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June 21, 2006



"His big idea - the use of state spending to underpin aggregate demand - was the solution to what we now know was only a temporary problem." And, if I understand Mr Bernanke's views on the matter, the temporary problem was itself a product of the state - in particular, the Federal Reserve.

Bob B

"[Keynes's] big idea - the use of state spending to underpin aggregate demand - was the solution to what we now know was only a temporary problem."

We probably aren't going to agree about this but I don't accept that was Keynes's big idea.

At most, state spending to boost economic activity was a policy implication of Keynes's new theory which intended to explain how a market economy could stagnate indefinitely and maintain high unemployment rates and where the supposed adjustment mechanisms of received, conventional wisdom didn't work (effectively). The evidence for this interpretation comes from within The General Theory:

" . .it is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse." [p.249]

Reverting to the economics literature at the time, there was much controversy as to what precisely this new theory amounted to and whether it really accomplished what it was supposed to. Early on, Keynes famously endorsed JR Hicks's interpretation in Econometrica 1937: "Mr Keynes and the Classics", which yielded the LM-IS diagrams that passed into so much mainstream undergrad teaching:

Some (convincingly IMO) argue that the source of what came to be called "Keynsianism" is attributable to the popular LM-IS presentations based on Hicks's interpretation.

FWIW my own preferred illuminating intepretation of the distinction between Keynes and what he dubbed "the Classics" is Modigliani: "Liquidity Preference and the Theory of Interest and Money" in Econometrica 1944. Sadly, I can't find a direct link but this is about Modigliani:

However, I agree with S&M: "Keynes' thinking was simple. High investment would lead to a high capital stock. And the law of diminishing returns meant that a high capital stock would mean low returns on capital." The trouble is that Keynes wasn't always consistent, he endorsed varying interpretations of his theory and discussion has continued since the publication of The General Theory as to what exactly he meant in places.

The way forward IMO is certainly to regard The General Theory, as a seminal text but recognise also the concurrent contributions of Tinbergen's econometric models and of Kalecki's neo-Marxist macro models. As I've suggested here before, the distinctive difference of the Labour Party and "leftists" in Britain was not about Keynesian economics but over microeconomic policies. After all, even before Butskellism of the 1950s into the early 1960s, there was Harold Macmillan's book: The Middle Way (1938), which sought to popularise Keynesianism among Conservatives, and then we had the Heath-Barber boom of the early 1970s, which was clearly inspired by Keynesianism and intended to avert a predicted rise in unemployment.

Self-avowed lefitists in Britain had no monopoly in a regard for Keynesianism. What was distinctive was the attachment of most leftists to state ownership of the commanding heights of the economy (hence Labour's 1983 manifesto), an aversion to the European Common Market (Labour's 1983 manifesto), and resistance to relaxation of price controls, especially controls of the market in rented housing. Famously, Mrs Thatcher, as education secretary in Heath's government (1970-4), approved more conversions of grammar schools to comprehensives than any other education secretary before or since.


[However, since the 1970s at least, the threat of revolution or collapsing demand have not been the main threats to animal spirits]

Are you sure? I seem to remember the Fed cutting rates aggressively in 1995, 1998 and 2001 precisely in order to ward of a risk of collapsing demand. It is a truism to say that monetary policy is run on explictly Keynesian lines.

I really don't recognise a word of what you're saying about Keynes or left-Keynesianism here.

Bob B

Well, Keynes did say that "animal spirits" (or optimisim) is what, in the final analysis, motivates entrepreneurs to invest but that is hardly a unique, novel insight. It's the distinctively different analysis that follows in the "Classics" and Keynesianism if an economy runs into a bout of low animal spirits where Keynes is suggesting something novel.

The received conventional ("Classical") wisdom at the time of The General Theory was that interest rates would fall with diminished animal spirits and that would stimulate consumption and investment spending and so ensure that saving (= not consuming) equalled investment. To reduce unemployment, the workers needed to accept reductions in going wage rates to induce businesses to increase offers of employment. Problem solved.

The important contribution of Keynesianism was to suggest a new theory explaining why those two adjustment mechansims might not work in reality: in summary:

- The "liquidity trap" set an effective floor in the financial markets below which money interest rates didn't fall or fall sufficiently to ensure the extra investment required to raise employment levels;

- The immediate effective of cutting wages was to cut aggregate monetary demand, very likely leading to price cuts because of competition between businesses(a deflationary spiral) in which businesses would be reluctant to invest until they could foresee an end to falling prices. Workers could only negotiate their money wages - they had no control over what happened to their real wages.

John Angliss

George Monbiot in his "Age of Consent" proposes that Keynes' "International Clearinghouse" which he was pushing for at Bretton Woods should be used to secure investment in countries with an overall deficit.

Does this work?

Sorry if it's not something you're familiar with - the idea has just been fascinating me.

angry economist

Didn't Friedman provide decent evidence that the Great depression was largely due to insufficient money supply in the US economy - i.e. constrained liquidity - as dearieme alluded to?

Does this case have no credence any more?

I always thought Keynes's proposed solution was always seen as a temporary measure, even by himself.

Keynes's ideas on wage stickiness also led to development of theories around inflation etc.

Aint it the case that he advanced knowledge a step, even if some of his ideas were found to be subsequently flawed (like many scientists etc)?

Bob B

Friedman certainly argues that the US depression from 1929 onwards was due to the FED running excessively restrictive monetary policy - I just don't know enough US economic history to assess how robust his analysis is. But even then, that doesn't clinch a case against Keynesian analysis.

Big problems in all this are the difficult task of separating out what Keynes actually wrote/said from what became Keynesianism - if that really matters - and resisting temptations to throw away babies with bath water.

Arguably, Hicks's LM-IS analysis (unintentionally) encouraged an interpretation of Keynes that variations in unemployment were due (mainly) to unwanted variations in aggregate demand because changes in supply-side factors all happen behind the analytical shifts in the respective curves. Money market factors are embodied in the LM curve while the IS curve embodies fiscal policy, animal spirits affecting investment and any changes in preferences between consumption and saving.

It was that analytical framework which led to the policy emphasis in Britain and America after WW2 on using fiscal instruments to fine tune aggregate demand and the neglect of supply-side factors. But I think both leftists and Conservatives were culpable in this.

Governments in West Germany and France, which were not so taken with Keynesianism and using fiscal policy to fine-tune demand, were less prone to neglect supply-side considerations. However, unlike Britain or America, both W Germany and France were in the position of having much larger agricultural sectors which were placed to provide labour to meet the demand of their growing manufacturing sectors. In addition, W Germany had the benefit of a stream of skilled refugees from eastern Europe - which is why the Berlin Wall was built in 1961.

Another important policy fault line in Britain IMO was the Phillips curve - the notion that there was a simple, stable trade-off between unemployment rates and inflation so that policy makers had the option of choosing a preferred mix according to political preferences.

Friedman and Edmund Phelps challenged this c. 1958 by saying that those in labour markets would quickly come to realise that governments were: (a) committed to maintaining "full-employment" and (b) accommodating a certain rate of inflation which unions would come to adopt as the basic starting point in wage negotiations.

It was this critical analysis that led on to the notion of "the natural rate of unemployment" and from there to NAIRU: the non-accelerating inflation rate of unemployment, which was determined by the structural features of labour markets (as well as, possibly, incentives in fiscal and social security systems). Attempts by government to boost aggregate demand to lower the prevailing unemployment rate below NAIRU would lead to accelerating inflation.

In a landmark speech to the Labour conference in 1976, Sunny Jim Callaghan as PM accepted the reassessment - Hattersley comments: "Towards the end of [Callaghan's] political life he became increasingly pragmatic. At the 1976 Labour conference he announced that the old Keynesian ideas of demand management and full employment were dead. And he went on to question whether they had ever had much relevance to the real economy."

The Conservative government of the 1970s and the following Labour government both adopted incomes policies to curb inflation. Up to Mrs Thatcher's election in May 1979, it is difficult to detect significant, principled differences between the two main parties over macroeconomic policy issues although there were certainly many distinctive differences between the parties over microeconomic policies.

Bob B

Further reflections: I've been posting to online debates for 10 years - in the late 1990s, it was quite common in discussions on economic policy to see messages like this in sentiment: "Of course, as we all know, Keynes is rubbish and what matters for economic stability is controlling the money supply . . "

Unfortunately for that claim, the IMF had already written the obituary of monetarism:

"...instability of monetary demand, especially in the context of supply shocks and declines in potential output growth, complicated the task of monetary authorities. As a result, during the 1980s most central banks – with some notable exceptions – either abandoned or downplayed the role of monetary targets".
IMF World Economic Outlook, October 1996, p.106.

There are several live and pressing issues in macroeconomic policy but whether Keynesian economics is rubbish isn't among them. The influence of Keynes, Tinbergen and Kalecki is there across virtually all discussions about policy, even if we now accept NAIRU and pay far more attention to supply-side issues. The focus of the policy debates has shifted IMO to issues raised in Andre Sapir's paper:

Globalization and the Reform of European Social Models - background document circulated at the ECOFIN Informal Meeting in Manchester, September 2005

Summary and commentary here:

And see the Economics Focus in last Saturday's The Economist (sub) on: The OECD Jobs Strategy:

There are unresolved questions about whether the prevailing fashion for inflation targeting among many central banks would be up to dealing with a serious bout of a deflationary price spiral in a major economy. What happened in Japan since 1992 is hardly reassuring.


Have to agree with Bob B and Dsquared here -I don't buy that keynes's big idea was state spending. That may be what leftists took from him. But so what.

I attach a lot of weight to Keynes's insights on causality. Keynes basically demolished the classical theory of interest by showing that aggregate saving is essentially a macroeconomic residual, causally determined by aggregate investment, and of zero relevance for the "determination of" interest rates.

In fact, after reading keynes you should reach the conclusion that macroeconomics is both more understandable and more coherent if you don't use the word saving at all. Unfortunatley legions of economics writers continue to confuse students, layment, and even fellow professionals by persisting....

(you need an example?

think Bernanke's "savings glut")

The implication of course was that there is no substance to the classical view that market economies automatically adjust to "higher" saving with sufficiently low interest rates to guarantee a return to full employment in "the long run".

The corollary is that we need to look for another theory of how interest rates are determined - hence liquidity preference, the focus on demand and supply of money, and also Keynes' interesting suggestion that in fact interest rates reflect convention in much the same way that stock prices do.

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