Fiscal policy: What does ‘Keynesian’ mean?

Jonathan Portes, 7 February 2012

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I joined the UK Treasury in 1987 and subsequently went to Princeton, where I studied with Rogoff and Campbell. Eventually, I ended up in the Cabinet Office, advising the Prime Minister, on the eve of the 2008 crisis. At no point during this period, however, did I think of myself as a ‘Keynesian’. Nor was it really a meaningful question. You might as well have asked a physicist if he was a ‘Newtonian’. Keynes was a great figure (indeed, one of the greatest Britons of the 20th century) and you had to understand his insights to understand macroeconomics; but the debate had moved on.

The Treasury approach to macroeconomic management throughout this period was that while fiscal policy mattered, it wasn't - for largely pragmatic reasons - sensible to adjust policy in order to manage demand; monetary policy was quicker, more transparent, and less subject to political distortion. The theoretical argument behind this was famously set out in Nigel Lawson’s 1984 Mais Lecture. And I fully subscribed to this view.

Of course, post-2008, things are rather more complicated. So what could it mean to be a ‘Keynesian’? I can think of a number of possible definitions.

Definition 1

Going back to the 1930s, Keynes himself obviously defined himself in opposition to the ‘Treasury View’ (often equated, perhaps somewhat unfairly, to ‘Say's Law’, that supply creates its own demand. See Quiggin 2011 for a historical discussion). The Treasury View argues that fiscal policy cannot, as an accounting identity, affect aggregate demand, because the government needs to get the extra money from somewhere, whether through taxes or borrowing. So a Keynesian is anyone who doesn't believe this identity means that fiscal policy can't affect demand. And this appears to be the definition espoused at one point by John Cochrane (2009) of Chicago University, who wrote:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of ‘crowding out’ is just accounting, and doesn't rest on any perceptions or behavioural assumptions.

As readers will know, this became the subject of a furious row in the econo-blogosphere, with Paul Krugman, Brad Delong, and Simon Wren-Lewis accusing Cochrane of "undergraduate errors" (Wren-Lewis 2012b). Cochrane himself seems to have retreated from this position, as Delong and others have pointed out (Cochrane 2012 and Delong 2012). But leaving US academic disputes aside, obviously in this sense I am a Keynesian – hence the title of my own blog! But then so is everybody else, including today's Treasury. Nobody, and I mean nobody, really believes that it is impossible by definition for fiscal policy to affect aggregate demand.

Definition 2

A more plausible, and traditional, definition is to say that a Keynesian is someone who believes that as an empirical matter, fiscal policy does have a substantial impact on aggregate demand; in contrast to those who believe that ‘Ricardian equivalence’ means that changes to government spending and borrowing will be substantially or wholly offset by changes to private sector spending and saving. More recently, the doctrine of ‘expansionary fiscal contraction’ went even further, and argued that tightening fiscal policy could, through exchange rate and confidence effects, actually increase demand and growth; a paper by Alesina and Ardagna (2009) was particularly influential in this respect, and even (tentatively and briefly) influenced the UK Treasury here, who argued in the 2010 Emergency Budget that: "These [the wider effects of fiscal consolidation] will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects" (HM Treasury 2010).

The Treasury has not as far as I am aware repeated this argument, since the evidence shows precisely the opposite. The original paper has been widely questioned, debunked by further IMF research, and (more importantly) experience has hardly verified its claims. The conventional wisdom now is very much that of the IMF, which by October 2010 had already concluded that: "Fiscal consolidation typically lowers growth in the short term. Using a new data set, we find that after two years, a budget deficit cut of 1% of GDP tends to lower output by about 0.5% and raise the unemployment rate by one third of a percentage point." This result was later formalised in Leigh et al 2010. The IMF has if anything strengthened its views since, with the current Chief Economist, Olivier Blanchard, saying recently: "[fiscal consolidation] is clearly a drag on demand, it is a drag on growth" (Blanchard 2012).

So I'm a Keynesian on this definition, but then so too are the Managing Director and Chief Economist of the IMF. And so indeed too are the Treasury, Bank of England, and the Office of Budget Responsibility; their models incorporate multipliers, and I do not think that senior officials at any of these institutions would deny for a minute that fiscal consolidation has, in practice, had a negative impact on growth in the UK. For example, the Monetary Policy Committee said in November 2011: "Growth had been weak throughout the past year, reflecting a fall in real household incomes, persistently tight credit conditions and the effects of the continuing fiscal consolidation." 

Definition 3

So under Definitions 1 and 2 I'm a Keynesian, but then so is pretty much everyone else whom one would take seriously. The final definition, then, of a Keynesian, appears to be a much more ‘political’ one – someone who thinks that slowing fiscal consolidation would be a sensible policy decision in the current UK (or US) economic context. But this definition seems to me to be misconceived, for two reasons. First, if ‘Keynesian’ means anything, it must surely have a more general significance than indicating one's position on a particular policy choice in a particular country at a particular time. Surely it should indicate a philosophy, a theoretical view, or at least a view of what the empirical evidence means?

Perhaps more importantly, it is quite clear that – now that the ‘expansionary fiscal contraction’ hypothesis has been discredited – the main argument between those of us who favour slowing fiscal consolidation in the UK and those who think that this would be a dangerous mistake is not about whether the direct impact would be positive. It is whether the price of this direct positive impact would be ‘credibility’ with financial markets, and hence a damaging rise in long-term interest rates that would more than offset the gains.

I think this risk is hugely exaggerated, while the damaging social and economic consequences of inaction are correspondingly not recognised (see my previous articles, Portes 2011a and 2011b), but the point here is not who's right, but that this debate really has nothing to do with Keynes at all. It's about a lot of things – how policymakers should deal with potential market irrationality, the role of the credit rating agencies, multiple equilibria, etc. But I don't see that taking one side or the other of these arguments makes you a Keynesian (or not). 

Finally, and returning to what I originally learned at the Treasury, there still remains the view that if we think demand is too low, then the right response is always through monetary rather than fiscal policy. Again, there is a vigorous debate among blogging economists on this topic (see Economist 2012 for an introduction to the debate). And here my perspective has indeed changed; I no longer subscribe to the Treasury View of the last two decades, described above, that fiscal policy never has any role to play in demand management, even though I don't think it should be the tool of first resort. (See the excellent discussion in Simon Wren-Lewis 2012a, especially the penultimate paragraph).

But just as this approach was motivated by pragmatism more than theory – monetary policy was better suited to this task - my change of mind is similarly motivated. If monetary policy alone was indeed enough in practice, we wouldn't be where we are now, with unemployment in the UK a million higher than the official estimate of the natural rate, and no prospect of it coming down in the immediate future. As I have argued previously (Portes 2012), any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate. 

So my views have indeed changed; not, I would argue, ideologically, but in recognition of the fact that life, and macroeconomics, is considerably more complicated than we thought. Again, this view is shared by Blanchard, who argues: "We’ve entered a brave new world in the wake of the crisis; a very different world in terms of policy making and we just have to accept it. ... Macroeconomic policy [specifically fiscal and monetary policy] has many targets and many instruments."

This pragmatic and questioning – but evidence-based – approach to macroeconomic policy is one I share. If he were here, I imagine Keynes would too.

References

Alesina, Alberto F and Silvia Ardagna (2009), “Large Changes in Fiscal Policy: Taxes Versus Spending”, NBER Working Paper No. 15438, October.

Blanchard, O (2012), “Driving the Global Economy with the brakes on”, blogpost, January.

Blanchard, O (2011). “The future of macroeconomic policy”, blogpost, March.

Cochrane, J (2009), “Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?”, University of Chicago webpage, version 2.5, 27 February.

Cochrane, J (2012), “Stimulus and etiquette”, blogpost, January.

Delong, B (2012), “John Cochrane says John Cochrane used to be a bullshit artist”, blogpost, January.Lawson, N (1984), Mais Lecture.

Economist (2012), “The zero lower bound in our minds”, 7 January.

Guajardo, J, D Leigh, and A Pescatori (2010), “Expansionary Austerity: New International Evidence”, IMF Working Paper 11/158, Research Department, International Monetary Fund.

HM Treasury (2010), “Emergency Budget”.

Leigh, D, P Devries, C Freedman, J Guajardo, D Laxton, and A Pescatori  (2010), "Will it hurt? Macroeconomic effects of fiscal consolidation", World Economic Outlook, October, International Monetary Fund

Monetary Policy Committee (2011), Minutes, Bank of England.

Portes, J (2011b), “Against Austerity”, Spectator, October.

Portes, J (2011a) “The Coalition’s Confidence Trick”, New Statesman, August.

Portes, J (2012), “The largest and longest unemployment gap since World War 2”, blogpost, January.

Quiggin, J (2011), “Blogging the Zombies: Expansionary Austerity – Birth”, blogpost, November.

Wren-Lewis, S (2012a), “Mistakes and ideology in macroeconomics”, blogpost, 10 January.

Wren-Lewis, S (2012b), “The return of Schools-of-thought macro”, blogpost, 27 January.

Topics: Macroeconomic policy, Politics and economics
Tags: Keynesianism, UK

Comments

Thank you

Thank for for this well-written piece and the insight into the decision-making. You seem to be referring to fiscal policy once the zero lower bound has been reached, as it has in the U.S. But this doesn't seem to fully appreciate the wrong-headedness that drove Britain and the EU to actually raise rates and engage in monetary contraction in addition to fiscal consolidation. Also, isn't the significant difference in the U.S. the opportunity to utilize the dollar and US bonds' unique position in global finance, combined with private credit market conditions and need for private deleveraging, to expedite and encourage investment in initiatives with components of public goods and positive externalities? The converse of your question "who is a Keynsian" at this time, in these conditions, "who isn't Keynsian", points only to people who only place value on nebulous arguments of crowding-out (despite widespread underutilization of existing capacity), moral hazard, credibility (as you mention), and ignorance of the existence of public goods and externalities (positive or negative). In other words, to paraphrase you, this is no one whom one should take seriously. So why are such people taken seriously? I think it's because well-crafted demagoguery for political or financial gain can appeal to certain sentiment that would rather wipe away the complexity to which you refer. And in so doing, wipe away the evidence contrary to their positions and replace it with vitriol against the "others". And so, an output gap remains, an opportunity to improve competitiveness is lost, and mitigable hardship goes unmitigated.

Jonathan Portes

Director of the National Institute of Economic and Social Research