Some perspectives on the relevance of John Maynard Keynes to the modern economy

(Dated: December 20, 2008, in response to Professor Joseph Stiglitz's article on Project Syndicate, "The Triumphant Return of John Maynard Keynes")

1) Consumerism: Keynes may be considered as one of the first intellectuals to have understood the meaning of the new age of consumerism in the 20th century. Throughout the Renaissance period, and even leading up to the early 20th century, the Western liberal tradition relied heavily on the ideals of the Protestant Reformation. The influence of these ideas in economics can be seen in the writings of Max Weber. In this worldview, pious thrift and delayed gratification formed the foundation of people's economic outlook. It was in this economic environment that Keynes advocated a consumerist (or even hedonistic) freedom to be able to stimulate demand in an advanced industrial economy. From that brave new world that contemplated releasing a much self-denied consumer from thrift and delayed gratification, we have come a long way eighty years later, where consumers are now so much immersed in instant gratification that they simply can't stop consuming even if they realize that they are neck-deep in debt.

2) Deficit financing: The free market knows no yesterdays, nor any tomorrows. It is relentlessly focused on the present. Of course, one may purchase insurance and future contracts to safeguard oneself against the vagaries of the future behavior of the market. But one would be doing that based on information that one has from outside the market framework. The market mechanism itself does not guarantee anything other than a random walk of price movements. While there are many advantages to this quality of the market, the single major disadvantage is that it does not reflect normal economic activity accurately. Sure enough, changes in economic activity can be sudden and random, but usually a nation's economy has some continuity to its functioning, and based on this assumption, economic decisions are often made looking into the future. Investments on raw materials, inventory management, extension of credit to consumers, time value of money, experimenting with new technology, R & D, hiring new employees are some examples where the trust in our ability to gauge the future is crucial. Thus there is some role for another institution like a central bank or the state to step in to ensure that the market mechanism, in its pre-occupation with the present, does not get too much out-of-touch with reality. In fact, when there is a severe downturn, a central bank's changes in interest rates or printing money could be insufficient, and the state needs to provide substantial budgetary support (overlooking any concerns about fiscal deficits in the short-term) to a market-based economy. This is the policy prescription of Keynesianism when the economy is experiencing seriously difficult conditions.

Provided that a group of experts can peek into the future and see some socio-economic facts that the market appears to be obviously missing, then there is some justification to take corrective action. However, there is no provision in Keynesian theory to release trillion after trillion in dollars into the national economy with no clear understanding about what the problem is. This approach of throwing the kitchen-sink could lead to massive mis-allocations of capital, rampant corruption and cronyism, which seems to be what is actually happening now. Moreover, out-of-control spending, and announcements of drastic changes in policies, by the central bank and the treasury department could prevent private capital from entering the market. But most importantly, the implication for the global economy with such massive expansion of money would definitely be detrimental, because the dollar is widely used as a reserve currency, as a safe store of value.

3) Market failures: Keynesian propensity to focus on market failures misses out on what seems to be a really important success story of the market mechanism. Unlike the oil shocks of 1973 and 1979, Western economies have successfully thwarted the negative effects of the sudden spikes in oil prices in recent years. The oil producing countries tripled the price of a barrel of crude oil during 1972-75 and then tripled it again during 1976-80. These oil shocks were among the main reasons why the American economy went through a prolonged period of stagnation and inflation in the 1970s. Similarly, in recent years, betting that the fast growing emerging economies like China would provide effective competition for oil-demand against the West, the oil producing countries took to another round of oil price hikes. Between 2002 and 2008, the price of a barrel of crude oil shot up from $23 to over $150. However, when the stock markets, financial markets and the real estates crashed in America, there was a simultaneous crash in the markets in Europe and Asia. This made the high oil prices unsustainable and they have crashed to below $40 in recent days. This crash in oil prices has shown that the advanced economies have shifted, in the last 30 years, to Services, Information and Innovation as the sources of economic value, rather than Manufacturing. Moreover, it has demonstrated that the world economy is not willing to put a high value on commodities, ahead of human capital, modern political systems and the rule of law.

This success of the world markets in thwarting the oil cartels did not come about through any interference from the central bank or the state. In fact, there has been a change in the methodology of measuring inflation in recent years. Central banks now remove food and energy prices and focus on 'core inflation'. They consider spikes in oil prices and food prices as something exogenous to the national economic system. As a result, they did not take any significant steps to counter the oil price hikes of recent years. In fact, they were quick to take advantage of the fall -- the US Federal Reserve cited the fall in oil prices as an indication of the waning of inflationary forces and cut interest rates much further than it would have done otherwise. Similarly, the governments in the advanced countries did not make substantial efforts to promote alternative energies. They kept dragging their feet on this issue, favouring the big oil corporations. So, it was solely through the work of the markets that the efforts of the oil cartels to hold the world economy to ransom has been thwarted. It may be noted here in passing that high volatility in the markets appears to be one of the mechanisms that helped to dismantle the oil prices.

4) Technology and innovation: Keynes did not have any penetrating insights about technology, in contrast to the works of famous economists like Adam Smith, Karl Marx and John Kenneth Galbraith. In his oft-quoted example on the pin factory, Adam Smith illustrated how division of labor in carrying out a technological process could lead to vast increases in the productivity of the laborers. Karl Marx wrote extensively about the negative impact that technological progress had on the poorer sections of society. John Kenneth Galbraith analyzed systematically how the nature of technological changes in the industrial economies was closely related to the organization of working people as large corporations, and how these forms of organization affected the performance of the economy.

In contrast, Keynesian theory seems to be an abstract theoretical edifice on capitalism, which is self-referential, and lays emphasis on logical consistency and precision. This was part of the larger movement among 20th century economists to increasingly use complicated mathematical language in their research papers. Technology and innovation are assumed to be exogenous to economic theory, and these two phenomenon impact the economy in whatever way they do so. Their influence is only measured posteriori through empirical means and used to explain past events. For example, Alan Greenspan used productivity gains, that could be identified in economic data, as an explanation for the stock market boom in the mid-90s. There is no theoretical framework in modern economics for explaining technology and innovation in a coherent manner, something that Keynesian theory would not be able to rectify.

5) Remains of empires: Keynes seems to have had a deep understanding for people's sense of justice. Indeed, in his "Economic Consequences of the Peace", he was able to foresee that the heavy war indemnities that the Allies had forced on Germany at the end of the First World War was unjust and it would lead to hyperinflation in Germany. However, by and large, Keynesian policies are a sort-of ad hoc prescriptions for the advanced industrial economies, without any broader intellectual framework (unlike Adam Smith who had much to say about international trade and technology, or Karl Marx who had much to say about social issues and history). After the Second World War, Keynes was looking at a world that had emerged from the remains of empires. Keynes was the main architect of the Bretton Woods institutions -- the IMF and the World Bank, and their functioning in contemporary world would leave no doubt that the concerns of empires weighed more in Keynes' mind, when he was helping draft the rules & bylaws of these institutions, much more than any liberal or social agenda.

This was the weakest link in Keynesian theory. American people who saw themselves historically as fighting for freedom from the British empire would not take easily to Keynes' prescription of state intervention. In contrast, Milton Friedman's libertarian agenda which minimized the role of the state struck a deep chord among Americans. In this context, it is of great concern that the new economic team of the President-elect Barack Obama does not include Professor Joseph Stiglitz who is the only serious economist that has a deep grasp of the new global order. Sixty three years after the end of the Second World War, the concepts of the nation-state and democracy have proved to be the only robust frameworks for representing the aspirations of people around the world. Thinking in terms of empires and realpolitik is regressive. Most leading economists would just like to implement a laundry list of changes to IMF and World Bank, and continue with business-as-usual. They don't have the professional credibility nor sufficient understanding that is required for America to benefit from the new equitable world order. Only Professor Joseph Stiglitz has demonstrated that ability through his books, "Making Globalization Work", "The Roaring Nineties", "Globalization and its Discontents" and "Fair Trade for All".

Note: (i) Professor Joseph Stiglitz's article "The Triumphant Return of John Maynard Keynes" can be accessed at Project Syndicate

Joseph E. Stiglitz

For the first time, Professor Joseph Stiglitz has allowed my above comment to remain in the Comments section of his article. On earlier occasions, he would remove my comments to his articles within a few hours of my posting them (except one time in September 2008, when he allowed an early draft of my FAQ on the Current Financial Crisis with the first 10 questions, but would not allow subsequent revised drafts to be posted). Either he has found my comment particularly insightful this time, or he is down on luck and needs all the support he can get to protest against his exclusion from President-elect Barack Obama's economics team. Either way, it's an honor for me to be associated with Professor Stiglitz.

(ii) I had also sent my comment on Keynes to about 100 economics professors. I received a response from Professor Edward Prescott who shared the 2004 Bank of Sweden Prize in Economics in memory of Alfred Nobel. His response:

"Say's Law holds. Supply creates its own demand.

You don't spend your way to prosperity. Output and income are equal to the product of productivity (output/market hour) and hours worked. There is no shortage of wants. Cutting marginal effective tax rates increases hours worked. High productivity results from good legal and regulatory policies."