The influence and confusion...

... when considering John Maynard Keynes.

Our ignorance of what causes economic ailments -- and how to treat them -- is profound. Downturns and financial crises are not regular occurrences, and because economies are always evolving, they tend to be idiosyncratic, singular events.

That's Amar Bhide writing yesterday in the Wall Street Journal. Our ignorance is profound? That from a distinguished professor of business at Columbia? An exaggeration maybe but I like the humility. As he points out there are still debates with respect to how we sunk so low during the Great Depression and what brought us out. And, downturns are somewhat idiosyncratic, each downturn is somewhat unique.

On what leads to a downturn I think there is general agreement that energy price spikes and financial crisis that come after a speculative bubble bursts precede downturns. In 2001 there was the dot.com bursting then the real shock of 9/11 which that thwarted real trade in goods and services, in 1991 the spike in oil prices when Iraq invaded Kuwait, the mid-seventies and 1981 - again high oil prices. We agree on some basics about monetary policy; the Fed's failure at the onset of the Great Depression to act as a lender of last resort, to let so many banks fail, was a disaster. The Fed policy under Paul Volcker that brought inflation under control in 1979 and the early 80's required an adjustment (downturn).

The debates tend to focus on magnitudes - how much of a role did monetary policy play versus FDR's New Deal policies? Then there is confusion with respect to what is a "conservative" response versus what is a "liberal" response to a downturn. GDP began to grow fairly rapidly when FDR took over until the recession within a depression that occurred in 1937. Though unemployment did not fall dramatically in the early years of the New Deal it is hard to say that FDR's policies had no impact. And what of John Maynard Keynes? He's been identified as an economic liberal though that's hard to square with what he actually wrote. He believed strongly in free markets and thought that the government ought to back out quickly after a downturn was over. His influence is undeniable not only because his analysis supported, broadly, what FDR was trying to accomplish but because he provided a framework for viewing the macro economy that persists today. His influence is reflected in the current fiscal response...

The economic theory behind the nearly $800 billion stimulus package may be cloaked in precise mathematics but is ultimately based on John Maynard Keynes's speculative conjecture about human nature. Keynes claimed that people cope with uncertainty by assuming the future will be like the present. This predisposition exacerbates economic downturns and should be countered by a sharp fiscal stimulus that reignites the "animal spirits" of consumers and investors.

Indeed Keynes' diagnosis led to a logical prescription, that the government must step in to halt then reverse the downward spiral. This doesn't mean that we should all embrace what are considered to be "Keynesian" policies today. As professor Bhide points out...

... there is no consensus about why huge public-spending projects and a zero-interest-rate policy failed to pull the Japanese out of a prolonged slump.

He goes on to argue against the particular fiscal approach being employed today particularly the anxiety peddling that was a large part of getting the stimulus package passed. Encouraging anxiety works against reversing "animal spirits." It is worth reading. The alternative, as Bhide points out, isn't to shrug our shoulders and wait for markets to adjust.

The alternative isn't, as the stimulus scaremongers suggest, to turn our backs to the downturn. We do have mechanisms in place to deal with economic distress. Public aid for the indigent has been modernized and expanded to provide a range of unemployment and income-maintenance schemes. Bankruptcy courts and laws give individuals another chance and facilitate the orderly reorganization or liquidation of troubled businesses. The FDIC has been dealing with bank failures for more than 70 years, and the Federal Reserve has been empowered to provide liquidity in the face of financial panics for even longer.

In short an opponent of the huge fiscal stimulus should not be characterized as someone who objects to the state having any role whatsoever. I think Harvard economist Greg Mankiw spoke for many by saying that fiscal policy can work to mitigate the symptoms (suffering) of the downturn but we shouldn't rely on fiscal policy to shock the economy out of a recession.