Keynesian Economics 101

[With a title like this, you are probably the only reader, so press on.]

Up to the depression of the 1930s, experts thought occasional recessions were an inevitable effect of the normal fluctuation of the economy, so the best action was to do nothing; it would correct itself and any attempts to fix it would only prolong the pain.  The reasoning was that in a slumping economy companies would close factories and lay off workers as inventories built up.  This would cause wages and interest rates to fall, making production cheaper, stimulating firms to reopen the factories and rehire the workers.  Free market capitalism would automatically control itself better than any government could.

In 1936, John Maynard Keynes (pronounced “Kaynes”) published his new theory in a book “The General Theory of Employment” that he knew would revolutionize economic thought.  He pointed out that it wasn’t price that drove the economy, but demand.  If Stetson hats in Philadelphia (where both my grandfather and great uncle worked) saw demand fall for their hats, they would not lower their prices, nor would they hire new workers however low their wages.

Keynes pointed out that demand could remain low for long periods no matter how cheap production became, and the economy would settle into a prolonged recession.  What was needed was for the government to kick-start demand with increased spending of its own.  Spending would not be as expensive as it appears because the hired workers would now be paying taxes rather than absorbing financial aid.  There would also be the multiplier effect of their increased spending supporting the hiring of still more workers.

This turned the conventional wisdom upside-down.  In a recession, governments tend to do what any family would do when money stops coming in—cut expenses, typically by cutting back on programs and laying off workers (“cut the fat”).

Keynes recognized that large increases in government spending are only possible if they had the foresight to build surpluses in the good times, something no elected government in the history of civilization has ever done.  Today’s innovation is to simply borrow from ourselves in unlimited quantities.  But, some say, it will eventually have to be paid back.  No, it doesn’t.  It is the government, and the debt can go on forever.

We see this debate far from settled.  The European Common Market is forcing Greece to cut back its bloated government social programs, but a population with less money will obviously purchase less of the country’s products.  Their economy is bound to spiral down and the government even less able to pay its debts.  But what is the alternative?  What country would pick up the bills of another country who wallows in profligate government spending with shorter work weeks, longer vacations, and better benefits?

Don’t expect me to suggest a solution.  I doubt even John Maynard Keynes would know what to do today.

About Roger Walck

My reasons for writing this blog are spelled out in the posting of 10/1/2012, Montaigne's Essays. They are probably not what you think.
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