During the Great Depression of the 1930s, Keynes attributed the recession to a “lack of demand” and advocated active government intervention, while classical economists believed in market self-regulation. This debate became the foundation of modern economic policy.
In the 1930s, the world was suffering from a severe economic downturn called the Great Depression. Classical economists, the dominant school of economics at the time, believed that all economic flows were self-regulating according to the laws of supply and demand, and that the economy would recover naturally. Artificial market intervention, they thought, would only make things worse. Keynes disagreed. Keynes believed that the cause of chronic economic downturns was a “lack of demand” due to falling incomes, which led him to advocate the “theory of effective demand,” which states that governments should artificially stimulate demand by cutting taxes and increasing spending to increase national income and investment.
Keynes’s theory shocked the economics community at the time. While traditional economic theory emphasized the self-adjustment of the market, Keynes emphasized the active role of the government. He warned that economies can’t find equilibrium on their own and can fall into prolonged stagnation, and argued that governments should actively intervene to prevent this. Keynes’ theories have since become the foundation of modern macroeconomics and have greatly influenced many policies that emphasize the importance of government fiscal policy, especially during economic downturns.
For simplicity, let’s imagine a simple economy consisting of households, firms, and financial markets. Businesses need labor to produce goods, households provide it, income flows to households, and households spend it to buy the goods they need. If households spent all the money they earned on goods, income would always match consumption. In the real world, however, households don’t spend all of their income immediately. The unspent portion of a household’s income is often saved, and this savings leaks out of the income and consumption cycle. Of course, this savings leakage doesn’t sleep under the household’s duvet or pillow. Households leave their savings in the financial markets, and companies invest them to purchase factors of production.
Keynes’ idea was that if the amount of savings is smaller than the amount of investment, the economy will fall into a chronic state of stagnation. As people save more and spend less, firms’ production activity shrinks, which reduces household income. As incomes decline, people become anxious about the future and reduce consumption as much as possible and increase savings, which further reduces household incomes, leading to a vicious cycle. Thus, from the perspective of the national economy as a whole, savings have a negative effect on aggregate demand, deepening the recession. Keynes famously said, “Consumption is a virtue, saving is a vice.” This is what he meant.
However, classical economists believed that even in this case, the problem would be solved naturally, as the “interest rate” would adjust elastically according to the laws of supply and demand. If saving is greater than investment, the law of supply and demand will cause the interest rate to fall, and if the interest rate falls, saving will decrease and investment will increase. Therefore, the classical economists believed that the size of saving and investment will match.
Keynes, however, did not think that the size of savings and investment would match just by adjusting the interest rate. He pointed out that savings and investment are more sensitive to future economic, political, and technological developments, not just interest rates, and emphasized the need for artificial demand expansion by the government to restore the economy.
Although Keynes’s arguments were heavily criticized and debated at the time, they gradually gained acceptance as the policy to overcome the Great Depression. In particular, Keynesian economics gained even stronger support after World War II, when active government intervention in the economy played an important role in the recovery process. His theories have become the basis for important discussions in many fields, including politics and society as well as economics, and are still considered an important part of economic policy in many countries today.
