Will Truss rehabilitate Keynes?

September 07, 2022 10:46
Liz Truss has become the United Kingdom's new prime minister. Photo: Reuters

The United Kingdom finally has a new prime minister, but will Liz Truss improve the dismal outlook for the British economy and political life? The conventional answer is no. As Shakespeare said, “when sorrows come, they come not single spies but in battalions.” That is certainly true of Britain today.

The UK is cursed with the G7’s highest inflation, steepest decline in real wages, and biggest budget and trade deficits. Making matters worse, Britain’s battalion of sorrows also overwhelms its politics. Truss’s three predecessors were the worst prime ministers in modern British history. So says the British public: According to the latest polling, David Cameron, Theresa May, and Boris Johnson all score postwar records for doing “a bad job as Prime Minister,” with each successive Tory leader rated worse than the previous one.

Truss seems to face similar opprobrium. Judging by her leadership campaign, she will provoke more conflicts with Europe, aggravate confrontations with China, intensify Scottish nationalism, and defy the United States over Anglo-Irish relations. Even more controversially, she wants to slash taxes, spend vast sums on energy subsidies, ramp up defense spending by 1% of GDP, immediately adding another £100 billion ($116 billion, or 5% of GDP) to the budget deficit while blaming the Bank of England for any resulting inflation.

Many other Western leaders are turning to unorthodox policies such as tax cuts and energy subsidies to dull the pain caused by the Ukraine war and sanctions on Russia. But Truss wants to defy orthodoxy on a much grander scale, as does Kwasi Kwarteng, her close friend and prospective Chancellor of the Exchequer. Kwarteng will be Britain’s first-ever finance minister who holds an economics-related PhD, and Kwarteng’s specialization in economic history, rather than the sterile mathematical modeling that now dominates the discipline, will give him the intellectual confidence to overrule Treasury and BOE officials whenever Truss requires.

According to conventional economic thinking, the Truss-Kwarteng experiment with borrowing and spending will produce disaster. After all, if inflation is caused by “too much money chasing too few goods,” it is bound to be aggravated by adding tax cuts and subsidies to consumer and business spending power.

But is it conceivable that Truss’s unorthodox response to stagflation could work?

Stagflation is the greatest mystery in economics. Nobody really understands why an economy with declining real wages and weak demand can experience a continuous inflationary process, as opposed to a one-off jump in prices caused by supply disruptions, a war, or a trade embargo.

The old monetarist doctrine that inflation is caused simply by central banks that print too much money has been convincingly refuted by experience, first in Japan from 1990 onwards, and then in the world as a whole since 2009. And theories attributing inflation to government spending or borrowing have even less empirical basis. In fact, inflation can have many different causes, which vary widely and depend on social, economic, and technological conditions in different countries at different times.

It is therefore possible, though unlikely, that inflation could be controlled by the unorthodox combination of policies promised by Truss: controlling and subsidizing energy prices, cutting real wages by breaking strikes and tightening anti-union legislation, getting the BOE to tighten monetary policy, and then using tax cuts and public spending to support politically-favored businesses and social groups. It is also possible, and perhaps more likely, that an advanced economy like Britain can operate with substantially higher inflation than the conventional 2% target. And it is very probable that running much larger public deficits will have no major effects on either inflation or interest rates when a squeeze on real wages is keeping consumption subdued.

If any of these statements turns out to be true, then Truss’s unorthodox policies could avert the deep recession that almost everyone in the UK now sees as inevitable – and without causing an inflationary disaster. US Presidents Ronald Reagan and Donald Trump were fiscal profligates who ignored economic advice by cutting taxes and running previously unthinkable deficits; yet the widely predicted catastrophes never followed.

Margaret Thatcher was even bolder in defying economic orthodoxy. In 1981, a famous letter to The Times from 364 leading economists denounced Thatcher and her Chancellor, Geoffrey Howe, for turning Keynesian economics on its head by imposing savage fiscal tightening in the midst of the deepest recession in Britain’s modern history. Because this huge cut in borrowing was accompanied by an equally huge reduction in interest rates and a 30% depreciation of sterling, Howe’s sensational 1981 budget turned out to be the low point of the 1980-81 slump and inaugurated a decade of record growth.

Could Kwarteng and Truss now achieve something similarly unexpected by putting Keynesian economics back on its feet? Will they expand deficits to stimulate growth while higher interest rates and a stronger currency keep inflation under control?

As a professional economist, I have been trained to resist the notion that a huge expansion of public borrowing could possibly be the right way to deal with double-digit inflation. But as a market analyst, I share Kwarteng’s preference for history over theory and human behavior over mathematical models.

In the 1980s, the Keynesian economic establishment patronized and ridiculed Thatcher for experimenting with a radically unorthodox policy. Today, the orthodox establishment is Thatcherite, and it is Keynesians who are radically heterodox. If Britain’s fiscal expansion works more or less as intended, Truss will become the first successful Conservative prime minister since Thatcher. And Britain will again be an international model for economic policy, this time by rehabilitating the Keynesian doctrine that governments should borrow boldly in recessions or periods of inadequate economic growth.

This core Keynesian analysis is sometimes exaggerated in extreme versions of Modern Monetary Theory, which is sometimes parodied as a “Magic Money Tree.” Last month, I joined in, calling the notion that US policymakers will be able to reduce inflation without causing a severe recession a “fairy tale.” But market prices for US bonds, equities, and the dollar all suggest that some version of it is credible to many investors in US assets. If markets now believe that the US possesses a Magic Money Tree, maybe Britain can find one, too. That may seem ridiculous to professional economists, but the rest of us should keep an open mind.

Copyright: Project Syndicate
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Chief Economist and Co-Chairman of Gavekal Dragonomics