Politics & Policies

John Maynard Keynes shows us a way out crisis

The work of John Maynard Keynes shows us that counter-cyclical fiscal policy and an easing of austerity may offer a way out of Eurozone crisis

Debates between ‘Hayekian’ and ‘Keynesian’ perspectives constitute one of the main conceptual fault-lines of the Eurozone crisis. In the second of two EUROPP articles covering this debate, Simon Wren-Lewis looks at how the current programme of austerity and the view that the private sector can do little wrong may be driving the continent further into recession. Policymakers must instead embrace the Keynesian response of counter-cyclical fiscal policies.

Let’s begin by imagining that the Eurozone was a single country, like the United States. The US is currently undertaking significant austerity, even though there is no market pressure to do so. In fact, quite the opposite is the case – it is an excellent time to borrow to invest. So why are the US, and also the UK, undertaking austerity? The main argument is that government debt is too high.

The Keynesian response is that this is the wrong time to be worrying about government debt. In a recession which is due to an increase in private sector saving, the government needs to run matching deficits to prevent output falling. For the world as a whole, if government deficits come down, private sector surpluses must fall to match. Normally monetary policy would encourage the private sector to save less by lowering real interest rates. However in many countries the monetary authorities have already lowered nominal rates (almost) as far as they can. In addition these authorities, or their governments, seem unwilling to let real interest rates fall by encouraging above target inflation in the future.

Advocates of austerity argued that reducing government debt would encourage private spending by boosting confidence. This was always an argument of hope over both theory and evidence, as the last two years has shown. So the only way the private sector surplus can fall to match lower public sector deficits is for output and incomes to fall, which prolongs and intensifies the recession.

This argument against austerity now is quite compatible with a view that government debt is much too high from a longer term perspective. It is all about choosing the right time to deal with that problem…

via Keynes, Counter-cyclical Fiscal Policy & a Way Out of Eurozone Crisis | The Big Picture.

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  1. Pingback: Keynes argued that slumps can happen because of declining wage | Job Market Monitor - May 27, 2014

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