Thanks to a very helpful episode of This American Life (#373, The New Boss), I now have a much better idea of the varying viewpoints on the New Deal and its effects.
Basically, Keynes’s general theory (which I’d been reading a lot about, without being entirely clear what it meant) said that if the economy goes into a downward spiral, and for whatever reason, the usual supply-and-demand does not seem to turn it around, government spending can work as a stop-gap.
FDR’s New Deal was Keynesian, but not really, because he never spent nearly as much as Keynes advised, and he also raised taxes and tried to balance the budget, which Keynes was hugely against. But then World War II came along, and FDR was forced to spend sufficiently.
Now, a number of economists (including Tyler Cowen, whose blog, Marginal Revolution, I regularly read without comprehension) disagree that Keynesian spending ended the Great Depression. Cowen points out that, while GDP was up because of wartime manufacturing and unemployment down because of enlisting, those figures are misleading, because people were still broke, and also dying. In terms of standard of living, WWII made the Depression worse.
The general consensus among economists at the time, however, was that Keynesian spending had ended the Great Depression, so until the 70s, Keynesian theory was the dominant school. However, Keynes had intended his ideas for times of economic uncertainty. Economists now thought they could completely control the economy and eliminate recessions by cutting taxes and increasing spending whenever the economy slowed down, and doing the opposite when things were going well – like tweaking a gauge. Meanwhile, politicians thought Keynesian theory gave them a free pass to spend as much as they wanted, so government just spent insanely on everything, raising the deficit.
Then, in the 70s, this stopped working. There was high unemployment, and no matter how much the government spent, inflation only got worse. In 1977, the Cato Institute was founded, and everybody decided Keynes had been wrong. A number of anti-Keynesian theories sprouted up (including the supply-siders, the Chicago school, and the monitors). The general idea was that the best way to control the economy is to have the Fed raise and lower interest rates. Not spending, not taxes – everything should be left up to the central bank.
Then, on December 16, 2008, the Fed lowered interest rates to 0% and the economy kept getting worse. So nobody knew what to do.
Keynes had an actual formula for this situation, in which you estimate what the economy would be producing at full-steam, then look at what the economy is actually producing, and figure out the difference (the short fall). The theory is that government spending or tax cuts will increase all spending and the economy will recover. But the government needn’t spend the entire amount of the difference, because what it spends produces more than that value as it spreads throughout the economy, which is called the Keynesian multiplier. This formula was what led Those What Do the Deciding to the ballpark stimulus figure.
But nobody really knows if this will work. The current stimulus is a good test of Keynesian theory, and if the economy is back on track in a year or so, Keynes will have been vindicated. Some economists think that a recession is simply the market self-correcting itself – it’s bringing inflated prices down, and should not be cured at all. Another objection is that a stimulus might end the recession, but result in even bigger inflation (plus debt and a larger, less efficient government) in the future.
