The Second Coming Of Keynes?

John Maynard Keynes (1883-1946) was the 20th century's most influential economist. His ghost animated government policies for 25 years after World War II, and these led to ruinous inflation and budget deficits. It is curious then that Keynes is enjoying an intellectual revival. The American Prospect, a liberal journal, recently put him on its cover under the headline THE SECOND COMING. And in a new book, economist Paul Krugman writes: "[T]he rebirth of Keynesian economics ... has been oddly ignored." Hub?

Keynes is not a man for our times. What afflicts most advanced societies is a sort of economic middle age. The largely invisible and spontaneous process by which companies and individuals create new products and jobs has become less vibrant. In the 1960s, the world's richest nations averaged about 5 percent annual economic growth; in the 1980s, that was 2.7 percent. Europe suffers from astronomical unemployment. In 1970, the European Community had a jobless rate of less than 3 percent; now it's 11 percent.

But these problems do not stem from too little spending-or, in Keynes's vocabulary, insufficient "demand." In the 1980s, consumers in most wealthy nations went on spending sprees; the personal-savings rate in the countries that belong to the Organization for Economic Cooperation and Development fell from 13 percent of disposable income in the late 1970s to 10.5 percent in the 1980s. Nor has government spending been restrained. In OECD countries, it rose from 36 percent of economic output in 1978 to 42 percent in 1993. If economic vitality depended only on spending, there would be no problem.

Something else has gone awry; in truth, we really don't know what. But one source of trouble lies with government policies that encourage "structural slumps," in the phrase of economist Edmund Phelps of Columbia University. This applies especially to Europe. High payroll taxes (which raise labor costs) and tight employment regulations (which do the same) hurt hiring. They also deter business start-ups and doom marginal firms. The climate for job creation and risk taking degenerates.

A few remedies are obvious. Last week the OECD issued a report concluding that "the private sector would create more jobs if there were fewer barriers to hiring." It cited high payroll taxes (our social-security tax and others like it) and minimum wages. The dilemma is that cutting these would help the economy only slowly, while instantly provoking a political firestorm. In France, the government proposed lowering the minimum wage for younger workers to 80 percent of the regular minimum. After massive street protests, the proposal was withdrawn.

But traditional "Keynesian" policies of larger budget deficits or looser credit do not defeat the dilemma. Although they may temporarily boost growth, large improvements require changes in how people and firms behave. If governments try to spend their way to faster growth, they risk colliding with the "natural rate of unemployment"-a concept conceived by Phelps and economist Milton Friedman. Unemployment could not be pushed below this "natural rate," they argue, except by a continuous rise of inflation. Stiff competition for scarce workers would push up wages and prices. This happened in the 1960s and 1970s.

Unfortunately, the "natural" unemployment rate may have risen in many countries. In practice, it's not "natural." It reflects government policies (how much does it cost to hire people?) and population patterns (are groups with higher jobless rates increasing?), among other things. If these change adversely, the natural rate rises. For example, Phelps thinks France's natural rate is 8.5 percent, up from 2.5 percent in 1970. (France's actual unemployment is now about 12 percent.) Phelps puts the U.S. "natural rate" at 6.5 percent. If true, the economy already faces higher inflation; other estimates, however, are lower.

All this is far from Keynes. What makes him a cult-like figure was his undeniable brilliance and his impatience with orthodox ideas. He is a model for anyone contesting the status quo. But to invoke Keynes now is misleading on two counts. First, we don't know whether Keynes would have endorsed many of the ideas now labeled Keynesian. Postwar Keynesianism was "by no means wholly Keynes's," as Robert Skidelsky writes in a new biography.

Gold standard: The second caveat is this: Keynes's theory rests on a huge misunderstanding. He argued that capitalist economies could become trapped in deep ditches of massive unemployment and unused industrial capacity from which they could not spontaneously escape. There wasn't enough "demand." This theory seemed to explain the depression and discredit the wisdom at the time that economies are automatically from slumps through adjustments of prices, wages and interest rates. By rejecting this, Keynes justified active government economic management.

The trouble is that the theory doesn't sit well with the facts. What made the Depression so bad was governments' efforts to save the gold standard (maintaining gold to back paper money), as economist Barry Eichengreen has shown. To guard their gold stocks, governments kept interest rates too high. This overwhelmed the economy's normal recovery mechanisms. Once countries left the gold standard (Britain in 1931, the United States in 1933), recoveries began. Between 1933 and 1936, U.S. unemployment dropped from 25 to 17 percent.

It is not that the "free market" is better than government or that economies, left to themselves, always thrive. What we call "the economy" is merely the amalgam of all the institutions, technologies, ideas and popular attitudes that propel production. And that includes government. Its economic intervention-whether by yesterday's gold standard or today's taxes-is inevitable. What we need is wise intervention, which is the hardest kind.

Books discussed include "Peddling Prosperity: Economic Sense and Nonsense in the Age of Diminished Expectations," by Paul Krugman (303 pages. Norton. $22); "Structural Slumps: The Modern Equilibrium Theory of Unemployment, Interest and Assets," by Edmund Phelps (420 pages. Harvard University Press. $49.95); "John Maynard Keynes: The Economist as Savior, 1920-1937," by Robert Skidelsky (731 pages. Penguin Press. $37.50), and "Golden Fetters: The Gold Standard and the Great Depression 19191939," by Barry Eichengreen (448 pages. Oxford University Press. $39.95).