Human Society and the Global Economy

by Kit Sims Taylor

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Overview

The Great Depression begot the Keynesian Revolution. John Maynard Keynes and his followers charted a new approach to economics -- they were able both to explain how such a thing as a depression could occur and to offer policy-makers a prescription for overcoming or even avoiding such downturns. This chapter examines the major elements of Keynesian economics, identifies some of the differences between Keynesian economics and neoclassical economics, and briefly assesses Keynesian economics both as an economic philosophy and as an economic paradigm.

John Maynard Keynes (1883-1946) was an unlikely revolutionary. His father, John Neville Keynes, was a noted economist. He enjoyed the privileges of class, which then included education at Eton and Cambridge. He became a student of Alfred Marshall, one of the early elaborators of the marginal theory of value. Yet he was able to see that neoclassical economics could not adequately explain the real world. By the early 1930s, Keynes was well aware that he was leading a successful attack on some of the foundations of neoclassical economics. In 1935, he wrote George Bernard Shaw:

...I believe myself to be writing a book on economic theory which will largely revolutionise -- not, I suppose, at once but in the course of the next ten years -- the way the world thinks about economic problems.

Keynes' new theory was published in 1936 as The General Theory of Employment, Interest, and Money. The preface warned the reader of the struggle between fundamentally different ways of understanding how an economy really works:

This book is chiefly addressed to my fellow economists. . . . I myself held with conviction for many years the theories which I now attack, and I am not, I think, ignorant of their strong points. . .

The matters at issue are of an importance which cannot be exaggerated. But, if my explanations are right, it is my fellow economists, not the general public, whom I must first convince. At this stage of the argument the general public, though welcome at the debate, are only eavesdroppers at an attempt by an economist to bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory, and will, until they are resolved, continue to do so.

The composition of this book has been for the author a long struggle of escape, and so must the reading of it be for most readers if the author's assault upon them is to be successful, -- a struggle of escape from habitual modes of thought and expression. The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

The old ideas that were the target of Keynes' assault held that economic downturns were always caused by non-economic events such as wars or crop failures. Moreover, the self-adjusting nature of the market would quickly bring economic activity back up to normal levels. For example, if unemployment increased, wages would fall. When wages fell, employers would hire more people and employment would go back to normal levels. Keynes pointed out that these misconceptions were mostly the result of attempts to apply theories applicable to bits and pieces of the economy to the entire economy.

• The Economics of Everything at Once

  One problem was rooted in the neoclassical habit of looking at one thing at a time, 'all other things remaining the same.' This approach is reasonable when we are studying the market for tomatoes: If good weather produces more tomatoes than normal, the price will fall to a level at which the buyers are willing to purchase all of the extra tomatoes. Note that the qualification 'all other things remaining the same' is simply understood here and does not usually need to be stated. A fall in the price of tomatoes is not likely to have a substantial effect on anything other than the quantity of tomatoes that we are willing to purchase.

  But 'all other things remaining the same' comes back to haunt us when we make statements about the entire economy or huge portions of it such as overall labor markets. If wages fall, employers will be willing to hire more people, all other things remaining the same. The problem is, all other things cannot remain the same. Since wages make up the major component of income, falling wages will reduce demand for goods and services. Employers will now have two major changes calling for adjustment: lower wages and reduced demand. Keynes set out to develop a new economics of everything at once to supplant the traditional economics of one thing at a time.
  
  

• The Real World

  Another problem came from ignoring the actual institutional arrangements by which wages and prices were set. Most wages and many prices did not immediately fluctuate with changes in supply or demand. Firms would usually reduce employment long before they would cut wages; and reduce output before they would cut prices. Yet neoclassical theory was based on 'ideal' markets in which price would rise or fall to bring about a new equilibrium of supply and demand. Rather than revise their theories to fit the actual conditions of the world, economists were more likely to find fault with the world for not living up to their theories:

  The classical theorists resemble Euclidean geometers in a non-Euclidean world, who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight -- as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry.

• The Long Run

  Another difficulty came from neoclassical economists' reliance on logical time rather than real time. Logical time has no direction: it can run backward as easily as forward. When supply forces meet demand forces to determine equilibrium price it is as if time does not exist at all. Most of the conceptual devices of neoclassical economics do not exist in real time. Logical time has no turning points or deadlines. When an economist says excess unemployment will disappear in the long run, how long is that? And what other changes will occur that require further adjustment before we ever arrive at 'the long run'?

  Keynes recognized that we move from one short run to another and that real economic problems must be solved in real time -- before the next election or before mass unemployment threatens the continuity of economic institutions central to capitalism or political institutions central to democracy:

  This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

• Money

  Yet another difficulty was due to the failure to understand the role of money. Early neoclassical economists treated money as if it were only a medium of exchange. The worker was really exchanging labor for goods and services; the capitalist was really exchanging goods and services for labor and raw materials: money simply played an intermediate role that simplified the transactions. This way of thinking had led economists to see every sale as a purchase. Since every sale was a purchase, it was theoretically impossible for supply to exceed demand. By producing, capitalists were spending. This line of thought was often stated as Say's Law of Markets: "Supply creates its own demand."

Keynes, however, reminded economists that money was also a store of value:

...the importance of money essentially flows from its being a link between the present and the future.

Money allows an indefinite period of time to lapse between a sale and a purchase. The capitalist might sell goods and services at a profit then wait for business conditions to improve before purchasing more labor and raw materials. In fact, Keynes pointed out, it was precisely during times of economic uncertainty that business people might prefer to remain liquid (hold money) rather than invest in new plant and equipment or hire more workers in order to increase output.

Keynes focused his new theory on the relationship between overall [aggregate] demand and output. The first step is to distinguish between a society's productive capacity and its actual level of production. Productive capacity depends on the size and skills of the labor force, the amount and quality of capital equipment, the amount and quality of infrastructure and such social and legal norms as determine who is expected to work (usually based on age and gender) and set the length of the normal work week.

Productive capacity, or full-employment output, represents a society's maximum sustainable output at any given point in time. This maximum might be surpassed temporarily if, for example, people work more hours than normal as during a war or other national emergency. And full-employment output will increase through time as the labor force grows, skills improve and new capital and infrastructure are added.

While it is difficult to exceed full-employment output for long, it is easy for the actual level of production to fall below full-employment output. If, for some reason, we were not willing or able to continue purchasing as much stuff as our economy is capable of producing, then the actual level of production must fall below the full-employment level. This was the set of questions that Keynes set out to answer: Why did our total demand sometimes fall below the level that would support full-employment output? And what could be done to push demand back up to the full-employment level? Note that Keynes is looking at the demand for everything at once, rather than the demand for one thing at a time.

A good starting point, then, would be to examine the various sources of demand. We can start with the new automobile rolling off the assembly line. General Motors would not have paid workers to build the car if they did not think it could be sold. So our first question is who might buy it? A family might buy it for their own use: that would be CONSUMPTION demand. A corporation might buy it for the car pool that will be used by the sales staff: that would be INVESTMENT demand. A county government might buy it for the car pool that will be used by its health inspectors: that would be GOVERNMENT demand. It might be sold abroad: that would be EXPORT demand.

Consumption Demand

Consumption demand is the simplest to understand. It goes up and down with our income. Keynes saw consumption demand as fundamentally passive. If our income increases, our consumer demand also increases, although not quite as much as our income since we will also increase our saving and pay more taxes. As our income falls, we will reduce our consumption demand, although not by as much as the fall in income since we will also reduce our saving and pay less in taxes.

Investment Demand

Investment spending, unlike consumption spending, is driven by expectations of future profits. Since profits are equal to revenue minus costs, expected profits are equal to expected revenue minus expected costs. Most capitalists can make a reasonable forecast of the expected costs of a potential investment project. But their forecasts of expected revenue are based on much more variable and fundamentally subjective judgments.

If revenue forecasts are volatile and subjective, then the overall level of investment spending must be volatile as well. In Keynes' analysis, the cause of economic downturns was rooted in "the uncontrollable and disobedient psychology of the business world."

Leakages and Injections

Now we can return to the flow of spending concept that was introduced in Chapter 1. The income generated by production is subject to three leakages before it returns to generate more production. Taxes must be paid. Some of the income will be saved. And some will be used to buy imported goods. Note that the amount of each of these leakages will rise and fall with the level of production. Note also that while the 'leaked' money might get spent, the operative word is might. Governments might spend the money they take in taxes. But they might also spend more or less than that amount. Other countries' export earnings might be used to purchase imports, but there is no guarantee that trade will be balanced. And the money we save might be borrowed for business investment, but then it might not.

Consumer spending is different, however. It is more or less automatic. If our incomes rise we will spend more; if our incomes fall we will spend less. Since there is no such 'predictability' to investment spending, government spending or exports, they are best considered as injections into the flow of spending.

When the total of the injections is larger than the total of the leakages, the economy will grow as production (and thus income) rise to meet the demand. But, as production and income rise, so do taxes, savings and imports. When the three leakages are (together) as large as the injections, the growth will stop.

The key to understanding fluctuations in output is to understand the relationship between consumer spending and other forms of spending (investment, government and exports). Our incomes are generated by all four types of spending: the auto worker probably does not know or care if the car she is assembling is going to be purchased as a consumption good, an investment good, by government or exported. As long as the paychecks keep coming in, she will keep spending.

But investment spending in particular is subject to large and unpredictable shifts. If business confidence falls, investment spending will plunge. Unfortunately, the paychecks of many workers will plunge along with investment demand. These workers will respond to their smaller paychecks by spending less on consumption. Their reduced consumption means that employment and income will be reduced for workers employed to produce consumer goods and services. Now these workers will reduce their spending as well. And on it goes.

The result is that total income and output will fall by more than the original fall in investment spending. These linkages from investment spending (or from government spending or exports) to income to consumer spending to income, etc. are called multiplier effects. These effects help explain why an economy may not quickly recover from a fall in investment spending. Whether the original collapse of business confidence was based on real or imaginary factors ceases to matter: once the fall in investment spending has brought consumer demand down with it, it will be difficult for business confidence to be restored.

The magnitude of the multiplier depends on the size of the leakages from the flow of spending. If every additional dollar of income generated twenty-five cents of taxes, ten cents of savings and fifteen cents of imports, that would leave fifty cents returning as additional demand. This additional demand would again increase production and income. And some of this additional income would be paid out in taxes, some would be saved, and some be used to purchase imports -- then the rest would again add to production and income. The process would go on and on, with the amount returning as new demand getting ever smaller. But these small increments would add to the total demand. If the leakages all add to 50% of the original amount, as in the example above, GDP would go up (or down) by twice as much as the original change in investment, government or export spending.

There is one important warning. While the multiplier can always work downward, it can only work upward when the economy has some unused production capacity. If the economy is running along at full employment, any increase in demand might raise prices more than output. The multiplier concept has often been criticized as a claim that we can "create something out of nothing;" or a claim that we can "spend ourselves into prosperity." But it implies no such thing. The something -- prosperity in terms of productive capacity -- has to be there first. The multiplier can only work to expand an economy which is underutilizing its productive capacity.

By examining the relationships among the various forms of demand and income, Keynes was able to explain the Great Depression in a way which neoclassical economists could not. A collapse of investment spending brought consumer spending down with it. And with low levels of consumer spending, it was unlikely that investment spending would soon recover. An auto company that is only running at 50% of capacity has no reason to build new factories. But Keynesian economics went far beyond simply being able to explain depressions and recessions. If government policy could affect the sizes of the leakages (taxes, savings and imports) and/or the injections (investment spending, government spending and exports), then aggregate demand could be managed. Demand could be purposely increased in a recession or depression and purposely reduced when over-full employment was leading to inflation. Government policies to manage demand fall into four areas: fiscal policy, monetary policy, trade policy, and income distribution policy.

• Fiscal Policy

  Keynes' analysis readily suggests a remedy. If a decline in investment spending -- with its corresponding multiplier effects on consumption spending -- has taken us into a deep recession, government can compensate with an increase in government spending. If investment spending were to fall by $50 billion, the decrease in income might bring down consumer spending by another $50 billion for a total fall in GDP of $100 billion. Government could replace the missing investment spending with an additional $50 billion in government spending -- which would lead to upward multiplier effects as the income generated by government spending leads to increased consumer spending. Note that the additional government spending would have to be financed through borrowing: if it were financed through tax increases it would not have the same effect since consumer spending would fall as taxes increased.

  Government spending need not be wasteful, although Keynes thought that even wasteful government expenditure was better than none at all. Public investment in infrastructure or housing could offset declines in private investment spending and provide society with useful assets. The goal should be to keep the total level of private investment plus public investment high enough to maintain full employment. Since private investment, driven as it is by subjective evaluation of future profits, is inherently volatile, Keynes concluded "that the duty of ordering the current volume of investment cannot safely be left in private hands." Public, or publicly-guided investment, "a somewhat comprehensive socialisation of investment" will be required to offset the fluctuations of full employment and maintain full employment.

  Another option for expanding the economy would be to keep government spending at its normal levels but to cut taxes. This would leave consumers with more purchasing power and increase consumption spending. One problem with this is that taxes would have be increased again once the economy returned to full employment.

  If the culprit is inflation, rather than recession, the remedy is contractionary fiscal policy rather than expansionary fiscal policy. Government can cut spending, reducing both government demand and -- through the resulting fall in income -- consumer demand. Or taxes can be increased, directly reducing consumer demand.

  Before Keynes, fiscal policy was mostly a matter of determining the necessary services that government needed to provide and calculating the level and types of taxation needed to pay for them. Budgets were to be balanced and that was that. After Keynes, fiscal policy became a form of demand management. When an economy falls into a slump, deficit spending should be used to inject additional demand into the economy. If an economy is beyond full employment and rapid growth is propelling demand into levels that cannot be met by the economy's productive capacity, government can head off inflationary pressure by running a surplus budget in order to reduce demand. The only time that government's budget should be balanced is when the economy is running smoothly at full employment.
  
  

• Monetary Policy

  Demand could also be managed through monetary policy. The central bank could allow the money supply to grow at a faster rate. This should bring down interest rates and encourage more of the type of spending that is sensitive to interest rates - spending on new factories, new houses and new cars, for example. Conversely, the central bank could reduce the inflation rate by slowing the growth of the money supply. This will raise interest rates and reduce the demand for new factories, houses and cars.

  Many Keynesians are skeptical of the usefulness of monetary policy in a depression or deep recession. Lower interest rates will not usually encourage a firm to undertake new investment if it already has considerable idle production capacity. Firms that are doing well in spite of the downturn will find plenty of bargains in the plant and equipment of their bankrupt competitors; the purchase of existing equipment adds nothing to employment. In a depression or deep recession it is not the high cost of capital that decimates investment spending, it is the absence of customers.
  
  

• Trade Policy

  Demand can also be managed through trade policy. Imports and/or exports can be encouraged or discouraged through altering the exchange rate; blocking imports with tariffs, quotas or other restrictions; subsidizing exports; or encouraging other countries to increase their economic growth rates (which will increase their imports). Trade policy must be used cautiously, however, since it can often backfire. Raising tariffs may lead to retaliation by trading partners. Generally, trade policy changes are usually negotiated with other countries rather than applied unilaterally.

By focusing on the interrelationships between income and consumer spending, Keynes was able to launch a powerful argument against tolerating huge disparities in the distribution of income. According to the pre-Keynesian argument, the growth of the economy depended on the level of investment which in turn depended on the amount of saving. Since only the rich could do any substantial saving, any changes in income distribution (through labor laws or government transfer-payment programs) which shifted income from the rich to the working class would reduce savings then investment then economic growth, ultimately hurting the very working class that such transfers were designed to help.

According to Keynes, however, the purpose of saving was not to provide financing for investment, rather its purpose was to release real economic resources from consumption so they can be used for investment. If the demand for video games is so high that no software programmers are available to write business accounting programs then there can be no investment in new business accounting programs.

But in an economy that is operating at less than full employment -- not using all of its economic resources -- real resources will be available for investment even without any increase in savings or corresponding decrease in consumption. And, according to Keynes:

full, or even approximately full, employment is of rare and short-lived occurrence. . . . and an intermediate situation which is neither desperate nor satisfactory is our normal lot.

So, except during the rare occurrences of full employment, low levels of investment cannot be blamed on insufficient savings. The more likely culprit is insufficient consumption. Redistribution of income from the rich to the working class will increase consumption by transferring income from those who would save it to those who will spend it. As the working class spends more, the capitalist class will invest more in order to meet the growing demand:

Thus our argument leads toward the conclusion that in contemporary conditions the growth of wealth, so far from being dependent on the abstinence of the rich, as is commonly supposed, is more likely to be impeded by it. One of the chief social justifications of great inequality of wealth is, therefore, removed.

We can concoct a numerical example. If the rich get half of all income (GDP) and save half of that while the working class gets the other half of all income and saves 10% of it, total savings comes to 30% of GDP (the 25% of GDP saved by the rich plus the 5% of GDP saved by the workers). Assuming the Incremental Capital Output Ratio is four, GDP can grow by 7.5% per year if all savings is invested. If government -- through taxes and welfare or labor laws -- redistributes half of the income of the rich to the working class, the workers will now have 75% of the GDP rather than only 50% as before. If each class continues to save the same proportion of their income, total savings will fall to 20% of GDP (the rich save half of the 25% of GDP that they receive, or 12.5%, while the workers save 10% of the 75% of GDP that they receive, or 7.5%). The growth rate will correspondingly fall to 5% per year (we are still assuming that all savings is invested). So the workers get a bigger share of the pie, but in the process the growth of the pie slows down. Twenty years down the road, the workers will be worse off than they would if they had continued to receive only half of GDP.

But wait, Keynes responds. The neoclassical argument carries the hidden assumptions that we always have full employment and that all savings will be invested. It is more reasonable to assume that investment itself will depend on the growth of consumption spending rather than on the level of savings. By redistributing income from the high savers -- the rich -- to the high consumers -- the workers -- the inducement to invest will actually be increased as consumer spending increases.

Under a 'pure' market economy market forces guide our decisions as to what to produce, how to produce it and who gets it. Under the system of guided capitalism that emerged from the Great Depression and Keynesian economics market forces still guide the what to produce and how to produce it decisions, but government takes a much larger role in answering the question of who gets it.

Before the Great Depression, governments of capitalist economies were expected to provide public goods, maintain a stable monetary system and enforce legitimate private contracts (and accomplish all of these with a balanced budget). The Depression and Keynesianism brought about governments that were also responsible for maintaining high levels of economic growth, low levels of unemployment and a less inequitable distribution of income than would result from market forces alone. In the United States, the new economic philosophy was even embodied in legislation -- The Employment Act - in 1946:

The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government . . . to promote maximum employment, production and purchasing power.

Many, of course, claimed that Keynesianism destroyed capitalism by substituting the command of government for the market in many aspects of economic life. Others, including Keynes, thought that the application of this new philosophy was necessary in order to save capitalism:

Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative. . . .

The authoritarian state systems of to-day seem to solve the problem of unemployment at the expense of efficiency and of freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated -- and, in my opinion, inevitably associated -- with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.

Keynesian economics posed a dilemma for orthodox economists. Simply ignoring it would leave them with no explanation of depressions and recessions. Nor could it impose itself on neoclassical economics gradually, as neoclassical economics had earlier imposed itself on classical economics, since Keynesianism addressed questions that neoclassical economics ignored. On the other hand, Keynes had not asked his fellow economists to toss out all or even most of their theories as had the Marxists and Institutionalists. Neoclassical economics could coexist with Keynesianism as long as it was recognized as a special theory which was applicable under conditions of full employment while Keynes would supply a general theory that was capable of explaining lapses from full employment.

For neoclassical economists, the solution was to rename their standard theories microeconomics and add a new section to the textbooks which would be called macroeconomics. The whole thing could now be called the Neoclassical/Keynesian Synthesis.

Unfortunately, Keynes had been prescient when he had noted how difficult it would be for economists to give up the old ideas. By the time Keynes wrote The General Theory economists had become addicted to expressing their theories in a highly mathematical form. Keynes himself was certainly no amateur when it came to mathematics -- in 1921 he had written a noted book on probability. Yet he was well aware that expressing economic concepts in mathematical form only served to disguise rather than illuminate the very real complexities of economic interrelationships:

Too large a proportion of recent "mathematical" economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.

John Maynard Keynes and his followers developed a new approach to economics that could both explain recessions and depressions and point the way to economic policies that could be used to end recessions and depressions. Keynesian economics starts with an understanding of the limitations of neoclassical economics, which is based on examining only one thing at a time in an economy in which money serves only as a medium of exchange. Keynesian economics attempts to understand an economy in which everything happens at once and in which money serves as a store of value.

Economic downturns were caused -- according to the Keynesians -- by deficiencies of aggregate demand. These, in turn, were usually caused by fluctuations in investment spending. The usual solution would be to restore demand by increasing government spending to compensate for the fall in investment demand.

Keynes also dispensed with the neoclassical argument for tolerating vast degrees of income inequality. Shifting income from high savers to high spenders, Keynes argued, would increase investment (and thus economic growth) since firms would have more reason to add increased production capacity.

The partial acceptance of Keynesian theory led to a bifurcation of economics into two branches. Neoclassical economics was relabled Microeconomics and Keynesian economics came to be called Macroeconomics. But this "Neoclassical/Keynesian Synthesis" turned out to be a highly unstable paradigm. Its demise will be covered in a later chapter.

1. What does Keynesianism change about capitalism? What does it leave intact?

2. What are the limitations to the use of Keynesian remedies for unemployment in an underdeveloped economy?

3. How did Keynesianism change the argument over the 'correct' distribution of income in a capitalist economy?

History of Economic Thought:

The Worldly Philosophers, Chapter ix, "The Heresies of John Maynard Keynes."

Economic Theory:

Economics Explained, Chapter 6, "Saving and Investing," Chapter 7, "Passive Consumption, Active Investment," Chapter 8, "The Economics of the Public Sector," Chapter 9, "The Debate About Government."

Economic History of the United States:

The Economic Transformation of America, Chapter 14, "The New Deal."

Economic History of the Western World:

The Making of Economic Society, Chapter 8, "The Evolution of Guided Capitalism."

Keynes, John Maynard

The General Theory of Employment, Interest, and Money, Harcourt, Brace & World, New York, 1964. Chapter 24: "Concluding Notes on the Social Philosophy towards which the General Theory might lead"

Lekachman, Robert

The Age of Keynes. Random House, New York, 1966. Lekachman combines a clear synthesis of Keynes' major ideas with the story of how his ideas became the basis of government economic policy.

Aggregate Demand

Animal Spirits

Consumption Demand

Demand Management

Employment Act of 1946

Export Demand

Fiscal Policy

Government Demand

Injections

Investment Demand

John Maynard Keynes

Leakages

Macroeconomics

Monetary Policy

Multiplier

Say's Law