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19 November 2010

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Basic Economics Part Seven

 

John Maynard Keynes

 

Recognized as an intellectual giant by liberals,

Keynes is seen by conservatives as a

dangerous, socialist subversive

 

John Maynard Keynes (1883-1946) was one of the most influential economists of the 20th century. Born in England, Keynes had an exceptionally wide range of interests.

 

In addition to his work as an economist, he was - often simultaneously - a high government official, the editor of an academic journal, a businessman (who managed his investments in bed each morning at breakfast), a teacher at Cambridge University, a college bursar, a collector of rare books, a patron of the arts, and a member of the literary set called the Bloomsbury Group.

 

Economic Theory Forged by the Great Depression

Keynes is best known for his book, The General Theory of Employment, Interest and Money (1936).

 

It’s a highly technical book (some say it’s just about unreadable) in which he sets out to solve the puzzle of the Great Depression of the 1930s - that millions of people, willing to work, could not find employment.

This iconic photograph is of a man trying to sell his car for $100 because he has lost everything in the Stock Market Crash of 1929 that triggered the Great Depression of the 1930s. The Crash and the Depression have been seen by many as repudiation of the laissez-faire economic system and yet, after the pain of a collapse has subsided, the economy tends to default back to uncontrolled free enterprise.

 

Keynes’s central message is that the prevailing belief that the free market would automatically adjust to the unemployment problem was wrong.

 

Keynes argued against the laissez-faire notion that the free market would relieve the unemployment problems on its own.

 

Such free-market economic theory maintained that the unemployed could always get jobs if they would work for lower wages. At the same time, business could restore its sales by adjusting to the lower wages through reducing prices. If all groups accept the discipline of the market, then prosperity, employment, and higher wages would soon be restored.

 

But, Keynes saw it differently. He said the free market was not self-correcting.

 

Supply and Demand out of Balance

He proposed, in the General Theory, that times exist in a market economy when the total demand of consumers and investors may not be enough to purchase all the goods the society has produced.

 

Business managers, finding that they cannot sell all they have on hand, will cut back on production and employment, and a depression will result. Keynes believed that, in a depression, there is no wage low enough to eliminate unemployment.

 

He stressed that the problem is low aggregate demand. Aggregate demand is economist-speak for the total spending of consumers, business, and the public sector. In times of low aggregate demand, he argued, it should be government’s role to spend more to increase total demand and reverse the economic downturn.

 

Government Action Needed to Halt Downturns

Because consumers were limited in their spending by the size of their incomes, they were not the source of business cycle fluctuations. Business investors and governments held the key.

 

In depressions the thing to do was either to enlarge private investment or to create public substitutes if private investment was slack.

 

In mild economic downturns, monetary policy in the shape of easier credit and lower interest rates might be enough to stimulate business investment and restore the aggregate demand caused by full employment.

 

More severe slumps needed the more extreme remedy of deliberate public deficits either in the shape of public works or subsidies to afflicted groups. Canada’s Economic Action Plan is pure Keynesian economics.

 

In other words, when the economy takes a serious dive, Keynes said the only way to break the cycle, and increase output and employment, was for the government to borrow funds which would be used to create more demand and employment.

 

This was a sharp contrast to the economic thinking of the times, which couldn't see anything good coming from larger government deficits.

 

As economist John Kenneth Galbraith put it, “The shock to conventional attitudes can hardly be exaggerated.”

 

Economic Chain Reaction

The whole aggregate model, in which growth, employment, and inflation all effect demand, can be seen as a chain.

 

Monetary easing reduces interest rates; lower rates spur investment; more investment boosts growth; faster growth cuts unemployment; too-low unemployment sets off inflation. If any link fails, the model falls apart.

 

But, the path of the economy can take unexpected curves that call for new solutions. Keynesian theory, for example, had not had to deal with stagflation, where inflation (in the 1970s when world oil prices increased dramatically) and unemployment occur together.

 

Inflation helped make social programs even more expensive, and unaffordable according to economic experts. Times continued to be tough and the government didn’t have the revenue to pump into the economy. The good times didn’t roll in so taxes couldn’t be raised to pay off the debt that had built up. And, paying off debt during economic growth was part of the Keynesian equation.

 

Keynes Theories Questioned

As far as the Depression was concerned, the Keynesian solution worked in one way; in another it didn’t. Certainly, people were put back to work and great projects were built.

 

However, the onset of World War II in 1939 had more to do with getting factories humming again than government

spending on roads and dams. Although, building the machines of war was government economic stimulus on the grand scale.

 

The application of Keynesian economics failed in the sense

that governments conveniently forgot the bit about putting money away for a rainy day. Policy makers who had never run up deficits before started to like them, and to like them a lot.

 

Keynes’s theory remains controversial, but in the years after World War II, his views became widely accepted among economists in England and the United States, and his critics were in the minority.

 

But, when governments continued massive spending after the economy turned rosy they started to rack up vast debts at a time when paying off debt was what Keynes called for. New economic approaches were called for.

 

 

Image credit

Mike Gifford

 

Back to Part Six

Go to Part Eight

 

Sources

Hazlitt, Henry. Economics in One Lesson,Three Rivers Press, 1988.

Henderson, David R, et al, Concise Encyclopedia of Economics.

McConnell, Campbell R, Brue, Stanley L. Economics, McGraw Hill

Samuelson, Paul. Economics, McGraw Hill, 1948.

Sloman, John. Essential of Economics, Prentice Hall, 1998

 

© Canada and the World, November 2010

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THE

BLOOMSBURY GROUP

 

In its day, the Bloomsbury Group had the reputation of being a pretty fast crowd.

 

The group’s name came from the fashionable central London in which most of its members lived.

 

It included the writers Virginia Woolf, her husband Leonard Sidney Woolf, Vita Sackville-West, Lytton Strachey, and E. M. Forster. Artists Vanessa Bell and Duncan Grant were also members.

 

There was a fair amount of sexual experimentation among group members, some of whom were gay and others bisexual.

 

The group was most active during the first quarter of the 20th century and its members were known for rejecting the rigid formality of the Victorian era.

 

DEFINITION

Aggregate demand: Total spending on goods and services made in the economy. It consists of consumer spending, investment, government spending, and the expenditure on exports, less any expenditure on foreign goods and services.

 

HOLY MACRO

 

The essence of Keynesianism is its emphasis on aggregates (grand totals): aggregate, or total, demand, total employment, and so on.

 

Thus, the policy response to a surplus of labour is not simply to increase the demand for labour, but to increase the demand for everything.

 

In the Keynesian view, growth, employment and inflation are not three separate questions, but one. Demand should sustain enough growth to lower unemployment, though not so much as to set off inflation; or at least, not too much inflation.

 

Keynes's theory of aggregate demand moved thinking from the microeconomics of the individual market force (i.e. the analysis of the behaviour of the individual units in the national economy, including business firms, workers, and consumers) to the macroeconomics of the entire purchasing power in an entire system.

 

Unlike the demand for a single product, which was assumed to depend primarily on its own price, aggregate demand depended primarily on the total of people's incomes.

 

TIME FOR A RETHINK

 

Economic theories are constantly changing. Keynesian theory, with its emphasis on activist government policies to promote high employment, dominated economic policymaking in the early post-war period.

 

But, starting in the late 1960s, troubling inflation and lagging productivity prodded economists to look for new solutions. From this search, new theories emerge.

 

These theories are debated and tested. Some are accepted, some modified, and others rejected as the search goes on for an answer to these basic economic questions:

 

• How do we decide what to produce with our limited resources?
• How do we ensure stable prices and full employment of resources?
• How do we provide a rising standard of living both for now and the future?

 

 

 

 

 

 

SWEDEN FIRST

 

Swedish economists had figured out how to boost their country's economy before Keynes’ theory became well known.

 

In the early 1930s, having concluded that the Depression’s hardship and unemployment could be relieved only by government action, a program was devised - along with substantial currency devaluation - which included government borrowing and public employment.

 

The country believed in supporting farm prices and a greatly strengthened social security system (old age pensions and unemployment compensation). By the latter part of the decade the Depression was over in Sweden because of government action, and the recovery did not depend on armaments and war as it did in so many other countries.

 

 

In 2005, a group of 15 conservatives was asked to identify The Ten Most Harmful Books in the 19th and 20th Centuries. They placed John Maynard Keynes’s The General Theory of Employment, Interest, and Money in tenth spot.