Understanding Keynesianism

Keynesianism is a catchall phrase for economics that is supposed to reflect the ideas of John Maynard Keynes (pronounced to rhyme with â€˜rainsâ€™), an Englishman born in 1883. These ideas were presented in the grandly-named General Theory of Unemployment, Interest and Money, the 20th centuryâ€™s most influential book on policy. The General Theory was published in 1936, the seventh year of the â€˜Great Depressionâ€™, when older â€˜laissez faireâ€™ economic policy (minimum intervention, free markets, tight credit) had failed. Keynesâ€™ ideas, matured by discussion with younger Cambridge colleagues like Richard Kahn, Joan Robinson, James Meade and Pierro Sraffa, would revolutionise economics and policymaking forever. Unlike traditional policymakers, who thought that depression and unemployment resulted from supplies drying up, Keynes said that the fate of economies actually hinged on demand: for goods, services, manpower and capital. What are the determinants of demand? Keynes asked what affected the demand for money, investment, jobs, savings and investment. He realised that at higher incomes the demand for money went up (and vice versa), while interest rate hikes made people put cash in banks, cutting demand for money. Savings and interest rates were related positively, but investment went down when interest rates rose. Employers hired more people when real wages (money wages divided by prices) fell, employment shrank when real wages soared. The cost of capital was essentially the interest rate, what companies had to pay if they borrowed to finance expansion. These elements added up into a totally new model of the economy. What was Keynesâ€™ formula for breaking out of recession? Keynesâ€™ demand-led vision meant that unless governments took action, a downturn would become self-sustaining and vicious. Suppose a shock, like the market collapse of 1929, wipes out a lot of savings and incomes â€” and the government does nothing. Many people, suddenly poorer than before, would cut down on consumption and spending. This would hit demand for all businesses, which would react with layoffs and production cuts. The newly laid-off would swell the ranks of the poor, deepening the recession and leading to bigger collapses. Keynes, therefore, said that the only way to break this cycle was to spend massively in a downturn. Itâ€™s foolish to expect individuals to open their wallets in a downturn, so the only agency that could boost demand was government. This explains the centrality of government spending programmes in Keynesian economics. How does Keynesian policy work? In a downturn, Keynes advised governments to fire up both monetary and fiscal policy â€” lower interest rates, lots of credit and lower tax rates plus state-funded job creation â€” and â€œdig trenches and fill them upâ€�. The flood of money and lower taxes lowered interest rates, cutting the incentive to save, lowering investment costs and encouraging new projects. Prices would rise, prompting higher production and encouraging more hiring by reducing real wages. In practice, European governments actually managed to dig themselves out of the depression by following Keynesian policies and by the end of the 1930s, Europeâ€™s rush to arm for World War II had pushed production and employment up. Rearmament was not Keynesâ€™ idea of a great state-funded project, but it did the trick anyway. What led to the backlash against Keynesianism? The backlash against Keynes began almost from the day he published, led by economists like Friedrich von Hayek, who had seen the worst excesses of totalitarianism in pre-war Europe. Hayek had an instinctive distrust of big government and argued that regimes simply didnâ€™t have the honesty, wits and ability to intervene effectively for long. Keynes always argued for quick policy bursts, not sustained intervention. He didnâ€™t believe in long-run policymaking, arguing: â€œIn the long run, weâ€™re all dead.â€� Nevertheless, by the 1970s practically every government worldwide was on a Keynesian drip. By the mid-1970s, the first oil shock had destabilised global markets and countries like America were going through â€˜stagflationâ€™ â€” stagnant growth where monetary boosts just added to inflation, not jobs. Thirty years after his death in 1946, the success of Keynesâ€™ formula had laid it open to a successful attack from the monetarists, led by Milton Friedman.

Understanding Keynesianism

Keynesianism is a catchall phrase for economics that is supposed to reflect the ideas of John Maynard Keynes (pronounced to rhyme with 'rains'), an Englishman born in 1883.

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