In light of the financial crisis and global recession of the late 2000s, several economists and other intellectuals find themselves once more drawn to the writings of British economist John Maynard Keynes, who famously diagnosed the Great Depression of the 1930s as an inevitable result of the inner workings of a market economy. His policy prescriptions were thus a much more activist government, intervening on a macro level to stabilize the economy.
This view was opposed by Austrian economist Friedrich Hayek, who attributed the crisis to monetary disequilibria stemming from monetary mistakes of the Fed in the 1920s, as well as a deeply flawed international monetary system in the wake of World War I. Based upon their “Austrian” theory of the business cycle, Hayek and his mentor Ludwig von Mises were able to predict the Great Crash of 1929.
Hayek countered Keynes’ arguments and predicted that the use of Keynesian remedies to combat unemployment would lead to an unsustainable tug-of-war between the printing press of the central bank and the wage demands of workers. This is exactly what happened during the Stagflation of the 1970s. Upon receiving his Nobel Prize in economics in 1974, Hayek thus commented that the economics profession had “made a mess of things”.
Hayek was joined by monetary theorist Milton Friedman who similarly pointed to the weaknesses of the traditional Keynesian policy prescriptions. Friedman predicted the Stagflation of the 1970s—high unemployment, rapidly rising inflation and slow growth—as a result of the government’s attempts at driving down the unemployment rate through expansionary monetary and fiscal policies.
Traditional Keynesian policies thus fell out of fashion, and Keynesian thought and policy prescriptions were only reborn in a revised version as “New Keynesian” economics which prescirbed the use of monetary policy, rather than fiscal policy in order to “stabilize” the economy. Traditional Keynesian fiscal policy has been revived, though, by the governments of crisis ridden countries in the wake of the market meltdown of 2008. In the words of Nobel Laureate and post-war Keynesian Paul Samuelson, commenting upon the financial crisis in 2009:
“[W]e see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself […] The Keynesian idea is once again accepted that fiscal policy and deficit spending has a major role to play in guiding a market economy.”
Peter Robinson of the Hoover Institution recently did a video interview on Uncommon Knowledge in which he invited two prominent intellectual figures to comment upon the financial crisis and the government response to it, asking the timely question: Are we all Keynesians now? His two guests, Professor of Economics John B. Taylor, who has positioned himself as an outspoken critic of Fed policies in the 2000s, and Professor of Law Richard Epstein, a founder of the field of Law and Economics, conclude that they most definitely are not Keynesians.
Both Taylor and Epstein outright reject Paul Samuelson’s above quoted statement, thereby leaning more towards Friedman’s views on how markets work and how the government should be constrained by rules when conducting policy – a major point for Friedman.
In light of recent experiences, a fellow of Epstein within the field of Law and Economics, Richard Posner, has performed a dramatic turnaround from being a believer in free markets to diagnosing the financial crisis as A Failure of Capitalism:
“[W]hat we have learned from the depression [i.e. the recent financial crisis and global recession] has shown that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails. The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.”
Posner recently confessed to “How I Became a Keynesian” in the New Republic, writing on Keynes’ General Theory (1936), that “despite its antiquity, it is the best guide we have to the crisis.” Epstein rejects Posner’s view on the crisis, and is highly skeptical of traditional Keynesian fiscal remedies:
“[Y]ou either have public or private creation of jobs, governments will create a few jobs and destroy many more.”
Taylor has through several papers and his 2009 book Getting off Track argued that government mistakes are at the root cause of the crisis. His main contention is that historically low interest rates in 2002-2004 stimulated a housing boom and excessive risk taking, adding that the boom “was accentuated by other government policies” such as those related to the two government-sponsored enterprises within the housing finance system—Fannie Mae and Freddie Mac. When the crisis hit, it was exacerbated by further government mistakes. Most importantly, in his view, the Fed misdiagnosed the situation as a liquidity crisis, and thought financial firms could be helped mainly by pumping more liquidity into the market. Then, when the full market meltdown hit in the fall of 2008, the government’s inconsistent treatment of financial firms created even more panic, according to Taylor’s analysis.
Taylor’s critique of former Fed Chairman Alan Greenspan and monetary mistakes made in the 2000s have been an important contribution to the debate on the financial crisis, as he has been able to convince many of the merits of his arguments. However, Taylor only goes so far in explaining the monetary origins of the crisis, as the whole notion of price stabilization, associated with his “Taylor Rule,” has proved to be a destabilizing force, not only in the U.S., but in many industrial countries during the last couple of decades, as I have commented upon in a recent article criticizing New Keynesian thought and policy-prescription, as represented by Olivier Blanchard, Chief Economist of the International Monetary Fund and our times leading New Keynesian textbook author.