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Misunderstanding Keynes

If you ask economists what went wrong during the Great Depression, you'll often hear, "We hadn't read Keynes yet." That's John Maynard Keynes, author of The General Theory of Employment, Interest and Money. After the crash, his description of economic crises — and how to get out of them — became so widely accepted that, in the 1960s, President Richard Nixon said, "We're all Keynesians now."

Well, we're not all Keynesians now. When you hear "Keynesian" today, it's usually with "Obamacare" and "socialists." It's Republican shorthand not only for the economic theory that governed the Obama administration's response to the crisis but also for the general Democratic outlook. And it's not a compliment.

"The president's team were fervent believers in the theories of a British economist called John Maynard Keynes," Majority Leader Eric Cantor, R-Va., wrote in his election year manifesto, Young Guns. He's right about that. Lawrence Summers, the former director of the National Economic Council, and Christina Romer, the former head of the Council of Economic Advisers, were two of the most influential Keynesian economists in the country. Obama didn't just have a team of Keynesians. He had the Keynesian all-star team.

Perhaps the president's team should have better explained their theories to Cantor. In his book, Cantor goes on to describe Keynesianism as the theory that "government can be counted on to spend more wisely than the people." He's wrong — and wrong in a way that's making it harder to recover from this crisis, and could make it harder to respond to the next one.

The idea is not about whether the government spends money better than individuals. After all, a lot of the policies advocated by the Keynesians, like the Making Work Pay tax cut, put money into the hands of individuals so that they can spend it. The idea is that the government has a role to play when, because of a convulsive downturn, a crisis begins feeding on itself.

Keynes — and others who later elaborated on his work, like Hyman Minsky — taught us that although markets are usually self-correcting, they occasionally enter destructive feedback loops in which a shock to, say, the financial system scares business and consumers so badly that they hoard money, which worsens the damage to the system, which further persuades other economic players to hoard, and so on and so forth.

In that situation, the role of the government is to break the cycle. Because businesses and consumers have stopped spending, the government breaks the cycle by spending. As clean as that theory is, it turned out to be a hard sell.

The first problem was conceptual. What Keynes told us to do simply feels wrong to people. "The central irony of financial crises is that they're caused by too much borrowing, too much confidence and too much spending, and they're solved by more confidence, more borrowing and more spending," Summers says.

The second problem was practical. "What I didn't appreciate was the extent to which we only got one shot on stimulus," Romer says. "In my mind, we got $800 billion, and surely, if the recession turned out to be worse than we were predicting, we could go back and ask for more. What I failed to anticipate was that in the scenario that we found we needed more, people would be saying that what was happening showed that stimulus, in general, didn't work."

Keynesianism may be a theory of crises, but it requires planning during noncrisis periods. And looking back, we weren't prepared to go Keynesian.

For one thing, if you're going to spend during downturns, you have to save during expansions. That wasn't a big part of the George W. Bush administration's policy.

Another clear takeaway is that formulas are more reliable than Congress. It would be much better if federal support for programs such as Medicaid and unemployment insurance was explicitly tied to the unemployment rate. Hoping Congress will act responsibly over any extended period of time isn't, as they say, a plan.

Rather than improving on Keynes, the Republican Party has turned against him and the Democratic Party has stopped trying to defend him, much less continue to implement his recommendations.

"The polarization of fiscal policy is one of the worst legacies to come out of the recession," Romer says with a sigh. "Before the crisis, there was agreement that what you do when you run out of monetary tools is fiscal stimulus. Suddenly, it's like we're back in the 1930s."

© 2011 Washington Post

Misunderstanding Keynes 07/20/11 [Last modified: Wednesday, July 20, 2011 7:19pm]
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