Keynesian theory in modern macro-economics
Alistair Darling MP, Chancellor of the Exchequer, 2007-2010 – “The dominant thinking in Europe at the moment is exactly repeating the mistakes (I believe) that were made at the end of the First World War”. This statement was made in reference to the fact that Germany is now imposing the idea of tough budget cuts in Greece in exchange for emergency loans. Darling compares this action to the forced pay of reparations by Germany, imposed by the Allies after WWI in the Treaty of Versailles. The fact that the debtor country has such a weak economy defies the possibility of making such large repayments. In order to repay such debts, the weak economy would first have to be strengthened.
Similarly to Angela Merkel, Chancellor of Germany, David Cameron seems to believe in an anti-Keynesianism theory and practice, since he has said that that the government deficit must be counteracted and that borrowing needs to be reduced. “ Some of the normal things that governments can do to deal with a normal recession, like borrowing to cut taxes, or increasing spending; these things won’t work, because they lead to more debt, which would make the crisis worse.” Cameron emphasises the word “normal” in order to make clear that currently the economy is not suffering from a short term, minor recession, but that we are suffering from a global and prolonged recession, in which tax cuts and increased borrowing and spending will not be effective, as eventually, loans need to be repaid, taxes sequentially need to be increased. Keynesian theory may be effective in the short term, used in order to “kick-start” an economy; however it may not work in the long run. This anti-Keynesian idea in the current economic climate is corroborated by Keynes himself: his famous quote “in the long run, we are all dead”- proving that the long-run is not considered a priority in Keynesian theory.
Keynesian theory in practice during a recession
Keynes believed that in order for an economy to once again prosper, monetary and fiscal policy would have to be altered. Keynesian theory revolved around the main idea that taxes and interest rates would have to be cut/reduced, leading to more spending.
The Method:
- Central banks (i.e. The Bank of England) would lend to commercial banks at lower interest rates.
- From there, commercial banks would lower their own interest rates to take advantage of the interest rate cut instigated by the central bank.
- The advantage would come in the form of increased borrowing by consumers (as repayment would be lower than usual).
- More borrowing would lead to more demand and spending on goods.
- Since firms would also be able to borrow at a lower interest rate, they too would be willing to spend more, therefore would employ more people and allow supply to meet demand at equilibrium.
- Higher employment would lead to more households having greater disposable incomes, again causing demand and consumption to rise (in this instance, possibly even without households borrowing more.)
Large increases in government expenditure and investment into public projects (such as infrastructure) are also used in Keynesian theory. If government expenditure were to increase, more money would be injected into the economy through the creation of business opportunity, higher employment and demand. This rapid increase in investment is attainable through fiscal deficit – which Keynes believed (if done purposefully and methodically) would aid an economy in recession. The fiscal deficit would come as a result of the issuing of government bonds (the revenue from which would be used to fund the government’s injection into the economy.)
The major drawback to this fiscal policy is the fact that the fiscal deficit would rapidly increase and eventually taxes would have to be raised in order to make repayments to those who would have previously invested into the bonds issued by the government.
Governmental tax cuts would also help an economy to prosper and emerge from recession. Tax cuts would lead to cheaper production, products and services. Rationality allows the assumption that demand will rise due to an increase in consumer confidence. Increase in demand leads to more payments for goods and services by households to firms: therefore allowing the payment of factors to increase – in turn causing households to have higher incomes, thus leading to an increase in expenditure (received by firms.) This would eventually lead to growth above the trend growth. This cycle of money is demonstrated by the circular flow model 2 (shown below). Eventually a government would be able to repay the loans (received upon the release of bonds) as tax revenue would increase exponentially to the original investment; this is known as the multiplier effect and is demonstrated by the Hoover Dam investment of $49 million in 1931. Besides this architectural development and its use –supplying hydro-electric power; private investment in the area also went up (seemingly out of nowhere, having previously been an almost empty desert.)- Circular flow Model 2
