3.3 Why the State Grew Gigantic
3.3.2 The Impact of Keynesian Ideas and
The economic crisis was accompanied by high and prolonged unemployment, creating new challenges for economists. In the USA, during the years of the New Economic Policy of Roosevelt, it was argued that there is a strong inverse correla- tion between public spending in infrastructure and unemployment.8A similar view prevailed in Europe. For example, in 1927, Sweden established a committee to investigate the causes of and ways to reduce unemployment, which included such eminent economists like Myrdal, Ohlin and Lindahl. The committee recommended state investments in public infrastructures to stimulate effective demand, along with measures to balance the public budget after the end of the business cycle (i.e. the deficits in the downward phase of the business cycle ought to be balanced with surpluses in the rising phase).9Also, according to Gravy (1975), in Germany, in the early 1930s, there were economists who proposed that the state ought to increase public spending to fight unemployment.
The economist, who changed radically the prevailing view on the use of eco- nomic policy as a means of smoothing the conjectural imbalances of the economy, was J. M. Keynes. Moving away from the views of classical and neoclassical economists, Keynes (1936) advocated for an economic policy that had interventionary rather than regulatory objectives. He emphasised the need for strong state intervention in cases of either prolonged unemployment, which emanated from losses in the flexibility of prices or from a slowdown in private investment due to pessimism in the business environment. According to the analy- sis presented by Karayiannis (2008), Keynes considered innovating entrepreneur- ship as the most decisive factor in economic growth and employment expansion.10
8See, for example, Clark (1935) and Walker (1935).
9In particular, see Myrdal (1939, 68, 70, 72, 77) and Lindahl (1939, 367).
10Famous is the reference of Keynes (1936, 162) to “animal spirits”, which are responsible for
“inciting spontaneous action” on the part of individuals and which if “dimmed and the spontaneous optimism falters, leaving us to depend on nothing but mathematical expectation, enterprise will fade and die”.
So, while he was adamantly opposed to initiatives by the state which encouraged rent-seeking entrepreneurship, he recommended the introduction of institutional arrangements to create an optimistic business climate. Only in instances where such efforts failed to bring about the expected results did he suggest (1936, 220, 378–80) the expansion of public debt to finance productive investment, such as infrastruc- ture, or to cover the difference between savings and investment. It is worth noting that Keynes never retracted his support for such kinds of public investment (see Keynes and Henderson (1929)). In Keynes (1942b, 277–8), he distinguished between current government spending and government spending for capital invest- ment by stating the following:
I should aim at having a surplus on the ordinary Budget, which would be transferred to the capital Budget, thus gradually replacing dead-weight debt by productive or semi- productive debt. . .But I should not aim at attempting to compensate cyclical fluctuations by means of the ordinary Budget. I should leave this duty to the capital Budget.
Keynes (1944, 366–7) made a similar proposal to the committee on public spending in the United Kingdom for the purpose of achieving balanced budgets. In contrast to what is asserted at times, he did not propose the increase of taxation to reduce unemployment, since such a policy would reduce effective demand, add a major disincentive to the economic activities of individuals and increase tax evasion (Keynes 1936, 373). Also, in various writings addressing the issue of overcoming the economic crisis, he stressed that any increase in public spending should be used solely for investment and production purposes and not for consumption (e.g. gifts to veterans of wars) for two reasons: first, because the repayment of interest and loans increases public debt since the returns from public consumption expenditures are small and, second, because the multiplier effects on employment are far greater when resources are used for investment.11 Realising the dangers of heavy state interventions, he suggested that public investments ought to be undertaken with extreme caution and subject to scientific scrutiny by a panel of economists not associated with the policies of the government since, as argued by Petridis and Karayiannis (2001), he considered politicians insufficiently qualified and unfit to undertake such a project. Moreover, in his work How to Pay for the War (1939–1940), he pointed out the dangers of increasing public debt since in his view, it reduces the incentives of individuals to work and creates inflation. From the above, we surmise that, if Keynes were alive today, he would not agree with the expansion of the public sector, either through funding consumer spending or
11As a matter of fact, in one occasion that he had to convince politicians to increase government spending, while maintaining a balanced budget, Keynes (1931, 236) proposed to postpone paying social benefits and instead spend the funds in public infrastructure to reduce unemployment. This explains why in the open letter he wrote to US President Roosevelt, Keynes (1933b, 36) noted:
It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads.
the proliferation of public enterprises and organisations.12The economic policies that were designed and applied after the Second World War, which contributed to the spectacular enlargement of the state, would not gain his support. Ironically, many policies that were implemented in his name reflect the views of his descendants and not his own.13
Keynes ideas and recommendations spread rapidly for a number of reasons.
First, they served the best interests of politicians who wished to expand their powers, especially as it pertained to the economy. Second, they gave hope to the unemployed and ordinary citizens through the concept of the state as a caretaker who is concerned about their welfare; third, they enabled labour unions to seek higher wages since the stimulation of the effective demand was expected to increase employment. In Europe, many proponents of strong state intervention not only adopted Keynes ideas and recommendations wholeheartedly but also ignored his warnings, frequently misinterpreting and misrepresenting the conditions that he had set for their implementation.14 Proponents included the Fabian Society, the Labour Party, which came to power in the United Kingdom after the war,15and Beveridge (1944), who proposed the adoption of a new regime for state intervention and provision of welfare services16 in order to prevent the appearance of massive unemployment after the war.17Setting 3 % as a minimum acceptable rate for unemployment, Beveridge concluded that the state had a duty to achieve this rate at any cost, even if it meant placing restrictions on property rights that had been adopted widely by various governments since 1946. A minimum
12As Keynes and Henderson (1929, 114) emphasized:
For the object is not to develop state enterprise as such. The object is to develop and equip the country through the instrumentality of such forms of organisation as already exist and lie ready to hand.
13Congdon (2007, 33–43) notes that renowned descendants of Keynes, such as Robinson, Harrod and Kaldor, expounded economic policies which were based more on their own socialist ideas and less on the writings of Keynes. For this reason, when referring to these policies below, we shall call them “Keynesian” to indicate that they differ from the policies suggested by Keynes.
14Leijonhufvud (1968) explains in detail the differences in the economic thought of Keynes and the economic models and ideas that were developed by Keynesians. Also, Booth (1983) demonstrates the deviations of “Keynesian” economic policies from those of Keynes in the UK immediately after the Second World War. In the same spirit, Tily (2003) criticises the followers of Keynes who distanced themselves from the substance of Keynes’s proposals for a monetary management of crises and insisted on the implementation of expansionary fiscal policies.
15Durbin (1989) explains how various positions of Fabian socialism influenced the economic policy agenda of the Labour Party.
16Unlike his followers, Keynes (1942a, 204–5) expressed serious reservations about the expansion of social welfare (mainly pensions), which would add a significant burden on the public budget, as it was proposed by Beveridge in 1942.
17It is worth noting that leading economists, such as Kaldor (1944) and Haavelmo (1945), suggested that, with balanced budgets, the transfer of resources through taxation from individuals to the state would have major positive effects on the growth of aggregate demand and hence on the absorption of unemployment.
unemployment rate policy was adopted by the United Kingdom, Australia, New Zealand, Canada, Norway, France, Belgium and Holland. The policy was even supported by the United Nations Convention in Havana in 1948, which decided that the states ought to aim at full employment.18Butting this trend was West Germany, where the economy was allowed to operate freely.
The Germans were not keen to adopt policies of state socialism, because they had experienced the negative effects of their implementation by Nazis, and sympathisers of other forms of socialism and the communists had been persecuted by Hitler. The USA may have also influenced the Germans, by encouraging the establishment of a free market economy, since the USA foresaw that West Germany could serve as a bulwark against the expansionist ambitions of the Soviets. Moreover, the free market economy had many friends and defenders.
The famous School of Freiburg, as well as politicians like Chancellor Erhart, embraced the ideas and economic policy proposals advanced by members of this School19and exerted strong influence.
In the USA, Keynes’ ideas and recommendations were popularised by many economists, including Hansen (1947, 1954), Lerner (1943, 1944) and Musgrave (1945). As was the case in Europe, supporters of Keynesianism in the USA emphasised the positive aspects of the new doctrine while failed to stress Keynes’
qualifications. The government in the USA did not rush to adopt Keynesian policies immediately after the Second World War.20 Such policies were implemented mainly between 1961 and 1969. During that period, several well-known economists, like Samuelson, Galbraith and Solow, advised the government to adopt active policies aimed at boosting effective demand and redistributing income, if needed.
As the prevailing climate was characterised by an urgency to increase govern- ment spending, many early Keynesian perceived that the waste of resources was an inevitable risk. Some, like Copland (1947), proposed that the resources from government debt should be directed exclusively to investments in infrastructure.
Friedman (1948) suggested that government debt should increase to the point where
18According to Rothbard (1974, 61–5), many intellectuals supported wholeheartedly the expan- sion of the state into the private economy for two reasons: first, because state authorities buy their services at lucrative remunerations and, second, because intellectuals are uncertain about the value that markets may attribute to their services.
19For further details in this respect, see Glossner (2010, 32–46).
20In particular, President Truman in his 1951Economic Report of the Presidentemphasised that:
. . .we should make it the first principle of economic and fiscal policy in these times to
maintain a balanced budget, and to finance the cost of defence on a ‘pay-as-we-go’ basis.
(Balassone and Franco 2004, 6)
Moreover, drawing on the analyses by Weinberg (1953) and Burkhead (1954), we can surmise that the USA did not adopt Keynesian policies until 1960 because, due to the optimism from the rising domestic and international consumption, private investments pushed the economy into a state of full employment of the labour force. On the contrary, many Western European countries applied strong Keynesian policies from the end of the war, which included even extensive nationalisations.
consumers would be willing to pay for public services, while Samuelson (1951) recommended that public expenditures be appraised by rigorous cost–benefit stud- ies. The dominant views on this issue can be found in a paper in the form of manifesto of principles and objectives of economic policy that was commissioned by the American Economic Association. The young but later distinguished economists Despres et al. (1950) were its authors. They proposed ways to minimise the impact of the expansion of the public sector into the private economy. Many policymakers ignored their suggestions. As a result, public expenditures and taxes rose rapidly, public budgets became permanently unbalanced, public debt increased precipitously21and the private sector in the great majority of democracies was reduced to half in the years prior to 1929.
Keynes’ ideas and recommendations, whose aim was to deal with temporary imbalances in the free market economy, were used as a springboard by supporters of social democracy to bring about a drastic increase in the size of the state.22This trend, which dominated Western style democracies until the early 1970s, took hold because many eminent economists were willing to ignore the warnings of their classical and neoclassical colleagues regarding the waste of resources, corruption, incompetence of political power and the reduction of civil liberties resulting from an uncontrolled expansion of the state in the free market economy.