A once-so-cool economist, his name has been a political epithet for the last last two decades. Times are different and economists are scrambling for the next big thing. Are Keynes's ideas hot or not?
Keynes' 1936 magnum opus, The General Theory of Employment, Interest and Money changed the face of macroeconomics in the early twentieth century. He advanced a way of thinking about a nation's entire economy at once. And he questioned the foundational assumptions of classical economics that economic activity would over the long run tend toward stability, full employment, and equilibrium.
William Barber says this about Keynes in in A History of Economic Thought 229 (Penguin Books 1967):
"The classicists were too preoccupied with questions of long-period economic growth to concern themselves directly with short-period instability; in any event - apart from the post-Napoleonic war years - the matter was not of major significance in their day and age. . . . Though some neo-classical writers made reference to ‘industrial fluctuations’ and to the ‘inconstancy of employment’, they were far more interested in the forces influencing output in particular markets than in those governing the output of the economy as a whole. Moreover, they were persuaded that full employment was the long run equilibrium position toward which the economy naturally gravitated and their analysis was built on this premise.
Even before his doubts about neo-classical presuppositions had crystallized, Keynes was suspicious of this attitude – ‘in the long run,’ he observed, ‘we are all dead’. As his thought took shape in the General Theory, economic analysis was reconstructed to bring short-period aggregative problems to the centre of the stage. The microeconomic questions around which the neo-classical tradition had been organized were pushed toward the wings. At the same time. Keynes was at pains to dissociate his position from the Marxist contention that capitalism was doomed. The essentials of the system, he maintained, could be preserved if reforms were made in time. An unregulated capitalism, however, was incompatible with the maintenance of full employment and economic stability."
Skipping through considerable detail, Keynes rejected the prevalent idea that an income depression (such as the Great One) was inevitably temporary and that once wages and prices fell far enough, firms would finally resume selling all they made and workers would all find jobs. Keynes said that inadequate consumer spending could cause an ecoomy to stagnate permanently. To end a depression, he said, spending had to rise. Although people could not be counted on to spend their way out of an economic depression-- a government could. And an initial increase in government spending, for example on New Deal style public works projects, would have a "multiplier effect" on total spending; an increase in total spending would cause consumption to increase and unemployment to fall and so on.
In Keynes' macroeconomic model, a decrease in spending leads to a decrease in employment, which leads to a further decrease in spending and so on. If people try to increase their saving (relative to spending) there will inevitably follow a fall in employment and production. The multiplier that made government spending such a panacea worked the same way in reverse to create what has come to be called the paradox of thrift. By attepmpting to increase the rate of saving, a society may create economic conditions under which the amount it can actually save is reduced.
Nascent neo-Keynesians should note that not saving hasn't worked out all that well. During the 1990's, the US personal savings rate fell from 8% to 2%. By 2005, it was negative. The good (or bad) news is that personal saving is on the rise. The Fed reported a positive savings rate in the last q of 2008. Economists are predicting that the rate will reach 4.5 % by the end of 2009.
The paradox of thrift rests on the premise that saved income falls through a hole in the floor and disappears. Not so. Saved income is standing by to purchase goods in the future. It shows up as investment in new factories, machines, education and other inputs for the product of future goods. In the long run (which Keynes dismissed as uninteresting) total demand and consumption doesn't fall because of increase saving relative to current goods consumption. It just changes form. In the short run, an increase in saving relative to current goods consumption causes some disruption. The current goods industry, so to speak, needs to lay off workers and adjust to reduced demand. The future goods industry usually can't move as fast. Future goods production depends on inputs like laws and scientific discoveries yet to be made, skills yet to be acquired and development of the next big idea.