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In the Nation's Interest

Keynes and the Universe

Joe Minarik
Senior VP & Director of Research

A friend sent me a “What is your answer to this?” message, referencing a Wall Street Journal op-ed column just before the holidays (John H. Cochrane, “An Autopsy for the Keynesians,” December 22).  Although swinging at a columnist in absentia is not usually good practice, the answer to this inquiry suggested a conversation with all of our CED members, on grounds of both the substance and the deportment of the piece.  So this is, I hope, a useful way to ring in the New Year.  (And by the way, Happy New Year!)

The point of the Wall Street Journal column, reduced to one sentence, is that “Keynesians” are both 100 percent wrong, and 100 percent responsible for everything that ails us (and that has anything to do with economics).  Keynesians were wrong about the remedy to the 2007 financial crash, and the recent strengthening of the economy proves that.  Keynesians were wrong about Japan’s economic woes, because that economy did not fall into an ever-accelerating deflation.  They were wrong about the economic growth after World War II.  The list goes on and on.  And if Keynesians have their way going forward, the damage will be compounded.

Even having been around the block a few times, this litany of invective was off the charts.  And having been around the block a few times, I have concluded long ago that caricature will get us, collectively, nowhere.

Let me start with the economics, such as it was, of the column.  And that starts with Keynes – John Maynard Keynes, the English economist who is the subject of the Journal column’s diatribe and of many others over the years.  My purpose here is not at all to deify Keynes.  In one respect, Keynes is much less than the column makes him out to be.  But he made at least one important contribution to economic thought, whereas the column attacks his name and legacy on the basis of other issues and circumstances on which he had much less (or nothing) to say.

The earliest of Keynes’ writings for which he is widely known today was a 1919 book (he was already an accomplished and mature economist, having been born in 1883) called The Economic Consequences of the Peace.  In it, Keynes foretold the catastrophic results of the privation imposed on Germany in the Treaty of Versailles that ended World War I.  Hey – not bad.  If only persons in authority had listened…

But Keynes’ Economic Consequences was focused on a particular time and circumstance.  The time passed and circumstances changed, and the consequent Great Depression captured all of the attention of economists and policymakers.  It was then that Keynes’ monumental contribution, The General Theory of Employment, Interest and Money, advanced economic theory pertinent to that crisis.  Although opinions about remedies for the depression were in a muddle at the time, the central tendency of contemporary thought was either passively to wait for the market to solve the problem, or, in the later words of U.S. President Lyndon B. Johnson, to save the chicken farm by starving the chickens (and insisting that governments balance their budgets).  Keynes provided the theoretical foundation needed to understand why the unaided market might not bring the depressed economy back to life (the “liquidity trap” of terrified potential investors unwilling to risk borrowing even at bargain-basement interest rates) and why government fiscal stimulus – increasing deficits – might dislodge that stasis.

Some today attack “Keynesianism” through a misunderstanding of its roots and intended application, as though it were a prescription for perpetual government deficits in expectation of ever-accelerating (or at least ever-rapid) economic growth.  It is no such thing.  Keynes was writing in and for the Great Depression.  His general theory recognized its own uses and their limits, including discussions of inflation.  How would Keynes have reacted to the issues of post-World War II prosperity?  We will never really know.  He died comparatively young, in 1946.  All that is left behind are a few late remarks in which he said that he saw more of a role for free markets and less for government than he had in the 1930s.

But the point today is not really Keynes as an individual.  He made a contribution to a field of knowledge that even today, after the further work of many other scholars, still does not have all of the answers.  Keynes was a brilliant man who in his intellectual prime of more than a half century ago knew less than we know today.  Of course, show me the field and the scholar for which that is not true.  Even in economics, the role of Milton Friedman in thinking about monetary policy has matured with changes in technology and institutions.  Fifty years ago – before the Internet, ATMs, “pre-approved” credit card applications, instantaneous global wire transfers and a host of other innovations – monetarists debated which monetary aggregate the Federal Reserve should target and control.  Today, such disputes seem quaint.  But this does not detract from Friedman’s contributions.  Similarly for Keynes.

When the Journal column attacks Keynesians today, I must concede that there are “sandbox Keynesians” out there.  Many undergraduates leave their first (perhaps only) macroeconomics classes remembering only that government deficits stimulate the economy, with no sense of nuance.  It is not a total shock that instructors talk mostly about policy problems, not management in good times – just as football coaches likely spend little time hashing out what to do when their teams get the ball on downs with a 30-point lead and 1:50 to play in the fourth quarter.  So students surely hear more about the responses to economic hard times, including the (to many) counterintuitive notion that government deficits can be necessary or even beneficial.

There are a few “sandbox Keynesians” even at a more exalted academic level, who seem to believe that government fiscal or monetary stimulus can be applied without limit and to only beneficial effect.  But they are quite few.  And then there are also many “sandbox supply-siders” who apparently believe that taxes can be cut essentially without limit at any time and that revenues will increase over and over.  In this respect, the “sandbox Keynesians” and the “sandbox supply-siders” have a lot in common:  Both believe that, so long as policy is tilted their way, budget deficits are of no concern (either because they do not matter, or because they will not occur).

However, what the Journal column missed is the existence of a more eclectic (I would assert “sophisticated,” or even “wise”) school of thought known as the “neo-classical synthesis.”  Although one could be quite fine-grained in a definition, I would generalize to say that the neoclassical synthesis merely recognizes that our complex, globally open economy has no one single policy answer that will suffice at all times; the proper policy at any given time depends on the circumstances, and just about all policy tools have some use at some time and in some circumstances.  To summarize, in a fashion that likely would have many academic theorists complaining of excessive generalization:

During times of excessive unemployment:  Keynes was right – in speaking about an economy that is significantly below full utilization of its productive resources, with consumers and producers demoralized by hard times.  Under those circumstances – but not otherwise – government can increase output and employment fairly directly.  The Federal Reserve can increase the supply of credit, thereby reducing interest rates and encouraging borrowing to finance big-ticket consumer purchases and business investment.  Monetary policy is the preferred first responder, because the Fed can act quickly and has no compunction about “taking away the punch bowl” when it no longer is called for.  However, in an extreme downturn, the economy may be caught in a “liquidity trap” – where prospective borrowers are so demoralized that they refuse to bite even if interest rates are near zero.  In circumstances approaching that extreme, the fiscal authorities – the Congress and the President – need to get on their collective horse and quickly provide stimulus in the form of tax cuts or spending increases, which most likely should be temporary.  Such fiscal stimulus would add to temporary deficits and permanent debt (more on that concern – and it is a concern – later).  But if productive resources – workers and factories and so on – would instead be sitting idle, there is no “crowding out” of investment, or of private-sector activity generally; indeed, there likely will be more investment with government stimulus than if unemployment were allowed to continue.  Thus, such deficits need not be “paid for,” at least in the short run (more on the long run in just a moment).  The 2007 financial crisis was a textbook example of such extreme circumstances crying out for policy action.

In times of full employment:  Once the economy is returning to “full employment,” however, the time for such Keynesian stimulus is over.  When producers no longer can pick idle resources off of the sidewalk, but instead must bid against each other to hire scarce, already employed resources, government deficits do crowd out private investment, and so any otherwise stimulative fiscal policy must be paid for.  These are the times to work off the burden of the public debt, to reduce the drain of interest costs on government budgets.  This allows lower taxes thereafter (more on that in a moment), and helps to keep interest rates low to facilitate capital formation for long-term prosperity through output and productivity growth.

Some who wish to knock down a caricature of a sandbox Keynesian might be puzzled at the nuance.  But an eclectic economist who understands the potential need in a weak economy for government fiscal stimulus – and hence budget deficits – will want to avoid those deficits, and even to run budget surpluses and pay down debt, when the economy is strong.  So recognizing the need both for budget deficits when the economy is weak, and for balanced budgets or even surpluses when the economy is strong, is perfectly rational.  In fact, it is where much of the economics profession is today.

And much of the economics profession realizes that the economy can stumble into a Catch-22.  A government can accumulate so much debt that it cannot access credit markets effectively, and therefore cannot mobilize fiscal stimulus in a severe economic downturn.  So again, those who want to have access to Keynesian tools in bad times are those who recognize most clearly the need for fiscal rectitude in good times.  Are they “Keynesians?”  Yes, in reality; no, in the terminology of the Journal column.

Incentives matter – but within limits:  It is not so much an element of the “neoclassical synthesis” as would be recognized by an academic, but many eclectic economists likely would acknowledge readily that incentives matter.  Lower tax rates are better than higher, all else equal, and tax rates should not be raised for sport.  Regulation should be subject to rigorous and impartial cost-benefit tests, and market-based mechanisms are preferable to command-and-control strictures.

But cutting tax rates on spec, assuming that more revenue will just roll in, is likely to turn out to be a loser.  Larger government budget deficits will inhibit more investment than lower tax rates will encourage, leaving the nation worse off after the round trip.  Limited increases in tax rates are not desirable, but may be less undesirable than raging government borrowing (another reason to keep debt – and debt-service costs – down), and within limits will have limited effects on incentives and productive economic activity.

Again, much of the economics profession fits this eclectic, “neo-classical synthesis” pattern – far more than would fall into the “sandbox Keynesian” class.  Attacking every economist who advocated fiscal stimulus in the aftermath of the 2007 financial crisis as though he or she were a “sandbox Keynesian” is rather like attacking a physician who prescribed penicillin for an infection as a “penicillinist” who would do only the same for a cancer patient or the victim of an injury in an accident.  It is attacking only a caricature, a straw man, not the prevalent body of thought.

So to an eclectic economist who fits this mold, how has economic policy performed since the financial crisis?  Well, better than it did during the Great Depression – which is part of the reason why we now see some signs of life in the economy.  Policy could have been better, in that stimulus was both too small and too slow (particularly because of the choice of some slow-moving spending programs to deliver it).  But the initial downturn was far, far worse than many would let on, and the structural damage to the nation’s financial sector was highly debilitating, and even today lingers as a problem.  The Journal column is far too blithe to dismiss both the crisis and the policies that addressed it.

Another point on which the column is dismissive of “Keynesianism” is the recent history of the Japanese economy.  The column would have you believe that Keynesianism predicts that Japan should have been beset by continuous and accelerating deflation.  A mere two-decades-plus of stagnation rather than outright implosion is not enough to satisfy the author.  I suspect that much of the economics profession would beg to differ, and would take Japan’s “lost generation” as a confirmation rather than a repudiation of Keynes’ notion of a “liquidity trap.”  I know that I would.

The column pulls “Keynesianism” into numerous other issues upon which, in my judgment at least, Keynes had nothing relevant to say (like Japan’s tsunami, ATMs, and suburban sprawl).  I believe that the key substantive points are as noted above.  But the one additional complaint that I would raise is on the entire approach and tenor of the column.

Often on those occasions in my experience when broad-minded but exasperated elected policymakers of the two political parties managed to talk, the dialog was reminiscent of the Journal column.  How can we take you seriously, one policymaker wearing a blue shirt would ask his opposition.  Look at the ridiculous things that Senator So-and-So or Representative So-and-So on your side has been saying.  Oh, no, another wearing a red shirt would answer.  He (or she) is far beyond the fringe, and doesn’t speak for us.  But while you are at it, the red shirt would continue, listen to Representative So-and-So or Senator So-and-So on your side.  How can we take you seriously when your side spouts such nonsense?  Oh, no, answers the blue-shirted policymaker.  He (or she) is way over the edge, and doesn’t speak for me.  And so on.

The lesson is that we live in a town whose ambient sound level is well past the threshold of pain, and where the parties are defined to each other – but not to themselves – by their extremes.  Reasonable people hold back from even attempts at communication across the aisle because the din of invective makes it all seem fruitless (and because they fear being branded as turncoats by extremists on their own sides).  Our electoral system, driven by primary elections that are dominated by the political extremes, gives us plenty of public figures who are eager to be the loudest, and who therefore raise the noise level still further as they decry the adversary at the other extreme.  Down that road lies deafness.  Vilifying some caricature of the other side accomplishes nothing.  What policy analysts should provide, instead, is a conciliatory discussion that shapes common ground – a new synthesis, perhaps.  Contributing to such a constructive dialog is our goal at CED.