Recession – can the government spend its way out?

Recent global events have, for some observers, heralded the death of the monetarist/ liberal-capitalist economic hierarchy which has dominated world economic thinking for so many years.

The greed and avarice of the few proclaimed bastions of the capitalist model have arguably reduced the world economy to rubble. A vicious circle of debt first triggered the credit crunch, which has led to the banking bailout and will now likely lead to a global recession. While both academics and bankers agree that the economy is in a precarious state, the extent of this is still being debated. Some influential thinkers believe that recent events could trigger a mass-scale depression reminiscent of the 1920s, whilst others believe that the crisis will not be so extreme. The consensus, however, seems practically unanimous. The UK, and indeed the majority of other developed countries around the world, are destined for recession, the depths of which are largely unknown.

In times of global economic difficulties business and investors alike turn to the government and central banks who, in their capacities as “lenders of last resort”, represent a safety net. Heard accompanying the cries for economic intervention is the name of one of the most influential, and arguably controversial, economic thinkers of all time – John Maynard Keynes.

Global economic policy throughout the 20th century was reminiscent of a pendulum swinging between liberal capitalism and monetarist ideals on one side, to government intervention and fiscal policy on the other. The idea of spending to avert a recession is not new, and dominated the post-war economic landscape. Even over the past two decades US policy has been more aligned to the new Keynesian rule, which uses the Fed Fund rates to manipulate GDP. The idea of spending to avert recession is neither new nor can be considered without reference to Keynes.

Keynes and fiscal policy

Keynes is a founder of modern macroeconomic theory and his policies are still debated to this day. The events of recent months have for some vindicated the need for “Keynesian” economic policy, which advocates that government intervention (spending, tax cuts, subsidies, interest rate manipulation etc – technically referred to as fiscal policy) can be used to smooth the economic passage in the face of recessions, depressions and inflated market growth through its effects on aggregate demand.

Keynes’ theories on the economy were developed most coherently in his treatise The General Theory of Employment, Interest and Money published in 1936. The book’s publication and philosophy was largely developed as a result of the Great Depression and the parallels with the current situation are thus apparent to some.

Fundamental to Keynes’ theories is the principle of government spending, particularly in infrastructure investment. Through what is termed the multiplier effect Keynes argued that increasing government spending results in a ‘trickledown’ effect, fostering employment and stimulating the economy through its impact on aggregate demand. Funds to facilitate this spending spree may be sourced through taxation and Keynes warned that increased taxation, whether through open or stealth taxes, has a negative effect on consumption and spending. However, the positive effect from spending outweighs this, meaning the balanced budget multiplier is positive overall and aggregate demand should be increased.

Keynesian principles dominated the post-war period and were the cornerstone of global economics throughout the 1950s and 1960s. To some observers it appeared as if the Cambridge luminary had resolved the most fundamental problem in economics. However, in 1973, political tension resulting from the re-arming of Israel by the US led to a trade embargo by the Organization of the Petroleum Exporting Countries (OPEC). This had devastating effects on the world economy. One of the fundamental tenets of modern economics, the Phillips Curve, which posits an inverse relationship between unemployment and inflation, was falsified. The world was exhibiting stagflation (rising inflation and rising unemployment). An application of Keynesian policy meant that unemployment would need to be tackled through expansionary policy and inflation through contractionary measures. This application was of course impossible and many believed Keynes’ theories were dead.

A modern recession?

As a society, the recent boom years have arguably made us more sociologically apathetic and economically expectant. Politics and economics are unfortunately, despite the proclamation of central bank independence, inextricably linked. A weak economy and unemployment leads to a disgruntled populace and difficulties come polling day. As a consequence governments will fight to ensure prosperity and GDP growth, even if it is somewhat naive. It is plausible to argue that the recent crisis means that governments are morally obliged to do all in their power to lessen the impact of a recession, for a government that bails out bankers and leaves the average man on the precipice of unemployment is surely destined for the gutter.

Alistair Darling has mused in public on increasing government borrowing to kick-start the economy. The fear of business and investors is one of “crowding out”, which is where government spending reduces private sector investment through higher real interest rates. The concern is that when the economy reaches an upward inflexion point, government spending will reduce the ability of the private sector to recover.

Will a spending plan work?

There is much controversy on the subject of crowding out. Arguably the most successful implementation of Keynesian policy was the Truman Doctrine/ Marshall Plan which saw over $13bn invested (equivalent to approximately $370,000,000,000 at today’s prices and yet a mere trifle compared to the US TARP programme) in post-war Europe.

However, as a principle, liberal economists have always criticised the notion of public spending and the events of recent times present a hugely different set of problems to those of either post-war Europe or the Great Depression. Similar proposals were implemented to bring Japan out of continued slump in the 1990s. Unfortunately they had little effect on the world’s second largest economy.

Potential problems

Firstly, government spending cannot simply be switched on or “fast tracked” as Alistair Darling has suggested. There will instead be a lag effect. Funds must be sourced, through either printing bank notes (which could have significant detrimental effects to an already weak pound), or through public auction of gilts by the Debt Management Office (“DMO”). Projects will then need to be ranked, planned, budgeted and approved before construction begins. The timeframe for this could be many years and arguably by 2011, when the project(s) start(s) to have the desired impact, the economy may well be on the brink of recovery.

Secondly, government debt is already close to £43bn (this is actually relatively low compared to other G7 nations). It has been estimated that this will rocket to £120bn by 2011. Such a change could have a serious impact on the value of the pound, increase inflation and reduce the ability to stimulate the economy through interest rate cuts.

Thirdly, there is the problem of off-balance sheet debt. The official figures show debt as approximately 38% of Gross Domestic Product (“GDP”); this, however, does not include the nationalisation of the banks or other recent spending packages. During the last recession in the 1990s the level of debt was considerably lower (c. 28%). The implementation of a Keynesian spending plan in the ’90s saw public debt skyrocket to largely unprecedented levels; the same is likely to happen again but the UK is not in as strong a position today as it was then and the impact could be far more detrimental to the long term health of the economy.

Fourthly, there is increasing reliance on Private Finance Initiatives (“PFI”) for infrastructure spend. The government has increasingly encouraged private companies to provide tenders for new projects based upon the argument that it increases efficiency and negates the crowding out problem. However, PFI is largely funded by bank lending in the first instance and the current reticence of banks to lend has been one of the principle causes of the recession. It is estimated that approximately £23.3bn of infrastructure projects are funded through PFI and how this circuitous funding problem will be resolved is unknown. One potential solution – the use of investor’s funds through pooled investment vehicles – is also improbable as investors increasingly seek lower risk assets.

So can it work?

Recent events represent what economists term a productivity shock and represent a short term decline in GDP growth as a result of reduced capital availability. Whether a spending spree is likely to work will ultimately depend upon how the money is spent. The government first needs to recognise that the free-flow of capital and loose lending criteria have been a fundamental cause of the current crisis and pending recession. Both short and long term policies need to be structured to resolve this.

The desire to have it ‘new and now’ through credit purchases and re-mortgaging is the root cause of the current problems. The government would be better off acknowledging that housing is over-priced and the town planning model of inner city development is fundamentally flawed. Following this, spending focused upon ensuring that long term aggregate supply grows in a sustainable fashion, through technological enhancement and improvements in labour and capital productivity, is key. If resources can be directed in this direction and the long run aggregate supply curve can be moved to the right, then the spending plan could work. If not, then the result could be higher unemployment, higher prices, fiscal crowding out and a prolonging of any recession.