of examples of Keynes disciples opposing deficits at the wrong moment. For example, Paul Krugman was scathing about the Bush administration plunging the US treasury into the red. So there will be nothing incongruous if Osborne and Balls go from sharply differing to fundamentally similar views on reducing the deficit.