VATSAL BAJAJ – NOVEMBER 30, 2018
John Maynard Keynes famously proposed a solution to lift the world economy out of the Great Depression in his 1936 book, The General Theory of Unemployment, Interest and Money. Disregarding classical economic theory which had been widely accepted for almost two centuries, Keynes contended that “the postulates of classical theory are applicable to a special case only and not to the general case.” In precise terms, Keynes challenged the classical assumption that free forces of supply and demand always achieve equilibrium and asserted that “free markets have no self-balancing mechanisms that lead to full employment.” Keynes rose to prominence in the Era of Recessionary Economics—the classical theorists couldn’t explain why the 1930s Great Depression didn’t self-correct. A paper by Abdul Rahim from the Kwame Nkrumah University of Science and Technology highlighted how “Classical economist[s] preached for patients, hoping for the ‘self-correcting’ mechanism of the economy to act. Time ran out as immediate answers were sought.” Non-intervention was clearly failing.
Keynes in contrast advocated for fiscal stimuli such as lower taxes and higher government spending to solve recessions as his aggregate demand model depended on consumption, investment, government spending and net exports. This theory proved to be a sound method of organizing an economy as exemplified by Germany’s 2010 economic miracle. Two years after the 2008 financial crises, Germany made a fast-paced recovery thanks to “tens of billions of euros” of government spending according to a German newspaper article in Der Spiegel. The article explains how the Germans used Keynes’ theories and “launched an extensive package of stimulus and bailout measures . . . to stimulate the domestic economy.” The logic was simple: higher government spending would stimulate aggregate demand, leading to higher output and economic growth. Keynesian economics had accomplished what classical economics had not. Economic slumps were solved by government intervention, and waiting for the self-correcting market as classical economists suggested was senseless because, as was poetically put, “In the long run, we’re all dead.”
Many economists from the Austrian School of Thought, however, disagreed with Keynes’ interventionist ideology. The Chicago School of Thought and the Austrian economic model both provide arguments similar to the Classical Thought which, on the surface, advocate for a laissez-faire economy and minimal government intervention. This idea aligned with the ideologies of many famous economists such as Adam Smith and Alfred Marshall. This ideology was referred to as the “invisible hand” whereby every individual’s self- interest will lead to promoting “an end which was no part of his intention . . . By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. ”
These two new models reached for support by citing Japan as an example. Japan has undergone stagflation for the past three decades, encouraged by an economic slump in addition to extremely low interest rates. All of the Japanese government’s attempts at fiscal stimuli including the three-arrow policy have horribly failed. An article in the Spectator demonstrates how Japan is a prime case showcasing disastrous Keynesian economic management. The author, James Bartholomew, remembers how he was told, during his visit to Japan, that the government’s demand-side policies would soon bulwark the economy. Yet, 30 years later, Japan’s debt had increased to “a massive 230 per cent of GDP.”
This phenomenon of stagflation, however, does not necessarily prove Keynesian theory wrong as explained in a paper about stagflation published at UC Santa Barbara. On the surface, it seems Keynesian economics failed to improve Japan’s condition. However, this paper contends that the “stagflation-induced falsification of Keynesian economics is unwarranted.” Theoretically, Keynesian economics allows for such a phenomenon because of the incorporation of inflation expectations: changes in inflation expectations shift the Philips curve, thereby allowing for stagflation. Japan’s economic failure can also be explained through the liquidity trap scenario that Keynes explained in The General Theory. Regarding liquidity traps, Keynes said “but whilst this limiting case might become practically important in future, I know of no example of it hitherto.” Such an example arose in Japan. The Japanese preferred to hold cash rather than debt because of extremely low interest rates which rendered any expansionary monetary policies redundant as such policies fail to influence consumption. The Japanese case, therefore, does not show a failure of Keynesian economics but actually illustrates its foresight.
Keynes’ broadness of theory allows economists such as Paul Krugman and Joseph Stiglitz to contribute to the school of thought. This dynamic nature of Keynes’ principles allows it to change and adapt as time progresses. The classical model’s denial of the existence of externalities and its strict belief in the theory of self-correction has been consistently proved wrong. Unshaken by the rise of authoritarian populism, the Keynesian model may have begun in a 1900s recession but transcends the centuries to come.
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