Image via Wikipedia
The media, most economists, and more especially left-wing politicians, often claim that cuts in government spending will hit economic growth. The idea is that cuts in spending will reduce demand in the economy, and that in turn will cause the economy to shrink.
They also believe that low interest rates are needed to boost growth. They worry that as the Bank of England raises rates to hold down inflation, growth will suffer.
This is, of course, the now infamous Keynesian idea that recessions are caused by insufficient demand in the economy. Yes, the Bank of England, the BBC and others all seem still to be entranced by that old idea.
Think about it all for a moment. The theory on fiscal policy is that the government’s borrowing and spending huge amounts of money (over 12 percent of GDP currently) will boost the output of the economy.
This theory is based on a fundamental misunderstanding of how markets work.
We all know that if demand for a product rises, the price rises. That in turn encourages production of that product (and tends to reduce demand). This feedback mechanism is the “price mechanism”, which ensures that in a free market, supply and demand are always balanced.
If the government borrows and spends, pushing up demand, that will push up prices – in other words, inflation will result. Even Keynesians acknowledge that. But they go on to claim that the increased demand will encourage increased supply.
The truth is that the encouragement to increased supply from increased demand acts through the price mechanism. It is that rise in prices that transmits the fact of increased demand for a product to increased supply of it.
But what if the demand is spread across the economy? Won’t that same mechanism cause output in general to increase? Keynesians think so, but they are wrong.
If prices in general are rising, as opposed to prices of a specific product, then there will be no particular incentive to produce more. This is because input costs will have risen, and the value of any profits made will have fallen, in proportion to that inflation. All that has happened is that the value of money in the economy has gone down.
If demand for bread goes up, the price goes up, and producers produce more. They do so by diverting resources in the economy from other uses, where the price has not similarly risen. They expect to make more money by doing so.
But if demand for everything rises, the price of everything goes up, and producers will not produce more – they might make more profit in cash terms, but since the price of everything has risen, that profit will be worth less to them.
We currently have an economy where the government is borrowing and spending enormous quantities of money. We have stalling output, though, and resurgent inflation. None of that is a suprise, except to Keynesians. Keynesians think that government deficits boost output and cause inflation as a by-product. In truth, government deficits simply cause inflation, and have little or no effect on output. And because they increase the role of government in the economy, over the longer term, they actually depress output, because government provision is less efficient than private provision.
So what of monetary policy? We currently have very low official interest rates and a credit shortage. It is believed by Keynesians that low interest rates stimulate the economy and increase production. They do so, it is alleged, by stimulating borrowing and spending, and discouraging saving. Back to that demand management again – this time working by boosting private sector demand rather than government demand.
In normal times, it is true that low interest rates stimulate borrowing and spending. However, exactly like borrowing and spending by the government, private borrowing and spending stimulated by low interest rates simply causes inflation, and does not increase output.
Excessively loose monetary policy does not stimulate economic growth. It simply causes inflation. That was the great revelation of the Monetarists in the 1980s.
But now it’s worse. Credit is no different from any other commodity. If you reduce the price (interest rates) then you encourage demand. But you also discourage supply. And lo and behold, we now have a credit famine, with credit-worthy businesses complaining that the banks will not lend.
Governments across the world are tackling the recession with historically low interest rates, far lower than the markets are signalling is appropriate, and with high borrowing and spending. The result is inflation, a credit famine, and recession. Economists and politicians are puzzled. How can these be the result of the policies that they have been brought up to believe are appropriate to tackle such circumstances?
In order to stop being puzzled, they need to rethink their whole concept of how the economy works.
To tackle inflation, we need much lower government spending and borrowing, and higher interest rates. That much is at least dimly understood by most.
What is not understood is that these policies will not adversely affect output. The truth is this: output cannot be massaged by managing the level of demand in the economy.
Indeed, by creating a credit shortage, the current monetary policy at least is hurting our output figures. Higher rates would help with this aspect at least.
To more comprehesively boost output and cut unemployment, we need supply side measures. That means reduced regulation and red tape, better education, lower taxes and so on. These are not a quick fix. They need concentrated work over many years to really get right. We embarked on that in the 1980s under Margaret Thatcher and Nigel Lawson, and then lost our way on it again with Tony Blair. We haven’t found our way again yet. Unfortunately David Cameron and George Osborne seem only too keen to believe the quick fix nostrums of the quack economists who seem to dominate debate.