In June 2011 an editorial article appeared in the Royal Economic Society newsletter which seemed to sympathise with attacks on what it called ‘deficit fetishism’. Not quite the legions of 364 economists that we saw in 1981 but, nevertheless, an indication that there seems to be a strong body of opinion within the economics profession that we should not be reducing the deficit rapidly.

In a counterpiece, also published in the Royal Economic Society newsletter, Prof. J. R. Shackleton and I argue that we should not be letting up on attempts to reduce the deficit. Even given current plans, £500 billion of further debt will accumulate in the five years from 2010-2011. There is certainly a degree of pragmatism about the government programme which will leave public spending at 40% of national income. In our reply we also point out that we would like radical supply-side liberalisation to ensure the most rapid adaptation to the restructuring of the economy away from the government sector.

But, at the root of complaints about deficit fetishism is a form of the ‘economics without prices’ that I described in ‘Were 364 Economists All Wrong?’. We can argue about the appropriate role of monetary policy in a recession but, except in very extreme circumstances, if the government borrows more money it reduces the resources available to the private sector. Instead of taking the economy back on the road to recovery, government borrowing further distorts the economy – Japan is a supreme example of this.

In a closed economy, if a government reduces borrowing, interest rates will tend to fall – not necessarily short-term interest rates that are currently anchored close to zero but long-term interest rates. The natural response to this is that saving will fall and private investment will increase. There may be circumstances in which this process will not happen but it is incumbent upon the opponents of reducing government borrowing to demonstrate that those extreme conditions exist.

In an open economy, the mechanisms are even clearer. The UK can borrow at the world real interest rate. Increased borrowing leads to more foreign investment in UK government bonds pushing up the exchange rate. The current account deficit that arises is the counterpart of the capital inflows necessary to finance government borrowing. The government is spending more than it is taxing and if the difference is not made up by private sector saving we import capital and run a balance of payments deficit. When government borrowing is reduced the process is reversed. This process is more complex and reliant upon much stronger assumptions if we have a fixed exchange rate – fortunately we are not members of the eurozone. For the purposes of illustration I have also assumed that the domestic private sector is not saving more than it is investing, but the principles do not change if we relax that assumption (say by taking an example such as Japan).

When we have extreme levels of government borrowing then other effects may be important. Real interest rates may rise as the government becomes less credit worthy. Furthermore, individuals might reduce current consumption if they fear higher taxes and a general loss of economic confidence due to high government borrowing. Surely the experience of Greece and Portugal (whose level of borrowing and accumulated debt is not very different from our own) suggests that both these effects are potentially important.

Indeed, recent work by LSE economist Ethan Ilzetzki with two co-researchers from the University of Maryland published by the NBER suggests the following:

• Fiscal multipliers are zero in countries with flexible exchange rates.


• Fiscal multipliers are lower in open economies.


• Fiscal multipliers are zero in high-debt countries.

The UK is an open economy with a flexible exchange rate – it was also on its way to becoming a high-debt country. The evidence does not support those economists who practice ‘economics without prices’. We can reduce our deficit with no danger to economic growth. As Nicholas Ridley said, ‘In the long run Keynes is dead’ – though it has to be said that Keynes understood the nuances of his work better than his followers.