Wednesday, March 7, 2012

Killing Keynes

There have been some suggestions recently that the revised fiscal rules which all 27 EU members have already agreed to as part of the revised Stability and Growth Pact and which 25 of the 27 are proceeding to “transpose the ‘balanced budget rule’ into their national legal systems, through binding, permanent and preferably constitutional provisions” via the  Treaty on Stability, Coordination and Governance is the death of Keynesian-style fiscal policies in the EU.  That is not the case.

Keynesianism, as it is typically described now, is a counter-cyclical policy that allows governments to run deficits in bad times is respond to downturns with “sufficiently large” surpluses run in the good times to fund these deficits.  Virtually all countries are very good at achieving the former, but very few accommodate the latter.  Rather than outlawing counter-cyclical policy the fiscal rules are actually an attempt to formalise it as is said in the SGP.
Member States should achieve a more symmetrical approach to fiscal policy over the cycle through enhanced budgetary discipline in periods of economic recovery, with the objective to avoid pro-cyclical policies and to gradually reach their medium-term budgetary objective, thus creating the necessary room to accommodate economic downturns and reduce government debt at a satisfactory pace, thereby contributing to the long-term sustainability of public finances.
Of course, this is not to suggest that Lord Keynes himself would be a devout advocate of this approach to fiscal policy.  Keynes did favour a counter-cyclical pattern of expenditure but his emphasis was on the confidence effects that increased government capital expenditure can offer in a downturn, rather than current expenditure which has become the emphasis of government expenditure.
In one of his more whimsical moments in the GT Keynes wrote:
"If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again . . . there need be no more unemployment. . . . It would indeed be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing."
Although the government is essentially giving away the money it is doing so in a manner to stimulate private-sector investment in order to obtain the money.  Anyway, away from Keynes and back to Keynesians.  Here is a table which shows how the proposed ‘balanced budget rule’ incorporating a 0.5% of GDP limit on the structural deficit is counter-cyclical.
Counter-cyclical balances
The first column is the output gap: the difference between the forecast actual GDP and the estimated potential GDP.  We will not go into the difficulties of determining this here.  The next column is the sensitivity of the budget balance to the output gap.  The figure used here is 0.5 which is not too different from the EU15 figure of 0.49 used by the European Commission.  The figure for Ireland is 0.40.  All the current sensitivity estimates can be seen here.

Multiplying the first number by the second gives the cyclical-component of the budget balance, i.e. the impact of the economic cycle of the budget.  For example, if the economy is growing above its potential rate and has an output gap of 2% of GDP this is forecast to lead to an improvement in the budget balance of 1% of GDP.
If a country has a debt of greater than 60% of GDP the allowed structural balance is 0.5% of GDP.  Adding the two together gives the overall balance the country should be aiming for at different stages of the economic cycle.

If should be clear that the allowed overall balances are counter-cyclical. When the economy is growing above its potential it is required to run overall surpluses, and in a downturn it is allowed to run deficits.  In the case of a very large output gap of –4% of GDP it can be seen that the rule allows a deficit of 2.5% of GDP. 
Counter-cyclical government spending has not been outlawed.  The intention is to try and ensure “sufficiently large” surpluses in the good times.  There is no guarantee of that but this is not the attempt to kill Keynes, or more specifically Keynesianism, that some have been claiming. 

For those who are making this claim it would be useful if they could provide references to their calls for fiscal restraint and a reigning in of government expenditure during the good times.

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