Keynesian versus neo-classical policies - A never ending struggle?

I find it both entertaining and fruitful how prestigious economists have gotten into fierce fights about the right approach on how to handle the economy. If you have a lot of time, you can read through Krugman’s How did economists get it so wrong and if you are still interested afterwards read through Levin’s open letter response. What is the whole struggle all about? Mr. Krugman claims that markets do not function without heavy government intervention and current models based on rational behavior are basically worthless. This questions the merits of a whole generation of economists and fierce criticism will inevitably follow such statements.

So who is right and who is wrong? It seems that, all the progress in technical modeling aside, economics will always be divided into two opposing views. One, based on the insight of Keynes of the 1930s, will propose state intervention in order to mitigate the amplitude of business cycles. The other, often called “neo-classical” school, will advocate a minimal role of the government that interferes as little as possible with the economy. There are a plethora of approaches somewhere in between imaginable and for the most part economic policy will not opt for one of the extremes. Although scholars have coined the term “neoclassical synthesis”, which means combining both views into one single approach, such a synthesis in the Hegelian tradition is a far cry.

The changes of political sentiment towards one of the two options seems to be almost as cyclical as the economy itself. After the Keynesian revolution, many economists believed they had solved the riddle of business cycles and could control them from now on. Stagflation in the 1970s gave rise to the opposing view again, successfully put into practice by Ronald Reagan and Margaret Thatcher. This movement is closely connected with Milton Friedman and is often described as monetarism. Monetarism proposes that the role of the state should be reduced to providing a stable monetary policy in order to ensure price stability. Now the pendulum is about to swing into the other direction and politicians are again following the Keynesian stimulus promise. To make it clear, Keynes was never out of the picture. The Federal Reserve intervened heavily and tried to steer the economy by contracting and expanding money supply anti-cyclically.

What seems to have happened in the current crisis is that we have gotten into something economics students learn in their introductory macro courses: The liquidity trap. In short, this phenomenon describes a situation where monetary policy cannot stimulate the economy further because interest rates are already close to zero and there are no negative interest rates (well, Sweden actually thinks there are, their banks have to pay now to deposit money at the central bank). According to Keynesian theories we would need, as the only remaining option, anti-cyclical government spending or nowadays more often tossed as a “stimulus package”. This involves much more political troubles as the public takes much more notice of such actions (they feel it affects them more directly in forms of higher taxes later, although theoretically expansive monetary policy can have the same wealth effect through inflation). In addition, the central bank is politically independent and can make its policies without approval of any parliament, whereas stimulus money needs the consent of democratic representations.

Personally, I think the truth lies somewhere in the middle. Both approaches have helped economies in different periods. It is and will stay a constant struggle between the two. Thinking a bit into the future, over-regulation and heavy government intervention seem to be down the road. This already paves the way for deregulation once governments realize the growth potentials of the economy have substantially shrunken. And the pendulum swings back again….