P3: Impact of Keynes

This 1000 word article is the third in a series of posts on Re-Reading Keynes. It traces the impact of Keynesian theories on the 20th century, as necessary background knowledge for a contextual and historically situated study of Keynes. It was published in Express Tribune on 4 Nov 2016.

The Global Financial Crisis (GFC) has created awareness of the great gap between academic models and reality. IMF Chief Economist Olivier Blanchard said that modern DSGE macroeconomic models currently used for policy decisions are based on assumptions which are profoundly at odds with what we know about consumers and firms. More than seven different schools of macroeconomic thought contend with each other, without coming to agreement on any fundamental issue. This bears a striking resemblance to the post-Depression era when Keynes set out to resolve the “deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory.”

Likewise, today, the inability of mainstream economists to predict, understand, explain, or find remedies for the Global Financial Crisis, has deeply damaged the reputation of economists and economic theories. Recently, World Bank Chief Economist Paul Romer stated that for more than three decades, macroeconomics has gone backwards. Since modern macroeconomics bears a strong resemblance to pre-Keynesian theories, Keynesian theories have fresh relevance, as described below.

In the aftermath of the Great Depression, economic misery was a major factor which led to the Russian Revolution and the rise of Hitler in Germany. Conventional economic theory held that market forces would automatically and quickly correct the temporary disequilibrium of high unemployment and low production in Europe and USA. Keynes argued that high unemployment could persist, and government interventions in the form of active monetary and fiscal policy were required to correct the economic problems. Many have suggested that Keynes rescued Capitalism by providing governments with rationale to intervene on behalf of the workers, thereby preventing socialist or communist revolutions. There is no doubt that strong and powerful labor movements in Europe and USA derived strength from the economic misery of the masses, and also took inspiration from the pro-labor and anti-capitalist theories of Marx. While it is hard to be sure whether Keynes saved capitalism, we can be very sure that Keynes and Keynesian theories were extremely influential in shaping the economic landscapes of the 20th Century.

Keynes actually met Roosevelt (FDR) to try to persuade him of the necessity of an aggressive fiscal policy and of running budget deficits, in order to lift the US economy out of recession. He was only partially successful. FDR, like nearly all political leaders as well as economists of the time, was convinced of the necessity of balancing budgets: this is the same ‘austerity’ being touted today as the cure for economic problems. Leading economists like Lionel Robinson and Friedrich Hayek argued in favor of austerity, and said that Keynesian remedies were dangerously wrong. They held the view that the Great Depression had been caused by excessively easy monetary policies in the pre-Depression period, and Keynesian interventions in the form of further easy monetary and fiscal policies would only prolong the agony.

FDR was not quite convinced by Keynes, but was politically savvy enough to announce that he would not balance the budget on the backs of the American people. Accordingly, he did go against his personal convictions, as well as his campaign promises of balancing the budget, which he believed to be a sound and necessary economic policy. Keynes felt that the economic policies of FDR were timid and hesitant, and prolonged the recession un-necessarily. In light of contemporary experience of the tremendously aggressive expansionary monetary policy in the post-GFC era, we can see that bolder steps by FDR would not have caused the harms that he was afraid of. In fact, after the economy recovered somewhat, FDR went back to conventional wisdom and started reducing budget deficits in 1936. This created a mini-recession which has been labelled the “Roosevelt Recession of 1937”. Duly chastened, FDR embraced Keynesian policies with greater conviction, and increased deficit spending right up to the second World War. It was the effectiveness of Keynesian policies that led even arch-enemy Friedman to state that “We are all Keynesians now,” though he later recanted. Indeed, he master-minded the Monetarist counter-revolution in the 1970’s which eventually led to a rejection of Keynesian insights, and a return to the pre-Keynesian ideas of austerity as a cure for recessions.  Forgetting the hard-learned lessons of Keynes led to a recurrence of problems very similar to those faced by Keynes in the form of GFC 2007.

Following the GFC, there has been a resurgence of interest in Keynes and Keynesian Theories. In the “Return of Depression Economics”, Krugman argued for the continuing relevance of Keynes, and stated that we could end the Great Recession immediately by implementing Keynesian policies.  China implemented Keynesian policies, and used a fiscal stimulus of $586 billion spread over two years, to successfully combat the global recession created by the GFC.  Unlike countries forced to implement austerity, which further wrecked their economies, the Chinese economy was able to perform well in the aftermath of the GFC. The Shanghai index had been falling sharply since the September 2008 bankruptcy of Lehman Brothers, but the decline was halted when news of the planned stimulus leaked in late October. The day after the stimulus was officially announced, the Shanghai index immediately rose by 7.3%, followed by sustained growth. Speaking at the 2010 Summer Davos, Premier Wen Jiabao also credited the Keynesian fiscal stimulus for good performance of the Chinese economy over the two years following the GFC.

Meanwhile, even IMF acknowledged the failure of austerity, the anti-thesis of the Keynesian policy. Massive damage was caused to Greece, Ireland, Portugal and other economies which were forced to tighten budgets in response to the recession. In the see-saw battle between Keynesians and Monetarists, after three decades of darkness, the Keynesian star seems to be rising. Strange as it may seem, many fundamental insights of Keynes were never actually absorbed by conventional economists. Keynes himself said that he had the greatest difficulty in escaping the habits of thought created by an economics education. Mainstream economists never made this escape. As a result, Keynesian theories remain an undiscovered treasure offering deep insights into current economic conditions.

The website page has many links to related materials on L3: Impact of Keynes

  1. The battle you depict as black and white is not. Keynes was first and foremost an historian. The movement of generations leads to many changes and many new and unexpected problems. Keynes and the running of a budget deficit are now considered almost synonymous. The deficits were necessary in order to pay for government activities – running schools, hospitals, the armed forces. During the 1930s, a period of economic depression and high regional unemployment, Keynes advocated such deficits along with public works programs of house building and road building in order to stimulate the national economy by pumping more money round. But Keynes saw such measures as interim devices to meet particular crises and affirmed that budgets should be balanced in ordinary times. So again we enter the territory of judgement to make selections between alternatives in terms of varying impacts on society and individual welfare. Judgement as Keynes noted is not based on numbers or economic theories but rather ethics. Something in short supply among many economists today.

    • Ken, I am using short 1000 word posts for a number of reasons, and all nuances cannot be compressed into this space. However, I do appreciate readers/commenters putting them in, to clarify.

  2. patrick newman said:

    Economists have only described and interpreted economic events, the point is to change them! (Some may have read a similar phrase elsewhere!).

    • Wiki: In Ancient Greek the word praxis (πρᾶξις) referred to activity engaged in by free men. The philosopher Aristotle held that there were three basic activities of man: theoria (thinking), poiesis (making), and praxis (doing). Corresponding to these activities were three types of knowledge: theoretical, the end goal being truth; poietical, the end goal being production; and practical, the end goal being action. Aristotle further divided the knowledge derived from praxis into ethics, economics and politics. He also distinguished between eupraxia (εὐπραξία, “good praxis”) and dyspraxia (δυσπραξία, “bad praxis, misfortune”).

      In Ancient Greek the word praxis (πρᾶξις) referred to activity engaged in by free men. The philosopher Aristotle held that there were three basic activities of man: theoria (thinking), poiesis (making), and praxis (doing). Corresponding to these activities were three types of knowledge: theoretical, the end goal being truth; poietical, the end goal being production; and practical, the end goal being action. Aristotle further divided the knowledge derived from praxis into ethics, economics and politics. He also distinguished between eupraxia (εὐπραξία, “good praxis”)[2] and dyspraxia (δυσπραξία, “bad praxis, misfortune”).[3]

      Yes — we study the world in order to change it, not just for the sake of study. The issues that Keynes dealt with are very much alive today — austerity, role of budget deficits — and the same confusions and intellectual battles continue. So it would be useful to achieve clarity on WHY these battles continue? Why were these problems not resolved and settled once and for all. Surely the truth has strong empirical evidence to support it and the falsehood can be strongly rejected with empirical evidence? This does not seem to have happened. Why?

  3. Neville said:

    Economic policy has to be relevant to the underlying fundamentals in operation at the time. For example, what were the Debt to GDP ratios for private debt in the 1930’s compared to now? The high war debt was to be repaid over many decades (100 years). The consumer buying power of the world at present is low and the supply of goods is over capacity to meet demand in the developed countries. Most of the money printed therefore has not found its way to the economy, but to the financial markets that are at high levels. Also, money today is not used only as a means of exchange but largely through various financial instruments as another large constituent of GDP. The emphasis should therefore be on development economics to bring more consumers to the market and on the write off of bad debts that will never be repaid. Keynes therefore is not relevant to first world problems at present, but certainly was in the post war period with high slack in the economies of the developed world.

    • In my reply to Patrick Newman, I have explained why I think Keynes continues to be relevant. But I agree that there are a lot of new factors that have entered the picture, so a Keynesian analysis would not be adequate for todays problems. But I feel that Keynes is like the A,B,C of economics, and we must first learn the basics before we go on to try to understand the more complex affairs surrounding us today. Furthermore, for a historical/contextual approach which I am trying to develop, it is better to look at the somewhat distant past — we can get a better perspective.

  4. anmayhew said:

    Asad: Your treatment of Keynes and his impact in the U.S. would be much strengthened and improved by nothing that the early expansionary policies of the New Deal came three years before publication of THE GENERAL THEORY and were born out of ideas that went back to post-WWI proposals for avoiding waste in the economy. On this I suggest reading William J. Barber’s two books, FROM NEW ERA TO NEW DEAL: HERBERT HOOVER, THE ECONOMISTS, AND AMERICAN ECONOMIC POLICY, 1921-1933 and DESIGNS WITHIN DISORDER: FRANKLIN D. ROOSEVELT, THE ECONOMISTS AND THE SHAPING OF AMERICAN ECONOMIC POLICY, 1933-1945.

    The story that you tell about Roosevelt and Keynes is certainly a story that can be found in textbooks but it is not accurate. It is true that Keynes provided an intellectual defense for early New Deal policy and so made the macro consequences of that policy acceptable to a lot of economists who were in a bit of a muddle. However, the programs themselves came first. It is also true that a balanced budget remained one, but only one of the goals of an administration that, as Barber’s second book title tells us was in considerable intellectual disorder. The story of how a wartime Keynesianism came to replace planned and more micro-focused projects that entailed, but were not driven by, the goal of having governments expenditures exceed revenues, is another story. The “hydraulic Keynesianism” that resulted was what generations were taught in Samuelson’s texts and the other texts that followed.

    If students are to learn of an appreciate the importance of historical context and of contingency in the evolution of economic thought, it would help a lot if you would weave some of this story into your rereading of the impact of Keynes.

    • Tnanks a lot for this correction and complexification. I will try to take it into account, but the number of books piled up in my MUST READ category is already too high. So I would appreciate it if you could help me out and provide the necessary details required for an accurate story. You have already provided a basic sketch.

      • anmayhew said:

        Asad: When time permits I will try to do so. –Anne

  5. Silwyson said:

    The fact is: Keynes has never gone away in the sense that governments have always been trying to manage the economy with fiscal and monetary policies – which (to me) is the essence of Keynes. Most governments run budget deficits to stimulate demand. It is merely cognitive dissonance of academics to think neoclassical economics is mainstream and solely responsible for the GFC, just because to them there is an apparent bias in research funding at universities.

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