If there is a rock star in economics, it must be John Maynard Keynes. He was born in 1883, the year the godfather of communism, Karl Marx, died. With this auspicious sign, when the world is faced with a severe choice between communism or capitalism, Keynes seems destined to become a powerful free market force. Instead, he offered a third method, which upended the world of economics.
Keynes grew up in a privileged family in England. He is the son of a Cambridge professor of economics and studied mathematics at the university. After serving in the civil service for two years, Keynes joined Cambridge University in 1909. He never received formal economics training, but in the following decades, he quickly became a central figure. His fame was originally derived from accurately predicting the impact of political and economic events.
His first prediction was a criticism of the damages imposed on defeated Germany after the First World War. Keynes correctly pointed out that having to pay for the entire war will force Germany into hyperinflation and have a negative impact on Europe as a whole. He then predicted that restoring the pre-war fixed exchange rate sought by Chancellor of the Exchequer Winston Churchill would hinder economic growth and lower real wages. The pre-war exchange rate was overvalued in the post-war losses of 1925, and attempts to lock it in did more harm than good. In both respects, Keynes was proven correct.
A big lady, but a great rebound
Keynes is not a theoretical economist: he is an active trader in stocks and futures. He benefited greatly from the “Roaring Twenties” and became the richest economist in history when the 1929 crash destroyed three-quarters of his wealth. Keynes did not predict the collapse and believed that negative economic events were unlikely to occur while the Fed was monitoring the US economy. Although caught off guard by the crash, the adaptable Keynes did rebuild his wealth by buying stocks in the post-crash sale. His reverse investment left him with a fortune of approximately US$30 million at the time of his death, making him the second-richest economist in history.
However, in the crash and the resulting depression, many others were far worse off, and this was the beginning of Keynes’s contribution to the economy. Keynes believed that free market capitalism is inherently unstable and needs to be reformulated to counter Marxism and the Great Depression. His ideas were summarized in his book “General Theory of Employment, Interest, and Money” published in 1936. Among other things, Keynes claimed that classical economics—the invisible hand of Adam Smith—applied only in situations of full employment. In all other cases, his “general theory” dominates.
Keynes’ “general theory” is always remembered for giving the government a central role in economics. Although it was written on the surface to prevent capitalism from slipping into the Marxist central plan, Keynes opened the door for the government to become the main agent of the economy. In short, Keynes believed that deficit financing, public spending, taxes, and consumption were more important than savings, private investment, a balanced government budget, and low taxes (classical economic virtues). Keynes believes that interventionist governments can use spending to exit and force their citizens to do the same, while at the same time using various macroeconomic techniques to smooth the future cycle to solve the depression.
Keynes supported his theory by increasing government spending in gross national output. This has been controversial from the beginning, because the government does not actually save or invest like companies and individuals, but instead raises funds through mandatory taxes or debt issues (repaid by taxes). Nonetheless, by adding the government to the equation, Keynes showed that when companies and individuals tighten their budgets, government spending—even digging holes and filling them—stimulates the economy. His ideas seriously affected the New Deal and the welfare state that emerged in the post-war era.
The battle for savings and investment
Keynes believes that consumption is the key to recovery, and savings is the chain that drags down the economy. In his model, subtracting private savings from the private investment part of the national output equation makes government investment appear to be a better solution. Only a large government that represents the people’s expenditure can guarantee full employment and economic prosperity. Even if he is forced to modify his model to allow some private investment, he still believes that it is not as effective as government spending because private investors are unlikely to undertake/overpay unnecessary work during difficult economic times.
How to simplify macroeconomics
It is easy to understand why the government adopted Keynesian ideas so quickly. It provides politicians with unlimited funds for pet projects and deficit spending, which is very useful for buying votes. For any company that obtains a government contract, the government contract quickly becomes synonymous with free funding, regardless of whether the project is implemented on time and on budget. The problem is that Keynesian thinking makes huge assumptions that are not supported by any actual evidence.
For example, Keynes assumed that no matter how much or how much capital is available for private lending, interest rates will remain the same. This allowed him to prove that saving hurts economic growth—although empirical evidence suggests that it has the opposite effect. To make this more obvious, he applied a multiplier to government spending, but neglected to add a similar multiplier to private savings. Over-simplification may be a useful tool in economics, but the simpler the assumptions used, the fewer real-world applications of the theory.
Theory in trouble
Keynes died in 1946. In addition to the “general theory”, he is also a member of the teams participating in the Bretton Woods Agreement and the International Monetary Fund (IMF). His theory continues to be popular and accepted by the public. However, after his death, critics began to attack the macroeconomic views and short-term goals of Keynesian thinking. They believe that compulsory spending may allow workers to be employed for another week, but what will happen afterwards? Eventually, the money ran out and the government had to print more, leading to inflation.
This is exactly what happened to stagflation in the 1970s. In Keynes’s theory, stagflation was impossible, but it still happened. As government spending crowded out private investment and inflation lowered real wages, Keynes’s critics gained more attention.Finally, Milton Friedman reversed the Keynesian capitalist vision and rebuilt free market principles in the United States
Keynes of the Times
Although no longer as respectable as before, Keynesian economics is far from dead. When you look at consumer spending or confidence data, you will see the product of Keynesian economics. The stimulus checks issued by the US government to citizens in 2008 also represent the idea that consumers can buy flat-screen TVs or survive economic hardship in other ways. Keynesian ideas will never completely leave the media or government. For the media, many simplifications are easy to grasp and can be divided into short sections. For the government, the Keynesian assertion that it knows how to spend taxpayers’ money better than taxpayers is a reward.
Despite these undesirable consequences, Keynes’s work is still useful. As we have seen in the work of Milton Friedman and the Chicago school economists who followed Keynes, it helps to strengthen free market theory through opposition. Blindly following the gospel of Adam Smith is inherently dangerous. The expression of Keynesianism forced free market economics to become a more comprehensive theory, and the long-lasting and popular reverberation of Keynesian thought in every economic crisis promoted the development of free market economics.
Friedman once said: “We are all Keynesians now.” But the full quote is, “In a sense, we are all Keynesians now; in another sense, no one is no longer We are Keynesians. We all use Keynesian language and devices; we no longer accept the original Keynesian conclusions.”