The next Keynesian revival

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Keynes is back. After being considered wrong, and consigned to the past, his theories — conceived to fight the depression of the 1930s — have become current again. Without mentioning the famous Cambridge economist by name, the policy framework envisaged by John Maynard Keynes now guides those looking for the best package of policies to fight stagnation, recession, or worse.

It was at about the same time as the new left revolution, the Prague Spring, the student revolts, and May 1968 in France, that market fundamentalists rallied around Milton Friedman and Friedrich von Hayek to start the anti-Keynesian counter-revolution. Competitive markets are self-regulating, and ensure the best allocation of resources for society stated the market fundamentalists, in sharp contrast with the economic experience between World War I and World War II, when the world economy stayed stuck in depression.

Over the next forty years, freeing up market forces was supposed to be the best thing economic policy-makers could do. When the recent credit crisis woke up the economic world, the package of policies held up as exemplary included a central bank independent of democratic politics and targeting inflation only; a floating rate for the currency on foreign exchange markets; and, finally, a balanced budget.

The Keynesian framework rejects a balanced budget, and calls for fiscal stimulus through budget deficits, especially when lowering interest rates fails to end stagnation. Thinking about the economy as driven by spending is once again accepted as basic macroeconomics.

Milton Friedman propounded the idea that exchange rates should be set freely in the foreign exchange market, not fixed at rates agreed with other governments. When, on August 15, 1971, the U.S. government reneged on its commitment to exchange dollars held by other governments into gold at a fixed price ($35 per ounce) countries in a surplus position vis à vis the U.S. (principally the Europeans) were forced to adopt some kind of floating rate. Otherwise they would be buying and accumulating dollars, in effect lending money to the U.S. so it could fund its external deficit.

It took some time, but the Europeans worked to establish fixed exchange rates among themselves, and eventually adopted the Euro as a common currency. Many countries, China for instance, refused to allow their currencies to float, and adopted a fixed rate of exchange instead. The floating currency countries such as Canada turned out in fact to be a minority.

The sacred anti-Keynesian struggle was fought behind an anti-inflationary banner. Government spending caused inflation said the market fundamentalists. The central banks were to cease buying and accumulating government debt, which increased the money supply and caused inflation. Without central bank funding, government deficits would no longer occur.

It turns out that it is private debt creation that is the problem, not government debt. The deregulation of financial markets under Reagan in the 1980s, and, again under Clinton in the 1990s, invited wide scale speculation and corruption. The need for government regulation of private credit creation by banks and other financial intermediaries has never been clearer.

Lower inflation rates came about because of de-localization of manufacturing to China and other low-cost centres, not through central bank inflation targeting. While the central bankers congratulated each other for their performance, the world credit markets choked on the poisonous debt packages put together by U.S. financial institutions.

Keynes famously compared financial markets to casinos, and argued that while casinos had their place, it would be a mistake to assign them the task of managing capital creation, which is more or less what has been done by our independent central banks.

Ambitiously, Keynes envisaged a world currency, "Bancor," to be issued by a world monetary authority, in order to encourage the strong countries in international surplus to adapt, and adjust their policies, to the needs of the weaker, deficit countries. At Bretton Woods, the Keynes plan was shelved in favour of the American designed IMF.

As people think through how to end the economic mess caused by applying market fundamentalism to financial institutions, they could do worse than re-visit Keynes. Using democratic political authority to limit the power of international finance seems more intelligent than ever.

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