What's happening at the
Wednesday 23 Aug 2017 | 12:51 | SYDNEY
Wednesday 23 Aug 2017 | 12:51 | SYDNEY

After the 'Keynesian moment'

By

COMMENTS

2 July 2010 14:53

I've posted before about the ongoing policy debate over the swing back to fiscal consolidation — a debate that also dominated the recent G20 meeting.

For now, the argument appears to have moved in favour of those advocating austerity. Policymakers across the developed world have announced spending cuts in a gamble that an incipient private sector recovery will prevent a re-run of the 1930s. Proponents of a more Keynesian approach are left wondering how they have seen such a quick reversal in the battle of ideas, and forecasting more economic pain ahead.

Might their pessimism be overdone? I have noted before that some advocates of fiscal consolidation have pointed to empirical work arguing that fiscal contractions can sometimes have expansionary effects: or to put it another way, maybe sometimes Keynes is wrong and Alesina is right

I suppose it's possible, but the trouble is, two of the most likely mechanisms to deliver the kind of anti-Keynesian outcomes that have occurred in the past do not look promising under current conditions:

  • Mechanism one is for private domestic demand to substitute for the withdrawal of government demand – presumably because fiscal retrenchment boosts private sector confidence and, via a sharp fall in interest rates, re-activates growth. But in most rich countries, nominal interest rates are already very low, suggesting that any stimulatory impact is unlikely to be particularly large.
  • Mechanism two is for external demand to replace domestic demand – that is, for an increase in exports to offset the withdrawal of government demand. But in a world where most developed economies are following the same policy prescription of belt-tightening, it's not obvious where the external demand will come from.

Maybe it can come from the developing world? After all, economic growth in emerging markets has been relatively resilient compared to the performance of the developed world, and (as a result) the developing world's share of the world economy is continuing to rise. 

Yet there remains a big question over whether the developing world is now big enough to serve as a locomotive for the rest of the world economy. This also leaves the rich world hostage to policy actions in emerging markets (something of an inversion of economic history, where the more typical pattern has been for developing country prospects to be side-swiped by policy shifts in the rich world). This is one reason why markets earlier this week reacted so badly to signs that China's economy has been slowing.

Photo by Flickr user flappingwings, used under a Creative Commons license.

You may also be interested in...