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by David Sharp, Founding President of the Australian Adam Smith Club (Melbourne) and author of Economic Simplicities

Observers of the current worldwide economic scene will, if they are historically minded, note a number of similarities to those that prevailed in the 1920-30s. These include ongoing currency wars, high and rising levels of unemployment, ever greater demands for subsidies and protection, much political instability, decreasing world trade, the moving of entire industries from more costly to less costly regions, growing fear and uncertainty about the future, and a seemingly inexorable drift towards a major war.

Faced with such circumstances, a classical economist, schooled in the prevailing economic orthodoxy, would most likely have advised a government to balance its budget, reducing, in so far as possible, its taxing and spending. In particular, it should refrain from any intervention in the economy. Following such a course would likely result in significant pain to the economy, but this could be expected to be of relatively short duration. More importantly, non- and under-performing elements would be purged from the economy, enabling a swift return to growth and prosperity. Such, in fact, was the advice given to USA President Herbert Hoover by his Treasury Secretary, Andrew Mellon, at the advent of the Great Depression. Hoover however rejected such advice and embarked on large-scale government intervention with the aim of maintaining the existing American level of employment and wages. Such policies were taken up and much expanded by Hoover’s successor as president, Franklin Delano Roosevelt.

The publication in 1936 of J M Keynes’ book, usually referred to as The General Theory, effectively repudiated the classical economic approach and instigated a revolution in economic thought. Keynes’ ideas dominated the discipline of economics until the 1970s, at which stage they were largely supplanted by the Monetarist ideas of Milton Friedman and the so-called Chicago School. However since approximately the start of the present century, Keynesianism has undergone a revival. It is appropriate to consider some of its concepts.

Market Failure

Keynes rejected the classical view that, if left alone, markets would clear i.e. everything available for sale would be sold if the price was right, and that the market worked automatically and continuously to arrive at that price, which price was reached at the equilibrium between supply and demand. To the contrary, Keynes saw in the post WW1 industrialized world many idle resources, particularly unemployed labour, which the market had failed, and was continuing to fail, to put to productive use. He perceived that prices, particularly wages, were “sticky”, and did not readily go down. He concluded that such idle resources were a consequence of insufficient effective aggregate demand. The remedy he proposed was for the government to spend more money, regardless of whether or not this meant it ran a budget deficit. It did not particularly matter for what purpose the government spent the money. A productive purpose was better, but if necessary the government could pay for holes to be dug in the ground and then filled up again. The essential aim was the injection of money into the economy to stimulate aggregate demand to the stage where all, otherwise idle, resources were employed.

Aggregation & National Accounts

In order for a government to ascertain where and to what extent there were idle resources that needed to be addressed and to determine the level of demand and the amount of any stimulus required, it was necessary for there to exist some form of national accounting. An entire new industry of statisticians, accountants and economists had to be created. In turn considerable aggregation of the components of such national accounts had to occur, such as to form aggregates of consumption, investment, labour, capital and so forth.

Benefit of Inflation

Considering the time and general circumstances in which he wrote, it is perhaps understandable that Keynes was not unduly concerned about inflation. He recognized that his policies could lead to inflation occurring. At least initially this was a benefit. Workers who would not accept a cut in wages would be subject to the same effective result by the value of their existing excessive nominal wage being eroded by inflation. If inflation became a problem government could soak up the excess liquidity by running a surplus budget, raising taxes and cutting spending.

No Depressions / Full Employment / Perpetual Prosperity

The promises of Keynesian theory were indeed alluring. A government that implemented and duly performed what was required would avoid future recessions or depressions, enjoy full employment, and experience uninterrupted prosperity. Keynes rejected the classical view that a recession or depression was the mark of an efficient market restoring itself to health. Rather they represented economic malaises to be avoided.

The spread of these ideas was rapid and extensive. In his 1945 UK book Full Employment in a Free Society, Sir William Beveridge wrote:

The policy of full employment outlined here is a policy of socializing demand rather than production. It attacks directly the central weakness of the unplanned market economy of the past — failure to generate steady effective demand for its own products.

In Australia, in similar vein was the 1945 book The Road to High Employment, by leading economist Professor Douglas Copland, from the University of Melbourne, the country’s centre of economics. The title of his book was a play on the critical 1944 book by the Austrian economist Friedrich von Hayek entitled The Road to Serfdom.

Short Term Focus

Keynes believed that economists should focus on the short term. The long term was difficult and unpredictable. In effect life was a series of short terms. One of his more famous lines is “The long run is a misleading guide to current affairs. In the long run we are all dead”.

Other Aspects

There are a number of other aspects of Keynesianism that should be discussed, such as the Paradox of Thrift, Barbarous Relic, Animal Spirits, Multiplier, Accelerator, Liquidity Trap, and so forth. They must await a further lecture.