Out of crisis comes opportunity. Unfortunately, neo-Keynesians are trying to seize this chance to rewrite both economic history and theory. As case in point is the Washington Post‘s October 19 piece by Robert Skidelsky entitled “We Forgot Everything Keynes Taught Us.” Attempting to rehabilitate Keynesian economics and denigrate the more successful monetarist approach, the neo-Keynesians achieve neither. However allowing the attempt to go unchallenged would, in Skidelsky’s own words, risk basing “economics on assumptions that [have been] so often discredited by events.”
Skidelsky’s neo-Keynesian thesis is “the New Economics, as Keynesian economics was known in the United States….[It] held that governments should vary taxes and spending to offset any tendency for inflation to rise or output to fall.” He states such manipulation was beneficial, effective, and would have prevented the current financial crisis. That it did not is because of the ascendancy of the monetarist school’s counter-argument that “inflation was due to governments’ printing too much money” and that “asset bubbles can [not] coexist with a stable price level.”
The fatal flaw in this simplistic explanation, that economic downturns could be governmentally fine-tuned away, are its empirical and theoretical inaccuracies. First, Keynesian economics was neither beneficial nor effective and has been rightfully superseded as a result. Second, nowhere in the monetarist approach exists the “theory” that stable prices equal stable markets; nor are there grounds for assuming a Keynesian-regulated economy equates to regulated markets.
Despite conceding the Keynesian failure — it “generated its own problems, causing it to collapse into stagflation in the 1970s” — Skidelsky states that “the years from 1950 to 1975 were a golden age.” Ignoring the author’s arbitrary date selection, an examination of post-WWII until monetarism’s successful implementation by Federal Reserve chairman Paul Volcker in the 1980s shows the U.S. experienced eight recessions during 1947-1982. During this 36-year period, CPI-U inflation (year-over-year) was above four percent in 19 years. Hardly “golden” results.
THESE RESULTS are intolerable today precisely because of the monetarist school’s success. Correctly attributing its rise to Milton Friedman (though incorrectly dating it to the 1970s — Friedman’s classic work, A Monetary History of the United States, 1867-1960, was published in 1963), Friedman definitively showed monetary policy’s primacy over Keynes’s fiscal policy. Its brilliance was basic: control monetary growth and you control inflation.
Monetarism’s success has caused us to forget inflation’s devastating effects. However, Keynes himself did not: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” Friedman was that one man in a million and, interestingly, he included Keynes’s quotation in his last major economic work.
Adherence to monetarism has almost eliminated U.S. inflation. During 1983-2007, inflation has been above four percent only five times. Similarly, only two recessions have occurred, one of which was the technical recession following 9/11/01.
Skidelsky is grudgingly forced to acknowledge this success (the “formula seemed to work”) but then tries to shift focus to say stable prices did not equate to stable markets. Yet there is no reason or monetarist claim the two should equate. Removing inflation certainly takes away a major source of instability, but hardly all.
Nothing prevents money from flowing into a sector and driving up prices — as occurred in the housing sector. The neo-Keynesians continue to hold the common misconception that rising prices equal inflation; when in fact, the relationship runs in reverse: a growing money supply (inflation) equals rising prices.
The neo-Keynesians also make another basic theoretical error by assuming their prescribed manipulation of fiscal policy — regulating the economy — necessarily equates to regulating markets. It does not, as eight recessions in 36 years attests.
THEIR FINAL ERROR is to attempt to use economic uncertainty (a point Skidelsky uses seven times in the last half of his article) to undercut monetarism. Again, just the opposite is true. The Keynesian approach, with its emphasis on constant fiscal tinkering on the economy, relies far more on certainty and “knowability” than monetarism. Friedman promoted monetarism precisely because of economic uncertainty: controlling money supply is much easier than controlling the entire economy as Keynesians attempt. Reliance on certainty indicts Keynes, not Friedman.
Aside from his empirical and theoretical errors, the author’s worst failing is the implicit “philosophization” of the current crisis. Keynes and Friedman produced economic theories, not political ones. Certainly both have been seized by politicians for their purposes, but this is not economics’ role or its failing. If we are going to discern the problems causing the current financial crisis, far better that we pursue it economically rather than politically. And far more likely that we will solve it that way as well. If we do so, we will stay on the current and correct monetarist course and resist Keynesian attempts to turn back the clock on the economy.