Aggregate demand: Keynes

Big ideas in economics

Thomas Carlyle called economics the “dismal science” because he didn’t like the conclusions economists drew. He wasn’t speaking of Thomas Malthus, although the prediction of Malthus that population growth would outstrip economic growth and lead to immiseration was plenty dismal. The label stuck because economists insisted on describing economic life as consisting of trade-offs. You can have more of something only at the cost of something else.

For all this, economists tended to be an upbeat group. The leading thinkers constructed their theories to explain the material progress they observed in the world. Malthus was an outlier who proved to be wrong. Karl Marx was an outlier who was wrong too, in the opposite direction, predicting a socialist paradise beyond capitalism.

By the 20th century, capitalism had displayed a tendency toward recurring panics. Investment became speculation which produced bubbles that inevitably burst. Demand would collapse, workers would be fired, firms would fold. But eventually calm would be restored and the cycle begin anew.

Then came the Great Depression of the 1930s. Deeper and more widespread than any of the panics that preceded it, this one went on and on. Many people wondered if it would ever end.

John Maynard Keynes explained why it might not end. The touchstone of existing economic theories, Marx’s excluded, was the concept of equilibrium. Alfred Marshall’s graphs specified where the equilibrium would be between supply and demand. Economists who wrote about the business cycle had graphs of their own, showing waves that rose and fell above and below an axis of equilibrium. Most theories described a tendency of economies to return to equilibrium when knocked out of it.

Keynes observed economies that refused to return to equilibrium, to climb out of the troughs in which they found themselves. He proposed a theory to explain this behavior.

His key concept was aggregate demand. This was the macroeconomic counterpart to Marshall’s microeconomic demand. The defining characteristic of a depression, Keynes said, was a shortfall in overall demand. An important customer of a manufacturer curtailed its usual order. The manufacturer responded by laying off workers. The workers cut back on household spending. The shops they frequented lost revenue and laid off some of their workers. The spiral continued, and the aggregate effect was a depression.

During previous depressions, the decline in aggregate demand had not been so great as to threaten the entire system. The healthy sectors of the economy carried the system until the wounded sectors recovered.

This time was different. Demand was so deficient that prices kept falling and falling. When prices fall, even people with money have an incentive not to buy, but rather to wait until prices fall more before they buy what they need. Their thriftiness, admirable on an individual scale, aggravates the deficiency in demand and makes things worse.

What to do?

Keynes nominated government to be the purchaser of last resort. When individuals refused to buy, government should step in. From the standpoint of Keynes’s theory, what the government bought didn’t much matter. But the politics surrounding any such action pointed toward fixing roads, building bridges and schoolhouses and tackling other projects that often went begging.

The money spent would have a multiplier effect. An unemployed worker hired by the government and paid $100 would spend nearly all that money supporting his family. The merchants who received his payments would pay their employees and vendors, who in turn would spend the money. The $100 of government money might produce $300 or $400 of new economic activity.

Keynes and others likened this to priming a pump. A pump that stops has to have water poured in for it to restart. This small amount of water allows the device to pump a much greater amount once it gets going.

To many people, Keynes’s counsel seemed dangerously wrongheaded. The depression had slashed tax revenues, throwing governments into deficit. The responsible thing to do was to cut government spending and tighten government belts. Keynes was saying governments should do the opposite. This road would lead to ruin.

Not so, said Keynes. The deliberate deficit would be temporary. Once the pump was primed, the water would start flowing. Prosperity would return. When it did, governments could pay back the debts they had incurred. During good times, governments should spend less than they took in. This countercyclical budgeting would balance in the long run and offset the ups and downs of the business cycle.

Keynes laid out all this and more in his 1936 General Theory of Employment, Interest and Money. He sent a copy to Franklin Roosevelt, who thanked him but kept his distance. Roosevelt was not the one to pioneer Keynes’s counterintuitive strategy. In fact, Roosevelt did just the opposite. In 1937 he took measures to cut spending rather than increase it. The result was a reversal of most of the progress that had been made since the bottom of the depression.

Yet Roosevelt found his way to Keynes’s policy by a back door. As Europe and Asia went to war, the president persuaded Congress to appropriate money for American defense readiness. This increased the deficit and produced the effect Keynes had predicted. The effect intensified after the United States itself went to war in 1941. Shortly the Great Depression was a memory and full employment a reality.

Notwithstanding the war experience, the United States never embraced the full Keynesian model. Nor did other countries. Governments got used to running deficits in downturns, but they never mastered the flip side of running surpluses in good times.They simply spent the extra revenues.