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Keynesian economics

Keynesian economics (/ˈkeɪnziən/ KAYN-zee-ən; sometimes called Keynesianism) are the various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand (total demand in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

Keynesian economics developed during and after the Great Depression, from the ideas presented by John Maynard Keynes in his 1936 book, The General Theory of Employment, Interest and Money. Keynes contrasted his approach to the aggregate supply-focused classical economics that preceded his book. The interpretations of Keynes that followed are contentious and several schools of economic thought claim his legacy.

Keynesian economists generally argue that, as aggregate demand is volatile and unstable, a market economy will often experience inefficient macroeconomic outcomes in the form of economic recessions (when demand is low) and inflation (when demand is high). These can be mitigated by economic policy responses, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, which can help stabilize output over the business cycle. 

Keynesian economists generally advocate a managed market economy – predominantly private sector, but with an active role for government intervention during recessions and depressions.
Keynesian economics served as the standard economic model in the developed nations during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the oil shock and resulting stagflation of the 1970s. The advent of the financial crisis of 2007–08 caused a resurgence in Keynesian thought, which continues as new Keynesian economics.

Historical context

Pre-Keynesian macroeconomics

Macroeconomics is the study of the factors applying to an economy as a whole, such as the overall price level, the interest rate, and the level of employment (or equivalently, of income/output measured in real terms).

The classical tradition of partial equilibrium theory had been to split the economy into separate markets, each of whose equilibrium conditions could be stated as a single equation determining a single variable. The theoretical apparatus of supply and demand curves developed by Fleeming Jenkin and Alfred Marshall provided a unified mathematical basis for this approach, which the Lausanne School generalized to general equilibrium theory.

For macroeconomics the relevant partial theories were: the Quantity theory of money determining the price level, the classical theory of the interest rate, and for employment the condition referred to by Keynes as the "first postulate of classical economics" stating that the wage is equal to the marginal product, which is a direct application of the marginalist principles developed during the nineteenth century (see The General Theory). Keynes sought to supplant all three aspects of the classical theory.
  
Precursors of Keynesianism

Although Keynes's work was crystallized and given impetus by the advent of the Great Depression, it was part of a long-running debate within economics over the existence and nature of general gluts. A number of the policies Keynes advocated to address the Great Depression (notably government deficit spending at times of low private investment or consumption), and many of the theoretical ideas he proposed (effective demand, the multiplier, the paradox of thrift), had been advanced by various authors in the 19th and early 20th centuries. Keynes's unique contribution was to provide a general theory of these, which proved acceptable to the economic establishment.

An intellectual precursor of Keynesian economics was underconsumption theories associated with John Law, Thomas Malthus, the Birmingham School of Thomas Attwood, and the American economists William Trufant Foster and Waddill Catchings, who were influential in the 1920s and 1930s. Underconsumptionists were, like Keynes after them, concerned with failure of aggregate demand to attain potential output, calling this "underconsumption" (focusing on the demand side), rather than "overproduction" (which would focus on the supply side), and advocating economic interventionism. Keynes specifically discussed underconsumption (which he wrote "under-consumption") in the General Theory, in Chapter 22, Section IV and Chapter 23, Section VII.
Numerous concepts were developed earlier and independently of Keynes by the Stockholm school during the 1930s; these accomplishments were described in a 1937 article, published in response to the 1936 General Theory, sharing the Swedish discoveries.

The paradox of thrift was stated in 1892 by John M. Robertson in his The Fallacy of Saving, in earlier forms by mercantilist economists since the 16th century, and similar sentiments date to antiquity.  
Keynes's early writings

In 1923 Keynes published his first contribution to economic theory, A Tract on Monetary Reform, whose point of view is classical but which incorporates ideas later to play a part in the General Theory : in particular, looking at the hyperinflation in European economies, he drew attention to the opportunity cost of holding money (identified with inflation rather than interest) and its influence on the velocity of circulation.

In 1930 he published A Treatise on Money, intended as a comprehensive treatment of its subject "which would confirm his stature as a serious academic scholar, rather than just as the author of stinging polemics", and which marks a large step in the direction of his later views. In it he attributes unemployment to wage stickiness and treats saving and investment as governed by independent decisions: the former varying positively with the interest rate, the latter negatively. The velocity of circulation is expressed as a function of the rate of interest. He interpreted his treatment of liquidity as implying a purely monetary theory of interest.

Keynes's younger colleagues of the Cambridge Circus and Ralph Hawtrey believed that his arguments implicitly assumed full employment, and this influenced the direction of his subsequent work. During 1933 he wrote essays on various economic topics "all of which are cast in terms of movement of output as a whole".
  
Development of The General Theory

At the time that Keynes's wrote the General Theory, it had been a tenet of mainstream economic thought that the economy would automatically revert to a state of general equilibrium: it had been assumed that, because the needs of consumers are always greater than the capacity of the producers to satisfy those needs, everything that is produced would eventually be consumed once the appropriate price was found for it. This perception is reflected in Say's law and in the writing of David Ricardo, which states that individuals produce so that they can either consume what they have manufactured or sell their output so that they can buy someone else's output. This argument rests upon the assumption that if a surplus of goods or services exists, they would naturally drop in price to the point where they would be consumed.

Given the backdrop of high and persistent unemployment during the Great Depression, Keynes argued that there was no guarantee that the goods that individuals produce would be met with adequate effective demand, and periods of high unemployment could be expected, especially when the economy was contracting in size. He saw the economy as unable to maintain itself at full employment automatically, and believed that it was necessary for the government to step in and put purchasing power into the hands of the working population through government spending. Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in the goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes wherein the economy operates below its potential output and growth rate.

Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut, although there was disagreement among them as to whether a general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem. Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation.
  
Origins of the multiplier

The Liberal Party fought the 1929 General Election on a promise to "reduce levels of unemployment to normal within one year by utilising the stagnant labour force in vast schemes of national development". David Lloyd George launched his campaign in March with a policy document "We can cure unemployment" which made the tentative claim that "public works would lead to a second round of spending as the workers spent their wages". Two months later Keynes, then nearing completion of his Treatise on money, and Hubert Henderson collaborated on a political pamphlet seeking to "provide academically respectable economic arguments" for Lloyd George's policies. It was titled Can Lloyd George do it? and endorsed the claim that "greater trade activity would make for greater trade activity ... with a cumulative effect". This became the mechanism of the "ratio" published by Richard Kahn in his 1931 paper "The relation of home investment to unemployment",^[27] described by Alvin Hansen as "one of the great landmarks of economic analysis". The "ratio" was soon rechristened the "multiplier" at Keynes's suggestion.

The multiplier of Kahn's paper is based on a respending mechanism familiar nowadays from textbooks. Samuelson puts it as follows:

Let’s suppose that I hire unemployed resources to build a $1000 woodshed. My carpenters and lumber producers will get an extra $1000 of income... If they all have a marginal propensity to consume of 2/3, they will now spend $666.67 on new consumption goods. The producers of these goods will now have extra incomes... they in turn will spend $444.44 ... Thus an endless chain of secondary consumption respending  is set in motion by my primary  investment of $1000.

Samuelson's treatment closely follows Joan Robinson's account of 1937 and is the main channel by which the multiplier has influenced Keynesian theory. It differs significantly from Kahn's paper and even more from Keynes’s book.

The designation of the initial spending as "investment" and the employment-creating respending as "consumption" echoes Kahn faithfully, though he gives no reason why initial consumption or subsequent investment respending shouldn’t have exactly the same effects. Henry Hazlitt, who considered Keynes to be as much a culprit as Kahn and Samuelson, wrote that ...

... in connection with the multiplier (and indeed most of the time) what Keynes is referring to as "investment" really means any addition to spending for any purpose... The word "investment" is being used in a Pickwickian, or Keynesian, sense.

Kahn envisaged money as being passed from hand to hand, creating employment at each step, until it came to rest in a cul-de-sac  (Hansen's term was "leakage"); the only culs-de-sac  he acknowledged were imports and hoarding, although he also said that a rise in prices might dilute the multiplier effect. Jens Warming recognised that personal saving needed to be taken into consideration, treating it as a "leakage" (p. 214) while recognising on p. 217 that it might in fact be invested.

The textbook multiplier gives the impression that making society richer is the easiest thing in the world: the government just needs to decide to spend more. In Kahn's paper it is harder. For him the initial expenditure must not be a diversion of funds from other uses but an increase in the total amount of expenditure taking place: something which would be impossible – if understood in real terms – under the classical theory that the level of expenditure is limited by the economy's income/output. On p174 Kahn rejects the claim that the effect of public works will be at the expense of expenditure elsewhere, admitting that this might arise if the revenue was raised by taxation, but says that other means are available which have no such consequences. As an example he suggests that the money may be raised by borrowing from banks, since ...

... it is always within the power of the banking system to advance to the Government the cost of the roads without in any way affecting the flow of investment along the normal channels.

This assumes that banks are free to create resources to answer any demand. But Kahn adds that ...

... no such hypothesis is really necessary. For it will be demonstrated later on that, pari passu  with the building of roads, funds are released from various sources at precisely the rate that is required to pay the cost of the roads.

The demonstration relies on "Mr Meade's relation" (due to James Meade) asserting that the total amount of money which disappears into culs-de-sac  is equal to the original outlay, which in Kahn's words "should bring relief and consolation to those who are worried about the monetary sources" (p. 189).

A respending multiplier had been proposed earlier by Hawtrey in a 1928 Treasury memorandum ("with imports as the only leakage"), but the idea was discarded in his own subsequent writings. Soon afterwards the Australian economist Lyndhurst Giblin published a multiplier analysis in a 1930 lecture (again with imports as the only leakage). The idea itself was much older. Some Dutch mercantilists had believed in an infinite multiplier for military expenditure (assuming no import "leakage"), since ...

... a war could support itself for an unlimited period if only money remained in the country ... For if money itself is "consumed", this simply means that it passes into someone else's possession, and this process may continue indefinitely.

Multiplier doctrines had subsequently been expressed in more theoretical terms by the Dane Julius Wulff (1896), the Australian Alfred de Lissa (late 1890s), the German/American Nicholas Johannsen (same period), and the Dane Fr. Johannsen (1925/1927). Kahn himself said that the idea was given to him as a child by his father.
  
Public policy debates

As the 1929 election approached "Keynes was becoming a strong public advocate of capital development" as a public measure to alleviate unemployment. Winston Churchill, the Conservative Chancellor, took the opposite view:

It is the orthodox Treasury dogma, steadfastly held ... [that] very little additional employment and no permanent additional employment can, in fact, be created by State borrowing and State expenditure.

Keynes pounced on a chink in the Treasury view. Cross-examining Sir Richard Hopkins, a Second Secretary in the Treasury, before the Macmillan Committee on Finance and Industry in 1930 he referred to the "first proposition" that "schemes of capital development are of no use for reducing unemployment" and asked whether "it would be a misunderstanding of the Treasury view to say that they hold to the first proposition". Hopkins responded that "The first proposition goes much too far. The first proposition would ascribe to us an absolute and rigid dogma, would it not?"

Later the same year, speaking in a newly created Committee of Economists, Keynes tried to use Kahn's emerging multiplier theory to argue for public works, "but Pigou's and Henderson's objections ensured that there was no sign of this in the final product". In 1933 he gave wider publicity to his support for Kahn's multiplier in a series of articles titled "The road to prosperity" in The Times newspaper.

A. C. Pigou was at the time the sole economics professor at Cambridge. He had a continuing interest in the subject of unemployment, having expressed the view in his popular Unemployment  (1913) that it was caused by "maladjustment between wage-rates and demand" – a view which Keynes may have shared prior to the years of the General Theory. Nor were his practical recommendations very different: "on many occasions in the thirties" Pigou "gave public support ... to State action designed to stimulate employment". Where the two men differed is in the link between theory and practice. Keynes was seeking to build theoretical foundations to support his recommendations for public works while Pigou showed no disposition to move away from classical doctrine. Referring to him and Dennis Robertson, Keynes asked rhetorically: "Why do they insist on maintaining theories from which their own practical conclusions cannot possibly follow?"