Keynesian economics has reference to a set of theoretical explanations for persistent unemployment and to specific governmental employment policies. The general notion behind Keynesian economics is that persistent unemployment derives from decreases in total private sector spending. According to Keynesian economists, the government can alleviate unemployment by increasing the total amount of spending in the economy.
Keynesian economic policy began during the European Great Depression. Some economists blamed the Great Depression on private spending. The German economist Wilhelm Lautenbach published a spending theory of unemployment in 1929, and the Nazi government acted in accordance with this theory by increasing spending on public projects and on the military. One of Keynes’s associates, Joan Robinson, remarked that “Hitler found a cure against unemployment before Keynes was finished explaining it.” In fact, in the German edition of his book, Keynes noted that “the theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state than … under conditions of free competition and a large degree of laissez‐faire.” The Polish economist Michal Kalecki also published a similar theory of unemployment in the mid‐1930s.
In the early 1930s, Keynes debated the Austrian economist F. A. Hayek over the causes of the Great Depression. Hayek argued that the Depression was caused by the manipulation of interest rates by central banks. When Keynes published his Treatise on Money in 1930, Hayek wrote a devastating critique of this treatise. While Keynes continued to attack Hayek’s theory, he also revised his own work in response to Hayek’s criticisms.
In 1931, one of Keynes’s students, Richard Kahn, developed an income‐expenditure multiplier to explain the Depression in terms of total spending. Keynes adopted Kahn’s theory of the income‐expenditure multiplier into his system, and the aggregate spending theory of unemployment was often referred to as the Kahn–Keynes theory. Keynes rose to a position of prominence in 1936 with the publication of his book The General Theory ofEmployment, Interest and Money. Keynes’s mentor, Alfred Marshall, had stressed the importance of prices and individual decisions, but Keynes downplayed the importance of incentives in structuring individual behavior. Keynes’s rejection of the tenets of neoclassical economics followed from his belief that output and employment are determined by irreducible aggregate forces in the economy. Individual decisions concerning relative prices, wages, and interest rates did not matter to Keynes because he thought psychological factors would override personal incentives. Keynes pointed to three fundamental psychological propensities that shaped behavior: the propensity to consume, one’s feelings regarding liquidity (i.e., money demand), and the psychological expectation of the future yield from capital assets. He concluded that the propensity to consume and the rate of new investment could cause total private spending (effective demand) to fall short of the level needed to produce full employment—two factors that hinged on psychology, rather than incentives and rational choice. In other words, if capitalists do not feel like investing and consumers do not feel like spending, then these psychological states of mind will result in mass unemployment.
Keynes was credited with developing a new theory of unemployment despite the fact that other economists had published similar work years earlier. Because many economists were already receptive to spending theories of unemployment, Keynes’s General Theory soon became popular. Of course Hayek had previously countered Keynes’s arguments, but for reasons that are unclear, Hayek neglected to review the General Theory.
The mainstream postwar version of Keynesian theory was not actually developed by Keynes. John R. Hicks published a paper in 1937 that laid out the standard IS/LM model for postwar Keynesian economics. IS/LM refers to a set of equations that sought to relate national income with the gross domestic product (GDP) and described how an economy could settle at a particular level of GDP that was below full employment. Some early Keynesians, like Joan Robinson, objected to the direction in which Hicks took Keynesian economics, and Hicks later admitted that he had deviated from what Keynes actually wrote. Yet Hicks’s version of Keynesian economics was to become the mainstream of Keynesian theory.
Hayek offered an alternative to Keynes’s theoretical conclusions with his 1941 book, The Pure Theory ofCapital. Ludwig von Mises and Henry Hazlitt wrote critiques of Keynesian economics from the perspective of the Austrian School. Mises chided Keynes for popularizing an abundance theory that derived from the philosophy of the businessman, rather than sound economics. However, it was too late for the Austrians to replace the popularity of Keynesian theory in the profession. Indeed, most economists ignored the fundamental arguments of Austrianism.
As far as policy is concerned, Keynes rejected comprehensive central planning of production, but did endorse partial economic planning. Keynes suggested that government should plan investment in new capital goods and direct communal savings. It was Abba Lerner, one of the foremost British economists after Keynes, who actually developed what came to be known as Keynesian fiscal policy. Lerner developed a proposal for functional finance, whereby it was proposed that politicians should run deficits during recessions and surpluses during economic booms. These surpluses and deficits would cancel out over time. Politicians would be able to deal with recessions, he argued, simply by cutting taxes and increasing spending, and could raise taxes later to pay down previously accumulated debt.
Keynesian monetary policy was developed by a group of early Keynesians, including Arthur Phillips, who noticed a statistical tradeoff between unemployment and inflation. These early Keynesians suggested that central banks should exploit this tradeoff and that central banks could reduce unemployment simply by printing more money. They were prepared to concede that this policy would cause inflation, but it also would increase total spending and reduce unemployment. Early Keynesians thought that they could use an active fiscal and monetary policy to fine‐tune the economy to permanently reduce unemployment while also controlling inflation and balancing the fiscal budget.
In the 1950s, the American economist, Milton Friedman, advanced several critiques of this postwar version of Keynesian economics. First, he cast doubt on the practicality of Keynesian policies and argued that activist fiscal policy can take years to formulate and implement. Given the time that it takes Congress to change spending and tax rates, the nation could not rely on fiscal policy to deal with economic crises. Second, Friedman developed what became known as his permanent income hypothesis, which holds that private spending is relatively stable, so there should be little need for Keynesian policies. It further suggests that Keynesian policies would have unpredictable effects. Finally, he proposed that the demand for money is stable and that a policy that seriously altered the money supply would have a strong impact on economic conditions. Indeed, an active monetary policy is uncalled for inasmuch as the alleged tradeoff between inflation and unemployment is temporary. If a central bank increases the supply of money, this action might reduce unemployment for a short time, but would ultimately result solely in higher inflation rates. Friedman recommended that politicians balance the budget in peacetime and that central banks expand the money supply at a slow and predictable rate. Thus, Friedman favored government policies and those of the central banks that constrained them to abide by strict rules, thus foregoing activist fiscal and monetary policies. James Buchanan and William Nordhaus criticized Keynesian economics by calling into question the motives behind deficit and inflationary policies. Nordhaus claimed that politicians would use deficit spending and inflation to increase their popularity during election years. After winning office, politicians would try to run surpluses and reduce inflation. Such policies would result in a political business cycle. Similarly, Buchanan argued that Keynesian economics broke down the fiscal discipline of politicians and would result in ever‐increasing public debt. Experience has confirmed the predictions of Buchanan and Nordhaus.
In the 1970s, Art Laffer and Jude Wanniski advanced yet another critique of Keynesian economics. According to this critique, which became known as supply side economics, the idea that higher taxes increased total revenue was wrong. According to supply side economics, confiscatory tax rates slow economic growth and reduce potential revenue. Keynesian tax policies work only as described if tax rates are low to start. The Reagan administration implemented supply side policies. Critics of supply side economics, however, have claimed that the Reagan deficits proved this theory wrong. The conclusions of supply side economics, they contend, do not indicate that tax cuts will reduce deficits. Although it is true that cuts in confiscatory tax rates might increase government revenue, deficit reduction requires spending control as well. It is true that both Warren Harding and Calvin Coolidge cut taxes and paid off the national debt, but they also reduced spending while revenue increased. Economists now all agree that confiscatory tax rates have serious supply side effects.
Robert Lucas carried Friedman’s critique of Keynesian economics further. According to Lucas, the alleged tradeoff between inflation and unemployment did not really exist. According to Lucas, people would come to anticipate inflationary policies and, once having anticipated them, will demand higher money wages. The result will be that inflation will have no effect on employment. The Friedman–Lucas and Buchanan–Nordhaus critiques of Keynesian economics caused most Keynesians to abandon major elements of their paradigm. With regard to policy, few Keynesians still brag about being able to fine‐tune the economy. Most Keynesians now claim that they can coarse‐tune the economy provided that they learn about recession quickly enough. Some Keynesians have even admitted that Keynesian policy is too hard to implement and that Friedman’s program is more practicable.
Most Keynesians have given up on aggregate analysis altogether. Economists like Greg Mankiw and Joseph Stiglitz developed “new Keynesian economics,” which focuses on wages and prices, rather than total spending. However, there remain a minority of dissenting post‐Keynesians, led by Paul Davidson and John Kenneth Galbraith, who follow Joan Robinson by adhering to the original version of Keynes’s theory, along with other early writers.
Twentieth‐century experience with Keynesian policies has caused most Keynesians to rethink their position. Keynesian policies were responsible for serious problems with inflation and the accumulation of large amounts of public debt. This debt accumulation was a function of public spending that was, for the most part, wasteful. Academic debate has revealed serious logical problems with Keynesian economics, especially in its earlier forms. Despite all of these problems, some economists persist in promoting Keynesian economics. However, because many Keynesian ideas have been overturned in the past, contemporary Keynesians are by no means certain to succeed in their efforts.
Buchanan, James, and Richard Wagner. Democracy in Deficit: The Political Legacy of Lord Keynes. New York: Academic Press, 1977.
Friedman, Milton. “The Role of Monetary Policy: Presidential Address to AEA.” American Economic Review (1968).
———. A Theory of the Consumption Function. Princeton, NJ: Princeton University Press, 1957.
Hayek, F. A. The Pure Theory of Capital. Chicago: University of Chicago Press, 1941 (2007 reprint).
Hazlitt, Henry. The Failure of the New Economics. Princeton, NJ: Van Nostrand, 1959.
Keynes, John Maynard. The General Theory of Employment, Interest, and Money. New York: Harcourt Brace, 1936 .
Lucas, Robert E., Jr. “Expectations and the Neutrality of Money.” Journal of Economic Theory 4 (April 1972): 103–124.
Mankiw, N. Gregory, and David Romer, eds. New Keynesian Economics. Vols. I and II. Boston: MIT Press, 1991.
Nordhaus, William. “The Political Business Cycle.” Review of Economic Studies 42 (April 1975): 169–190.