What is Keynesian Economics?

Keynesian economics is like a crutch for capitalists…

While a market economy can regulate itself most of the time, sometimes it gets injured and can’t heal itself. Keynes introduced temporary fixes for when economies get stuck in a recession. He argued that government spending could help hold a market economy together until it got strong enough to stand on its own. When an economy was healthy again, the government could raise taxes and recoup its money.

Keynesian economics is a school of thought that says aggregate demand (total spending by consumers, businesses, and government) is the primary driving force in a market economy. If demand falls and the economy goes into a slump, output (production of goods and services) decreases, which leads to unemployment.

Before Keynesian economics, the classical view was that, if demand falls and the economy wavers, prices and wages will eventually drop too and restore market equilibrium. In other words, the market would adjust on its own without any outside influence.

Keynesian economists disagreed. They argued that prices and wages are “sticky”— They don’t adjust that quickly. If demand continues to fall, there is a point at which prices can’t fall anymore because companies will go out of business. Wages can’t always be slashed. If consumers still aren’t buying at the lowest price, output will decrease, and unemployment will increase. As unemployment increases, demand will continue to fall, and the economy will continue to contract.

According to Keynes, when the natural market forces of the economy break down, the government should look mainly to fiscal policy (tax cuts and government spending) to stimulate economic activity, avoid economic collapse, and ensure the social welfare of citizens.

If there's a recession, Keynes held the government should engage in deficit spending (funded by borrowing rather than through taxation) to increase consumer demand and stimulate economic growth. Then, when full employment returns and the economy is stronger, the government can raise taxes to pay back the debt.

The Keynesian model also considers the unpredictability of human psychology, which classical economic theory ignores. The idea is that people stop spending if they feel pessimistic about the economy, which contributes to economic slumps. Government spending can restore confidence and help stimulate demand and consumer spending, which will increase both output and employment to jumpstart an upward leg of the business cycle (the natural ups and downs of a capitalist economy).

Keynesian economics was the brainchild of British economist John Maynard Keynes, who observed the fallout from the Great Depression in the 1930s and tried to come up with a solution. When Keynes published A General Theory of Money, Interest, and Employment in 1936, the economic philosophy of the day was the classical theory of free market capitalism.

The classical theory of economics was based on the ideas of Scottish philosopher Adam Smith, the father of laissez-faire economics (which opposes most government involvement in the market).

Adam Smith published The Wealth of Nations in 1776, the same year that the Founding Fathers drafted the Declaration of Independence. His theories influenced their decision to set up a limited government for the US.

Classical economists believe that consumers and producers make decisions based on self-interest, which drives voluntary exchange in the free market economy. Supply and demand — the amount of something available and how much buyers desire it — naturally set price levels and output (production).

When fluctuations in the economy occur, natural market forces — the “invisible hand” of the market — allow the economy to regulate itself through competition (companies competing for customers) and the laws of supply and demand, without government interference.

Classical theory depends on the idea that prices and wages are flexible. It says that when demand rises, prices and wages will rise to meet demand, and vice versa when demand falls. Like classical theorists, Keynes believed that, in the long run, the market could naturally balance itself. But he also famously said, “In the long run we are all dead.” He advocated for fiscal stimulus when the invisible hand of the market got stuck.

According to Keynesian theory, prices and wages are “sticky” (don't change easily). When demand continues to fall, there is a point at which prices can’t fall anymore without companies going out of business. If consumers still aren’t buying at the lowest price point, output falls, and unemployment increases. The economy contracts — The invisible hand of the market breaks.

Keynes says this is where the government should step in to stimulate economic activity, avoid economic collapse, and support its citizens.

Keynesian economics came to life during the Great Depression of the 1930s. President Franklin D. Roosevelt is often credited for basing his New Deal policies on Keynesian theory to rescue the economy, but this isn’t entirely correct. FDR was more interested in a balanced budget, but his first priority was to restore confidence in the economy. He created work programs, adjusted interest rates, and handed out farm subsidies.

By 1937, unemployment was down as the economy got stronger. But FDR reigned in spending too soon in order to balance the budget, and the economy fell into what became known as the Roosevelt Recession between 1937 and 1938. FDR changed course and continued deficit spending throughout World War II, while efforts at home during the war also helped boost the economy by stimulating industry. Government programs such as Social Security, unemployment insurance, and food stamps that were introduced as part of the New Deal are still in effect today.

Austrian economist Friedrich Hayek believed that the New Deal wasn’t sustainable. He felt that Keynesian policies would result in inflation (an overall increase in prices that reduces the purchasing power of money). Hayek believed that government intervention encroached on people’s liberty and produced inefficiencies.

Hayek’s* Road to Serfdom*, which appeared in Reader’s Digest in 1945, struck a chord with American individualism. It echoed an original fear of the Founding Fathers — the danger that the Federal Reserve, the country’s central bank, would have too much power. In 1950, Hayek settled in at the University of Chicago, which became the center of neoliberal economic thought. According to neoliberalism, government intervention creates distortions in the market.

Some of Hayek’s theories were carried forward by American economist Milton Friedman. But while Hayek argued for no government involvement, Friedman pushed for controlled monetary policy (management of the money supply). Friedman argued that, if the Federal Reserve had done its job better, the Great Depression wouldn’t have happened.

Friedman is associated with the economic theory of monetarism, which advocates control over the amount of money injected into the economy. His theory was that affecting prices and output by influencing the money supply was all the government needed to do to stave off another depression. On the other hand, he argued that too much government spending would lead to inflation and unemployment.

By the 1970s, inflation in the US was soaring, output stagnated, and unemployment was high. A new type of economic crisis was occurring — “stagflation” (inflation plus stagnation). Keynesian economics ran into problems with stagflation.

An injection of money to lower unemployment by increasing aggregate demand would raise prices. If you threw money at inflation, you would only create hyperinflation (extreme inflation). Friedman argued that stagflation disproved Keynesian economics. During the 1970s, both Hayek’s and Friedman’s ideas rose in popularity.

Keynes’s focus on government spending financed through borrowing and Hayek’s distrust in the government’s ability to guide the economy led to competing schools of economic thought. Keynesian theory became known as demand-side economics. Supply-side economics evolved from the ideas of Hayek and Friedman.

Supply-side economists focused on reducing regulation and cutting corporate taxes to stimulate growth. If businesses had more money to invest, the thinking went, they could hire more workers and increase production, which would stimulate the economy. Supply-side economics entered the mainstream in the 1980s under President Ronald Reagan’s “trickle-down economics,” which advocated deregulation and corporate tax cuts.

The Great Recession following the 2008 financial crisis brought renewed interest in Keynesian economics. Leading economists looked back to the Great Depression to figure out what to do. The Federal Reserve lowered short-term interest rates to try to stimulate the economy through monetary policy. The American Recovery and Reinvestment Act, which increased spending on education, infrastructure, health, and renewable energy, was one example of expansionary fiscal policy.

Classical economists believe that supply creates its own demand. If demand slips, prices and wages fall. As prices decrease, people resume spending, which stimulates production and boosts demand. But Keynes pointed out that prices and wages don’t adjust quickly enough, so a decrease in aggregate demand will result in a decrease in production. For Keynes, demand creates its own supply.

Aggregate demand is the total spending on all goods and services produced in the economy within a period of time. Aggregate demand can be broken into four main parts:

• Consumer spending
• Investment spending
• Government spending
• Net exports (exports minus imports)

A change in any of these four components could affect aggregate demand or gross domestic product (GDP). Keynes’s theory is that government deficit spending increases aggregate demand when the other three components aren’t strong enough, which can lift an economy out of a recession.

When a recession occurs, people feel pessimistic about the state of the economy and hang on to their money. As people spend less, aggregate demand decreases. When lowering interest rates doesn't get people and firms to borrow because they've lost confidence, it’s called the liquidity trap. Basically, monetary policy stops working.

The multiplier effect explains how an increase in consumer spending, investment spending, or government spending can help stimulate economic growth by increasing aggregate demand. For example, when the government spends money, someone gets paid. That person saves some of that cash and spends the rest. Their spending becomes someone else’s income, who also keeps some and spends some, and so on. The initial expenditure by the government causes a ripple effect throughout the economy leading to more total spending.

If people think the economy is terrible and they might lose their jobs, they stop spending and hoard their money. When consumers spend less, companies lose revenue and lay off workers. Unemployed workers have no income, so they stop spending. The paradox is that the more people hang on to their money out of fear, the worse the economy gets, which ends up causing more harm.

Keynesian economics accounts for human psychology, which Keynes called “animal spirits.” He argued that changes in confidence and herd mentality can help explain why economies fall into and recover from recessions — regardless of underlying economic factors. When people lose faith in the economy, they stop spending. When they feel good about the economy, they spend and invest. Animal spirits can create self-fulfilling prophecies for the economy as a whole.