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KEYNESIAN ECONOMICS

The role of state in its economy cannot and should not be discounted. While the economy has its own “mind,” there are times when the state should actively intervene to ensure its (economy) stability. This paper will dwell on Keynesian economics, a theory stating that government’s active intervention in the marketplace and monetary policy is the best method to ensure economic stability and growth. This economic theory by John Maynard Keynes provides that the government is responsible to smooth out the bumps in business cycles. These interventions would come in different forms depending on the prevailing economic or market condition: government spending and tax breaks to stimulate the economy during recessions or declines, and government expenditure cuts and tax hikes in good times to curb or prevent inflation.

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Keynes, the father of modern economics

John Maynard Keynes (5 June 1883 – 21 April 1946), a British economist also known as the father of modern theoretical economics, had made a great impact on contemporary economic as well as political theory. His ideas were tapped by governments for their fiscal policies. He is most well known on his interventionist policy when it comes to fiscal and monetary measures, specifically, to mitigate the undesirable effect of recessions, depressions, and even booms. An article from the Time magazine on 100 Most Important People of the Century, contend that “[h]is radical idea that governments should spend money they don’t have may have saved capitalism.”[1]

As an economist, his first share of international fame was when he was selected as a delegate of the Paris Peace Conference of 1918–1919. It was during this conference that the victors of the World War 1 (specifically, Woodrow Wilson, Georges Clemenceau, and David Lloyd George) imposed war reparations on Germany. Keynes held his tongue during the conference but let out a roar as soon as he returned to England.[2]

He wrote a book entitled The Economic Consequences of Peace. He wrote that the Germans would not be able to pay the victors. He called Wilson a “blind, deaf Don Quixote,” Clemenceau a xenophobe with “one illusion — France, and one disillusion — mankind,” and Lloyd George a “goat-footed bard, this half-human visitor to our age from the hag-ridden magic and enchanted woods of Celtic antiquity.” Keynes predicted that the reparations demanded by the victors would keep Germany impoverished and might ultimately threaten the neighboring countries, if not all of Europe.[3] And we know that he is indeed right as if it was a prophecy.

The book sold almost a hundred thousand copies on that period. But it was only later on after three decades that the real effect of his treatise was felt. After the end of World War II, both US and Britain (as victors of the war) remembered Keynes’ admonition. The best way to attain a lasting peace is by helping the vanquished start all over again – public investing to create trading partners and building solid democracies (like in the case of Germany, Italy, and Japan during that war). [4]

Overview of Keynes Contributions

Keynes established that branch of economics that is termed “macroeconomics” today. This is his greatest influence in the history of economics. This actually came from a book he wrote during the depths of the Great Depression. The book is called “The general theory of employment, interest and money” (published 1936). The idea is pretty much easy to understand: Governments should not leave the market alone when, and especially, the economy is running slow (interventionist policy of the government as against the laissez-faire policy). It is during periods of dull economy or recession that markets are saturated and businesses either do not invest, or reduce their investment. Such situation, according to Keynes, is a prologue for a very dangerous cycle: “less investment, fewer jobs, less consumption and even less reason for business to invest.”[5]

In 1942, John Maynard Keynes was raised to the House of Lords and was accorded the title Baron Keynes of Tilton, County of Sussex. Keynes played a crucial role in the negotiations that transpired in the creation of the Bretton Woods system (the system/conference that created the World Bank, International Monetary Fund, and the World Trade Organization, as we know it today). He was the head of the British Commission and the chairman of the World Bank Commission. He was the brainchild behind the management of currencies between and among countries. He advocated the creation of a world central bank, the International Clearing Union, that will be responsible for the common world currency unit.[6], [7]

Main Constructs of Keynesian Economics

Against classical thinking

Keynesian economics is also known to other scientists and economists as Keynesianism, or simply, Keynesian Theory. This is an economic theory mostly based on the ideas, writings, and principles of the early 20th-century economist from London, John Maynard Keynes. In this classical economic principle, a mixed economy is promoted, i.e., both the state (or government, specifically) and the private sector are expected to have a significant role in economic affairs. This theory sought to provide explanations, if not solutions, to what some other social scientists of that era believed to be the failures and flaws of laissez-faire (a French phrase meaning “let do”) economic liberalism, which advocates that the private sector and the market should have an optimal performance without intervention of the state.[8], [9]

In Keynesian economics, trends in the macroeconomic level almost always overwhelm the individual behavior in the microeconomic level. Most classical economists in the late 1700s to early 1800s argued that economic process are based on continuous improvement in potential output. Keynes expressed a contrarian view: the driving factor of any economy is the aggregate demand, which is especially true, according to Keynes, during periods of economic slowdowns or downturns (recession or depression). It is through this argument that he justified that government’s intervention could be used to stimulate demand at a macro level. Such policies of the state may help avert high unemployment rate and deflation. This principle puts the government or state the primary actor responsible for pulling a country out of a depression or recession. Again, this is an opposite perspective from a supply-side economics. Using Keyne’s principle, the government should encourage spending by taking the lead and making more money available for circulation. This activity will drive and encourage people to spend more, and eventually, invest more, thus, making the economy pull itself back up to its normal state.[10], [11]

Keynes believed that the level of employment and output can primarily be determined by effective demand or aggregate demand. In essence, Keynes was arguing that it is actually the demand which creates its own supply, up to a certain limit set by full employment. The classical economic theory, as called by Keynes before he published his book The General Theory of Employment Interest and Money, postulates that demand will tend to the optimal employment level as soon as adjustment in prices takes place. But classical economic theory did not work, as shown in the sharp fall of output and employment in the 1930s, and the self-correcting process predicted by this theory did not materialize. In the neo-classical theory, the two main costs are those from labor and money. If there were more labor than demand for it, wages would fall until hiring began again. If there was too much saving, and not enough consumption, then interest rates would fall until people either cut their savings rate or started borrowing.[12], [13]

Wages, spending, and excessive saving

During the Great Depression of the early 19th century, a lost of incentive to produce was considered the barometer of economic collapse. Massive unemployment was caused only by rigid and high real wages. The proper solution targeted was to cut down wages.

To Keynes, however, the determination of existing wages is significantly complicated. To him, people will definitely resist reductions in nominal wages. He believed that to boost employment, real wages had to go down, i.e., the nominal prices should drop faster than or more than prices. However, this might result to reduced consumer demand, and might even pose a threat to aggregate demand of goods. Wage cuts could make the matters much worse. And this is where Keynes encourages the government to intervene, and intervene strongly, and do the spending for the people, and create its own demand, thereby, creating its own supply. The government, encouraging spending among the people, may actually promote economic activities leading to the healing of the economic situation.[14], [15]

Keynes believes that excessive saving, i.e. saving beyond planned investment, can be a serious problem, and can encourage recession or even depression. Excessive or abnormal saving results if investment falls – may be due to over-investment in earlier years, falling consumer demand, or pessimistic business expectations. Classical economists believed that interest rates would fall due to the excess supply of “loanable funds.” To Keynes, there is and should be an interaction between excess supplies in different markets, as unemployment in labor markets seems to encourages excessive saving—and vice-versa. Rather than prices adjusting to attain equilibrium, the main story is one of quantity adjustment allowing recessions and possible attainment of underemployment equilibrium. [16]

Active fiscal policy

It was noted that classical economics wanted to balance the government budget by slashing expenditures or raising taxes to have more funds. To Keynes, this would only exacerbate the problem: Following either of the policies (slashing government expenditure or raising taxes) would encourage saving and, thus, decrease the aggregate demand for both labor and products. An example of this is how Keynesians view Hoover’s 1932 tax hike as making the Depression only worse. Roosevelt was said to have been influenced by Keynes’s ideas, especially the ones Keynes sent as an open letter to him in the New York Times (December 16, 1933), on how insufficient buying power has caused and even aggravated the Great Depression. During Roosevelt’s presidency, he adopted many aspects of Keynesian economics, especially when the United States suffered from recession which was followed by further fiscal contraction.

Keynes’s theory postulated that active state interventionist policy could be effective in helping the economy recover (Keynesian economics is especially applicable when the economy is in a downturn or simply slowing down). Rather than looking at the unbalanced government budgets as incorrect, Keynesian economics advocated what has been eventually called countercyclical fiscal and governmental policies: to resort to deficit spending when (i) an economy is suffering from a recession or slow moving economy or simply when recovery is taking a long time making unemployment high to the point of being unmanageable; and (ii) there is inflation in boom or bullish times resulting from either increasing taxes or, as classical economists would encourage, cutting back on government expenditures. Keynes argued that governments should intervene and solve short- to medium-term problems rather than waiting for the anticipated self-correction of market forces to actually do it, because as what Keynes has argued, “in the long run, we are all dead.”[17]

It should be noted, though, that mere deficit spending is not the main tenet of the theory – it s not Keynesianism. Deficits are being used by government to finance even offensive wars. Again, Keynesian economics is not merely spending. It is more of a proposition or a postulate that there are instances that the economy warrants active government intervention, i.e., fiscal and monetary policies. Further, Keynesianism also encourages counter-cyclical policies. An example of these is when taxes are raised when there is significantly abundant demand-side growth. This is to cool down the economy and at the same time prevent inflation, even if budget surplus exists. Contrary to Keynesianism, classical economists would argue that the government should cut taxes in the event of budget surpluses, so as to return the flow of money to private entities. Another example of Keynesianism’s counter-cyclical propositions is, as stated above, when it would encourage deficit during economic downturns, as against the proposition of classicals who would rather recommend cut down on government expenditures and outlays.[18]

Criticism

Keynesian economics was criticized by many free market economists and philosophers. Friedrich Hayek’s seminal work The Road to Serfdom, written in 1944, criticized Keynesian economic policies being fundamentally collectivist in approach, saying no matter how sound the policies are, these would require centralist planning which would make a country vulnerable to totalitarian regimes. Keynes is aware of the potential pitfalls of this theory, as can be observed in his foreword to the German version of the The General Theory of Employment Interest and Money, where he declared,

the theory of aggregated production, which is the point of [The General Theory of Employment Interest and Money], nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire.[19]

James Buchanan, another economist, followed the criticism of Hayek by noting that Keynes may have been more concerned with what was a good policy is, but not on how it would be implemented. In Buchanan’s book Democracy in Deficit, he notes that Keynesian economics ay have not considered how, for example, deficit spending would give a “blank check” to politicians and bureaucrats.[20]

Overtime, one will realize that the theory has its potential pitfalls especially if applied against its assumptions. But Keynesian economics has proven how it was able to explain previous recessions and help the economies in recovering from it.

 
Complete notes

 

1.                  Reich, R. B. “John Maynard Keynes.” The Time 100. Available at http://www.time.com/time/time100/scientist/profile/keynes.html (accessed November 12, 2007).

 

2.                  Ibid.

 

3.                  Ibid.

 

4.                  Ibid.

 

5.                  Wikipedia, The Free Encyclopedia, “John Maynard Keynes,” http://en.wikipedia.org/w/index.php?title=John_Maynard_Keynes&oldid=172522945 (accessed November 19, 2007).

 

6.                  Ibid.

 

7.                  Reich, R. B. “John Maynard Keynes.” The Time 100. Available at http://www.time.com/time/time100/scientist/profile/keynes.html (accessed November 12, 2007).

 

8.                  Akerlof, George A. “The missing motivation in macroeconomics.” American Economic Review 97, no. 1 (2007): 134.

 

9.                  Reich, R. B. “John Maynard Keynes.” The Time 100. Available at http://www.time.com/time/time100/scientist/profile/keynes.html (accessed November 12, 2007).

 

10.              Akerlof, George A. “The missing motivation in macroeconomics.” American Economic Review 97, no. 1 (2007): 138.

 

11.              Reich, R. B. “John Maynard Keynes.” The Time 100. Available at http://www.time.com/time/time100/scientist/profile/keynes.html (accessed November 12, 2007).

 

12.              Akerlof, George A. “The missing motivation in macroeconomics.” American Economic Review 97, no. 1 (2007): 140.

 

13.              Reich, R. B. “John Maynard Keynes.” The Time 100. Available at http://www.time.com/time/time100/scientist/profile/keynes.html (accessed November 12, 2007).

 

14.              Akerlof, George A. “The missing motivation in macroeconomics.” American Economic Review 97, no. 1 (2007): 147–148.

 

15.              Keynes, John Maynard. The general theory of employment, interest and money. Cambridge: Harcourt, Brace and Company, 1936, pp. 35–38.

 

16.              Ibid., p. 39.

 

17.              Ibid., 46.

 

18.              Akerlof, George A. “The missing motivation in macroeconomics.” American Economic Review 97, no. 1 (2007): 148.

 

19.              Keynes. “Foreword to the General Theory.” Foreword to the German Edition/Vorwort Zur Deutschen Ausgabe, as cited in “Keynesian economics,” Wikipedia, The Free Encyclopedia.

 

20.              Wikipedia, The Free Encyclopedia, “John Maynard Keynes,” http://en.wikipedia.org/w/index.php?title=John_Maynard_Keynes&oldid=172522945 (accessed November 19, 2007).

 

 
Bibliography

 

Akerlof, George A. “The missing motivation in macroeconomics.” American Economic Review 97, no. 1 (2007): 134–148.

 

Keynes, John Maynard. The general theory of employment, interest and money. Cambridge: Harcourt, Brace and Company, 1936.

 

Reich, R. B. “John Maynard Keynes.” The Time 100. Available at http://www.time.com/time/time100/scientist/profile/keynes.html (accessed November 12, 2007).

 

Wikipedia, The Free Encyclopedia, “John Maynard Keynes,” http://en.wikipedia.org/w/index.php?title=John_Maynard_Keynes&oldid=172522945 (accessed November 19, 2007).

 

Wikipedia, The Free Encyclopedia, “Keynesian economics,” http://en.wikipedia.org/w/index.php?title=Keynesian_economics&oldid=171056445 (accessed November 19, 2007).

 

Note

 

Keynes, John M, An open letter to President Roosevelt, New York Times, December 16, 1933.

 

[1] Reich, “John Maynard Keynes.”
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] Wikipedia, The Free Encyclopedia, “John Maynard Keynes.”
[6] Ibid.
[7] Reich, “John Maynard Keynes.”
[8] Akerlof, “The missing motivation in macroeconomics,” 134.
[9] Reich, “John Maynard Keynes.”
[10] Akerlof, “The missing motivation in macroeconomics,” 138.
[11] Reich, “John Maynard Keynes.”
[12] Akerlof, “The missing motivation in macroeconomics,” 140.
[13] Reich, “John Maynard Keynes.”
[14] Akerlof, “The missing motivation in macroeconomics,” 147–148.
[15] Keynes, The general theory of employment, interest and money, 35–38.
[16] Keynes, The general theory of employment, interest and money, 39.
[17] Ibid., 46.
[18] Akerlof, “The missing motivation in macroeconomics,” 148.
[19] Keynes. “Foreword to the General Theory.” Foreword to the German Edition/Vorwort Zur Deutschen Ausgabe, as cited in “Keynesian economics,” Wikipedia, The Free Encyclopedia.
[20] Wikipedia, The Free Encyclopedia, “Keynesian economics.”