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Relevance of Keynesian Economics

Geoff Riley

17th October 2014

Year 12 Economist Archie Barnes has written this excellent assignment on the contemporary relevance of Keynes

John Maynard Keynes is the Einstein of economics. He is the face of a field; he is without a doubt the most famous economist there ever was and ever is and possibly ever will be. To assess his economic policies and ideas and there effects and relevance on and to the Economies of the world today we must first try to define Keynesian economics without spreading into tomes of paper and devoting copious amounts of time.

Keynes came to the forefront of the economic world in the early and mid-1930's as he, like virtually every other economist at the time, tried to understand the great depression and solve the issues and thereby bring back the prosperity of the boom years; ultimately the second world war catalysed economic recovery but policies developed in the post-depression Era still hold true today. Amongst other things, Keynes believed that the economies of the world had magneto 'trouble'[1]. There was nothing fundamentally wrong with the economy just a small problem which was causing the whole economy to slump and spiral downwards. Fix the Magneto and the whole economic engine will spark back into life.

Prior to Keynesian Economics the prevalent economic view was that the economy was cyclical it would go through modest lows and modest highs. Consumer demand would always, in the long run, outstrip producer's capability to supply so therefor Swings and changes in Economic output and Employment would be cyclical and modest. They were also believed to be self-adjusting, that is that there would be no intervention needed. The theory went that if demand fell then wages and prices would also fall leading to an increase in aggregate demand restoring the economic balance.[2] Markets would always clear due to the higher demand than supply the right price just had to be found first, hence the fluctuations. To quote Adam Smith 'what is prudent in the conduct of every private family can scarce be folly in that of a great kingdom.'[3] Before Keynes this was the economic policy of most of the world. The great depression changed all these assumptions. What had up until know been considered economic fact was shattered by the greatest depression the world had and still has ever seen.

Keynes came up with a varied series of solutions but they were based around his biggest central creation; Macroeconomics :that the whole economy as an entity in itself is more than a sum of its parts and that changes within the part will have wider economic consequences greater than the individual consequences at first. This loosely is the definition of a macro economics. Keynes invented Macroeconomics and his other theories justify this. Aggregate Demand [4] and Animal spirits formed key parts of Keynes views on the depression economy and why it wouldn't recover cyclically like the prevailing economic models would have predicted(although they had been chucked out the window at this point.) Another theory that in part explained the great depression for Keynes was the paradox of thrift[5]. The liquidity trap[6] was another contributor to the failure of governmental economic policies in the great depression. The multiplier effect[7] was a key Keynesian policy that is key to the macroeconomic model and one of the capstones of Keynes plan for economic recovery; what Keynes proposed was that after a big economic shock markets would not automatically recover as previously supposed. They would keep on receding until they reached some point of lower equilibria. This was assuming that there is no intervention. Keynes supposed that, contrary to common economic school at the time, the free market was not self-correcting and normal natural economic stabilizers would not always work to correct them.

The great depression was caused by the Wall Street Crash of 29-30. This led to financial ruin for many speculators who had bought into the novelty of stocks in the boom of the 20's and led to a cataclysmic decline of consumer pending a collapse of banks which lead to the creation greater tariffs by the American government and lack of imports on foreign goods. The collapse of free trade put everyone on a downwards spiral towards economic recession and hardship. The main monetary policy tool of the time to try and regulate and control the financial markets was controlling interest rates and inflation[8]. Although it was not called a Macro policy this was the main way governments had of regulating Macroeconomic changes. This did not work in the 1930's or again in the 2008 crisis long after Keynes had published his theories. The reason for this failure was due to the liquidity trap. This was identified by Keynes as where consumer's preference or demand for liquid assets (hence liquidity trap) is greater than the increase in money in the system (which is defined as inflation). Any attempt to encourage consumers to hold an asset that isn't liquid, i.e. can be consumed, through monetary policy is doomed to failure as consumer's preference for cash is greater. This is because there is a rate below which interest rates simply can't go so if it has no effect when brought as low as possible then there is nothing that can be done through monetary policy. This is known as liquidity Trap.

The liquidity Trap was linked to another idea coined by Keynes, the paradox of thrift; the paradox of thrift is that if animal spirits, another term coined by Keynes, ebb or fall then people consumers will have a higher propensity to save and thus save more. This leads to a fall in consumer consumption and has knock on effects throughout the whole economy causing a negative multiplier effect which will decrease aggregate demand by far more than the original drop in consumer consumption[9]. This fall in aggregate demand will lead to a fall in incomes and so is actually not beneficial to the consumer. But to the consumer it seems entirely logical to save in times of hardship and spend less (and it is as they have no influence over the wider macro-economic conditions and can't influence them.). The government in efforts to increase consumer spending, especially on durable goods which are bought on credit such as houses and cars, often slash interest rates which will in a deep recession often have very little effect and simply lead to a liquidity trap.

I touched on animal spirits earlier as they are linked to many other of Keynes' economic policies and ideas. Animal spirits are a mix of ideas which combined influence consumer confidence to spend or save. A combination of consumer confidence and there mood as well as confidence in the future outlook will lead to either saving or spending. It only takes very small changes in animal spirits to have large effects on the economy. In recession's Keynes argued that there would be a fall in animal spirits leading increased saving and a paradox of thrift scenario would emerge. The small drop in animal spirits leading to a large decrease in spending is because of the fact that there is significant herd behaviour amongst investors, consumers and humans in general. The initial small drop can spiral as other investors and consumers follow suit in their lack of spending leading to a large drop in spending.

All of these ideas about causes and issues of recessions revolve around the mainstay cause of recessions as identified by Keynes: aggregate demand or a fall there of. Aggregate Demand is defined as consumer spending + government spending + business investment + exports – imports. The first three factors in calculating Aggregate demand are heavily influenced by animal spirits. When they are high then aggregate demand increases and the economy will experience growth. When animal spirits are low they will decrease as they are all interlinked so a fall in one will likely lead to a fall in others of them due causing a negative multiplier effect. A rapid fall in aggregate demand, often triggered by a shock to the system which leads to a decrease in animal spirits leading to an increase in saving and decrease of aggregate demand, will trigger a recession as spending and investment decreases and economies stagnate.

The multiplier effect and its consequences form the keystone to Keynes policy on combating a recession. The multiplier effect is the phenomena that if you invest £1000 then some or all of it will get re-invested into the economy and then again. If the government spends 10bn on infrastructure it pays a construction firm to build the project. That firm then sub contracts to the value of 9bn. those sub-contractors pay suppliers for raw materials. Those suppliers and all the other links pay wages to their workers. An initial investment of 10 bn pounds has a much larger and far reaching impact than the initial investment. All of this spending boosts Aggregate Demand to a tune far above 10 bn pounds. Keynes linked the multiplier effect and its effect on aggregate demand through a term called elasticity. He said that when the elasticity of the Economy was high then an initial investment would lead to a high multiple whilst an Economy with low elasticity would lead to a smaller multiple for investemen.t

The existence of the multiplier effect is the key reason for Keynes's avocation of a policy of fiscal stimuli in times of recession. He argued that to get economies out of recession you had to increase aggregate demand. Neither consumers nor businesses have the financial muscle to significantly change the aggregate demand on their own and animal spirits mean that they won't change it together because they have a higher propensity to save .No one except the government can single handedly combat recessions. To increase aggregate demand governments had to inject money into the system. They could do this in two ways either through cutting taxes or investing in the economy. Keynes argued for investment because it was a direct cash injection already spent and likely to be spent again because spending by the government increase animal spirits and creates consumer confidence. Cutting taxes gives the consumer more money but they are likely to keep saving that money than invest it into the economy so therefore it would have no effect. A fiscal stimulus creates a multiplier effect as the cash injection is re-invested around the economy boosting aggregate demand and leading to an increase in animal spirits. An increase in animal spirits will lead to an increase in consumer spending not just of the money spent by the government but also money that they would otherwise have saved as they have higher confidence in the economy both now and in the future. This multiplier effect was the justification for Keynes of spending over austerity policies.

Keynes also introduced the concept of Sticky Wages. Classical view said that a drop in demand during a recession would lead to a drop in recession to bring it back in line and the economy would redress. This didn't happen in the great depression. Keynes pointed out that this was because although it makes economic sense to cut wages in a recession the people who have the power to do that are human and have a moral conscience they often feel that it would be unfair to slash wages; a survey of the UK public said that it would be unfair to reduce someone's wage from £18 to £15 because that's what other people doing similar jobs at different firms were paid. Although it makes economic sense it often doesn't happen. A cut in wages might also lead to a drop in worker satisfaction which will most likely lead to a drop in productivity. This Keynesian policy sits on fairly shaky ground as although is often true equally we see classical theory prevailing and pay freezes are often implemented at struggling firms in order to try and cut costs to stay afloat e.g. at BA and many other large companies after the recession which saw a drop in demand leading to a lack of income against their costs so to stay afloat many companies were forced to cut wage costs.

Keynesian policies were never employed to their full effect because the Second World War created a period of full employment and economic stimulus as the government invested in industry to fuel the war effort. Roosevelt's new deal in America was a prime example though of Keynesian policies in action. The new deal was a series of Economic and Fiscal stimuli brought in by Roosevelt once he was elected to replace president hoover in 1933 on the back of a campaign to end the depression through action. Up to this point Hoover had been Subscribing to the classical school of economic thought and simply waiting for the economy to re-balance. As we know this didn't happen because of some of the factors mentioned above. Roosevelt brought in massive investments in infrastructure by creating a governmental body called the public works administration; this invested heavily in major infrastructure projects especially dams which created electricity as well as creating jobs. These pulled America out of recession as Keynes would have predicted. They exploited the multiplier effect as well as focusing on the poorest in society the rural farmers ; this was because poorer people have a higher propensity to spend than save so if you increase their incomes you will get a higher multiplier for your buck than spending on the middle and upper classes.

Keynesian policies were though fully vindicated, even though they were never intentionally implemented as a combat to the depression, by the second world. Governments were forced to follow Keynesian policies without even realising it spending huge amounts on the war effort and investing heavily in industries. This led to full employment and a post war (I don't think one can call a time of war an economic recovery) economic recovery. Thus Keynes was fully vindicated in his policies. Unfortunately he didn't live to see it dying tragically early in 1946.

Keynes policies were linked to an economic indicator developed by a man called William Philips who developed an economic indicator called the Philips curve which showed a remarkable correlation between inflation and un-employment. It showed that they could be balanced and traded off against each other so you could use high inflation to remove un-employment or vice versa. Unfortunately this was just a strong correlation rather than economic fact [ii] and so in the 1970's when the world went into recession this correlation collapsed and governments were suddenly finding that they could not balance inflation and un-employment. This was called Stagflation where increased inflation was suddenly having no effect on un-employment whereas before it had worked to reduce un-employment. As the Philips curve was linked to Keynesian school of thought in the economics world it fell out of favour as economists who had previously questioned the Philips curve came to the fore and Keynesian theory was left by the way side. Common consensus among the economic world (you may notice that this shifts rapidly) became that fiscal stimulus would now actually have very little effect even in a recession.

People started to float the notion that Boom and Bust was finally solved and the economy would be stable and growing form there on. Gordon Brown was one of those people who famously claimed to have solved boom and bust just a couple of years before the Recession.

How wrong they were. After the Recession of 2007-08 which was the worst recession ever seen since the great depression there was a period of introspection within economics as the bust had come again and the prevalent economic theory was again thrown by the way side. By October that year Keynesian policy came back to the fore and world economies turned back to his theories to try and escape recession. Major fiscal stimulus packages were announced in many countries with both Britain and America introducing Quantative easing to boost their economies by keeping inflation up and the world also slashed interest rates. Without a fiscal package to go with it this might have led to a Liquidity Trap but as it was introduced with a wide range of fiscal stimuli the world managed to on the whole avert a major slip back into recession in 2010 and the economics world shifted away from Keynesian theories and started again to debate their effectiveness as although they had averted a double dip recession and pulled the world out of a recession they had not slashed un-employment or produced resurgent growth as might have been expected.

Britain still employs Keynesian policies, approving and staying committed to projects such as cross rail and HS2 throughout the depression era in order to boost growth. The rejuvenation of Stratford alongside the Olympic park is another good example of a Keynesian esque policy. George Osborne often though implemented austerity packages instead of fiscal stimuli, especially cutting welfare spending for the poorest in society. As I said before they have a higher propensity to spend than richer people so although it feels like they are saving money Keynesian policies would actually have advocated either increasing welfare spending or increasing investment in projects such as the rejuvenation of the docklands and London Gateway and potentially major infrastructure such as Boris island Airport. This would have in the long run boosted economic growth and led to an increase in taxes boosting both the economy and the government.

In my opinion Keynesian Policies were influential in helping us out of recession and they are still relevant today. Many critics of Keynes forget that he died before he would see them fully implemented in a post war stable economy and so never had a chance to fine tune his work as his policies are mainly concerned with depression economics and combating recessions and returning to growth. Keynesian economics are not always suitable but in recessions many economists should be a lot slower to discard them than they have been in the past.

[1] Tim Harford : Thursday Night Keynes Soc

[2] http://www.investopedia.com/terms/k/keynesianecono...

[3] Economics: the user's guide pg. 146

[4] http://en.wikipedia.org/wiki/Keynesian_economics

[5] http://econ.economicshelp.org/2009/10/liquidity-tr...

[6] http://econ.economicshelp.org/2007/02/keyness-para...

[7] http://www.economicshelp.org/blog/1948/economics/t...

[8] http://econ.economicshelp.org/2009/10/liquidity-tr...

[9] http://econ.economicshelp.org/2007/02/keyness-para...

Keynes hadn't published yet but these were Keynesian theories. They went against classical theory.

[ii] Which Philips fully acknowledged but was blamed for anyway.

Geoff Riley

Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.

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