The Public Policy

We’re All Keynesians Again

If only Keynesians knew their own history.

By From the April 2009 issue

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John Maynard Keynes is fashionable again, thanks at least in part to President Barack Obama. Obama's economic team features economists like Larry Summers, whom the BBC termed a "pugnacious Keynesian." Yet Obama's team maintains a centrist reputation within academia, avoiding the liberal label despite their Keynesianism.

This reconciliation of the ideas of Keynes, the father of progressive economics, with the mainstream would not have been respectable 30 years ago. "Keynes has become a dirty word to many people," wrote Robert Skidelsky, the noted biographer of Keynes, in the August 1981 issue of The American Spectator. "The easiest way for any economist to make a name for himself is to attack the fallacies of the Keynesians."

What precipitated Keynes's comeback from dirty word to White House savior? Dr. Bruce Caldwell, an economic historian at Duke University, noted the key to Keynes's recent popularity: "[Keynes's] theory, by providing a theoretical justification for action, is custom-made for a crisis. 'Don't just sit there, do something' is a universal human instinct when times get bad.'"

Franklin Delano Roosevelt succumbed to this instinct during the Great Depression. Keynes's unorthodox ideas regarding deficit spending provided the basis for the New Deal. On December 31, 1933, Keynes spelled out, in an open letter to FDR, the underpinnings of his style of crisis economics. He suggested that the purpose of the New Deal should be twofold: recovery and reform. The latter could wait, though. The former involved immediate massive debt-financed spending, by hook or crook. How the money was spent didn't matter too much: "the object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months."

The logic behind Keynes's "good hard shove" was further developed in his masterpiece, The General Theory of Employment, Interest, and Money, published in 1936. Keynes's basic insight is that in recessions pessimistic consumers and businessmen hoard cash and refuse to spend no matter how low interest rates become, rendering monetary policy useless. The solution to this "liquidity trap" is for the government to offset the lack of demand for goods and services with public spending.

The common wisdom, for a long time, was that FDR's New Deal public spending ameliorated the Great Depression and World War II defense spending defeated it. Now, however, economic historians are divided on the subject. By and large, economists subscribe to Milton Friedman's thesis that monetary policy drove both the Depression and its recovery.

Other historians, such as Robert Higgs and Amity Shlaes, have advanced the argument that the government's unpredictable interventions into the market impeded private-sector planning, and that the New Deal was mostly ineffectual or counterproductive. But the idea that inaction is unthinkable in the face of a crisis remains powerful today. Confronting an apparent liquidity trap, the Federal Reserve has taken Friedman's monetary critique to heart and lowered interest rates to zero over the past year. Yet the downturn persists. When all else fails (or at least appears to fail), Keynes's deficit spending presents itself as an option.

Keynes, then, is like the foul-weather friend of economists, appearing only when times are tough. Dr. Paul Davidson, the author of John Maynard Keynes, noted that in this sense today's Keynesian stimulus plan was utterly predictable: "When things get bad then suddenly people realize that Keynes had something to say."

Keynes's ideas, however, lose their luster when the economy is not in crisis. Keynes began to fall out of favor in the '70s, when neo-Keynesians like Paul Samuelson, Robert Solow, and James Tobin—all Nobel recipients—began to think that Keynes's policies could not only ward off future recessions, but also keep the economy at full employment. They failed to appreciate Keynes's distinction between voluntary and involuntary employment, and embarked on the quixotic goal of eliminating all unemployment. "What was called Keynesian economics, developed by Paul Samuelson and others, had nothing to do with what Keynes said," Davidson argued. "Samuelson got it all wrong, he assumed there was a trade-off between employment and inflation.… Keynes doesn't say that at all."

Samuelson's mistaken belief, which became Federal Reserve policy, was that, even in strong economies, expanding the money supply would decrease unemployment. This policy inevitably led to too much money chasing too few goods, and caused inflation. Samuelson neglected Keynes's dictum, "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency." Indeed, after about 20 years of the neo-Keynesians' attempts at fine-tuning the economy, Americans were tired of inflation rates as high as 14 percent in 1980 and the attending malaise. By the election of 1980, Americans were thoroughly sick of Samuelson's Keynes and ready for Friedman.

Even Obama's economic team somewhat reflects this shift from Keynes to Friedman. Austan Goolsbee, an advisor, taught at the University of Chicago, Friedman's intellectual sacristy. Goolsbee even eulogized Friedman in the New York Times after his 2006 death—as did Summers. Jason Furman, a member of the Council of Economic Advisors, draws criticism from the left for his conservative defenses of Wal-Mart and free trade.

The fact remains, though, that, along with other centrist officials like Christina Romer and Timothy Geithner, these economists are unabashedly Keynesian, as evidenced by their stimulus plan. Furman's declaration in a 2008 Los Angeles Times article that the Keynesian view of stimulus is "standard textbook economics" displays a paradoxical combination of Friedman's libertarianism and Keynes's activist government philosophy. For Obama's administration, Keynes is not a progressive savior but merely a technical contributor to the mainstream understanding of recessions.

DOES THEIR KEYNESIANISM MEAN that this cadre of economists will repeat the mistakes the neo-Keynesians made in the "Great Inflation" years? Perhaps they too underestimate the threat of inflation. The stimulus bill is slated to cost over $1 trillion, including interest, and the president has promised deficits of over $1 trillion for the next few years. Add to that the current $10.9 trillion national debt, and then consider that there are over $50 trillion of unfunded liabilities in entitlements about to start coming due when the Baby Boomers retire.

Meanwhile, the Fed's balance sheet has more than doubled in the past year, to nearly $2 trillion. While this expansion of the money supply boosts lending and counters deflation in the short term, it will be one more inflationary factor for the government to address when the economy recovers. Surely Obama's team is aware of these threats, and probably in the same textbook it found Keynes's stimulus there is a policy measure supposed to preempt inflation once recession is defeated.

On the other hand, Keynes himself might caution them with his maxim that the future isn't risky so much as uncertain. No matter how sensitive to the risk of inflation the Obama team's model is, they cannot be certain based on past experiences that their countermeasures will tamp down monetary expansion's pernicious effects.

Furthermore, Summers's stated goal of a stimulus that is "targeted, timely, and temporary" is far from Keynes's model. Davidson explained, "Keynes was for the government spending us back to prosperity, but it wasn't this pump-priming, jump-starting kind of operation." Instead, Keynes would have the government maintain aggregate demand for as long as it took for the private sector to recover full potential. Anything else would merely increase the debt without fixing the economy.

If only Keynesians knew their own history. "Every crisis is different, the social world constantly evolves, the regulations that get imposed are great for the last crisis and useless for the next one. But the study of history does provide perspective," Caldwell explained. "[Economists'] obsessive focus on the latest theoretical twists and econometric innovations… contributes mightily to the problem."

Today's iteration of Keynesians believe that, armed with the latest technical models, they can succeed where the neo-Keynesians of the 1960s and '70s failed. That they don't know history doesn't mean they are doomed to repeat it, but their failure to understand the risks of government activism does mean they are doomed to fail.  

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About the Author

Joseph Lawler, former managing editor of The American Spectator, is editor of Real Clear Policy. Follow him on twitter: @josephlawler.