The Lure Of Keynes

Published in Investing on 28 November 2011

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.

Interest rates

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".

Criticisms

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.

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Comments

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tux222 29 Nov 2011 , 9:19am

The problem is governments. Borrowing to invest in bad times is the easy bit. Trouble is, they always find reasons not to bother repaying debt in the good times. Far "better" to chuck the money at their electorate! That's been going on for decades and gets us to where we are today -- so far in debt that we're all in danger of running out of lenders.

tru2me 29 Nov 2011 , 11:09am

Wonder if George Osborne's Autumn speech today prompted your scribing Alan?

Glad I have not contributing to a pension fund.
Did I hear that the Chancellor was going to use pension fund money to apply for long overdue infrastructure spending on roads?

Savers have been sc - - - ed.
Now it is the turn of pensioners.

But it keeps it off that balance sheet.
He's a shrewd man that George.

vinchainsaw 29 Nov 2011 , 1:15pm

Two things.

Firstly, Keynes has picked up a bad rap over the last couple of years, largely because the Americans have developed their own version of Keynesianism. Their version goes along the lines of spend, spend, spend and it doesnt matter what you spend it on.

Keynes argued the government should be building infrastructure in downturns to pick up the employment slack of private industry. This infrastructure would then be used in upturns.
Cash for clunkers, earmarks etc are not what he had in mind. Its nto spending he advocated; it was a specific type of spending.
And it makes sense. Feasibly you could probably build projects more cheaply in downturns.

Secondly, Keynes' policy depended on governments running a surplus in the good times, enabling them to leverage up in the bad times.
Obviosuly that didnt happen and governments the world over were already leveraged to the max going into the downturn.

Keynes could work, just not in the current market. And it cannot work if the policy is to simply dish out money instead of building things.

NeilW 29 Nov 2011 , 1:22pm

Keynes is 1930s based upon fixed exchange rates such as the Gold standard and the Bretton Woods agreement.

That all ended in 1971 when currencies became essentially free floating and non-convertible. And that changes everything as it gives you an extra degree of freedom to play with.

Government 'debt' is then no longer 'debt' if it is denominated in its own currency. It is a mere liability that can be eliminated with an accounting journal.

The standard bearers that bring Keynes into the 21st Century are the Post-Keynesians. Everybody should read Debunking Economics by Steve Keen as a grounding into why most of economics is illiterate rubbish based upon provably false assumptions.

Then you realise that in a credit economy it is the level of private debt that matters, and that a free for all in private debt inevitably leads to a bunch of Ponzi schemes and a financial collapse.

NeilW 29 Nov 2011 , 1:26pm

"Secondly, Keynes' policy depended on governments running a surplus in the good times, enabling them to leverage up in the bad times."

Only in earlier works. By the later works he agreed with Abba Lerner on Functional Finance.

"Lerner approached Keynes and asked: ‘Mr. Keynes, why don’t we forget all this business of fiscal policy, public debt and all those things, and have some printing presses.’ Keynes, after looking around the room to see that no newspaper reporters could hear, replied: ‘It’s the art of statesmanship to tell lies but they must be plausible lies.’”

andrew97d 29 Nov 2011 , 4:02pm

"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."

Will someone please tattoo this on Gordon Browns and
Ed Balls faces. Where were the necessary higher interest
rates between 2000 and 2007 to stop the housing boom ?.

Philmoco 29 Nov 2011 , 4:06pm

I've no truck with HMG providing a "control rod" mechanism for spend control as long as any extra spend is directed to creating assets [not maintaining them which should be out of revenue]. It should never be used to expand governmental [local or central] overhead costs on UK plc.
HMG's target must always be to run a lean machine - ever since the recovery from WW2 which taught and re-taught the population how to live frugally, politicians have allowed all to wax fat, allowed wasteful spend on consumption rather than asset accrual, promoted significantly by Mrs T.
Problem is such a policy tends to lose votes - so it never happens!

vinchainsaw 29 Nov 2011 , 5:22pm

NeilW,

Interesting. Need to brush up on my economics. Think I need to give the wife a Xmas list with some good books!

TMFBoing 30 Nov 2011 , 10:40am

Wonder if George Osborne's Autumn speech today prompted your scribing Alan?

It might have had something to do with the timing ;-)

"Lerner approached Keynes and asked: ‘Mr. Keynes, why don’t we forget all this business of fiscal policy, public debt and all those things, and have some printing presses.’ Keynes, after looking around the room to see that no newspaper reporters could hear, replied: ‘It’s the art of statesmanship to tell lies but they must be plausible lies.’”

Yes, that's a great quote ;-)

I guess printing money achieves essentially the same effect as saving surpluses during good times - it just passes the charge on to future good times through inflation rather than past good times through prudent fiscal management.

Cheers,
Alan
TMFBoing

wastedyouth 27 Dec 2011 , 6:29pm

The phrase "borrowing to invest" has been used by Gordon Brown. It is an oxymoron. Try borrowing on your credit card and investing in a bank deposit account, and see the result.

The basic flaw in Keynes is that you cannot borrow at a rate which is hgiher than the return you get from investing. Even a child can figure that one out.

Keynes is popular with Governments because it makes them believe they have control over the economy, when in fact they don't, and they can be seen by voters to be doing something to help the economy, which is easy to explain to the electorate in a positive way and is popular, since everyone thinks they will beneifit but someone else will pay.

Keynes, whilst being highly intelligent and astute in some ways , is also an idiot in other ways.

wastedyouth 27 Dec 2011 , 6:30pm

On the other hand, he might have proof read his theories for spelling errors before publishing them.

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