Taking the Name of Lord Keynes in Vain
Friday, February 20, 2009
Keynes is being invoked in Washington these days; it is a pity few seem to understand what he thought.
The eminent economist John Maynard Keynes is having a moment these days, as policymakers and pundits search for answers to the current economic problems. The Wall Street Journal recently dubbed Keynes “The New Old Big Thing in Economics.” The Christian Science Monitor ran an article called “Raising Keynes: An old economist finds new rock-star status.” New York Times columnist Paul Krugman has said the country is in a “Keynesian Moment.”
But if we are going to attempt to solve the problems of today by drawing inspiration from Keynes, then we should pay attention to his mature ideas rather than to the textbook versions of what he said, some of which reflect Keynes’s earlier thinking. When we do this we shall find that some of his policy proposals were quite different from today’s “Keynesian” wisdom. Other proposals were extraordinarily radical and far from what is being proposed by lawmakers on the political left or right today.
It is true that in the 1920s and early 1930s, Keynes advocated measures such as deficit-financed public works expenditure to offset recessions. But that was not unique to him. Such “orthodox” academic economists as Frank H. Knight, Jacob Viner, and Paul H. Douglas also advocated such policies, albeit on different grounds. So when advocates of deficit spending for public works projects invoke Keynes, they could just as easily invoke orthodox economists as well. Either way, by the late 1930s, Keynes was not an advocate of many of the countercyclical policies being advocated today. For example, with respect to increasing investment through public works—or what today we are calling “infrastructure improvements”—Keynes’s view is highly nuanced.
Keynes did not think that public works expenditure was very effective in countering existing or impending recessions. He believed that it was difficult to get the timing right.
In the first place, he preferred that such investments be made without deficits. But if they were to be made as “loan expenditure”—that is, through a deficit in the portion of the government’s budget allocated to long-term expenditures like infrastructure—the expenditure should be covered by a surplus in the portion of the budget allocated to ordinary expenses like transfer payments, or through a special fund accumulated in prosperous times for just such purposes. If a deficit were incurred, the investments should be “self-liquidating,” that is they should repay their costs over the long run. Thus his strong, but not rigid, preference was against deficit-financed public works.
It is important to note that Keynes did not think that public works expenditure was very effective in countering existing or impending recessions. For one, he believed that it was difficult to get the timing right; it would take a long time to plan and execute the appropriate projects (indeed, many of the projects would not take effect until the pressing economic problem was inflation and not recession).
The more fundamental reasons for his preference against deficit-financed public works, however, emerge from the theoretical framework he built in his masterwork General Theory of Employment, Interest and Money (1936). As economists Bradley Bateman and Allan Meltzer stress, Keynes was convinced that avoiding depressions required the maintenance of a high level of investor confidence. He believed that (in general and not just during slumps) confidence tended to be too low. This low confidence was due to radical uncertainty generated by speculation inherent in financial markets, especially the stock exchange. This speculation could give rise to unsustainable asset bubbles. The ever-present threat of such speculative activity creates instability in the expectation of investment returns. As a result, investment spending will fluctuate unpredictably. This in turn creates further instability of investor expectations.
In Keynes’s view, the financial uncertainty generated by such speculation was an unnecessary social burden. It tended to keep long-term interest rates above where they would lead to full employment. The task of good economic management is to reduce this uncertainty burden and lower long-term interest rates through a kind of “socialization of investment.” The state in one way or another (Keynes is not entirely clear on this) should undertake large investments with no thought of speculative gains or advantage. The long-term social return on capital should be its only guide. And it should do this reliably, as part of a well thought-out plan, and on a permanent basis. Stabilization is to be achieved not by temporary and discretionary policies, but by permanent changes. Stimulus follows stability, not vice versa.
Keynes opposed immediate, short-term stimulus in 1937 when the British unemployment rate was 11 percent—much higher than we are experiencing today.
Contrast these views with what is happening today. Today’s financial and economic problems have yielded a chaotic and unpredictable response from policymakers. But Keynes rejected a hodgepodge of reactive policymaking.
Now it is true that government direction of capital is something Keynes advocated. But the current direction of capital by government is being conducted in a manner that flies in the face of Keynes’s underlying justifications for such state involvement.
For example, the stimulation of investment has thus far been ad hoc. The Treasury and Federal Reserve have infused capital into some firms but not others. In the case of financial firms, the rationales have been to promote liquidity or prevent insolvency or both. The government has moved on to direct capital into the troubled automobile industry. The Federal Reserve and the Treasury are buying mortgage-backed securities, thereby making more credit available to the housing industry. The construction trades are expecting a huge infusion of capital under the rubric of “infrastructure” spending. And now an enormous list of other industries has been approved for temporary stimulation by the Obama administration.
It is difficult to imagine that Keynes would be enthusiastic about these temporary and discretionary policies given his diagnosis of the fundamental problem.
The historical record is helpful here. Keynes opposed immediate, short-term stimulus in 1937 when the British unemployment rate was 11 percent—much higher than we are experiencing today. Furthermore, he opposed temporary reductions in the short-term rates of interest because he believed that variability of interest rates sent the wrong long-term message. As he argued in “How to Avoid a Slump,” an article in the Times of London newspaper, “A low enough long-term rate of interest cannot be achieved if we allow it to be believed that better terms will be obtainable from time to time by those who keep their resources liquid.”
Secondly, insofar as the stimulus policies affect investment, do they produce a sustainable allocation of capital in the longer run? Stability of investment is the key. In Keynes’s view, the state ought not imitate the erratic nature of private investment. If it does, it will generate the same kind of uncertainty that investors face when private individuals undertake the direction of investment. Instead of guessing what other investors will do, individuals will have to guess what the government will do next. Will the state direct capital here or there? How much will be directed? Will the state reduce expenditure if the economy were to pick up —by how much? Furthermore, entrepreneurs outside of the directly stimulated sectors are unlikely to make substantial investments on the basis of temporary propping up of demand.
Are we prepared to accept a permanent alteration in the sources of investment? Do we want policies that will 'forever more' infuse capital into major financial entities whenever they get into trouble?
Keynes’s most radical reform—the socialization of investment—is now before us as the government has emerged as a majority investor in financial firms. But this socialization is a “temporary” or “emergency” measure and thus severed from Keynes’s rationale of permanence and stability.
Today we face several fundamental policy questions: Are we prepared to accept a permanent alteration in the sources of investment? Do we want policies that will “forever more” infuse capital into major financial entities whenever they get into trouble? Do we want the government determining the major industries into which capital should flow? Do we want the real Keynes’s solution?
I am not advocating that we follow Keynes’s approach to management of the economy. But it is worth pointing out how much is being done in Keynes’s name that has nothing to do with what Keynes taught or believed. This “rock star” economist may the hottest thing around, but surely he is also rolling over in his grave.
Mario Rizzo is a professor of economics and the Director of the Program on the Foundations of the Market Economy at New York University.
Image by Corbis/Darren Wamboldt/The Bergman Group.