Chapter 2

Two Visions of the Economy

What was dierent about Keynesian economics from everything that went
before? Consider the two following physical analogs of a modern economy.
In the first; think of the economy as a fruit bowl (see Figure 2.1). The fruit
bowl represents the economic infrastructure. In it is a ball; this represents
gdp - the value of all goods and services produced in the United States in
a given year. The bowl is continually rocked by random economic events
- the Gulf war, the invention of the personal computer, Hurricane Katrina.
These events move the bowl and gdp goes up (to the right) or down (to
the left). But whatever happens to the infrastructure, the system itself is
self-correcting in the sense that the ball always moves towards the bottom
of the bowl. The unemployment rate, when the ball is at its rest point, is
what economists now call the natural rate of unemployment. This is how
economists before the Great Depression thought of the economy.
Keynes saw things dierently - he was much less inclined to view the
economy as a self-correcting mechanism. Instead of the fruit bowl model
he proposed what I call the windy boat model. In this view of the world
the economic infrastructure is like an ocean. The boat is gdp, and random
events, the Gulf war, the invention of the personal computer and Hurricane
Katrina are like the wind. The wind could blow from the east; it could blow
from the west. When the wind stops - the boat is becalmed wherever events
leave it.
Keynes went further than this. In the fruit bowl view of the world,
the shocks that rock the bowl are predominantly fundamental; these are
shocks that will have a lasting eect on the ability of the economy to produce
commodities and satisfy human wants. The invention of the automobile. The
5

CHAPTER 2. TWO VISIONS OF THE ECONOMY

As the bowl
rocks, the ball
moves back and
forth

Shocks rock
the bowl

The ball always

returns to the
same point

Figure 2.1: The Fruit Bowl Model of the Economy

discovery of oil in Alaska. The personal computer. In the windy boat view
they might also include what Keynes called the animal spirits of investors
and Alan Greenspan referred to as irrational exuberance. In other words
- the wind might blow for no sound economic reason and it might leave the
economic boat stranded in calm waters with high unemployment for a very
long time. When writing about his view of the long run and the short run in
1924 when the debate was about the speed that prices would adjust Keynes
famously asserted that; In the long run we are all dead!1 .

2.1

The Depression and Economic Theory

Keynes was a very clever man - but he was a polemicist and pragmatist first
and a social scientist second. He was a student of Alfred Marshall, one of the
founders of modern economics. Keynes studied under Marshall in Cambridge
England in the early part of the twentieth century. During the 1920s Keynes
1

A Tract on Monetary Reform (1924, Chapter 3).

2.1. THE DEPRESSION AND ECONOMIC THEORY

The wind
blows the boat
The wind can
blow in any
direction

The boat is blown

around and can
end up anywhere

Figure 2.2: The Windy Boat Model of the Economy

wrote a number of books on economics including a Treatise on Money and
a major work on the theory of probability that was not well received by the
critics.2 He worked as a bureaucrat, an academic and a journalist but he
did not come to prominence in the public eye until the publication of a best
selling book in 1920, the Economic Consequences of the Peace (1920). In it,
he argued that the Treaty of Versailles, which sliced up German assets after
World War I, was unworkable and would have disastrous consequences for
international relations and world peace.
In the late 1920s Keynes was a conventional fruit bowl economist. It
was his interpretation of the Great Depression that caused him to change his
views and to develop an alternative theory that would justify policies that
he believed were the right way to cure the Great Depression. Fruit bowl
economists argued that in hard times everyone needed to tighten their belts.
Just as a family would need to save more if its income fell so the consensus opinion amongst mainstream fruit-bowl economists was that government
2

A Treatise on Probability, Keynes (1921). For a discussion of the reception of the

Treatise see Robert Skidelsky (1992), pages 6773

CHAPTER 2. TWO VISIONS OF THE ECONOMY

must do the same. Keynes argued for exactly the opposite. His remedy for
the Great Depression was a massive public works programme paid for by
borrowing or by printing money.
It was one thing to be sure of oneself and another to explain why state of
the art economic theory was wrong. As Keynes put it in the opening chapter
of the General Theory;
The classical theorists resemble Euclidian geometers in a nonEuclidian world who, discovering that straight lines apparently
parallel often meet, rebuke the lines for not keeping straightas
the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the
axiom of parallels and to work out a non-Euclidian geometry.
To convince his fellow economists that they were wrong - Keynes made
two major changes to the fruit bowl model of the economy. First, he insisted
on overturning the paradigm of demand and supply as applied to the labor
market. Second, he introduced animal spirits as a separate fundamental
factor that determines unemployment.
Supply and demand is a building block of modern economic theory. According to this model, one that had persisted for over a hundred years when
Keynes was writing, the price of a good and the quantity sold are determined
by the intersection of a downward sloping demand curve and an upward sloping supply curve. When applied to the labor market, the model implied that
there could be no unemployment in the sense that Keynes defined it since
the price of labor (the money wage) would either rise or fall until demand
was equal to supply. How could this model be a good description of a world
where unemployment of over twenty percent could persist for more than five
years? Keynes proposed instead to throw out the labor supply curve and
replace it with the idea that employment is determined only by demand.
This bold proposal was successful because the policies that were suggested
by Keynes were successful. But it was also a major weakness that would
return to haunt Keynesian economists in the two decades following WWII.

2.2

Macroeconomics before Keynes

The state of the art in understanding business cycles in the 1920s was summarized in an influential book, Industrial Fluctuations, by the British economist

2.2. MACROECONOMICS BEFORE KEYNES

30

Percent of the labor force

25
20
15
10
5
0
90

00

10

20

30

40

50

60

70

80

90

00

Unemp loyment

Figure 2.3: The Unemployment Rate Since 1890

Arthur Pigou.3 In it, he listed at least six dierent causes of business cycles
including errors of optimism and pessimism, agricultural fluctuations caused
by the weather, shocks to productivity as a consequence of new inventions,
monetary fluctuations, industrial disputes and changes in tastes. These were
all possible causes of disturbances to the fruit bowl. Nobody at this time
disputed the fact that, left to itself, the fruit bowl will tend to return to
its unique rest point. The Great Depression of the 1930s changed this view
forever.
Figure 2.3 plots the percentage of unemployed persons in the United
States from 1890 through 2007. The ups and downs that occur at irregular
intervals are a manifestation of business cycles and it is these ups and downs
that Pigou attributed to a laundry list of possible causes from optimism and
pessimism to changes in tastes. There are two features of the graph worth
noting. First, the upward spike that began in 1929 and ended in 1941 is
much larger than any spike in unemployment that has occurred before or
since. The closest episode is the recession that occurred in the last decade of
the nineteenth century in which unemployment reached 18% and exceeded
3

Pigou (1929).

10

CHAPTER 2. TWO VISIONS OF THE ECONOMY

10% for six years in a row. Second, fluctuations in the unemployment rate
since 1941 have been less volatile than fluctuations before world war two. I
will return to this latter fact when I discuss the success of Keynesian policies.
A recession is a time in which families tighten their belts and reduce
expenditure. Since there is less money coming into the household - less
must necessarily go out. According to the fruit bowl view of economics the same applies to government. Because tax revenues are reduced during
a recession the government should cut back on its expenditure. This fruit
bowl view was overturned by Keynes who provided a theory that explained
why governments should instead spend more during recessions.

2.3

Macroeconomics after Keynes

The Great Depression was significant because it put a dent in the notion of
the unregulated capitalist economy as a self-correcting system. According to
the theory laid out by Pigou in Industrial Fluctuations the Depression must
have been caused by one of the six fundamental factors listed above. The first
problem with Pigous theory is that it is dicult to identify a fundamental
shock of significant importance that could have triggered a depression of the
magnitude that was experienced in the 1930s. The second problem is that
whatever this shock might have been, a self-correcting economy should have
returned quickly to a state of full employment.
As an alternative to the classical model of demand and supply Keynes
threw away the labor supply curve, one of the equations that economists
used to describe a rest point of the classical economic system. He replaced
this equation with what he called the animal spirits of investors. In one
stroke this solved both problems of the Pigouvian system. The impulse that
caused the Great Depression was a spontaneous fall in expectations about
the future - a kind of mass hysteria aecting all stock market participants
simultaneously. In this interpretation of events the stock market crash was
the impulse that triggered the Great Depression. The failure of the system to
return to full employment followed from the fact that the economy does not
possess any self-correcting mechanism of the kind envisaged by Pigou and
his contemporaries. In Keynes view, any level of optimism or pessimism
would be consistent with a rest point of the system since the forces that tend
to restore equilibrium are either non existent or so weak that we would not
expect to see them operating in finite time.

2.3. MACROECONOMICS AFTER KEYNES

11

In contrast to the fruit bowl view that government should reduce expenditure in a recession; Keynes argued instead that the government should borrow
money and use it to stimulate aggregate demand. He explained why this was
appropriate with his alternative windy boat theory of the economy. In the
fruit bowl economy - every dollar spent by government is one less dollar spent
by households since the size of the pie is fixed. In windy boat economics,
an extra dollar spent by government increases the size of the pie and causes
an increase in the amount available to both government and households.
Keynes argued for deficit spending, that is, during recessions the government should borrow and use the borrowed money to purchase goods and
services from private firms. He explained how this increase in government
expenditure would cause a change in the equilibrium of the economy that
would stimulate employment and cause an expansion in economic activity
that would make everyone better o.
Keynes ideas were tried in a half-hearted way during the Great Depression by Franklin Delaware Roosevelt who initiated relatively modest public
works programs.4 These were too small to have much eect. Deficit spending
on a large scale wasnt tried until the United States entered WWII and at
this time Keynesian policies were dramatically successful. The U.S. economy
rebounded and in the early 1940s unemployment fell to historically low levels,
gdp growth accelerated and output per person finally caught up with where
it would have been if the depression had not occurred.
During the first three years of the depression stocks lost 84% of their peak
value and investment expenditure fell to zero. At the same time unemployment went up from 4% in 1929 to 25% in 1933. According to Keynes - the
drop in the value of the stock market caused the increase in unemployment
and he constructed a theory that was taught to several generations of postwar students which explained why. His explanation involved a spontaneous
loss in confidence (animal spirits) that caused a drop in purchases of new
investment goods; nobody wanted to invest in capital if the existing capital,
embodied in firms, was worthless. The drop in investment caused businesses
to fire workers because they could not sell everything they were producing.
These workers, in turn, bought less consumption goods and the net result
was a new equilibrium of the economy with higher unemployment and a lower
value of gdp.
To correct the situation Keynes argued for a massive public works pro4

Robert Skidelsky (1992, Chapter 14).

12

CHAPTER 2. TWO VISIONS OF THE ECONOMY

gramme. In 1940 government expenditure was equal to 12% of gdp, a number

that is roughly equal to investment expenditure in the same year. By 1945
government expenditure had increased to 50% of gdp, and unemployment fell
from 15% to 2%. This is exactly the result that was predicted by Keynes who
argued that if private investment expenditure is too low it must be replaced
by government expenditure to increase aggregate demand. The success of the
Keynesian explanation of these events led the Nobel prize winning economist
Milton Friedman to assert in a 1965 interview with Time Magazine that We
are all Keynesians Now.5

2.4

How to Fix Keynesian Economics

Although there is much in Keynesian economics that has merit; it is a static

theory that fails to account for the way that forward looking households
plan for the future. In my book Expectations Employment and Prices I
retain the basic idea of Keynesian economics, that the macroeconomy is not
a self-correcting system, but I make two changes that put the theory on a
sounder theoretical footing. First, I provide a foundation to Keynes theory
of aggregate supply in which I explain why flexible prices are not sucient
to maintain full employment. In other words, I explain why the economy is
not a self correcting mechanism. Second, I provide a dynamic foundation to
Keynes theory of aggregate demand that replaces his static theory of the
multiplier.
According to the Keynesian theory of the multiplier, a one dollar increase
in government expenditure causes a more than one dollar increase in expenditure on goods and services. Every dollar spent by government increases
employment. The newly employed workers, in turn, spend some fraction of
their increased income on goods and services and these increases generate
additional employment. The additional employment generates further expenditure and a cascade of additional expenditures that converges to a final
5

There appears to be a long history of misattributions of this quote. In private correspondence, Riccardo DiCecio pointed out to me that the phrase We are all Keynesians
now, often attributed to President Nixon is from Milton Friedman and incomplete. Nixon
said Im now a Keynesian in economics according to journalist Howard K. Smith of ABC
news. Friedman in an interview with Time said in one sense, we are all Keynesians now;
in another, no one is a Keynesian any longer. However, Time magazine only quoted We
are all Keynesians now.

2.4. HOW TO FIX KEYNESIAN ECONOMICS

13

increase in aggregate demand that is larger than the initial increase in government purchases by a multiple that depends on the propensity of households
to save. In Keynesian theory, a recession is caused by a lack of demand by
firms and it must be replaced by the demand of government. It is the success
of this theory in influencing politicians that accounts for a vastly increased
role of government in the post-war economy.
In the theory I develop in my 2009 book, in contrast to the standard
Keynesian approach, consumption depends on wealth as well as income. I
argue there that the Great Depression was caused by a fall in stock market
wealth that triggered a fall in consumption. The drop in consumption and
the drop in investment were both secondary events caused by the change in
business confidence. This diers from the Keynesian account where there is
a causal chain from business confidence to investment to consumption. The
dierence is significant since the Keynesian theory suggests that investment
must be replaced by government purchases to restore aggregate demand. I
will explain this dierence and the policy proposal that it leads to in Chapter
10.