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Economic Monthly Report

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Is Keynesianism coming back?

Tue, Feb 17 2009, 09:13 GMT
by La Caixa Economic Research Dept.

La Caixa

When the 1929 Depression took place, governments reacted by letting their economies spontaneously find their own balance according to the classical remedies then current. If a bank failed that was good because in this way the market put each one in its place. Nor did the gold standard facilitate the implementation of a national monetary policy. The fact is that the flood of bank failures, companies closing down and the boost in unemployment reached alarming levels while the mechanisms that were supposed to rebalance the situation failed to work. In view of the seriousness of the situation, governments decided to put all their weight on the economy in order to redirect the crisis toward a balance that the market was unable to bring about on its own.

This historical experience brought John M. Keynes to develop a new economic paradigm that broke with the classical tradition, a view that dominated Western economic thinking for decades. Furthermore, it served as justification for strong state intervention in the economy, both directly in certain sectors of economic activity and through extensive regulation in nearly all spheres, particularly in the financial sector. For many years, Keynesian policies were the basis for the big leap in prosperity enjoyed following the end ofWorld War II.

This was so until the Eighties. Persistent inflation, low growth and high unemployment that came after the energy crises in the Seventies could not be solved using traditional Keynesian ideas that merely managed to boost government deficits and thus complicate things even more. With a new swing of the pendulum, the classical ideas of economic liberalism again began to sprout and a current of deregulation was started that at the same time advocated less government involvement in the economy and orthodoxy in the public accounts. As of the mid-Eighties, these new ideas in economic policy made high growth possible and brought inflation and unemployment down to low levels.

The global financial crisis set off as of mid-2007 that brought with it a serious economic recession could mean another swing of the pendulum in the way we understand the economy. The radical measures taken by the US authorities would indicate that the memory of the Great Depression is still current in American society. The rapid intervention of the US authorities in the financial system suggests that no one wants to see a repetition of the 1929 disaster that has been so extensively studied. The amount of funds committed to halting the crisis is enormous. The International Monetary Fund, a body little to be suspected of favouring a planned economy, ended up publishing a special report justifying and advocating that governments should not fail to act with all the resources available to them to compensate the collapse in aggregate demand. In Europe, governments at first considered that the crisis would not affect them and that it was a problem for the United States. Finally, however, the evidence became clear and the governments have decided to break taboos in their measures to sustain the financial system and to find the resources to halt the recession and prevent a depression.

Will these fiscal measures be successful? There certainly are huge risks. But the measures are to deal with an emergency situation, with a crisis that is different from all others and for which the only comparable precedent is the depression in the Thirties of last century. Once normal economic activity is recovered, there will be ample time to reform regulatory rules, the modulation and links between the state and the economy. Perhaps there will also arise a new economic paradigm.

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Published on  Tue, Feb 17 2009, 09:22 GMT