Aggregate demand or death
This stark alternative – aggregate demand or death – is undoubtedly antiquated Keynesian thought, but it is deeply engrained in our collective imagination
This week David Lipton, an American who works at the International Monetary Fund, told the government to give growth a chance: “doing nothing is not a good answer given the problems that could arise when very, very low growth becomes entrenched,” he warned England’s Tories via the Daily Telegraph.
Taking great pains not to offend England too much, however, he stopped short of admonishing us outright – to the contrary, he said, he was only here to help: “we’re trying to give advice that’s appropriate for that circumstance. In general, it is to make progress on adjustment but to do it in a way that is gradual if you have the room to do that.”
In this way he said much by saying little: by providing the UK with “advice” that was utterly devoid of specifics, his words implied a competing ideology, and Lipton – a former adviser to the Obama administration – wound up championing a policy Ed Miliband has supported for nearly a year: namely, “promote growth to tackle debt”. Borrow from the future to pay for the past.
Noting that we run a deficit of £15 billion per calendar month as things currently stand, this is no trifling proposition. But in responding to it, most of the British population – and the government – did not venture to question the validity of one assumption which underpins Lipton’s dichotomy: namely, that present spending results in growth, and taking on more debt to finance present spending will result in still more growth.
This stark alternative – aggregate demand or death – is undoubtedly antiquated Keynesian thought, but it is deeply engrained in our collective imagination.
Even politicians who hate public spending base their rhetoric upon it, justifying austerity to their public by telling our inner six-year-old that the choice between fiscal profligacy and fiscal austerity is similar to the difference between a lolly today and a brand-new Schwinn next summer. Spending now will increase GDP, we are told, but if we put it off a little while, the rewards will be even greater.
A simple premise. But is it correct?
Apparently not, and not just in the long-term, but in the short term too, according to a recent working paper on the subject published by the European Central Bank (WP1450/July 2012). The authors of the paper, which focuses exclusively on the Eurozone, write:
the impact of discretionary fiscal impulses on real GDP growth is contingent on the level of debt, i.e. it is positive and larger at low government debt levels.
“the short-run impact of debt on GDP growth is positive and highly statistically significant, but decreases to around zero and loses significance beyond public debt-to-GDP ratios of around 67%.
“For high debt-to-GDP ratios (above 95%), additional debt has a negative impact on economic activity. Furthermore, we can show that the long-term interest rate is subject to increased pressure when the public debt-to-GDP ratio is above 70%, broadly supporting the above findings.”
More interestingly, theirs is not the first working paper that has been put out under the aegis of the ECB on the subject, nor is it the first that has arrived at this conclusion. Two years ago, a similar paper (1237/2010) noted that
“the average impact of government debt on per-capita GDP growth… (has) a turning point… beyond which the government debt-to-GDP ratio has a deleterious impact on long-term growth, at about 90-100% of GDP.”
The researchers tested their conclusions by altering the content of the sample pool, and found that the removal of statistical outliers within what I will call the “1989 NATO and Friends” economies from the sample did not substantially affect the results -- with the exception of removing both Greece and Ireland, which changed the “debt threshold (to) 45%.”
So if your country is very small, you have had to go cap-in-hand to the European Central Bank, your economy is a basket case, and you have capital outflows of 10 percent per annum, fiscal stimulus has a beneficial effect where the outstanding notional on your public sector debt is above 50 percent of GDP.
But if you are a reasonably stable, AA+, BMW-driving, 4-bedroom, 2.5-bath, slightly overweight middle-manager kind of country, a debt ratio of about 50 percent is about as high as you want to go without compromising long-term growth.
Of course, Britain, and indeed all of old-school NATO, is currently well beyond that.
This is where we have to start examining the validity of the Keynesian orthodoxy of Messrs Obama, Lipton, and Miliband. In 2002, Britain’s public debt was 29 percent of GDP. Britain’s public debt is currently 66.1 percent of GDP (official figures, as of October 1st 2012) and is racing upward at a rate of 11 percent of GDP per annum. Including various interventions propping up the financial sector, UK public sector debt totals up to nearly 150 percent of GDP.
If we are not already at the threshold where debt compromises growth, we will be there very, very soon. And if Baum et al. are right, further “fiscal easing” or “stimulus” will have a negative aggregate effect on growth; if additional spending will not promote growth, the traditional reasons to adopt such a policy become significantly less compelling.
While the authors do not venture any reasons for why public sector debt blunts growth, it would not be hard to guess at a few. The market responds to systemic crises, and can see that high levels of debt necessitate high levels of personal taxation -- which hurts long-run aggregate demand because “consumers… boost spending (only) if (a downward) change in tax liabilities is permanent… (and will) wait to increase spending until a tax change affects their take-home pay”.
The market sees this causes inflexibility in providing favourable tax conditions to manufacturing enterprises such as Bombardier.
It sees that such circumstances increase the likelihood of high levels of future taxation which drives away capital.
The market knows that the all-loving, all-embracing welfare state which spends half its GDP spoiling the nation’s children without meeting its obligations grows up to be a feral monster and also that such a country’s spending habits are “boringly average” for the European Union.
Above all, the market plans – day in, day out, and long in advance – to give such countries a very wide berth.
Read more on: David Lipton, ed miliband, gdp, government spending, uk government spending, ecb, keynesianism and the eurozone, Keynesian climate, and keynesianism
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