The world takes a fancy to Keynesianism - Views on News from Equitymaster

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The world takes a fancy to Keynesianism

Mar 12, 2009

A country once known for its distaste for any philosophy other than capitalism has now become topsy-turvy. In a giddy state of confusion, it has turned towards government intervention on a massive scale. Top level discussions now revolve around nationalizing banks and picking up stakes in private companies. Yes, we talk of the US (and its infamous Wall Street). It is a place where 'government intervention', just a while back, was looked upon with a frown. It was met with utter contempt from the corporate world which loathed any kind of interference from the authorities. Regulation became a taboo and was thought of as the last thing needed by behemoth private financial companies which considered themselves to be mature and wise enough to be infallible.

Well, the US government listened. It consciously kept parts of its financial markets lightly regulated, having strong faith in the merits of capitalism to all by itself ensure that resources are at all times allocated in the best way possible.

Look at where we are now. Ok granted that hindsight is always twenty-twenty, and it is not like someone came and told the US government that a lack of regulation and such a laissez-faire management of the economy would cause so much harm. Otherwise they would not have done it right? Wrong.

It was John Maynard Keynes (1883 -1946), a pre-eminent British economist, who first said that the private sector's decisions sometimes lead to inefficient macroeconomic outcomes. His ideology was therefore in favor of active policy responses by the government such as monetary policy actions by the central bank and fiscal policy actions by the government for the purpose of stabilizing output over a business cycle.

With the governments of all the major countries announcing bailout packages, rate cuts and other such government action, it is the Keynesian line of thinking that they are adopting and implementing. Its principles include the theory that the total demand for goods in an economy might be insufficient during economic downturns, leading to unnecessarily high unemployment and losses of potential output. Exactly the situation that we are currently in. It suggests that the solution to this is that government policies should be used to stimulate the wavering demand, which will help in increasing economic activity and consequently reduce unemployment and deflation.

For instance, according to Keynes a booming economy and high demand growth would call for raising taxes to cool the economy and to prevent inflation. Similarly in an economic downturn, it would be appropriate for the government to engage in deficit spending on labor intensive infrastructure projects to give a fillip to employment and prop up wages. Thus, continuously engaging in counter cyclical policies to calibrate the growth of the economy in a smooth and even manner.

On the other hand, the opposite doctrine termed 'classical economics' suggests that the authorities should cut taxes when there are budget surpluses, and cut spending /increase taxes—during economic downturns. Thus trusting in the invisible hand of the market to adeptly allocate resources on the basis of price signals in the market. Some would argue that this is the thinking that has got us to where we are right now.

The essence of Keynes argument is that governments should solve problems in the short run rather than waiting for market forces to do it in the long run. That is because "in the long run, we are all dead." Taking a leaf out of Keynes' book, that is what governments the world over are doing currently. With strong arguments both for and against the theory, what remains to be seen is how beneficial all these government initiatives turn out to be in the long run.

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