Classical vs. Keynesian Economic Theory Explained

Classical Economics and the Invisible Hand

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 argues 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 produce more goods. As price rises, demand falls. As price falls, demand rises, but producers' willingness to supply more goods decreases as well. These foundational assumptions were challenged by the spiraling economic collapse that followed the 1929 stock market crash.

The Great Depression and the Failure of Classical Theory

While classical economists recognized that boom and bust cycles existed within the free market economy, they believed these cycles would be naturally corrected if the business cycle were left to run its course. Eventually, prices would fall low enough during a recession that consumers would begin buying goods and services again. However, the great economist John Maynard Keynes argued that this was not always the case. During a severe economic contraction, consumers would rationally fear for their jobs and "hide their money under the mattress," according to Keynes. This behavior, while prudent for the individual, was destructive for the economy as a whole, causing consumption to plummet further. More individuals would be laid off, only intensifying the downward cycle. Even investors would effectively hide their money — that is, refuse to invest in commerce and infrastructure — given the turbulent economic climate.

The Gold Standard and Deflationary Pressures

Ironically, wages that were too high may have intensified the Great Depression. According to conventional classical wisdom, wages were supposed to fall during a recession. However, wage rates remained constant until 1931, which effectively meant that in an environment of rapidly decreasing prices, real wages had risen. Wages proved to be "sticky" — resistant to change — yet consumers did not spend their additional purchasing power, and layoffs continued to increase.

Adding to the problem was the fact that the United States remained on the gold standard, which limited the amount of money it could print to its available gold reserves. The Federal Reserve was forced to adopt a deflationary economic policy to remain on the gold standard: in an effort 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 rates that banks were forced to charge consumers (Smiley 2008). The economy thus continued its downward spiral of reduced investment, decreased production, rising unemployment, and falling consumer demand.

Keynes and the Case for Government Intervention

The solution to this spiral was government spending, according to the Cambridge-educated British economist John Maynard Keynes. As one account summarizes: "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 or 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.