By Rouchir Sharma
Last year the consensus opinion was that we are all Keynesians now. Virtually everyone in the commentariat believed that John Maynard Keynes’s solution for the Great Depression—heavy government spending to resuscitate the economy—was also the answer to today’s global downturn. The first cracks in the consensus appeared with the outbreak of the fiscal crisis in Greece earlier this year. Across the developed world, critics began to argue that government spending had reached the point of diminishing returns, and was producing an anemic recovery that mainly benefited special-interest groups. And the electorate listened. From Europe to the United States, as voters started to reward candidates focused on fiscal discipline and less government intervention, Keynesianism quickly fell out of favor.
One key exception was U.S. Federal Reserve chairman Ben Bernanke. Dissatisfied with the gradual recovery and a high unemployment rate, he let it be known that he thought more stimulus was in order, and realizing that was not in the congressional cards, he decided to take monetary activism to a new level by offering an open-ended commitment to pump as much money into the system as required to meet the Fed’s dual mandate of maximum employment and price stability. This is the first time a Fed chairman has explicitly stated that monetary policy can turbocharge an economic recovery. Bernanke says he is doing everything Milton Friedman would have had the Fed do. Friedman, the father of monetarism, argued that the Great Depression was largely the result of a major contraction in money supply, and that such a severe economic outcome could have been avoided had the Fed held the money supply stable.
The public doesn’t buy it. There’s a growing backlash against the Fed’s monetary activism, for two reasons. It is increasingly clear that the Fed can print all the money it wants to but has no control over where it ends up. Ever since the Fed stepped up talk of quantitative easing this summer, the prospect of easy money has driven up prices of commodities and emerging-market stocks, and Wall Street is abuzz with talk of the “next bubble.” Second, monetary activism suffers from the same fundamental flaw as Keynesianism, in that it protects inefficient players instead of injecting renewed vigor into the economy. In a telling statement of the Fed’s thinking, New York Fed member Brian Slack recently said that, with luck, quantitative easing will work by keeping “asset prices higher than they should be,” as that adds to household wealth. This is why stimulus can be so unpopular: it often benefits the rich (who own a disproportionate share of inflating assets such as stocks) at the cost of the poor (who are hurt most by the related rise in food and energy prices).
In a sign of the times, some of the most popular videos on YouTube this year are satires on economic policy; the latest lampoons the Fed amid a growing feeling that policymakers are committing what economist Friedrich Hayek called the “fatal conceit” in micromanaging the economic cycle. Hayek hated policy intervention of any kind. Keynes, Friedman, and Hayek were leading lights of the three most influential schools of economic thought of the last century. Hayek was associated with the Austrian school, ascendant in the 19th and early 20th centuries, which argued that the private sector should be left free to carry out the task of any readjustment in a downturn. Faith in the market’s purging power served the U.S. well in the 19th century, when the economy emerged stronger after each recession, but was taken too far in the policy mix of tight money and high taxes that led to the Great Depression and the rise of the Keynesians.
Keynesianism and monetarism are now suffering a similar distortion. Keynes would probably never have supported big government deficits during boom times, such as those that led to our current debt crisis. Likewise, Friedman would probably not have backed the new Fed use of monetary policy as a tool to engineer expansion rather than merely cushion the pain in a downturn.
The systematic perversion of Keynes’s and Friedman’s thought is now resulting in a fall in their fortunes, leaving Hayek triumphant, once again.
Sharma is head of Emerging Markets at Morgan Stanley Investment Management.