Why the Keynesian Model Cannot Explain Britain

Lots of Keynesians think recent events in Britain support the Keynesian model—particularly the Keynesian critique of “austerity.”  Put aside the fact that Britain clearly isn’t “stuck” in a liquidity trap, rather the BoE simply does not want to push inflation even higher.  Let’s say my monetary offset theory is wrong.  Does this rescue the anti-austerity thesis?  Unfortunately no.

Step 1.  The Economist magazine reports (in the back) that Britain has the third largest budget deficit in the world, significantly bigger than the US as a share of GDP.  So fiscal policy is obviously expansionary using a simplistic metric that doesn’t adjust for the business cycle.

Step 2.  Then Keynesians point to the cyclically-adjusted deficit, which is presumably much smaller in Britain, and has been shrinking.  Unfortunately this won’t work either, but the reasons are more subtle.  Just how far below potential is the UK economy?  The honest truth is that no one has a clue.  But let’s use the sorts of measures that Keynesians would rely on.  The unemployment rate is roughly the same as in the US.  So by that measure the output gap is similar, although a bit smaller in the UK because they have a slightly higher natural rate of unemployment.  But almost all economists think that no single labor market indicator is perfect.  And all the other measures show the UK doing far better than the US, especially total employment, which hits record levels in the UK month after month, while lagging 3 million below early 2008 levels in the US (a country with a faster growing population.)  Here’s the bottom line: The UK has a smaller output gap than the US using any plausible set of labor market metrics.  This means that the cyclically-adjusted budget deficit in Britain isn’t just modestly larger than the in the US, but a great deal larger.  And yet the US has not experienced the near zero growth of the UK.  Why not?

Step 3.  Then the Keynesians point to the low RGDP growth in Britain, and claim this somehow proves Britain has a massive output gap, and hence fiscal policy is actually quite austere.  I hope everyone can see the problem with this argument.  It makes the Keynesian theory almost impossible to refute.  Indeed demand-side explanations would appear correct even if Britain’s problems were 100% supply-side.  Here’s why.  If growth slowed sharply for supply-side reasons, the government officials would likely sense that they had a structural deficit problem and cut back on spending.  The alternative would be an exploding debt ratio.  If Keynesians (wrongly) assumed the slowdown was demand-side driven, and that the output gap was huge, they would severely overestimate the amount of austerity, assuming the cyclically-adjusted deficit to be much smaller than it actually was.  All economic slowdowns would contain stylized facts that seemed to confirm the Keynesian, demand side, anti-austerity view, even if (by assumption) the slowdown was structural.

Step 4.  So is this simply a “he said, she said?”  No, we have powerful evidence of supply-side problems in Britain.  Recall that the Keynesian model doesn’t just predict that fiscal austerity reduces output, they have a specific mechanism—lower employment.  The Keynesian model has no explanation for a slowdown that occurs when employment is hitting record levels but productivity is awful.  Thus the stylized facts fit the supply-side model at least as well as the Keynesian model, if not better.  And then there’s that British inflation problem . . .

But I don’t want to overstate things.  The UK unemployment rate is somewhat elevated, and hence they probably have both supply and demand-side problems.  It’s OK for Keynesians to blame the elevated UK unemployment rate on fiscal austerity, but they cheat when they blame the horrible RGDP numbers on austerity, which look dramatically worse than the unemployment figures, much less the employment figures.  Indeed they shouldn’t use RGDP at all; NGDP is a better measure of demand, the P/RGDP split reflects supply-side factors.

Step 5.  Keynesians that are not yet convinced need to think really hard about the implications of the famous Krugman/Mankiw debate over trend reversion, which occurred at the beginning of the recovery.  Mankiw suggested that RGDP would not return to the old trend line, and Krugman got outraged, suggesting that if the labor market improved then RGDP would grow faster than trend during the recovery.  (And insulted Mankiw in the process.)  Well guess what, both the US and the UK have seen some improvement in the labor market, and yet both countries have seen no reversion to trend, indeed in Britain RGDP growth has been dramatically below trend rates of 2.5%.  Mankiw wasn’t just a bit more correct than Krugman, he was overwhelmingly more accurate.

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