False economic assumptions

“Even most of those who had previously argued that monetary policy was the only appropriate counter-cyclical weapon in the policy-makers’ toolkit accepted in 2008-9 that a fiscal stimulus was necessary to prevent the economies of the United States and the United Kingdom spiralling from recession to depression.” So we are assured by Sir Howard Davies in his review in Prospect of Universal Man, the recent Keynes’ biography by Richard Davenport-Hines.

Really?

True, Keynesian remedies were articulated strongly at the G20 Washington summit in November 2008 and the G20 London summit in April 2009. But Davies’s limiting his reference only to the USA and UK speaks volumes. At the London summit Sarkozy and Merkel organised a separate press conference in which they repudiated further fiscal stimulus.

But even British economists have long been divided about the merits of increasing the budget deficit as a method of macroeconomic expansion. Gordon Brown may in late 2008 have listened particularly to Keynesian advisers, but as early as February 2010, 20 leading figures—not at all admirers of the Chicago faculty and its rational expectations, efficient-markets theorists—wrote an important letter to The Sunday Times. They distanced themselves from Brown’s policies and urged “a compelling case” for “a credible plan” to eliminate the budget deficit over the course of the next Parliament (the one to follow the May 2010 general election).

Why has elite economic opinion in Britain, the Keynesian homeland, become more ambivalent about fiscal reflation than its counterpart on the other side of the Atlantic? The answer surely lies in the sequel to the 1981 Budget. The Thatcher government’s commitment to strong public finances caused it to raise taxes (by a sizeable 1.5 per cent of gross domestic product) in the midst of a recession. 364 academic economists wrote to the Times protesting that this tightening of fiscal policy was misguided in the circumstances and would lead to an intensification of the recession. In the event, the 364’s letter to the Times was badly timed and substantially wrong, and many of its signatories came to regret it.

Davies was a civil servant in the Treasury in 1981. His review of Universal Man invites the interpretation that he disapproved of the 1981 Budget. If so, his views would be similar to those of his close Oxford friend, Peter Stothard, who was then writing on economics and politics at the Sunday Times, and had a scoop which broke the news of the fiscally restrictive 1981 Budget in advance. Davies certainly has had no enthusiasm in his subsequent highly distinguished career for “monetarism” and such profanities as “sterling M3”, the measure of money in circulation. (In his after-dinner speeches he can be quite brutal about such matters.)

He ought perhaps to be told that some British monetarists, including the author of this article, are underwhelmed by the efficient markets hypothesis and the rational expectations school, and more generally by the current incumbents of the Chicago economics faculty. Indeed, the arguments for strong public finances, which provided the rationale for both the 1981 Budget and European fiscal consolidation in the last few years, have little to do with rational expectations and the efficient markets hypothesis. As officials in the Greek finance ministry are now finding out, they appeal more to the laws of arithmetic.