Keynes in a Time of Long-Lasting Unpredictability
John M. Keynes (1883-1946) published The General Theory of Employment, Interest, and Money (1936) during the Great Depression. He set forth an economic theory focusing on aggregate demand that was informed by human suffering across the UK and the US. His theory favors governmental intervention for the sake of stimulating jobs, through growth of private businesses and fair competition. Keynes aimed at long run economic stability by balancing the interests of all citizens and the state. In that spirit, Keynesian economic theories have not only provided a compass for embedded liberalism during the post-World War II era, but also furnished theoretical tools and policy prescriptions for economic stability in the 21st century.
Adam Smith’s The Wealth of Nations (1776) characterized the invisible hand that guides the laissez faire economy as a system under which individuals, by pursuing their own desires, will aid realizing a desirable social outcome. Keynes (1936) argued, however, that human nature and the “phenomenon of crisis” that occur within the socio-economic realms are “sudden and violent,” causing unnecessary hardships and long-term economic deterioration. What is more, he also pointed out that economies do not necessarily return to an equilibrium by themselves. This insight was recognized in the post-WWI period, when investments were very high, as were expectations regarding prosperity and peace. Production and consumption began to naturally restore due to the positive future expectations and the capitalist driven West was able to rapidly re-establish and grow the trade between Europe and the US. All of this, as envisioned by Keynesian theory, would bring forth low unemployment rates and a rise in the standards of living.
Later, given exceptionally positive future expectations, the US and its stock market began to expand rapidly and entered a bull market. New investors flooded markets due to “low margin broker loans,” which allowed individuals to buy stock at a fraction of its worth, while borrowing the rest from a brokerage firm (Smiley & Keehn 1988, 129). Based on an “excited vision of quick profits” (Smiley & Keehn 1988, 130), brokers lent money to many individuals, yet without “scrutiny” regarding the capacity to pay back credit. The new investors and the accessibility to loans gave a sense of false security within the economy. During the period of 1928-1929 preferences started to change, however, and an “involuntary liquidation of loans” accelerated the decline in the security of market prices. This increased the pressure of brokers against the banks regarding the safety of their deposits, making the market extremely volatile.
The rapid increase in investment after WWI, pushed forth into production and the stock market, Keynes (1936, 195) analyzed, did not “correspond to a change in propensity to consume.” After all, the financial speculations and the fluctuation in investment did not correlate to the true (liquid) spending power within the economy. And this set the initial stages for an economic crisis. The short-term rapid investment, hiring, production, and wealth accumulation caused “marginal efficiency to fall more rapidly than the rate of interest in the face of the prevailing institutional and psychological factors,” which was directly “interfering with laissez-faire” conditions and the ability for the economy to restore itself to a natural equilibrium (Keynes 1936, 139). And this drove economies in the 1930s into a period of Great Depression.
Following this depression, Keynes proposed to increase governmental intervention through governmental spending, financed through debt, to provide unemployment relief. Over the course of WWII, the US increased its federal spending to stimulate the aggregate demand, and in turn high unemployment rates became a distant memory. During the post-WWII period, the federal spending efforts of the US expanded beyond the military sector. The Employment Act of 1946 they aimed at offering employment to all to increase production and purchasing power (cf. Scitovszky 1946). The “multiplier effect,” Keynes explained, would help so that increased governmental investment through public works, subsidies, or policies to aid employment would stimulate employment and real income. Once initiated, the “multiplier effect,” based on a “consumption psychology of the community,” would increase even further the ability to hire and to consume, leading to economic growth at a stable rate (Keynes 1936, 83). The interconnectedness between the state and the people, highlighted by Keynes, reveals the possibility of stable employment within a market system that allows independent consumer choice.
The economic growth of the post WWII reconstruction efforts began to subside over the course of the 1960s, however, leading to a rise in unemployment. The large civil conflicts happening in the Middle East – especially the Yom-Kippur War in 1973 and the Iranian Revolution in 1979) – as well as the US support of Israel, incentivized the Arab Petroleum exporting countries (OAPEC) to institute oil embargos on the US’ imports. In addition, OAPEC introduced production cuts, raising the global price on oil (cf. Corbett 2013). The changes in the price of oil had a trickle-down effect on production and shipments of goods and services, causing inflation to rise and employment rates to decline further. As a result, the US was back in a recession at the start of 1980.
Eventually, then, the 1990s and the early 2000s brought doubt to the effectiveness of Keynesian theories. A congressional agenda titled The Republican “Contract with America” (1994) aimed to restore the laissez faire system by cutting down governmental spending and encouraging small local business incentives. Friedrich A. Hayek (1899-1992), in the Road to Serfdom (1944, 108), argued for decentralization of the economy as governments “cannot consciously balance all considerations bearing on the decisions so many individuals.” The free market price, so Hayek, signals what is best for individuals and their communities. With a narrow focus on the price mechanism, Hayek (1944, 95) urges that both the decisions of the consumers and producers should be based on the “spontaneous and uncontrolled efforts of individuals” rather than the “conscious control” that comes from governmental intervention.
Yet, information available from prices, signaled through markets, is limited. The 2008 financial crisis is a prime example of how lack of regulation can result in society wide economic degradation. The private banking sector created a lucrative system to make quick profit through subprime mortgages and extremely risky securities that were sold to other banks and investors (cf. Chitale 2008). During the 2000s, housing prices grew steadily, enabling private banks to envision a profitable forecast. The steady increase in price allowed subprime borrowers to refinance their mortgage payments. To the investors, this provided a sense of security. However, using price as sole point of information can turn out being insufficient. After the peak of the housing bubble in 2006, the market was subject to a price correction forcing many subprime loans to default (cf. Chitale 2008). Thus, as subprime borrowers could not refinance their mortgages, securities that had been sold based on those subprime mortgages lost value, and banks that had been selling these securities were unable to cover the losses. All of this drove the economy into a recession in 2007-2008.
President Obama’s Recovery Bill in 2009 was a rapid return to Keynesian theories. The bill facilitated over $800 billion governmental spending and resulted in the creation of 3.5 million jobs by the end of 2010. The output gap, that is, the difference between the actual GDP and what the economy would have produced at full employment, was at 7.5% in 2009 and dropped to 5.7% by 2011 (Boushey 2011).
The recent Covid-19 pandemic has shaped the normative understanding behind unpredictability and its massive impact on the global economy. Through such periods, as Kenyes (1936, 106) put it nicely, “spontaneous optimism falters.” It is in these cases that governmental intervention is necessary to stimulate initiative and to provide prospects for future stability. The Biden administration introduced governmental stimulus efforts across all economic sectors, including unemployment benefits, tax cuts for businesses, direct deposit payments for households, all of which created positive expectations and facilitated economic growth (cf. Pramuk 2021).
Through looking at the history of these economic developments it is very clear that governmental intervention, set forth by Keynes, has not only been necessary to overcome the hardships of the post-World War periods but remains important today within the ever-growing globalized order. Contrary to Hayek’s defense in support of laissez faire economics, it is very clear that when the economy is left unregulated, long-lasting periods of economic deterioration can emerge rapidly. Keynes’ promotion of employment, through governmental spending, not only spurs household income but also increases overall economic growth within private sectors. Governmental interventions can create a dynamic and healthy balance between the economy, the state, and its people, making it much more apt for navigating unpredictable moments of economic instability.
Works Cited
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