Another section of the new chapter for the paperback edition of Zombie Economics. Comments much appreciated
Expansionary Austerity – Death
As we saw in Chapter I, the experience of World War II, and the contrast with the Depression that preceded (and produced) it, marked the death of the classical case for expansionary austerity
This quote from Australia’s White Paper on Full Employment, published in 1945 is worth restating:
Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources. (Commonwealth of Australia 1945, 1)
In sharp contrast with previous wars, the full employment of the war years was maintained after the return of peace. In 1919, the British government of Lloyd George had promised ‘a land fit for heroes’, and had delivered instead the grinding misery of the 1920s. By contrast, under conditions that were far more challenging, the Attlee Labour government elected in 1945 transformed Britain into a modern social democratic nation.
The example of the Attlee government shows the force of Keynes’ observation that ‘the boom, not the slump, is the time for austerity’. The war had destroyed much of Britain’s overseas wealth as well as a substantial portion of the housing stock and left the country heavily indebted to the United States. It was therefore, necessary to adopt tight fiscal policies. Nevertheless, Attlee’s years in office saw the restoration of full employment, strong economic growth and rising living standards. At the same time, inflation was constrained.
Similar outcomes were achieved in other developed countries. All adopted the basic Keynesian premise that governments were responsible for maintaining economic activity at a level consistent with full employment and price stability.
On the Keynesian view, where resources are under-employed, an increase in public consumption or in investment expenditure constitutes a direct addition to aggregate demand. The same is true the additional private demand arising from a reduction in taxation or an increase in transfer payments. Conversely, reductions in public expenditure, or increases in taxes reduce demand.
It follows that austerity is a contractionary policy, appropriate in boom periods when demand threatens to outrun the productivity capacity of the economy, leading either to inflation or to unsustainable trade deficits. In the Keynesian view, Expansionary austerity’ is a contradiction in terms.
The Keynesian analysis dominant during the decades after 1945 did not exclude from consideration the indirect effects on which the Treasury View had relied. However, Keynesians argued that the direct effects of fiscal expansion or contraction would be more important than any second-round effects. Equally importantly, some second-round effects would reinforce the initial impacts of fiscal policy. In particular, in an economy with high unemployment, an initial increase in demand would be amplified as the beneficiaries of public expenditure used their increased income to demand more goods and services.
The key issues here may be understood in terms of the Keynesian concept of the multiplier and the anti-Keynesian idea of ‘crowding out’. These concepts have been around since the 1930s, and play a central role in the debate over fiscal policy. In the academic literature on macroeconomic theory, however, they have been obscured by the elaborate sophistication of DSGE models. So, it’s worth taking a little time to see how they work
The idea of the multiplier is simple, though some elementary mathematics is required to get the full picture. Suppose that, in a depressed economy, the government cuts taxes or makes once-off cash payments to households, spending, say $100 per household. Some of this money will be saved, and some spent. To simplify the illustration, suppose that households spend two-thirds and save one-third. These proportions are called the (marginal) propensity to consumer and the (marginal) propensity to save.
The money spent by households will create additional demand for goods and services, leading businesses to rehire unemployed workers and bring idle capital back into production. The newly hired workers, in turn, will spend some of their additional income. If they have the same propensity to save as other households, they will spend two-thirds of their additional income, or four-ninths of the additional stimulus. This second round effect will further increase demand, and so on, giving rise to an infinite series
Using high-school algebra, it’s not hard to work out that this series is a geometric progression and that the total increase in income is equal to the initial increase divided by the propensity to save. In this case, the propensity to save is one third, so the final multiplier is three.
The most important counter to the Keynesian analysis of fiscal policy was the idea of ‘crowding out’ which was at the core of the ‘Treasury view’ discussed in the previous section. The central idea of crowding out is that expansionary fiscal policy will require the government to issue additional debt. In the absence of accommodating changes in monetary policy, increased sales of debt will lead to higher interest rates, and therefore to lower private borrowing both for consumption and, more importantly, for investment. The result is that higher government spending ‘crowds out’ private investment that is presumed to be more effective.
Keynes’ colleague John Hicks developed an analysis which combined the Keynesian theory of the fiscal multiplier with the possibility of crowding out. Hicks’ approach was represented in the famous ‘IS-LM’ diagram which has given pain, but also enlightenment, to generations of students in introductory macroeconomics courses.
This book is not the place to recapitulate the IS-LM model ( textbook cite needed). What mattered was that the model formalized Keynes’ basic insight that policies of fiscal expansion would work well when demand was weak and particularly in the ‘liquidity trap’ situation where interest rates are close to zero. By contrast, in a boom, fiscal austerity would reduce interest rates, exactly as in the Treasury view of the world.
It’s also important to remember that the IS-LM model captured only part of Keynes theory, the part sometimes referred to derisively as ‘hydraulic’. Keynes ideas about uncertainty, which inspired post-Keynesian economists like Minsky did not fit into the formulation and were omitted.
During the Keynesian period, critics such as Milton Friedman did not, in general, argue against the basic Keynesian proposition that fiscal policy could stimulate the economy in times of recession. Rather, Friedman argued that, for a variety of reasons, the multiplier effect was unlikely to be as large as was suggested by Keynesians, and that fiscal policy would take effect with long and variable lags. Hence, Friedman argued, macroeconomic stabilization was best pursued through adherence to rules, such as a fixed growth rate for the money supply,
Partly reflecting the impact of arguments like Friedman’s governments varied in the extent to which they adopted policies of Keynesian demand management. Some adopted active fiscal policy measures to stabilize the economy, Others primarily relied on the ‘automatic stabilizers’ that are a feature of the social democratic welfare state. When the economy contracts, tax revenues fall and governments must pay more in unemployment and welfare benefits. These changes produce an automatic fiscal stimulus. Conversely, in a boom, government revenue increases and expenditure falls.
For nearly three decades, Keynesian macroeconomic management was highly successful. Full employment was maintained through automatic stabilizers and fiscal stimulus. On the other hand, incipient inflationary outbursts, such as that during the Korean War, were brought under control through the appropriate use of contractionary policy, that is, austerity.
Even after the monetarist counter-revolution of the 1970s, the Treasury View of expansionary austerity, was not revived. From the mid-1970s, to the early 1990s, the main policy objective was to reduce inflation. As a result, economic policymakers generally favored contractionary monetary policies. Fiscal policy was also generally contractionary, at least in its objectives. Having gone deeply into deficit during the crises of the 1970s, governments mostly sought (with mixed success) to restore budget balance.
As long as reducing inflation was accepted as the primary goal of policy, few economists bothered to deny that the contractionary policies needed to achieve this goal would produce painfully low growth and high unemployment. The only exception came at the high point of faith in rational expectations and New Classical Economics when it was argued that a sufficiently credible commitment to reduce the growth of the money supply could produce an immediate, and costless, reduction in inflation. The experience of the Thatcher government, which followed this prescription and generated a huge increase in unemployment, led to the abandonment of this theory, at least in serious public policy discussions.
As late as the 1990s, then, expansionary austerity was a dead idea.
John Quiggin 
para 7.
The same is true the additional private demand … probably should read:
The same is true [of] the additional private demand …
Bill Mitchell argues generations of student misinformation: “The concept was developed further by John Hicks (then J.R. Hicks) after a 1936 conference at Oxford where various economists attempted to “model” the General Theory. This was the birth of the famous (but erroneous) IS-LM model that is standard fare for intermediate macroeconomics students”.
Whether there is a liquidity trap or not is irrelevant
It’s an important excerpt, because here we visit the battle field for western democracy and the soul of centre/centre left parties like the ALP, probably lost already, given the opportunistic conversion of some within labor’s hierarchy to Kasperite nostrums, against the backdrop of hegemonic, heterogenising articles like FTA’s.
John, is it possible that financial markets, with their total obsession with public debt, have made Hicks irelevant? That is, crowding out has now become the markets’ top priority. They are just as worried about private household debt as public debt. But they seem to think that corporate debt can easily rise and generate further demand – at least in the long run. It all goes all our teaching of economics but are financial markets a new phenomena we need to have regard for?
‘…the Attlee Labour government elected in 1945 transformed Britain into a modern social democratic nation.’
I think this may be overstating the case somewhat – certainly if one compares British labourism to that in other parts of northern Europe.
Also, the record of Keynesian policy in Britain is a deeply contested one. In practice the Treasury always prioritised price stability over employment. From 1945 to 1975 the British economy was beset by recurrent inflationary and balance of payment crises – in the context of which deindustrialisation proceeded apace while the attempted ‘Americanisation’ of remaining industry was largely unsuccessful.
@jrbarch Since you’re arguing from authority, let me observe that Keynes argued, quite convincingly, that the presence of a liquidity trap is relevant. I don’t think that calling your anti-Keynesian argument “modern” outweighs the fact that it’s wrong. Please take this back to the sandpit, it’s not going in the book.
@John Quiggin
John – I’m not wishing to be confrontational re your consigning MMT to a sandpit; nor push MMT on your blog as I respect you have no time for it.
I do think that the discussion on the IS-LM model in Bill Mitchell’s blog and other similar posts should be read by students. The ‘facts’ can then speak for themselves – hopefully students can separate out these from MMT if they think that is logical. What can I do? Bow out gracefully I guess – wish you all a merry xmas and happy and prosperous new year ….
Cheers ,
jrbarch
For the Dynamic Stochastic General Equilibrium chapter, there is a good quote from John von Neumann that I’ve always liked that you might be able to work in (I think I might have already mentioned it?)
“With four parameters I can fit an elephant, and with five I can make him wiggle his trunk.”
In this context it should not surprise what they can make their elephant do.
@John Quiggin
I understand that the section of the new book has been posted online so that a critical review can be provided. I will use this opportunity to highlight an issue which also affects some of the articles written by Paul Krugman. Let me concentrate on the following sentences:
“Keynes’ colleague John Hicks developed an analysis which combined the Keynesian theory of the fiscal multiplier with the possibility of crowding out. Hicks’ approach was represented in the famous ‘IS-LM’ diagram which has given pain, but also enlightenment, to generations of students in introductory macroeconomics courses.”
It really surprises me that while one “zombie” (expansionary austerity) is declared dead, another one (IS-LM with crowding out) is resurrected, making the otherwise “hard to disagree” fragment of the book quite controversial. It is not about a “liquidity trap” but about understanding the relationships between the components of the system outside of the trap. IS-LM is not a simplified (although still confusing) model which can be taught to students and later amended by adding more elements such as uncertainty. IS-LM is flawed rather than merely limited and teaches students how to use an incorrect methodology (the “general equilibrium” approach) in the analysis rather than enlightens them (I can comment further on this topic if requested). It was eventually recanted by its author J.Hicks..
IS-LM is the foundation of the neoclassical version of Keynesianism which failed. The inability to understand the root causes of the failure within the already shifting paradigm allowed for “the monetarist counter-revolution of the 1970s” to happen.
The main problems are that IS-LM model simply does not describe the current monetary system (with endogenous money) as it relies on the quantity of money as an exogenous variable. It is also static and therefore cannot be used to analyse the behaviour of the system outside of an equilibrium and the effects of changes in the exogenous parameters.
These issues including internal inconsistencies (I would interpret one of them as a stock-flow inconsistency) have been identified in the following paper (available on the Internet separately as ISBN: 0 7334 1726 4) Nevile, JW ‘IS-LM and Macroeconomics after Keynes’ in P. Arestis, M.Desai and S.Dow (eds.) Money Macroeconomics and Keynes: Essays in Honour of Victoria Chick, Vol. 1 Routledge, London, 2002 (with P. Kriesler)
“Interestingly, despite the specific criticisms of the IS-LM framework, discussed above, Chick does not raise two fundamental issues, which have been identified as major themes of her writings. In particular, the editors of her Selected Essays have identified the endogeneity of credit creation and “the significance of historical time for economic process” (1992, p.ii). Both of these have been used to dismiss the IS-LM framework as not having any operational significance. Although rejecting the
framework, Chick does so mainly because of problems with its logic, rather than due to these “external” critiques.”
…
“This paper accepts the traditional views about the importance of factors lacking in IS-LM, but recognises that Keynes did use an equilibrium concept in the General Theory, although one very different from the Walrasian general equilibrium in IS-LM. After looking at Keynes’ own views on IS-LM, it comes to the conclusion that Hicks’ 1937 article did have the faults that post Keynesians typically ascribe to IS-LM. Moreover, an examination of the writings of Chick on IS-LM suggested further problems with IS-LM. Chick argues that IS-LM is not internally consistent. There are two prongs to her argument. The first is that it is not enough to assume prices are determined exogenously. IS-LM can only be applied if the general level of prices is assumed to be constant. The second focuses on the implied assumptions about financial markets. Chick argues that “for there to exist an equilibrium with positive rates of savings and investment savers must at some interest rate exhibit absolute “‘illiquidity’
preference”. This must continue as long as the equilibrium continues. Except in the case of a stationary state this requires that an IS-LM is a short term equilibrium. However, in as much as comparative static analysis is useful, it is useful for comparisons of different states of the economy or
long period equilibrium situations. Given Chick’s analysis there seems nothing left for IS-LM to do.
Our final evaluation is more damning than that of Chick herself.”
As to “financial crowding out” I would leave it to Ricardian Agents. I can comment further on this topic if requested.
In this extract, you (JQ) seem to skirt around the edges of a Keynesian explanation of the 1970s stagflation without giving it. The narrative skips abruptly from “nearly three decades [of] Keynesian macroeconomic management” to “after the monetarist counter-revolution of the 1970s”. Since the Stagflation era is always going to be the principle counterexample of the Zombie hordes it’s important to confront it head on.
I don’t know what explanation you favour; personally I’d go with demand-pull inflation created by Nixon and Johnson’s deliberate inflation and de-Bretton-Woodsing to pay for the Great Society, the OPEC oil shock, and the Vietnam war simultaneously. In this context, a reference to Kalecki’s “Political aspects of full employment” seems apt, as does challenging the oft-repeated canard that inflation hurts the poor more than the rich.
It can hardly be a coincidence that 3 decades of Keynesianism had given rise to an increasingly empowered and post-materialist middle/working class who were secure enough in their prosperity to start increasingly challenging the inequities of western society, as the Paris 68/Woodstock generation which gave rise to 2nd wave feminism, anti-racism/civil rights, core country anti-colonialism, anti-war, etc movements showed. From capital’s perspective the painful monetary/fiscal policies of the 70s played an important social role. Fiscal and monetary contraction disciplined these generations by reintroducing the fear of poverty and unemployment, giving rise to the “me generation” 80s who focussed only on their own material well-being.
The 70s wasn’t a mystery. A supply shock and loose monetary policy and a reluctance to tax and spend. The most popular and simplest demand side model that was being used didn’t provide for something happening on the supply side (as it didn’t have a supply side). That wasn’t Keynes’ fault he didn’t create that simple model. Also, back in those bad old days the economy suffered under the burden of a workforce that was not completely subjugated, and not completely (limbo-dancer) flexible. As a consequence there was an attempt by labour to maintain its share of income in the 70s. Either this desire had to be accommodated with some inflation or the consequence was recession. Luckily in our brave new world labour takes whatever crumbs the masters inefficiently let fall from their table, and are grateful for that. Nowadays the labour force is lucky to get pay that keeps pace with inflation, note the recent Qantas agreement 3 per cent per year.
I’m not arguing with that Freelander, I’m just saying that it seems to be a hole in JQ’s narrative as he’s presented it above.
“The same is true the additional private demand arising from a reduction in taxation or an increase in transfer payments. ” I think there is a “for” missing there.
Also, “Using high-school algebra, it’s not hard to work out that this series is a geometric progression and that the total increase in income is equal to the initial increase divided by the propensity to save. In this case, the propensity to save is one third, so the final multiplier is three.”
Sadly this sort of thing is not longer taught in high school. I learnt it during first year Uni, and I given that universities are now teaching a lot of things in first year that were previously part of the high school maths curiculum, it would not surprise me if it is now a second year subject.