We're trapped, but a 'treaty' could save us: Modern Keynesians tell us to stop worrying about inflation, but the great economist would have been far more radical, says Robert Skidelsky

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The Independent Online
KEYNES is coming back into fashion. William Rees-Mogg (Independent, 13 July) says that something must be done to overcome the slump or we will face a resurgence of Fascism. The 'extraordinary impotence' of the recent G7 summit reminds him of the Thirties, when the world economy was allowed to collapse.

The big difference from the Thirties, and the reason for the impotence, is that prices are still rising even as economies are slumping. A nightmare is unfolding in Western Europe, and perhaps also in the United States.

In the Seventies we had to endure rising inflation to maintain reasonably full employment. The European exchange rate mechanism (ERM) was devised to combat inflation by stopping governments printing money at will. To some extent it has worked, but we are now faced with ever higher levels of unemployment to maintain a 'reasonable' rate of inflation - meaning below 10 per cent.

No one has the slightest idea how to escape this trap. But to recognise it as a trap rather than a trade-off is where wisdom begins.

The experience of the Eighties vindicated much of Keynes's analysis. His central message was that an economy has no natural tendency to full employment: the level of employment depends on the level of demand, or spending on consumption and investment.

This could be too low to provide jobs for everyone seeking work, and Keynes thought economies could oscillate for decades around a low employment point, with feeble booms giving way to renewed slumps. In such circumstances, he argued, governments should intervene to boost spending by lowering interest rates, cutting taxes or spending more themselves.

Keynes's analysis dates from the Twenties, which the Nineties threaten to resemble. Then, unemployment in Britain stood at 10 per cent. Interest rates could not be lowered because Britain was tied to a fixed exchange rate system - the gold standard - with an overvalued pound. Keynes advocated a big programme of loan-financed public spending, which he thought would set off a cumulative increase in prosperity.

Why is the solution not that simple today? The key difference is the behaviour of prices.

Between 1921 and 1923 the British consumer price index fell by almost 40 per cent, and then declined more slowly for the rest of the decade. In those days depressions were always accompanied by falling prices, and booms by rising prices, with price stability over the cycle. Restoration of price levels was an essential part of recovery: lightening the burden of consumer debt, restoring capital values (especially in the property market), and increasing profits at the expense of wages.

In 1929, when the world depression struck, the case for raising prices became even more powerful. Between 1929 and 1933 the world consumer price index fell by 25 per cent. In 1931 Keynes wrote: 'Modern capitalism is faced . . . with the choice between finding some way to increase money values (prices) towards their former figure, or seeing widespread insolvencies and defaults and the collapse of a large part of the financial structure.' In Means to Prosperity in 1933 he called for international public works financed by borrowing to raise prices from their 'abnormally low level' and thus restore the capital resources of the banking system and the flow of bank loans.

A slowdown in inflation now, after a period of rapidly rising prices, would have the same effect on the financial system as falling prices did in the Twenties and Thirties, after a period of zero inflation. Today's equivalent of 'restoring' prices to their previous level would be to increase the rate of inflation. After the sacrifices of high unemployment and lost production to eliminate inflation, it would mean allowing prices to rise again to create a semblance of prosperity.

This is the solution proposed by those who are climbing back on to the Keynesian bandwagon. They say we should stop worrying about inflation 'for the time being' - we can start worrying about it again in two or three years' time. Meanwhile, we should devalue within the ERM, or leave the ERM, or the ERM should abandon low inflation as a goal. There is a vague hope that the resumption of growth will eventually have a moderating influence on prices.

But this is a frivolous approach to economic policy. It is inconceivable that Keynes would have sanctioned it. He always insisted on stable prices as the necessary condition for a stable social order.

It is unprecedented in European history that the operation of the economic system should depend on a continual rise in prices. In societies where inflation is normal, the rate will tend to be raised by wage bargaining - that is why maintaining an inflation rate above zero tends to increase unemployment. Britain requires 10 per cent unemployment to maintain an underlying inflation rate of 4 to 5 per cent, which is a measure of how the economy has deteriorated since the Fifties and Sixties. Much of Europe is in no better shape.

Keynes would have twisted and turned to find a way out of this trap. In some moods he might have said: 'Go for an almighty crash. Jack up interest rates. Keep them high enough, for long enough, to produce a fall in prices, whatever the cost in unemployment. Much of the world's business and banking would be ruined; we would all be poorer; but under the pressure of extreme hardship we might learn a better way of managing our affairs.'

I would have some sympathy for that view, because I believe self-interest cannot be enlightened unless prices are stabilised. Such a radical solution would be safer than in the Thirties because capitalism has no serious ideological rivals. On the other hand, it would destroy any hope of a decent evolution in former Communist countries, and risk social convulsion.

For Britain, where the social consequences of eliminating inflation might seem too high, Keynes would surely have proposed a National Treaty between the major economic groups to keep costs stable over two or three years. He would also have proposed public works aimed at reducing unemployment by, say, one million. After their experiences in the Eighties, the unions might not be willing to buy a national agreement on wages, but it would surely be worth trying.

Internationally, Keynes would have been attracted by a joint European-American-Japanese loan programme to reconstruct Eastern Europe and the former Soviet Union. They have a scarcity of usable capital equipment; we have a surplus.

The former Soviet Union's need for capital has been estimated at more than dollars 100bn ( pounds 52bn) a year, chiefly to rebuild infrastructure and expand energy production. Low-interest credits tied to the purchase of capital goods would create an assured export demand in the creditor countries, enabling them to expand safely together. Keynes had no quarrel with enlightened self-interest of this kind.

There is no painless route back to price stability, and postponing the task will only increase the pain. We can achieve it either by increasing unemployment or relearning the habits of co-operation. Mr Major is well placed to try the latter.

The author is chairman of the Social Market Foundation. The second volume of his biography of Keynes will be published by Macmillan in November.