Is it time to turn back to Keynes?

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.

Remembering the past

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.

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.

Doomed to repeat it?

What to do?  In many applied disciplines, like medicine, practitioners go back to basics when the facts change.  If their current practice fails to produce the desired result, they search their armamentarium for others.  If their assumptions prove wrong, they look for more appropriate ones.  But not modern macroeconomists – they say we must simply endure what they call secular stagnation.

This is an unhappy prediction.  Monetary policy does not work today; instead, this is the perfect time for fiscal policy.  There are immediate needs to repair roads and bridges, rebuild energy grids, and modernize other means of travel.  Expansive Keynesian fiscal policy will benefit the economy in both the short and long run.

We argue in our new book, Keynes, Useful Economics for the World Economy, that these recommendations can be seen as inferences from a simple and effective model of the short-run economy.  We show how hard it was for Keynes to break away from previous theories that work well for individual people and companies – and even for the economy as a whole in the long run – to define the short run in which we all live.  We also stress Keynes’ interest in the world economy, not just in isolated economies.  After all, the IMF is perhaps the most enduring remnant of Keynesian thought left today.

Authors’ note: Peter Temin is Elisha Gray II Professor Emeritus of Economics at MIT and the author of “Lessons from the Great Depression” (MIT Press) and other books.  David Vines is Professor of Economics and Fellow of Balliol College at the University of Oxford, and joint editor of a number of books on global economic governance.

Editor’s note: Temin and Vines are coauthors of “The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It”.

References

Lucas, R (2009), “Why a Second Look Matters”, Council on Foreign Relations, March 30.

Krugman, P (2011), “A Note on the Ricardian Equivalence Argument Against the Stimulus (Slightly Wonkish)”, Krugman blog, The New York Times, December 26.

Barro, R (1974), “Are Government Bonds Net Wealth?”, Journal of Political Economy.

Barro, R “On the Determinants of the Public Debt”, Journal of Political Economy.

Poterba, J M and L H Summers (1987), “Finite Lifetimes and the Effects of Budget Deficits on National Savings”, Journal of Monetary Economics.

Carroll C and L H Summers (1987), “Why Have the Private Savings Rates in the United States and Canada Diverged?”, Journal of Monetary Economics.

Published in collaboration with VoxEU

Author: Peter Temin is the Elisha Gray II Professor Emeritus of Economics at the Massachusetts Institute of Technology (MIT). David Vines is Professor of Economics in the Economics Department, Oxford University, and a Fellow of Balliol College, Oxford as well as Director of the Centre for International Macroeconomics at Oxford’s Economics Department.

Image: A man looks at an electronic board displaying share prices in Tokyo July 8, 2009. REUTERS/Yuriko Nakao