Money-isms: Keynesianism

Welcome to a special week-long series where we take a look at some prominent economic theories.  Don’t worry, it won’t be nearly as horrifyingly dull as it sounds; this is still the Amateur Financier, after all.  Plus, it’s always good to have a little background when you’re reading about things like ‘monetarism’ or ‘Austrian school economics’, or as in this case,


Founded By

John Maynard Keynes was a British economist whose most influential book, The General Theory of Employment, Interest, and Money was written as a response to the Great Depression.  He was involved in British politics before and during World War Two, and helped to create the International Monetary Fund and the World Bank before his death in 1946.  He was also married to a Russian ballerina, Lydia Lopokova, a fact I mention just in case you ever need to defend the sexiness of economists.

Just Look at That Sexy Mustache
Just Look at That Sexy Mustache

The Theory

Keynes’ major insight was that the government could have a impact on the economy, working to stabilize it.  The results of private decisions and private enterprise could be inefficient, due in part to slow response of prices and wages to changes in supply and demand.   He also viewed recessions and depressions not as regular parts of the business cycle, but as problems that needed to be solved, most readily via government intervention.

One of the major parts of Keynes’ philosophy is the need for counter-cyclical economic policies, attempts by the government to counteract the excessive lows and the highs in the economic cycle.  During recessions, for example, he advocated government spending to help prop up businesses and give a boost to the economy, while during boom times, the government should rein in market extravagances by increasing interest rates or decreasing government spending.  In this way, the government would be a counterbalance to the business cycle, helping to stabilize it.

Two of the other ideas that Keynes helped to popularize are the multiplier and the paradox of thrift.  The multiplier argument maintained that spending could have a bigger effect than the initial amount spent. If the government provides for $10 million in payments, for example, the benefits to the broader economy can end up being much more than $10 million.  The initial recipients of the money will likely spend or invest it, with companies that will in turn spend or invest it, and so on.  The initial $10 million may lead to many times the economic benefit, as the money works its way through the system.

The paradox of thrift, on the other hand, maintains that while saving is good for the individual, if done in aggregate, it can be harmful to the economy as a whole.  Decreased spending leads to decreased demand, decreased demand can lead to lower economic growth and possible downsizing, potentially decreasing the total amount saved due to anemic growth and lower incomes.  The paradox is, while saving is good for the individual, saving too much can be bad for the economy.

Criticism of Keynesianism

One of the major philosophies opposed to Keynesian economics is Monetarism, another school of economic thought (which we’ll cover in more depth tomorrow).  Their major criticism has been that governments are, if anything, even worse at responding to fluctuations in the economy than the private sector.  By the time the government recognizes the problem, formulates a response, and puts the response into practice, the problem may have become greatly exacerbated, or it may have disappeared.  The monetarists lean towards a much less expansive role for government in economic policy, which is counter to the more interventionist Keynesian economic thought.

Keynesian policies also come under attack from Austrian School economists (again, more on them later this week), who denounce the Keynesian focus on the collective group rather than the individual.  They maintain that focusing on broad government action rather than micro-economic factors leads to collectivism and mis-spending of capital.  They also maintain that programs that start as temporary fixes to counterbalance an economic downturn can turn into permanent, expanding government programs that grow to consume larger and larger portions of government spending.

There’s also historical evidence (as noted below) that Keynesian approaches to boosting the economy are far from sure things.  In a deflationary environment, such as during the Great Depression, putting more money into the system (which Keynes recommends), can serve to counteract the forces of deflation and boost the economy.  However, in downturns with high inflation, such as the ‘Stagflation’ of the 1970’s, a further increase of money into the system will only aggravate the problem.

A Brief History

Keynes and his theories rose to prominence in the midst of the Great Depression, where the idea of the government ‘priming the pump’ to boost the economy was one already being taken up by Roosevelt, among others.  The success of government spending (either in the form of New Deal programs or military spending during World War II) at lifting the economy was considered to be proof of Keynes’ concepts, and they were put into practice in America and elsewhere through most of the forties, fifties, and sixties.

As mentioned, though, Keynesianism was unable to cope with the economic stagnation and inflationary climate of the 1970s.  From the Reagan administration (and its contemporaries in other countries) until 2008, Keynesian ideas and methods of dealing with the economy were pushed to the side, superceded by monetarism and supply-side ideals.  Attempts to use government as a cushion against the rises and drops of the economy were curtailed in favor of a philosophy of letting the economy run with as little government intervention as possible.

However, with the economic downturn of 2008, there’s been a resurgence of Keynes and his approach to economics in public life.  The great amount of spending by the US government over the past few years in an attempt to spur on growth is right in line with Keynesian monetary policy.  (We’ll have to see how if Keynes is still in fashion when the recession abates and Keynesian economics dictates that the government should cut spending to slow down the economy.)

Three Sentence Summary

Keynesianism stresses the need for government to serve as a counteracting force to the excesses of private economy.  The main thrust is that the government can counter the economic excesses of the private sector, spurring on growth when it’s slow and restraining over-zealous government expansion.  Recently, such interventionist ideas have become more common, in wake of the economic problems of 2008.

8 Responses to Money-isms: Keynesianism

  1. Very well written and interesting article.

    Now a question, what happens when the government debt gets to big and can no longer pump money into the economy? I think we are getting close to seeing that happen.

    On a side note, I am new to the Yakenzie Challenge as of Sunday. It will be good getting to know and support your blog.

  2. Nice job on putting this together. I’m no economist and only recently began reading about Keynes and Hayek.

    I could see the multiplier argument working back when everything was done my hand. Money would be spread around. These days too much of gov’t stimulus is staying in too few pockets. His other concept of paradox of thrift must have merit, short term. But long-term wouldn’t the increased wealth and financial stability equate to a more stable economy?
    .-= LeanLifeCoach´s last blog ..Financial Intervention With Aging Parents =-.

  3. How fun! Back in the day (and still to some extent) I was a big reader of political theory and news . . . I’ve never turned my focus on economics in any systematic way, but have been thinking about it. Your series will be a great leaping off point!

    I’m looking forward to the series.
    .-= Simple in France´s last blog ..This week’s Yakezi Carnival =-.

  4. Keynes would not be so popular, if there was no merit to the theory. The same goes for monetarism. But in the end I don’t think that either theory can always provide an answer to any economic problem.

    As for the recent interventionist ideas of the US government, don’t forget that not only did the federal government try to stimulate the economy with a huge budget deficit along Keynes, but the Fed also played an enormous role blowing up its balance sheet by trillions of dollars. As a matter of fact, the Fed has been playing a tremendous role for decades now starting with the stock market crash of 1987.
    .-= ctreit´s last blog ..The Personal Finance Story of the Movie UP: Ellie and Carl Fredricksen =-.

    • It’s always good to get a goodly number of replies; hopefully, this will keep everyone interested and involved through the rest of this series. Now, to respond to some of the individual comments:

      @BibleDebt: To grossly simplify things, my understanding is that governments can, in theory, spend indefinitely, although the more money they put into the system, the greater inflation becomes as a result. (It makes sense; if the supply of dollars doubles, stores will require twice as many dollars to purchase the same items, for example.) The problem of too much inflation (perhaps even approaching hyperinflation) could result from trying to spend our way out of a downturn, but remember that another tenant of Keynesism is the multiplier; the hope is that the amount of money needed to boost the economy is much lower than the amount that causes all sorts of inflation related havoc.

      @LeanLifeCoach: Glad you like the idea for this series; I thought it would be interesting. The multiplier effect did sort of run into trouble this past bailout; with so many bankers using the money to shore up their accounts rather than spreading the money out, the multiplier would be fairly low (less than one, most likely), making it rather ineffective. As for the long term consequences of the paradox of thrift, one of Keynes’ points was the focus on the short term; as he was found of noting, ‘In the long term, we’re all dead.’ You do have a point, of course; saving more as a society would be a good thing, although a bit rough at first if done all at once.

      @Simple in France: I’m glad you’re looking forward to this series. Here’s hoping that the rest of the series meets your approval. Good luck studying further!

      @Financial Samurai: You’re quite welcome. Keynesism does provide a good defense for expanded government spending during downturns, although as of late, I’d say that both parties have been indulging their spending muscles quite a bit. Whether the Republicans’ seeming change of heart on the issue still holds when (if) they find themselves back in power and cutting their spending becomes a policy issue rather than election rhetoric, we’ll have to wait and see.

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