The economics of John Maynard Keynes.
Last time we have discussed the developments in macroeconomics of the first 3 decades of 20th century - that is 20th century macroeconomics before 1936, when John Maynard Keynes published his General theory, which changed the whole field of modern macroeconomics.
Before Keynes, general economic thought consisted of fairly well developed microeconomics explaining the allocation and distribution of resources in the economy, a macroeconomic theory explaining the forces determining the general level of prices (that was quantity theory of money) and also a very loose set of notions concerning economic growth. The theory of business cycles was missing.
John Maynard Keynes is doubtlessly one the most important figures in the entire history of economics. His writings completely revolutionized macroeconomic theory and practice of economic policy in the 20th century.
His book The General Theory of Employment, Interest and Money, General theory, in short, published in 1936, is generally regarded as probably the most influential social science treatise of the 20th Century, in that it quickly and permanently changed the way the world, scientific and public, looked at the economy and the role of government in society. No other single book after Keynes's has had quite such an impact.
Born in 1883 (died 1946), he was a son of John Neville Keynes an important British economist on his own right.
He was educated at Cambridge University, and after performing some functions for British government, he returned to Cambridge and become an academic economist.
But he was not only an economist, he was engaged in many different activities, was interested in theatre, literature, and the ballet - he married a ballerina and was associated with a famous group of British intellectuals and artists, which included Virginia Woolf, for example.
He took a number of government posts throughout his life. He was active in business affairs for himself, he was a stock investor - and very able in this activity, his net wealth rose from near bankruptcy in 1920 to more than 2 million US dollars by the time of his death in 1946.
He was also a very able mathematician; in 1921, he published a very good treatise on probability.
However, the single most important aspect of Keynes as economist is his orientation toward policy. He attended the peace conference after the First World War as a representative of British treasury Department, and published two books concerning problems of practical economic consequences of peace and war.
In 1926, he published a short book under the title The End of Laissez-faire, in which he claimed that the automatic adjustment of the economy to equilibrium position at full employment is only an economic myth, fiction, it is not a correct deduction from the principles of economics.
So Keynes did not believe in Adam Smith's metaphor of invisible hand of markets.
He rejected this vision because for him it was an intellectual mistake and because it constituted for him a dangerous illusion when it informed one's political vision in matters of economic policy.
In 1944, he was instrumental in the formation of the International Monetary Fund (IMF) and the World Bank, very important economic institutions in the 2nd part of the 20th century.
But his most important contributions to economic policy, and of course to economic theory, are contained in his General theory, of 1936.
In General Theory Keynes stated that his theory is a general theory in the sense that previous theory is a special case to be placed within his more general framework. By previous theory, Keynes meant both classical and neoclassical economics, the economics of Ricardo, Say, Mill, Marshall and others.
Classical and neoclassical economists assumed that equilibrium at macro level in capitalism could only be achieved at full employment of resources, especially labor. So in general classical and neoclassical economists held that unemployment in capitalism is either voluntary (people do not wan to work at market wage), or that unemployment is temporary, short lived, or that unemployment is caused by government intervention (for example minimum wage legislation).
Therefore, the best policy to achieve macroeconomic equilibrium and full employment is laissez faire policy, policy of governmental non-intervening in the economy.
The basic point made by Keynes in his General theory is that equilibrium at less than full employment of resources (especially labor) could exist in capitalism for a long period. And that classical and neoclassical view of full employment of resources in capitalism is only a very special situation, which rarely occurs in reality. In this sense, he thought that his theory is more general than classical macroeconomics, which could be applied to explain the economy only in one, very special case of full employment of resources.
Therefore, he rejected the view that capitalism is a stable and self-adjusting economic system,
According to Keynes, there are forces inherent in capitalism, which could bring the system to a long-lasting depression.
In this, Keynes rejected the optimistic vision of classical and neoclassical economists about free market and laissez faire capitalism as a economic system which is optimal on the macro level.
According to Keynes, orthodox theory (classical and neoclassical macroeconomics) was unable to explain such problems as business cycles, long-lasting depressions or involuntary unemployment. This was the major problem with orthodox macroeconomics, because the problems of business cycles and unemployment were the most serious economic problems of his time.
I should recall you here, that since 1929 capitalism had been suffering the great depression, so the publication of General theory in 1936 was in part a intellectual response to this biggest economic catastrophe of capitalism in history.
Few words on the great depression
The Great Depression was the worst economic slump ever history, and one which spread virtually all over the industrialized world. The depression began in late 1929 and lasted for about a decade.
The worst hit were the most industrialized countries, including the United States, Germany, Britain, France, Canada, and Japan.
Construction industry, for example, virtually stopped in the United States and other countries. Incomes for Farmers in US dropped by about 50%.
Unemployment rate rose in US from 3% in 1929 to 25% four years later - it was a drastic increase in unemployment.
US production level dropped by about 30% in the first two years of the depression.
More or less disastrous were the consequences of the depression in other capitalist countries.
Therefore, it was a devastating international crisis.
We should remember that Keynes's General theory was published in such a time, the years of most severe international economic depression. Keynes's motivation was, in part at least, to find a scientific explanation for such crises and to develop political tools to ease the consequences of the depression.
Since orthodox economics could not explain such deep and long lasting depressions and laissez-faire policy (policy of not intervening in the economy), could not help in bringing the economies back to the full employment states, Keynes had to depart from orthodox macroeconomics. He therefore constructed completely new macroeconomic theory.
Let's examine his theory in a little more detail.
First, in general theory Keynes rejected the classical macroeconomic concept of Say's Law. Say's Law accepted by majority of classical and neoclassical economics holds that supply creates its own demand, which means that production generates expenditures and demand by firms and households, which are just sufficient to buy out all commodities produced.
If Say's law holds in the economy, than there is no place for any serious economic crisis.
Production is determined by real factors, like the stock of labor, the stock of capital, technology and the like, and the production process creates sufficient purchasing power to maintain the full employment of resources. There is always full employment of economic resources. This was the view of classical macroeconomists.
Keynes rejected Say's law, and argued that it is not production, which generates demand, but it is rather that production adjusts to demand created by firms and households.
The demand side of the economy determines production and employment level in Keynes's analysis; they depend on the expenditure decisions of households and firms.
Keynes stated that production and employment are determined by the so-called effective demand, the sum of investment and consumption expenditures by firms and households.
In this view Keynes has turned classical theory on its head - production is determined by demand, while in classical view demand was adjusted to production.
The most important implication of this theory of effective demand is that the level of production determined by demand (the sum of investment and consumption expenditures) is at equilibrium point, but this equilibrium does not have necessarily to be at full employment of resources.
Since it is effective demand that creates production, than if effective demand is not as great as full employment demands, than it will generate production level, which does not require full employment of resources. The implication of Keynes's view is that there could be equilibrium in capitalism at less then full employment of resources.
In classical view it was impossible because, equilibrium was determined by the production, supply side of the economy, so classical economists assumed that there is full employment of resources and that production at full employment generates demand and equilibrium state.
The rejection of Say's law and the statement that effective demand generates production allowed Keynes to argue that there is a possibility of equilibrium in capitalism at less than full employment of resources.
Why there should be an effective demand not sufficient to generate the production that would require full employment?
What is the reason for which effective demand could be so low, as to create low level of production - the level that would not require full employment of labor, for example?
In other words, what is Keynes's explanation of the instability of capitalism? Why capitalism can achieve equilibrium at less than full employment of resources? For what reason effective demand could not generate full employment level of production?
As we stated before effective demand is the sum of aggregate investments and consumption.
Keynes focused on the problem of why investment part of effective demand did not normally settle at the level that guarantees full employment.
Investments in his theory depend on the so-called marginal efficiency of capital, which is an estimate of the future returns of investments, in other words it is the rate of return from capital that businessmen expect to achieve.
The problem is that the businessmen assess the profitability of investments on the basis of their expectations about future - marginal efficiency of capital is the expected rate of profit. So their calculations of the marginal efficiency of capital are based on their assessments about the future trends of the economy, and those assessments are influenced by psychological, irrational factors.
Future is uncertain and expectations are volatile, they change quickly and irrationally. Investors moods (waves of optimism or pessimism), states of confidence, and what Keynes called `animal spirits' of the investors play a key role in the formation of their expectations and investment decisions.
By animal spirits, Keynes meant some kind of intuitive, unconscious mental actions, irrational actions, not based on economic calculation.
If such irrational, psychological factor influence investors assessments of marginal efficiency of capital, than their investment decisions are not rational.
Since investments as a part of effective demand, play a big role in determining levels of production and employment, than those levels of production and employment depend on uncontrollable, and extremely unstable psychological factors - like those animal spirits.
So, investment decisions are to a large degree not rational and therefore investment levels are volatile - this is the fundamental reason for which effective demand can, for example, fall drastically even if the economy if performing well from the rational point of view.
Unstable investment expenditures are the main reason for capitalism being unstable in Keynes's system. If investors driven by irrational moods, animal spirits, lose confidence in the future prospects of the economy, than the effective demand can decrease significantly and for a long period, and the equilibrium will be achieved at less than full employment of resources.
These are, in short presentation, Keynes's reasons for why in capitalism there can be long lasting economic depression.
Keynes made also a very important contribution in the theory of interest rate by stating that the market interest rate is determined not in the investment-savings market (as classical economists thought), but in the market for money, for him interest rate is determined by the forces that shape the supply and demand for money.
What is important about theory of money, and monetary policy, is the fact, that Keynes did not believe much in the effectiveness of monetary policy in fighting with economic depressions. There were several reasons for this belief of Keynes, for example, he thought that monetary authorities are not able effectively to control the money supply.
In overall, from our point of view it is important to know, that he was very sceptical about the power of monetary policy to influence real variables, like the level of production of employment.
Keynes's revolutionary book concludes with an important chapter on the “social philosophy toward which the General theory might lead'. This is the chapter about Keynes's economic philosophy and his views on the economic policy. He described here what tools of economic policy could help the economy to recover from major depressions.
As we said before, already in 1920s, Keynes was against the laissez-faire policy, but in General theory (published in 1936) he came to a more extreme anti-laissez-faire position. He stated that government should intervene in the economy in many areas.
First, state should control the level of interest rates in the economy, tending to lower market interest rates, to increase investments and therefore, to increase effective demand.
Further, the action of the state should be extended to two fields in which laissez faire policy (policy of not intervening in the economy) had most clearly shown its deficiencies: 1) the determination of the level of output and employment; 2ndly - the distribution of wealth and income.
On the first field, Keynes even reached the point of preaching some form of “socialization of investment”. Given that the level of investments normally, in a laissez faire regime, tend to lead to the economy with underemployment equilibira, the state should have right or duty, to intervene in order to ensure full employment.
Therefore, state should control the level of aggregate investments, probably by taking public investments in private enterprises, or originating of some kind of public-private partnership in investment projects.
In any case, state should be actively monitoring the level of investment, and intervening if the level was not sufficient for the full employment.
In regard do the distribution of income and wealth, Keynes pointed out that the natural tendency of a laissez-faire policy is towards the determination of arbitrary and unjust distributive patterns - he thought that there is too much inequality and poverty in laissez-faire capitalism.
He believed that large amount of savings generated by a very unequal distribution of income in laissez-faire capitalism, serve only to keep the level of aggregate demand at a low level, because there is a class of people in capitalism who do not invest their money directly increasing the demand, but receive their incomes from savings and do not perform very useful functions in the economy.
So he proposed lowering the interest rate to diminish the role of rentier class in the economy, he even proposed the program of the euthanasia of the rentier class. He of course meant economic euthanasia, not physical one.
Therefore, state should intervene to create more equal distribution of income and wealth in capitalism, by various means of fiscal policy.
All those propositions in economic policy seem to be quite radical, and many economists both contemporary to Keynes and modern economists, consider Keynes to be radical, anti-liberal or even socialist, but himself Keynes thought that he was not radical, but rather conservative.
He did not aim at introducing drastic changes in the institutional structure of capitalism.
He was basically conservative, he was a proponent of personal freedom and private property, and generally advocated only such changes as would preserve the essential elements of capitalism - like private property and markets.
His view was that if the worst defects of the system were not removed, individuals would reject capitalist system and lose much more than they gained. He thought that the continuation of laissez faire policy, would lead to some kind of revolution leading to socialism or authoritarian or totalitarian state.
Himself he was not a socialist, he did not advocate that state should take over the ownership of the means of production.
He rejected Marx's vision and theory, both because he thought Marx's economics was not scientific and because he recognized that Marxian social system would destroy the classes of entrepreneurs and intellectuals.
He was against socialist and totalitarian systems, although he admitted that those systems could solve some of the economic problems he dealt with. As for example, socialism can introduce egalitarian society, at least in principle.
At the same time, he knew that socialist or totalitarian solutions would be achieved only at the cost of losing private property and individualism, associated with capitalism.
Those characteristics of capitalism -individualism and private property, did possess for Keynes important economic and political advantages - greater economic efficiency, innovative economy, variety of life, freedom to choose and the like.
As you can see Keynes held a broad, philosophical view about the economic policy, and his vision was based on particular ethical values - he cared about liberty, efficiency and equality.
In general, he was a proponent of some version of a third way between capitalism and socialism or advocated refined, amended capitalism, capitalism free of two important evils - unemployment and inequality.
He proposed that state should intervene in the economy on a wide scale, but he wanted that those interventions did not damage the fundamentals of capitalism - free markets and private property. He was anti-laissez-faire economist, but still he was liberal, he was not socialist or radical.
He thought that it is possible to correct the evils of capitalism (unemployment, excessive inequality) without destroying capitalism and its benefits (freedom and efficiency).
Good afternoon,
Last time we have discussed the economics of John Maynard Keynes, we have outlined some theoretical developments in his general theory and the policy prescriptions implied by his Keynes's theory.
Today we will continue the review of the developments in the 20th century macroeconomics.
Last time I described the policy proposals he advocated, to recall you, he proposed that the state should control the level of interest rates in the economy, and also the level of aggregate investments in the economy by “socialization of investment”, that is by by taking public investments in private enterprises, or originating of some kind of public-private partnership in investment projects.
Also he thought that state should intervene in the distribution of wealth and income by making this distribution more equal.
All those propositions in economic policy seem to be quite radical, and many economists both contemporary to Keynes and modern economists, consider Keynes to be radical, anti-liberal or even socialist, but himself Keynes thought that he was not radical, but rather conservative.
He did not aim at introducing drastic changes in the institutional structure of capitalism.
He was basically conservative, he was a proponent of personal freedom and private property, and generally advocated only such changes as would preserve the essential elements of capitalism - like private property and markets.
His view was that if the worst defects of the system were not removed, individuals would reject capitalist system and lose much more than they gained. He thought that the continuation of laissez faire policy, would lead to some kind of revolution leading to socialism or authoritarian or totalitarian state.
Himself he was not a socialist, he did not advocate that state should take over the ownership of the means of production.
He was against socialist and totalitarian systems, although he admitted that those systems could solve some of the economic problems he dealt with. As for example socialism can introduce egalitarian society, at least in principle.
But at the same time, he knew that socialist or totalitarian solutions would be achieved only at the cost of losing private property and individualism, associated with capitalism.
And those characterstics of capitalism -individualism (personal freedom) and private property, did possess for Keynes important economic and political advantages - greater economic efficiency, innovative economy, variety of life, and the like.
So, as you can see Keynes held a broad, philosophical view about the economic policy, and his vision was based on particular ethical values - he cared about liberty, efficiency and equality.
In general he was a proponent of some version of a third way between capitalism and socialism or advocated refined, amended capitalism, capitalism free of two important evils - unemployment and inequality.
He proposed that state should intervene in the economy on a wide scale, but he wanted that those interventions did not damage the fundamentals of capitalism - free markets and private property. He was anti-laissez-faire economist, but still he was liberal, he was not socialist or radical.
He thought that it is possible to correct the evils of capitalism (unemployment, excessive inequality) without destroying capitalism and its benefits (freedom and efficiency).
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