Keynesian economics

• 1. Introduction

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  Keynesian economics takes its name from John Maynard Keynes, the British economist whose 1936 book, The General Theory of Employment, Interest and Money, arrived in the middle of the Great Depression and changed how governments understood their role in an economy. At the time that book appeared, unemployment had reached 25% in the United States and as high as 33% in some other countries. The prevailing wisdom held that markets would sort themselves out. Keynes said they would not. That argument planted a question at the heart of modern economic policy: when an economy collapses, should a government wait, or should it act? The answer Keynes gave shaped the decades that followed, survived a near-death in the 1970s, and returned with fresh urgency during the 2008 financial crisis.

• 2. A Theory Born From Collapse

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  Say's Law had been the bedrock of classical economics for generations. It held, in Keynes's own summary, that supply creates its own demand: whatever is produced will eventually be bought once the right price is found. David Ricardo had expressed this logic clearly, and it underpinned the confidence that economies were essentially self-correcting. The Great Depression shattered that confidence. Keynes argued that when a general glut occurred, producers overreacted by laying off workers, which reduced demand further and deepened the slump. The market, left alone, could stay stuck well below its productive potential for a long time. His core insight was that aggregate demand, the total spending in an economy, could fall short of what the economy was capable of producing. That gap between potential and actual output was the problem. To bridge it, he believed governments needed to step in and put purchasing power in the hands of working people through direct spending.

• 3. Long Before Keynes

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  John Law, Thomas Malthus, and the Birmingham School of Thomas Attwood had all worried about insufficient demand long before Keynes formalised the idea. The American economists William Trufant Foster and Waddill Catchings were influential advocates for this view in the 1920s and 1930s, framing the problem as underconsumption rather than overproduction. J. M. Robertson had raised what would later be called the paradox of thrift as early as 1892. The Stockholm school of Swedish economists was developing similar ideas during the 1930s; their accomplishments were described in a 1937 article published in direct response to Keynes's General Theory, documenting how close the Swedish discoveries had come. Keynes's earlier publications also showed the ground being prepared. His 1923 work, A Tract on Monetary Reform, drew attention to the opportunity cost of holding money and its effect on circulation. His 1930 Treatise on Money attributed unemployment to wage stickiness and treated saving and investment as driven by separate, independent decisions. What was missing was a single, comprehensive theoretical framework that the economic establishment would accept. That was Keynes's unique contribution.

• 4. The Multiplier and Its Origins

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  Richard Kahn published a paper in 1931 titled The relation of home investment to unemployment, which Alvin Hansen later called one of the great landmarks of economic analysis. Kahn described how a single act of public spending rippled through an economy: workers employed on a public project spent their wages, and the recipients of that spending spent in turn, creating a chain of activity far larger than the original outlay. The economist Paul Samuelson illustrated the mechanism precisely. Suppose, he wrote, that hiring unemployed workers to build a $1000 woodshed puts $1000 in income in their hands. If they have a marginal propensity to consume of 2/3, they spend $666.67 on new consumption goods. The producers of those goods then spend $444.44, and so the chain continues. The word multiplier came from Keynes himself, who suggested the rechristening of what Kahn had originally called his ratio. The concept had earlier precedents: Hawtrey had sketched a respending mechanism in a 1928 Treasury memorandum, and the Australian economist Lyndhurst Giblin had published a multiplier analysis in a 1930 lecture. Some Dutch mercantilists had even speculated about an infinite multiplier for military spending, reasoning that money spent within a country never truly disappears. But it was Kahn's 1931 paper, and then Keynes's endorsement in a series of 1933 articles in The Times titled The road to prosperity, that gave the idea its lasting theoretical home.

• 5. Government, Deficits, and the Business Cycle

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  Winston Churchill, then Conservative Chancellor, gave clear voice to the opposing view in the late 1920s. It was, he said, orthodox Treasury dogma that state borrowing and state expenditure could create very little additional employment and certainly no permanent additional employment. Keynes set out to dismantle that dogma. He cross-examined a senior Treasury official, Sir Richard Hopkins, before the Macmillan Committee on Finance and Industry in 1930, and drew the admission that the Treasury's first proposition, denying any employment benefit from public works, went much too far. Keynes's argument for active fiscal policy rested on two instruments: reducing interest rates through monetary policy to make investment more affordable, and increasing public spending directly during downturns. A key clarification he offered was that Keynesianism is not simply an endorsement of deficit spending at all times. If a government ran a deficit of 10% in one year and 5% the next, that would in fact be contractionary. Conversely, a government moving from a 10% surplus to a 5% surplus would be running an expansionary policy despite never borrowing a cent. The relevant variable is the change in net spending relative to economic conditions, not the deficit level in isolation. Keynes's ideas influenced Franklin D. Roosevelt's diagnosis of the Depression, and Roosevelt adopted several aspects of the approach, especially after 1937 when contractionary fiscal policy pushed the United States back into recession despite the Depression's supposed end.

• 6. Trade, Surpluses, and the Bancor

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  In the last years of his life, Keynes turned seriously to the problem of international trade imbalances. He led the British delegation to the United Nations Monetary and Financial Conference in 1944, the gathering at Bretton Woods that established the postwar system of international currency management. His proposal, known as the Keynes Plan, called for an International Clearing Union that would issue its own currency, the bancor, exchangeable with national currencies at fixed rates. Every country would hold an overdraft facility denominated in bancor. The plan's most striking feature was its treatment of creditor nations. Keynes argued that countries running trade surpluses exerted a negative externality on their trading partners, draining global aggregate demand and enriching themselves at the expense of others. He proposed taxing surplus countries to create pressure to eliminate imbalances. American opinion resisted the principle of equal treatment between debtors and creditors, and the plan was rejected. Geoffrey Crowther, editor of The Economist at the time, put the stakes bluntly: if economic relationships between nations are not brought fairly close to balance, no set of financial arrangements can rescue the world from the impoverishing results of chaos. Keynes had arrived at protectionist positions through the Depression years, advocating tariffs and quotas and eventually describing the assumption that sectoral labour mobility was perfect as nonsense, in the Daily Mail of the 13th of March 1931. His 1933 National Self-Sufficiency article in The Yale Review, published in June of that year, argued that nations should prefer diverse domestic activity over deep international specialisation whenever the economic loss was not severe.

• 7. Rise, Stagflation, and Return

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  After World War II, Keynesian economics became the standard framework for economic policy in Western industrialised countries through what is often called the Golden Age of Capitalism, a period of low, stable unemployment and modest inflation. Republican US President Richard Nixon declared in 1971 that he was now a Keynesian in economics, a statement that captured how thoroughly the approach had crossed political lines. The oil shock of 1973 broke that consensus. Inflation rose sharply alongside unemployment, a combination the Phillips curve had implied was impossible, and the word stagflation entered the lexicon. The 1970s saw neoliberalism replace Keynesianism as the dominant paradigm, and monetarism, supply-side economics, and new classical macroeconomics all gained ground. Critics including Friedrich Hayek, Ludwig von Mises, and Milton Friedman argued that Keynesian policies distorted market signals, fuelled inflation, and generated unsustainable public debt. Friedman added that he believed Keynes's political legacy was harmful, predicting that benevolent economic management would tend toward authoritarian governance over time. The 2008 financial crisis produced what has since been called the 2008-2009 Keynesian resurgence, as governments around the world reached for fiscal tools to stabilise collapsing demand. Paul Krugman's work on the liquidity trap helped explain why Japan's long stagnation had persisted despite near-zero interest rates: when short-term rates approach zero and private investment remains insufficient to end deflation, monetary expansion simply adds to idle bank reserves, precisely the condition Keynes had described decades earlier.

• 8. Critics, Schools, and Legacy

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  Paul Sweezy, writing in 1946, acknowledged the value of Keynes's analysis of effective demand but described Keynes as a prisoner of his neoclassical upbringing, arguing that he never examined capitalism as a total system and treated the state as a deus ex machina rather than a class institution. Michal Kalecki, generally enthusiastic about the Keynesian revolution, predicted in his article Political Aspects of Full Employment that full employment would eventually produce a more assertive working class, threatening the social position of business leaders enough to prompt political elites to displace Keynesian policy even at the cost of their own profits. James M. Buchanan argued that Keynesian fiscal policy rested on the unrealistic assumption that economic decisions would be made by wise technocrats insulated from political pressures, and blamed the approach for what he saw as a decline in fiscal discipline, with deficit spending institutionalising a permanent disconnect between government spending and revenue. Multiple schools of economic thought now claim Keynes's legacy: neo-Keynesian economics, New Keynesian economics, post-Keynesian economics, and the new neoclassical synthesis. Keynes's biographer Robert Skidelsky has written that the post-Keynesian school has stayed closest to the spirit of Keynes's original monetary theory, including its rejection of the neutrality of money. Economist Alan Blinder, in a 2014 paper, argued that the association of Keynesianism with political liberalism in the United States is incorrect: both Ronald Reagan and George W. Bush pursued policies that were in practice Keynesian, even as both men positioned themselves as conservatives. The debate Keynes started in 1936 over whether markets reliably self-correct, and whether governments must sometimes intervene, remains the central fault line in macroeconomics today.