I.

Introduction

Keynesianism, approach to economic policy based on the theories of the British economist John Maynard Keynes. Keynes's most important book, The General Theory of Employment, Interest and Money (1936), appeared in the depths of a slump which seemed to be going on for ever: unemployment in the United Kingdom had averaged 11 per cent in the 1920s and almost 20 per cent in the first half of the 1930s. According to Keynes, the economy did not behave in the way assumed by the “classical” economic theory which had held sway for over a century, but in a different way, which called for different government policies.

II.

Classical Economics

The classical economists assumed that full employment was the normal state of affairs, towards which the economy naturally gravitated. Changes in taste or technology, or the opening up of markets at home or abroad, might mean that jobs were lost in some industries, but would also mean that new jobs were created in others. Any unemployment that emerged would be temporary, soon being eliminated by the operation of market forces, and in particular by the flexibility of wages. If people stayed unemployed, this could only be because they were demanding excessive wages. At a lower wage they would be bound to find a job. In this sense, unemployment was “voluntary”.

III.

Keynes's Theory

Keynes argued that the economy did not automatically tend to a state of full employment, and that market forces could not be relied on to pull it out of recession. Suppose, for example, that there is initially full employment, and that for some reason businesses decide to cut their investment in new machinery. Those who make machinery will lose their jobs and have less to spend on consumer goods, so that some of those who make consumer goods will lose their jobs as well. Thus a “multiplier” effect gets under way, leaving the economy at a lower level of employment, incomes, and output than before. There are, Keynes maintained, no automatic forces at work in the economy which will put an end to this. Wage cuts will not help, because although they will reduce business costs, they will also reduce what workers can buy, so that business cannot sell any more than before. Thus, there is high unemployment because there is too little demand (that is, expenditure) in the economy. Only government action to cut taxes or increase its own expenditure (even though this means a budget deficit for a while) can bring the economy back to full employment. In short, the government must ensure that there is enough demand in the economy to create and maintain full employment, but not so much as to lead to inflation.

IV.

Keynesian Policies

In the United Kingdom, Keynesian policies were put into effect in the 1940s and continued until the late 1970s. The government would forecast the likely level of demand in the economy over the next couple of years. If it looked too low (as in 1952, 1958, and 1971), the government would increase its own expenditure, or cut taxes or interest rates. If it looked too high (as in 1941, 1955, and 1973), the government would do the opposite. The effect on the budget was regarded as of secondary importance. The aim was to keep total demand growing in line with the economy's capacity to produce, so that demand would be high enough to maintain full employment, but not so high as to generate inflation. Similar policies were pursued by most other developed countries: in the United States, for example, Keynesian policies were used by President John F. Kennedy to pull the American economy out of recession in the early 1960s.

V.

Inflation and Monetarism

From the beginning of the 1970s Keynesianism came under fire from the new doctrine of monetarism (which was essentially a restatement of the 19th-century classical economics which Keynes had dismissed in the General Theory). In most developed countries, the full employment and rising standards of living enjoyed for a quarter of a century after World War II had been accompanied by inflation: in the United Kingdom the retail price index rose at an average annual rate of about four per cent, though in some other countries the rate was less than this. Keynesians had long recognized that once full employment had in effect been guaranteed by the government, it would be difficult to maintain a stable price level if trade unions were free to demand, and employers to concede, whatever wage increases they liked. For this reason a series of incomes policies designed to reduce the size of wage and price increases was intermittently implemented in the United Kingdom between the late 1940s and the mid-1970s, in the United States by President Richard M. Nixon in 1971 and President Jimmy Carter in 1978, and in other countries as well. But the success of these policies, though sometimes underestimated, was not sufficient. From the late 1960s onwards, there was a tendency for the inflation rate to accelerate alarmingly.

According to the monetarists, accelerating inflation was the consequence of Keynesian policies which attempted to keep unemployment too low—below the “natural” rate of unemployment at which the economy tended to settle down, and at which the inflation rate would be stable. The only way to reduce unemployment, according to this argument, was to reduce the natural rate itself, by “supply-side” policies, such as more training and lower unemployment benefits, designed to make market forces work more effectively.

VI.

Outlook

Since the late 1970s Keynesianism has been out of fashion, overridden by monetarist arguments which have both contributed to and benefited from the political shifts that have put more emphasis on low inflation than low unemployment. But the severity of the world recessions in the early 1980s and early 1990s bears eloquent testimony to the underlying validity of Keynesianism. Nonetheless, if it is ever to make a comeback, Keynesianism will have to be at the international level: the globalization of the world economy, and in particular the virtual elimination of controls on international capital movements, severely limit how far Keynesianism could be practised in one country. Keynesian policies would have to be pursued in a coordinated way by the six or eight major world economies; and political factors may make such coordination difficult.