Keynesian theory is central to understanding the Great Depression. We'll review just the theory here, and reserve for other sections the opportunity to see if the events of the 1930s bear out the theory.

Keynesianism is named after John Maynard Keynes, a British economist who lived from 1883 to 1946. He was a man of many contradictions: an elitist whose economic theories would be embraced by liberals the world over; a bisexual who enjoyed a happy and lifelong marriage to a Russian ballerina; a genius with an uncanny ability to predict the future, but whose works were often badly organized and sometimes very wrong. I mention this only because many of Keynes' critics try to refute his theories by pointing to the man himself. This is worse than irrelevant, of course; such criticisms are often prejudiced.

What is not in contention is that even Keynes' critics call him the greatest and most influential economist of the 20th century. For this reason, he is known as "the father of modern economics."

When the Great Depression hit worldwide, it fell on economists to explain it and devise a cure. Most economists were convinced that something as large and intractable as the Great Depression must have complicated causes. Keynes, however, came up with an explanation of economic slumps that was surprisingly simple. In fact, when he shared his theory and proposed solution with Franklin Roosevelt, the President is said to have dismissed them with the words: "Too easy."

Keynes explanations of slumps ran something like this: in a normal economy, there is a high level of employment, and everyone is spending their earnings as usual. This means there is a circular flow of money in the economy, as my spending becomes part of your earnings, and your spending becomes part of my earnings. But suppose something happens to shake consumer confidence in the economy. (There are many possible reasons for this, which we'll cover in a moment.) Worried consumers may then try to weather the coming economic hardship by saving their money. But because my spending is part of your earnings, my decision to hoard money makes things worse for you. And you, responding to your own difficult times, will start hoarding money too, making things even worse for me. So there's a vicious circle at work here: people hoard money in difficult times, but times become more difficult when people hoard money.

The cure for this, Keynes said, was for the central bank to expand the money supply. By putting more bills in people's hands, consumer confidence would return, people would spend, and the circular flow of money would be reestablished. Just that simple! Too simple, in fact, for the policy-makers of that time.

If this is the proposed definition and cure for recessions, then what about depressions? Keynes believed that depressions were recessions that had fallen into a "liquidity trap." A liquidity trap is when people hoard money and refuse to spend no matter how much the government tries to expand the money supply. In these dire circumstances, Keynes believed that the government should do what individuals were not, namely, spend. In his memorable phrase, Keynes called this "priming the pump" of the economy, a final government effort to reestablish the circular flow of money.

Let's return now to the reasons why people start hoarding money in the first place. There are many possible explanations, all of which are open to argument. It may be a consumer loss of confidence in the economy, perhaps triggered by a visible event like a stock market crash. It may be a natural disaster, such as a drought, earthquake or hurricane. It may be a sudden loss of jobs, or a weak sector of the economy. It may be inequality of wealth, which results in the rich producing a surplus of goods, but leaving the poor too poor to buy them. It may be something intrinsic within the economy which causes it to go through a natural cycle of recessions and recoveries. Or the Federal Reserve may tighten the money supply too much, compelling people to hang on to their disappearing dollars. This last point is especially important, since many critics of activist government believe that is how the Great Depression started.

As mentioned above, Keynes' advice on ending the Great Depression was rejected. President Roosevelt tried countless other approaches, all of which failed. Almost all economists agree that World War II cured the Great Depression; Keynesians believe this was so because the U.S. finally began massive public spending on defense. This is a large part of the reason why "wars are good for the economy." Although no one knows the full secret to economic growth (the world's top economists are still working on this mystery), wars are an economic boon in part because governments always resort to Keynesian spending during them. Of course, such spending need not be directed only towards war -- social programs are much more preferable.

In seven short years, under massive Keynesian spending, the U.S. went from the greatest depression it has ever known to the greatest economic boom it has ever known. The success of Keynesian economics was so resounding that almost all capitalist governments around the world adopted its policies. And the result seems to be nothing less than the extinction of the economic depression! Before World War II, eight U.S. recessions worsened into depressions (as happened in 1807, 1837, 1873, 1882, 1893, 1920, 1933, and 1937). Since World War II, under Keynesian policies, there have been nine recessions (1945-46, 1949, 1954, 1956, 1960-61, 1970, 1973-75, 1980-83, 1990-92 ), and not one has turned into a depression. The success of Keynesian economics was such that even Richard Nixon once declared, "We are all Keynesians now."

Keynesianism in the Postwar Era

After the war, economists found Keynesianism a useful tool in controlling unemployment and inflation. And this set up a theoretical war between liberals and conservatives that continues to this day, although it appears that Keynesianism has survived the conservatives' attacks and has emerged the predominant theory among economists. Before describing this battle, however, we should take a look at how the money supply is expanded or contracted.

In the U.S., there are several ways to expand the money supply. The most common is for Federal Reserve banks to buy U.S. debt from commercial banks. The money that commercial banks collect from the sale of these government securities increases the amount they can lend. A second way is to loosen credit requirements, thereby increasing the amount of money generated by the banking system. A third way is to cut the prime lending rate, which is the rate the Federal Reserve loans to commercial banks. To reduce money in the economy, the Fed commits all the opposite actions.

To fight unemployment, the Fed traditionally expands the money supply. This creates more spending in the economy, which creates more jobs.

But what would happen if the Fed expanded the money supply too much? For example, let's suppose the Treasury printed so much money that it made every American a millionaire. After everyone retired, they would notice there would be no more workers or servants left to do their bidding… so they would attract them by raising their wages, sky-high if necessary. This, of course, is the essence of inflation. Eventually, prices would rise so much that it would no longer mean anything to be a millionaire. Soon, everyone would be back working at their same old jobs.

To fight inflation, then, the Fed contracts the money supply.

The Federal Reserve thus has an important role in balancing the economy. Too little money in the economy means crushing unemployment; too much money means runaway inflation. Finding the right balance is the job of the Federal Reserve Board, a job which calls for considerable discretion -- hence the term discretionary monetary policy. Making the correct decisions depends on reading the economy correctly, and some Boards have been better at it than others. In the early days especially, the Fed had a tendency to overreact to developments, sometimes causing more harm than good. But the art of discretionary policy has improved over time. And the effects of monetary policy, even when handled poorly, are immediate, profound and easily measurable. No serious economist claims otherwise -- supply-siders aside.

Milton Friedman's attack on Keynesianism

Of course, Keynesianism has its critics, most of them conservatives who loathe the idea that government could ever play a beneficial role in the economy. One of the first major critics was Milton Friedman. Although he accepted Keynes' definition of recessions, he rejected the cure. Government should butt out of the business of expanding or contracting the money supply, he argued. It should keep the money supply steady, expanding it slightly each year only to allow for the growth of the economy and a few other basic factors. Inflation, unemployment and output would adjust themselves according to market demands. This policy he named monetarism.

During the 70s, monetarism reached the peak of its popularity among conservative economists. Today, however, Friedman stands virtually alone among top economists in his belief that it contains any merit. Monetarism was tried in Great Britain during the 80s and it proved to be a disaster. For almost seven years, the Bank of England tried its best to make it work. According to monetarist theory, the British economy should have enjoyed low inflation and high stability. But in fact, it went berserk. The economy sank into a deep recession, while the lead economic indicators zigged and zagged. Although inflation came down, this was at the price of rising unemployment, which soared from 5.4 to 11.8 percent. Between 1979 and 1984, manufacturing output fell 10 percent, and manufacturing investment fell 30 percent. Eventually, the Bank of England came under overwhelming pressure to abandon monetarism, which it did in 1986. The experiment was such a failure that not even conservatives abroad wish to repeat it.

Along with Great Britain, President Reagan announced that the U.S. would also follow a monetarist policy. However, this was simply a cover story, meant for public consumption only. In reality, the government's policies were thoroughly Keynesian. Government borrowing and spending exploded under Reagan, with the national debt climbing to $3 trillion by the time he left office. Paul Volcker, Chairman of the Federal Reserve Board, battled inflation during the severe recession of 1980-82 through the Keynesian method of raising interest rates and tightening the money supply. When inflation looked defeated in 1982, he abruptly slashed the prime rate and flooded the economy with money. A few months later, the economy roared to life, in a recovery that would last over seven years. The American experience was in direct contrast to Great Britain's. As a result, most economists abandoned monetarist theory.

Friedman is also famous for a second theory, this one containing much more merit. It's called the natural rate of unemployment, and it goes something like this:

Imagine an economy where the cost of everything doubles. You have to pay twice as much for your groceries, but you don't mind, because your paycheck is also twice as large. Economists call this the neutrality of money. If inflation worked this way, then it would be harmless. Indeed, most presidents after World War II decided to accept high inflation if it meant low unemployment, and therefore urged the Federal Reserve to conduct an expansionary monetary policy. But why is it that when the Fed expands money by, say, 5 percent, that all prices and wages everywhere do not go up by 5 percent as well? Why is it that the neutrality of money does not make this expansion meaningless? Friedman argued that it was because the public was unaware of the expansion, or what it meant, or by how much if it did. In other words, they didn't know that they should raise their prices by 5 percent. When the extra money was pumped into the economy, therefore, it was unwittingly translated into more economic activity, not higher prices.

Of course, if businessmen knew that a 5 percent increase was coming, it would be in their best interest to just raise their prices 5 percent. That way, they would make the same increased profits without having to work for them. If everyone did this, then the Fed's monetary increases would become meaningless -- instead of resulting in more jobs, it would just create higher inflation. Friedman and others argued that as businessmen became savvier and learned to follow the Fed's actions, they would build their inflationary expectations into their prices. Not only would this make inflation worse, but the nation would be left with no tool to fight unemployment, which would eventually rise as well. The twin dragons of inflation and unemployment would therefore grow together, forming "stagflation."

Friedman showed that monetary policy could not be used to wipe out unemployment, one of the optimistic goals of the Keynesians shortly after World War II. Instead, the most monetary policy could do was keep unemployment at about 6 percent, which is the rate normally achieved when the inflation rate is what the market expects it to be. Friedman called this the "natural rate of unemployment," and it secured his fame. But Keynesian policies are still useful in keeping the unemployment rate as close to 6 percent as possible.

Robert Lucas' attack on Keynesianism

An even bigger attack on Keynesianism came from Robert Lucas, the founder of a theory called rational expectations. Although one aspect of this theory won Lucas the Nobel Prize in 1995, history has not been kind to the rest of it. Lucas himself has abandoned work on rational expectations, devoting himself nowadays to other economic problems, and his once broad following has almost completely dissipated.

There are two main parts to rational expectations. First, Lucas believed that recessions are self-correcting. Once people start hoarding money, it may take several quarters before everyone notices that a recession is occurring. That's because individual businessmen may know that they are making less money, but it may take awhile to realize that the same thing is happening to everyone else. Once they do recognize the recession, however, the market quickly takes steps to recover. Producers will cut their prices to attract business, and workers will cut their wage demands to attract work. As prices fall, the purchasing power of the dollar is strengthened, which has the same effect as increasing the money supply. Therefore, government should do nothing but wait the correction out.

Second, government intervention ranges from ineffectualness to harm. Suppose the Fed, looking at the leading economic indicators, learns that a recession has hit. But this information is also available to any businessman in any good newspaper. Therefore, any government attempt to expand the money supply cannot happen before a businessman's decision to cut prices anyway. Keynesians are therefore robbed of the argument that perhaps the Fed might be useful in hastening a recovery, since Lucas showed that the Fed is not much faster than anyone else in discovering the problem.

Lucas then gave a slightly fuller version of the Milton Friedman argument outlined above. Suppose the Fed established a predictable anti-recession policy: for every point the unemployment rate climbs, it increases the money supply by a certain percent. Businesses would come to expect these increases -- hence the term, rational expectations -- and would simply raise their prices by the anticipated amount. In order to be effective, monetary policy would have to surprise businesses with random increases. But true randomness would make the economy less stable, not more so. The only logical conclusion is that the government's efforts to control the economy can actually be harmful.

Lucas' work enjoyed incredible prestige in the 70s. But today we know there are at least two major flaws in the theory.

First, it is not reasonable to believe that business owners determine their prices by following macroeconomic trends. Can you cite the Federal Reserve's rates and policies at the moment? The inflation and unemployment rates? Growth in the GDP? Even more improbably, do you set your prices and wage demands by these indicators? Only an economist (who knows all these statistics anyway) would think this is natural behavior.

Second, recessions last for years, which is far longer than people's ignorance of their onset. Lucas and his followers searched for every model imaginable that would keep businessmen aware of the leading economic indicators and yet ignorant of the fact that they were in a recession. Needless to say, they failed.

The recessions of 80-82 and 90-92 were clear refutations of Lucas' theory. Jimmy Carter was explicitly voted out of office for a misery index (unemployment plus inflation) that crested 20 percent. Yet it was not until 1987 that the unemployment rate fell back to 1979 levels. It is ludicrous to believe that it took the public eight years to figure out that they were in a recession and that they needed to cut prices back to the required level. And voters were highly aware that they were in a slump for most of the 90-92 recession; James Carville found a resonating campaign slogan for an entire election season with "It's the economy, stupid." Yet the economy did not even start to recover until the summer of 92, with employment taking even longer to rebound.

By the mid-80s, it was already apparent that neither monetarism nor rational expectations were adequate theories, and neo-Keynesianism started making a comeback. (Lucas won the Nobel Prize for that part of his theory which states that businessmen can compensate for expected monetary increases by raising their prices accordingly. Which is true in principle, but not often in practice.) One of the basic problems of conservative theories is that they place an almost religious faith in the belief that leaving markets alone always results in the best. How, in that case, does one explain recessions and depressions? Or the fact that depressions have disappeared since government started taking an active role? Besides, the belief that we should let national disasters like the Great Depression run unchecked for years while waiting for the economy to correct itself borders on the immoral.

The rise of the New Keynesians

Today, neo-Keynesianism has returned to prominence. At the heart of this updated version is the theory that people are not perfectly rational, but nearly rational. That is, they do not carefully weigh the unemployment rate, inflation rate and monetary policy before deciding to cut their monthly prices by, say, $24.13. Instead, people have only a fuzzy idea of where their prices should be, and make their best guesses. But because people are self-interested animals, they tend to err in their own favor, underestimating how much they really need to cut. This results in a long lag between the recognition of a recession and the decision to cut prices in earnest. In fact, the lag is so long that discretionary monetary policy is warranted in cutting the recession short.

But won't a businessman's rational expectations negate the Fed's actions? The answer, it turns out, is not completely. The Fed's decision to expand the money supply in 1982 was widely debated and highly publicized. Yet businessmen generally did not compensate for the Fed's announced moves by raising their prices. There are many reasons: a large percentage of businessmen could still be expected to remain unaware of the Fed's actions, or what they mean. For many, raising prices incurs certain costs (reprinting, recalculating, reprogramming, etc., not to mention a dip in business) that eat into the increases and may not make them worth it. And even if they do deem the price hikes worth it, it takes many companies quite some time to put them into effect. (Sears, for example, has to reprint and remail all its catalogues.) Also, remember that the impulse to raise prices cancels out the impulse to lower them, which is also how Lucas believed markets cured recessions. Others may be engaged in price wars with their competitors. So, for these and other reasons, expanding the money supply still results in job-creation, despite the counter-effect of rational expectations.

The re-emergence of Keynesianism is testimony of its staying power. Almost certainly, future economic theories will incorporate its findings.

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