Concepts: The Economic Consequences of John Maynard Keynes

Gunnar Jaerv
Gunnar Jaerv 23 January 2021

John Maynard Keynes built on the ideas of Irving Fisher to propose a solution to the shortcomings of free markets that left the markets themselves mostly intact.

Working during the 1920s and onwards, Keynes opposed a return to the gold standard after the First World War and took a leading role in the Bretton Woods Conference after the Second World War.

In between, he laid the foundations of an approach to economics that stressed outcomes and encouraged state intervention.

Irving Fisher and the money supply

Irving Fisher is mostly remembered for his work on money. Here is Fisher’s formula:

P = MV + M1V1

P is prices. M is ordinary cash money in circulation; M1 is bank deposit money. V is the velocity of money, and V1 is the velocity of bank deposits — how quickly they are spent.

Everyone knows that prices rise when the supply of money rises. In this sense, you cannot change the money supply without changing the economy; if you do, prices in the new money will expand until they match real prices. If potatoes are $1 a pound and the supply of dollars doubles, some people hope to buy two pounds of potatoes; others suspect that potatoes will be $2 the pound tomorrow. Both are right and neither; increased investment thanks to increased supply of money can increase the actual supply of potatoes, lower the cost of production and thus lower the real price as well as reducing the real value of money. (Getting as much of the first effect and as little of the second as possible was Keynes’ work.)

Fisher’s formula adds something to this understanding because it takes into account the rate at which money is spent. If money is added to the economy but is spent slowly, the effect is not the same as if the money is added fast and spent fast. The speed it’s spent at increases its effect of driving up prices. It also increases its stimulatory effect on production and investment.

The final element in Fisher’s formula is the T: the number of transactions. A small number of large transactions have more effect than a large number of small ones. This transaction refers to the initial one that brings the money into the economy into the first place.

That’s Fisher’s formula. Using it, we can understand what’s likely to happen to the economy if money is pumped into it. If the money goes into bank accounts and stays there, the answer is “not much.” If it’s spent almost immediately the effect will be far greater.

Depression, growth and demand

Fisher helps us understand how events like the Great Depression can happen: when no-one has any money to spend, the few who have what money there is hold on to it. Less money moves around the economy; fewer businesses put out invoices, more go bust, unemployment rises, and every time it does, the practical, available high-velocity money supply dwindles still further. Aggregate demand across the economy falls; without demand, production falls and there is soon nothing to buy, just as for most people there is no money to buy it with, and no jobs available in which to earn any.

In the 1930s, with one in four US workers unemployed, the possibility of a downward spiral with no end in sight wasn’t a nightmare; it was the news. The stock market fell for three years straight. Just printing banknotes doesn’t solve this problem.

So what does this have to do with Keynes?

Keynes and the Depression

Keynes is often thought of as the ‘tax and spend’ economist. If the traditional, classical economics viewpoint was summed up by Winston Churchill in 1905, that ‘for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle,’ the Keynsian view is commonly held to be the opposite. Deficits don’t matter, and government should spend. Though it’s true that Keynes was concerned with how governments should manage the economy to the benefit of all participants, there is more to Keynes than this.

Keynes’ great insight was to propose an additional lever in economic management: to address money supply directly through public borrowing, and to address velocity at the same time and through the same policy. Keynes saw a need to not just give people money, but to get them to spend it too.

The General Theory

In 1936 Keynes published The General Theory of Employment Interest and Money, which he told George Bernard Shaw would “largely revolutionize” the global approach to economic problems. Keynes laid out this problem: the classical economic view is that free markets tend to an ideal equilibrium. Left to themselves everyone will find a job, every business will find a way to make money, and the Invisible Hand of Adam Smith will operate to ensure a productive economy with strong aggregate demand and supply to match.

Keynes, writing in the Great Depression, pointed out that some free markets settled in a different equilibrium, and argued that they could settle on a permanent underemployment equilibrium. Worse, an economy with falling production reversed the normal economic rules that kept investment equal to savings. Instead, as businesses lost money and workers lost jobs, investment fell but savings fell further. The equality between the two was maintained at a cost of slumping production, employment and income. This is what actually was happening outside his window as he wrote.

What was the answer?

Spending our way to wealth

Put briefly the Keynesian solution was this: government should and could borrow and spend money into existence and pay it directly to people, individuals, who would then spend it almost immediately. The initial transaction would be, in Fisher’s terms, singular — only one entity, government, would spend.

And velocity would be high. People who have been unemployed and have now found work typically spend their money on real products — clothing, food — rather than saving it. Aggregate demand would rise and stimulate production. Businesses would see there was money to be made, hire people and start making things; individuals would have money to spend and things to buy with it. Taxation could recover the excess and help to prevent inflation.

Keynesian stimulus was the thinking behind much of the Roosevelt New Deal, which was intended to rescue the wider economy as well as provide income to the unemployed. In the view of classical economics Keynesianism is heresy, a kind of world-turned-upside-down attitude to everything from sovereign debt to the nature of money that can still be found in counterarguments to descendents of Keynes like the advocates of Modern Monetary Theory now. But Keynes’ solution worked.

It worked even better in the Second World War.

Keynes and the War

Keynes’ economic ideas proved decisive in the Second World War when they were implemented by the US government to drive the largest ever expansion in production and prosperity in the whole of human history.

These statistics show the effects:

1929 $0.105 $1.109 NA Depression began
1930 $0.092 $1.015 -8.5% Smoot-Hawley
1931 $0.077 $0.950 -6.4% Dust Bowl
1932 $0.060 $0.828 -12.9% Hoover tax hikes
1933 $0.057 $0.817 -1.2% New Deal
1934 $0.067 $0.906 10.8% U.S. debt rose
1935 $0.074 $0.986 8.9% Social Security
1936 $0.085 $1.113 12.9% FDR tax hikes
1937 $0.093 $1.170 5.1% Depression returned
1938 $0.087 $1.132 -3.3% Depression ended
1939 $0.093 $1.222 8.0% WWII, Dust Bowl ended


The dollar amounts are nominal GDP in trillions, and real GDP in trillions. The years 1929 to 1933 wiped three billion dollars off the US GDP. The years 1933 to 1939 added it back. But from 1939 to 1946 the story is even stranger:

1939 $0.093 $1.222 8.0% WWII, Dust Bowl ended
1940 $0.103 $1.330 8.8% Defense increased
1941 $0.129 $1.566 17.7% Pearl Harbor
1942 $0.166 $1.862 18.9%
1943 $0.203 $2.178 17.0% Defense spending tripled
1944 $0.224 $2.352 8.0% Bretton Woods
1945 $0.228 $2.329 -1.0% WWII ended, recession
1946 $0.228 $2.058 -11.6% Truman budget cuts

In these years, the US was supporting its own armed forces, and those of China, the USSR, and Great Britain through Lend Lease. Demand from Chaing Kai-Shek, Stalin and Churchill was high — limitless, in fact — but payment was deferred. Yet the economy doubled in size. Jobs opened, wages went up. The bucket rose, Churchill notwithstanding.

By 1955, the average American teenager had the same disposable income as the average family of four in 1935. The average per-capita US income in 1935 was $474 a year. In 1945 it was triple that; in 1955 it was $1,881.

Keynes and inflation

Classical economists warned that inflation would be the result, and it was. The great danger of inflation in these circumstances is a wage-price spiral. With a greater supply of money, prices rise. Faced with higher prices the employed demand more money in wages. Faced with higher wage bills employers raise prices. Savings are diminished, investment deterred and eventually the public loses trust in money and the economy collapses, as with Weimar Germany or Zimbabwe. The US never got this bad but inflation was a problem.

Keynes proposed to solve this problem by raising taxes to mop up the excess money supply and subsidizing basics such as foodstuffs, meaning it would then be possible to ask workers to accept lower wages and help break the spiral. It was tried but did not work. There was too much spare purchasing power; in this sense, the Keynesian solution to the Depression had actually worked too well.

The only solution found was direct intervention by government in the form of maximum price fixing for most major industries. This was practiced throughout the War in the US, Britain and elsewhere (including in Nazi Germany). Britain was regarded as the greatest success but it worked everywhere. This innovation was not Keynes’ but that of his student John Kenneth Galbraith, who was actually in charge of price fixing in the US during the War.

Keynes after the War

After the War, Keynes had a major influence on the Bretton Woods conference and his ideas were adopted into the mainstream of Western economic thought; Richard Nixon claimed to be a Keynesian, ironically on the occasion of taking the US out of the Bretton Woods agreement; even Milton Friedman said, ‘we are all Keynesians now.’

However, Keynes’ theory had a fatal flaw — it was ‘all gas, no brakes’; there was no inbuilt way to deal with inflation. Taxation was never fully effective. Sticking too close to Keynes left western economies facing both inflation and stagnation simultaneously, known as ‘stagflation,’ a kind of inexplicable economic exhaustion that nations reached back to classical economics to solve. This move brought its own set of problems, particularly issues with aggregate demand, income stagnation and unemployment, and many of the solutions currently being proposed sound much like those proposed by Keynes.


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