Lessons from Keynes in the age of coronavirus

There was general praise for Chancellor Rishi Sunak’s 11th March budget statement, which unveiled a stimulus package, worth £175bn over five years. Observer columnist Will Hutton summed up the mood: “Yet a Rubicon has been crossed. Keynesianism has been restored to its proper place in British public life.” Even the erstwhile austerians joined the chorus of praise, including George Osborne.

These budget calculations have now been overtaken by the coronavirus pandemic. It is already clear that “paying for the virus” will dwarf the promised spending on infrastructure. Sunak has already earmarked an extra £350bn, or 15 per cent of GDP, emergency package, an unprecedented jump outside wartime. And this is just the start. Boris Johnson and Donald Trump have donned the mantle of war leaders, the latter calling for “sacrifice” to ensure “complete victory.” Yet few have paused to consider what a war economy is like.

It is above all a shortage economy. All essential supplies are rationed. This is because, during a war, supply falls relative to civilian demand, partly because imports are interrupted, partly because the government’s demand for war materials goes up. The war economy is an excess demand economy. You can’t have both guns and butter.

Excess demand is the opposite of the typical Keynesian problem of deficient demand. But Keynes tackled it in his pamphlet How to Pay for the War (1940). Civilian consumption, he said, had to be reduced to release resources for military consumption. Without an increase in voluntary saving, there were only two ways to reduce civilian consumption: inflation or higher taxes.

Inflation would do the trick by making food and other civilian necessities more expensive, but this would hit the low-paid particularly hard. Keynes rejected this as socially unjust.

The solution he and the Treasury jointly hit on was to raise the standard rate of income tax to 50 per cent, with a top marginal rate of 97.5 per cent, and lower the threshold for paying taxes. The latter would bring 3.25m extra taxpayers into the income tax net. Everyone would pay the increased taxes which the war effort demanded, but the tax payments of the three million would be repayable after the war in the form of tax credits. There would also be rationing of essential goods. By these means, Keynes intended to combine sound anti-inflationary finance with social justice.

Despite our leaders’ rhetoric we are not in a war economy situation today. But we may get to a position where we experience a slump in production but no slump in incomes. This is how it happens.

A recession is normally triggered by a banking failure or a collapse in business confidence. Output is cut, workers are laid off, spending power falls and the slump spreads through a multiplied reduction in spending. Supply and demand fall together until the economy is stabilised at a lower level. In these circumstances, Keynes said, government spending should rise to offset the fall in private spending.

The situation we now face is the opposite. It is not that business wants to produce less. It is forced to produce less because a section of its workforce is being prevented from working. The economic effect is similar to wartime conscription, when a fraction of the workforce is extracted from civilian production. Production of civilian goods falls, but aggregate demand remains the same: it is merely redistributed from workers producing civilian goods to workers conscripted into the army or reallocated to producing munitions. What happens today will be determined by what happens to the spending power of those made compulsorily idle.

The government has ordered schools to close, but businesses would only experience this as a shock to demand if the teachers were to be dismissed without pay. But of course this will not happen: the government is committed to go on paying people for not working.

In practice, two processes are underway today. Firms are being asked to switch production from consumer goods to “ammunition” like ventilators, in an eerie echo of wartime logic. Much more important are the steps being taken to keep up aggregate demand by paying workers for not working. Although so far the government has only promised guaranteed loans to businesses, it is inexorably being driven to paying wages directly as in the United States. With production falling, this is the path to the shortage, or excess demand, economy: fewer goods to buy but just as much money to buy them.

There are already signs of excess demand in certain retail sectors due to panic buying and interruption of wholesale supply chains. In the short run, this may be choked off by a combination of informal rationing, staying at home, and voluntary saving. But if the pandemic lasts for more than two or three months, we will be faced with the alternative, posed by Keynes in 1940, of reducing consumption by inflation or higher taxes.

Governments will be tempted to “pay for the war” by allowing prices to rise, but as Keynes pointed out this would be socially unjust. The correct alternative would be higher taxes on wealth and incomes. Further, in the spirit of Keynes’s 1940 proposal, part of the proceeds of the taxation could be earmarked for the payment of a basic citizens’ income as and when “peacetime” conditions returned.

I’m not saying we will experience the true strain of a war economy, or the possibilities it opens up. The virus may simply go away after a brief journey round the planet. But it will be well to be alert to the consequences of a longer stay. And this turn of events should deepen our understanding of what it is to be a Keynesian.

Robert Skidelsky’s latest book is What’s Wrong with Economics? A Primer for the Perplexed (Yale University Press)