A Keynes insight into free markets

Posted on December 21, 2008 in Debates, Governance Debates

TheStar.com – Business – A Keynes insight into free markets: Seminal economist’s interventionist views fell from grace in the hyperinflation 1970s. They’re back
December 21, 2008. Ann Perry, BUSINESS REPORTER

“When the facts change, I change my mind,” John Maynard Keynes once famously quipped. Perhaps that helps account for the resurrection of the long-dead British economist’s theories, which fell out of fashion in the 1970s but have recently regained favour among policy-makers grappling with the deepening global economic crisis.

Even staunch free-market, small-government advocates are turning to Keynesian economics – which has come to stand for government spending as a means to stabilize the economy – to get themselves out of the current jam.

Prime Minister Stephen Harper has become an unlikely convert, as exemplified last week when he abandoned his widely questioned forecast for a small surplus next year, and suggested a planned stimulus package could drive the federal deficit to as much as $30 billion.

“I think Harper has had a Keynesian moment,” said Joe Martin, director of business history at the Rotman School of Management at the University of Toronto, adding that his “calculus” was likely “both political and sound public policy.”

Harper isn’t alone.

Governments around the world are readying massive stimulus packages aimed at jump-starting flagging economies as central banks run out of room to cut interest rates.

The International Monetary Fund has prodded them along with its proposal for global fiscal stimulus of 2 per cent of gross domestic product.

On Friday, U.S. President George W. Bush swallowed his hard-line free-market impulses and extended a $17.4 billion (U.S.) lifeline to ailing automakers.

Under ordinary economic circumstances, Bush said, “I would not favour intervening to prevent the automakers from going out of business. But these are not ordinary times.”

The same could be said of the Great Depression of the 1930s in which Keynes forged his seminal theories. Until then, most economists had believed that the economy was essentially self-regulating, and that drops in demand would drive wages and prices lower, which in turn would revive demand and employment.

But the protracted Depression changed all that. Indeed, one of the reasons Keynes came to the fore was a widespread feeling “that capitalism had failed,” said Martin.

Keynes was a Cambridge-educated economist who had originally focused much of his work on monetary policy – actions by central banks to control the money supply. He gained world prominence with his 1936 book, The General Theory of Employment, Interest and Money. But even before its publication, “he was arguing that recovery from the Depression could be speeded up by fiscal policy, in particular by government increasing its spending,” said Queen’s University economics professor Gregor Smith.

Keynes, who died in 1946, said market forces don’t necessarily come into equilibrium on their own. In such circumstances, governments should increase spending to boost demand and help return the economy to full employment.

That idea spread around the world in subsequent decades, said Smith, “and it came to be widely believed that one of the roles of government was to prevent business cycles and stabilize the economy as a whole, and that the government could do that in part by following what’s sometimes called a counter-cyclical fiscal policy where they would spend more in recessions and less in booms.”

But somewhere along the way, Keynes fell out of favour. “Saying what Keynes really said is rather like interpreting the Bible,” said Thomas Velk, director of the North American studies program at McGill University in Montreal and a self-described anti-Keynesian. “There are as many interpretations as there are pastors looking at it.”

Those who invoked Keynes’s name in the decades after World War II “were to my way of thinking big-government types who advocated a quasi-socialist collection of strategies,” Velk said, adding that “the big-government strategy proved to be a failure over the long run.”

Indeed, Keynesianism largely lost its lustre in the 1970s, when skyrocketing interest rates, inflation and a deep recession provoked a reaction against his theories from those who posited that government was the problem, not the solution. Enter Margaret Thatcher, Ronald Reagan, and a return to free-market economics that persisted until the current crisis.

But Hugh Mackenzie, an economic consultant and a research associate at the Canadian Centre for Policy Alternatives, argued Keynes’s theories were “misrepresented and distorted” to mean governments didn’t need to worry about deficits.

Keynes, he said, would have pointed out that persistent deficits lead to inflation “because the economy will eventually start humming along at full capacity and you’re still dumping stimulus into the system because you’re spending more than you’re raising. So the other half of the Keynesian equation wasn’t applied.”

Now, many economists and politicians are dusting off Keynes’s theories.

“A year ago, it was still fashionable for people to say, when governments intervene in the economy, they only ever cause trouble and the best thing for government to do is stay out,” said Mackenzie. “And suddenly we’ve rediscovered the idea that even at this macro level that governments have good things to do, and in fact in some circumstances are the only institution that can really do anything. And that’s certainly where we find ourselves now.”

But Rotman’s Martin argued there is “no comparison” between the current crisis and the 1930s, and said the danger is that massive stimulus could set off another cycle of spiralling government deficits and debt. “There is no doubt that the government of Canada has to do some fiscal stimulus for political reasons,” he warned. “But it had sure better be careful.”

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