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What Would Keynes Say Now?

One hopes that governments will not have to choose between higher prices and increased taxes to finance efforts to combat the COVID-19 pandemic. But it’s not too early for policymakers to start thinking about how to pay for this particular war.

LONDON – The United Kingdom’s new Chancellor of the Exchequer, Rishi Sunak, has done what Prime Minister Boris Johnson wanted him to do following the forced resignation of Sunak’s predecessor, Sajid Javid, in February. In his March 11 budget, Sunak turned on the spending taps by unveiling a stimulus package worth £200 billion ($235 billion) over five years.

“It was a budget of which […] J.M. Keynes could have approved,” wrote political commentator Matthew Parris in The Times. And there was even more praise for Sunak’s March 17 announcement of an extra £350 billion to support UK businesses through the coronavirus pandemic. UK fiscal policy, it seems, has at last been restored to its proper place after years of austerity.

But I am skeptical about these latest “return of Keynes” stories. This is partly because there has been no principled repudiation of austerity, and partly because most of the new converts simply equate Keynes with budget deficits. In fact, Keynesian arithmetic can also point to surpluses.

For starters, there is nothing Keynesian about Sunak’s £350 billion package to protect the economy against COVID-19: Any government will spend freely to protect its people against such disasters. Even the austere former Conservative Chancellor George Osborne would have recognized that these are not normal times. But Keynes would have asked something that no one so far has, namely, “How do we pay for it?” – a matter to which I shall return shortly.

Before I do, consider Sunak’s budget-day announcement of an extra £175 billion in public investment over five years. “Investment in roads, rail, housing, broadband and capital projects as a proportion of the economy will rise to levels not seen since the 1970s,” enthused the Financial Times, which had been a staunch champion of the last ten years of spending cuts. Certainly, this seems to mark a return to the fiscalism of the Keynesian era, and Sunak hinted as much: fiscal policy, he said, should play a “more active role” in stabilizing the economy. But what neither the chancellor nor the FT explained is why this fiscal Exocet missile is being fired only now.

For example, Sunak announced a £2.5-billion fund to fill 50 million potholes on UK roads over the next five years. But why could this program not have been started in 2010, when there would have been fewer potholes and many more people available to fill them (because UK unemployment then stood at 8%, as opposed to just under 4% today)? The orthodox answer is that the government “couldn’t afford it” in 2010, but that its prudent deficit-reduction policy since then has now given it the “fiscal space” to launch the initiative. This is nonsense. What a government can afford is limited only by the amount of real resources it can command, and not by self-imposed financial constraints.

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The pothole story has an important moral, though. Not only should the fiscal stimulus have come a lot earlier; it now risks coming at the wrong point in the economic cycle. Keynes wrote that, “the boom, not the slump, is the right time for austerity at the Treasury.” True, it doesn’t feel much like boom-time right now; forecasters were pointing to a possible UK recession even without the coronavirus. But the UK and other Western economies undoubtedly have less fiscal capacity today than they did ten years ago.

Third, having spent the last 40 years “fighting inflation,” and continually warning of its re-emergence if fiscal policy was unchained, governments are now turning a blind eye to this risk. But although “cost-push” inflation is indeed unlikely to be a problem in an era of decentralized labor markets, expanding demand at full employment will still result in faster price growth. So, at some point, governments will have to raise taxes if inflation is to be avoided. By loosening and tightening fiscal policy at the wrong times, they would repeat the “go-stop” approach that discredited Keynesian demand management in the 1970s.

That brings me back to the virus. Johnson has said that the UK needs to go onto a war footing, and other leaders such as French President Emmanuel Macron have said the same about their countries. But a war economy is a shortage economy in which you can’t have both guns and butter. Butter has to be rationed to produce more guns. The problem then becomes one of excess demand, not deficient demand.

Keynes recognized this in his 1940 pamphlet How to Pay for the War. UK civilian consumption needed to be cut, either by higher prices or higher taxes. Keynes advocated a steeply progressive income tax (with a top marginal rate of 97.5%) on the grounds that it was “fairer” than inflation. And, in an imaginative twist, he proposed that the taxes collected automatically from the poorest workers would be repaid by the government after the war.

It is to be hoped that the COVID-19 pandemic will not force today’s governments to make such a choice. But it’s not too early for policymakers to start thinking about how to pay for this particular war; and it’s good to be reminded of tough Keynesian arithmetic.;