The Keynesian genie is recalled from the bottle
Gerard Baker,
Financial Times, May 3, 2001
For years they have met in dwindling gatherings, offering mutual support and reassurance in an effort to keep the flame of their faith flickering in a hostile world.
Like persecuted religious sects in totalitarian countries, they have been subjected to biting ridicule for their adherence to a philosophy that is publicly derided by the establishment as primitive and outmoded. They have watched in despair as many of their former fellow-believers have abandoned them, publicly recanted, and joined the march along the safe and broad boulevards of conventional thought.
But suddenly, just as their creed looked set to be consigned to official historical textbooks on ideological error, the small band of believers who still subscribe to Keynesian thought are emerging from their captivity into the blinding daylight of public economic debate.
The Keynesians bring with them notions such as the possibility of market failure, the efficacy of fiscal policy as a tool of demand management, the inherent capacity of financial markets to produce crisis, and the economic worth of public investment. They also refuse to bow down before the God of central banking as the fount of all economic power and wisdom.
For almost 30 years the "Keynesian consensus" - the view that governments should play a role both in macro-economic demand management and the micro-economics of allocating scarce resources - has been in retreat. It has been forced back by the ideological might of a conservative combination of supply-side, free market and monetarist thought.
During the past decade, the ideological battle has been one-sided. The prosperity of the roaring '90s seemed to be built on a combination of extreme fiscal conservatism, the apotheosis of financial markets as perfect suppliers of capital, and a consensus that demand management was best left to the Federal Reserve. The Fed's chairman seemed to possess a rare genius and his success enhanced the status of all central bankers.
But as faith in the US success of the past few years is tested by its first serious slowdown in a decade, there are signs of renewed interest in Keynesian ideas. The most obvious example in recent months is in the unaccustomed support for the idea of fiscal policy as an economic stabiliser.
It is easy to dismiss the conversion of Republican politicians and conservative economists to a large tax cut in the current circumstances as simply shameless intellectual inconsistency. It is also true that the $1,350bn, 10-year tax reduction approved this week by congressional leaders owes more to supply-side dogma than to Keynesian ideas about the need for a fiscal stimulus.
But the debate has nonetheless summoned the Keynesian genie from the bottle and it may prove difficult to get it back in. If the fiscal stimulus has the effect claimed for it by George W. Bush's administration and its supporters, and produces a swift recovery, it will mark a significant turning point in the history of economic ideas as practical solutions.
This unexpected interest in fiscal policy reflects how the conditions that threatened to choke off Keynesian ideas have changed in the past year or two. Faith in the power of the central bank to fine-tune demand is on the wane.
The jury is still out on the Fed's dramatic attempts to restart the faltering US economy this year. Despite last week's unexpectedly strong showing for first quarter gross domestic product - figures that could well be revised downwards - the outlook remains extremely weak.
If, as many economists suspect, the US is experiencing a classic investment boom-and-bust cycle for the first time in decades, all Keynes' oft-forgotten warnings about the limited usefulness of monetary policy as companies seek to restore equilibrium to their balance sheets will seem highly relevant again.
This is not only a US phenomenon. For the past six years, Japan has provided a classic example of Keynes' "liquidity trap" and the failure of interest rates to affect consumption or investment.
Another aspect of the current environment that gives new hope to followers of Keynes is the questionable performance of financial markets in channelling investment.
At a conference of the Keynesian Jerome Levy Institute in New York last week, a number of followers of the greatest English economist claimed the investment boom of the past 10 years was a vindication of their belief in market failure.
The private sector has invested at least $70bn in a fibre optic network in the past five years that is operating at less than 10 per cent capacity. At least as much again has been poured into a variety of telecommunications and internet technology that may sit idle for years until demand recovers.
As James K. Galbraith of the University of Texas, his very name a reminder of the sway Keynesian economists once held, argued: "Is it really so obvious that this investment represented a wiser choice than spending on public transport, roads and schools?"
Indeed, the investments of the past few years may come to represent the greatest misallocation of resources since Mao Zedong mobilised millions of Chinese to force sparrows out of the trees.
The fate of this revival in Keynesian ideas of course depends on what happens to the US economy in the next year. If it experiences a period of prolonged weakness, the old faith will continue to grow.
But if the US avoids recession and smartly resumes growth, the faith may remain as outdated as ever.
The ability of the economy to absorb an investment surplus on the current scale without a period of serious economic weakness, and to prolong a business cycle that has already broken records would be the surest sign of all that, in the long-run, Keynes is indeed dead.