U.K. Experience Casts Doubt on Viability of Keynesian Remedies

July 26, 2012

The plight of the United Kingdom's economy is a useful rejoinder to those who believe the fixed exchange rate is the main driver of the economic problems in the Eurozone. The United Kingdom responded to the financial crisis by running large fiscal deficits, cutting interest rates to zero, and "printing money" through several rounds of quantitative easing, says Economic Policies for the 21st Century.

Yet over this period, the result has been worse macroeconomic performance in the United Kingdom than in Spain, a country "trapped" in the euro straightjacket. This outcome is fundamentally inconsistent with the Keynesian view that the key to recovery in peripheral Europe is devaluation and monetary-financed deficit spending.

  • Since the end of 2006, pound sterling has depreciated by about 20 percent relative to the euro, with an average devaluation of 25 percent over this period.
  • The depreciation was designed to boost growth by increasing competitiveness and exports.
  • Similarly, while some may argue that the poor performance of the United Kingdom in recent periods is due to austerity measures, the actual national income data show that government spending has increased in four of the past five quarters.

What has been the aggregate result of these Keynesian measures? The U.K. economy has contracted by 0.5 percent cumulatively since September of 2010 -- a time span in which even Spain managed modest growth. This offers a valuable illustration for Europe's peripheral economies, each of which is seeking relief from economic crises.

  • The weakness of the peripheral European economies -- Spain, Greece, Italy, Portugal and Ireland -- is often attributed to an "uncompetitive" real exchange rate.
  • The idea is that wages in these countries rose faster than productivity, which means that the cost of an hour of labor is too expensive relative to the value of its output.
  • An extension of this logic train is that if the euro currency didn't exist, it would be easy for these countries to solve their problems by simply devaluing their currency.
  • However, as can be seen in the experience of the United Kingdom, currency freedom and flexibility is not a silver bullet to economic woes.
  • In fact, the ability to print money and finance government likely brings with it a host of problems that far exceed the benefits to be had from currency flexibility.

Source: "U.K. Experience Casts Doubt on Viability of Keynesian Remedies," Economic Policies for the 21st Century, July 9, 2012.

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http://economics21.org/commentary/uk-experience-casts-doubt-viability-keynesian-remedies

 

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