Introduction
Travis Tatko wrote an article The Man Behind the Graphs: A Profile of John Keynes
published in Vol. III Issue I Columbia/Barnard Economics Society Journal Fall 2001
This is very true. Between the two World Wars the world economy was shaken by the Great Depression. Unemployment reached record levels. There were national general strikes. Orthodox thinking in economics was not prepared to deal with this. Neo-classical thinking was that full employment was the economies normal operating level. Departures from it would be short term and minor and remedied by the economy itself. Economists schooled in the neo-classical tradition explained the problem as resulting from rigidities frustrating the adjustments necessary to achieve full employment. One rigity emphasized was workers claiming wages that were socially irresponsible. The other rigidity was that many businesses had reached the scale that they could unduly influence prices.
On the international level, politicians appealed for business confidence and insisted on balanced budgets and monetary soundness. Many leaders tried to remedy the problems of their nations by resticting trade with other nations bringing retaliation. Keynes's General Theory of Employment, Interest and Money tried to give a theoretical justification for government action to promote full employment. Classical economics was too interested in long-period economic growth. Marx came closer but his analysis was too concerned with his assumptions about the downfall of the capitalist system. Neo-classical economists thought that full employment was inevitable. Keynes did not think that capitalism was doomed. Nor did he think that nothing needed to be done. Unregulated capitalism would not lead to full employment or economic stability. Keynes said his General Theory was "a struggle of escape from habitual modes of thought and expression". He said that the neo-classical system described "the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away".
Attack on Say's Law
The neo-classical assumption (that a self regulating economy would lead to a full employment equalibrium) was based on Say's Law which held that "general" overproduction was impossible although "partial" overproduction could happen. All income would be spent either on consumption of goods or on investment goods.
Neo-classical writers wrote about money in motion (in other words money when spent). Keynes focused on money when it was held. People wanted to hold money as a reserve against problems. But another reason for people holding money was speculative. Especially in times of low interest rates people may hoard. Say's Law was undercut: hoarding could not be ruled out as irrational. An economy could become stuck at a level below its potential because of hoarding and lack of confidence.
Interest Rates, Saving and Consumption
Economics has for a long time been concerned with income, saving, investment, money and interest rates. Keynes gave a new twist to ideas on money and interest rates.
But what causes interest rates to be what they are? The supply of money could be regulated by the government but the demand for money was established by the desires of the community. So the question was "What factors would induce the public to hold the available stock of money?"
Keynes argued that interest rates were not determined by an equalibruim between saving and investment. Banks usually try to lend at interest. But in times of depression the banks' ability to lend is reduced because fewer borrowers are interested in borrowing.
Neo-classical thought stressed interest rates as the most important factor influencing the level of people's savings. Keynes disagreed. For him, people wanted an acceptable level of income. When their income covered that amount they may think about saving. But few people were influenced by interest rate changes when deciding how much they would save. The neat neo-classical balance between saving and investment was destroyed. Decisions to save or invest (in capital or goods) were independent of each other.
Investment
Interest rates were no longer important to the question of whether to save or invest. However, interest rates were still important to the question of whether businesses would invest in plant and equipment or rather seek interest rewards. If interest rates were greater than the rewards from investment then spending on plant and equipment would not happen.
Throughout The General Theory Keynes also stressed the importance of psychological factors to economic decisions and analysis. Investment spending may not happen even when calculations based on immediate return suggest that they would be profitable. This may happen when entrepreneurs are bearish.
It could not be assumed that investment will be increased with a reduction in interest rates. Bearish expectations could neutralze the reductions in interest rates. A more active role for government as a spender was necessary to improve economies in depression:
Equalibrium between Intended Saving and Intended Investment
Keynes and the neo-classical writers agreed that an equalibrium between intended saving and intended investment was necessary to aggregative equalibrium. Neo-classical writers thought that this equalibrium could be achieved by adjusting interest rates. Keynes, as we saw, disagreed with this connexion between saving rates and inteest rates. So Keynes had to give a different exlanation of this equalibrium. Keynes linked savings rates to income rather than to interest rates.
What Adjustments Follow?
The next question was if investment increased what increase in incomes could be expected? Keynes argued (following R. F. Kahn) that an increase in investment would have a multiplier effect . An increase in investment leads to higher demand. More workers and raw materials would be necessary to produce more goods. Additional rounds of spending and re-spending are likely to follow. The stimulus of increased investment radiates throughout the economy. Income and employment are increased.
The same multiplier effect happens to a fully employed economy. Prices would be bid up but real output (production) would not be increased to match the increase in demand. Keynes was less concerned with this problem because he was writing in the 1930's where the problem he was concerned with was economic depression.
Implictions for Economic Policy
Keynes destroyed confidence in the ability of government regulation of interest rates (monetary policy) to increase employment. Keynes argued that government spending (fiscal policy) was more importanat. Keynes did not agree with traditional thinking that governments should always balance their budgets. He called for deliberate deficit budgets to increase demand.
Keynes attacked the idea that unemployment could be cured by wage cutting. Wage cuts would be more likely to make the problem worse by reducing demand even more. Price cutting would also follow; that would have a depressing effect on expectations. Investment that would restore full employment might be discouraged.
Conclusion
Keynes' criticims were based on 2 main observations:
1. an unregulated market was likely to be unstable. Active government involvement was needed and thrift was not always (especially in times of underemployment) a good thing for society.
2. laissez-faire was a fair weather system. It was able to be remarkably productive and creative when conditions were good but needed government guidance in unstable times.
Keynesian thought has been absorbed into the economic policy of of most Western countries and has probably been one of the factors helping bring sustainable and stable economic growth to the world in recent history.
At a time of unparalleled political unrest and economic insecurity, John Keynes challenged the
prevailing and time-honored economic theory of laissez-faire, a tradition led by the virtual
demigods of economic theory - Adam Smith and John Stuart Mill. As Keynes uttered in the now-famous
words, "The difficulty lies not so much in developing new ideas as in escaping from old ones,"
Keynes perpetuated both his own fame and notoriety, ensuring his enduring status as perhaps the
most controversial figure in modern economic thought.
The habit of overlooking the relation of the rate of interest to hoarding may be part of the explanation why interest has been usually regarded as the reward for not spending, whereas in fact it is the reward for spending.
Whilst ... the enlargement of the functions of government ... would seem to be a terrific encroachment on individualism, I defend it ... as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative."
