Commentary Magazine

The Study of Man: Is Keynesian Economics Outdated?

When prices went up instead of down during last year’s recession, all economic theories, including those of the late John Maynard Keynes, were defied. Here Robert Lekachman explains why a new theory is needed.




The major theoretical generalizations of economics have usually filled a felt need. This need generally rose from the dissatisfaction with conventional explanations which failed to answer important questions of public policy, and which still less adequately accounted for the decisions that men found it profitable to make in their daily lives. The message of individual initiative in Adam Smith’s Wealth of Nations fell upon the prepared ground of late 18th-century experience. In the English community of the period, increasing numbers of merchants were discovering how much more money they could make by ignoring than by obeying the nagging restrictions upon their buying and selling which a fussy mercantilist state had imposed. At the same time a great many ordinary workers were finding it desirable to evade apprenticeship regulations and breach the laws of settlement which, in theory, prevented them from leaving places where wages were low and work was scarce and going where wages were higher and work more plentiful. In short, what was going on was a boom in individual initiative, an outburst of artistic, literary, commercial, agricultural, industrial, and scientific ingenuity seldom paralleled in human history. Naturally the state opposed its manifestations, and political economists were at a loss to explain its nature.

Thus proper opinion in 1776, the year Smith’s great treatise appeared, judged this display of energy not alone as unlawful but also as departing from sound economics. Such are the lags in human thought that the best exposition of the mercantilist proposition that it is the state’s function to direct the economic activities of its citizens, appeared less than a decade before the Wealth of Nations, with the publication of Sir James Steuart’s An Inquiry into the Principles of Political Economy—at a time when fewer and fewer Englishmen in their daily lives acted in accordance with Steuart’s principles.

Smith’s own massive tome was an ideological triumph, pointing out to the British public that the conduct which they found convenient and profitable was also good economics and sound politics. If a hand was to direct their activities, English merchants much preferred it to be invisible. And since, like human beings everywhere, these same merchants preferred to believe that what they did was right as well as profitable, no theory could have been more convenient or more reassuring to them than Smith’s doctrine that the pursuit of individual advantage maximized the community’s welfare.

These are the usual rationalizations to be found in the record of economic ideas. Sharing the alarm of other members of the English upper classes at the regrettable tendency of the poor to multiply, Malthus in his population theory could offer a splendid sop to the conscience of the well-to-do. Since the imprudence of the poor in marrying early and fathering large families explained their poverty, the well-to-do were absolved of responsibility. Indeed, charity to the poor could only encourage them in their folly.



In our own time, the sweeping triumph of Keynesian economics has testified not only to the intellectual virtuosity of Lord Keynes but also to the realization, first by ordinary folk and then by economists, that conventional theory deviated more and more from the facts it purported to explain. While conventional theory did not quite deny the possibility of depression, its entire emphasis was upon the tendency of depressions to be brief and adjustment to full employment to be rapid. With admirable subtlety, economic theory demonstrated that if prices were cut when demand fell and workers at the same time accepted lower wages, then recovery could not fail to be rapid. No doubt the theorist faced by the spectacular length and depth of the 1929-33 depression could point out that in fact prices and wages had not been rapidly cut—and the theoretical validity of the explanation stood unimpugned. There was something in this argument, but not much. For an economics whose remedies depended upon the existence of conditions nowhere present had little usefulness. Wages were not very flexible. Prices were, if anything, still less flexible. Under the circumstances, what did the speculations of orthodox economists have to offer? Very little.

In fact, the instincts of the politicians proved to be a good deal more helpful. There is some justice in the view that President Roosevelt’s low grades in his economics courses at Harvard were bits of luck for the United States. President Hoover, a much better student of economics, knew that governmental intervention and governmental deficit spending could do only harm. It takes a good deal of technical training to worry about inflation at the depths of a depression. Roosevelt knew only that he had to do something to meet the emergencies as they arose—even if what he did one week conflicted with what he had just done the week before.

Although some of Roosevelt’s advisers—notably Tugwell and Currie—were familiar with Keynes’s ideas before Keynes’s General Theory appeared in early 1936, the teachings of that work were not specifically embodied in the policies of the early New Deal. What Keynes’s generalizations did above all was to make sense out of the chaotic economic problems of his period—the same service that Adam Smith had rendered to his time. It is a measure of Keynes’s success that any short summary of his conclusions now sounds like a string of platitudes. Keynes explained that at the center of the depression’s very existence was a deficiency of spending. Why had spending stopped? Not because of any thrift on the part of consumers—they were willing enough to spend if only someone would give them income. No, the faintheartedness of investors was the heart of the matter. When businessmen become gloomy, they refrain from buying the machines and constructing the factories which employ many men to begin with, and, through spending and re-spending, still further increase income and employment. With businessmen in this mood, workers cannot find jobs however low the wage they are willing to accept. When jobs shrink in number, incomes shrink, sales drop still further, and the gloom of investors deepens even more.

In the very depth of a depression, political exhortations to be of good cheer and to greet the prosperity just around the corner are likely to have no effect: businessmen looking about them see little chance to profit from new investment. Only government can fill the investment gap. Its best technique is public works, financed by a deliberately planned deficit. In time, business confidence will return and the public-works programs can be curtailed mostly because of the increase in spending originally induced by government action.

Now all of this made excellent sense—its technical merits completely aside. It assured the unemployed that the reason they couldn’t find jobs was that there weren’t any to be found. It told businessmen what they too knew: that cutting prices has little effect upon customers who lack income. It assured the government that the deficits it was incurring were an absolute necessity, not a measure of its political immorality. If anything, the government could be criticized for not running much bigger deficits, and thus speeding recovery—it was just this criticism that Keynes made of New Deal spending policies. Keynesian economics have been called depression economics, and while the label in many respects is inaccurate its psychological appositeness is considerable. Just as Smith had assured the Englishmen of his time that what they did was sound in theory as well as profitable in practice, Keynes convinced even a majority of his colleagues that the instinctive response of liberal governments to depression was good economics. The next generation in economics belonged to the new theories of the Keynesians because these new theories alone could exorcise the devil of depression.




Do keynesian generalizations continue to apply? Do the institutional changes of a quarter of a century demand still newer economics to make order and sense out of factual chaos? I shall suggest that some of the problems which arouse agitated economic discussion seem less and less susceptible to Keynesian solutions. Three major domestic problems are inflation, economic growth, and the concentration of economic power. The economic advance of the underdeveloped countries is the towering international problem, but I shall not endeavor to discuss it (following in that respect Keynesian precedent). The other three problems, however, are closely interrelated and, in terms of Keynesian solution, extremely perplexing.

In the General Theory, Keynes dismissed the problem of inflation with the strategic assumption that until full employment was reached no general price rise would take place. If this assumption corresponded with the facts of experience, then an economy which moved along at no more than full employment or, perhaps, at a level just short of full employment could hope to enjoy substantial price stability. Recent experience indicates that the assumption does not accord with reality. On the contrary, the price level frequently begins to rise long before complete recovery has been achieved. During the 1957-58 contraction the consumer price index actually rose. To the student of Keynesian economics such events present dilemmas. At its simplest, Keynesian policy has always favored monetary restraints when prices rise. The familiar Federal Reserve weapons—open market sales of securities, and variations in rediscount rates and reserve requirements—can quickly shrink the money supply and increase the cost of borrowing. But Keynesian policy in times of unemployment preached an expansion of the money supply and, at need, public-works expenditures. What does the Keynesian do when unemployment and prices rise together? How can he avoid an unpleasant choice between unemployment and inflation? As a practical matter, he cannot. Liberals will accept some inflation in order to eliminate unemployment; conservatives, as the record of the Eisenhower administration demonstrates, will accept some unemployment to avert inflation.

Although the liberal may generally prefer a little inflation to a little unemployment, he may also be puzzled about why he must choose. As for conservatives, a dilemma exists for them also. It is not only a matter of winning re-election: intelligent conservatives know that the issue of recession in an election year can destroy any administration, as the elections of 1958 reminded them. Conservatives, like liberals, favor high rates of economic growth. Can such rates be reconciled with price stability? Such an influential conservative economist as Sumner Slichter answers this question with a flat negative, and is willing to accept some inflation in order to enjoy adequate economic expansion. Since full use of men and machines is a necessity for high rates of growth, since prices tend to rise long before full use of these resources, any conservative emphasis upon price stability demands that monetary controls restrict credit before expansion has gone very far. Price stability means unemployment. Economic growth implies some inflation. Where, oh where are the classic simplicities of Keynesian economics?



What has gone wrong with the Keynesian universe? Why does such perverse economic behavior afflict both conservative and liberal? Although the questions are easier to ask than to answer, some of the elements of a response are plain to sight. Keynes’s strategic assumption that prices would rise only after full employment had been acheived was founded upon a notion of market organization and a conception of business behavior which no longer apply to the characteristic operations of American enterprisers. Assuming something like free competition, Keynes relied upon the rivalry between businessmen to induce physical expansion in output without changes in price, until the limits of expansion were reached. As Gardner Means has had occasion to point out once more, free markets and business rivalries have little to do with the determination of prices in most manufacturing industries. In steel, autos, and a host of other industries, price leaders announce prices and the other members of the industries promptly follow. Whether such agreement is tacit or overt is less important than the fact that prices are administered by conscious decision rather than allowed to reach levels determined by the free interplay of demand and supply in the market. The astute calculations of our industrial giants often lead them to prefer smaller sales at higher prices to larger sales at lower prices. Indeed, it may even strike them as desirable to raise prices while demand is falling, much as the auto companies did at the start of the 1958 model year.

Union behavior tends to intensify the pressure upon prices. During each of the post-World War II recessions, average wage rates rose even in the face of declining employment Given the administered prices of their employers, union leaders have been by no means wrongheaded in pressing for higher wages in bad times as well as in good. Since they have no reason to suppose that lower wages will be translated into lower product prices, they cannot sensibly conclude that restraint on their part will increase employment during recessions. Under these conditions, the hope that wage rises will not exceed productivity gains (even if it were easy to measure the latter) is very slight.

These institutional facts help to explain the annual charades which unions and managements stage. As the expiration date of a contract approaches, unions and managements negotiate with mounting bluster. A sense of crisis begins to filter out to the public. Noble in pose, management declares, frequently in paid advertisements, that it holds the line against wage increases much more in the public interest than in its own. Equally public-spirited, union leaders call upon management to unlock their pirate chests of profits and enlarge the mass purchasing power upon which prosperity depends. Ultimately, sometimes after a short strike, management concedes a substantial wage increase. With sighs of pain, the company then raises its prices, frequently by an amount much in excess of the increase in wage costs. It remains to be seen whether the outcome of the current strike in the steel industry will represent a departure from an old script and whether industry will make a more genuine attempt to hold the price line.

Keynesian doctrine considered government influence upon prices as symmetrical, tending toward restraint during expansion and encouragement during contraction. In truth, the actual policies of American governments of all complexions have operated to prevent price drops at any time. Here the largest offender is our disastrous farm program which prevents food prices from dropping and deprives the community of the full benefits of the technological revolution on the farm. That revolution has converted agriculture from the sentimentalized way of life of the strong in heart to an industry located on the land. But agricultural policy is not the only government policy responsible for the pressure toward higher prices. Tariffs, discrimination against foreign bidders for defense contracts, and wasteful procurement practices by the defense agencies all add to the upward bias of prices. These are institutional mechanisms deeply imbedded in our political system.

And finally, the very protections which groups threatened by inflation have endeavored to erect have themselves diminished the economy’s resistance to price increases. Escalator clauses in union contracts, semiautomatic increases in old age pensions by successive Congresses, variable annuity plans, and wage reopening clauses in long-term contracts, all lessen the damage inflation can wreck on any one single group, and as a consequence diminish each group’s active opposition to inflation.

The reasons why inflation threatens, converge to a single point: organizational pressure upon prices has superseded individual pressure, and it is a great deal more powerful. National unions, national corporations, veterans’ groups, farmers’ lobbies, and big government itself have all discovered that stable prices hold no thrill and that inflation can be turned to group profit. The economist’s need now is to understand the principles which animate these organizations. Here an economics newer than the Keynesian is essential, if we are to learn how large organizations make the decisions which both create and solve our problems.




Such an investigation quickly brings us to the issue of economic concentration of power. Here nothing is certain. Among economists there is considerable debate about whether economic concentration has increased, decreased, or remained the same in the 20th century. While the statistical evidence is susceptible to all of these interpretations, two generalizations do emerge: by any measure, the large corporation is influential, and statistical measures do not and cannot encompass all the dimensions of corporate power. In manufacturing, the 113 largest companies own nearly half of all the assets. This impressive statistic undoubtedly underestimates the real influence of these industrial colossi, because there is no convenient way of measuring the importance of personal ties, interlocking directorates, and informal communities of interest. We do know that in a wide range of industries including aluminum, autos, tin cans, agricultural machinery, cigarettes, steel, rubber tires and tubes, meat products, and distilled liquors, a single firm dominates the pricing policy of the entire industry and the largest four firms produce far more than half the total output of the industry. The cheerful are fond of pointing to the increase in the actual number of small enterprises as evidence that little merchants and manufacturers can still get along in our economy. The evidence is inconclusive because it frequently ignores a fundamental question about the changing meaning of individual independence. Legal form aside, how much real freedom of action do automobile dealers or gasoline station operators have? At least partly, their tolerated existence is a convenient way of allowing auto and petroleum companies to exercise control over the distribution of their products without assuming some of the financial risks of marketing.

Neither malevolence nor conspiracy is the issue: the gigantic arouses alarm simply because it is gigantic. Quite justly Americans have been suspicious of power wherever it is located. In the market place, the anti-trust acts testify to a continuing reluctance to allow the big to control the small. Unfortunately, current economic theory says little that is helpful. In Keynesian economics, there is no direct consideration whatsoever of the problem. Other discussions rely cloudily upon the anti-trust laws to curb excessive concentration, or on the hope that large organizations will check each other, or identify a change of corporate ethos. In these discussions, helpful insights are to be found but all of them suffer from a damaging lack of specificity. Until theorists offer, as they used to, plausible answers to questions of what given economic units will do in given economic circumstances, theory is weak and ineffective.

In one way or another, the popular attitudes to concentration illustrate the defects of current theory. Take first anti-trust. In our history, Congressional enthusiasm for enforcement of these statutes has fluctuated. Generally appropriations for the Anti-Trust Division of the Department of Justice have been much too small to permit continuous surveillance over the competitive practices of the economy. However, even if appropriations were more generous, one wonders whether the anti-trust laws could really check the probable drift of greater and greater economic power into fewer and fewer hands. Since both efficiency and power are associated with size, the tension between the American love of efficiency and the American distrust of power will usually inhibit positive action. How far could any Department of Justice advance toward the restoration of an approximation to genuine competition, if the price to be paid were some degree of economic efficiency?

But an even graver handicap to anti-trust enforcement is the absence of adequate economic theory to guide either the anti-trust attorneys or the economists who advise them. An illustration should make this crucial point clear. Last year Judge Weinfeld declared illegal under the provisions of Section VIIa of the Clayton Act the proposed merger between Bethlehem Steel and Youngstown Sheet and Tube. The key passage of Section VIIa prohibits mergers whose effect is diminution of competition. During the trial, much of the argument revolved around the question whether an enlarged Bethlehem could offer greater competition to United States Steel, the industry’s largest firm, or whether the merger would simply eliminate one competitor, encourage still other mergers, and diminish competition in this not very competitive industry. Judge Weinfeld’s conclusion that the second result was more probable than the first was no doubt correct, but anyone who reads the decision is likely to reflect that the Judge reached his results primarily on the basis of common sense, legal definition, and astute inference, rather than on the basis of any economic theory.



Even when the government wins its case, the question often is what can be done to prevent a repetition of the practices which caused prosecution. Thus in the Tobacco Case of 1946, the courts agreed with the government’s contention that the industry’s Big Three had tacitly conspired to restrain commerce by reaching agreements in two critical areas: the percentages of leaf tobacco each company was to acquire, and the prices and mark-ups of finished cigarettes. Without defending the companies, it is still difficult to see how a few giants in a single industry can refrain from tacit, if not overt, agreement. The essence of size is interdependence. The leaders of any one of these companies would have been fools indeed if they had pretended that what each of them did would have no immediate repercussions on the behavior of the other two. Since the government asked for no affirmative relief, it is possible that its attorneys were equally baffled. The rocks on which the anti-trust laws may well founder are the pervasiveness and the subtlety of economic power, and the difficulty of advancing practical alternatives to its exercise by those who possess it.

The anti-trust laws are a mode of diminishing economic power. Galbraith’s notion of countervailing power is a way of saying that economic power need not be feared because its possessors check each other rather than exploit the general public. The ingenious hypothesis which he advanced in American Capitalism pointed to the tendencies of business units on opposite sides of the market to limit each other’s freedom of action, much as the large retail food chains decrease the capacity of oligopolistic suppliers to charge exploitative prices, as the United Automobile Workers makes it harder for the auto companies to charge the prices which produce maximum returns, and as the government ultimately acts to strengthen the weaker parties in economic contests. When he wrote his book Galbraith made one significant reservation about the efficacy of countervailing power: in time of inflation, collusion was more likely than countervailance. In the years which have elapsed, the reservation has come to bulk larger and larger. The mechanism fails and the public risks exploitation when higher wages are promptly translated into higher prices.

The final approach to corporate power emphasizes the changing objectives of those who wield that power and the altered ethos of the corporations in which they operate. In somewhat different ways both A. A. Berle and David Lilienthal have observed in the large corporation an evolving social conscience, or, at the least, a consciousness that there is much more to the corporation’s role than the single-minded pursuit of profit. Corporation leaders have begun to identify their political role. The role demands that corporate executives balance the interests of customers, stockholders, management, employees, government, and general public. While the degree to which such notions have converted business leaders is no doubt exaggerated, the question would still remain, even if the largest claims were granted, how do the corporate leaders perform their feats of agility in the balancing of so many conflicting interests? What does the hypothesis tell us about what the business unit will do in a specific circumstance of dividend, wage, or location policy?




The drift of this discussion leads to the depressing conclusion that the distance between the assumptions—and conclusions—of contemporary economics and the real world which that economics purports to describe grows wider and wider. Because conventional economics emphasizes individual action, it offers no useful guide to an understanding of how unions and corporations—which mingle the political and the pecuniary—reach their decisions. Handicapped by this gap in their theory, economists have been in a poor position to comprehend the full nature of an inflation largely caused by organizational influences, reconcile the growth needs of the community with a fair degree of price stability, or grapple with the problems of concentrated economic power.

In short, to revert to the beginning of this essay, we are now in a situation remarkably similar to that of the mercantilists in the decade before the Wealth of Nations. Different problems afflict us, old explanations fail to suffice, and the time cries for a new theory. Until such a new theory appears, liberals will be severely handicapped. Possibly one of the reasons why liberal Congressmen, like liberal intellectuals, seem curiously hesitant about the proposals they make and the changes they advocate, is an uneasy consciousness that they are living on the remnants of the vital ideas of the 1930’s. If this speculation has any point, it suggests that liberalism’s next thrust will come only in the wake of theoretical generalizations which explain the 1960’s as well as Keynes explained the 1930’s.

By now it is glaringly obvious that I have no such new theory to offer. Still, without advancing a theory, it is possible to ponder about what a theory should be like. Essentially, the new theory should be a theory of organizations rather than of single human agents engaged either in maximizing profits if they are businessmen or maximizing satisfactions if they are consumers. A relevant new theory must merge politics with economics—contrary to the century-old tendency of economists to convert their subject into a detached scientific discipline. Once political economy, economics should become political economy again. The new politics of its title will include trade unions and large corporations, pressure groups, and government.

What are the likely sources of such a theory? No doubt many Keynesian doctrines will be salvaged, just as Keynes himself depended heavily on his predecessors, even those whom he criticized most severely. It will draw upon the organizational theory pioneered by Chester Barnard and most subtly expounded by Herbert Simon. At hand it has a neglected American source, the institutionalist tradition which began with Veblen and was carried forward in the work of Commons and Perlman. It is an appealing vision to imagine a union between the institutional insight into the life of society and the Keynesian technique of aggregative analysis.

In the meantime, it might be well if the general public did not take economists too seriously. This may be one of the periods when clear thought, an open mind, a willingness to examine the facts, and a pragmatic attitude yield better results than the received theories of economics.



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