February 2011 marks the 75th anniversary of one of the groundbreaking economics books written by JM Keynes in 1936: The General Theory of Employment, Interest, and Money. Luzzetti and Ohanian (full paper here) shed light on the influence of Keynes’s ideas in shifting economic paradigm and policy. They assert that the long-lasting clout of Keynes’s General Theory was due to the fact that Keynes was “in the right place at the right time”.
As the Depression persisted for years in the UK and the US, it became increasingly difficult to reconcile chronically high unemployment with equilibrium theory that posited wage adjustments would reduce unemployment to normal levels. The General Theory was, in large measure, written in response to the inability of equilibrium theory to confront the Great Depression.
Furthermore, US macroeconomic time series following the publication of the General Theory appeared consistent with Keynes’s predictions. As government spending soared in the 1940s, rising from about 16% of GDP in 1939 to 48% of GDP in 1944, the unemployment rate plummeted from 17.2% to 1.2% (Margo 1993). This increased economists’ confidence in the Keynesian model, and the stable and prosperous economy of the 1950s and 1960s further solidified this confidence.
But perhaps the central factor behind the longevity of the General Theory was a series of breakthroughs in econometric methods that began in the 1940s. These methodological developments transformed the qualitative ideas of the General Theory into quantitative propositions. These breakthroughs included Haavelmo’s 1944 paper that integrated more formally probability theory with econometric methods, and other Cowles Commission classics on identification, estimation, and causal ordering.
These econometric developments formed the basis of the toolkit used to analyse business cycles following the General Theory both among university economists and policymakers. Throughout the 1960s, the economy continued to grow with remarkable stability, and for many observers, this stable prosperity was due in considerable part to the General Theory’s tenets.
And, Keynesian economics started to lose steam by the early 1970s due to poor forecasting performance of Keynesian econometric models; increasing recognition of supply-side factors as drivers of fluctuations (Kydland and Prescott 1982); and the breakdown of the Phillips curve, the authors argue. Here is a partial rebuttal to this view as well.
But, Keynesian economics is back again after the recent global financial and economic crisis. It will persist.
The notion of an inflation-unemployment trade-off and aggregate demand management remain at central banks, and the Keynesian vision provides a well-established framework for carrying this vision on within the context of policies that tie central bank behaviour to the joint mandate of promoting both low unemployment and price stability. This makes it politically unimaginable for a central bank, faced with a crisis, to argue it is unlikely they can increase output and trying to do so might make matters worse.
The General Theory will continue to have a large audience among policymakers as long as governments are pressed to boost nominal spending during periods of crisis, whether or not those efforts are effective.