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Old Prescription for Current Chaos

In times of mounting unemployment, economists cling to the legacy of John Maynard Keynes like no other, associating his name with the escape from the Great Depression and the rescue of capitalism.

In times of mounting unemployment, economists cling to the legacy of John Maynard Keynes like no other, associating his name with the escape from the Great Depression and the rescue of capitalism.

The British economist's revolutionary insight was that the economy had no self-correcting mechanism that would end a slump, that the economy like a sinking ship could founder and leave society destitute indefinitely.

The Keynesian prescription was for government to step in where dispirited businesses would not and spend borrowed money like crazy on anything that would get the unemployed back to work.

Ironically, President Franklin D. Roosevelt, closely linked to Keynes historically, never really practiced Keynesianism to its full extent because of political pressure to balance the federal budget in the 1930s, economic historians said. The U.S. economy revived only when factories revved up for World War II.

Even so, economists cite the genius of Keynes - a writer, teacher, money manager and arts patron who married a Russian ballerina - when they encourage President-elect Barack Obama and Congress to enact a massive spending bill as soon as he takes office.

"Most economists consider themselves Keynesians of one variety or another, in the sense that there is a role for active government intervention," said E. Roy Weintraub, a Duke University economics professor. But when people talk about Keynes in times like these, "they are trying to recapture an older set of meanings."

The idea is that "large-scale capital projects should be done with some sense of social community in mind," said Weintraub, who grew up in the Philadelphia area and whose father was a prominent post-Keynesian at the University of Pennsylvania.

Such public works in the 1930s included dams, electric utilities and state parks. Nowadays, Gov. Rendell and other governors are banging the drum for bridges. Some are pressing for renewable-energy projects.

Weintraub said Keynes, whose most famous book, The General Theory of Employment, Interest and Money appeared in 1936, would favor aid to the U.S. auto industry, as well as extended unemployment benefits and other government spending.

With its financial-system bailouts, the government has committed roughly $7 trillion to shove the economy back on track. That's triage, not the Keynesian economics expected from the Obama administration.

Some economists oppose Keynesian deficit spending. Daniel J. Mitchell, a senior fellow at the conservative Cato Institute in Washington, would rather see that money left in private hands.

"Government is capable of starting recessions, government is capable of dragging them out, making them worse," Mitchell said, "but not capable of making them shorter."

However, in the period since Keynesian stimulus was assimilated into economic practice after World War II, the average duration of recessions was 10 months, compared with 18 months from 1919 to 1945, according to the private National Bureau of Economic Research.

Martin D. Weiss, president of Research Inc., of Jupiter, Fla., favors government stimulus. But, he said, it is too soon. "We're not at that stage of the cycle. The best time for the government to step in," Weiss said, "is at the end."

For decades, Keynesian stimulus has been used prematurely, to prevent recessions rather than to get out of them, a maneuver that builds overconfidence and aids the formation of bubbles, George Cooper argued in The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy, published this year.

"If this were a normal cycle, I would argue that we should allow the downturn to play out for a year or so before stimulating the economy," Cooper said.. "However . . . this is not a normal cycle, and the damage to confidence is already so severe that we have already collectively learnt the lesson of irrational exuberance."

Keynes, who lived from 1883 to 1946 and whose father was an economist, would probably be delighted with all the attention he is getting. He had high expectations.

In 1935, he wrote to playwright George Bernard Shaw saying he was working on a book that would revolutionize the way the world thinks about economic problems, though not immediately.

Before Keynes, economists assumed that wages would fall enough in a downturn to stimulate hiring and that interest rates could fall far enough to stimulate investment. Keynes watched the Great Depression drag on and remade economic theory to match a world in which none of the expected happened.

But economic practice did not change overnight.

"I don't think his ideas were ever really adopted by the Roosevelt administration," said Hugh Rockoff, an economics historian at Rutgers University in New Brunswick.

In the 1930s, the biggest budget deficit as a percentage of gross domestic product was 5.9 percent in 1934, when the U.S. unemployment rate was more than 20 percent. Economists now are expecting a $1 trillion federal deficit in fiscal 2009 and 2010, or as much as 7 percent of GDP.

Keynes urged bigger spending in the 1930s. But key figures in the Roosevelt administration resisted budget deficits. "I think the financial markets would have screamed bloody murder," said Michele I. Naples, an economics professor at the College of New Jersey.

A push to balance the budget in 1937 led to another buckling of the economy, economists said. Now, a balanced budget even in relative good times is a rarity.

Naples said Keynes also had some important insights into finance. As a speculator himself, placing his bets while still in bed, he knew that the games of financiers could distort investment in the real economy.

Writing in his General Theory about the stock market, but expressing a concern equally applicable to other spheres of investment, Keynes said:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill-done."