Keynesianism: The Real Story

Ask any mainstream, modern economist about Keynes and his contributions to economics, and chances are you will be told that “he’s the guy who said you should expand government in recessions”. This is such a well-established story that the very question in itself would motivate the economist to raise an eyebrow or two and carefully examine you for signs of delusion.

Depending on political leaning, economists will either say that Keynes was a socialist/statist (conservatives, libertarians) or a liberal (socialists, statists).  Both will agree, though, that Keynes’s contributions were all about expanding government. Austrian economists, who are often libertarian by political leaning, will confidently say that their theory is the one that preserves limited government and free markets. In fact, most economists would habitually tell you that Austrian economics is the free-market theory and Keynesian economics is the “grow government” theory.

Few, if any, of those who pass confident judgments on Keynesian economics have ever read anything by Keynes’s hand. When I actually began studying The General Theory of Employment, Interest and Money as a freshly baked BA with a major in economics (and philosophy), I soon found out that an astounding number of professors at the department where I got my degree considered the General Theory “unreadable”. I, for one, thought it was fascinating - though admittedly it took me until I was halfway through graduate school before I felt that I had a reasonable command of the book’s content.

Which goes toward making my point. Keynes, like Hayek, Hicks, Pigou and other economists who laid the groundwork of the discipline in the early 20th century, did not start their reasoning with “consider lemma”. They began with real-world problems and then applied whatever methodology was appropriate for the problem. To someone who is trained entirely, or even predominantly, in technical economics of the past 25-30 years, Keynes’s approach to problem-oriented reasoning can indeed seem inaccessible.

Arrogantly, many of my contemporary graduate students dismissed this old-fashioned approach to scholarly work as “history of economic thought”.

As we will see in a later article, this arrogance has come home to the economics departments to roost.

Back to Keynes. The fascinating thing about Keynes is that he took on problems that, essentially, had been left untouched by others. As his scholarly career progressed, those problems tended to become more and more systemic in nature, culminating with the General Theory. I do not wish to spoil the plot of the book for those of you who have not yet read it, but let me put it this way: it is not a book about how to expand government in recessions.

It is not even a book about recessions or the business cycle.

It is a book about the interaction between uncertainty and macroeconomic activity.

Sounds weird? Probably, and that is not your fault. If you have any economics on your resume, you have most likely been served basic macroeconomics that can be captured in the IS-LM general equilibrium model. You have possibly studied a number of aspects of “sticky prices” which, you were told, can explain why the economy is not operating at full employment.

Some of you may have studied labor-market economics and browsed through theories of search costs, insiders vs. outsiders and maybe even a dollop of NAIRU.

If you have learned about Keynes, you were probably told - again - that he proposed growing government. You may also have encountered suggestions that Keynes thought “sticky prices” explained unemployment.

All of that belongs in the conventional-wisdom bucket. At no point, though, does uncertainty enter the picture.

The best way to explain Keynes’s use of uncertainty is to start with a quote from Chapter 16, also known as Sundry Observations on the Nature of Capital:

An act of individual saving means—so to speak—a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day's dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand,—it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

Do you see the key point here? When consumer spending declines today, revenue tightens for businesses. As revenue gets tighter, businesses scramble to find any reason to believe that sales will pick up in the foreseeable future. Keynes makes the point that his decision not to buy a pair of boots today does not constitute a promise to come in tomorrow, or next week, and buy that pair of boots.

The consumer may or may not come back; the point is that no one, probably not even the consumer, knows when he will make that spending decision. All that we know for sure, so to speak, is that the decline in consumer spending today has made the future of the shoe store in question more uncertain.

Herein lies an essential element of Keynes’s contribution to macroeconomics. At the time when he began writing macroeconomics the prevailing wisdom was that when consumer spending declines the prices of consumer products would decline fast enough to motivate consumers to resume spending in the “short run”. Keynes, on the other hand, makes the point that prices can fall all they want - it does not mean that consumers feel confident enough to go out and increase spending again.

Part of the controversy between Keynes’s predecessors is a controversy over what side of the economy, supply or demand, drives economic activity. Those faithful to pre-Keynesian economics would say that supply always creates its own demand (a.k.a., Say’s law). When there is excess supply - as in the case with the non-purchased boots - supply will create its own demand through declining product prices.

By contrast, Keynes stated that a decline in demand could not necessarily be countered with a decline in the price of that product. First of all, nothing says that the decline in price will make the consumer better off; for all we know his income could have fallen even more rapidly. In that case the pair of boots have, relatively speaking, become more expensive.

He does not even have to be facing a reduction in his real wage; maybe his employer has just been purchased in a hostile takeover and he has no idea what employment security he can count on. Or maybe the news this morning was full of surprisingly bad economic forecasts.

In other words: uncertainty injects itself between the consumer and the pair of boots he was considering buying.

So long as consumers feel uncertain about the future they will not go out and spend money. Keynes’s contribution was to analyze the systemic, macroeconomic effects of uncertainty on a macroeconomic scale. When it gets strong enough, and widespread enough, there is no telling how deeply into a recession, or a depression, the economy can sink.

Said Keynes. Then he spent a good part of the book analyzing the conditions under which the economy can recover again. But that is a different story, one we will have to get back to.

That's all for now. If you want to know more about uncertainty and macroeconomic stability, check out my dissertation which was published by Ashgate (now part of Rutledge) in 2002.