Paste your Google Webmaster Tools verification code here

What would Keynes have said? Ouija board active!

The loss of triple A status on UK government bonds has intensified the demands for a Plan B. So-called Keynesians demand an increase in both public spending and the public sector deficit.

What might Keynes himself have said about the current situation? Lacking a Ouija board, I am unable to communicate directly with the great man himself. But we can get a very strong hint from the title of the first major work which Keynes published when confronted with the 1929 financial crash. It is the Treatise on Money. His most famous work was not published until 1936, when the Great Depression was well and truly over. Its full name is the General Theory of Employment, Interest and Money.

So Keynes was very much a monetary economist, who thought monetary factors are crucial to an understanding of how the economy works – quite different from the modern day public spending caricature set up by his ostensible followers. In particular, he attached great importance to the long-term rate of interest, the rate on government bonds (gilts). For Keynes, a crucial policy aim during a slump was to have a low long term rate of interest. Without it, recovery would just not happen.

There are several reasons for his view, which are directly relevant today. The obvious point is that a high interest rate means borrowing is expensive, which deters investment. Further, if you can get a high return on an asset guaranteed by the UK government, why bother to undertake risky ventures at all?

The link between the interest rate on bonds and the wealth of the private sector is perhaps even more important.  If a Plan B is brought in and bond rates stay at 2 per cent, fine. But if they go to the 8 per cent levels, which have been seen in Southern Europe, because of worries about the resulting increase in the deficit, three quarters of the wealth held in bonds is wiped out.  This wealth effect would be a powerful depressant of private sector spending, both corporate and individual.

Finally, for Keynes there was the subtle but essential ingredient of all business cycle fluctuations, the concept he called ‘animal spirits’. Here, we are much more in the world of psychology rather than pure economics. At one level, animal spirits is just another phrase for the degree of optimism or pessimism which firms feel. But they are much more complex than this. They also involve confidence, in the specific sense of the confidence which you have in your view about the future. For any given level of optimism, the less confident you are about your view, the less you will spend. High interest rates add to uncertainty and undermine confidence.

This is why any Plan B involves considerable risk. It might work, but we might end up even worse off and with a higher deficit to boot. Policy at the moment is much more about psychology rather than the mechanistic calculations of so-called Keynesians.

Paul Ormerod

As published in City Am on Wednesday 27th February 2013

Leave a Reply


We are recruiting for a Marketing Executive Assistant. For more information please check our JOIN US page.

Contact Us

56-58 Putney High Street, London, SW15 1SF
Phone: 0208 878 6333
Visit Us On TwitterVisit Us On Linkedin