Keynesianism in the Great Recession Right diagnosis, wrong cure

Ideology provides the intellectual and moral foundations of an economic order. From the late 1970s to the first decade of the twenty-first century, neoliberalism was the dominant ideology that legitimized the institutions of global capitalism. The principal tenet of neoliberalism was that the less hampered the market, the fewer the distortions in the economy and the more efficient the allocation and distribution of resources. According to neoliberalism, intervention by the state in any form – whether directly by producing goods or regulating the private sector’s own production and distribution of goods, or indirectly through fiscal or monetary policy – was the source of distortions or barriers to the efficient allocation of resources.

In finance, the two key pillars of neoliberal ideology were the efficient market hypothesis and the rational expectations hypothesis. Efficient market hypothesis held that without government-induced distortions, financial markets are efficient since they reflect all information made available to market participants at any given time. It also maintained that all stocks are perfectly priced according to their inherent investment properties – knowledge of which all market participants possess equally and act on as rational individuals maximizing their self-interest.

Markets thus move towards equilibrium or stability where supply and demand for assets are perfectly matched. Rational expectations hypothesis provided the theoretical basis for the efficient market hypothesis with its assumption that ‘individual agents in the economy – be they individuals or businesses – operate on the basis of rational assessments of how the future economy will develop’.

These two theories collapsed with the onset of the global financial crisis in 2007-2008, when financial market players collectively lost faith in market valuations, panicked, and engaged in ‘irrational’ herd behaviour, bringing down not only the financial market but also the whole economy. This led to a discrediting of neoliberalism in general.

Robert Lucas, one of the key proponents of the rational expectations hypothesis, probably best expressed the crisis of neoliberal theory when he paraphrased a well-known adage about atheism to say: ‘Everyone is a Keynesian in a foxhole.’ This was the same Lucas who, in 1996, told a journalist: ‘One cannot find good, under-40 economists who identify themselves as Keynesian … people don’t take Keynesian theorizing seriously anymore: the audience start to whisper or giggle to one another.

Neoliberals never denied a crisis could take place, but they were convinced that if one did, it would be the result of government intervention in the economy. However, with the cut backs in government regulation of the financial sector that had taken place during the 25 years since the Reagan era, it was difficult for neoliberals to blame government for the financial crisis that broke out in 2008.

Despite this, they were not short of prescriptions for dealing with the crisis – as bequeathed to them by neoliberal pioneers such as Friedrich Hayek or Ludwig Von Mises of the so-called Austrian School. Deficit and debt reduction was their answer. One Nordic Central Bank official had this pithy summary of Hayek’s approach:

‘According to Hayek, measures should be focused on the underlying challenges, such as public debt, that had created the crisis. In Hayek’s opinion, higher public debt would inevitably end up funding unproductive investments and consumption in the public sector, which would lead to low growth. Instead, government budgets should be brought into balance and regulations hampering economic activity should be removed. In Hayek’s view, this would, over time, provide the basis for healthy, self-driven economic growth, even if the measures taken might deepen the crisis in the short term.

This ‘purging of past excesses’ approach, with its acknowledgment that it would be accompanied by high economic and social costs, was a suggestion no-one wanted to hear in a collapsing economy. What most wanted to hear was the Keynesian solution that had been discredited more than two decades before, during the ‘stagflation’ crisis of the 1970s and early 1980s: massive government counter-cyclical action in the form of either a fiscal stimulus or an expansive monetary policy.

Most economists of all stripes did not anticipate the severity of the financial crisis. Whatever schools of thought they belonged to, most appeared to believe that the ‘great moderation’ (the achievement of stable growth, with the elimination of deep recession and high inflation) was not about to end so drastically and dramatically. Ironically, except perhaps for those who had taken seriously the work of Hyman Minsky (who was largely ignored by established economics during his lifetime), few Keynesians appeared to notice that the United States (US) economy had been propped up by what political economist Colin Crouch called a ‘privatized Keynesianism’, wherein government and business were keeping consumers afloat with massive debt.

When the crisis began, however, Keynesianism was in the best position to explain it, along with Marxism. And with Marxist economists relegated the intellectual periphery, Keynesians or neo-Keynesians were also best positioned with the tools to manage the crisis. Intellectual leaders of this school included Paul Krugman, Joseph Stiglitz and Robert Shiller, who had drilled holes in neoliberal theory and practice before the crash. What united them was their skepticism about unfettered market forces, respect for the role of irrationality and imperfect information in the decisions of economic actors, fear that effective demand was being gutted by rising inequality, and advocacy of decisive government intervention to correct market failures.

Keynesianism can be said to have made a vigorous comeback over the past few years. Indeed, it has supplanted the neoliberal orthodoxy. It has come up with an explanation of the financial crisis based on Keynes’ concept of ‘liquidity preference’. It has deployed, with some success, the fiscal and monetary bazooka it rushed to the economic battle front. It has had a strong rationale for tougher regulation of finance and a set of solid prescriptions for doing so.

Despite all this, however, Keynesianism’s impact on policy-making has been limited and, in the case of financial reform, minimal. The aim of this paper is to shed light on this paradox.