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Peter Spiller: What lessons can Keynes teach today’s policymakers?

08 June 2021

Capital Gearing Trust’s Peter Spiller examines some of the risks around inflation that global policymakers are flirting with.

By Peter Spiller,

Capital Gearing Trust

Keynesian economics has been out of fashion for four decades, but in a short period has been re-established as the guiding force for policymaking. Even the more extreme version, Modern Monetary Theory, is respected if not overtly adopted.

It seems, therefore, worthwhile re-examining the history of why Keynesianism, having seemed to work well, led in the late 1960s and 1970s to high inflation and gave way to a monetarist approach as a result.

Keynes developed his theories in an era of deficient demand and high unemployment following the great depression. He described an economy operating below its full potential as having an ‘output gap’. Keynes’ policy advice to governments was to close output gaps by running fiscal deficits until the economy returned to full employment. Conversely if an economy was running ahead of its potential, causing a negative output gap, the government should reduce demand by maintaining a fiscal surplus.

There were two difficulties with the approach. The first was that policy operates with a lag, so the relevant output gap was not the present one but the one that would prevail in the future, perhaps a year or more ahead. The second more important difficulty was the weight put on the estimation of the output gap itself. The problems are demonstrated by the ‘Barber Boom’ in the UK from 1971 to 1973.

A Bank of England paper published in 2001 points to the role played by real-time mismeasurement of the output gap. Barber based his policies on the Treasury’s estimate of a large and growing output gap during what was then described as the ‘depression of early 1972’. Later analysis by the Bank of England suggests there was no output gap, at least as measured at the end of 1972. This resulted in inflation building to almost 10 per cent ahead of the 1973 oil crisis.

An even more stark example occurred during the 1976 chancellorship of Dennis Healy, when the Treasury estimated the output gap to be 7.5 per cent. The government launched an economic stimulus designed to deliver 5.5 per cent annual growth for 1976-1979. This resulted in rampant inflation, peaking at 25 per cent and remaining at high levels for the rest of the decade. Subsequent analysis revised the estimate of the 1976 output gap down from 7.5 per cent to 0.7 per cent.

The sources of potential ‘mistakes’ today are parallel. The most fundamental is the absolute conviction, based on the experience of the last 30 years, that inflation is not and will not be problematic (or possibly an unstated recognition of the necessity of inflation to deal with extraordinary levels of debt). That means that interest rates can be set far below the levels implied by the Taylor rule for a sustained period.

It means that any blip in inflation, such as the likely upturn over the next six months, can be looked through. It means that inflation 1 or 2 per cent above target even for a sustained period can be tolerated in the name of flexible average inflation targeting. It means that the QE programme can remain accommodative.

The same conviction drives fiscal policy in the US. The level of fiscal stimulus has been extraordinary, especially in view of forecasts that include unemployment levels of 3.5 per cent by the end of 2022. And large stimuli will continue. The deficit going into the Covid crisis was over 5 per cent of GDP. With that as a base, 2022 will see part of the current $1.9trn stimulus, plus 1 per cent of GDP at least from the $2trn programme for infrastructure and education spending that are promised over the next eight years.

The latter are in theory paid for by increased corporation tax, but those revenues will not be recouped for over 15 years. Nor is this policy accidental. Secretary Yellen wants to run the economy ‘hot’. That echoes the era of chancellor Barber.

The theory then was that a ‘hot’ economy would lead to wage inflation. That would force companies to invest in capital goods and improve productivity, substituting capital for labour. There is exceptionally little evidence that this ever happened. The most egregious parallel is in the approach to the speed limits. Barber was misled by the rise in unemployment into overstimulating a fully employed economy.

Yellen is quite deliberately stimulating an economy that on the conventional view will have a minimal output gap in 18 months’ time. That is because both the Treasury and the Federal Reserve are placing great emphasis on bringing disadvantaged groups into the workforce. Implicitly, if the pursuit of that goal leads to a shortage of labour among better placed groups, then that is a price worth paying. The outcome is likely to be higher wages, an essential ingredient to accelerating inflation. So, the similarities of current policy to those of the early 1970s are intended.

There are many differences in context between the 1970s and today but none of these differences can fully mitigate the inflationary risks running a negative output gap. Treasury secretary Yellen talks of having the tools to control inflation if necessary. Of course, such tools are available but their deployment would deliver a crunching blow to the economy. Nothing in the zeitgeist suggests any appetite at all for such a policy.

Peter Spiller is manager of Capital Gearing Trust. The views expressed above are his own and should not be taken as investment advice.

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