Keynesian vs. Classical Views on Government Spending

Introduction

Debates about macroeconomic policy tend to focus on two major schools of economic thought — the classical school and the Keynesian school, or derivatives thereof. One of the central debates concerns whether government should increase spending in order to fight recessions. This debate also relates to the question of maintaining a balanced government budget. The latter is policy in many jurisdictions, particularly in the United States, reflecting a classical fiscal policy view, while the Keynesian view is more often reflected in national-level policy, especially outside of the United States.

Increased Government Spending and the Keynesian Position

With respect to how best to handle a recession, increased government spending is typically viewed as a yes-or-no decision. Keynes argued that government spending should be increased during recessions to help manage economic downturns, a view opposed by classical economists. Perhaps the most obvious recent example of this debate being put into practice came in 2009, when, during the depths of the recession, President Obama sought to increase spending to help stabilize the economy, a position opposed by Republicans. There was obviously a political dimension to this conflict as well, but the roots of the conservative position lie in the underlying economic debate.

Keynes is credited with popularizing the idea that government spending can be used during recessions to bolster the economy. The underlying principle is that the economy is driven by several growth components — government spending, business investment, net exports, and consumer spending. In a recession, consumer spending and business investment decrease, and if all else is equal, the economy will contract as well. The government can, however, offset this decrease with an increase in its own spending. Furthermore, there is a multiplier effect associated with increased government spending: certain businesses must expand to meet government demand, more people can be employed, and both of these outcomes feed further spending. In essence, the increased government spending creates a virtuous cycle — a positive feedback loop that counters the negative feedback loop of the recession (Investopedia, 2018).

This view of deficit spending is often a mischaracterization of Keynes's precise prescription for maintaining full employment. Keynes argued that "the scale of investment should be equal to the savings which may be expected to emerge…when employment, and therefore incomes, are at the desired level." In other words, Keynes only favored deficit spending during times of recession and was otherwise opposed to it. This socialization of spending was meant to focus on temporary measures exclusively during downturns, in order to maintain employment as close to full as possible (Brown & Collier, 1995).

The Neoclassical Counterargument

The classical view — or more accurately, the neoclassical view — holds that markets should be left to find their own equilibrium, which would provide a better allocation of resources in the long run. Deficit spending, or indeed substantial government influence in any form, would lead to inefficient resource allocation. Government intervention necessarily creates distortions in the economy, meaning that even in times of recession, government interference would ultimately be harmful (Khan & Aziz, 2011).

In essence, these two positions approach the issue from very different and fundamentally incompatible perspectives. The Keynesian approach is pragmatic, seeking to maintain full employment in the short run, and does not place great weight on leaving economic outcomes entirely to market forces. Equilibrium, in this view, is not necessarily quick to arrive, and in any case is likely to produce winners and losers. Economic equilibrium, even if considered a worthy goal, is not the same thing as a society in which everyone has a job and can meet their basic needs.

The neoclassical view, by contrast, is largely unconcerned with short-term human outcomes. To the extent that human welfare matters within this framework, it is evaluated on an aggregate, long-run basis; short-run casualties are treated as an acceptable cost. The pursuit of a purely market-driven economy is considered a worthy end in itself. The question of whether such an economy is actually desirable is assumed rather than examined — of course the market is ideal, because in theory it achieves the best asset allocation. As such, anything that runs counter to economic purity — including deficit spending during recessions — is considered undesirable by default.