No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seventeen: A Short History of Macroeconomics 433 that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing…Labour is not more truculent in the depression than in the boom—far from it.” Wages had fallen in Great Britain during the decade, but not enough to clear the market. Was there something else going on that was impeding market clearing? Keynes theorized that classical economics had relied on a fundamentally wrong assumption, Say’s Law, which argued that production of goods and services provided the basis of purchasing power. In a world of Say’s Law, if a producer of shoes produced 100 pairs of shoes per day, the value of those shoes would be purchasing power for the producer and his or her workforce to purchase other goods. What if something prevented buyers from purchasing the producer’s shoes? What if markets were full of “bulls and bears,” and subject to large changes in optimism (bullishness) and pessimism (bearishness)? In Keynes’ mind, stock markets were little more than gambling casinos. Emotional mood swings were par for the course, and investment spending was ultimately governed by psychological factors. When excessive “bearishness” prevailed, investment spending would dry up, something with which most classical economists derided by Keynes would agree. But rather than prices falling enough to make investment goods attractive and spending resume, you would instead see a vicious downward spiral: workers in the capital goods industries would become unemployed and would not have purchasing power—they could then not buy other consumption goods and services. This would result in reduced production of consumption goods, and workers in those industries would be laid off, reducing their purchasing power, which would result in lower demand for goods those workers would normally buy. And on and on the vicious spiral would go. Indeed, in Keynes’ model, for a group of workers to take a wage cut, they would only be contributing to the problem—since there would be less spending than normal, and the spiral would continue downward. There are numerous critiques of this Keynesian story, such as here and here, which we will not explore. Yet the conclusion for Keynes is this: The solution to the depression is to stabilize the total spending in the economy, what he called effective demand (and modern macroeconomics calls aggregate demand, or AD). For Keynes, the normal state of affairs is underemployment equilibrium; the classical case of full employment was only a special case—thus he claimed his was the more “general theory.” In his model, savings was declared bad (and given the pejorative term “money hoards,” as if money that is not spent on consumption is necessarily idle and serves no other function) while consumption was good. This led him to advocate for income redistribution, since savers by their hoarding would harm the economy, while lower income groups could be counted on to spend more of their income. And if this was not sufficient to get to a full employment, then government should engage in public works. It didn’t even matter what the public work was: you could pay one group of workers to dig a hole, while paying another group of workers to fill it up. No, I’m not making this up!