“Keynesian deficit spending makes sense – but over and over again it has not worked.” A recent article by James Bartholomew in the right-wing Spectator magazine made this claim, citing a number of examples, from Ireland to Japan. In these country case-studies he suggests that falling government deficits have been associated with economic recovery, or that rising deficits have accompanied stagnation or recession.
Unfortunately, the article contains virtually no economic analysis which could be used to explain these concurrences. The Japanese economy has stagnated since the bursting of its financial bubble more than 20 years ago. Its governments have run budget deficits since then, and the national debt has risen to around 2.5 times national income. But did these persistent deficits cause the stagnation? Or were they mostly a consequence of it? It could be claimed that in the absence of the boost to spending provided by the government, performance would have been even worse. Richard Koo has certainly made this claim.
The central problem in Japan today is excessive saving by the corporate sector, and the lack of private investment opportunities. The country’s ageing population and shrinking workforce has also been a drag on economic activity. Growth per capita has actually been better than in a number of other rich countries in recent years. Structural reforms which encourage firms to redistribute a higher share of profits to shareholders and workers in the form of dividends and wages respectively, would go a long way towards boosting growth in private sector consumption and improving the allocation of investment. This will reduce the government’s deficit; if nominal GDP (the sum of growth and inflation) starts to exceed the latter over a number of years, the national debt as a proportion of GDP will start to shrink. But this assessment in no way validates Bartholomew’s claim that reducing the deficit would on its own boost GDP growth. In fact, with the high levels of corporate debt accumulated during the 1980s boom, and the subsequent bursting of the bubble, Japan found itself in a ‘balance sheet recession‘. Thus for years firms were forced to use earnings to pay down debt rather than invest, despite very low interest rates. An attempt to reduce the deficit was made in 1997 with tax rises, but this helped to tip Japan back into recession and the deficit rose as a result. The attempt proved self-defeating.
Deficit hawks often cite individual countries’ experiences with deficit reduction and recovery. But they invariably fail to analyse the drivers of growth and their causes. Small economies open to international trade can boost growth if their currencies are devalued and they are able to cut interest rates significantly. This could stimulate an expansion in net exports, along with private consumption and investment. Growth in these components of demand will stimulate growth in GDP, raising tax revenues and reducing public spending on social welfare, thus leading to a falling government deficit. In an environment such as the current world economy, with an overall weakness in demand and international trade, and interest rates in many countries already at extremely low levels, these potential drivers are absent for most economies. Deficit reduction by all countries simultaneously will inevitably be a drag on global activity.
Keynes’ ideas covered far more ground than simply deficit spending in a recession. The main innovation in his magnum opus, The General Theory, was the concept of effective demand. Indeed in this book, the core of the analysis ignored government altogether, and focussed on the instability of private investment as the driver of economic fluctuations. Only in the final chapters did he make the case for the ‘socialization of investment’, by which he meant government intervention to stabilize and stimulate the latter in order to avoid mass unemployment. In practice this could involve all sorts of policies, from monetary and fiscal to industrial and technology. In my view this leaves the choices facing any government somewhat open, amply justifying Keynes’ view that his theory was a general one.
Bartholomew’s mistaken views can also be countered using the theory of ‘sectoral financial balances‘. In a closed economy with no international trade, but with a private and a public sector, the government deficit necessarily equals the private sector financial surplus (saving minus investment). If the private sector (firms plus households) is in balance, and thus saving is equal to investment, then the economy can grow with the government budget also in balance. However, if the private sector is a net saver (savings exceed investment, typical in a recession), then the government has no choice but to run a deficit. The two must balance. This is a matter of accounting and not of contestable theory. Attempts to reduce the deficit will slow the economy further. The deficit can only fall if the private sector balance moves from surplus towards balance, and it can only be in surplus if the private sector is borrowing overall and accumulating debt.
The article cited above is therefore misleading in its claims that what it calls ‘Keynesian’ policy is ineffective. In the absence of a theory which can satisfactorily explain the cited examples, it has no basis in economics and no basis in fact. It is attempting to rubbish popular opinion with crude and ill-founded story-telling. In fact, some of the comments below the piece confirm this. It should be exposed for what it is: simply wrong-headed.