What would Keynes have done?

Expect plans for higher borrowing, tax cuts, and more spending in Monday’s pre-Budget statement. With Britain sliding into depression, it is not surprising that the old Keynesian tool kit is being ransacked. But Keynesian economics is not just about fixing damaged economies. You don’t need very sophisticated economics to spend your way out of a depression. In one form or other – usually by war or war preparations – governments have been doing this throughout history.

It does require very sophisticated economics to prove that depressions cannot happen. This was the economics Keynes set out to challenge in his great book, The General Theory Of Employment, Interest And Money, written during the Great Depression of the 1930s. His own ideas, he wrote, were “extremely simple, and should be obvious”. Economies were inherently unstable; governments had a vital role to play in stabilising them.

These heresies were too simple and obvious for the economics profession. For after a long and rather successful trial run, Keynesian economics was obliterated by the free-market revolution which swept the Anglo-American world under Thatcher and Reagan. In a notable comeback, updated versions of the theory Keynes had challenged “proved” that unregulated or lightly regulated market economics were very stable, and that government interventions only made things worse. In apparent disregard for mathematical demonstrations to the contrary, crises and crashes, booms and busts continued to occur, and politicians continued to try to mitigate their consequences, their common sense being stronger than their logic. This is roughly the situation we are in today. Economic theory points to non-intervention: politics points to intervention. Keynes’s attempt to marry the two in the notion of “practical statecraft” failed.

Keynes’s “simple and obvious” ideas can be summed up in two propositions. The first is that large parts of the future are unknowable. “The outstanding fact,” he wrote, “is the extreme precariousness of our estimates of the basis of knowledge on which our estimates of prospective yield [of securities] have to be made.” The “unknowability” of the future imparted an inherent instability to financial and investment markets, leading to periodic outbreaks of “herd behaviour”, when “new fears and hopes will without warning take charge of human affairs”. He called the economics of his day a “polite technique which tries to deal with the present by abstracting from the fact that we know very little about the future”.

How was this “abstraction” achieved? By assuming, Keynes wrote, that uncertainty could be “reduced” to calculable probability, and therefore to the same status as certainty itself. This underlies today’s “efficient market hypothesis” which treats uncertainty as measurable risk; its acceptance explains the explosion of the derivatives market since the 1980s, which has brought the financial system crashing down.

Keynes’s second proposition is that depressions can last a long time, longer than it is politically safe to tolerate. He did not doubt that markets worked “in the long run”. “But this long run,” he wrote in his best-known remark, “is a misleading guide to current affairs. In the long run we are all dead.”

Keynes offered a number of reasons why economies did not simply “bounce back” after a great shock (the Dow Jones index did not recover its 1929 prices till 1952). However, his clinching argument in his 1930s debates with free market economists such as Friedrich Hayek was political. It was much too risky to allow economies to slide into deep depression. The example of Hitler was vivid in the minds of all democratic politicians. In 1928, at the height of Weimar Germany’s prosperity, the Nazis got 2 per cent of the vote. By 1930 they were up to 18 per cent. In 1933 Hitler was in power.

During that time, German unemployment had risen from two million to six million. Hayek and the free market economists never had an answer to this argument. So what should the British Government do now? In 1931 Keynes favoured the devaluation of sterling, but this is now irrelevant: the pound is not fixed to gold as it was in his day, and is sinking quite naturally. The suggestion most favoured by editorial columns is to cut interest rates and go on cutting them. Keynes was certainly not against this, but “cheap money” to counter depression is not specifically Keynesian, and he doubted the efficacy of monetary policy on its own.

The Bank of England might flood the market with money, but this would not necessarily produce lower interest rates – and therefore greater lending – if the tendency to hoard money was going up at the same time. “The possession of actual money,” Keynes wrote, “lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.” As the adage has it: you can bring a horse to water but you can’t make it drink.

This leaves fiscal policy as the unique instrument in the Keynesian tool kit. It is idle to speculate whether Keynes would have favoured tax cuts or public spending increases. His remedies were always tailored to their impact on the state of confidence. His essential point was that, in a depression, a government stimulus was needed to offset the decline in private spending. This would mean running a temporary budget deficit. If pessimistic analysts are right in predicting a shrinking of GDP next year in the order of 3 to 4 per cent, the increase in the current deficit might have to be very large, even larger than the 2 per cent Vince Cable is proposing.

With output and inflation falling, Keynes would not have worried now about the “dangers of inflation”. He would have expected the budget deficit to shrink automatically as the economy recovered, and would have imposed new taxes as and when they were needed. “The boom, not the slump,” he wrote in 1937, “is the right time for austerity at the Treasury.”

The final question is this. Will we be content simply to take Keynes out of his cupboard from time to time, dust him down, and put him in charge of rescue operations, before putting him back firmly in his cupboard? Or will we now try to run our affairs paying proper attention to his insights into financial instability so as to prevent these alternations of mania and panic from periodically seizing control of our lives?