Posted by Joseph Y. Calhoun, III

If you want to know why the UK economy is in such bad shape, reading this dribble from David G. Blanchflower, former member of the MPC, should be enlightening. He is quite concerned that governments will get a clue and cut spending. Since he reveres Keynes that is seen as tantamount to economic suicide:

March 10 (Bloomberg) — John Maynard Keynes wrote during the Great Depression that only “fools and madmen” will tell you “the path of escape is to be found in strict economy.”

Several countries have now started “strict economy,” or fiscal tightening, after the biggest financial crisis since World War II. The most obvious examples are Greece and Ireland. Portugal has released plans to cut its deficit to 2.8 percent of gross domestic product in 2013 from 8.3 percent this year by reducing spending on civil servants and public investment, and raising taxes on high incomes and stock-market gains.

Any cuts in spending need to be dependent on evidence of growth in private industry. Growth is what will generate an increase in tax revenue. A sensible proposal would seem to be that the fiscal and monetary stimulus should continue at least until half of the loss in growth since the start of the recession has been re-established. Later is better than sooner.

In Blanchflower’s view of the economy, further debt is the only cure for the pain wrought by excessive debt. If you find that a bit confusing that’s because you obviously haven’t read John Maynard Keynes. Or it could be because you have - The General Theory is hard read. Here’s one area where the Keynesians go wrong:

All this talk of fiscal retrenchment is too much, too soon. Cutting public spending will increase unemployment, unless monetary policy can be loosened to compensate, and there seems little leeway to do that.

Well, I’d have to agree that tightening the fiscal purse and not offsetting it with a loosening of monetary policy would likely lead to another dip in the economy. But why is monetary policy constrained? It is constrained because of the huge current fiscal deficits. Central banks do not want to be seen as enabling the government spending by monetizing the debt and so must run a tighter policy than they normally would to compensate. If the fiscal deficits were less - or even better eliminated - then the central bank would have the leeway to accomodate the demand for money and prevent deflation. Any positives from a deficit financed fiscal stimulus will almost totally be offset by a tighter monetary policy.

There is a price to pay for the past profligacy of governments and individuals, both of which ran up debts spending more than they could afford. The price can be paid in several ways but it must be paid. If you use fiscal policy to try and improve the economy you just make the problem worse. The debt that is the source of the problem just grows larger and any positive effects are largely offset by the central bank running a monetary policy that is tighter than it would otherwise be. They have to do that to maintain market credibility on inflation. If the market perceives the central bank as monetizing government debt it is game over. On the other hand, if you use monetary policy to stimulate demand, the debt doesn’t rise and the economy will respond through a rise in exports via a lower exchange rate. This isn’t perfect since you get higher inflation and more malinvestment but it is better than deflation and it is better than fiscal stimulus.

If Mr. Blanchflower is typical of the thinking of the MPC in the UK it is no wonder their economy is in such sad shape.

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