Global Financial Crisis in 2008 and the Return of Keynes

By September 17, 2018 Economic Analysis
Crisis 2008-Keynes


The 2008 crisis finds some similarities with the Great Depression. In both cases, there were sharp and unexpected economic collapses, they both started in the United States, and both rapidly spread to the rest of the world. Today, the financial system is more complex and the economic ideas are not only sustained on a theoretical construction. In fact, nowadays there are financial interests from different institutions with different economic and political power. Keynes not only tried to expose the deficiency of the predominant ideas in his days, but he also substituted them for an alternative analysis –The General Theory-. Between World War II and his death in 1946, Keynes contributed to the creation of an institutional order in Bretton Wood that sought to avoid another crisis of similar consequences (Knoop, 2004, 39).
The Keynesian recipes worked from 1945 until 1973, when the oil crisis started a completely new scenario of coexistence of inflation and unemployment (ibid, 105). This circumstance had not been anticipated by Keynes because in 1973, for the first time, inflation was not based on demand but in cost (prices grew because energy and oil prices went up). Without economic recession and demand, prices kept rising, so demand inflation became cost inflation. For the first time, problems of unemployment and inflation coexisted and Keynes’ policies were replaced by Monetarist theories (ibid, 55).
The subprime crisis of 2008 was a new stage of the crisis that made unemployment coexists with a deflationary situation instead of with inflation, i.e. there was unemployment with lower prices and deflation. At the beginning of the crisis, deflation came with the expectation of low prices. That, along with the fact that many people lost their jobs and consequently their purchase power, delayed consumption. This situation would have jeopardized the economy as it would have made prices fall even below the production costs, with the resulting loss of the companies. However, Keynesian theory was resurrected and his policies provided a solution.

Keynes’s theoretical frame and perspective for the 2008 crisis

The 2008 crisis was a liquid assets crisis where the markets’ uncertainty played the main role in individuals’ decisions. In the General Theory, Keynes placed special emphasis on the agents’ expectations. This way, any economic forecast becomes uncertain, and crises are tied to changes in the expectation of the economic actors causing “prices reflect the market sentiment on the value of the assets rather than investors’ decisions based on discounted expected returns” (Bilginsoy, 2015, 294). According to Keynes, the investors’ expectation is not only determined by the expected efficiency of a certain asset, but by its animal spirit. Keynes believed that when uncertainty becomes higher, economic agents generally prefer liquidity overspending, and as a consequence of consumption, investment, and demand are reduced (Knoop, 2004, 43). The preference for liquidity in the subprime crisis was, therefore, a natural consequence of a dynamic economic system.
The most common explanation of a crisis for Keynes is not the rise in taxes rates, but a collapse in the efficiency of the capital. Furthermore, pessimism and instability that comes with the breakdown in the capital efficiency provoke that people prefer liquidity, which assumes a decrease in investment. (Bilginsoy, 2015, 267-268).
The tendency of Western economies in the years previous to the 2008 crisis was related to the concept of the liquidity trap, analyzed by Keynes. Liquidity among the investors generated new investments due to the high expectations of the economic boom, but the recession came, monetary policy also became very inefficient. The 2008 Crisis is also a crisis in the effective demand; this means that most people prefer liquidity. The question that arises here is how the subprime crisis originated in a financial world can have effects on the demand and the real activities of the economy. The Keynesian theory argues that the explanation is on money neutrality. The classical approach considers that changes produced in the money supply will only affect nominal variables (the price level, nominal wages, and nominal output), and not the real variables (real output, unemployment, labor, capital, and technology). This is known as money neutrality (Knoop; 2004, 36). Unlike Classical economists, Monetarists believe that this so-called money neutrality is only held in the long run. The reason for this has to do with inexact information and price misperceptions. However, for Keynes money is not neutral since it constitutes part of the banks’ liabilities. Banks have assets in the form of money because those assets will be validated by liquidity fluxes coming from companies, families, and even states. Therefore, according to Keynes money is not merely a means of exchange, but a tool to finance investments and to buy financial assets.

Keynes’ recipes for the 2008 Crisis

The financial crisis of 2008 had two main problems; unemployment and deflation. Keynes provided the answer to combat the two dilemmas simultaneously by stimulating the global demand. For such a purpose, the recipe of what should be done is simple: lower taxes, lower interest rates, raise public spending and reduce the exchange rate to make export selling more competitive (Knoop, 2004, 42).
However, today’s world has some limitations to the Keynesian model. Nowadays, the main problem is not inflation as it was in the 50’s and 60’s (ibid, 48). Furthermore, in those years, employment was always below 8% (ibid). In Western countries, especially within the frame of the European Union, the monetarism and dominant discourse has been to restrict budgets, cut public spending, and raise taxes. Despite this, the solution from a Keynesian perspective is quite different: lower taxes and increase spending. The problem is that by doing this, countries would generate deficits and public debt, and countries like the EU members cannot any longer use the monetary policy instruments that Keynes used since they do not control over interest rates and/or the exchange rate.
As we can see, the complex world in which we live nowadays makes harder to implement Keynesian policies again. Back in the 30’s, these countries could maintain a policy of lowering taxes and rising public spending, consequently increasing the deficit and public debt indefinitely (Galbraith, 1975, 156-157). Today, these countries have signed a stability pact through which the EU disciplines the public spending and the public debt of each member. As for the problem of the high unemployment, Keynes would recommend expansionary policies for countries with a high rate of unemployment, sustained in time. This, along with tax cuts and higher government spending should stimulate the economy. The problem is that the EU membership limits these possibilities as public deficit must not exceed 3% and public debt cannot go over 60% according to the Stability Pact.
In the 2008 crisis, the Federal Reserve System and the European Central Bank tried to lower interest rates with the goal of people keep investing, and counteract the subprime crisis. However, in a context of uncertainty, people rather use cash since it gives more ‘protection’ to their real economy. As an alternative to the crisis, Keynes would propose in general terms; capital control and regulation. This would enable liquidity towards desirable investments.


The 2008 crisis revealed the following paradigmatic points: a belief that economic risk can be quantified, that financial liberalization brings virtues, and that the advantages of markets depend on banks intervention. It is very difficult to have a new General Theory nowadays. For that to happen, the current system should go back to the animal spirits of human behavior.


-Cihan Bilginsoy, A History of Financial Crisis: Dreams and Follies of Expectations (Economic as Social Theory) (2015).
-John Kenneth Galbraith, The Great Crash of 1929, (1975).
– The Stability and Growth Pact (SGP), Economic and Financial Affairs (2015) European Commission.
-Todd A. Knoop, Recessions and Depressions / Understanding Business Cycles (2004) New York.

One Comment