How Keynesian policies would not have worked then, and why they will not work now
As calls for Plan B mount, it is increasingly being suggested that the UK is making the same mistakes as in the Great Depression of the 1930s by not expanding fiscal policy. This paper demonstrates that the UK government in the 1930s did not make serious fiscal policy errors. The evidence suggests that increasing government borrowing in the 1930s would not have significantly changed the course of the economy.
If looser fiscal policy would not have made much difference to the course of the Great Depression, there are reasons to believe that it would be even less effective in current circumstances. Developed, indebted, open economies with floating currencies respond least well to increased government borrowing: the UK economy fits that description.
Legitimate debate surrounds the conduct of monetary policy. Whilst it is plausible that a loose monetary policy is appropriate in the current circumstances, drawing on a comparison with the 1920s, this paper shows that, if the crash of 2008 permanently reduced the supply potential of the UK economy, loose monetary policy may simply lead to higher inflation with no benefit to output.
There is, therefore, no case for Plan B where such a plan involves raising planned government borrowing. Indeed, if a fiscal stimulus is applied and has short-term benefits, there is a danger that taxes will have to rise to reverse it just as the economy recovers. It is important to note that, regardless of whether the economy has suffered a temporary or a permanent loss of capacity, supply side liberalisation could be a very important complement to fiscal austerity.
2011, Current Controversies 34