Keynes rejected these postulates as either wrong or inapplicable to the new world of institutional capitalism in which corporate managers had replaced entrepreneurs, labor unions now intervened to negotiate on behalf of workers, and banks and investment houses emerged to act as intermediaries between savers and investors. As for Say’s Law, Keynes thought that the existence of widespread unemployment contradicted the hypothesis that supply creates its own demand. He pointed out that producers and consumers act independently and not necessarily according to the same calculations. For these reasons, Keynes rejected Say’s Law and asserted the reverse: that it is consumer demand that calls producers into action. As for wages, he observed that there were unemployed laborers more than willing to work for prevailing wages, which meant that they were not “voluntarily” unemployed but were out of work because they had no offers of employment. To complicate matters, Keynes rejected the assumption that employers could easily reduce wage rates during slumps. Wage rates, he argued, were “sticky” rather than fluid (as the classical economists supposed) in a downward direction. The existence of labor unions ready to defend labor contracts or to call worker strikes made it even more difficult for employers to cut wages during slumps. (They typically cut production and employment instead.) In addition, wage cutting across the economy has deflationary effects, so it is possible for the price level to fall faster than wages, leaving the real wage as high or higher than when the process started.
As for saving and investment, Keynes again emphasized that savers and investors were no longer the same parties as they may have been in the previous century, but rather independent actors in the economy, operating on different views of the future. Now, savings and investment had to be brought together by financial intermediaries. He went further to argue that savings are a “leakage” from consumer demand and therefore tend to draw down investment as well, since investors respond to the ups and downs of consumer demand. Consumers change their rate of saving, and businesses and entrepreneurs their level of investment, for reasons largely independent of the interest rate. This means that there is no automatic mechanism to direct the flow of savings into investment and to maintain the two quantities at roughly equal levels.
Keynes concluded that there was no obvious process of adjustment in wages, prices, and interest rates that would correct the slide in employment and output. Under certain circumstances, there could be a general overproduction of goods, widespread unemployment, hoarding of money by consumers, and a collapse of investment—all occurring at the same time and in response to one another. This meant that the market might reach equilibrium at levels well below full employment; and Keynes argued that this was in fact what had happened in the 1930s. Wage demands could remain above the level where businesses are prepared to hire, especially in times of deflation. There might be times when low or even negative interest rates would prove insufficient to induce people to spend and invest. As incomes fall, so also do savings and the purchasing power of consumers. Those with jobs and incomes, seeing what is happening around them, hold back on purchases, further worsening the situation. Where there is weak consumer demand, there will be little investment, and thus no expansion in employment and incomes, and no progress in society. For all these reasons, slumps can be self-perpetuating and need not correct themselves by the natural operation of market processes. In that case, some external intervention is required to restore consumer demand, investment, and employment.
Having rejected the economic principles of the “classical” school, Keynes went on to attack its moral postulates as well. The virtue of thrift, for example, was not as socially beneficial as many claimed. Thrift, which might make sense for individuals, results in general harm when it is too widely practiced because it leads to the withdrawal of consumption from the marketplace and a consequent reduction in consumer demand. Since savings are not automatically used up in investment in times of slack consumer demand, increased savings can lead to a reduction in the wealth of the community and an acceleration of the downward economic spiral. This was his “paradox of thrift,” a not-so-subtle attack on the nineteenth-century proposition that thrift and deferred consumption are the foundations for order and progress.b Keynes reversed the traditional formula, insisting that consumption and debt, rather than thrift and saving, are the keys to prosperity.
The basic problem according to Keynes, and the reason that market economies so often fall short of potential output and “overshoot” on both the up and down sides, is that investors and businesses must make calculations about spending and hiring in the face of a fundamentally uncertain future. Investors are the “prime movers” of the economy, and also the source of market volatility. Consumers, by contrast, behave fairly predictably, spending a stable percentage of their incomes on goods and services of various kinds, except on occasions when fear and panic lead them to reduce expenditures and increase savings. Investors, on the other hand, must allocate funds based upon uncertain assessments of conditions many years into the future. “Our knowledge of the factors that will govern the yield of an investment some years hence is usually very slight and often negligible,” Keynes wrote in The General Theory. To complicate matters further, the evolution of stock markets requires investors to make judgments about how other investors assess the future—since those assessments, when added up, determine the value of stocks.
Keynes pointed to the distinction between risk and uncertainty. Risks are subject to calculation but uncertainties are not. Investors, Keynes argued, confront an unknowable future—that is, an uncertain future—when they commit funds for five, ten, or thirty years. They cannot know if a war, inflation, a natural disaster or some other unpredictable event will intervene to undermine their investments. In a rational universe, investors might keep their funds on the sidelines permanently due to the impossibility of knowing what the future holds. In the world as it is, Keynes suggested, investors are moved not by calculations of risk but by alternating moods of confidence and pessimism that are socially contagious but loosely grounded in real conditions. These are the “animal spirits” that at bottom drive the market economy. Keynes thought that investor uncertainty was a factor that kept interest rates too high because it required lenders to demand a premium on loans. Uncertainty also cut in the other direction: from the standpoint of businessmen, future profits may appear too uncertain to justify the loans required to expand or start their enterprises. In times of pessimism, uncertainty was one of the factors that drove the economy along in a downward spiral. This element of Keynes’s theory pointed in the direction of central bank policy to maintain interest rates at low levels to eliminate the “uncertainty premium,” even if such a policy risked inflation or weakening of the currency.
Keynes thus drew a portrait of the market economy that was very close to the opposite of that drawn by his eighteenth- and nineteenth-century predecessors. They saw a system that operated like a machine with its various parts working together to keep it moving forward even in the face of external shocks, which might slow it down but could not knock it off course for very long. In their view, entrepreneurs and investors were the rational and calculating participants that kept the economic machine moving. Keynes described a system that was inherently prone to booms and busts because its various parts did not work in harmony and because it was greatly influenced by shifting investor moods. In his theory, investors and entrepreneurs were the dynamic but capricious elements, putting their funds into play and withdrawing them according to those shifting moods about future prospects and in response to the spending and saving decisions of consumers.
Thus, consumers and investors increased or reduced their spending in a reciprocal dynamic, creating a “pro-cyclical” bias in the system and giving the market its boom-and-bust character. Keynes looked to government spending and borrowing as a countercyclical factor that might stabilize the system, particularly during slumps when consumer hoarding and investor pessimism sent the economy into a downward spiral. This new role for government may have represented his most radical departure from his nineteenth-century predecessors.
Keynes was by no means the first economist or public figure to call for public spending or public works projects to reduce unemployment during slumps. Spending on public works was a common theme in political platforms in the United States and Great Britain during the 1920s and 1930s, though the proposals were generally set forth as emergency measures, not as a systemic means of stabilizing the economy over the long term. Keynes