Why Keynesian economics encourages spending
What changed in the Great Depression? In 1929, the American economy started to collapse and by 1933, when things reached rock bottom, it had shrunk by 30%. Millions of people lost their jobs, a quarter of the US population was unemployed, and it was pure chaos.
Classical economists who thought employment would always remain around a “natural” level were shocked. While they argued that in the long run employment would recover, not everyone accepted this response. Enter John Maynard Keynes with his famous quote: “In the long run we are all dead.”
Keynesian economics says there’s no guarantee that any left-over money will be reinvested into the economy. And when people start to panic as they did in 1929, investment might be seriously reduced. Reduced investment means people are paid less, which means they spend even less, which reduces investment even more… you get the idea. To break out of this cycle, Keynes argued that governments could stimulate the economy with spending 💰
If a government borrows money to spend on a new infrastructure project, all the people working on said project will have money in their pockets. They’ll probably spend some of that new income and it becomes part of the economic cycle. If they spend some at their local bar, the bar owner now has a bit more cash which she can spend… and the cycle continues. In jargon-y terms, the “fiscal multiplier” turns a bit of government spending into a lot of good for the economy.
During World War II, huge government spending on the military helped boost growth – seemingly proving Keynes right. And after the war, Keynesian economics became mainstream, pushing countries down the road to recovery.
But by the ‘70s, the ideology had fallen out of favor. People worried about governments crowding out private investment, whether government spending would always trickle down to increased economic growth, or whether it would just lead to people hoarding even more cash. The biggest worry was inflation: whether too much money in the economy would drive prices up and cause more problems than it solved.
Keynesian economics wasn’t fully discredited – it played a key role in government responses to the 2008 financial crisis, when they boosted spending to stabilize the economy. But the ‘70s brought more than just disco music with it – a new breed of economics boogied along too. Greed is good, right?
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