Stephen King: Why it's time to take a fresh look at Keynes

Nevertheless, the expression still has validity. Keynes' arguments - once the conventional wisdom for macroeconomists, but these days seen by many as a little old hat - are all of a sudden looking remarkably apposite. You can't keep the ashes of a great economist down.

In his General Theory of Employment, Interest and Money, Keynes talked a great deal about effective demand - that level of demand that exists within an economy based on the combined expectations of all those who are involved in economic activities of one sort or another.

This definition of demand is a "subjective" definition, reflecting the changing "animal spirits" of those engaged in economic activities.

Importantly, in the Keynesian world, there is no guarantee that effective demand will be equal to the level of demand required to ensure full employment.

Sometimes, effective demand may be too high - prompting Keynes to write, in 1940, a pamphlet entitled "How to Pay for the War" - and, on other occasions, effective demand may be too low - the 1930s Depression, inspiration for the General Theory, is the obvious example.

Keynes was not, however, the most lucid of writers, and economists to this day disagree with each other about what exactly he was trying to say. Nevertheless, there are some enlightening interpretations of Keynes' efforts.

One of the best-known is the IS/LM framework of John Hicks, an attempt to tie together the main messages from the General Theory in one simple chart with only two lines.

At this stage, I should emphasise that those of you who dabbled with economics at school or university and as a result now develop a cold sweat at the merest mention of IS and LM curves have nothing to fear. I simply want to stress that through IS/LM it is easy to show that movements in interest rates on their own carry ambiguous implications for the performance of an economy. And it is this ambiguity about interest rates that is relevant for recent developments in the UK.

Long-term interest rates are falling to remarkably low levels, suggesting that something very odd is going on. IS/LM provides a framework to assess what, precisely, may be happening.

In broad terms, Keynes' theory and Hicks' framework suggest that interest rates might fall for one of two reasons. First, there might be an expansion of the money supply. With an increase in the supply of money and no increase in the demand for money, interest rates - the price of money - should fall.

Monetary loosening, in turn, should lead to higher-than-desired money holdings, leading people to swap money for other assets, including consumer durables and capital equipment.

Thus aggregate demand should rise, thereby leading to a higher level of economic activity (or, in an extreme monetarist world, higher inflation).

Second, there might be a contraction in aggregate demand. Consumers or companies might choose to save more, perhaps reflecting uncertainties about the future, or the Government might choose to tighten fiscal policy. Whatever the reason, an autonomous decline in demand should lead to lower activity and, importantly, lower interest rates.

In this model, contractionary forces fall into two camps: those, like tighter monetary policy, that lead to higher interest rates, and those, like tighter fiscal policy, that lead to lower rates.

In other words, knowing that interest rates are low tells you nothing about the prospective state of the economy. What you need, in addition, are some explanations for why interest rates are low.

Some of today's plausible explanations are neither specific to the UK, nor particularly worrying. Better-integrated global financial markets have led to greater convergence long-term interest rates between countries, irrespective of differences in growth and inflation. Heightened central bank credibility has made government bonds a much safer bet than before: inflationary expectations are stable, even in the light of oil price shocks, making government bonds the low-yielding, low-risk assets they always should have been.

Companies the world over are showing caution in their investment plans, despite remarkably high profit levels, suggesting that there will be no imminent return to a late-1990s-style boom in capital spending.

And then there's the role of Asian central banks, intervening to prevent their currencies from appreciating and, in the process, acquiring fixed-income securities by the sackload.

The UK, however, has an additional issue. It's all to do with pension funds: the promises that have been made, the regulatory constraints that have been imposed, and the process of discounting future liabilities with a lower and lower interest rate.

I'll keep the story as simple as possible, to allow me more time to spend on the Keynesian implications of what could be a growing crisis.

Ten years ago, British company pension schemes were the envy of the world, or at least of those European countries that had pay-as-you-go pension systems. The UK, after all, had a funded pension system, and therefore there was no reason for the Government, or for anyone else, to worry about future unfunded pension liabilities.

Then came the stock market crash. Many company pension schemes had insufficient funds to meet their future liabilities. The companies, unsurprisingly, felt obliged to top up these funds.

At the same time, regulators became increasingly insistent on a "mark-to-market" approach to the valuation of pension funds, which allowed no room for future capital appreciation. Designed as an insurance policy against the possibility of further stock market crashes, this approach encouraged funds to switch out of risky equities into safe bonds, notably index-linked gilts.

Higher savings flows into fixed-income assets and lower investment put downward pressure on long-term interest rates. But because these interest rates are used to work out the net present value of future pension liabilities - the lower the rate of interest, the bigger the current problem - a vicious circle was created. The more companies saved, the lower interest rates became, leading to an ever-higher net present value of future liabilities, forcing even more savings.

The most worrying feature of this story is not the so-called bubble in bonds, but rather the story's depressingly self-defeating economic characteristics.

With the baby boomers heading for retirement and, as a result, the dependency ratio for the UK economy likely to rise, what we need is more output and, importantly, higher productivity.

One possible - although not foolproof - way to achieve this is through more investment. Current conditions, however, appear to be choking off capital spending.

In the world of IS/LM, what we are seeing is an autonomous rise in corporate savings which in turn must be leading to lower output - and lower interest rates - than might otherwise have been the case.

Effective demand, if you like, is being heavily constrained by a peculiar mixture of false promise and misguided regulation.

With weak investment, disappointing GDP growth and a softening labour market, maybe Keynes' downward demand multiplier is beginning to bite.

The pension story is not, therefore, a story confined to a technical bubble in index-linked securities. Sure, real yields are very low in the UK, and maybe the day will come when yields rise and the price of index-linked securities falls.

The really big issue, however, is the impact of pension funding on investment and future economic output.

The paradox of thrift - in this case, institutionalised ineffective demand - is becoming a serious burden for the UK economy.

It is time for policymakers and advisers - government, regulators, actuaries - to dust off their copies of the General Theory before the UK economy ends up in a really big mess.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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