German Finance Minister Peer Steinbruck ridicules UK/Keynesian policies to rescue world from recession

In an interview with Newsweek magazine, the German finance minister, Peer Steinbruck, has launched an outspoken attack on the UK government’s plans to help pull Britain out of the economic downturn. In an unusual breach of standard diplomacy, he attacked the UK’s decision to cut VAT and raise the national debt to record levels.

Mr Steinbruck said the UK’s switch from financial prudence to heavy borrowing was both “crass” and “breathtaking”.

Criticising the UK government’s decision to cut VAT (sales tax) from 17.5% to 15%, Mr Steinbruck questioned how effective this will be. “Are you really going to buy a DVD player because it now costs £39.10 instead of £39.90?” he said.
“All this will do is raise Britain’s debt to a level that will take a whole generation to work off.”

Saying the UK government was now “tossing around billions”, Mr Steinbruck questioned why Britain was now closely following the high public spending model put forward by 20th Century economist John Maynard Keynes. “The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking,” he said.

“When I ask about the origins of the [financial] crisis, economists I respect tell me it is the credit-financed growth of recent years and decades….. Isn’t this the same mistake everyone is suddenly making again, under all the public pressure?”

UK Chancellor Alistair Darling announced in last month’s pre-Budget report that the government would inject an extra £20bn into the UK economy in a bid to get it moving again. At least £15bn of this total will come from increased government borrowing, which is expected to take the UK national debt to £118bn next year.

Until now Gordon Brown had been casting himself as a thought leader of the attempts to get the world out of recession. Most other European government’s have also increased public spending to try to ease the impact of the economic downturn.

France recently announced plans to spend 26bn euros, and the European Commission wants to spend 200bn euros across the European Union.

At the risk of turning this post into an economic lecture what follows are my own observations:

Mr Steinbruck has a point. You can’t spend what you don’t make. If the Government fails to “kick start” the rest of the economy then the Government debt burden will result in higher taxes on a smaller economic base making that base less productive and prolonging the recession.

To defend Mr Brown, much of the UK Government’s apparent borrowing is Bank Bail Out related and so assuming the Government is able at a future date to offload its shares in the banks it will not be as bad as £100bn.

I think the timing of the stimulus plans may be wrong. We are going into a recession and everyone knows it. What is needed is to change expectations, but the somewhat panicked noises coming from our Governments are in fact not re-assuring they are telling everyone the recession will be long and hard. Mr Obama may actually benefit from his long and frustrating wait until January.

Keynes usually favoured direct government spending rather than tax cuts because the marginal propensity to import is lower for government spending than it is on consumer spending. Put simply the UK consumer will spend £8bn of the £20bn given it on imports. Boosting your economy via tax cuts in the British case is at best inefficient, at worst cavalier. Spending money the Brown way is definitely wrong.

Although Keynesian policies dominated the economic agenda of the western world from more or less the 1930s to the late 70’s the actual evidence for them getting any economy out of the depression is weak. There is an argument that they were responsible for the relative stability of the post war economic cycles – but this is saying they stop you falling into a hole not that they can get you out of one, once yo are in one.

Franklyn D Roosevelt tried Keynesian policies in his first term, but by 1936 most of the spending policies were being cut back. What got the world out of the deflationary spiral of the 1930s was World War 2. Spending on infrastructure projects did not get Japan out of its deflationary period of the 1990s.

There is an argument that the Government can alter timings by spending as we go into recession and shift the impact so that it is more gradual, but the problem is that Government spending distorts the economy and slows the process through which economic assets are released by failing businesses to be free to be invested in more efficient uses. Extreme proponents of free markets might argue that recessions are only made longer by such Government intervention.

Another problem is that the debt burden is so big an ominous that everyone |(with a job) will save preparing for the tax burden to come (or leave) making recovery harder to achieve. There is certainly a risk that the economy will take longer to recover because of the bigger tax burden makes the economy less efficient in balance of trade/efficiency terms.

The high stakes risk of adopting the Brown approach is that the Government triggers a run on the currency and a period of stagflation as the devalued currency results in a higher cost of imports. In the long run currency devaluation always results in inflation. The risk is quite high for the UK where the manufacturing base is quite small and the marginal propensity to import is very high. It is less risky for the US.

In short, the problem was that the economies of the world were in a consumption lead bubble fed by borrowing not growth in economic efficiency. You should not try to get out of the resulting collapse by following a policy of further borrowing.

Some people are destined to lead their lives as a warning to others. Mr Brown may be blazing a trail that Mr Obama might be wise not to follow.