This series of articles aims to provide a brief overview of the evolution of Economic thought through the lens of some of the key contributors to the discipline. Using Adam Smith’s Wealth of Nations as a jumping-off point, through John Maynard Keynes’ General Theory, Karl Marx’s Das Kapital, and the more recent contributions of Joseph Schumpeter and Milton Friedman. The series will conclude with an evaluation of modern-day Economic consensus.
The History of Economic Thought series consists of 6 main articles:
2. History of Economic Thought: John Maynard Keynes
3. History of Economic Thought: Karl Marx
4. History of Economic Thought: Joseph Schumpeter
5. History of Economic Thought: Milton Friedman
6. History of Economic Thought: Modern Day
History of Economic Thought: John Maynard Keynes
An Introduction to Keynes:
John Maynard Keynes was a British Economist famed for challenging of the Classical Economic “Free Market” status quo. He is most keenly associated with his advocacy for an increased role of Government in the economy and his ideas on Interest Rates. Keynes was most active in the early portion of the 20th century. Attending the Versailles Peace Talks in the aftermath of World War One in the capacity of Economic Adviser for Britain. He lobbied firmly against what he perceived to be excessive sanctions levied against Germany at this time. His defining work, The General Theory of Employment, Interest and Money, was first published in 1936, ten years before his death in 1946.
Figure 1: An artistic rendering of The Father of “Keynesian Economics” John Maynard Keynes
Keynes vs. the Classical School
Existing Classical Theory had held that a given economy should default to a status of full employment. That anybody who found themselves in a situation of being unemployed did so wilfully by failing to prescribe to established market wage conditions. Essentially, they were greedy and asked for more than the standard market wage. In turn, The Classical School offered a simple solution: “In case of unemployment, a general cut in money wages would take the economy to the full employment level.” (Chand, 2014).
Keynes took issue with this notion, making specific note of the mass unemployment that existed in the US over the course of the Great Depression. The money wage here relates to the sum paid to workers at face value, while the real wage accounts for inflation. Thus demonstrating the actual purchasing power that the money received accounts for.
Moreover, the contention that the unemployment which characterises a depression is due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts. It is not very plausible to assert that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing (Keynes 1936, p. 13).
The Great Depression saw a period where many people were willing to work for greatly reduced wages. Yet, unemployment remained extraordinarily high, peaking at 25.59% in May 1933 (Petrosky-Nadeau and Zhang, 2013). This reality ran counter to the existing ideas of the dominant Classical school of Economics characterised by David Ricardo, Alfred Marshall, and Arthur Pigou.
To quote Keynes once more:
Labour is not more truculent in the depression than in the boom—far from it. Nor is its physical productivity less. These facts from experience are a prima facie ground for questioning the adequacy of the classical analysis. (Keynes, 1936, p. 14)
Are Workers Irrational?
Keynes took further issue with what he deemed to be a foundational irrationality amongst workers as a whole. Workers would contest bitterly any fall in the money wage while passively accepting the impact on real wages – i.e., the cost of inflation. In a year that has seen record inflation rates recorded worldwide, this contention seems as apt now as ever.
Logically, one might assume that workers themselves make a tacit acknowledgement of what they can control – their money wage – vs. what they can’t – the overall cost of living. Keynes seems to acknowledge the realities of this seeming contradiction himself in the following passage:
Every trade union will put up some resistance to a cut in money-wages, however small. But since no trade union would dream of striking on every occasion of a rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment which is attributed to them by the classical school. (Keynes, 1936, p. 16)
For Keynes, all economic activity – and by extension the level of employment in a given economy – boiled down to the degree of Consumption (or purchasing) within it. Please note in the below passage “aggregate demand” constitutes total demand – or in other words, the total number of persons willing and able to purchase a given good or service at its established market price.
Consumption—to repeat the obvious—is the sole end and object of all economic activity. Opportunities for employment are necessarily limited by the extent of aggregate demand. Aggregate demand can be derived only from present consumption or from present provision for future consumption. (Keynes, 1936, p. 56)
Keynes highlighted several specific ideas for what governs an individual’s “Propensity to Consume”. The key point is that any income that is not consumed – or spent – by an individual is saved. Reasons, according to Keynes, for why a given individual might save rather than spend include; the establishment of a rainy day fund, reserved in case of emergency. The planning for future family-related expenditure – a child’s college fund for example. The desire to pass money on through inheritance, and amusingly “To satisfy pure miserliness…” (Keynes, 1936, p. 58).
Figure 2: Keynes proposed that a healthy economy required a priority on spending over saving
To Save, or not to Save…
At the core of Keynes’ economic philosophy is the conflict between an individual’s propensity to spend vs. save. The key to a healthy economy is a happy marriage between both opposing forces. If nobody is willing to spend, demand must fall, and so, in turn, must the production. The demand for labour – or persons – to produce said goods and services must fall also. With the logical outcome of a fall in Investment, thus ultimately being increased unemployment.
One Person’s Saving is Another’s Lost Income
While Keynes’ understood people’s inclination or desire to save, he argued that one person’s spending by necessity represents another’s income. The act of saving directly reduces the income of other persons in the economy. Ultimately reducing the overall level of economic activity.
This notion marked a pronounced departure from the existing Classical school of thought, adherents to whom, according to Keynes, believed that: “every act of increased saving by an individual necessarily brings into existence a corresponding act of increased investment” (Keynes, 1936, p. 89).
The Role of Government and The Multiplier Effect
Keynes’ primary point of demarcation from the Classical school of Economic thought was his advocacy for an increased role for Government. The traditional Laissez-Faire view of the economy dictated that the market should be allowed to function by itself, with Government only intervening in so far as to allow safe and regular market functioning.
Keynes argued that in times of difficulty or economic contraction, the Government did have a role to play. In the event of a slowing economy, the Government should invest directly to stimulate spending, in turn raising demand – and ultimately employment levels.
The effectiveness of such a policy, according to Keynes, would be determined by what he termed “The Multiplier Effect”. An initial injection of Government investment would ripple outward through the economy, creating more employment opportunities as it went along. If the Propensity to Consume amongst a given population were high, the gains from increased investment could – all other factors being held constant – in turn be substantial.
It follows, therefore, that, if the consumption psychology of the community is such that they will choose to consume, e.g. nine-tenths of an increment of income, then the multiplier K is 10; and the total employment caused by (e.g.) increased public works will be ten times the primary employment provided by the public works themselves, assuming no reduction of investment in other directions. (Keynes, 1936, p. 61)
If the population in question held a greater Propensity to Save than consume, the effect of increased investment would be significantly reduced. The number of the Multiplier “K”, as Keynes phrases it here, and the corresponding impact on economic activity would be significantly than a population in which people spent freely.
A Word of Caution
Though Keynes championed the merits of increased Government investment and the corresponding Multiplier effect, he did not advocate reckless abandon concerning Government expenditure. He anticipated that Government investment in excessive volumes would quickly lead to a state of diminishing returns. As people saved more and more in nominal vs. percentage terms, inflation would be inevitable.
The ultimate endgame of which he outlined in the following passage:
When full employment is reached, any attempt to increase investment still further will set up a tendency in money-prices to rise without limit, irrespective of the marginal propensity to consume; i.e. we shall have reached a state of true inflation. (Keynes, 1936. p. 62)
A Subject of Interest
Keynes’ general insight into the role of interest rates in the economy was to introduce the notion of what he termed “liquidity preference”. Terming the interest rate “the reward for parting with liquidity for a specified period” (Keynes, 1936, p. 84).
As the interest rate itself represents the cost of borrowing, it can effectively be said to represent the cost of money. In accordance with the basic principles of Supply and Demand, an increase in the money supply should therefore reduce the effective price of money, i.e. the interest rate. A lower interest rate should be logically expected to spur increased investment.
Liquidity preference amounts to a preference for people to hold cash savings over long-term investments such as government bonds. An increase in the interest rate would reduce the price of assets such as bonds (effectively a government I.O.U. which promises a financial return at a fixed rate of interest at a future date). Thus, if the interest rate remains low for an extended period, investors may logically elect to hold their cash close to their chest, in the anticipation of a future hike in interest rates.
Collective Uncertainty and Animal Spirits
For all of his equations and hyper-academic prowess, Keynes ultimately qualified his theories against a background of uncertainty, over absolute predictability. Memorably evoking the notion of “animal spirits” to describe the ultimate unpredictability of economic performance and behaviours. Outcomes are ultimately being driven by the somewhat intangible expectations of the wider populace.
Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (Keynes, 1936, p. 81)
Uncertainty as the Driver of Liquidity Preference
It is this spirit of uncertainty which serves to drive Keynes’ notion of liquidity preference. Expecting people to react differently based on their own market expectations.
The individual, who believes that future rates of interest will be above the rates assumed by the market, has a reason for keeping actual liquid cash, whilst the individual who differs from the market in the other direction will have a motive for borrowing money for short periods in order to purchase debts of longer term. (Keynes, 1936, p. 85).
Viewing said expectations to be a product of what he termed “mass psychology”, Keynes cited a scenario whereby people anticipating a change in prevailing market conditions – such as a rise in interest rates – may prefer to hold cash or liquid resources. In order to be best placed to take advantage and profit accordingly when said change occurs (Keynes, 1936).
Figure 3: Keynes (right) attending the first ever meeting of the International Monetary Fund’s (IMF) Board of Governors on March 8th, 1946, the year of his death
Stagflation and a Fall from Grace
Having been the dominant school of economic thought in the aftermath of World War II, Keynes' credit took a severe hit during the 1970s. Rising “stagflation” – a previously un-envisaged scenario where economic growth remained low amidst rising inflation levels – occurred across many advanced economies. This greatly reduced Government's willingness to spend, and general support of Keynesian doctrine diminished accordingly.
The Re-Rise of Keynesianism
The Keynesian theory, however, saw a significant resurgence in popularity in the aftermath of the 2009 financial crisis. Many central banks responded to the crisis with historic cuts in interest rates and vast levels of the market investment. The US Federal Reserve famously employs a policy of Quantitative Easing – a move to bolster the money supply through the purchase of long-term financial securities such as government and corporate bonds (Jackson and Curry, 2022).
Keynes’ influence has been further felt in the ongoing response to the Covid-19 Pandemic, with Governments worldwide implementing historic levels of Fiscal and Monetary stimulus. The US Federal Reserve has once again instigated a policy of extensive Quantitative Easing while global interest rates have been reduced to historic lows. Fiscal relief packages – fuelled by Government Spending – have been implemented everywhere from Afghanistan to Zimbabwe (Policy Responses to Covid-19, 2021).
Far from the market being self-correcting, direct Government intervention is just the medicine required in a time of a crisis.
Legacy and Conclusion
John Maynard Keynes was a revolutionary force in the field of economics. By challenging the prevailing economic conventions of his time he brought a renewed vigour to a field that had grown stale and impotent in the face of unforeseen circumstances. Economics is a field of study in a constant state of flux, and lively debate rages to this day on the merits of Keynes’ theories vs. those of a more openly free-market persuasion. His influence and continued relevance in the area of global economic policymaking, however, remains utterly undeniable.
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Figure 3: IMF, Public Domain, (1946). Assistant Secretary, U.S. Treasury, Harry Dexter White (left) and John Maynard Keynes, honorary advisor to the U.K. Treasury at the inaugural meeting of the International Monetary Fund's Board of Governors in Savannah, Georgia, U.S., March 8, 1946. Retrieved from