skidelsky part 3

PART THREE

Macroeconomics in the Crash and After, 2007–

The years running from the early 1990s to 2007 (or, seemingly, from the mid-1980s in the US) are known as the Great Moderation. This was a period of exceptional stability in world economic affairs. Between 1992 and 2007 inflation in the advanced economies averaged 2.3 per cent; economic growth 2.8 per cent.1 Many attributed this success to the creation of independent central banks with a mandate to target inflation. With money at last expected to be ‘kept in order’ by independent central bankers, and governments expected to balance their budgets, the market economy was behaving as most economists said it should. The era of ‘boom and bust’ was over, declared Britain’s Chancellor of the Exchequer, Gordon Brown.
Figure 24. Output growth in the advanced economies during the Great Moderation2


Figure 25. CPI inflation in the advanced economies during the Great Moderation3


The euphoria of the pre-crash years was by no one better previsioned than Hyman Minsky:
Success breeds disregard of the possibility of failure. The absence of serious financial difficulties over a substantial period leads to a euphoric economy in which short-term financing of long-term positions becomes the normal way of life. As the previous financial crisis recedes in time, it is quite natural for central bankers, government officials, bankers, businessmen and even economists to believe that a new era has arrived.4

The ‘surprise’ global economic collapse of 2008–9, the worst since the Great Depression of 1929–32, shattered the glass. It forced activist – that is, discretionary – responses from governments that were partly experimental, but that also involved using old tools which had become rusty through neglect. These emergency measures prevented the collapse from becoming another Great Depression. But they failed to produce complete recovery, and they left macroeconomic policy in a mess.
We can identify five distinct stages of the crisis:

1. The collapse of the American sub-prime mortgage market in August 2007. This activated central banks’ role as lenders of last resort.
2. The escalation of the financial crisis with the collapse and rescue of the major US investment bank Bear Stearns in March 2008. The confidence among banks in the quality of each others’ assets deteriorated markedly after this, leading to reduced interbank lending and much greater use of available central bank credit lines. The Fed became a global ‘lender of last resort’, making credit swaps available to fourteen central banks. There was no fiscal response to the first two phases.
3. The collapse and non-rescue of the investment bank Lehman Brothers during the weekend of 13–14 September 2008, which started the third and most acute phase of the financial and economic crisis. A week of total credit paralysis followed, with the payments systems everywhere endangered. Many banks in the USA, UK, Europe and elsewhere went bankrupt and had to be rescued. (Of 101 banks with balance sheets of over $100 billion in 2006, half failed.) Between September and December 2008, the Federal Reserve and the European Central Bank made available €2 trillion of credit to banks at 1 per cent interest, and started buying government and commercial debt on a small scale. In the fourth quarter of 2008 and first quarter of 2009, GDP in industrial nations fell at an annualized rate of 7–8 per cent. GDP growth slowed down in China and Asia, the main transmitters of the crisis to the developing world being the collapse in their terms of trade (including commodity prices) and paralysis of private capital markets. With an 8 per cent GDP drop, Russia experienced the fastest and steepest collapse in the G20 world.
4. Unlike in 1929–30, the economic collapse produced energetic government responses. Governments strengthened deposit insurance, recapitalized and nationalized banks with public funds, and bought toxic assets. In September 2008 the US government nationalized the insolvent mortgage lenders Fanny Mae and Freddie Mac, transferring their $5 trillion of debt to the taxpayer. US Treasury Secretary Henry Paulson announced a $700 billion bailout plan (the Trouble Asset Relief Program) to buy up distressed bank assets; the Icelandic, Benelux and German governments also bailed out parts of their banking systems.5 In October 2008, the G20 committed its members to co-ordinated interest rate cuts and bank recapitalizations. Substantial discretionary fiscal responses included €200 billion from the EU (mainly Germany), $298 billion from Japan, $586 billion from China and $800 billion from the USA. China’s stimulus amounted to 12.7 per cent of its 2008 GDP, the US’s 6 per cent. ‘Cash for clunkers’ was an imaginative early fiscal initiative. The consensus is that the initial response, running from autumn 2008 to spring 2009, stopped the slide into another Great Depression. The ‘green shoots’ of recovery started in the second quarter of 2009. Output fall slowed, risk premia fell, and stock and bond markets recovered. Led by China, Germany and Japan, economic recovery spread to the USA, the UK and the Eurozone in the second half of 2009.
Recovering is not the same as recovery. From medicine we can borrow the idea of an ‘acute’ phase. In the acute phase, all the main ‘health’ indicators are downwards. The collapse then stops and recovery starts. In a serious illness you can take yourself to be fully recovered if you get back to where you were before. In the same way, ‘full health’ can be said to be when the economy recovers its pre-crisis peak. But perhaps you were overdoing it before, which is why you got ill. And the same is true with economies. They may have been growing above trend pre-crash.
Figure 26. Comparing the effects of the 1929 and 2008 crash6


So getting back to their pre-crash peak may be overdoing it again. This would be true of a recovery based on re-igniting the housing bubble.
Speed and strength of recovery varies not just from depression to depression, but from region to region. There can be a period of ‘crawling along the bottom’, or anaemic growth, or very strong (above-trend) recovery. A stylized representation of recovery from 2008–9 would look like this: Asia V-shaped; US U-shaped; Europe a combination of L-shaped (flat-lining) and W (double-dip).
5. Once the corner had been turned, the narrative of the Great Recession changed drastically. The banking crisis turned into a fiscal crisis, and the public debt problem took centre stage. It was at this point that the arguments for austerity began to gain traction. Austerity policies aimed to restore fiscal balances. The restoration of fiscal balance was seen as the necessary condition for recovery of private sector confidence, and hence investment and economic growth. As government tightened the fiscal screws, economic growth fizzled out, coincidentally or not.
Government success in averting another Great Depression has given rise to a piece of mythology: the world economy was saved by the central banks. Typical is the following by Chris Giles of the Financial Times: ‘They saved the global economy from the financial crisis.’7 This is sloppy journalism. It ignores the fact that the proportion of GDP spent by governments was twice as large as in 1929–30, so the automatic stabilizers were much larger. More importantly, it ignores the large discretionary fiscal stimulus in the first six months of the slump. Recapitalizing banks was a fiscal operation, involving governments raising vast sums in the bond markets. It was governments, not central banks, learning from Keynes, not from Milton Friedman, that prevented a slide into another Great Depression, just as it was governments gripped by deficit panic that aborted recovery after 2010.
The communiqué of the September 2009 G20 summit in Pittsburgh read:
Our national commitments to restore growth resulted in the largest and most coordinated fiscal and monetary stimulus ever undertaken. We acted together to increase dramatically the resources necessary to stop the crisis from spreading around the world . . . The process of recovery and repair remains incomplete . . . The conditions for a recovery of private demand are not yet fully in place. We cannot rest until the global economy is restored to full health, and hard-working families the world over can find decent jobs . . . We will avoid any premature withdrawal of stimulus. At the same time, we will prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a cooperative and coordinated way, maintaining our commitment to fiscal responsibility.8

The G20 communiqués of this period, mainly crafted by Gordon Brown, could have been important milestones in the development of global economic government. However, while Brown was engaged in ‘saving the world’, his domestic political base was crumbling, and in May 2010 he lost the British general election. The next two chapters will tell of the ‘premature withdrawal’ of fiscal stimulus, tasking only a much weaker monetary stimulus with restoring the global economy to ‘full health’.

The Disablement of Fiscal Policy

‘Now this deficit didn’t suddenly appear purely as a result of the global financial crisis. It was driven by persistent, reckless and completely unaffordable government spending and borrowing over many years.’
David Cameron, March 20131
I. THE FISCAL CRISIS OF THE STATE

The ‘austere’ fiscal response to the Great Recession is part of the story of the disablement of fiscal policy since the end of the 1970s. With the overthrow of the Keynesian revolution, the government’s budget was retired as an instrument of short-run demand management. This task was left to monetary policy.
The UK is a good example of the snares of pre-crash fiscal orthodoxy. Gordon Brown’s ‘golden rule’, announced in 1997, was that ‘over the economic cycle, we will borrow only to invest and not to fund current spending’. To this was added a ‘sustainable investment’ rule: ‘public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level’.2 This was understood to be under 40 per cent. These rules helpfully distinguished between current and capital spending. Budget balance was defined as a zero deficit on current account, and net capital spending equal to the economy’s growth rate, over an economic cycle of between five and eight years, or about 2 per cent. The purpose of the Brown constitution was to create a bit more policy space for New Keynesian fiscal policy, against a background of relentless hostility to public expenditure. However, the constitution shared the general presumption of the day that, with price stability secured by monetary policy, the economy would be cyclically stable at its natural rate of unemployment. Lowering the natural rate of unemployment was the task of supply-side policy, much as Nigel Lawson had said in his Mais Lecture of 1984, though Labour put its emphasis on government training and work programmes to improve employability.
Gordon Brown was not an imprudent Chancellor. Between 1997–8 and 2006–7, the current account balance averaged 0.1%. Over the same period public sector net borrowing averaged 1.6%. With economic growth averaging 2.8% over the period, the national debt fell from 43.35% of GDP to 36.6%. Unemployment fell from 7% to 5%. Inflation averaged a little over 2% a year. This was a record of successful economic management. Brown could, and did, claim he had stuck to his fiscal rules.3
However, Brown’s claim was less robust than it seemed. First, the successful pre-crash current account outcome was achieved by redefining when cycles started and ended, and balancing early surpluses against later deficits. By 2006–7, with the current spending budget in deficit, maintaining the golden rule over the next cycle would have been ‘challenging’. Secondly, capital budget probity was being flattered by extensive use of the Private Finance Initiative (PFI) to build hospitals, schools and some expensive transport projects. PFI replaced spending financed by public debt with spending undertaken by private firms for which they were repaid by leasing agreements over periods of up to thirty years. It added nothing to the public debt, but gave rise to a higher stream of recurrent costs over the life of the asset than ordinary public procurement would have done. Its use allowed Brown to get a lot of capital spending ‘off budget’ and stick within the ‘prudent’ debt/GDP limit of 40 per cent.
The issue for macroeconomic policy is not whether PFI was a sleight of hand, but whether the investment it made possible would have taken place in its absence. A Keynesian would argue that, given the state of public opinion, PFI was the only way open to the government to drag private investment up to the level of full employment saving. It did this by converting uncertain into certain expectations for a large class of investments. In the absence of PFI, unemployment would have been higher and growth slower. PFI was as Keynesian as it was possible to be in a non-Keynesian world. The unfortunate effect of the deception, though, was to disguise the extent to which government procurement policy was actually propping up the British economy.
Figure 27. UK tax revenue and spending4


The economic downturn of 2008–9 caused a large deterioration in government fiscal positions and a rise in public debt to GDP ratios.
Advanced country governments acquired large deficits willy-nilly, as their revenues shrank and their spending on unemployment benefits rose. But there were also substantial discretionary responses: in Britain these included a temporary cut in VAT from 17.5 per cent to 15 per cent and accelerated capital spending. Rescuing the banks involved governments raising hundreds of billions in the bond markets, causing deficits to balloon: the rescue of the Royal Bank of Scotland alone cost £46 billion. Rescue operations included the co-ordinated $1 trillion stimulus measures agreed by the G20 in London in April 2009, with the British Prime Minister Gordon Brown taking the lead.5
The acute phase of the world crisis was over by the third quarter of 2009; however, a secondary Eurozone crisis was superimposed on the original one in 2010–11. Given the pre-crash orthodoxy, and a widespread misunderstanding of the public financing problem, it is not surprising that the fiscal brakes were slammed on. The fact that ‘Keynesian measures’ had averted a politically life-threatening collapse of the world economy was considered much less important than the unbalanced budgets governments were left with. Gordon Brown refused to be ‘another Philip Snowden’ (for the original one, see pp. 112–13). The trouble, explained his Chancellor, Alistair Darling, was the ‘Taliban wing’ of the Treasury who thought Snowden was right.8
Figure 28. Government budget deficits6


Figure 29. Government net debt7


The global turning point can be dated from the meeting of the G7’s finance ministers at Iqaluit in Canada in February 2010, which, dominated by the Greek crisis, committed governments to slashing deficits.9 Orthodox economists argued that cutting public spending would boost output by reducing borrowing costs and increasing confidence. In a pallid echo of Keynes’s ‘paradox of thrift’, the larger G20 acknowledged, in a declaration following its 2010 Toronto summit, that ‘synchronised financial adjustment [i.e. if all governments tried to reduce their deficits simultaneously] across several major economies could adversely impact the recovery’,10 but only President Obama stood out against the stampede towards what Germany’s Finance Minister Wolfgang Schäuble approvingly dubbed ‘expansionary fiscal consolidation’. Obama was supported by economists Paul Krugman, Joseph Stiglitz, Robert Shiller, Larry Summers, Nouriel Roubini and Brad DeLong. But ‘expansionary fiscal consolidation’ became the consensual view of Europe’s finance ministers.11 The majority of financial economists supinely followed the lead of the consolidators. Of the UK’s top economic journalists, Martin Wolf and Samuel Brittan of the Financial Times and Larry Elliott of the Guardian were lonely dissenters. This was at a time when global output was still 5 per cent below what it had been pre-crash.12 The British economics profession was largely silent.
This change of gear presumed that the recovery from the slump that had started in the third quarter of 2009 had gained strong independent momentum, and that fiscal consolidation was needed to maintain this momentum. In practice the shift to austerity in the UK and the Eurozone was followed by a marked slowdown in recovery, so much so that by mid-2010 most commentators were predicting a ‘double-dip’ recession or an L-shaped recovery. The truth was that the economies of the world were on life-support, and governments were switching the machines off.
II. THE BRITISH DEBATE

Contrary to David Cameron’s rhetoric, UK public finances before the crash were not out of line with major comparators (see Figures 28 and 29). The real deterioration in the UK government’s position, as for all governments, took place because of the slump, the British economy contracting by about 7 per cent between the second quarter of 2008 and the third quarter of 2009.
Labour’s Chancellor of the Exchequer Alistair Darling announced a ‘fiscal consolidation plan’ in his pre-budget statement of autumn 2009. This committed the government to reducing the budget deficit, then projected to be 12.6 per cent of GDP in 2009–10, to 5.5 per cent by 2013–14, and to have net debt falling as a percentage of GDP by 2015–16.
Two letters that appeared in the British press early in 2010 give the flavour of the British debate. Twenty economists, headed by Tim Besley, wrote a letter to the Sunday Times on 4 February 2010, arguing that a faster pace for deficit reduction, especially on the spending side, was needed to sustain the recovery and restore confidence. Marcus Miller and Robert Skidelsky fronted a reply in the Financial Times on 18 February, arguing that the ‘timing of the measures should depend on the strength of the recovery’. Each letter got the support of a Nobel Prize-winner. The war of the economists had resumed. It has continued ever since.
Martin Wolf explained the state of opinion in mid-2010. The cutters emphasized that world economic recovery had been stronger than expected, that government deficits ‘crowd out’ private spending, and (if they were Austrian economists) that a deep slump was needed to purge past excesses. More moderate cutters argued that cutting the deficit would avoid a spike in borrowing costs, pointing to the peaking of Greek government debt at 12 per cent. Should fiscal tightening lead to the weakening of the recovery, monetary expansion (quantitative easing) was always available to offset it. The postponers emphasized the fragility of the recovery, its dependence on fiscal stimuli, and the existence of huge private sector surpluses. Wolf agreed with the postponers. ‘If anything, further loosening is needed.’13
Of key importance in swinging the debate in the UK over to the fiscal consolidators’ side was the political narrative spun by the Conservatives. As Chancellor of the Exchequer from 1997 until 2007, Gordon Brown had imprudently made ‘prudence’ his watchword. The Conservatives now milked the story of Brown’s fall from grace for maximum electoral impact. Reckless spending by the Labour government had not only contributed to the scale of Britain’s economic collapse, but had left Britain dangerously deep in debt. The Conservative narrative also protected the City of London by blaming the crisis on Labour.
A key point in this tale spun to deceive was that a large part of the post-crash deficit was not cyclical, but ‘structural’; that is, caused by government over-spending preceding and during the crash. Therefore, it was not sufficient to rely on the natural forces of recovery to eliminate the deficit: surgical operations were needed. And unless the government started on such operations immediately, belief in the government’s determination to restore budget balance would wither, causing confidence to flag and recovery to falter.
The Conservatives did not actually accuse the Labour government of having caused the world slump. Their charge was that, by breaking its own fiscal rules it had deprived itself of the ‘fiscal space’ to respond to the crisis by weakening confidence in government’s management of the public finances. A government, like any household threatened with mortgage foreclosure, should cut its spending as soon as possible: instead the Labour government had increased its spending. The government was unable to make a successful defence of its record and, in the general election of May 2010, lost power to a largely Conservative Coalition government, headed by Cameron. George Osborne became Chancellor of the Exchequer. In October 2008, Osborne had denounced the growing public deficit as a ‘cruise missile’ aimed at the heart of the British economy. As Chancellor, he was so vociferous about the dire straits to which Labour had reduced the public finances that people wondered whether he was inviting speculators to do a ‘bear’ on Britain.14
Osbornism

In his first budget, in June 2010, Osborne pointed to the consequences of failure to tackle the deficit:
Higher interest rates, more business failures, sharper rises in unemployment, and potentially even a catastrophic loss of confidence and the end of the recovery. We cannot let that happen. This Budget is needed to deal with our country’s debts. This Budget is needed to give confidence to our economy. This is the unavoidable Budget.

He announced tax increases and spending cuts, which, he claimed, would reduce the budget deficit (public sector net borrowing, PSNB) in a ‘single parliament’, i.e. by 2015, from 11 per cent of GDP to 1 per cent. Net debt would peak at 70 per cent of GDP before falling to 67.4 per cent in 2015–16. At the same, he specifically pledged to liquidate the ‘structural’ or ‘cyclically adjusted’ deficit’ (see below, p. 237), then estimated at 5.3 per cent of GDP, over the same period.* The measures he announced represented a fiscal policy tightening of 6 per cent of GDP. The Office for Budgetary Responsibility (OBR), the new Treasury watchdog he had set up, predicted that this would reduce the growth rate in the economy by only 0.4 per cent over the following two years.
Basing his policy on OBR forecasts, Osborne predicted that the British economy would grow 2.3% in 2011, 2.8% in 2012, and 2.9% in 2013.15 The fiscal forecast thus depended on the output forecast. Actual growth turned out to be 1.5% in 2011, 1.3% in 2012, and 1.9% in 2013, and Osborne had to borrow £40 billion more in 2010– 11 than he had anticipated because of the growth slowdown. In 2010, the OBR reckoned that the economy would grow by 17.2 per cent between 2010 and 2016; in fact it grew by 12.9 per cent (see p. 270). Such errors were bound to wreak havoc with the budget figures. PSNB was still over £50 billion in 2015–16: it is now expected to fall to £30 billion by 2021–2. Net debt (in November 2017) was now expected to peak at 88.8 per cent of GDP in 2017–18. Five-year targets, actual or rolling, have been abandoned. The ‘structural’ deficit has slowly come down, but this was because the economy eventually started growing faster than Osborne was able to cut spending. His cuts delayed the reduction of all the deficits, rather than expedited them.
So much for the record. Three questions may be asked. The first, and broadest, concerns the theory of fiscal policy in a slump. The second examines the confusions surrounding the notion of the ‘deficit’ and its financing. The third is about the effect of the slump on the long-term growth prospects of the economy.
The Theory behind Austerity

Keynesians say that national output falls when there is an excess of planned saving over planned investment. Typically the private sector wants to save more than it wants to invest. To the extent that this creates an excess demand for bonds, the private sector’s excess saving will be exactly mirrored by an increase in the public sector’s ‘dissaving’ – more familiarly, by an increase in the budget deficit. If the government now tries to increase its own saving by cutting its spending, the result will be a fall in national income and output until the excess of saving over investment is eliminated by the community’s growing impoverishment.
Figure 30. Estimates of UK cyclically adjusted budget deficit16


An identical argument can be made in terms of output and income. If output falls below trend there is an ‘output gap’: the economy is producing less output than it could, there is spare capacity of plant and workers. If there is an output gap, an increase in loan-financed government investment will cause a multiplied increase in output. By the same token, a reduction in the deficit (fiscal consolidation) would cause the output gap to grow – spare capacity to increase by a multiple of the reduction.
The crucial mistake in Osborne’s austerity policy was to ignore the distinction between the numerator and denominator of the public debt fraction. He concentrated on cutting the numerator (the deficit) and ignored the effect of his policy on the size of the economy (the denominator).
Although Osborne no doubt had an ideological reason to slash the deficit, the technical mistake was that of his advisers. The OBR’s Fiscal and Economic Forecasts running from June 2010 largely ignore the impact of changes in government spending on national saving, investment, income and output. For example, the OBR Forecast of June 2010 (p. 33) said that the fiscal consolidation would have ‘no effect’ on output growth. In November 2011, the OBR acknowledged that falling government consumption and investment would reduce GDP growth slightly, but claimed that this would be ‘fully offset’ by looser monetary policy (p. 56). In December 2012 it was wondering why it had overestimated growth in the previous two years. Its answer was higher than expected inflation and weaker than expected investment (p. 27). By December 2013 it was admitting that ‘Fiscal consolidation is highly likely to have reduced growth in recent years’, other things being equal. However, with a budget deficit of 11 per cent of GDP ‘other things would almost certainly not have been equal’ (p. 53).
The OBR never attempted to update its pre-crash estimates of the fiscal multiplier. Its forecasting model, in other words, was a barely modified pre-crash model, in which fiscal multipliers were assumed to be close to zero because the economy was at full employment. This was despite the fact that the British economy had shrunk by almost 7 per cent between 2008 and 2009, from peak to trough of the crisis.
The OBR’s understanding of the economy was boosted by three academic arguments.
The IMF and fiscal multipliers
At the end of 2008, with output still falling, IMF forecasters spoke of a multiplier of between 0.3 and 0.8. What this meant was that fiscal expansion could not help the economy; even more importantly, that fiscal contraction would do it very little harm. Nothing better illustrates the orthodox pre-crash mindset that budget operations had no effect on the real economy. In March 2009, at the depth of the crisis, IMF staff reinforced the message that it was safe to start cutting deficits by estimating negative fiscal multipliers of between 0.3 and 0.5 for tax increases, and 0.3 and 1.8 for spending cuts. By 2013, IMF economists Olivier Blanchard and Daniel Leigh admitted they had got it wrong: fiscal multipliers had been ‘substantially above 1’.17 Their review of the evidence from twenty-six countries, entombed in tortuous econometrics and technical jargon, concluded that ‘the forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation’. They found an ‘unexpected’ output loss of 1 per cent a year ‘for each 1 per cent of GDP consolidation’. Their models, they said, had let them down: ‘Under rational expectations, and assuming that the forecasters used the correct model, the coefficient on the fiscal consolidation forecast should be zero.’ This was as near as their prose allowed to admitting that they had been using the wrong model. But so had every other prominent forecasting organization. They were all wrong together. On such foundations was policy built and lives blighted.18
The Bocconi School
In 2010, the doctrine of ‘expansionary fiscal contraction’19 swept Europe’s finance ministries. Propounded by economists of the Bocconi School in Italy, it reversed the sign of the Keynesian multiplier by claiming that fiscal consolidation would cause output to grow by increasing confidence. The boost to confidence induced by a ‘credible programme of deficit reduction’ would stimulate enough extra demand to more than offset any adverse effects of fiscal contraction.
In April 2010, a leading proponent of this doctrine, Alberto Alesina, assured European finance ministers that ‘many even sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions even in the very short run’.20 A key point in Alesina’s presentation was that spending cuts were much more effective than tax increases. Osborne took him at his word. In his consolidation plans, tax increases played a minor role; the emphasis was on spending cuts, especially cuts to welfare and public sector employment.
Following criticism of his methodology and findings by IMF and OECD staff, Alesina became considerably more circumspect. By November 2010 he was writing: ‘sometimes, not always, some fiscal adjustments based upon spending cuts are not associated with economic downturns’.21 But the damage had been done.
Since 2011 little has been heard of ‘expansionary fiscal contraction’. We got the contraction, but not the expansion.
Reinhart and Rogoff and the 90 per cent barrier
Two American economists, Carmen Reinhart and Kenneth Rogoff, produced another correlation to bolster the austerity case. They attributed the ‘vast range of crises’ they had analysed to ‘excessive debt accumulation’.22 They noticed that, once the public debt–GDP ratio crashed through the 90 per cent barrier, ‘growth rates are roughly cut in half’.23 Early in 2013 researchers at the University of Massachusetts examined the data behind the Reinhart–Rogoff work and found that the results were partly driven by a spreadsheet error:
More importantly, the results weren’t at all robust: using standard statistical procedures rather than the rather odd approach Reinhart and Rogoff used, or adding a few more years of data, caused the 90% cliff to vanish. What was left was a modest negative correlation between debt and growth, and there was good reason to believe that in general slow growth causes high debt, not the other way around.24

Reinhart and Rogoff explained lamely that:
We do not pretend to argue that growth will be normal at 89% and subpar (about 1% lower) at 91% debt/GDP any more than a car crash is unlikely at 54mph and near certain at 56mph. However, mapping the theoretical notion of ‘vulnerability regions’ to bad outcomes by necessity involves defining thresholds, just as traffic signs in the US specify 55mph.25

It is hard to believe that even academics are so naïve as not to realize that politicians and journalists would seize on the actual speed limit rather than the ‘vulnerability regions’. George Osborne said that Reinhart and Rogoff were the two economists who influenced him most.26
It is important to understand why these economists got things wrong. Technical mistakes in data mining there may have been, but these were trivial. The reason they were wrong was that the forecasting models they were using led them to expect the results they got: fitting the data to the model was child’s play for a competent technician. These models were based on the neo-classical tool kit – rational expectations, optimizing agents, forward-looking consumers, unimpeded markets, equilibrium – which demonstrated the stability of economies at their natural rate of unemployment. The forecasters got what they expected and started scratching their heads only when real events proved them wrong.
The main features of the British Treasury’s position in 2010 reflected the mainstream forecasting models of the time:

1. Based on the Bank of England’s macroeconomic model, the Treasury forecast a V-shaped recovery, with economic growth bouncing back to about 3 per cent as early as 2011.27 They discounted the possibility of an L-shaped recovery and ‘underemployment equilibrium’. In short, they accepted the IMF’s position on the smallness of the fiscal multipliers.
2. With a strong economic recovery, gradual deficit reduction would not be contractionary: in fact it would keep the recovery going by giving confidence that public finances were being brought under control. Repairing the damage of the Brown Chancellorship loomed larger in the Osborne–Treasury mind than repairing the damage of the slump. In any case, any minor contractionary impact of fiscal tightening could be offset by monetary (quantitative) easing. These were the essentials of Alesina’s doctrine.
3. Confidence was especially important because of the worsening of the Eurozone debt crisis, especially that of Greece. So the Treasury argument was that, provided the government had a ‘credible’ deficit reduction plan, there would be no domestic obstacle to rapid and sustained recovery, but if it did not, it might well face a confidence-destroying fiscal crisis. In fact, Osborne argued that austerity would generate confidence, because it signalled the government was ‘living within its means’.
To explain the nugatory fiscal multipliers estimated by the IMF and others, three familiar items from the neo-classical repertoire were trotted out.
Real crowding-out
The American economist John Cochrane wrote: ‘If the government borrows a dollar from you, that is a dollar that you do not spend . . . Jobs created by stimulus spending are offset by jobs lost from the decline of private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.’28 This was the replay of the Treasury View of the 1920s. In his first budget, George Osborne talked about an overblown state ‘crowding out private endeavour’. Thus closely did policymaking track academic simplicities.
Ricardian equivalence: government borrowing is simply deferred taxation. Expecting to pay taxes, people would increase their savings. The increased savings would completely offset the extra government spending, leaving a multiplier of zero. Osborne actually referred to ‘Ricardian equivalence’ in his Mais Lecture of 2010.29
Financial crowding-out
The government’s increasing demand for funds puts upward pressure on interest rates. The rise in interest rates will offset any stimulus afforded by the extra borrowing. This was a cogent argument for the Eurozone, where the European Central Bank was constitutionally debarred from buying government debt. However, it was untrue for the USA, the UK, China and Japan, whose central banks could be ordered or persuaded to buy gilts to offset any sign of a rise in longterm interest rates. This would enable the deficit to continue without financial crowding-out. In the extreme case (see Appendix 8.1, p. 246), the deficit can be entirely financed by advances from the central bank.
Figure 31. Cost of government borrowing


In practice, the UK Treasury was able to go on borrowing at very low rates of interest, mainly because the Bank of England was buying up government securities.
The confidence fairy
This was decisive for the Treasury. Greek government bond yields rose to 10 per cent in May 2010. As Besley and co. pointed out in their letter to the Sunday Times, the risk was that ‘in the absence of a credible deficit reduction programme’ there would be a ‘loss of confidence in the UK’s economic policy framework’. Agents with the correct model of the economy (i.e. Besley and co.’s model) would realize that a government which embarked on fiscal expansion was out of control. This would lead to a crisis of confidence, leading to an escalating cost of government debt as fear of default grew.30
The analogy with Greece was entirely misconceived, because the Greek government depended on the international bond markets; Britain’s did not. The further assumption that bond markets had the ‘correct’ model of the economy is ludicrous. In April 2010, they had ‘priced in’ a self-sustaining recovery. By July they were ‘pricing in’ a double-dip recession.31 They were the creators of the ‘noise’ on which their deals depended.
The Treasury’s arguments were different ways of saying there was no output gap and therefore no positive multiplier. They are contemporary versions of the Treasury View which Keynes fought against in 1929–31, and which he wrote the General Theory to refute; modern restatements of Say’s Law. Economics had come full circle.*
At the popular level, austerity policy was supported by a collection of such catchphrases as ‘The gravity train had to stop’ and ‘You can’t spend money you haven’t got’, which came much more readily to mind than more sophisticated Keynesian arguments. Two exhibits from the treasury of financial folklore resonated strongly with the public.
First, was the Swabian housewife. This mythical lady made her appearance on the world stage when German Chancellor Angela Merkel praised her in 2008 for her frugality, which, she implied, should be followed by business and governments. The latest version of this prudent housewife was produced by the British Chancellor of the Exchequer Philip Hammond in his spring budget statement of March 2018: ‘First you work out what you can afford. Then you decide what your priorities are. And then you allocate between them.’ This is good advice for households, but nonsense for governments. With its power to raise taxes, to borrow and re-borrow, and to print money indefinitely, the government’s budget constraint is much looser than that of the individual household.32
The second was the claim that the national debt was a ‘burden on future generations’. There are two fallacies in this. First, insofar as spending is financed by bonds, not taxes, this represents an intragenerational transfer between bond-holders and taxpayers at a single point in time.33 Secondly, if a government borrows from this generation to create assets for the use of future generations (as in the case of a long-gestating infrastructure programme) or, indeed, simply to avoid periods of ‘lost growth’, no net burden arises for any generation, present or future.
There was a more substantial public finance argument in favour of balancing the budget at full employment. This was that the public sector was bound to allocate capital less efficiently than the private sector. It was one thing to have the unemployed digging holes and filling them up again; another to replace private sector with public sector jobs. At full employment, efficiency issues replace demandmaintenance questions.
Having given full allowance for the attraction of orthodox rhetoric, it should not have been too difficult for competent politicians to get over the idea that ‘If no one’s buying cars there’s no point in making them’, or ‘If the government borrows money to build you a house, that’s a benefit both to you and your children’.
The Mythology of the Structural Deficit

With the onset of the crisis the fiscal numbers worsened dramatically. Public sector net borrowing (PSNB) in 2009–10 was projected to be 11.2 per cent of GDP. The national debt was set to rise to 65 per cent of GDP in 2009–10 and to 75 per cent in 2013–14. It was the abrupt turnabout in the fiscal position that converted the story of Gordon Brown’s prudence into one of extravagance, clearing the ground for the consolidators. ‘Cutting the deficit’ became Osborne’s obsession. But which deficit was to be cut?
The basic concept for the deficit is public sector net borrowing. This is the raw, unadjusted difference between government receipts and expenditure. At any given rate of taxes and spending, PSNB rises automatically in a downturn as tax revenue falls and spending on unemployment increases; and it shrinks automatically in an upturn for the reverse reason, providing economies with a ‘built-in’ stabilizer. It can either be a plus number (meaning the budget is in deficit), a minus number (meaning a surplus) or zero (meaning balance).
But there is also a ‘structural’ or ‘cyclically adjusted’ deficit: the excess of government spending (both current and capital) over ‘normal’ revenue – the revenue it would expect to receive if the economy were normally employed. (CAB (Cyclically Adjusted Budget Balance) = BB (Budget Balance) – CC (Cyclical Component).) The OBR explains:
The size of the output gap . . . determines how much of the fiscal deficit at any one time is cyclical and how much is structural. In other words, how much will disappear automatically, as the recovery boosts revenues and reduces spending, and how much will be left when economic activity has returned to its full potential. The narrower the output gap, the larger the proportion of the deficit that is structural, and the less margin the Government will have against its fiscal target, which is set in structural terms.34

It was the ‘structural’ deficit, ‘the sticky bit’, which would remain after recovery that Osborne aimed to reduce to zero by 2015–16.
The structural deficit is a typical piece of new classical mythmaking. It reflected the prevailing orthodoxy that fiscal expansion cannot raise the ‘normal’ or ‘trend’ rate of growth of a market economy, but it can reduce it, by diverting resources to the less efficient public sector. In other words, it comes out of the ‘crowding-out’ stable of thought. From this point of view, structural deficits are especially vicious since, unlike the automatic deficits that arise from an economic downturn, they are deliberately predatory on the private sector. But for a Keynesian this is the reverse of the truth: the ‘normal’ level of economic activity set up as a benchmark by the new classical economist, against which to estimate the size of the structural deficit, may be severely sub-normal in terms of an economy’s productive potential; in which case the so-called ‘structural’ deficit is simply the deficit the government should ‘normally’ run to keep the economy fully employed. It is part of the state’s fiscal sustainability, not a derogation from it.
In November 2008, Gordon Brown’s Treasury estimated the structural budget deficit at 2.8 per cent for 2008–9. In June 2010, Osborne pledged to liquidate a structural budget deficit of 5.3 per cent for 2009–10. (See Figure 32 for IMF estimates.)
How had a cyclical downturn caused the estimate of the structural deficit to roughly double? The answer given by the Osborne Treasury was that the previous government had overestimated the ‘normal’ rate of growth of the British economy and therefore the revenues that would accrue from it:
Figure 32. Estimates of the UK structural deficit, pre- and post-crisis35


. . . a property boom and unsustainable profits and remuneration in the financial sector in the pre-crisis years drove rapid growth in tax receipts. The spending plans set out in the 2007 Comprehensive Spending Review were based on these unsustainable revenue streams. As tax receipts fell away during the crisis, the public sector was revealed to be living beyond its means.36

There is obviously some truth in this. The British economy had been growing in a lopsided way, with the financial sector ballooning while the rest of the private economy stagnated. Labour’s pact with the Mephistopheles of high finance ruined it in the end. But the tale of the structural deficit also reveals the flimsy nature of the macroeconomics on which policy was – and continues to be – based.
Hysteresis

In a 1986 paper Olivier Blanchard and Larry Summers used the word hysteresis to describe a situation not when output falls relative to potential output, but when potential output itself falls as a result of a prolonged recession.37 What happens is that the recession itself shrinks productive capacity: the economy’s ability to produce output is impaired, on account of discouraged workers, lost skills, broken banks and missing investment in future productivity. That is, economic contraction and slow recovery can damage the supply-side of the economy, so recovery becomes a matter not of increasing demand but of rebuilding supply. In the post-recession years, the impact of hysteresis was felt not so much in the continuation of high unemployment but in the collapse of productivity, as workers were forced to move to lower productivity jobs.38
Marcus Miller and Katie Roberts have produced a stylized picture (Figure 33) of what may have happened in countries like the UK since 2008.
Instead of supply recovering to restore previous potential output, the economy resumes growth with a lower potential output. This matters for the structural deficit in the sense that lost productive capacity, and the concomitant reduced tax base and larger spending, turns deficits that previously were cyclical into deficits that are structural. With fewer people paying taxes when the economy returns to growth, the cyclical deficits will persist.
Figure 33. Hysteresis31


Figure 34 focuses on labour supply. In the first instance, demand for labour falls as a consequence of an external shock – for instance a banking crisis, as in 2008. This shifts the labour demand curve from LD1 to LD2 with the result that employment decreases from point A to B. Over time, the skills of those who have been made redundant by the fall in demand start to depreciate. This is represented in the shift in the labour supply curve from LS1 to LS2. Even with a resurgence in demand bringing back the curve from LD2 to LD3 the depreciation of skills has left the economy at a permanently lower level of employment, D.
The implication of hysteresis is that any policy which minimizes the period of recession minimizes the loss of potential output. It is a modern answer to the Treasury View.
Figure 34. Adjustment of labour supply in response to an external shock


III. AUSTERITY: A COMPARATIVE ASSESSMENT

The recovery patterns shown in Figure 35 are correlated with the intensity of austerity policies. Contrary to Alesina, the less austerity, the quicker the resumption of growth. The crucial years are 2011–12, when the US continued growing, the UK grew but at a weaker rate than the US, and the Eurozone went into a double-dip recession.
American policy was broadly Keynesian, despite anti-Keynesian rhetoric which was fiercer than anywhere else, except Germany. Fiscal austerity only really started in 2013 when Congress forced spending cuts on the Obama Administration. By then, however, the economy had recovered its lost output. The Bush Administration produced the $152 billion Economic Stimulus Act of 2008, a large part of which consisted of $600 tax rebates to low- and middle-income households. In early 2009 President Barack Obama signed the American Recovery and Reinvestment Act. This mandated the government to inject $831 billion (originally $787 billion) into the US economy over the decade 2009–19. Most of this was spent in 2009 and 2010. In July 2010, a report of the President’s Council of Economic Advisers claimed that the stimulus had saved or created 2.5–3.6 million jobs, and had caused US GDP to be 2.7–3.2 per cent higher than it would have been without the stimulus. This was in line with the projections by the non-partisan Congressional Office of the Budget.41 Fiscal expansion was accompanied by monetary easing in the form of quantitative easing (QE). The US performance was not especially robust: the proportion of working-age adults in work fell from 72 to 67 per cent, income inequality widened, productivity fell. But it was much better than in Britain and Europe. It showed that Keynesian policy worked.42
Figure 35. Post-crash outcomes: UK, USA and Eurozone40


The Eurozone has had the worst record, partly because EU fiscal rules mandated balanced budgets, mainly because austerity was imposed on Eurozone governments as a condition of loans from the ECB and IMF. Italy, Portugal, Spain and Greece all experienced double-dip recessions. A recent study estimates that cumulative output losses due to fiscal austerity in the euro area between 2011 and 2013 range from 5.5 per cent to 8.4 per cent of GDP, depending on estimates of the multiplier.43 Greece is the worst example; the country was set up to fail by a troika of creditors, which forced it to implement impossibly stringent austerity policies in order to receive additional loans, its GDP, in consequence, falling by 27 per cent. The euro crisis was only finally overcome in 2013–14.44
The UK is an intermediate case. The British government was not forced into austerity, it chose it. The main impact of austerity was felt in 2011–12. In late 2010, George Osborne was proclaiming that the economy was ‘on course’ and that Britain was ‘on the mend’.45 The economy promptly proceeded to flat-line for two years. Osborne later admitted that he had got himself ‘into a sort of hole: shut in my room, didn’t go out’.46 The stagnation forced a rethink. The fiscal consolidation targets were pushed outward in time; further monetary measures came in the form of a second (and then third) bout of monetary easing, and the Treasury started to subsidize crippled bank lending. The economy slowly mended as the austerity was relaxed.
Jordà and Taylor presented a ‘counterfactual analysis’ of Coalition austerity in the UK during the Great Recession. Their analysis of what would have happened to the patient had he not taken the medicine (austerity) is shown in Figure 37.
Figure 36. Post-crash outcomes: Germany, Greece and Eurozone47


Figure 37. UK austerity – counterfactual medicine48


Simon Wren-Lewis of Oxford University calculates the cost of austerity up to 2017 as between £4,000 and £13,000 per household.49 As for workers, the situation was worse still. Ninety per cent of the population have not had a pay rise for ten years, and household debt is back to its pre-crash level.
IV. CONCLUSION

One might be tempted to conclude that the debate between the Keynesians and the Osbornians, like the confrontation between Keynes and Sir Richard Hopkins before the Macmillan Committee in 1930, resulted in no clear-cut victory for either side. Osborne could (and did) argue that GDP had recovered to its pre-crash level by 2013–14, that Britain now had full employment, and that the public finances were relatively sound. In other words, the Keynesian contention that, in the absence of a stimulus, the British economy was bound to remain in semi-slump, had no foundation. Automatic recovery forces and the confidence-raising effects of austerity were enough to lift the economy out of slump territory. In different words, there were no multipliers to be had from fiscal stimuli.
However, this conclusion would be wrong, for three reasons. First, it does not acknowledge that the return to growth in mid-2009 was not ‘automatic’, but was the result of the Keynesian measures taken in Britain and elsewhere to stimulate the economy. The reversal of these measures in Britain did not ‘restore’ growth; it was accompanied by a reduction in growth by an estimated 1 per cent a year between 2010 and 2015.50
Secondly, all competent authorities agree that fiscal contraction delayed recovery, slowed down growth and destroyed growth potential. Headline unemployment in Britain has fallen to just under 5 per cent, the lowest since 1975, but this excludes the millions of part-time workers who say they would work full-time if they could, those forced into precarious self-employment and on to zero-hour contracts, and those over-qualified for the jobs they do. The vaunted flexible labour market revealed by the recession has delivered a sizeable ‘jobs gap’. If we take just two categories – those claiming unemployment benefit and those of the employed who say they would work longer hours if such work was available – about 11 per cent of the British workforce is ‘under-employed’.51 The opportunity to use available labour and cheap borrowing costs to build infrastructure was ignored: only 105,000 houses were built in Britain in 2011, the lowest number since the 1920s.
Thirdly, fiscal austerity was partly offset by monetary expansion and a fall in the sterling exchange rate. This is in line with the view that fiscal contraction in a recession need not cause a decline in aggregate demand, if there are offsetting forces of demand expansion. Still, the stagnation of 2010–12 suggests that the theory linking fiscal tightening to recovery is wrong. It was based on the careless view that a reduction in public spending is the same thing as a reduction in the deficit. But if the reduction in public spending reduces the growth rate, as is now generally acknowledged, it simultaneously reduces government revenues. This simple fact explains the disappointing progress towards deficit reduction.
In reality, the only deficits the deficit-hawks really mind about are deficits incurred to protect the poor. The wealthy have never been against tax cuts for themselves, even if this widens the deficit; and their economist friends have been busy demonstrating what wonderful multipliers are available for the economy if governments take this course. To cut the deficit for the poor and expand it for the rich – what more could one ask of government fiscal policy?52
APPENDIX 8.1: MONETARY FINANCING OF THE DEFICIT

A government with its own central bank does not have to raise money from the public to pay for its spending. It can simply order the central bank to print the money on its behalf. It incurs a liability to ‘its’ bank but not to anyone else; and its debt to its own bank never has to be paid back – a debtor’s dream! To limit this unique privilege of printing money, the convention (and in some cases legal requirement) has grown up that government spending has to be covered by taxation or borrowing from the public (considered deferred taxation). ‘Monetary financing’ of the deficit is advocated as a ‘last resort’ policy only for a ‘worst-case scenario’, when orthodox fiscal expansion to counter a recession is disabled by fears of rising debt.53
Technically, the central bank credits the Treasury with, say £50 billion, or alternatively the Treasury can issue £50 billion worth of debt, which the central bank agrees to hold indefinitely, rebating any interest received to the Treasury. The advantage of such financing is that it will raise aggregate demand without enlarging the national debt – the money the government owes to its holders. (For it to have its full effect, the increase in the money supply must be seen as permanent.) But, as Adair Turner writes: ‘[I]t is also clear that great political risks are created if we accept that monetary finance is a feasible policy option: since once we recognise that it is feasible, and remove any legal or conventional impediments to its use, political dynamics may lead to its excessive use.’ More succinctly, Ann Pettifor put it thus: ‘It is the bond market that keeps governments . . . honest.’54
It follows that I do not agree with modern monetary theorists that, because the government creates the money it spends, it is freed from the budget constraint faced by the individual firm or household. It is, of course, true that if the government spent no money, there would be no taxes. (But then there would be no government either!) But it does not follow that the money it spends automatically returns to it as tax revenue. As Anwar Shaikh rightly notes: ‘There is no such thing as a money of no escape.’55 The value of modern monetary theory is not in trying to prove that government can issue debt without limit, but in emphasizing that the ‘bonds of revenue’ are far looser than the deficit hawks claim.
* Osborne left himself some room for manoeuvre by making these five-year ‘rolling targets’, leaving it for the OBR to judge whether he was ‘on course’ at the start of any five-year period.
* As far as I can tell, the idea of bringing idle resources into use by means of the balanced-budget multiplier was never considered by policymakers. The government increases its expenditures (G), balancing it by an increase in taxes (T). Since only part of the taxed money would have actually been spent, the change in consumption expenditure will be smaller than the change in taxes. Therefore the money which would have been saved by households is injected by the government into the economy, itself becoming part of the multiplier process. The multiplier is greater still in a progressive tax system, since the rich save a greater proportion of their incomes than the poor. For advocacy of this policy, see Stiglitz (2014).

The New Monetarism

‘The government’s real case is that expansionary monetary policy will offset any contractionary influence of the Budget.’
Financial Times, 20101
‘The problem with QE is that it works in practice, but it doesn’t work in theory.’
Ben Bernanke, 20142
‘While monetary policy . . . provided the necessary emergency medicine after the financial crash, we have to acknowledge there have been some bad side-effects. People with assets have got richer. People without them have suffered.’
Theresa May, 20163
‘I find it hard to reach the conclusion that, over a longer time-frame, the outcome of our policies has been – or will be – to redistribute wealth and income in an unfair or unequal way.’
Mario Draghi, 20164
The withdrawal of fiscal stimulus in 2010 left only one expansionary tool – monetary stimulus. Quantitative easing (QE) – buying up government debt in order to put more money in the hands of private business – was the inferior substitute for fiscal expansion, and the offset to fiscal contraction. This is the straightforward economics of the matter. It may be that politically it was the only thing that could have been done. But no one should pretend that it was superior. The chosen vessel for watering parched economies was much more leaky than the rejected alternative.
I. PRE-CRASH MONETARY ORTHODOXY

Throughout the Keynesian ascendancy, the Bank of England had demanded that it be given ‘operational independence’ to prevent democratic governments from inflating the money supply. In 1998 the Bank finally got what it wanted.
The Bank of England Act mandated the Bank of England: ‘(a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment’.5 The Bank’s Monetary Policy Committee (MPC) was empowered to set the level of the official interest (‘base’ or ‘policy’) rate6 independently of Parliament, a break from post-war practice when the policy rate was determined by the government: Margaret Thatcher, for example, used to veto rises in interest rates on the ground that it would ‘hurt our people’. In the new regime, the Bank would control inflation by varying Bank Rate. Inflationtargeting was from the outset ‘conceived as a means by which central banks could improve the credibility and predictability of monetary policy. The overriding concern was . . . to reduce the degree of uncertainty over the price level in the long run because it is from that unpredictability that the real costs of inflation stem.’7
Having learned from the experience of the failed monetarist experiment of the 1980s, the Bank of England did not directly target money, yet ‘for each path of the official rate given by the decisions of the MPC, there is an implied path for the monetary aggregates’.8 Thus the monetary aggregates remained the most important indicator for monetary policy. The MPC’s preferred measure for this was broad money (M4), which included bank deposits. In addition, the Bank retained its traditional role as lender of last resort, a role denied to the European Central Bank.
Bank Rate, less familiarly the ‘base rate’, is the interest rate or ‘price’ that the central bank charges for lending money to member banks. The theory is that a change in the base rate pushes the yield curve upwards or downwards. It is immediately transmitted to the interbank lending rate. Banks will then adjust their own lending rates, both short-term and long-term. This will affect how much income is saved and invested. In 1930 the Bank of England had denied that it had such power over commercial lending rates, and uncertainty remained about the impact of the short-rate on the long-rate.9
The supposed transmission mechanism from the base rate to the level of spending and prices in the economy can be summarized by Figure 38. The channels work as follows:

• Market rates: changes in the official rate affect the structure of market rates.
• Asset prices: ‘Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home-owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households’ wealth and can increase their willingness to spend.’10
• Expectations/confidence: Changes in the policy rate influence expectations about the future course of the economy. Expectational effects are unpredictable. Take, for example, a rise in the policy rate. On the one hand, this might be taken as a sign that the central bank wishes to slow down the growth of the economy to stop it from ‘overheating’, dampening expectations of future growth. But it could also be interpreted as a sign that the economy is growing faster than the central bank had previously predicted, which might increase confidence in the economy.12
Figure 38. The transmission mechanism of monetary policy11


• Exchange rate: An unexpected decrease in the interest rate relative to overseas would give investors a lower return on UK assets relative to their foreign currency, tending to make sterling less attractive. That should lower the value of sterling, increasing the price of imports and lowering the price of exports. At first glance, this would appear to increase UK output, but the effects of exchange rate changes can be unpredictable. For example, if the change in export and import prices have a negligible impact on demand (in technical terms, if UK import demand and demand for exports are ‘price inelastic’), then output will fall.*
The Bank’s approach can be captured by the Taylor Rule (see Appendix 7.3): when inflation is above target, this signals that spending is growing faster than the volume of output being produced, so the Bank of England should increase the base rate to make savings more attractive relatively. Conversely, if inflation was below target, the base rate should rise.
The framework of policy was Wicksellian rather than Friedmanite: bank rate should be set to achieve the target rate of inflation. But ‘flexible inflation targeting’ incorporated the New Keynesian feature of allowing for (small) shocks to Wicksell’s ‘natural’ rate. The policy framework also emphasized the importance of policy rules to anchor expectations. In normal times the Bank would ‘set interest rates such that expected inflation rate in two years’ time is equal to the target’. But in the face of a shock its aim should be to ‘bring inflation back to target over a period of more than two years and explain carefully why the heuristic has changed’.13 In this way the Bank could adapt its policy to changing circumstances and evolving knowledge, ‘so that the policy regime as a whole is robust to changing views about how the economy works’.14 At least, that was the theory. The contradiction between setting a policy rule to anchor expectations, and explaining why it could not be relied on, was never resolved.
The Bank’s preference as between inflation and output can be captured by the following ‘loss function’:15
Losst ≡ (πt − π*)2 + λ(yt)2

Here π represents current inflation, π* the inflation target, and so πt – π* gives the gap between desired and current inflation. Similarly, yt represents the output gap, λ is a term representing the Bank’s concern with output. If λ = 0, the Bank does not care about output and will attempt to curb inflation at all costs. If λ is high, the Bank might tolerate higher inflation if this avoids a fall in output and employment. Finally, the inflation and output gap terms are squared to show that (a), deviations from target inflation and output in either direction are equally undesirable and (b), large deviations are much less desirable than smaller ones.16
A much-praised feature of the British arrangements was the symmetrical nature of the inflation target.17 Policy was set to avoid the evils of both inflation and deflation. An inflation rate expected to run above target would indicate that aggregate demand was running ahead of aggregate supply; an inflation rate below target would indicate a shortage of demand relative to supply. Targeting the inflation rate was thus a way of balancing aggregate demand and supply, with the inflation target replacing the Keynesian full employment target. This reflected Milton Friedman’s view that unemployment would normally be at its ‘natural’ rate if prices were kept constant. Varying bank rate to meet a pre-set inflation target was the monetary version of fiscal fine-tuning.
This pared-down version of macroeconomic policy rested on the view that the expectation of stable inflation (together with ‘prudent’ fiscal policy) would cause the real economy to be stable, barring large shocks. Certainly the Great Moderation years saw a decent correlation between growth and low inflation, in apparent vindication of central bank policy.
But whether the anti-inflation commitment was the main cause of low inflation is doubtful. There was a large downward pressure on prices following the entry of hundreds of millions of low-wage workers from China, East Asia and Eastern Europe into the global labour market.19 Mervyn King acknowledges the help from this factor when he talks about a ‘nice’ environment for monetary policy.20
Figure 39. Output growth and inflation in the advanced economies during the Great Moderation19


But, with a rogue elephant in the corner, the whole system is liable to crash down, and this is what happened in 2008–9. The rogue was the financial sector. Deluded by their apparent success in keeping inflation low, policymakers ignored the troubles brewing in the banks. With the unexpected collapse of the financial system in 2008–9, monetary policy faced a challenge not seen since the Great Depression.
II. WHY QUANTITATIVE EASING?

The Bank of England was slow to respond to the growing signs of banking crisis. In Howard Davies’s words, ‘[it] lectured on moral hazard, while the banking system imploded round it’. Unlike the US Federal Reserve, the European Central Bank also worried about ‘imaginary inflationary dangers’.21 But following the collapse of Lehman Brothers in September 2008 the policy rates of the main central banks were rapidly slashed towards zero.
Figure 40. Cutting interest rates: central banks’ base rates22


This was the traditional response. With the economy still in free fall, interest rate policy could do no more. An extra tool was needed. Alistair Darling, Britain’s Chancellor of the Exchequer, announced on 18 January 2009 that the Bank of England would set up an asset purchasing facility (APF), which would be ‘useful for meeting the inflation target’. Quantitative easing had arrived.
Two days later, the Governor of the Bank, Mervyn King, explained the thinking behind it:
The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank’s history, it is sensible for the MPC to prepare for the possibility . . . that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures. They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital market.23

The theoretical case for QE was built on the idea of a liquidity trap.
Figure 41. Liquidity trap


The situation which produces the ‘trap’ is one in which the expected rate of return on investment (Wicksell’s ‘natural rate of interest’) is lower than the lowest rate of interest banks are willing to charge for loans. The zero bound is the limit of what interest rate policy can achieve to lower commercial banks’ lending rate. At the zero lower bound (ZLB) the demand for money to hold becomes perfectly interest elastic (expands without limit).* This is because the sense of security from holding cash, even at zero interest, trumps the cost of forgone expected financial returns. Once the zero lower bound is attained, central banks must turn to other means to lower loan rates in the market.
QE was called unconventional monetary policy because the conventional pre-crash policy of controlling credit by price was no longer available. As a consequence, central banks had to gamble with the Fisher–Friedman version of monetarism which had broken down in the 1980s. Willy-nilly, central bankers became quantity theorists.
III. QUANTITATIVE EASING PROGRAMMES, 2008–16

The Fed was quickest off the mark. The need for large-scale QE was the lesson Ben Bernanke drew from the Friedman and Schwartz story of the Great Depression. Shortly before he became Chairman of the Federal Reserve Board in 2006, Bernanke wrote: ‘By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy.’24 Equipped with this historical lesson, Bernanke and most other central bank governors were determined to avoid this mistake when the crisis hit in 2008. The Fed announced its first asset purchase programme in November 2008.25 ‘Extraordinary times call for extraordinary measures,’ declared Bernanke.26
In its initial round of purchases (QE1), between November 2008 and March 2010, the Fed bought $1.25 trillion of mortgage-backed securities (MBS), $200 billion of agency debt (issued by the government-sponsored agencies Fannie Mae and Freddie Mac) and $300 billion of long-term Treasury securities, totalling 12 per cent of the US’s 2009 GDP. Its second round of purchases (QE2) – $600 billion of long-term Treasury securities – ran between November 2010 and June 2011, and its third round (QE3) started in September 2012 with monthly purchases of agency mortgage-backed securities.27 The programmes were wound up in October 2014, by which point the Fed had accumulated an unprecedented $4.5 trillion worth of assets,28 equivalent to just over a quarter of US GDP in 2014. In the composition of its purchases, the Fed, as we shall see, was more adventurous than its British counterpart.
In the UK, QE has come in three bites. The Bank of England injected £200 billion of electronic money into the British economy between March 2009 and January 2010 (QE1), and £175 billion between October 2011 and November 2012 (QE2 and QE3), making £375 billion in all, or 22.5 per cent of 2012 GDP. The majority of its purchases were of highly liquid gilts, though the Bank also bought a small amount of commercial paper and corporate bonds. After the Brexit vote in June 2016, the Bank of England decided to resume QE in August.
For the ECB, ‘repo’ operations, known as LTROs or long-term refinancing operations (designed to refinance banks), remained its main source of balance-sheet expansion until it started its asset purchase programme in 2015.29 That is, it was bank salvage, not monetary policy. In 2012, the ECB President, Mario Draghi, promised to do ‘anything it takes’ to preserve the euro. This pledge, which was opposed by Jens Weidmann, President of the German Bundesbank, saved the European Monetary Union. In March 2015, the ECB started to buy €60 billion of euro-area public sector debt per month. A year later, this monthly amount was increased to €80 billion and high-grade corporate bonds became eligible for purchase. The amount dropped back down to €60 billion in April 2017, and to €30 billion in January 2018. In July 2017, the ECB held assets to the value of 40 per cent of 2016 Eurozone GDP.30 For each of the three central banks, the scale of their balance-sheet expansion was unprecedented.31
Three strong arguments backed the new programmes. The first was that they were simply an extension of the ‘open-market operations’ technique practised by all central banks as part of their normal money-market management. Open-market operations (OMOs) were the means by which the central bank supplied the banks’ marginal liquidity needs on a daily basis, either by buying or selling government securities or by means of ‘repo’ transactions, so as to keep the inter-bank lending rate close to the policy rate. However, QE was ‘unconventional’ in the sense that the technique had never been used outside Japan in a situation in which the total supply of liquidity had dried up. Nevertheless, the fiction persisted that QE did not mark a permanent expansion of the money supply, since the bonds which were bought would be sold again as soon as the economy was back to ‘normal’.
The second argument was pragmatic: fiscal policy had been ‘disabled’ by the huge expansion of public deficits in the first six months of the crisis, and conventional monetary policy by the zero lower bound. QE was the best of a waning number of options.
The third argument was ideological. Monetary expansion was preferable to public investment, since it avoided a ‘government role in the allocation of capital’.32
IV. HOW WAS QE MEANT TO WORK?

Tim Congdon explains the expected real balance effect by invoking Fisher’s Santa Claus: agents finding themselves with excess money balances at the existing rate of inflation spend the excess by increasing their purchases. The cumulative attempt of recipients to get rid of the extra money raises all prices to a level at which the desired ratio of money-holding to expenditure has been restored. Thus a stable demand for real balances is brought into equilibrium with the increased supply of money through a rise in nominal income. How this rise will be shared between output and prices will depend on the size of the output gap.33
How much extra money will Santa Claus need to spray round the community to achieve a given inflation target? In the Fisher theory the answer was given by the money multiplier: the amount of new bank loans which can be created by an increase in reserves (‘base money’) in a fractional reserve banking system. If the reserve requirement is 10 per cent, an injection of £1,000 will enable additional loans of £900, leading to additional spending and deposit creation, with the total of new money summing to a multiple of the original injection.34 If the money multiplier is known, then so will be the effect of any given amount of QE on nominal income (output plus prices). However, if the money-multiplier mechanism is leaky, the amount of new money needed to raise nominal income to a desired level is unknown. For example, the excess could ‘automatically be extinguished through the repayment of bank loans, or what comes to the same thing, through the purchase of income yielding financial assets from the banks’, leaving the quantity of money (deposits) the same.35
Keynes had pointed out the problem when he warned in 1936 that, ‘if . . . we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip’.36 He identified two such slips or ‘leakages’ from the circular flow. First, creating extra bank reserves would have no influence on spending if ‘the liquidity-preferences of the public are increasing more than the quantity of money’.37 In other words, the effect of money on prices depended on the amount spent, not on the quantity created. In his earlier Treatise on Money he had identified another slip. Even if demand were to be stimulated by cash injections, it might not be demand for currently produced output. Recipients of the new money might use it to buy existing assets, such as stock exchange securities or real estate or Old Masters.38 In this event QE would have to rely on an indirect wealth effect on consumption to achieve its desired impact on nominal income.
It was considerations of this kind that led Keynes to conclude that the only secure way to get new money spent in a slump was for the state to spend it itself.
How did the Bank of England expect QE to work in practice? The answer is, it didn’t quite know. Its chosen route, in the Bank’s own words, was ‘the creation of central bank reserves . . . by buying outright from the private sector assets that have either a longer duration and/or higher credit risk than the corresponding liability’.39 In non-Bank speak, it would create riskless cash reserves for the banks by buying their riskier assets.
What, in the Bank’s view, would this achieve? In its earliest presentations, the Bank of England specified two main transmission channels from these reserves to spending. The first was the ‘portfolio substitution’ channel; the second, the ‘bank funding’ channel. They are illustrated in Figure 42 below.
The bank funding or, more familiarly, lending channel was a straightforward substitution for the inability of the Bank to get its base rate of interest below zero. As a result of QE, commercial banks would hold significantly higher levels of reserves. This would induce them to lower the interest rates they charged on loans. This would increase their loan portfolios. The spending of the loans would expand the economy.
Figure 42. Four key monetary debates40


In practice, the Bank of England didn’t much believe in this channel, and believed in it even less after a short period of experience. Only 30 per cent of government securities were bought from banks; the rest from non-banks. The reason is understandable. Given the impairment of banks’ balance sheets, and the collapse in the confidence of borrowers, there was not much hope for a rapid increase in bank lending. Therefore QE1 was explicitly designed to get round the banking system, not through it.
The Bank of England (like the Fed, but unlike the ECB) put its main hopes in portfolio rebalancing/substitution. This was to be activated by buying government bonds from private investors, like pension funds and insurance companies. As the Bank put it:
Insofar as investors regard other assets – such as corporate bonds and equities – as closer substitutes for government bonds than money, we might expect them to re-balance their portfolio towards these assets if their money holdings are boosted by temporary bond purchases . . . This would tend to put upward pressure on the prices of those assets.41

Keynes had thought that if bond yields fell too low, people would prefer to hold cash than buy bonds. But the Bank reasoned that a policy aimed at reducing the excess demand for bonds would cause investors to switch not to cash but to financial assets like equities, which promised higher, if riskier, returns. The increase in the paper wealth of the new asset holders would encourage them to spend more.* In other words, the Bank, following Friedman’s lead, implicitly jettisoned the speculative demand for money from Keynes’s liquidity preference function. The desire for liquid assets might go up, but there would be no leakage from the circular flow of money.
As time went on, the Bank discovered extra channels. In particular, it started to attach increasing importance to the effect of its announcements in activating the required responses. At first it hoped to take advantage of their ‘surprise’ effect. When it discovered that the surprise soon wore off, it started to emphasize signalling and ‘forward-guidance’. When the Bank acts, its actions give clues to what it will do in the future, and these clues are signals; ‘forward-guidance’ is an explicit commitment to act in a certain way under specified conditions. In its most explicit form, the forward-guidance channel works through policymakers making long-term commitments to keep interest rates exceptionally low. The policy boasts a placebo effect – self-fulfilling prophecies producing a recovery without undertaking the significant risks of expanding the central bank’s balance sheet.
Hence, the commitment to continue the low bank rate and asset purchases for a definite length of time was considered crucial to achieving the hoped-for effect of the policy, i.e. raising the inflation rate. Like similar pronouncements from the Treasury concerning time-limited deficit-reduction targets, signalling and forward-guidance were attempts to boost the credibility of the policy.
In 2013, Mark Carney, the new Governor of the Bank of England, signalled the Bank’s intention to keep bank rate at its then current level of 0.5 per cent until unemployment had fallen to 7 per cent.
As the BBC explained:
The Bank can only directly control the short-term interest rate. But this rate has already been cut to the lowest level that the Bank feels comfortable with . . . another way for the Bank to support the economy has been to offer this indicator, by which companies and mortgage borrowers can estimate for how long such low interest rates may be around for in terms of months or years. Forward guidance is thus a way of converting low short-term interest rates into lower long-term interest rates. The thinking is that if the High Street banks can be convinced that they will be able to borrow overnight from the Bank of England at just 0.5% for many nights – indeed many months or years – to come, then they will hopefully be willing to lend money out to the rest of us for the longer term at a commensurately lower interest rate as well.42

There is a trade-off between credibility and pragmatism. Bank Rate was kept at 0.5 per cent until August 2016, even though British unemployment had been below 7 per cent for the previous two years. However, commitments to keep a policy in place for a period of time cease to be credible if circumstances point to a change of policy. In October 2017 base rates started to come off the floor for the first time since the crisis began. How long it will be before they reach what is regarded as normal depends on the momentum of recovery, about which no one can be certain. However, it could be argued that the emergency short-term rate of close to zero set in the winter of 2008 is now well below the equilibrium rate for a recovered economy – its only effect being to sustain ‘zombie’ companies which should exit economic life.
It should be noted that the explicit purpose of the whole exercise was to raise inflation to its target of 2 per cent. In fact, the expectation of higher inflation was a crucial part of the mechanism for increasing spending: if households and firms expect prices to go up (or, equivalently, the real rate of interest to fall) they will increase their current purchases of goods and machinery to get them at a cheaper price. Who would not buy today, if they expect higher prices tomorrow? However, if higher prices were expected to boost investment, it was soon realized that, if this was achieved, inflation would depress consumption by increasing goods’ prices. As far as increasing output was concerned, raising the rate of inflation was a doubleedged sword.
V. ASSESSMENT

How does one assess the achievement of QE? As with any assessment of policy, a fundamental problem lies in the difficulty, indeed impossibility, of isolating the impact of the policy from contamination by external factors. It is relatively easy to evaluate the impact of QE on financial variables such as interest rates, bond rates, stock exchange prices, and so on. But what is the effect of such changes on real GDP? There is no particular virtue in achieving financial targets as such. It matters not whether interest rates or asset prices go up or down, except in terms of their effects on output and employment. These financial events were simply transmission mechanisms to the real economy. If they fail to transmit recovery the policy is useless.
In Figure 43, the dark grey bubbles are what the authorities wanted to achieve through QE, while the effect of the medium grey bubbles is indeterminate. What they didn’t want were the light grey bubbles: for banks to sit on their reserves and not lend; and for investors to buy financial assets and not spend. There was clearly a risk of asset bubbles, but the Bank hoped that an asset boom would produce increased capital investment and consumer spending through a wealth effect. In this 2013 assessment of Britain’s experience of QE there were five light grey bubbles and only three dark grey ones.
The Portfolio Rebalancing Channel

This channel was supposed to work, in the first place, by depressing the yield of gilts. This would induce holders of gilts to switch to equities: ‘If QE successfully raised equity and corporate bond prices, we might expect firms to respond by making more use of capital markets to raise funds. In other words, there would be a positive effect of QE on the quantity of debt and equity raised, as well as its price.’43
Joyce et al. estimate that the first (£200 million) wave of the Bank of England’s asset purchases, from March 2009 to January 2010, reduced gilt yields by around 1 per cent, comparable to a 1 per cent reduction in short-term rates.45 Meaning and Warren (2015) estimate that the total £375 billion of QE reduced yields by around 0.25 per cent through the effects of increased supply of bonds alone (i.e. excluding expectational effects).46 This lowered borrowing costs throughout the economy. The fall in the cost of government borrowing, and interest payments on the national debt, improved the fiscal numbers, enabling budgetary policy to be somewhat looser than it would otherwise have been, given the commitment to austerity. And it lowered, at least temporarily, the cost of finance for companies, which had spiked dramatically in 2008–9.47 External MPC member David Miles believes that ‘a significant part of the fall in spreads on sterling corporate bonds is specifically linked to the Bank of England’s purchases of gilts’.48
Figure 43. Good and bad outcomes of QE44


Over the period from 4 March 2009 to 22 January 2010, the FTSE index rose by 50 per cent. But so did the Euro Stoxx 50 and the German Dax without the benefit of QE. Even the Bank of England, hardly a disinterested observer, concedes that it ‘would be heroic to attribute all of these gains to QE’.49 Nevertheless, ‘the evidence is consistent with [a portfolio rebalancing channel] effect’, though it is ‘impossible to know what would have happened in the absence of QE’.50 The equity and housing markets recovered much more quickly than the rest of the economy, but there is no way of showing how much of this was due to QE.
The Bank Lending Channel

What is clearer is that QE failed to stimulate bank lending. While commercial bank reserves at the Bank of England (‘narrow money’) rose dramatically (from £30 billion in March 2009 to over £300 billion by the end of November 2013),51 the annual growth rate of bank lending fell from 17.6 per cent in February 2009 to negative in September 2010 (Figure 44). Theory tells us why. The private sector was increasing its saving. Banks were less willing to lend, and firms and households to borrow. The increase in central bank cash was not nearly enough to offset the huge rise in liquidity preference. Even Mario Draghi, the President of the ECB, was forced to admit that the monetary expansion would fail to unblock the bank lending channel if ‘banks . . . hold on to precautionary balances’.52
The consensus view is that the modest recovery in UK bank lending in 2012 was mostly due to the government subsidizing programmes like Funding for Lending and Help to Buy, which were fiscal rather than monetary policies. Funding for Lending was introduced in July 2012, and Help to Buy in April 2013. The first was ‘designed to incentivise banks and building societies to boost their lending to UK households and private non-financial corporations (PNFCs) . . . by providing funding to banks and building societies . . . with both the price and quantity of funding provided linked to their performance in lending to the real economy’.54 The second was designed to help people with as little as a 5 per cent deposit to buy a home; the government encouraged banks to approve such mortgage requests by guaranteeing the repayment of a percentage of the loan. But to this day bank lending is well below the historical average.
Figure 44. Growth in UK bank (M4) lending53


The failure of QE to revive bank lending has led to even more unconventional policy. In January 2017, Mario Draghi started taxing ‘excess’ reserves held by commercial banks at the ECB in order to encourage them to lend. There is a limit to this – commercial banks will turn to other methods of storing money if it becomes expensive to store reserves at the central bank. In early 2016, the Bavarian Banking Association recommended that its member banks start stockpiling physical cash.55
The dilemma is straightforward. If negative rates on central bank reserves do not feed into lending rates, they are useless; if they do, they will hit banks’ profitability unless banks start charging depositors interest for holding their money in banks as well.56 If this happens, there will be a flight into strong-boxes.57
The Exchange Rate Channel

The Bank supposed that part of the extra cash it pumped into the economy would be used to buy foreign securities, forcing down the exchange rate and thus enlarging export demand.
Figure 45 shows that the fall in the sterling exchange rate preceded QE; further, it only very temporarily improved the current account balance.58
The Signalling Channel

It is hard to gauge the impact of signalling. A number of analyses have used ‘event study’ methodology, inspired by the efficient market hypothesis. This asserts that market prices adjust to ‘news’ rather than actual events. Using this method, researchers have discovered announcement effects on bond yields, currency and equity prices.59 But those committed to the ‘surprise’ theory of market behaviour are bound to conclude that central bank announcements will be subject to diminishing returns, and this seems to have been the case. Market participants, having accustomed themselves to unconventional monetary policy, became increasingly acute in guessing the size and timing of the next wave. As a consequence, QE2 had much less impact than QE1. However, central banks played the strategic game. By announcing changes in the composition of purchases, like the Fed’s ‘Operation Twist’ and the Bank of England’s decision to ‘increase the amount of shorter dated securities’, they were able to surprise investors and continue, at least in their own view, to make impacts on yield curves.61
Figure 45. UK exchange rate and current account, and QE60


Through the four channels above, the injection of narrow money (M1) was supposed to influence the movement of broad money and, through broad money, growth in nominal GDP.
Broad Money

Broad money is largely synonymous with bank lending. As we have seen, bank reserves went up while bank lending fell. The same story can be told with broad money.
The presumed relationship between narrow money and broad money (the money multiplier) never emerged, because the decrease in velocity of circulation offset the effect of QE. ‘I accept that the growth of money in the QE period has been much lower than I had been hoping,’ wrote Tim Congdon to the author. ‘Nevertheless, it has stopped a much worse recession.’
Figure 46. Growth in UK money supply and money lending post-crash62


Figure 47. UK broad money (M4) growth64


Effect on Output and Unemployment

The Bank of England estimated that the level of real GDP was boosted 1.5–2 per cent by QE1.64 There is huge uncertainty about this: we can be reasonably confident about the sign of the effect but not its magnitude. What is clear from the table overleaf is that the monetary injection over the period 2009–12 far from offset the depressing effects of fiscal policy, as the Treasury had expected.
In 2012, the Bank of England stated that: ‘Without the Bank’s asset purchases, most people in the United Kingdom would have been worse off . . . Unemployment would have been higher. Many more companies would have gone out of business.’65 It is impossible to say.
In a 2016 assessment, the Bank concluded that it was not asset purchases as such which boosted activity, but their effect on sentiment.66 Keynes, too, had written that ‘a monetary policy . . . may prove easily successful if it appeals to public opinion as being reasonable and practicable and in the public interest, rooted in strong conviction, and promoted by an authority unlikely to be superseded’.68
Figure 48. UK output and unemployment67


Effect on Inflation

QE was meant to have a joint effect on prices and output, but there was considerable confusion about the relationship between the two. Was it the effect on output that was supposed to bring inflation up to target? Or was it the rise in inflation (more accurately, the expected rise in inflation) which was supposed to lift output? Targeting inflation presupposed that inflation governed output: people would spend more because they expected prices to go up. This is how the real balance effect was supposed to work. Keynesians reversed the causality: it was people spending more that caused prices to go up. Therefore the target should have been output, not inflation; and the tool fiscal policy, not monetary. The Bank’s failure to boost inflation (except possibly in the first bout of QE) was due to a deficiency of aggregate spending.
Who was right? Figure 49 shows that the period 2008–16 demonstrated no better correlation between money (narrow or broad) and inflation than did the monetarist experiment of the 1980s. The best correlation during the Great Recession was with oil prices (Figure 50).
Figure 49. UK CPI inflation and QE69


The Keynesian conclusion is clear. The inability of QE to get inflation up to target ‘in the medium term’ was due to the government’s failure to get output up to trend in the short-term. This was true not just of the UK. The Bank of Japan has been using QE for nearly four years without getting inflation anywhere near its 2 per cent target. In the circumstances Governor Haruhiko Kuroda’s pledge to deliberately overshoot the target in order to raise inflation expectations was somewhat lacking in credibility.
Distributional Effects

The effects of QE were supposed to be distributionally neutral. It wouldn’t be true to say that savers were bound to lose and assetholders bound to gain from QE, as many savers own pension funds. Nevertheless, the balance of gain went to the rich. The median or typical household in UK held only around £1,500 of gross assets, while the top 5 per cent of households held an average of £175,000, or around 40 per cent, of the financial assets of the household sector held outside pension funds.70 By enriching the already wealthy, QE increased the well-documented concentration of private wealth in ever fewer hands. But richer households have a much lower marginal propensity to consume – that is, they spend a lower proportion of new income than poorer people. So enriching the already wealthy had a much smaller impact on overall spending than if the same amount of money had gone to lower-income groups.
Figure 50. Oil prices and UK CPI inflation71


Figure 51. Distribution of UK household financial assets, 201172


This distributional effect is not a generic consequence of QE but of the way it was done. The political neutrality of the Bank was thought to be its great advantage in conducting macroeconomic policy, because it would not be tempted to direct money for political ends, i.e. to secure the re-election of the government. In a speech at the LSE in 2017, Mark Carney repeatedly claimed that the central bank was an agent of ‘the people’.73 But the chain of accountability is not clear. Theoretically, the central bank acts on a mandate from the government, which depends on renewable popular support. This larger accountability is jammed, though, because only a small group of insiders understands the technique of monetary policy. In practice, the bank’s accountability is to the financial system, which means to existing asset owners.
USA and Eurozone

Let’s look again at the diverging recovery rates between the UK, USA and the Eurozone. In the last chapter it was suggested that these can be correlated with the impact of fiscal policy. Can we find a similar relationship with monetary policy? Or, more plausibly, was it the combination of the two which explains the different outcomes?
There is general agreement that QE was more successful in the United States than in the UK, and less successful in the Eurozone than in either. The broad explanation for these discrepancies is that there was more ‘stimulus’ from both fiscal and monetary policy in the USA than in the UK, and more stimulus from monetary policy in the UK than in Europe.
Figure 52. Post-crash outcomes: UK, USA and Eurozone74


Studies of US ‘credit easing’ show that it achieved a bigger ‘bang per buck’ than asset purchases in the UK. Whereas in the first round of QE in both countries (2008/9–10) the Fed injected only half the amount of money relative to GDP as the Bank of England (7 per cent to 14 per cent), it is estimated that the injection had double the effect on GDP (4 per cent as against 1.5–2 per cent).75 If this is so, the probable reason is that the Fed’s QE programme was overwhelmingly targeted at the most distressed parts of the financial system and purchased riskier mortgage-backed securities, whereas the Bank of England bought virtually only Treasury gilts. However, one cannot segregate this supposedly ‘bigger bang per buck’ from the simultaneous $800 billion fiscal stimulus enacted by President Obama in February 2009. What seems clear enough is that the US authorities, both monetary and fiscal, were together willing to take bolder action to get the US economy moving again than those in the UK and the Eurozone.
The euro was afflicted by two original sins – the disconnect between fiscal and monetary policy and its neo-liberal monetary constitution. The European Central Bank was technically debarred from buying government debt. As a result, the monetary response to the crisis can be summarized as ‘too little, too late’. Its first response to the storm signals was actually to raise interest rates in July 2008. It was then slower than the Bank of England and the Fed to cut them as the Great Recession unfurled. Similarly, it only arrived at QE on the UK and US scale in 2015.
The consequences of the ECB’s passivity before then were dire. Whereas in the UK monetary policy was used deliberately to offset the effects of fiscal austerity, in the EU there was no offsetting action from the ECB. By 2011 US real GDP had recovered to its pre-crash levels; the UK followed in 2013, but the Eurozone not until 2015, after suffering a double-dip recession. Only since 2015, with the Juncker investment programme (see above p. 257), have expansionary monetary and fiscal instruments both come into play.
Why was the ECB was so slow to act? The three central banks have somewhat different mandates but this was not decisive.76 A more important institutional constraint was that the ECB’s rules forbade it from holding more than a third of any specific bond issue, or more than a third of any one country’s debt. Without a single eurobond jointly guaranteed by all members, this limitation was inevitable.
An even more important explanation is the ECB’s misreading of the crisis. It saw it as temporary – in February 2008, ECB President Jean-Claude Trichet was warning of the risk of an inflationary spiral.77 This partly reflected the theoretical framework of the day in which inflation was seen as the main obstacle to steady state, marketled economic growth. In addition, until the sovereign debt crisis hit the Eurozone in 2010, the financial impact of the US collapse was limited. But the ECB’s passivity also reflected a particular historical mindset. For the ECB, heir to the Bundesbank, the supreme danger to avoid was a repetition of the hyperinflation of the early 1920s. By contrast, it was the Great Depression of 1929–32, and the need to avoid a repeat of that, which had the biggest historical impact on Ben Bernanke and other US policymakers.
Governments whose policies fail to achieve their promised results always claim that they were pursuing policies that would have succeeded had it not been for unexpected ‘headwinds’. Thus MPC member Spencer Dale, speaking in 2012:
Some commentators have pointed to the weakness of growth over the past couple of years as evidence that the impact [of QE] has been relatively limited. But this seems a silly argument. The scale of the headwinds affecting our economy over this period – in terms of the squeeze in households’ real incomes stemming from the rise in commodity and other import prices, the fiscal consolidation, the tightening in credit conditions, and the fallout from the Eurozone crisis – has been huge. These headwinds have to be taken into account when assessing the effectiveness of the policy actions taken to offset them. There is a legitimate debate as to exactly how effective our policy actions to date have been. But I have little doubt that without them our economy would be in a far worse state today.78

Figure 53 below, taken from a Bank of England paper, claims to show what would have happened to broad money and output growth without QE1.
Just as economic models are provable only ceteris paribus, so all empirical assessments are relative to counterfactuals. But which headwinds to blame and which models to use depend on one’s theory of the economy.
Figure 53. Bank of England estimates of effect of QE on UK growth rates79


Taking his cue from the Friedman and Schwartz explanation of the Great Depression of 1929–32, Tim Congdon believes that the relative failure of QE was due to not printing enough money. ‘We know’, he argues, ‘both that governments can print money and that economic agents have a finite demand for real money balances. We therefore believe that policy-makers can engineer whatever inflation rate they choose. The generation of inflation, and the prevention of inflation, seem extremely easy: just print the right amount of money.’80
In contrast, by 2014 the Bank of England had more or less given up on QE:
the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them – which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.81

Thus the Bank sought to exculpate itself both for responsibility for the crash of 2008 and for the weakness of the recovery.
VI. CONCLUSION

QE offers as good an experiment in macroeconomic policy as we are likely to get, which is not that good. Attempting an empirical assessment of its effects is bedevilled by the omnipresence of counterfactuals. We are trying to compare what happened with what might have happened had policy been different – had there been more QE, or had it been done in a different way, or had it not been done at all, or had something else been done, or had fiscal policy not been contractionary.
So the best we can do is to compare what it set out to do with the actual outcome. On this test the conclusion is reasonably clear. It promised to boost output by raising the rate of inflation, while being neutral on distribution. In fact, over five years (2011–16) it failed to get inflation up to target; it had, at best, a weak effect on output; and it was far from being distributionally neutral. After nine years of emergency money, the financial system remains as dangerously stretched as it was before the crisis, and the economy as dangerously dependent on debt.
Economic theory can help explain why.
The first generation of monetary reformers – Fisher, Wicksell, the early Keynes – believed passionately that the way to prevent booms and slumps was to keep the price level stable. The QTM seemed to give the monetary authority a scientific basis for doing this. To guarantee monetary autonomy the reformers were willing to jettison the erratic control of the gold standard. But they were no more willing than the gold enthusiasts to entrust monetary policy to governments. Monetary policy should therefore be independent both of the gold standard and of the state.
The main disputes at this stage concerned the transmission mechanism from money to prices. This harked back to still-earlier disagreements about the nature of money. Was it cash or credit? For Fisher, money was cash: control of the monetary base or ‘narrow’ money was key to control of prices. Since even at that time most transactions were financed by credit, there needed to be a determinate relationship between money and credit, which was found in the monetary multiplier. This depended on the existence of a ‘real balance effect’. Enter Fisher’s Santa Claus, sprinkling the cash equivalent of goodies round the house. Milton Friedman and the American monetarists were Fisher’s heirs.
Wicksell saw money as credit, not cash. The key to control of the money supply was the control of bank credit. This could only be done by regulating the price of credit (or interest rate); the terms on which banks made loans. The early Keynes was a Wicksellian; and central bank policy in the Great Moderation of the early years of this century, with its reliance on Taylor rules, owed more to Wicksell than to Fisher or Friedman.
However, Wicksell raised a troubling problem for those who relied on monetary therapy alone to keep prices steady. As Henry Thornton had already noted, there were two interest rates needing attention, not one. The first was Bank Rate, and the structure of commercial lending rates which supposedly depended on it. The other was the ‘natural’, or ‘equilibrium’ rate, the expected real rate of return on investment. The task of the central bank was to keep the market rates equal to the natural rate.
This was the point of entry for the Keynesian revolution. Keynes came to see that the crucial element of volatility in market economies was not in fluctuations in the price level but in fluctuations in Wicksell’s natural rate. So policy should be directed not to stabilizing prices, but to stabilizing investment. Fiscal policy had to be the main instrument of ‘demand-management’, since it was spending, not money, which needed to be managed.
The economic collapse of 2008–9 showed that monetary policy directed to the single aim of price stability was not enough either to maintain economic stability or to restore it. The economy collapsed, though the price level was stable.
QE was an attempt to apply Friedman’s lesson of the Great Depression, as learned by Bernanke, to a situation where nominal interest rates had reached their zero lower bound. Preventing a collapse in the money supply was to be achieved by what was euphemistically called ‘unconventional’ monetary policy, but was really just a re-run of Fisher’s Santa Claus. Pump enough cash into the economy and the extra spending it produced would soon lift it out of the doldrums. But this supply-side monetary therapy took no account of the collapse of investment demand. The recipients of the central bank’s cash either did not spend it, or did not spend it on currently produced output, so ‘broad money’ – bank deposits – fell, even as narrow money (reserves) exploded. In the language of Keynes’s Treatise on Money, the money got stuck in the ‘financial circulation’. At best it achieved about 20–25 per cent of the expected output gain, but at the cost of pumping up unstable asset prices and producing a finance-led recovery.
The crisis left the relationship between fiscal and monetary policy unresolved. If push came to shove, most policymakers in 2009 would have said that fiscal consolidation would restore sufficient ‘confidence’ to allow monetary policy to raise the rate of inflation. In fact, confidence was not restored. This left monetary policy ‘overburdened’. It was now expected to push up output as well as prices, with no more agreement than before about which pushed up what.
The best that can be said for QE is that it was a default position. Central banks were right to reduce Bank Rate to the zero bound. But the main effect of their reliance on portfolio rebalancing to boost output was to boost the portfolios of the wealthy, with minimal effects on output. One doesn’t need headwinds to explain why.
APPENDIX 9.1: A NOTE ON TIM CONGDON

Professor Congdon occupies an important but lonely position in the history of monetary thought and current debates about monetary policy. He can be called a Keynesian monetarist.
He is a monetarist in that he believes that the level of (nominal) national income is determined by the money supply, i.e. that changes in the money supply are the primary cause of changes in national income. (He also adds ‘and wealth’ from time to time.) Further, he believes that changes in the money supply have an equi-proportional impact on income; if the money supply increases by 20 per cent, then income will increase by 20 per cent too.82
All of which is to say he believes in the Quantity Theory of Money. But he is a broad money monetarist. He believes that broad money (cash and bank deposits, roughly speaking) is the relevant measure of the money supply. As such, he stands in contrast to Fisher and, at some points in his career at least, Friedman, who thought that national income was determined by the amount of ‘base’ or narrow money in the economy (cash and central bank reserves), as these in turn determine the level of bank deposits via the ‘money multiplier’ effect.*
As far as policy is concerned, Congdon believes that (a) the central bank can directly control the level of broad money in the economy, and (b) that as long as money growth is kept stable by the central bank, economic disaster can be avoided. In his account, the 2008 crash was caused by a fall in the quantity of money, and if central banks had simply pumped more money into the economy, then we could have been spared the worst of the recession.
So much for Congdon the monetarist. Congdon is also a peculiar kind of Keynesian in that he takes his Keynes from Keynes’s A Treatise on Money, not from The General Theory. Like Keynes, he believes in the possibility of autonomous collapses in the money supply (e.g. following a shock to investment), leading to falls in nominal income, but believes that these can be successfully offset by the monetary authority pumping money into the economy – if necessary without limit. Congdon’s spiritual home, that is, is with Irving Fisher, Ralph Hawtrey and the monetary reformers of the 1920s who tried to use monetary policy to prevent the oscillations of the business cycle. But he condemns the Keynesian attachment to ‘fiscal policy’ as at best redundant, and at worst (the more general case) pernicious.
Thus Congdon rejects equally the fiscal element of the Keynesian revolution and the money-multiplier mechanism of most monetarists. So he is something of an outlier. I have benefitted enormously from my exchanges with him, as well as from his published writings, but I always end up not quite understanding why he holds the positions he does – and so passionately. So the object of this note is to ask: is his position coherent? Are his prescriptions useful?
The interrogation can be grouped into three parts: his use of evidence; the gaps in his theory; and his rejection of any sort of fiscal policy.
Evidence, and the Use Thereof

Evidence is of utmost importance to Congdon. In contrast to mainstream work in economics – ‘unscientific and shoddy’83 – he believes that the monetarist approach is on the side of logic and facts, and that the evidence for his position is so ‘overwhelming’ that monetarism can be treated as a ‘true proposition’.84 So we might start by seeing if the evidence he presents can meet this high bar.
Congdon’s central piece of confirmatory evidence is the correlation between the rates of growth in nominal income and broad money over time. In one of our (many) exchanges, Congdon wrote, ‘the evidence is overwhelming – from all countries in all periods of more than a few quarters – that changes in [the money supply] and [nominal income] are related’.85
Could such evidence, by itself, secure the monetarist position? Surely not. Congdon’s claim is that changes in the money supply cause changes in national income. But we know that correlation does not imply causation, and in a fiat money economy there are compelling reasons to believe that the arrow of causation can run in the opposite direction. Nearly all money in the modern economy is created by commercial banks making loans,86 and it is plausible that banks’ lending behaviour is caused by changes in the real economy.
Congdon knows this. In contrast to his statistical over-confidence, he recognizes elsewhere that ‘the citing of numbers does not establish a definite causal link or prove a rigorous theory beyond contradiction’.87 Moreover, the faith he has in his evidence is not especially consistent. Indeed, he can veer from certainty to circumspection in the space of a page. In the Introduction to his Money in the Great Recession (2017), underneath a figure showing the behaviour of broad money in the 2000s, Congdon writes that ‘it is immediately clear that a decline in the rate of change in the quantity of money must have had a role in the Great Recession, just as it did in the Great Depression’.88 Yet later in the very same paragraph he cautions: ‘more research and analysis is needed before strong statements about causality can be ventured’!89
Interpretation aside, what about the evidence itself? In his contribution to Money in the Great Recession, Bank of England economist Ryland Thomas disputes the evidential backing for monetarism. First, he notes that ‘the behaviour of nominal spending in the early years of the [Great Recession of 2008–9] . . . did not conform to a simple monetarist relationship where spending follows broad money growth with a lag’.90
Such a finding is uncomfortable for Congdon. Nevertheless, he tries to circumvent this genre of criticism by conceding that, in the short-term, the causal link between broad money and nominal income/wealth can break down because of Keynesian-type ‘animal spirits’91 – a notion which elsewhere in the book he castigates as ‘woolly’, ‘imprecise’ and ‘journalistic’.92 Similarly, he emphasizes that changes in the money supply determine the ‘equilibrium’ level of nominal income and wealth, but that actual values can fluctuate around this point.93
Keynes’s rejoinder – ‘in the long-run, we are all dead’ – is apposite here. How long or short is the short-run? What happens in the short-run – in a recession, for example – has an enormous impact on people’s lives over a long period. Equilibrium theory is no use for analysing short-run fluctuations, since it excludes these by assumption. Yet Congdon has no qualms using the QTM to support his short-term policy prescriptions,94 even though it is an equilibrium theory.
In fact, Thomas’s statistics pose an even more fundamental problem for Congdon. Using data stretching from 1870 to 2010, Thomas notes that there is no evidence of a stable monetarist relationship ‘where contractions in money lead contractions in nominal GDP . . . in many periods broad money growth appears to move contemporaneously with or even to lag nominal spending’.95
That is to say, changes in nominal spending have often occurred before changes in broad money. In contrast to Congdon’s view, Thomas rightly concludes that ‘the relationship between money and spending within and across business cycles [i.e. in both the short- and long-run] is complex’.96 The evidence, then, does not prove Congdon’s case, as he seems to believe. It does not disprove it either. Highly abstract theorems like the QTM are so enfiladed with ceteris paribus conditions that they are neither provable nor disprovable. Thus it is always possible to say that quantitative easing in the UK in 2009–10 failed to boost broad money growth to the expected extent because of a misguided simultaneous tightening of banking regulations.97 A robust theory should not require too many qualifying conditions.
Theoretical Gaps

Congdon relies on theoretical argument – as all economists must – to support his monetarist hypothesis. Specifically, he proposes a transmission mechanism from money to nominal income/wealth based on the ‘real balance effect’.98 Congdon calls this the ‘hot potato argument’;99 it is the necessary assumption on which his theory hangs.
The basic argument is that agents have a desired ratio of money to expenditure. In the event of a monetary shock – if the central bank expands the money supply, for example – then agents end up with ‘too much’ money relative to this ratio.100 As a result, they increase their spending to get rid of the excess. The process continues until the excess is ‘extinguished by a rise in sales [output] or prices’.101 Which it is depends on whether there is any spare capacity in the economy, but either way nominal income increases.
The main criticism of Congdon’s transmission mechanism is that it is leaky. Take the equation of exchange, the identity at the heart of the QTM:*
MV = PT

Congdon argues that purchases of securities from the non-bank private sector directly increases broad money (deposits), which, according to him, will lead to an equi-proportional increase in nominal income. In other words, it has no impact on velocity. But this simply ignores the leaks. I focus on three here.
Will the money be spent?
In order for the real balance effect to work, agents have to respond to an increase in their deposits by actually spending their extra money; if they hoard it, the transmission mechanism breaks down. In terms of the equation of exchange, an increased propensity to hoard is reflected in a fall in the velocity of circulation.
Congdon may dismiss any such increase in liquidity preference as a short-term phenomenon. But quantitative easing has further implications for the behaviour of velocity. When a central bank engages in QE by buying securities and assets from private sector agents, most of it will go to the wealthy minority that owns substantial assets. The wealthy have a much smaller propensity to spend – they save a larger proportion of any increased money they get – than the poor. The consequence of such an exercise will therefore be to slow down the velocity of circulation, as a single given unit of money will change hands fewer times. The decline in velocity will at least partially offset the attempt to increase the quantity of money. The equi-proportionality condition is violated.
Similarly, the wealthy are much more likely to spend new money on buying assets and on financial speculation. Does this matter for Congdon’s transmission mechanism?
What if the money is spent on assets?
In the equation of exchange, T is composed of a mix of transactions that contribute to the real economy, and other transactions, mainly financial. The evidence presented in this chapter gives us reason to believe that a disproportionate amount of QE money will be spent on financial speculation, and not in the real economy, meaning that asset prices will rise. Should we worry?
Not according to Congdon. His argument is as follows: ‘a capitalist economy has a range of mechanisms by which arbitrage between different asset markets prevents prices and yields in one class moving out of line with prices and yields in another’. Further, ‘over time . . . the hot potato of excess money circulates from one asset market to another and from asset markets to markets in goods and services’.102
This assumes a perfect fluidity in money flows between the different factors of production. There is no allowance for stickiness. Again, Keynes’s reminder that ‘in the long-run, we are all dead’ is the right response to this line of argument.
Recent experience does not suggest that asset bubbles simply ‘sort themselves out’. Undirected expansion of the money supply, even if its intention is to boost nominal output, risks fuelling the next wave of speculation (cf. the dotcom bubble). Ironically, Congdon’s QE, far from restoring equilibrium nominal income, would be a source of further monetary instability.
What if the money leaks abroad?
People can get rid of their excess money by spending it on imports and the like, so that the money leaves the economy. This, though, does not obstruct the equilibrating mechanism in Congdon’s eyes. When the money leaks abroad, the exchange rate goes down, which leads to currency purchases which offset the previous leak, in a replay of Hume’s price–specie–flow mechanism. Ultimately, this tactic will ‘work’, in that the money will eventually work itself into the real economy. As Hume said, one cannot get water to flow uphill.
Flooding the economy with money hardly amounts to a scientific monetary policy. The truth is that monetarists have no idea how much money they will need to pump into an economy to lift it out of recession. There is no reason to believe that the private sector’s desired holding of cash balances is independent of the business cycle. In short, there is no predictable real balance effect. And one consequence of ‘feeding the hoarder’ is that when the hoarder starts to spend again and velocity approaches its ‘normal’ level, a lot of excess money is sloshing around the economy, setting the stage for a runaway inflation.
Rejection of Fiscal Policy

‘Forget about fiscal policy. It doesn’t do any good to short-run economic activity . . . and may do a lot of long-run harm.’103
Congdon’s objection to any form of fiscal policy is the hardest part of his position to understand. It is not that he objects to increased spending in a slump. Indeed, he believes that it is indispensable. Nor does he mind much whether it is the government or the central bank which ‘prints’ the extra money: he often uses the two terms interchangeably. It is to the government spending the extra money that he objects. His view is quite different from those of people such as Adair Turner, who have advocated ‘monetary financing of the deficit’. Congdon’s essential point is that the state should have no influence on the way the extra money is spent. Why is this?
Once again, he believes evidence is on his side. In a ‘statistical appendix’ to his 2011 book Money in a Free Society,104 Congdon presents data from a number of countries between 1981 and 2008 which show there is no relationship between changes in governments’ discretionary spending – the spending which results from cuts in taxes or deliberate boosts to spending – and changes in output gaps. Keynesian theory would suggest that an increase in fiscal deficits would cause a shrinkage in the output gap. But there is no evidence of such an effect. Therefore the Keynesian case for fiscal policy falls to the ground.
But the logic is faulty. The fact that changes in discretionary spending and output gaps are not correlated can be seen as evidence of the effectiveness of fiscal policy. Governments tend to respond to negative output gaps by increasing their discretionary spending – all other things being equal, then, one might expect a negative correlation between discretionary spending and budget deficits. But other things aren’t equal; there is no overall correlation, and so the negative correlation must be being offset by a different effect. The missing link lies in the positive effect of government spending on the output gap, i.e. in the effectiveness of fiscal policy!
Empirical support in favour of fiscal policy is at least as strong as the evidence Congdon marshals against it. Countries that responded to the Great Recession with more extensive fiscal programmes performed, on the whole, better than those which didn’t.
If the evidence is inconclusive, we have to turn to theory. And indeed, Congdon appears to reject fiscal policy a priori. He writes: ‘an increase in the public debt, due to the incurrence of a public deficit, is not an increase in the nation’s wealth’.105 This is rhetoric, not science. What if the money is spent on the creation of real assets, such as railways or houses? Following Ricardo, Congdon rejects the possibility of productive state spending.
Indeed, one of the main advantages of fiscal policy is that a government can direct the flow of the new spending in the economy. When a recession hits, private investment spending falls far more than consumption spending, and this cannot be wholly explained as a rational response to a fall in the long-run risk-return profile of investment – ‘animal spirits’ must be at play. Keynes recognized this psychological aspect to investment spending. In this event, the government can use fiscal policy to maintain a ‘normal’ level of investment, in order to avoid the erosion of the economy’s productive capacity.
Even if the government runs a deficit in order to finance its current spending, it can contribute to the wealth of the economy. This can be explained by reference to the equation of exchange. If the government borrows money from the bond markets that otherwise wouldn’t have been spent, and then spends this money, the overall velocity of money increases. Nominal income increases as a result, without any prior expansion in the money supply.
Of course, if the Quantity Theory of Money were the correct theory of macro-policy, there would be no need for discretionary fiscal policy: all the stabilization needed could be done by monetary policy. But the QTM begs so many questions, and attempts to apply it encounter so many ‘leaks’, that dogmatic rejection of fiscal policy seems indefensible to me on scientific grounds.
At one point in Money in the Great Recession, Congdon writes mockingly that ‘at the start of the third millennium economists sometimes pretend to be practising a “science” or at least an intellectual discipline with scientific pretensions’.106 Mainstream economics for him hasn’t been ‘scientific’ enough. When it comes to explaining the Great Recession, for example, the ‘mainstream view . . . is untestable, and deserves to be condemned as unscientific and shoddy’.107
My difficulty with Tim Congdon is that he is constantly invoking scientific ‘proofs’ in a field that defies scientific testing. His scientific efforts arise from a doomed attempt to ‘prove’ passionately held value judgements. He is a monetary reformer because he has an intense dislike of state intervention. As a result he dismisses any evidence that monetary policy may be ineffective and fiscal policy may be effective. Like the monetary reformers of a century ago he turns to money to ameliorate the human lot because he cannot bear to turn to the state.