The New Old Big Thing in Economics: J.M. Keynes

The U.S. and dozens of other nations are returning to massive government spending as a recession fighter. It's not because they're sure it'll do the trick. It's because they're running low on options and desperate for tools -- even old ones -- to fight the global downturn.

Around the world, interest rates have been slashed and trillions of dollars have been committed to bailouts. But the global recession is deepening anyway. So policy makers are invoking the ideas of British economist John Maynard Keynes (pronounced "canes"), who argued that governments should fight the Great Depression in the 1930s with heavy spending. With consumer and business spending so weak, he argued, governments had to boost demand directly.

Drama was a Keynes tool. During a 1934 dinner in the U.S., after one economist carefully removed a towel from a stack to dry his hands, Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers.

Keynesian policies fell out of favor in the 1970s, as government spending was blamed for helping to spur inflation around the world. But with the global economic turmoil being compared to the 1930s, government spending is once again back in vogue.

"The situation is so severe that we're all Keynesians again -- Keynesians in the foxhole," says Martin Baily, a former Clinton White House economist at the left-leaning Brookings Institution. "It really is such a difficult time that we're going to need to use whatever ammunition we have."

The economic turmoil is spurring people around the world to dust off Keynes's work. Nick Butler, a former energy executive now at the University of Cambridge's Judge Business School, is launching a new group called the Keynes Society to spark new thinking about economics and "revive the sense of pragmatic creativity which seems so lacking, and so necessary at the moment."

The International Monetary Fund is urging countries to boost spending by about 2% of their output -- more than $1 trillion total -- and it's likely they'll exceed that amount. President-elect Barack Obama is planning a stimulus package of as much as $775 billion over two years. China promises to spend almost $600 billion, while the European Union is pushing a package of more than $250 billion. India and Japan also have announced stimulus plans -- although nations often overstate the extent of new spending.

Critics argue that government deficits drive up interest rates and reduce investments in the private sector, which they say is more efficient at deploying capital to improve society. "The U.S. economy has soared highest when the federal government was shrinking, and it has stagnated at times of government expansion," says Brian Riedl of the Heritage Foundation, a right-leaning think tank.

Still, with the U.S. economy facing 1930s-style threats, the Obama administration is looking back to that period for guidance. President Franklin Roosevelt's Works Progress Administration provided jobs to millions of Americans during the Great Depression, though it had critics who said the program wasted money on unnecessary projects. The heavy government spending that followed World War II ultimately filled much of the employment gap.

Keynesian fiscal stimulus remained popular globally into the 1960s, particularly in rebuilding Europe and Japan after the war. Latin American nations boosted their economies in the 1960s and 1970s through heavy investment in transportation infrastructure, as governments expanded their budgets thanks to natural-resources income. The efforts often seemed to work. Growth accelerated in the U.S. and Europe, and the big developing markets of the time in Latin America.

But limits of Keynes-inspired growth were reached in the following decades. Many countries mistimed their spending, pouring money into their economies just as they were riding out a downturn and leading to economic overheating. Latin America regularly succumbed to hyperinflation, while in the U.S. the "misery index" -- the combination of inflation and joblessness -- climbed to 20.8% in 1980, from 10.8% a decade earlier.

Many nations also wasted their money on unnecessary projects: Japan became notorious for investing in little-used airports and bridges leading into sparsely populated islands. Indonesia started a national car project that lost money and was riddled with corruption.

With the rise of Ronald Reagan and Britain's Margaret Thatcher, critics of stimulus policy came to the fore. The goal became to shrink government.

Monetary policy also began to play a bigger role, as central bankers drove up interest rates to bring down inflation. Recessions seemed to grow more distant and less painful. The era from the early 1980s until the recent crisis became known as "the Great Moderation," when economic activity and inflation became less volatile. U.S. Federal Reserve chairmen, especially Alan Greenspan, became economic rock stars for bringing stability to the U.S. economy.

But during this period of financial turmoil, monetary policy has been inadequate. Banks and other creditors remain wary of lending because they're afraid they won't get repaid. The U.S. Federal Reserve lowered its interest-rate target to near zero last month from 5.25% in mid-2007, and is employing other tools to restore growth, but the economy has continued to spiral downward.

So, nations are turning again to government stimulus spending to try knocking the economy back on track. Economists say that if governments can get money into the economy quickly, targeting projects that will have the biggest effect, and make sure the spending is temporary, they can avoid inflation and wasteful spending. "We do need a jolt to really cushion the blow of this shock," says Morgan Stanley economist Richard Berner. "We need a stimulus that is temporary but substantial."

In the U.S., direct government payments to consumers in 2001 and 2008 provided some temporary relief during recessions. But since only a fraction of the funds were spent, while the rest went to savings or debt, the stimulative effect was disappointing.

Now, to ensure money is spent, the U.S. and other nations are focusing on infrastructure investment to create jobs, starting with the battered construction sector. President-elect Barack Obama says he is planning the largest public-works program since the 1950s construction of interstate highways. He also plans to use stimulus funds to repair schools, expand broadband Internet access and put energy-efficient technologies in public buildings.

Similarly, in China, the government plans to pour more money into hard infrastructure such as railways and airports.

Europe has been warier of ramping up spending, because it took many years to reduce its budget deficits. Europe also has greater spending built in, because unemployment benefits there are more generous than in the U.S. and have a deeper stimulative effect. But leaders are still forging ahead on their own packages, including a $69 billion stimulus package in Germany.

For any infrastructure investment to succeed as stimulus, nations must ensure people are hired quickly to work to reverse the downturn -- and don't become part of a permanent program. U.S. governors say their states have $136 billion in "shovel ready" projects that are fully planned and simply lack funding.

But critics doubt those claims. Historically, infrastructure projects have proven to fall behind schedule and over budget. Boston's Big Dig highway project started out in the 1980s as a $3 billion effort but topped $15 billion two decades later.

Lawmakers and a variety of interest groups are already grasping for the government cash. Last month, the Association of Zoos and Aquariums, noting New Deal programs that funded zoos decades ago, made a plea for its "shovel-ready" zoo and aquarium projects to be eligible for federal stimulus funding.

Inflation has quickly disappeared as a concern around the world. It's likely to reappear once growth perks up. That leaves a big test for the resurgence of fiscal stimulus: Once the economy revives, Mr. Keynes warned, the spending needs to be reversed and deficits cut. That's something nations have had a hard time doing.

Write to Sudeep Reddy at sudeep.reddy@wsj.com