How to Pay for the War on Covid

We still have a lot to learn from Keynes’ ideas, even under today’s new conditions. Indeed, we may be confronted with the following paradox: economies enjoying a strong recovery will be paying higher wages and salaries than before, but producing smaller quantities of consumer goods. Basically, a situation could come about whereby the economy is working at full pace, but it is impossible to supply the consumer goods that such a pace of economic output would naturally tend to demand. This is a major political issue, to be dealt with promptly.

It was the great economic crisis of 2008 that showed that Keynes was not dead and buried, despite appearances to the contrary (to judge by official economic science, as taught at universities around the world). In fact, “a quarter of an hour” was not enough to sum up (and to repudiate) his theories, as claimed not so long ago by a Nobel prize-winning economist teaching at a leading American university.

The changing fortunes of the general theory

Though “free market thinking” became the credo not only of conservatives but also of most of the Left in Europe and elsewhere, the belief that the market functions better than the state – always and under all circumstances – is also coming under fire. Actual events are giving the lie to predominant thinking. This happened following the crisis of 1929 too: the long lines of unemployed workers outside soup kitchens toppled the certainties of “an established but irrelevant orthodoxy,” as Nobel prize-winner James Tobin wrote in 1983, evoking the impact that The General Theory of Employment, Interest and Money had had on young American economists, upon its publication in 1936. As we know, the apotheosis of Keynes’ influence in the academic and economic policy worlds occurred in the thirty years following World War ii. During those trente glorieuses années – as they came to be known – countries on both sides of the Atlantic experienced the surge of individual incomes as well as the growth of social security networks. These features gave Western societies such an attractive human face as to become one of the most relevant causes of the collapse of communist regimes and, more in general, of the abandonment of the idea that there could exist a successful alternative to adopting a market economy. French historian Francois Furet put it bluntly after the fall of the Berlin wall: for the first time in 150 years, no alternative system would challenge representative democracy and market capitalism. During the trente glorieuses, Keynesian macroeconomics was an established and uncontroversial doctrine taught at universities, while governments and international bodies – from the OECD to the IMF and the European Economic Community – regarded the Keynesian array of monetary and fiscal policies as a normal component of the economic policy arsenal.

Starting in the 1970s, however, new problems such as inflation and stagflation – that is, unemployment combined with inflation – seemed to defy both theoretical explanation and the armory of Keynesian economic policy.

The protracted intellectual efforts of brilliant economists such as Friedrich von Hayek and Milton Friedman thus rehabilitated the orthodoxy overthrown by Keynes’ General Theory. This seemed not like a pendulum swing, but like the final elimination of a heresy that had temporarily seized hold of people’s minds. Indeed, in 1983, at a conference convened on the centenary of Keynes’ birth, Paul Samuelson – one of the first and most important Keynesian economists in the United States – disowned that legacy: “It’s true”, he said, “that markets don’t function perfectly in the short term, and economic policy interventions can have major effects for a while. But these days people are learning fast, and the easy Keynesian victories are far behind us.” And yet, 25 years later, the explosion of the 2008 crisis forced Samuelson to change his mind again: “The cause of the worst financial crisis of the past hundred years is to have granted free rein to the libertarian capitalism of Friedman-Hayek’s ‘laissez-faireism’ […]. Those two men are dead, but their poisoned legacy lives on.”

The great return of keynesian instruments

The year 2008 marked the end of the renewed primacy of orthodox economics, and the pandemic of 2020-21 further reinforced its demise, at least with regard to economic, monetary and fiscal policies. After the trente glorieuses, following the second world war, and then after the subsequent thirty years – marked by a return to orthodoxy – the world of politics, economics and finance came to see that the market cannot eliminate risk; uncertainty and economic fluctuations are an inevitable part of the market.

Probably it is not possible to prevent sudden and unexpected crises, but governments and central banks must be ready to step in as soon as the threat of a major crisis materializes. The instruments of economic policy formulated by Keynes take account precisely of that fact.

Nevertheless, university teaching has remained more or less the same as it was during the years of orthodoxy. I doubt that universities have abandoned mathematical models based on the assumption that there is perfect knowledge of the future and perfectly functioning markets. The world of academia has seen no real “return of the master” (to quote the title of a book on Keynes by Robert Skidelsky). There has, however, been a return to Keynesian ideas and to the economic policy instruments deriving from those ideas, in the policies of governments and central banks.

What is the policy of low or even negative interest rates introduced by central banks after the 2008 crisis, if not the fulfillment of a Keynesian hope? What is quantitative easing? And what inspired the major deficit public spending programs launched by Joe Biden? In Europe, what is the significance of the suspension of the Stability Pact during the pandemic? And what is Next Generation EU, if not an economic recovery policy based on deficit spending?

So Keynes is back, if not in theory, then certainly in practical inspiration for central bankers and governments alike.

He has been resuscitated in the form of a set of monetary and fiscal instruments which central banks and governments are willing to use if economies suffer from low employment and struggle to keep the economy going. It is no coincidence that, following the outbreak of the Covid-19 pandemic (in an article published by the Financial Times), Mario Draghi was the first to argue for the full use by central banks and governments of Keynesian economic policy instruments.

We still need to take stock of the pandemic. It is causing a two-fold crisis – on the supply side and on the demand side – and the two are strictly linked to each other. The restrictions required in order to control the spread of the illness are hampering supply, but this also has an impact on the incomes of workers and businesses. This impact, in turn, negatively affects aggregate demand. Curing the depression caused by the pandemic involves the use of both monetary and fiscal policy instruments, in a somewhat different combination from what would be adopted in the event of a “simple” fluctuation in aggregate demand. It involves defining an economic policy which combines interventions on both the demand and the supply sides.

The present paradox: recovery with low consumption

But this is not all—far from it. There is widespread agreement both in governments and among economists that our economies need to undergo a radical transformation. We need to combine policies aimed at economic recovery after the fall in GDP due to the pandemic with policies aimed at transforming the economic system entirely. There is agreement on the need to reinforce our health systems and to spend more on research in this area. In the meantime, people have become conscious of the need to face environmental and climate issues, while moving at the same time in a digital direction. So while on the one hand the economic crisis due to Covid requires policies to support demand – implemented by means of Keynesian instruments, monetary policies and public finance – on the other, it calls for a far-reaching transformation of our productive structures to adapt them to present and future conditions.

If special attention will have to be paid to health spending, if investments will have to be made in the digital economy, if industrial activities will have to be transformed in the direction of the green economy, then it follows that we are calling for huge investment programs. Such programs would also greatly contribute to solving unemployment problems caused by Covid. But another very serious problem will emerge as well: one relevant to consumption, which no one seems to have noticed so far.

To put the question in its essential terms, post-Covid economies might be able to return quickly to full employment. By projecting the high growth rates of this period, perhaps even countries like Italy – where the unemployment problem is “structural” – might be able to attain levels of employment never seen before. This is possible and perhaps even probable if fiscal and monetary policies maintain their present stance.

But another question is bound to arise: the goods that will be produced might be different from the goods demanded by a full employment society.

If we invest solidly in environmental projects or in health projects, we might go towards full employment of the available workforce. Such a society will want to consume goods which will not be available, at least not to the extent that the market would demand. A conflict will arise as to the destination of productive resources. Will they be devoted to satisfying the demand for consumer goods, thus preventing the transformation of the productive system? Or will resources be devoted to those aims, thus leaving an unsatisfied demand for consumer goods?

If we need to allocate huge resources to the production not of consumer goods but of investment goods, at least for some time, then we may paradoxically have economies functioning at full pace, paying higher salaries and wages than before, and yet producing smaller quantities of consumer goods. Basically, a situation could come about whereby the economy is functioning at full pace, but it is impossible to provide the consumer goods normally required by such a pace of economic activity.

Political issues

This is a new (or perhaps old?) problem that needs to be examined and discussed. It is a difficult one, because its solution cannot be entrusted – at least not exclusively – to market mechanisms. Such a choice would clearly create difficult political problems.

Let us consider the economic and political aspects separately. At the economic level, as I have said, we need to govern overall income trends in order to avoid inflationary pressures, but we also need to ensure that the composition of the resulting demand corresponds to the supply situation—something we consider essential. But this problem has a complex political aspect: to say that we can make the system function with full employment but that we cannot guarantee that the output will have the composition that would naturally emerge if everyone were free to spend their incomes as they pleased, is tantamount to saying that we must impose an intertemporal choice that will benefit future generations but that will certainly limit, if not harm, the consumption opportunities of present generations. How are we to tackle this problem?

Our deliberations about the transformation of economies – necessitated not only by the pandemic but also by environmental demands and by the requirements imposed by technological progress – thus become political deliberations.

How can we steer a free society in this direction? One answer that was given fifty years ago to a different problem, but one with some similar characteristics, was called “incomes policy”. This policy was designed to control domestic price trends in relation to international price trends. Even back then, some observers identified a more complex aspect of this issue—namely, a possible inconsistency between a division of output between consumer and investment goods suited to the medium-term requirements of the economy, on the one hand, and a composition of output that would result from people’s freedom to spend their income however they pleased, on the other. Societies acknowledge – albeit reluctantly – that part of the income generated will be taken by the state to meet the cost of producing collective goods. But apart from this, what kinds of consumption should be reduced and which sectors of society should reduce their own consumption to permit the investments required to transform the economies?

Paying for the war

This is the economic and political problem posed by the present state of our economies. It has emerged as we have entered the era of effective policies to deal with climate change and the digital revolution, and it has been exacerbated by Covid. There is a pamphlet by John Maynard Keynes dating back to February 1940 which helps define the problem we will be dealing with now. While Keynes’ main preoccupation in the Twenties and Thirties was how to prevent and fix cyclical downturns and the ensuing unemployment, in his pamphlet How to Pay for the War, he concentrated on a completely different problem. He argued that in wartime the mobilization effort will most likely produce full employment. But the problem which arises is that people will be mostly engaged in producing goods needed by the war effort—weapons, means of transportation needed to move the troops and the weapons, medical supplies, consumption goods needed to feed the armies and so forth. If people were paid their full wages and salaries they were likely to want to purchase consumption goods that were not available. Inflation would be a form of tax which would compress purchasing power to fit with the availability of consumption goods.

Keynes suggested that instead of leaving inflation to do the job, one could devise a system of deferred pay: people would receive a lower income today, so that the purchasing power would stay within the limits of the supply of consumption goods. The deferred pay would then be given to people after the end of the war, so that they could provide an additional demand which would help the transformation of the economy, from war to peace.

Keynes’ proposal was basically a precursor of the “incomes policies” idea that failed during the post-war years. And yet they could again prove necessary, should we find ourselves confronted with the need for a structural transformation of our economies.

As a matter of fact, the trade unions and the Labor Party flatly rejected Keynes’ proposal at the time. The same fate was suffered by suggestions that “incomes policies” might be needed. And yet the problem exists and might pose itself again very soon. From an economic point of view, the question is: who is going to assess the composition of demand? Politically, who is entitled to take decisions on this? Are the trade unions the official representatives of workers as consumers? Or should parliament discuss and decide on these matters? It is obvious that authoritarian regimes are in an easier position with respect to such problems. If China decides to concentrate on capital accumulation – as it has over the last thirty years – no one can dispute this decision. But in democratic systems? How do we assess the claims of the present generation as opposed to the claims of coming generations?

We must reconsider this idea of Keynes’ and decide whether – and if so how far – it can be adapted to the problems that face us.

The prominent Italian academic economist, Giorgio Lunghini, who died before his time, once called Keynesian theories a “latent legacy”. And so they are. Keynes’ writings contain valuable lessons that have only been partially understood and utilized. To deal with the problems of our societies today, it might behoove us to fully understand and utilize those lessons.


This article appeared in Aspenia.it.

Aspenia international 93-94

Giorgio La Malfa

is an economist who completed a fresh Italian translation of John Maynard Keynes’ magnum opus, The General Theory of Employment, Interest and Money, in 2019.

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