FEATURE KEYNES, HAYEK AND THE GREAT RECESSION The writings of Keynes and Hayek are rich with lessons on the causes of the current crisis and ways out of it, says Robert Carling. This essay is based on an address to the University of Queensland alumni meeting in Canberra on 26 September 2012 conomic history has unfolded before The rise and fall and rise of Keynes our eyes over the past five years as Keynes’ name long ago became synonymous the worst financial crisis, the deepest with fiscal stimulus (‘pump-priming’) and recession (now dubbed the Great deficits in times of recession. The world quickly ERecession), and the weakest recovery (the Feeble embraced Keynesian pump-priming solutions Recovery?) combined to deliver the biggest global when economies went into free fall in late economic shock since the 1930s. The shock 2008, and even today there are voices in favour was unevenly distributed, but its epicentre of more of the same, or at least a tolerance for in the major advanced economies ensured large fiscal deficits as long as economic activity the whole world suffered the fallout. Future remains subdued. However, we need only take generations will look back upon this era with a little detour through the history of economic fear and loathing just as we look back upon the thought to appreciate that the wisdom of this Great Depression. rush to embrace Keynesian solutions is open Similar to the turmoil of the 1930s to challenge. revolutionising economic thinking then, the The early 1970s were the heyday of shocks of the last few years have breathed new post-World War II Keynesianism, in Australia life into old controversies about how economies as much as elsewhere. The Australian government work, why crises happen, and how to recover and its key economic advisory body, the from them. These controversies were never Treasury, accepted the Keynesian consensus resolved, but went into hibernation during the in that they believed in the management of Great Moderation—the era of almost continual aggregate demand through fiscal policy to economic expansion, low inflation, falling dampen the business interest rates, and booming stock markets from cycle. It is true that the the early 1990s to 2007. Now, the arguments Treasury was also a strong between Keynesians, Austrians and neo-classicists advocate of what are have returned with as much vigour as ever before. today called supply-side John Maynard Keynes and Friedrich von policies to strengthen the Hayek were key protagonists in the economic economy’s productive debates of the 1930s. Their theories, policy capacity. Moreover, the prescriptions and teachings cover much of the Keynesianism that it ground occupied by opposing camps in the contemporary debate. For this reason, the writings of Keynes and Hayek are rich with Robert Carling is a Senior Fellow at lessons on the causes of the current crisis and The Centre for Independent Studies. ways out of it. POLICY • Vol. 28 No. 4 • Summer 2012-13 17 KEYNES, HAYEK AND THE GREAT RECESSION believed in was of the symmetrical kind, circumstances of the 1930s.) He did not believe which sought to tighten fiscal policy in an that an easy monetary policy would be effective inflationary upswing as well as loosen it in in sparking a recovery in those circumstances, a downturn, not the one-sided expansionary and therefore, advocated two key changes in Keynesianism more popular with politicians. fiscal policy: first, that the government should Despite these qualifications, it is correct to say not struggle to balance its budget in the face that the Treasury at the time advised the of falling revenue; and second, that it should government within a Keynesian framework. borrow to fund a large-scale public works Not long into the 1970s, however, program. The first is not at all controversial Keynesianism began a retreat that continued today. Only the terminology has changed to up to the 1980s, initially because it had no something like ‘let the automatic fiscal stabilisers answer to the stagflation of that era. This work.’ But it was quite a radical thought in revision of Keynesian thinking strongly the 1930s. It is the second prescription that influenced the Commonwealth Treasury, which remains controversial. had a major falling-out with the Whitlam After the war, the reinterpretation of Keynes government in 1974 over the latter’s refusal to continued in earnest and led to notions such countenance fiscal tightening in the midst of as using fiscal policy to fine-tune the economy rampant inflation and an economic downturn. and influence the level of consumer spending. The Treasury eventually won that argument. But Keynes never advocated fine tuning. His Keynesian fiscal policy, if not exactly dead context was that of a deep slump, not an and buried, went into cold storage just like in ordinary business cycle, and his version of other countries. But then it made a spectacular pump-priming was a blunt instrument, not comeback with the onset of the global financial a scalpel. He is also reported to have rejected crisis in 2008, and was embraced once again by the idea of using fiscal policy to boost consumer the Commonwealth Treasury as well as economic spending through temporary cash payments managers all around the world. or tax cuts for households. His response to that idea was similar to Milton Friedman’s later Keynes and the Keynesians permanent income hypothesis.2 Keynes’ name Strange though it may seem, there is an essential has become associated with big government distinction between Keynes and the Keynesians. and deficit financing as a normal state of Many of the things that have been said and affairs, but he never advocated them. In fact, done in the name of Keynes since World War he is on record saying there was no need for II are nowhere to be found in his writings the size of government to exceed 25% of the and statements. They are actually interpretations economy—a figure that has been far exceeded and embellishments of what he wrote and in all developed countries. said. This process started even before Keynes When the counter-Keynesian revolution died. He is reported to have said after some came in the 1970s, it jettisoned what the discussions with Keynesian economists in the Keynesians had advocated, and to a lesser extent, United States that he was the only non- undermined the crux of Keynes’ own theory. Keynesian in the room. We can only imagine Fine tuning was discredited. The failure of fiscal what he would have made of some of stimulus in conditions of stagflation came to the policy views attributed to him since his be widely accepted. The ‘rational expectations’ death in 1946. school undermined Keynes’ theoretical We cannot know how his thinking would foundations.3 The fiscal multiplier was thought have evolved in the modern world, but the to be much smaller than previously believed. essence of his General Theory1 in the 1930s was Activist fiscal policy was thought more likely to that fiscal pump-priming should be used in be destabilising than stabilising. These revisionist the context of a deep and lingering slump and thoughts culminated in the view that fiscal deflation. (In that sense, the General Theory policy should focus on medium- and long-term was actually a theory tailored to the specific goals, such as strengthening the supply side of 18 POLICY • Vol. 28 No. 4 • Summer 2012-13 KEYNES, HAYEK AND THE GREAT RECESSION the economy, while short-term management did not follow the Keynesian formula. There should be left to monetary policy. The budget were few ‘shovel-ready’ public works projects, would fluctuate symmetrically between deficit and much of the stimulus was aimed at consumer and surplus, but mainly on account of automatic spending. In addition, they were too eager to responses of revenue and expenditure to the ignore the lessons of the counter-Keynesian business cycle, not activist stabilisation policies. revolution of the 1970s and 1980s. Had they The extent to which that message was heeded those lessons, they would have known internalised in policy circles has been overstated. that stimulus was subject to various endogenous Keynes and Keynesians came to be viewed offsets such as leakage into imports. Because of with much reservation, but were not totally these offsets, stimulus can end up being quite rejected. In Australia, for example, we still had weak per dollar of stimulus applied, especially some discretionary fiscal stimulus in the early in an open economy. The fiscal multiplier 1990s recession. By and large, the political is thus small and tends to shrink to zero the temptation to tinker with fiscal policy for more time passes after the stimulus is applied.4 short-term economic management went At best, fiscal stimulus in 2008–09 acted as untested for an unusually long time during the a circuit-breaker to soften the downward Great Moderation, until the global financial economic spiral. It did not kick-start a sustained, crisis and the Great Recession, when the robust recovery, nor should it have been Keynesians came in from the cold. expected to. And in many countries, it ratcheted Most countries applied large doses of fiscal up already uncomfortably high or unsustainable stimulus in 2008 and 2009, with Australia’s levels of public debt, thereby adding to the risk being among the largest even though the of future instability. recessionary forces here were not as strong as elsewhere. Three years on, the discretionary At best, fiscal stimulus in 2008–09 stimulus has been withdrawn here and elsewhere, even though large fiscal deficits remain in most acted as a circuit-breaker to soften the countries. However, the cessation of discretionary downward economic spiral.