Classical vs. Keynesian Economic Theory

Classical vs. Keynesian economic theory Classical economic theory was the generally accepted economic paradigm until the Great Depression. Classical economics is said to have begun with the publication of Adam Smith's influential 18th century treatise the Wealth of Nations. In this text, Smith states that the 'invisible hand' of the market should be allowed to govern human economic decision-making. Producers supply their product to meet consumer demand, and the market arrives at a fair equilibrium price naturally. When consumers are willing to pay more, suppliers make more goods.

As price goes up, demand goes down. As price goes down, demand goes up, but producer's willingness to produce more goods goes down as well. These assumptions were challenged by the spiraling downward of the economy after the 1929 stock market crash. While classical economists did recognize that there were boom and bust cycles within the free market economy, they believed that these cycles would be naturally corrected if the business cycle was left to run its course.

Eventually, prices would become so low during a recession consumers would begin to buy goods and services again. However, the great economist John Maynard Keynes stated this was not always the case. Consumers during a severe economic contraction would wisely fear for their jobs and 'hide their money' under the mattress, according to Keynes. This policy, while wise for the individual, was unwise for the economy, and would cause consumption to plummet still further. More individuals would be laid off, only intensifying the cycle.

Even investors would 'hide their money' under the mattress -- i.e., not invest in commerce and infrastructure -- given the turbulent economic climate. Ironically, wages that were too high may have intensified the Great Depression. Wages were supposed to plummet during a recession, according to conventional classical wisdom. However, wage rates were constant until 1931, which effectively meant in an environment of rapidly decreasing prices, wages had gone up.

Wages proved to be 'sticky' to changes in the economy, yet consumers did not spend their additional money, and layoffs continued to increase. Adding to the problem was that the United States was still on the gold standard, which meant that the amount of money it could print was limited by its amount of gold reserves.

The Federal Reserve was forced to adopt a deflationary economic policy to remain on the gold standard: to be fiscally responsible it increased its discount rate, the rate at which member banks could borrow from the central bank, effectively raising the interest rate the banks were forced to charge to consumers (Smiley 2008). The economy thus continued in its downward spiral of allowing less money for investment, decreased production, increased unemployment, and decreased consumer demand.

The solution to this spiral was government spending, according to the Cambridge-educated British economist John Maynard Keynes: "Keynes believed that consumption was the key to recovery and savings were the chains holding the economy down. In his models, private savings are subtracted from the private investment part of the national output equation, making government investment appear to be the better solution. Only a big government that was spending on behalf of the people would be able to guarantee full employment and economic prosperity.

Even when forced to rework his model to allow for some private investment, he argued that it wasn't as efficient as government spending because private investors would be less likely to undertake/overpay for unnecessary works in hard economic times" (Beattie 2010). For the world to extricate itself from the Great Depression, said Keynes, the government must intervene in the market. Keynes' rationale is one reason that the current administration's stimulus package in response to the recent economic downturn has been termed Keynesian in nature.

Keynes advocated spending money and increasing the deficit during recessions, and avoiding deficits during expansionary periods to stem inflation. Because of his fear of a 'hoarding' effect Keynes also tended to view a higher level of overall employment as a greater necessity than classical economists. Due to Keynes' influence, the federal government increased in size, nearly doubling within a few scant years: "during the 1920s, there were, on average, about 553,000 paid civilian employees of the federal government. By 1939 there were 953,891 paid civilian employees, and there were 1,042,420 in 1940" (Smiley 2008).

Keynes also advocated a 'loose' money policy and lowering interest rates to encourage investment during recessions. Rather than an invisible hand, Keynes conceived of a government that was forever tinkering with the economy. Keynes passionately believed that it was unwise to wait for markets to naturally 'correct' themselves. "Keynesians believe that what is true about the short run cannot necessarily be inferred from what must happen in the long run, and we live in the short run.

They often quote Keynes's famous statement, 'In the long run, we are all dead'" (Blinder 2008). Furthermore, in contrast to classical economists, Keynes wrote that prices tended towards rigidity -- hence the 'stickiness'.