Keynesian Spending

Further to your interview with Alistair Darling, we would like to dissent from the attempt to use a public works programme to spend the country’s way out of recession.

It is misguided for the Government to believe that it knows how much specific sectors of the economy need to shrink and which will shrink "too rapidly" in a recession.

Thus the Government cannot know how to use an expansion in expenditure that would not risk seriously misallocating resources.

Furthermore, public expenditure has already risen very rapidly in recent years, and a further large rise would take the role of the state in many parts of the economy to such a dominant position that it would stunt the private sector’s recovery once recession is past.

Occasional slowdowns are natural and necessary features of a market economy.

Insofar as they are to be managed at all, the best tools are monetary and not fiscal ones. It is inevitable that government expenditure and debt naturally rise in a recession but planned rises in government spending are misguided and discredited as a tool of economic management.

If this recession has features that demand more active fiscal policy, which is highly disputable, taxes should be cut. This would allow the market to determine which parts of the economy shrink and which flourish to replace them.

This letter, signed by many top English economists, is an appeal to the UK government, which criticizes Keynesian ideology of increasing government spending (In the case of UK it would be directed towards public works) in order to battle recession. Before evaluating statements criticizing this decision, it is important to first understand why such decision may be appealing to the UK government.

The theory behind Keynesian way of battling a recession is the idea that government spending and government involvement in the economy is the best policy that can be adopted in order to tackle the negative GDP growth. According to Keynesian theory, a government should borrow money, and inject it into the economy in order to provide people with income. This income could be spent on various goods and services, which could propagate investment causing an increase in aggregate demand. An increase in aggregate demand would lead to increase in GDP growth (ceteris paribus) which in turn constitutes economic growth.

This theory does provide some interesting possibilities of fighting a recession, however it is severely limited by all the points expressed in the letter above, as well as by an inherit logical flaw in its very core, which although not expressed explicitly in the letter, will be relevant to further discussion. Lets examine the first criticism of using Keynesian macroeconomic policies presented in the letter.

The first voiced concern deals with the governments lack of knowledge about which sectors of the economy are in the greatest need of funding, and which ones do not need it as much, if at all. Typically, the economy is divided into four specific sectors: primary, secondary, tertiary and quaternary. Primary sector is commonly associated with Agriculture and secondary sector is the manufacturing sector. The tertiary sector includes services, whilst the quaternary sector includes all intellectual/ cultural activities. If indeed the UK government lacks such information, it is running a high risk of stimulating the sector of the economy which does not possibly need to be stimulated nearly as much as a different sector. Such a mistake would lead to a serious misallocation of resources. This would effectively waste government funds, as they were not directed at the real weaknesses of the economy. This is hence by all means is a valid concern.

The second problem is the one of consistently high spending by the public sector leading to stunning the private sector after the recession is over. There is a definite assumption here, that what will be publicly build, will be publicly owned after the recession, and that it will not be privatized. With that assumption, this is once again a very valid concern. If government decides to spend funds on all areas of economy, such as hospitals, schools or transport services, and then it will refuse to privatize all that has been built, the market structure in all those markets would effectively become a monopoly (all of which are owned by the government). This can cause major problems for the private sector, as monopolistic market structure is defined by high barriers to entry and exit, hence it would be unlikely for a firm to be established, which would have real chances of competing with government ran businesses. Often mentioned consequences of a monopolistic market are higher prices and lower supply, as well as lack of economic efficiency. Lack of competition may also remove the incentive for innovation. This is hence not only a concern for the private sector, but also for consumers, who could be affected by higher prices (...than would be attainable with competitive market structure).

"Occasional slowdowns are natural and necessary features of a market economy."

This statement is the one I may have some issues with. I would agree that those slowdowns are a natural feature of the market economy (as shown by the business/trade cycle), however I am not sure as to the necessity of such slowdowns in a market economy. To my understanding, necessity means something that should/ ought to happen.. I do not agree with this statement, as I believe that slowdowns are not necessary, and that all economies would be better off without them, for a slowdown hinders economic growth, can lead to job cuts, can cause social unrest, and is hardly beneficial in any way to the society. Unless "necessary" is used as a synonym to "unavoidable" I do think this statement is incorrect.

The next section focuses on fiscal vs. monetary policy. It is suggested that monetary policy should be used over fiscal policy, as the latter being "misguided and discredited as a tool of economic management". For a poorly informed person, such a statement would be considered as rather bold, however the fact is, that Keynesian policies have been tried many times in the past, and they have yet to succeed. A prime example of this is the US government policy in the 1930 with Hoover and Roosevelt. They adopted Keynesian economics, and went with every advice on fiscal policy management ever proposed by Kaynes, and yet the overall result was that the GDP growth kept declining, and unemployment was still unsatisfactorily high. Much of fiscal policy, of which Keynes was an admirer has hence been discredited by reality. I do believe that there is a more inherit flaw in the theory itself, which is why the theory has failed to succeed in the past and will fail to succeed in the future.

If a government wishes to increase its expenditure, it needs funds to do it. It can do two things: print money or borrow it from the national/central bank. The first idea is a surely no, as it will lead to just a proportionate increase in prices, and people will end up having effectively as much money as they did before. So the only real choice that a government has is to borrow that money from a bank. The important thing to remember is that this bank, is already a part of the economy. This means that what government really does is takes the money out of the economy, and injects it back, its nothing more than that. This means that there is no actual increase in AD, as the government it is simply reallocating the money more so than anything else. On the other hand, even a reallocation of funds, so that it is people with large MPC which receive the newly distributed funds, could increase AD, as the money is now in the hands of people who spend rather than save. The problem with this is, that in times of economic downturn, people are much more hesitant to spend, and they much rather save the money in case they need it for future, so effectively, the money just makes a full circle from a bank to government to people back to the bank. There is hardly an increase in consumption, which is why Keynesian recession policies have failed in the past.

The alternative to this is the use of monetary policies, which include interest rate management, quantitative easing or funding to name a few. There is a major downside to using monetary policy, especially in the context of battling a recession, and that is that economists typically estimate that the full effects of monetary policies can be observed properly only after 2-3 years have past.

Fiscal policy takes long time to setup, but the effects are observable very quickly once it has been implemented. The initial change in fiscal policy can be fairly immediate, however the fine-tuning would take a lot of time, as for example taxes can be changed in most countries maximum once a year. I do not see particular advantages of the use of monetary policy as opposed to fiscal policy for Kenya, as the article suggests.

The final paragraph states that the best way of using of fiscal policy (if such a need arises) is to cut taxes. The need for more fiscal policy in the current state of the economy is disputable, as fiscal policy rarely (if ever) leads to desired effects. The idea is thus that cutting taxes could result in better understanding of which parts of the economy are shrinking, and which will be there to replace them. The emphasis is on the fact that the market will correct itself, and the gaps will be filled after the recession, and implies that further government interference would be undesirable.

This letter is written surely by a group of specialists in their fields, who do believe in the the (almost) perfect nature of the market. They believe that the markets have the ability to adjust and modify to fully accommodate clients needs. I am sure they wont deny that there are cases where market failure exists, and governments should intervene, however the letter above provides very constructive and accurate criticism of Keynesian policies as means of tackling recession.