Is Keynesian economics realy dead?

Joseph E. Stiglitz, Professor of Economics, Columbia University, Project Syndicate

Since capitalism's beginnings, the market economy has been subject to fluctuations, to booms and busts. Capitalist economies are not self-adjusting: Market forces might eventually restore an economy of full employment, as Keynes said, but in the long run we are all dead. Keynes proposed clear prescriptions for hard economic times: Expansionary monetary and fiscal policy. He thought fiscal policy particularly important in situations where monetary policy was likely to be ineffective.

In advanced economies, Keynesian economics is the bread and butter of economic forecasting and policy making. Expansions are longer and downturns shallower and shorter, because Keynesian prescriptions work. Of course, theory and practice have been refined. The theory of asymmetric information provides much of the micro-foundations for modern macroeconomics. But some of the simplest and most important precepts, formulated well before these micro-foundations were well established-such as the fact that temporary income tax cuts are unlikely to be effective, while temporary investment tax credits can be extremely powerful- are as valid today as ever.

We learn from economic policy failures as well as from successes. When the IMF forced large expenditure cuts in East Asia, output in those countries fell-just as Keynesian theory predicted.

In early 1998, when I was chief economist of the World Bank, I debated the U.S. Treasury and the IMF concerning Russia. They said that any stimulation of the Russian economy would incite inflation. This was a remarkable admission: Through their transition policies, they had managed, in just a few years, to decrease the productive capacity of the world's number two superpower by more than 40 percent, a devastating outcome greater than that of any war!

The loss went well beyond the cutback in military expenditures, overwhelming the civilian industrial and agricultural sectors. In August 1998, with the ruble's devaluation, we tested the alternative, Keynsian hypotheses: production soared, and relatively quickly, showing that policies emphasizing excessive austerity had caused unnecessary idleness of human and physical resources, and unnecessary suffering.

Remarkably, the IMF was slow to learn the lesson. While it belatedly recognized its fiscal policy mistake in East Asia, it repeated it in Argentina, forcing expenditure cuts that deepened recession and boosted unemployment-to the point where things finally fell apart. Even now, the IMF has not acknowledged the lesson: It still insists on further cutbacks as a condition for assistance.

The IMF continues to insist on an alternative economic "theory" (though using that term may suggest a higher level of analysis than is merited)-one which Keynes fought against over sixty years ago. In a nutshell, Keynes struggled against the notion that if only countries would cut their deficits, "confidence" would be restored, investment would return, and the economy would again attain full employment. Under "IMF" theory, investors, seeing government resolve to eliminate deficits, flock to the country, economic performance recovers, and the policy is vindicated. The government's budget targets are more than met. The temporary "pain" paid handsome rewards.

I know of no country where this scenario has played out successfully, for there are two key problems with this "theory." Confidence is important, but it is only one factor. For example, even if investors in telecoms become utterly confident in the U.S. economy, they are not going to invest in more fiber optics, given today's huge excess capacity. Similarly, Argentina's export industries were unlikely to attract investors, regardless of the fiscal deficit, given the overvalued exchange rate, low export prices, and the many foreign markets that remain closed to Argentine goods.

Even if "confidence" were the single most important factor, deficits are not the only, or even the most important factor determining investor confidence. A country in recession or depression does not inspire confidence. Contractionary policies only exacerbate recession. Investors in such a situation take a wait-and-see approach.

As they wait, they will not like what they see. After all, the first effect of the expenditure cutbacks is a further decline in income, and with it profitability of investment. With the decline in income, tax revenues decline, and, if the country has any kind of social safety net, expenditures increase. The hoped-for improvement in the fiscal position does not materialize. At this point, the IMF castigates the country for failing to fulfill its commitments. But it is the IMF that should be castigated-for pushing an economic theory that was rejected long ago.

Between 1999 and 2001, Argentina's central government had done an impressive job of cutting back its expenditures, net of interest, by 10 percent. What would have happened if Argentina's provincial governors had also miraculously been converted to the IMF's niggardly "logic," as demanded? I believe the downturn would have come earlier and more precipitously. Today's unemployment rates of 20 percent or more (with another 10-15 percent of hidden joblessness) would have been seen even before last December. Riots and political protests would have broken out earlier, too.

Economics is a difficult subject, because we cannot conduct controlled experiments. There are not two or three Argentina's, one following the experiment that I described above, and another adopting the policies that I prefer. But we do have a wealth of experience from which to draw inferences. This wealth of experience all points in one direction: Keynes's teachings are still very much alive, and Argentina today would be in far better shape if his lessons had been taken to heart.