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Father of a mistaken orthodoxy: John Maynard Keynes

Since President Obama's re-election the American financial press and world stock markets have been anxious about the so-called "fiscal cliff". This is the sharp fall in the US budget deficit that would occur in 2013 on present policies, which include the cancellation of tax cuts dating back to George W. Bush's presidency. The Congressional Budget Office has estimated that next year these policies would lead to a fall in the deficit of over $500 billion, roughly half of the existing budget gap. Keynesian textbook orthodoxy says that the projected deficit reduction represents a severe tightening of fiscal policy, which will withdraw spending power from the economy and so reduce demand, output and employment. 

But will it? The thinking behind modern fiscal policy was first developed in Keynes's 1936 General Theory, particularly in its Chapter 10, and with far more clarity in his 1939 essay, "How to Pay for the War". The essence of Keynes's message was that taxation and government spending should be varied to influence the total level of expenditure. By according government a benign role in managing the economy, Keynes's ideas were plausible and attractive to "the socialists of all parties", to quote one of Hayek's better-known phrases. For many economists in the world's top finance ministries, Keynesian textbook orthodoxy is the textbook orthodoxy today. In their view, if a downturn in the economy threatens, the budget deficit must be increased. Further, to advocate strong action to cut the budget deficit in a recession is economic illiteracy, even madness. 

However, the textbook maxims of Keynesian fiscalism do have their critics. Towards the end of his life these included Milton Friedman, the redoubtable champion of monetarism and the free market. In January 1996 two British economists, Brian Snowdon and Howard Vane, interviewed Friedman in his San Francisco apartment. They asked him: "In the light of your work on the consumption function and monetary economics in general, what role do you see for fiscal policy in a macroeconomic context?" His rebuff to the Keynesian consensus was trenchant:  

None. I believe that fiscal policy will contribute most if it doesn't try to offset short-term movements in the economy. I'm expressing a minority view here, but it's my belief that fiscal policy is not an effective instrument for controlling short-term movements in the economy. 

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Postkey
February 15th, 2013
9:02 AM
Democrats and Republicans both feared the 'Fiscal Cliff' and rightly so?  In the USA, in the  'Great Depression' aggregate demand fell and, in the 1930's, GDP declined by 28%.  In the USA, in the  'Great Recession', aggregate demand fell by a greater amount than it had in the 'Great Depression' but GDP declined by  'only' 5%. Without governments increasing their expenditures, then GDP would have fallen by a greater amount? http://www.scribd.com/doc/116293469/Keen-2012-Fiscal-Cliff-Lessons-From-...

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