Keynesian economics

(Part I)

John Maynard Keynes wrote his landmark work The General Theory of Employment, Interest, and Money during the depths of the Great Depression. While President Herbert Hoover (perhaps the last political leader to uphold the theories of classical economics) was telling everyone who would listen that recovery was just around the corner, things were going from bad to worse. As the unemployment rate mounted, production plummeted, more and more Americans demanded that the federal government do something. When Franklin Roosevelt defeated Hoover by a landslide in 1932, he had a mandate for the government to do whatever was necessary to bring about recovery.

Keynes provided a blueprint. The problem, he said, was inadequate aggregate demand. People were just not buying enough goods and services to employ the entire labor force. In fact, aggregate demand was so low that only the government could spend enough money to provide a sufficient boost.

Keynes defined aggregate demand as consumer spending, investment spending, and government spending (plus net exports). Consumption is a function of disposable income. When disposable income is low, said Keynes, consumption is low. This was the problem Americans were having during the Great Depression.

Investment, which is largely a function of the marginal efficiency of investment, or the expected profit rate, was also very low during the Depression. So we could not hope that an upturn in investment would lead the way out of the Depression. The only hope was for the government to spend enough money to raise aggregate demand sufficiently to get people back to work.

What type of spending was necessary? Any kind, said Keynes. Quantity is much more relevant than quality. Even if the government employed some people to dig holes, said Keynes, and others to fill up those holes, it would still be able to spend the country out of these economic woes.

Where would the government get the money? There were two choices: print it or borrow it. If the government printed it, wouldn't that cause inflation? Keynes thought this unlikely; during the Depression, the country had been experiencing deflation, or falling prices. Who would even think of raising prices when he was having trouble finding customers?

What about budget deficits? Nothing improper about these, said Keynes. Although the common wisdom of the times was that the government must balance its budget, there was absolutely nothing wrong with deficits during recessions and depressions. It was necessary to prime the pump by sucking up the idle savings that businesses were not borrowing and using those funds to get the economy moving again.

Once government spending was under way, people would have some money in their pockets. And what would they do with that money? You guessed it - they'd spend it. This money would then end up in other people's pockets, and they, in turn, would spend it once again.

That money would continue to be spent again and again, putting more and more people back to work. In the process, the deficit would melt away. The government could cut back on its spending programs while tax receipts swelled, so we could view the budget deficits as a temporary expedient to get the economy off dead center.

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