Economics, like all intellectual enterprises, is subject to the law of diminishing disciples. A great innovator is entitled to some poetic license. If his ideas are at first somewhat rough, if he exaggerates the discontinuity between his vision and what came before, no matter: Polish and perspective can come in due course. But inevitably there are those who follow the letter of the innovator's ideas but misunderstand their spirit, who are more dogmatic in their radicalism than the orthodox were in their orthodoxy. And as ideas spread, they become increasingly simplistic--until what eventually becomes part of the public consciousness, part of what "everyone knows," is no more than a crude caricature of the original.
Such has been the fate of Keynesian economics. John Maynard Keynes himself was a magnificently subtle and innovative thinker. Yet one of his unfortunate if unintentional legacies was a style of thought--call it vulgar Keynesianism--that confuses and befogs economic debate to this day.
Before the 1936 publication of Keynes' The General Theory of Employment, Interest, and Money, economists had developed a rich and insightful theory of microeconomics, of the behavior of individual markets and the allocation of resources among them. But macroeconomics--the study of economy-wide events like inflation and deflation, booms and slumps--was in a state of arrested development that left it utterly incapable of making sense of the Great Depression.
So-called "classical" macroeconomics asserted that the economy had a long-run tendency to return to full employment, and focused only on that long run. Its two main tenets were the quantity theory of money--the assertion that the overall level of prices was proportional to the quantity of money in circulation--and the "loanable funds" theory of interest, which asserted that interest rates would rise or fall to equate total savings with total investment.
Keynes was willing to concede that in some sufficiently long run, these theories might indeed be valid; but, as he memorably pointed out, "In the long run we are all dead." In the short run, he asserted, interest rates were determined not by the balance between savings and investment at full employment but by "liquidity preference"--the public's desire to hold cash unless offered a sufficient incentive to invest in less safe and convenient assets. Savings and investment were still necessarily equal; but if desired savings at full employment turned out to exceed desired investment, what would fall would be not interest rates but the level of employment and output. In particular, if investment demand should fall for whatever reason--such as, say, a stock-market crash--the result would be an economy-wide slump.
It was a brilliant re-imagining of the way the economy worked, one that received quick acceptance from the brightest young economists of the time. True, some realized very early that Keynes' picture was oversimplified; in particular, that the level of employment and output would normally feed back to interest rates, and that this might make a lot of difference. Still, for a number of years after the publication of The General Theory, many economic theorists were fascinated by the implications of that picture, which seemed to take us into a looking-glass world in which virtue was punished and self-indulgence rewarded.
Consider, for example, the "paradox of thrift." Suppose that for some reason the savings rate--the fraction of income not spent--goes up. According to the early Keynesian models, this will actually lead to a decline in total savings and investment. Why? Because higher desired savings will lead to an economic slump, which will reduce income and also reduce investment demand; since in the end savings and investment are always equal, the total volume of savings must actually fall!
Or consider the "widow's cruse" theory of wages and employment (named after an old folk tale). You might think that raising wages would reduce the demand for labor; but some early Keynesians argued that redistributing income from profits to wages would raise consumption demand, because workers save less than capitalists (actually they don't, but that's another story), and therefore increase output and employment.
S uch paradoxes are still fun to contemplate; they still appear in some freshman textbooks. Nonetheless, few economists take them seriously these days. There are a number of reasons, but the most important can be stated in two words: Alan Greenspan.
After all, the simple Keynesian story is one in which interest rates are independent of the level of employment and output. But in reality the Federal Reserve Board actively manages interest rates, pushing them down when it thinks employment is too low and raising them when it thinks the economy is overheating. You may quarrel with the Fed chairman's judgment--you may think that he should keep the economy on a looser rein--but you can hardly dispute his power. Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.