Amid scepticism over the free-market consensus, the financial crisis has paved the way for a Keynesian resurgence. But, warns Oliver Kamm, this is not the time for grandiose ideological theses.

"The State," wrote John Maynard Keynes in 1936, "will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways."

The shift in economic thinking in the 1930s had the feeling almost of religious revival. Keynes had uncovered and remedied a crucial defect of the capitalist economy: that equilibrium might be achieved at a level in which capitalists would refrain from investing. This liquidity trap was not self-correcting: it would lock the economy into stagnation. Government action was needed to fill the gap and stimulate demand.

Keynes’s arguments had enormous political traction, but fell into disfavour in the great inflation of the 1970s. Restrictive monetary policy, monetary targeting, privatisation, fiscal retrenchment and curbs on trade union power became part of the programmes of resurgent conservatism – especially in the UK, under Margaret Thatcher, and with the Reagan administration in the US. But quite suddenly, with the financial crisis that turned into full-scale panic in the autumn of 2007, the politics of Keynesianism returned. Governments throughout the advanced industrial economies are mounting big fiscal stimulus packages, aggressive monetary easing – and even nationalisation of the banks.

To some, this represents a welcome supersession of dogmatic free-market ideas of the type popularly associated with the Thatcher Governments. Less plausibly – and a view I shall discount – is the notion that the whole crisis has been caused not by an absence of regulation, but by government attempts in the US to direct mortgage lending to higher-risk (or subprime) borrowers. Aside from these ideological theses, it is highly tempting also to infer, from the deep recession and economic damage precipitated by the financial crisis, that policy tends to go in cycles. On this argument, there was too much intervention in the Keynesian era, culminating in the exercise of power by interest groups in the corporatist 1970s. Inflation and trade union power then had to be tamed in reaction, but the era of deregulation and markets may now too be ending. None of these interpretations of the current predicament quite covers it, however.

The explanation that I favour takes something enduring from the shift to economic liberalism – among social democratic governments as well as conservative ones – in the 1980s and 1990s. This is not so much an argument for markets as for transparency, rules and economic openness.

The limits of these approaches are reached, however, when considering the financial system. Asset prices and exchange rates are not prices like any other. They can overshoot fundamental values, in both directions. There is a strong case – one that is not being observed by today’s policymakers – for open-border policies regarding the movement of goods and labour. But the case for the free movement of capital flows is different, and weaker. In principle, financial markets allocate capital to the most productive uses. In practice, capital flows will be disruptive if the banking system is not sufficiently developed to cope. That is what has happened in today’s financial crisis.

Comparisons between today’s crisis and the Great Depression of 1929–33 are misleading and, in any case, there is a common misconception about Keynes’s analysis of the causes of the Depression. This is not a crisis of capitalism so much as a crisis of one particular segment of the market economy: the financial system. It is true, however, that the crisis was born and amplified in the private sector. Much more stringent regulation is needed to anticipate and prevent future such disasters.

One problem with imagining that there is a Keynesian precedent that augurs now for a Keynesian resurrection is that the Great Depression was not strictly caused by a deficiency of aggregate demand. It was driven rather by an idée fixe of adherence to the Gold Standard. Monetary policy in the 1930s aimed to defend convertibility of the dollar into gold (from 1879 to 1933 there was a fixed price of one ounce of gold for $20.67). Adherence to the gold standard reflected a belief that money had to be backed by some asset, otherwise confidence in the currency and in the solvency of the Government would be undermined. It was a bizarre notion and a destructive one. It meant that the Federal Reserve could not properly act as lender of last resort to the banking system, because it had to take account of the demand for gold. (If it lent money to banks, then there would be more money in circulation, thereby reducing the credibility of the Fed’s guarantee to exchange paper currency for gold.) Consequently monetary policy was kept cripplingly tight.

A second problem with the Keynesian parallel is that today’s crisis is likewise not a fundamental problem with the real economy. The global economy has been pulled into a deep recession by failings in a dysfunctional financial system. It is true that financial deregulation was advanced as part of the wider liberalising impulse of the 1980s. But there were sound reasons for, say, abolishing fixed commissions in the stock market (which reduced the costs of trading) and encouraging financial innovation (which allowed companies to manage their risks better, and investors to diversify their portfolios more efficiently). The real danger was that, as the securities industry devised ever more complex products, the risks to the wider financial system were overlooked.

Lessons from the Asian crisis

A better parallel for today’s crisis is not the Great Depression but the Asian currency crisis of 1997–8. That crisis was admittedly on a regional and much smaller scale, but the causes and remedies have similarities. The region had experienced rapid growth through borrowing short-term, in overseas markets, and lending long-term, for capital projects. The crisis had a proximate spark –panic in international markets as Russia defaulted on its sovereign debt – which led to a contagious loss in confidence in the emerging economies. The Asian economies, with underdeveloped banking systems, experienced a collapse in their currencies. Their foreign-currency liabilities became a crippling burden. Deep recession and intense hardship followed.

Yet the region – with the notable exception of Malaysia, which imposed capital controls and whose political leadership advanced bizarre anti-semitic explanations of the crisis – kept its ties to the global economy and its place in the international trading system. Growth eventually resumed. The determination of Asian leaders – especially in China, which had not been caught up in these ructions – never again to be so vulnerable to turmoil in the foreign exchange markets in fact contributed to the long expansion of the global economy in the 2000s. A huge glut of Asian savings was built up and recycled in the western advanced industrial economies. The US current account deficit was sustained by massive capital flows from Asian into US Treasuries. There was so much capital sloshing around the western economies that interest rates were kept below market clearing levels – and an unsustainable boom in asset prices and expansion of credit were the consequences.

This is a simplistic and schematic background but it is, I believe, a more convincing explanation for today’s economic turmoil than grandiose ideological theses. This is a not a crisis of capitalism or the undermining of the principles of economic liberalism. It is a severe malfunctioning of one part of the capitalist economy, its financial sector. Banking crises are a periodic hazard because banks are tied to each other through the wholesale lending market. A combination of factors has caused that market to freeze up. Policymakers kept interest rates too low, and – partly owing to an inflation-targeting approach that made no attempt to prick asset-price bubbles – presided over a massive explosion of credit. Regulation in the banking sector, and especially capital requirements, paid too little attention to the need for liquidity. When a shock occurred in the banking sector, namely a realisation that an entire class of asset-backed securities was impossible to value accurately, then banks hoarded cash and refused to lend. Hence the vertiginous collapse in economic activity. Whereas there are numerous historical cases of collapses in the prices of particular assets or asset classes, this is a collapse of a credit bubble – and credit, being the lifeblood of the economy, needs to be restored. 

It would be a mistake to interpret the crisis measures undertaken by governments as a refutation of the principles advanced in the preceding two or three decades, precisely because they are limited to repairing the financial system. Keynesian stabilisation policy is premised on the idea that capitalism is cyclically unstable and requires the operation of automatic stabilisers – monetary and fiscal policy.

The counter-revolution in economic thought at the end of the 20th century had no difficulty assimilating this insight in practice. Governments are unable to abolish the business cycle, and need to moderate its fluctuations. That does not imply, however, that government has any particular expertise or role in taking command of important segments of the economy.

Finance is different, because it is not an industry that makes products so much as an essential utility that pervades the entire economy. It cannot be left to fail, because it will bring the entire economy down with it. Where the financial regime failed in recent years was a misalignment of incentives and poor regulation. Bankers had scant conception of the risks they were taking on; and given that finance is above all a discipline of the efficient management of risk, this was a huge systemic failing. The significant but limited sense in which the neo-liberal consensus of the late 20th century failed was in its indulgence of perverse incentives in the financial sector. Financial markets rewarded companies that reorganised themselves – whose executives saw the constituent businesses as a portfolio of assets to be traded. Hence, for example, the disastrous business strategy of Royal Bank of Scotland, which extended to buying a Dutch bank, ABN Amro, at a hugely inflated price at the top of the market, and building up a US banking network with punishing exposure to a collapsing housing market.

Economic and political liberalism needs to come to terms with these failures rather than reinvent itself wholesale. The system it haltingly replaced in the 1980s and 1990s had misunderstood the limits of human knowledge and wastefulness of attempts at government planning. The poor regulation and misaligned incentives of today’s financial system are an indication not of a renewed statism but of the importance of a framework of rules. In macroeconomic policy, the need for transparency and openness remains an important lesson. The last thing the global economy needs at this time is a resumption of the self-defeating policies of protectionism and the imposition of barriers to immigration. And the worst inference that politics could draw is that the role of the state is to plan and command rather than to stabilise.

There are three huge tasks ahead for policymakers and economic agents. First, monetary easing needs to be radical enough to stem any incipient deflationary pressures. Secondly, there needs to be a fiscal stimulus on the part of the US that is big enough to fill the gap left by a collapse in private consumption and investment. Thirdly, there needs to be a decisive and painful writedownof assets in the banking system; bad debts must be purged from the system, and the bankers who presided over these failures need to be replaced.

But as with Asia in the 1990s, adherence to the principles of economic openness is the only long-term solution to catastrophic failures born in the financial system. These are difficult times. The global economy faces its sternest test since the 1970s, and possibly since the 1930s. But the levers of economic policy are now better understood. There will be a swing in the regulatory system, and probably an overreaction. But a rebirth of dirigisme and state control would be neither likely nor desirable.

Oliver Kamm is a leader writer for The Times