Why even Keynes would be concerned about the risks of further stimulus

Paul Ormerod
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THE loss of the AAA credit rating on UK government bonds has intensified the demands for a Plan B. So-called Keynesians are demanding an increase in both public spending and the public sector deficit.

But what might the late great economist John Maynard Keynes himself have said about the current situation? Lacking a Ouija board, I am unable to communicate directly with the man himself. But we can get a very strong hint from the title of the first major work Keynes published when confronted with the 1929 financial crash. It is the Treatise on Money. And his most famous work was not published until 1936, when the Great Depression was well and truly over. Its full name is the General Theory of Employment, Interest and Money.

So Keynes was very much a monetary economist, who thought that monetary factors are crucial to understanding how the economy works – quite different from the public spending caricature set up by his ostensible followers today. In particular, he attached great importance to the long-term rate of interest – the rate on government bonds. For Keynes, a crucial policy aim during a slump was to have a low long-term rate of interest. Without it, recovery just wouldn’t happen.

There are several reasons for this view, and they are directly relevant today. The obvious point is that a high interest rate means borrowing is expensive, which deters investment. Further, if you can get a high return on an asset guaranteed by the UK government, why bother to invest in risky ventures at all?

The link between the interest rate on bonds and the wealth of the private sector is perhaps even more important. If the government shifts to Plan B, and bond rates stay at 2 per cent, all is fine. But if interest rates reach 8 per cent – as seen in southern Europe – because of worries about the resulting increase in the deficit, three quarters of the wealth held in bonds is wiped out. This wealth effect would be a powerful depressant of private sector spending, both corporate and individual.

Finally, for Keynes there was a subtle but essential ingredient of all business cycle fluctuations, the concept he called “animal spirits”. Here, we are much more in the world of psychology than pure economics. At one level, animal spirits is just another phrase for the degree of optimism or pessimism which firms feel. But it is more complex than this. These spirits also involve confidence – specifically the confidence you have in your view about the future. For any given level of optimism, the less confident you are about your view, the less you will spend. High interest rates add to uncertainty and undermine confidence.

This is why any Plan B involves considerable risk. It might work, but we might end up even worse off and with a higher deficit to boot. Policy at the moment is much more about psychology than the mechanistic calculations of so-called Keynesians.

Paul Ormerod is an economist at Volterra Partners, a director of the think-tank Synthesis and author of Positive Linking: How Networks Can Revolutionise the World.