Sorting Through Keynesian Rubble

A Brief History of John Maynard

Keynes v. Milton Friedman

Should governments run deficits to pay for ‘stimulus packages’? ‘Of course!’ say many Democrats, liberals, socialists and others who flatter themselves that they are ‘progressive’. ‘Heaven forbid!’ say many Republicans, libertarians and others in the USA and Canada who like to think of themselves, quite wrongly in some cases, as ‘conservative’. On occasion, these opinions, whether ‘left’ or ‘right’, may rest on some understanding of how a market economy works. But all too often, it seems, they are mere gut reactions—nothing but the result of prejudice and ideological bias.

There can be no fruitful debate between those whose minds are made up. But academic economists, at any rate, are usually willing to listen to those who disagree with them on such matters. As the Paul Samuelson said to me a few years ago, ‘I never bother to talk to anyone who agrees with me: I learn nothing from them’.1 Unfortunately, few people pay much attention to the complex and many-sided disagreements among academic economists. Occasionally some towering figure, a Keynes or a Milton Friedman – or some less than towering figure such as a Galbraith – is adopted by the public as a symbol of what they wish to approve or hate. But few bother to find out what their hero, or villain, really has to say.

This is a pity. There are few more urgent public policy questions today than deficits and ‘stimulus packages’. If politicians, journalists, broadcasters, business tycoons and union bosses—and most academics too for that matter, had a better idea of why economists take the positions they do, of why they disagree and why they agree, their own disagreements might be more cautious, more capable of being modified or corrected in light of a fuller analysis. Instead of a partisan slanging match we might get genuine conversation. We might even get some agreement on useful policy measures.

To help foster such conversation by this article, I have sketched out with a very broad brush the evolution of economic theory since the Great Depression as it relates to unemployment and inflation and to the power (if any) of government to deal with those notorious bogeymen. And because even academic economists sometimes look at the real world I have also included some potted economic history.

Pre-History: Employment Theory before 1936
In a well-functioning market economy the total value of what is supplied is equal to the total value of what is demanded. At any time there can be too much of some items, which means that there must be too few of some others. Prices then adjust to wipe out such discrepancies. If coal (say) is in short supply whereas cotton textiles are piling up unsold, the price of coal rises and that of textiles falls until both markets are in balance.

But an oversupply of all commodities at the same time – which means less demand for productive labour – can only be temporary. As soon as prices adjust, the economy returns to equilibrium, normal output levels are produced and labour is again fully employed.

The key to ‘full employment’, therefore, is quick and easy adjustment of all prices including wages. No action by government is required.

This venerable doctrine is logically impeccable, and is a true now as when it was first formulated two hundred years ago by the French economist Jean-Baptiste Say (1767-1832). In the dawn of modern economics at the beginning of the nineteenth century, Say’s ‘law of markets’ became orthodoxy among the first generation of Adam Smith’s followers in England.

Only one major economist, Robert Malthus (1766-1834), felt any doubt. When the Napoleonic wars ended in 1815, the British economy quickly sank into deep depression as lavish defence expenditures were suddenly cut off, and as tens of thousands of demobilized ex-servicemen were dumped on the civilian labour market. Massive unemployment dragged on for four more years though wages and prices fell. Malthus saw clearly that his colleagues’ elegant theory failed to describe what was actually happening before everybody’s eyes, and he searched about for some better explanation of lasting unemployment. It seemed obvious to him that something he called ‘effective demand’ was the key. For if total spending in the economy is too low, businesses will cut back on production and lay off workers. And if wages fall that may actually make matters worse, for total spending will then be even less. Malthus thought that a remedy might be found by redistributing income from businessmen (who save too much) to rentiers and country gentlemen (who spend every penny), for which he was later ridiculed by Karl Marx. More seriously, because he provided no clear explanation of how unemployment could become permanent, he failed to convince his great friend David Ricardo (1772-1823) and other members of their circle who remained wedded to Say’s doctrine despite its spectacular failure.

For another century, notwithstanding many drastic and prolonged recessions, it was assumed by all good economists that a market economy will automatically find equilibrium at full employment by the free movement of wages and other prices. Malthus was honoured as the father of population economics, but his heterodox employment theory was dismissed as a regrettable lapse.

The Keynesian Revolution
In 1930, one year into the Great Depression at a time when unemployment in Britain was 20% of the workforce, the most famous economist of the day produced his magnum opus, five years in the making: a two-volume Treatise on Money which rested on the orthodox assumption of Say and Ricardo—that a market economy will automatically equilibrate at full employment. Its author, John Maynard Keynes (1883-1946), was an eminent Cambridge academic who had become an international celebrity in 1920 with his brilliant polemic against the Versailles Treaty, Economic

Consequences of the Peace
But Keynes was more than an academic: he was a working economist with expert knowledge of the real world. As Bursar of King’s from 1919 to his death, he greatly enriched his college by judicious investment of its financial assets and prudent management of its real estate. Between 1924 and 1937 he built up a personal fortune of half-a-million pounds by operations in foreign exchange. For most of the inter-war years he was chairman of a major insurance company. And in 1941 he became a director of the Bank of England. By 1930 it was obvious to him that he must drastically rethink the entire conceptual framework of employment theory.

Inspiration came two years later as he began to read the recently discovered letters between Malthus and Ricardo. This was the moment of truth: Malthus had been right after all.

One cannot rise from a perusal of this correspondence without a feeling that the almost total obliteration of Malthus’s line of approach and the complete domination of Ricardo’s for a period of a hundred years has been a disaster for the progress of economics. Time after time in these letters Malthus is talking plain sense, the force of which Ricardo with his head in the clouds wholly fails to comprehend.22

Keynes set to work to develop Malthus’s key insight, and to complete the task by showing clearly how a market economy could settle down into a so-called ‘equilibrium’ with millions of unemployed workers. He published the result in 1936 as The General Theory of Employment, Interest and Money. Orthodox, or ‘classical’ economics as Keynes misleadingly called it, is true in the special case of full employment, and all the virtues of free markets (which Keynes strongly believed in) are manifest. But in the general case, the level of employment can be anything above some very low minimum; and if it is far below full employment classical economic theory is turned on its head, many efficiencies of the free market disappear, and dangerous political pressures soon emerge for totalitarian solutions.

It all depends on the level of ‘effective demand’ as Malthus had recognized. There is no guarantee that market forces alone will produce the right level. But since in a capitalist society government can control effective demand directly through taxes and spending and indirectly through its power over the money supply, demand can be stabilized at the full employment level whatever turbulence may appear in the private sector. At a time when Europe seemed about to succumb to communism or fascism, when in Britain, the Empire and even in the USA there were strident demands for socialism, Keynes saw his theory as a means of saving capitalism from itself. Just how did it work?

The key assumption is that except in primary production many prices adjust very sluggishly, if at all to large reductions in demand. Faced with a large, unexpected drop in sales, manufacturers and retailers increase their inventories. To get inventories back to tolerable levels they reduce production (or wholesale purchases) and lay off employees. Only belatedly and reluctantly do they cut prices, and they hardly ever cut wages. To the extent that this is characteristic of the economy as a whole, the total of what is produced, and the total employment of those who produce it, is determined by total demand.

Total demand is the sum of private consumption spending (the largest component), private spending on capital goods, net exports, and government expenditure. Total consumption depends upon total income. If income rises for some reason, consumers spend some but not all of the increase. Their spending creates further increments of income for others, who in turn re-spend some, but not all, of what they get. As fractions of fractions converge to zero the process stops, and the end result is that some particular increment to national income (say a sudden increase in exports of $1 million) has raised national income by some multiplied amount – say by $5 million. For any given levels of private capital spending, net exports and government expenditure therefore, this dependence of consumption demand upon national income means that at one only particular level of national income, total demand will equal total supply; and output and employment will be at equilibrium levels. As Paul Samuelson quickly recognized and pointed out, this equilibrium will be ‘stable’ provided that consumers choose to spend less than 100% of any increase in their incomes (or to reduce spending by less than 100% of any fall in income.)

Given this crucial proviso – which Milton Friedman was soon to attack – and given the demonstrable stickiness of prices especially in a downward direction, Keynes had therefore solved ‘the great puzzle of effective demand’ with which Malthus had wrestled in vain.

The implications for government policy in a recession are obvious. If a sudden, calamitous collapse of financial asset values destroys business confidence and dries up private spending on capital goods, and if recessions in other countries strangle our exports, national production and income will fall by a multiplied
amount, bringing employment down with it. But if government uses its fiscal powers to reduce tax rates, private consumption will rise; and if it also increases its own expenditures (say on public capital projects like hydroelectric dams, roads and bridges), the sum of these increases may be enough to offset the decline in business investment. In principle, therefore, national income can be stabilized at the full employment level. Since these measures will produce a budgetary deficit and rising national debt – always unwelcome – some governments may prefer to require their central banks, as Keynes himself recommended, to increase the money supply and so bring down interest rates. Lower interest may tempt private businesses to go ahead with capital spending projects shelved when the economy collapsed. But if business confidence is truly shattered, lower interest rates will do little for aggregate demand, though they may help to avert some bankruptcies.

Deficit budgets may therefore be the only option.3 Indeed, even if the government merely sits on its hands the budget will almost certainly go into deficit anyway as income-linked tax revenues decline. As well perhaps to be hung for a sheep as for a lamb, and go for a big deficit through a massive, Keynesian ‘stimulus package’. Just how bad would this be?

It all depends on the present size of the national debt, how big the government’s current operating deficit is, how long it is expected to last and at what levels, how fast the economy is expected to grow when normal, full-employment levels of output have been restored, what level of surpluses might then be expected, and what rates of (nominal) bond interest and price inflation are likely. These numbers – all but the first two of which are conjectural – determine how much bigger the national debt will be when the recession is over, how much extra it will cost to service the debt, what the relation of that debt will be to national income, and whether it would then be worth trying to pay some of it off by budgetary surpluses. For centuries many advanced capitalist countries have had large and perennially growing national debts. The paper issued by government to finance them is an important part of the portfolios of private and public investors, and might perhaps be allowed to grow at about the same rate as national income.

Therefore insofar as the difference between those who hate deficits and those who love them has any rational basis, it depends on differing expectations of some very uncertain numbers. In general, deficit haters fear that the national debt might grow to a level at which the cost of servicing it would both hamper the ability of governments to continue normal programs and also impose serious costs on future generations. Deficit-lovers are optimistic about the numbers, arguing that only a ‘stimulus package’ can restore economic growth, which would then fairly quickly solve all short-term fiscal problems.

Keynesian Orthodoxy
In 1936 Paul Samuelson, perhaps the greatest economic theorist of the twentieth century, was a twenty-one year old graduate student at Harvard. As he later recorded, “The General Theory caught most economists under the age of thirty-five with the unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea islanders.”4

For the next three or four years theoretical economists in Britain and the USA busied themselves with tidying up and formalizing Keynes’s sprawling and confusing masterpiece. The Second World War afforded dramatic confirmation of the Keynesian doctrines. The enormous, unintended ‘stimulus package’ of war expenditures in the USA brought the Great Depression to a sudden end: the national unemployment rate fell from 17.3% in 1939 to 4.7% in 1942 and to 1.2% by 1944. Most importantly perhaps, Samuelson’s Economics: An Introductory Analysis, which made the core of the Keynesian system apparent to the meanest intelligence, first appeared in 1948. It dominated the field for 50 years, was translated into 41 languages, and sold over four million copies. And as Samuelson himself said ruefully somewhat later, ‘once an idea gets into the elementary textbooks, however bad it may be, it becomes practically immortal’.

Meanwhile the new ideas had not gone unnoticed by governments and those who advised them. Some of the latter – such as the Canadians A. F. W. Plumptre and R. B. Bryce – had been students of Keynes at Cambridge, then the Mecca for economic studies throughout the Empire. In Britain, Canada, Australia and the USA, White Papers or their equivalent in 1945 or 1946 declared the intention of governments to use their fiscal and monetary powers to stabilize national income at full employment without inflation. In Canada it was Bryce who convinced the all-powerful C. D. Howe of the efficacy of Keynesian ideas. In April 1945 Howe presented the White Paper on Employment and Income to the Dominion Parliament, which explicitly committed the government to deficit spending in times of unemployment. From 1945 to 1970, in consequence of these policies, real income grew throughout the USA, Canada and many other advanced economies as never before in the history of the world, though there were occasional slight wobbles in economic growth and a short burst of inflation during the Korean war. A whole generation of young men and women born since 1939 grew up knowing nothing of recession and unemployment.

Only one major economist, Milton Friedman of the University of Chicago, escaped the ‘disease’ and resisted the new orthodoxy. Friedman criticized the theoretical basis of, and questioned the evidence for, the all important concept of a functional relation between total consumption spending and national income. He also drew attention to some important practical difficulties in the way of implementing Keynesian measures. But for nearly twenty years his objections were largely ignored by the profession and only heeded by those Republicans who instinctively distrusted Keynesian ideas because their author was a Brit, an aristocrat and
an intellectual. Meanwhile, the Democrats, with no hang-ups about such things enthusiastically embraced Keynesian orthodoxy. Under the Kennedy and Johnson administrations it was generally supposed that the business cycle was finally licked and that all that remained was ‘fine-tuning’ the economy.

Inflation and the Challenge to Keynesian Orthodoxy
However, by the end of the 1960s things began to go wrong. The USA was facing serious inflation and balance-of-payments deficits, meaning – at that time when the dollar was still tied to gold – a lethal attrition of its gold reserves. These things happened because the government tried simultaneously to sustain both the ‘Great Society’ social program of LBJ and fight the unexpected and ever more costly Viet Nam war. Keynesian orthodoxy required that government should maintain balance by raising taxes to pay for the war. But the war was deeply unpopular and Congress was unwilling to grant the tax increases.

As a result, the economy overheated as aggregate demand exceeded the capacity of the economy to supply. Prices began to rise as Keynes (and every one else) predicted. If prices rise continuously, the money supply must be increased at an appropriate rate, else interest rates will rise and depress production and employment. Management of the national money supply is the task of the central bank: in the USA the Federal Reserve Board, in Britain by the Bank of England and in Canada by the Bank of Canada. By the early 1970s the monetary consequences of an inflation at a rate faster than the Fed wanted to validate by monetary expansion created something entirely new – and not adequately explained by Keynesian theory: simultaneous inflation and unemployment. These plagued most of the capitalist world for most of the 1970s.

Why was the Fed unwilling to expand the money supply fast enough to prevent recession? Because of fears that if it did so, inflation would accelerate. To explain this we must backtrack a little.

‘Crude’ Keynesian theory implicitly assumes that all prices are stable up to ‘full employment’, but that as soon as capacity output has been reached any further increase in demand will simply be dissipated in price inflation. The real world is less clear-cut. In 1958, a New Zealand economist then at the London School of Economics, A. W. Phillips, published a study showing that from1861 to 1957 the annual rate of inflation of money wages in the United Kingdom was negatively related to the level of unemployment. At about 6% unemployment, wages were stable: at lower unemployment rates they rose, reaching an inflation rate of about 10% per annum, or more, as unemployment fell to one or two percent of the workforce. At unemployment greater than 6% wages tended to fall, though very slowly.

The following year Phillips’s Canadian colleague at the LSE, Richard Lipsey, provided a theoretical rationale, and economists all over the world began to look for and discover ‘Phillips Curves’ in their own national data. The rate of price inflation was generally assumed to be wage inflation minus the average rate of productivity growth, say 2% annually. Two years later Samuelson and his longtime MIT colleague Robert Solow presented a paper to American Economic Association reporting their own estimate of the American Phillips Curve and arguing that government therefore had a ‘menu of choice’ for Keynesian demand management: high employment and high inflation at one end of the ‘trade-off’ (as it was soon labeled), price stability and high unemployment at the other end. The new doctrine was canonized in the sixth edition of Samuelson’s textbook in 1964.

The ‘trade-off’ produced a flurry of activity among macroeconomists. My own contribution to the debate was to show that in a small trading economy like Australia where I was then living, and which was bound by IMF rules to a fixed exchange rate, the existence of a domestic Phillips Curve completely destroys the possibility of ‘economic control’ – which all Australian economists at that time (Keynesians to a man) held as an article of faith. Any attempt to maintain a rate of inflation different from the world rate will be defeated as changing relative prices improve or worsen Australia’s trade balance and so feed back on the domestic level of income and employment. Australia must take both that rate of inflation and that level of unemployment determined by the rest of the world.5

Within a year there appeared the most powerful and far-reaching contribution so far, eclipsing and superseding all previous studies such as my own: Milton Friedman’s Presidential Address to the American Economic Association in 1967.

Samuelson and Solow had recognized that if the public comes to expect inflation at recent rates, actual inflation will increase as agents try to protect themselves by buying now rather than waiting, by inserting cost-of-living clauses in contracts for future sale and so forth. But they ignored or discounted its significance. Friedman picked up the ball and ran with it. If the public learns from experience and comes to expect inflation at current rates, then any attempt by government, either by monetary or fiscal measures, to increase employment beyond an a certain equilibrium level of unemployment (which he tendentiously labeled the ‘natural rate’) would only cause ever-increasing inflation, requiring ever-increasing monetary expansion to sustain it. The policy implications of his argument are that government has no control over the level of employment except in the very short period in which expectations remain unchanged. This is deadly blow to Keynesian orthodoxy.

Why had that orthodoxy worked so well for nearly thirty years? Because, so it now appears, the general public almost always expected prices to be about the same next year as this, despite any price increases that had actually occurred. When I was a consultant for the Canadian Prices and Incomes Commission in 1969-1970. I commissioned Gallup to investigate this. Up to the late 1960s, Canadians had always expected price stability despite several periods of sharp inflation. After that date they always expected inflation at various levels depending on recent experience, as had Americans. It would appear that this sudden change of heart was brought about as a result of a massive propaganda campaign by the US government, unable to raise taxes, to ‘jaw-bone’ Americans into believing that it was their patriotic duty to fight inflation by foregoing wage and price increases. Canadians get all their news and views from the USA.

In effect, argued Friedman and his even more radical successors at the University of Chicago, Keynesian policy depends upon the government’s being able to deceive the public in its own best interests—consistent indeed with Keynes’s Old Etonian, upper-class paternalism, but utterly at variance with the ethos of Chicago, spiritual home of American populism for a century.

The policy implications of Friedman’s counter-revolution are that the government should resist deficit spending as a means to increase employment, and that the central bank should aim at monetary stability— meaning a steady rate of monetary expansion equal to the ‘real’ rate of growth of the economy. This may initially produce a period of anguish during which inflationary expectations are corrected, and unemployment may even rise temporarily: ‘short-term pain for long-term gain’. But when expectations are again in order the economy will return to the ‘natural’ rate of unemployment, at which those reporting themselves unemployed are out of work voluntarily, preferring to wait until the right job comes up at the right place and the right salary, to dish-washing in a Chinese restaurant. If this is a genuine macroeconomic ‘equilibrium’, the total of those unemployed at any time will be equal to the total of job vacancies to be filled. The richer any society, the longer individuals can afford to wait, hence the higher the ‘natural’ rate can be.

Friedman’s critique of Keynesian policies was carried further by younger colleagues at Chicago, notably Robert Lucas who won the Nobel Prize in 1995 for exploring the implications of ‘rational expectations’ in macroeconomics. Friedman had assumed that people form expectations in light of past experience only, which is irrational since it ignores current information. If all expectations are rational, and if all markets clear instantaneously, then the notorious ‘policy-ineffectiveness’ theorem results: government can never have any effect upon production and employment, even in the shortest run. Keynesian economics is dead.

Chicago Orthodoxy and the ‘New Right’
These dramatic results gave much comfort to American Republicans, who for once had wrested the intellectual high ground from the Democrats. They were accompanied by other characteristically (but by no means uniquely) Chicago doctrines: Friedman’s correct insistence that inflation is ‘always and everywhere a monetary phenomenon’, his reasonable grounds for distrusting discretionary government stabilization policies and his consequent preference for ‘rules’, his allowable doubts as to the efficacy of too much government regulation of private industry, and his strong prejudice—by no means always rational—in favour of individual freedom from the power of the state.

By the end of the 1970s a ‘New Right’ consensus had begun to emerge around these ideas. The Reagan administration in the USA, and Margaret Thatcher’s government in Britain were advised by enthusiastic converts to Friedman’s doctrines. They largely abandoned Keynesian demand management, preferring to stabilize the economy through ‘hands-off’ monetary control by the central bank. Deregulation and other measures to make the private sector, and government, more competitive were actively pursued. Mrs. Thatcher’s famous and much needed resistance to Arthur Scargill and the militant unions he controlled was crucial. These measures, and more particularly the public’s willingness to look at the economy in a new way, turned things around. Inflation died away, balance of payments crises disappeared when currencies were set to float freely, and employment settled down at levels with which the vast majority in both countries were content. Though it had many bitter opponents among those whose private interests were harmed, ‘Reagonomics’, much reviled at the time, actually worked. And so, even more triumphantly, did Margaret Thatcher’s policy. It was really only in the mid-1980s that the British economy fully recovered from the effects of the Great Depression, the war and the post-war Labour governments, and became as competitive and prosperous as any of its European trading partners.

This new orthodoxy of minimum government and deregulation worked pretty well for the next twenty-five years. Government policy in North America producing ‘short-term pain’ caused a brief recession in 1982, and there was a more serious recession in 1990-91with more protracted effects. Overall economic growth was never again so fast as during the golden age of Keynesian orthodoxy. And increasing income inequality began to appear in the 1990s. But on the whole the ‘long-term gain’ of a more competitive, inflation-free economy, aided by NAFTA, benefited almost all Canadians, especially in the twelve or thirteen years after 1995. Things only began to run into trouble again when in the USA deregulation of financial institutions,usually supposed in all capitalist countries to need careful regulation, eventually led to the inordinate expansion of uncollectible debt which collapsed with such disastrous effects last autumn.

Moving on from Chicago Economics
Is Keynesian economics dead? Recall As Mark Twain quip that ‘the reports of my death are greatly exaggerated’. Economic theory doesn’t stay put. Whatever is happening to the real world out there, we economists keep chipping away at our predecessors’ theories, criticizing and refining them, and in the best of all possible worlds, trying to test them against the numbers. By the mid-1980s a new generation of Young Turks had fairly clamped their teeth into Chicago orthodoxy, thoroughly digesting its key insight of rational expectations and spewing out the obviously fatuous, ad hoc assumption of instantaneous market clearing.

These so-called ‘New Keynesians’ combined rational expectations with various realistic assumptions about the real world, in particular the inescapable fact that market information can never be perfect. They were then able to show that in a wide variety of cases it is rational for buyers and sellers to stick with existing prices regardless of current imbalances of supply and demand. Since as we have seen, the entire Keynesian enterprise rests upon the assumption that many prices are sticky in the short run, Keynesian analysis is up and running once again. Of course it is a short-run analysis. But as Keynes himself once said, ‘In the long run we are all dead’.

It is probably fair to say most American macroeconomists are now ‘New Keynesian’6 and I would guess that some of the most influential today such as Paul Krugman and Joseph Stiglitz would incline to this view. Each has gone on record in support of a well-conceived, Keynesian ‘stimulus package’ in which government expenditure is targeted in particular to ‘infrastructure’: public investment that will make the economy more productive and efficient, and leave us with a benign legacy of the recession.

We can therefore go back to old-fashioned Keynesian theory to explain why a merely financial collapse last year led to the world recession of today. The shock to confidence caused by substantial paper losses, even though we might reasonably expect most of these to be recovered over the long haul, led many people, rich and poor, to revise their spending plans drastically. The consequent prospective fall in sales revenue led producers to cut back on capital spending, and on existing production, capacity and employment. And the further reductions in aggregate demand caused by lower profits and employment incomes had a ‘multiplier effect’ on the economy as Keynesians put it. And when the USA sneezes the rest of the world gets pneumonia. The effect is therefore further multiplied as recession in America’s world market causes American exports to fall off. And so it goes on until increased public expenditures start to kick in.

The Bottom Line
When the central bank alone can steer the economy along a growth path of ‘full employment’ (that is, Friedman’s ‘natural rate of unemployment’), active, Keynesian demand management by government is unnecessary. If, as the Economic Council of Canada recommended a generation ago, tax-rates and expenditures are set so as to produce balance at full employment, then the surpluses and deficits which result when total output and employment wobble act as quasi-Keynesian ‘automatic stabilizers’. In such a world it makes a lot of sense to pursue Chicago orthodoxy. Balanced budgets over the cycle, small government, free trade, vigorous anti-monopoly policy, judicious deregulation—all promote the health of the private sector, on which we depend for most wealth-creation in a capitalist economy.

But if this happy state of affairs suddenly collapses into mass unemployment and prolonged depression, as it has once or twice in each of the last two centuries, it’s a very different story. For when the economy is massively under-employed for any length of time, normal price signals no longer work, wages and prices are sluggish especially in a downward direction, and we are back in Malthus’s world of 1815-20 or Keynes’s world of 1929-39. Without a gradual recovery of export markets (as in the 1820s) or a major war (as in 1939), we must either wait for what may be many years of stagnation before confidence slowly recovers, or our governments must deliberately stimulate effective demand though large, deficit-financed public expenditures. In our globalized world economy there’s no hope for an early recovery of any one country’s export markets today; and no one wants another world war.

Does this mean that Keynes only gave us a special theory of employment after all, relevant only in times of deep recession? If prices are sufficiently flexible in the vicinity of full employment to stabilize the economy without too much intervention from the central bank or government budget, yes. If not, no. But what does seem fairly clear is this: that at the present juncture we are deeply mired in a Keynesian world in which only Keynesian remedies can be of much help.

What then? In good times – one might almost say in ‘normal’ times – it is sensible to be a Chicago-style deficit-hater. In very bad times like the present it is probably more sensible to be a Keynesian deficit-lover.

Biography of author
Anthony Waterman is Fellow of St John’s College, Winnipeg and Professor Emeritus of Economics in the University of Manitoba. His most recent book is Political Economy and Christian Theology Since the Enlightenment (Palgrave Macmillan, 2004). In 2007 he was elected Distinguished Fellow of the History of Economics Society (USA).

1 Why then did he want to talk to me? To disagree about Adam Smith and theology.
2 J. M. Keynes, Essays in Biography, p. 98; in The Collected Writings of John Maynard Keynes, vol X. London: Macmillan, 1972.
3 It need hardly be added – though perhaps in light of some recent pronouncements it should be – that such measures are only possible for national governments with monetary sovereignty. State, provincial and municipal governments may borrow to finance large capital projects (e.g. hydroelectricity in Manitoba) which promise future income; but they must always balance their operating budgets since they have no central bank to make sure that their bills can be paid and their bonds sold at tolerable prices. Large operating deficits for more than a year or two would drastically reduce their credit rating.
4 P. A. Samuelson, ‘The General Theory’ (1946), reprinted in The Collected Scientific Papers of Paul A. Samuelson (ed. Stiglitz), vol. 2. Cambridge MA: MIT Press 1966: see chap. 114, p. 1517.
5 Whether the same would then have been true of Canada, an equally small trading nation, depended on the operation of the floating exchange rate which the IMF allowed to Canada as a special exception. The Canadian economist R. A. Mundell, then at the MIT, explored this question thoroughly and was eventually
awarded a Nobel Prize, the first and only Canadian to be so honoured.
6 Save for a small heterodox enclave of those who call themselves ‘Austrian’ after their patron saint, Ludwig von Mises (1881-1973). F. A. von Hayek (1899-1992) was the most distinguished member of this group but he remained in conversation with the orthodox main stream and was awarded a Nobel Prize in 1974 for his (1930s) work on business cycles.

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