Advancing a Free Society

Surely You’re Joking, Mr. Keynes?

Sunday, April 24, 2011

Writing about web page http://www.debtonation.org/wp-content/uploads/2010/06/Fiscal-Consolidation1.pdf

The British government is seeking to bring the public debt under control by cutting back public spending. A popular story is going around, however, that suggests this is either crazy or a thinly disguised plot to undermine the public sector; see for example Johann Hari's blog, The biggest lie in British politics, March 29, 2011.

How does this story work? It runs like this. Start from the government’s plan for cutting public spending:

  • With lower spending, the national income will fall.
  • With lower national income, tax revenues will fall.
  • With lower tax revenues, public borrowing will remain high.
  • With public borrowing still high, the public debt will be hard to shrink.
  • The burden of the debt relative to GDP could even rise.

In this story, the public debt is hard to control because it pushes back when the government tries to cut spending. It pushes back so hard that cutting public spending is actually counter-productive. In fact, the story implies that the government should spend its way out of debt! This is because more public spending would generate higher national income, higher tax revenues, less borrowing, and less debt relative to GDP.

How good is this story? It has a logic, purely Keynesian in spirit. But is it true? One issue could be that it leaves such factors as business confidence and the exchange rate out of the calculation. Ultimately, however, it’s an empirical question. That is, it can be answered by looking at how the public debt has actually responded to changes in public spending in the historical record.

It’s clear how both the UK Treasury and the independent Office of Budget Responsibility answer this question. They predict that, with the current fiscal squeeze, Britain’s public debt will rise more slowly, peak in 2014 at around 70 percent of GDP, and then start to fall. In other words, deficit reduction will eventually win. Given enough time, cutting public spending will not be counterproductive.

Continue reading Mark Harrison…