American Economics, Part 2 – The Legacy of John Maynard Keynes

| June 8, 2020 | 0 Comments

Over a period of two weeks in March 2020, the value of the American stock market fell by approximately 30%. The drop was largely caused by a drastic fall in oil prices and fears of major economic fallout from the novel coronavirus. Over the same time, millions of American workers were sent home from their jobs, many of them without paychecks. Economic analysts raised a howl, predicting a major recession as a result of the market loss and reduced production.

In response to these events, the Federal Reserve announced that it was cutting its benchmark interest rate as low as it could. On the heels of this action, Congress passed a MASSIVE economic stimulus package of $2.2 trillion, equal to half of the federal government’s annual operating budget. What was the impetus behind these moves? What effect does cutting the interest rate have on the economy at large, and why does the Fed cut the rate when they think a recession is approaching? Why is the federal government willing to take on more debt in order to mail checks to tens of millions of Americans? In this installment of “American Economics” we will try to answer some of these questions.

Supply and Demand

The most basic forces at work in the economy of any country are the forces of supply and demand. Understanding supply and demand will be essential in much of what is said in this article.

Supply refers to the quantity manufactured and available of any particular item or group of items. An economic rule called the “law of supply” says that, all other things being equal, the quantity supplied of any good rises when the price of the good rises. With higher prices, suppliers now have more incentive to produce the good and of course they are interested in taking advantage of the income gain. When the price of a good falls, the quantity supplied falls. If you remember our plastic spoon example from last week’s article, you will recall that American manufacturers were being undersold by the Chinese manufacturers. Chinese manufacturers were willing to sell their plastic spoons for less than the Americans, causing the price of plastic spoons to drop. Because the price fell, American plastic spoon manufacturers were making less money than previously and they had to cut back on production to minimize their losses. This resulted in workers being laid off and plastic spoon factories being shut down or being converted to produce something else. When tariffs are imposed on Chinese plastic spoon manufacturers, they cannot sell their spoons for so little any more. The price of spoons in America goes back up, and suddenly American plastic spoon manufacturing is profitable again. The factories revert back to plastic spoon manufacturing, hire more workers, and increase their spoon production, resulting in higher supplies of plastic spoons.

Demand refers to the quantity demanded of any particular item or group of items. The “law of demand” states that, all other things being equal, the quantity demanded of a good falls when the price rises. When the price of a good rises, buyers of that good must now pay a larger amount of money to get the same amount of good. This has the understandable effect of stifling sales. When the price goes up, the would-be buyers will often buy less than they otherwise would have. They may buy another good instead or they may just make do with less. When plastic spoons are made in China and the price is cheap, busy mothers may choose to just use plastic spoons for their family meals rather than spend the time washing metal ones. When the inflow of Chinese plastic spoons is stifled by tariffs and the price goes up, those same mothers might easily revert back to using the real silverware. Demand falls when prices rise.

If supply goes up when the price of a good rises and demand goes down when the price of a good rises, what happens to all the good that is now being produced and not sold? This situation creates a surplus of the good. A surplus drives prices down, because it not profitable for a company to produce a good and not sell it. It is better for the good to be sold at a cheaper price than for it to sit in the company’s warehouse and collect dust.

If demand for a good rises and manufacturers do not immediately ramp up production to meet the increased demand, a shortage is created. This shortage raises the perceived value of the good and the selling price rises to match the new value. Because the price of the good is higher, manufacturers want to produce more because they can make more money doing so. Existing factories increase production and new factories are built until the shortage is eliminated.

Thus the laws of supply and demand are always in conflict with each other. When not interrupted by outside forces, the laws of supply and demand will work together (or fight each other) to create a price equilibrium. This equilibrium point is the selling price of a good where manufacturers are supplying just enough of a good to meet the demands of the consumers of said good and consumers are demanding all of the good that manufacturers are willing to supply.

The theories of Adam Smith

In 1776, a Scottish economist by the name of Adam Smith published a book with the cumbersome title An Inquiry into the Nature and Causes of the Wealth of Nations. In this book, Smith laid out the foundations of what is now considered classical free-market economic theory. Smith contended that, when left to themselves, the forces of supply and demand work together in a free-market economy to maximize economic benefits for the most people possible. Smith contended that the selfish desires of mankind (his desire to make money) actually worked to the advantage of society by causing him to produce the maximum amount of goods possible. Smith described the free market economy as being guided by an “invisible hand” that brought about these positive outcomes. Smith promoted the idea that governments should not get heavily involved in their country’s economy, but let the natural forces of supply and demand direct the economy. Smith felt that a non-manipulated economy was more resilient in the long term.

Smith’s ideas had a major impact on economic theory and practice for decades, and, indeed, up until today. Influenced by Smith’s theories, the British Empire eventually moved from the policy of mercantilism (a system that maximizes exports and minimizes imports in an economy) to policies promoting free trade and less government intervention in the market. Smith’s theories caught on in America and have influenced U.S. economic policies for almost 200 years. However, parts of Smith’s economic theory have fallen out of favor in recent decades, due to the ideas of a man named John Maynard Keynes.

The theories of John Maynard Keynes

John Maynard Keynes was a British economist whose ideas and writings fundamentally changed how many people thought about economics. His ideas are the basis of the modern school of economic thought known as Keynesian economics, along with its various offshoots. While there are many components of Keynesian economics, there is one item in particular that has changed how governments get involved in the markets of their respective countries.

Classical economic theory (the school of economic thought promoted by Adam Smith) contains the thought that “supply creates its own demand.” What this means is that the very act of producing a good drives demand because inputs are demanded to make the good. The demand created by the mechanics of supply will generate supply to meet the demand and so on. Classical economics says that, though supply and demand are both components of a market, supply is the component that is driving the economic engine. An economy that is supplying a lot of product is a booming economy. This “supply creates demand” statement is known as Say’s Law.

John Maynard Keynes rejected Say’s Law (or at least his interpretation of it), promoting instead that demand is superior to supply in driving the economy of a society. If a good is demanded by consumers, this demand drives the production of the good and the economy does well. The difference between these two positions is subtle, but it makes a major difference in the economic policy that a government develops to influence the economy of its constituency.

Keynes also rejected Smith’s idea that a government should not get involved in the market. He did not disagree with Smith’s statement that the market will do better in the long run with no government intervention. However, he said, “In the long run we are all dead.” He also felt that saying that the market was better off without intervention was an excuse on the part of economists to not get involved when the market was in trouble. “Economists,” he said, “set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.”[i]

Keynes’ well-known book, The General Theory of Employment, Interest and Money, came off the press in 1936, the middle of the Great Depression. The idea that the government should intervene in the market to improve the short-term wellbeing of the economy was understandably attractive to a world that was crippled by high unemployment and poor production. The book caught on quickly and Keynesian economics became very influential in shaping government economic policy in many countries.

Let me summarize these ideas in case this last section was a little confusing. Adam Smith said that the market was better off in the long run if the government never got involved. Keynes did not disagree, but said that because the government could help produce a better market in the short run by getting involved, it should. Adam Smith said that supply drives the economy, while John Maynard Keynes said that demand drives the economy.

The Results

Because of John Maynard Keynes’ ideas, the U.S. government is now interested in getting involved in the operations of the market to improve short-term market outcomes. How is it going to get involved? Remember Keynes’ idea about demand being the main driving force in an economy? If an economy is slowing down, the government’s answer is to increase demand to stimulate the economy. Demand is created when people go to the store and spend the money that they have on goods they need or want. Demand is also created when businesses invest in more buildings or more machinery that will increase their output. Demand increases when people and businesses have more money that they feel free to spend than they did before.

The United States government increases demand by making sure that people and businesses have money available to spend. The $1,200 stimulus checks that have been given to every American adult by the government is an attempt to increase demand. The government is hoping that the money will encourage millions of Americans to buy more than they otherwise would have, thereby creating demand that will hopefully keep the economy from slowing as much as it otherwise would have. Similar to the stimulus checks are the extra $600 per week that unemployed individuals are receiving and will continue to receive until the end of July. Granted, the physical welfare of the recipients of all this extra money is also a concern of the government, but these decisions are certainly being made for the economy’s sake as well as the people’s.

The government has also made hundreds of billions of dollars available as loans to small and medium-sized businesses under something called the Payment Protection Program. The money is to ensure that these businesses that have seen a decrease in revenue because of the economic shutdown will still have enough operating funds to keep paying their workers. Because these workers are still getting paid, they will have income to spend at the grocery store, the pharmacy, and on, keeping the demand engine rolling.

The Federal Reserve has lowered their benchmark interest rate to the lowest level possible, 0% - .25%. The result of this low benchmark is that local banks will be able to make loans to individuals and businesses at much lower interest rates than they could have a year ago. This is intended to encourage borrowing, which money will then be spent on a new house for an individual or new equipment or infrastructure for a business. The more loans that are encouraged by low interest rates, the more demand will be created when the borrowed money is spent.

The U.S. government wants to keep the money moving. When a recession hits, people have a tendency to hoard money and spend less. Less spending leads to a decrease in demand, which means more worker layoffs, which means less worker income, which means less expenditure, which means less demand. The effects tend to snowball. On the contrary, the government wants to keep people buying things so demand stays high, so employment stays up, so income and spending stays high, so demand stays high. The goal of expansionary monetary policy (policy that stimulates the economy) is to keep spending (demand) high so the economy can keep rolling.

Is it all positive?

So, can the government just encourage spending whenever they want through expansionary monetary policy and always ensure a completely positive outcome? As you would probably expect, the answer is no.

An effect of pumping extra money into any economy is inflation. Now, inflation is not terrible. The U.S. Federal Reserve actually has a goal of maintaining an approximately 2% annual inflation rate to stave off the possibility of deflation, which they consider to be much worse than low inflation. However, high inflation is costly to a society for a variety of reasons. Inflation always rises when a lot of money is injected into the economy, and if too much money is added, inflation can reach these unhealthy levels. The reason for this inflation is simple. Extra money available means more money spent which means more demand. More demand means higher prices. Overall higher prices equals inflation, because the same amount of money now buys less. The money has devalued. It is true that higher prices on goods result in higher wages for the workers of the companies that produce the goods. However, because they are paying more for what they need to live, the increase in wages does not raise the long-term living standard of the workers.

Because increased demand makes companies more likely to hire more workers, expansionary money policy lowers the unemployment rate. Economists recognize that, in the short term, there is a trade-off between unemployment and inflation. An economic downturn will temporarily result in one or the other, depending on the action the government takes or doesn’t take. If the government takes no action during an economic recession, unemployment will be high and inflation will be low. If the government helps out with extra money, unemployment will be lower than it otherwise would have been, and inflation will be higher. The U.S. government almost always chooses the option of injecting money in order to prevent high unemployment. Thus the government’s actions during economic recessions lead to higher inflation.

Introducing more money also encourages Americans to consume high levels of goods in order to keep the economy rolling. This only increases the American tendency to consume more than we really need. This is a topic I will discuss further in the next and final installment of American Economics.

~Leonard Hege

Definitions of economic terms in this article obtained from:
Principles of Macroeconomics, Seventh Edition, by N. Gregory Mankiw

[i] A Tract on Monetary Reform (1923), Ch. 3, p. 80.


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