by Rachel Reeves needs a new economic narrative to break the fear of deficits and debt 24th November 2023 To observe the basic thinking behind Jeremy Hunt’s Autumn Statement on 22 November, and how Rachel Reeves will respond, is to find that the Chancellor and his shadow inhabit the same mental universe. They both aim to lift the British economy out of the doldrums, and they agree that doing so depends on improving the efficiency of the supply side of the economy – the way capital and labour are used. But they disagree about how this can be done: there is a Conservative supply-side story and a Labour supply-side story. The political challenge facing both politicians is to persuade voters – and the markets – that their version offers the best hope for Britain’s future. The
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Rachel Reeves needs a new economic narrative to break the fear of deficits and debt
24th November 2023
To observe the basic thinking behind Jeremy Hunt’s Autumn Statement on 22 November, and how Rachel Reeves will respond, is to find that the Chancellor and his shadow inhabit the same mental universe. They both aim to lift the British economy out of the doldrums, and they agree that doing so depends on improving the efficiency of the supply side of the economy – the way capital and labour are used. But they disagree about how this can be done: there is a Conservative supply-side story and a Labour supply-side story. The political challenge facing both politicians is to persuade voters – and the markets – that their version offers the best hope for Britain’s future.
The Conservatives are a party of business and what business wants is tax cuts. Hunt obliged with what he called the “biggest tax cut on work since the 1980s”. The argument is that cutting taxes leads to an upsurge in work effort, and hence in economic growth, but with a budget deficit of 4 per cent of GDP, the national debt at 100 per cent, debt interest rising to 4.5 per cent and inflation at 4.6 per cent, promising tax cuts risks “spooking the markets”. Hunt has been emboldened to try by the forecast fall in the inflation rate, which reduces the cost of government borrowing and thus increases his “fiscal space”.
To stop the cost of debt rising, Hunt has promised years of tight spending settlements – his “fiscal bind”. As he told Bloomberg recently: “Our priority is to bring down inflation, and when you’re trying to bring down inflation, you have to be really careful not to pump extra money into the economy.”
Labour offers a “modern supply-side approach” to, as Reeves puts it, “rebuild our economic strength” and “secure our supply chains we can trust”, an approach she calls “securonomics”. Growth will not be generated by tax cuts but by providing “catalytic investment through a new national wealth fund to unlock billions of more in private sector investment”. In a piece for the Financial Times in September, Reeves explained that a Labour government wouldn’t “borrow to fund day to day spending and we will reduce national debt as a share of the economy”.
But Labour will have an even harder task than Liz Truss did in her brief spell as prime minister in avoiding a bond market sell-off, because the party wants to increase public spending as a share of GDP. It has also pledged to reduce public debt as a percentage of GDP by the end of it first parliamentary term. How, given its spending commitments, will Labour eliminate the deficit on current spending and proportionally reduce public debt? Reeves insists she will not raise taxes, so her assumption must be that public spending will be more efficient than private spending, leading to faster growth that will close the budget deficit.Top of FormBottom of FormTop of FormBottom of Form
These political pronouncements signal the desperate attempt by party leaders to retain some fiscal discretion when economic orthodoxy rules out the need for fiscal discretion. But if self-imposed fiscal rules are constantly being broken – none of them have been adhered to for the last 15 years – there is something fundamentally wrong with the economics on which they are based. This is why we must reinsert the theories of John Maynard Keynes and Karl Marx into our national economic debate.
In The General Theory of Employment, Interest, and Money (1936), Keynes wrote that “the outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes”. His book was about the first of these failures; he offered no theory of distribution, and barely a hint about how it might connect to his theory of aggregate demand.
For Keynes, capitalism’s “failure to provide for full employment” was systemic. Previous economists had talked about “lapses from full employment”. Keynes’s startling idea was that unmanaged market economies could lapse into full employment in moments of excitement, but that their normal state was one of a rather somnolent “underemployment equilibrium”. They required electric charges to jolt them into life.
The reason for this underemployment, Keynes argued, was that, because the future is radically uncertain, investment depends on “animal spirits” not on rational calculation. So Keynes thought that individuals and businesses were more likely to hoard or conserve money than embark on risky enterprises. Since capitalist enterprise depends on lending and borrowing money in expectation of future returns, any tendency to hoard money is likely to keep the rate of interest on loans far too high to sustain permanent full employment. What the late American economist Alvin Hansen called “secular stagnation” always threatened capitalist economies. This is the basic premise of Keynes’s “general theory”.
In Keynes’s theory the government had the job of providing enough extra electric current – spending power – to jolt economic agents into more active life, either through the direct effect on the long-run real rate of interest of extra government spending, or by measures to stabilise and stimulate profit expectations. With continuous full employment, economies would grow faster; the extra growth would bring nearer the day of bliss when people would earn enough not to have to work so hard.
Keynes’s theory of “underemployment equilibrium” was rejected by most economists and policy makers. The orthodox view, even at the height of the Keynesian era in the 1950s and 1960s, was that ;his “general theory” applied only to special cases when failing economies had to be rescued by emergency measures such cheap money, public works or tax cuts.
During the 1980s, when the rational expectations theory – that people make decisions based on the best available market data – was ascendant, it was believed that “lapses” from full employment would become increasingly rare. The notion of uncertainty, which Keynes had taken to be an inherent condition of capitalist existence, came to be explained in terms of imperfect information, which could be resolved by improved data and calculating power. Milton Friedman reduced the instability of capitalism to the instability of money, to be corrected by independent central banks. In today’s algorithmic age, uncertainty might be reduced still further through predictive algorithms. In this way uncertainty was squeezed out of economics. Keynes, it turned out, had loosened the bonds of orthodoxy; he did not break them.
Keynes had little to say about the second “outstanding fault” of the capitalist system – its “arbitrary and inequitable distribution of wealth and incomes”.
Redistribution of resources has been a central concern of the left since the 19th-century French socialist Pierre-Joseph Proudhon described property as “theft”. Historically, the left has deployed two main arguments for redistribution. The first was that free competition led not to equilibrium but to monopoly. All late 19th-century economic reformers, both on the left and right, looked to break up monopoly power, in the name of the market or democracy or justice. The question was whether it could be done by reform or demanded a revolution.
In the 1890s welfare economists developed a case for redistribution even in markets where there was no monopoly power. This was based on the idea that transfers of money from the rich to the poor would, up to a point, increase the happiness of society. Naturally the rich disagreed; and the argument for redistribution based on “the declining marginal utility of money” gradually collapsed.
In all these intellectual traditions, the economic link between maldistribution and unemployment was undeveloped, because, until Keynes’s later intervention, unemployment was not considered a systemic feature of a capitalist system. The left argued its case for redistribution on moral grounds, not macroeconomic ones.
Except for one tradition. Within Marxism, but not exclusive to it, was something portentously called the “realisation” problem, and which the economics profession (barely) knows as the theory of underconsumption. As Karl Marx wrote in Capital: Volume 3 (1894): “The last cause of all real crises always remains the poverty and restricted consumption of the masses as compared to the tendency of capitalist production to develop the productive forces.”
The basic idea, most familiar from the writings of the 20th-century liberal thinker JA Hobson, is that increases in inequality will reduce the inclination to consume, making it harder to sustain aggregate demand. Hobson stated the problem succinctly in 1889: “Saving, while it increases the existing aggregate of Capital, simultaneously reduces the quantity of utilities and conveniences consumed; any undue exercise of this habit must, therefore, cause an accumulation of Capital in excess of that which is required for use, and this excess will exist in the form of general over-production.” Hobson saw in the cumulative tendency towards inequality inherent in the capitalist system the main cause of its crises of overproduction. Taxing the excess savings of the rich would stabilise the economy by increasing the buying power of the poor.
Keynes snootily charged Hobson (who was not a trained economist) that he had ignored the role of “liquidity preference” in keeping up interest rates: the correct theory of capitalist malfunction was one of underinvestment, not overinvestment. Keynes’s strategy of steering the discussion of deficient demand away from distribution was politically astute. Taxation of surplus wealth was central to Hobson’s remedy for underconsumption, whereas Keynes’s policies to reduce unemployment had no explicit distributional implications.
Nevertheless, underconsumptionism is the most suggestive of the theories linking macro to microeconomics. Both Lenin and Rosa Luxemburg took up Hobson’s idea that deficient domestic consumption leads to imperialism and military spending as capitalists seek a “vent” for their surplus savings. Today’s “vent” is provided by luxuries as well as speculation in liquid securities which cause the periodic breakdown of the financial system. And quantitative easing, designed as emergency treatment, has aggravated the fragility by selling central bank money to owners of financial assets rather than scattering it through the population in the form of “people’s QE”.
In the mid-20th century era of Keynesian social democracy, both macro- and microeconomic policy proceeded in parallel, reinforcing each other, without being joined at the hip. Policy makers accepted an empirical relationship between the “compression” of earnings between 1945 and 1980 and the most sustained period of Western economic growth ever. But from the 1980s the empirics have inverted: increased earnings “dispersion” has come with a slowdown in economic growth.
The shift away from Keynesian social democracy from the 1970s was signalled by two policy changes. First, since mainstream economists deemed unemployment voluntary, governments dropped the full employment commitment. Second, the budget was no longer seen as an instrument for redistribution. As a result, there were no fiscal barriers to either the rise in unemployment or inequality. There has just been a continuous fiscal squeeze as the economy obstinately refused to grow at the rate required to reduce the public debt and support welfare entitlements.
Public policy responses to economic stagnation are undermined by fear of deficits and debt. Accepted during times of emergency, they are repudiated for “normal” times. At the root of this is the belief that borrowing in bad times needs to be repaid in good times, so governments shouldn’t add to the national debt. But Keynes argued that capitalist economies were normally “underemployed”, prone at best to sickly recoveries from slumps, so they needed a permanent “exogenous” stimulus to regain or maintain the good times. This would not cause repayment problems: government spending in the first period would add to government revenue in the next period, so the debt would continually be repaid on a rolling basis. Equally, a deficit would only be inflationary at full employment.
Further, as well as selling bonds to the public, a national government with its own currency can sell the debt to itself and so need never “go bankrupt”, nor suffer from speculation that drives up interest on its bonds. Fear of “the debt” is often a form of paranoia.
However, for more timid souls a budget balancing strategy is available – the balanced budget multiplier – which shows how deficits, when coupled with higher taxes, could be expansionary. It is an ideal Keynesian tool for an underemployed economy whose managers are terrified of continuous deficits. It shows that when a government increases taxes and spending by the same amount, the result is a net increase in total spending, because households and businesses would save part of what the government has taxed.
With a balanced budget multiplier the budget remains balanced but always provides a stimulus. This stimulus ensures full employment. Without the stimulus the budget could be balanced, but at a lower level of revenue and spending. Hence the “fiscal bind” that both Hunt and Reeves find themselves in: Hunt would be left without enough revenue to reduce taxes, Reeves without enough revenue to increase spending. A determination to stick to orthodox “fiscal rules” threatens both with political ruin: Hunt will be forced to chip away at social entitlements; Reeves will lack the money to pay for her green investments.
The problem with the balanced budget multiplier is not so much on the spending, but on the tax side. A Labour government would face the problem of raising the tax burden from an already historically high level, which is why the party resists the idea. It doesn’t know how to raise the revenue in a way that reassures the markets and makes sense to the voter. Economists must ease Rachel Reeves’s task by providing her with a narrative to break out of the new neoclassical paradigm in which policy has been trapped for far too long.