keynesian vs classical in economics

Keynes made a big contribution to economics in the 1930s. His seminal work on aggregate demand changed the prevailing paradigm and offered a view of the economy directly at odds with prevailing classical theories. The question is which view has been proven right over the long term and which view holds the answer to our economic objectives. To state right from the beginning, my view is that the work of classical economists best represents the workings of the economy and most likely holds the solution to economic problems and objectives. Keynesianism arrives on the scene after the Great Depression in the 30's and the first world world war. Its analysis states that classical views of the macro economy are flawed and that economies can come into equilibrium at dangerously low levels of economic activity following shocks (recessions, sudden price changes, credit crunches etc). It only really gained traction as a the default method of economic approach after the second world war, when all major western democracies turned to aggregate demand management as a means of providing stability, employment, growth whilst controlling infaltion. In summary the Keynes view was that economies go into recession because there is too little demand in aggregate. People have chosen not to consume but to save instead (the paradox of thrift). In short the Keynesian viewed the economy as a machine: - prime a pump here and the economy responds predictably - inject cash there and inflation and employment come into a new equilibrium in a known way and at acceptable levels - hold back government spending there and the economy will gently relax and not overheat What went wrong for Keynesianism? Through 20-30 years of its ascendancy (from 50s to the mid to late 70s), Keynesians followed the prescriptions of their economic model with some success in accelerating and decelerating economic activity. But by the 70s the economies of the world were increasingly reacting in unpredictable ways, every round of fiscal stimulus was followed by ever more violent economic shocks and the injection of more cash, runaway inflation and more chaos. The inflation knocked onto currencies, confidence in countries, IMF bailouts, busts quickly followed booms, and the booms were less and less impressive. Then the very thing the Keynesian analysis said could not happen, happened. Both inflation and unemployment started to rise together (so called stagflation). The Philips curve (much loved by Keynesians) was no longer a predictable curve and most Keynesian economists were caught like rabbits in headlights. They literally did not know what to do next. Step forward the neo-classicists. The Chicago school (led by Milton Friedman), gave a perfectly clear and straightforward analysis. Nothing new here as Keynes had done a similar thing years earlier. However he not only reversed the view of Keynes, but also showed how the policies leading up to, for example, the Great Depression were caused by the wrong application of classical economics and an overly tight monetary policy. Fundamentally economies are naturally (but not predictably) given to highs and lows. According to the Classical view, the best way to manage economic activity in a normal situation is to keep a stable monetary environment with minimal government intervention (laissez faire capitalism), where the lows will naturally recover. As long as the economy is as dynamic as possible and free enterprise is not crowded out of the capital markets by Governments tinkering and large scale public spending, the mechanisms of markets will correct the imbalances. For Friedman and others the problem in the Great Depression was not the Keynesian analysis, ie that economy stabilised at low levels of activity and needed a stimulus. But instead that the money supply was allowed to collapse by central banking authorities meaning, credit was not available to flow into the free enterprise system, which therefore could not create jobs. It was therefore monetary contraction that led to deflation and credit collapse not a shortfall in aggregate demand (which instead was just a summary of the micro economic detail). But also, by implication, monetary expansion (above the level of economic growth) led to inflation and ultimately chaos. This policy later became the hallmark of the Keynesian approach as they desparately tried to bail out Government spending by printing more and more money. For the Keynesian, inflation was caused by cost-push factors (materials costs), or demand pull factors (too much disposal income), not by monetary imbalances. It was the classicists that were proven right. This has been demonstrated time and again in every country by analysis of the money supply (M2) as a proportion of output, and its direct impact on prices (inflation). The Credit Crunch of 2007 had the potential to turn into another Great Depression. Taking the UK as an example output dropped hugely and a response was required. It is fair to say we saw a small Keynesian style expansion in government spending in 2008 above its trend increases. The increase was about 25bn pounds net. However, it was the neo-classical approach advised by Friedman that was used to avoid the potential economic meltdown. The Quantitative Easing (QE) programmes followed by the Bank of England pumped 550bn pounds into the economy to avoid deflation and the chain reaction of a credit collapse. Whilst all major economies saw significant contraction, we did not see the years of grinding desparation and stagnation of the 1930s. Companies could survive, re-finance their balance sheets, move forward with investments and continue to retain staff. In truth economies appear to follow the rules of chaos theory rather than a predictable machine. Whilst they can appear benign and predictable at the macro level, they are dynamic and unpredictable at the micro level. Any apparent machine like harmony at the macro level, is in reality a seething mix of millions of daily, individual transactions, rationality and sentiment. The classical response to this is to allow the market to act organically, find its own level and allow the market to respond flexibly to changes without Government intervention. All in the context of a sound monetary framework. The Keynesian response is to poke and prod at prices and demand until a temporary market rigidity is achieved, around some arbitrary goals deemed desirable. The latter approach simply stores up the equivalent of tectonic forces in the markets until when they break, they do so catastrophically. The former approach will lead to ups and downs that naturally correct themselves, unless overwhelming forces require either tightening or loosening of that monetary framework (see Credit Crunch comments). The more we see a gradual reduction in taxation and Government expenditure, the more we will see dynamism return and economies grow, producing opportunities for all not just for the technocrats in Government.