Economies are like waves with both crests and troughs. When economies overheat, they naturally crash in order to correct themselves. Then when we experience dips, prices naturally adjust until people start to buy again.
John Maynard Keynes (1883-1946) was a British economist who spearheaded a revolution in economic thinking. He proposed that government intervention was necessary to moderate these booms and busts. Before Keynes, thinking held that supply was the economy’s prime motivator. They believed producers would simply adjust prices until the desired number of units sold. But in the 1930s, faced with a lingering recession, Keynes argued we should look at aggregate demand.
Classical economic thinking held that, in a downturn, full employment was achieved by “supply side” price adjustments. Employees would lower their wage demands and producers would reduce profit expectations, yielding lower selling prices, to the point where consumers could no longer resist. Keynes argued that full employment could be better achieved by increasing aggregate demand through the use of policy. (Monetary policy refers to the government’s control of the money supply — like when the Fed adjusts interest rates, and fiscal policy is control over government expenditures and taxation). He proposed government could do three things:
- Increase expenditures on things like highways.
- Reduce taxes on consumers and business, thus increasing disposable income and after-tax profits.
- Increase the money supply by lowering interest rates.
The first two typically result in budget deficits but, under his philosophy, these deficits are to be paid back when the economy looks good.
Keynesian thinking became popular in the 1940s and 1950s, to the point where almost every capitalist country adopted his recommendations. In the 1970s, these principles were challenged by other schools of thought, which argued against the effectiveness of government’s ability to regulate the economy and the natural business cycle. But in the economic crisis of 2008, this thinking resurfaced and was greatly employed throughout the world.