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Page last updated at 17:40 GMT, Wednesday, 22 October 2008 18:40 UK

How to kick-start a faltering economy the Keynes way

Keynes, the influential economist
JM Keynes, who advocated spending your way out of trouble
Out of fashion for the past 30 years, British economist JM Keynes is suddenly the man of the moment as governments try to stave off recession. His key idea? Spend, spend, spend, says economist John Sloman.

Rescuing ailing banks is only one half of the solution to the current global economic turmoil. The other is to keep spending buoyant to prevent a slide into recession.

But how to do that? With worries about ballooning personal debt, falling house prices and rising unemployment, many people are cutting back on spending. Christmas will probably not be enough to revive fortunes on the high street.

One answer lies with the ideas of John Maynard Keynes, the most influential economist of the 20th Century. It was his proposals that helped the world recover from the Great Depression of the 1930s. With unemployment in the UK, the US and many other countries reaching 20% or more in the early 30s, the task was massive. Whole economies were grinding to a halt.

Keynes' solution was simple. Governments needed to spend more. Spending on roads, hospitals and schools would have to offset the lack of private spending.

This is pretty much what Chancellor Alistair Darling is arguing today. If private spending is slowing, then the government needs to take up the slack by bringing forward billions of pounds of expenditure on construction projects, such as new schools, social housing and hospitals. Now is not the time to cut back on spending on Crossrail, the London Olympics or defence procurement. If government borrowing must rise, then so be it.

Demand and supply

In the long term, the means to economic growth lie on the "supply side" - in increased productivity and increased investment in research and development.

In other words, to achieve long term growth, the capacity of the economy needs to rise.

But that's the long term. The present problem is not lack of capacity, it's ensuring current capacity is used - that the output firms could produce actually gets produced. Recession is caused by a lack of demand, not a lack of supply.

The long run is a misleading guide to current affairs - in the long run we are all dead
JM Keynes

So how do we tackle the problem? What's the best way of boosting demand? Is Alistair Darling right in his proposals?

There are different ways of influencing demand.

One is to use monetary policy. This involves altering interest rates. If recession is looming, central banks could cut interest rates - as many did, by half a percentage point, on 8 October.

But this has its drawbacks. Central banks may be unwilling to cut interest rates if inflation is high. After all, most have been charged with keeping inflation to a target level, which inflation has been well above recently.

Even if the central bank does cut its rate - the rate at which it lends to banks - banks themselves may not pass it on to customers.

Finally, even if customer rates are cut, borrowing and spending may hardly increase. With impending recession, people may try to cut back on their debts rather than spend, and businesses may be reluctant to invest.

Tax cuts

The alternative to monetary policy is fiscal policy. This involves changes in taxes and/or government expenditure. If taxes fall and/or government expenditure rises, this should stimulate the economy.

People walking past a SALE sign
Resisting temptation

Some of this will occur automatically as the economy slows down. Tax receipts will fall as people earn and spend less, while government spending on benefits is likely to rise as more people lose their jobs. But these "automatic stabilisers" will have only a limited effect. At best they will reduce the size of the downturn.

To have a more substantial effect the government must directly cut tax rates and/or increase expenditure.

The problem with tax cuts is they can't normally be introduced overnight. They take time to plan and implement. And even then, people may choose to save the money rather than spend it.

This brings us back to government expenditure.

One alternative here would be to give people greater benefits. But this is rather like tax cuts and people may not spend any more.

In Japan, back in 1998, the government gave out free shopping vouchers in an effort to stimulate spending. But many people simply used their vouchers and saved their money. Spending hardly increased at all. From 1998 to 2003, Japanese annual growth averaged a mere 0.4%

So expenditure on projects would seem to be the best way of boosting demand.

Other catches

Many projects simply cannot be speeded up. Planning and construction often operate to fixed timetables. There is some room for manoeuvre, but maybe not enough.

Construction work in east London
Work continues on the 2012 Olympics

Then there's the effect on borrowing. Money borrowed commits the government to paying interest. The bigger the debt, the more interest must be paid, and this comes from taxpayers.

Already annual borrowing in the UK is one of the highest in the world as a percentage of GDP. And it's rising fast.

These annual debts accumulate over the years. At least in this respect the UK is not doing so badly by comparison with other countries such as France, the US, Germany, Italy and Japan.

Although government debt may be rising, the good news for the taxpayer is that if interest rates fall, as they almost certainly will, it will cost the government less to service these debts.

Keynesian medicine

Keeping expenditure up is vital and increased government expenditure is probably the best way of achieving this. But another crucial factor is confidence.

Keynes, the influential economist
The man with the plan

If people believe the policy will work, it probably will. Firms will start investing more and consumers will start buying more. The vicious circle of recession could become the virtuous circle of recovery.

But creating confidence depends on politics as much as economics. If people see world leaders mean business and that they won't let recession take hold, then it won't.

If, however, politicians vacillate or there's no international harmonisation of policies, then any remaining confidence may evaporate and we could suffer from prolonged recession similar to that in Japan in the 1990s and early 2000s.

John Sloman is Director, Economics Network, the Economics subject centre of the Higher Education Academy, based at the University of Bristol. He is author of Economics, Essentials of Economics and various other textbooks.


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