Old master's theory fails to solve New Labour dilemma

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The most influential work of John Maynard Keynes, the great economist who died 50 years ago last weekend, was forged by the Great Depression. With unemployment and job insecurity once again the scourge of the big industrialised economies, Keynes's analysis ought to have a new relevance half-a-century after his death.

In 1933, when unemployment in Britain stood at 2.6m or 19.9 per cent of the workforce, Keynes recommended an extra pounds 100m a year in government spending to tackle the problem directly though the creation of public- sector jobs. That is the equivalent of pounds 4bn today, when we have unemployment of around 2m or 8 per cent.

Yet it is only necessary to state the figure to realise how little faith today's policy-makers have in simple Keynesian solutions. It is not as if pounds 4bn is very much money in the context of total public spending. Politicians evidently do not have faith in either the diagnosis or prescription.

New-Labour politicians especially would not dream of making extra spending commitments to cut unemployment, and not just because they fear the ''tax- and-spend'' label. They are committed to supply side policies - such as better education and reform of the benefit system - in order to improve growth and create the incentives that will get people back to work. It is hard to imagine anything further from Keynes's emphasis on the lack of demand in the economy as the source of the unemployment problem.

There is an interesting parallel between New Labour and the Labour Party of the 1930s, which was equally resistant to Keynesian ideas. Keynes's 1936 masterpiece, The General Theory of Employment, Interest and Money, made no impact on economic policies until the start of the Second World War enforced an experiment with increasing the scale of government. Before the war the explicitly socialist Labour Party was as conventional in its economics as New Labour is now.

Keynes's biographer, Robert Skidelsky, has pointed out that, even before Keynes, Labour did not remotely accept the socialist analysis of unemployment. This saw mass joblessness as the reserve army of labour, created by investment in machines to replace men, and resulting in a "crisis of overproduction" for capitalism. Instead, the party of Ramsay MacDonald shared the belief of the Conservatives and Liberals in free markets, sound money, a balanced budget, thrift and free trade.

In his essay The Labour Party and Keynes, Lord Skidelsky writes: ''British socialism by and large assumed that capitalism had solved the economic problem.'' The Labour Party's policies were directed at ensuring the morality of that success. The blatant lack of success enjoyed by capitalism during the Great Depression posed a serious policy dilemma - but one Labour did not resolve by a wholehearted embrace of Keynesianism.

After the war, facing a transformed economic landscape with a hugely increased government sector, the economic establishment embraced and absorbed Keynes's ideas into the mainstream of theory. Keynesianism became the new orthodoxy.

Rising inflation subsequently led economists to revise Keynesian theory. Monetary theory was welded to Keynes's basic framework. The classic illustration is the Phillips Curve, the negative link between unemployment and wage or price inflation observed in Britain in the 1950s.

In its simple form, this suggested the government could choose to ''buy'' lower unemployment with higher inflation. However, the curve broke down. Over time a given level of unemployment was seen to be associated with higher and higher rates of inflation. Milton Friedman and others introduced expectations of future inflation into the wage-bargaining process and showed that the simple trade-off would become more unfavourable over time as wages were bid up to compensate for the expected inflation.

The state of the economy worsened in the 1970s with stagflation - high inflation with low or zero growth - which proved impervious to Keynesian remedies. Higher inflation did not ''buy'' any gains. As the economic consensus could perhaps explain the problem but certainly not remedy it, alternative monetarist theories blossomed. These emphasised the monetary side of the economy, to which Keynes had paid relatively little attention in his General Theory, and recommended that the government should follow rules setting targets for monetary growth rather than actively trying to manage the level of demand in the economy.

A second blow to the post-war consensus came from economists' attempts to weld macroeconomics, based on Keynes's work, with microeconomics, draw from earlier theories basing economic behaviour on rational choices by individuals. The motive was economists' perpetual desire to prove that their subject, with its testable theories and equations, is closer to a real science than are other social sciences. But the hunt for microeconomic foundations for macroeconomic behaviour ended with economic models that patently bore almost no relation to the facts.

Take the ''rational expectations hypothesis'', for which University of Chicago economist Robert Lucas won the Nobel Prize last year. In essence this says that individuals do not make consistent mistakes in their expectations of the future. Rationality dictates that consistent errors would be corrected, so there are only random mistakes in, say, price expectations. This is too powerful a premise for most economists to reject, trained as they are to base their analysis on the notion of rational ''economic agents''.

The trouble is that applying rational expectations leads to predictions that are not consistent with the facts - for example, that there is not even any short-term trade-off between jobs and inflation. Much of the economics profession these days spends its time either drawing up more complicated abstract models that might fit the real world better, or looking for a more acceptable set of facts.

This is the uncomfortable position in which the subject remains. There is no academic consensus about how the economy works, as a crop of books with titles such as The Death of Economics* and The Crisis of Vision in Modern Economic Thought** bear witness. At the same time there is an orthodoxy amongst politicians that emphasises old-fashioned fiscal and monetary prudence at a time when the most pressing problem in the big industrial economies is, once again, mass unemployment and, in some cases, deflation.

Although this might suggest that the time is ripe to go back to Keynesian basics, this is unlikely to provide a solution. Not only is there no sympathy anywhere along the political spectrum for the notion that bigger government is desirable, there are also key elements in today's economy that were absent in the 1930s, and so were not addressed by the master. These include the wave of rapid technological change and the diminished economic relevance of national boundaries.

If New Labour is to escape the yoke of the current free market and sound money orthodoxy, it needs a new visionary. In his essay, written nearly a quarter of a century ago, Lord Skidelsky said: ''Now the Keynesian consensus in turn is breaking down and we have to see how the Labour Party will confront the reappearance of its old dilemma: the lack of any success to moralise.'' Twenty-four years on, the lack of success in the industrial economies is even more apparent, and the dilemma more acute.

* 'The Death of Economics' by Paul Ormerod, Faber & Faber

** 'The Crisis of Vision in Modern Economic Thought' by Robert Heilbroner and William Milberg, Cambridge University Press