Will We Be Keynesians?

The debate for the times is over the optimal level of government intervention in economies. This concerns the choice between a monetarist approach, that accepts government intervention only for money supply controls, and the Keynesian one, that strongly favours government intervention in booms and recessions, and regulation throughout the ordinary business cycle.

Will We Be Keynesians?

The latest financial crisis has provoked an outburst of writings, articles and books in the press, in the academia and in other areas all over the world. All of them have predicted some effects with different views. Some of the most powerful economies are coming out of the recession and are giving more and more positive signs of growth. Thus, it is time now to understand what the effects have been and what they will be on both a pragmatic and a theoretical level to manage the economies in the future.

U.S. Treasury Secretary Timothy Geithner and economist Paul Krugman were among the first to give good explanations of the latest financial crisis. In their opinion, the credit crisis that originated the financial crisis was caused by the implosion of the shadow banking system. The shadow banking system consists of intermediaries between lenders and borrowers, which are non-bank financial institutions that lend money in exchange for fees or by exploiting differences in interest rates paid to them by the borrower and paid by them to the lenders. The financial institutions of this system do not accept deposits, so they are not subject to the same regulations of the traditional commercial banking system. For instance, they did not have to keep as much money in the proverbial vault relative to what they borrowed and lent, so they could have a higher financial leverage. They normally borrowed from lenders in liquid (ie. easier to sell) markets, meaning that they would have to frequently repay and borrow again from these lenders. However, they used the funds to lend to corporations less liquid assets (such as derivatives and other financial instruments), such as mortgage-backed securities sometimes called "toxic assets". These assets declined significantly in value as housing prices declined.

In the last decade, the importance of the shadow banking system has significantly increased with flourishing pension funds, hedge funds, investment banks and other non-bank financial institutions. In early 2007, lending through this system slightly exceeded lending through traditional commercial banks. At the same time, home prices declined. At that point the shadow banking system began to not obtain investor funds in exchange for most types of mortgage-backed securities or asset-backed commercial paper, thus it could not provide funds to mortgage businesses. The rest of the story is known to most of us. Because of the global connections of today's financial systems, the effects of this crisis hit most of the world's countries after having provoked a deep financial crisis in the U.S.

Different contrasting measures followed: government interventions with bailouts of financial institutions, stimulus packages in different forms and reduction in pay of executives of certain banks that have been bailed out; the U.S. Federal Reserve and other central banks all over the world intervened to inject money supplies in order to avoid the risk of a deflationary spiral in which higher unemployment rates cause lower levels of consumption.

Some more long-term proposals include financial cushions or capital requirements to all financial institutions, or an expansion of the restrictive regulation applied to the traditional commercial banking system - also to the shadow banking institutions. Furthermore, more avant-gardiste scenarios propose a new post-capitalist system to replace current capitalism in our economic world: this system includes a number of proposals such as socialist economics, cooperative economics (based on the worker cooperative), participatory economics (based on participatory decision making as an economic mechanism to guide the allocation of resources and consumption), technocracy (where decision makers are selected through their knowledge and not their political capital), economic democracy (based on a market economy with a democratic control of firms by their workers) and others.

However, the most realistic debate for the time being is over the optimal level of government intervention in economies. This concerns the choice between a monetarist approach, that accepts government intervention only for money supply controls, and the Keynesian one, that strongly favours government intervention in booms and recessions, and regulation throughout the ordinary business cycle.

In history, economic policy-makers have shown a shift in their preference for one theory to the other. From the end of the Great Depression to the early 1970s, Keynes has inspired economic policies. However, the 1970s oil crisis and the recession that followed gave path to the advancement of monetarism: UK Prime Minister Margaret Thatcher brought monetarism into the British economy after her 1979 election, while Paul Volker at the head of the Federal Reserve brought monetarism into US economic policy. By the mid 1980s, though, both these countries and others abandoned monetarism to progressively switch to "pragmatism": by this theory, neither Keynesian nor monetarist theories were to be constantly followed, but only a reasoned choice at each time based on the specific circumstances. This was the main approach to economic policy in the 1990s and early 21st century.

The recent financial crisis led to a revival of the Keynesian approach in 2008 and 2009 across different countries in the world: on 17 February 2009 the U.S. President approved a plan to combat recession, inspired by the Keynesian theory; the UK Prime Minister and different economists at international financial institutions advocated a coordinated international intervention to face the recession; the Governor of the People's Bank of China proposed to adopt the IMF Special Drawing Rights as a centrally managed global reserve currency. Many books and papers published in 2009 backed the choice of economic policy-makers to move again towards Keynesianism, by comparing certain key indicators such as growth, inflation and unemployment between the Keynesian period (until 1973) and the monetarist and pragmatic period (from 1974 to 2008). Both globally and in various countries, these indicators showed that more advantageous results were obtained in the first period rather than in the second one.

Nevertheless, many people also criticized the revival of Keynesian ideas, often arguing that government interventions will be effective in the short run but will induce greater crises in the medium and long term. Despite the criticism, this time Keynesian revival was advanced by economic policy-makers and not by the academia (as was the case 70 years ago). Would this mean that this resurgence will last longer or forever? This is hard to tell since economic evidence may lead in a few years to a different opinion. What is certain is that government intervention was the only way to save the world from a second great depression, and that has been so far very effective.

In the next issue we will analyze a pragmatic case of a country that has recently faced serious problems in its system… Wait and see!



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