In the United States, where the slump began, industrial production declined by a third between 1929 and 1933 and unemployment exploded from 3 percent to 25 percent of the workforce. More than a third of the country’s banks failed between 1931 and 1933, leaving depositors broke and the credit system badly damaged. In Great Britain the decline was not as steep, in part because the country’s economy had never fully recovered from the war. Nevertheless, economic output declined by a third there as well, exports declined by more than half, and unemployment rose to about 20 percent of the workforce in 1932. It was a global catastrophe that bottomed out only when the world’s economic machinery ground to a halt in 1933.
Disasters of this magnitude were not supposed to happen in market economies, which were thought to possess self-correcting features. When the slump dragged on, Keynes concluded that there was something wrong with the adjustment mechanisms of the market that was not accounted for in the standard economic theories. Much like the Great War, for Keynes the Great Depression called into question the received wisdom of the time.
This was the background for his General Theory, where he laid out the theoretical case for countercyclical government spending policies that proved to be so influential in the postwar era. Like The Economic Consequences of the Peace, this book too was widely discussed and reviewed when it first appeared, frequently in newspapers and magazines that catered to policymakers and intelligent laymen. But whereas the former set out a lucid argument that no one could misunderstand, The General Theory contained a bewildering mix of new concepts and arguments, critiques of old theories, and loosely related excursions into subjects like stock market speculation and mercantilist theories, all of which led to confusion among readers as to what the central point actually was. Paul Samuelson, one of Keynes’s American expositors, found it to be “a badly written book,” full of “mares’ nests of confusions,” where flashes of insight were interspersed with arguments that seemed to lead nowhere.7 Keynes developed a meandering argument in his tour de force and left it to others to work out the implications.
In The General Theory, Keynes mounted an attack on what he called the “classical” school of economics, the doctrine of free and self-adjusting markets developed by the political economists of the previous century. The classical theory, he suggested, is not a general theory but rather a special theory applicable to a condition of full employment and to an economy of small producers, independent workers, and competitive markets—circumstances that no longer obtained in modern economies, increasingly dominated by large institutions and by labor unions. A central theme of Keynes’s theory, and of Keynesian economics in general, is that market economies do not automatically adjust to systemic shocks like stock market crashes, widespread bank failures, famines, and wars. A second is that the market system, left on its own, will operate most of the time at levels below full employment and potential output.
In an early chapter, he set down and rejected three postulates of “classical” political economy that (he claimed) were central to the theory of self-correcting markets. The first was Say’s Law, named for Jean-Baptiste Say, a nineteenth-century economist who held that aggregate supply creates its own aggregate demand, or as Say put it, “The general demand for products is brisk in proportion to the activity of production.” Thus, a general glut across the entire economy ought never to occur because demand should always be sufficient to soak up the goods produced. The second principle, and one related to Say’s Law, was that widespread unemployment should never occur because workers, even during slumps, should find employment by adjusting their wage demands downward to levels where employers will hire them. A third was that savings are a form of deferred consumption that are put to work in the form of investment for the production of future goods, with the interest rate regulating the general volume of savings and investment at any particular moment. The flexible movement of prices, wages, and interest rates allows the market to adjust quickly to changes in production, the demand for labor, and increases or decreases in saving.
Keynes rejected these postulates as either wrong or inapplicable to the new world of institutional capitalism in which corporate managers had replaced entrepreneurs, labor unions now intervened to negotiate on behalf of workers, and banks and investment houses emerged to act as intermediaries between savers and investors. As for Say’s Law, Keynes thought that the existence of widespread unemployment contradicted the hypothesis that supply creates its own demand. He pointed out that producers and consumers act independently and not necessarily according to the same calculations. For these reasons, Keynes rejected Say’s Law and asserted the reverse: that it is consumer demand that calls producers into action. As for wages, he observed that there were unemployed laborers more than willing to work for prevailing wages, which meant that they were not “voluntarily” unemployed but were out of work because they had no offers of employment. To complicate matters, Keynes rejected the assumption that employers could easily reduce wage rates during slumps. Wage rates, he argued, were “sticky” rather than fluid (as the classical economists supposed) in a downward direction. The existence of labor unions ready to defend labor contracts or to call worker strikes made it even more difficult for employers to cut wages during slumps. (They typically cut production and employment instead.) In addition, wage cutting across the economy has deflationary effects, so it is possible for the price level to fall faster than wages, leaving the real wage as high or higher than when the process started.
As for saving and investment, Keynes again emphasized that savers and investors were no longer the same parties as they may have been in the previous century, but rather independent actors in the economy, operating on different views of the future. Now, savings and investment had to be brought together by financial intermediaries. He went further to argue that savings are a “leakage” from consumer demand and therefore tend to draw down investment as well, since investors respond to the ups and downs of consumer demand. Consumers change their rate of saving, and businesses and entrepreneurs their level of investment, for reasons largely independent of the interest rate. This means that there is no automatic mechanism to direct the flow of savings into investment and to maintain the two quantities at roughly equal levels.
Keynes concluded that there was no obvious process of adjustment in wages, prices, and interest rates that would correct the slide in employment and output. Under certain circumstances, there could be a general overproduction of goods, widespread unemployment, hoarding of money by consumers, and a collapse of investment—all occurring at the same time and in response to one another. This meant that the market might reach equilibrium at levels well below full employment; and Keynes argued that this was in fact what had happened in the 1930s. Wage demands could remain above the level where businesses are prepared to hire, especially in times of deflation. There might be times when low or even negative interest rates would prove insufficient to induce people to spend and invest. As incomes fall, so also do savings and the purchasing power of consumers. Those with jobs and incomes, seeing what is happening around them, hold back on purchases, further worsening the situation. Where there is weak consumer demand, there will be little investment, and thus no expansion in employment and incomes, and no progress in society. For all these reasons, slumps can be self-perpetuating and need not correct themselves by the natural operation of market processes. In that case, some external intervention is required to restore consumer demand, investment, and employment.
Having rejected the economic principles of the “classical” school, Keynes went on to attack its moral postulates as well. The virtue of thrift, for example, was not as socially beneficial as many claimed. Thrift, which might make sense for individuals, results in general harm when it is too widely practiced because it leads to the withdrawal of consumption from the marketplace and a consequent reduction in consumer demand. Since savings are not automatically used up in investment in times of slack consumer demand, increased savings can lead to a reduction in the wealth of the community and an acceleration of the downward economic spiral. This was his “paradox of thrift,” a not-so-subtle attack on the nineteenth-century proposition that thrift and deferred consumption are the foundations for order and progress.b Keynes reversed the traditional formula, insisting that consumption and debt, rather than thrift and saving, are the keys to prosperity.
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