In Praise Of Keynes

Bloomberg Business Week provides a clear and cogent description of the macro economy that was invented by Keynes (with some help) to explain the Great Depression and the problem of restoring full employment.  Keynes viewed the economy in terms of the spending by households, business and government.  Recessions occur when one or more of these sectors decide to spend less and increase their savings.  The "Paradox of Thrift" explains why savings, which is necessary in an economy, and is regarded as a virtue when it applies to individuals,  can lower aggregate demand below the level required for full employment.  Ordinarily, the central bank can use monetary policy to restore spending and increase employment.  Conventional monetary, however, loses its effectiveness when interest rates approach zero.  Keynes explained how fiscal policy can prime the pump and create the conditions for aggregate demand to rise to the level required for full employment.  He also argued that governments should run budget surpluses in good times so that they have the means to run budget deficits during deep recessions.

The success of Keynesian theory in explaining the recovery from the Great Depression led to wide acceptance of his theory.  Some economists, particularly those at the University of Chicago, objected to Keynesian theory for a variety of reasons.  They favored a view of the economy that did not require an active role by the government.  They also wanted to explain the macro economy in the terms of the micro theories that they knew and loved.  That is, they hoped to reduce macro economic theory to micro theory as one might reduce chemistry to physics.  Over time, they won the debate within the academy and most of the research in macroeconomics was focused on the development of models based upon the key assumptions embedded in microeconomics.  They won the academic debate, but the models founded on micro economic assumptions have been less than useful in forecasting macroeconomic events like recession and inflation.  Nevertheless, economists schooled int this tradition have powerfully resisted the use of fiscal policy to restore aggregate demand.  They favor supply side theories which argue for structural changes in the economy.  Unfortunately, structural changes take a long time to implement.  Moreover, the intent is to make a nation's economy more competitive so that growth can be restored by increasing exports and running current account surpluses.  Keynes argued that this could not restore global economic growth. It is impossible for every country to run trade surpluses because the sum of surpluses and deficits must be equal to zero.