Analysis Of Keynes Economic Thought Critically Economics Essay

Abstract

The purpose of this paper is to analyze Keynes’ Economic thought critically, how his thoughts have revolutionized macroeconomic thinking and how his policy issues have influenced the policy decisions of the governments of different countries of the world. Finally, this paper will try to analyze the relevance of Keynes’ policy views in the perspective of Bangladesh.

Introduction:

John Maynard Keynes was a British economist whose ideas have profoundly influenced the theory and practice of modern macroeconomics, as well as the economic policies of governments. He identified the causes of business cycles, and advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions. His ideas are the basis for the school of thought known as Keynesian economics, and its various offshoots.

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A study of the evolution of Keynes’ policy views is, by itself, both interesting and rewarding. The issues involved are quite complex and, in the area, there a lot of misconception among the historians of economic thought. It is quite true that Keynes’ global fame lies basically in his contribution to pure theory. In fact he revolutionized macroeconomic thinking by his magnum opus, The General Theory of Employment, Employment and Money (1936). But it is also equally true that his real interest, as an economist, lay not in pure theory but in policy. He always wanted to correct the economy by suitable policy devices. His strong social sense and commitment never allowed him to live very long in the ivory tower of an academe.

Background:

John Maynard Keynes was born on 5 June, 1883 in Cambridge to a middle-class family. His father, John Neville Keynes, was an economist and a lecturer in moral sciences at the University of Cambridge and his mother Florence Ada Keynes a local social reformer. Keynes won a scholarship to study at Eton, where he displayed talent in a wide range of subjects, particularly mathematics, classics and history. In 1902 Keynes left Eton for King’s College, Cambridge after receiving a scholarship for this also to study mathematics. The famous Alfred Marshall begged Keynes to become an economist. [1] Keynes began his professional career with a solid, substantial book, Indian Currency and Finance (1913). This book was essentially policy oriented. It was an attack on the Report of the British Flower Committee of 1898 which had recommended the adoption of the Gold Standard for India. Thereafter for some time, he didn’t engage himself in any scholarly economic analysis. But in 1919 he wrote a book — The Economic Consequences of the Peace – which brought him instant international fame. It was chiefly concerned with policy issues – the German reparations problem. In order to understand the changes in Keynes’ thought we have to consider the three main books that he wrote in the inter war period. These are (1) A Tract on Monetary Reform (1923), (2) The Treatise on Money (October 1930), and (3) The General Theory of Employment, Employment and Money (February1936). In the first Keynes’ followed the quantity theory of money which he learnt from his teachers-Alfred Marshall and Alec Pigou. He didn’t break any new ground but followed the traditional path. In the second book Keynes’ really wanted to innovate. The third book, the General Theory (GT), which completely changed the nature of macroeconomic theory in the form of his well known C+I+G=Y equation was entirely novel and truly original. In all these three books Keynes’ was concerned with the most intractable contemporary economic problem-that of unemployment. This was the problem that was plaguing British economy since the end of the First World War. In all these three books Keynes had been arguing against the classical approach of combating unemployment by a cut in the nominal wage rate.

Keynesian Economics:

According to Keynesian theory, some microeconomic-level actions – if taken collectively by a large proportion of individuals and firms – can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate. Such a situation had previously been referred to by classical economists as a general glut. Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn with unnecessarily high unemployment and losses of potential output. In such a situation, government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Keynes argued that the solution to the Great Depression was to stimulate the economy (“inducement to invest”) through some combination of two approaches: a reduction in interest rates and government investment in infrastructure. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment. [2] Keynes sought to distinguish his theories from and oppose them to “classical economics,” by which he meant the economic theories of David Ricardo and his followers, including John Stuart Mill, Alfred Marshall, Francis Ysidro Edgeworth, and Arthur Cecil Pago. A central tenet of the classical view, known as Say’s law, states that “supply creates its own demand”. Say’s Law can be interpreted in two ways. First, the claim that the total value of output is equal to the sum of income earned in production is a result of a national income accounting identity, and is therefore indisputable. A second and stronger claim, however, that the “costs of output are always covered in the aggregate by the sale-proceeds resulting from demand” depends on how consumption and saving are linked to production and investment. In particular, Keynes argued that the second, strong form of Say’s Law only holds if increases in individual savings exactly match an increase in aggregate investment. [3] 

Keynes sought to develop a theory that would explain determinants of saving, consumption, investment and production. In that theory, the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy.

Marginal Propensity to Consume and Marginal Efficiency of Capital:

Keynes developed the concept of marginal propensity to consume (MPC) and Marginal efficiency of Capital.

Marginal propensity to consume: When the income of the household increase by a certain amount, only a fraction of this increase is spent on consumption. If we look at the consumption function-

C=`C + cY

Here the coefficient c is called the MPC. Keynes argued on the basis of a psychological law of consumption that the MPC out of income was less than unity and would decline as income rose. The implication is that, in the developed capitalist economy, the national propensity to consume tends to decline, which if not matched by increased investment, will cause the effective demand to fall short of full employment output.

Marginal efficiency of Capital: The Marginal Efficiency of Capital is the relationship between the prospective yield of an investment and its supply price or replacement cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type.

Keynes says on page 135 of General Theory:

“I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price.”

Wages and spending:

During the Great Depression, the classical theory defined economic collapse as simply a lost incentive to produce, and the mass unemployment as a result of high and rigid real wages.

To Keynes, the determination of wages is more complicated. First, he argued that it is not real but nominal wages that are set in negotiations between employers and workers, as opposed to a barter relationship. Second, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical economists admitted that these exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility. However, to Keynes, people will resist nominal wage reductions, even without unions, until they see other wages falling and a general fall of prices.

He also argued that to boost employment, real wages had to go down: nominal wages would have to fall more than prices. However, doing so would reduce consumer demand, so that the aggregate demand for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment-perhaps already discouraged by previous excesses-would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downward as those who had money would simply wait as falling prices made it more valuable-rather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) can make a depression deeper as falling prices and wages made pre-existing nominal debts more valuable in real terms.

Money Illusion: The term was coined by John Maynard Keynes in the early twentieth century, and Irving Fisher wrote an important book on the subject, The Money Illusion, in 1928. [4]  The existence of money illusion is disputed by monetary economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth. It has been contended that money illusion influences economic behavior in three main ways:

Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.

Contracts and laws are not indexed to inflation as frequently as one would rationally expect.

Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.

Money illusion can also influence people’s perceptions of outcomes. Experiments have shown that people generally perceive a 2% cut in nominal income as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. Further, money illusion means nominal changes in price can influence demand even if real prices have remained constant.

If workers use their nominal wage as a reference point when evaluating wage offers, firms can keep real wages relatively lower in a period of high inflation as workers accept the seemingly high nominal wage increase. These lower real wages would allow firms to hire more workers in periods of high inflation.

Excessive Saving:

To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem, encouraging recession or even depression. Excessive saving results if investment falls, perhaps due to falling consumer demand, over-investment in earlier years, or pessimistic business expectations, and if saving does not immediately fall in step, the economy would decline.

The classical economists argued that interest rates would fall due to the excess supply of “loanable funds”. The first diagram, adapted from the only graph in The General Theory, shows this process. (For simplicity, other sources of the demand for or supply of funds are ignored here.) Assume that fixed investment in capital goods falls from “old I” to “new I” (step a). Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have saving (S) equal to investment. The interest-rate (i) fall prevents that of production and employment.

Keynes had a complex argument against this laissez-faire response. The graph below summarizes his argument, assuming again that fixed investment falls (step A). First, saving does not fall much as interest rates fall, since the income and substitution effects of falling rates go in conflicting directions. Second, since planned fixed investment in plant and equipment is mostly based on long-term expectations of future profitability, that spending does not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a negative interest rate at equilibrium (where the new I line would intersect the old S line). However, this negative interest rate is not necessary to Keynes’s argument.

Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in the short run. Instead, the supply of and the demand for the stock of money determine interest rates in the short run. (This is not drawn in the graph.) Neither changes quickly in response to excessive saving to allow fast interest-rate adjustment.

Finally, because of fear of capital losses on assets besides money, Keynes suggested that there may be a “liquidity trap” setting a floor under which interest rates cannot fall. While in this trap, interest rates are so low that any increase in money supply will cause bond-holders (fearing rises in interest rates and hence capital losses on their bonds) to sell their bonds to attain money (liquidity). In the diagram, the equilibrium suggested by the new I line and the old S line cannot be reached, so that excess saving persists. Even if the liquidity trap does not exist, there is a fourth (perhaps most important) element to Keynes’s critique. Saving involves not spending all of one’s income. It thus means insufficient demand for business output, unless it is balanced by other sources of demand, such as fixed investment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, or what classical economists called a general glut. [5] This pile-up of unsold goods and materials encourages businesses to decrease both production and employment. This in turn lowers people’s incomes-and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes, the fall in income did most of the job by ending excessive saving and allowing the loanable funds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession does so. Thus in the diagram, the interest-rate change is small.

Active Fiscal Policy:

As noted the classicals wanted to balance the government budget. To Keynes, this would exacerbate the underlying problem: following either policy would raise saving (broadly defined) and thus lower the demand for both products and labor. For example, Keynesians see Herbert Hoover’s June 1932 tax increase as making the Depression worse.

Keynes′ ideas influenced Franklin D. Roosevelt’s view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction. But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s.

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Keynes′ theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called countercyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nation’s economy suffers from recession or when recovery is long-delayed and unemployment is persistently high-and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because “in the long run, we are all dead. [6] 

This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal stimulus (deficit spending) could actuate production. But to these schools, there was no reason to believe that this stimulation would outrun the side-effects that “crowd out” private investment: first, it would increase the demand for labor and raise wages, hurting profitability; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is persistently high, above the non-accelerating inflation rate of unemployment (NAIRU). In that case, crowding out is minimal. Further, private investment can be “crowded in”: fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation. Second, as the stimulus occurs, gross domestic product rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector’s growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-term growth of potential output.

Multiplier Effect and Interest Rate:

Two aspects of Keynes’ model had implications for policy:

First, there is the “Keynesian multiplier”, first developed by Richard F. Kahn in 1931. Exogenous increases in spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A government could stimulate a great deal of new production with a modest outlay if:

The people who receive this money then spend most on consumption goods and save the rest.

This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase consumer spending.

This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of equilibrium. This story is modified and moderated if we move beyond a “closed economy” and bring in the role of taxation: the rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that was available to invest. To Keynes, the amount of investment was determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But during more “normal” times, monetary expansion can stimulate the economy.

Criticism:

While Milton Friedman described The General Theory as ‘a great book’, he argues that its implicit separation of nominal from real magnitudes is neither possible nor desirable; macroeconomic policy, Friedman argues, can reliably influence only the nominal. [7] He and other monetarists have consequently argued that Keynesian economics can result in stagflation, the combination of low growth and high inflation that developed economies suffered in the early 1970s.

Austrian economist Friedrich Hayek criticized Keynesian economic policies for what he called their fundamentally collectivist approach, arguing that such theories encourage centralized planning, which leads to malinvestment of capital, which is the cause of business cycles. [8] Hayek also argued that Keynes’ study of the aggregate relations in an economy is fallacious, as recessions are caused by micro-economic factors. Hayek claimed that what starts as temporary governmental fixes usually become permanent and expanding government programs, which stifle the private sector and civil society.

Other Austrian school economists have also attacked Keynesian economics. Henry Hazlitt criticized, paragraph by paragraph, Keynes’ General Theory in his 1959 extensive critique of Keynesianism: The Failure of the New Economics. In 1960 he published the book The critics of Keynesian Economics where he gathered together the major criticisms of Keynes made up to that year. [9] 

Murray Rothbard accuses Keynesianism of having “its roots deep in medieval and mercantilist thought.” [10] 

Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and particularly emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted behavior from people, which totally contradicted the economic understanding of their behavior at a micro level.

My Understanding:

Although Keynes explicitly addresses inflation, The General Theory does not treat it as an essentially monetary phenomenon nor suggest that control of the money supply or interest rates is the key remedy for inflation. This conflicts both with neoclassical theory and with the experience of pragmatic policy-makers.

It is not always true which is said in multiplier effect that when a government will stimulate the economy, the extra spending will induce businesses to hire more people and pay them. Those who get the extra spending due to government stimulation may follow the capital-intensive method rather than labor-intensive method.

Keynes has argued that in the developed countries national propensity to consume tends to decline as income increases. But if we consider in the perspective of some developed countries like USA and others, this interpretation differs with the reality, as national propensity to consume tends to increase in these countries as income rises.

Keynes nevertheless successfully convinced multitudes of supposedly knowledgeable economists to accept a series of arguments. Savings became bad and deficits became good, and the prudent accumulation of reserves for foreseeable and unforeseeable contingencies was imprudently responsible for disastrous consequences. The accumulation of capital assets becomes an economic obstacle rather than an economic advantage. Investment and employment is stimulated by inflation and hindered by price declines. Market liquidity becomes more of a problem than an advantage.

As is repeatedly pointed out throughout Keynes, “The General Theory,” there is absolutely no evidence that excess savings play any role in initiating periods of economic distress.

Like Marx and all socialists, Keynes appears totally ignorant of the inherent inefficiency of government management. He has total faith in the capabilities of government and “community” administered economic systems. Keynes offers narrower administered solutions directed at controlling interest rates, directing investment flows, redistributing wealth, and ultimately directing the activities of major business entities.

Keynes thus draws a broad conclusion based on his very narrow special case. His conclusion applies only for a closed system – thus necessarily hobbled with grossly limited economic productivity and living standards – that determinedly ignores long term implications. Even for closed systems, rigid wage systems must put greater pressures for adjustment on other cost factors – each with their own complex of impacts – that Keynes doesn’t consider.

Bangladesh Perspective:

Keynesian economics, insofar as it is formulated in the General Theory of Employment, Interest and Money, has little validity in the context of underdeveloped economies like Bangladesh that Keynesian involuntary unemployment is not the kind of unemployment of which these economies suffer, and the problem is one of long-term economic development rather than the attainment of ‘full employment’ in the Keynesian sense.The doctrines of excessive saving and inadequate consumption do not apply to underdeveloped countries like Bangladesh, where inadequate saving is one factor limiting the growth of investment and income. But some of the doctrines of Keynes can be useful if they are properly implemented.

At a time of recession, Keynes suggested an economic policy to increase the aggregate demand (e.g. through consumption, investment, and government purchases). No wonder big economies around the world have announced big budgets and taken unprecedented investment programs in the recent economic recession. Bangladesh’s national budget for FY2009-10 seemed to have targeted the Keynesian need for investment. Admittedly, Bangladesh is a passive victim of the global recession and cannot blindly follow the steps of developed economies. The government budget of Bangladesh has always been in deficit. The reason behind this deficit is lower government revenue collection and higher government spending. Rather than seeing unbalanced government budgets as wrong, A Keynesian interpretation of the estimated results suggests that by raising consumption expenditures, government spending on infrastructure also stimulates the demand-constrained Bangladesh economy, which causes greater utilization of production capacities. In turn, it increases national output through a multiplier-accelerator mechanism. Thus, deficit spending in a proper way induces positive effects on GDP growth and on employment in the short-run through increased consumption demand. This initial government investment may ‘crowd out’ private investment by increasing interest rate. In that case expansionary monetary policy can be adopted to decrease interest rate and induce private investment. So, an effective policy mix can increase the level of employment without affecting private spending too much. Though there is chance of inflationary pressure to grow as we are experiencing now, a proper distribution of the supply of money need to be assured to prevent the condition of inequality and poverty from worsening.

Conclusion:

Keynes is widely considered to be the father of modern macroeconomics, and by various commentators such as economist John Sloman, the most influential economist of the 20th century. Prior to dying Keynes was a key figure in the establishment of the International Monetary Fund (IMF). The advent of the global financial crisis in 2007 has caused resurgence in Keynesian thought. The former British Prime Minister Gordon Brown, President of the United States Barack Obama, and other world leaders have used Keynesian economics to justify government stimulus programs for their economies. Though Keynes’s ideas have been doubted, distrusted, nearly discarded and heavily altered his ideas are still a topic of discussion and practice in 21st century economic policy.