Keynesian economics
Keynesian economics, or Keynesianism, is an economic theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest and Money, published in 1936.
In Keynes' economic theory, general economic trends can overwhelm the specific behavior of individuals. Instead of economic output being based on continuous improvements to production, as Political Economy and Economics had focused on from the late 1700's, Keynes asserted that a fall in the "aggregate demand" for goods was the driving factor in general economic downturns. From this he argued that statistical measures of overall economic activity could be used to balance supply and demand at a "macro" level. Hence, Keynes' theories and the economics which are based on them are called Macroeconomics in contrast to theories which focus on the behavior of individuals which have been termed Microeconomics.
The key central conclusion of Keynesian economics is that there is no strong automatic tendency for the level of output and employment in the economy to move toward the full employment level. This conflicts with the conclusion of neoclassical economics, known as Say's law, that adjustment in prices and interest rates would tend to produce full employment in the economy. The attempts to connect macro and micro economics views have been the source for much of the most fertile research in economics since Keynes General Theory, with micro economists attempting to find macro formulations for their ideas, for example Monetarism, and Keynesian economists attempting to define solid micro basis for Keynesian behavior. In the post war period, this process came to be called the neo-classical synthesis.
Historical background
John Maynard Keynes was one of a wave of thinkers, writers and artists who perceived increasing cracks in the assumptions and theories which held sway at that time. As physics began to question the necessity of absolute time, writers began to question the structured narrative, and composers the need for tonal harmony - Keynes began to question two of the pillars of economic theory then in effect: the need for a solid basis for money, generally a gold standard, and the theory, expressed as Say's Law which stated that decreases in demand would be balanced by decreases in supply, or in prices, reaching equilibrium again.
Keynes himself was intimately associated with the Bloomsbury group and drank in the atmosphere of changing how people thought about problems. But it was his experience with the Treaty of Versailles which pushed him to make a break with previous theory. He penned "The Economic Consequences of the Peace" in 1920, which not only recounted the general economics, as he saw them, of the Treaty, but the individuals involved. The book established him as an economist who had the practical political skills to influence policy.
In the 1920's Keynes published a series of books and articles which focused on the effects of state power and large economic trends, developing the idea of monetary policy as something separate from merely maintaining currency against a fixed peg - he increasingly believed that economic systems would not automatically right themselves along a curve which economists call "the optimal level of production". However, he neither had proof, nor a formalism to express these ideas.
In the late 1920's the economic system of the globalized economy began to break down. Britain, at the time, was the central country, and endorsed free trade policies so that it could make use of competitive advantage - Britain bought food and other low value goods from elsewhere, and used the labor freed up to produce high value goods which it exported abroad. This use of Riccardo's theory of comparative advantage brought Britain to the pinnacle of an empire that spanned the globe and included India, Egypt and colonial possessions around the globe, as well as allied nations such as Canada and Australia who defered to British policy on economic and military matters.
With the economic collapse in Germany into hyper-inflation, and the beginnings of a global drop in production which would eventually become termed "The Great Depression", critics of the gold standard, self-correcting nature of economies and production driven paradigms of economics moved to the fore. Dozens of different schools and ideas contended for visibility. Into this void Keynes stepped, circulating a simple thesis: the Depression was caused because in the 1920's there had been a speculative boom in production and investment - there were more factories and transportation networks than could be used at the current ability of individuals to pay. This focus on "insufficiency of demand", and the formalism he created which allowed governments to monitor the crucial components of an economy, created a wave of young economists who adopted his theory and methods.
Arrayed against this new idea where economists who insisted that business confidence, not lack of demand, was the root of the problem, and that the correct course was to slash government expenditures, in order to restore confidence in the eventual return to a full gold standard.
Keynes' theory
Keynes explained the level of output and employment in the economy as being determined by Aggregate Demand. Aggregate demand is the total demand for goods and services in the economy. In microeconomic theory, adjustments in prices, in particular wage and interest rates, would automatically make aggregate demand tend to the full employment level. Keynes, pointing to the sharp fall in employment and output argued that whatever the theory, this self-correcting process had not happened. The central point at issue was whether "demand deficiency" was possible. According to classical economists - the more generally used term for the practice prior to General Theory - demand deficits were symptoms, not causes, of recessions and economic dislocation, and could not happen in a properly functioning market.
In the classical theory, two elements of an economic system were believed to produce a state of full employment. First, the push and pull of supply and demand set the price of goods, and the constant shifting of price allowed the two forces to equalize. Second, when the system produced extra wealth, it could be either saved for future consumption or invested in future production, and there was a system of supply and demand that affected this choice too. The interest rate on savings behaved like a price, equalizing the supply and demand of investment funds.
Even in the worst years of the Depression, this theory defined economic collapse as the loss of incentives to produce. The proper solution was to reduce the price of labor to subsistence levels, causing prices to fall so that buying (employment) would pick up. Funds not paid out in wages would be available for investment, perhaps in other sectors. Plant closures and layoffs were a necessary medicine. The other crucial policy was to balance national budgets, either through increased taxation, or, more usually, through slashing expenditures.
Keynes' theory argued that this would exacerbate the underlying problem: by cutting expenditures or raising taxes, the government would be reducing money in circulation, and thus lowering demand. This, in turn, would cause business owners, not merely to lower prices, but to reduce output in order to maintain previous price. According to Keynes, the classical analysis offered no way out of a system-wide collapse. Lowering wages would remove capital available for investment, since it would reduce expected profits. Instead, it would simply lower consumption, so the total demand for goods would drop. Investment in new production would then become more risky, less likely. He argued that once the expectation of lower prices became built into assumptions, it would spiral downward.
Keynes' theory suggested that active government policy could be effective in managing the economy. Keynes advocated counter-cyclical fiscal policies: deficit spending when a nation's economy was sluggish and the suppression of inflation in boom times by either increasing taxes or cutting back on government spending. His macroeconomic model offered a way of calculating the equilibrium state of an economy and defining inflation and recession as departures from it; thus policy could proceed from analysis.
This contrasted with the neoclassical analysis of government intervention in the economy. It was always clear that government work was an alternative. It could increase wages temporarily and therefore increase the demand for goods, stimulating production. But there was no reason to believe that this stimulation would outrun the side effects that discouraged investment — the government, competing with private interests, would be bidding up the wage rate, leading to no overall increase in economic activity. The underlying assumption was that capital had to be directed to increasing productive capacity. A public-works program diverted capital from its proper job.
Two details of Keynes' model had implications for policy:
First, there is the "Keynesian multiplier." In his way of tracking aggregate national production, Keynes argued that increases in consumption do not equal increases in production. The effect on production is always a multiple of the increase in spending. Thus a government could stimulate a great deal of new production with each modest outlay.
Second, Keynes re-analyzed the effect of the interest rate on investment. In the standard model, interest rates determined the supply of funds available for investment. For Keynes, the supply depends on the productivity of the system, the very thing that his fiscal proposals were intended to affect. (In this re-definition, the interest rate depends on the preference that people have about holding onto money, the ratio of money held to the total amount of money in circulation. This view opens the possibility of regulating the economy through changes in the money supply, but Keynes argued that this approach would be relatively ineffective compared to the use of fiscal policy.)
Thus Keynes argued that the total economy consisted of aggregate supply and aggregate demand. That Consumer demand was the largest portion, and drove Investment demand, which came out of profits of supplying consumer demand, and was for the production of capital. Lower profits lead to lower investment, and lower investment lead to lower employment, which lead to lower consumer demand. Thus, Keynes argued, the third sector of demand was Goverment demand. Keynesian theory then argued that Goverment demand should be used to cushion the shocks of rapid decrease in Consumer demand, or to buffer hyperinflationary shocks. General theory related the government sector to the control of the interest rate, and from there, the supply of available investment and consumer demand.
However, it was with John Hicks that Keynesian economics produced a clear economic model which policy makers could use to attempt to control economic activity. This model, the IS-LM model is nearly as influential as the sector analysis of Keynes in actual policy - it relates demand for three quantities - Money, Investment and general Commodity. The method is, in fact, a classical three commodity market analysis. The goverment, by controlling the supply for money and the interest rate - which has a direct impact on investment demand, could balance economic output, increasing demand when there was slack, and reigning in excess demand to prevent the economy from "overheating".
Subsequent developments in Keynesian thought
In the post-WWII years, Keynes' policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis, and attempted to use fiscal and monetary policy to manage the economy. Most western countries enjoyed low, stable unemployment and modest inflation.
Keynesian analysis was combined with classical economics to produce what is generally termed "the neoclassical synthesis" which dominates mainstream economic thought. A widely held view was that there was indeed no strong automatic tendency to full employment, but that if government policy were used to ensure full employment, the economy would behave as classical theory predicted. Classical theory was extended by describing basic economic actors as being rational decision makers, who would engage in marginal trade offs (See Marginalism) to improve their net happiness, or utility. The utility function became the bridge to join Macroeconomics to Microeconomics.
These ideas began to lose favour in the 1970s. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation. Keynesian analysis suggested that government policy should be used to stimulate demand in response to unemployment, but reduce it in response to inflation, leading to a contradiction. Attempts to resolve this led to Keynesian ideas losing favour to new ideas based upon neoclassical analysis, including monetarism, supply-side economics and new classical economics.
More recently, there has been a revival in Keynesian ideas, with particular emphasis on giving the Keynesian macroeconomic analysis theoretically sound foundations in microeconomics. These theories have been called new Keynesian economics. In no small part these are due to persistent discrepencies between the post-war wave of theories and actual events, particularly the creation of persistent budget deficits in major industrialized nations, and the falling of real wages. The heart of the neo-Keynesian critique rests, first on the idea of a rational economic actor and the efficient market hypothesis which rests on such economic actors, and second on the nature of the demand for money. Keynesian economics believes that both money and commodity are undifferentiated: money doesn't matter, and what people buy does not matter either, these two points have been the focus of the attack on Keynes' theory which undermined its general supremacy in economics departments and among policy makers. The neo-Keynesian response is to use game theory and information theory to show that rational economic actors can choose persistently sub-Pareto optimal conditions, and that information theory shows that markets are inherently inefficient, that "perfect movement of information" is an impossibility.
The Radical journalist and economist Will Hutton regards Gordon Brown as being the first "real" Keynesian Chancellor of the Exchequer, although an argument could be made for Stafford Cripps and Roy Jenkins.