It may turn out that the erstwhile discredited John Maynard Keynes’ key error may have been that, in the long run, he is not dead after all. What both the left and the right identify as today's problems and their solutions stir dusty memories from my generation of economists.
My generation entered the “dismal science” during the twilight years of Keynesian economics, but ripened in graduate school under the full force of the conservative, neoclassical revolution. Now, much of what my professors – including Martin Feldstein, Greg Mankiw and Larry Summers – taught us to cast away is coming back for a reprise. However, like George Carlin’s seven dirty words, the old Keynesian lingo still seems banished. Are these Keynesian terms below rising from the dead, only unspoken and invisible as ghosts?
Liquidity trap. We've relied on monetary policy to manage business cycles since Reagan – in particular, interest rates. Keynes posited a condition where confidence and interest rates might be so low that reducing interest rates further would have no effect on borrowing and economic activity. People would be just too fearful, and interest rates would be too low to matter. He called this condition the “liquidity trap,” and used it as an argument against those who advocated monetary policy instead of government spending (“fiscal policy”). If our current state is not a liquidity trap, then what is? Our recent death spiral began when the Fed slammed its foot down on the interest rate gas pedal but the lending community completely failed to respond.
Fiscal multiplier. Keynes prescribed government deficit spending in economic downturns. He argued that supply-side interventions would fail due to the liquidity trap, plus the slowness of supply-side policies (thus the “in the long run, we are all dead” quote). He predicted that supply-side stimuli wouldn’t work as long as aggregate demand stayed low and nobody had the confidence to buy things. Therefore, he favored direct government spending over tax cuts, because buying roads and bridges and hiring people would “prime the pump” and get production started again. Sound familiar? Both left and right say the next stimulus package has to include direct federal spending. Feldstein declared last spring's fizzled tax rebates a miscalculation on his part and on the part of his fellow neoclassicists.
Automatic stabilizer. Keynesian economists taught that governments should embrace deficits during downturns because a downturn is the worst time to cut spending and raise taxes. It is the time when people need the most safety net spending, such as unemployment benefits. Also, tax revenues naturally decline as the income base falls. The last thing people need during a recession – Keynesians said – is for higher taxes to cut their take-home pay even more. Now, even most Republican fiscal conservatives are willing to use deficit spending as a stabilization tool.
Neoclassical theory predicts that government spending will just “crowd out” private business investment, resulting in zero net growth. True, the size of the economy is the sum of government spending, consumer spending, private investment and net exports, so increasing government spending seems like it should grow the economy. But deficits would drive up interest rates and drive down the private investment part of the equation. Government spending would also drive up inflation, decreasing the consumer spending part of the equation (in inflation adjusted dollars) and exports. Rational expectations could even make these mechanisms cancel the stimulative effects of government spending sooner rather than later.
Are the Keynesians right, after all? We’ll know in four to six years. Are the neoclassicists right, after after all? We’ll know that in two to twenty years, as the pipers come calling. Place your bets.