Perhaps John Maynard Keynes’ most lasting, important, and influential contribution to economic thought was his rejection of the assertion by classical economists  that the economy was always self-regulating and that capitalism was characterized by an inherent stability that negated any role for management. Keynes notes in The General Theory of Employment, Interest, and Money:

“The celebrated optimism of traditional economic theory…teach that all is best…provided that we will let well alone, is also to be traced, I think, to their having neglected to take into account of the drag on prosperity…exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a society which was functioning after the manner of classical postulates” (see page 33-34).

 Moreover, the durability of Keynes’ belief that government action can and is expected to mitigate recessions through various policies, especially those intended to stimulate aggregate demand and, therefore, alleviate the painful effects of unemployment, can be clearly seen in recent examples. Particularly, both the response and the effects of the federal government and the Federal Reserve during the  Great Recession largely vindicate Keynes’ emphasis that the government must pursue expansionary and stabilizing policy during times of economic destress in order to mitigate the damage and facilitate a faster recovery.

Aggregate Demand the Old Fashioned Way:

     One of the most explicit nods to the logic of Keynes’ in respect to federal government policy during the economic downturn was the Obama administration’s American Recovery and Reinvestment Act  (2009) which attempted to provide the largest fiscal stimulus in decades to the economy by granting $787 billion for programs meant to increase both confidence and spending. Although the form, content, and premise of this act has been criticized there is evidence that it did provide an expansionary push to the fledging economy. For instance, a study by the Congressional Budget Office in 2014 found that the results of the policy were positive over the period 2009-2013 and lead to consistent increases in output and decreases in unemployment as shown in the output below.

     Consequently, it has been estimated that the auto industry bailouts under the Bush administration saved 1.5 million or more jobs alone. Reuters notes a failure of the auto industry “[W]ould have resulted in the loss of 2.63 million jobs and those losses would still have stood at more than 1.5 million in 2010. If only GM had been shut down, the job losses would have been almost 1.2 million in 2009, shrinking to 675,000 in 2010.”

Similarly, another study done by Alan Blinder and Mark Zandi attempted to estimate the comprehensive impacts of federal government action during the recessionary period and find the encouraging results shown below.

Blinder and Zandi are able to conclude that:

“[I]t is clear that laissez faire was not an option; policymakers had to act. Not responding would have left both the economy and the government’s fiscal situation in far graver condition. We conclude that Ben Bernanke was probably right when he said that ‘We came very close in October [2008] to Depression 2.0.’”

     Consequently, beyond the scope of this post but perhaps just as important are multiple other public policies that appear to have been effective (recommended read) in stimulating the economy and reducing the human suffering caused by the downturn. Ultimately, though these government programs are arguably imperfect in many respects, the available evidence, to the extent that the counterfactual can be estimated, indicates that it must be admitted that Keynes’ was correct in suggesting that policy makers have an important role in managing short-run business cycle downturns. Indeed, an interesting blog post by Paul Krugman drives this point home, and one must not forget Keynes’ famous words in A Tract on Monetary Reform :

“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

And Monetary Policy Too?

     Though there has been much speculation and debate on Keynes’ view of monetary policy, it seems that Keynes did not reject a useful role for it, at least to some extent. Perhaps more importantly, Keynes believed that the private market would not provide adequate investment without a government mechanism to correct for this tendency, noting in The General Theory of Employment, Interest, and Money :

“I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment” (see page 378).  

Therefore, although Keynes is popularly associated with the use of fiscal policy to manage aggregate demand, modern monetary policy serves the same purpose and seeks to induce investment through control of the interest rates. Through multiple transmission mechanisms, as covered by Mishkin here, monetary policy works to influence the economy in the short-run and to mitigate economic downturns.

Indeed, as the graph above illustrates, the Federal Reserve has aggressively worked to lower the federal funds rate in order to stimulate investment. Furthermore, the Federal Reserve’s guiding dual mandate reflects Keynesian logic about the active role of the government in a healthy economy. Bernanke emphasizes this element of monetary policy noting:

     “First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy.”

    Furthermore, in 2015 Bernanke argued that lack of proactive and aggressive monetary policy by the European Central Bank was a major factor in why European recovery was much weaker than that of the United States:

“Europe’s failure to employ monetary and fiscal policy aggressively after the financial crisis is a big reason that eurozone output is today about 0.8% below its precrisis peak. In contrast, the output of the U.S. economy is 8.9% above the earlier peak… In November 2010, when the Fed undertook its second round of quantitative easing, [the] German Finance Minister… reportedly called the action “clueless.” At the time, the unemployment rates in Europe and the U.S. were 10.2% and 9.4%, respectively. Today the U.S. jobless rate is close to 5%, while the European rate has risen to 10.9%.”

The unconventional attempts to stimulate the economy can be seen in the expansion of the Federal Reserve’s balance sheet shown below. Importantly, there is empirical evidence that quantitative easing did stimulate the economy and alleviate unemployment as:

[T]he Fed’s QE purchases in 2009 had a stimulative effect on the US economy similar to that of a 1 percentage point cut in the federal funds rate… cumulative rounds of Fed QE had the equivalent effect of a 2.5 percentage point cut in the federal funds rate. According to this analysis, the Fed’s cumulative QE programs reduced the unemployment rate by more than 1 percentage point as of early 2015.”

     Overall, it does seem apparent from the above evidence that unconventional monetary policy has played a role in stimulating the economy since the downturn. More generally, there are reasons to think monetary policy is largely effective in the short-run as it has been shown in research by Christina Romer that monetary policy has significant impacts on the real economy and work by Mishkin indicates that these effects apply to the economy during  financial crises as well. More specifically, it does seem apparent that the policies by the Federal Reserve (recommended reading) have been responsible for helping to facilitate the recovery seen in the American economy through both monetary and macroprudential avenues.

     Therefore, to sum it all up, it seems relatively clear that Keynes was correct on the premise that government must play an active role in managing the macro economy, especially in times of crisis. Particularly, actions by both the federal government and the Federal Reserve have been shown to have averted further economic decline during the recessionary period beginning in 2008 and helped to facilitate a greater recovery.


The Great Recession: Why Keynes Was Right About Government’s Role in the Economy