Keynes returns. In fact, he should be “sanctified”…

´´´so that economists could claim having a patron saint taken from their ranks!

Peter Temin and David Vines make a contribution to that effort in Why Keynes is important today:

Ricardian Equivalence is a theory that concludes that any expansion of public spending will be offset by an equal and opposite decline in private spending. The theory is based on a few important assumptions. It assumes forward-looking consumers who adjust their current spending in anticipation of future taxes to pay for the spending. Under these conditions, any increase in current spending leads consumers to anticipate a rise in future taxes and decrease their current spending to save for this.

This theory dominates current macroeconomic discussion. It fits into the form of current macroeconomics that assumes not just forward-looking consumers, but flexible prices as well. And if a Keynesian suggests fiscal policy in current conditions, a modern economist is likely to invoke Ricardian Equivalence.

Remembering the past

Keynes faced exactly this opposition in 1930. He was a member of the Macmillan Committee convened by the British government to analyse the worsening economic conditions of that time. His recommendation for increased government spending – what we now call expansive fiscal policy – was opposed by Norman and other representatives from the Bank of England. They did not invoke Ricardian Equivalence because it had not yet been formulated; instead they simply denied that increased government spending would have any beneficial effect.

Keynes opposed this view, but he did not have an alternate theory with which to refute it. The result was confusion in which Keynes was unable to convince a single other member of the Macmillan Committee to support his conclusions. It took five years for Keynes to formulate what we now call Keynesian economics and publish it in what he called The General Theory.

He based his new theory on several assumptions, two of which are relevant here. He assumed that consumers are only forward-looking part of the time, being restrained by a lack of income at other times, and that many prices are not flexible in the short run wages in particular are ‘sticky’. These assumptions give rise to involuntary (Keynesian) unemployment which expansive fiscal policy can decrease.

Which theory is relevant today? We know that wages are sticky – countries in Southern Europe have found it impossible to implement requests from their creditors that they reduce wages swiftly. And we know that not all private actors in the economy are forward-looking. Before the crisis, borrowing and spending increased in ways that could not be sustained;  now consumers are not spending and business firms are not investing even though interest rates are close to zero.

Those are the conditions described by Keynes in which expansive fiscal policy works well. They also are the conditions in which monetary policy does not, even though modern macroeconomic policymakers came to rely entirely on monetary policy for stabilisation. There is a disconnect between the needs of current economies and theories of current macroeconomists.

Doomed to repeat it?

What to do? In many applied disciplines, like medicine, practitioners go back to basics when the facts change. If their current practice fails to produce the desired result, they search their armamentarium for others.  If their assumptions prove wrong, they look for more appropriate ones. But not modern macroeconomists – they say we must simply endure what they call secular stagnation.

This is an unhappy prediction. Monetary policy does not work today; instead, this is the perfect time for fiscal policy. There are immediate needs to repair roads and bridges, rebuild energy grids, and modernise other means of travel. Expansive Keynesian fiscal policy will benefit the economy in both the short and long run.

A quarter century ago, however, Peter Temin teamed up with Barrie Wigmore to write “The end of one Big Deflation”:

This paper provides a new account of the recovery from the Great Depression in the second quarter of 1933. Our argument is that President Roosevelt established a new macroeconomic policy regime shortly after his inauguration in March 1933 that altered expectations and stimulated investment. The key to this change was Roosevelt´s devaluation of the dollar and the resulting rise in farm prices and incomes….

So monetary policy was effective at a time (Great Depression) where the economic situation was an order of magnitude worse than today? What made Temin change his mind?

Interestingly, Cassel had explained, before the fact, both how a country could get into a Great Depression AND how it could come out of it. “Going into and getting out of” was the consequence of monetary policy!

I think economists should look for their “patron saint” elsewhere!

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