John Maynard Keynes created the theoretical arguments for a new type of economic strategy: government intervention used to smooth out the business cycle. Keynes died in 1946, but his ideas created the Keynesian school of economics and led to the development of macroeconomics. Keynes' ideology dominated the economic paradigm from 1945 until the late 1970s. According to Keynes, free markets do not always contain self-balancing mechanisms; sometimes government intervention is necessary to minimize downturns and promote growth. He believed that without state assistance, the booms and busts in the business cycle could spiral out of control.
Macroeconomics and the Business Cycle
Keynes' specific interpretations were rarely new; most of his concepts were known to other thinkers at the time, but his overall proposal was radical. Keynes combined three principle tenets. The first was that aggregate demand could be predictably manipulated by several factors. The second was that prices are sticky and economic adjustments are not always efficient. It was the third tenet that was significant: in the short run, changes in aggregate demand impact real output and employment more than prices. In other words, governments could try to manipulate consumption and investment without price changes creating negative effects.
Keynes also believed that individual agents act correctly according to microeconomic incentives, but sometimes the aggregate of individual decisions leads to adverse aggregate outcomes. The dominant economists at the time were unable to refute Keynes' attacks. An entirely new study of economics, one that focused on the aggregate impacts, was developed.
Government Management of the Economy
Contemporary notions of monetary and fiscal policy stem from Keynes' concepts. A common Keynesian analogy compares the economy to a car. If the economy is going too fast, government policy can step on the brakes. Conversely, it can hit the gas when the economy is too slow.
Later economists such as F.A. Hayek, Milton Friedman, Murray Rothbard and Joseph Schumpeter challenged Keynes' notion of government management. Nevertheless, Keynes' policies remain very popular with the International Monetary Fund (IMF), the World Bank and most governments around the world.
Politicians loved Keynes' ideas. Not only did Keynes offer the first plausible explanation of the Great Depression, but his theories created a scientific justification for massive spending without raising taxes. During subsequent business cycles and recessions, politicians could offer a proposal different than "let the market sort it out."
It is worth noting that some governments arrived at counter-cyclical policy decisions before Keynes published "A General Theory" in 1936. Herbert Hoover launched the first anti-depression interventions in the United States in 1930. Keynes' theories did not really take hold until after WWII with the Bretton Woods Agreement.
Keynes was the most famous economist in the world by 1944. He led a British proposal to create supranational economic entities and a global plan for addressing macroeconomic issues. Not all of Keynes' plans were adopted; he faced considerable pushback from the U.S. in particular, but his general principles became dominant.