The story of the rise of Keynesian economics is fascinating. From the late 19th century onwards, neoclassical economics theory dominated the mainstream discourse of macro and microeconomics. Under the assumption that humans are rationale and their decisions are rooted in efforts to maximize the utility of their purchasing power, neoclassical economics theory stressed the importance of microeconomics influence on macro level markets. Heavily reliant on mathematical models and statistics, neoclassical economics theory asserted that a free market and a focus on individualistic methodology offered reliable foundations by which to navigate and forecast maximum utility in a marketplace. Yet, neoclassical economists’ belief in the fixed behaviors of individuals desire to maximize profit in their daily life has felt increased scrutiny as the global economy has shown itself to be more capricious than their mathematical models suggest. Although solid as an outline, neoclassical economics theory did not take into account the complexities of interactions on an individual level. It did not adequately address the idea of “rationality” in individuals or the possible influence of the macro-level economics on the micro: models such as the general equilibrium theory made assumptions about the consistency of the rational human behavior in the marketplace. No matter how much neoclassical economics took pride that its mathematical models made it “practical”, its theories were somewhat removed from the complicated thoughts and behaviors of economic people. Thus, neoclassical economics theory has been challenged.
World War II changed the economic landscape forever, and neoclassical economics was among the challenged. From the ashes of a devastating war that had its roots in a financial and economic collapse, economic thinkers sought to find a way to prevent a reoccurrence of a Great Depression post-1945. Critics of neoclassical economic theory and its attention to micro-economy censured this system for supporting excessive investment without corresponding consumption, as well as unfettered and unaccountable greed of those who had control of finances, such as banks. As a result, a new economic world order was required: On one hand, too much focus on individualism and micro-economics was viewed skeptically. On the other, the rise of communism post-1945 demonstrated the dangers of economic engineering with too much government intervention. A balance was found and so began the rise of Keynesian theory in neoclassical economics.
John Maynard Keynes
First presented in a 1936 book The General Theory of Employment, Interest and Money, John Maynard Keynes was an English economist that stressed the importance of a mixed economy: one that appreciated both the vitality of the micro and macro-economy in order to provide a level of checks and balances to the system. Whereas neoclassical economic theory asserted that the micro level influenced macro economic institutions, Keynesian assumed both levels developed, succeeded, and failed together. Thus, the basis of Keynesian economics was that government management was needed in order to control recessions or economic depressions. Keynesian economics operated with the belief that government intervention would be most effective during the times of economic malaise in the private sector of the economy: at times of low demand or high unemployment, government management could stimulate the economy for the purpose of boosting employment or controlling inflation. Keynesian economics saw the most effective role of government spending to be through a reduction in interest rates and an investment in infrastructure. The assumption that this economic stimulation by government would create was an economic positive feedback cycle: Government investment would create employment, which boosts income, which increases spending, which increases production, which increases employment, which boosts income etc. etc.
Keynesian economics became widely regarded by economists and political institutions, with it influencing economic decisions from the Great Depression until the 1970s where greater attention was paid again to free market and neoclassical economics theory. However, following the economic collapse of 2008, leaders, such as US President Barack Obama, are returning to the principles of Keynesian and macro-economics in order to stabilize the global economy.
Keynesian theory in neoclassical economics is often viewed to be inherently contradictory. Yet, another school of economics known as neoclassical synthesis combined elements of neoclassical and Keynesian economics into one. Neoclassical synthesis fuses the micro-level models promoted by neoclassical theory of economics with the Keynesian belief that creating demand through government, not free market, could create further demand. There were several economists that popularized neoclassical synthesis, including John Hicks with his IS/LM model which linked micro-level demand and employment as being influenced by three important components provided limitations of government effectiveness in interfering: overall business forecasts, government budget, and the amount of money in circulation. Another supporter of neoclassical synthesis was Paul Samuelson whose research on Welfare economics reinforced greater attention to macroeconomics as a means of regulating the micro. Neoclassical synthesis believed in both economic worlds.
