Active fiscal policy

As noted,[clarification needed] the classicals wanted to balance the government budget. To Keynes, this would exacerbate the underlying problem: following either the expansionary policy or the contractionary policy[clarification needed] would raise saving (broadly defined) and thus lower the demand for both products and labour. For example, Keynesians would advise tax cuts instead.[11] Keynes' ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction. But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s. Keynes developed a theory which suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called countercyclical fiscal policies, that is, policies that acted against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because, "in the long run, we are all dead."[12] This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal stimulus could actuate production. But, to these schools, there was no reason to believe that this stimulation would outrun the side-effects that "crowd out" private investment: first, it would increase the demand for labour and raise wages, hurting profitability; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating. The Keynesian response is that such fiscal policy is appropriate only when unemployment is persistently high, above the non-accelerating inflation rate of unemployment (NAIRU). In that case, crowding out is minimal. Further, private investment can be "crowded in": Fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation. Second, as the stimulus occurs, gross domestic product rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-term growth of potential output. In Keynes's theory, there must be significant slack in the labour market before fiscal expansion is justified. Contrary to some critical characterizations of it, Keynesianism does not consist solely of deficit spending. Keynesianism recommends counter-cyclical policies.[13] An example of a counter-cyclical policy is raising taxes to cool the economy and to prevent inflation when there is abundant demand-side growth, and engaging in deficit spending on labour-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns. Classical economics, on the other hand, argues that one should cut taxes when there are budget surpluses, and cut spending—or, less likely, increase taxes—during economic downturns. Keynesian economists believe that adding to profits and incomes during boom cycles through tax cuts, and removing income and profits from the economy through cuts in spending and/or increased taxes during downturns, tends to exacerbate the negative effects of the business cycle. This effect is especially pronounced when the government controls a large fraction of the economy, and is therefore one reason fiscal conservatives advocate a much smaller government. "Multiplier effect" and interest rates Main article: Spending multiplier Two aspects of Keynes's model has implications for policy: First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. Exogenous increases in spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A government could stimulate a great deal of new production with a modest outlay if: The people who receive this money then spend most on consumption goods and save the rest. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase in consumer spending. This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: The rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect. Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determines the amount of fixed business investment. That is, under the classical model, since all savings are placed in banks, and all business investors in need of borrowed funds go to banks, the amount of savings determines the amount that is available to invest. Under Keynes's model, the amount of investment is determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But, during more "normal" times, monetary expansion can stimulate the economy.[citation needed] [edit]IS/LM model The IS/LM model is nearly as influential as Keynes's original analysis in determining actual policy and economics education. It relates aggregate demand and employment to three exogenous quantities, i.e., the amount of money in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above.[citation needed] [edit]Phillips curve The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve. This curve, which was more of an empirical observation than a theory, indicated that decreased employment implied decreased inflation, and increased employment implied increased inflation. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output and employment—and then use the Phillips curve to predict an increase in inflation.[citation needed] [edit]History [edit]Precursors Keynes's work was part of a long-running debate within economics over the existence and nature of general gluts. While a number of the policies Keynes advocated (the notable one being government deficit spending at times of low private investment or consumption) and the theoretical ideas he proposed (effective demand, the multiplier, the paradox of thrift) were advanced by various authors in the 19th and early 20th centuries, Keynes's unique contribution was to provide a general theory of these, which proved acceptable to the political and economic establishments. [edit]Schools See also: Underconsumption, Birmingham School (economics), and Stockholm school (economics) An intellectual precursor of Keynesian economics was underconsumption theory in classical economics, dating from such 19th-century economists as Thomas Malthus, the Birmingham School of Thomas Attwood,[14] and the American economists William Trufant Foster and Waddill Catchings, who were influential in the 1920s and 1930s. Underconsumptionists were, like Keynes after them, concerned with failure of aggregate demand to attain potential output, calling this "underconsumption" (focusing on the demand side), rather than "overproduction" (which would focus on the supply side), and advocating economic interventionism. Keynes specifically discussed underconsumption (which he wrote "under-consumption") in the General Theory, in Chapter 22, Section IV and Chapter 23, Section VII. Numerous concepts were developed earlier and independently of Keynes by the Stockholm school during the 1930s; these accomplishments were described in a 1937 article, published in response to the 1936 General Theory, sharing the Swedish discoveries.[15] [edit]Concepts The multiplier dates to work in the 1890s by the Australian economist Alfred De Lissa, the Danish economist Julius Wulff, and the German American economist Nicholas Johannsen,[16] the latter being cited in a footnote of Keynes.[17] Nicholas Johannsen also proposed a theory of effective demand in the 1890s. The paradox of thrift was stated in 1892 by John M. Robertson in his The Fallacy of Savings, in earlier forms by mercantilist economists since the 16th century, and similar sentiments date to antiquity.[18][19] Today these ideas, regardless of provenance, are referred to in academia under the rubric of "Keynesian economics", due to Keynes's role in consolidating, elaborating, and popularizing them. [edit]Keynes and the classics Keynes sought to distinguish his theories from and oppose them to "classical economics," by which he meant the economic theories of David Ricardo and his followers, including John Stuart Mill, Alfred Marshall, Francis Ysidro Edgeworth, and Arthur Cecil Pigou. A central tenet of the classical view, known as Say's law, states that "supply creates its own demand." Say's Law can be interpreted in two ways. First, the claim that the total value of output is equal to the sum of income earned in production is a result of a national income accounting identity, and is therefore indisputable. A second and stronger claim, however, that the "costs of output are always covered in the aggregate by the sale-proceeds resulting from demand" depends on how consumption and saving are linked to production and investment. In particular, Keynes argued that the second, strong form of Say's Law only holds if increases in individual savings exactly match an increase in aggregate investment.[20] Keynes sought to develop a theory that would explain determinants of saving, consumption, investment and production. In that theory, the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy. Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly objects to its main theory—adjustments in prices would automatically make demand tend to the full employment level. Neo-classical theory supports that the two main costs that shift demand and supply are labour and money. Through the distribution of the monetary policy, demand and supply can be adjusted. If there were more labour than demand for it, wages would fall until hiring began again. If there were too much saving, and not enough consumption, then interest rates would fall until people either cut their savings rate or started borrowing. [edit]Military Keynesianism Main article: Military Keynesianism [edit]Postwar Keynesianism Main articles: Neo-Keynesian economics, New Keynesian economics, and Post-Keynesian economics Keynes's ideas became widely accepted after WWII, and until the early 1970s, Keynesian economics provided the main inspiration for economic policy makers in Western industrialized countries.[3] Governments prepared high quality economic statistics on an ongoing basis and tried to base their policies on the Keynesian theory that had become the norm. In the early era of new liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation, an era called the Golden Age of Capitalism. In terms of policy, the twin tools of post-war Keynesian economics were fiscal policy and monetary policy. While these are credited to Keynes, others, such as economic historian David Colander, argue that they are, rather, due to the interpretation of Keynes by Abba Lerner in his theory of Functional Finance, and should instead be called "Lernerian" rather than "Keynesian".[21] Through the 1950s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. In 1971, Republican US President Richard Nixon even proclaimed "I am now a Keynesian in economics."[22] However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction. This stagflation meant that the simultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary. This dilemma led to the end of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of ideas based upon more classical analysis, including monetarism, supply-side economics,[22] and new classical economics. At the same time, Keynesians began during the period to reorganize their thinking (some becoming associated with New Keynesian economics); one strategy, utilized also as a critique of the notably high unemployment and potentially disappointing GNP growth rates associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and maximal economic growth at the cost of somewhat higher inflation (its consequences kept in check by indexing and other methods, and its overall rate kept lower and steadier by such potential policies as Martin Weitzman's share economy).[23] Multiple schools of economic thought that trace their legacy to Keynes currently exist, the notable ones being Neo-Keynesian economics, New Keynesian economics, and Post-Keynesian economics. Keynes's biographer Robert Skidelsky writes that the post-Keynesian school has remained closest to the spirit of Keynes's work in following his monetary theory and rejecting the neutrality of money.[24][25] In the postwar era, Keynesian analysis was combined with neoclassical economics to produce what is generally termed the "neoclassical synthesis", yielding Neo-Keynesian economics, which dominated mainstream macroeconomic thought. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as neoclassical theory predicted. This post-war domination by Neo-Keynesian economics was broken during the stagflation of the 1970s. There was a lack of consensus among macroeconomists in the 1980s. However, the advent of New Keynesian economics in the 1990s, modified and provided microeconomic foundations for the neo-Keynesian theories. These modified models now dominate mainstream economics. Post-Keynesian economists, on the other hand, reject the neoclassical synthesis and, in general, neoclassical economics applied to the macroeconomy. Post-Keynesian economics is a heterodox school that holds that both Neo-Keynesian economics and New Keynesian economics are incorrect, and a misinterpretation of Keynes's ideas. The Post-Keynesian school encompasses a variety of perspectives, but has been far less influential than the other more mainstream Keynesian schools. [edit]Relationship to other schools of economics The Keynesian schools of economics are situated alongside a number of other schools that have the same perspectives on what the economic issues are, but differ on what causes them and how to best resolve them: [edit]Monetarism Monetarists and Keynesians are in agreement over the fact that issues such as business cycles, unemployment, inflation need to be addressed, but have fundamentally different perspectives on the capacity of the economy to find its own equilibrium and as a consequence the degree of government intervention that is required to create equilibrium. Keynesians advocate that when the economy is experiencing a decline in confidence that governments should borrow under-employed savings from the economy and spend it on infrastructure, while monetarists argue that governments should balance their budgets and regulate the supply of money through interest rates. Keynesian policies fell out of favour in the 1970s when it was realised that government spending was leading to inflation rather than create the economic stimulation that was required. Monetarism then became the dominant economic school and as a consequence, inflation rates fell across most developed countries and since the 1980s have remained significantly lower than they were in the 1970s. The Global Financial Crisis, however, has convinced governments of the need for Keynesian type interventions and highlighted the difficulty in stimulating economies through monetary policy alone during a liquidity trap. [edit]Austrian School Austrian economists favour diminished government intervention in the economy. They have a particular interests in the business cycle, arguing that economic booms are caused by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks.[26] The excess supply of funds to capital tends to cause capital goods prices to rise and stimulates an unsustainable shift of investment from consumer goods to capital goods. The bidding up of house prices due to the abundance of credit prior to the Global Financial Crisis add credibility to the Austrian perspective, but does not form part of the mainstream thought. [edit]Stockholm School The Stockholm School rose to prominence at about the same time that Keynes published his General Theory and shared a common concern in business cycles and unemployment. The second generation of Swedish economists also advocated government intervention through spending during economic downturns[27] although opinions are divided over whether they conceived the essence of Keynes' theory before he did.[28] [edit]Criticisms [edit]Austrian School criticisms Austrian economist Friedrich Hayek criticized Keynesian economic policies for what he called their fundamentally "collectivist" approach, arguing that such theories encourage centralized planning, which leads to malinvestment of capital, which is the cause of business cycles. Hayek also argued that Keynes's study of the aggregate relations in an economy is fallacious, as recessions are caused by micro-economic factors. Hayek claimed that what starts as temporary governmental fixes usually become permanent and expanding government programs, which stifle the private sector and civil society.[29] Austrian economist Henry Hazlitt criticized, paragraph by paragraph, Keynes's General Theory in The Failure of the New Economics.