Keynesian economics is a theory of aggregate economic phenomena that stresses the importance of total spending at the national level. The two most fundamental propositions of early Keynesian Economics were that; Forces within market economies generate prolonged periods of severe unemployment; and Government intervention can counteract this unemployment by increasing total spending.

More specifically, early Keynesian Economists argued that there are irreducible forces within market economies that cause periods of high unemployment. Thus, Keynesians distinguished between the behavior of individuals driven by relative prices and aggregate behavior driven by income and spending.

John Maynard Keynes created Keynesian economics when he published his "General Theory of Employment interest and Money" in 1936. Keynes wrote this book to try to explain the persistence of unemployment in industrialized countries during the inter-war period. At the time, the "General Theory" was revolutionary precisely because it explained depressions in a way that did not reduce behavior to the level of the individual. Instead, Keynes argued that aggregate saving often exceeds aggregate investment, thus causing a buildup of unspent income and a decline in aggregate spending. Keynes tried to explain these relative shortfalls in investment by arguing that investors were prone to irrational panics and that savers ignore interest rates when they decide how much they want to save. Furthermore, Keynes argued that prices and wages could not fall rapidly enough to restore full employment quickly.

This contradicted conventional economic theory at that time, which maintained that market economies are inherently stable and self-correcting. Prior to Keynes’ book, most economists argued that market economies do not suffer from under-spending because all revenue from production ends up as income, which individuals either spend or loan out. Also, Classical economists argued that if something disturbed the market system and caused unemployment prices and wages would fall, and in so doing, restore full employment.

This Keynesian approach also differed sharply from the Austrian approach that Mises and Hayek took in explaining depressions. Mises and Hayek emphasized the importance of relative prices in capital markets in their explanation of the trade cycle, and identified inflation as the cause of unsustainable investment booms that led to depressions.

Keynes persuaded most of other economists in his time that his explanation for persistent unemployment was correct, and in so doing brought about a short lived "Keynesian Consensus". Early Keynesian economists accepted certain aspects of Classical and Austrian Economics. Keynesian Economics accepts the Classical idea that wage and price adjustments take place, but take time. However, Keynes feared that time that it took for markets to adjust left many unemployed long enough for totalitarian movements, such as Communism and Fascism, to attract them. Thus, politics played a prominent role in the early debates over Keynesian economics. In addition, Keynesians argue that changes in the money supply alter real interest rates. This is a central part of the Mises/Hayek explanation of depressions, though Keynesian dispute the Austrian claim that distortions in interest rates cause problems in capital markets.

Since Keynes believed that market economies are inherently unstable and do not fix themselves through deflation, it was only natural for him to recommend government intervention in response to unemployment. There are two types of Keynesian Economic policies, passive and active. Keynesians advocate using "automatic stabilizers" to counteract alleged instability in the economy. Keynesians argue that progressive income taxes and welfare payments counter variations in aggregate demand. Progressive income taxes and Welfare transfer income from upper income households to lower income households. Since upper income households save more of their income and low-income households consume more of their income, these practices keep aggregate saving low and aggregate consumption high. Keynesians believe that these measures reduce the instability of markets but do not eliminate it. Thus, Keynesians believe that the government should play an active role in stabilizing markets.

Keynesians advocate the use of activist fiscal and monetary policies. Initially, Keynesians believed that they could use these policies to "fine tune" the economy. Activist fiscal policies alter the amount of deficit spending by government. Government deficits equal total tax revenue minus government expenditures. Hence, Keynesians argued that governments should increase spending and decrease taxes to counteract reductions in private spending.

Activist monetary policies alter the growth rates of money supplies by central banks. Keynesians believed that they could use monetary policy to reduce unemployment permanently by generating inflation. Keynesians believed that there is a stable trade of between inflation and unemployment. This belief that inflation fools workers into supplying more of their time to the labor market. Keynesians argue that workers never learn from these mistakes, and consequently, government officials can choose a variety of combinations of inflation and unemployment. The name for this alleged stable trade off between output and inflation is the Phillips Curve.

Milton Friedman successfully challenged Keynesian Economic theory and policy recommendations. Friedman raised a series of practical, theoretical, and historical problems with Keynesian economics. Most particularly, Friedman demonstrated that legislatures take to long to formulate activist fiscal policies, fiscal policy is itself weak and unpredictable, and that monetary policy only fools workers for short periods of time. Robert Lucas refined Friedman’s arguments by asserting that workers will not fall for any systematic attempt to fool them and that all economic phenomena reduces down to the individual level.

James Buchannan and William Nordhaus raised further doubts over Keynesian Economics when they questioned the political motives behind actual Keynesian policies. They each argued that politicians would use Keynesian policies to generate support for themselves. Nordhaus argued that politicians would do this by enacting expansionary policies just prior to elections and more restrictive policies after the elections were over. According to Nordhaus, this practice generates a "political business cycle" that disrupts the private sector. Buchannan argued that Keynesian economics provided an excuse for politicians to buy votes from today’s voters by accumulating debt at the expense of future voters. Buchannan’s arguments indicate that Keynesian Economics is an intellectual justification for intergenerational transfers of wealth. This notion of a "political business cycle" and the potential for excessive debt accumulation posed further problems for Keynesians to deal with.

Supply Side Economists also attacked Keynesian economics for neglecting the effect that marginal tax rates have on economic growth. Supply Sider’s argue that high marginal tax rates reduce economic growth by discouraging work and investment. Keynesians believed that increases in tax rates always increase revenue, but this assumes that individuals work and invest for before tax income. Supply Side Economists proved Keynesians wrong on this point by arguing that individuals act upon after- tax income, not before tax income. Consequently, the Keynesian belief that changing tax rates merely alters aggregate demand is also wrong.

During these attacks, Keynesian economists split into separate groups. Some Keynesians, known as Post- Keynesians, held on to the notion that under-spending plagues market economies. Post- Keynesians like Paul Davidson and Sydney Weintraub stress the role of uncertainty in causing declines in total investment expenditures. Joan Robinson (who was close to Keynes himself) went further still by endorsing the economic policies of Mao in communist China. Generally, Post- Keynesians argue that capitalism suffers from fundamental flaws that generate constant instability. Consequently, these "fundamentalist Keynesians" argue for aggressive activist policies.

Most Keynesians now accept Friedman’s and Lucas’s arguments but continue to believe in activist policy. These Keynesians reformed old Keynesian economics into "New Keynesian Economics". New Keynesian Economics focuses on problems in the adjustment of market prices. In this view, markets are relatively stable, but if something happens to disturb them, they will fail to adjust back to full employment. According to New Keynesian Economics, market prices and wages adjust to disturbances slowly. For example, the costs of changing prices, known as menu costs, slow shopkeepers as they react to decreased spending. Also, the cost of monitoring workers make entrepreneurs reluctant to cut wages because they fear that workers will react by reducing effort. This leads entrepreneurs to pay "efficiency wages" that exceed market-clearing wages.

New Keynesian economists reject the aggregate analysis of their predecessors in favor of individualistic economic models. Given that aggregate analysis made Keynesian Economics new and revolutionary the advent of New Keynesian economics constituted a reversal in the "Keynesian revolution". Although Post Keynesians continue to argue for their more original form of Keynesian economics, most economists reject the revolutionary elements of early Keynesian economics.

Experience with Keynesian economics has led many to doubt both the theoretical validity and the practicality of Keynesian economics. Economists like James Buchannan blame Keynesian Economics for the accumulation of peacetime debt in western industrialized countries. Friedman and Hayek blamed Keynesian economics for the inflation that plagued many nations following the Second World War. Despite this, many economists continue to promote Keyensian Economics, in one form or another.

Doug MacKenzie

Kean University

Sources on Keynesian Economics

Buchannan, James, and Wagner, Richard "Democracy in Deficit" (1976)

Davison, Paul "Controversies in Post Keynesian Economics" Elgar, (1991)

Bellante, Don, and Garrison, Roger "Phillips Curves and Hayekian Triangles: Two Perspectives on Monetery Dynamics" History of Political Economy (1988)

Keynes, John Maynard "The General Theory of Employment, Interest, and Money" (1936)

Hazlitt, Henry "The Critics of Keynesian Economics" The Foundation for Economic Education (1995)

Leijonhufvud, Axel "Information and Coordination" Oxford U. Press (1981)

Mankiw and Romer "New Keynesian Economics" Vols. I+II MIT Press (1991)

Roberts, Paul Craig "The Breakdown of the Keynesian Model" The Public Interest 52 (1978)

Robinson, Joan "Economic Heresies" London, MacMillian, (1971)