The Rise and Fall of Keynesianism

By the end of the Great Depression, faith in the laissez-faire market had fallen. Politicians and policy makers were looking for a new system to not only fix the economy but to secure their place against the rise of Communism and Fascism. John Maynard Keynes (1883-1946), with his penchant for practical economics and policy, was instrumental in the planning of Britain’s economy during both World Wars. His theory, which came to be known as Keynesianism, basically argued that state-intervention was needed to avert market failure and guarantee full employment.[1] By the 1950s, much of the world had adopted his theories and became a part of what was called the ‘Keynesian Consensus’. This was alongside a ‘Golden Age of Economic Growth’ – seemingly validating the theories of the Keynesian Consensus. But, after decades of state-intervention, nations began moving back towards unfettered free market economies. The justifications of 40s economists was no longer sufficient to maintain a state-interventionist economy.[2] This essay will be examining the causes of these shifts and how world events may have influenced them.

Keynesianism ultimately rose as a result of Keynes’ activism alongside major world events; its fall can be attributed to the transient nature of its implemented policies, which result was sparked by world events.

The rise of Keynesianism can be attributed to distrust in unregulated Capitalism borne from the Great Depression, the apparent success of Keynesian theory during wartime and the focus on gaining political acceptance. Its fall can be accredited to the nature in which Keynesianism was implemented, the existence of Stagflation, the rise of the Chicago School and the ascension of Capitalist-leaning world leaders.

The failure of unregulated Capitalism during the Great Depression created a vacuum wherein Keynesianism could gain a foothold. By the 30s, there was a general consensus among economists that the depressed economy would need government intervention to become revitalised.[3] Mass unemployment turned Keynes’ focus from monetary policy to the problem of employment. With his “General Theory”, Keynes challenged the Classical Theories of economics.[4] Keynes argued that markets could not automatically correct themselves and would have to face government intervention to serve society to the fullest. Keynes’ ideas permeated to many of the young economists of the age.

John Kenneth Galbraith (2000) was one such Keynesian among a network of young economists aiming at promoting Keynesian policy in America. Galbraith described the incumbent President, Roosevelt, as an ‘available Keynesian’ – while, as Roosevelt accepted the policies of Keynesianism, which ignored the dangers of debt in favour of alleviating unemployment, he ignored its underlying theory. [5]

The Keynesian theory opposed the conservative fiscal policies of the treasury and many policy makers, leading to slow adoption by the state – but the adoption of some Keynesian ideals within the New Deal gave it the legitimacy that it needed to grow. Despite the adoption of Keynesian theory with regards to public employment and state-planning, it would take further validation of Keynesian theory for it to entrench itself into government policy completely.

Despite ‘wartime prosperity’ being a fallacy, Keynesians were able to convince politicians that the economic growth seen during WW2 proved their theory of beneficial deficit spending. The concept of ‘war prosperity’ is the belief that a state of ‘total war’ can be good for the economy due to the full employment of resources and production. America’s entry into WW2 saw Gross National Product (GNP) rise considerably and unemployment sink to a record low. Keynesians claimed that this validated their theories.[6] Spending on the military had risen considerably, funded by deficit, and Keynesians maintained this was what managed to end the depression.[7]

Evidence exists to refute the Keynesian connection with ‘wartime prosperity’. Higgs (1995) argued that mass conscription was the true alleviator of unemployment and that an outdated system of counting military spending into the GNP contributed to the apparent economic success. In actual fact, the war harmed civilian production which suffered as a result of rationing and a severe opportunity cost.[8] Keynesians, also, proved to be wrong again when they predicted that the end of the war would cause a depression. Despite this, the economy went through an unprecedented boom. Keynesians, however, were able to shift their previous prediction and claim credit for predicting the boom.[9]

In England, successful wartime planning in the economy gave the Labour Party a strong platform which allowed Attlee to defeat the incumbent Prime Minister, Winston Churchill. The planned economy had ‘won the war’ and Labour Party advocates such as Barbara Castle argued that it could “win the peace”.[10] Attlee’s victory resulted in the nationalisation of industry and the rise of a welfare state. Keynes’ idea of humane and regulated Capitalism was becoming policy.

The success of the Keynesians can, ultimately, be attributed to their focus on promoting their policies directly to politicians – who found the ease of gaining public support through deficit spending appealing. Both during and after World War 2, the threat of Communism and Fascism posed a problem to liberal democracy. Rather than an actual belief in the system, Skidelsky (2009) argued that the adoption of Keynesianism was mostly borne from convenience. For business leaders, it served as a barrier to socialism and for politicians, it justified larger defence budgets.[11] Keynes’ influence in the creation of the Bretton Woods System further led to a legitimisation of his policies.[12]

It must be noted, however, that the implementation of Keynes’ theories should not be accurately attributed to his true ideas but rather the unfortunate nature of practical politics. In an effort to spread their ideas, Keynesians had allowed policy makers to bastardise their theories.[13] What came to be known as ‘Military Keynesianism’ was popular, especially as a result of the Cold War, for justifying large defence budgets.[14] Much of the theory had been sacrificed for practical policy which benefitted the policy makers. More focus was centred on planning and spending, rather than sound economic judgement. This led to huge deficits and warning signs of inflation, both of which were excused as minor problems by Keynesians who, in their theory, believed inflation to be a small price to pay for decent levels of employment. This lack of concern for deficit or rising inflation leads to Keynesian policy being highly transient. Very few resisted this Consensus as the world went through a Golden Age of Economic Growth until the 70s.[15]

The existence of Stagflation contradicted Keynesianism and brought its implementation into disrepute.[16] From the beginning, the Austrian School had condemned the practice of manipulating the economy. To them, the economy was a rule of nature. Tampering with it could only bring harm in the long run.[17] Keynesians argued that inflation was a small price to pay for full employment and that demand management would keep it sustainable. The advent of stagflation – an unprecedented combination of unemployment, stagnation and inflation – disproved this theory.[18] Stagflation proved to be highly unsustainable and, with the Oil Shocks of the 70s, an economic crisis forced policy makers into action.[19]

The collapse of the Bretton Woods system had already discredited Keynesianism and the reinvigoration of nations after its removal further belied Keynes’ image.[20] Inflation was already a problem as the price of goods soared under Keynesian Consensus policies, but the Oil Shocks were what sparked a massive economic crisis.[21] The high oil prices, as a result of the Oil Shocks, made inflation too much to bear by most households, as necessities became too expensive. As a result, trust was dwindling in the mixed economy and the intellectual opposition of the Chicago School was gaining credibility worldwide against the Keynesian Consensus.

The Chicago School, with economist Milton Friedman at its helm, was instrumental in discrediting the Keynesian Consensus and providing an alternative. Inspired by Hayek, who had been a Professor there years before, and his book Road to Serfdom, the Chicago School espoused the virtues of free markets and sound monetary policy.[22] The Chicago School filled the vacuum that the Keynesian Consensus had left behind. With the Conservative Party abandoning their Keynesian-inspired macroeconomic goals in 1979 and both Britain and the USA suffering from stagflation, the Chicago school and neoliberal economics seemingly provided an alternative solution.[23] The ideology that formed this solution was called ‘Monetarism’. Monetarism rejected the theory of demand management and espoused the importance of free markets and sound monetary policy.[24]

Distrust in a mixed economy and the intellectual influence of the Chicago School led to the rise of leaders such as Britain’s Margaret Thatcher and America’s Ronald Reagan. Even if some of their policies were not neoliberal in nature,[25] they became the spearheads of neoliberalism in the late 20th century, becoming the strongest proponents for free markets worldwide.[26] Their rise to power was not only a victory for the Chicago School but also for those wishing to crush stagflation.

Paul Volcker, Chairman of the Federal Reserve, saw inflation as a threat to America. He was inspired by Monetarism and, with Reagan’s support, used its polices to instate countermeasures against inflation. This culminated in a short recession and Volcker became increasingly unpopular, but he eventually reached his goal and slew the “inflationary dragon”.[27]

World events such as the Great Depression, World War 2, the Cold War and the Oil Crisis did have a profound effect on the rise and fall of Keynesianism. Its rise can mostly be attributed to Keynesians fervour and ability to convince politicians to adopt their policies in light of the Great Depression and World War 2. Its fall can be attributed to the bastardisation of its original theory by politicians and the advent of stagflation, sparked by the Oil Shocks. Keynesianism’s replacement, the Chicago School, also had a huge role in convincing leaders to change their economic policies, in a similar vein to Keynesian economists.

Both the rise and fall of Keynesianism highlights the power of ideas but also their vulnerability to world events and human manipulation. Keynesianism was founded as a virtuous answer to a system perceived as exploitative and unstable, but its desperation to become policy resulted in its bastardisation. The Chicago School and neoliberalism can also be said to have followed the same route of state-led bastardisation but the general consensus has become that private enterprise rather than state-intervention is the way forward in the economy.

Bibliography

  • Clarke, Simon “Chapter 9: Economists and the State: The Keynesian Revolution.” In Keynesianism, Monetarism and the Crisis of the State. 221-286. Aldershot, England: Edward Elgar Publishing Ltd., 1988.
  • Episode One: The Battle of Ideas. Commanding Heights PBS. Accessed May 8, 2015. http://www.pbs.org/wgbh/commandingheights/shared/minitext/tr_show01.html.
  • Frieden, Jeffrey. Global Capitalism. New York: W.W. Norton, 2006.
  • Higgs, Robert. World War 2 and the Triumph of Keynesianism. The Future of Freedom Foundation. Accessed May 8, 2015, http://fff.org/explore-freedom/article/world-war-ii-triumph-keynesianism/.
  • Jan, Sarwat., Ahmed Saber Mahmud and Chris Papageorgiou. What Is Keynesian Economics?. International Monetary Fund. Accessed May 10, 2015. http://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm.
  • John Kenneth Galbraith. Commanding Heights PBS. Accessed May 8, 2015. http://www.pbs.org/wgbh/commandingheights/shared/minitext/int_johnkennethgalbraith.html.
  • John Maynard Commanding Heights PBS. Accessed May 8, 2015. http://www.pbs.org/wgbh/commandingheights/shared/minitextlo/prof_johnmaynardkeynes.html.
  • Middleton, Roger. “The Rise and Fall of the Managed Economy.” Refresh, 10 (1987): 5-8.
  • Shleifer, Andrei. “State versus Private Ownership,” Journal of Economic Perspective 2, no. 4 (1998): 133-150.
  • Skidelsky, Robert. Keynes: The Return of the Master. London: Allen Lane, 2009.
  • William A. Niskanen. “Reaganomics.” The Concise Encyclopedia of Economics (1988): 1-4. econlib.org/library/Enc1/Reaganomics.html. Accessed April 1, 2011.
  • Yergin, Daniel and Joseph Stanislaw. The Commanding Heights. New York: Simon and Schuster, 1998.

Footnotes

[1] Daniel Yergin and Joseph Stanislaw. The Commanding Heights (New York: Simon and Schuster, 1998), 127.

[2] Andrei Shleifer, “State versus Private Ownership,” Journal of Economic Perspective 2, no. 4 (1998): 135.

[3] Roger Middleton, “The Rise and Fall of the Managed Economy,” Refresh no.5 (1987): 6.

[4] John Maynard Keynes, Commanding Heights PBS, accessed May 8, 2015, http://www.pbs.org/wgbh/commandingheights/shared/minitextlo/prof_johnmaynardkeynes.html.

[5] John Kenneth Galbraith, Commanding Heights PBS, accessed May 8, 2015, http://www.pbs.org/wgbh/commandingheights/shared/minitext/int_johnkennethgalbraith.html.

[6] Robert Higgs, World War 2 and the Triumph of Keynesianism, The Future of Freedom Foundation, 1, accessed May 8, 2015, http://fff.org/explore-freedom/article/world-war-ii-triumph-keynesianism/.

[7] Ibid., 1.

[8] Ibid., 2.

[9] Ibid., 3.

[10] Episode One: The Battle of Ideas, Commanding Heights PBS, 7, accessed May 8, 2015, http://www.pbs.org/wgbh/commandingheights/shared/minitext/tr_show01.html.

[11] Robert Skidelsky, Keynes: The Return of the Master (London: Allen Lane, 2009), 103.

[12] Episode One: The Battle of Ideas, 6.

[13] Skidelsky. Keynes: The Return of the Master, 104.

[14] World War 2 and the Triumph of Keynesianism, 4.

[15] Yergin and Stanislaw. The Commanding Heights, 128.

[16] Sarwat Jan et al., What Is Keynesian Economics?, International Monetary Fund, accessed May 10, 2015, http://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm.

[17] Simon Clarke, “Chapter 9: Economists and the State: The Keynesian Revolution,” in  Keynesianism, Monetarism and the Crisis of the State (Aldershot, England: Edward Elgar Publishing Ltd., 1988): 225.

[18] Yergin and Stanislaw. The Commanding Heights, 129.

[19] Jeffrey A. Frieden, Global Capitalism (New York: W.W. Norton, 2006), 366.

[20] Ibid., 364.

[21] Yergin and Stanislaw. The Commanding Heights, 129.

[22] Ibid., 146.

[23] Middleton, “The Rise and Fall of the Managed Economy,” 7.

[24] Ibid., 8.

[25] William A. Niskanen. “Reaganomics.” The Concise Encyclopedia of Economics (1988): 3, www.econlib.org/library/Enc1/Reaganomics.html. Accessed April 1, 2011.

[26] Episode One: The Battle of Ideas, 19.

[27] Ibid., 4.