This piece published today by Project Syndicate is as insightful a critique as I've seen of the consensus that has emerged among policymakers that government deficits must be cut to restore economic growth.
Not that we haven't taken a stab at that ourselves.
But Skidelsky has authored a biography of Keynes, so he knows the economics here a whole lot better than we do and can put them into language that strikes much closer to home.
The writer, who also happens to be a member of the British House of Lords, not exactly a hotbed of Soviet-style central planning, starts out by observing that "contrary to Keynes, orthodox economists believe that, after a big shock, economies will ‘naturally' return to their previous rate of growth, provided that governments balance their budgets and stop stealing resources from the private sector." And Skidelsky notes that the theory underlying this way of thinking was set out in the July Bulletin of the European Central Bank. (I would add that it has also been embraced by inflation hawks at the Fed and in the Obama administration.)
The problem with debt-financed public spending, according to this view, is that it will "crowd out" private spending by causing real interest rates to rise or by leading households to increase their saving because they expect to pay higher taxes later, Skidelsky explains. Either way, he says they say, a fiscal stimulus will not only have no effect; the economy will be worse off, because public spending is inherently less efficient than private spending.
So what of the fact that such crowding out has yet to happen, Skidelsky asks? Sure enough, the deficit hawks have a fallback position: "The problem with fiscal stimulus, they say, is that it destroys confidence in government finances, thereby impeding recovery. So a credible deficit-reduction program is needed now to ‘consolidate recovery.'"
But what is it about cutting the deficit, he continues, that is supposed to restore confidence? As Skidelsky summarizes the scenario posited by the ECB and its fellow travelers: "Deficit reduction may lead consumers to believe that a permanent tax reduction is on the horizon. This will have a positive wealth effect and increase private consumption. But why on earth should consumers believe that cutting a deficit, and raising taxes now, will lead to tax cuts later? One implausible hypothesis follows another."
Oh sure, fiscal consolidation, its advocates claim, "might" lead investors to expect improvement on the supply side of the economy, says Skidelsky. But, he insists that it is unemployment, loss of skills and self-confidence, and investment rationing "that are hitting the supply side."
Not to worry, say the deficit hawks. "Credible announcement and implementation" of fiscal-consolidation strategy ‘may' diminish the risk premium associated with government debt," which will reduce real interest rates and make ‘crowding in' of private spending more likely, Skidelsky explains again.
Never mind that real interest rates on long-term government debt in the US, Japan, Germany, and the United Kingdom are already close to zero. As the author puts it: "Not only do investors view the risks of depression and deflation as greater than those of default, but bonds are being preferred to equities for the same reason."
He also puts paid to the idea that the reduction of governments' borrowing requirements "might" have a beneficial effect on output in the long run, owing to lower long-term interest rates. "Of course, low long-term interest rates are necessary for recovery," Skidelsky writes. "But so are profit expectations, and these depend on buoyant demand. No matter how cheap it is for businessmen to borrow, they will not do so if they see no demand for their products."
Wrapping up, Keynes' current champion describes the ECB's arguments as amounting to the "scraping the bottom of the intellectual barrel."
The truth is that it is not fear of government bankruptcy, but governments' determination to balance the books, that is reducing business confidence by lowering expectations of employment, incomes, and orders, he insists, convincingly in my book. "The problem is not the hole in the budget," he says, "it is the hole in the economy."
For argument's sake, he goes so far as assume that the ECB is right and that fears of "unsound finance" are holding back economic recovery. In that case, he wonders, are such fears rational, or are they not exaggerated in today's circumstances (except, possibly, in countries like Greece)? "If so," Skidelsky asks, "is it not the duty of official bodies like the ECB to challenge irrational beliefs about the economy, rather than pander to them?"
Alas, the writer concludes by labeling governments in the current environment "intellectually disabled," and their theory of the economy "a mess."
His solution: "Policymakers need to re-learn their Keynes, explain him clearly, and apply his lessons, not invent pseudo-rational arguments for prolonging the recession."
We couldn't have said it better.