The UK Experiment

Deathbed of Keynesian Economics Will Be in U.K.: Matthew Lynn

Commentary by Matthew Lynn

Feb. 23 (Bloomberg) -- The U.K. has produced notable economists over the years, but John Maynard Keynes, the guru of government intervention, was one of truly global significance.
So it may be fitting that the U.K. will also become the deathbed of Keynesian economics.

Britain has been following the mainstream prescriptions of his followers more than any developed nation. It has cut interest rates, pumped up government spending, printed money like crazy, and nationalized almost half the banking industry.

Short of digging Karl Marx out of his London grave, and putting him in charge, it is hard to see how the state could get more involved in the economy.

The results will be dire. The economy is flat on its back, unemployment is rising, the pound is sinking, and the bond markets are bracketing the country with Greece and Portugal in the category marked “bankruptcy imminent.” At some point soon, even the most loyal disciples of Keynes will have to admit defeat, and accept that a radical change of direction is needed.

The public debate about the state of the British economy was enlivened last week by a brawl between economists.

On Feb. 14, a group that included the former Bank of England policy makers Tim Besley, Howard Davies, Charles Goodhart and John Vickers published a letter to the Sunday Times calling on the government of Prime Minister Gordon Brown to control the ballooning deficit. If it didn’t, the stability of the economic recovery would be threatened, and there would be a run on the pound, they warned.

Keynesian Backlash

That brought a stinging response from the Keynesians, who are urging the U.K. to spend its way out of recession. Nobel laureates Joseph Stiglitz and Robert Solow were among the signatories to letters written by a group of 67 economists insisting that deficit spending was the only way to salvage the economy. The letters, published in the Financial Times, argued that a “a sharp shock” now “would be positively dangerous.”

So who is right, and who is wrong? It’s a debate that matters to the rest of the world. After all, if demand management doesn’t work here, it won’t work anywhere.

The U.K. has some experience of mass letter writing from Keynes’s devotees. In 1981, a group of 364 economists wrote an open letter ripping into the policies of then Prime Minister Margaret Thatcher. They turned out to be totally wrong, of course. With hindsight, no one can now dispute that her policies led to a long and durable economic revival.

Budget Blowout

And just as the Keynesians were wrong three decades ago, they are wrong now.

The U.K. has been in Keynes overdrive for the past 18 months. The budget deficit is already more than 12 percent of gross domestic product, on a par with Greece. And while the Greeks are cutting spending, the British deficit is widening. Figures for January showed another fiscal blowout. At the same time, interest rates have been slashed to 0.5 percent. And the pound has slumped in value, which is supposed to boost demand for British goods, and help close the trade gap.

Just about everything possible has been done to encourage consumption. The results have been miserable.

Stimulating the economy isn’t working.

In fact, it’s only making it worse. Consumers and businesses don’t want rising taxes. A falling currency pushes up the cost of everything the U.K. imports, stoking inflation. Savers get decimated, and yet the banks remain reluctant to lend because they rightly believe the economy is in the doldrums.

Recipe for Recovery

What’s needed is a total change of direction. Get the deficit under control. Raise interest rates to restore confidence in the pound, and reward saving. Cut taxes to stimulate enterprise and investment.

And yet the real lesson of the U.K. in 2010 will be of wider significance. A country can’t spend its way out of a recession. And it can’t fix what was at root a problem of too much debt by just borrowing more and more.

In the country of its birth, Keynesian economics is being tested. If the economy isn’t growing at a healthy clip again by the end of 2010, its failure will be obvious to everyone.


In our recent post Trouble in UK we examined the evidence for the next credit crisis trigger.  It is becoming clear to many in the public, and even some economists, that attempts at asset reflation and increased deficit spending are not pulling the economy out of a hole. 
At this late hour, it is our best hope for restraint to present itself, interest rates to rise and allow the bad debts to be written off as deflation kicks into high gear.

Deflation is very hard to resist even when governments have influence over the printing press.  It can be delayed, as happened during the 2001 recession with accommodative policy, but 9 years later it has not been defeated.

We need deflation.

Not because we want to see job losses and people losing their homes and businesses, but because, like the forest fire that cleans out the build up of wood debris periodically, deflation cleans up the mistakes of past years.

With the modern philosophy of the Nanny State that promotes "equality & fairness", every one is allowed to make mistakes and not suffer any consequences.  The State demands we give up most of our civil rights for its benevolence, yet there is something pathological about all this sovereign good will.

In our view, the forces behind this type of world view are anything but benevolent.
For who will be so bold as to step forward and tell their fellow citizens that they should obey the sovereign command?

We examined this issue in a recent post here: