Keynesian economics focuses on psychology, uncertainty and expectations in driving macroeconomic decisions and behaviour. As we shall see, in Keynesian economics, the state of animal spirits is vital.

Keynesian economists and free markets

• Keynesian economists believe that free markets are volatile and not always self-correcting.
• The free-market system is naturally prone to periods of recession & depression
• The volatility of aggregate demand (AD = C+I+G+X-M) can be explained by important changes in consumer and business sentiment – also known as animal spirits.
• In a world of economic stagnation and/or depression, the standard rules of economics may no longer apply and direct intervention in the economic may be essential
• Free markets are not always self-correcting:
• When a recession or a depression occurs, the free market economic system is not necessarily self-correcting – indeed en-masse, individuals can become trapped in a deflationary depression which is in no one’s interest but which, left on our own, no one can counter-act.
• Persistent deflation can be as costly as high inflation – it can be damaging especially in economies where there are huge levels of private & public sector debt

Keynes on under-employment equilibrium One of Keynes’s revolutionary propositions was that following a big economic shock - usually a collapse in investment - there were no automatic recovery forces in a market economy. The economy would go on shrinking until it reached some sort of stability at a low level. Keynes called this position "under-employment equilibrium" Professor Robert Skidelsky, Biographer of Keynes

You cannot always rely on new inventions / innovations and other natural economic stabilisers to drag an economy out of a recession (they do happen though – as the Austrian school believes)

Savings and aggregate demand

• The paradox of thrift helps to explain why a rise in precautionary saving (i.e. people looking for security) can lead to a fall in demand and incomes and a reduction in output, income and wealth.

• In other words – negative multiplier and accelerator effects can drag production and employment in the economy to a low level where it can remain for some time unless there is some external stimulus to lift demand and output again

• On an international level, when the global desire to save exceeds the global willingness to invest the result is a contraction in world demand and production, a fall in incomes and employment, which eventually brings savings back into balance with investment

The risks of a deflationary depression

Recession (and worse – a deep depression) represents a pure waste of scarce economic resources. Unemployed workers want to work, and businesses want to use their productive capacity to supply goods and services. If they did, then the things they produced would be available for all to buy, and the incomes they received would enable them to purchase the products of others. Incomes from higher wages and stronger profits would be made feeding through the circular flow in the standard macro model.

But in a recession a country can experience a persistent state where output is well below potential.

The Liquidity Trap:

• In normal circumstances it is possible to boost demand by cutting interest rates. But there is a level below which interest rates cannot go (they have been at 0.5% in the UK since the spring of 2009 and at low levels in other countries) and at that point monetary policy may become powerless.

• Moreover, even if interest rates can be lowered this may have no effect if people cannot or will not borrow. This is known as the liquidity trap.

• At this point, aggregate demand can only be boosted by the Government borrowing more, either to spend directly or to give to others via tax cuts or the like.

• In other words, we need a targeted Keynesian fiscal stimulus. Keynesians believe that the size of the fiscal multiplier effect is higher for government spending than for tax cuts.

Animal spirits

• John Maynard Keynes coined the notion of animal spirits which refers to the driving force that gets people and businesses going in the economy

• Animal spirits helps to explain why countries fall into a recession but also what eventually brings about a recovery. It refers to a broad mix of confidence, trust, mood and expectations and animal spirits can fluctuate very quickly as populations of people change their thinking. This focus on animal spirits helps to explain why psychology can be so important in macroeconomics.

• When animal spirits are poor then there is a risk of a slowdown or a recession. Individuals save more, businesses save more too and, because demand and profits are lower than expected, they may opt to cut back on production and perhaps postpone or cancel capital investment projects.

• Higher saving and reduced investment both have the effect of reducing demand and incomes in the circular flow causing an economic contraction.

Keynesian economics and fiscal deficits

Keynesian economists are usually supportive of the state borrowing more money during times of weakness.

1. Government borrowing can benefit growth: A budget deficit can have positive effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can boost productivity and employment.
2. Demand management: Keynesian economists support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. If crowding out is not a major problem - fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle
3. Low interest rates – it makes sense for the state to borrow when interest rates are low and inject extra demand into the economy, especially when private sector demand (C+I+X) is low

Naturally there are counter-arguments to this:

1. Financing a deficit: A budget deficit has to be financed through the issue of debt. If the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of debt. This raises the possibility of the government falling into a debt trap where it must borrow more simply to repay the interest on accumulated borrowing.
2. A government debt mountain: As state debt rises, there is an opportunity cost involved because interest payments on bonds might be used in more productive ways, for example on health services or extra investment in education. Higher public sector debt also represents a transfer of income from people and businesses that pay taxes to those who hold government debt
3. Crowding-out - the need for higher interest rates and higher taxes. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then ‘fiscal crowding-out’ is said to be occurring.
4. Risk of capital flight: High levels of state borrowing and debt risk causing a ‘run on a currency’. This is because the government may find it difficult to find sufficient buyers of debt and the credit-rating agencies may decide to reduce the rating on sovereign debt. Foreign investors may choose to send their money overseas perhaps causing a currency crisis