Keynesianism And State Interventionism Research Paper

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Keynesianism, whatever its variants, assigns to the State the responsibility to regularly intervene in the operation of the economy so as to maintain its performance at a high level of employment and growth (Hall 1989). Keynesianism believes in the effectiveness of this intervention. From Keynes’ analysis of the preference for liquidity and the economic crisis of the 1930s it has retained a definite skepticism concerning the effectiveness of monetary policy. Investment and consumption are held to be little affected by interest rates; it therefore suffices to have a monetary policy that maintains interest rates at a sufficiently low level. On the other hand, Keynesianism stresses countercyclical management of overall demand by means of fiscal and budget policies: financing expenditures by public borrowing in case of recession; seeking a budget surplus to hold down inflation in the rising phase of the cycle. Fiscal constraint can be relaxed to finance welfare programs. This is a decisive change with respect to classical economics that deemed a balanced budget to be the highest priority. The Keynesian stimulus works via a sort of self-fulfilling prophecy concerning investment and demand. Prewar policy held to the contrary that the modest means available to the government was a guarantee for democracy, allowing it to stand up to populist excesses and to unlimited demands from special-interest groups.

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Keynes would have been hostile to Keynesianism. In all likelihood he would have espoused, although in different terms, the criticism expressed by Friedman (1968) and Lucas (1976) towards the Keynesians’ conception of State intervention in the economy. But this criticism, albeit radical (and essentially well taken), is aimed less at the principle than at the modalities of an effective State intervention. Keynesianism, for all its ‘naıvete,’ has managed to make this intervention accepted. This is the paradox that ensures a long life for intellectual and political debate about Keynes’ writings. This contribution is divided into three sections: a history of the reception encountered by Keynesian ideas: criticism of these ideas, and the relevance of Keynes today.

1. The Reception Of Keynesian Ideas

Keynesianism was not born with Keynes. Hicks (1937) notably formalized the IS-LM curves that jointly determine the global income and the rate of interest, via the relations between investment, savings, demand and supply of money. Samuelson (1948) provided the analytical frameworks of macroeconomic policy. Put briefly, the synthesis thus established, neoclassical in spirit, resituates Keynes’ work in the conventional framework of market equilibrium. It eliminates the role of agents’ expectations, which was decisive for Keynes (as well as eliminating the role of the ‘state of confidence’), and replaces it with a mechanistic vision of the economy that is reduced to a few global parameters. Phillips (1958) then added the curve linking wage increases, rising prices and the unemployment rate. The development of national accounting and statistical apparatus provided the basis for econometric modeling. Little by little economists, following in this respect the theory of economic policy elaborated by Tinbergen (and drawing politicians and political discourse in their wake), came to espouse the use of macroeconomic models for the quantitative evaluation of State policy. Keynesian policy is fundamentally a policy designed to fine-tune short-term fluctuations in the economy. If short-term forecasts given by a model are accurate, then the long-term evaluation of the effects of a policy is presumed to be reliable. The long-term outcome is engendered by a carefully constructed chain of short-term periods. Keynes thought, on the contrary, that the agents’ view of the long term had a direct effect on their current behavior.

From the 1930s to the 1950s the reception of Keynesian ideas spread through three channels: the influence of professional economists’ expertise on political decision making (seeking new explanations for the economic crisis); new demands formulated by political parties (themselves conditioned by previous experience); and the capacity of Keynesian ideas to spawn broad political coalitions. The configuration of history fostered the convergence of these three channels: the heritage of the war economy (when the ‘young’ Keynesians had demonstrated the effectiveness of State organization and intervention); the needs of reconstruction (which called for a high level of public investment), and the expansion of social policies aimed at achieving full employment. In the light of the prewar risk of confrontation between the labor agenda (leading to nationalization of the means of production) and that of capitalism (laissez-faire liberalism), Keynesianism offered a compromise. Full employment and sustained growth could be achieved in a capitalist economy through the judicious use of macroeconomic management (without interfering with the management prerogatives of private capital). Labor could see full employment guaranteed, and capital could continue to control investment.

But in order for Keynesian policy to be effective two structural conditions were necessary: a system of appropriate institutions; and a common language and beliefs shared among the actors in the economy. These conditions were fulfilled to various degrees depending on the country—more highly developed in Great Britain and France though differently, than in the United States or Germany. The State must be linked to the actors by a set of institutions that structure the flow of information and resources. These institutions ensure a common assessment of the economic situation and provide security for anticipations (notably via property rights and contract law). A relationship of confidence between the central bank, the State, and financial markets is crucial for the financing of public debt and establishing regulation of the banking system. At the same time, shared views of the expected and legitimate role of the State must spread throughout the economy and society. This ‘conventional’ foundation creates the state of confidence enabling each actor to constitute favorable anticipations (of demand and investment). The combination of these anticipations is self-fulfilling of the forecast projected by the macroeconomic model; it allows State intervention to attain its goals. This double system of institutions and shared conventions paradoxically ensures the effectiveness of Keynesian policy. Without this system, Keynesian policy is nothing. This is what the Keynesians forgot. They consequently come to believe in the State as a deus ex machina. In neglecting the question of expectations they left the way open for the school of rational anticipations. The return in force of market economics and neo-classical rationality was the outcome.

2. Criticism Of Keynesianism

A series of attacks, some old (Hayek, Buchanan) and others recent or renewed (Friedman, Lucas, Sargent), converged in the late 1960s and early 1970s, leading to a collapse of Keynesianism.

Hayek and Buchanan had paved the way, one by rejecting any sort of validity for macroeconomics in itself, the other by demolishing the myth of the State as an enlightened despot. Keynesianism opens the floodgates of inflation by facilitating uncontrolled creation of credit. Then come wage and price control policies that eliminate inflation at the cost of much higher unemployment than that which would have resulted under a stable currency regime (Hayek). Economics can be seen as a science that gives people greater control over their environment, but it has no command over politics. Governments are more interested in collecting the maximum number of votes than in pursuing the public good (Buchanan).

The Phillips relationship had given Keynesian policy its missing link: that of setting wages. Fine tuning efforts could focus on the inflation unemployment dilemma: how much unemployment is needed to ensure price stability? The stagflation of the 1970s (high unemployment and high inflation occurring simultaneously) was its downfall. Friedman reintroduced anticipations. He showed that the trade-off between inflation and unemployment is only temporary: it stems from inflation that is not anticipated by agents. Eventually unemployment returns to its natural rate, which is determined by structural socioeconomic characteristics, but at the price of higher inflation. Discretionary monetary policy cannot durably stabilize either interest rates or unemployment at low levels. Keynesians situate themselves in a world where everyone anticipates that prices will remain stable, and where this anticipation persists no matter what happens to prices and wages. This world has vanished. Friedman updated his 1948 program: replacing a discretionary monetary policy with public adoption by the monetary authorities of a set rule. In the present instance this means: setting a growth target for the money supply (using a specified monetary aggregate); avoiding sudden changes, not overreacting to events. In 1948 this ‘monetarist’ framework had received no attention. Economists had adopted the highly flattering position of ‘advisor’ to the managers of the economy (and thereby justifying the development of their profession). The contrast between the massive unemployment of the Great Depression and the success of the post-war economy had persuaded the economy’s managers of the efficacy of systematic State intervention. ‘Friedmanian’ rules are now widely followed by monetary authorities (like the Federal Reserve Bank or the European Central Bank).

Lucas’s criticism was aimed at the use of macroeconometric models. The theory of economic policy (Tinbergen 1952) underlying this use is invalidated by the fact that actors adapt their rules of decision to modifications in economic policy. The variables controlling economic policy are thus endogenous to the system; the structure of the models varies with economic policy. No reliable projection of future behavior and trends can be obtained by extrapolation of series and correlation with the past. In order for a change in the rules to have a chance of being effective (i.e., leading to foreseeable trends) it must be publicly debated and understood by the actors in the economy. Once again, despite a few pockets of resistance, this criticism ultimately dealt a fatal blow to substantive macroeconomics ‘defined by itself to be the body of expertise … devoted to the development and refinement of forecasting and policy evaluation methods’ (Lucas 1980, p. 250). This discipline failed to foresee the return of economic growth at the dawn of the twenty-first century. But this has not prevented the teaching of macroeconomics to continue in academia.

Now that the din of the dogmatic battles has ceased, a more balanced assessment is possible. The structuring role of the anticipations of agents is now recognized. They introduce an irreducible element of unpredictability. What counts in the dynamics of the economy is action and coordination. Economic policy must abandon the aim of influencing the course of events by substantial and discretionary means. Its field of action relates to the rules that serve as the framework of reference for private forecasts and actions. At bottom, for these rules to be effective they must be debated and made public. They leave room for interpretation in action and for innovation. They provide a framework that can be publicly revised and adjusted in keeping with the results obtained. This does not imply, however, an absence of concern for joblessness and full employment, but rather a clearer consciousness of the properties of various policy instruments and how they complement each other. The unemployment rate can no longer be a direct target of economic policy. Measuring an unemployment rate under full employment is meaningless. Firms and employers have many options other than unemployment at their disposal for adjusting to fluctuation in the demand for products and to the outlook for innovation. Satisfactory allocation of social risks is the task of welfare economics. Providing a framework of stability and security that safeguards the anticipations and terms of agreements concluded–this should be the essence of economic policy (Lucas 1976). But can this modest objective satisfy the body of professional economists, who are much more numerous than in the past and permanently accustomed to the comforts and remuneration of policy expertise?

3. The Relevance Of Keynes Today

Keynesianism is dead, but what of the writings of Keynes himself? In his ferocious criticism of Tinbergen in 1939 Keynes already expressed the arguments that were later expanded by Lucas (who did so without making any reference to the writings of Keynes). This criticism originates in Keynes’s Treatise on Probability (1921). As early as this work he understood that the problem is a double one, that of measurement and that of ‘passing from statistical description to inductive generalisation’ (Keynes 1939, p. 566). If all causal factors must be measurable for economic policy to be subjected to statistical tests and forecasting, ‘it withdraws from the operation of the method (of Tinbergen) all those economic problems where political, social and psychological factors, including such things as government policy, the progress of invention and the state of expectation, may be significant’ (1939, p. 561). Keynes was likewise prudent concerning the arithmetic of the multiplier. Lastly, for Keynes the prime target of monetary policy was the value that actors accord to the conventions that they follow on financial markets. It is the state of confidence that is important, and not directly interest rates and unemployment.

‘Neo-Keynesians’ have counter-attacked. They integrated into the Keynesian scheme rational anticipations and the possibility of exogenous shocks and of constraints on individual supplies and demands. But in so doing they remain open to these criticisms of Keynes. And by insisting on the rigidity of costs, their recommendation of wage flexibility paradoxically converges with that of liberals attached to the idea of reducing the natural unemployment rate. The ‘pos-tKeynesians’ (Davidson 1991) insist on the radical and non-probabilistic uncertainty that surrounds the decision-making of economic agents. They thus move closer to the institutional (and not solely political) content of Keynes’ message. They attempt to express his relevance to the current context. This uncertainty stems from an instability in the overall trajectory of the economy. Institutions must be created to construct a ‘corridor’ that restricts the range of directions that actions can take. Following Keynes’ intuition on inference and probability, it should probably be added that institutions allow people to make judgement and inference on situations of action which are well-founded and secure.

It is time to leave behind the paralysis of opposing schools and dogmatic assumptions (in particular regarding States vs. the market, or the nature of the market, or rationality). Too often a worthwhile idea is rejected, on the pretext that it comes from the opposing school. Little by little a macroeconomics of rules is expanding in which government of the economy by the State is permissible (a posthumous victory for Keynesianism). But, as thought Keynes, this government must be limited in scope and in ambition (Skidelsky 1999). The dynamics of the economy are above all the result of the actions, anticipation and coordination of the actors. These actors are diverse in terms of their identities, their means and ends (and in the relationship they establish between means and ends). The knowledge they have acquired of their terrain renders their action irreplaceable in a context of uncertainty. A framework of democratically debated, stable and foreseeable rules seems necessary for the implementation of collectively effective actions. But the debate is shifting to the status of these rules (are they prescriptive rules, or guidelines open to interpretation in action?) and to the status of macroeconomic variables (objectives, constraints, or simple by-products of market activity?).


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