03 May 2011

Back from the dead? Understanding the death of Keynesianism and its potential revival

Current debates about whether to further support the economy or to focus on reigning in the  deficits are reminiscent of an older question about whether Keynesianism is dead. Regardless of what one think should be the appropriate response in the current crisis, it is clear that post 1970s governments' attention have de facto shifted to controlling inflation, often at the expense of unemployment. Why this has happened is still not entirely understood.

The first way to approach this question is by asking what determines macroeconomic policy more generally. Here, three sets of explanations stand out.

1) The role of Ideas: the theoretical superiority of monetarism meant Keynesianism was abandoned and replaced.

2a) Interest - Partisanship: basically, this theory assumes that the left cares about the working class and the right about asset owners and high income earners. As a result, the left will favour policies that reduce unemployment at the expense of inflation, whereas the right will do the reverse (Hibbs, 1977, ;but see Alt and Chrystal, 1983).

2b) Interest - Political Business Cycle: this theory assumes that elected governments are office seekers and maximise the odds of getting re-elected, while the voters are rational but short-sighted. Governments will then expand the economy pre-election to maximise the chances of getting re-elected and tighten budgets after having been elected (Tufte, 1978; Nordhaus, 1975; but see Leiwin 1991).

3) Institutions / Corporatism: Certain institutional structures are more conducive to Keyenesian Macropolicy. This is either because of greater state capacity and a history of activist government policy (Hall, 1990; Weir and Skocpol, 1985) or because of the presence of Corporatism (institutional arrangements whereby governments, capital and labour jointly decide the direction of the economy). In the latter case, corporatism makes both more likely and more feasible for Keynesian policies to be undertaken. It is more likely because labour's interests are taken into account and are more consistent with capital's interest. It is more feasible because governments can mitigate the adverse inflationary effects of expansionary policies by agreeing with the social partners to moderate their wages (Schmidt, 1982; Katzenstein, 1985; Schonfield, 1984).

With respect to (1), the onset of the oil shocks and the demise of the traditional trade off between inflation and unemployment contested the theoretical predictions of Keynesianism. 

In the 1970s, only corporatist economies were capable of controlling inflation while reflating the economy. As monetarism developed and the unions' strength decreased, this proved that it was possible to control inflation without relying on a corporatist framework. This affected (3)

Changes in the international environment meant that traditional Keynesian tools became more limited and less effective. Governments lost a lot of complementary policy tools (trade control, tariffs, state subsidies, etc). Keynesian policies were also less effective in the context of more open economies and no capital controls.

(2a) and (2b) were potentially affected by the external changes mentioned above but also by internal changes. If expansionary fiscal and monetary policy to support the economy was not effective anymore, governments lose their incentives to electioneer (i.e.: spend more to increase their chances of getting releected). Internal changes may have included convergence to the median voter or it may have moved to the right. In either case, the consequence would be that left wing parties would have to ignore the more left part of their electorate. To the extent that they are more unemployment averse than the median, this would reduce reliance on inflation creating expansionary policies.

Oddly enough, the occurrence crisis has in many respects reinvigorated Keynesianism. First, because it was successful in mitigating and shortening the crisis. Second, because as of today, no inflationary pressures are being felt. True, deficit hawks are challenging the Keynesian paradigm from a slightly revamped angle. However, most debt related problems are either structural and stem from pre-crisis issues (demographic/pension problems and health care related costs) or have been sparked by the underwriting of the financial sector. Automatic stabilisers in the form of unemployment benefits and extra social spending can hardly be blamed for current problems. Whether a new policy paradigm emerges remains an open question.

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