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Unrepentant: The FT's chief commentator, Martin Wolf, refuses to admit his errors (photo: Brangelina Clawson/World Bank)

Among his many gifts, John Maynard Keynes had a flair for self-advertisement. By giving his 1936 book of new economic ideas the title of The General Theory of Employment, Interest and Money, he deliberately echoed the name that Einstein had chosen over 20 years earlier for his theory of relativity. Economics might be a human science rather than a natural one, but Keynes's message was that it could still aspire to the rigour and modernity of scientific endeavour.

According to numerous accounts, the policy impact of The General Theory was greatest in the field of public finance. Whereas before Keynes governments were convinced that they should balance their budgets, afterwards they accepted that the budget position should be used to stabilise the business cycle and to secure higher employment. In the 1950s and 1960s Keynesian fiscal activism was often praised as one of economics' greatest contributions to the happiness of mankind. The old budget-balancing principles were mocked as little better than the tribal customs of out-of-date finance ministries, whereas Keynesianism could boast of its scientific credentials.

But there was a problem. A large budget deficit implied a big increase in the national debt and debt holders needed to be paid a rate of interest. Of course the larger the debt, the higher were the interest payments. Even worse, in the Britain of the 1970s runaway inflation pushed up the nominal rate of interest to unprecedented peaks. Investors had therefore to be paid interest rates well into the teens, to persuade them to buy current issues of government debt. As the stock of debt rose because of persistently high deficits, and as maturing low-interest-paying government securities were rolled over into new high-interest-paying equivalents, the burden of interest payments soared.

The Thatcher government decided that enough was enough. The growth of public debt had to be checked. In the 1981 Budget the government raised taxes in order to reduce the budget deficit, even though the economy was in a bad recession. A move back towards a more balanced budget position was seen as essential, regardless of Keynes's intellectual legacy. To many economists in British universities, this so-called "tightening" of fiscal policy would reduce spending power, undermine demand and output, and destroy jobs. At the prompting of two leading figures in the Cambridge economics faculty, 364 university economists wrote a letter to The Times in protest against the 1981 Budget. They were accusing Treasury ministers not just of folly, but of ignorance of the best thinking on the subject, which in their view was the thinking that came from Keynes' General Theory.

Given their elevation of economic principles to scientific status, the Keynesians saw the 1981 Budget almost as a laboratory experiment. Not only did they believe that an increase in the budget deficit stimulated aggregate demand and that a reduction in the deficit restrained it. They were also confident that the budgetary stance was one of the most powerful influences — perhaps even the most powerful single influence — on economic activity. The letter from the 364 warned that "present policies will deepen the depression", and threaten "social and political stability".

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January 7th, 2015
10:01 AM
"In the 1970s Sir Samuel Brittan, who might be described as the George Orwell of financial journalism, became its most acclaimed contributor, and was widely regarded as a champion of the free market and a trumpet-blower for monetarism." This is what S.B. said post the G.R. "Where will the money come from? The Bank of England printing works at Debden. This is not a joke. Under a paper money system the amount of money in existence is a conscious national decision. Don't talk to me about the money printing excesses of countries like Zimbabwe. Just because you cannot draw a line, it does not mean a line cannot be drawn. Ideally monetary policy should be the first line of defence against both slump and inflation. But with official policy interest rates down to ½ pc, there is not much more that can be done by conventional monetary policy; and tax cuts and public works may be necessary to put the money into circulation.(It goes without saying that in opposite conditions of inflationary pressure public sector surpluses would be required.) So far from being socialistic this analysis was developed in the 1930's and 40's by those who wanted to save the capitalist system. But, as always we are in danger of forgetting everything we have ever learned.“

January 7th, 2015
9:01 AM
"As Smallwood points out, the Treasury and Bank drew the wrong conclusion from the apparent success of the combination of fiscal contraction and monetary expansion in the 1980s and 1990s. "In both cases, the contractionary impact of tax rises and spending cuts was counterbalanced by substantial falls in interest rates, and of the sterling exchange rate at a time when our export markets were growing," he writes. Exports and investment took up the slack left by budgetary cuts."

Malcolm McLean
December 5th, 2014
2:12 AM
The flip side of Keynes' policy is that governments should reduce spending and raise taxes during a boom. But that's politically very difficult. People will accept spending cuts, reluctantly, when the economy is in difficulty, but what politician can close a hospital ward when things are booming? The basic idea is government borrows, creates investment, then repays the debt from the expanded economy. For Keynes' prescription to work, the economy must be capable of absorbing investment. For modern Britain, that's really the snag. Infrastructure projects like HS2 will shave half an hour off a two and a half hour train ride between London and Leeds - something, but it's not like the difference between a railway and horse and cart. And HS2 will cost billions. A modern information economy can see companies with spectacular growth. But generally they start off with tiny investments. That's the nature of the Internet, the new economy doesn't respond in the same way as the manufacturing economy to purchases of expensive machinery, instead little mustard seeds blossom overnight into mighty trees.

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