John Maynard Keynes's ideas are firmly back in vogue (Getty Images)

The Keynesian comeback

The coronavirus pandemic has allowed policymakers to revive discredited economic theories

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This article is taken from the October issue of The Critic. To get the full magazine why not subscribe? Right now we’re offering three issue for just £5.

Defeating inflation was one of the most important benefits of the Conservative government from 1979 to 1997. The average annual inflation rate — measured by the retail price index — was 12.6 per cent in the ten years to 1979, whereas in the five years to 1997 it was 2.6 per cent. Naysayers complained at the time that the cost was recession and high unemployment, and the benefit-cost arithmetic was for debate.

In fact, the reduction of inflation to the low single digit rates was followed by excellent outcomes on output growth and job creation. In the 15 years to 2007, when the Great Recession hit the British economy among others, national output rose by over a half and the number of jobs climbed by three million. This was the period of “NICE-ness”, of non-inflationary, consistently expansionary growth.

Some economists still revere Milton Friedman

Basic to that achievement was an upheaval in thinking about macroeconomic policy and central to that upheaval was Milton Friedman’s intellectual contribution. The University of Chicago economist made two key arguments.

First, in a large body of work with a number of colleagues he demonstrated that inflation was “always and everywhere a monetary phenomenon”, meaning that it arose over extended periods only when the quantity of money increased more rapidly than the quantity of goods and services.

In the Britain of the 1960s and 1970s it was widely believed that inflation could and should be limited by direct government interference in wage and price setting (that is, by “prices and incomes policies”, to use the standard phrase). According to Friedman, this was misguided.

Second, in his 1967 presidential address to the American Economic Association he proposed that no trade-off between inflation and unemployment is to be found in the long run. Attempts by over-ambitious policymakers to seek “full employment” by so-called “expansionary fiscal policy” would be accompanied not by stable and tolerable high inflation, but by a wholly unacceptable process of ever-accelerating inflation.

Academic hostility to monetarism was pervasive, despite its success in policymaking circles

Friedman’s accelerationist hypothesis implied that the UK’s postwar commitment to full employment should be dropped. Instead macroeconomic policy — and particularly monetary policy — should focus on price stability.

At any rate, it should seek low inflation which approximated to price stability and helped markets to work efficiently. Ultimately this would be better for jobs and productivity than the hell-for-leather expansionism inherent in being geared towards the full employment goal.

Of course, Friedman’s ideas were controversial, and bitter debates marked the adoption of monetarist policies in the late 1970s and early 1980s. The overwhelming majority of academic economists disliked both Friedman’s macroeconomic recommendations and his free-market evangelism.

Monetarism, and the more established tradition of the quantity theory of money from which it was descended, were widely ignored in university instruction. When they were mentioned, they were either pooh-poohed as naive and wrong or lambasted as the cause of high unemployment and proletarian misery. Academic hostility to monetarism was pervasive, despite its success in policymaking circles.

The spree of US money expansion in recent months is likely to lead to a serious and very worrying upturn in inflation

The Keynesian-monetarist debates are history. The relevant question now is, “Which of the two sides has most influence on current macroeconomic policy-making?”  Without doubt the Keynesian academics have won. This is certainly true in Britain and North America. It is also becoming increasingly true in Europe, where the Bundesbank legacy of sound money is under assault from Latin financial permissiveness. Particularly important at the intellectual level has been New Keynesianism, heralded as “the science of monetary policy” in a 1999 article in The Journal of Economic Literature by Richard Clarida, Jordi Gali and Mark Gertler.

New Keynesianism is a way of analysing the economy with a mere three equations, none of which refer to the quantity of money. It spread from the universities, where it began, to central bank research departments and more recently to the elite decision-taking levels of central banks and finance ministries. As vice-chairman of the Federal Reserve, the USA’s central bank, Clarida is one of the most powerful figures determining the monetary policy of the world’s leading economy.

The coronavirus pandemic has given the New Keynesians an opportunity to put their ideas to work. In the USA the one month of April saw an increase in the quantity of money on the once standard M3 definition of 7.8 per cent. This was an increase greater than in any full year in the previous decade.

The increase in M3 in the year to June 2020 was more than 26 per cent, above the top numbers recorded in the inflationary 1970s and in fact the highest figure since 1943. (I quote from data prepared by Shadow Government Statistics, a private sector consultancy. The Fed itself no longer deigns to calculate the numbers.)

Yes, some economists — including the author of this article — revere Friedman’s work. We continue to watch the patterns of money increase or decrease as they unfold in central bank press releases from month to month.

In my view the spree of US money expansion in recent months is likely to lead to a serious and very worrying upturn in inflation over the next two or three years. New Keynesianism — like Old Keynesianism, with its constant insistence on “fiscal reflation” to deliver full employment — will prove disastrous. Time will tell.

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