Keynesianism explained: the theory born from the Great Depression

The collapse theory could not explain

In the 1930s the world economy stalled. According to the IMF, the economic theory that existed at the time could neither explain the causes of that collapse nor supply a public policy answer able to restart production and employment. John Maynard Keynes worked in that gap. The same source credits him with leading a reversal in economic thinking that overturned the then prevailing idea, namely that free markets would provide full employment on their own as long as workers stayed flexible about their wage demands.

The book that carries the reversal came out in 1936: “The General Theory of Employment, Interest and Money”. In its concluding notes Keynes names the outstanding faults of the economic society he lives in as its failure to provide full employment and its arbitrary and unequal distribution of wealth and incomes.

Aggregate demand, the pivot of the theory

The IMF sums up the main plank of the theory that came to bear Keynes’s name in one sentence: aggregate demand, measured as the sum of spending by households, businesses and government, is the most important driving force in an economy. It is close in spirit to the figure used to size an economy, the subject of the Recap on GDP, since both look at a total rather than at the choices of one shop or one family.

Economist Alan Blinder, in the entry he wrote for the Concise Encyclopedia of Economics, defines Keynesian economics as a theory of total spending in an economy and of its effects on output and inflation.

Keynes himself uses a sharper term. In chapter 3 of the General Theory he calls effective demand the value demand takes at the point where the aggregate demand function is crossed by the aggregate supply function. Then comes the sentence everything else rests on: the effective demand associated with full employment is a special case, realised only when the propensity to consume and the inducement to invest stand in a particular relationship to one another.

Why the labour market does not clear by itself

Blinder points to the technical claim that separates Keynesians from their theoretical opponents. In the Keynesian view prices, and especially wages, respond slowly to changes in supply and demand, and the result is periodic shortages and surpluses, above all of labour. A surplus of labour is unemployment.

If wages lag, a fall in demand is not absorbed by a quick adjustment in prices, so it lands instead on how much gets produced and how many people stay employed. That is the mechanism by which unemployment can persist during a recession. Blinder sets this stickiness against new classical theory, which stresses the ability of a market economy to cure recessions through downward adjustments in wages and prices.

The multiplier, or what a dollar of spending returns

If the government adds spending, how much does output rise? The answer sits in a single number, the fiscal multiplier. The IMF puts it directly: when the multiplier is greater than one, an extra dollar of government spending produces more than a dollar of extra output.

Practical example: Blinder offers a purely illustrative calculation, tied to no historical episode. Ten billion dollars of extra government spending could raise total output by fifteen billion, which is a multiplier of 1.5. With a multiplier of 0.5, the same ten billion generate five. The outcome depends on the value the multiplier takes, and that value is what economists argue about.

Countercyclical policies

According to the IMF, Keynes advocated so-called countercyclical fiscal policies, which act against the direction of the business cycle. Among the measures the same source says Keynesian economists recommend is deficit spending on labour-intensive infrastructure projects, intended to stimulate employment. Deficit spending means paying out more than comes in, and the gap feeds into public debt, which is where this theoretical argument meets a government’s accounts.

Keynesianism and classical economics, side by side

The comparison below sticks to the two points the sources document directly. A fuller account of the classical school, and of the neoclassical school born from the late-19th-century marginalist revolution, belongs to separate Recaps.

What Keynes asked of the state

Chapter 24 of the General Theory holds the most quoted and most misread line in the book: a fairly comprehensive socialisation of investment, Keynes writes, will prove the only means of securing an approximation to full employment. The wording is strong, and it has to be read together with what sits around it. Keynes specifies that the state will have to exercise a guiding influence on the propensity to consume, partly through its scheme of taxation and partly by fixing the interest rate — instruments that steer the decisions of private actors rather than transfer ownership of firms to the state.

The same chapter also carries his explicit objection to accepted classical theory. Keynes does not accuse it of internal logical error. He accuses it of tacit assumptions that are seldom or never satisfied, with the consequence that the theory cannot solve the economic problems of the actual world.

Thirty years at the centre, then stagflation

According to the IMF, Keynesian economics dominated economic theory and policy from the end of the Second World War until the 1970s. Then its popularity fell, and the same source gives two reasons together. The first is stagflation, for which Keynesian theory at the time had no adequate policy response. The second is monetarist economists, who doubted the ability of governments to regulate the business cycle with fiscal policy.