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Peter Crabb: How do we reverse the Keynesian stimulus and loose money?

Policymakers around the world are asking themselves, “What would John do?

That would be Lord John Maynard Keynes. In response to the financial crisis and drastic economic downturn governments responded with a large dose of Keynesian policy. The question now is if it is time to stop.

In 1965, Time magazine ran a piece with the title “We Are All Keynesians Now”. The article showed the growing acceptance of a large role of government in the economy — specifically, that the government should respond to changes in the business cycle.

“First the U.S. economists embraced Keynesianism, then the public accepted its tenets. Now even businessmen, traditionally hostile to Government's role in the economy, have been won over. They have begun to take for granted that the Government will intervene to head off recession or choke off inflation, (and) no longer think that deficit spending is immoral.”

The slow growth and high inflation of the 1970s reversed this trend. Keynesianism lost its allure. In the 1980s and 1990s a declining role for government was pursued.

The economic downturn of this past year as been met with a chorus of We are all Keynesians Again! Even beyond the trillion-dollar deficit of the United States, governments throughout the world are continuing massive programs of fiscal stimulus and loose monetary policies.

The U.S. Federal Reserve policymaking committee announced this week it will keep interest rates near zero. However, according to the Fed’s announcement “economic activity has picked up.” since the committee last met in August.

It appears we may be turning a corner. So policymakers must know consider how to undo the massive dose of Keynesian medicine. What would John do?

John Maynard Keynes’ treatise, The General Theory of Employment, Interest and Money, included as part of an overall theory of the business cycle the idea of sticky wages. According to this theory an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production.

We have seen just what Keynes would predict. Rather than lower wages, we have a high number of layoffs and increasing levels of unemployment. But if the employment situation is improving and economic activity is picking up, Keynes’ theory would suggest that it’s time for the reverse — less government spending and a reduction in the government deficits.

Leaders of the G-20 group of countries will meet in Pittsburgh beginning this week. The question is certainly on their mind, but it is unlikely they will follow the Fed’s announcement of a turnaround in economic activity with announcement of their own that it is time to withdraw the stimulus spending.

Writing for The Wall Street Journal, Bob Davis suggests G-20 leaders will look to the International Monetary Fund for help. Davis writes, “participants say they will announce their determination to withdraw stimulus, but leave it to the IMF to figure out specific benchmarks.”

The IMF reportedly has specific indicators that will help determine appropriate timing for following Keynesian theory and reducing spending. These may include various interest rate spreads or the volume of inter-bank lending.

Financial market indicators today appear to support the Fed’s view today that the economy is on the mend, but there may not be much support for keeping interest rates low and continuing government spending.

The stock market has risen more than 50 percent since March but fell dramatically following the Fed’s announcement. Gold and other commodity prices remain elevated, and the dollar is declining against other currencies, both suggesting that inflation may pick up.

If deficits remain and inflation picks up, the problems of the 1970s will return. We may then no longer ask what John would do because we would no longer be Keynesians, again.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.

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