The case for stimulus: a response to Lord Desai

With his criticism in June 30th’s Guardian of Lord Skidelsky’s recent attack on the government’s fiscal policy, Professor Lord Desai has provided the devotees of what Nobel prizewinner Paul Krugman calls ‘dark age macroeconomics’ with a very eminent new recruit.

The central tenet of this school is that every pound of government borrowing and spending is a pound of private borrowing and spending displaced.  As Lord Desai puts it, “If Osborne does not spend, he does not borrow.  So the money stays back in the business sector’s balance.”  Government borrowing to finance deficit spending just ‘crowds out’ private borrowing: and so can only be justified if it “would have a bigger multiplier effect than the private sector would achieve”.

Alas, this plausible-sounding story is based on a fallacy – one first exposed by Keynes seventy-five years ago.  The savings of the private sector do not automatically get invested as the classical economists taught, because the private sector can choose to hold money, rather than to lend to the productive but risky corporate sector – and it does so in spades when confidence collapses and the demand for liquidity soars, as is now the case.  The money stays back in the business (and household) sector’s balance all right – and that is precisely the problem: there it sits, either paying down debt or in cash, unborrowed and unspent.

Fortunately for all of us, UK policy-makers recalled this central lesson of the Keynesian enlightenment in the immediate aftermath of the recent financial crisis.  So as the private sector’s net saving surged from close to zero in 2007 to 7.6% of GDP in 2010, the government borrowed these funds and spent them – generating an off-setting increase in its deficit from -2.8% to -10.2% of GDP and preventing this massive withdrawal of private sector spending from translating into a collapse of aggregate demand even greater than the one we experienced in 2009-10.

Contrary to Lord Desai, the critical condition needed for Lord Skidelsky’s argument in favour of continued fiscal stimulus is therefore not that the multiplier on government spending be higher than that on private spending, but that the private sector is not yet prepared to reduce its net saving.

That this condition currently holds is easily demonstrated by the current, exceptionally low level of market interest rates, despite high government borrowing.  To the dark age macroeconomists who hold that the private sector is being crowded out of the market for loanable funds, this is a conundrum.  To the vast majority of practical central bankers and the rare academic economists who cleave to the Keynesian view that private sector saving is directed at repairing its bombed-out balance sheet by reducing debt and at assuaging its fears for the future by increasing its holdings of liquid cash, it makes perfect sense.

But for the time being, this argument over fiscal policy itself is academic.  Mr. Osborne has staked his political reputation on austerity, and that will not change.  Hence the attractions of the idea of creating a National Investment Bank.  Here is a practical way of accommodating the private sector’s desire to save and putting it to work in productive projects – without bursting the budget deficit.  Even dark age macroeconomists should approve of that.


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