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1.6 The Rise and Fall of the Keynesian Consensus

The elimination of mass unemployment during the Second World War had a

profound influence on the spread and influence of Keynesian ideas concerning

the responsibility of government for maintaining full employment. In the

UK, William Beveridge’s Full Employment in a Free Society was published

in 1944 and in the same year the government also committed itself to the

maintenance of a ‘high and stable level of employment’ in a White Paper on

Employment Policy. In the USA, the Employment Act of 1946 dedicated the

Federal Government to the pursuit of ‘maximum employment, production

and purchasing power’. These commitments in both the UK and the USA

were of great symbolic significance although they lacked specific discussion

of how such objectives were to be attained. In the case of the UK, Keynes

thought that the Beveridge target of an average level of unemployment of 3

per cent was far too optimistic although there was ‘no harm in trying’ (see

Hutchison, 1977). Nevertheless the post-war prosperity enjoyed in the advanced

economies was assumed to be in large part the direct result of Keynesian

stabilization policies. In the words of Tobin who, until his death in 2002, was

the USA’s most prominent Keynesian economist:

A strong case has been made for the success of Keynesian policies. Virtually all

advanced democratic capitalist societies adopted, in varying degrees, Keynesian

strategies of demand management after World War Two. The period, certainly

between 1950 and 1973, was one of unparalleled prosperity, growth, expansion of

world trade, and stability. During this ‘Golden Age’ inflation and unemployment

were low, the business cycle was tamed. (Tobin, 1987)

In a similar vein, Stewart (1986) has also argued that:

the common sense conclusion is that Britain and other Western countries had full

employment for a quarter of a century after the war because their governments

were committed to full employment, and knew how to secure it; and they knew

how to secure it because Keynes had told them how.

It is also the case that before the 1980s it was conventional wisdom that real

output had been more stable in the USA ‘under conscious policies of built-in

and discretionary stabilisation adopted since 1946 and particularly since 1961’

compared to the period before the Second World War (Tobin, 1980a). This

was one of the most widely held empirical generalizations about the US

economy (Burns, 1959; Bailey, 1978). However, Christina Romer, in a series

of very influential papers, challenged the conventional macroeconomic wisdom

that for the US economy, the period after 1945 had been more stable

than the pre-Great Depression period (see C. Romer, 1986a, 1986b, 1986c,

1989, 1994). Romer’s thesis, expressed in her 1986 papers, is that the business

cycle in the pre-Great Depression period was only slightly more severe

than the instability experienced after 1945. In a close examination of data

relating to unemployment, industrial production and GNP, Romer discovered

that the methods used in the construction of the historical data led to systematic

biases in the results. These biases exaggerated the pre-Great Depression

data relating to cyclical movements. Thus the conventional assessment of the

historical record of instability that paints a picture of substantial reductions in

volatility is in reality a popular, but mistaken, view, based on a ‘figment of

the data’. By creating post-1945 data that are consistent with pre-1945 data

Romer was able to show that both booms and recessions are more severe

after 1945 than is shown in the conventional data. Romer also constructed

new GNP data for the pre-1916 era and found that cyclical fluctuations are

much less severe in the new data series than the original Kuznets estimates.

Thus Romer concludes that there is in fact little evidence that the pre-1929

US economy was much more volatile than the post-1945 economy. Of course

this same analysis also implies that the Great Depression was an event of

‘unprecedented magnitude’ well out of line with what went before as well as

after. As Romer (1986b) writes, ‘rather than being the worst of many, very

severe pre-war depressions, the Great Depression stands out as the unprecedented

collapse of a relatively stable pre-war economy’. In other words, the

Great Depression was not the norm for capitalism but a truly unique event.

Although initially critical of Romer’s findings, DeLong now accepts that

Romer’s critique is correct (DeLong and Summers, 1986; DeLong, 2001; see

also the DeLong and Romer interviews in Snowdon, 2002a).

In a recent paper Romer (1999) has surveyed the facts about short-run

fluctuations relating to US data since the late nineteenth century. There she

concludes that although the volatility of real macroeconomic indicators and

average severity of recessions has declined only slightly between the pre-

1916 and post-1945 periods, there is strong evidence that recessions have

become less frequent and more uniform. The impact of stabilization policies

has been to prolong post-1945 expansions and prevent severe economic downturns.

However, there are also examples of policy-induced booms (for example

1962–9 and 1970–73) and recessions (for example 1980–82) since 1945 and

this is what ‘explains why the economy has remained volatile in the post-war

era’.

Even if we accept the conventional view that the post-war economy has

been much more stable than the pre-1914 era, not everyone would agree that

there was a Keynesian revolution in economic policy (the opposing views are

well represented in Stein, 1969; Robinson, 1972; Tomlinson, 1984; Booth,

1985; Salant, 1988; Laidler, 1999). Some authors have also questioned whether

it was the traditional Keynesian emphasis on fiscal policy that made the

difference to economic performance in the period after 1945 (Matthews,

1968). What is not in doubt is that from the end of the Second World War

until 1973 the industrial market economies enjoyed a ‘Golden Age’ of unparalleled

prosperity. Maddison (1979, 1980) has identified several special

characteristics which contributed to this period of exceptional economic performance:

1. increased liberalization of international trade and transactions;

2. favourable circumstances and policies which contributed to producing

low inflation in conditions of very buoyant aggregate demand;

3. active government promotion of buoyant domestic demand;

4. a backlog of growth possibilities following the end of the Second World

War.

As Table 1.2 indicates, growth of per capita GDP in Western Europe, which

averaged 4.08 per cent during the period 1950–73, was unprecedented. Although

Crafts and Toniolo (1996) view the ‘Golden Age’ as a ‘distinctly

European phenomenon’, it should be noted that the growth miracle also

extended to the centrally planned economies: Latin America, Asia and Africa.

During this same period growth of per capita GDP in Japan was nothing less

than exceptional, averaging 8.05 per cent. Table 1.3 presents data on growth

Table 1.2 Growth of per capita GDP, world and major regions, 1820–1998

(annual average compound growth rates)

Region 1820–70 1870–1913 1913–50 1950–73 1973–98

Western Europe 0.95 1.32 0.76 4.08 1.78

Western offshoots* 1.42 1.81 1.55 2.44 1.94

Japan 0.19 1.48 0.89 8.05 2.34

Asia (excluding –0.11 0.38 –0.02 2.92 3.54

Japan)

Latin America 0.10 1.81 1.42 2.52 0.99

Eastern Europe and 0.64 1.15 1.50 3.49 –1.10

former USSR

Africa 0.12 0.64 1.02 2.07 0.01

World 0.53 1.30 0.91 2.93 1.33

Source: Maddison (2001), Table 3-1a.

Table 1.3 Growth rates (GDP), 1820–1998

Country 1820–70 1870–1913 1913–50 1950–73 1973–98

France 1.27 1.63 1.15 5.05 2.10

Germany 2.01 2.83 0.30 5.68 1.76

Italy 1.24 1.94 1.49 5.64 2.28

UK 2.05 1.90 1.19 2.93 2.00

USA 4.20 3.94 2.84 3.93 2.99

Canada 4.44 4.02 2.94 4.98 2.80

Japan 0.41 2.44 2.21 9.29 2.97

Source: Adapted from Maddison (2001).

rates of GDP for the G7 for the same five sub-periods over the period 1820–

1998. The table further demonstrates the historically high growth performance

achieved during the period 1950–73, especially in France, Germany, Italy and

Japan (see Chapter 11).

Whatever the causes, this ‘Golden Age’ came to an end after 1973 and the

economic problems of the 1970s brought the Keynesian bandwagon to an

abrupt (but temporary) halt. The acceleration of inflation, rising unemployment

and a slowdown in economic growth (see Tables 1.3–1.5) during the

1970s were attributed, by Keynesian critics, to the misguided expansionary

policies carried out in the name of Keynes. Taking the 1960–2002 period as a

Table 1.4 Unemployment rates, 1964–2002

USA Canada Japan France Germany Italy UK

1964 5.0 4.3 1.1 1.4 0.4 4.3 2.6

1965 4.4 3.6 1.2 1.5 0.3 5.3 2.3

1966 3.6 3.3 1.3 1.8 0.2 5.7 2.2

1967 3.7 3.8 1.3 1.9 1.3 5.3 3.3

1968 3.5 4.4 1.2 2.7 1.5 5.6 3.1

1969 3.4 4.4 1.1 2.3 0.9 5.6 2.9

1970 4.8 5.6 1.1 2.5 0.8 5.3 3.0

1971 5.8 6.1 1.2 2.7 0.9 5.3 3.6

1972 5.5 6.2 1.4 2.8 0.8 6.3 4.0

1973 4.8 5.5 1.3 2.7 0.8 6.2 3.0

1974 5.5 5.3 1.4 2.8 1.6 5.3 2.9

1975 8.3 6.9 1.9 4.0 3.6 5.8 4.3

1976 7.6 7.1 2.0 4.4 3.7 6.6 5.6

1977 6.9 8.1 2.0 4.9 3.6 7.0 6.0

1978 6.1 8.4 2.2 4.7 3.0 5.3 5.7

1979 5.8 7.5 2.1 5.3 2.7 5.8 4.7

1980 7.2 7.5 2.0 5.8 2.6 5.6 6.2

1981 7.6 7.6 2.2 7.0 4.0 6.2 9.7

1982 9.7 11.0 2.4 7.7 5.7 6.8 11.1

1983 9.6 11.9 2.7 8.1 6.9 7.7 11.1

1984 7.5 11.3 2.7 9.4 7.1 7.9 10.9

1985 7.2 10.7 2.6 9.8 7.2 8.1 11.2

1986 7.0 9.6 2.8 9.9 6.5 8.9 11.2

1987 6.2 8.8 2.8 10.1 6.3 9.6 10.3

1988 5.5 7.8 2.5 9.6 6.2 9.7 8.5

1989 5.3 7.5 2.3 9.1 5.6 9.7 7.1

1990 5.6 8.1 2.1 8.6 4.8 8.9 6.9

1991 6.8 10.3 2.1 9.1 4.2 8.5 8.6

1992 7.5 11.2 2.2 10.0 6.4 8.7 9.7

1993 6.9 11.4 2.5 11.3 7.7 10.1 9.9

1994 6.1 10.4 2.9 11.8 8.2 11.0 9.2

1995 5.6 9.4 3.1 11.4 8.0 11.5 8.5

1996 5.4 9.6 3.4 11.9 8.7 11.5 8.0

1997 4.9 9.1 3.4 11.8 9.7 11.6 6.9

1998 4.5 8.3 4.1 11.4 9.1 11.7 6.2

1999 4.2 7.6 4.7 10.7 8.4 11.3 5.9

2000 4.0 6.8 4.7 9.3 7.8 10.4 5.4

2001 4.7 7.2 5.0 8.5 7.8 9.4 5.0

2002 5.8 7.7 5.4 8.7 8.2 9.0 5.1

Notes: Standardized unemployment rates (percentage of total labour force up to 1977, thereafter

percentage of civilian labour force).

Source: OECD, Economic Outlook, various issues.

Table 1.5 Inflation rates, 1964–2002

USA Canada Japan France Germany Italy UK

1964 1.3 1.8 3.8 3.2 2.4 5.9 3.2

1965 1.6 2.5 6.6 2.7 3.2 4.5 4.8

1966 3.0 3.7 5.1 2.6 3.6 2.2 3.9

1967 2.8 3.6 4.0 2.8 1.6 1.6 2.4

1968 4.2 4.1 5.4 4.6 1.6 1.5 4.7

1969 5.4 4.5 5.2 6.0 1.9 2.4 5.5

1970 5.9 3.4 7.7 5.9 3.4 5.0 6.4

1971 4.3 2.8 6.4 5.4 5.2 4.9 9.4

1972 3.3 4.8 4.8 6.1 5.5 5.8 7.1

1973 6.2 7.6 11.6 7.4 7.0 10.8 9.2

1974 11.0 10.8 23.2 13.6 7.0 19.0 15.9

1975 9.2 10.8 11.9 11.8 5.9 17.2 24.1

1976 5.8 7.6 9.4 9.6 4.3 16.7 16.7

1977 6.5 8.0 8.2 9.5 3.7 18.5 15.9

1978 7.6 8.9 4.2 9.3 2.7 12.1 8.2

1979 11.2 9.1 3.7 10.6 4.1 14.8 13.4

1980 13.5 10.2 7.8 13.5 5.4 21.2 18.1

1981 10.4 12.5 4.9 13.3 6.3 19.6 11.9

1982 6.2 10.8 2.7 12.1 5.3 16.5 8.7

1983 3.2 5.9 1.9 9.5 3.3 14.7 4.6

1984 4.3 4.4 2.3 7.7 2.4 10.8 5.0

1985 3.6 4.0 2.0 5.8 2.2 9.2 6.1

1986 1.9 4.2 0.6 2.6 –0.1 5.8 3.4

1987 3.7 4.4 0.1 3.3 0.2 4.7 4.2

1988 4.1 4.0 0.7 2.7 1.3 5.1 4.9

1989 4.8 5.0 2.3 3.5 2.8 6.3 7.8

1990 5.4 4.8 3.1 3.4 2.7 6.4 9.5

1991 4.3 5.6 3.2 3.2 3.5 6.3 5.9

1992 3.0 1.5 1.7 2.4 1.7 5.2 3.7

1993 3.0 1.8 1.3 2.1 5.1 4.5 1.6

1994 2.6 0.2 0.7 1.7 4.4 4.1 2.5

1995 2.8 2.2 –0.1 1.8 2.8 5.2 3.4

1996 2.9 1.6 0.1 2.0 1.7 4.0 2.5

1997 2.3 1.6 1.7 1.2 1.4 2.0 3.1

1998 1.6 1.0 0.7 0.7 1.9 2.0 3.4

1999 2.2 1.7 –0.3 0.5 0.9 1.7 1.6

2000 3.4 2.8 –0.7 1.7 0.6 2.5 2.9

2001 2.8 2.5 –0.7 1.6 2.0 2.8 1.8

2002 1.6 2.3 –0.9 1.9 1.3 2.5 1.6

Notes: Percentage change over previous year of consumer prices (calculated from indexes).

Source: International Monetary Fund, International Financial Statistics, various issues.

whole, on average in the ‘Golden Age’ both unemployment and inflation

were low. In the period 1983–93, inflation came down but unemployment

remained stubbornly high in many countries, especially in Western Europe

where high unemployment has been attributed by some economists to hysteresis

effects and/or various labour market rigidities (see Chapter 7). In the

most recent period, 1994–2002, inflation was low but unemployment remained

high in Western Europe while it declined in the USA. But only in the

period 1973–83 do we see the simultaneous combination of high unemployment

and high inflation, i.e. stagflation. To the critics of Keynesianism

stagflation was an inevitable legacy of the ‘Golden Age’ of demand management

(Friedman, 1975; Bruno and Sachs, 1985; DeLong, 1997; see also

Cairncross and Cairncross, 1992, for a discussion of the legacy of the 1960s).