The New York Times, November 30, 2008
What Would Keynes Have Done?
By N. GREGORY MANKIW
IF you were going to turn to only one economist to understand the problems
facing the economy, there is little doubt that the economist would be John
Maynard Keynes. Although Keynes died more than a half-century ago, his
diagnosis of recessions and depressions remains the foundation of modern
macroeconomics. His insights go a long way toward explaining the challenges
we now confront.
According to Keynes, the root cause of economic downturns is insufficient
aggregate demand. When the total demand for goods and services declines,
businesses throughout the economy see their sales fall off. Lower sales induce
firms to cut back production and to lay off workers. Rising unemployment and
declining profits further depress demand, leading to a feedback loop with a
very unhappy ending.
The situation reverses, Keynesian theory says, only when some event or policy
increases aggregate demand. The problem right now is that it is hard to see
where that demand might come from.
The economy’s output of goods and services is traditionally divided into four
components: consumption, investment, net exports and government
purchases. Any expansion in demand has to come from one of these four. But
in each case, strong forces are working to keep spending down.
CONSUMPTION The Conference Board reports that consumer confidence is
near its record low. It is easy to understand why consumers are so scared.
House values have declined, 401(k) balances have shrunk and unemployment
is up. For many people, the sense of economic uncertainty is greater than
they’ve ever experienced. When it comes to discretionary purchases, like a new
home, a car, or a washing machine, wait-and-see is the most rational course.
A bit more saving is not entirely unwelcome. Many economists have long
For the overall economy, however, a recession is not the best time for
households to start saving. Keynesian theory suggests a “paradox of thrift.” If
all households try to save more, a short-run result could be lower aggregate
demand and thus lower national income. Reduced incomes, in turn, could
prevent households from reaching their new saving goals.
INVESTMENT In normal times, a fall in consumption could be met by an
increase in investment, which includes spending by businesses on plant and
equipment and by households on new homes. But several factors are keeping
investment spending at bay.
The most obvious is the state of the housing market. Over the past three years,
residential investment has fallen 42 percent. With house prices continuing to
decline, increased building of new homes is not likely to be a source of robust
demand over the next few years.
Business investment has lately been stronger than residential investment, but
it is unlikely to pick up the slack in the near future. With the stock market
down, interest rates on corporate bonds up and the banking system teetering
on the edge, financing new business projects will not be easy.
NET EXPORTS Not long ago, it looked as if the rest of the world would save
March 2008, the dollar fell 19 percent against an average of other major
currencies. By increasing the price of foreign goods in the
reducing the price of American goods abroad, this depreciation discouraged
imports and bolstered exports. Over the last three years, real net exports have
increased by about $250 billion.
In the coming months, however, the situation may well go into reverse. As the
international capital has been looking for a safe haven. Ironically, that haven
move that will put a crimp in the export boom.
GOVERNMENT PURCHASES That leaves the government as the
demander of last resort. Calls for increased infrastructure spending fit well
with Keynesian theory. In principle, every dollar spent by the government
could cause national income to increase by more than a dollar if it leads to a
more vibrant economy and stimulates spending by consumers and companies.
By all reports, that is precisely the plan that the incoming Obama
administration has in mind.
The fly in the ointment — or perhaps it is more an elephant — is the long-term
fiscal picture. Increased government spending may be a good short-run fix,
but it would add to the budget deficit. The baby boomers are now starting to
retire and claim Social Security and Medicare benefits. Any increase in the
national debt will make fulfilling those unfunded promises harder in coming
Keynesian economists often dismiss these long-run concerns when the
economy has short-run problems. “In the long run we are all dead,” Keynes
The longer-term problem we now face, however, may be more serious than
any that Keynes ever envisioned. Passing a larger national debt to the next
generation may look attractive to those without children. (Keynes himself was
childless.) But the rest of us cannot feel much comfort knowing that, in the
long run, when we are dead, our children and grandchildren will be dealing
with our fiscal legacy.
So what is to be done? Many economists still hope the Federal Reserve will
save the day.
In normal times, the Fed can bolster aggregate demand by reducing interest
rates. Lower interest rates encourage households and companies to borrow
and spend. They also bolster equity values and, by encouraging international
capital to look elsewhere, reduce the value of the dollar in foreign-exchange
markets. Spending on consumption, investment and net exports all increase.
But these are not normal times. The Fed has already cut the federal funds rate
to 1 percent, close to its lower bound of zero. Some fear that our central bank
is almost out of ammunition.
Fortunately, the Fed has a few secret weapons. It can set a target for longerterm
interest rates. It can commit itself to keeping interest rates low for a
sustained period. Most important, it can try to manage expectations and
assure markets that it will do whatever it takes to avoid prolonged deflation.
The Fed’s decision last week to start buying mortgage debt shows its
willingness to act creatively.
It is hard to say how successful monetary and fiscal policy will be in avoiding a
deep downturn. But as events unfold, you can be sure that policymakers in the
Fed and Treasury will be looking at them through a Keynesian lens.
In 1936, Keynes wrote, “Practical men, who believe themselves to be quite
exempt from any intellectual influence, are usually the slave of some defunct
economist.” In 2008, no defunct economist is more prominent than Keynes