KEYNESIAN ECONOMIC THEORY

Until the onset of the Great Depression (1929–1939), it was conventional wisdom in classical economics that the best way to manage the economy was to take a laissez-faire, or "hands off," approach. Classical economists believed that, left to their own devices, economies tended toward full employment on their own, and that the best way to deal with a depression was to expand the money supply and wait for the economy to return to "equilibrium."

In his landmark 1936 book, The General Theory of Employment, Interest, and Money, the English economist John Maynard Keynes (1883–1946) argued that the classical economists had it all wrong. Some depressions were so severe that consumer demand needed to be artificially stimulated by government fiscal policies such as deficit spending, public works programs, and tax cuts. During deep depressions, Keynes believed, when the government expanded the money supply pessimistic consumers would simply hoard the money rather then spend it. As proof that Keynesian economic theory was true, economists pointed to the fact that the U.S. economy recovered from the Great Depression only through heavy deficit spending during World War II (1939–1945). Keynesianism became official government policy when the Employment Act of 1946 gave the federal government the explicit responsibility to use fiscal policy to maintain full employment as a way of keeping consumer demand and economic growth strong.

During the administrations of Democratic Presidents John F. Kennedy (1961–1963) and Lyndon B. Johnson (1963–1969), Keynesian economic theory guided government policy. A major tax cut in 1964 that spurred economic growth seemed to prove again that Keynes' faith in government fiscal measures had more validity than laissez-faire economics. By the early 1970s even Republican President Richard M. Nixon (1969–1974) admitted, "We are all Keynesians now." However the 1970s introduced a new phenomenon that Keynesian economic theory seemed to have no answer for: high inflation together with high unemployment— a phenomenon known as "stagflation." Keynes and all other economists had believed that when unemployment is low, inflation would be high because a fully employed economy consumes a lot, thus, prices would be driven upward. Stagflation seemed to leave the government without options: if it stimulated demand to reduce unemployment inflation would climb, but if it dampened demand to fight inflation unemployment would rise.

Stagflation turned out to be so difficult a problem that by the time President Ronald Reagan (1981–1989) entered office he was calling Keynesian economic theory "a failed policy." In a return to laissez-faire economics, he proposed that the government stop deficit spending and grow the money supply at a stable rate. The currency growth has been kept under control, and with budget cuts and an expanding economy, the budget was balanced under President William Clinton (1993-2001).

See also: Inflation, John Maynard Keynes, Laissez Faire, Stagflation