What Would Keynes Say Now?

John Maynard Keynes was one of the world’s great economists. His General Theory was exactly that. When I was a student my teachers and I used distinguish between “Keynesian” and “bastard Keynesian”, the latter referring to models or policies that focused simply and crudely on stimulating aggregate demand to cure deep recession or depression.

Keynes, as a great economist, would have a subtle and deep understanding of current problems. He would be proposing better remedies than modern “bastard Keynesians” who seem to believe that fiscal stimulus of demand is the main answer to our problems. However, he had a blind spot about wages. Assuming that the world’s banking system is fixed by some version of the current American plan, wages might turn a bad recession into a tragedy for some nations. Australia is one nation at risk.

The Role of Models

Policy-makers have mental models, even if they are madmen only partly remembering the scribbling of some defunct economist. Nowadays, their advisers sometimes have more formal statistical models, but in my experience little notice is taken of such constructs.

Any model needs to simplify. My basic point is this. Any adequate portrayal of the modern economy must recognise demand and supply in a myriad of markets both within countries for non-traded goods and services (a vanishing set) and between countries, which ultimately means globally.

There are differences in the speed with which markets clear. The global markets for oil and gold are two fast-clearing markets. Labour markets in nations where trade unions are still powerful, or provision of information is still imperfect, or people are deeply conservative in holding on to previous norms in pay demands, are slow to clear.

It is the assumption about market clearing that divides economists interested in macroeconomic policy or modelling. Neo-classical economists, as I understand their work, deny that any market fails to clear but build in assumptions of imperfect information or mistaken expectations to justify laggard adjustment.

As a young economist I used the notion of money as a buffer stock as part of what I (and others) called “general disequilibrium” models. I was powerfully criticised by some at the University of Chicago (and their friends) but this debate is still unresolved except for the purely semantic point that everyone is always and everywhere in some sort of equilibrium, even when falling from the top of the Eiffel Tower.

I do not wish to debate this matter today. Manifestly, when a modern nation, like Australia, can have 12 per cent of its workforce unemployed or underemployed even at the top of its biggest boom for a century, as Australia did in 2007, there is some imperfection that prevents the labour markets from clearing.

I am not up to date with modern economic models, and I suspect all the points I shall make today have been made in whole or in part by others. Yet the balance of policy is with the “bastard Keynesians”, as the current focus on stimulating demand in all serious nations shows.

“Aggregate demand” is made up of the whole myriad of demand components recognised in simple “Keynesian” models—demand for consumption goods by domestic households, for investment goods by domestic businesses, for exports by foreigners, demand for resources by governments, demand for labour by governments and businesses (some of which may need to be met from abroad in Australia’s case) and so on. There are many classes of goods and services in each category, and aggregation (necessary in models) is fraught with conceptual difficulties.

The supply side is just as various. Consumption goods are mostly produced by domestic or overseas businesses, machinery and other capital goods are produced by different firms here and abroad, and labour is supplied by households. The technical conditions of supply are heavily influenced (in the longer term) by “technical progress”, itself influenced by spending (by governments or businesses) on research and development (R&D) and the availability of entrepreneurs. Easier to produce but equally necessary are supplies of appropriately trained engineers, geologists, accountants, venture capitalists, even economists.

A nation’s tax policies by influencing incentives will influence supply and demand in every market to an extent not well understood. I recall a graph from the talk of a visiting American economist that strongly suggested that it was only when the US capital gains tax was reduced to 20 per cent that the US venture capital industry really took off.

We all know that correlation does not imply causation, but there is plenty of anecdotal evidence to suggest that reducing the top rate of income tax well below 50 per cent will encourage the supply of effort by certain highly skilled humans. Perhaps the chief impact is on such people’s country of residence, because such people are highly mobile internationally.

Overshadowing all of this is the fact that the state of confidence plays an enormous role in modern economies—Keynes and his “animal spirits”.

When I was a student, my teachers and I recognised that policy actions that reduced the confidence of households and business would tend to be self-defeating.

With this framework in mind—there is no generally accepted “model” available to this writer at least—the natural questions to ask are:

1. Can governments meaningfully stimulate output and create jobs now, and at what cost to future output and jobs?

2. What is the most efficient way to stimulate output and jobs, should one conclude that stimulus has a chance of working?

3. Especially in a highly globalised economy, is the level of labour costs (relative to costs in competitor nations) likely to have a disproportionate impact on economic outcomes and, if so, can governments influence labour costs?

Is fiscal stimulus likely to work? To make an obvious point, if stimulus is applied calmly in an atmosphere of trust among and between governments, households and businesses, there is a chance that stimulus will promote some increase in output and jobs. But there are many pitfalls, and a government that is seen to be throwing money at people who do not need it, and thereby placing a future burden on current taxpayers or their descendants, may find little net effect as a result of their spending, welfare transfers or tax cuts.

When this same government by deliberate policy action is making it more costly for firms to hire people, any net overall demand stimulus may be negated as the propensity of business to hire is reduced.

So stimulus that builds confidence, and which reduces (or at least does not increase) costs of hiring may be helpful, while stimulus that reduces confidence is likely to fail.

Another highly relevant constraint concerns debt. Keynes, I am sure, would have been concerned at the great build-up of debt in the past thirty years, as a ratio to GDP, far higher than it reached in the great booms of the 1880s and the 1920s. Households that feel overcommitted in an economic downturn may use windfalls, including those provided by government, to reduce debt rather than spend.

Heavily indebted nations also find constraints on their freedom to act, including attempts to stimulate economic activity.

Global Financial Gridlock

Before discussing the possible forms of fiscal stimulus, I should pause to make an obvious point. The primary problem now afflicting the world economy is not lack of “aggregate demand”, or even the ability or willingness of households or businesses to supply goods and services, but gridlock in the global financial system.

If Keynes were still with us, I suspect this is where he would be directing most of his attention. The presence of enormous numbers of “toxic loans”, the near total loss of trust in and among bankers, and until very recently the lack of decisive efforts to solve this problem, show the size of the challenge.

My suggestions include that bank “bailouts” be paid for by equity, giving taxpayers some chance of recovering their investment, that toxic loans be formally corralled and sold off at a large discount to nominal value, and that we do not let apparent shortages of trustworthy bankers hold up the rescue efforts. Basic banking is a simple business, and there are plenty of young Treasury officials or older retired bankers who could competently run a basic bank while new regulatory rules get sorted out and implemented.

The United States has recently announced a plan to free up “toxic assets”— relabelled “legacy assets”—by selling them to fund managers, including hedge funds, who will be allowed to keep the large profits they are likely to make by buying such loans cheap with very great help from cheap loans provided by the US government.

What sort of stimulus is likely to be best? Again we enter uncharted territory. My hypothesis, however, is that stimulus that encourages the efficiency of markets, and has a chance of raising the sustainable long-term capacity of the economy, is more likely to work to raise output and jobs than “bastard Keynesian” policies that simply seek to increase consumer demand.

A fine economist named Elhanan Helpman concluded in 2004 in a book called The Mystery of Economic Growth:

After we account for the accumulation of inputs, large differences in income per capita remain across countries. More than half of the cross-country variation of income per capita—and even more so in the variation of the growth rate in income per capita—arises from the differences in TFP.

TFP is Total Factor Productivity. He went on: “investment in research and development explains a substantial part of this variation, particularly in the industrial countries”. So policies to stimulate R&D would seem likely to do more good than harm in stimulating productivity.

Stimulating productivity might be seen as working against job creation, and in some short-term sense this may be true. But any nation, like any business, is engaged in a struggle to survive and prosper with many competitor nations, or at least many competing businesses located in other nations.

The “mystery” of economic growth may be half-explained by R&D spending, which itself depends on tax policies as well as direct spending by governments or grants to encourage research by universities or development by businesses.

I suspect that much of the remaining difference in long-term growth performance is explained by national and corporate culture that might be summarised by the term “entrepreneurial flair”. Keynes would undoubtedly have seen (or did see) this as an important component of a nation’s “animal spirits”.

Instead of handing cash to people in various “battler” categories—unless of course there is an immediate need, as in the case of people who lose everything in a natural disaster like Victoria’s recent bushfires—a sensible government would spend time deciding how best to encourage entrepreneurial flair.

I believe that low rates of tax on capital gains are particularly important, including the detail of tax rules. Australia allows negative gearing for property developers, but not for entrepreneurs. Is it surprising that Australia is very good at property development and not so good at entrepreneurial activity?

Australia’s treatment of corporate failure is also rather different from other nations, especially the USA. Here we have the ever-present threat of corporate regulators pouncing on entrepreneurs who fail, whereas in some other nations one or two episodes of business failure are regarded as useful training, like a duelling scar in old Vienna. “Let the buyer beware” might be a more appropriate focus of corporate regulators in a truly dynamic capitalist society.

The Role of Monetary Policy

Keynes did not expect too much of monetary policy in depression, famously saying that easing would quickly reach a point where it was “pushing on a string”.

As noted, when young I analysed the role of money in a modern economy as an important buffer stock, an approach that suggests why money might pool unused if confidence is low.

Monetary policy has been eased in many countries—but not in Australia—to a point where cash rates are close to zero and in some cases central banks have embarked on what is called “quantitative easing”—exchanging suspect private paper for presumably safer government paper.

I believe Keynes now would feel there had been too much pushing on the string as a substitute for directly sorting out the causes of financial system gridlock. He would have shared my concern that the growing pool of excess cash would be difficult to soak up as the recovery builds, and therefore threaten that recovery by spilling into inflation of asset or goods prices.

In fact, I shall be mighty surprised if the current episode of super-easy monetary policy does not create another episode of inflation, perhaps including the next asset bubble or bubbles.

Wage Rigidity or Wage Flexibility?

Despite my high praise, Keynes had a distinct blind spot when it came to the prospect of wage flexibility. He stated that wage cuts would not increase aggregate demand and therefore jobs, and that in any case one can imagine flexible wages in operation only in “highly authoritarian” societies like those (at the time) of Italy, Germany or Russia, but not in France, the United States or Great Britain.

However, economists who have analysed examples of recovery from the Great Depression have reached rather different conclusions. Australia (whose experience Keynes misreported in The General Theory) benefited from the wage cuts achieved by its then Arbitration Commission as well as the massive devaluation of the Australian pound. The United Kingdom cut wages by abandoning the gold standard and thus raising prices while wages were relatively fixed. The United States struggled to recover, despite substantial “New Deal” spending in the 1930s, because relatively rigid money wages and price deflation raised real wages but quickly recovered during the Second World War when price inflation exceeding wage inflation reduced real wages.

I am indebted to a recent paper by the former Treasury Secretary John Stone, for pointing out a stunningly prescient comment by four state Treasury heads in a paper for the 1931 Premiers’ conference. The paper said:

Employment must be made profitable. This cannot be done by government relief works or subsidies to private industry, but only by removing obstacles to reduced costs, and by the restoration of confidence.

A very un-Keynesian prescription, but one that fits Australia now just as well as it did in 1931.


If Keynes were alive and working in the British Treasury now, these are the issues he would be grappling with, lending his mighty mind and his powerful pen to solving the current global crisis as quickly and as efficiently as possible.

Keynes would be spending most of his time solving the problem of global financial gridlock. As for fiscal stimulus, it is very likely his mantra would be, “It’s the supply side that needs fixing.”

Sadly, my best guess is that he would retain his blind spot on wage flexibility, and to the extent his views on wages prevailed (as would be likely with Gordon Brown’s Labour government), it would be so much the worse for the United Kingdom.

My main cavil with Steven Kates’s fine essay in the March Quadrant, entitled “The Dangerous Return to Keynesian Economics” was its title. I would insert Bastard before Keynesian. But Kates supports my basic hypothesis when he quotes from Keynes’s posthumously published paper on “The Balance of Payments of the United States”, a paper that, sadly, I had never before read:

I find myself moved, not for the first time, to remind contemporary economists that the classical teaching embodied some permanent truths of great significance, which we are liable to-day to overlook because we associate them with doctrines which we cannot now accept without much qualification. There are in these matters deep undercurrents at work, natural forces, one can call them, or even the invisible hand, which are operating towards equilibrium. If it were not so, we could not have got on even so well as we have for many decades past.

Clearly the great economist had already moved on. Should he have by some miracle survived until now in good health, he would have moved on further. The debate I would like to have with him concerns the labour market.

This is an edited version of the address P.D. Jonson presented to the Keynes Seminar, Trinity College, University of Melbourne, in April.

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