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Keynes, the universe and everything Samuel Brittan UCL speech, 02/02/2010 Versailles The true and boring title of this talk would be "A Macroeconomic Perspective" This would have guaranteed an empty hall. I shall try and make it more interesting by looking at it partly through the eyes of John Maynard Keynes who has become fashionable again for obvious reasons. But I must warn you that I am not an expert on "what Keynes really meant", still less on what he would be saying if he were alive today. I am taking the controversial course of assuming that he meant what he said when he said it. I am not by nature an idolater; but the advantage of following a few of Keynes's ideas was his extreme responsiveness to the world around him and his ability to absorb and rationalise its changing moods. I have to cover a great deal of ground in a very short period. So by all means take notes if you want to. But the material will be on my web site fairly soon. So you do not have to. A frequent complaint against political economists is that they hide their vision of how the world works behind complex detail and mathematical models. This charge has even been levied against Keynes who was normally a brilliant writer, but whose canonical 1936 General Theory has been subject to almost as much controversial analysis as the Bible or the works of Richard Wagner. His vision did of course change with the years. But it was always there to find for those who knew where to look. He first burst forth on the wider public with his famous denunciation of the Treaty of Versailles in his 1919 polemic, The Economic Consequences of the Peace. It might at first sight have seemed an unlikely best seller with its tables of coal and steel production and the commodity composition of German exports and imports in the last pre-war year of 1913. There were several reasons why it nevertheless sold so well among readers who did not normally devour such figures. First and foremost were his portraits of the Allied and German leaders. There was for instance the description of the French President, Georges Clemenceau "throned in his grey gloves, on the brocade chair, dry in soul and empty of hope, very old and tired, but surveying the scene with a cynical and almost impish air…He had one illusion - France; and one disillusion -mankind, including Frenchmen, and his colleagues not least." Keynes did not tell us that Clemenceau was originally a proper doctor, not of philosophy or economics but of medicine, and entered politics on the extreme left of the socialist party. Some of the most famous of Keynes's pen-portraits were not in the original book but appeared afterwards in a separate essay. This was true for instance of his remarks on Lloyd George which were considerably shortened on the advice of his friends. Then there was his portrait of one German negotiator, Carl Melchior, with whom he literally fell in love and was withheld from publication until after Keynes's own death. In more serious vein and not to be forgotten were Keynes's own doom-laden warnings about the future of Europe. Such warnings usually go down well, as they would today. Nevertheless what remained in the memory of readers who were not particularly interested in the German reparations problem was his preliminary chapter on Europe before the Great War, which he described as an "economic Eldorado." True that the greater part of the population worked hard and lived at a low standard of comfort…"But "escape was possible for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts and amenities beyond the compass of the richest and most powerful monarchs of other ages." He warned that that "the principle of accumulation based on inequality" was a vital part of the order, which depended on unstable psychological conditions. But he had little doubt that it was a successful system while it lasted. Secular Stagnation By the 1930's his vision had changed, not only in relation to the economic depression of the time; his view of the pre-1914 order had also darkened. (The reader interested in this aspect should probably start with the last few chapters of the General Theory, following back references where necessary.) Keynes's stark conclusion was that full employment had rarely been achieved in peacetime in any economy except in rare periods of exuberance. He formulated a "psychological law" that savings tended to rise in more than in proportion to income and tended to outrun investment opportunities. Interest rates did not, or could not, fall enough to bring them into line; and the equilibrating factor had to be, for want of anything better, permanent slump-like conditions. American economists who embraced this version of Keynes called the doctrine "secular stagnation" and braced themselves for a big slump following World War Two. Postwar Nearly Golden Age But that slump never materialised and in the second part of the 20th century savings were more often inadequate than excessive; and as governments were reluctant to let interest rates rise to the extent required we had periodic bouts of inflation. What had gone wrong with the "psychological law" of savings? At any one time people on higher incomes saved more than those on lower incomes. But as total income rose, the curve relating savings to income rose with it. So if national income doubled over two or three decades savings did no more than double - sometimes they did less. In that period there were attempts to boost economic growth by stimulating demand. Milton Friedman's main contribution in my view was to show that such policies risked not merely inflation, with which we can live, but accelerating inflation with which we cannot. He embodied this view in the doctrine of the "natural rate of unemployment". But it has now been politically sanitised by being renamed the "output gap" which can gaily be discussed by financial analysts and Labour Ministers, who do not always realise the implications of what they are saying. Return of Oversaving Yet to most people's surprise, Keynes's chronic savings surplus has come back, thanks to China's phenomenal savings rate. This is probably more an example of Chinese policy than of any "economic law". On IMF estimates Chinese national savings amounted in 2009 to no less than $4.3 trillion when measured at purchasing power parity. This was 49 pc of China's own GDP and 28 pc of global savings (again at purchasing power parity). The oil producing states have had large but highly variable savings surpluses which reflected the varying degrees of demand pressure in the world economy, but were not an independent causal factor. Germany, after all the turmoil of unification, once again has a savings surplus, but it is now a much smaller part of the world economy than it used to be. While the threat of high unemployment in the West in most of the postwar period came from union monopoly and other producer interest groups it now comes as it did in the 1930's from deficient demand - too little spending. In the postwar period Governments tried to hold the unemployment rate below the natural rate with the aid of various expedients such as so-called incomes policies, the danger now is that they tolerate it being above the natural rate. The world was kept in balance at the beginning of the 21st century by the US, which developed an abnormally low savings ratio, and thereby acted as a consumer of last resort, in the company of other smaller economies such as the UK and Spain, which behaved very much as an English speaking country. The boost in US consumption was aided and abetted by the Federal Reserve's low interest policy rate policy, which was justified in the circumstances. It was also enhanced by large budget deficits incurred by a supposedly strait-laced Republican Administration. Add to this irresponsible lending by financial institutions desperate for higher yield; and one must admit with hindsight that the pudding was overegged. Sarajevo All this came to an end with the credit crunch which began towards the end of 2007 and culminated in the insolvency of Lehman Brothers in the autumn of 2008. I will not enter into the debate on whether that institution should have been rescued. But I would compare its collapse to the assassination of the Austrian Archduke in Sarajevo in 1914, which triggered off World War One but was hardly its fundamental cause. A world depression has been prevented by rock-bottom official interest rates and money creation by central bank creation of money - known by the new fangled name of "quantitative easing". This was aided and abetted by a leap in budget deficits in Western countries. Their total fiscal deficits have been running at around 9 or 10 pc of GDP, with the US and the UK registering around 12-13 pc. This is a good place to remark on the absurdity of the arguments between the proponents of fiscal and monetary policy. Both are methods of regulating total spending in the economy. In normal circumstances there is much to be said for using monetary policy to control inflation and for balancing the current budget over a business cycle to prevent a pile up of debt. But a threat of world depression does not constitute normal circumstances. Monetary policy on its own comes up against the zero interest rate constraint. More fundamentally, you cannot in a reasonably free economy force banks to lend or businesses to borrow. This is the element of truth behind the popular saying "You cannot push against a string." It is probably the thought behind the notorious sentence in Keynes's preface to the German edition of the General Theory: "The theory which the following book purports to provide is much more easily adapted to the conditions of a totalitarian state" than traditional orthodox economics. This was written in1936 when the Nazis had been in power for three years. In a totalitarian state you can push against a string by ordering banks to lend and businesses to invest for approved purposes. Helicopters But to come back to Western economic policy today: if governments simply increase their borrowing they run the risk of pushing up interest rates against themselves, thereby undermining recovery. The most straightforward way of fighting depression would be the notorious one of dropping dollar and other currency notes by helicopter, as discussed but not advocated by Milton Friedman. An alternative, suggested by Keynes in a moment of desperation would be to bury notes in the ground and leave it to the forces of self interest to dig them up. Both methods would also encourage physical fitness. I have to accept that policymakers and the vast army of commentators are not sophisticated enough to adopt such simple remedies. But don't tell me that people will not spend this new money for fear of inflation. If you are afraid of inflation you do not hoard the money you pick up in the street. You spend it as soon as possible. Meanwhile, in the world as it is, if Western countries begin slashing their deficits, as conventional opinion so loudly demands, what will supply the offset to Chinese savings? Most of the suggested answers are non-starters. It is easy enough to criticise the Chinese demand stimulus for concentrating too much on dubious public investment, including the building of ghost cities without inhabitants. We could all run the Chinese economy better than the Chinese authorities. It would be best to take Chinese economic policy as given and concentrate our strictures on the abysmal denial of human rights in that country. In any case the Chinese authorities are now reining back domestic demand for fear of inflation. So there is not much scope for an early stimulus from that direction. .. What then are the prospects of a stimulus from elsewhere in the world.? A rise in Western private investment is not impossible. But it is hardly likely to take off while prospects for final demand are so muted and there is still talk of a double dip recession. The best long run hope for an offset to Chinese saving is investment boom in other emerging countries that have been less hard hit by the recession than the industrial West. But that is hardly likely to develop quickly on the scale required. The Deficit Spectre It would be foolhardy to encourage a further great rise on consumer or housing debt, at least in the English-speaking countries. If there were a single Western fiscal authority, I would unhesitatingly say: let the budget deficits run for a while, if necessary financed by the central banks - which, to be fair, Gordon Brown has tried hard to achieve. In the absence of such a common front what are the real limits to how far an individual country, fortunate enough to have is own currency and borrow in it, can go out on a limb in its fiscal policy? Unfortunately Keynes did not take the final logical step of endorsing budget deficits and indicating their safe and desirable limits. He put too much emphasis on the distinction between government current and capital spending - more than it can bear - as does the British Government today. He also placed too many hopes on a fiscal stimulus paying for itself through an increase in the national income and associated tax revenue. Financial market types worry about selling government debt; but this is not the true limit, which concerns real things. Faced with the threat of depression governments have every justification for borrowing from central banks - "printing money" if you like. If this means continuing or even increasing so-called quantitative easing so be it. I hope that the audience will forgive me if I end with a parochial British illustration. The most controversial Budget in recent decades was the 1981 Budget introduced by a Conservative Government which increased taxation in a recession and provoked a famous letter of protest from 364 economists. It is a matter on which commentators still come to blows even in retrospect. I am not going to state a view now. But I will remind people that the main consideration in the mind of the then Chancellor, Geoffrey Howe was none of the highbrow considerations advanced by Government economic advisers but a simple fear that he would not be able to sell enough government securities (gilts in UK parlance) to finance the looming deficit. (This turned out at around 3pc of GDP. No doubt the Treasury, which always exaggerates on such occasions may have forecast twice as much if he had not taken action. Even this would be about half the 12 pc at which the deficit is now running). But with all due respect, so-called common sense can be a bad guide. The true justification for the 1981 Budget was that inflation had been running at 15pc and it was a priority to reduce it. Economic stimulation in these circumstances would have made no sense. There is no comparison with the present position, when underlying inflation is around 0-3pc, world real interest rates are near zero and there are masses of savings (both actual and hypothetical at full employment levels of world income) looking for a safe home. Meanwhile I can only reply to the masses of exhortation that the first priority of a new British Government should be to reduce the fiscal deficit: "I beg to differ." Forget all the logic chopping on whether the UK recession has really ended or not,. UK output is some 10 pc below its previous trend, as the Bank of England Governor, Mervyn King, has just reminded us; and inflation is still under control. Most of the learned algebra one is given on how too much borrowing creates a "debt trap" - in which governments have to borrow more and more simply to pay the interest on the debt - assumes that total out put is fixed and unaffected by a fiscal stimulus. The correct answer is surely that it is worth pursuing an expansionary monetary and fiscal policy until the point where the loss on the terms of trade or the boost to inflation begins to outweigh the gains to domestic output and employment. Postcript I am often asked "Are there any limits in your view to the permissible budget deficit?" That is the wrong question. It is not my view that physical output growth should be pushed a l'outrance. I am always careful to list the objectives of policy as growth and low inflation. I can by pass metaphysical questions on the relative importance of the two objectives. As Milton Friedman showed there is no ultimate choice the two. If a stimulative fiscal policy is supported on the monetary side and pushed too far, the result will soon show up in unacceptably high inflation. Thus there is no realistic possibility of budget deficits reaching billions of percent of GDP with a sensible macroeconomic policy. But the limits are given by the state of the economy rather than the fiscal figures at any one time.
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