From the TUC

Fiscal fallacies (1): Keynes wanted ‘Government loan-expenditures’, NOT deficit spending

09 Nov 2015, by in Economics

For decades Keynes’ approach to public spending has been understood as ‘deficit spending’. But this reflects a serious misunderstanding of his practical initiatives and the associated theoretical reasoning and justification. Undoubtedly choosing his language with great care, Keynes consistently championed ‘government loan-expenditures’.

His argument was that in conditions of high unemployment (most obviously in a recession, but not exclusively so), such spending would not only improve the conditions of the economy, but they would also pay for themselves. “Look after the unemployment, and the Budget will look after itself”, as he said (KOW, p. 104 – see end for source).

The logic is so simple as to be obvious. Government spending creates new economic activity, income and (better) jobs; as a result, the government’s tax revenues are increased, and its expenditures on benefits reduced. In addition the overall impact on the economy is amplified so that it is greater than the original expenditure outlay, through a series of repercussions that are known as the multiplier process. Those newly employed by the government will spend their salaries, with the first repercussion then increasing production and employment in the private sector. The next repercussion comes as those newly employed by the private sector spend their salaries. And so on in a virtuous circle. But the reverse also holds. Cutting government spending reduces private sector production, with the repercussions on jobs and incomes operating in the opposite direction.

Now the size of the multiplier is a matter of some controversy, but the estimates used by the authorities are far too small, as recognised even by the IMF. Under present conditions a figure of 1.5 is probably a reasonably conservative estimate, so that an increase of spending of £50bn would increase GDP by £75bn. Such a figure is also reasonably consistent with the experience of the last parliament, though the action was in the growth space: cutting spending growth led to lower economic growth and greatly reduced improvements in the public finances, as tax revenues fell well short of and benefit spend significantly exceeded expectations (most of the early improvement in the public finances came because of the hit to VAT and the large cut in investment spending; the later improvement came as the government relaxed their cuts).

And now the absolutely fundamental point. For Keynes, any such government spending was not deficit spending, because he understood the spending as the most sensible means to reduce the deficit: ‘deficit-reduction spending’ might be more apt, but rather contorted. The same is true for ideas that more debt should be tolerated – debt as a share of income should fall not rise under a judicious programme of government loan-expenditures.  The obvious comparison is between the 1930s, when (from 1934) the government was finally persuaded to address the unemployment crisis with increased expenditure, and outcomes over the past five years under George Osborne’s policies. (The exception is when expansion proceeds faster than the private sector can cope, most obviously in war.)

Public sector debt, % GDP (1909-2014)


But there was an immediate need to finance any new government spending; Keynes’s language is plain that he wanted the spending financed by borrowing. Cutting spending elsewhere or raising taxes would have the effect of reducing demand, when the need was for expansionary policy.

In his public initiatives, he gave little more detail on the specifics of ‘loan financing’. These cannot be understood apart from the broader context of his initiatives to set low interest rates across all government borrowing instruments; conventionally these would be understood as monetary policy initiatives aimed at reviving the private sector. The imperative was that any additional government borrowing should not distort the desired conditions of interest, and this meant a potential role for so-called ‘monetary financing’, especially when spending was running rapidly ahead of available saving. In World War Two the vast rise in government spending and rapid deployment of previously idle resources meant an ongoing substantial need for monetary financing. The Treasury devised a new mechanism – ‘Treasury deposit receipts’ (TDRs) – through which retail/high-street banks were obliged to create money (i.e. a deposit ) and lend it to the government (Treasury) in exchange for a piece of paper (receipt).  An alternative source of monetary financing is to have the central bank create the deposits; today this idea has been captured as ‘peoples’ quantitative easing’.

(The same argument today might suggest that monetary financing is necessary normally under conditions of severe and rising unemployment, when the associated falls in aggregate income and hence aggregate saving mean a reduced demand for government debt. Under current conditions with – potentially very extensive – spare capacity, but rising employment, aggregate incomes and hence aggregate saving, there is a ready demand for government debt and the role for monetary financing is less clear-cut. Though given the increased fragility of the global economy and volatility in financial markets, the position is not set in stone.)

(Note also that the interest rate paid on TDRs was set very low at 1 1/8%, and into the future Keynes saw a need only to cover administration costs: effectively debt-free money. The long rate was set at 3% throughout the war; while Keynes envisaged progressively lower rates into the peace, he continued to support a non-negligible rate so as not to alienate those with savings.)

Under the TDR scheme the Treasury mobilised the ability of private banks rather than the central bank to create credit (after all, they needed something to do, as now). Ultimately though these were matters for the technician. In a late contribution (a 1942 radio address, ‘How much does finance matter?’) he simply affirmed that these matters had been resolved:

… no doubt there is a technical problem, a problem which we have sometimes bungled in the past, but one which today we understand much more thoroughly. It would be out of place to try to explain it in a few minutes on the air, just as it would be explain the details of bridge-building or the internal combustion engine or the surgery of the thyroid gland. As a technician in these matters I can only affirm that the technical problem of where the money for reconstruction is to come from can be solved, and therefore should be solved. (KOW, 218)

(Though he did go on to stress the fundamental importance of keeping interest rates low.)

In his public campaigning, his strategy was instead to keep more to the real world, constructing a positive narrative around employment but also by exposing the practical absurdities and logical inconsistencies in rival arguments.

Observing the authorities’ ability to achieve full employment for the conduct of war, he dismissed the idea that state spending somehow conjured something out of nothing:

For hitherto war has been the only object of governmental loan-expenditure on a large scale which governments have considered respectable. In all the issues of peace they are timid, over-cautious, half-hearted, without perseverance or determination, thinking of a loan as a liability and not as a link in the transformation of the community’s surplus resource, which will be otherwise wasted, into useful capital assets.

I hope that her government will show that Great Britain can be energetic even in the tasks of peace. It should not be difficult to perceive that 100,000 houses are a national asset and a million unemployed men a national liability. (MTP, 354-5)

As now, housing was always prominent.

When the county council builds houses, the country will be richer [even] if the houses yield no rent at all. If it does not build houses, we shall just have nothing to show for it except more men on the dole. (KOW, 104)

Note too he saw the spending as effective even if it generated no return; later he would construct the paradoxical example of filling bottles with money and paying people to dig them up. His point was that all spending would expand the economy through expanding demand; there was no need to aim action exclusively at expanding the productive potential of the economy, though plainly he favoured doing useful and valuable things (not least the arts).

And fundamentally he rejected too the idea that such actions would mean living beyond our means:

They think that we are poor, much poorer than we were and that what we chiefly need is to cut our coat according to our cloth, by which they mean that we must curtail our consumption, reduce our standard of life, work harder and consume less; and that is the way out of the wood. This view is not, in my judgement, in accordance with the facts. We have plenty of cloth and only lack the courage to cut it into coats. (KOW, 64)


Anything we can actually do we can afford. Once done it is there. (KOW, 223; his italics)

Today our means are understood in terms of capacity (and the ‘output gap’), but, in the context of present policy deliberations.  judgements about the multiplier tend to be strongly related to judgements about capacity (though rarely understood as such – here).

We all understand that the Chancellor’s likening the public finances to a household budget is a fallacy. The actual logic of reality is that there are macroeconomic consequences to government spending that policymakers pretend do not exist. These consequences explain the Chancellor’s failure to bring the public debt under control. They explain why opposing spending cuts is not to support bigger deficits and higher debt. It is the Chancellor’s policies that threaten “borrowing forever”.

KOW, Keynes on the Wireless, a collection of his radio addressed published in 2010 (Palgrave Macmillan)
MTP, The Means to Prosperity, combined four newspaper articles in a 1933 pamphlet, and is reprinted in modern editions of his Essays in Persuasion, most recently in 2010 (Palgrave again).

7 Responses to Fiscal fallacies (1): Keynes wanted ‘Government loan-expenditures’, NOT deficit spending

  1. Tony Hart
    Nov 10th 2015, 8:26 am

    Understand the argument for HMG loan-expenditures completely. Would you like to address what should happen in a period of prosperity, such as we had from 1997 through 2010? Should not HMG have set up a sovereign fund then? Mind you, the Tories should have done the same with the oil income in the Eighties.

  2. Phil
    Nov 10th 2015, 1:53 pm

    Nice piece Geoff, but I don’t think that this is applicable today. Keynes was dealing with a situation in which the external sector is balanced. He assumed that this would be the norm for a number of reasons that have now shown themselves to be false.

    Now we know that,

    (S – I) + (G – T) = (M – X)


    M > X


    (S – I) + (G – T) = <0

    We know that running a private sector deficit to "fund" the external deficit is unsustainable. It leads to a build-up or private sector debt that tends to blow up. So, that leaves the government sector to run the deficit. This is far more sustainable.

    Does this mean that government debt will have to increase constantly until the external deficit disappears? Yes. Does it mean that government debt/GDP will have to increase constantly? Not necessarily. That depends on GDP growth.

    The fact of the matter is that Keynes' ideas — although more politically palatable — are no longer relevant in a world with serious structural trade imbalances. In this world Keynes' old policy rival Abba Lerner's functional finance ideas make far more sense.

    One last thing: empirically speaking, the government sector has run fairly consistent deficits even when trade has been balanced throughout the 20th century. This was because the private sector had relatively high savings desires. So, Keynes' ideas may well have been outdated in the post-war era even with balanced trade. But whatever you think about that we can be SURE that they are outdated with structural trade imbalances.



  3. Fiscal fallacies (2): accounting identities and the case for government loan-expenditures
    Nov 10th 2015, 4:21 pm

    […] is a variant or extension of deficit spending arguments, and this approach was contested in the first of these two […]

  4. Stephen Ferguson
    Nov 11th 2015, 10:42 pm

    “These consequences explain the Chancellor’s failure to bring the public debt under control. ”

    Why does public debt have to be brought “under control. “? And why is it a “failure” not to do so?

    As the ‘monopoly issuer’ of my own unique-to-me words, I am in no sense burdened, or otherwise impaired, by the ‘word deficit’ incurred typing out this comment. Same goes for all the words I have ever uttered / put to paper.

    I won’t run out of my own words – ever.

    Similarly in no sense is the UK government – as the monopoly issuer of the UK £ – burdened, or otherwise impaired, by the ‘deficit’ / ‘debt’.

  5. Geoff Tily

    Nov 12th 2015, 3:34 pm

    Thanks for these. I will come back properly on accounting identities later. But on Stephen’s comment …

    I understand the nature of money. But I can also understand fears about excessive public debt. The point I am trying to make is that a progressive position on spending might not be opposed to a conservative position on debt. (Though over the past couple of days the Conservative party’s position seems to be getting less conservative.) It seems to me that this is an easier position to argue from a political point of view, given the apparent public concern about debt. I recognise I might be wrong on both the economics and the politics, but do not think these matters should be regarded as a done deal.

  6. Stephen Ferguson
    Nov 14th 2015, 10:42 am

    Thanks Geoff.

    Unfortunately going down the ‘deficit dove’ route – i.e. we still in the medium term need to ‘fix’ the deficit – validates and affirms the very household budget metaphor on which “fears about excessive public debt” are based.

    Arguing from within the (false) ‘deficit hawk’ framing, means ‘deficit doves’ have lost the argument even before the debate as begun.

    You may have heard about a recent presentation on this very topic by Bill Mitchell followed by subsequent debate on the platform with Ann Pettifor and Richard Murphy…

    “Professor Bill Mitchell – Reframing the Progressive Agenda, London”

  7. Fiscal fallacies and sectoral balances: response to the critics
    Nov 19th 2015, 5:08 pm

    […] last two posts on ‘fiscal fallacies’ (‘Keynes wanted government loan expenditures NOT deficit spending‘ and ‘accounting identities and the case for government loan-expenditures‘) have […]