John B. Judis: The misunderstood John Maynard Keynes
...[T]he tendency only to turn to Keynes for technical advice in bad times doesn't really do justice to his worldview. Keynes's ideas were not just a prescription for an ailing economy; they were a complete theory of capitalism, one meant to be relevant in both good times and bad....
... As Robert Skidelsky makes clear in his masterful threevolume biography, Keynes was a "new Liberal"--but with Bloomsbury's aesthetic idealism and disdain for vulgar capitalism thrown in. "I want to mould a society in which most of the existing inequalities and causes of inequality are removed," he declared. He initially thought this could be accomplished through classical economics. But, in the 1920s, he decided otherwise.
In the wake of demobilization after World War I, Britain had suffered a steep recession and unemployment climbed above 15 percent. According to classical theory, the economy should have eventually returned to a full-employment equilibrium--which is what Keynes expected would happen. But it didn't. Instead, the unemployment rate hovered around 10 percent for the rest of the decade, then shot above 20 percent after the Great Depression hit Britain in 1930.
Moreover, the remedies suggested by classical economics--wage cuts, balanced budgets, and the gold standard--simply made things worse. Not only did unemployment rise, but social unrest spread. In 1926, an attempt to cut miners' wages led to a general strike. Keynes sympathized with the strikers whom he saw as "victims of cruel economic forces which they never set in motion."
Over the next decade, Keynes attempted to devise policies that would restore full employment--and a new theory of capitalism to back them up. He argued that market economies, if left to their own devices, could reach equilibrium at well below full employment. This challenge to classical economics rested on his reinterpretation of the relationship among three core economic activities--investment, savings, and consumption.
According to classical theory, if unemployment were to rise, consumption would decline, but savings would increase. The increase in savings would lead to lower interest rates, which would lead to greater investment, which would lead to the restoration of jobs--in short, back to full employment. But Keynes rejected this logic. During a recession, lost jobs and wage cuts would lead to a reduction in consumer demand, which meant less incentive for businesses to invest and banks to loan. And, if businesses--skeptical about the rate of return from an investment--failed to invest, more workers would lose their jobs, consumption would decline even further, national income would go down, and any initial increase in savings would be wiped out. The economy would reach equilibrium with a high number of unemployed, which is exactly what happened in Great Britain in the 1920s and 1930s.
Keynes's theory inverted the relationship between savings and investment. Instead of the amount of savings determining the amount of investment, the amount of investment determined the amount of savings. It also inverted the relationship between consumption and savings. If the inducement to invest was determined at least partly by consumer demand, then the greater the propensity to consume rather than save, the greater the inducement to invest. Consuming, in short, was preferable to saving.
These two inversions had radical implications for government policy. In the past, governments had advocated budget cuts and tax increases, along with wage cuts and lower interest rates, to escape recessions; Keynes was arguing that, except for lower interest rates, these measures made matters worse. And, in a severe recession or depression, when pessimism about future business profits made lenders reluctant to finance investment, even government attempts to lower interest rates wouldn't help. What was needed instead? Budget deficits, rather than budget balancing, and public investment and income transfer programs designed to put money in the pockets of the poor--that is, the people most likely to spend, not save it....
Read entire article at New Republic
... As Robert Skidelsky makes clear in his masterful threevolume biography, Keynes was a "new Liberal"--but with Bloomsbury's aesthetic idealism and disdain for vulgar capitalism thrown in. "I want to mould a society in which most of the existing inequalities and causes of inequality are removed," he declared. He initially thought this could be accomplished through classical economics. But, in the 1920s, he decided otherwise.
In the wake of demobilization after World War I, Britain had suffered a steep recession and unemployment climbed above 15 percent. According to classical theory, the economy should have eventually returned to a full-employment equilibrium--which is what Keynes expected would happen. But it didn't. Instead, the unemployment rate hovered around 10 percent for the rest of the decade, then shot above 20 percent after the Great Depression hit Britain in 1930.
Moreover, the remedies suggested by classical economics--wage cuts, balanced budgets, and the gold standard--simply made things worse. Not only did unemployment rise, but social unrest spread. In 1926, an attempt to cut miners' wages led to a general strike. Keynes sympathized with the strikers whom he saw as "victims of cruel economic forces which they never set in motion."
Over the next decade, Keynes attempted to devise policies that would restore full employment--and a new theory of capitalism to back them up. He argued that market economies, if left to their own devices, could reach equilibrium at well below full employment. This challenge to classical economics rested on his reinterpretation of the relationship among three core economic activities--investment, savings, and consumption.
According to classical theory, if unemployment were to rise, consumption would decline, but savings would increase. The increase in savings would lead to lower interest rates, which would lead to greater investment, which would lead to the restoration of jobs--in short, back to full employment. But Keynes rejected this logic. During a recession, lost jobs and wage cuts would lead to a reduction in consumer demand, which meant less incentive for businesses to invest and banks to loan. And, if businesses--skeptical about the rate of return from an investment--failed to invest, more workers would lose their jobs, consumption would decline even further, national income would go down, and any initial increase in savings would be wiped out. The economy would reach equilibrium with a high number of unemployed, which is exactly what happened in Great Britain in the 1920s and 1930s.
Keynes's theory inverted the relationship between savings and investment. Instead of the amount of savings determining the amount of investment, the amount of investment determined the amount of savings. It also inverted the relationship between consumption and savings. If the inducement to invest was determined at least partly by consumer demand, then the greater the propensity to consume rather than save, the greater the inducement to invest. Consuming, in short, was preferable to saving.
These two inversions had radical implications for government policy. In the past, governments had advocated budget cuts and tax increases, along with wage cuts and lower interest rates, to escape recessions; Keynes was arguing that, except for lower interest rates, these measures made matters worse. And, in a severe recession or depression, when pessimism about future business profits made lenders reluctant to finance investment, even government attempts to lower interest rates wouldn't help. What was needed instead? Budget deficits, rather than budget balancing, and public investment and income transfer programs designed to put money in the pockets of the poor--that is, the people most likely to spend, not save it....