Keynes Versus Reagan

There is something of a Keynesian revival going on right now. The bookshelves are filling with a wide variety of biographies, examinations of theory, comparisons with monetarism, and other angles all designed to give some insight into the Keynesian theory and why it has become so fashionable currently.

In that vein I have been reading Robert Skidelsky’s book: “Keynes: The Return of The Master” and recommend it highly. It is especially strong on the comparison between Keynesian ideas and those of what Skidelsky calls the ‘New Classicals’ which has been the prevailing dogma of the past few decades.

“It took a massive crisis and the loss of trillions of dollars of wealth for us to be reminded that the world is actually, gasp, a quite complicated place”

Those of you who follow what I say here regularly are aware, probably far too acutely so, of my dislike for modern economic theory upon which I lay much of the blame for the current economic mess we are in – the rest of the blame goes to the politicians who enacted New Classical ideas without truly having a clue as to their ramifications.

The larger point that needs to be made is that we have lived through an era where ideologically driven politicians co-opted an economic theory, and acted upon it, precisely because, on the surface at least, that theory supported their ideology. It gave a patina of intellectual soundness to the politics even if the politicians in question could not have delved too deeply into the theory at all.

And this is conjunction of economics with politics which forms the most interestingpart of Skidelsky’s analysis.

The immediate post-war years, from roughly 1950 through 1970, was a golden era of economic performance throughout the western and industrial world. All modernized economies, not just America, shook off the tribulations of World War II and emerged reinvigorated. Growth was strong throughout the world and unemployment very low by historical standards: the UK was typical of Europe with an average unemployment rate of about 1.6% during those decades, while it was the US that appeared to have lingering unemployment problems because it averaged around 4.8%. The vaunted flexibility of the American labor markets, so much lauded nowadays, actually produced a steadily higher level of unemployment than the far more rigid markets of Europe and Japan.

During those years the prevailing economic regime was based upon a set of ideas and institutions that owed their existence to Keynesian or quasi-Keynsian theory. The objective of public policy was to manage the balance between inflation and unemployment using the insights of a piece of economic theory called the ‘Phillips curve’. The idea being to keep the economy operating at full employment through the constant use of government interventions in the marketplace. Since full employment in these years was defined just as it sounds, very low or negligible unemployment, intervention was both frequent and, often, heavy handed. An accepted byproduct of this activity was a relatively constant and slightly higher level of inflation – the Phillips curve was designed to give policy makers insight into the balance they needed to make to keep the economy nudging towards full employment and away from either runaway inflation or, worse, deflation. The twin scourges of deflation and joblessness were etched so deeply in the public’s mind that the modest rate of inflation was seen as an acceptable cost for strong job markets.

Institutionally these policies were supported by strong unions – they negotiated long term wage deals that limited damaging fluctuations in incomes; by quiescent businesses who benefitted from predictable business conditions and an consistent inflation rate that made debt burdens easy to manage; by tight currency and exchange rate controls built around the dollar; and by trade arrangements that limited capital flows but encouraged tariff reductions – these latter two are known collectively as the Bretton Woods system after the locale at which they were negotiated.

This whole edifice is suffused with Keynsian thinking. Economists were generally thought to be using Keynsian ideas, even in the US where the older classical ideas still had a strong academic presence.

The upshot was a golden era for wealth creation: average GDP throughout the industrial world grew 4.8% annually and in no year did GDP growth worldwide fall below the IMF’s benchmark of recession of 3% growth. I should add that this IMF benchmark works because it includes fast growing countries like China whose annual growth is around 9%. For them a drop of a few percent would feel like a recession even though there would still be growth. Because there are enough such countries the IMF argues that the world as a whole is in recession when its annual growth slips below 3%. When more mature countries like the US slip a few percent they drop into negative GDP movement and so our local definition of recession is different. Along with this steady growth the average inflation rate was 3.9%; and the unemployment rate, as I have noted was very low.

All this ended in the 1970’s.

The massively inflationary funding of the Vietnam war combined with the oil crisis undermined the Keynesian vision of employment management: unemployment rose quickly right around the world despite government actions designed to limit it. Worse: the presumed relationship between inflation and unemployment – the Phillips curve – broke down. We had both high inflation and high unemployment at the same time. These were the years of ‘stagflation’.

The apparent break down of Keynesian thinking opened the door for a counter-revolution in economics led by Milton Friedman and his colleagues at the University of Chicago. In broad terms their new vision of the economy, which was a modified and more rigorous version of the Classical theory of David Ricardo, argued that it was exactly the government interventions that were causing all the problems, and that the proper focus of policy should be to minimize government, lower taxes, control inflation, and allow the ‘self-correcting’ mechanisms of the marketplace take care of the rest.

In other words the focus of policy should shift from demand management – keeping wages high and unemployment low – towards supply management – keeping taxes low, deregulating markets, weakening unions, and eliminating government programs.

This was supposed to unleash the power of capitalist wealth creation by getting rid of all the rigidities and inefficiencies that were alleged to be the natural counterpart of government intervention.

Allow business to run free of control and it would produce wealth sufficient to lift everyone, even those who are not part of the business elite.

This new theoretical system – dubbed the New Classical system – swept into dominance on the backs of a parallel political shift towards the right in the US and the UK. The apparent collapse of Keynesian economics was associated, successfully by conservative politicians, with meddlesome and rotten government. In a replay of the early 1800’s the resurgence of a heavily individualistic politics and a deregulated market system can be seen as a reaction to the supposed endemic corruption of government. Ricardo had belabored the superiority of markets over governments for exactly the same reasons Friedman gave: governments, they said, can never be as efficient as free markets in the allocation of scarce resources. And since allocation is what an economy is presumed to be for, it follows that government ‘is the problem’.

The near simultaneous arrival of Reagan in the US and Margaret Thatcher in the UK, both equipped with New Classical notions of market effectiveness, marked the end of Keynes domination of economic policy. From 1980 through last year the Friedmanite agenda reined supreme. So much so that Keynes fell off the curriculum in many top universities.

Let me reprise the main point of difference between the two economic theories: Keynes places great emphasis on the notion that markets cannot be relied upon to self correct – they face too much pure uncertainty [not simply risk] to be automatically equilibrium seeking. To the far more mathematically driven and purist Friedman this possibility was apostasy of the very worst kind: the New Classicals see markets as the apogee of mechanical and smoothly operating systems, that, if left alone by government, will absolutely always converge on the ‘best’ solution. In this sense Friedman was simply channeling Ricardo.

To get this supply side vision enacted the whole fabric of the older regime had to be tossed overboard: unions had to be restricted as impediments to the market’s ability to adjust – don’t forget that to a devout New Classical economist there is no involuntary unemployment: anyone who doesn’t have a job is ‘choosing’ not to work; the foreign exchange, trade and capital flow restrictions of Bretton Woods were replaced with floating exchange rates and globalized markets; business was unfettered from regulation; and the central bank was focused upon inflation management in order to provide business with a consistent environment in which to take risks.

The Reagan revolution was, at heart, a return to the premises of the Classical economists of the 1800’s. Crucially as the memory of the Great Depression faded from the public’s attention, so did the lessons learned: even some of the most discredited ideas of the Classicals were rehabilitated. Say’s Law, which argues that production will bring about sufficient demand – an idea Keynes had thoroughly debunked – re-emerged as supply side economics. The re-emergence of Say’s Law meant that the idea that aggregate demand can fall even when supply remains strong, the central motivation for Keynesian policy prescription, could be dismissed as impossible.

The outcomes?

Well the numbers don’t seem to bear out the New Classical argument.

The Reagan era has seen world GDP growth of 3.2% – down from 4.8%. This may not seem a lot but the world’s wealth would be 50% greater had the Keynes era of 4.8% been maintained.

Not just this but the world has, according to the IMF definition, had no less than six recessions in the Regan era compared with none under the Keynes regime. Things have become a lot more bumpy – which is what we would expect whenever markets have to keep adjusting without the smoothing influence of government.

And this dubious record has come at a great cost: unemployment has risen everywhere, in some places quite sharply. This is particularly true in Europe average unemployment rates have skyrocketed from the low 1% to 2% range to the persistent 7% and above range: the UK average went from 1.6% to 7.4%, while the US went from 4.8% to 6.1%.

Finally the vaunted ‘tight money’ inflation targeting of the Reagan era produced an average inflation rate of 3.2%. This is better than the 3.9% of the Keynes era, but not so significantly so that the unemployment cost is warranted.

Then we reach last year and our current crisis.

The wheels finally fell off the Reagan era ideology and the New Classical theory: deregulated markets span out of control. Financial systems teetered on the precipice of oblivion. Interest rates were ineffective as policy levers – we had reached the much feared ‘zero bound’ at which interest rate changes have no further effect. Nowhere in sight was the vaunted self-correction so beloved and admired by Friedman and through him Reagan.

The only policy lever left to fend of total collapse was a solid dose of Keynesian fiscal stimulus. Government intervention, the very devil incarnate, turns out to be the only possible remedy to our ills – as long as we want to avoid a depression.

Keynes roared back along with the lessons drawn from the 1930’s.

Hence the current interest.

My perspective has been Keynsian all along: the New Classical vision and its associated Reagan style ‘rugged individualism’ has seemed naive and utopian to me since I first came across them. They are ideas that look impressive on paper, but they place a massive burden for their efficacy on a set of assumptions simply untenable in the real world. It was a reaction to this naivete that drove Keynes to try to move economics into a more realistic realm. He rejected the purity and mechanistic movement of Classical theory. He viewed uncertainty as endemic to human discourse. He supported capitalism only as modified and contained within boundaries that limited its excesses – he was also strongly anti-socialist, preferring a ‘middle way’. He imagined a higher ethic for wealth creation than simple materialism. He decried what he saw as the inherent instability of financial markets. And he loathed the implications of huge inequalities of income distribution, which he saw as destabilizing democracy itself.

Friedman, Reagan, Lucas, and Bush and all the other champions of the deregulatory, free wheeling, supply side regime of the past three decades have a much simpler and far less nuanced view of society than Keynes did. The burden of the Great Depression and its incalculable human cost was too distant in their minds to shape or inform their ideas. They believed in simple mechanisms, simple relationships, simple cause and effect connections, and simple rules. Above all they believed government to be an irredeemably corrupt and pernicious influence on human affairs.

It is as if they were tilting, as the Founding Fathers did, against government in the guise of a corrupt 18th century monarch. They overlaid such a monarch’s sins onto todays’ modern technocratic and bureaucratic democracy. It is an epic failure of intellectual grasp, and an extraordinary attempt to recapture the sensibilities of a late 1700’s coffee house.

That we were duped by their portrayal of that simplicity is a testimony to our own decadence and lack of education. The allure of the New Classical and Reagan vision lies within its easily understood maxim: ‘the government is bad’. They were wrong. Keynes had already taught us that. It took a massive crisis and the loss of trillions of dollars of wealth for us to be reminded that the world is actually, gasp, a quite complicated place. A place where naive visions and simple solutions can very often condemn us to disaster.

So Keynes is back. Let’s hope we don’t forget him so quickly this time.