Essay: Brink Back Keynes

Perhaps it is time to revive Keynesian policy. The fact that monetary policy in the US and Britain does, in practice, take into account unemployment and growth as well as inflation is taken as a sign that some secret Keynesian demand management is at work. From this point of view, the odd men out are what Anatole Kaletsky calls the “sado-monetarist” central bankers and finance ministers of continental Europe who are wedded to price stability and the Maastricht criteria. I believe that Keynesian policy does have a role to play in improving the performance and stability of economies. But this belief does not warrant either historical or theoretical amnesia; nor should it blind us to the practical difficulties, particularly on the fiscal side, of reinstating even a modest version of Keynesian policy.

My story falls into three parts. First, the unravelling of the Keynesian revolution; second, I consider a counterfactual: what might have happened to the Keynesian revolution had it been left in the hands of (an ageless) Keynes? Finally, I look at the case for, and conditions of, a cautious revival of Keynesian policy.

In 1976 Keynesian policy was declared dead in its birthplace. In his speech to the Labour party conference, James Callaghan, the prime minister, said that “the option of spending our way out of recession no longer exists”; it had worked in the past only by “injecting bigger and bigger doses of inflation into the economy.” In his 1984 Mais lecture, Nigel Lawson stated the new orthodoxy: “The conquest of inflation should be the objective of macroeconomic policy. And the creation of conditions conducive to growth and employment should be the objective of microeconomic policy.” In the 1985 White Paper, Employment: The Challenge for the Nation, the government accepted responsibility for controlling inflation, deregulating the labour market and providing employment help for particular groups. In his 1994 Mais lecture, Tony Blair endorsed the Lawson framework: a Labour government would have “an explicit target for low and stable inflation” and would balance the budget. Employment would be handled by supply side policy. The main difference was that a Labour government would shift the emphasis from deregulation to “active” supply side policy-education, training and special measures for the longterm unemployed. Contrast this with the famous 1944 White Paper on employment in which the government took responsibility for maintaining a “high and stable level of employment.”

Practice has not always matched theory. In Britain, there was a large addition to discretionary public spending at the bottom of the recession and in the run up to the general election in 1991-92; and in the US, the anti-Keynesian Reagan government managed to create a record budget deficit in the 1980s. But this is quite different from the Keynesian policy of the 1960s, with its explicit unemployment and growth targets, backed by an openly avowed philosophy of demand management. For the time being Keynesian policy is officially dead: governments are committed to price stability, that is all. On the other hand, monetarist policy, although still openly avowed, is at least half dead, the victim of the collapse of monetary targeting. But “control of inflation” is not identical to monetarism: monetarism is a particular means of controlling inflation and depends on one view of the transmission mechanism from money to prices. Policy can be “non-Keynesian” without being “monetarist”; and it can be “Keynesian” without being inflationist.

In theory the situation is even less clear. In Keynes’s General Theory, the level of activity depends on “three fundamental psychological factors”: the propensity to consume, the inducement to invest and the attitude to financial liquidity. Keynes agreed that these could be related in such a way as to allow a “satisfactory average level of employment,” but they often were not. Keynes brought in government to supply on a permanent basis what history had provided only fitfully through new gold discoveries and wars: a quantity of money and volume of investment consistent with continuous full employment.

Keynesianism was, however, never quite accepted in the form Keynes bequeathed it. Franco Modigliani demonstrated in 1944 that full employment could be restored by increasing the quantity of money but only if real wages fell. This reformulation deprived Keynes’s theory of much of its bite but did not at first dent the case for Keynesian policy. A world in which money wages did not fall and business confidence remained variable was still one which might be thought to need demand management. But it exposed all kinds of pitfalls in the theory supporting intervention. First, the rigidity of money wages was taken as given. There was no theory behind it. But is it an inescapable fact of life or is it contingent on trade union power? Second, was Keynes’s theory of “liquidity preference”-the desire to hold cash in preference to real investments-an important determinant of interest rates or not? This bears on the question of whether an economy is self-stabilising: if the “liquidity” demand for cash is low relative to the investment demand then there need be no shortfall of investment relative to saving.

Other problems emerged in the course of applying Keynesian policy. The concept of full employment remained fuzzy. For how long and by how much could prices be allowed to rise before full employment could be said to exist? After a brief interlude of Phillips Curve Keynesianism, in which there appeared to be a reliable trade-off between inflation and employment, most Keynesians took the view that governments should target very low levels of unemployment and use control over prices and wages to restrain inflation.This had become politically contentious by the late 1960s.

the economist who demolished Keynesian orthodoxy almost single-handedly was Milton Friedman. His theoretical constructs-the permanent income hypothesis (1957), the stable demand for money function (1956, 1963) and the theory of the “natural rate of unemployment” (1968)-were daggers aimed at the heart of Keynesian self-confidence. What they purported to show was the essential redundancy of the whole Keynesian enterprise. Economies were more cyclically stable than Keynes had supposed; multipliers were small, or non-existent; government manipulation of prices had no permanent real effects, they only raised the inflation rate. These “policy ineffectiveness” propositions were to be hardened still further by the rational expectations school of Robert Lucas, which assumes that all market actors discount inflationary illusions and make rational judgements based on their own longterm interests. Friedman’s contention that it was political interference with the supply of money, not the instability in the business demand for money, which caused economies to misbehave, led to his famous “money rule”-the view that the money supply should be set to grow at a constant rate. More generally, it led to a restatement of the pre-Keynesian notion that the most important macroeconomic function of governments was to keep stable the purchasing power of money.

Friedman did not think that the Keynesian enterprise was benignly redundant. By treating economies as sick when they were in fact healthy, the Keynesian doctors made them sick. By neglecting problems of supply, Keynesian governments allowed the growth of monopolistic pricing which raised the “natural rate of unemployment.” By trying to keep actual unemployment below the natural rate by doses of monetary expansion, they unleashed inflation and inflationary expectations. By ignoring the problem of “long and variable lags,” they destabilised economies which would otherwise have been relatively stable. The crucial evidence for the Friedmanites is the period 1966-73, before the first oil price shock officially brought the Keynesian golden age to an end. During that time economies started to exhibit a rising “misery index,” as alternating inflationary “goes” and unemployment-creating “stops” left both inflation and unemployment higher with each cycle.

For a fuller account of the unravelling of the Keynesian revolution we need to bring in other names. Friedrich Hayek’s critique of Keynesianism was more fundamental than Friedman’s, inasmuch as he denied the validity of macroeconomics per se. The thrust of his message was that governments can never have the knowledge necessary to plan economic life; but that in trying do so they destroy the dispersed knowledge contained in the price system needed to co-ordinate the activities of free economies. Thus moderate planning tended to lead to demands for more and more planning- a hypothesis seemingly confirmed by the collectivist creep of the 1960s and 1970s. Meanwhile, James Buchanan’s public choice theory demolished the “benign despot” myth of government which had underlined much Keynesian advocacy of state intervention. Buchanan showed that the incentives facing politicians made them more interested in maximising votes than stabilising economies. In 1976 Assar Lindbeck wrote that “a pessimist, or a cynic might… be tempted to say that the most severe difficulties of economic policy are embedded in the political rather than in the economic system. Consequently, the best thing to do would be to avoid discretionary policies altogether, rather than trying to make the interventions more sophisticated.” Finally, and less directly, analyses of economic growth by historians such as Douglass North, which emphasised the importance of property rights and ethical beliefs, started to yield very different policy prescriptions from those fashionable in the heyday of Keynesian-influenced “development economics.” They also suggested that the spectacular growth experience of the golden age of the 1950s and 1960s had little to do with Keynesian theory or policy.

In short, what were the main criticisms of the Keynesians and the system they had created by the early 1970s? They had no theory of inflation, or rather they thought that cost-push inflation was the only relevant terrain for policy, so their only anti-inflation policy was incomes policy. They had no concept of the “natural rate of unemployment,” the rate below which inflation would start rising. They had no interest in the possibilities of a supply side, deregulating attack on unemployment. They could not see that macropolicy is subject to “long and variable lags” and that fine-tuning can therefore be destabilising. They had no theory of politics or bureaucracy and turned a blind eye to the psychological propensity of politicians to maximise their votes, and of bureaucrats to expand their budgets. They had no interest in the “state of confidence” or expectations, or rather they attended to only a small subset of these. Connected to the last point, they had no interest in the institutional (as opposed to policy) conditions for successful market performance, and specifically in the role of secure property rights and policy rules. This, in turn, was related to their lack of faith in the private enterprise market system, and of their belief that the only thing necessary for superior outcomes was to have superior people in charge.

all these blind spots can be traced back to Keynes himself and more generally to the circumstances of the Great Depression which gave rise to them. But they are not fundamental to Keynes’s General Theory and they could have been corrected within the framework Keynes bequeathed. To return to my counterfactual: how would Keynes have accommodated the anti-Keynesians? Let us go through the list, and check it against what Keynes believed.

First, Keynes had an orthodox theory of inflation-the quantity theory of money. This was the basis of the anti-inflationary policy he outlined in How to Pay for the War (1940) which is why anti-Keynesians such as Hayek supported it. But Keynes thought it was irrelevant to the analysis of short-run employment and production problems and invalid when output was depressed. I remember suggesting to Nicky Kaldor in the 1970s that Keynesians should be re-reading How to Pay for the War. He said that the problem was completely different: it was cost-push inflation which was the trouble.

Second, Keynes had no explicit theory of the “natural rate of unemployment.” But one can easily be developed from the General Theory, particularly from chapter 21 which hints at the existence of different levels of full employment associated with different pressures on prices.

Third, Keynes himself understood that demand-deficient unemployment was not the only kind. This is even clearer if his published writings are taken as a whole. Keynes tended to ignore supply side unemployment because demand-deficient unemployment seemed far more pressing and more easily malleable. His followers then obliterated the distinction.

Fourth, the spurious precision of the multiplier made the business cycle seem more controllable than it really was. But Keynes himself was conservative in his use of this arithmetic. His extreme scepticism about econometrics-publicly revealed in his critique of Jan Tinbergen in 1939-was ignored by his followers, but it lay at the heart of his policy caution. The policy ambitions of the Keynesians were mainly responsible for the mathematicisation of economic policy in an attempt to give spurious precision to what is necessarily vague. This led them to place an exaggerated faith in short-term forecasting models, and the number of equations in these models expanded exponentially.

Fifth, Keynes’s lack of a theory of politics was his most important blind spot, inherited without question by his followers, who at least should have had many more years of experience of government intervention to make the necessary corrections. In his book Innocence and Design (1986), David Henderson has given touching testimony to his surprise, when he entered government service, that “vested interests” rather than “ideas” determined large swathes of government policy. However, Keynes’s over-confidence in his ability to persuade politicians to do the right thing was balanced by a very strong dose of prudence. On the whole he was risk-averse in policy, partly because he shared Hayek’s doubts about government’s ability to “manage” the future, although not to the same extent. James Meade’s comment on him in 1945, “revolutionary in thought and very cautious in policy,” just about sums him up.

Sixth, Keynes was extremely alert to the psychological repercussions of policy. Psychological crowding out is possible even at low levels of economic activity if businessmen mistrust government policy.

Seventh, Keynes was more of a pragmatic act-utilitarian than Friedman or Hayek, but this can be exaggerated. He believed in having rules, but applying them flexibly. Examples include his policy of balancing the budget over the cycle (1937) and the design of the Bretton Woods system (1942-44). These are modifications of the Victorian rules of finance, not replacements. The Keynesian demand of the early 1960s that fiscal policy should be used to balance saving and investment at the economy’s growth potential had no warrant in Keynes.

As was natural with any creative mind, Keynes’s work was designed to show where and when existing rules should be broken, not kept. He never subsequently had the time, leisure or experience of peacetime government intervention to rebalance the picture. Because the Keynesians never seemed to learn anything from their experience, this rebalancing task was left to the anti-Keynesians. Further, Keynes’s policy ideas were built on the situation of the 1930s, when it seemed that the only alternatives were totalitarian or democratic planning. This idea was inherited by his followers and clung to long after it had ceased to be true-John Kenneth Galbraith is a notable example.

There was no reason why the historical setting of Keynes’s General Theory should have become permanently embedded in the structure of Keynesianism. But their years in power made the Keynesians hubristic. Keynes’s faults, partly the faults of his time, were “corrected” by exaggerating them. All the spaces he retained in his General Theory for the classical kinds of analysis were obliterated. As Joan Robinson once famously remarked: “We sometimes had difficulty in getting Maynard to see the point of his revolution.” But what they saw as his incomplete success in escaping from “habitual modes of thought” was exactly what kept his theory sane. The Keynesians’ reaction to any attack on their orthodoxies was so hostile that the attack on them had to take place under the banner of anti-Keynesianism.

I am not claiming that Keynes, had he lived on in full possession of his powers, would have embraced Friedman and Hayek. Nor do I accept Hayek’s argument that he was far too clever to have stuck by the General Theory when times changed. What I am claiming is that the General Theory framework could have accommodated most of the necessary amendments proposed by the anti-Keynesians. Keynes himself would never have allowed his thought to be frozen. He would have gone on adapting his theory to accommodate shifting reality within the spacious framework he had set up. The single paragraph on structural unemployment in chapter two would have been expanded into a separate chapter, incorporating a “natural rate” of unemployment. He would have spent more time on the theory of inflation. He would have attempted a synthesis between competing theories of the rate of interest. He would have developed his criticisms of econo-metrics. He would have wanted to consider the problems of economic management in open economies. He would have added a chapter on the importance of expectations in relation to government policy. And so one might go on.

There is one doubt. It is undeniable that the successes attributed to full employment policy in the 1950s and 1960s greatly strengthened the self-confidence of the Keynesian economists. So there is always the possibility that the cautious and hesitant Keynes I am describing at the start of the revolution might have become as over-confident as his disciples, failing to notice that his chariot was melting as it flew too near to the sun. Somehow I do not think so. He craved for influence, but not office, and he was, in his own words, “properly brought up”-schooled not just in the older economics, but in moral philosophy. This, I think, would have saved him.

the keynesian revolution seemed like a paradigm shift, and was widely interpreted as such. In retrospect we can see that the classical paradigm was not overthrown, but was declared redundant for a range of short-run problems of particular concern to short-run governments. The monetarist-rational expectations counter-revolution, in turn, declared Keynesianism redundant. Friedman called it a “failed experiment.” The theory of short-run stabilisation was to be expelled from economics because it was ineffective in terms of its stated goals and, moreover, it gave governments too much power to mismanage economies. The primacy of the long run was reasserted. This left governments without a theory of short-run economic statesmanship to prevent or mitigate shocks. If the current trend to farming out responsibility for managing money to central banks is carried to its logical conclusion, governments will be left with no macroeconomic tasks whatever. Economic policy proper will be concentrated on the single point of making markets more efficient.

In so far as this is a necessary reaction against the abuses of discretionary power, well and good. But to the extent that it rests on assertions about the behaviour of modern economies, the situation is less satisfactory. A number of assertions underpin the new theories of economic policy. First, economies are held to be “naturally” more cyclically stable than the Keynesians believed. Second, business cycles will still occur, but as long as labour markets are flexible any resulting unemployment will be voluntary. Third, in so far as abnormal unemployment does from time to time occur, it will be transitory. The most important policy implication of these propositions is that fiscal and monetary policy, unless it takes people by surprise, cannot improve any existing situation.

The Keynesian counter-attack has been directed against these three propositions. Two main Keynesian “schools” can be identified: the post-Keynesians and the new Keynesians. Post-Keynesians, such as Paul Davidson, believe that the existence of radical uncertainty is a necessary and sufficient condition for the development and persistence of demand deficient unemployment. But whatever its theoretical attractions, post-keynesianism offers far too nebulous a guide to policy. The new Keynesians, prominent in the Clinton administration, derive the possibility of economic depression from random shocks impinging on sticky prices. They then explain persisting unemployment by hysteresis, a word derived from applied physics to describe the persistent effect of a temporary shock. I quote Tony Blair to show how far this idea has penetrated political thought:

“The failure of macroeconomic policy had permanent effects on the supply side of the economy through the reduction in investment, the withering of the capital stock and the rise in numbers of longterm jobless. This reduced productive capacity, raised the sustainable level of unemployment and reduced the trend growth rate of the economy.”

New Keynesianism argues that sticky prices are rational because of transaction and information costs and explains how shocks to demand can destroy supply. The idea of the perfectly flexible economy is a chimera; it is thus the task of governments to keep it on a virtuous path with appropriate stimuli-for example, by varying the rate of interest.

The strength of new Keynesianism is that it offers a plausible story to explain the persistence of heavy unemployment in Europe following the two big shocks to demand in 1980-82 and 1990-92. Its weakness is that it fails to explain why European unemployment has diverged so drastically from the US and east Asian experiences. The usual explanation is the famed flexibility of US and east Asian labour markets. But it may also be that the economic management of these economies has been less rigid than that of their European counterparts.

where are we now? Prices, output, employment and growth all matter. Recent orthodoxy has confined macropolicy to the control of money and prices, leaving the performance of the real variables to lightly regulated market forces. The new Keynesians argue that macroeconomic policy should once more concern itself with the stabilisation of real variables such as output and growth. But such policy must be shorn of its old hubristic accompaniments. The “natural rate” hypothesis is accepted; fine-tuning rejected; footloose capital and non-Keynesian market sentiment are facts of life.

Under these conditions, the only “Keynesian” policy which has a chance of being credible is a commitment to stabilise nominal GDP or aggregate cash spending. The idea is for governments to maintain a stable growth of demand in money terms. They would automatically be obliged to reduce the growth of aggregate spending if inflation rose above its permitted range, but they would have discretion to increase it if unemployment rose above the best estimate of the level consistent with stable inflation. In this more modest version of Keynesianism, output, employment and growth are not targets to be aimed at, but limitations or constraints on the pursuit of pure anti-inflationary policy.

With persistently high unemployment the case for reasserting the relevance of Keynesian analysis and policy is strong. However, the problems in reviving Keynesian policy even in this modest form have to be honestly faced. The first is the risk of inflation. Having gone through all the pain to get a modicum of price stability, no government is going to risk reigniting inflation. Probably these risks are now exaggerated. But financial markets have extremely long memories, and government credibility is easy to lose and very hard to regain.

The second problem is the shortage of instruments. The one macroeconomic instrument still in use is monetary policy. But its effects are highly uncertain, because money, being created by the market, is not a precise and targetable quantum. As Keynes said, the forces of optimism may triumph over an interest rate “which, in a cooler light, would seem to be excessive”; conversely, “the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough.” Currently real interest rates in the G7 countries are already very low, at 1.7 per cent on average. Fiscal policy is a far more powerful instrument, but for that reason it is more open to abuse. Keynes tried to limit government discretion by suggesting a modified version of the balanced budget rule: governments should aim to maintain budget balance over the cycle. He believed that such a fiscal rule was the key to the maintenance of low interest rates.

Most governments now seem to accept fiscal rules of this kind. However, it remains an aspiration rather than a reality. Since 1975 governments in industrial countries have run continuous budget deficits, ranging from 3 to 10 per cent of GDP, resulting in a doubling or trebling of net public debt. The upswing of the late 1980s reduced these deficits, but did not eliminate them and they widened again in the early 1990s. Part of these deficits are now structural, reflecting a permanent gap between governments’ revenues and expenditure. In these circumstances, fiscal policy cannot now be used for expansionary purposes and interest rate policy suffers collateral damage. Specifically, the fear of an inflationary bail out of the public debt causes lenders to boost nominal interest rates, leading to psychological crowding out even at high rates of demand-deficient unemployment. The commitment to fiscal rectitude enshrined in the Maastricht treaty, together with some actual progress in reducing deficits, is probably the main reason for the fall in interest rates since 1990. But unless the structural deficits are eliminated, fiscal and monetary policy will continue to remain out of phase with the cycle, with the expansion of the deficit pushing up interest rates when they ought to be low, and vice versa. A government cannot do its Keynesian job of reducing the uncertainty inherent in private sector activity if its own activities generate uncertainty. To paraphrase Keynes, actions of governments must be such as to leave markets with more to hope than to fear.

In principle, the gap between public revenues and expenditures could be closed by raising taxes. Since the early 1970s, taxes have gone up but expenditure has gone up even more. There is more than a suggestion here of a cat chasing its tail. The growing tax burden has reduced the revenue base and enlarged “rescue spending” by slowing down the rate of economic growth. It is a fact too little remarked on that the last time most western governments were in a position to balance their books “honestly”-without an inflation tax-was in the mid-1960s, when the share of public spending in GDP was about 30-35 per cent. This was also the height of the golden age.

The main condition of restoring even a modest version of Keynesianism -let us call it Eisenhower Keynesianism-is that budgets should be balanceable at low rates of inflation and unemployment. The main requirement for this is that developed country governments should spend far less than they do-between 5 and 15 percentage points less, depending on country and tradition. Keynesian stabilisation policy is inconsistent with the continuous growth of public spending. You can have one or the other but not, beyond a certain point, both. The essence of effective Keynesian government is that it should be limited in scope and ambition. For all his backsliding Keynes recognised this