New Cambridge Propositions
New Cambridge advanced two key propositions that remain important but debatable today:
- (i) the government budget balance determines the current account balance; and
- (ii) the international competitiveness of an economy determines GDP.
Both propositions describe medium-term outcomes and may be reversed in the short term before multiplier/accelerator and asset adjustments work through.
The first proposition was based on the combination of an accounting identity and, as pointed out in the introduction, a specific empirical observation. The national accounting identity based on flows of funds—the fundamental identity—simply says that the sum of three financial balances—domestic private net lending, domestic public net lending, and foreign net lending (the funds lent by foreigners, also equal to the current account deficit)—has to be equal to zero. With standard notations, and with CAB standing for the current account balance, this meant that (S- I) + (T - G) + CAB = 0. The empirical observation in the UK in the 1960s and early 1970s was that domestic private net lending (S - I, what Godley at the time called the net accumulation of financial assets of the private sector, including both firms and households) hardly changed in relation to GDP (or rather, at the time, gross national product). This meant that changes in government budget deficits and current account deficits were roughly of the same magnitude. It was felt at the time that the budget balance was more exogenous than the external balance since government expenditures could be controlled while exports depended on foreign demand, thus leading to the claim that the government budget balance determines the CAB. It has to be pointed out that in the early 2000s, Godley had reversed the main direction of causality. He then argued that the sum of the private and external balances was more likely to influence the budget balance (Godley and Izurieta 2004).
The second proposition—a Kaldorian one—was based on the assumption that current account deficits could not go on forever and hence that an economy lacking international competitiveness would eventually be forced to slow down, through either monetary or fiscal austerity policies, or both. Thus, international competitiveness, or what Godley and Cripps (1983: 296) called the trade performance ratio, that is, the ratio of exports to the propensity to import goods from abroad, was the long-term determinant of GDP—a proposition that can be attributed to Roy Harrod (1933). This proposition has given rise to a large theoretical and empirical literature, closely related to the export-led growth model and mainly developed by writers in the Kaldorian tradition. The proposition, instead of being stated in stationary terms, has been mainly presented in growth terms under the name of the balance-of- payments growth constraint, surveyed in detail by John McCombie and Anthony Thirlwall (1994). The first proposition has only survived in the form of the fundamental identity based on the three financial balances. As we shall see in the next section, the financial balances approach has been endorsed by a broad group of Post-Keynesians as well as several financial analysts. On the other hand, the stability of domestic net private lending turned out to be a temporary phenomenon, which could not justify the twin-deficit proposition of New Cambridge, later picked up by mainstream economists and the International Monetary Fund (IMF) to justify the imposition of austerity policies to developing countries.
