Is Keynesianism Running Dry?

Via Perspectives from Pictet,

Why policymakers must be brave and innovate with economic policy

Even though the policy mix is extraordinarily stimulating, developed-world economies just cannot embark on a virtuous circle of recovery. Worse still, governments, whose finances have been bled dry, are powerless to boost demand. This all suggests Keynesian policies have failed. A fresh approach to economic policy is needed. But policymakers will need to be both bold and brave.

The current state of economies is serious and worrying: although deliberate expansionary policies have been pragmatically implemented since March 2009, governments and central banks throughout the developed world have been unable to push recalcitrant economies back into the virtuous loop of self-sustaining recovery. The implications are plain for all to see: once governments apply a brake to public spending, growth slows considerably. Economies of the developed world have become addicts, ‘hooked’ on government spending.

The annualised rate of US economic growth has slackened to no more than 2%, down from 6% in Q2 2009, in spite of the mix of reflationary fiscal policies and the US Federal Reserve’s unprecedented quantitative easing. Europe’s economies are heading for recession, crippled by draconian budget austerity in many countries intended to redress astronomical public-sector deficits and national debt. Worst-case scenarios are pointing to Europe’s GDP shrinking by 2% over the coming 12 to 18 months. This calamitous failure of economic policies will have serious social, political and, self-evidently, economic repercussions.

Keynesianism running dry

Both US and European economies see jobs being destroyed once growth slows below 2%. If recession bites, obviously jobs are wiped out on a more massive scale and household income shrinks. Unemployment and contracting income penalise social well-being in developed nations: the number of people living below the poverty line is rising non-stop. Although this stratum of society was considered just a marginal fringe twenty years ago, it now accounts for between 10% and 20% of the total population in most developed economies (15% in the US, 12% in France, 21% in the UK).

Draconian austerity measures in a setting of lacklustre growth make a recipe for despair in the population, creating a breeding-ground for ever more popular extremist political parties. Recent general elections in Greece, France, the Netherlands, Austria and Sweden have seen farright populist and parties disturbingly making electoral breakthroughs or scoring big gains. Modern societies can no longer promise future generations a better, brighter future. Political instability precludes the vital nationwide consensus being formed to push through measures required to rebuild the foundations of a solid economy.

This economic-policy stalemate, in particular, is becoming increasingly blatant. Traditional Keynesian remedies are proving both unworkable and ineffectual. Record public deficits of 10% of GDP in 2009, inflated by the host of budget reflationary programmes, have resulted in governments being either de facto or potentially insolvent. Since then, with no financial ammunition left, governments have been unable to push through any further reflationary measures and compensate for the drop in wages by distributing increased social-welfare benefits. Worse still, by slashing public spending, a strategy regarded by economists as essential to restore countries’ sustainable financial viability, policymakers are making matters worse: as growth slows, deficit-cutting targets are being missed and the trajectory on public debt is moving ever further away from its optimal pathway. With no credit to dispense, State-administered Keynesianism is, in effect, bankrupt as government spending levers can no longer be activated.

A new role for government needs to be envisaged

How serious have things become?
After all, Keynesianism’s limitations have been apparent for some time. By seeking to kick-start growth by boosting consumer spending, it has become clear that modern economies no longer rely on consumption. To be more precise, the dynamics of virtuous, self-sustaining economic growth are not triggered by consumer spending. In contrast, the dynamics feed through eventually into consumption – they are instigated by investment and, by extension, jobs. This key focus on the investment/employment duo has been noticeably lacking in the US and European economic policy mix over the last four years. The time has come to review the role government and the State, shown now to be effectively toothless, play in influencing economic growth.

As governments alone are no longer able to spend and stimulate growth, they need to turn towards encouraging spending by other economic players, especially those who can intervene effectively to boost jobs and incomes, i.e. businesses. To do that though, politicians will need to be both bold and brave. At a time when capitalism is being accused of the most reprehensible wrongdoings, policymakers will need to display great courage to promote the virtues of entrepreneurship and business. However, while Keynesianism may be looking bankrupt, demand-side economic policies are looking dead in the water as well. As a result, moving to economics geared to boosting supply is absolutely indispensible. The rub is that the policies for this still have to be invented.

There has, however, been one illustrious precedent: the supply-side economies implemented with success by the Reagan Administration in the early 1980s, followed by twenty-five years of sustained growth in a period referred to as the era of the ‘Great Moderation’. The fresh approach to economic policy now will need to be generous in seeking to promote innovation. Investment and job creation tend not to happen without a major wave of innovation. Of course, innovation cannot be decreed into existence. But it can be nurtured through fiscal incentives that favour risk-taking. Huge tax breaks for R&D and capital spending would be likely to form the major building-blocks of any future budget policy to stimulate supply. Making such moves would call for great political courage as, nowadays, it is regarded as socially equitable and electorally advantageous to tax – even so heavily as to veer close to financial repression – those generators of wealth most liable to be most useful in boosting supply.

A fresh approach to economic policy

There is a second challenge though.
Unchecked, supply-driven economic policies tend to lead to excess. Modern economic history covering the Great Moderation period has demonstrated that overgenerous use of credit always ends in tears. First of all, in the 1990s, the belief that boom-and-bust cycles were things of the past thanks to the advent of revolutionary new information and communications technologies lured companies into running up huge borrowings beyond what their returns on equities could withstand. This sparked the bursting of the bubble and TMT (technology, media, telecom) crash. Then, from the early 2000s, it was households’ turn to overstretch themselves with debt, culminating in the sub-prime crisis. Moreover, innovation per se should not be regarded as universally wonderful. Just take the example of financial innovation which, unregulated, lay behind the ballooning debt.

Excess lending will inevitably lead to artificially-driven economic growth as it breaks the link between the cycles of innovation and economic growth. The virtuous qualities of real economic growth evaporate and become unreal. Growth fuelled by excess credit leads inevitably, as night follows day, to ballooning bubbles, burst by devastating crashes on financial markets. Fresh and well formulated supply-focused economic policies would need to take due account of such undesirable and destabilising implications. This concern points to a new role for central bankers, implying, by osmosis, a fresh style of monetary policy being needed as well. Inflation targeting (keeping core inflation around 2%), the sacred cow for central banks since the early 1980s, is no longer appropriate for either today’s growth conditions or for an innovative, supply-geared economic policy mix.

Imagination will be required to forge this new role for central banks. Not to mention the bravery in calling into question the orthodoxy that has held sway for so long. In the past though, periods when there have been serious ruptures in cyclical economic patterns have often seen major shifts and key policy breakthroughs. However, all the courage and boldness will be futile if the will to bounce back is lacking. The challenge is most daunting. The direction of economic policies over the next few years will dictate the structural trends for developed economies for decades to come. We just have to hope that policymakers will dig deep amid all the grave economic, political and social crises today to find that courage to be bold and innovative.