The undeniable shift to Keynes

More than three decades have passed since Richard Nixon, the Republican US president, declared: "We are all Keynesians now."

The phrase rings truer today than at any time since, as governments seize on John Maynard Keynes's idea that fiscal stimulus – public spending and tax cuts – can help dig their economies out of recession.

The sudden resurgence of Keynesian policy is a stunning reversal of the orthodoxy of the past several decades, which held that efforts to use fiscal policy to manage the economy and mitigate downturns were doomed to failure. Now only Germany remains publicly sceptical that fiscal stimulus will work.

The new Keynesian consensus was set out in the communique issued by the Group of 20 leading industrialised and emerging economies in November, in which they vowed to "use fiscal measures to stimulate domestic demand to rapid effect" within a policy framework "conducive to fiscal sustainability".

The incoming administration of Barack Obama is preparing a two-year fiscal stimulus package with a reported price tag of $675bn-$775bn, which many Washington-based analysts believe could swell to $850bn (£580bn, €600bn) or even $1,000bn – between 5 per cent and 7 per cent of national income.

Gordon Brown, UK prime minister, told reporters in late December that if monetary policy was impaired – in large part because of problems within the financial system – "then governments have to use fiscal policy, and that has been seen in every country of the world".

Launching France's fiscal stimulus, President Nicolas Sarkozy said: "Our answer to this crisis is investment because it is the best way to support growth and save the jobs of today – and the only way to prepare for the jobs of tomorrow."

But not all policymakers have been so keen to jump on board what they see as a dangerous journey, not back to the theory Keynes laid out to combat a deep and protracted economic slump but to the failed fiscal fine-tuning of the 1970s, in which governments tried to maintain full employment at all times.

Germany has voiced the strongest principled objections to large-scale fiscal stimulus packages. Peer Steinbruck, the finance minister, has complained about the "crass Keynesianism" pursued by Mr Brown, accusing him of "tossing around billions" and saddling a generation with having to pay off British debt.

Jurgen Stark, an executive board member of the European Central Bank, who was previously vice-president of the Bundesbank, warned of a "substantial risk" of a repeat of the 1970s. "I really cannot see why discretionary fiscal policies, which have proven to be ineffective in the past, should work this time," he said.

Jean Claude Trichet, ECB president, has taken a cautious stance, arguing in a Financial Times interview for countries to allow their deficits to rise in line with the so-called automatic stabilisers – such as higher unemployment benefits and reduced tax revenues during a recession – but warning that the prospect of future tax rises could reduce consumer confidence. "One might lose more by loss of confidence than one might gain by additional spending," he said.

In the US, Lawrence Summers, the former Treasury Secretary now lined up to head Mr Obama's National Economic Council, said the fiscal stimulus will address the need to increase investment in energy, education, health and infrastructure as well as the need to stimulate the economy.

Laurence Boone, a Paris-based economist at Barclays Capital, argued that large European countries fall into two camps. In one are countries with highly indebted consumers where housing markets have made a big contribution to economic growth in recent years – namely the UK and Spain. Here, fiscal stimulus packages were larger and focused on supporting consumers and housing.

Elsewhere, especially Germany and France, stimulus plans were less ambitious and "are set to rely more heavily on public sector investment, especially in infrastructure, with little support to consumption", Ms Boone notes.

The contrasting rhetoric is more exaggerated than the reality of the differing positions. In gung-ho Britain and France, for example, the planned fiscal stimulus is no bigger than in reluctant Germany. And in all three countries, reduced tax revenues and higher welfare state payments will contribute the vast majority of prospective higher budget deficits, not the discretionary measures introduced in recent months.

The US stimulus package appears to dwarf the European efforts. But any fiscal stimulus has to be larger in the US to have a similar effect because more generous European social safety nets guarantee higher payments to the unemployed.

Mr Trichet argues that these "automatic stabilisers?.?.?.?have perhaps twice as much influence?.?.?.?as apercentage of GDP in the euro area as compared with the US".

But it is clear a worldwide shift towards Keynesian deficit financing has occurred this year. Partly this is the result of the credit crisis impeding the effectiveness of monetary policy, partly the fact that interest rates cannot be cut further in the US and Japan, and also partly because banks will not lend to many households and companies even if they want to borrow.

But the move towards using fiscal policy as a means of boosting advanced economies still has limits, recognised by all those who experienced the 1970s.

Unsustainable fiscal positions can destroy confidence. The US, which issues the dollar, the world's reserve currency, has more latitude than most. But even Mr Obama has been keen to stress his ambition to "get our mid-term and long-term budgets under control".

Smaller countries with fragile currencies, such as the UK, are even more vulnerable to the effects of the confidence of foreign investors. The UK government announced a five-year government austerity package to reduce deficits from 2011 at the same time as its stimulus in an attempt to provide evidence of its longer-term good intentions. Continental European economies are bound by the stability and growth pact, limiting both budgets and debt. But the deterioration of the outlook for the global economy has been so rapid that addressing the immediate problems has overtaken consideration of longer-term consequences.

This trend was first evident almost a year ago in January, when Dominique Strauss-Kahn, the managing director of the International Monetary Fund, stunned delegates at the World Economic Forum in Davos when he called for "a new fiscal policy [as]?.?.?.?an accurate way to answer the crisis".

On the podium with him was Mr Summers. He remarked: "This is the first time in 25 years that the IMF managing director has called for an increase in fiscal deficits and I regard this as a recognition of the gravity of the situation that we face."

Mr Summers now argues that the outlook has deteriorated further. With the prospect of the economy remaining weak and unemployment high for a protracted period, he believes spending on projects that continue beyond 2009 is justified.

Critics said this was a convenient cover for spending programmes that the Democrats wanted anyway. However, many economists agreed with the argument. "The US economy needs not only a large package of fiscal stimulus in 2009 but one that provides substantial support beyond next year," said Ed McKelvey, an economist at Goldman Sachs.

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