Keynes and the Credit Crisis

What would John Maynard Keynes have made of the current crisis affecting the United States? How different from the Great Depression would the crisis have appeared to him? Would he have advocated Keynesian policies? Would he have approved of the approach of the Fed Chairman, Ben Bernanke. In a recent CEPR paper, Alex Leijonhufvud, the great scholar of Keynes’s work, has this to say:

1. On the differences between the Great Depression (in Britain) and the current credit crisis.

The current situation is almost the opposite of the one that Keynes had to deal with. The background to the great depression in Britain was the declining trend in the return to investment since the end of World War I … the imperative of defending the exchange rate has caused it [Britain] to maintain too high a level of interest rates. The combination of declining marginal efficiency of capital and [high] interest rates propelled the country into recession.

The process leading up to today’s American financial crisis had the dollar exchange rate supported by foregin central banks exporting capital to the United States. This capital inflow was not even discouraged by the Federal Reserve policy of extremely low interest rates…the Fed was lured into keeping rates far too low far too long. The result was inflation of asset prices combined with a general deterioration of credit quality.

2. How NOT to deal with the credit crisis?

Consider the case of Japan. Eighteen years after its big crash, Japan has still not completely emerged from its aftermath … the United States also has a small advantage over Japan in that some part of the financial damage has to be absorbed by foreign interests, be they German banks or small Norwegian communities.

Japan tried policies inspired by Keynesian economics (building bridges to nowhere)…to little apparent avail. Why? Recall that in the Keynesian theory, public work spending is supposed to work when unemployed labour is cash constrained. That was not Japan’s problem. Business firms could not or would not borrow to finance investment … [And], in the early years, banks would not lend.

The other lesson to draw from Japan is that once the credit system has crashed, a central bank policy of low interest rates could not counteract this failure … the standard Keynesian policies are not the answer.

3. Is Bernanke’s approach right?

As in the Japanese case, the lesson of the Depression is the the collapse of credit cannot be reversed and that the consequences linger for a very long time. Until a year ago, the Fed Chairman Ben Bernanke was a consistent and outspoken advocate of a monetary policy of strict inflation targeting, a doctrine which required exclusive concentration on keeping consumer prices within a narrow range with no attention to asset prices, credit quality an unemployment.

Fortunately, Ben Bernanke and Mervyn King have shown that they realise that we must move beyond that doctrine.

4. Prospects for the future.

The likely prospect for the United States in any case is a period of stagflation. The issue is going to be how much inflation and how much unemployment and stagnation are we going to have.

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