Blog post

Even Keynes can’t help us now


High rates of inflation around the world have all but ended the popularity of MMT, or Modern Monetary Theory, and its proposition that sovereign governments can spend as much as they want. But current economic conditions also call into question the usefulness of a much more established and accepted theory: Keynesian economics.

The standard Keynesian doctrine is to run a budget surplus in good times and then use deficit spending to stimulate the economy in bad times. This argument did and still does make logical sense. But that just doesn’t apply to the present moment.

One problem is that it’s hard to tell which are the good times and which are the bad. Following the 2011 euro crisis, Germany was widely criticized for not spending more to stimulate other European economies. The EU was clearly going through bad times. German leaders insisted that caution was in order and there was a need to save funds for possibly tougher times ahead. Few observers of the Anglo-American establishment were convinced of this.

Today, with war in Ukraine raging and German energy supplies uncertain, is it so obvious that then German Chancellor Angela Merkel got it wrong? And even if it was, the German insistence on austerity doesn’t sound so crazy anymore. The very near future may require large energy bailouts, a very large Italian bailout, not to mention additional military challenges and spending.

The general point is that in times of volatility, it is difficult to know when budget deficits should increase or contract. This doesn’t necessarily militate in favor of current austerity, but it takes a lot of confidence out of the usual Keynesian recommendations.

A second problem with Keynesian recommendations is that governments have not done enough to accumulate surpluses in times of prosperity. Many governments therefore lack fiscal space, or at least the markets perceive this to be the case. Even though Keynesian theory says they should expand fiscal policy, they cannot always do so with impunity.

The recent history of the British government is a paradigmatic example of this. Under Prime Minister Liz Truss, the plan was to increase spending on energy subsidies and cut some taxes. Whatever else you can say about the details of these policies, they fit the Keynesian recipe for fiscal expansion in bad times (although it should be noted that many leading Keynesian economists strongly opposed them ).

The problem is that the markets didn’t like the policies, and the pound fell and borrowing rates on government bonds rose. Financial markets have been choppy, and now Truss’ days are over.

Now Rishi Sunak is prime minister. What should he do exactly? He could try the opposite of the Truss plan, namely raising some taxes and cutting some spending, or at least bend the trajectories of future spending. In Keynesian terms, however, this policy is misguided. The UK is likely entering a recession and the Bank of England has said it could be the longest recession on record. Is it really wise to engage in austerity when times turn bad?

Moreover, the existing figures do not indicate that the UK should engage in austerity. Its debt to GDP ratio is around 80%, which is not astronomical. For a time economists Carmen Reinhart and Kenneth Rogoff tried to convince the profession that debt levels are dangerously high at 90% of GDP, but those arguments were dismissed for having data errors and now those claims are discredited. It is not easy to argue today that an 80% debt-to-GDP ratio requires austerity.

A final issue is that inflation rates are expected to remain relatively high for some time to come. I am relatively optimistic about the ability of many Western economies to bring inflation down to around 3% or 4% within a few years. But at these rates of inflation, nominal demand is quite robust, so why would expansionary fiscal policy be needed to stimulate nominal spending flows?

In a recent interview, Sunak declined to be specific about his budget plans. Can you blame him? Macroeconomists are no longer there to advise him.

The UK government appears to be in a state of Zugzwang, a chess term for the situation where there is no good move but there is nonetheless a requirement to do something. Chancellor Jeremy Hunt has indicated that austerity will be the chosen path.

The macroeconomic establishment of the Anglo-Saxon world won’t quite admit it, but Keynesian economics is no longer a reliable guide to fiscal policy. The real influence will go to whoever offers a credible alternative.

More from Bloomberg Opinion:

• What would Modern Monetary Theory do about inflation? : Clive Crook

• Keynes was right – at least about buying property: John Authers

• Economics Needs Some More Theories: Karl W. Smith

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is co-author of “Talent: How to Identify the Energizers, Creatives and Winners in the World”.

More stories like this are available at