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Keynesian Theory

Mar 18, 2017 by Dwaipayan Bose | 107 Downloaded
Picture courtesy - PIXABAY

British economist, John Maynard Keynes, is perhaps the most influential economist since the birth of economics as a separate social science discipline in the late 1700s. His definitive economic treatise, The General Theory of Employment, Interest and Money, published in 1936, is central to modern macro-economic thought. The crux of Keynes’ theory of employment, interest and money, also known as the Keynesian Theory, is that aggregate demand determined a country’s GDP. Though the theory seems intuitive, if stated as such, it challenges the fundamental tenet of classical economics, individuals always maximized utility. The most important corollary of Keynesian theory is that, Government intervention could moderate economic cycles and bring a country out of recession. To understand Keynesian Theory in relation to other schools of economic thoughts, let us take a brief walk down the history of evolution of economics.

Classical Economics

Economics as separate discipline was born in the late 18th century, when Adam Smith, known as the father of economics, published his epic work, The Wealth of Nations. From a historical, Adam Smith’s work was published when the Industrial Revolution (mechanized system of production) had begun in Europe and new economic system was taking shape, Capitalism. The economic framework explained in “The Wealth of Nations” is regarded as the fundamental basis of capitalism. Theeconomic principles theorized by Adam Smith is known as classical economics. The basic premise of classical economics is that, an economic system, when left to itself without any intervention by the Government, will be able to regulate itself and produce the maximum output. As per Adam Smith, the food that we eat is not due to benevolence of the baker; the baker is producing food grains for his own interest. In the classical economics, every member in an economic unit works in their self-interest and in the absence of Government will allocate resources in the most efficient manner.

Classical economists postulate that, that, when people are given the freedom to buy or sell, goods or services, as much as they please, individual’s self interest will propel the nation to prosperity. Classical economists advocate free market, free trade, low taxes, minimum Government regulations and spending. Prosperity of western nations, due to Industrial Revolution in the 19th century, was driven almost entirely by private enterprise and therefore, classical economics is seen as the foundation stone of capitalism. The best testimony to classical economics is the growth of a young nation, United States of America, to an economic superpower in the late 19th century, based on the economic framework of free market, trade and minimal Government intervention, as enshrined in the American constitution.

Neo-classical Economics

The next stage of evolution of economic thought beginning in the late 19th century is known as neo-classical economics. Though neo-classical economics is built on classical economics, it is a distinct school. Like in classical economics, free market, free trade and minimum Government intervention is central to neo-classical economics also. A major difference between classical economics and neo-classical economics is in how goods are priced. Classical economists like Adam Smith postulated that goods are priced based on the cost of raw material, electricity, labour, rent and the owner’s profit. In neo-classical economics the price is governed by demand and supply.

Neo-classical economics is based on three fundamental assumptions. Firstly, neo-classical economists believe that, individuals are rational and always act in a manner to get the maximum utility from their income. Secondly, they believe that, firms always try to maximize profits. Finally, they assume that, individuals act independently of each other on the basis of full information. To understand this with the help of an example, let us assume that you want to buy a shirt. Since you want maximum utility, you will try to buy it at the lowest possible price. The shop keeper will try to sell it you at the highest possible price, to maximize profits. Since, you want to buy and the shop-keeper wants to sell, both of you will arrive at a price that is mutually acceptable. If there are many people who want to buy the shirt that you want to buy (high demand), but only a limited number of shops sell the shirt (low supply), the price of the shirt will be higher. If there are few people who want to buy the shirt (low demand), but many shops are selling the shirt (low supply), then the price of the shirt will be lower.

One of the most important concepts of neo-classical economics is equilibrium, which is point at which demand and supply balances and prices are determined. In neo-classical economics this price is known as the market clearing price or simply market price. Readers, who trade in stocks, see this phenomenon in action every day in stock. The economics discipline of micro-economics (which explains economic activities of individuals and firms) is based on neo-classical economics. An important characteristic of neo-classical economics was that, the theories were mathematical in nature. The common perception in academia is that, a theory explained by mathematical equations theory is always robust; but is it?

Keynesian Economics

The post civil war economic boom in the United States from 1870s right up to 1930 coincided with the neo-classical age in economics. Neo-classical economists believed that, the equilibrium (which we explained above) in the long run will ensure that individuals are able to buy at cheapest price and firms will be able to produce goods on a continuous basis, thereby enabling employment and economic growth.

The 1920s was a great period for stock markets in the US, but on October 29, 1929 the stock market crashed by 12% and by the next 3 years, the Dow Jones had fallen 90% from its 1929 high. The stock market crash of 1929 marked the beginning of a severe recession in the US. Readers of our blog may be familiar with recessions; normally it lasts for 2 – 3 maximum, but that recession lasted for 10 years and therefore, it is known as the Great Depression. The effect of Great Depression was not just limited to the United States, but it spread all over the world.

The effect of Great Depression was especially severe in India; the policies of the British Raj during the Great Depression made it worse. Trade worsened and the impact on the Indian farmer in the 1930s was especially severe as the Raj increased the rent to compensate for loss of revenues through trade. Some Indian historians believe that the Civil Disobedience movement led by Mahatma Gandhi was a by-product of the sufferings of Indians in British Raj during the Great Depression.

John Maynard Keynes challenged the tenets of neo-classical economicsbecause it could not explain the Great Depression. In neo-classical economics, if demand falls the price of goods will also fall, which will increase demand and bring the economy back to equilibrium. If this theory is true, Keynesians argue, why did we not, see this phenomenon in action during the Great Depression? Why did the economy not come back to equilibrium for a long period of time? The central hypothesis of Keynesian theory is that, there can be situations (during recessions) where price and demand, will not automatically correct and bring the economy to normal equilibrium; in such situations, the economy will remain depressed for a long period of time. Though equilibrium may exist in such conditions, it will not be a normal equilibrium but a dismal equilibrium and high unemployment is the root cause of such a situation.

Keynes did not just diagnose the root cause of Great Depression, he also provided a solution and that is why he is considered the most influential economist of all times. Keynes saw excessive savings relative to investments (we have explained the difference between savings and investments in our blog before) as a serious problem, encouraging recessions and unemployment. In a democracy, you cannot force people to invest and so Keynes postulated that the Government must invest to make up for the shortfall in private investment. The response of the Republican Government in the US, led by President Herbert Hoover, to the recession in 1930s, cutting Government expenditure to make up for revenue shortfall was disastrous and worsened the recession; thousands of banks failed and the law and order situation worsened in the country. In the Presidential elections in 1932, Hoover was resoundingly defeated by Democrat nominee Franklin Delano Roosevelt, who whole-heartedly embraced Keynesian theory. Roosevelt’s economic policy, known as the New Deal, was based on Keynesian principles, and involved massive spending in infrastructure projects like interstate highways, bridges, ports etc. Infrastructure spending by the Government created jobs and put money in the hands of people. More money in hands of people, due to higher employment, increased aggregate demand, incentivized private sector capex and consequently higher levels of employment in the economy. New Deal was successful in pulling the US out of a severe decade long recession and is a fitting testimony to the effectiveness of Keynesian economics. Keynesian theory was adopted by the countries in Western Europe after World War II and the post World War II period saw unprecedented GDP (and prosperity) growth in Europe and America.

I would like to draw our reader’s attention now to the infrastructure spending in our Union Budget. The 2017 Budget plans for a massive Rs 4 Trillion investment in infrastructure comprising of highways, railways, waterways and civil aviation. This is on top of Rs 2.2 Trillion spending in the 2016 Budget. Infrastructure spending by the Government usually does not have an immediate impact on aggregate demand and make a significant difference to the employment rate, but experience in the US from the 1930s has shown that, over a period of time, it has the potential to boost economic growth and employment. Some readers may think, why is it taking so long for our Government’s fiscal measures to translate into economic growth (GDP)? The US example shows us that, fiscal policy cannot instantaneously result in GDP growth; it takes time.

Another important aspect of Keynesian theory is with respect to monetary policy. Keynesian theory of interest is based on the demand and supply of money. As per the Keynesian theory, increase in money supply will result in economic growth only if prices are somewhat rigid. Keynesian economists suggest that, if prices are not rigid money supply will only cause inflation. In Keynesian economics, fiscal policy is therefore, more important than monetary policy.

Criticism of Keynesian theoryby later economists

Keynes’ theory came in for criticism from later economists, particularly Nobel Laureate, Milton Friedman, who believed in the primacy of monetary policy over fiscal policy. Friedman studied the examined the role of money supply and GDP in the US, and postulated that, in the short run effect of change in money supply was on GDP growth and only in the long run on prices (inflation). Milton Friedman correctly predicted slowdown in economic growth along with high inflation (known in economics parlance as stagflation) in the 1970s; a phenomenon which was witnessed by India also in the late 70s and also to a limited extent in the last few years of the UPA – 2 regime.

Economists who believe in the Friedman school of thought are known as monetarists and advocate the use of monetary policy over fiscal policy in economic growth. Monetarists favour price stability to moderate economic cycles and advocate that the central bank should focus on inflation only. The monetarist view influences the monetary policies of most central banks, including the Fed and the RBI. The very successful economic policies followed by US and UK Governments in the 1980s, led by President Ronald Reagan and Prime Minister Margaret Thatcher respectively, were based Friedman’s economic thought. The success of Reagan’s economic policies (also known as Reaganomics) also led to the development of an extension of neo-classical economic school, known as new classical economics. New classical economics emphasized on micro-economics (role of individual and firms). New classical economics accepted the Keynesian paradigm of price rigidity and also accepted the monetarist view with regards to the effect of money supply on GDP in the short run.

Resurgence of Keynesian Theory and Conclusion

However, Keynesian economics saw a huge resurgence in the wake of the Economic Crisis of 2008. Some of readers will know that, the financial crisis of 2008 was unprecedented in scale in many decades. It was the worst financial crisis since the Great Depression. Many countries around the world, to a limited extent, India as well, are still feeling the after effects of the Economic Crisis of 2008. Within a few months of the Lehman Brothers collapse, which marked the nadirof the financial crisis, governments around the world realized that, monetary policy by itself will not be able to drag countries around the world out the recession. There was a global move towards Keynesian fiscal stimuli provided by the Governments. Government stimuli lead to fiscal deficits, but it was necessary to drag economies around the world, including India, out of recession.

Keynesian theory today, again serves as the foundational basis for fiscal policies of most Governments around the world including, the current BJP led NDA Government in India. As discussed earlier, the Government is spending massive amounts on infrastructure development. In the medium term, we hope to see the effects of Keynesian policies of the Government on our GDP growth. The green shoots of recovery in our economy due to Government policies are already visible in the corporate earnings across a number of sectors. This will benefit industries across a vast swathe of sectors, which will benefit equity investors. As I am finishing this post, the Nifty is at an all time high, above 9100. The Golden Age of capitalism in the West was triggered by Keynesian theory and lasted for at least 30 years. However, the growth story of India is still in its early youth. This should be a great time to invest in equities in India.

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Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development

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