Simple way to think about the Keynesian model.
Keynesian, New Keynesian.
But let's boil it down to essentials.
Economic downturns are very often caused by a shortfall in aggregate demand.
Aggregate demand you can think of very crudely as spending.
So more formally,
aggregate demand is consumption plus investment plus government spending.
Think of that as a flow of funds,
a flow of revenue directed to producers of goods and services.
Consumption plus investment plus government spending.
If aggregate demand falls, in essence,
that means the flow of revenue to producers of goods and services
is also falling, or it's lower than it had been, or lower than we want it to be.
And this creates a problem of economic adjustment.
The question, then, is how well does an economy
handle this problem of economic adjustment.
There exists an equilibrium, to use that famous economic
phrase, which has become a kind of joke.
But there exists an equilibrium in which that flow of spending falls, and
at more or less the same, time wages fall also.
So even though spending is down, costs and
expenses are down, and businesses can keep on producing what they had been producing,
keep output at its previous level, keep profits at their previous level and so on.
But allthough that's a possible equilibrium,
very often that's not what happens.
This is a problem, and economists call it price and wage stickiness.
Let's focus on wage stickiness.
So if we're talking about costs falling for businesses, for a lot of businesses,
the main costs, especially at the margin, is labor cost.
It's hiring more people.
It's paying someone to do something.
So if your revenue is falling, to keep your same profit in real inflation
adjusted terms, it's very hard to cut the wages of your workers,
because workers don't like having their wages cut for
reasons which may be emotional, or we economists would call behavioral.
But think of it as a problem of morale.
If you've been working seven years at a company, and
all of a sudden your wage is cut, you feel like you're not valued anymore,
you feel like maybe you'll be fired.
You feel you're not treated very well.
You complain about the boss, you don't work as hard.
Maybe you create trouble, in extreme conditions, you sabotage production.
And it's very costly for bosses, in many situations,
to cut the wages of their employees.
So wages are somewhat sticky.
And often if that flow of revenue is slowing down,
what will happen is the employers lay off some of the laborers,
very often the least abled ones, and then you have increased unemployment.
Those people don't have jobs.
Their expenditures fall.
That, in turn, contracts revenue streams for other parts of the economy, and
you get this progressive downturn where many different sectors at once are all
shrinking or contracting or falling back, because of this initial shortfall of
aggregate demand combined with what economists call price and wage stickiness.
Particular strengths of the Keynesian model.
The first strength of the Keynesian model, first and most obvious strength,
is that it explains a good deal of real-world business fluctuations.
That is, you can go out and look at economic history, and
you find numerous important cases where a major problem,
or the major problem, has been a shortfall in aggregate demand.
The classic example, I think, is the Great Depression.
Go back to 1929 through 1932.
You have a very large number of bank failures in the United States.
People essentially lose their checking accounts, or lose part of that value.
Consumer spending is much lower.
There's a big negative shock to aggregate demand, and as a result,
you end up with this shortfall in economic output.
The Keynesian model explains some parts of the Great Depression very well.
The Keynesian model has a few major weaknesses.
The first, simply,
is that not all economic downturns are caused by declines in aggregate demand.
The second weakness of the Keynesian model,
is that it is often better as a diagnosis than as a cure.
So Keynesians typically recommend activist monetary policy, or
activist fiscal policy, to get an economy out of a downturn.
There's a lot of evidence form history that fiscal policy
very often doesn't work very well.
Monetary policy, in my opinion, is much more effective.
But to advocate that kind of monetary policy,
you don't actually need the full Keynesian model.
You can be what Scott Sumner and I called neo-monetarists.
Be a sophisticated quantity theory, and you can pick up a lot of the better sides
of the Keynesian argument without picking up a lot of the excess theoretical baggage
that is often found among Keynesian economists.
Those are not the only criticism of Keynes, but
I think they're two of the most direct and straightforward.