Article / 31 August 2016 at 1:46 GMT

Economists collide over Keynes redux

Managing Partner / Spotlight Group
United Kingdom
  • Global interest rates are low, in some cases below zero
  • Academics contend that monetary policy is exhausted 
  • They advocate greater government expenditure to boost growth 
  • The evidence is not in favour of the Keynesian multiplier 
  • Central bankers advocate structural reform as the way ahead

By Stephen Pope

The elite of global central banking assembled over the last weekend of August at Jackson Hole in the Grand Teton National Park, Wyoming.
They probably imagined that they were gathering to consider the ways and means by which sophisticated monetary policy and further liquidity incentives could contribute to boosting national, regional, and indeed global, GDP. As usual their doors were opened to fellow economists from academia.

 Keynesian advocates take on central bankers over their policy prescriptions. Photo: iStock

However, the central bankers were provided with something of a rude and unexpected shock from Christopher A. Sims, an American econometrician and macroeconomist. He currently holds the John J.F. Sherrerd Chair as Professor of Economics at Princeton University and boldly told the assembled masters of money that their policies were making things worse!

He deserves to be listened to as, together with Thomas Sargent, he won the Nobel Memorial Prize in Economic Sciences in 2011 in recognition for his empirical research on cause and effect in the macroeconomy. [1]

He dismissed the decline in interest rates since the global financial crisis, to zero or even negative in some cases, and challenged the idea that the time value of money should ever be seen as negative.
Global Interest Rates
Source: Global Central Banks

Instead he told the central banking community that increased government spending was required to lift the world’s major economies from stagnation. The pursuit of innovations in monetary policy was diverting attention from the inaction of fiscal policy makers.

Professor Sims said:

“...So long as the legislature thinks it has no role in this problem, nothing is going to get done ... the best hope is that people at central banks are willing to say publicly that this is what is necessary.”

In rates we trust

Developed nations around the world have leaned on their central banks since the financial crisis of 2007-8. The US, Eurozone, UK and Japan have all turned to their respective monetary authorities to deliver highly accommodative policies and many liquidity inducements to encourage increased spending by businesses and consumers.

Much of this has been done against a backdrop of austerity as government spending has been trimmed in the face of rising levels of debt to GDP. To this extent, in most developed economies it is monetary policy alone that has been the anvil upon which whatever economic recovery transpired was forged.

Professor Sims is just the latest among a growing number of experts including another Nobel Laureate, Professor Paul Krugman [2], and Larry Summers [3] who warn that this experiment has reached its limits.

In the Eurozone and Japan rates have fallen to 0.0% and -0.10% as an attempt to encourage borrowing and spending. Sadly, job creation, GDP growth and inflation remains subdued. The situation in these two economies was cruelly summed up when the audience politely laughed as Benoît Coeuré, an official of the European Central Bank (ECB), pointed out that in the Eurozone inflation had doubled last month from an annual rate of 0.1% up to 0.2%. The Eurozone has not achieved its CPI target of +2.0% since December 2012.

Increase state spending? Oh please, not this nonsense again!

My regular readers will know that I am no fan of excessive state expenditure. I have seen much empirical evidence verifying that government expenditure, both at a national and especially a local level, is highly inefficient at spending tax payers' money or borrowed funds.

So I scratch my head when I hear leading luminaries of economics and investment all jump on the hobby horse of a larger role for the state. That is the route to a socialist experiment, one that has repeatedly failed. If in doubt, just look at France under the rule of François Hollande.

I would counter this view by noting that in the US there was no hard-biting austerity and yet real GDP growth increased at an annual rate of 1.1% in second-quarter 2016, according to the second estimate released by the Bureau of Economic Analysis (BEA). Inflation remains weak as consumer prices rose 0.8% year-on-year in July of 2016, following a 1.0% increase in the previous two months and below market expectations of 0.9%. It is the lowest inflation figure since December.

What about market minds?

Mohamed A. El-Erian, formerly at PIMCO and now the chief economic adviser at Allianz, warned in a recent book, “The Only Game in Town” [4], that time was running out. If developed nations do not increase spending and pursue structural reforms in the next few years, Mr El-Erian predicted, they will be locked into a new reality of slower growth.

Mr El-Erian suggests that unless rates are increased central banks will be severely handicapped as they try to ward off future economic crisis, as they would have little room to cut rates. I am sorry, but this writing is the sort of pabulum that is in denial about the depth of the current crisis. Raising rates now in Japan, the Eurozone and UK when the economies are so fragile would simply undermine the level of GDP and its growth for the next eight quarters, if not longer.

This would be central-banking cacoethes and prove to be inimical to the goal of growth and price stability.

I will agree with Mr El-Erian that the situation of the global economy is increasingly exigent and that what is required is a positive movement away from an excessive level of dependence on central banks. However, that means the national governments around the world must do more, not expect the central banks to do less. But they must do more, as Mr El-Erian says, on structural reform, but not on state spending.

This is a time to unleash entrepreneurial zeal by using an increasing amount of supply-side reforms. It is no time to raise corporation tax, as the UK’s opposition Labour leadership contenders want to do, nor is it time to give more ground to trade unions. Business enterprise has to pay its fair share of tax, but just that: a fair and incentivised share.

Time to confront Keynes

Any student of macroeconomics will learn that a basic identity of the discipline is the Keynesian identity, i.e.

Y = C + I + G + (X – M )

This is not theory – not at all – it is an identity. The level of national income or GDP, i.e. Y in the identity, will rise if government spending, or G, rises and all other things remain the same. However, in most cases if G increases it is down so through an increase in taxation so consumer expenditure C and/or business investment I will decline.
US Govt Spending
Source: BEA . Create your own charts with SaxoTrader; click here to learn more

What the chart shows is not that when spending goes up it adds to GDP growth or when it declines it subtracts from it. The coloured rectangles in the top panel represent the different components of US government spending from 2006 to 2014. They indicate how the change in each component, be it positive or negative, relates to the change in the overall level of GDP. 
The black line is not GDP growth but is instead the sum of the various components of government spending, i.e. total G. GDP growth is shown in the bottom panel.

The green and red overlays show that from 2006 to 2009 government spending rose and yet GDP growth contracted. Then from 2009 to 2012 the opposite was the case. Even if we run the data and lag GDP growth so that G in time period n influences GDP growth in n + 1 or n + 2, the impact is barely altered.

The whole argument over boosting GDP growth by boosting government expenditure is based on the economic idea of “ceteris paribus”, i.e. all other things will remain equal.

The typical Keynesian advocate (Sims, Sargent, Krugman and Summers) will say that an increase in G will cause private consumption and investment to increase also, so that a unit of extra government spending will cause GDP to rise by more than a single unit. This is the Keynesian multiplier.

I am with the counter view which stems from the Austrian and Chicago School. I suggest that an increase in G will tend to make private-sector spending fall by a greater amount, so that a unit of extra government spending will cause GDP to fall.

Indeed, through history there are examples of both national and regional governments wasting money. Contracts get awarded on a basis of graft, political favour and honouring old debts. Projects go ahead not on the basis of a “Return on Capital Employed”. More realistically it is done on the basis of “Building Political Capital”.

In short, money spent by politicians is not nearly as likely to channel resources to valuable uses as money spent by private investors. One reason for this is that governments are inclined to raise taxes and are also inclined to boost welfare spending. 

That means that before any welfare monies find their way back into the economy there is a long time lag, the addition state spending has to go through several filters before being allocated. The eventual area of welfare recipient spending is typically on lower-value-added products that do not add much to the overall growth of the nation. Better to overhaul the welfare system so that the most vulnerable receive their due whilst malingerers are rooted out.

A decrease in taxes has the opposite effect on income, demand and GDP. It will boost all three, which is why people cry out for a tax cut when the economy is sluggish. When the government decreases taxes, disposable income increases. That in turn translates to higher consumer demand and increased production, i.e. GDP.

I have little sympathy for banks that say they cannot earn from a zero-rate, flat-yield curve environment. Many banks are paying the price for having been far too casual with their credit facilities in the past. Too many banks have been given a clean bill of health by inadequate stress tests.

My suggestion is that monetary expansion can continue whilst the focus of fiscal policy prescriptions for a sluggish economy and high unemployment is lower taxes. The central bankers would agree as they have constantly urged lawmakers to tackle structural inefficiencies and liberalise the labour market.

Low rates, low taxes, low state spending and low barriers for fairly regulated enterprise. It is the market enterprise that will deliver growth, not the dead hand of the state, which is slow, unaccountable and fiscally irresponsible. There is a need for new economic, liberal thinking, not a Keynesian redux.

What a shame not too many are listening.


[1]Christopher Sims and Thomas Sargent studied how economic policy, such as raising interest rates or cutting taxes, affects macroeconomic variables such as GDP and inflation.

The academy said Sims had developed a method based on "vector autoregression" to analyse how the economy is affected by temporary changes in economic policy and other factors, e.g. the effects of an increase in the interest rate set by a central bank.

In praising Thomas Sargent, the academy identified his work examining the post-World War II era, when many countries initially tended to implement a high-inflation policy, but eventually introduced systematic changes in economic policy and reverted to a lower inflation rate.

[2]: Nobel Memorial Prize in Economic Sciences 2008

“New Trade Theory and the New Economic Geography”

Sole recipient, Professor Paul Krugman

Professor of Economics at the Graduate Center of the City University of New York

[3]Lawrence Henry "Larry" Summers is President Emeritus and Charles W. Eliot University Professor of Harvard University.

US Treasury Secretary July 2 1999 ~ January 20 2001 under President Bill Clinton

[4]“The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse”, El-Erian, Mohamed A. Penguin Random House © January 26, 2016 ISBN: 9780812997620

— Edited by Susan McDonald

Stephen Pope is managing partner at Spotlight Ideas

goldfinger goldfinger
A well written and considered piece. I enjoyed reading it. Of course banks make money in a zero interest environment. Look at credit card and overdraft rates.I have a couple of friends paying 7% on borrowings because they won't give guarantees. Banks need to look at their top line and how to reduce it.. But that would mean mega bonuses being cut, but don't let me go on about overpaid and non-intelligent footballers.
johnnyw johnnyw
Glad to hear you like the Austrian School (I did the Level 1 online course), I really like the Austrian school. The Chicago school and the Austrians are very different. The Austrians from what I understand think these macro 'aggregates' are meaningless. Economics in One Lesson would basically argue against almost all government intervention 'helicopter' money as well as inflation. I think these arguments make a lot of sense, and I suspect the only reason why 'mainstream' economics is 'mainstream' is because of the political vested interests and from private corporations that gain significant privileges from it (such as removal of competition from the market or government enforcing regulatory barriers of entry). Like you said, socialism will fail, and I don't like what I see when I listen to these decorated elites and 'experts.' I'd rather listen to Robert Murphy argue with the nobel prize holding Krugman.


The Saxo Bank Group entities each provide execution-only service and access to permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on or as a result of the use of the Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer
- 沪ICP备13028953号-1

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail