The one-trick New Keynesian ponies are back in town

I learned long ago that when you consult a surgeon the recommendation will be surgery. After about 10 or more knee operations (both legs) as a result of sporting injuries, and, then some, to undo the damage done by previous surgery, I ran into a physiotherapist who had a different take on things. He showed me ways the body can respond to different treatments and retain the capacity for high-level training and performance even with existing damage. I still run a lot and his advice was worth a lot. The point is to watch out for one-trick ponies. The analogy is not quite correct because sometimes surgeons get it right. I don’t think the same can be said for a mainstream economist, who are also one-trick ponies. If you ask a mainstream economist what to do about macroeconomic policy they recommend hiking interest rates and cutting fiscal stimulus if the CPI starts to head north, irrespective of circumstances. But the message is getting blurred by realities, especially since the GFC. More pragmatic policy makers realise that just responding in the textbook manner hasn’t provided a sustainable basis for nations to follow. In the last week, we have seen the contradiction between the one-trick ponies, who are desperate to get back into their textbook comfort zone, and those who see the data more clearly. In Britain, one part of the Bank of England, the Financial Policy Committee has indicated the way forward is going to require careful policy support for businesses because many SMEs have loaded up on debt during the pandemic and face a precarious future. In the same week, a private sector bank economist, who is also an external member of the Bank of England’s Monetary Policy Committee, called for interest rate hikes and a deeper withdrawal of fiscal support (and central bank coordination of that support) to deal with, an as yet, unclear inflation threat.

Mainstream economists are out of sorts at the moment.

Their textbook comfort zone has been invaded by sensible policy settings for once, which are allowing unemployment to go below previously considered minimums and wages growth to pick up.

Worst nightmare for the neoliberal mainstreamers who think the nation has to tolerate elevated levels of unemployment and underemployment and suppress wages growth so that businesses can survive.

Well, survive is not quite their aim, is it?

Rather, they want the state to ‘socialise the losses and privatise the gains’, and if that wasn’t enough they want the gains to be large and at the expense of the workers share in national income.

So they are desperate to condition the public debate to return policy making to the mixes that have been dominant for three decades or more – monetary policy (interest rate changes) is to dominate an pursue low inflation while fiscal policy should be biased towards surplus.

Pity the GFC came along.

And then even worse, the pandemic.

We are now in an era of fiscal dominance because it has become obvious that the New Keynesian mainstream policy assignment with monetary policy dominant doesn’t actually achieve the intended outcomes.

First, adjusting interest rates up and down is a very inefficient way to manage the non-government sector spending cycle. It is indirect, unpredictable, and subject to unknown time lags.

Second, it is likely to be perverse. Increasing interest rates to reduce inflationary pressures might just do the opposite, if business costs rise and they have the market power to pass the margin squeeze on in the form of higher prices.

Third, the bias towards fiscal surplus and ‘repairing the budget’ when in deficit, biases economic outcomes towards stagnation and elevated levels of unemployment and underemployment.

The combination of using an inefficient monetary policy with an effective but recession-oriented fiscal strategy doesn’t make sense.

But this is what the one-trick ponies among the New Keynesians think is smart.

They have some qualifications relating to situations when interest rates get so low that the only way is up. Then, some fiscal stimulus, temporary at best, is possible.

And during that stimulus period, they wait for the day they can start recommending fiscal cuts again.

And they never wait for unemployment to bottom out.

And, they justify ridiculously high and persistent unemployment as the minimum that is possible without causing hyperinflation.

The problem historically is that the various so-called steady state unemployment levels are never stable and so they are continually adjusting the level up and down to fit the story.

During the 1990s, for example, the unemployment rate in the US, Australia and elsewhere, fell significantly below the estimated NAIRU level.

Inflation continued to taper.

So after being wrong for some years, suddenly these econometric studies started coming up with lower NAIRUs. Magic.

In Britain last week, economist (Michael Saunders) who works for Citigroup, but is also an external member of the Bank of England’s Monetary Policy Committee, claimed that the Bank will have to hike interest rates sooner than later because he thinks inflationary pressures are rising.

He gave an interview to the Daily Telegraph (October 9, 2021) – Brace for interest rate rises, warns Bank of England rate-setter

Saunders claimed that “rates could rise before the end of the year”.

Remember always, that private bank economists typically claim interest rates have to rise because their companies make more profits when they do.

The media always seeks voice from these characters without disclosing that they have a vested interest in the result that they are recommending.

The Telegraph article repeated the mainstream mantra that increasing interest rates:

… would help bring inflation under control and limit the risk of a winter cost of living crisis in the face of surging energy markets and a severe labour shortage in key parts of the economy.

Of course, if increasing interest rates could accomplish these goals then it would be via a crisis anyway – of business insolvencies, rising unemployment, household mortgage foreclosures and credit defaults.

As the article notes, “millions of households” are on “variable mortgages” (more than 20 per cent) and British busines is “£1.4 trillion” in debt.

The article also reinforces something that Modern Monetary Theory (MMT) economists regularly point out that inflationary pressures are often driven by government policies, typically those that think a user-pays system helps ‘repair’ the fiscal situation.

In this case, the Government is due to “increase its price cap” on electricity and gas supply which will add, according to the Telegraph, “£400-a-year” to household bills.

Saunders has also been pressuring the Bank of England to end its QE program, which has allowed Treasury bond yields to remain low during the pandemic.

The British government has, effectively been issuing debt to itself, paying itself interest, and it is such a farce.

Saunders also tried to maintain the myth that ‘markets’ dictate terms.

He told the Telegraph that:

… markets have priced in over the last few months an earlier rise in Bank rate than previously and I think that’s appropriate … I think it is appropriate that the markets have moved to pricing a significantly earlier path of tightening than they did previously.

In this neoliberal era, governments have allowed the ‘markets’ (read: profit-making gamblers) to dictate terms.

But the GFC and now the pandemic has shown that the markets are supplicants to the state and try to manipulate the state to render the maximum corporate welfare possible, while hiding behind the veil of ‘responsibility’.

Further, to think that the markets know best is the trick they try to use to hide the fact that the interests of firms that make up the amorphous ‘market’ are rarely aligned with the general interests of the populace.

His other message was that with labour markets tightening, wages growth might occur, which of course can either impinge on the profit margin or be passed on via high prices, while markups are preserved.

The fact that wages growth has been so poor tells me that companies are hardly doing it tough. In fact the net rate of return on capital for private non-financial corporations in the UK has averaged 10.9 per cent between the March-quarter 1997 and the March-quarter 2021, and during the pandemic it only dropped to 9.2 per cent (ONS Profitability of UK companies time series)

So the idea that to stop firms protecting inflated profit margins, the Bank of England has to impose additional costs on both households and firms, just because workers are enjoying better wage prospects for the first time in ages, is typical of the mainstream economics outlook.

Another economist, interviewed in the same Telegraph article, said that if the Government continues with its plan to push up utility prices in April 2022 then it will squeeze household disposable income, which will cut consumer spending.

Far from being a proportionate way to deal with (temporary) price pressures arising from the pandemic and supply chain disruptions, such a move would just push the British economy back towards recession and damage workers’ livelihoods.

A recession would be the last thing that British businesses would want right now.

Somewhere else at Threadneedle Street, a different story was emerging.

Last week (October 8, 2021), the Financial Policy Committee of the Bank of England issued its – Financial Policy Summary and Record – October 2021 – which indicated that:

Households and businesses are likely to need continuing support from the financial system as the economy recovers and the Government’s support measures continue to unwind.

This support will take the form of increased lending.

They concluded that:

It is in banks’ collective interest to support viable, productive businesses, rather than seek to defend capital ratios by restricting lending.

I guess you are trying to reconcile the views of the FPC and the mainstream stuff from Saunders.

Stop trying – they are at odds.

The former is in response to the challenge faced and the need to prevent a major recession.

The latter is the application of the ‘one-trick pony’ mainstream approach to aggregate policy – see a price rise, hike rates, cuts fiscal stimulus!

There are transitory price pressures at the moment, which is unsurprising given the global chaos created by the pandemic.

But the FPC knows that there are structural imbalances in terms of debt vulnerabilities that are not ephemeral and will take consider effort to resolve.

Hiking interest rates is the last thing the Bank of England should be thinking about – irrespective of what the ‘market’ wants (profits) – given these debt vulnerabilities.

The FPC wrote that “UK corporate debt vulnerabilities have increased moderately over the Covid pandemic”.

But the problem has been that the rising debt:

… has been concentrated in … small and medium-sized enterprises (SMEs). Many of these SMEs had not previously borrowed and some would not have previously met lenders’ lending criteria … As the economy recovers and Government support, including restrictions on winding up orders, falls away, business insolvencies are expected to increase from historically low levels.

So, insolvencies will rise as fiscal support is withdrawn.

Then add rising cost of servicing that debt buildup for firms that have less market power (to defend markups) than the larger firms, and you have big trouble.

The recovery will stall and the vicious cycle would intensify.

While large corporations in Britain have increased their debt levels by 2 per cent during the pandemic, SMEs have increased their debt holdings during the pandemic by 25 per cent (December 2019 to March 2021).

The FPC noted that:

SMEs are more likely to face particular financial pressures as they have been disproportionately impacted by the pandemic, and have increased their debt more than larger companies.

The accompanying report issued by the FPC (October 8, 2021) – Financial Stability In Focus: The corporate sector and UK financial stability | October 2021 – provides more detail.

We learn that:

Around two thirds of the increase in gross debt for the corporate sector as a whole is accounted for by SMEs, reflecting both the expansion in loan supply to SMEs via government loan schemes, and the fact that smaller businesses are most likely to operate in sectors affected by the Covid pandemic.

Some SME sectors (arts and recreation and accommodation and food) have seen:

… average debt increases of more than a third relative to their pre-Covid debt levels. These sectors were also more likely to take advantage of broader government support Opens in a new window.

Both the fiscal support (which included loans) and changes to the insolvency rules have protected these businesses.

Around 33 per cent of SMEs now held debt that was more than 10 times the cash they held.

This ratio was 14 per cent pre-pandemic.

In March 2021, the UK government-owned – British Business Bank – which says it is “dedicated to making finance markets work better for small businesses” – published its – Small Business Finance Markets 2020/21.

It showed that 43 per cent of SMEs in the UK relied on British government financial support in 2020. In 2019, the figure was 13 per cent.

The Report showed that 70 per cent of the rise in debt for SMEs during the pandemic had come from government emergency loans

The latest insolvency statistics published by the British Insolvency Service (September 17, 2021) – Monthly Insolvency Statistics August 2021 – show that insolvencies in England and Wales for August 2021 were:

71% higher than the number registered in the same month in the previous year.

And this was despite the ‘Breathing Space Scheme’ and other government measures that were introduced to cope with the pandemic

These measures not only restricted normal insolvency processes but also provided “Enhanced government financial support”.


During the GFC, the mainstream economists were sidelined in the debate by the policy pragmatists, who knew they had to run large deficits and have central banks buying most of the public debt, if the system was to survive the financial collapse.

After staying largely quiet for a year or so, these characters crept out again declaring that governments would go broke, that there would be accelerating inflation and interest rates would have to rise.

Somehow, they were believed, despite their credibility being shot leading into the GFC.

The same pattern is playing out with the pandemic.

The deficit/debt and inflation phobes, the one-trick ponies, are increasingly coming out and attempting to force the debate back on their terms.

Who knows whether we are done with this nonsense forever.

But the reality is clear – to deal with the continuing pandemic, and then, climate change will require fiscal dominance to continue and attempts to reassert the mainstream biases will deliver politically unacceptable consequences for governments that try.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

This Post Has 9 Comments

  1. Raising rates can cause a recession, which I suppose ought to be deflationary. But isn’t that the equivalent of killing a patient to reduce his/her blood pressure?

  2. One problem I have with learning about MMT is that I find it increasingly difficult to stomach the bleating of mainstream economics commentators.

    When I was a kid my dad would shout at the television when the footy was on. Now I am 48, dad still shouts at the TV, and I have started shouting at my iPad. Just yesterday when the SMH wheeled out Chris Richardson to bleat about debt and deficit I shouted bullshit! And my husband accused me of frightening the cats.

  3. Bradley,I totally relate to your comments. The neoliberals have huge megaphones and their narratives are by and large never challenged. It’s infuriating.

  4. @eg it’s not that simple. Raising rates is super for the rich, bad for the poor. Whether it is overall deflationary or inflationary depends a lot on how much debt there is, and where it is, you cannot conclude any specific thing will occur without knowing these dynamics. All things equal on borrower/saver propensities though, rate hikes net inject currency, so have an inflationary bias. Yet you can still get a recession if the debt payments put people out of work and the net interest-income is hoarded rather than spent.

    @Neil… thanks, for that one-liner. 😀

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