Lord Keynes Comes Back to the American Economy

From the time of Franklin Delano Roosevelt to the 1970s, most American politicians of both parties lived and died by what, loosely speaking, we call Keynesian economics. The label is confusing; American Keynesianism had only a limited connection with the complicated, subtle and sometimes contradictory ideas put forward by Lord Keynes (rhymes with “trains”).

The cornerstone of American Keynesianism was a belief that deficit spending by government could stimulate real economic growth. The demand for goods and services created by federal spending would stimulate new jobs and businesses so that gross national product would grow faster than national debt.

American Keynesianism was the economics of pork barrel: Government could provide popular new programs without raising the taxes to pay for them. Politicians loved this idea. John Maynard Keynes himself had suggested during the Depression that it would be good for the economy if the British government stuffed jars with pound notes, buried them deep in the earth and leased the right to dig them up to private companies.

American Keynesianism reached the height of its prestige in the 1960s, its policies widely credited with a generation of economic progress. Self-confident economists believed they had conquered the business cycle, the alternation between periods of growth and contraction that mark the history of market economies. Economists and many politicians believed that they could “fine tune” the economy--stimulate it with government spending or, when it threatened to “overheat” into a period of inflation, cool it by cutting back spending or raising taxes.

Only 20 years ago, many smug economists believed that our basic economic problems had been solved. They dismissed critics from left and right as crackpots or throwbacks. Our current landscape--towering budget and trade deficits, Third World debt and stock market crashes on the scale of 1929--would have seemed impossible to the confident technocrats of the Lyndon B. Johnson years.

The turning point came in the 1970s; an accelerating inflationary spiral began to destabilize the world economy. Richard M. Nixon, the last President who truly believed in American Keynesianism, took a leaf out of archliberal John Kenneth Galbraith’s book to impose wage and price controls. But after a pause, inflation continued; oil price hikes lit an inflation fire that could not be extinguished. The Keynesian consensus melted away.

With hindsight, we can see what the Keynesians missed in the 1970s. American Keynesianism assumed that the U.S. economy could not be affected by external shocks. The Keynesians believed that the level of economic activity depended on fiscal policy, independent of natural factors like crop shortages and human factors like the Organization of Petroleum Exporting Countries. This happened to be largely true from the 1930s to the 1960s; the Depression reduced America’s reliance on international trade and World War II made us the greatest economic superpower in history. But in the 1970s, OPEC engineered increases in the price of the single most important raw material in the world, then the Europeans and Pacific Rim countries, led by Japan, began successful invasions of the American market.

Keynes, like Adam Smith, was a political economist; he saw economics as part of a larger whole, both shaping and being shaped by the interplay of historical processes. In simplifying Keynesianism for the benefit of American policy-makers, the economist lost this wider vision and turned a world view into a technique. This gave American Keynesianism an irresistible power as long as the technique worked but left it helpless when a changing situation blunted its policy tools. The once-dominant Keynesians fell from favor, to be replaced by a mixture of monetarists, rational expectations theorists, supply-siders, neo-Marxists and other exotic fauna.

This was bad news for politicians. American Keynesianism believed that the key to economic growth was demand, especially consumer demand. The more money in the hands of the average American consumer, the better for the whole economy. Except for the supply-siders, the new schools of economists tended to be more pessimistic. Inflation, lack of international competitiveness, the trade and federal deficits--all were caused by the same problems, said the grim new realists: The American people earn too much, spend too much and get too much from the government. This is not a healthy platform for politicians to run on, and both parties are looking for alternatives to the politics of austerity.

After a decade of silence, Keynesian voices are again being heard, although the message is somewhat changed. The “New Keynesians” are more internationally minded and less dogmatic than their predecessors. Like the old school, today’s theorists believe that demand determines the level of economic activity, but they believe global demand, not domestic demand, is the key. They do not believe that the U.S. economy can be considered apart from foreign economies and they do not believe that government deficit spending is the only important policy tool.

In particular, the New Keynesians place more emphasis on international trade. In the 1960s, huge U.S. budget deficits on the scale of those of the last eight years would have led to catastrophic inflation. This was always the fear of conservative critics of Keynesian budget deficits. Yet in the 1980s the rate of inflation slowed dramatically even as the government printing presses worked harder than ever before. The New Keynesians believe that while excessive budget deficits used to created domestic inflation, they now create balance of trade problems. Because American factories are not competitive in many industries, our budget deficits no longer stimulate economic growth here efficiently: They stimulate growth in Japan, Europe and the Third World.

The global Keynesians believe that the United States has two basic policy challenges. First, it must cooperate with other countries to increase global demand. The purchasing power of Third World countries, now restricted by debt burden and depressed living standards, must be increased so that these countries can absorb more exports from more advanced countries. At the same time, the United States must compete with other countries to produce goods more efficiently so that we can gain a share of new markets.

The old Keynesians were sometimes accused of being tolerant of waste in government spending. Although they did not support willful waste, they tended to be more concerned with the level of federal spending than with the performance of particular programs. Their years were marked by the growth of unproductive farm subsidy programs, mammoth welfare programs that failed to bring recipients back into the work force and a never-ending stream of pork-barrel projects, both military and civilian.

The New Keynesians care much more about how government spends its money. They look at the role government plays throughout the rapidly growing Pacific Rim and argue that America must use its federal spending to enhance our competitiveness.

The New Keynesians do not embrace the politics of austerity; they argue that we cannot starve ourselves into prosperity and they call for a shift in consumption toward more productive patterns. We should not consume less, say the New Keynesians, but smarter. More schools, less champagne; more new research and development facilities, fewer pork-barrel road projects.

As the debate over national economic policy grows, the New Keynesians will be heard in both political parties; as voices opposing the politics of austerity and retrenchment, they plan to play an influential role after the Reagan years.