The Big Question: Who was JM Keynes, and does he offer answers to the economic crisis?

By Archie Bland

Tuesday, 28 October 2008

Why are we asking this now?

For decades, undiluted Keynesian economic policies have been dismissed as irrelevant: right for their time, perhaps, but outdated by subsequent changes in the economy. But it looks as if things are changing. In the face of the current financial crisis, government after government has moved towards more Keynesian solutions to economic problems. The UK is among them. Alistair Darling recently declared that "much of what Keynes wrote still makes a lot of sense"; yesterday, in a speech on economic policy, Gordon Brown declared that it was responsible to boost spending with the aim of speeding up economic activity, even if borrowing had to increase to do so. John Maynard Keynes once said that "in the long run, we are all dead"; more than 60 years after his own passing, though, his ideas seem to have come back to life.

So who was John Maynard Keynes?

Keynes was among the most important economists of the 20th century. Even his most vociferous contemporary critic, Friedrich Hayek, said that he was "the one really great man I ever knew, and for whom I had unbounded admiration". Born in 1888, he was educated at Eton and Cambridge, where he studied economics. His influence steadily grew after he graduated in 1905; he warned of the disastrous consequences against the reparations that Germany was forced to pay after the First World War, and his views were borne out by the country's hyperinflationary problems and the subsequent Great Depression. The work that really cemented his place in economic history, though, was 1936's snappily titled General Theory of Employment, Interest and Money.

What was his big idea?

Most contemporary economists subscribed to the neoclassical theory that held that the problems of unemployment were best dealt with by leaving it to the market to reduce wage levels to a point at which employers would start to take people on again. Keynes disputed the idea that recessions were self-correcting. He made the argument that it was quite possible for an economy to be in equilibrium with less than full employment, and that high unemployment would depress demand, thus making an escape from recession difficult and slow. In his view, it was up to the government to stimulate demand by enacting public spending projects that would increase employment and by reducing taxation to encourage people to spend more.

Did it catch on?

In the 1930s, Roosevelt did enact Keynesian ideas in America, and their influence can be felt to an extent in Hitler's Germany around the same time. But the Second World War was the major boost for Keynes's ideas around the world, demonstrating as it did that large public spending – 'deficit financing' – could create something close to full employment, something conventional politicians in the thirties claimed was impossible.

Did those ideas survive the war?

They did. After Keynes's ideas were developed by economists like Paul Samuelson and James Tobin, they became the economic orthodoxy that guided most western governments for the next two decades. In the UK, expanding public spending and cutting taxes successfully kept unemployment below one million for thirty years. Even Richard Nixon declared himself a Keynesian. But in the 1970s, that orthodoxy was challenged.

Why did Keynes's ideas go out of fashion?

Keynes's approach began to appear limited in relatively uncompetitive economies, like the UK's. A labour shortage and an excess of demand triggered stagflation – the combination of inflation with economic stagnation – and traditional Keynesian remedies seemed unable to control it. When James Callaghan publicly repudiated Keynesian policies in 1976, it seemed like the death knell of his approach. "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending," Callaghan said. "I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step."

What was the alternative, and how did it work?

Governments like Margaret Thatcher's believed that the only way out to escape economic crisis and quell inflation was monetarism, the economic policy propagated by critics of Keynes like Milton Friedman. That involved getting a grip on the supply of money, reducing taxes, reducing the upward pressure on wages by taking on the unions – and accepting unemployment, at least in the short term, as the necessary consequence. In the recession of the early 1990s, not even the Labour party advocated a Keynesian approach.

What's different today?

By Thatcher's time, the impact of high unemployment in the 1930s was a distant memory, and so she and her government felt able to enact policies that risked increasing it; it may be that the problems that accompany high inflation are sufficiently long past to mean that the psychological barrier to Keynesian policies is no longer in place.

Today's economic circumstances do seem to fit a more Keynesian solution. Inflation is likely to stay low in the coming downturn, meaning that the upward pressure of increasing demand is likely to be manageable; and critics who say that public spending often takes too long to counter the economic problems they were instituted to solve can be answered with the point that this is likely to be a fairly long recession. In that environment, the government seems to have decided that the time is ripe for a Keynesian renaissance.

So what can we expect?

Yesterday's speech from Gordon Brown indicated that the Government is willing to borrow more money to increase public spending, and major investment projects are likely to be brought forward. Crossrail, for instance, may easily turn up years sooner than initially planned. In a speech last week, Alistair Darling also pointed to the 2012 Olympics as an obvious target for investment. The green lobby, meanwhile, will be arguing that the coincidence of the impending recession with the government's new 80 per cent target for reductions in carbon emissions by 2050 makes this the perfect moment to boost spending on alternative energy resources and more environmentally friendly housing.

Is there a consensus on all this?

Certainly not: there remain voices in the economic argument that insist the Government's shift will be a disaster. Sixteen economists signed a letter to The Sunday Telegraph this weekend that characterised the government's approach as "misguided and discredited". "The Government cannot know how to use an expansion in expenditure that would not risk seriously misallocating resources," they wrote. "If this recession has features that demand more active fiscal policy, which is highly disputable, taxes should be cut. This would allow the market to determine which parts of the economy shrink and which flourish to replace them." Whatever policies hold sway this time, one thing is clear: the battle over the wisdom of a Keynesian approach is by no means over, and probably never will be.

Should we take a lesson from JM Keynes?

Yes

*Keynes's approach is most effective at times when inflationary pressures are not particularly high – like now

*The laissez-faire approach has not been particularly successful lately, so why should we stick with it?

*Investment will be a godsend for infrastructure – and could even help solve our environmental crisis

No

*The market does a better job of working out which parts of the economy need to expand and contract

*Boosting the state could stunt the resurgence of the private sector once the downturn is over

*When Japan tried to spend its way out of recession in the 1990s, the result was huge debt

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