Keynesian Economics

We (Lara and Murphy) are adherents of the Austrian School of Economics, which adopts an individual “micro” framework in order to understand the importance of free markets, sound money, and private saving. In total contrast to the Austrian School is the Keynesian School, which derives its name from John Maynard Keynes (1883-1946). The Keynesian School endorses government intervention and inflation, and it often blames saving for hurting economic recovery.

Keynes the man is one of the most influential economists of all time, though Austrian scholars would say this influence was very unfortunate. His most famous work was The General Theory of Employment, Interest, and Money—often simply abbreviated as “The General Theory”—which came out in 1936, in the heart of the Great Depression.

To understand the bold rhetorical move that Keynes made in his famous book, we must remind the reader of the huge impact that Einstein’s theory of relativity had had on the academics of that time. (The two components of Einstein’s theory were published in 1905 and 1915.) Einstein’s new framework for physics definitely overturned classical mechanics as Isaac Newton had formulated, but it did so by paying homage to the old giant: At “normal” (for human experience) velocities and masses, the equations in Einstein’s system “reduced to” Newton’s laws. So Einstein’s breakthroughs simply made the old classical physics a “special case,” in contrast to Einstein’s more general framework. In this view, Newton was still a great thinker, but he had only described a small portion of natural phenomena.

This is what Keynes claimed to be doing in economics, with his general theory. Keynes argued that the old classical economists were right when they praised the virtues of the free market, and when they claimed that additional government spending would crowd out private spending and not create more new jobs—so long as we were operating at “full employment.” In other words, Keynes thought the classical economists did a good job explaining how a market behaved in “normal times.” To hear Keynes describe matters in his book, Adam Smith and J.B. Say were great thinkers, but they were only describing a portion of economic phenomena.

By the time the General Theory came out in 1936—seven years after the great stock market crash of 1929—it seemed to many observers that capitalism had failed. Keynes offered an explanation, claiming that an economy could get stuck in a rut if there were inadequate “Aggregate Demand.” Without enough total spending in the economy to buy all of the products that businesses were able to create, Keynes warned that factories would remain idle and workers would remain unemployed.

The solution to massive unemployment, according to Keynes, was for the government to step in and spend money. Ideally the government would buy useful things (such as bridges and schools) but in the extreme, Keynes argued that “prudent” purchases were not necessary for his argument. To drive home his point, Keynes went so far as to propose that the government put money in jars and then bury them in abandoned coal mines, so that businesses would hire workers and employ excavation machinery in order to dig the bottles up. Keynes actually believed that this would be a better government policy in the midst of a depression compared to “doing nothing” and waiting for the economy to naturally heal itself.

Because Keynesian economics diagnoses recessions as being due to inadequate spending, it follows that saving is deplored in this framework. In the Keynesian view, when workers save their paychecks, they are not out in the community spending money and stimulating businesses. The official term is the “Paradox of Thrift,” in which the community tries to do the prudent thing by saving more, but this only ends up making the recession worse.

To be sure, Austrian economists have critiqued the so-called “Paradox of Thrift” and identified its flaws. In this blog post we simply want readers to be aware of the difference between Austrian and Keynesian economics. Even though the Austrian approach lines up with common sense, notice that our major universities, government posts, and media typically espouse a Keynesian position. This is why analysts on CNBC fret about retail sales in December, and economists care about surveys of “consumer optimism.” The Austrians recognize the importance of saving, especially in times of crisis, whereas the Keynesians focus on boosting spending, regardless of its composition.

For more information on the Austrian approach, and for a reading list covering the topics we have mentioned above, see our post on the Austrian School of Economics.