The Evolution of Keynesianism: Spending Our Way Out of Recession
Written on
Chapter 1: The Foundations of Keynesian Thought
In this continuation of our exploration, we delve into Keynesianism's trajectory throughout the 20th century, examining its decline and the subsequent emergence of neoclassical economics during the 1980s.
John Maynard Keynes, who emerged from an academic lineage, attended Cambridge University, where his father was an economics professor. Under the guidance of Alfred Marshall, a thinker aligned with Adam Smith, Keynes developed his theories.
Throughout his career, Keynes occupied various roles in both government and academia. His tenure at the British Treasury during World War I gave him unique insights into the Treaty of Versailles, which imposed severe reparations on Germany. In his book, The Economic Consequences of the Peace, Keynes articulated the view that these reparations were fundamentally flawed and posed significant political risks.
While his early criticisms proved prescient, they did not imply that he opposed all forms of government intervention. His seminal work, The General Theory of Employment, Interest, and Money, published in 1936 during the height of the Great Depression, challenged the classical notion of a self-regulating market. Keynes posited that full employment was not a natural condition, necessitating proactive government intervention.
Keynes, educated in classical economics, questioned the prevailing belief that the economy would automatically recover from downturns. This belief was predicated on the assumption that prices would adjust to eliminate imbalances, leading to wage reductions that would allow businesses to hire more workers.
He argued that prices, especially wages, could be "sticky," meaning they resist downward adjustments due to contracts, labor unions, and employees' reluctance to accept pay cuts. Although real wages typically decline during recessions, with hourly workers facing reduced hours and salaried employees often finding lower-paying jobs, Keynes contended that this adjustment process would be slow and incomplete. He famously noted, "In the long run, we are all dead," emphasizing that classical economics failed to address the lengthy recovery periods.
Instead of waiting for a distant "long run" resolution, Keynes advocated for government spending and tax policies that could expedite the return to full employment.
Keynesianism diverged from focusing on individual economic agents, shifting attention to the broader concepts of Aggregate Demand and Aggregate Supply. When economic downturns occur, rising unemployment and declining consumption result in reduced Aggregate Demand. A key insight from Keynes was that government spending constitutes part of this Aggregate Demand. Therefore, increasing government expenditure could counterbalance falling private consumption, facilitating a return to full employment.
However, this approach overlooks the "crowding out" effect, where increased government spending must originate from the private sector, potentially negating its benefits. Proponents of classical economics argue that crowding out perfectly offsets any increase in government spending in the long run, which raises further questions about the effectiveness of Keynesian solutions.
Critics such as journalist Henry Hazlitt have expressed skepticism about the assumption that government can allocate resources more effectively than individuals. Hazlitt noted that those who earn money are often viewed as too shortsighted to invest wisely, while politicians and bureaucrats are trusted to invest with "perfect foresight." If Hazlitt were writing today, he might add a sarcastic note to his criticism.
Keynesianism fundamentally transformed our understanding of the economy. Classical economics operated under Say's Law, which posited that demand arises from production: only by creating goods can income be generated to fuel spending. In contrast, Keynes argued that consumer demand is the primary driver of economic activity. Thus, when consumption declines, it must be stimulated to sustain economic momentum, leading to the perception that we can "spend ourselves rich."
Despite significant criticism, Keynesian theories remained popular among policymakers, as they provided a framework that aligned with their objectives. Keynes' model granted economists and politicians a sense of control and authority, while equipping them with essential concepts, even for those who disagreed with his specific policy recommendations.
Section 1.1: The Public Choice Theory Perspective
As highlighted in Hazlitt's critique, Keynesian theory assumes that government can spend money judiciously. However, economist James Buchanan, awarded the Nobel Prize in 1986, argued against this assumption. His contributions to political economy, particularly through the theory of public choice, revealed that political actors often prioritize their interests over the public good. Elected officials and bureaucrats are frequently motivated by self-interest rather than altruism.
Buchanan's journey reflected a shift from leftist beliefs to an understanding of the value of free markets, recognizing the flaws in economic interventionism and macro-management.
Many proponents of Keynesian economics fail to consider why the government should be trusted to execute complex economic actions effectively. Government officials are, after all, composed of the same self-interested individuals as those in the private sector. A wealth of stories illustrates the pitfalls of entrusting power and resources to such actors.
Section 1.2: The Disintegration of Keynesian Policies
Keynesian policies gained traction in response to the Great Depression; however, they began facing scrutiny in the 1970s. The increased government spending associated with these policies led to inflation, effectively replacing one economic challenge with another. The oil crisis of the 1970s further complicated matters, highlighting that recessions could arise from both demand and supply shocks.
Traditional Keynesian responses, focused on stimulating aggregate demand, were ill-suited for addressing supply-side disruptions. Policymakers grappled with the dual challenges of rising unemployment and inflation, where increasing government spending to combat unemployment could exacerbate inflation.
The events of the 1970s set the stage for the rise of neoclassical economics in the 1980s under leaders like President Reagan and Prime Minister Thatcher. Their administrations emphasized deregulation, privatization, and personal responsibility, challenging the Keynesian framework.
Despite the economic growth that followed, mainstream economists protested against these shifts, arguing that they lacked a sound theoretical foundation. However, alternative economic theories, including those proposed by Austrian economists like Mises and Hayek, provided robust support for these new policies.
While Keynesian economics faced significant challenges, it was not entirely vanquished. The 2008 financial crisis ushered in a revival of Keynesian ideas, as policymakers turned to government spending to stabilize the economy. Nevertheless, the lessons of economics remain complex and often counterintuitive, leaving room for ongoing debate about the role of government in economic management.
Chapter 2: The Resurgence of Keynesianism
The first video, "Keynes and the Crisis of Capitalism," explores how Keynesian theories evolved in response to economic crises and their relevance today.
The second video, "Keynesian Economics and Deficit Spending with Jacob Clifford," discusses the principles of Keynesian economics and the implications of deficit spending in modern economies.
In our next discussion, we will examine the resurgence of Keynesianism in contemporary economic discourse, exploring its implications and the lessons learned from past experiences.
Reference: Foster, Peter, 2014. "The Rise and Fall and Rise of John Maynard Keynes" Chapter 10 of Why We Bite the Invisible Hand, Pleasaunce Press.