Chapters 22-24
Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Oser Summary Main Page
Chapter 22: The Keynesian School
John Maynard Keynes (1883-1946) was the son of John Neville Keynes (a logician and political economist), a student of Marshall and Pigou (See Chapters 14 and 21), and held important positions in many areas. At age twenty-eight he became editor of the Economic Journal, and managed the investments of its publisher, the Royal Economic Society, and the finances of King's College of Cambridge. He was chairman of the board of a life insurance company, the director of several other companies, on the governing body of the Bank of England, a high government official, a journalist, and a professor at Cambridge. After World War I, he was the principal representative of the British Treasury. Keynes was also his country's chief negotiator in organizing the International Monetary Fund and the International Bank for Reconstruction and Development, and in obtaining the United States postwar loan to Britain.
Overview of the Keynesian School
The Social Background of the School
Keynes ideas grew out of the depression of the 1930's, but the roots of his ideas can be traced back to the works of Mitchell (Chapter 18), Marx (Chapter 10), Hobson (Chapter 21), Veblen (Chapter17), and many other economists prior to 1929. The growth of large-scale industrial production and commerce allowed for more statistical measurement and control providing a more adequate basis for the inductive aggregative approach. After World War I, the private-enterprise economies of the Western world were not performing as well as they had in the past. Production seemed to be outrunning consumption, population growth was declining, no new inventions like the steam engine, railroad, electricity, or automobile were stimulating investment, and price competition was declining which reduced the rate of replacement of old equipment. These developments supported the spreading anxiety about secular stagnation.
The Essence of the Keynesian School
The major principles of Keynesian Economics fall under three headings:
1. The immediate determinants of income and employment. These determinants are consumption and investment spending. Keynes assumed a high correlation between national income and the level of employment, although this is not necessarily true. Investments in automation to replace labor could cause national output and income to increase more rapidly than employment. However, Keynes neglected changes in technology because he was mainly concerned with the short run. Government spending provides an addition to total spending.
2. The ultimate determinants of income and employment, or the determinants of consumption and investment spending. Keynes assumed that consumption was determined by the size of income, was a stable proportion at each level of income, and falls as income rises. Investment spending is determined by the rate of interest and the marginal efficiency of capital, or the expected rate of return on new investments. The rate of interest depends on liquidity preference and the quantity of money. Therefore, the three main influences on income and employment are the propensity to consume, the desire for liquid assets, and the profits expected from new investments.
3. The idea that laissez faire was obsolete and the government needed to intervene to promote full employment by forcing the rate of interest down to stimulate investment, increase government deficit spending, and redistribute income to increase consumption spending. Keynes wrote that capitalism, if wisely managed could be made more efficient for attaining economic ends than any alternative system, but that it was itself extremely objectionable in many ways. The problem was how to develop an efficient system that did not offend our notions of a satisfactory way of life.
What Groups of People did the Keynesian School Serve or Seek to Serve?
Keynesian economics offered something for almost everybody, including laborers, businessmen, bankers, and farmers. Counter depression measures helped stimulate business activity providing greater opportunities for profit and more jobs for labor. Government controls gave the banking system liquidity, security, and stability, and bankers found government bonds to be a profitable investment. Farmers were provided with subsidies and regulations to raise their incomes. In defending government intervention, a spokesman for farmers claimed that each dollar received by a farmer generated a seven dollar increase in national income.
How was the Keynesian School Valid, or Correct in its Time?
The Keynesian approach provided the basis for national income accounting, and stimulated a large amount of fruitful inductive research related to the real world. The methodology is applicable to a wide variety of research including inflation and depression, to wartime and peacetime, to international economics and a closed national economy, and to public finance and the business cycle. Keynes formulated a general theory of income and employment, denied Say's law (Chapter 8), and demolished the classical and marginalist idea that a private-enterprise system would be self-adjusting at full employment. Keynes provided a program and theoretical justification for doing something about the problems (wars, depressions, etc.) that undermined laissez faire. Keynes showed that the neoclassical idea that reductions in wages would overcome a depression was incorrect. An entire economy cannot easily increase sales by cutting wages since wages are a source of demand for goods as well as a cost of production. Cutting wages would reduce expectations for future business activity, causing a postponement in investment spending, and make the depression worse.
How Did the Keynesian School Outlive its Usefulness
The school has not outlived its usefulness, but it does have some weaknesses and inadequacies. As mentioned above, Keynes assumed that consumption was determined by the size of income, was a stable proportion at each level of income, and falls as income rises. This appears to be true in the short run, but historically, the percentage spent on consumption has remained fairly stable as per capita income has risen. Keynes underestimated the potential possibilities of new technology and the capital investments it would stimulate, and denied the importance of economic growth of industrialized countries. The Keynesians were willing to accept a slow, but steady inflation to stimulate the economy, but this idea has become unpopular because of how it affects interest rates, stock prices, foreign trade, and government and corporate bond sales. Although Keynes preferred that the government finance useful rather than useless projects, the school has also been criticized for its willingness to accept wasteful government spending.
Immediate Determinates of Income and Employment
The immediate determinates of income and employment are consumption and investment spending. Ignoring government spending, the relationships are:
Y = C + I
where: Y = income, C = consumption, and I = investment
Savings (S) is the difference between income and consumption or
S = Y - C
Since Y - C = I, then S = I
Several examples are provided to illustrate how savings and investment are always equal. If a person saves fifty dollars, this simultaneously and involuntarily increases a retailer's investment in inventory of goods. When a business increases its investment through the creation of bank credit, new workers are hired, and their wages become saving until they are spent. When the workers spend their wages, a retailer or tavern keeper's investment declines by that amount. As inventories are replaced and increased because of the increase in business, incomes rise, and saving rises to match the increased investment caused by the expansion of bank credit.
Including government spending (G) and taxes (T), then income (Y) and saving (S) become:
Y = C + I + G and Y - C = I + G
S = Y - C - T
S + T = Y - C and since Y - C = I + G
S + T = I + G and S = I + (G - T), i.e.,
S = I + government deficit, or
S = I - government surplus
Keynes assumed that consumption depends on income, but consumption would not rise as much as income rises, or fall as much when income declines. Increasing investment spending also increases income, consumption, and savings, and decreasing investment caused income, consumption, and saving to decline. When consumption and investment spending are not adequate to maintain full employment, the government should add to income through spending financed by deficits.
Ultimate Determinants of Income and Employment
The multiplier measures the effect on income of a change in spending. The size of the multiplier is the reciprocal of the marginal propensity to save. For example, if the marginal propensity to save is .25 the multiplier is 1/.25 = 4. This means that an added dollar to investment spending will increase income by a dollar, adding 75 cents to spending and 25 cents to saving. This, in turn adds another 75 cents to income, and 56.25 cents to spending. As this process continues over time, income will be increased by $4.
According to Keynes, investment is determined by the marginal efficiency of capital and the supply price or replacement cost of the asset. The marginal efficiency of capital is the rate of discount that would make the present value of the expected returns equal to the supply price of the capital asset. It is the expected rate of profit of a new investment, before deducting depreciation and interest costs. Investments will be made up to the point where the marginal efficiency of capital is equal to the rate of interest.
The rate of interest depends on the liquidity preference and the quantity of money, i.e., currency and demand deposits. The liquidity preference depends on three motives: transaction, precautionary, and speculative. The quantity of money depends on central bank policy, i.e., open market operations, reserve requirements, and the rediscount rate. An increase in the quantity of money will lower the interest rate unless the public's liquidity preference is increasing more than the quantity of money. A lower interest rate will not decrease saving, as classical and neoclassical theory predicted, but instead will stimulate investment and subsequently income and saving.
The determinants of saving and investment are the propensity to consume, the schedule of marginal efficiency of capital, and the interest. rate.
Government Policy to Promote Full Employment
During depression, the government should stimulate private investment by forcing the interest rate down. Keynes was sympathetic toward entrepreneurs, but not to finance capitalist, speculators, or passive receivers of interest. He was skeptical of the success of monetary policy and thought interest rates were less important than government deficit spending in stimulating full employment. The economy could also be stimulated by redistributing income, although Keynes did not emphasize this approach. According to Oser, Keynes's greatest contribution was adapting economics to the changing institutional structure of modern society.
The "Stockholm School"
The Stockholm School studied aggregative economic processes in a way similar to Keynes. In 1933, Gunnar Myrdal drew a distinction between planned (ex ante) income, saving, and investment, and past (ex post) income, saving, and investment. Ex ante analysis is required to explain expectations for the future. To some extent they are based on the present or past, but there is no routine connection between the present or past and future expectations. Discrepancies between planned saving and planned investment represent disequilibria in the economy. Income shifts to the level where ex post saving and investment are equal. Where planned saving exceeds planned investment, income will fall until realized saving and investment are equal. If planned investment exceeds planned saving, income will rise until realized investment and saving are equal.
Chapter 23: Modern Theories of Economic Development and Growth
Many economists from different schools are interested in economic growth and development. Although these two terms have been used interchangeably, they have different meaning. Economic growth is defined as increasing total output, while economic development refers to rising output per man-hour. Economic development implies improvement, or increasing efficiency. The two do not necessarily move in the same direction since output per man-hour could be increased by idling the least efficient workers and factories. Growth, on the other hand can result in many ways that do not increase efficiency, i.e., by increasing the hours of work, or by increasing the number of young people, women, and old people in the work force.
An interest in economic growth and development has increased over the years for a number of reasons including:
Economic growth is associated with military power,
Western Europe and the United States have suffered from unemployment and stagnation,
The U.S. and Russia have been competing in terms of growth and economic develop to capture world attention,
Most of the poor countries (underdeveloped, developing, emerging) are promoting growth and economic development,
Capitalism and communism are fighting for leadership and the alliances with poor countries,
The idea that government policies can promote growth and economic development has become pervasive, and
The recognition that exporting capital investments in undeveloped areas stimulates fuller employment in the industrialized countries.
Schumpeter: The Decay of Capitalism
Joseph Alois Schumpeter (1883-1950) served as Minister of Finance of the Austrian Republic in 1919, became a professor at the University of Bonn in Germany, and taught at Harvard from 1932 until his death. His History of Economic Analysis, edited after his death by his wife is a monument to his scholarly achievements. Schumpeter was devoted to the institutions of capitalism, but agreed with Marx that capitalism was doomed, although for different reasons.
Schumpeter's theoretical system of business cycles and economic development was based on innovations and the entrepreneur. Entrepreneurs introduce new innovations such as the introduction of new products, new sources of supply of raw material or semi-manufactured goods, and new ways to organize an industry. Without new innovations, profit and interest would disappear, and the accumulation of wealth would cease. Business fluctuations occur as part of the process of adapting to innovation. Every depression represents a struggle toward a new equilibrium.
Schumpeter did not believe capitalism would survive for three reasons:
1. The obsolescence of the entrepreneurial function. Technological progress is becoming the work of teams in giant industrial organizations that have replaced the individual entrepreneur.
2. The destruction of the political strata that protected capitalist society. Big business destroys small and medium sized firms and weakens the political position of the middle class. Farmers who also defend capitalism are declining as a percentage of the population. College graduates who are incapable of professional work and object to manual work, develop a hostility toward capitalism in rationalizing their own inadequacies.
3. The destruction of the institutional framework of capitalist society. Policies that are destroying capitalism include progressive taxation, labor legislation that shifts questions related to wages, hours, and factory discipline to the area of politics, and the regulation of big business. Capitalism is kept alive by artificial devices. Government spending will become permanent policy, and international trade will come to be managed by political considerations. This will become "guided capitalism", or "state capitalism" as government ownership and management of industrial sectors increases. Such a state will suffer from inefficiency which could be eliminated by returning to pure capitalism, or by advancing to full socialism.
Baran: The Marxist Analysis
Paul Alexander Baran (1909-1964) was a professor of economics at Stanford University and an advocate of Marxian socialism. In The Political Economy of Growth he defended socialism stating that socialism could not be charged with the misdeeds of Stalin and his puppets. Soviet Russia's system of totalitarian socialism shows "that socialism in backward and underdeveloped countries has a powerful tendency to become a backward and underdeveloped socialism." Baran wrote that economic development involves a class struggle to transform society into an economy based on comprehensive economic planning for growth without the benefits of private enterprise.
Underdeveloped countries must also consider the problem of economic surplus. Actual economic surplus is the difference between society's actual current output and its actual current consumption. The potential economic surplus is the difference between the output that could be produced and essential consumption. The actual surplus is less than the potential surplus for a number of reasons including:
excess consumption of the rich and middle class,
output lost because of unproductive workers,
output lost because of irrational and wasteful organization, and
output lost because of unemployment caused by capitalist production and the deficiency of effective demand.
The potential economic surplus could become the planned economic surplus under socialist comprehensive economic planning guided by reason and science. The guiding force would not be profit maximization, but instead a rational plan reflecting society's preference related to current versus future consumption. The entrepreneur is the symbol of capitalist exploitation. Therefore, Marxism cannot allow the entrepreneur to play a crucial role in the economic system. According to Baran, the attainment of economic and social progress in underdeveloped countries requires the establishment of a socialist planned economy.
Nurkse: Balanced Development
Ragnar Nurkse (1907-1959) was a professor at Columbia University. He emphasized the development of undeveloped countries that required simultaneous expansion of industries that would support each other to increase their chances of success. Countries remain poor because of the lack of capital formation and their vicious cycle of poverty. The demand for capital is determined by the incentives to invest, and the supply of capital is governed by the ability and willingness to save. On the supply side there is a small capacity to save resulting from the low level of real income. On the demand side the incentive to invest is low because of the small buying power of the people, caused by their low income and low productivity. To advance, poor countries have to rely on industrialization. Two types of industrialization include producing manufactured goods for export to industrial countries, and manufacturing for domestic markets in underdeveloped countries. The second type provides the greatest opportunity for undeveloped countries, but requires a simultaneous advance in domestic agriculture. A balanced expansion is a means of accelerating the overall rate of output growth. This requires a synchronized investment of capital in a wide range of different industries to enlarge the market for all of them. To defeat the grip of economic stagnation, undeveloped countries have to be deliberately organized by central direction or collective enterprise. Most underdeveloped countries will need a combination of private and government action related to saving and investment.
Myrdal: National Economic Planning
Gunnar Myrdal (1898-1987) was a leader of the Swedish Social Democratic Party, a senator, minister of commerce, and executive secretary of the United Nations Economic Commission for Europe. There were three themes in his discussion of the problems of poor countries including:
A widening gap between the rich and poor countries,
The view that standard economic theory could not adequately explain or help narrow this gap, and
The governments in poor countries would need to play a larger role to stimulate economic development.
The widening gap between rich and poor countries can be explained by the principle of circular and cumulative causation. This Principle of circular movement could also work to sustain a cumulative process of improvement with less poverty, more food, improved health, and higher working capacity.
Although the doctrine of equality provides the basis for Western thought, orthodox economic theorists avoided the doctrine by emphasizing production and exchange, and expressing doubts about the need for reforms related to the distribution of income and wealth. Ideas used to evade the equality doctrine include the notion of a harmony of interest, laissez faire, the free-trade doctrine, and the view that the economy tends toward a stable equilibrium. According to Myrdal, standard economic theory is a rationalization of the dominant interest of the industrial countries, and is not concerned with the problems of underdeveloped countries.
Underdeveloped countries need much more government planning and intervention to have a chance of producing economic development. Their national plan should be focused on the long run needs of the community rather than the profits of individual firms. A larger share of their national income will have to be devoted to investment, and a forceful population policy is needed to control fertility. Imports of less necessary goods should be restricted, exports should be subsidized, and infant industries should be protected. Their governments needs to own and operate public utilities that are essential for growth, but tend not to be profitable such as railroads, highways, irrigation projects, and port facilities. Other desirable policies include support from intergovernmental and World Bank loans, land reform to raise productivity in agriculture, and widespread measures of government controls. These policies should promote an upward cumulative process where the scope of private enterprise is enlarged rather than restricted. This process could lead to a world that included an equality of opportunity between nations, racial and religious groups, and individuals that would raise the levels of production and promote social justice.
Rostow: Stages of Economic Growth
Walt Whitman Rostow (1916-2003) was a professor of economic history at the Massachusetts Institute of Technology, a consultant to the Eisenhower administration, and chairman of the State Department's Policy Planning Council under President Kennedy. Rostow's analysis of economic growth was based on five developmental stages:
the traditional society,
the preconditions for take-off,
the take-off,
the drive to maturity, and
the age of high mass consumption.
The traditional society stage involves low productivity based on pre-Newtonian science and technology. Newton was a symbol for the point in history when men realized that the external world was subject to a few knowable laws and could be manipulated in a productive way. The traditional society represents the world before Newton. Changes occurred during this stage, but per capita production remained low.
The precondition for take-off stage includes a society in transition where new scientific knowledge is applied to agriculture and industry, world markets and rivalries expand, economic progress is viewed as good and necessary, education broadens, enterprising men take risk and seek profits, commerce expands, investment increases, manufacturing firms appear, and political nationalism develops with strong national governments.
The take-off stage represents an industrial revolution where growth increases at a compound rate, there is greater investment in social-overhead capital, technological development increases in industry and agriculture, and those with political power give high priority to the modernization of the economy. This stage usually begins with a sharp stimulus such as a political revolution, a technological innovation, or a new favorable international environment such as a rapid rise in export prices. New industries expand rapidly and a large proportion of profit is reinvested. For example, the take-off occurred in Great Britain from 1783 to 1802, in France from 1830 to 1860, in the United States from 1843 to 1860, and in Germany from 1850 to 1873.
It takes approximately 60 years to move from the take-off to the drive to maturity stage where modern technology spreads over all economic activity, ten to twenty percent of national income is invested, the economy widens and deepens in its range of activities, and the character of leadership changes from industrial baron to professional manager of a bureaucratic machine.
The age of high mass consumption stage includes a shift toward the consumption of durable goods and services. Real income per capita rises, the percentages of urban population, office workers, and skilled factory jobs increase, and more resources are allocated to social welfare and security as well as private consumption. The mass production of an inexpensive automobile such as Henry Ford's 1913 assembly plant is a symbol of this stage. Western Europe and Japan entered this stage during the 1950's.
Rostow's five stages provide a dynamic theory of production and include an inner logic and continuity. Economic decisions that determine the rate of growth and productivity are influenced by human objectives other than economic motives. Rostow listed six other motives he labeled propensities. These include the propensities to develop fundamental science, to apply science to economic ends, to accept innovations, to seek material advance, to consume, and to have children.
Rostow's theory and analysis has received wide attention and approval because it is evolutionary, grounded in historical research, seems to show a predestined affluence for all, and presents a case for an inner logic that moves from one stage to the next requiring no deliberate effort or decision to promote growth.
Chapter 24: Economic History in Perspective
A Time Scale of Economic Doctrines
The graphic below illustrates the evolution of the various schools and streams of economic thought. Each rectangle represents a major school or area of thought. Oser's two-page illustration includes the names of the economists involved in each group, and connections (solid and dashed lines) between the schools and areas to show their relationships. For example, Oser's more involved illustration shows that the physiocrats were opposed to the ideas of the mercantilists (dashed line connection), but Adam Smith and the classical school were friendly toward the physiocrats (solid line connection). However, the classical school was antagonistic toward the views of the Marxist, marginalist, and single tax theory. The marginalist and neoclassical school disagreed with the views of the classical school, and Keynes rejected some of the major ideas of neoclassical school. The neoclassical school was friendly toward monetary economics, mathematical economics, and monopolistic competition, but disagreed with welfare economics, and Marxism or socialism.
The Impact of Three Scientific Revolutions on Economics
Three revolutions in scientific thought were developed by Newton, Darwin, and Einstein. Their discoveries influenced many areas of research beyond their own specilized fields of science. In this section Oser reviews their influence on economic thought.
Newton
Isaac Newton (1642-1727) made many significant contributions to mathematics and physics. The law of gravitation (the attractive force between two bodies in the universe varies proportionally as the product of the masses of the two, and inversely as the square of the distance between them) was his most famous mathematical statement. This was a revolution in seventieth-century thinking because Newton relied on experimental evidence, popularized the idea that the universe was governed by natural laws, and that space, time, and matter were independent of each other. The classical school used the idea that there were natural laws that guide the economic system and the actions of men. Newtonian thinking in classical economics supported laissez faire and the ideology that justified property incomes, rent, interest, and profit as necessary and just rewards for the ownership and productive use of wealth.
Darwin
Charles Robert Darwin (1800-1882) claimed to have applied the doctrine of Malthus to the whole world of animal and vegetable kingdoms. Darwin's discoveries related to the struggle for existence, natural selection based on individual differences, the survival of the fittest, and the evolution of the species were incorporated into Marxian thinking (Chapters 9 and 10), the German school (Chapter 11), and the institutional school (Chapter 17). The social Darwinists emphasized the struggle for existence and the survival of the fittest. The poor, the sick, and the uneducated were viewed as inferior beings, and should not blame society or the rich for their condition. The social Darwinists and the classical economists came to the same conclusion that laissez faire was the best policy, and that man should not interfere with the natural order of things. The neoclassical school was impervious to Darwin's ideas, and oriented toward Newtonian thinking that universal laws were applicable everywhere and would insure the best possible world without government interference.
Einstein
Albert Einstein (1879-1955) developed and presented the theory of relativity in 1905 which has some interesting implications for the social sciences. His influence on the social sciences has not been as great as Newton and Darwin probably because the social sciences have developed a relativity approach of their own independently. Einstein's theory shows that what is true for an observer in one system may not be true for an observer in another system. In the social sciences the relativistic outlook is represented by clichés such as "frame of reference," "value system," and "point of view." An example of where the approach has been applied to economics is the Keynesian idea that wasteful government spending is better than doing nothing if that is the only way available to stimulate the economy during a depression. If the alternatives are doing useful work or wasteful work, then wasteful government spending is a bad idea relative to the alternatives.
Why Study Economics and Its History?
Our study of economic history helps us understand what makes an economy work, what makes it hang together and function. Economic theory helps us reach our economic goals. It helps us understand our past, that many groups have contributed, but that no group has a monopoly on the truth. It also helps reveal unsolved problems and unanswered questions. It helps us see that even if all people fully understood economic theory, disagreements and conflicts would remain because of different views of what is good and what is bad, which goals should be adopted and which rejected, and what the priorities of each goal should be. Hopefully, as our understanding grows we will become more civilized, more humane, and more considerate of our fellow inhabitants of this planet.
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Go to Chapter 1 and the links to all Chapters. (Summary).
Related summaries:
Martin, J. R. Not dated. A note on comparative economic systems and where our system should be headed. (Note).
Milanovic, B. 2019. Capitalism, Alone: The Future of the System That Rules the World. Harvard University Press. (Summary).
Piketty, T. 2014. Capital in the Twenty-First Century. Belknap Press. (Note and Some Reviews).
Porter, M. E. 1980. Competitive Strategy: Techniques for Analyzing Industries and Competitors. The Free Press. (Summary).
Porter, M. E. and M. R. Kramer. 2011. Creating shared value: How to reinvent capitalism and unleash a wave of innovation and growth. Harvard Business Review (January/February): 62-77. (Summary).
Thurow, L. C. 1996. The Future of Capitalism: How Today's Economic Forces Shape Tomorrow's World. William Morrow and Company. (Summary).
