Keynes, Cameron and cuts

October 18, 2010
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David Cameron received a first at Oxford, studying Philosophy, Politics and Economics.  One can imagine that he managed to avoid reading Keynes’ General Theory during his university years but it is inconceivable that he did not gather a passing acquaintance with the great man’s thought. And the most familiar of Keynes’ insights is that during a recession one should increase the government deficit. And yet, the basis of the coalition’s economic policy is a brutal reduction in government spending. Why?

A recession, by definition, is a lack of aggregate demand.  When the animal spirits of firms and households turn fearful, they do not spend all their income but instead stash a large part of it under their mattresses. And that, of course, is the situation we find ourselves in today.

Households are paying down debt, corporations are sitting on ever-larger piles of cash, banks, despite the lowest borrowing costs in human memory are not lending. Our ability to produce is not matched by our desire to buy. And if consumption and investment are falling, if aggregate demand is stagnating, then firms have no reason to hire, which of course makes the downturn self perpetuating.

Keynes’ solution was for the government to step in through deficit spending and create that demand which will jump-start the economy.  Even hiring men to dig ditches and then hiring others to fill them is better than doing nothing.  The ditch diggers will spend their salaries, creating incentives for the private sector to hire new workers, breaking the recessionary feedback loop. World War II proved Keynes right.  Massive spending, financed by government debt, brought the world out of depression.

Cameron, Clegg and Osborne tell us they need to make these “painful” cuts because of high government debt levels are spooking bondholders who will demand higher interest rates. But so far, investors are not fleeing gilts but flocking to them.  Rates are lower today than they were a month ago or a year ago, actually an entire 2% than their average for the past 20 years.

So why is the coalition gung ho for deficit reduction?  In part it must be because it seems politically safe. For the great majority of us, with little knowledge of economics, cutting the deficit makes intuitive sense.  In difficult economic times, each of us feels safer saving than spending. An individual family, faced with an uncertain future, should not spend profligately.  Hiring someone to dig and then fill holes in my garden would be the height of stupidity. But we are fooled by the fallacy of composition. If all of us are parsimonious, then the economy remains stuck in a rut.  After all, my deferred purchases are your lost sales and if your sales are falling, you are not likely to hire me to make more widgets.

Cameron must know this. It is in every introductory economics course.  Could it be that that his government is embracing this new austerity not to placate non-existent bond vigilantes, not because of a belief in the doctrine of “Ricardian Equivalence” but because cutting spending on benefits, on welfare, on the NHS is what his party wanted to do anyway?