Page 77 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes

Caselet The Case of Borrowing Born Out of the
Great Depression

A t the core of Keynesian economics is the idea that fiscal policy (government
taxing and spending) should be used as a tool to control an economy.

It was a theory espoused by one of the 20th century's greatest thinkers, British economist
John Maynard Keynes, whose ideas helped shape the modern world economy and are still
widely respected and followed today.
Keynes's magnum opus – The General Theory of Employment, Interest and Money (1936) – was
a direct response to the Great Depression. He argued that governments had a duty, one
that had hitherto been neglected, to help keep the economy afloat in times of trauma.
It was a rebuke to an idea from Frenchman Jean-Baptiste Say (1767-1832) that in the economy
as a whole "supply creates its own demand", meaning that merely producing goods would
create demand.

The assumption until the Great Depression had been that the economy was in large part
self-regulated - that the invisible hand, left to itself, would automatically raise employment
and economic output to optimal levels. Keynes strongly disagreed.

During a downturn, he said, the drop in demand for goods could cause a serious slump,
causing the economy to contract and pushing up unemployment. It was the responsibility
of government to kick-start the economy by borrowing cash and spending it, hiring
public-sector staff and pouring cash into public infrastructure projects - for example,
building roads and railways, hospitals and schools. Interest-rate cuts can go some way
towards lifting an economy, but they are not the whole answer.
According to Keynes, the extra cash spent by the state would filter through the economy.
For example, building a new motorway creates work for construction firms, whose
employees go out and spend their money on food, goods and services, which in turn helps
keep the wider economy ticking over. Key to his argument was the idea of the multiplier.

Say the US government orders a $10bn (£6bn) aircraft carrier. You might assume the effect
of this would be merely to pump $10bn into the US economy. Under the multiplier
argument, the actual effect would be bigger. The shipbuilder takes on more employees
and generates more profits; its workers spend more on consumer goods. Depending on
the average consumer's "propensity to consume", this could raise total economic output
by far more than the amount of public money actually injected.
If the $10bn increase caused total United States economic output to rise by $5bn, the
multiplier would be 0.5; if it rose by $15bn, the multiplier would be 1.5.
Keynesianism has always been controversial. On what basis, ask many of its critics, should
we assume that governments know best how to run an economy? Is economic volatility
really such a dangerous facet?
Despite this, Keynes's arguments appeared to provide a solution to the Great Depression
in the 1930s, and Franklin D. Roosevelt's New Deal - unveiled in response to the crisis - is
seen as a classic example of a government "priming the pump" of its economy by spending
billions amid a recession. Arguments still rage over whether it was this or the Second
World War that eventually brought the Depression to an end, but the powerful message
was that state spending worked.
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