Keynes advised the government during the first world war and participated in the Versailles peace conference, which ended up extracting punitive reparations from Germany.
The experience was dispiriting for Keynes, who wrote a number of scathing essays in the 1920s, pointing out the risks of the agreement and of the post-war economic system more generally.
Frustrated by his inability to change the minds of those in power, and by a deepening global recession, Keynes set out to write a magnum opus criticising the economic consensus and laying out an alternative.
He positioned the “General Theory” as a revolutionary text—and so it proved.
The book is filled with economic insights.
Yet its most important contribution is the reasoning behind the proposition that when an economy is operating below full employment,
demand rather than supply determines the level of investment and national income.
Keynes supposed there was a “multiplier effect” from changes in investment spending.
A bit of additional money spent by the government, for instance, would add directly to a nation's output (and income) .
In the first instance, this money would go to contractors, suppliers, civil servants or welfare recipients.
They would in turn spend some of the extra income.
The beneficiaries of that spending would also splash out a bit, adding still more to economic activity, and so on.
Should the government cut back, the ill effects would multiply in the same way.
Keynes thought this insight was especially important because of what he called “liquidity preference”.
He reckoned that people like to have some liquid assets on hand if possible, in case of emergency.
In times of financial worry, demand for cash or similarly liquid assets rises; investors begin to worry more about the return of capital rather than the return on capital.
Keynes posited that this might lead to a “general glut” : a world in which everyone tries to hold more money, depressing spending, which in turn depresses production and income, leaving people still worse off.
In this world, lowering interest rates to stimulate growth does not help very much.
Nor are rates very sensitive to increases in government borrowing, given the glut of saving.
Government spending to boost the economy could therefore generate a big rise in employment for only a negligible increase in interest rates.
Classical economists thought public-works spending would “crowd out” private investment; Keynes saw that during periods of weak demand it might “crowd in” private spending, through the multiplier effect.
Keynes's reasoning was affirmed by the economic impact of increased government expenditure during the second world war.
Massive military spending in Britain and America contributed to soaring economic growth.
This, combined with the determination to prevent a recurrence of the Depression, prompted policymakers to adopt Keynesian economics, and the multiplier, as the centrepiece of the post-war economic order.
Other economists picked up where Keynes left off.
Alvin Hansen and Paul Samuelson constructed equations to predict how a rise or fall in spending in one part of the economy would propagate across the whole of it.
Governments took it for granted that managing economic demand was their responsibility.
By the 1960s Keynes's intellectual victory seemed complete.
In a story in Time magazine, published in 1965, Milton Friedman declared (in a quote often attributed to Richard Nixon) , “We are all Keynesians now.”
But the Keynesian consensus fractured in the 1970s.
Its dominance was eroded by the ideas of Friedman himself, who linked variations in the business cycle to growth (or decline) in the money supply.
Fancy Keynesian multipliers were not needed to keep an economy on track, he reckoned.
Instead, governments simply needed to pursue a policy of stable money growth.
An even greater challenge came from the emergence of the “rational expectations” school of economics, led by Robert Lucas.
Rational-expectations economists supposed that fiscal policy would be undermined by forward-looking taxpayers.
They should understand that government borrowing would eventually need to be repaid, and that stimulus today would necessitate higher taxes tomorrow.