High rates of inflation around the world have pretty much ended the popularity of MMT, or Modern Monetary Theory, and its proposition that sovereign governments can spend as much as they want. But current economic conditions also call into question the usefulness of a much more established and accepted theory: Keynesian economics.
The standard Keynesian doctrine is to run a budget surplus in good times, and then use deficit spending to stimulate the economy in bad times. That argument made and still makes logical sense. But it just doesn’t apply to the current moment.
One problem is that it’s hard to tell which are the good times and which are the bad. Following the euro crisis of 2011, there was widespread criticism of Germany for not having spent more to stimulate other European economies. The EU was obviously seeing some bad times. German leaders insisted that caution was in order, and that it was necessary to save funds for possibly more difficult times ahead. Few observers in the Anglo-American establishment were convinced.
Today, with the war in Ukraine raging and German energy supplies in doubt, is it so obvious that then-German Chancellor Angela Merkel was wrong? And even if she was, the German insistence on austerity no longer looks so crazy. The very near future may require large energy bailouts a very large Italian bailout, not to mention additional military challenges and expenditures.
The general point is that in volatile times, it is difficult to know when budget deficits should be expanding or contracting. That doesn’t necessarily militate in favor of current austerity, but it takes a lot of confidence away from the standard Keynesian recommendations.
A second problem with the Keynesian recommendations is that governments did not do enough to build up surpluses in good times. Many governments therefore are running out of fiscal space, or at least markets perceive that to be the case. Even if Keynesian theory says they ought to be expanding with their fiscal policy, they can’t always do so with impunity.
The recent history of the UK government is a paradigmatic example. Under Prime Minister Liz Truss, the plan was to boost spending on energy subsidies and cut some taxes. Whatever else you might say about the details of those policies, they did fit the Keynesian recipe for fiscal expansion in tough times (though it is noteworthy that many leading Keynesian economists strongly opposed them).
The problem is that markets didn’t like the policies, and the British pound fell and borrowing rates on government bonds rose. Financial markets were roiled, and now the Truss days are over.
Now Rishi Sunak is prime minister. What exactly is he supposed to do? He might try the opposite of the Truss plan, namely raise some taxes and cut some spending, or at least bend downwards the trajectories for future spending. In Keynesian terms, however, that policy is ill-advised. The UK is likely entering a recession, and the Bank of England has declared it may be the longest recession on record. Is it really wise to engage in austerity when times are turning bad?
Furthermore, the extant numbers do not indicate that the UK has to engage in austerity. Its debt-to-GDP ratio is about 80%, which is not astronomical. For a while economists Carmen Reinhart and Kenneth Rogoff tried to convince the profession that debt levels are dangerously high at 90% of GDP, but those arguments were shot down for having data errors and now those claims are discredited. It is not easy to now argue that a debt-to-GDP of 80% requires austerity.
A final problem is that rates of inflation are likely to stay relatively high for some while to come. I am relatively optimistic about the ability of many Western economies to get inflation down to the range of 3% or 4% within a few years. But at those inflation rates, nominal demand is pretty robust, so why would expansionary fiscal policy be needed to boost nominal expenditure flows?
In a recent interview, Sunak refused to be specific about his fiscal plans. Can you blame him? The macroeconomists are no longer there to advise him.
The British government appears to be in a state of Zugzwang, a chess term for the situation where there is no good move yet there is nonetheless a requirement to do something. Chancellor Jeremy Hunt has indicated that austerity will be the chosen path.
The macroeconomic establishment of the Anglo world won’t quite admit it, but Keynesian economics is no longer a reliable guide to fiscal policy. The real influence will go to whoever comes up with a credible alternative.
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