Keynesianism

The Great Depression was the empirical refutation of classical liberalism's most confident claim: that markets, left to themselves, would self-correct and return to full employment. By 1933, US unemployment stood at 25%. European economies were in comparable distress. The gold standard, which constrained governments' ability to expand money supply or run deficits, converted a severe recession into a prolonged catastrophe. Something in the classical account was deeply wrong.

John Maynard Keynes's General Theory of Employment, Interest and Money (1936) provided the diagnosis and the remedy. Markets did not automatically clear; aggregate demand could fall short of full-employment output and remain there indefinitely. The culprit was investment volatility: businesses invested based on expectations about future returns, and those expectations could become collectively pessimistic in ways that were self-fulfilling. When investment collapsed, income fell, which validated the pessimism that had caused investment to collapse in the first place.

The remedy Keynes prescribed was government intervention to maintain aggregate demand when private investment faltered. Fiscal policy -- government spending and taxation -- could substitute for deficient private investment. In a depression, when the private sector was paralyzed by pessimism and liquidity preference (the preference to hold cash rather than invest), government spending could provide the demand that private actors would not. The "multiplier effect" meant that government expenditure would generate more than its face value in economic activity as the initial spending circulated through the economy.

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.John Maynard Keynes, The General Theory (1936)

Keynesianism shaped postwar economic policy in the United States and Western Europe, producing -- in conjunction with the institutional framework of Bretton Woods, strong labor unions, and regulated finance -- the most sustained period of broad-based prosperity in American history. From 1945 to roughly 1973, median incomes grew rapidly, inequality declined, and unemployment remained low. This period is remembered, with some nostalgia, as the postwar golden age.

The stagflation of the 1970s -- simultaneous inflation and unemployment, which Keynesian models did not predict -- provided the intellectual opening for a counterrevolution. Critics argued that Keynesian demand management had produced wage-price spirals, fiscal profligacy, and structural rigidities. The more penetrating analysis, which the counterrevolution's victors did not advertise, was that Keynesianism had also produced full employment -- which, by reducing worker desperation, had strengthened labor's bargaining power and compressed the profit share of income. The restoration of employer power was a political project as much as an economic one.