Keynes helped us through the crisis – but he's still out of favour

Extract from The Guardian

A brief burst of Keynes prevented a 1930s-style collapse that might have led to a more fundamental rethink of the status quo

 US Treasury secretary Henry Morgenthau Jr (left) and British economist John Maynard Keynes conferring during the Bretton Woods international monetary conference. Photograph: Alfred Eisenstaedt/Time & Life Pictures/Getty Image

Larry Elliott Economics editor

Sunday 7 February 2016 23.24 AEDT

Keynes’s General Theory of Employment, Interest and Money is to economics what Joyce’s Ulyssesis to literature: a classic that lots more people start than finish. The same applies to two other seminal works from the dismal science: Adam Smith’s Wealth of Nations and Karl Marx’s Capital.

It is a fair bet, though, that a good chunk of the Keynes devotees at last week’s British Academy celebration of the 80th anniversary of the publication of the General Theory in February 1936 had ploughed their way through Postulates of the Classical Economy to Notes on Mercantilism, while only occasionally thinking they would rather be reading Tinker Tailor Soldier Spy.

  Robert Skidelsky, author of a biography of Keynes. Photograph: Richard Saker for the Observer

The event pitched Lord Robert Skidelsky, author of the magnificent three-volume biography of Keynes, in a debate with Sir Nicholas Macpherson, shortly to retire as permanent secretary to the Treasury. Its title, From Keynes to Corbynomics: the General Theory at 80 was a bit of a misnomer because Skidelsky didn’t dwell on the Labour leader’s economic ideas and Macpherson said that, as a civil servant, it wasn’t proper to do so. Instead, the pair took up two themes: whether Keynes and his ideas had made a comeback following the financial and economic crisis of 2007-09, and what Keynes would have made of the handling of the economy by the Treasury since the crash.

Skidelsky said there had been no lasting return to Keynesian ideas since the market meltdown, paradoxically because a brief burst of Keynes prevented a 1930s-style collapse that might have led to a more fundamental re-think of the status quo.

This seems an accurate assessment. The initial response to the crisis followed Keynes’s ideas pretty much to the letter, with an assumption that action should be taken to prevent what was clearly going to be a painful recession turning into a full-blown depression.

Central banks were the first to act. They sought to make money cheaper and more plentiful through deep cuts in interest rates and quantitative easing. Keynes was primarily a monetary economist who believed that governments should only turn to fiscal policy - raising public spending and cutting taxes - when all other options had been exhausted. Fiscal policy was deployed in 2008-09, but only as a supplement to monetary policy.

Up to a point, the strategy worked. There was no second Great Depression and within six to nine months output had steadied across most of the global economy. Attempts were then made to return to business as usual as quickly as possible. That meant reducing the budget deficits that had ballooned during the recession and making only cosmetic changes to the debt-driven economic model that had been found wanting from 2007-09.

Fiscal policy was relaxed by Alistair Darling during the depths of the crisis, but the Treasury was already returning to a more orthodox approach to the management of the public finances even before Labour left office in 2010. George Osborne then adopted the sort of approach that would have been followed in the early 1930s: using low interest rates and QE to boost growth while at the same time cutting spending and raising taxes in order to rein in the budget deficit.

Macpherson said the mix of loose monetary policy and tight fiscal policy had been right, and mounted a robust defence of the Treasury’s reluctance to run deliberately higher deficits in an attempt to boost growth. The nine arguments presented included a lack of “shovel-ready” projects for the government to finance, the fear that any increase in demand would benefit foreign importers rather than UK firms, and the likelihood that individuals and businesses would anticipate that spending increases now would necessitate tax increases or spending cuts later, and reduce consumer spending and investment as a result. One questioner asked whether Macpherson was right to say that Keynes would have approved of the government’s economic strategy since 2008. “Of course not”, Skidelsky snorted.

So what would Keynes say if he were still alive today and updating the General Theory? Firstly, that one of the book’s main themes - the difference between risk and uncertainty - has been borne out by the financial crisis. Keynes argued that risk could be quantified but uncertainty could not, which made all the algorithms that sought to measure the riskiness of complex financial instruments useless in a market gripped by panic.

 John Maynard Keynes in his library. Photograph: Tim Gidal/Getty Images

The second lesson he would draw would be of the need to rethink the way economics is taught, with a much reduced emphasis on mathematical models and the restoration to the curriculum of economic history.

His third conclusion would be that the global financial system has been made more vulnerable by the stripping away of controls that hindered the free movement of capital. Supporters of capital liberalisation argue that it makes financial markets more efficient, but Keynes said efficient markets were not necessarily effective markets and drew a distinction between capital used for productive purposes and capital used for speculation. The story of the years leading up to the crisis (and the years since, for that matter) is that there was too much of the latter and not enough of the former.

The fourth lesson would be contained in a special chapter in the 2016 edition of the General Theory devoted to the eurozone. Keynes would have been at his most acerbic in detailing the manifold failings of monetary union, from its flawed design to the succession of avoidable blunders made by the European Central Bank and European finance ministers since 2007.

Seeking an explanation for why the eurozone has performed so poorly in the past eight years, Keynes would say the answer is simple: the ECB was not only slow to cut interest rates but raised them twice in 2011; it took more than half a decade longer than the US Federal Reserve or the Bank of England to get round to QE; and, most damagingly of all, European policymakers insisted on austerity programmes that resulted in still weaker growth and even higher levels of unemployment. Fiscal policy becomes even more important in a monetary union, because individual countries give up the right to set their own interest rates and to devalue (or revalue) their currencies.

In the fifth and final lesson, Keynes would seek to explain why the recovery from the crash had, so far at least, been tentative and incomplete. His argument would have been that cutting interest rates to  zero and boosting the money supply through QE were enough to halt the downward spiral in 2009 but not sufficient to bring about a lasting recovery.

Keynes would say the way to achieve this would be through a global growth pact, including more aggressive use of fiscal policy. His detractors would say what’s needed is a dose of Joseph Schumpeter’s “creative destruction” so that new, dynamic enterprises can replace old, inefficient ones. In truth, policy is neither Keynesian nor Schumpeterian, which is why we are where we are.