1. Senior Scholar, Levy Economics Institute of Bard College
Recovering Keynes’s Approach to Economic Policy
Notes prepared for a presentation at the 4th International Conference on Developments in Economic Theory and Policy Special Session on Economic Policy, Faculty of Economics and Business of the University of the Basque Country, Bilbao 5th-6th July, 2005
Jan Kregel
Senior Scholar, Levy Economics Institute of Bard College

2. How Did Keynesians lose the Policy Debate?
The failure to recognize that Keynes’s policies were anchored in the concrete historical conditions facing the United Kingdom in the 1920s and the 1930s.
The translation of this failure into a simplified “hydraulic” Keynesianism that was based on the elimination of any concrete representation of the actual sectoral composition of output from the discussion of aggregate demand.

3. Keynes and the “real world” of British industrial decline
Lord Skidelsky has recently emphasized the importance of current conditions in the United Kingdom on the evolution of Keynes’s approach to policy.
He notes that Keynes’s major policy concern was to remedy the negative impact on employment of the collapse of export demand for Britain’s major export industries:
textiles, coal-mining, iron and steel, machinery, and shipbuilding
These sectors:
Produced 50 per cent of British industrial output
employed 25 per cent of the occupied work force
accounted for some 6 per cent of the 9-10 per cent unemployed in the 1920s.
In particular sectors, such as iron and steel, shipbuilding and coal unemployment rates were 22 per cent, 35 per cent and 16 per cent in 1928.

4. There were three policy responses
A traditional devaluation of the currency -- impossible given the political decision to return to gold at pre-war parity with the dollar.
Decrease production costs through wage reductions – also politically and socially difficult
Failing flexible exchange rates Keynes’s alternative policy had to take as givens
exchange rate overvaluation
high interest rates
This made domestic investment unattractive so the only alternative was:
for the government to engage in debt financed pubp9c works investment in building roads, houses, telephones, schools, and public utilities.
This became the basis of “Can Lloyd George Do It?” the Liberal party platform of public works in 1929.
The General Theory provided the justification of increasing aggregate demand to solve the general employment problem

5. Keynes warned that constant composition of output is a simplification
This simplification is important to make the point that the overall increase in demand will provide a better support for the overall restructuring of the economy that was necessary,
but it does not reflect that restructuring.
In this sense it is static, when what is wanted is a shift of labour from the declining sectors to the expanding sectors, something that Keynes thought would be extremely slow.
While industrial restructuring did take place in the 1930s after the Slump by 1937 unemployment in the north was still 15 per cent, compared to 5 per cent in the south.
Skidelsky suggests that these concrete facts explain why in 1937 in conditions of general unemployment over 10 per cent Keynes warned against the dangers of inflation, and argued that “we are in more need today of a rightly distributed demand than of a greater aggregate demand”.

6. When Is A Government Deficit Inflationary?
Keynes was concerned with the question of whether debt finance of war rearmament would be inflationary.
He argued that inflation could be avoided if demand was directed to the surplus labour areas and reduced in the shortage ones.
“Whether demand is or is not inflationary depends on whether it is directed towards trades and localities which have no surplus capacity.
To organise output in the Special Areas is a means of obtaining rearmament without inflation”.
Thus Keynes is implicitly arguing that the assessment of the level of aggregate demand should be measured against the impact of the government deficit on inflation and its distribution across sectors.

7. Hydraulic Keynesianism Discards Keynes’ “real world” concerns
Inflation is where Keynesian theory lost out to monetarism in the 1970s.
Hydraulic Keynesianism had no place for Keynes’s concerns for sectoral imbalance
Or for its impact on prices.
It simply called for a government deficit capable of filling the deflationary gap (although deflation referred not to the behaviour of prices but to output and employment).
Indeed, in Hicks more elaborate version of the Hicks-Hansen theory, prices are taken as a parameter.
There was thus no policy response to the stagflation of the late 1950s or the 1970s.
Nor for the policy conundrum caused by the external disequilibrium in the presence of unemployed resources

8. Keynesian Policy Conundrum
With inflation and unemployment (stagflation) and an external deficit the demand management theory was two instrument short
Fleming-Mundell brought in the interest rate to deal with the external equilibrium, but that still left inflation
Friedman solved the problem by promoting flexible exchange rates to solve the external equilibrium, a stable demand for money to look after inflation and a balance budget.
The Keynesian response was “incomes policy”.

9. Incomes Policy?
The most sensible proposals limited wage increases in all categories to the increase in average productivity.
This would penalize industries with below average productivity giving them higher average wage costs and thus lower returns, while it gave an incentive to industries with above average productivity whose unit costs would be declining.
But this was precisely the kind of adjustment in wages that Keynes believed to be impossible to implement, and ignored the impact of external demand on the declining sectors. In these sectors declining sales would be reducing investment and productivity growth, so that they would be hit by both increasing unit labour costs and declining sales.
The net result of this sort of incomes policy would have been to increase the generation of unemployment while it did little to help transformation. It exemplifies the reliance on relative price adjustments and ignores the primary importance of income effects.
A better policy, following Keynes would have been to direct government demand to those sectors experiencing declining export growth.

10. How to Evaluate Fiscal Policy?
This raises the question of the appropriate evaluation of the impact of the fiscal balance on the economy.
Keynes’s view clearly suggests that the level of unemployment is not the appropriate measure.
Neither would the aggregate level of output since there is no unique relation between employment and output (although this was the working assumption of the General Theory).
One way of taking into account the problem of directing aggregate demand to particular sectors is through an employer of last resort (ELR) programme.
In ELR employment can be directed towards those sectors that are losing external demand, and in favour of training labour to increase demand in those sectors in which demand is increasing.

11. What Other Policies do we Need?
It would thus be more appropriate to evaluate the fiscal balance with respect to inflation, as long as it is accepted that a fiscal deficit may be associated with both excess and deficient demand.
But, assessing budget policy with respect to its impact on inflation will also require subsidiary policies.
For example, the inflationary impact of a particular budget stance will depend not only on the distribution of ELR jobs and training, but also on the composition of government expenditure in addition to the ELR programme.

12. Capital Account Budgeting
Capital account budgeting: consumption expenditures separated from capital investment projects.
Keynes’s advocated a current account budget balance. This would ensure that citizens knew the real cost of government services, and would avoid moral hazard.
The capital account, including ELR expenditure, would be used for countercyclical demand policy. An ELR programme would provide an implicit counter-cyclical aspect, but it would have to be in constant deficit as determine by the demand for money for liquidity purposes.
Thus, when the pool of ELR workers was declining, because private sector was attracting ELR workers, this would be a sign to reduce the capital account deficit.
This combines assessment of deficit with inflation and the level of employment, since a falling pool of ELR workers would represent excess demand for labour and the possibility of wage inflation in that sector.

13. Expenditure Tax
But Capital Budgetting refers to the expenditure side of fiscal policy.
On the revenue side, Kaldor proposed an expenditure tax to supplement Keynesian aggregate demand management.
The tax would have a highly progressive rate structure to support domestic saving and investment -- marginal rates would have to exceed 100 per cent.
This policy could be supplemented by a proposal endorsed by Milton Friedman -- a negative income tax, and a special tax on luxury goods.
One of the biggest obstacles to the development of Latin America has been the impact of foreign investors, inequality in the distribution of income and open trade in increasing the import of luxury goods. Prebisch accepted it for use in Latin America.
Many Asian economies actively controlled the import of all consumption goods as part of policies to support domestic industry.
Given the current WTO engagements, for many countries the only policy instrument available to control imports is fiscal policy based on expenditure, rather than on income or on transactions.

14. Compliance Issues
Fiscal policy has also to be concerned with compliance. This is important for two reasons – the impact on aggregate demand, and the impact on inequality and redistribution of income.
Benjamin Higgins (Economic Development, London: Constable, 1959, pp. 526ff} has proposed an amendment to Kaldor’s consumption tax proposal to ensure that compliance is “self-enforcing”.
He proposed adding a penal tax on excess inventories and introducing a turnover tax, “to devise a closed system, so that anyone failing to report one taxable transaction will either find himself paying more under another tax, or having the transaction reported by the other party to it, because the other party can reduce his tax liability by honest reporting”

15. Sectoral Industrial Policy --International Competitiveness
In addition to aggregate demand policies, Erik Reinert has argued that no successful developed country has been able to bypass the “mandatory passage” of domestic industrialisation via the introduction of increasing returns industries and by keeping those productivity gains in the form of rising domestic real wages. This is also the basis of the Prebisch approach to resolving the obstacle to development posed by the declining terms of trade.
Here the Asian experience is instructive in two respects.
It explicitly rejected specialisation in trade based on comparative advantage and supported domestic industrialisation based on what Amsden has terms “getting prices wrong”.
It was based on a process of using a low wage base for the replication of existing developed country technologies in manufacturing based on domestic industry. Despite extremely low national savings, Korea was able to use its domestic financial system to fund these investments and generate income growth which eventually produced extremely high savings rates
But this is a message that should be read not only be developing countries, but also be developed countries, for it builds on Schumpeter’s idea of “creative destruction”, but creative destruction depends on a domestic financial system that supports investment in new technology, and an institutional and regulatory environment that supports the creation of increasing productivity investment.

16. External Environment – The International Financial System
Finally, as Keynes emphasized in his work on the international financial system in the post-war period, in the absence of flexible exchange rates, full employment was impossible in one country due to asymmetric adjustment.
An international system to dampen the negative impact of asymmetric adjustment on domestic policy would be required.
We know that Keynes was not successful in promoting flexible exchange rates, nor was he successful in creating a system in which these transfers would be automatic between deficit and surplus countries without impact on the exchange rate and thus on the competitiveness of the declining export sectors.
Experience with structural adjustment policies in the 1990s shows that flexible exchange rates by themselves may not be sufficient to ensure domestic policy autonomy.
The liberalization of capital markets has given institutional investors control of domestic monetary policy as well as exchange rates.
Thus, a policy to manage capital inflows will be part of the support for flexible exchange rates to ensue domestic policy autonomy for a successful price stabilisation policy based on managing the budget deficit.