The Great Economists Page 16

  In Britain, the pace of austerity had slowed alongside the economy, but was such a policy necessary? Part of the rationale for cutting government spending was that investors would not want to lend to the UK if it did not show that it was reducing its budget deficit. Otherwise the government’s debt might increase to unsustainable levels. This view was exacerbated by the context of the euro crisis that erupted in early 2010. Britain was, of course, not party to that crisis and may even have benefited as investors sought safer investments in non-euro countries. But that backdrop drove some of the thinking about deficits and austerity.

  At the end of 2009, during the midst of the Great Recession, Greece needed a bailout after admitting that its government accounting was at best unreliable. Investors sold off Greek government bonds and eventually other euro area countries with high levels of government debt also saw their borrowing costs rise. As fewer investors were willing to lend Greece money, it became more expensive and ultimately impossible for the Greek government to borrow to finance its normal operations. Portugal faced a similar problem. It was a different picture for Ireland and Spain as well as Cyprus, all of which rescued their own banks. But in doing so, their budget deficits shot up and they ended up also needing help from the ‘troika’ that oversaw the rescue programmes for countries which shared the single currency: the EU, the European Central Bank (ECB) and the IMF.

  European governments believed that fiscal discipline was needed to restore investor confidence, so pushed ahead with austerity. Before the crisis, Greece borrowed at the same advantageous rates as Germany since bond markets seemed to view the euro area as one entity. That contributed to too much borrowing by the Greek government. Though that scenario is unlikely to be repeated, euro area leaders came up with additional reforms to try to enforce fiscal restraint. They stressed the need for member countries to adopt fiscal discipline if they are to share a single currency and a common monetary policy.

  There is a move to create a fiscal union which would go beyond the budget deficit rules that are centrally enforced by the European Commission, which can set penalties for countries that miss their targets. There is even discussion of establishing a European Treasury as the central fiscal authority for the euro area. It certainly adds a political dimension to the austerity debate and also raises questions over whether the EU is heading towards a federal system, with fiscal powers split between nations and supranational institutions.

  After the acute phase of the euro crisis subsided, concerns over economic weakness prompted the ECB to do something it declined to do during the Great Recession. For the first time, in 2015, the ECB undertook quantitative easing (QE) and made large-scale cash injections into the economy by buying government debt. This increase in the amount of money available to lend had, via the simple mechanics of supply and demand, the effect of driving down borrowing costs, which have since remained cheap. This is in the context of low government bond yields around the world, which would be expected in a slow-growth environment.

  The combination of slow growth and low borrowing costs has added a new dimension to the austerity debate. Should governments be taking greater advantage of cheap rates to invest? Should budget deficits and debt be a secondary consideration when economic growth remains sluggish?

  Investment and low interest rates

  This question is being asked in both Europe and the US. In America, there is a push for more infrastructure investment, although the Republicans in Congress remain concerned about adding to the fiscal deficit. Of course, Republicans traditionally follow a non-interventionist philosophy, and are suspicious about the role of government in both investment and the economy in general. As former Republican President Ronald Reagan observed of government intervention: ‘government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. If it doesn’t move, subsidize it,’23 and remarked on a separate occasion, ‘The nine most terrifying words in the English language are: I’m from the Government and I’m here to help.’24

  This explains why the US plan is counting on private investors to help finance its projects.

  On the other side of the Atlantic, the debate over investment has found more political common ground. Britain has moved into the spotlight when it comes to this debate since the vote to leave the European Union in June 2016 led the Bank of England to restart QE, which helps sustain low borrowing costs. Yields on ten-year government debt, known as gilts, fell to record lows of around just 1 per cent after the Brexit vote. Record lows had also been reached for twenty-and thirty-year debt. It meant that, for the first time, the British government could sell debt by paying around 1 per cent interest for a decade. Even with interest rates being raised in 2017 for the first time since the banking crisis, borrowing costs remain fairly low. So, do low interest rates affect the question of whether governments should borrow to invest now?

  Keynes pointed out that there is no ‘crowding out’ of private investment when the economy is operating below its potential. ‘Crowding out’ refers to how governments borrowing to invest would make it harder for private firms to do so because their demand for loans would push up the interest rate and make it more expensive for others to borrow. However, since the British economy lost over 6 per cent of its output during the 2008 recession, and interest rates for loans are low, ‘crowding out’ would be unlikely, because the economy has lost so much output that there is a lot of scope for the public and private sectors to invest before their demand for funds pushed up borrowing costs. Moreover, increasing public investment can help economic growth, as it can have a ‘crowding in’ effect. In other words, government investment can make private investment more efficient, for example a good telecoms infrastructure increases the returns to a pound invested by a private company by giving them the fibre network to deliver faster services.

  In Britain, public investment has been slashed deeply. It is easier to cut capital expenditure on projects such as highway repairs than to reduce the current budget dominated by public sector services. During the height of austerity, between 2008 and 2011, public investment fell from 3.3 per cent of national output to 1.9 per cent, a staggering 40 per cent decline. Will that ground be made up and, more pertinently, will this trend of low investment be reversed? It would likely mean adopting Keynes’s view that public investment should be separated out from what governments spend from day to day. Unlike such current spending, Keynes would argue that investment generates future returns and should not be lumped in with daily payments for civil servants in assessing the budget of a government. Indeed, with the establishment of a National Infrastructure Commission in 2015, and given this context of low borrowing costs, the British government now aims to invest and reverse the years of cuts to public investment.

  The European Union has also acted on a large scale. The EU changed its focus to take advantage of low rates in a way that should not lead to ballooning budget deficits.

  European Commission President Jean-Claude Juncker’s infrastructure investment fund, the European Fund for Strategic Investments (EFSI), commonly referred to as the Juncker Plan, was established in 2015. It sought to raise the considerable sum of €315 billion over three years by working with the European Investment Bank (EIB), which issues bonds to finance projects that develop digital, transport, energy and other infrastructure, as well as improve funding for small and medium-sized enterprises (SMEs). This is indeed a way to leverage a relatively small sum into an ambitious pool of money. The EU has itself invested €16 billion and there was a further €5 billion put in by the EIB. The top AAA-rated EIB can then issue bonds, taking advantage of low interest rates, to leverage the initial €21 billion into a fund large enough to make a difference in jump-starting European growth. The European Commission plans to increase the size and duration of the EFSI. Bolstered by its initial success, European policymakers are keen to rejuvenate infrastructure, which needs to be updated in many countries in order to keep up with the needs of business
es, particular in a fast-changing digital era.

  The EFSI ambitiously seeks to encourage private companies to invest, thereby largely reducing the impact of the infrastructure spending on government fiscal positions. But that means a reliance on public-private partnerships, which have a mixed record when it comes to maintaining long-term infrastructure projects, such as railways.

  Still, the focus of the fund on small and medium-sized enterprises, which are Europe’s best job creators but have suffered most from the low amounts of bank lending while the banking system rebuilds itself after the financial crisis, is pertinent.

  These SMEs would also benefit from updated infrastructure. During the last recession, it was public investment that was slashed as a part of austerity programmes in the EU, just as it was in Britain, much to the detriment of spending on infrastructure. Investment in the euro area has been around 15 per cent below its pre-crisis level. Thus, the OECD and others have argued that increases in public investment would boost economic growth and thus even reduce government debt.

  Why, then, has it been so difficult to increase investment since the crisis? One constraint has been the imposition of fiscal austerity by governments whose main focus is on the budget deficit, which for the most part includes capital investment. It’s only in the very recent past that economic growth has regained priority. That largely explains the public side, but private investment has also dropped sharply since the recession.

  German companies, for instance, have doubled their retained cash in the past decade, and others have as well. American multinationals have amassed record amounts of cash on their balance sheets. Resolving why these companies don’t invest is key to understanding why one of the pillars of growth, investment, hasn’t delivered during the recovery.

  Government and consumer spending were hit hard and slow to recover, leaving deficient demand, both public and private, which is a disincentive for companies to invest since future sales don’t look strong. The sharpness and the duration of the Great Recession also created uncertainty over whether or not to commit funds for investment stretching well into the future. Plus, the time it took for decimated banking systems in Europe and America to recover forced some companies to retain their earnings in case they needed cash during a time when bank lending remained constrained. For investors there were also other, more enticing, places to put cash. Stocks, for instance, were pushed to sky-high levels by low interest rates across major markets. But global stock markets have since been descending from their heady heights. And there’s uncertainty from the US, which has begun to normalize (i.e. raise) interest rates earlier than the rest of the world. This means that investments with fixed returns, such as in infrastructure, can be relatively more attractive. Traditionally, investing in roads or energy doesn’t achieve a high return, though it does tend to be stable. Yields from infrastructure such as utilities and toll roads are usually set by regulators and range from 3 to 4 per cent. In a low-rate environment, that’s not a bad return. Of course, one of the challenges is still the slowness with which major public projects are granted approval. Still, there’s no shortage of such projects being proposed by EU member states. In any case, growth in the world’s largest economic entity would help the world economy.

  The renewed focus on growth by not just the European Commission but also national governments offers more opportunities to reconsider the investment and growth nexus pointed out by Keynes. The debate over whether governments should themselves be borrowing more to invest, and whether such capital expenditure should be separately considered in budgets as Keynes proposed, is unsettled. So, what would Keynes make of the current austerity debate, which has shifted to become more about a debate over government investment?

  Keynes on the government’s role in the economy

  Keynes argued for government spending as a means to counteract slow economic growth. Especially during a recovery from a recession or depression, private demand is deficient, so extra spending by government is needed to ensure that aggregate demand remains sufficient to maintain full employment. But what would Keynes have made of the debate over governments borrowing to invest in times outside acute crises or recession?

  The cash hoarding that he predicted is evident in the post-crisis economy. Even though interest rates are very low, not enough firms are borrowing to invest, which has contributed to the slow-growth environment. For the reasons noted earlier, when investment doesn’t respond to interest rates, unlike in normal times, monetary policy is no longer enough to boost the economy, which means that fiscal policy is also needed to increase investment and generate more growth.25

  Investment is one of the components identified by Keynes that make up the level of aggregate demand in the economy. Consumption is generally viewed as being more stable than investment. When income increases, consumption tends to rise but not as much and also declines by less. Since some income is saved while the rest is consumed, the gap between consumption and production must be filled by investment if full employment is to be maintained.

  Classical economists had assumed that savings automatically became investment. Keynes’s insight was to treat savings distinctly. He discovered the ‘paradox of thrift’ that arises when, as more people try to save, the aggregate amount of savings in an economy actually falls. This happens because, as savings increase, consumption falls, which reduces total output, which in turn reduces the income from which savings are made. The problem gets worse the richer societies become since wealthier people tend to save a higher fraction of their income. This is why he advocated ‘heavy death duties’, which would redistribute wealth, especially unearned wealth, towards those more inclined to consume than save.26 So, some redistribution of wealth from the rich would help investment, but Keynes worried that too much redistribution would hurt growth.

  As Keynes believed that the normal tendency was for the marginal propensity to save to be stronger than the incentive to invest, he was supportive of governments borrowing to invest since he believed the economy usually operated below its potential and public investment should therefore supplement private investment. His idea was to use fiscal policy to maintain a high level of public or semi-public investment. Investment should encourage consumption by raising the overall level of output and thus income to consume out of. The more consumption there was, the higher the national income, and therefore the greater the savings of the society that could be used to finance investment. A permanently high level of publicly directed investment would offset fluctuations in private investment, and contribute to the economy remaining in a ‘quasi-boom’.27 Keynes viewed the state as an investor in line with its role in providing a social safety net discussed earlier, though he worried about the costs of Beveridge’s welfare state.

  Keynes proposed government action to accelerate or delay investment projects as necessary: ‘I expect to see the State … taking an ever greater responsibility for directly organizing investment … I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.’28

  Keynes urged the government to take on a greater role in investment as the need became clearer. His notion of ‘socializing investment’ may well encompass a government-backed infrastructure bank or fund to help get projects off the ground. He might not have viewed private sector participation as necessary, but might have been willing to include private investors who would pool their money with the government to build infrastructure. This is in line with the EU investment fund described earlier that leverages public funds to attract private financing.

  Would this policy lead to persistent budget deficits? This was one of the criticisms of Keynes. It’s why governments have been reluctant to borrow to invest. They fear bond investors will ask for higher returns to lend them money, increasing the borrowing costs for a country that could jeopardize its economic growth.

  The verdict is far from settled. The Chicago School of monetarists say that Keynes’s cou
nter-cyclical policies are bound to fail since their effects will be anticipated, either immediately or after a short lag. Harvard economist Robert Barro argues that future tax rises to pay for government deficit spending are figured into long-term interest rates by investors and savers. That will lead to higher rates in the future and make government borrowing more expensive and the budget deficit less affordable. This view can be traced to David Ricardo. Under Ricardian equivalence, rational people know that the government debt will have to be repaid at some point in the form of higher taxes so they save in anticipation and do not increase current consumption that boosts growth. Still, the perceived need to increase investment and economic growth has shifted the public debate closer to what Keynes advocated even during non-crisis times. There is also a growing inclination to separate capital from current spending in government accounts, so investment doesn’t count the same as day-to-day public spending. Given the debate over low investment, low borrowing costs and concerns over growth, Keynes’s relatively lesser-known views on public investment could have a greater impact on the structure of an economy than his better-known arguments about government deficit spending.

  Keynes’s legacy

  Keynes passed away in 1946 after helping to construct the post-Second World War Bretton Woods System, which included the formation of the sister institutions of the IMF and the World Bank. His memorial service was held at Westminster Abbey, close to Parliament, where he had latterly become a member of the House of Lords. He was survived by his widow, Lydia Lopokova, who continued his work with the Arts Council of Britain and lived another thirty-six years.