Why Keynes is important today?

Eco Historians Peter Temin and David Vines have this article.

There is huge animosity to fiscal stimulus today based on Ricardian equivalence. The authors show how Keynes faced a similar situation in 1930s:

Macroeconomists have largely failed in explaining and recommending policies since the Global Financial Crisis of 2008.  Today when thinking about fiscal policy they cite Ricardian Equivalence to deny the efficacy of Keynesian analysis (which was abandoned in the turbulent 1970s that signaled the end of rapid growth).  They seem unaware that they have revived the views of Montagu Norman, Governor of the Bank of England, in 1930.

Ricardian Equivalence is a theory that concludes that any expansion of public spending will be offset by an equal and opposite decline in private spending.  The theory is based on a few important assumptions. It assumes forward-looking consumers who adjust their current spending in anticipation of future taxes to pay for the spending.  Under these conditions, any increase in current spending leads consumers to anticipate a rise in future taxes and decrease their current spending to save for this.

This theory dominates current macroeconomic discussion.  It fits into the form of current macroeconomics that assumes not just forward-looking consumers, but flexible prices as well. And if a Keynesian suggests fiscal policy in current conditions, a modern economist is likely to invoke Ricardian Equivalence.

Keynes faced exactly this opposition in 1930.  He was a member of the Macmillan Committee convened by the British government to analyze the worsening economic conditions of that time.  His recommendation for increased government spending – what we now call expansive fiscal policy – was opposed by Norman and other representatives from the Bank of England.  They did not invoke Ricardian Equivalence because it had not yet been formulated; instead they simply denied that increased government spending would have any beneficial effect.

Keynes opposed this view, but he did not have an alternate theory with which to refute it.  The result was confusion in which Keynes was unable to convince a single other member of the Macmillan Committee to support his conclusions.  It took five years for Keynes to formulate what we now call Keynesian economics and publish it in what he called The General Theory.

He based his new theory on several assumptions, two of which are relevant here.  He assumed that consumers are only forward-looking part of the time, being restrained by a lack of income at other times, and that many prices are not flexible in the short run wages in particular are ‘sticky’.  These assumptions give rise to involuntary (Keynesian) unemployment which expansive fiscal policy can decrease.

We are looking at same issues today as well. Just that the opposition is to Keynesianism:

Which theory is relevant today?  We know that wages are sticky – countries in Southern Europe have found it impossible to implement requests from their creditors that they reduce wages swiftly.  And we know that not all private actors in the economy are forward-looking.  Before the crisis, borrowing and spending increased in ways that could not be sustained;  now consumers are not spending and business firms are not investing even though interest rates are close to zero. 

Those are the conditions described by Keynes in which expansive fiscal policy works well.  They also are the conditions in which monetary policy does not, even though modern macroeconomic policymakers came to rely entirely on monetary policy for stabilization.  There is a disconnect between the needs of current economies and theories of current macroeconomists.

The authors are writing a book on Keynes looking at his ideas. Should be interesting to read..

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.


%d bloggers like this: