By W. Max Corden
When I was a student at Melbourne University’s Commerce Faculty immediately after the war – from 1946 to 1949 – the memories of our parents, and of the ex-servicemen who came back from the war, were of the Great Depression. Never again! It was a memory of unemployment and of real misery, either experienced directly or endlessly heard about from our parents.
Richard Downing was a young and charismatic lecturer in the Faculty who had spent time first at the University of Cambridge and then in Geneva with the International Labour Office. He brought back to Melbourne the message that economists had found a solution to the problem. There need not be another depression. This solution has come to be known as Keynesian economics, and in subsequent years has provided the basis for undergraduate textbook macroeconomics.
I was influenced by this enthusiasm, and especially by Downing. Ever since, in my view, John Maynard Keynes was the greatest economist. Of course there were others, notably Adam Smith, David Ricardo and Alfred Marshall – all from Britain – but Keynes has made the greatest difference to macroeconomic policies and perhaps to welfare in developed countries. And we have indeed not had another great world depression.
As every student knows, Keynesian policy involves the government and the central bank managing aggregate demand through monetary and fiscal policies so as to steer the economy to avoid both excessive inflation and excessive unemployment. The central bank manages monetary (or interest rate) policy and the government manages fiscal policy, the latter in the form of varying fiscal deficits or surpluses. Usually monetary policy is more flexible and is manipulated to obtain short-term equilibrium.
But a real problem arises when aggregate demand needs to be increased to avoid excessive unemployment, but normal monetary policy has become ineffective (or rather weak in its effects). That is exactly what happened in the United States and some other countries in 2008, or even earlier in Japan. And it is then that Keynesian fiscal policy turned out to be really important. Even if governments were already in substantial debt they had to run deficits – and to do so quickly – to avoid a serious recession, one that might even turn into a depression.
I wrote an article about that time entitled “Ambulance Economics: the pros and cons of fiscal stimuli” which was all about the world having had a heart attack and the “Keynesian ambulance” having to come to the rescue. Suddenly, what I had learnt at Melbourne University at the age of 22, turned out to be very relevant – more relevant than much that had been introduced into macroeconomic courses since those years.
To reflect on this situation in which many countries, notably the United States, found themselves, one has to understand the reasons why monetary policies can become ineffective. There are actually three. Some of these applied at that time to the United States and some even earlier to Japan. First, interest rates might have been brought down close to zero, and could go no further, and yet a lack of aggregate demand remained. Second, there had been a financial crash especially affecting banks, so that commercial banks and other intermediaries would not lend to private firms in need even though there were firms and households wanting to borrow. And thirdly, the central bank may have scope for lowering interest rates, and private banks may be willing to lend, but firms and household may not wish to borrow because they have got themselves greatly into debt and prefer to pay off their debts. This is called “deleveraging” and usually happens after a big boom caused by a “borrowing binge”.
So fiscal stimuli are needed even when governments already have big debts. If they avoid fiscal expansions because of their existing debts, they may allow a country to sink into a prolonged recession – and, at the worst, into a real depression.
These have been serious issues since 2008, and particularly now in Europe. Australia, the lucky country, has escaped many of the problems. The United States did have a fiscal stimulus in 2009, but many economists (like myself) thought it was not enough. Yet others opposed the policy because the US government already had big debts. Perhaps the answer is that in good times governments should run surpluses – and certainly pay off their debts – so that in bad times they can increase the debts and get a solid “Keynesian stimulus”. Another answer is that fiscal deficits should finance public investment of long-term value, rather than just financing current consumption or investment with low social value. The increase in long-term government liabilities caused by higher debt would then be matched by increased national assets.
That is just my opinion! You don’t have to agree with me, except to concede that the issues have lately been very important. John Maynard Keynes and Richard Downing would certainly think so.
W. Max Corden is an Australian economist who is most well known for developing the international trade model “Dutch Disease”. He is a graduate of the University of Melbourne and completed his Ph.D in economics at the London School of Economics. He has worked at a number of Universities nation wide and is currently meritus Professor of International Economics at SAIS and a Professorial Fellow in the Department of Economics of the University of Melbourne.
 “Ambulance Economics: the Pros and Cons of Fiscal Stimuli”, Policy Insight No 43, Centre for Economic Policy Research , January 2010, www.cepr.org/pubs/