The Global Economic Crisis and the Resurgence of Keynesian Economics

By: Wolassa L. Kumo

[ Posted On: 2009-02-27 ]

1. Introduction

At present the world is in the first networked recession of its kind triggered by the combination of three factors: the crisis in the credit markets, the collapse of the housing markets and decline in equity markets. The World's biggest economy, the United States entered into recession in December 2007, followed by the European Union and Japan around November 2008. Declining demand in advanced economies has dampened the growth prospects in several emerging economies such as China.

Many believe that the root cause of the current global economic crisis is the adoption of neoliberalism (promulgated in the Washington Consensus coined by Williamson in 1989 (Williamson 2004)) as the new orthodoxy following the collapse of the dominance of Keynesian economics in 1979. The theoretical foundations of the proposals of the Washington Consensus are the usual analyses advanced by neoliberal economic theory. According to this argument economies are in crisis because of impediments to the free operation of the market. The impediments came from the over inflated interventionist Keynesian state and its expansionary and redistributive policies that deform market data and signals. The solution, according to the neoliberal thinking is the withdrawal of the state from the economy and the reinstatement of the unhindered operation of the market (Mavroudeas & Papadatos, 2005).

Neoliberalism propagated further that the operation of the financial system should be liberated from the state grip and prerogatives and be left to the free operation of the market forces while the interest rate should be determined competitively. Moreover, the withdrawal of the state from the economy required the privatization of all the activities and enterprises that were state-owned and directed, the limitation to a minimum of all state regulations and adequate guarantees for property rights, opening of the economies to liberalise international trade, capital movements and financial activities including the market determination of exchange rate between currencies, and abolition of protectionism (Mavroudeas & Papadatos, 2005).

For over two decades, therefore, neoliberal philosophy turned the global economy into a headless chicken. President Reagan and Prime Minister Thatcher were the prime drivers of the neoliberal philosophy in the 1980s. However, there is a widespread debate regarding whether the neoliberal economic theory promoted development or hindered it especially since the onset of the current global financial crisis in mid 2007. At present many agree that the Washington Consensus and its neoliberal philosophy was a total failure. The neoliberal economic theory led to crises after crises and impoverishment of many both in developed and developing countries.

The financial meltdown caused by excessive greed and speculation and the virtual absence of any meaningful regulatory intervention proved that the free market economy does not have any mechanism to self correct itself.

The Keynesian economic theory that markets do not have any automatic mechanism to self correct in the short run is incontestably true now as it was in the 1930s and subsequently.

2. The Keynesian Economics

The Keynesian economics emphasises the role of aggregate demand in the determination of aggregate output. It argues that the decisions of private economic agents some times lead to inefficient macroeconomic outcomes such as lower employment and output. During such business cycles, the government can stabilise output and employment through expansionary fiscal policy in combination with appropriate monetary policy actions. Keynes's General Theory of Employment, Interest, and Money Published in 1936, is considered to be the foundation of macroeconomics.

According to the Keynesian economics, aggregate output in an open economy is composed of aggregate private sector consumption, aggregate private sector investment, aggregate government consumption and investment and the aggregate trade balance. The Keynesian economics postulates that an increase in government consumption and investment leads to an ever greater increase in output through a multiplier effect. The basic concept of the Keynesian multiplier is that an increase in fiscal expenditure contributes to multiple rounds of spending which could finance itself thereby ensuring higher output and increased employment.

The Keynesian macroeconomic analysis proved an indispensable tool of economic policy after Hicks (1937) developed the IS-LM model, representing investment-saving and liquidity-money supply relations respectively. This model combines equilibria in the goods and services market (IS) and financial markets (LM) thereby establishing an equilibrium level for demand in the economy.

Another central concept in Keynesian economics is the notion of uncertainty. Keynes argued that economic agent's face uncertainty in their daily decision-making processes . Agents' inability to predict the future accurately is one of the reasons why free market economy may not always lead to optimal economic outcomes. According to Perlman and McCain (1996), in contrast to Knightian aleatory or factual uncertainty, Keynesian uncertainty refers to epistemic uncertainty that exists owing to man's limited ability to understand beyond a limited sphere. Moreover, for Keynes uncertainty involves the absence of any scientific basis on which to form probabilities making the concept different from risk, i.e. no objective probability distribution could be assigned to the occurrence of the future uncertain events as opposed to risky events.

From 1941 -1979 Keynesian economics dominated macroeconomic analyses and policy. Based on the Keynesian economic theory, governments in industrialised countries intervened in the business cycles by increasing spending and reducing taxes and interest rates to boost aggregate demand during recessions. However, the 1973 oil shock and repeated recessions with rising unemployment and inflation (stagflation) undermined the prescription of demand management. Monetarists and supply side economists began to provide alternative economic views on how business cycles ought to be managed.

3. Criticisms of Keynesian Economics

The Monetarist Critic of Keynesian Economics

Monetarism is a type of macroeconomic theory that focuses on the role of money in the economy. This differs significantly from Keynesian economics, which emphasizes the role that the government plays in the economy through expenditures, rather than on the role of changes in monetary policy. According to monetarists, managing the money supply is a key in ensuring the stability in the economy. The markets will take care of the rest in the economy. Thus, according to this theory, markets are more efficient at dealing with inflation and unemployment.

The main proponent of monetarism is Milton Friedman, a Nobel Prize winning economist, who argued that markets naturally move toward a stable centre, and that it was an incorrectly set money supply that causes the market to behave erratically. With the collapse of the Bretton Woods Institutions system in the early 1970s and the subsequent increase in both unemployment and inflation, governments turned to monetarism to explain their predicaments and it was then that this economic school of thought gained more prominence (Radcliffe, 2008).

The key features of Monetarism are: (a) The control of the money supply is the key to setting business expectations and to fighting the effects of inflation; (b) Market expectations about inflation influence forward interest rates; (c) Inflation always lags behind the effect of changes in production; (d) fiscal policy adjustments do not have an immediate effect on the economy; and (e) A natural rate of unemployment exists; trying to lower the unemployment rate below that rate causes inflation ( Radcliffe, 2008).

The supply side economics, economic thinking that focuses on free market system that encourages supply or production of goods and services through such incentives as tax cuts complimented monetarism as a tool of neoliberal economic policies of Western governments since the 1980s.

The Lucas Critic

In his famous 1976 article: Econometric Policy Evaluation: A Critique, Robert Lucas, the 1995 Nobel Laureate in economics, discussed the meaning and the failure of "the theory of economic policy." The theme of the Lucas critic concerns the nature of the responses of the private economic agents to changes in government policy. He argues that policy changes are ineffective because agents anticipate such future policy changes. Accordingly, since private agents anticipate monetary disturbances, any monetary policy change is ineffective. Any real effects in the economy occur through price level shocks, i.e. difference between anticipated and non-anticipated monetary shocks (Muchlinski, 2005). Thus the Lucas critic is also known some times as "the hypothesis of rational expectations."

The Lucas critic led to the emergence of New Classical Macroeconomics (NCM) with a paradigm opposed to Keynesian economics. The NCM opposes the view of an inherent instability in the economy which needs to be governed by macropolicy or government intervention, the view also shared by monetarists. Both schools of economic thought believe that all instabilities and fluctuations in the economy are due to the erratic behaviour of the authorities.

The rise of the NCM was associated with the fundamental theoretical upheavals among economists and economic theory such as the emergence of new phenomenon like stagflation which led to controversies and terminological changes in traditional Keynesian economics. The key principles of the Lucas critic are (1) representative agent model and the rational expectations hypothesis, (2) the rejection of Keynesian macroeconomics and macroeconometrics, and (3) the neutrality of money (Muchlinski, 2005).

The Austrian School Critic

Another school vehemently opposed to Keynesian economics is the Austrian school. This school advocates an ultra free market system in which government should not play any role. For this school individual human actions necessarily bring optimal solutions to economic problems. In particular, the Austrian economist, Hayek criticizes Keynesian economics as fundamentally collectivist and economic analysis based on economic aggregates as fallacious. According to him, recessions are caused by microeconomic factors.

However, the scope of this school in economic thinking is limited mainly due to its rejection of the use of mathematics and econometrics in economic analysis.

4. The New Keynesian Economics

The new Keynesian economics emerged as a response to the various criticisms of Keynesian economics during the 1970s. It is a modern macroeconomic School of thought based on the ideas of John Maynard Keynes.

The main disagreements between New Keynesian Economics and one of the staunch critics of Keynesian economics, the New Classical Economics is that the latter build their theories on the assumption that wages and prices are flexible, agents are rational and prices clear market and adjust demand and supply quickly while for Keynesians prices and wages are sticky, thereby causing involuntary unemployment (Mankiw and Romer, 1991).

Keynesians as well as Monetarist believe that monetary policy affect employment and output in the short run because prices respond sluggishly to change in out put while for New Classical Economics money is neutral.

The elements of new Keynesian economics—such as menu costs, staggered prices, coordination failures, and efficiency wages—represent substantial deviations from the assumptions of classical economics, which provides the intellectual basis for economists' usual justification of laissez-faire. In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new Keynesian economics provides a rationale for government intervention in the economy, such as countercyclical monetary or fiscal policy (Mankiw and Romer, 1991).

However, the neoclassical synthesis tries to marry key ideas of Keynesian and classical economics as a compromise. The heart of the new synthesis is the view that the economy is a dynamic general equilibrium system that deviates from an efficient allocation of resources in the short run because of sticky prices and perhaps a variety of other market imperfections. In many ways, this new synthesis forms the intellectual foundation for the analysis of monetary policy at the Federal Reserve and other central banks around the world (Mankiw and Romer, 1991).

5. The Keynesian Revival of 2008 / 2009

The 2008/09 global economic crisis has shaken the foundation of the free market consensus of the past two decades. Several countries including the United States have embarked on massive fiscal stimulus plans to rescue the financial and the real sectors of the economy. Barrack Obama's stimulus package of $878 billion approved by the government in February 2009 represents the biggest fiscal stimulus ever.

Some of the EU countries have moved beyond fiscal stimulus and nationalized some of their failing banking industries. The current responses of the governments across the globe on the global recession fully recognizes the Keynesian view that markets do not have any automatic mechanism to self correct and that government intervention is necessary to revive the economy. We hope the famous New Keynesian economists such as Paul Krugman, Joseph Stieglitz and Greg Mankiw are behind Obama's stimulus package and advocate for more stimulus than less. The biggest fear at present is not that the stimulus is too big but that is it too little and hence many not be effective. If the multiplier effect fails to raise the current level of spending beyond the $2 trillion gap in the US consumer demand at present, the Obama stimulus plan may not rescue the US economy from the current recession soon.

Among the emerging economies, China has already begun a massive government spending programmes to compensate for the sharp decline in aggregate demand due to the contraction in global demand for the country's export. Keynesian aggregate demand management has once again become a critical policy instrument for both developed and developing economies.

We are all Keynesians now! However, as Keynes himself agrees, in the long run, the market forces will drive the economy into equilibrium, if the government takes appropriate actions to correct the short run fluctuations through appropriate macropolicies. Price still provides the best signal in resources allocation if greed and speculation are minimized and adequate level of regulatory measures are instituted.

Capitalism has survived numerous booms and busts since 1690s, and 122 recessions in 21 advanced countries since 1960 alone. With economic policies based on Keynesian principles of demand management, capitalism will survive many more business cycles to come.

References:

•Hicks, J. 1937. 'Mr. Keynes and the Classics: A Suggested Interpretation,' Econometrica, vol. V (April, 1937),

•Mankiw, N. Gregory, and David Romer, eds. 1991. New Keynesian Economics. 2 vols. Cambridge: MIT Press,

•Mavroudeas, D. S. & Papadatos. D. 2005. Neoliberalism and the Washington Consensus. Available at http://www.econ.uoa.gr/UA/files/1435329852..pdf

•Muchlinski, E. 2005. The Lucas Critic and Keynes's Response - Considering the History of Macroeconomics, Freie Universitat Berlin, Department of Economics, Institute for Economic History and Economic Policy.

•Perlman, M. and McCain, CR. 1996. Varieties of uncertainty, In Uncertainty in economic thought, edited by C. Schmidt, Cheltenham, UK: Edward Elgar, 9-20.

•Radcliffe, B. 2008. Monetarism: Printing Money To Curb Inflation;
http://www.investopedia.com/articles/economics/08/monetarism.asp

•Williamson, John. 2004. A Short History of the Washington Consensus,' paper commissioned by Foundation CIDOB for the conference 'From the Washington Consensus towards a new Global Governance,' Barcelona, September 24-25.

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About The Author: Dr. Wolassa L. Kumo -- is a development practitioner and researcher. His research interests include risk and uncertainty, productivity and efficiency, finance and investment, currency substitution and development problems of Africa. Currently, he is working as a researcher in a public institution with a primary responsibility in econometric modelling. Previously, he taught Principles of Economics in an academic institution.

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