3.2.7 Keynesian Economic Theory
3.2.7 Keynesian Economic Theory
As the Great Depression showed, the free-market economy does not always correct itself immediately during cycles of boom and bust. In fact, the Great Depression seemed to get worse as time passed, causing hardship
for many.
The "natural law" according to classical liberalism is that where there is economic freedom the economy will correct itself. Classical liberal economic theory follows a belief that if producers are given the economic freedom to produce goods and
services, they will produce what people want and the invisible hand economy will meet the most needs of individuals. Although classical liberals agreed that bad times will be followed by good times, and the instability of the free market system,
they also believed that through self-interest of entrepreneurs and investment, the market would fix itself.
Classical liberal economists also believe that self-reliance and self-interest will lead people to save their earnings for recessions
or depressions. The assumption was that people and governments supposedly understand this cycle, and therefore they will save when times are good (boom) to protect themselves when times are bad (bust). Therefore, there is no need for the government
to get involved.
Think about this for a moment. Is this assumption of human nature and self-interest true for people you know? Do individuals save when times are good? Do they know or anticipate when the economy is about to take a downturn?
Does the market always regulate itself?
British economist John Maynard Keynes did not believe
that the economy would always correct itself according to the principles of classical liberalism.
During the
depression, he saw that the business cycle was not stable. He felt that
during times of economic instability, people tended to hang on to their
money. He saw that when times were bad, people were not confident in the
economy and
did not invest. This caused further downturn and prolonged the
recession.
Keynes' Demand Side Economic Theory
Keynes believed that consumer demand causes the highs and lows of the business cycle. When times are good, people spend freely, causing inflation.It also leads to an oversupply of goods that no one wants to buy. When times are bad, people do not spend or invest, creating a downward spiral. Effective demand means that supply and demand works only when consumers have purchasing power. Keynes ideas were called demand-side economics, as opposed to supply-side economics.
Keynes believed the government should regulate and stimulate the economy. When the business cycle is on an upswing, the government and its central bank should raise interest rates and raise taxes to encourage people to limit spending and save their money while at the same time reducing government spending. This would cool economic activity. As the economy slows, the government should lower interest rates, lower taxes, and increase government spending even if it means the government has to go into a temporary deficit that would be paid back during boom times.
Decreased taxes and lower rates for borrowing would put more money in people's pockets, leading to increased spending that would pump money back into the economy.
Keynes' Solution: Fiscal and Monetary Policies
Keynes' theories included both fiscal and monetary policies. Fiscal policies include government spending, taxation, and government borrowing. Monetary policies are those that control the money supply in a country, including printing money and establishing interest rates.
Classical Economic Theory |
Keynesian Theory
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Keynes ideas were implemented in many countries during and after the Great Depression. Keynes was one of the chief economic advisors at the Bretton Woods Conference, which was an international conference held near the end of World War II to help prevent another global recession. The Bretton Woods Conference helped establish international rules for trade, the World Bank, and the International Monetary Fund, large institutions that all had a part in preventing another Great Depression following World War II.
His ideas remained a powerful influence until the early 1970s, and there is renewed interest in them today. There will be further examination of various modern economic systems in Unit Six.
As you read, consider the issue question:
- How did Keynesian demand side economics alter classical liberal approaches to the business cycle?
- What ideas are presented about classical liberalism and laissez-faire capitalism?
- How were these ideas a rejection of classical liberalism or an extension of greater freedoms for all?
- How were these policies and programs justified?
Keynesian Economics and Today's Economy
- Who is represented by the character in the hat?
- What is the cartoonist's perspective on Keynesian economics today?
- What perspective does he have regarding classical liberalism?
The Recession of 2008
The modern industrial world entered a recession in December 2007. It was precipitated by the deregulation of the banking industry and speculation in American real estate and equities. Financial institutions loaned money recklessly to unsecured borrowers for mortgages; the result is sometimes referred to as the "subprime lending crisis".For example, lenders Fannie Mae and Freddie Mac were allowed to buy people's mortgages without keeping any significant amount of capital on hand. In other words, these financial institutions owned other people's debts. As house prices increased, and people were forced to renew mortgages at rates they could not afford to repay, they defaulted on their loans. These companies were left owning the titles to properties that no longer had significant value.
For example, a house with a mortgage of $300 000 now might be worth less than $100 000. In other words, banks loaned money to people who had no form of security and had not shown that they had the ability to repay their loans. Many people bought houses at inflated prices, renegotiated their mortgages, and ended owing more than they could hope to repay.
As the crisis mounted, many large banks and lending organizations faced failure and bankruptcy. International trade decreased. Thousands lost their jobs.
The global recession led many governments, especially that of the United States, to look at Keynesian policies again. The American government spent millions bailing out industries that failed or were about to fail. Classical liberal economists (free-market supporters) largely criticized this move, as they believed this intervention distorted the natural course of the business cycle, giving these companies an economic advantage. Modern liberals applauded the intervention, claiming that the mass unemployment would have caused undue suffering across America. In essence, the decision was these companies were simply 'too big to fail'.