The Return of John Maynard Keynes
John Maynard Keynes was a profane, arrogant, promiscuous, overtly bisexual British elitist. He was on the board of directors of the British Eugenics Society. In the early 1900s he was a member of the free love Bloomsbury Group, many of whose members complained that Keynes' behavior was too dirty for them. He slept with the men from Bloomsbury and his students at Cambridge and took his lovers to dinner parties where he talked about being married to them almost 100 years before same-sex marriage became fashionable. He's also recognized as one of the most influential economists of the 20th century.
Keynes published "The General Theory of Employment, Interest and Money" in 1936. At the time it was believed that recessions would cause prices to drop until they would reach prices at which people could afford to buy - the economy will sort itself out. Keynes was looking at the economy of the 1930s and realized that this was not true - that economies do not always right themselves. He called this a "failure of effective demand" - weak demand means inventory piles up, high inventory means greater inefficiency and low income, and the low income means there's even less demand. Keynes' principle of aggregate demand was an attempt to correct classical economics. Every economy has a certain production capacity, that depressions occur when demand does not meet the capacity of supply, and that the public sector (government) could avoid depressions by stimulating demand and bring the two in line if the private sector wasn't stimulating enough demand. Keynes' advice is credited (with some controversy) for getting America out of the great depression, either slowly when FDR wasn't spending as much as Keynes calculated he should spend or faster when World War 2 forced America deep enough into the red that it started working.
Keynes theory ruled for 30 years after World War 2, as mid-twentieth century Keynseans advised cutting taxes and increasing government spending to bring the economy up, and increasing taxes and decreasing spending when the economy gets overheated. By the 1970s the Democratic majority had earned a "tax and spend" label by using Keynesian policies to justify the war on poverty, the space race, and military spending in Vietnam. The economy eventually ran out of Keynsean wiggle room as America spent more money and still got, high unemployment, and high inflation. The Keynsean controls had stopped working.
By the late 70s the Keynsean system was out and groups like Milton Friedman's Monetarists, the Chicago School, and supply siders were in. Economists of the late twentieth century economists advocated using the Federal Reserve interest rate to control the economy. That's why we heard so much about the Alan Greenspan and the prime interest rate in the 80s and 90s - Greenspan was lowering the interest rate when the economy needed stimulus and raising it to prevent things from overheating.
Post-Keynsean theory ruled for 30 years as Volcker and Greenspan raised or lowered the interest rate, but by the late 1990s the economy ran out of wiggle room on December 16 2008. The Federal Reserve cut interest rates to zero, the economy kept getting worse worse, and the Fed realized that they couldn't cut rates below zero. The supply side controls seem to have stopped working. And that's why economists have gone retro and are talking about Keynes again - because our economy's deflationary spiral looks to some people a whole lot like the one that Keynes saw in the 1930s when he wrote the General Theory, and with thirty years to update their theories the Keynesians are hoping their policies will work even better this time around.
From the perspective of monetarists this is crazy. His ideas were pronounced dead after Keynesian policies stopped working in the 1970s which proved he was wrong and that his ideas were dead. But by the same argument doesn't this mean that because supply side ideas stopped working last December that Milton Friedman's ideas are dead? I don't think so. I think actual economic systems are more complicated that either of these theories can fully represent, and that in the absence of perfect and complete knowledge both sides are imperfect but useful abstractions that ought to be used where reasonable and applicable. For better or worse, the stimulus package will be the first major test of Keynesian policies and it will be interesting to see how this goes.
(This post was cribbed very heavily from the Planet Money podcast, in a segment which was also featured on This American Life.)
Keynes published "The General Theory of Employment, Interest and Money" in 1936. At the time it was believed that recessions would cause prices to drop until they would reach prices at which people could afford to buy - the economy will sort itself out. Keynes was looking at the economy of the 1930s and realized that this was not true - that economies do not always right themselves. He called this a "failure of effective demand" - weak demand means inventory piles up, high inventory means greater inefficiency and low income, and the low income means there's even less demand. Keynes' principle of aggregate demand was an attempt to correct classical economics. Every economy has a certain production capacity, that depressions occur when demand does not meet the capacity of supply, and that the public sector (government) could avoid depressions by stimulating demand and bring the two in line if the private sector wasn't stimulating enough demand. Keynes' advice is credited (with some controversy) for getting America out of the great depression, either slowly when FDR wasn't spending as much as Keynes calculated he should spend or faster when World War 2 forced America deep enough into the red that it started working.
Keynes theory ruled for 30 years after World War 2, as mid-twentieth century Keynseans advised cutting taxes and increasing government spending to bring the economy up, and increasing taxes and decreasing spending when the economy gets overheated. By the 1970s the Democratic majority had earned a "tax and spend" label by using Keynesian policies to justify the war on poverty, the space race, and military spending in Vietnam. The economy eventually ran out of Keynsean wiggle room as America spent more money and still got, high unemployment, and high inflation. The Keynsean controls had stopped working.
By the late 70s the Keynsean system was out and groups like Milton Friedman's Monetarists, the Chicago School, and supply siders were in. Economists of the late twentieth century economists advocated using the Federal Reserve interest rate to control the economy. That's why we heard so much about the Alan Greenspan and the prime interest rate in the 80s and 90s - Greenspan was lowering the interest rate when the economy needed stimulus and raising it to prevent things from overheating.
Post-Keynsean theory ruled for 30 years as Volcker and Greenspan raised or lowered the interest rate, but by the late 1990s the economy ran out of wiggle room on December 16 2008. The Federal Reserve cut interest rates to zero, the economy kept getting worse worse, and the Fed realized that they couldn't cut rates below zero. The supply side controls seem to have stopped working. And that's why economists have gone retro and are talking about Keynes again - because our economy's deflationary spiral looks to some people a whole lot like the one that Keynes saw in the 1930s when he wrote the General Theory, and with thirty years to update their theories the Keynesians are hoping their policies will work even better this time around.
From the perspective of monetarists this is crazy. His ideas were pronounced dead after Keynesian policies stopped working in the 1970s which proved he was wrong and that his ideas were dead. But by the same argument doesn't this mean that because supply side ideas stopped working last December that Milton Friedman's ideas are dead? I don't think so. I think actual economic systems are more complicated that either of these theories can fully represent, and that in the absence of perfect and complete knowledge both sides are imperfect but useful abstractions that ought to be used where reasonable and applicable. For better or worse, the stimulus package will be the first major test of Keynesian policies and it will be interesting to see how this goes.
(This post was cribbed very heavily from the Planet Money podcast, in a segment which was also featured on This American Life.)