The Keynesian Revolution was a fundamental reworking of economic theory concerning the factors determining employment levels in the overall economy. The revolution was set against the then orthodox economic framework, namely neoclassical economics.
The early stage of the Keynesian Revolution took place in the years following the publication of John Maynard Keynes' General Theory in 1936. It saw the neoclassical understanding of employment replaced with Keynes' view that demand, and not supply, is the driving factor determining levels of employment. This provided Keynes and his supporters with a theoretical basis to argue that governments should intervene to alleviate severe unemployment. With Keynes unable to take much part in theoretical debate after 1937, a process swiftly got underway to reconcile his work with the old system to form neo-Keynesian economics, a mixture of neoclassical economics and Keynesian economics. The process of mixing these schools is referred to as the neoclassical synthesis, and Neo-Keynesian economics may be summarized as "Keynesian in macroeconomics, neoclassical in microeconomics".
Historical context The revolution was primarily a change in mainstream economic views and in providing a unified framework – a number of the ideas and policy prescriptions advocated by Keynes had ad hoc precursors in the underconsumptionist school of 19th-century economics, and some forms of government stimulus were practiced in 1930s United States without the intellectual framework of Keynesianism.
The central policy change was the proposition that government action could change the level of unemployment, via deficit spending (fiscal stimulus) such as by public works or tax cuts, and changes in interest rates and money supply (monetary policy) – the prevailing orthodoxy prior to that point was the Treasury view that government action could not change the level of unemployment.
The driving force was the economic crisis of the Great Depression and the 1936 publication of The General Theory of Employment, Interest and Money by John Maynard Keynes, which was then reworked into a neoclassical framework by John Hicks, particularly the IS/LM model of 1936/37. This synthesis was then popularized in American academia in the influential textbook Economics by Paul Samuelson from 1948 onward, and came to dominate post-World War II economic thinking in the United States. The term "Keynesian Revolution" itself was used in the 1947 text The Keynesian Revolution by American economist Lawrence Klein. In the United States, the Keynesian Revolution was initially actively fought by conservatives during the Second Red Scare (McCarthyism) and accused of Communism, but ultimately a form of Keynesian economics became mainstream; see textbooks of the Keynesian revolution.
The Keynesian revolution has been criticized on a number of grounds: some, particularly the freshwater school and Austrian school, argue that the revolution was misguided and incorrect; by contrast, other schools of Keynesian economics, notably Post-Keynesian economics, argue that the "Keynesian" revolution ignored or distorted a number of Keynes's fundamental insights, and did not go far enough.
Theory of employment A central aspect of the Keynesian revolution was a change in theory concerning the factors determining employment levels in the overall economy. The revolution was set against the orthodox classical economic framework, and its successor, neoclassical economics, which, based on Say's law, argued that unless special conditions prevailed, the free market would naturally establish full employment equilibrium with no need for government intervention. This view held that employers will be able to make a profit by employing all available workers as long as workers drop their wages below the value of the total output they are able to produce – and classical economics assumed that in a free market workers would be willing to lower their wage demands accordingly, because they are rational agents who would rather work for less than face unemployment.
Keynes argued that both Say's law and the assumption that economic actors always behave rationally are misleading simplifications, and that the classical economics was only reliable at describing a special case. The Keynesian Revolution replaced the classical understanding of employment with Keynes's view that employment is a function of demand, not supply.
Other "revolutions" in economics
Prior to Keynes Professor Harry Johnson has written that economics in its modern form can be seen as dawning with the Smithian Revolution against mercantilism. Prior to Keynes there were five other major developments in economic thought rapid enough in pace to be characterised as revolutions, most notably the Ricardian. Another noted revolution is the marginalist revolution, which is taken to mark the transition from classical economics to neoclassical economicsSometimes in sources discussing the revolution, neoclassical economics called is just plain classical. in the 1870s. Collectively, these fashioned the classical economic orthodoxy that Keynes attacked.
Note however that in economic practice, as opposed to economic theory, the behavior of industrializing nations in the 19th century has frequently been described as mercantilist or embodying economic nationalism, as in the American School of 19th-century American economic practice.
After Keynes The rise of Monetarism, particularly in the 1970s and via the work of Milton Friedman, is considered the next major change in mainstream economic theory and practice, and has at times been described as the "monetarist revolution".The "monetarist revolution" in monetary theory, Karl Brunner, Review of World Economics (Weltwirtschaftliches Archiv), 1970, vol. 105, issue 1, pages 1–30 The stagflation of the 1970s led to a loss of influence by classical Keynesian economics, and continuing tensions between Keynesian economics and neoclassical economics led in the 1970s to the division between New Keynesian economics and New classical macroeconomics; these are also referred to as the saltwater school and freshwater school, due to the American universities with which they are associated. In development economics, this period is referred to as the Washington Consensus period, and the economic expansion of the 1980s, 1990s, and early 2000s has been referred to as The Great Moderation.
Within academia the post WWII high point of free market economics occurred in the 1990s, with several free market economists winning the Nobel Prize. Increased skepticism concerning the free market consensus was fueled by the 1997 Asian financial crisis and the dot-com bubble. The 2008 financial crisis led to a resurgence of interest in Keynesian economics, the 2008–2009 Keynesian resurgence.
Background When Keynes published his General Theory in 1936, the influence of free market economics on policy making had already declined substantially compared to the almost unchallenged ascendancy it had enjoyed in Britain during the 1840s - 1860s.This was due to political and moral influences more than any change in mainstream economic thinking. The growth of regulation and state intervention in economic affairs, starting in Britain from the 1860s, spreading to Europe and gathering pace in the 70s and early 80s, was catalogued in dismay by the economic liberal Herbert Spencer in his The Man vs the State (1884). At first the reforms seem to have been largely a spontaneous reaction against economic distress resulting from free market policies, by the last two decades of the 19th century intellectual and moral (if not mainstream economic) support arose from diverse quarters such as German progressives, the Fabians and Pope Leo XIII with his social encyclical Rerum novarum. More wide ranging reforms then followed with the early precursors to the welfare state brought in by Bismark and Lloyd George. See The Great Transformation (book) chapters 12 - 18. By the mid-1930s much of the first and second world was already under the sway of communism or fascism, with even the US departing from economic orthodoxy with the New Deal. There had not been a corresponding decline for neoclassical economics in the academic sphere however. According to economic historian Richard Cockett, within academia the prestige of free market economics was still near its peak even in the 1920s. In the 1930s neoclassical economics began to be challenged within academia, though at first by various diverse schools which apart from Marxism were mostly of only local influence - such as the Stockholm schoolLike the Stockholm school Keynes may have been inspired in part by the earlier work of Knut Wicksell in Sweden or in the US the Administered price theorists.
In 1930, Keynes was in his late forties, and in October his A Treatise on Money was published. It was criticized by Ralph Hawtrey, Dennis Robertson and Friedrich Hayek. However, so-called "Circus", consisted of Richard Kahn, James Meade, Piero Sraffa, Joan Robinson and Austin Robinson, began a seminar to examine the Treatise. Keynes did not attend these seminars but was informed of their discussions by Kahn. Keynes was little influenced by the various heterodox economists of the 1930s, his General theory was written largely in a Marshellian framework though with some important points of dissent such as the idea that excessive savings can be harmful for the overall economy. Keynes asserts that when savings exceed available investment opportunities it makes it impossible for business as a whole to make a profit and so layoffs and increased unemployment will result. In chapter 23 of the General Theory Keynes traces the genesis of this idea to, among others, Mercantilist thinkers of the previous three centuries, to the Fable of the Bees and to the dissenting economist J A Hobson with his Physiology of industry (1889).
The course of Keynesian Revolution argue that there are three components to the Keynesian revolution: a policy revolution, a theoretical (or intellectual) revolution, and a textbook revolution. These are addressed in turn.
Intellectual Keynes's revolutionary theory was set out in his book General Theory of Employment, Interest and Money, commonly referred to by the abbreviated title General Theory. While working on the book, Keynes wrote to George Bernard Shaw, saying "I believe myself to be writing a book on economic theory which will largely revolutionize, not I suppose at once but in the course of the next ten years – the way the world thinks about economic problems … I don't merely hope what I say, in my own mind I'm quite sure" Professor Keith Shaw wrote that this degree of self-confidence was quite amazing especially considering it took more than fifty years for the Newtonian revolution to gain universal recognition; but also that Keynes's confidence was fully justified. John Kenneth Galbraith has written that Say's law dominated economic thought prior to Keynes for over a century, and the shift to Keynesianism was difficult. Economists who contradicted the law, which inferred that underemployment and underinvestment (coupled with over-saving) were virtually impossible, risked losing their careers.JM Galbraith. (1975). Money: Whence It Came, Where It Went, p. 223. Houghton Mifflin.
Keynes's General Theory was published in 1936 and provoked considerable controversy, yet according to professor Gordon Fletcher it rapidly conquered professional opinion.