Keynesian economics are based on the ideas of John Maynard Keynes,who is remembered by economists as the founder of macroeconomics and by everyone else as the instigator of governments' deficit spending--two half-truths that add up to less than a whole. The two images are related this way:
Keynes advocated counter-cyclical fiscal policies: deficit spending when a nation's economy was sluggish and the surpression of inflation in boom times by either increasing taxes or cutting back on government. His macroeconomic model offered a way of calculating the equilibrium state of an economy and defining inflation and recession as departures from it; thus policy could proceed from analysis.
Keynesians doubt whether his theories were actually followed, or even understood, by the policymakers who claimed them. But the apparent success of programs such as the New Deal in the United States gave an air of authority to the theories which they were said to embody. Macroeconomic analysis thus became the academic standard.
Now, Keynes published his GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY in 1936 as a continuation of a debate about the British economy that had started even before the Great Depression began in 1929. The nation had not achieved full employment since the end of World War I, and the standard theory indicated that it should have.
Chronic unemployment shows that a certain amount of productive power is idle, but an economy tends to use all of its resources, in the standard theory. An industry might shrink, even die. But the claim was that the productive power set loose there--the workers, the capital--would be reinvested in something else.
Two elements of an economic system were supposed to produce this state of maximum output. First, the push and pull of supply and demand set the price of goods, and the constant shifting of price allowed the two forces to equalize. Second, when the system produced extra wealth, it could be either saved for future consumption or invested in future production, and there was a system of supply and demand that affected this choice too. The interest rate on savings behaved like a price, equalizing the supply and demand of investment funds.
The demand for investment varied from industry to industry, ensuring that capital would always flow where it was needed to maximize output.
Even in the worst years of the Depression, this theory defined economic collapse as the loss of incentives to produce. The proper solution was to reduce the price of labor to subsistence levels, causing prices to fall so that buying would pick up. Funds not paid out in wages would be available for investment, perhaps in other sectors. Plant closures and layoffs were a necessary medicine.
Now, everyone knew that government work was an alternative. It could increase wages temporarily and therefore increase the demand for goods, stimulating production. But there was no reason to believe that this stimulation would outrun the side effects that discouraged investment--the government, competing with private interests, would be bidding up the wage rate, and so forth.
The underlying assumption was that capital had to be directed to increasing productive capacity. A public-works program diverted capital from its proper job.
Keynes saw that this analysis offered no way out of a system-wide collapse. Lowering wages would make capital available for investment--but it would also lower consumption, so the total demand for goods would drop. Investment in new production would then become more risky, less likely. There was no reason to imagine that one effect would outrun the other.
To put it differently: the Depression had already lowered wages and the effective demand for goods, and nothing in this state of affairs was encouraging new production.
For economies do NOT tend to maximize the use of their resources. An economy can become stuck at a level of under-utilization because of the preferences of the various agents in the system. Workers might not accept the devastation of their pay rates that recovery from a system-wide collapse required, nor would those who still had wealth necessarily risk it on the investments needed.
On its own, this common-sense observation has no great power. But Keynes developed an alternative to the existing economic model that let him quantify the aggregate effects of these preferences.
Two details of the model had implications for policy:
First, there is the "Keynesian multiplier." In his way of tracking aggregate national production, Keynes found that increases in consumption do not equal increases in production. The effect on production is always a multiple of the increase in spending.
Thus a government could stimulate a great deal of new production with each modest outlay.
Second, Keynes re-analyzed the effect of the interest rate on investment. In the standard model, the interest rate determined the supply of funds available for investment. For Keynes, the supply depends on the productivity of the system, the very thing that his fiscal proposals were intended to affect.
(In this re-definition, the interest rate depends on the preference that people have about holding onto money, the ratio of money held to the total amount of money in circulation. This view opens the possibility of regulating the economy through changes in the money supply, but Keynes did not pursue that approach.)