Keynesian economics

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Keynesian economics (pronounced /ˈkeɪnzjən/), also called Keynesianism, or Keynesian Theory, is an economic theory based on the ideas of 20th century British economist John Maynard Keynes. Keynesian economics promotes a mixed economy, where both the state and the private sector play an important role. Keynesian economics differs markedly from laissez-faire economics (economic theory based on the belief that markets and the private sector operate well on their own, without state intervention).

In Keynes's theory, general (macro-level) trends can overwhelm the micro-level behavior of individuals. Instead of the economic process being based on continuous improvement in potential output, as most classical economists had believed from the late 1700s on, Keynes asserted the importance of aggregate demand for goods as the driving factor of the economy, especially in periods of downturn. From this he argued that government policies could be used to promote demand at a macro level, to fight high unemployment and deflation of the sort seen during the 1930s.

A central conclusion of Keynesian economics is that there is no strong automatic tendency for output and employment to move toward full employment levels. This conclusion conflicts with the tenets of classical economics, and those schools, such as supply-side economics or the Austrian School, which assume a general tendency towards a welcome equilibrium in a restrained money-creating economy. In neoclassical economics, which combines Keynesian macro concepts with a micro foundation, the conditions of General equilibrium allow for price adjustment to achieve this goal.

More broadly, Keynes saw his as a general theory, in which resource utilization could be high or low, whereas previous economics focused on the particular case of full utilization.

Contents

[edit] Historical background

John Maynard Keynes was one of a wave of thinkers who perceived increasing cracks in the assumptions and theories which held sway at that time. Keynes questioned two of the dominant pillars of economic theory: 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 only cause price declines, rather than affecting real output and employment.

In his political views, Keynes was no revolutionary. He was pro-business and pro-entrepreneur, but was very critical of rentiers and speculators, from a somewhat Fabian perspective. He was a "new" or modern liberal.

It was his experience with the Treaty of Versailles which pushed him to make a break with previous theory. His The Economic Consequences of the Peace (1920) not only recounted the general economics, as he saw them, of the Treaty, but the individuals involved in making it. The book established him as an economist who had the practical political skills to influence policy. In the 1920s, 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 to attain "the optimal level of production." This is expressed in his famous quote, "In the long run, we are all dead," implying that it does not matter that optimal production levels are attained in the long run, because it would be a very long run indeed.

In the late 1920s, the world economic system began to break down, after the shaky recovery that followed World War I. With the global drop in production, critics of the gold standard, market self-correction, and production-driven paradigms of economics moved to the fore. Dozens of different schools contended for influence. Further, some pointed to the Soviet Union as a successful planned economy which had avoided the disasters of the capitalist world and argued for a move toward socialism. Others pointed to the supposed success of fascism in Mussolini's Italy.

Into this tumult stepped Keynes, promising not to institute revolution but to save capitalism. He circulated a simple thesis: there were more factories and transportation networks than could be used at the current ability of individuals to pay and that the problem was on the demand side.

But many economists insisted that business confidence, not lack of demand, was the root of the problem, and that the correct course was to slash government expenditures and to cut wages to raise business confidence and willingness to hire unemployed workers. Yet others simply argued that "nature would make its course," solving the Depression automatically by "shaking out" unneeded productive capacity.

[edit] Keynes and the Classics

Keynes explained that the level of output and employment in the economy was determined by aggregate demand or effective demand. In a reversal of Say's Law, Keynes in essence argued that "man creates his own supply," up to the limit set by full employment.

In "classical" economic theory—Keynes's term for the economics prior to General Theory (and specifically that of Arthur Pigou)—adjustments in prices would automatically make demand tend to the full employment level. Keynes, pointing to the sharp fall in employment and output in the early 1930s, argued that whatever the theory, this self-correcting process had not happened.

In the neo-classical theory, the two main costs are those of 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.

[edit] Wages and spending

During the Great Depression, the classical theory defined economic collapse as simply a lost incentive to produce. Mass unemployment was caused only by high and rigid real wages. The proper solution was to cut wages.

To Keynes, the determination of wages is more complicated. First, he argued that it is not real but nominal wages that are set in negotiations between employers and workers, as opposed to a barter relationship. First, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical economists admitted that these exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility. However, to Keynes, people will resist nominal wage reductions, even without unions, until they see other wages falling and a general fall of prices. (His prediction that mass unemployment would be necessary to deflate sterling wages back to pre-war gold values had been proven right in the 1920s).

He also argued that to boost employment, real wages had to go down: nominal wages would have to fall more than prices. However, doing so would reduce consumer demand, so that the aggregate demand for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment—perhaps already discouraged by previous excesses—would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downward as those who had money would simply wait as falling prices made it more valuable—rather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) can make a depression deeper as falling prices and wages made pre-existing nominal debts more valuable in real terms.

[edit] Excessive saving

Classics on Saving and Investment.

To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem encouraging recession even depression. Excessive saving results if investment falls, perhaps due to falling consumer demand, over-investment in earlier years, or pessimistic business expectations, and if saving does not immediately fall in step.

The classical economists argued that interest rates would fall due to the excess supply of "loanable funds." The first diagram, adapted from the only graph in The General Theory, shows this process. (For simplicity, other sources of the demand for or supply of funds are ignored here.) Assume that fixed investment in capital goods falls from "old I" to "new I" (step a). Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have saving (S) equal to investment. The interest-rate fall prevents that of production and employment.

Keynes had a complex argument against this laissez-faire response. The graph below summarizes his argument, assuming again that fixed investment falls (step A). First, saving does not fall much as interest rates fall, since the income and substitution effects of falling rates go in conflicting directions. Second, since planned fixed investment in plant and equipment is mostly based on long-term expectations of future profitability, that spending does not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a negative interest rate at equilibrium (where the new I line would intersect the old S line). However, this negative interest rate is not necessary to Keynes's argument.

Keynes on Saving and Investment.

Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in the short run. Instead, the supply of and the demand for the stock of money determine interest rates in the short run. (This is not drawn in the graph.) Neither change quickly in response to excessive saving to allow fast interest-rate adjustment.

Finally, because of fear of capital losses on assets besides money, Keynes suggested that there may be a "liquidity trap" setting a floor under which interest rates cannot fall. (In this trap, bond-holders, fearing rises in interest rates (because rates are so low), fear capital losses on their bonds and thus try to sell them to attain money (liquidity).) Even economists who reject this liquidity trap now realize that nominal interest rates cannot fall below zero (or slightly higher). In the diagram, the equilibrium suggested by the new I line and the old S line cannot be reached, so that excess saving persists. Some (such as Paul Krugman) see this latter kind of liquidity trap as prevailing in Japan in the 1990s.

Even if this "trap" does not exist, there is a fourth element to Keynes's critique (perhaps the most important part). Saving involves not spending all of one's income. It thus means insufficient demand for business output, unless it is balanced by other sources of demand, such as fixed investment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, or what classical economists called a "general glut". This pile-up of unsold goods and materials encourages businesses to decrease both production and employment. This in turn lowers people's incomes—and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes, the fall in income did most of the job ending excessive saving and allowing the loanable funds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession does so. Thus in the diagram, the interest-rate change is small.

Whereas the classical economists assumed that the level of output and income was constant and given at any one time (except for short-lived deviations), Keynes saw this as the key variable that adjusted to equate saving and investment.

Finally, a recession undermines the business incentive to engage in fixed investment. With falling incomes and demand for products, the desired demand for factories and equipment (not to mention housing) will fall. This accelerator effect would shift the I line to the left again, a change not shown in the diagram above. This recreates the problem of excessive saving and encourages the recession to continue.

In sum, to Keynes there is interaction between excess supplies in different markets, as unemployment in labor markets 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.

[edit] Active fiscal policy

As noted, the classicals wanted to balance the government budget, through slashing expenditures or (more rarely) raising taxes. To Keynes, this would exacerbate the underlying problem: following either policy would raise saving (broadly defined) and thus lower the demand for both products and labor. For example, Keynesians see Herbert Hoover's June 1932 tax hike as making the Depression worse.

Keynes's ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the Depression. During his presidency, he adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again. Something similar to Keynesian expansionary policies had been applied earlier by both social-democratic Sweden and Nazi Germany. But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s.

Keynes's theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called counter-cyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve short-term problems rather than waiting for market forces to do it, because "in the long run, we are all dead."

This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal stimulus (deficit spending) could actuate production. But to these schools, there was no reason to believe that this stimulation would outrun the side-effects that "crowd out" private investment: first, it would increase the demand for labor and raise wages, hurting profitability. Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating. Worse, it would be shifting resources away from productive use by the private sector to wasteful use by the government.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is persistently high, above what is now termed the Non-Accelerating Inflation Rate of Unemployment, or "NAIRU". In that case, crowding out is minimal. Further, private investment can be "crowded in": fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation. Second, as the stimulus occurs, gross domestic product rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-term growth of potential output.

Invoking public choice theory, classical and neoclassical economists doubt that the government will ever be this beneficial and suggest that its policies will typically be dominated by special interest groups, including the government bureaucracy. Thus, they use their political theory to reject Keynes' economic theory.

In Keynes' theory, there must be significant slack in the labor market before fiscal expansion is justified. Both conservative and some neoliberal economists question this assumption, unless labor unions or the government "meddle" in the free market, creating persistent supply-side or classical unemployment. Their solution is to increase labor-market flexibility, i.e., by cutting wages, busting unions, and deregulating business.

It is important to distinguish between mere deficit spending and Keynesianism. Governments had long used deficits to finance wars. But Keynesian policy is not merely spending. Rather, it is the proposition that sometimes the economy needs active fiscal policy. Further, Keynesianism recommends counter-cyclical policies, for example raising taxes when there is abundant demand-side growth to cool the economy and to prevent inflation, even if there is a budget surplus. Classical economics, on the other hand, argues that one should cut taxes when there are budget surpluses, to return money to private hands. Because deficits grow during recessions, classicals call for cuts in outlays—or, less likely, tax hikes. On the other hand, Keynesianism encourages increased deficits during downturns. In the Keynesian view, the classical policy exacerbates the business cycle. In the classical view, of course, Keynesianism is topsy-turvy policy, almost literally fiscal madness.

[edit] "Multiplier effect" and interest rates

Two aspects of Keynes's model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. The effect on demand of any exogenous increase in spending, such as an increase in government outlays is a multiple of that increase—until potential is reached. Thus, a government could stimulate a great deal of new production with a modest outlay: if the government spends, the people who receive this money then spend most on consumption goods and save the rest. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase consumer spending. This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that was available to invest. To Keynes, the amount of investment was determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But during more "normal" times, monetary expansion can stimulate the economy, mostly by encouraging construction of new housing.

[edit] Keynes and redistribution

Keynesians and redistributionists tend to associate with each other. Keynes, in the twenties, wrote about a hydro-electric project. In his opinion it would have been better if the rewards of the project had gone to the worker-builders rather than to the investers who had financed the project.

Keynesians believe that fiscal policy should be directed towards the lower-income segment of the population, because that segment is more likely to spend the money, contributing to demand, than to save it. Keynesians also tend to go further than Keynes himself, and to believe that all savings is excessive savings.

[edit] Postwar Keynesianism

After Keynes, Keynesian analysis was combined with classical economics to produce what is generally termed "the neoclassical synthesis" which dominates mainstream macroeconomic thought. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as classical or neoclassical theory predicted.

In the post-WWII years, Keynes's policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis and had a theory that told them what to do. In this era of new liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation.

It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt to understand and control economic activity. This model, the IS-LM model is nearly as influential as Keynes' original analysis in determining actual policy and economics education. It relates aggregate demand and employment to three exogenous quantities, i.e., the amount of money in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above.

The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve. This curve, which was more of an empirical observation than a theory, indicated that increased employment, and decreased unemployment, implied increased inflation. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output and employment—and then use the Phillips curve to predict an increase in inflation.

Through the 1950s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction. This stagflation meant that both expansionary (anti-recession) and contractionary (anti-inflation) policies had to be applied simultaneously, a clear impossibility. This dilemma led to the rise of ideas based upon more classical analysis, including monetarism, supply-side economics and new classical economics. This produced a "policy bind" and the collapse of the Keynesian consensus on the economy.

[edit] Criticism

The strength of Keynesianism's influence can be seen by the wave of economists who have based their analysis on a criticism of Keynesianism.

One school began in the late 1940s with Milton Friedman. Instead of rejecting macro-measurements and macro-models of the economy, the monetarist school embraced the techniques of treating the entire economy as having a supply and demand equilibrium. However, they regarded inflation as solely being due to the variations in the money supply, rather than as being a consequence of aggregate demand. They argued that the "crowding out" effects discussed above would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was largely ignored by early Keynesians.

Monetarism had an ideological as well as a practical appeal: monetary policy does not, at least on the surface, imply as much government intervention in the economy as other measures. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and inspired a wave of revisions to Keynesian theory.

Another influential school of thought was based on the Lucas critique of Keynesian economics. This drew heavily on developments in microeconomic theory, and in particular the idea of rational expectations. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted behaviour from people, which totally contradicted the economic understanding of their behaviour at a micro level. New classical economics introduced a set of macroeonomic theories which were based on optimising macroeconomic behaviour, for instance real business cycles.

Keynesian ideas were criticized by free market economist and philosopher Friedrich Hayek. Hayek's most famous work The Road to Serfdom, was written in 1944. Hayek taught at the London School of Economics from 1931 to 1950. Hayek criticized Keynesian economic policies for what he called their fundamentally collectivist approach, arguing that such theories, no matter their presumptively utilitarian intentions, require centralized planning, which Hayek argued leads to totalitarian abuses. Hayek claimed that what start as temporary governmental fixes usually become permanent and expanding government programs, which stifle the private sector and civil society. Keynes himself described the critique as "deeply moving", which was quoted on the cover of the Road to Serfdom.

James Buchanan followed the criticism by noting that, since Keynes had roots in the classically liberal or free market economic tradition, he was more concerned with what was good policy, not on how it would be executed. In the book Democracy in Deficit, he notes that Keynes never thought out how, say, deficit spending would give a blank check to politicians to run deficits even when orthodox Keynesian analysis didn't find it proper.

The Anarcho-capitalist economist Murray Rothbard was also hugely critical of Keynes. His essay Keynes, the Man[1] is a scathing attack upon both his economic ideas and personage.

[edit] Keynesian responses to the critiques

Macroeconomics has responded to the critique of Keynesianism by incorporating more detailed microfoundations into basically Keynesian models.

The heart of the 'new Keynesian' view rests on microeconomic models that indicate that nominal wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment prevails. This is a practice which, according to economist Paul Krugman "never works in theory, but works beautifully in practice."[citation needed] This integration is further spurred by the work of other economists which questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in the economy.

In the end, many macroeconomists have returned to the IS-LM model and the Phillips Curve as a first approximation of how an economy works. New versions of the Phillips Curve, such as the "Triangle Model", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in inflation. In the 1990s, the original ideas of "full employment" had been replaced by the NAIRU theory, sometimes called the "natural rate of unemployment." This theory pointed to the dangers of getting unemployment too low, because accelerating inflation can result. However, it is unclear exactly what the value of the NAIRU is—or whether it really exists or not. While the Keynesian triumphalism of the 1960s is certainly not due for a revival, Keynesian ideas persist, often used to attain very conservative goals. Many observers find it hard to distinguish the new Keynesianism from old monetarism, except that the latter's emphasis on the money supply has been dropped or downgraded.

[edit] See also

[edit] External links

[edit] Critical links



Macroeconomic schools of thought
Keynesian economics • Monetarism • New classical economics • New Keynesian economics • Neo-Keynesian Economics • Austrian School • Supply-side economics • Post-Keynesian economics
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