The UK economy will bounce back!*


* Bank of England Monetary Policy Committee 04/02/2021

Occasionally in these posts I’ve talked about the importance of a Keynesian approach to economic policy. When I studied for A-level economics in the mid-1960s Keynes was a cornerstone of economics. Within 15 years he had become an historical figure rather than a guide to contemporary policy.

Now, the impact of Covid on the economy has brought him back into fashion.

Keynes’ understanding of the economy was that you had to pay close attention to the amount of effective demand for goods and services. If the public had money in their pockets to buy goods and services, the economy would grow. If they didn’t – simply because they were poor – they couldn’t afford to buy them and the economy would suffer from the lack of demand.

This understanding of the economy led to his politically strong argument about the role of Government. In the 1930s, as the economy was stumbling, governments were in trouble because tax revenues were falling (less earning = less spending = lower tax revenue). They reacted by lowering public expenditure to try to make up budget deficits. This action led in turn to cuts in basic benefits – such as unemployment benefit.

In the 1930s the impact of this simple English orthodoxy was disastrous. By cutting public expenditure, you cut demand for basic goods and services and increased unemployment. This reduction in demand led to a fall in tax revenues. Orthodoxy dictated that you had to keep cutting public expenditure… and the cycle continued with even lower demand.

Keynes policy for governments was for them to increase public expenditure to drive up demand for goods and services.  Tax revenues would rise and the cycle would be reversed. This rise in government public expenditure was (and is) called counter-cyclical.

This was pretty orthodox policy from the 1940s to the late 1970s and into the1980s – when it became heresy.

Balancing the Government’s books (and leaving demand to look after itself) became the ‘new normal’ under Thatcher. In 2010 it became normal under David Cameron. His Government managed to slow down economic growth following the financial crash by cutting public expenditure and prolonging austerity. The resulting economic slump was longer than necessary because there was no effective increase in demand for goods and services. (There was no effective increased demand for goods and services because the Government cut public expenditure).

But that was then.

Covid has seen a massive increase in public expenditure – most of it going directly to replace wages in the furlough scheme. The Prime Minister has the idea in his head that infrastructure projects and public expenditure on them will increase demand (and level-up ‘left behind’ areas). So Keynes is (sort of) back on the agenda.

I have gone over this is some detail because – as with all rediscovered older orthodoxies – there are some issues to which its new disciples will have to pay attention.

The idea of increasing public expenditure in order to increase demand for goods and services is the bedrock of Keynesian economics. But for counter-cyclical policy to work, it’s important that this expenditure is of the right kind. For this all to work, the idea is to get money to people – who will then buy goods and services – and in doing so increase demand. This process continues with the original money repeatedly pumped into many cycles of improving the economy. In Keynesian terms, the pound multiplies from its origin and increases demand several times.

But not all money does this. Let’s take the two recent examples of increases in public expenditure.

The first is last July’s announcement of a stamp duty holiday. The Government abolished stamp duty on buying property between £125000 and £500000[1]. If you bought a property for £125000 you had previously paid no stamp duty – and this tax break gave you nothing new but if you bought a property for £500000 this policy saved you £15000. The Keynesian hope is that the extra £15000 would then be recycled into the economy and increase demand for goods and services – multiplying throughout the economy. Overall this stamp duty holiday cost the Exchequer £3.8 billion a year.

The second example is the extra £20 a week on universal benefit that everyone receiving it has been given since the start of the crisis. This is a straightforward cash-in-hand increase (The extension of which is the subject of much political debate at the moment). This costs the Exchequer £6 billion a year.

Let’s work through the impact of these sums of money against the objective of increasing demand for goods and services as part of Keynesian policy to improve demand.

I know that in some parts of the country you cannot buy a house for £125000 but, for example in the northeast of England, you can. Most people buying houses in Bishop Auckland receive nothing from stamp duty relaxation, so the local economy receives no increase in demand for goods and services. On the other hand, nearly everyone buying houses in the South East of England gains from this – and most will receive the whole £15000.

So where will that money go? How will it multiply? What do middle-class people do with extra cash? Some may be spent on a new kitchen. Most of those will involve using components from abroad – so the money that multiplies the demand for goods and services may well help Milan or Dusseldorf. The multiplier leaks and adds little to the British economy.

In the last year none of those £15000s will have been spent on foreign holidays. Most of it will have been saved. As we shall see below – those save money are a bit of a problem for successful Keynesianism so I don’t see how this £3.8 billion increase in public expenditure multiples much benefit to the British economy.

Moving on from these examples to the current economy as at February 2021. On 4th February the Bank of England’s Monetary Policy Committee claimed that the ‘British economy would bounce back’.

Much of this bounce is to come from what they estimate to be the £125 billion pounds that the public has not spent (and therefore has in their savings) compared to 2019.

This is an enormous sum of money. Compare this to the sums I have been using as examples above. If £6 billion in Universal Benefit can play a role in improving the demand for goods and services in the economy. £125 billion would have an enormous multiplying impact.

There’s always a ‘but’ though, and in this case two big ones. The bank has carried out a sample survey of those with these savings. Respondents revealed that more than two-thirds of these potential consumers will hold on to their savings. Hypothetically bankers love people to save but in the current economic crisis – caused by a lack of demand – money saved does not increase demand for goods and services and therefore will not help.

The second most likely thing that will happen to this saved money is that it will be spent on a very good holiday. The moment the vaccination programme in the UK looks like being matched by vaccination programmes in overseas holiday destinations a longer and smarter than usual holiday will be booked. The money saved from not going on last year’s holiday will be spent on this year’s more expensive one.

And – yes, you’ve guessed it – nearly all of the money spent on that holiday will go to improve the flow of goods and services in other countries. That huge amount of savings will be good news for economies on the Mediterranean and further afield.

The lesson is that Keynesian counter-cyclical expenditure doesn’t work with those who already have money.

Given the impact of the Covid crisis on worsening existing inequalities in this country, it is not surprising that economic inequalities have correspondingly increased.

The Financial Conduct Authority now carries out regular analyses of the economic security of the population. In February they published their latest survey of where people were in October 2020.

They found that the Covid crisis has put one in four UK adults at financial risk. This is defined as over-indebtedness, low savings or low or erratic earnings. This number increased by a third between February and October 2020 and by the latter date represented more than a quarter of the UK adult population. The survey found that a higher than average number of young adults and those from black and minority ethnic backgrounds had become more vulnerable since March.

These people – a quarter of the adult population – are economically insecure. Many of them are more insecure than they were just a few months ago

Now let’s return to the £6 billion that may or may not be spent on continuing the £20 uplift on Universal Benefit. How likely is it that this money will increase demand for goods and services in this country? Given the local way in which recipients of Universal Benefits live their lives, nearly all of that money will be spent on local goods and services. That means, that in poorer areas, that money will multiply by creating demand for more goods and services.

If you want to create counter-cyclical increase in the demand for goods and services – don’t give money to the better-off.

To recap.

  • The crisis has meant that some people have come out of it having saved £125 billion more than they had before.
  • A very different quarter of the adult population is now at financial risk.
  • Very sharp inequalities in our economy will have a direct impact on how the British economy comes out of this crisis.

Let’s return to the economy bouncing back.

  • If Keynesianism is to work in getting the economy going it would be very wise to increase the demand for goods and services from those people who actually buy local goods and services.
  • In Keynesian terms it would be a waste of money to give extra resources to those people who will either save it or spend it abroad.

So let’s wait for the March 3 budget to see how much the Government really want to make Keynes work for them. It’s not about how much the Government increases public expenditure – it’s about how that money is spent.

[1] Slightly different schemes in different UK nations. These examples apply to England.