The Great Depression inspired people to rethink stock markets, macroeconomics, and the role of government. In particular, John Maynard Keynes was inspired to write The General Theory of Employment, Interest and Money (published in 1936), striking at the heart of neoclassical economics theories based on equilibrium seeking free markets. Keynes was concerned with achieving full employment, something he claimed was impossible within the context of free markets. So far, so good.
The bizarre twist is that Keynes thought that excessive savings would ultimately be the undoing of industrial economies. He presents a thorough analysis, which depends primarily upon inelasticity in savings and spending. One of the more unusual outcomes of his analysis was that fear of capital losses could drive nominal interest rates below zero.
Despite oddities like negative interest rates, Keynes’ ideas were rapidly adopted internationally, giving socialism respectable academic credentials. Governments then and now tinker with fundamental market forces (money supply, discount rates, stimulative spending, …) to regulate market dynamics. Money supply and discount rates are largely attributable to Milton Friedman’s monetarism. Stimulative, often deficit spending comes under the rubric of Keynesian economics. Perhaps the most compelling reason for the widespread adoption of Keynesian economics is that Keynes argued that balanced budgets exacerbated instability during periods like The Great Depression. Whether or not you believe his argument, he had nonetheless green lighted deficit spending and politicians couldn’t be happier.
Over seventy years after Keynes burst onto the international scene, despite substantial evidence that Keynes’ conclusions were flawed, governments continue the deficit spending politicians find so addictive.
The obvious conclusion is that politicians are astoundingly quick to adopt academic justifications that support their policy objectives (overwhelmingly pork barrel politics), but will just as conveniently turn a blind eye toward Himalayan evidence that dashes the academic underpinnings of their spending plans. Keynes’ demand management ideas have been in decline since Milton Friedman’s 1956 Quantity Theory of Money, and just about completely discredited since the Johnson administration when Friedman predicted lower inflation and a recession based on the Federal Reserve crimping money supply growth. The economy almost proved him right, delivering a no-growth period, though no recession. Keynesians largely ignored the Fed’s actions. Later when the U.S. government ran a surplus (1968-9) and the Fed had greatly expanded the money supply, Friedman predicted significant inflation, while Keynesians predicted higher unemployment and lower inflation. This time Friedman had nailed it and the Keynesians were off by a mile.
Forty years after the rise of Milton Friedman and monetarism, politicians still cling to Keynesian justified deficit spending and income tax as an obvious mechanism for defeating the ‘threat’ posed by excessive savings. Both facets of Keynesian thought are still in active use despite the availability of more efficient, liberal economic (free-market) alternatives. “Underlying most arguments against the free market is a lack of belief in freedom itself,” Milton Friedman.
Further reading:
The Fall of Keynes: Milton Friedman and the Monetarist Revolution