Keynesian Economics

1. A Keynesian believes that aggregate demand is influenced by a host of economic decisions—both public and private—and sometimes behaves erratically. The public decisions include, most prominently, those on monetary and fiscal (i.e., spending and tax) policies. Some decades ago, economists heatedly debated the relative strengths of monetary and fiscal policies, with some Keynesians arguing that monetary policy is powerless, and some monetarists arguing that fiscal policy is powerless. Both of these are essentially dead issues today. Nearly all Keynesians and monetarists now believe that both fiscal and monetary policies affect aggregate demand. A few economists, however, believe in debt neutrality—the doctrine that substitutions of government borrowing for taxes have no effects on total demand (more on this below).

2. According to Keynesian theory, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices. This idea is portrayed, for example, in phillips curves that show inflation rising only slowly when unemployment falls. Keynesians believe that what is true about the short run cannot necessarily be inferred from what must happen in the long run, and we live in the short run. They often quote Keynes’s famous statement, “In the long run, we are all dead,” to make the point.

Monetary policy can produce real effects on output and employment only if some prices are rigid—if nominal wages (wages in dollars, not in real purchasing power), for example, do not adjust instantly. Otherwise, an injection of new money would change all prices by the same percentage. So Keynesian models generally either assume or try to explain rigid prices or wages. Rationalizing rigid prices is a difficult theoretical problem because, according to standard microeconomic theory, real supplies and demands should not change if all nominal prices rise or fall proportionally.

But Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending—consumption, investment, or government expenditures—cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase. Keynesian models of economic activity also include a so-called multiplier effect; that is, output increases by a multiple of the original change in spending that caused it. Thus, a ten-billion-dollar increase in government spending could cause total output to rise by fifteen billion dollars (a multiplier of 1.5) or by five billion (a multiplier of 0.5). Contrary to what many people believe, Keynesian analysis does not require that the multiplier exceed 1.0. For Keynesian economics to work, however, the multiplier must be greater than zero.

3. Keynesians believe that prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor. Even Milton Friedman acknowledged that “under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages.”1 In current parlance, that would certainly be called a Keynesian position.

No policy prescriptions follow from these three beliefs alone. And many economists who do not call themselves Keynesian would nevertheless accept the entire list. What distinguishes Keynesians from other economists is their belief in the following three tenets about economic policy.

4. Keynesians do not think that the typical level of unemployment is ideal—partly because unemployment is subject to the caprice of aggregate demand, and partly because they believe that prices adjust only gradually. In fact, Keynesians typically see unemployment as both too high on average and too variable, although they know that rigorous theoretical justification for these positions is hard to come by. Keynesians also feel certain that periods of recession or depression are economic maladies, not, as in real business cycle theory, efficient market responses to unattractive opportunities.

5. Many, but not all, Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems. Here, however, even some conservative Keynesians part company by doubting either the efficacy of stabilization policy or the wisdom of attempting it.

This does not mean that Keynesians advocate what used to be called fine-tuning—adjusting government spending, taxes, and the money supply every few months to keep the economy at full employment. Almost all economists, including most Keynesians, now believe that the government simply cannot know enough soon enough to fine-tune successfully. Three lags make it unlikely that fine-tuning will work. First, there is a lag between the time that a change in policy is required and the time that the government recognizes this. Second, there is a lag between when the government recognizes that a change in policy is required and when it takes action. In the United States, this lag can be very long for fiscal policy because Congress and the administration must first agree on most changes in spending and taxes. The third lag comes between the time that policy is changed and when the changes affect the economy. This, too, can be many months. Yet many Keynesians still believe that more modest goals for stabilization policy—coarse-tuning, if you will—are not only defensible but sensible. For example, an economist need not have detailed quantitative knowledge of lags to prescribe a dose of expansionary monetary policy when the unemployment rate is very high.

6. Finally, and even less unanimously, some Keynesians are more concerned about combating unemployment than about conquering inflation. They have concluded from the evidence that the costs of low inflation are small. However, there are plenty of anti-inflation Keynesians. Most of the world’s current and past central bankers, for example, merit this title whether they like it or not. Needless to say, views on the relative importance of unemployment and inflation heavily influence the policy advice that economists give and that policymakers accept. Keynesians typically advocate more aggressively expansionist policies than non-Keynesians.

Keynesians’ belief in aggressive government action to stabilize the economy is based on value judgments and on the beliefs that (a) macroeconomic fluctuations significantly reduce economic well-being and (b) the government is knowledgeable and capable enough to improve on the free market.

The brief debate between Keynesians and new classical economists in the 1980s was fought primarily over (a) and over the first three tenets of Keynesianism—tenets the monetarists had accepted. New classicals believed that anticipated changes in the money supply do not affect real output; that markets, even the labor market, adjust quickly to eliminate shortages and surpluses; and that business cycles may be efficient. For reasons that will be made clear below, I believe that the “objective” scientific evidence on these matters points strongly in the Keynesian direction. In the 1990s, the new classical schools also came to accept the view that prices are sticky and that, therefore, the labor market does not adjust as quickly as they previously thought (see new classical macroeconomics).

Before leaving the realm of definition, I must underscore several glaring and intentional omissions.

First, I have said nothing about the rational expectations school of thought. Like Keynes himself, many Keynesians doubt that school’s view that people use all available information to form their expectations about economic policy. Other Keynesians accept the view. But when it comes to the large issues with which I have concerned myself, nothing much rides on whether or not expectations are rational. Rational expectations do not, for example, preclude rigid prices; rational expectations models with sticky prices are thoroughly Keynesian by my definition. I should note, though, that some new classicals see rational expectations as much more fundamental to the debate.

The second omission is the hypothesis that there is a “natural rate” of unemployment in the long run. Prior to 1970, Keynesians believed that the long-run level of unemployment depended on government policy, and that the government could achieve a low unemployment rate by accepting a high but steady rate of inflation. In the late 1960s, Milton Friedman, a monetarist, and Columbia’s Edmund Phelps, a Keynesian, rejected the idea of such a long-run trade-off on theoretical grounds. They argued that the only way the government could keep unemployment below what they called the “natural rate” was with macroeconomic policies that would continuously drive inflation higher and higher. In the long run, they argued, the unemployment rate could not be below the natural rate. Shortly thereafter, Keynesians like Northwestern’s Robert Gordon presented empirical evidence for Friedman’s and Phelps’s view. Since about 1972 Keynesians have integrated the “natural rate” of unemployment into their thinking. So the natural rate hypothesis played essentially no role in the intellectual ferment of the 1975–1985 period.

Third, I have ignored the choice between monetary and fiscal policy as the preferred instrument of stabilization policy. Economists differ about this and occasionally change sides. By my definition, however, it is perfectly possible to be a Keynesian and still believe either that responsibility for stabilization policy should, in principle, be ceded to the monetary authority or that it is, in practice, so ceded. In fact, most Keynesians today share one or both of those beliefs.

Keynesian theory was much denigrated in academic circles from the mid-1970s until the mid-1980s. It has staged a strong comeback since then, however. The main reason appears to be that Keynesian economics was better able to explain the economic events of the 1970s and 1980s than its principal intellectual competitor, new classical economics.

True to its classical roots, new classical theory emphasizes the ability of a market economy to cure recessions by downward adjustments in wages and prices. The new classical economists of the mid-1970s attributed economic downturns to people’s misperceptions about what was happening to relative prices (such as real wages). Misperceptions would arise, they argued, if people did not know the current price level or inflation rate. But such misperceptions should be fleeting and surely cannot be large in societies in which price indexes are published monthly and the typical monthly inflation rate is less than 1 percent. Therefore, economic downturns, by the early new classical view, should be mild and brief. Yet, during the 1980s most of the world’s industrial economies endured deep and long recessions. Keynesian economics may be theoretically untidy, but it certainly predicts periods of persistent, involuntary unemployment.

According to the early new classical theorists of the 1970s and 1980s, a correctly perceived decrease in the growth of the money supply should have only small effects, if any, on real output. Yet, when the Federal Reserve and the Bank of England announced that monetary policy would be tightened to fight inflation, and then made good on their promises, severe recessions followed in each country. New classicals might claim that the tightening was unanticipated (because people did not believe what the monetary authorities said). Perhaps it was, in part. But surely the broad contours of the restrictive policies were anticipated, or at least correctly perceived as they unfolded. Old-fashioned Keynesian theory, which says that any monetary restriction is contractionary because firms and individuals are locked into fixed-price contracts, not inflation-adjusted ones, seems more consistent with actual events.

An offshoot of new classical theory formulated by Harvard’s Robert Barro is the idea of debt neutrality (see government debt and deficits). Barro argues that inflation, unemployment, real GNP, and real national saving should not be affected by whether the government finances its spending with high taxes and low deficits or with low taxes and high deficits. Because people are rational, he argues, they will correctly perceive that low taxes and high deficits today must mean higher future taxes for them and their heirs. They will, Barro argues, cut consumption and increase their saving by one dollar for each dollar increase in future tax liabilities. Thus, a rise in private saving should offset any increase in the government’s deficit. Naïve Keynesian analysis, by contrast, sees an increased deficit, with government spending held constant, as an increase in aggregate demand. If, as happened in the United States in the early 1980s, the stimulus to demand is nullified by contractionary monetary policy, real interest rates should rise strongly. There is no reason, in the Keynesian view, to expect the private saving rate to rise.

The massive U.S. tax cuts between 1981 and 1984 provided something approximating a laboratory test of these alternative views. What happened? The private saving rate did not rise. Real interest rates soared. With fiscal stimulus offset by monetary contraction, real GNP growth was approximately unaffected; it grew at about the same rate as it had in the recent past. Again, this all seems more consistent with Keynesian than with new classical theory.

Finally, there was the European depression of the 1980s, the worst since the depression of the 1930s. The Keynesian explanation is straightforward. Governments, led by the British and German central banks, decided to fight inflation with highly restrictive monetary and fiscal policies. The anti-inflation crusade was strengthened by the European monetary system, which, in effect, spread the stern German monetary policy all over Europe. The new classical school has no comparable explanation. New classicals, and conservative economists in general, argue that European governments interfere more heavily in labor markets (with high unemployment benefits, for example, and restrictions on firing workers). But most of these interferences were in place in the early 1970s, when unemployment was extremely low.