George Kerevan: It's Keynesian, captain, but not as we know it

Published on Tuesday 21 October 2008 22:25

THAT most mischievous of economists, John Maynard Keynes (1883-1946), must be chuckling in his grave.

The age of Keynesian intervention in the economy was famously written off by the then prime minister Jim Callaghan in a speech to the Labour Party conference in 1976, when he said: "We used to think you could spend your way out of recession by boosting government spending. I tell you, in all candour, that option no longer exists. And in so far as it did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by higher unemployment as the next step."

But Keynes is undergoing an unexpected revival in the face of impending recession. The Chancellor now cites him as the intellectual justification for the government's decision to throw its fiscal golden rules out of the proverbial window, and borrow and spend its way out of recession. "Much of what Keynes wrote still makes a lot of sense," opines Alistair Darling.

Keynes remarked that "even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist". He would be amused to find Darling falling into that category. What Keynes meant, of course, was that politicians have a bad habit of justifying bad policies with reference to outdated ideas.

I've always had a soft spot for lanky Maynard Keynes. He hardly fits the stereotype of the modern academic economist mumbling incoherently on Newsnight. Keynes was an iconoclast; a rampant bisexual who surprised his Cambridge male circle by upping and marrying a stunning Russian ballerina; an inveterate gambler who made himself a millionaire; a brilliant writer; and a conceited genius who despised politicians. Love him or loathe him, he was one of the most influential people of the 20th century. And that includes creating the IMF, the Word Bank … and the Arts Council.

Keynes was ruthless in discarding ideas (including his own) if they failed to act as a guide to changed circumstances. "The difficulty lies not so much in developing new ideas," he argued, "as in escaping from old ones."

Were the ghost of Keynes to revisit his old stamping ground at the Treasury, he would happily tell Darling that the present crisis is no re-run of the 1930s.

Keynes wrote a fascinating book on the Great Depression, entitled The General Theory of Employment, Money and Interest. It is his most famous work though, curiously, his least well written. The similarity of the Great Depression with today's crisis is that it began with a banking collapse. Economists of the time thought the resulting downturn would be short-lived as falling prices boosted demand. Instead, we had a decade of mass unemployment. Somehow, the demand motor had stalled.

Faced with passivity on the part of the Treasury, Keynes suggested printing money and spending it on hiring the unemployed to build roads and other public works. His advice was rejected but a similar scheme was employed by a certain Mr Hitler.

Keynes was right at the time, but he was clever enough to realise that his pragmatic, short-term solution was only an expedient to ward off revolution. To provide a permanent fix, it would be necessary to explain why the normal market recovery mechanism had jammed during the 1930s.

In The General Theory, Keynes argued that the defect lay with industrial investment. To simplify absurdly, low profit expectations were limiting future investment at the same time as a credit crunch was driving the real cost of capital higher. (At the time, profit expectations were low because of trade barriers, a fragmented industrial structure and a lack of technical innovation.) In these circumstances, public spending was needed to kick-start demand to the point that profit expectations rose, and normal investment returned. The investment battery was flat and needed a fiscal jump start.

Does this analysis apply now? Certainly, we needed to use public money to reboot the banking system (though hanging a few bankers at Murrayfield would have been more popular). However, I don't think recession in today's real economy is the result of a prior collapse in industrial investment.

On the contrary, the driver of the UK economy during the Gordon Brown decade has been consumer spending fuelled by personal debt, either in the form of equity release or credit cards, underpinned by ludicrously low interest rates. This is a very different world from the Keynesian 1930s. But now the credit crunch has kiboshed the housing market, consumer expenditure is about to fall off a cliff, plunging the economy into recession.

Yes, a fiscal boost is necessary – short term – to stave off the worst of the human consequences of this downturn. But the ghost of John Maynard Keynes would tell you that letting public borrowing rip in contemporary circumstances is going to have serious consequences.

For a start, as Callaghan pointed out, if the fiscal aspirin is taken in too large a dose the patient gets wage inflation and the economy eventually stalls. Darling is lucky that current inflationary expectations are low. On the other hand, there is little excess capacity in the economy, so triggering inflation would not be that difficult.

Next, unlike most eurozone economies, the UK already has a structural budget deficit even before we do any counter-cyclical borrowing and spending. Last year, the government borrowed 36 billion (2.8 per cent of GDP) even though growth was near trend. Trebling that to 100bn per annum could make foreign lenders nervous and cause a flight from sterling. That could put a floor on interest rate cuts, which the economy desperately needs.

I'm not sure the ghost of Keynes would be willing to have his name taken in vain by Darling. Keynes' ever subtle imagination might recommend we boost consumer spending through tax and interest rate cuts, rather than funding building projects using French contractors, Indian steel and German machinery – meaning the cash leaks out of the economy.

However, the real Keynesian question is: what do we need to fix permanently about the UK economy? I suspect he would be surprised that we have come to rely on unsustainable consumer debt as our economic lubricant. A gambler like Keynes would tell you that running your economy like a casino will always end in tears.