Keynesianism

The “Keynesian Revolution”

The main body of Keynes's economic thought was developed during the interwar period in response to the perceived shortcomings of the classical economic theory that had held sway in Britain throughout the nineteenth century. This advocated a laissez faire style of economic management on the grounds that an unregulated free market would automatically tend toward an equilibrium state providing an optimal allocation of resources. As such, classical economics maintained that any rise in unemployment or decline in economic activity would ultimately prove to be self-rectifying through a corresponding reduction in wages.

Although Keynes accepted many of the tenets of classical economics, his central departure was to argue that economic theory needed to move beyond abstract propositions, and needed to account for the social forces and conditions in which a market economy operated. On this basis, Keynes argued that the mechanism of the free market would not of itself produce a state of full employment because the social factors determining the level of wages (primarily believed to be the increased organization of the trade union movement) would ensure that the price of labor did not adjust in a smooth, rapid, and automatic fashion. Instead, wage rigidity in a period of recession would exacerbate unemployment, compound the decline in consumption, and create industrial strife. As a result, an unregulated free market economy would tend toward an equilibrium state with an unnecessarily high level of unemployment and would therefore produce conditions that were incompatible with the goals of social harmony and political stability.

For Keynes, the central task was to discover a form of economic management that would preserve the centrality of the market while saving it from its own unpalatable consequences. In 1936, Keynes published his General Theory on Employment, Interest and Money, set within the context of a deep depression and the persistence of mass unemployment. Keynes [Page 508]believed the key cause of this was an insufficient level of “aggregate demand” for goods and services. Because the only means by which an unregulated free market economy could recover from a recession was through a process of falling wages, and because this offered no prior means of raising the level of aggregate demand, Keynes argued that active government intervention was now required to secure this objective.

The primary means by which Keynes envisaged that this would be achieved was through the use of a countercyclical fiscal policy. In the event of a recession, governments would be expected to use cuts in taxation and higher levels of public expenditure (including public works programs if necessary) to boost the level of aggregate demand and to thereby stimulate economic activity. In a contrary fashion, these policies were to be reversed should the economy start to expand too rapidly, with the use of higher taxation and cuts in public spending to constrain any inflationary tendencies.

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