Lesson 6


Keynesian Economics

John Maynard Keynes (1883-1946)

VIDEO: Masters Of Money │ Episode 1 │ John Maynard Keynes Documentary

John Maynard Keynes (1883-1946)

Keynes calls his historical predecessors (Smith, Say, Ricardo, Malthus, Mill) classical economists. His goal is to replace their classical theory by a new theory with more adequacy to the alleged real problems of the modern economy in the situation of the Great Depression. In the classical economists’ view a market economy naturally tends to restore itself to full employment after temporary shocks. They suggest lowering the production costs, especially wages, to overcome recessions. And that’s exactly what an entrepreneur who can’t sell his product profitably any more would do: trying to be a better competitor on the market by reducing costs of production and the price for his goods. For Keynes, however, in a situation like the Great Depression this is the wrong cure. According to him lower wages lead to less income and therefore less demand on the consumer side weakening the economy even more. With less demand entrepreneurs are forced to reduce production which results in higher unemployment rates – a self reinforcing death spiral of deflation. To avoid that Keynes suggests that during a depression the government shouldn’t be inactive or make things worse by bringing down public spending. Instead the government should steer and support aggregate demand. How? By increasing expenditures with borrowed money. Within a central bank monetary system, heavily endorsed by Keynes, borrowing money is equivalent to creating money out of thin air and increasing the money supply.

So whenever you hear central bankers or politicians talking about the danger of a close by deflation be aware that their reasoning stems from a Keynesian economic doctrine. The Keynesian theory by nature is very attractive for politicians and fractional reserve banking advocates. It delivers an elegant moral justification for deficit spending and the business model of our banking system.

Keynes studied Marx intensely. Marx wanted to expropriate the means of production from the private sector. Deep in his heart Keynes shared Marx’ contempt for the profit motive of the entrepreneur but yet argued the case for a different method in the endeavor for a fairer distribution of wealth. Keynes was economically literate enough to see that market forces and the accumulation of capital are necessary to create wealth. Nevertheless he was of the opinion that capitalism has to be managed wisely. In his view the Great Depression was a result of laissez-faire capitalism. And he strongly believed that the business cycle is a natural phenomenon of the free market. This pessimism towards economic freedom should be recognized as the cornerstone of his thoughts that result in the advice to policy makers to boost the overall demand during a recession by deficit spending with money borrowed into existence. In the Great Depression he saw the empirical rebuttal of capitalism. There might be a market equilibrium of production and demand, Keynes said, but only in the very distant future and “in long run we are all dead”. That quotation shows very well what Keynes was up to. He tried to conceptualize an economic theory that allows to react to economical problems in the present to really help people at need.

The title of his main work General Theory of Employment, Interest and Money shows that Keynes was a monetary theorist. To prevent mass unemployment monetary policy was the key element to him. He criticized the classical economists for their view of money as neutral to the economy, a veil in front of the exchange of real goods and services that has no effect on the economical development itself. In the classical theory – at least in Keynes’ understanding – an expansion or reduction of the money supply would influence prices but not production or employment. In Keynes’ model however money supply is nothing short of a neutral veil but has a wide influence on the entrepreneurs’ investing behavior. This effect is mediated by the interest rate. How? Keynes explains it this way: The interest rate is the result of the supply and demand of money. If the money supply increases by virtue of monetary policy while demand remains constant, interest rates go down and investing on credit becomes cheaper and more attractive for entrepreneurs. These additional investments triggered by the expansion of the money supply, e.g. through government borrowing, do have an immediate positive effect on the production and employment within the economy.

So far, so good. But critics of Keynesian Economics, especially the Austrian economist Friedrich August von Hayek, pointed out that Keynes’ conclusions derive from wrong assumptions about the real causes of the Great Depression.

Hayek shares Keynes’ view of the effect that an alteration of the money supply has on production and employment. But he sees the Great Depression as a result of the Federal Reserve System, the US central bank founded by the government in 1913. As the lender of last resort in the biggest economy of the world the Fed had an immense effect on the expansion of the money supply before 1929. Commercial banks now saw their risk of going bankrupt reduced, since there was always the possibility to get cheap money from the central bank to pay out creditors. That led to an escalation of fractional reserve banking and an overdone creation of check book money. In addition to that the government could now borrow money directly from the Fed without having to compete with other debtors on the free market.

With artificially lowered interest rates the economy turned euphoric, especially in the Roaring Twenties. For Hayek booms generated artificially through credit expansion necessarily lead to misallocations of capital. Without a free market interest rate resulting from real people’s supply and demand of money the production of goods can never match the real demand. Why? Because for entrepreneurs real demand now becomes indistinguishable from the artificial demand caused by the additional money supply. Finally the misallocations during the euphoria meet the real demand and people realize that they don’t really want the products. The bubble starts to burst. This is the tipping point when an economy arrives in a recession.

How can one argue that this is capitalisms’ fault, the fault of the free market? It’s been the government’s fault to install a central bank in the first place! The recession in 1929 grew out to a huge depression because politicians were still thinking in classical terms. That’s why they didn’t lower interest rates and didn’t support demand on credit but reduced expenditures and lifted the interest rate. Therefore the sheer magnitude of the misallocation of capital due to the expansion of the money supply became visible and the recession turned into a veritable crash. The crash could have been prevented through money printing – Keynes is right in that regard. But that would have led to even more misallocation of capital, more waste of resources and a further increase of the drop height of the inevitable final crash. A permanent increase of the money supply to prevent the crash would lead to a hyperinflation and the loss of people’s trust in the purchasing power of the money. All of a sudden the whole civilization would be thrown back to a state of barter.

Part of Keynes’s theory was that governments should start to pay their loans back in times of economic recovery to slowly reduce the money supply to a moderate level again. Unfortunately there is a conflict of interest: In democratic societies governments now would have the choice to either pay back loans or spend the additional tax income on social welfare. Only the latter would help them to gain more votes in the next election, if the majority of the voters are economically illiterate.

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