The difference between Keynesian and classical economics

Posted a few days back on Quora in answer to the question: What is the difference between Keynesian and classical economics? There are 13 other replies which not much more than prove to me that no one without a truly specialist knowledge of classical theory would have the slightest idea what an economist between the late eighteenth and nineteenth centuries would have understood about anything in relation to the operation of an economy. Their ignorance of what classical economists believed is matched by their ignorance of how an economy actually works. Anyway, this is what I wrote.

The differences between classical and Keynesian economics are so vast that to accept one version of how an economy works means you must reject the other. Classical economic theory is the theory that was developed between let us say 1776 and the 1870s, almost entirely by philosophers and business people who were actually looking at the economy. Modern economic theory has almost entirely been developed within universities by people who have neither a philosophical training nor have ever run a business as their primary mode of earning a living.

Here’s the difference. Classical economic theory begins from the existence of a market economy in which, on one side of the equation, there is a mass of people who would like to buy goods and services, and on the other side there are people who would like to earn their living by producing and selling things to others. The producers continually try to work out what to produce that others will buy, and do it by trying to decide what buyers will pay enough for in total to cover their production costs. These producers hire employees and the combined incomes of producers and wage earners become the purchasing power of the community.

Classical economic theory is thus entirely supply-side driven. And what is particularly interesting about reading the classical literature is that government regulation was an important part of how the economic system worked. The very first Factory Act in Great Britain was introduced in 1802, and there were many others that came after. The notion that classical economics was simply leave everything to the market is 100% wrong. If you look at the greatest economics text of the era, John Stuart Mill’s 1848 Principles of Political Economy, the final 200 pages are devoted to discussing the role of government in ensuring that economic activity was carried out in a morally acceptable way to the benefit of the entire community.

But crucially, classical theory assumes the role of the independent entrepreneur as the linchpin in making an economy work. Try to find a modern economic text that starts from there. Other than my own – Free Market Economics, Third Edition – none of the major mainstream texts starts from the supply side and none – as in zero – feature the role of the entrepreneur.

Keynesian economics assumes economies are driven from the demand side. That is, it is buying goods and services that makes an economy grow and employ, not their production. It is based on the total confusion between the demand for a single product – the greater the demand for shoes the greater the production of shoes will be along with the greater the level of employment for shoemakers. Demand affects individual products; demand in aggregate does not affect the level of output in total. The more that is produced, the higher the level of demand, for the obvious reason that the more that is produced, the more there is that buyers are able to demand. But if you are a Keynesian, you will go on believing that the cause of higher output is higher demand, whereas the reason more can be demanded is that more output is being produced. Public spending may have many benefits, but increasing the level of income and speeding up the rate of economic growth is not one of them. If anything, higher levels of public spending slow things down and lower real incomes below levels that otherwise would have been reached.

Keynesian economics is based on the fallacious belief that buyers will not buy as much as an economy can produce, and therefore demand must be stimulated to ensure everything produced is bought and that everyone who wants to work is employed. A great theory if you are in government and need a justification for taking as much money as you can get away with from income-earning citizens and spending it yourself. But a pernicious theory if you are interested in raising living standards as rapidly as possible.

As far as reading the classics go, no one nowadays does mostly because no one nowadays can. This is what I now write quite a lot about in my academic work. Just the two words “consumption” and “saving” have transmogrified since classical times to such an extent that if you apply the modern definitions you cannot make sense of what economists before Keynes were saying. But Mill’s chapter On Rent seems straightforward enough, if this is the kind of thing that interests you.

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9 Responses to The difference between Keynesian and classical economics

  1. Motelier

    I have this arguement daily, along with competition policy.

    One “bright spark” bought up buggies and carts and how the supply of these had declined due to reduced demand.

    So I asked “bright spark what effect this had on the economy?

    Uhhhhhmmmmm.

    Then began an exercise on teaching that supply of newer technologies before that demand was needed (think horseless carriages) had provided the opportunity for expansion and new employment that absorbed those in the buggy and cart industries along with lots of other people.

  2. JohnA

    It is based on the total confusion between the demand for a single product

    … AND …

    where is the other part of the confusion, please?

  3. Brian

    John A
    I believe the other part is “aggregate demand”…
    as in “demand in aggregate does not affect the level of output in total.”
    But yes, the sentence was left hanging.

  4. There is a place in the World where this is playing out right before our eyes.

    Venezuela. There is lots of demand in Venezuela. Demand for basic food items and necessities like a$$ wipe papers.
    Yet despite all that demand, the Venezuelan economy has been contracting.
    The Maduro government can hand out fists full of dollars to people to “boost” demand, yet it would make precisely zero difference. It’s not money the Venezuelans need, it’s production.

    In fact, Chavez and Maduro did indeed effectively hand out fists full of dollars early in the piece. They robbed the private sector and handed out free $hit to people. That “stimulus” didn’t boost the economy, it destroyed it.

    There was lots of demand in the former USSR. People needed and wanted cars, white goods, housing etc. But none of that demand helped the Soviet economy because the Soviet production was fvcked.

    History is littered with evidence that boosting demand doesn’t help the economy, yet the economists of today – like that wanker Krugman – keep preaching it.
    It’s like the modern day socialists and Marxists. Despite endless evidence that the ideology is evil, countless millions of people – especially mouldy smelling professors – still crave it.

  5. Entropy

    I regard the political difference is that classical economics tries to explain how an economy works. Keynesian economics tries to explain how an economy can be shaped.

    Note that isn’t the same as a practical difference.

  6. Y

    “Keynesian economics is based on the fallacious belief that buyers will not buy as much as an economy can produce, and therefore demand must be stimulated to ensure everything produced is bought”

    The notion that buyers will buy whatever an economy produces does sound slightly crazy to begin with. What if some factories go absolutely nuts producing washing machines or whatever?

    However, there seem to be two arguments that support it, if my thinking is correct. First, all possible goods actually will be bought *if the price is low enough*. Second, entrepreneurs know this full well and don’t want to go horribly bankrupt, so it generally doesn’t ever happen.

    Just thinking out loud here, feel free to tell me if I’m wrong. Sometimes I fall back on the idea of a fur trapper. He’s in the woods and he needs supplies – food, clothing, tools etc. Well, if he wants that he’d better get some furs to sell in town. He converts his time and effort into value (furs) that he can swap for other things he needs. So he has to supply in order to consume. I think this is on the right track.

  7. Roger W

    I think the telephone might be a classic example to prove the point?
    There was not a massive demand for the telephone. Indeed, there was much speculation at first that one or two a town might be more than sufficient. And then people found that they liked them!

  8. Tator

    Have had this debate with many left wing muppets over the last month during the SA Election. They honestly believe that Keynesian economics works when it never has anywhere in the world and they deride classical economics as “trickle down” which is a totally different concept with regards to taxation rates. Now thanks to Steve, I have a sledgehammer to beat them over the heads with as this answer in Quora outlines everything perfectly and maybe simple enough for a left wing moron to understand. But not holding my breath.

  9. Demand can increase the productivity of an economy. The way to increase demand is to see that as many as possible of the available avenues of worthwhile employment are utilized. The cash creating government entity, in Australia’s case the Commonwealth government is capable of creating uses for the available steel,
    concrete, plaster farm output etc. and therefore to ensure the economy is operating at near full employment.
    In the 2008 crisis Rudd, Gillard, Swan and Lindsay Tanner were absolutely correct to hand out $900 widely and to introduce the school halls and home insulation programs.
    Anyone who believes otherwise does not understand economics at all.

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