Keynesian Stabilization Policy - Case Study Example

Keynesian Stabilization Policy Introduction The purpose of this paper is to outline the basic tenets of Keynesian stabilization policy as formulated and defended by John Maynard Keynes, with particular attention to the economic realities of the United Kingdom in the 1930's. Secondly, this paper will offer a critique of Keynes' notion of stabilization, on its face ("Is stabilization the right goal") and its mechanisms ("Can stabilization work as intended"). Finally, this paper will address "modern" Keynesian thought and its counterarguments. This paper will seek to demonstrate that, even in the neo-Keynesian context, the fundamental tenets of the theory offer neither a cohesive method to understand today's economic realities, nor do they prescribe ways to improve economic functioning. Classic Keynes: A Response to Depression John Maynard Keynes grew up in and attended Cambridge. He was a prominent member of the Bloomsbury Group, which was a literary group in London which, among other things, espoused socialist and interventionist solutions to economic and social problems. Keynes' experience during and after World War II in the Treasury helped to form his ideas about pricing, demand and monetary policy. He predicted the hyperinflation in Germany as a result of the unrealistic demands of the Versailles Treaty of 1919. Keynes supported the theory of "pump priming" during the depression of the 1930's, which was formalized in his magnum opus of 1936, The General Theory of Employment, Interest and Money (Keynes). One can view Keynes' formative years as a response to the realities of post-war Europe, a stagnating English economy, and subsequent Depression throughout the world. He saw that government's relatively small role in the economy could be increased if governments overcame their short-term resistance to increasing debt in peacetime. He saw the Great Depression reduce overall output in the world by 50% from 1929 to 1932 (Sachs). At the time of the Great Depression, the role of monetary policy had not yet been explained1. On the other hand, the drop in demand was obvious and compelling: (Kindleberger) It was clear to Keynes that demand collapse was the primary cause of economic depression. Contrary to subsequent accounts, the 1920's was not a period of uninterrupted prosperity in Europe. Sustained growth started only in 1925, and was cut short four years later. According to Kindleberger: Recovery from the First World War was hindered in Europe by the loss of the cream of its youth and the relative setback to its position owing to the stimulus to economic growth in the dominions, Japan and the United States2. Thus Keynes' entire adult career saw only a short period of nearly full employment, preceded and followed by periods of stagflation and outright depression. The respective governments' response to the economies' poor performance was fiscal restraint which, in Keynes' view, was clearly not working. The Fundamentals of Classic Keynesian Theory Keynes claimed that demand buoyed economies. Central to his theory was that demand from both the private and the public sector was essentially the same. To the extent that the private sector did not provide demand, the public sector could increase demand in order to keep the economy humming. Keynes felt that inflation was not a major problem unless the economy approached "full" employment, which was a much higher number than attributed by most economists at the time. Keynes' theories included three basic tenets: 1. Aggregate demand is composed of government and private demand. Both stimulate the economy when they increase. Aggregate demand is not inflationary unless it increases at a time when the economy is fully-employed. 2. Changes in demand do not affect prices, at least in the short term. Their main effect is on output and employment. Prices do not change readily-particularly in the case of wages-to accommodate demand. 3. Since wages respond slowly (both up and down), unemployment acts as a "balancing" mechanism. That means that, as demand fluctuates, employment moves more than prices in the short- and medium term. Keynes' natural inclination was to protect employment as a matter of public policy. That is, it was in the broader interest of society, in Keynes' opinion, for government to "prime the pump" to maintain aggregate demand at a level which assures full employment. Put another way, it was not the employees' "fault" that their jobs were so insecure. Thus, to balance the inequities of capitalism, government needed to act as a demand counterbalance to offset the unfair effects on the working men and women. The Monetarist Revolution: Pendulum Swings Milton Friedman fundamentally challenged Keynes' demand-driven model of economics. His "Monetary History of the United States" in 1963, co-written with Schwartz, demonstrated that the US Treasury's contraction of the money supply by 1/3rd from 1929 to 1932 accounted for a good deal of the economic contraction during the period (Friedman). Subsequent improvements in 1934 to 1937, and during World War II, were therefore ascribed to changes in both the supply and the velocity of money. Velocity was, for Friedman, the more important variable, as the multiplier/demultiplier effect magnified the impact of demand collapse during depressionary periods3 Friedman claimed that government demand was not equivalent to private demand. He revived the theory of "rent," which suggested that the greater government demand, the lower overall productivity would be achieved. In the table below, "rent" is the gap between prices charged as a result of government demands (in the form of taxes or costs of regulation). That is, prices move up and demand moves down as the government's share of demand increases. Furthermore, Friedman advocated a limited government role: reduced government demand, less 'crowding out' of private-sector demands for capital, and overall increases in economic activity. Unlike Keynes, Friedman believed that it was not possible for monetary or fiscal policy to control for full employment. His approach was to provide predictability and stability in the monetary supply, allowing the free market to assure increases in productivity, and subsequently in employment. Neo-Keynesian Theory Samuelson and others did not subscribe to Friedman's model of small government and stability in prices. Samuelson and the MIT School favored more interventionist policies, free trade, and government provision of a tax structure which supported income distribution in order to obviate the more egregious faults of "raw" capitalism. Although Samuelson accepted Friedman's monetarist interpretation of the causes of the Great Depression, he and his colleagues successfully countered that the reduction in world trade, triggered mainly by the Smoot-Hawley Tariff, was a major contributor to the depth and breadth of the subsequent economic downturn (Zimmerman). Furthermore, the new Keynesians, while accepting the importance of monetary policy and inflation, returned to Keynes' fundamental notions that monetary policy can be used to guide employment, wages are sticky, and prices do not change much over the short term (at least not downwards). Certainly newly emerging countries, such as India and China, point to a demand-driven economic miracle where monetary policy is less important than gains in productivity and private-sector demand. Keynes would argue, were he alive today, that even government investment in such newly-emerging giants is fairly efficient: it provides needed infrastructure which provides improvements in productivity, employment and further economic growth. One could broadly argue that the neo-Keynesian theories hold sway with many of the larger economies in Europe, and certainly with the European Central Bank. The notion of "job creation" is at the center of French and German monetary and fiscal policy. In Germany, for example, the "ABM," or "Arbeitsbeschaffungsmassnahme4" is a major government initiative to assure the semi-employment of longer-term unemployed. It accounts for as much as 5% of total employment in Germany, reducing official rates of unemployment to about 8% today (BIH). In France, where 25% of all workers are employed by the State, increases in state employment are regarded as an economic stimulus-clearly Keynesian economic practice at work. Conclusion: Who is right Who is wrong It is tempting to compare European neo-Keynesian policies with those of the United States, and to claim that superior US growth therefore dictates that Keynes was wrong in his fundamental theories. This would not be fair to either neo-Keynesians or the Chicago School adherents. What is more difficult for neo-Keynesians to defend is the whole concept of "stabilization." The underlying motivation of modern Keynesians is to "correct" the instabilities of the free market, and to help the workers who are prey to the fluctuations in employment (Barnett). It is valid to compare "full-employment optimization" policies in Belgium and Italy to those "laissez-faire" policies in the US. One can suppose that full-employment policies which use government demand to expand the economies have less effect in countries where significant barriers exist to labor mobility. In the case of Italy and Belgium, language and custom prevent workers from changing either locations or type of work. In southern Belgium, the loss of the coal and steel industry has not freed labor to move into new occupations; in Italy, only small enterprises represent growth in employment and the economy. Both countries have national debt in excess of 130% of GNP, and both have enjoyed slower GDP growth than their neighbors, despite long-term "pump-priming." One is tempted to point to one's political proclivities in order to predict their favorite economic theories: conservatives prefer Friedman, liberals Keynes. The reality is more complicated: neo-Keynesians accept the importance of monetary stability, but would counter that governments play an especially important demand-generating role in newly-emerging economies. Chicago School adherents would argue that monetary stability is all that is needed to promote growth, pointing to Taiwan, Chile and Korea. Both are right, and neither "school" encompasses the complete truth. Bibliography Barnett, WA and He, Yijun. Stabilization Policy as Bifurcation Selection: Would Keynesian Policy Work if the World Really Were Keynesian. Thesis. St. Louis: Washington University, 2006. BIH. "Arbeitsbeschaffungsmassnahme (ABM)." 2007. BIH Integrationsaemter. 17 October 2007 . Friedman, M and Schwartz, AJ. A Monetary History of the United States, 1867-1960. New York: NBER, 1963. Keynes, JM. The General Theory of Employment, Interest and Money. Cambridge: Cambridge University Press, 1936. Kindleberger, C. The World in Depression, 1929-1939. Berkeley: University of California Press, 1973. Sachs, J and Larrain, F. Macroeconomics in the Global Economy. New York: Prentice-Hall, 1993. Zimmerman, G. "The New Keynesian View." The Quarterly Journal of Austrian Economics (2003): 61-72. Read More