Economics, Keynesian

A Theory of the Depression

Keynesian economics originated as an attempt to explain and remedy the effects of the Great Depression, the greatest and most dramatic economic and political crisis the Western world had experienced thus far. Soaring unemployment, a slump in industrial production, and falling personal incomes posed an increasingly tense political threat. Even more unsettling was the fact that the Soviet Union seemed to be booming economically at the same time, adding to an atmosphere of intellectual helplessness and political fear in the West. In this darkest hour of economic theory, prevailing theories were unable to explain prolonged unemployment and to offer feasible policy prescriptions. Instead, economists cynically negated what could be observed on the streets.

As late as in 1933, prominent economist (and teacher of Keynes at Cambridge University) Arthur Cecil Pigou published A Theory of Unemployment in which he argued that perfect competition would automatically generate a full-employment equilibrium. He believed that wages and prices, being determined in competitive markets, were sufficiently flexible to allow for an instant self-adjustment of the economic system. Short-term inefficiencies could thus be neglected. This reasoning was rooted in the theorem set forth by the French economist Jean-Baptiste Say, who argued (in 1803) that supply automatically created its own demand. If industries and manufactures produced more output, higher wages would be paid to workers, which allowed them to consume what had been additionally produced. In this setting, macroeconomic government demand policies were believed to have no influence on the level of unemployment and output.

Keynes's The General Theory of Employment, Interest, and Money was a deliberate attack on these beliefs. His argument rested on the observation that prices and wages did not adjust instantly but might be fixed or might change only at a very small pace so that equilibrating forces would take very long to produce an effect. At the same time, Keynes also argued that economic actors based their decisions on their expectations of the future. In times of crisis, dwindling incomes meant that a smaller portion of income was saved. Ever lesser funds were available in the economy for investment as economic actors used up their personal savings for consumptive purposes. Entrepreneurs, faced with reduced demand, saw no incentive in investing themselves, even at historically low interest rates, fostering the view that monetary policies in this case were not suitable policy measures to improve the economic situation. As a result, and counterintuitive to conventional theory, an equilibrium of underemployment was feasible, a deadlock in which nothing moved, all actors being pessimistic about the future. Keynes showed that an underemployment equilibrium was not a permanent fate but could be addressed by adequate government action—especially public investment by which aggregate demand was stimulated. His description of the functional relation between investment, government spending, and national income allowed the modeling of the so-called multiplier, which calculated how a specific change in government spending or investment, or in exports, would increase output and the demand for workers. This account was innovatively grounded in the observation of the psychology of investment behavior. Keynes's contribution—with his account of “animal spirits,” the “spontaneous optimism” of economic behavior, as the major driver of changes in demand, output, and employment—is hard to exaggerate: Markets are moved by animal spirits, not by reason.

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