Keynesians are wrong: Cutting public spending can boost economic growth

The key aim of George Osborne’s economic policy has been to eliminate the financial deficit of the public sector.  The main way of trying to achieve has been to squeeze public spending.  The orthodox economic textbooks maintain that this withdraws demand from the economy, and so leads to the growth rate being slower than it would otherwise be.

But can contractionary fiscal policy of this kind actually expand the economy?  At first sight, it seems something of a contradiction, the concept that spending less might cause higher growth.  An oxymoron, one might say – where I am using the word in its regular sense and not referring to those Greeks who voted ‘no’ in the referendum.   The very idea provokes howls of derision and outrage, from leading Keynesians such as Stiglitz and Krugman downwards.

Yet we have been here before.  In early 1981, the UK economy had moved into a deep recession, comparable in size to that which we experienced during the financial crisis.  In the budget of March of that year, the then Chancellor, Geoffrey Howe, cut the financial deficit by 1.5 per cent of GDP, or some £20 billion in today’s prices.  This prompted no fewer than 364 university economists to write to the Times in protest, explaining that the policy was completely misguided and would only serve to prolong the recession.  In fact, the economy began to recover during 1981, and posted a healthy growth rate of 2.2 per cent in 1982, followed by a boom rate of 3.9 per cent in 1983.

One swallow does not make a summer.  Is there any other evidence?  Tim Congdon, in a recent article in the journal Economic Affairs, claims that since the 1980s, ‘expansionary fiscal contractions’ have been the norm rather than the exception both in the UK and the US.  Keynesian support for fiscal activism is, he argues, unsupported by a large body of recent evidence.  To cite just one example, Congdon points to the substantial fiscal tightening under the Conservatives from 1994 and initially continued by Gordon Brown until 2000.  Over this period, the UK economy grew rapidly.

There are good theoretical reasons for thinking that cutting the government deficit could stimulate rather than contract the economy.  The classic paper was written by Robert Barro of Harvard as long ago as 1974.  Its rather mysterious title, ‘Are government bonds net wealth?’, has not prevented it from becoming one of the most cited papers in the whole of economics.  Barro, who was subsequently awarded the Nobel Prize for work such as this in macroeconomics, essentially argued that a nation cannot make itself better off by increasing its public debt. More recently, the work of the Italian economist Alberto Alesina, now also based at Harvard, has been influential in policy making circles in the European Commission and European Central Bank.

The simple view that more government spending boosts the economy appears to make common sense.   The opposing views are more subtle and complex.  But it is the latter which at present have the upper hand.

Paul Ormerod

As published in City AM on Wednesday 12th August 2015

Image: “George Osborne 0482am” by alltogetherfool is licensed under CC BY 2.0

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