Analysis

A post-Brexit spending boost is entirely justifiable

Strident pessimism over a no-deal Brexit is creating the ideal conditions for Keynesian stimulus, says Bernard Connolly.

Philip Hammond © James Gourley/Shutterstock
Philip Hammond's warnings can be ignored

What are the circumstances in which fiscal expansion (see below) might be appropriate? And those in which it would be inappropriate? These questions are extremely important in Britain. There has been a stream of pronouncements warning against a no-deal exit, and lurid warnings of fiscal disaster should a government pursue such a course. That has led to plans from No.11 and the Treasury to support the economy if necessary with expansionary fiscal policy.

Any sensible discussion of this question must start by recognising the causes of our present economic situation, in which negative real (ie, after-inflation) interest rates and asset-price and credit bubbles are necessary to keep on deferring recession across the globe. The cause of the problem is too little saving: too much spending has been brought forward from the future. As that future now looms into our present, there is a need to repair (or attempt to repair) balance sheets by reducing spending relative to income. That means the economy will slow below its trend growth rate unless the private sector is given greater and greater incentives such as negative real rates, the illusion of stockmarket and housing wealth, and insouciance about debt levels to bring even more spending forward from the future. In such circumstances, fiscal expansion simply means that instead of giving the private sector more incentives (via monetary policy) to bring spending forward, the public sector does the deed itself. Thus fiscal expansion, of the sort routinely recommended by economists such as David Blanchard and Larry Summers, just builds up more trouble for the future.

A genuinely Keynesian approach would look different. Keynes identified a coordination failure in which excessive pessimism or uncertainty about other people's spending in the future, and thus about future employment, depresses today's spending relative to sustainable full-employment levels. It is in those circumstances that expansionary fiscal policy is justifiable. If it is done quickly enough to prevent an economic downturn from materialising that is, by offsetting through government spending an incipient shortfall in private spending the private sector's financial position is necessarily made better than if a Keynesian intervention had never happened.

As a result, once the private sector's fears are shown to have been unjustified, private spending can be higher than otherwise in each future period, by a proportion of the improvement in the balance sheet. As a further result, government spending can be correspondingly lower in future, without threatening to slow the economy below trend. That is, the present value of future cuts in government spending offsets the initial increase in such spending. In short, fiscal expansion in the conditions under which it makes sense according to Keynes maintains short-run equilibrium and also, at least relative to the highly unsatisfactory starting-point, it maintains the appropriate balance between present and future spending. Fortunately, such conditions are extremely rare. Even in the financial crisis, they lasted only for about six to nine months (from mid-September 2008 to mid-March or mid-June 2009).

Yet the relentless propaganda about the supposedly deleterious effects of a no-deal Brexit corresponds exactly to the Keynesian template of excessive pessimism. Fiscal expansion in such circumstances until the pessimism is shown to have been unwarranted is eminently justifiable. Importantly, it will not have the effect warned of by chancellor Philip Hammond: it will not worsen the government's financial position in present-value terms. It will simply make the private sector's financial position in the present better than in its absence. In turn, this means that government spending in the future can fall without threatening to slow the economy (as private-sector spending can be higher).

Why do No.11 and the Treasury spout the nonsense they do? Perhaps they are hopeless at economics. The alternative hypothesis that they are not (or not just) incompetent but have other motives has implications which would be very disturbing indeed.

I wish I knew what fiscal policy was, but I'm too embarrassed to ask

In theory, governments aim to keep control over public spending, avoiding incurring too much debt as a proportion of GDP. This notion of running balanced budgets has come under particularly fierce attack during the post-2008 era, as heavy national debt burdens and persistent government overspending (deficits) have failed to drive inflation or interest rates up.

Economist John Maynard Keynes argued in the 1930s partly as a response to the Great Depression of that decade that during slumps in private-sector spending, the government should raise public-sector spending to compensate and help kickstart private-sector demand, even if that meant running a deficit. Keynes also supported balancing budgets during the good times in order to have this leeway to spend more in tougher times. Unsurprisingly, politicians often favour the first part of Keynes' prescription over the second.

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