Half a decade has passed since the bursting of a huge asset-price bubble, and the U.S. economy is still depressed. More than ten million Americans are jobless, and many more are working part time. The gross domestic product has yet to recover its pre-bust level. In Florida and other areas where the speculative frenzy ran hot, vast developments stand empty. Overseas, things are no better, and in some places they’re worse. Britain looks much like America. In Continental Europe, a debt crisis is wreaking havoc. Democratically elected governments appear powerless to turn things around. Political extremism is on the rise.
So conditions are grim when, on New Year’s Day, 1935, the English economist John Maynard Keynes mails a letter to George Bernard Shaw. “I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems,” Keynes tells his friend. “I can’t expect you, or anyone else, to believe this at the present stage. But for myself I don’t merely hope what I say,—in my own mind, I’m quite sure.” Keynes is right. When “The General Theory of Employment, Interest and Money” appears, in February, 1936, it provides an intellectual justification for the large-scale public-works programs that Keynes has been advocating for years, and that F.D.R.’s Administration has recently launched as part of the New Deal. Keynes argues against the idea that the economy will recover on its own, and in favor of active measures—the manipulation of public expenditures, taxes, and interest rates—to spur growth and employment. His theory will become the keynote of a new era of economic policymaking. The main impediment to such policies, Keynes writes, is the lingering influence of outmoded theories:
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
Today, some regard Keynes himself as that academic scribbler, entrancing a generation of mindless followers. For many others, he’s the economist whose sweeping theory, shaped by a Great Depression, remains the surest guide out of our current woes. In the wake of the global financial crisis of 2007-09, President George W. Bush and President Barack Obama both launched tax-relief and spending initiatives designed to stimulate growth. Nicolas Sarkozy, in France, and Gordon Brown, in Britain, proclaimed the end of the free-market era. We were all Keynesians, and knew it—for about five minutes.
In 2010, Britain’s new government turned away from expansionary policies and introduced major budget cuts, making arguments that harked back to Keynes’s opponents in the nineteen-thirties, such as Friedrich Hayek, an Austrian economist who taught at the London School of Economics. Soon Greece, Ireland, and other debt-burdened European countries were launching ever more Draconian austerity programs. On this side of the Atlantic, with unemployment remaining stubbornly high, conservative economists insisted that the Keynesian medicine had failed to cure the patient and had perhaps even worsened the disease—an argument seized upon by Republican politicians.
“Keynesian policy and Keynesian theory is now done,” Governor Rick Perry, of Texas, declared during a Republican Presidential candidates’ debate last month. “We’ll never have that experiment on America again.” The following night, however, President Obama proposed what, in all but name, was another Keynesian stimulus package: a four-hundred-and-fifty-billion-dollar jobs program, consisting of tax cuts and increases in federal spending.
Seventy-five years after the publication of “The General Theory,” there is a fierce and consequential argument about what, in Keynes’s economic theory, is living and what, as Perry would have it, is “done.” Has the global economy’s stuttering progress since 2008 demonstrated the limitations of Keynesian policies—or the dangers of abandoning them prematurely?
The publishing industry, at least, has been bullish on Keynes in the past few years. Robert Skidelsky, the author of a monumental three-volume Keynes biography, responded to the financial crisis with a new primer titled “Keynes: The Return of the Master.” Another eminent English historian, Peter Clarke, followed up with “Keynes: The Rise, Fall and Return of the 20th Century’s Most Influential Economist,” while new collections on Keynes and Keynesianism have appeared from Cambridge University and M.I.T. This fall, there is “Capitalist Revolutionary: John Maynard Keynes,” by Roger E. Backhouse, an economic historian at the University of Birmingham, and Bradley W. Bateman, an economist at Denison University; “Keynes Hayek: The Clash That Defined Modern Economics,” by the British journalist Nicholas Wapshott; and “Grand Pursuit,” a history of economics by Sylvia Nasar, the author of “A Beautiful Mind,” which devotes many pages to Keynes and his contemporaries.
So what was the core of his message? Before the Great Depression, most economists adhered to a Newtonian conception of the economy as a self-correcting system. When the economy entered a slump, businesses laid off workers and shut down factories—but these negative trends contained their own remedy. The trick was to look at price changes. Unemployment drove down wages (the price of labor) until firms found it profitable to start hiring again. Idling factories drove down interest rates (the price of borrowing) until entrepreneurs found it worthwhile to take out loans and re-start production. Before very long, prosperity would be restored. Attempts to hasten this process were liable to interfere with the natural forces of adjustment and make things worse. As Hayek wrote in “Prices and Production” (1931), “The only way permanently to ‘mobilize’ all available resources is . . . not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure.”
In “The General Theory,” Keynes took aim at this view of the world. His central insight was that the economy was driven not by prices but by what he called “effective demand”—the over-all level of demand for goods and services, whether cars or meals in fancy restaurants. If car manufacturers perceived that the demand for their products was lagging, they wouldn’t hire new workers, however low wages fell. If a restaurateur had vacant tables night after night, he would have no incentive to borrow money and open a new venture, even if his bank was offering him cheap loans. In such a situation, the economy could easily remain stuck in a rut, until some outside agency—the government was Keynes’s favored candidate—intervened and spurred spending. Only then would private businesses be emboldened to expand production and hire workers.
Nasar, in her capacious and absorbing book, makes the key point well:
What made the General Theory so radical was Keynes’s proof that it was possible for a free market economy to settle into states in which workers and machines remained idle for prolonged periods of time. . . . The only way to revive business confidence and get the private sector spending again was by cutting taxes and letting business and individuals keep more of their income so they could spend it. Or, better yet, having the government spend more money directly, since that would guarantee that 100 percent of it would be spent rather than saved. If the private sector couldn’t or wouldn’t spend, the government would have to do it. For Keynes, the government had to be prepared to act as the spender of last resort, just as the central bank acted as the lender of last resort.
For three decades after the Second World War, Keynes’s theory provided the framework for policymaking on both sides of the Atlantic. The West enjoyed a time of rapid growth and rising standards of living, and although it would be simplistic to ascribe these trends solely to the prescriptions of policymakers, economists who balked at Keynesian doctrine were often cast aside.
Three-quarters of a century later, Keynes’s notion of “effective demand,” now usually called “aggregate demand,” is still a mainstay of policymaking around the world. Whenever the economy stumbles and unemployment starts climbing, discussion inevitably centers on what can be done to boost spending and investment. Few economists, on the left or the right, seriously advise the government to sit on its hands and let the price system work its magic. Rather, the conversation turns on what methods the authorities should use to stimulate the economy, besides cutting interest rates. Liberal economists, like Paul Krugman and Joseph Stiglitz, usually favor infrastructure spending. Conservative economists, like Greg Mankiw and Glenn Hubbard, tend to prefer tax cuts. But neither group questions the need for the government to step in and bolster demand.
In the course of his career, Keynes advocated tax cuts and interest-rate cuts, but he didn’t limit himself to those measures. During the nineteen-twenties, when the unemployment rate reached double figures, and British monetary policy was hamstrung by the gold standard, Keynes called for additional spending on public housing, roadworks, and other civic projects. “Let us be up and doing, using our idle resources to increase our wealth,” he wrote in 1928. “With men and plants unemployed, it is ridiculous to say that we cannot afford these new developments. It is precisely with these plants and these men that we shall afford them.”
With the onset of the Great Depression, Keynes stepped up his calls for action. But, as outlays on unemployment benefits increased and tax revenues declined, the budget deficit ballooned, generating alarm at His Majesty’s Treasury. In the summer of 1931, the government made deep spending cuts, intending to restore confidence in government finances. Keynes warned that the effect would be to worsen the slump, throwing more people out of work. He said that budget deficits were a by-product of recessions, and that they served a useful purpose: “For Government borrowing of one kind or another is nature’s remedy, so to speak, for preventing business losses from being, in so severe a slump as the present one, so great as to bring production altogether to a standstill.”
As the Depression deepened, seeming to confirm his warnings, Keynes sharpened his theoretical arguments. In 1933, drawing on an article by his student Richard Kahn, he made the case that one dollar of additional government spending—on a new railway station, say—could ultimately generate two dollars, or even more, in additional output and income. This was the so-called “multiplier” effect. As the unemployed were set to work on public projects, he reasoned, they would spend their wages on other goods and services, which would prompt businesses to take on more workers. Those workers, in turn, would spend more, leading to further hiring, and so on. What’s more, all of these newly employed workers would be paying taxes, which would bring down the budget deficit. “It is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the Budget,” Keynes wrote. “There is no possibility of balancing the Budget except by increasing the national income, which is much the same thing as increasing employment.”
In Keynes’s day, many people—including politicians sympathetic to Keynes—were suspicious of the multiplier. The whole thing smacked of sophistry. Wapshott, in a long overdue and well-researched book that usefully gathers together much hitherto scattered information, recounts Keynes’s 1934 visit to the White House, where he expounded the logic of the multiplier to F.D.R. After he left, Roosevelt remarked to Frances Perkins, his Labor Secretary, “I saw your friend Keynes. He left a whole rigmarole of figures. He must be a mathematician rather than a political economist.” Despite the enormous public-works projects of the New Deal, F.D.R. didn’t formally adopt deficit spending as a policy tool. Indeed, he kept a keen eye on the red ink. In 1937, with the economy on the mend, he ordered tax hikes and spending cuts, which caused the economy to crater again. President Truman was even more suspicious of Keynesian theorizing. “Nobody can ever convince me that Government can spend a dollar that it’s not got,” he told Leon Keyserling, a Keynesian economist who chaired his Council of Economic Advisers. “I’m just a country boy.”
The multiplier continues to spark controversy. Echoing the arguments that Keynes’s opponents at the Treasury made during the nineteen-thirties, conservative economists like Robert Barro, at Harvard, argue that it is close to zero: for every dollar the government borrows and spends, spending elsewhere in the economy falls by almost the same amount. Whenever individuals see the government boosting spending or cutting taxes on a temporary basis, Barro maintains, they figure that these policies will eventually have to be paid for in the form of higher taxes. As a result, they set aside extra money in savings, which cancels out the stimulus.
Barro’s caution may apply in certain conditions—say, a highly indebted economy with close to full employment. It’s certainly true that the Keynesian multiplier varies according to how stimulus funds are spent; how the central bank reacts to higher government spending (if it raises interest rates, interest-sensitive spending will fall, reducing the multiplier); and, most important, whether workers and machinery are lying idle. But Keynes didn’t advocate deficit spending for an economy at full employment. It was only when the economy was in a deep slump, he thought, that higher output “could be provided without much change of price by home resources which are at present unemployed.”
This jibes with history. Immediately before and during the Second World War, the U.S. government borrowed unprecedented sums to finance the military buildup, and the economy finally recovered from the Great Depression. In 1937, one in seven American workers was jobless; in 1944, one in a hundred was. A wartime economy may present a special case, but a recent working paper published by the National Bureau of Economic Research looked at data going back to 1980 and found that government investments in infrastructure and civic projects had a multiplier of 1.8—pretty close to Keynes’s estimate.
So why didn’t the Obama Administration’s 2009 stimulus package usher in a true recovery? Keynes would have pointed out that, with households and firms intent on paying down debts and building up their savings in the aftermath of a credit binge, large-scale deficit spending is needed merely to prevent a recession from turning into a depression. With interest rates already close to zero, Keynes would have argued that the economy was stuck in a “liquidity trap,” greatly limiting the Federal Reserve’s scope for further action. He would also have noted that the stimulus was—especially compared with the devastation it meant to address—rather small: equivalent to less than two per cent of G.D.P. a year for three years. Even this overstates its magnitude, given that much of the increase in federal spending was offset by budget cuts at the state and local levels. In its totality, government spending didn’t increase much at all. Between 2007 and the first half of this year, it rose by about three per cent in real dollars.
Besides, recovering from a financial meltdown requires more than government spending: the banking system has to be recapitalized (in the nineteen-nineties, Japan’s cash-hoarding “zombie banks” were a drag on its stimulus programs); bad debts have to be written down; sector-specific problems must be addressed. Following the crisis of 2008, both the Bush and the Obama Administrations moved promptly to shore up the banking system, but they neglected to deal with the housing debacle. A more effective mortgage-modification program for homeowners who are under water on their loans would have helped. In 2009, when the Obama Administration launched a refinancing program, it predicted that between three and four million people would get some relief, but so far fewer than one million mortgages have been modified. The lingering effects of the housing crisis continue to weigh down the rest of the economy.
Finally, Keynes would have directed our attention to international problems. A confirmed internationalist, Keynes would undoubtedly have supported the head of the Chinese central bank’s call, in 2009, for the creation of a new global reserve currency to be issued and controlled by the International Monetary Fund. (Keynes proposed almost precisely the same thing in 1944, at Bretton Woods, where he helped design a new international economic system, but the Americans ruled it out.) The rationale is that if the issuer of the reserve currency acts irresponsibly, the rest of the world is at its mercy, so it might be better to have an international currency that no single country controls. For now, the Chinese proposal has gone nowhere; the world’s focus is elsewhere. But, as the Asian economies continue their rise, it is sure to come back onto the agenda.
And Keynes would have had strong views about the European sovereign-debt crisis. The U.K. economy of his day, like the current U.S. economy, was dependent on global capital flows, and Keynes knew what excessive government debts could do to an economy. In 1919, he was an adviser to the British delegation at the peace talks in Paris, which saddled Germany and Austria with crushing debts. Outraged by this Carthaginian settlement, he wrote his first best-seller, “The Economic Consequences of the Peace,” warning that the Versailles Treaty would prove disastrous for the victors as well as for the defeated. Today, he would be advocating major debt write-downs for countries like Greece and Portugal. The so-called “rescue packages” that these nations have received in recent years have barely reduced their debt, while the austerity policies imposed on them have plunged their economies deeper into the abyss, exactly as Keynesian theory would predict.
Indeed, these days the strongest evidence for Keynesianism has been negative. The recent slowdown in the U.S. economy occurred just as Obama’s 2009 stimulus package was running dry. The U.K. economy provides an even more striking case study. As in this country, the authorities reacted to the 2008 financial crisis by cutting interest rates, boosting public expenditure, and allowing the budget deficit to rise sharply. In 2009 and in the first part of 2010, the economy began to recover. But since the middle of last year, when the Conservative-Liberal coalition announced substantial budget cuts to balance the budget, growth has virtually disappeared. “The reason the current strategy will fail was succinctly stated by John Maynard Keynes,” Robert Skidelsky and the economist Felix Martin wrote in the Financial Times recently. “Growth depends on aggregate demand. If you reduce aggregate demand, you reduce growth.”
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What Would John Maynard Keynes Tell Us To Do Now?
