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Keynes’ Economic Theories Re-emerge in Government Intervention Policies

BY Admin  February 23, 2009 at 5:20 PM EST

John Maynard Keynes : Library of Congress

Keynes was an influential policy analyst and economist who lived from 1883 to 1946. His seminal work, “The General Theory of Employment Interest and Money,” became a founding force behind modern macroeconomics after it was published in 1936.

Keynes supported government intervention during times of economic turmoil. Among the theories he presented in “General Theory” was that economies are chronically unstable and that full employment is only possible with a boost from government policy and public investment. Keynes believed that it was up to the government to bridge the gap between the economy’s potential and its actual output during a financial crisis, even if that meant taking on debt.

A civil servant to Britain in the early 1900s, Keynes later lectured at Cambridge University and worked for the British Treasury. He first rose to prominence with his 1919 book, “The Economic Consequences of the Peace,” which criticized elements of the Treaty of Versailles and forecast the unstable financial conditions it created in Germany after World War I.

“General Theory” was written amid the Great Depression and was largely a product of his study of a prolonged period of unemployment in Britain after the war. The emergence of President Franklin Roosevelt’s “New Deal” spending programs during the 1930s helped solidify Keynes’ legacy and spawn Keynesian economics.

Keynes was also one of the fathers of the 1944 Bretton Woods accord, which established the World Bank and the International Monetary Fund, and which put in place a system of fixed exchange rates.

Comparisons to a second Great Depression have percolated recently in the United States, with unemployment above 7 percent, the economy shrinking and major banks filled with soured assets from bad mortgages.

After inheriting one of the worst financial climates in decades, President Barack Obama pressured Congress to quickly pass a sweeping $787 billion economic stimulus bill. The American Recovery and Reinvestment Act gives state governments billions to pay for services like infrastructure rebuilding and other programs, increases unemployment insurance and cuts taxes for many Americans.

Dean Baker, co-director of the Center for Economic and Policy Research, said the idea that the government should stimulate the economy through spending or tax cuts comes largely from Keynes’ formalization of these ideas.

“When you have a downturn as you have now and the private sector is sort of grinding to a halt, the government has the ability to boost demand basically by just spending money,” Baker said.

“The argument is that during a downturn, we have all these idle resources: we have all these people who need jobs, we have excess capacity in our factories throughout the economy,” he said. “In that context the government can spend money. [Keynes] was front and center of that.”

NewsHour business and economics correspondent Paul Solman, who is preparing to teach seminar on Keynesian theory at Yale University, said the economist changed how the world thought about recessions.

“The dominant paradigm in economics before Keynes was that markets would right themselves and that all you really had to do was wait it out,” Solman said. Keynes said that a recession could become self-reinforcing, and wrote that waiting out a recession can lead to a downward spiral that destroys wealth.

In Keynes’ view, when main pillars of the economy are failing – consumer spending, investment and net exports – the only pillar that is left to support the economy is the government.

While Keynesian ideas may hold influence over policymakers on both sides of aisle, skeptics say that the specific policy approach of the Obama administration’s stimulus package is off-base.

Robert Barro, a Harvard economist, said that while it is a good idea for the government to try to restart the ailing financial system by propping up failing banks, he is leery about governmental spending as a form of ecomomic stimulus.

Barro says that Keynesian thinking on using government spending as stimulus won’t yield the results advertised. While supporters of Mr. Obama’s stimulus assume that government spending will be amplified via a multiplier effect — government money spent to build a bridge will also provide wages for workers — Barro’s research suggests otherwise.

The massive amount of money spent to fight World War II has often been used to argue that government spending helped pull the American economy out of the Great Depression. but Barro argues that the government’s war spending came at the expense of other types of spending, and that the multiplier effect was diminished.

“The typical multiplier associated with extra defense expenditure is around 0.8, meaning that about 20 cents on the dollar of extra spending comes at the expense of private consumer spending, private investment, etc.” Barro wrote in an e-mail. “For non-defense purchases, it is hard to get precise estimates, but the estimated multiplier is close to zero.”

The stimulus bill only received three Republican votes in Congress: moderate senators Arlen Specter, Susan Collins and Olympia Snowe. The other Republicans argued that tax cuts were the best way to help the economy, a position Barro shares.

Solman said that even those detractors are Keynesian, too — tax cuts as stimulus are part of his theories as well. And according to Dean Baker, President John F. Kennedy’s tax cuts were envisioned as a Keynesian stimulus.

While debates continue about enacting Keynesian theory as policy, Solman said that Keynes highlighted a truism about economics that is as relevant today as during the Great Depression: economies are driven by psychology.

“Economics is all about psychology, what he calls ‘animal spirits,’ or interchangeably, ‘spontaneous optimism,’” Solman said. “He says that if enterprise is going to rely only on mathematical gain … enterprise would fade and die. Growth is all about keeping the hope alive.”