The Troubling Return of Keynesianism
DECADES of macroeconomic research suggests that the Federal government's stimulus plan to return the U.S. economy to growth will not work. Indeed, the revival of old-fashioned Keynesianism to fight the recession seems to stem more from political expediency than modern economic theory or historical experience, maintain Ira Brannon, former senior advisor to the Treasury, and Chris Edwards, director of Tax Policy Studies at the Cato Institute, Washington, D.C., in Cato's Tax & Budget Bulletin.
The idea of using fiscal policy to boost the economy during a downturn was championed by John Maynard Keynes in the 1930s. He argued that market economies can get stuck in a deep rut and that only large infusions of government stimulus can revive growth. Keynes posited that high unemployment in the Great Depression was due to "sticky wages" and other market difficulties that prevented the return of full-employment equilibrium. Interestingly, point out Brannon and Edwards, Keynes did not offer any evidence that sticky wages were a serious problem, and later research indicated that wages actually fell substantially during the 1930s. Instead, one needs to look at a range of government interventions to explain why the downturn lasted so long.
Despite the flaws in Keynes' analysis, his prescription of fiscal stimulus to increase aggregate demand during recessions became widely accepted. Governments came to believe that--by manipulating spending or temporary tax breaks--they could manage the economy scientifically and smooth out business cycles. Many economists thought that there was a trade-off between inflation and unemployment that could be exploited by skilled policymakers. If unemployment was rising, the government could stimulate aggregate demand to reduce it, but with the side effect of somewhat higher inflation.
The dominance of Keynesianism ended in the 1970s. Government spending and deficits ballooned, but the result was higher inflation, not lower unemployment. These events, and the rise of monetarism led by Milton Fried-man, ended the belief in an unemployment-inflation trade-off, Keynesianism was flawed and its prescription of active fiscal intervention was misguided. Indeed, Friedman's research showed that the Great Depression was caused by a failure of government monetary policy, not that of private markets, as Keynes had claimed.
Even if a government stimulus were a good idea today, policymakers probably would not implement it the way Keynesian theory would suggest, Brannon and Edwards reason. To fix a downturn, policymakers would need to recognize the problem early and then enact a countercyclical strategy quickly and efficiently However, U.S. history reveals that past stimulus actions have been too ill-timed or ill-suited actually to have helped. Further, many policymakers are driven by motives at odds with the Keynesian assumption that they will pursue the public interest diligently.
The end of simplistic Keynesianism created a void in macroeconomics that was filled by the "rational expectations" theory developed by John Muth, Robert Lucas, Thomas Sargent, Robert Barro, and others. …