1 Keynes in context

I’m joined by Jonquil Lowe and Andrew Trigg who both teach Economics at The Open University. Both have been heavily involved in Block 2. So if we could start with you Jonquil, can you talk us through how Block 2 picks up from Block 1?

Yes, Block 1 was all about data and how data can tell us something about the state of the economy and whether things are going wrong. That’s a bit like looking at the dashboard of a car. And just as with a car if you’re looking at the dashboard and the red lights are flashing you want to know what can policymakers do to steer the economy back on track. And that’s essentially what Block 2 is all about.

But the economy is of course much more complex than a car, Andrew.

Well yes there are different ideas about how an economy works. So we’re not sure whether the car’s the right analogy really but we’re going to run with it and see if we can try and introduce some basics of economics using that approach. One approach is that the economy is self-correcting. That there’s no need for government intervention. Until the 1920s that was the main approach followed in economics. There was a change then in the Great Depression with the unemployment and the crisis, the banking crash of 1929, where the great economist John Maynard Keynes came in and said we can do something; we can intervene to make a difference when there’s unemployment and crisis. The car analogy comes in there whereby, you know, we can steer the car. We can steer through economic problems.

Well a bit more than that he actually said we have to steer the car, if we don’t steer the car, we’re on a collision course.

And how influential were his ideas in those days?

Well throughout the 1920s nobody was listening to him really. It was only in the 1930s when the Great Depression set in that his ideas were listened to. In 1936 his General Theory was published. And that had a huge impact internationally.

And what were the ideas that he was advocating at that time?

Well his main idea was that he used to joke that you should pay people to dig holes and fill them in again. And that that would get the economy going because if people were paid money then they would spend money and other people would be employed making things that would be consumed by the people who were being paid to dig the holes. Of course he thought the money would be spent on more important things, useful things.

Shall we just talk about fiscal policy and monetary policy because a key for students in this block is understanding the difference between the two?

Yes. Fiscal policy and monetary policy they’re both strands of what we call macroeconomics. And macroeconomics was really invented by Keynes. Before Keynes there was a very laissez-faire attitude towards the economy and a feeling that along with the teaching of Adam Smith, if you like, that if everybody pursued their own self-interest then collectively the economy would work and everybody would have jobs. And the Great Depression showed that that wasn’t the case. If individuals pursue their own self-interest sometimes the economy actually doesn’t work fine. It goes wrong. There simply aren’t enough jobs in the economy for people.

And so the two strands of policy to try and steer the economy and keep it operating towards the full employment level are fiscal policy and monetary policy. Now Keynes is very much associated with fiscal policy but in some respects that’s a bit misleading because he was also a monetarist. But fiscal policy is all about using government spending and taxation to put more money into the hands of the people who can go out and spend and get income circulating in the economy as a whole.

And Keynes said this was really important because sometimes the economy fails because the private sector loses confidence in the economy. Loses what he called animal spirits. And then firms hang on to their money. They don’t want to invest. The economy doesn’t grow. And it’s important in that situation for the government to step in and for the public sector to make the investment that the private sector won’t. So that’s fiscal policy. Monetary policy has become, at least until the financial crisis in 2008, the mainstay of just keeping the economy ticking over in non-crisis times. And this works more indirectly. If we’re going to thrash our car analogy then fiscal policy is a bit like putting your foot on the accelerator and sometimes on the brake. Whereas monetary policy is rather more like driving through the gears. It’s more indirect.

So conventionally it involves using the interest rate. So if interest rates are low then it’s cheap for firms to borrow, that tends to stimulate investment. It’s also as you know, if you have a mortgage say, if interest rates are low then you can borrow to buy a big house. The housing market, as it booms you feel wealthy. You feel more confident. You go out and spend and that all helps the economy as well. So interest rates can be raised and lowered to influence the level of activity in the economy. And that’s the essence of conventional monetary policy.

Andrew, how important is it for students to really have a clear idea of what the difference is between monetary and fiscal policy?

Well they're the main policy choices for the government and for the Bank of England, the government in the UK, traditionally it’s the Treasury Department that decides fiscal policy. So that involves its spending decisions: how much to spend on the National Health Service, how much to raise in terms of taxes, setting VAT and so on and so forth. Monetary policy is decided in recent years by the Bank of England. The Bank of England sets the rate of interest. And does other things as well which this block talks about, in terms of how much money it releases into the financial system. So it’s important what interest rate policy, monetary policy is and it’s important what spending and taxation policies. Those are big decisions for macroeconomics, for running the economy as a whole. And they have international implications in terms of how much money flows into the economy, exports and imports.

So how do policymakers know how much accelerator to apply to use your car analogy or which gear to choose?

That’s where economic models come in and building an economic model is going to be a core activity in this block. So using an economic model is a bit like lifting the bonnet and looking at how the engine works. An economic model is a representation or an image of the economy that focuses on the key factors, the key relationships in the economy.

And it relates back to what we were saying about the dashboard of the car in terms of the information about the car, the temperature gauge and so on and so forth. That with the economy we’ll be looking at the level of output GDP, which we’ve looked at in Block 1, we’ll be looking at the level of inflation and unemployment, and this block we’ll focus mainly on unemployment and GDP. So driving the car you’d be looking at these indicators, you'd be steering the economy. And the model would help to look at the gearstick, the accelerator pedal, how you try and react to these indicators.

So clearly sometimes it works and sometimes it doesn’t. And when we had the financial crisis in 2008, did the model break down?

Well the Queen asked the question why did nobody predict this? Why did nobody see this crisis? It did provoke a major change of thinking in economics about whether we have really understood how economies work. We had a period of boom. Gordon Brown told us that boom and bust was over. We had this period of growth throughout the 1990s and into the 2000s. And then there was this major, as we all know, financial crisis that started in 2007. You might call it an epic recession that started in 2008. Suddenly Keynes was back. There was a return of Keynes. He’d been sort of forgotten about during the post-war period. And suddenly Chancellors throughout the world, finance ministers, were discovering Keynesian levers on how to react. Even though the borrowing was going up, governments were spending more than they were earning. The governments were spending money in a Keynesian approach to try and get the economy out of the crisis to reduce the borrowing because of all the money that’s been spent on unemployment benefit. All the waste involved with high unemployment, governments were spending. This was the Keynesian response, macroeconomic response to the recent economic crisis of 2008.