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BRIA 25 3 John Maynard Keynes and the Revolution in Economic Thought

CONSTITUTIONAL RIGHTS FOUNDATION
Bill of Rights in Action
SPRING 2010 (Volume 25, No. 3)

Revolution and Change

England’s Glorious Revolution  |  John Maynard Keynes and the Revolution in Economic Thought  |  William Jennings Bryan, the “Great Commoner”

John Maynard Keynes and the Revolution in Economic Thought

British economist John Maynard Keynes believed that classical economic theory did not provide a way to end depressions. He argued that uncertainty caused individuals and businesses to stop spending and investing, and government must step in and spend money to get the economy back on track. His ideas led to a revolution in economic thought.

John Maynard Keynes (pronounced canes) was one of the great economic thinkers. Born into an academic family in 1883, his father was a noted philosophy and economics professor at Cambridge University. His mother was a teacher who later served as mayor of Cambridge.

Keynes attended Eton, England’s best prep school. After Eton, he went to King’s College at Cambridge University. He earned a degree in mathematics, but his curiosity extended to many fields—history, classical literature, the arts, and moral philosophy. He learned economics from Cambridge’s leading economist, Alfred Marshall.

Brilliant, an outstanding student, and intellectually curious, Keynes did not pursue a traditional academic career. He did work as a university lecturer, but he also spent much of his life working in government, writing books and articles (for newspapers, magazines, and academic journals), and working as a financial consultant. Keynes also played the stock market, which he considered a casino. He lost his shirt more than once but ended up with a substantial investment fortune.

In 1906, Keynes got a job in Britain’s colonial India Office as a junior clerk. His curiosity propelled him to become an expert in India’s finance system.

Britain’s Leading Economist

When World War I broke out in 1914, Keynes joined Britain’s Treasury ministry. He specialized in financial relations among the allies. At the Paris Peace Conference after the war, he was in charge of the ministry’s position on how much Germany should pay in war reparations—financial compensation to the victors.

Keynes found that allied leaders believed Germany should pay for the “whole costs of the war,” including widows’ pensions. Keynes disagreed. He called for reparations that Germany had a reasonable “capacity to pay.” Keynes believed that by financially crippling Germany, all European nations would suffer.

In May 1919, the final draft of the Treaty of Versailles shocked Keynes. It demanded the Germans pay billions of dollars over a period of 30 years.

Keynes declared, “The Peace is outrageous and impossible and can bring nothing but misfortune.” He resigned from the Treasury. Returning to Cambridge, he took charge of the finance department at King’s College and wrote a book, The Economic Consequences of Peace. The book made him famous.

In his book, Keynes attacked the leaders at the Paris Peace Conference. He predicted the harsh treaty would impoverish Germany and would lead to a war of German revenge. He also criticized the leaders for dealing only with political matters like redrawing national borders while ignoring economic cooperation needed to bring permanent peace to Europe. Published in 1919, Keynes’ book was an international bestseller.

Keynes lived in Bloomsbury, an area in central London. He was a long-time member of a circle of famous writers, painters, and performing artists. A passionate supporter of the arts, he frequently attended the theater, art galleries, and the ballet. In 1925, he married ballerina Lydia Lopokova.

On their honeymoon to the Soviet Union to visit Lydia’s family, Keynes met with communist economic planners to observe Marxist socialism in action. Upon returning to Britain, Keynes wrote an essay attacking the Soviet system. He called it a system using “the weapons of persecution, destruction, and international strife” along with “an obsolete economics textbook” (Marx’s Das Kapital).

In the 1920s, Keynes began to focus on the problem of Britain’s unemployment. It had remained stuck around 10 percent since the end of the war. Like most economists at that time, he believed monetary policy would remedy an economic slump.

This meant that the nation’s central bank, the Bank of England, should lower interest rates and increase the money supply. These monetary measures were supposed to halt falling prices, boost industrial production, and revive hiring.

But Keynes was puzzled when monetary policy did not lift Britain out of its economic rut. In 1924, he explored a radically new way to combat unemployment by hiring the jobless to build roads, bridges, and other government-financed projects.

Keynes also became embroiled in a controversy concerning the gold standard. At this time, most industrial countries tied the value of their paper currency to gold. For example, one French franc might be backed by 1/100 of an ounce of gold in the French treasury. Britain had gone off the gold standard during the war. In 1925, Winston Churchill, Britain’s finance minister, acted against Keynes’ advice and returned the nation to the gold standard. Keynes opposed this move because it limited the paper money supply to the amount of gold in the Bank of England’s vaults. By holding back the money supply, the gold standard helps to control inflation in boom times. But Britain was in a long economic slump.

Thus, the gold standard hobbled monetary policy, which called for an expansion of the money supply to stimulate economic growth. Also, Churchill set the British pound’s value in gold high. This made the nation’s exports too expensive to complete with other countries.

As Keynes predicted, returning to the gold standard worsened Britain’s unemployment. In 1928, he helped draft a Liberal Party election campaign proposal to reduce unemployment by government-funded public-works projects. Then the New York stock market crashed on October 24, 1929.

Keynes and the Great Depression

The stock market crash ended a frenzy of speculation that had driven up stock prices far beyond their real value. The U.S. central bank, the Federal Reserve, had used monetary policy to try to rein in speculation by increasing interest rates. But the Fed’s policy caused a sharp drop in consumer spending for major purchases such as automobiles and houses.

Following the disaster on Wall Street, people began to withdraw their money from the nation’s banks, causing many banks to fail and many depositors to lose their money. The Federal Reserve refused to pump more money into the banking system and even raised interest rates further in 1931. This made it more difficult for individuals and businesses to borrow and spend.

The crash led to the Great Depression. During the 1930s, industrial production in the U.S. dropped by nearly 50 percent. Unemployment reached 25 percent of the labor force. The U.S. offered no unemployment insurance, only bread lines filled with jobless workers and their families.

The Depression quickly spread to Europe and around the world. Relying on monetary solutions, most central banks cut interest rates and increased their money supply. Britain finally abandoned the gold standard in 1931. But the economic damage was too severe. Consumers and businesses, gripped by fear of the future, hoarded cash and stopped spending. Meanwhile, the U.S. and other nations cut their spending and raised taxes to balance their budgets.

As the worldwide depression became more severe, Keynes concluded that the free-market capitalist system had no remedy for a long and deep economic decline. Reducing interest rates and other monetary policy solutions were not enough. Keynes feared that if capitalism did not find a way to address mass unemployment, desperate people might turn to communism or fascism.

Keynes argued that the government must save capitalism. In a 1931 radio broadcast, he revived his earlier backing of public-works projects and called for the major redevelopment of central London. He asserted that the reduction of government relief payments to idle workers and an increase in tax revenue from suppliers of materials would offset the cost of such projects.

In 1932, Keynes began to argue publicly that the solution to mass unemployment depended on more, not less, government spending. This would require the government to borrow money and temporarily run a deficit.

The following year, Keynes wrote a series of newspaper articles explaining the “employment multiplier.” This was a new economic concept that he and one of his students, Richard Kahn, had been developing.

Keynes pointed out that newly employed public project workers and suppliers would have cash to spend again, causing more demand for goods and services from private businesses. With more orders coming in, Keynes predicted, businesses would regain confidence and begin to hire workers. These workers would in turn spend their paychecks, multiplying demand, and so on.

Despite his reputation as Britain’s leading economist, Keynes had little luck convincing the government. The Treasury continued to insist on spending cuts and balanced budgets.

In December 1933, the New York Times published an article by Keynes directed at newly elected President Franklin D. Roosevelt. Keynes advised Roosevelt to focus first on the terrible unemployment problem. Keynes presented his case for the government to borrow and spend large amounts of money on public-works projects. Earlier, Keynes had passed on to FDR an explanation of the “employment multiplier.”

In May 1934, Keynes visited Roosevelt in Washington, but FDR was reluctant to adopt Keynes’ ideas. Nevertheless, Keynes had many meetings with government officials, Wall Street investors, business leaders, and university economists. He tried his best to persuade them to embrace his big idea that explained why severe depressions occurred and how to end them.

Keynes’ Big Idea

Keynes had been working on the puzzle of persisting unemployment in Britain for over a decade. In 1936, he published The General Theory of Employment, Interest, and Money, which revolutionized economics.

In his book, Keynes declared that free-market capitalism had failed to provide a remedy for an economy stuck in a long-lasting depression with mass unemployment. He wrote that relying on traditional monetary solutions like lowering interest rates was not enough. In uncertain times, businesses and individuals shy away from borrowing and lending money.

Keynes argued that uncertainty brought on by a shock to the economy, such as the 1929 Stock Market Crash, cripples “effective demand.” Effective demand is the actual amount of consumer and investor spending in an economy. When effective demand is up, businesses are profitable and employment is high.

When uncertain consumers and investors sharply cut back on their spending, effective demand drops. Businesses lose confidence about future sales and income. To cut costs, they start to lower prices, reduce wages, and lay off workers. Unemployed workers do not have much money to spend, which further reduces spending throughout the economy. Thus, a vicious downward spiral goes into motion, leading to failed businesses and mass unemployment.

Keynes challenged a key free-market principle that saving is always good because it provides the money for investing in businesses. Keynes agreed saving was a good idea during normal economic conditions. But he argued that it hurt the economy in a depression. If people hoard their cash in a depression, he said, they will obviously spend less. This only worsens “effective demand” and feeds into the downward economic spiral.

Keynes recognized that it makes sense for individuals to hold on to their money in uncertain times, but he pointed out that their reduced spending harms the economy as a whole. As people spend less, companies sell less and invest less in production. The economy gets worse. Keynes called this the “paradox of thrift.”

When uncertain consumers and investors are not spending in a depression, where should the money come from to pump up “effective demand”? Keynes answered that government should take on this role.

Keynes pioneered the use of national economic statistics (macroeconomics). He estimated how much a government should spend to increase “effective demand” and achieve full employment.

Keynes called for governments in a depression to hire jobless workers directly for public works like roads, dams, and schools. He was confident that the “employment multiplier” would then stimulate private business activity and rehiring to end the depression.

The most controversial part of Keynes’ theory concerned how the government would finance its public-works spending. He said that the government would have to borrow the money by selling treasury bonds. It should not attempt to balance its budget but should run a temporary deficit. Raising taxes to pay for the public works would take more money out of people’s hands, he explained, defeating the goal of boosting “effective demand.”

Keynes concluded that lowering interest rates, expanding the money supply, and other monetary policies could only go so far. Getting an economy out of a deep depression, he argued, required fiscal policy measures such as government borrowing and deficit spending. He also thought tax cuts could help, but he noted that people were likely to save some or all the money they gained rather than spend it.

Keynes recognized that his deficit spending solution to boost “effective demand” could explode the national debt and cause inflation in the future. But he thought the government could address these problems by increasing taxes once prosperity returned.

Thus, “effective demand” (sometimes called “aggregate demand”) was at the center of Keynes’ General Theory about the cause of and remedy for severe depressions. This was his big idea.

Traditional economists argued against deficit spending and government intervention in the economy. They pointed out that in the long run the economy would correct itself. Keynes famously replied, “In the long run, we are all dead.” Keynes wanted to relieve the tremendous suffering a depression caused and avoid a possible communist or fascist revolution.

Many younger economists in the world enthusiastically accepted Keynes’ radically new ideas. Older economists tended to defend free-market principles and warn about the dangers of government intervention in the private enterprise system.

Keynes’ chief opponent was Friedrich A. Hayek, an Austrian free-market economist and harsh critic of socialism. Hayek rejected Keynes’ argument for massive government spending to end a depression. Instead, Hayek called for individuals to save more, directly contradicting Keynes’ “paradox of thrift.” Saving more, Hayek argued, would enable greater private investment in business.

Keynes and the New Deal

When Keynes published his book in 1936, the New Deal was operating in the U.S. Numerous government employment programs such as the Works Progress Administration (WPA) hired workers to construct government buildings, roads, and other public projects. The purpose of the WPA and similar New Deal programs was relief for the jobless. The New Dealers did not design these programs to increase “effective demand,” as Keynes wanted.

Keynes calculated that the U.S. federal government needed to borrow billions of dollars for its employment programs to stabilize “effective demand” and get the U.S. on the road to recovery. But the New Deal borrowed and spent far less. The government even raised taxes, further crippling consumer and investor demand. By 1936, the unemployment rate was lower but still more than 15 percent.

In 1937, President Roosevelt took a sharp turn and decided to balance the budget. He ended some job program funding, cut other government spending, and raised taxes. In addition, the Federal Reserve reduced the money supply to curb renewed stock market speculation.

These fiscal and monetary policies were the exact opposite of what Keynes advised. As a result, “effective demand,” in Keynes’ view, took another hit in the U.S. Industrial production declined, business investment dropped, consumer spending decreased, and unemployment surged to 20 percent in 1938. Some called this the “Second Depression.”

A debate then took place among Roosevelt’s economic advisers. One group wanted to spend less and balance the budget. The other group agreed with Keynes that the government needed to borrow and spend more to strengthen “effective demand.”

The Keynesians won the debate and deficit spending resumed. By 1940, however, war in Europe and Asia had its own influence on “effective demand” in the U.S. Factories began to convert to producing weapons. In March 1941, the Lend-Lease Act authorized producing and transporting defense materials to Britain and other countries fighting Germany and Japan.

When the U.S. entered World War II in December 1941, wartime spending grew enormously. Deficit spending soared to $50 billion per year between 1943 and 1945. This was far above the annual budget deficits in the 1930s. Meanwhile, unemployment shrank to 1 percent.

The Fate of Keynesian Economics

As the war ended, Keynes took a leading role in negotiating an international agreement to prevent a repetition of the economic decline that followed World War I. In July 1944, 40 nations signed the Bretton Woods Agreement. This agreement, mainly designed by the U.S., established a stable currency exchange system, opened up free trade, and provided loans to poor countries to develop their economies.

In 1945, Keynes negotiated an agreement with the U.S. to settle what Britain owed for the Lend-Lease program and to secure post-war aid. Keynes hoped for a $6 billion “gift” from the U.S. in recognition of Britain’s heroic war effort. He had to settle, however, for a $3.75 billion loan at 2 percent interest.

Plagued by heart disease, Keynes died in London in 1946 at age 62. He never lived to see the “Keynesian Revolution.” For two decades after the war, nearly all economists were Keynesians. Most advocated government deficit spending in bad times and government surpluses in good times.

Economic Terms

central bank A special bank operated by the government, such as the U.S. Federal Reserve, that sets monetary policy.

monetary policy Central bank monetary policy increases or decreases the money supply to try to control inflation and avoid depressions. Central banks set certain interest rates that eventually affect businesses and the consumers by making it more or less expensive to borrow money.

fiscal policy The spending, borrowing, and taxing policy adopted by the government.

effective demand Keynes’ term for actual consumer spending on goods and services plus investor spending on capital goods such as computers for business operations.

In the 1970s, a spike in oil prices led to a dangerous combination of high inflation and unemployment. Keynesian economics did not seem to apply to this situation. Milton Friedman, a University of Chicago economist, led a revival of free-market economics. Friedman stressed less government spending, little regulation of private enterprise, and lower taxes.

Free-market capitalism took off in the U.S. after 1980. Free-market economists argued that the private enterprise market system was self-regulating and needed little government oversight. Banks, investment companies, and other financial institutions were de-regulated. Economists increasingly relied on mathematical computer programs to predict investment risk.

Then things fell apart in 2008. Real estate values fell dramatically, spurring huge losses in banking and financial institutions and destabilizing the stock market. Businesses along with state and local governments cut wages and laid off workers. Unemployment grew to more than 10 percent. Millions of homeowners could not afford their mortgage payments, which led to increased foreclosures and further depressed real estate prices. In a recurring cycle, financial institutions, which had invested heavily in mortgages, continued to suffer substantial losses.

Amid this financial uncertainty, people sharply reduced their spending and investing (“effective demand”). Many hoarded cash in low interest savings accounts and bought gold, further reducing demand. Another Great Depression seemed near.

The Bush and Obama administrations rescued banks, other financial institutions, and auto companies with billions of dollars in loans. Congress passed a $787 billion government-spending program to stimulate the economy. Keynesian economists said this was too little. Free-market economists said it was too much and would cause further damage by increasing the national debt, inflation, and taxes. By the end of 2009, the prospects for the U.S. economy were at best uncertain.

For Discussion and Writing

1.  What are the similarities and differences between the Great Depression of the 1930s and the Great Recession today?

2.  According to Keynes, what is the “paradox of thrift”? Do you think it is true? Explain.

3.  What was Keynes’ “big idea”? Do you think it was the right remedy for ending the Great Depression? Why? Do you think it is the right remedy today for ending the Great Recession? Why?

For Further Reading

Skidelsky, Robert. John Maynard Keynes, 1883–1946: Economist, Philosopher, Statesman. New York: Penguin Books, 2003.

Skousen, Mark. The Big Three in Economics: Adam Smith, Karl Marx, and John Maynard Keynes. Armonk, N.Y.: M.E. Sharpe, 2007.

A C T I V I T Y

Jobs, Jobs, Jobs

By the end of 2009, 8 million jobs had been lost in the U.S. Great Recession. Economists predict a slow employment recovery. This has prompted a variety of proposals for creating more jobs. Form small groups to discuss the proposals listed below. Each group should select three proposals, rank them by importance, and then defend the top-ranked one before the rest of the class.

Proposals to Create More Jobs

1.  Grant federal aid to states to prevent layoffs of teachers, police, and other state and local government workers.

2.  Grant federal aid to states to fund construction of highways, bridges, and other transportation projects.

3.  Grant federal aid to states to make schools, libraries, and other public buildings more energy efficient.

4.  Create a direct government employment program to hire jobless workers for public projects as the Work Progress Administration (WPA) did during the Great Depression.

5.  Provide a tax credit to companies that hire new workers.

6.  Provide a tax credit to those who purchase a newly constructed house.

7.  Provide a tax credit to homeowners who install energy saving windows and doors or solar heating.

8.  Cut taxes for small, large, or all businesses.

9.  Cut taxes for individuals.

10.  Cut government spending and reduce the national debt.

Groups may also devise their own proposals.