from Lars Syll
What will be the lasting effects of the covid-19 pandemic? Start with the size of the state. Over the next year government debt will rise sharply, as spending jumps and tax revenues collapse. When the economy recovers, attention will turn to paying it down. “Capital and Ideology”, a new book by Thomas Piketty, shows that after the first and second world wars many governments in the West turned to heavier taxation of the incomes and wealth of the richest to achieve that goal …
Central banks’ innovations will also have lasting consequences. Few economists believe that the explicit co-operation between the fiscal and monetary authorities risks creating runaway inflation … However, just as the use of quantitative easing in 2008-09 opened the door to more of the same down the road, it will become harder to make the argument that the “magic money tree” does not exist … If central banks promised to fund the government during the coronavirus pandemic, they might ask, then why shouldn’t they also fund it to launch an expensive war against a foreign enemy or to invest in a Green New Deal?
Calls for a more activist fiscal-monetary government will come against a backdrop of structurally higher demand for state spending. The public sector tends to provide labour-intensive services in which productivity improvements are difficult, such as health care and education. It must match the salaries of workers in other sectors in order to retain its own, even as they become less productive relative to the overall economy—a phenomenon which raises the cost of provision. Long before the coronavirus pandemic, fiscal wonks argued that government spending would soar during the 2020s, even in the absence of a crisis. That was not only or even primarily because an ageing population would raise demand for health care, but because health systems would be able to treat a wider range of illnesses more effectively, which would push up costs.
The likely economic effects of the pandemic reach far beyond the role of the state … But the redefined role of the state could prove to be the most significant shift. The rules of the game have been moving in one direction for centuries. Another radical change is looming.
‘New Keynesians’ have long been arguing that, at the zero lower bound of nominal interest rates, central bankers don’t have the tools to effectively fight recessions. This yours truly and other Post Keynesian economists have criticized, arguing that those monetary measures don’t work even when we’re not even close to the zero lower bound.
In the ‘New Keynesian’ world we don’t need fiscal policy other than when interest rates hit their lower bound (ZLB). In normal times monetary policy suffices. The central banks simply adjust the interest rate to achieve full employment without inflation. If governments in that situation take on larger budget deficits, these tend to crowd out private spending and the interest rates get higher.
Now, the logic behind the New ‘Keynesians’ loanable-funds-IS-LM-theory is that if the government is going to pursue an expansionary fiscal policy it will have to borrow money and thereby increase the demand for loanable funds which will — “other things equal” — lead to higher interest rates and less private investment. According to this approach, the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a Post Keynesian point of view, this is a belief resting on nothing but sheer hope.
We have to start using good old Keynesian fiscal policies. Keynes — as did Lerner, Kaldor, Kalecki, and Robinson — showed that it was possible to promote economic growth with an “appropriate size of the budget deficit.” The stimulus a well-functioning fiscal policy aimed at full employment may have on investment and productivity does not necessarily have to be offset by higher interest rates.
Under the pressure of Covid-19, more and more economists and politicians have now come to realize that the ‘New Keynesian’ dogma is wrong and that we need other stabilisation (read fiscal) tools to get the economy going. That’s great. Now we’re eagerly awaiting the ‘New Keynesians’ to also finally wake up …