Keynesian vs. Neo-Classical Economics: A Historical Overview

Introduction: The Evolution of Economic Thought

The word economics is derived from the Greek "oikonomikos," meaning skilled in household management. Although the root word is very old, the discipline of economics as we understand it today is a relatively recent development. Modern economic theories emerged in the 17th and 18th centuries as the Western world began its transformation from an agrarian to an industrial society. Despite the enormous differences between then and now, the economic problems with which society struggles remain essentially the same. How does a nation balance available resources against demand on a regional, national, and now global scale in order to produce high levels of employment and create real and lasting wealth for its citizens? What motivates workers to engage in the economic struggle of building wealth? How does a nation provide, create, and maintain a rising standard of living for present and future generations?

Progress in economic thought toward answers to these questions tends to move in small steps rather than evolving smoothly over time, because economic systems are most often governed by the old adage "if it works, don't fix it." Only when problems arise — or when a set of significant new economic influences enters the marketplace — do individuals become willing to change a complicated economic system. A new school of thought emerges as changes in the economy yield fresh insights and challenge old ways of thinking. That new school eventually becomes the consensus view, only to be pushed aside by the next wave of ideas or brought into question by the next economic crisis. This process continues today, and the motivating force behind the evolution of economic ideas remains the same as it was three centuries ago: to understand the economy so that we may use it wisely to achieve society's goals.

The dominant economic theory of recent decades has been that of John Maynard Keynes. Keynes developed theories of "demand-side" economic controls, and his theories were chiefly influenced by the experience of the Great Depression, which affected not only the Americas but also Europe and Australia. Reacting to the severity of the worldwide depression, Keynes in 1936 broke from the classical tradition of a laissez-faire approach to government involvement in the economy and published The General Theory of Employment, Interest, and Money. To fully understand Keynes, one must understand his work as a reaction to the existing conditions of the economic slowdown that created the depression. His theories, which shaped the economic policy of democratic governments for roughly 70 years, were founded in a response to a lagging economy in need of revitalization rather than as a blueprint for ongoing economic progress. However, Keynesian theories have begun to lose their hold in more modern times.

Classical Economic Theory and Its Foundations

The classical view assumed that in a recession, wages and prices would decline and thus restore full employment. Because of lower prices for goods, individuals would be able to purchase more with their limited wages, and the economic cycle would re-energize itself. However, the widespread nature of the Great Depression had left individuals without any income for a prolonged period, and therefore the economy did not have enough resources to jump-start itself again — it needed fresh investment before it could recover.

The classical tradition began with the publication in 1776 of Adam Smith's monumental work, The Wealth of Nations. The book identified land, labor, and capital as the three factors of production that fuel economic growth — the major contributors to a nation's wealth. In Smith's view, the ideal economy was a self-regulating market system that automatically satisfies the economic needs of the populace by measuring supply and demand. He described the market mechanism as an "invisible hand" that leads all individuals, in pursuit of their own self-interest, to produce the greatest benefit for society as a whole. Smith rejected the idea that only agriculture was productive and recognized that individual labor and manufacturing power were assets to the country.

Keynesian Theory and Government Intervention

While Adam Smith emphasized the production of income, David Ricardo added to the theory by focusing on the distribution of income among landowners, workers, and capitalists. Ricardo saw a conflict between landowners on the one hand and labor and capital on the other, suggesting that the growth of population and capital, pressing against a fixed supply of land, would push up rents while holding down wages and profits. Together with Thomas Robert Malthus's idea of diminishing returns — which explained how low living standards could persist in the face of continuing economic expansion — these three thinkers accurately described the conditions that would ultimately bring about a depression.

Responding to the economic reality of the 1930s, Keynes held that falling prices and wages, by depressing people's incomes, would prevent a revival of spending rather than stimulate one. As the global economy languished, his theories proved themselves against the classical model. Keynes insisted that direct government intervention was necessary to increase total spending by investing in the economy and thereby restarting economic activity.

Keynes's arguments created the basis for the modern rationale for using government spending and taxation to stabilize the economy. Under his framework, government should spend money and decrease taxes when private spending is insufficient and a recession threatens. Conversely, government should reduce spending and increase taxes when private spending is excessive and inflation threatens. Government was thus to abandon the laissez-faire approach to economic activity and function instead like a flywheel on an engine — preventing the economy from slowing under great strain while restraining it from accelerating too fast during periods of expansion. Keynes's analytic framework, focusing on the factors that determine total spending, remains the core of modern macroeconomic analysis.

Conclusion: Shifting Paradigms in Economic Policy

Economic theories are changing constantly. Keynesian theory, with its emphasis on activist government policies to promote high employment, dominated economic policymaking in the post-war period. But government over-involvement stalled economic progress starting in the late 1960s, creating troubling inflation and lagging productivity. This new malaise prodded economists to look for new solutions. The supply-side economics resurgence, framed as neo-classical theory, recalls the Classical School's concern with economic growth as a fundamental prerequisite for improving society's material well-being. It emphasizes the need for personal worker incentives if the nation's economy is to grow and sustain itself into the future.