Economics and the 2008 crisis: a Keynesian view
Economics and the 2008 crisis: a Keynesian view

Start this free course now. Just create an account and sign in. Enrol and complete the course for a free statement of participation or digital badge if available.

Free course

Economics and the 2008 crisis: a Keynesian view

Keynes and government debt

Keynes recognised the need, in times of crisis, for government borrowing to finance a sizeable expansion of government spending. The government traditionally borrows by issuing loans (referred to as government bonds or gilts) that it promises to pay back at a future date. In the meantime, interest is also paid to holders of these bonds.

Let i be the rate of interest paid on government bonds. If a bond worth £100 is issued by the government and bought by a private individual or bank, then after one year the government will pay out a percentage rate of interest. Say the rate of interest is 6%; this means that the government pays out £6 after one year. The total value of bonds (debt) issued by the government can be denoted by the term D. Thus the total interest payment made by the government is iD.

If the total amount of debt owed by the government is £300 million, for example, then the debt repayments in a particular year would be

total interest payments = 6% × £300 million = £18 million

It follows that the total government deficit is the primary deficit (government spending minus taxation) plus these debt interest payments

total deficit = government spending − taxation + total debt interest payments

This is the total government deficit that economists and policymakers usually worry about. In a more compact notation, the total deficit is

G − T + iD

In the case of Greece, during the European financial crisis that started in 2010, the main problem has been trying to service the interest payments on its debt. This problem has been compounded by the lack of confidence in Greek bonds in the world financial markets.

The ‘sound finance’ advice given by policymakers, in the European Commission and beyond, has been for Greece to cut government spending and increase taxes in order to meet its debt interest payments. From the perspective of Keynes, however, the problem with this austerity approach is that the reduction in government spending will, via the multiplier, reduce national income and the ability of the economy to generate tax revenue. In the face of this type of crisis, Keynes would have called for the government to boost income using government infrastructure spending.

Take, for example, the Liberal spending programme of £300 million in 1929, referred to earlier in the section. Keynes assumed that the government would have to take out a loan (i.e. issue bonds). Assuming that it had to pay interest of 6% on this loan, then in the first year of the spending programme government would have to meet debt interest payments of £18 million. The key question is how these debt interest payments can be covered. Using the multiplier, one can specify what happens to income and taxation receipts.

The tax-modified multiplier relationship takes the form

normal cap delta cap y equals one divided by one minus b times open one minus t close times normal cap delta reverse solidus te cap g

The multiplier captures the impact of a change in government spending (ΔG) on national income (ΔY).

Activity 15

Assuming a propensity to consume (b) of 1/2 and a tax rate (t) of 1/3, calculate the size of the multiplier.

Answer

The multiplier for this example is

equation sequence one divided by one minus open one solidus two close times open one minus one solidus three close equals one divided by one minus one solidus three equals one divided by two solidus three equals three divided by two equals 1.5

For the fiscal stimulus of ΔG = £300m, the change in income would be

ΔY = 1.5 × 300 = £450m

This means, taking into account the leakage of income into taxation, that a multiplier of 1.5 leads to a £450m increase in income, in response to the £300m increase in government spending.

Now what is the impact, in this example, on receipts from taxation? In the aggregate demand model there are additional receipts from taxation (ΔT ) since the income out of which taxation is paid has increased

ΔT = t ΔY = (1/3) × 450 = £150 million

The amount of tax paid out by the national economy increases by £150 million, since there is more income available out of which to pay taxes. The government has put an additional £150 million into its coffers. For Keynes, this shows that his public expenditure increase of £300 million is affordable. With tax receipts increasing by £150 million, the £18 million of debt interest payments on the government’s infrastructure loan can easily be covered.

But what about the deficit? In this example, the deficit increases by £150 million since only half of the £300 million outlay is recouped in tax receipts. There has been no increase in the tax rate to balance the budget, as before. However, Keynes distinguished between current and capital expenditures. Current expenditures are used up in the short run, when capital stock, among other things, is fixed. In contrast, capital expenditure is expenditure made on items that are available for future use, in the long run: a period of time in which the capital stock can change. For Keynes, investment in infrastructure is not included as part of current expenditure or of the current fiscal deficit. Investment, for example in transport, would provide an increase in the assets of the country, helping the productivity of private firms, enabling them to transport their goods to customers (as would investment in education).

So for Keynes investment can be earmarked for a separate wealth-creating part of the national accounts: ‘It is not the miser who gets rich; but he who lays out his money in fruitful investment’ (Keynes, 1972, p. 123). On this basis, the investment in infrastructure could be classified as improving the health of the public sector accounts. If the accounts were in surplus, the new tax receipts would add to that surplus; if the accounts were in deficit, the new tax receipts would be used to pay off the country’s debt. Out of the £150 million tax receipts, £18 million would be used to cover debt interest payments, but a clean £132 million would be added to government coffers. For Keynes, you can spend your way out of debt, contrary to the quotation from Daniel Hannan earlier in this section (see 'The debt problem').

DD209_1

Take your learning further371

Making the decision to study can be a big step, which is why you'll want a trusted University. The Open University has 50 years’ experience delivering flexible learning and 170,000 students are studying with us right now. Take a look at all Open University courses372.

If you are new to university level study, we offer two introductory routes to our qualifications. Find out Where to take your learning next?373 You could either choose to start with an Access courses374or an open box module, which allows you to count your previous learning towards an Open University qualification.

Not ready for University study then browse over 1000 free courses on OpenLearn375 and sign up to our newsletter376 to hear about new free courses as they are released.

Every year, thousands of students decide to study with The Open University. With over 120 qualifications, we’ve got the right course for you.

Request an Open University prospectus371