Our basic economics series moves on to economic theory, and takes a look at Keynesianism.
The economic policies of most modern free-market countries are based on two main planks, the sets of ideas known as Keynesianism and Monetarism. In this series we'll take a look at both, starting with an overview of the Keynesian school.
Named after its founder, John Maynard Keynes, Keynesian economics came to dominate much of 20th century thought, challenging the idea that a pure "laissez faire" approach by governments will lead to the best overall macroeconomic outcomes. This led to the familiar "mixed economy" that characterises, to greater or lesser extents, the government policies behind just about all of today's developed economies.
Free market failures
What Keynes recognised is that while individuals might make the best microeconomic decisions for their own interests, the aggregate result often leads to an inefficient macroeconomy.
Demand at the individual level can change very quickly, but due to the inevitable lags, the supply side can take quite a lot longer to catch up -- leading to over-capacity (or a "general glut" as it was known to classical economists).
And that could quickly lead to a downward spiral. A slowing economy reduces spending power and lowers demand. That leads to over-supply, so manufacturers start to cut back their production, contracting and losing jobs on the way, slowing pay rises, and so on. The redundant and poorer workers then cannot spend as much, so their contributions to aggregate demand falls, leading to greater over-capacity... and so on.
The Keynesian solution
Keynes's answer was a two-pronged approach. He argued that during downturns, governments should use their own fiscal and monetary policies to stimulate the economy, helping to bridge the gap between demand and supply faster than a pure free market would.
Early Keynesians put their focus more on fiscal policy, arguing that governments should increase their spending during downturns, invest in public works and infrastructure, and run a budget deficit by borrowing money to achieve it. That was counter to the prevailing classical theory in the early days, which stressed the value of a balanced budget. But Keynes argued that his approach would actually stimulate the economy by a multiple of the amount invested, leading to greater productivity during the good times when, through a budget surplus, the debts could be repaid.
The argument was that government money used to pay people carrying out infrastructure work would end up being mainly spent, and would then end up in the pockets of everyone from shopkeepers to manufacturers, who would in turn have greater spending power, and so on. So, more spending and the resulting greater demand would boost prospects for the supply side.
In all, Keynes stressed the need for a counter-cyclical approach to fiscal policy, balancing extra spending during tough times against cutbacks and even higher taxation during boom times.
This extended to monetary policy too, where the key tool for Keynesians is interest rates. During downturns, lowering interest rates makes borrowing more attractive, enabling people and organisations to borrow more cheaply in order to boost their expenditure, invest in their businesses, etc. And at the same time, it helps make saving less attractive, shifting the balance in favour of spending.
And during boom times, higher interest rates would help to cool over-exuberance and inflation.
Keynes's belief that governments should step in to influence the economy in the short term, rather than leaving the free market to rebalance things in the long term, led to his famous quotation that "In the long run, we are all dead".
One of the early criticisms of Keynesian economics came from the monetarist school, led by Milton Friedman in the 1940s.
Monetarist ideas criticised the early Keynesian focus on fiscal policy and strong government spending, arguing that the money supply had a far greater role to play in the control of prices and inflation, and it wasn't all down to just the balance of supply and demand.
This led to modifications of the Keynesian model, which in its more modern form encompasses the use of monetary policy considerably more strongly than did its earlier proponents.
No commies please
Other criticism include claims that Keynes's ideas boosted the ideal of centralised planning, as practised to disastrous ends by the Communist governments of post-war Eastern Europe. But even if Keynes did not champion anything quite that extreme, the general criticism that centralised planning leads to a less efficient distribution of capital than that achieved by distributed microeconomic decisions is a valid one.
A number of variations on Keynes's early ideas have been adopted by various groups, and we have something of a neo-Keynesian synthesis today that attempts to reconcile weaknesses and encompass ideas from other schools of thought, but that would be getting too deep for this overview.
One thing for sure is that Keynesian was not the answer to all our economic ills (no more than any other economic school), but it does seem to have developed into one of the least bad approaches. What do you think? Please feel free to share your thoughts.
More in this series: