Before myths become theory they must be tested by reality – by facts on the ground. Sometimes that takes a long time. Sometimes when what has become conventional wisdom can be shown to be flawed by developments theoreticians had not predicted.

This is certainly the case with the long-running dispute between the Keynesians and the Friedmanites.

During the 1980s and the 1990s when small changes in monetary policy kept economies on track, it came to be widely believed that government expenditure for macroeconomics management no longer provided an appropriate instrument of control. While Richard Nixon, president of the United States in the late ‘sixties and the early ‘seventies, declared that “we were now all Keynesians” his later successor held different views.

President Ronald Reagan, supported by Prime Minister Margaret Thatcher of Britain, thought that “government was not the solution to economic problems but was itself a problem”. Their policies put Milton Freidman on a higher pedestal than John Maynard Keynes.

This myth is now exploding. It has been given up as governments around the world scramble to put together stimulus packages to revive their faltering economies. However, before suggesting how Keynes gained favour once again with policymakers, let me mention some other myths that have been felled by the way the current economic crisis has developed.

The first myth to be shattered was the belief that the world economies were now decoupled; that the emerging economies had developed a dynamic of their own and would not be severely affected by the ebbs and flows emanating from industrial economies. It is extraordinary that this belief was shared by so many serious analysts.

There was no way emerging markets could escape hurt while the economies of rich countries were being wounded. In the words of The New York Times columnist Thomas Freidman, the world had become flat. The flattening had occurred because of the easy flow of goods, services, capital – even people – across international borders. This is what came to be called globalisation. But globalisation meant that goods times will be shared along with those that were bad.

The second myth that stands discredited concerns the behavior of consumers. For decades, US consumption has been the backbone of the global economy, providing the engine of growth for the rest of the world.

With a degree of irrationality attributed to American consumption habits, the US households not only supported the manufacturers in East Asia. They were also behind the transfer of enormous amount of income and wealth to the Middle East, North Africa, and Russia. For many households in the US living beyond their means had become standard behaviour, supported by growing debt either in the form of home equity or credit card borrowing.

These consumption habits were not dulled even by 9/11 or the crash of the stock markets in March 2001. But there was a limit to the number of shocks the consumers were prepared to absorb. After a long pause household savings in America have returned to positive territory. The global economy will have to find another engine to pull itself forward.

Then there was the assumption or the myth that the value of the dollar will have to decline given the growing trade and balance of payments deficit the country was experiencing. Some even predicted a massive decline in the value of the dollar with respect to all other currencies. That happened but only for a while. As the global economy plunged into recession and stock market valuations declined all around the world, those with savings to invest rushed into US government assets, raising the value of the dollar. Even the plunge in interest rates orchestrated by the Federal Reserve did not deter foreign investors. It transpired that they were not looking for high returns but were searching for security in troubled times.

Another myth to explode was that the private sector could be expected to manage itself; there was a social utility to greed. Alan Greenspan, who headed the Federal Reserve for nearly two decades, was the most articulate exponent of this belief. It must have been extremely painful for him to admit that the private sector could not be left to its own devices. It could not responsibly self-regulate.

It should have been expected that money would flow into the institutions that held out the promise of high returns by borrowing cheaply and investing in whatever they found attractive. It is not surprising that hedge funds gained such popularity.

With these myths dashed and a great part of the global financial system in ruins, it is certain that what would rise from these ashes would be very different from what got destroyed. There will have to be changes in the way governments manage their economies and in the way in which countries interact with one another. There will be changes in both the near term and the long term. All of them will have significance for countries such as Pakistan.

Over the short-term, these states have to restore health to their economies. Over the long-term they must be able to provide for the citizenry. Some of the countries currently in crises have been battered by the severe down-turn in the global economy. Other, like Pakistan, have been affected not only by the adverse changes in the global economic environment but also by government mismanagement.

What options are available to the second group of countries? What is the appropriate role of the state in these countries? This brings be back to the discussion with which I began this article: the contention between the Keynesians and the Friedmanites concerning public policy towards economic stabilisation.

Keynes has won out in most parts of the world. Most governments have set aside concerns about fiscal deficits and inflation and are opting for significant increases in public expenditure to stimulate their economies. Within the space of a few weeks, President-elect Barack Obama has increased the number of jobs he wishes to create through his stimulation programme. He has gone from a target of two to three million.

On the other side of the globe, China, troubled by rising urban unemployment, has announced a stimulus package of nearly $600 billion. Across the border, the Indian government will probably spend an additional $60 billion on accelerating the rate of economic growth.

In Pakistan, however, the government has been advised by the IMF to cut down public sector expenditure. This is being recommended although income per head of the population in 2009 is likely to stagnate while the rates of growth will remain respectable in both China and India. Why would the Keynesian approach not work for Pakistan?

The answer is simple. Initial conditions in the three countries are very different.

In China there is no budgetary problem and the rate of domestic savings is very high. The government can afford to pump money into the economy without fearing a high rate of inflation. In India, large flows of foreign capital have built large reserves which, in turn, don’t produce worries on the external side. Its budgetary situation is not much better than that of Pakistan’s but the government can temporarily increase its expenditure without igniting inflation or creating a balance of payments crisis. The room for maneuver in Pakistan is very limited for the state. The government can’t stimulate the economy through increased expenditure without creating another crisis.