What competing theories on economic growth might mean for global outlook

What competing theories on economic growth might mean for global outlook

Perhaps the question that provokes the most debate among economists is: what happened in 1950?

As Chart 1 shows, global GDP increased massively from that year until 2008, particularly when compared with the first half of the century.

Keynesian economists argue that it was a consensus among global governments around the ideas of John Maynard Keynes that led to the post-war boom.

Keynes advocated counter-cyclical economics: that if an economy were growing at persistently above its potential rate, the proper response of government would be to cut back its own spending. If an economy were growing significantly slower than its potential rate, the correct response would be for the government to increase spending until the economy reaches potential.

Central to the understanding of how politicians misjudge the true state of the economy is to grasp that there is a trend rate of growth and a cyclical rate of growth, with the latter represented by the GDP number covered in the media and quoted by politicians.

The trend growth rate doesn’t tend to change much over the short term, and is mostly only influenced by population and productivity growth. The cyclical GDP number is influenced much more by government policy and other shorter-term factors.

What drove growth?

Those who criticise the Keynesian consensus explanation of the sharp rise in global growth after 1950 contend the economy had plenty of room to grow after World War II, so the higher government spending was very productive because the world economy after 1950 essentially gathered all of the growth that didn’t happen during the war.

Critics go on to argue that policymakers persisted with this approach beyond the period when global developed market economies were operating at below potential, with the result that by the 1970s governments were pouring extra spending into economies that didn’t need it. Most economists agree that extra spending in an economy that is already at potential simply creates higher inflation, not higher growth.

This higher inflation then has the effect of slowing the economy to below trend levels, so policymakers are faced with a combination of slowing growth and rising inflation, a phenomenon known as stagflation. 

Critics of the Keynesian consensus argue this is what the world looked like in the 1970s, and it took a shift away from the consensus by Ronald Reagan and Margaret Thatcher, who focused on reducing inflation and improving the trend growth rate rather than simply managing the cyclical growth rate. 

This involved, according to its advocates, a policy of reforming the supply side of the economy to improve the structural growth rate, even if this leads to intermittent recessions. Advocates of this view contend that Keynesian economics will always end with inflationary bubbles, while improving the structural growth rate is not inflationary.

Boom and bust

At the turn of the millennium, the Keynesian consensus appeared to be dead, with global economies growing steadily and inflation not a serious problem, but that consensus was itself destroyed by the global financial crisis of 2008.