Did the Keynesian revolution start in the 1930s?

An amazing paper by Barry Eichengreen (BE). It  was written in 1999 and there is evidence that certain thinking has changed since then.

So did the K-revolution start in 1930s itself? There are strong reasons to think so:

For most economists, the crowning intellectual achievement of the 1930s was John Maynard Keynes’s General Theory of Employment, Interest, and Money. Keynes promised, to those willing to wade through his recondite prose and intricate arguments, a new era in which economic policies, especially fiscal policies, would banish the business cycle. The gospel of Keynes was surely one of the cornerstones of the golden age of stability and growth that prevailed for a quarter of a century after World War II. 

But was there already a “Keynesian revolution” in economic policy making in the 1930s? Observing the more active use made by certain governments of monetary and fiscal instruments than in the 1920s, some authors would have it be so. Publication of the General Theory was not an isolated event; not only had the book been underway for a number of years, allowing drafts to be aired before receptive audiences of Cambridge students and circulated to Keynes’s faithful correspondents, but at least some similar ideas had been developed by economists in other countries. And the severity of the slump that started in 1929 did much to erode the legitimacy of the doctrine of balanced budgets and laissez faire, creating fertile ground for experimentation with 
new approaches to economic policy making.

BE says despite people knowing Keynes writings, his ideas hardly found any acceptance. It was not fiscal policy but monetary policy which was at the centre:

I argue in this chapter that there was no Keynesian revolution in the 1930s. Arguments  related to the General Theory had little impact on the actual policies of central banks and governments. Fiscal policy in particular made a very limited contribution to recovery from the Depression. Governments ran large budget deficits only where necessary to underwrite substantial increases in military spending that were impossible to finance by other means. Keynesian ideas were invoked, where expedient, to justify these deficits, but the driving force was militarization, not countercyclical stabilization.

Monetary policy, not fiscal policy, was the force behind recovery from the Depression.  Whether central banks cut interest rates and stabilized the supply of money and credit was the single most important determinant of the timing and pace of recovery. This is an uncomfortable fact for followers of Keynes. Observing the low level to which interest rates had fallen in the 1930s, The General Theory dashed cold water on the idea that interest-rate cuts could be used to jump-start recovery from the Depression. With its concept of the liquidity trap, Keynes’s theory was widely seen after World War II as explaining why monetary policy was ineffectual in a slump. 

The problem then was gold standard:

In fact, this was an entirely counterfactual story. There was little evidence of a liquidity trap in the 1930s, either in the United Kingdom, the country that was Keynes’s principal concern, or elsewhere. There was little evidence that low interest rates were a binding constraint on expansionary monetary policies, given the other instruments in central banks’ arsenals. The constraint was not the ability of central banks and governments to reflate their economies but rather their willingness to do so.

Above all, the fact and ideology of the gold standard stood in the way. So long as the gold standard remained in place, the commitment to defend the central bank’s gold reserves and stabilize the gold parity was an insurmountable obstacle to the adoption of expansionary policies.  Indeed, so long as the ideology of the gold standard prevailed, governments and central banks failed to even recognize the need to remove that obstacle. And only when it finally was removed did recovery from the Depression at last commence.

There was no real Keynesian revolution but Nominal revolution.

Thus, the fundamental change in policy making in the 1930s was not the Keynesian revolution but the “nominal revolution” — the abandonment of the gold standard for managed money. In fact, the intellectual basis for this revolution was Keynes’s own earlier work, in The Tract on Monetary Reform, published in 1923, ideas he largely neglected in The General Theory.

Why nominal? Difference between nominal and real in eco is inflation. The focus then was mostly on real and having very little inflation because of gold standard. Abandoning gold standard led increasing the money supply and then higher inflation…

The paper then goes on to suggest the dominant econ thought was to “let markets work” and “protect gold standard” at all times. In case there is a problem, let markets liquidate!  He goes on to highlight how this thought was prevalent in most major countries  showing examples from US, UK, Germany, France etc.

Fascinating account..

On Sweden he says:

The Swedish Riksbank articulated a policy of stabilizing the price level in what may have been the first such policy ever adopted by a central bank. It imparted credibility to the policy by taking advice from experts like Gustav Cassel, David Davidson and Eli Heckscher and by constructing a weekly consumer price index to provide an explicit, independently verifiable monetary target. In Sweden as in Britain it was primarily interest-rate sensitive sectors producing for the home market that led the recovery.

I just pointed a paper which shows Sweden did nothing of this sort. It was also just trying to devalue its currency. So as I said above, new findings on eco history have led to some new beliefs..

Have we learnt anything? He goes to Japanese crisis in 1990s and says the liquidate and gold standard views remained even then:

Looking back on the monetary and fiscal policies of the 1930s from the end of millennium suggests too many parallels for comfort. The Japanese economy remains becalmed in what is now a decade-long depression. For much of the 1990s, Japanese policy makers were reluctant to act for fear of creating another bubble economy like that which Japan had experienced in the 1980s. Better to liquidate stocks, liquidate real estate, and purge the rottenness out of the system. There was, moreover, the worry that deficit spending would drive up interest rates and crowd out more productive investment, given the weakness of the Japanese financial system and the banks’  reluctance to lend. Shades of the Treasury view! And there was even the fear that an expansionary monetary policy would unleash inflation, this in the face of the most pronounced deflation experienced by a major industrial country in the second half of the 20th century. Shades of gold standard orthodoxy!

Finally, it takes time for thoughts to sink in:

This recent experience is thus another reminder that entrenched views change only slowly. This is also the lesson of the interwar years. There was no Keynesian revolution in the 1930s in the sense of sharply expansionary fiscal policies adopted with the purpose of propelling economies out of the slump. Expansionary monetary policies were pursued, but abandoning the gold standard was an indispensable prerequisite for their adoption. Although Keynes provided justification for this policy as well, this was not the Keynes of the General Theory as much as the Keynes of the Tract, in which he had argued that monetary policy could be used to target exchange rate stability or to target price stability, but that there was no guarantee that the former would imply the latter.

Governments forced to choose were well advised to opt for stabilizing the level of prices. In Keynes’s own words, “when stability of the internal price level and stability of the external exchanges are incompatible, the former is generally preferable; and…on occasions when the dilemma is acute, the preservation of the former at the expense of the latter is, fortunately perhaps, the line of least resistance.” Although it took some time to sink in, by the mid-1930s this once iconoclastic point had almost become conventional wisdom. 

Must read…



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