Latest global downturn puts Keynes vs Hayek back in spotlight

One of the most divisive issues in macroeconomics has just moved back onto centre stage after both sides - one joyously and the other reluctantly - believed the debate had been settled.

Faced with a severe economic downturn that threatens not just recession but depression, what should policymakers do?

The answer in 2008 when the failure of Lehman Brothers triggered a freeze in global trade and a recession in most advanced economies was to borrow from the thinking of John Maynard Keynes.

Confronted by a sudden drop in spending by consumers and households instead saving ahead of a surge in unemployment and a subsequent drop in investment by business, there is a danger that the depression will become a self-fulfilling prophecy.

While the cause may have been a market failure, such as the reckless financial innovation that led banks to rack up debts secured against worthless sub-prime mortgages, the markets cannot correct the problem on their own.

The only entity that can intervene is the government, which has the ability to cut interest rates, print money and raise debt and pump money into the economy in order to offset the lack of demand from the private sector.

Roosevelt’s New Deal with its massive outlay on infrastructure projects to create jobs for millions of workers is a good example of Keynesianism in action

Faced with that prospect the leaders of the rich countries ripped pages out of Keynes’ work, The General Theory, and used their G20 London Summit to collectively pump $1 trillion into the global economy.

It worked. Depression was averted but at the cost of accumulation of government debt.  Disciples of Friedrich Hayek and Milton Friedman urged governments to embark on austerity to prevent economies quite simply going bankrupt as Greece almost did in 2011.

Anyone with 10 minutes on their hands could have a look at a rap music take on the battle between Keynesians and Hayek supporters here (much better than it sounds).

Almost nine years on from the onset of global financial crisis on 9 August 2007 and the world is locked in stagnant low inflationary growth and the argument on how to get the economy started again is resurfacing.

The International Monetary Fund, which was instrumental in the $1 trillion rescue but which then advocated austerity, has had another change of heart.

Its second-in-command David Lipton warned of volatile financial markets and low commodity prices creating fresh concerns about the health of the global economy.

The recipe is old-fashioned government intervention. While this means cutting interest rates, the fact that rates in many countries are at zero or even negative — so banks pay to lend money — means that fiscal policy has to take a “more prominent place” with a particular focus on infrastructure spending.

The fact that interest rates are at such low levels has made borrowing more to fund long-term infrastructure an option

This is because infrastructure investment can be particularly beneficial, not only because it is deeply needed in some advanced economies, but as it has positive spillover effects to the rest of the economy in terms of jobs, wages and a better-run country overall.

Without such action the prospects are grim. Given the IMF’s habit of bland and technical language, Lipton’s warning of growing risk of “economic derailment” stands out.

He is not alone. The Organisation of Economic Cooperation and Development said leading indicators pointed to slowing growth in the UK, US, Canada, Germany and Japan.

The fact that interest rates are at such low levels has made borrowing more to fund long-term infrastructure an option, but one that the UK and other European governments have avoided.

In January the UK’s Debt Management Office issued £1.5bn of debt that does not need to be paid back until 2060 at an interest rate of 2.33%. It was 1.25 times over subscribed.

This is not to say that the world is heading for another 2008-style slump. The year has got off to a very uncertain start but as Nouriel Roubini, one of the few economists to warn about that crash nine years ago, says the rest of this year will be anaemic for global growth.

Even more reason for governments to use the opportunity to borrow cheap and invest long term. So far the government has tried to entice the private sector rather than simply borrow and invest.

The recent speculation that EDF, the French state-owned energy company, may pull out of plans to build much-needed nuclear power stations is a reminder than not everything can be left to foreign investors.

Keynes and Hayek may be long gone but the Keynesians may just be about to move back into the ascendancy.

More about the author

About the author

Phil has run Clarity Economics, a London-based consultancy, since 2007 and, before that, was Economics Correspondent at The Independent.

Phil won feature writer of the year Work Foundation Work World media awards in 2009, and was commended by the Royal Statistical Society in 2007.

He is the author of Brilliant Economics and The Great Economists.

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