The economy is about to collapse again

Keynes: the master's return again

My book, Keynes: The Return of the Master, was published in the fall of 2009, a year after the 2008 global banking collapse and massive bailouts by governments around the world. This was accompanied by the bailout of a bankrupt banking system and extensive monetary and fiscal stimulus programs. Unlike after the Wall Street crash in 1929, governments did not remain passive during the 2008/2009 crisis. I assume that these interventions prevented another Great Depression: While economic output remained in recession for 13 quarters after the 1929 collapse, the decline in production after the 2008 collapse was limited to four quarters.

With their backs to the wall, everyone is a Keynesian

Before the economy could really recover, the measures were already scaled back as a result of the 2008/2009 crisis. Fear of possible over-indebtedness led governments to cut public spending, and the "return of the master" proved short-lived. "I guess everyone is a Keynesian in a foxhole," said Robert Lucas, the high priest of Chicago economy. Keynes was apparently only intended for emergencies.

Today the pattern is similar. Governments have been forced to shut down much of their economies to stop the spread of the coronavirus pandemic and have provided generous financial resources to safeguard the incomes of businesses and millions of working people. But they hoped that if the economy reopened, the national budget would be eased if the upswing takes a V-shape. So that the national debt does not get out of control, tax increases are already being discussed again.

That seems reasonable. Many entrepreneurs and economists consider the market system to be fundamentally healthy. It does get sick from time to time and therefore needs medication, but basically it is self-healing, like the human body. Treatment should therefore be limited in scope and duration. This is especially true given the risks of political medicine. The British economist John Maynard Keynes (1883-1946) rejected this analogy between the market system and the self-healing body, believing instead that a market system left unattended by the state could never be healthy.

Keynes for beginners

Most who have heard of Keynesianism believe that this economic school aims to allow budget deficits to run. This is wrong. Keynesianism is an economic theory that enables a balanced level of production and employment with the help of the state budget. This can go hand in hand with either a budget surplus, a budget deficit or a balanced budget, depending on the current economic situation. It is not in itself desirable to balance the national budget. Rather, economic upswings and downturns should be balanced out. But why is this balance so important?

Keynes ‘revolutionary insight was that capitalist market economies do not automatically tend towards full employment. Your normal state tends to be underemployed, which is worsened with severe depression. This claim shocked economists at the time, whose models taught that persistent unemployment was impossible with flexible wages. Keynes' colleague from Cambridge Arthur Pigou expressed this conviction as follows: “With perfectly free competition among workpeople and labor perfectly mobile ... there will always be at work a strong tendency for wage-rates to be so related to demand that everybody is employed "(Pigou, 1933). Based on this argument, unemployed workers must choose not to work by insisting on wages that employers cannot pay them. When Keynes saw the millions of unemployed around him during the Great Depression, he realized that something may be wrong with the models! People don't want to be unemployed. They cannot find work regardless of their wages.

Paradigm shift

Keynesian economics begins with a paradigm shift. Keynes assumes that people are unemployed because there is no demand for work. But this consideration had not really convinced the economists. They cited all sorts of bizarre reasons to show that what looked like unwanted unemployment was in fact a "leisure choice." Even today, I would assume that most economists, deep down, believe that almost all unemployed people could find a job if they really wanted to, or if government benefits didn't offer them an alternative income.

But why don't economies recover quickly from collapses? What about the idea of ​​the V-shaped recovery? Surely, if an employer doesn't want to hire me at £ 500 a week, I can lower my wage claim until it's worth hiring me. The orthodox economist has a ready-made answer: By insisting on unrealistic wages, workers steal their own jobs. Against this assumption, Keynes gave two reasons why even flexible wages cannot maintain or create full employment.

Purchasing power theory of wages

His first argument was that every producer is also a consumer: my wages are your income, because with my wages I buy your goods. If my wages go down, your income goes down. A reduction in production costs (be it through wage cuts or layoffs) deepens a slump in which purchasing power and overall demand are reduced at the same time. A decline in income in one part of the economy reduces production in another part, and so on. A downward spiral is created as unemployment spreads rapidly across the economy. After all, purchasing power will only stabilize at a significantly lower level when people stop saving. But nothing is done to stimulate consumption and thus promote recovery. Only trained economists get the crazy idea that the path to recovery is for everyone to cut spending.

Trust and money holding

Keynes ‘second argument against the idea of ​​the V-shaped recovery had to do with the holding of money. It is characteristic of a crisis that companies hoard their money or increase their cash reserves instead of investing. The greater this “liquidity preference”, the higher the interest rate that the lenders charge. In order to boost production, however, borrowers need lower, not higher, interest rates. So when confidence is low, the higher interest rates z. For example, the banks are required to invest even less, consume less and employ less.

Flexible wages and inflexible interest rates are leading to a deepening of the slump. Unlike Robert Lucas, the economy remains in recession without state “stimulation”. But mainstream economics is making a comeback: Depression or deep recessions are very rare occurrences, like the “black swans” by Nassim Taleb (2008). It would be absurd to organize economic life as if the next slump was imminent. Market economies would have an internal stability, so that crises would be very rare occurrences. But Keynes has denied that: Black swans can appear out of nowhere at any time.

The reason for this, according to Keynes, is that the theory of the "self-balancing" market economy depends on the idea that anyone, and especially investors, can accurately predict the future. If they could accurately calculate the value of the assets they buy today ten years from now, they would never buy things at wrong prices. As Keynes (1937) wrote: "The calculus of probability ... was supposed to be capable of reducing uncertainty to the same calculable status as that of certainty itself." But that is a myth. "Actually, however, we have, as a rule, only the vaguest idea of ​​any but the most direct consequences of our acts" (Keynes, 1936). This is a second paradigm shift that opened the eyes of many economists. This had serious consequences. Because the future is uncertain, private investment - which depends on the expectation of future returns - will be volatile. Prosperity depends on people's "animal spirits". When they feel confident, hire more workers; if you are pessimistic, hire less.

Stabilization policy

Two conclusions can be drawn from this representation of market behavior: first, breakdowns are always possible because the future is uncertain; and second, when they happen, there are no “automatic” market mechanisms to ensure rapid recovery. That is why the state must act as a “compensation mechanism” in the market economy. He increases or decreases the demand as needed.

There are two things that governments should do, not just in an emergency, but permanently:

  1. You should stabilize investments. They can do this through public investment programs. Keynes (1936) wrote: "I expect to see the state, which is in a position to [take] long views ... taking an ever greater responsibility for directly organizing investment." but since the 1980s the share of government in total investment has fallen dramatically, increasing the instability of investment.
  2. Governments should pursue “counter-cyclical” policies to limit the effects of further fluctuations. That means stimulating the economy with additional government spending when private spending falls and curbing it when it increases. This can be done on the income or expenditure side, or on both sides. The “multiplier”, which is based on the “marginal propensity to consume”, shows governments what overall effect the additional or reduced demand will have on the economy.

These two balancing functions, public investment and countercyclical policies, are necessary to ensure full employment and stability in capitalist market economies. And the more resources are used continuously, the higher the growth rate and the greater the social satisfaction. This, in a nutshell, was the Keynes message.

Counter arguments

Let us now consider the main objections to Keynesian theory and politics. The first, as we have seen, is that mainstream economists believe that market economies have a natural stability, contrary to what Keynes believed. But there are also arguments against individual Keynesian instruments.

  1. Anti-Keynesian economists teach that public investment is less efficient than private investment. They even crowd out private investments. This is true when all the resources of the economy are used to the full. However, if there is spare capacity, public investment can crowd in private investment by increasing aggregate demand for goods and services. Most governments drastically cut public investment after the 1970s. Growth was halved and unemployment rose. Indeed, some public investment is not used efficiently, but that should be balanced against the inefficiency of unemployment.
  2. Monetarian economists - descendants of Milton Friedman - claim that Keynesian “countercyclical” policies are bound to be inflationary. Governments cannot control the business cycle; and even if they could, in an effort to win votes they would print so much money that inflation would creep up and eventually accelerate.

This monetarist criticism is partly justified. But here too we have to compare the Keynesian system with the monetarist alternative. Monetarists claim that if there were no “shocks”, markets would be “countercyclically stable” because people can rationally look ahead to the future. The main "shock" that must be countered is unexpected changes in price levels. These can lead people to trade at wrong prices. The key to economic stability is therefore a low and constant rate of inflation. This requires that control of the supply of money or interest rates be removed from the responsibility of politicians and transferred to independent central banks. This system was tested in most countries in the 2000s. It did not prevent an economic collapse from 2008 to 2009.

Even the policy of quantitative easing - flooding the economy with central bank money, or M0, in 2009-2012 - did not result in a V-shaped recovery after the collapse. The monetarists' fallacy is that the money supply (which includes expanded money or bank credit) is not directly under the control of the central bank. How much bank credit causes an expansion of the monetary base depends on Keynes ‘" animal spirits ". A very high interest rate can end a boom, but even a negative real interest rate may not lead to a recovery if animal spirits darken.

Policy recommendation

The answer to the failure of both old-fashioned Keynesianism and newfangled monetarism is not to abandon the balancing role of the state, but to make it as automatic as possible. The state should commit to two things: a public investment program and a job guarantee in the public sector.

The first would more tightly limit investment volatility; the second would create a buffer of jobs that would automatically expand in a downturn and decrease in an upswing. Public investment does not necessarily mean public ownership. Part of this could be borne by quasi-state institutions such as public investment banks or companies with state participation. These would be subject to a broad central government mandate and thus reflect national goals, but separate business from political decisions. The public job guarantee would be funded centrally, but with projects selected and managed locally. The result of both policies in common would be that, for the first time since the industrial revolution, unwanted unemployment would be eliminated.

Marxists would argue that such an updated Keynesian program is just a pipe dream. A capitalist economy needs a "reserve army of the unemployed" to increase profits and lower wages. Only a fully socialized economy, they say, can eradicate unemployment and sustain wage growth. Indeed, Keynesian-led capitalist economies had an average unemployment rate of 2% to 3% from 1950 to 1975, half the rate since then, with wages rising rather than stagnating, and inflation only slightly higher than during monetarist leadership.

No system of political economy is perfect. But it should not be judged in comparison with an ideal system, but with the real alternatives. Keynes set out to save democracy from the two challengers of his time - fascism and communism. He said that if we continued laissez-faire policies in the face of mass unemployment, political freedom would not survive. However, if the problem is properly analyzed, it may be possible to cure the disease while maintaining efficiency and freedom.

These considerations are still relevant today. I doubt that the western population will tolerate a political economy for long periods of time that brings with it persistent unemployment, frequent economic crashes, stagnant wages and extreme inequalities in wealth and income. Keynesianism does not solve all economic problems. Keynes (1936) wrote that the two great mistakes of capitalist societies were the failure to create full employment and its arbitrary and unequal distribution of income and wealth. He set out to overcome the first mistake, which was the big problem at the time. Combining these two therapies with the Green New Deal remains the greatest economic challenge of our time.


Keynes, J. M. (1936), The General Theory of Employment, Interest and Money, Macmillian.

Keynes, J. M. (1937), The General Theory of Employment, The Quarterly Journal of Economics, 51, 212-223.

Pigou, A. C. (1933), The Theory of Unemployment, Macmillian.

Taleb, N. (2008), The Black Swan: The Power of Highly Unlikely Events, Hanser.

Title: Keynes: The Recent Return of the Master

Abstract: The current crisis repeats the patterns of previous crises. Against a backdrop of falling production and rising unemployment, central banks and governments around the world are trying to save their economies from a major crash. The formula for this stabilization policy is based on the lessons of the British economist John Maynard Keynes, which he described after the Great Depression in 1936 in his “General Theory of Employment, Interest, and Money”. For the slump but also beyond, Keynes provided insightful policy recommendations that can be applied in the 21st century.

JEL Classification: B22, B31, E00