David Vines is a Professor of Economics and Fellow of Balliol College, Oxford University
What is the state of macroeconomics six years after the financial crisis?
Macroeconomics is now a confused discipline. In the run-up to the global financial crisis, economists believed in the ability of financial markets to regulate themselves. As a result they saw the task of macroeconomic policy as very limited – simply to stabilizing inflation through the use of interest-rate policy.
The task of fiscal policy was thought to be merely that of to ensuring the solvency of public finances, if necessary through policies of austerity. Financial stability would – it was thought - be ensured by the private sector, since it was in the interests of all financial institutions to properly manage their risks and to not get into financial difficulties.
But we now know that these beliefs were deeply misleading. Financial institutions took excessive risks, and provoked the public sector into having to bail them out, creating a huge increase in public debt.
As a result, austerity is now being imposed in many countries, precisely because of the increase in public debt caused by banking failure. And a tightening of financial regulation is forcing banks to curtail lending, just when an expansion such lending is needed to support the global recovery.
What is needed in these circumstances is a policy to promote growth. That will require austerity policies to be greatly modified, at least temporarily. It will also require a radically reformed financial system, one which will increase lending in a way which promotes growth, whilst not taking too many risks. But there are grounds for hope. Many macroeconomists are coming to see how these changes can be brought about which will move economies in this required direction.
The Eurozone seems to slide into a triple-dip recession. What went wrong?
The policy of austerity in Europe has been especially damaging. What Europe now needs is a recovery of competitiveness in the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) and a very great increase in spending in Germany where the policy of austerity needs to be radically reformed.
It is normal for a country, when in the position of the PIIGS countries, to devalue the currency a great deal and then to begin to grow again by greatly expanding exports. This is what happened in Thailand, Korea, Malaysia and Indonesia, after the East Asian financial crisis in 1997.
But because this is not possible in Europe, because the PIIGS countries belong to a monetary union, recovery in these countries will take much longer than it did in East Asia. Many reforms are necessary in the PIIGS countries. But more important than this is an expansion of demand in German, to enable Germany and other countries in the North of Europe to buy more exports from the PIIGS countries. And this expansion of demand in Germany should be so large as to cause inflation in Germany of 4% – 5 % for a number of years: at least three or four.
That will enable relative costs to fall in the PIIGS countries, without actually requiring deflation in those countries. By contrast, the deflation which is currently emerging in those countries is likely to lead to crisis, and quite possibly to default, and to the collapse of the whole European project.
How can Keynesian economics help Europe to get back onto a favorable path of economic growth?
This is time when the going is tough. The response of many policymakers, and economists, is that what you do when the going gets tough is to adapt: to increase taxes, to cut public expenditure, and to reduce the provision of welfare.
By contrast, the response suggested by Keynesian economics is to do the opposite: large increases in public expenditure are necessary: taking European countries very definitely in the opposite direction. It will be possible to carry out such expenditures in a prudent and careful manner, by increasing expenditure on infrastructure. This means improved airports, better railways, the provision of faster broadband services, and, especially, the adoption of more environmentally friendly forms of power generation.
Increased public expenditure on such infrastructure projects in a country will increase the size of its valuable public sector assets, and these assets will act as a counterparty, or collateral, to the resulting increases in public debt.
Of course the size of public sector debt is of great concern in Europe at present, where there is a rapidly growing number of old people. But the right time to worry about these debts is when the recovery is well underway. At that time the output of the private sector will be increasing again and, as a result, taxes will be rising again.
Furthermore that will be the time to actually increase tax rates, and to begin to bring public sector debt back down again. In the meantime the public sector must act as a cushion.
Attempts to continue with a sustained policy of austerity will, in fact, generate continued low growth and a continued low level of tax revenues, rather than pushing the fiscal position in the right direction. The ability of liberal political systems to survive, in the face of a continuing policy of austerity, is now very much open to question.
Thank you very much.
Keynes: Useful Economics for the World Economy. Peter Temin and David Vines, 2014, The MIT Press.
David Vines is a Professor of Economics and Fellow of Balliol College, Oxford. His research is on international macroeconomics and global governance. He has been Director of an ESRC Research Programme on Global Economic Institutions, and from 2008 to 2012 was the Research Director of a European Union Framework Seven Research Programme on the Economics of Global Governance: the European Dimension. His publications The Leaderless Economics: Why the World Economy Fell Apart and How to Fix It (Princeton University Press, 2013) with his colleague Peter Temin. He is currently working on international cooperation on macroeconomic policies, designed to ensure that the recovery from the global financial crisis is sustained.