The Keynesian excuse for not cutting spending

Mar 03 2010

In a speech to the Bank for International Settlements by José Manuel González-Páramo, a member of the Executive Board of the European Central Bank first discusses the economics of deficits. He sets out a number of conditions under which we should be relatively sceptical of the kind of argument the Government are making, that cutting deficits too soon would imperil the recovery:

- "If the fiscal starting position is precarious and the adjustment is credible;

- If financial markets react by lowering long-term interest rates;

- If households have correctly understood the need for fiscal adjustment and have factored this into their spending decisions; in other words, if households are – at least partly – “Ricardian”;

- and if monetary conditions are accommodative."

Now given that Britain is facing particularly sharp deficits which are clearly affecting business confidence, there is a particularly strong case that we should be cutting deficits sooner rather than later. Which makes Mr. González-Páramo's comments about fiscal policy in the eurozone particularly telling:

"To conclude, it is therefore essential that consolidation targets are reflected as soon as possible in specific, detailed tax and spending plans. Credible and detailed fiscal adjustment plans should reassure investors, creating a more favourable, long-term financing environment. Credible and detailed fiscal adjustment plans should provide certainty for households making their saving and investment decisions. Credible and detailed fiscal adjustment plans would also facilitate the task of monetary policy in maintaining price stability, while gradually returning to a more normal, post-crisis monetary environment."

We need the same from our politicians here. Even if we accept the Government's case that cuts should be delayed till 2011-12 - and we don't - they should be trying to build credibility by setting out a specific plan to cut spending, not just a promise to cut deficits.

After all, the Government are claiming that they need deficits now to provide a Keynesian stimulus but they were running deficits long before the recession. Their failure to set out a credible plan for cuts suggests that they are mostly using "crass Keynesianism" (as the Germans called it) as an excuse for fiscal profligacy, rather than seriously trying to manage economic demand over the economic cycle. Buchanan and Wagner, in a classic work of political economy - Democracy in Deficit: The Political Legacy of Lord Keynes, made a powerful case that this is a critical flaw in the political economy of Keynesian stimulus. Regardless of whether it can work in economic theory, in reality politicians aren't responsible enough to use the licence Keynes gave them to run deficits responsibly:

"Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian message, politicians can spend and spend without the apparent necessity to tax."

- Buchanan, J. M. & Wagner, R. E. (1977)

To turn to a slightly less scholarly source, this appears to be the Government's real policy on the fiscal crisis:

"I've been working on a plan. During the exam, I'll hide under some coats, and hope that somehow everything will work out."

- Simpson, H. (1993)