One of the hardest things in the world for anyone do to is to change their mindset. Keynes, who suckled at the teats of classical economists, took off the emerald glass spectacles he was given to wear, and took a long hard look at the Depression-era. He had in his life also variously been a businessman and a fairly successful speculator. What he saw was that the theories he taught and had been taught could not explain what was happening.
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In a teeny nutshell, classical economics based itself on some key assumptions in modeling the macroeconomic landscape. One was that demand always exceeded supply. The other was that because demand always outstripped supply, involuntary employment was impossible. All you had to do to get a job was accept what was on offer. These assumptions made sense-–if you lived in the 18th century. To argue then that people were short of food and basic necessities, and that if you could provide it, they would always buy it, made sense.
Keynes's big a-ha was to realize that in the 20th century, supply could exceed demand. At least, supply of items for discretionary spending could certainly exceed demand. If you didn't have the money to buy it, you would do without it. But if your economy was based on lots of people buying stuff they didn't really need, then when demand evaporated, so did your jobs. Because if people weren't buying stuff, it didn't matter how little money they were willing to accept as pay. No manufacturer would hire 100 employees to make shoes if he only needed to make 10 shoes, and one employee would suffice for that. Even if you could pay them at 1/100th the salary of the one employee.
It seems so trite to us. So obvious. But at that time that was as big a realization as Gallileo's realization that the sun did not turn round the earth. Suddenly, the world was different and you weren't in Kansas any more. That's some powerful thinking.
Here're some other things about classical economics that Keynes thought didn't fit the 20th century world:
Savings weren't irrelevant. Money wasn't irrelevant. Those classical economists assumed that people who had money either spent it (e.g., buying cloth) or used it to invest in factors of production (e.g., looms to weave cloth). This makes a lot of sense when most people didn't have access to bank accounts, and the modern monetary system didn't exist. In the 20th century, we had banks and a modern monetary system. Many more people had money to spend, and to save. But classical economists in love their theories said, "Well, if people weren't investing in new business opportunities, then just lower interest rates on bank deposits. This would make it uneconomical for them to save and so they would invest it in money-making businesses." Keynes's insight was that people weren't accounting machines seeking to make their money work harder. People were people. And since they could save, they saved to protect themselves from uncertainty.
And that is the next major milestone. A milestone that was rapidly discarded post-Keynes. People did not know what the future would bring. Even collectively, they weren't prescient. They weren't omniscient. And so they would fall back on convention, on what everyone else was doing, because that was safe. So instead of your rational homo economicus--a kind of Warren Buffet, rational, intelligent, and willing to bet that everyone else was dead wrong--you had lemmings. Lemmings who might buy shares of companies that were grossly overvalued and had no sensible business plan because hey, everyone else was doing it. The market was not automatically self-correcting. Because everyone was doing the same conventional thing. People didn't want to be radical with their money. They wanted to do what seemed safe. Even if it really wasn't.
The economists need to take a reality check from time to time. All that geeky number crunching theory must be real orgasmic, but sometimes you gotta raise your head from the desk and look at the real world. I love it that Keynes did that.
Keynes's General Theory got a lot of things right. And he got it right especially for that situation at that time. Unlike what economists want to think, that's not an indictment. Because economics is ultimately a social science. At the heart of it, it's not billard balls bouncing around a table. It's about people and human systems, each and all complex and changing. There CAN be no magic bullet theory that applies across the board, a Grand Unified Theory of How People Behave for Always and Forever. What explains things at a microeconomic level doesn't scale upward to the macro. What explained things for the 19th century isn't going to explain things for the 20th. Sure, nice mathematical equations and graphs probably help get the cushy professorships and the lucrative consultancies. But these explain what happened before. Maybe, just maybe, things have changed. Time to look out the window.
