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September 2012 Policy Study, Number 12-9


A Short History of Economic Theory


John Maynard Keynes: The Triumph of Government Interventionism



John Maynard Keynes was the founder of a school of economic thought that has dominated a century of history.[49] In The General Theory, Keynes introduced the ideas of marginal propensity to consume, the inducement to invest, money-wages and price, the business cycle, and the policy implications of his work, but rejected the principles of Adam Smith and Jean-Baptiste Say while supporting an active fiscal policy.[50]


In his flagship argument, Keynes proposed the radically new idea of a “marginal propensity to consume” that was behind the demand side of an economy and laid the groundwork for his entire theory.[51] The marginal propensity to consume was defined by Keynes as the increase in consumption that results from one additional unit of currency spent.[52] It linked directly to his concept of the multiplier effect, which measures the amount that investment and savings move in response to additional consumption.[53] According to Keynes, marginal propensity to consume was directly connected to the multiplier, since it demonstrated how investment could lead to full employment.[54] Keynes’s equations led him to conclude that the marginal propensity to consume fluctuates directly with total output, i.e., more output and consumption equals more employment.[55] Keynes decided that the marginal propensity to consume would lead to economic stability.[56] Moving from the marginal propensity to consume, Keynes explained how investment tied his entire theory together, from the business cycle to money-wages.[57]


According to Keynes, investment was superior to saving as a means of stimulating the economy.[58] The amount of investment in an economy was linked to cyclical fluctuations that persist temporarily and ultimately reverse direction.[59] Keynes also connected investment to the marginal propensity to consume, as they both varied in proportion to the economic climate, whether in a boom or a bust.[60] The “Trade Cycle” described by Keynes was caused by over- and under-investments in the economy, creating alternating bull and bear markets.[61] Keynes held that economic busts must be ended by remaining in a perpetual state of “quasi-boom” through the application of his theory.[62] To describe the national economy, Keynes put forth the equation Y = C + I + G, where the GDP is equal to consumer spending plus investments and government expenditures.[63] For Keynes, investment was essential to the rest of his theory, particularly money-wages and price.[64]


Money-wages and price were the linchpins of Keynes’s theory on employment and connected to his argument on the business cycle.[65] The wage-unit is an amalgam of the money-wage and the labor-unit: simply put, the amount paid for a single unit of labor to perform for a given amount of time.[66] As part of his stability principles, Keynes asserted that moderate changes in employment would not result in a noticeable change in the money-wages.[67] Attempts to fix money-wages to stem unemployment were futile in liberal democracies, stated Keynes, but could be workable under authoritarian regimes.[68] Keynes asserted that prices were connected to the business or “trade” oscillations because of the regular, cyclical nature of the market.[69] Keynes felt that investment and wage-units were inextricably combined, because the public tends to invest only when real wages are rising.[70] From this standpoint on investment, Keynes transitioned to his theory on the business cycle and recessions.[71]


The boom-and-bust nature of a free market was Keynes’s greatest challenge, and he sought to prevent future recessions by increased government intervention.[72] As defined by classical economists, the business cycle was a natural progression of economic activity caused by a failure in the structure of supply and demand, while Keynes argued for a breakdown in the quantity demanded.[73] The business cycle was tied to saving, which Keynes despised as “hoarding” and an unproductive waste of money, when compared to investment.[74] From this, Keynes derived the idea that consumption, or spending, neutralizes recessions by moving in a countercyclical manner.[75] The multiplier effect stabilizes the economy at a state of “quasi-boom,” smoothing out the troughs and crests of the business cycle and moving the economy slowly upward.[76] The business cycle, then, was able to be defeated using increased spending and higher consumption, permanently erasing booms and busts.[77] Concluding his thoughts on the regulation of the business cycle, Keynes turned to the broader policy implications of his work.[78]


Keynes looked beyond the economic aspects of theory and outlined the wider sociopolitical impact of his ideas.[79] In keeping with his countercyclical fiscal policy, Keynes advocated large public works to bolster consumption during recessions, which was widely implemented by President Franklin Roosevelt.[80] Bigger government was also necessary if the aforementioned public works were to take place, and Keynes emphasized a paternalistic welfare state.[81] Public and private deficit spending was arguably the most important part of Keynes’s fiscal policy, since he held that deficits were irrelevant in the face of a recession.[82] Government intervention in the economy joined several of these threads together, and Keynes wholeheartedly supported an ubiquitous central authority.[83] Railing against the gold standard, Keynes advocated its replacement with fiat money instead, which would allow greater elasticity and response to business needs.[84] The political ideas put forth by Keynes were nurtured by his concepts of supply and demand, which lie at the heart of his theory.[85]


One of the chief factors influencing Keynes’s General Theory was his perception of aggregate supply and aggregate demand.[86] Keynes reversed Say’s Law and pronounced that “Demand creates its own supply,” cementing his emphasis on “demand-side” economics. Consumption is more important than production because it encourages investment, according to Keynes, and continuous investment would produce the desired countercyclical activity in the market.[87] His reversal of Say’s Law actually misquoted the original, and Keynes portrayed it as though Say believed that everything produced was automatically bought, clearly not the Law’s original intention.[88] In reality, Say’s Law explains recessions as a problem with business calculations leading to overproduction and unsold goods.[89] Aggregate demand is the most important part of the economy, Keynes opined, and should be encouraged by every means possible.[90] With his vision of economic equilibrium, Keynes led the way for a century of economic policies in the western world.[91]


Armed with Keynesian economics, the governments of Western Europe and America fought the Great Depression using fiscal policy.[92] Fiscal policy emphasized deficit spending and lower tax rates during a recession, with budget cutting and higher taxes during a surplus.[93] Keynes backed fiscal policy as a solution to the business cycle of boom-and-bust, stabilizing the economy.[94] Keynes derided monetary policy’s concern with long-term inflation, famously quipping that, “In the long run, we are all dead,” proving his deep concern for short-term unemployment and recessions.[95] As the inspiration for the New Deal, Keynesian economics promoted massive public works to stimulate the economy out of a recession.[96] Bigger government with more intervention was the hallmark of Keynes’s economic theory, but he admitted that it would work best in totalitarian countries such as Italy, Germany, or the Soviet Union, not democracies.[97] Clearly, Keynes has irreversibly influenced the course of political economics through his work on fiscal policy.[98]


While supporting an active fiscal policy and rejecting the principles of Jean-Baptiste Say and Adam Smith, John Maynard Keynes’s The General Theory explained the sociopolitical aspects of his work, the business cycle, price and money-wages, the inducement to invest, and the marginal propensity to consume.[99] Regardless of a person’s stance on Keynesian economics, there can be no doubt that he represented a watershed in the history of economic thought.[100] It is fitting that Keynes wrote the best testament to his own theory, “Ideas shape the course of history.”[101]




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