The Limits of Keynesianism?

Is an age of austerity unavoidable? That is the question James McDonald asks in a thought-provoking piece that outlines the policy response to the financial crisis, and the problems that high levels of private debt pose to recovery.

Felix Salmon approvingly flags down this passage:

The markets have highlighted a fundamental shortcoming in Keynes' ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.

It is worth considering why a government might find itself unable to borrow in the private markets. Consider the examples McDonald cites: the PIIGS. Here is McDonald on Europe's seemingly atypical debt crisis:

Indeed, one of the most striking aspects of the eurozone crisis is that bond markets have not discriminated between causes of excessive debt.... What we are seeing, in other words, is a wholesale revision of the rules about debt that have held true for decades.

It is certainly true that the PIIGS evoke Tolstoy's description of unhappy families, but do their mutual yet disparate problems really portend a dramatic break with the rules that have governed debt in the post-war period? After all, McDonald omits the most salient point: all of the PIIGS are members of the Euro. It should not surprise us that a fixed exchange rate system calls the debts of high debt and low growth countries into question. By forfeiting monetary sovereignty, the PIIGS were left vulnerable to nominal shocks -- such as the financial crisis -- without the usual buffers of monetary easing or devaluing. Like the Gold Standard in the 1930s, the Euro has forced the PIIGS to adopt deflationary policies at precisely the wrong moment. Unfortunately, austerity is self-defeating here since it depresses growth; the denominator of the debt-to-GDP ratio shrinks in tandem with the numerator. This is Fisher's debt deflation on a sovereign level.

Fixed exchange rate systems merely substitute default risk for exchange rate risk. Debts that would otherwise be sustainable suddenly catch the ire of bond vigilantes who (legitimately) doubt the prospects for growth under the exchange rate regime. The same was true, of course, for Argentina in 2002 -- although in that case the culprit was not monetary union, but rather a currency peg. Insofar as this offers any lessons about the supposed practical limits of Keynesian stimulus, it would seem to be: do not surrender monetary sovereignty by joining a fixed exchange rate system.

There is another way for a government to get shut out of the bond markets: high inflation. If a country's central bank lacks credibility in promoting price stability and inflation reaches some critical point, private lenders will demand prohibitively high interest rates. Of course, this risks spiraling out of control: the inability to finance deficits in the international markets creates the temptation to monetize them instead. Inflation accelerates, making bond markets even more wary of lending money. In the worst case, this ends with Zimbabwe-style hyperinflation. But given that most advanced economies are still stuck in a liquidity trap, this is not terribly relevant right now.

As long as a country remains in the Goldilocks territory of controlling its own currency (especially if it can denominate debt in that currency) without letting inflation run too high, it should be able to engage in counter-cyclical Keynesian policy. Indeed, Salmon notes that the U.S. can happily still borrow at historically low rates, although the political winds are blowing the other way towards fiscal consolidation. But then comes this somewhat puzzling passage:

[W]e’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option.

The problem is not a dearth of private capital willing to lend to sovereigns; the problem is the lack of growth prospects for the PIIGS makes private capital unwilling to lend to them at affordable rates due to worries about eventual default. Hence, the necessary interventions of the ECB, EFSF, and the IMF. The irony is that we still suffer from a surfeit of savings: China et. al. have trade surpluses to recycle, and increased savings in the West are still eagerly seeking safe, liquid investments. That the 10-year Treasury bond recently yielded less than two percent and gilts touched lows not seen since the 1890s shows that the markets are desperate for debt from sovereigns that can credibly promise NGDP growth.

If the "Keynesian game" is indeed over, it is because of the misguided choices of politicians in countries that can still borrow to pursue austerity instead, while the PIIGS suffer under a renewed version of that old barbarous relic. And that is what makes this all so tragic. With a little bit of clear thinking and political will, a double dip would be preventable. Alas, we seem determined to forget our history.