IS KEYNESIANISM DEAD? / THE FINANCIAL TIMES OP EDITORIAL

Is Keynesianism dead?

When debt is the disease, fiscal medicine may be as likely to harm as heal

Andy Haldane

Women and children stand in line to receive food from priests at the New Hope Mission in New York during the 1930s Depression © Bettmann Archive

The conjoined crises of the Great Crash of 1929 and the Depression of the 1930s left lasting scars on households and businesses. 

The resulting desire for safety through saving led to economic stagnation — what John Maynard Keynes dubbed the “paradox of thrift”. 

“Keynesianism” emerged as an emergency response.

In this environment, Keynes reasoned that government needed to act as spender and risk-taker of first resort. 

Doing so could revive the animal spirits of the private sector and, with them, growth. 

And when put into practice, this Keynesian multiplier largely worked, helping reflate the world out of the Depression.

Having dominated policymaking up to the 1970s, Keynesianism was then jettisoned for monetarist policies as stagflation displaced stagnation. 

But this century it has staged a remarkable comeback in response to a new set of conjoined crises, the global financial crisis, Covid and the Russia-Ukraine war. 

Indeed, the new interventions have dwarfed any previous peacetime stimulus.

But while cushioning the effects of crises, such mammoth interventions have left their own lasting scars: public debt across the G7 now exceeds annual GDP, with debt ratios doubling — in the UK and US almost trebling — since the start of the century. 

This raises questions about the effectiveness of future fiscal stimulus, especially in high-debt countries such as the UK, US and Japan. 

Is Keynesianism now diminished, perhaps defunct? 

Fiscal multipliers operate through three key channels. 

First, their effect on household and business spending. 

In order to work, Keynesian policies need to catalyse private spending. 

But if people anticipate that borrowing today means higher taxes tomorrow, stimulus might prompt saving rather than spending — something first identified by David Ricardo in 1820.

Second, their strength depends on how borrowing costs respond to stimulus. 

For example, if extra borrowing is perceived as increasing the likelihood of governments inflating away or defaulting on their debts in the future, this will raise borrowing costs and depress demand today.

Third, multipliers depend on how monetary policy reacts — for example, whether central banks accommodate fiscal stimulus or instead offset its effects by tightening policy. 

The latter is more likely when inflation itself is above target.

If all three channels operate in ways that damp any stimulus, its impact is likely to be diminished. 

Indeed, it could become negative. 

Francesco Giavazzi and Marco Pagano found that fiscal contractions in Ireland and Denmark in the 1980s boosted demand. 

This trick was then repeated in crisis-stricken Portugal, Italy, Ireland, Greece and Spain (PIIGS) this century. 

The common denominator in all of these cases, and in many emerging markets, was unusually high public debt.

Evidence elsewhere confirms this pattern. 

In a study of 44 countries, Ilzetzki, Mendoza and Végh find evidence of fiscal stimulus depressing growth — a negative fiscal multiplier — when countries’ public debt exceeds 60 per cent of GDP. 

With all of the G7 having debt ratios above this threshold, might we now be entering the twilight zone for Keynesian policies?  

Looking more closely at each of the channels of fiscal transmission supports that contention. 

Historically, economists have been sceptical about the ability of households and companies to anticipate future tax rises when making spending choices. 

But precarious public debts are increasing the salience of this concern.

Surveys in the UK, US, France, Italy and Japan suggest future tax rises are now one of the main factors damping sentiment and curtailing spending. 

For example, fears of tax rises among UK companies rose sharply ahead of each of the last two Budgets, topping their worry list. This caused savings to rise and growth to stall. 

Next month’s Budget is shaping up for a hat-trick.     

The effects of fiscal precarity on borrowing costs — the second channel — are also increasingly visible. 

Long-term yields in the G7 countries have risen 4 percentage points since Covid, due to inflation and fiscal concerns. 

Remarkably, yields in (recently debt-stricken) Portugal, Ireland, Greece and Spain now sit below those in the G7. 

The PIGS have flown. 

Yields are also becoming more sensitive to news about deteriorating deficits, as recent research by David Aikman has demonstrated.

Central banks — the third channel — are now amplifying these pressures. 

Monetary policy was unprecedentedly accommodative after the global financial crisis. 

But after missing inflation targets for more than five years, central banks in the UK, US and euro area have stirred from their slumber, raising short-term rates and pivoting to quantitative tightening.

Taken together, this evidence suggests many countries are entering a new era. 

When debt is the disease, fiscal medicine may be as likely to harm as heal. 

Keynesianism, if not dead, is potentially defunct, except when squarely focused on public investment. 

Unlike in the 1930s, today’s “paradox of thrift” is of governments’ rather than the private sector’s making. 

To resolve it, governments will need to remember that thrift, like charity, begins at home.

The writer is an FT contributing editor and former chief economist at the Bank of England