Wednesday, September 11, 2013

Is The Economy Self Adjusting?

Its all too common to find people who have never read Keynes, and who have been misinformed about his essential ideas, claim that he was an advocate for big government and large government budget deficits.  This article written by Keynes just prior to his publication of his General Theory, may contribute to a better understanding of his economic thinking which attacked the prevailing economic theories which assumed a self-correcting economy which provided full-employment in the long term.

The article was written in 1935 during the Great Recession, and during an even longer period between the two great wars when Britain suffered from an extended period of unemployment.  The conventional wisdom at that time was that prices would adjust automatically so that long term periods of unemployment were not possible.  The fact of high unemployment in this period led Keynes and others to question the wisdom of economic theories which suggested that the economy was self adjusting.  Keynes, and his fellow critics, came to believe that the economy was not self-adjusting even in the long run.  He provides his reasons for departing from conventional wisdom in this article and explains why he decided to become one of the "cranky heretics" who questioned the assumptions behind the self-regulating economy.

The conventional wisdom at that time was based upon the theories of Say and Ricardo which supported the concept of the self-adjusting economy.  Keynes also made the point that Marx's critique of capitalism was based upon his understanding of Ricardo's theory, which led him to argue that the contradictions in capitalism would lead to its demise.  Keynes was hopeful that a modified form of capitalism could provide for full-employment and maintain many of the advantages of capitalism.  To do so, however, he had to attack the conventional wisdom that assumed a self-adjusting economy that led to full-employment in the long-term.

Most economists realized that there was excess capital and labor.  Therefore, there was not a problem if insufficient capital.  The basic problem was insufficient demand.  Keynes attacked the assumption of self adjusting prices, including the rate of interest, which supported the concept of the self-adjusting economy.  He argued that the interest rate could be adjusted by government to increase consumption and demand for residential housing.  He understood that personal consumption could also stimulated by policies which provided more disposable income to those with a higher tendency to spend a larger share of their income.  He was concerned, however, with creating an imbalance between consumption and capital investment.  Therefore, he argued that lower interest rates would encourage capital investment which would be made available to satisfy growing consumer demand.  He also believed that unconventional fiscal policies  could be used to stimulate demand.

Keynes elaborated on the ideas in this article when he wrote The General Theory in the following year, but the essence of his thinking, which focused on the determinants of demand,  and the fallacy of the self-correcting economy at full-employment were captured in this article, as well as the arguments used by conventional economists against government interventions that would keep the economy from self-adjusting.

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