Keynes created another straw man in The General Theory. The straw

man was J.-B. Say and his famous law of markets. Steven Kates calls

The General Theory “a book-length attempt to refute Say’s Law.” But

to do this, Keynes gravely distorted Say’s law and classical economics

in general. As Kates disclosed in his remarkable Say’s Law and the

Keynesian Revolution, “Keynes was wrong in his interpretation of

Say’s Law and, more importantly, he was wrong about its economic

implications” (Kates 1998, 212). In the introduction to the French

edition of The General Theory, published in 1939, Keynes focused

on Say’s law as the central issue of macroeconomics. “I believe that

economics everywhere up to recent times has been dominated . . . by

the doctrines associated with the name of J.-B. Say. It is true that his

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 185

‘law of markets’ has long been abandoned by most economists; but

they have not extricated themselves from his basic assumptions and

particularly from his fallacy that demand is created by supply. . . .

Yet a theory so based is clearly incompetent to tackle the problems of

unemployment and of the trade cycle” (1973a [1936], xxxv).

Unfortunately, Keynes failed to understand Say’s law. He incorrectly

paraphrased it as “supply creates its own demand” (1973a

[1936], 25), a distortion of the original meaning. In effect, Keynes

altered Say’s law to mean that everything produced is automatically

bought. Hence, according to Keynes, Say’s law cannot explain the

business cycle. Keynes falsely concluded, “Say’s Law . . . is equivalent

to the proposition that there is no obstacle to full employment” (26).

Interestingly, Keynes never quoted Say directly, and some historians

have thus surmised that Keynes never read Say’s actual Treatise, relying

instead on Ricardo’s and Marshall’s comments on Say’s law of

markets. (For a detailed discussion of Say’s law, see chapter 2 of this

book.) Keynes went on to say that the classical model under Say’s

law “assumes full employment” (15, 191). Other Keynesians have

continued to make this point, but nothing could be further from the

truth. Conditions of unemployment do not prohibit production and

sales from taking place that form the basis of new income and new

demand.

Say actually used his own law to explain recessions. As such, Say’s

law specifically formed the basis of a classical theory of the business

cycle and unemployment. As Kates states, “The classical position was

that involuntary unemployment was not only possible, but occurred

often, and with serious consequences for the unemployed” (Kates

1998, 18).

Say’s law concludes that recessions are not caused by failure of

the level of demand (Keynes’s thesis), but by failure in the structure

of supply and demand. According to Say’s law, an economic slump

occurs when producers miscalculate what consumers wish to buy, thus

causing unsold goods to pile up, production to be cut back, workers to

be laid off, income to fall, and finally, consumer spending to drop. As

Kates elucidates, “Classical theory explained recessions by showing

how errors in production might arise during cyclical upturns which

would cause some goods to remain unsold at cost-covering prices”

(1998, 19). The classical model was a “highly-sophisticated theory

of recession and unemployment” that was “obliterated” with one fell

swoop by the illustrious Keynes (Kates 1998, 20, 18).4

Keynes’s Nemesis

On one point Keynes was right: Say’s law is Keynes’s nemesis. It

specifically refutes Keynes’s basic thesis that a deficit in aggregate

demand causes a recession and that artificially stimulating consumer

spending through government deficits is a cure for depression. To

quote Kates, “Say clearly understood that economies can and do enter

prolonged periods of economic depression. But what he was at pains

to argue was that increased levels of unproductive consumption are

not a remedy for a depressed level of economic activity, and contribute

nothing to the wealth creation process. Consumption, whether

productive or unproductive, uses up resources, while only productive

consumption is capable of leaving something of an equivalent or even

higher value in its place” (1998, 34).

Let us return to Samuelson’s model of income determination—the

Keynesian cross he invented to represent unemployment equilibrium

(see Figure 6.1). We see now that saving and investment do not involve

two separate schedules at all. Except in extreme circumstances,

savings are invested. As income increases, savings and investment

both increase together. Thus, there is no intersection of S and I at a

single point and therefore no determination of macro equilibrium.

The Keynesian cross crumbles under its own weight.

The Inflationary Seventies: Keynesian Economics on

the Defensive

Experience is often a far greater teacher than high theory. While the

theoretical battle over Keynesian economics ensued during the postwar

era, no event raised more doubts about the Keynes-Samuelson model

than the inflationary crises of the 1970s, when oil and commodity

prices skyrocketed while industrial nations roiled in recession. Under

standard Keynesian analysis of aggregate demand, inflationary recession

was not supposed to happen.

Keynesians relied heavily on the Phillips curve, a concept popularized

in the 1960s and based upon empirical studies on wage rates and

unemployment conducted in Great Britain by economist A.W. Phillips

(1958). Many economists were convinced that there was a trade-off

between inflation and unemployment. Reproducing an idealized Phillips

trade-off curve (see Figure 6.6), Samuelson described the “dilemma for

macro policy”: if society desires lower unemployment, it must be willing

to accept higher inflation; if society wishes to reduce the high cost

of living, it must be willing to accept higher unemployment. Between

these two tough choices, Keynesians considered unemployment a more

serious evil than inflation (Samuelson 1970, 810–12).

But in the 1970s and 1980s, the idealized Phillips trade-off fell

apart—Western nations found that higher inflation did not reduce

unemployment, but made it worse. The emergence of an inflationary

recession and the collapse of the Phillips curve caused economists

to question for the first time their textbook models. In their search

for alternative explanations, a sudden renaissance of new economic

theories arose—from Marxism to Austrian economics.

TRADE-OFF BETWEEN INFLATION

AND FULL EMPLOYMENT

+6

+5

+4

+3

+2

+1

0

–1

–2

+9

+8

+7

+6

+5

+4

+3

+2

Phillips Curve

P/P W/W

Annual Price Rise (percent)

Annual Wage Rise (percent)

1 2 3 4 5 6 7 8

Figure 6.6 The Phillips Curve Trade-Off Between Inflation and Full

Employment

Source: Samuelson (1970: 810). Reprinted by permission of McGraw-Hill.

Keynesian Economics Makes a Comeback: The

Creation of Aggregate Supply and Demand

Yet Keynesian economics was able to make a surprising recovery

with the discovery of a new tool that could explain the crises of the

1970s: aggregate supply and demand, or AS-AD. When Bill Nordhaus

signed up as coauthor of the twelfth edition (1985), Samuelson’s

Economics added the new AS-AD diagrams. Samuelson and other

Keynesians used AS-AD to explain the inflationary recession of the

1970s (see Figure 6.7).

As Samuelson stated, “Supply shocks produce higher prices,

followed by a decline in output and an increase in unemployment.

Supply shocks thus lead to a deterioration of all the major goals of

macroeconomic policy” (Samuelson and Nordhaus 1998, 385).

Alan Blinder, a leading Keynesian, also used AS-AD to explain

the contortions in the traditional Phillips curve. According

to Blinder, prior to the 1970s, fluctuations in aggregate demand

Potential Output

P

P

P´

E´

E

AD

AS

AS´

Q Q

Q

Real GDP

Figure 6.7 Aggregate Supply (AS) and Aggregate Demand (AD) Model

Explains an Inflationary Recession

Source: Samuelson (1998: 385). Reprinted by permission of McGraw-Hill.

had dominated the data. In the 1970s, however, aggregate supply

dominated, and the result was stagflation. “That inflation and unemployment

rose together following the OPEC shocks in 1973–74

and in 1979–80 in no ways contradicts a Phillips-curve trade-off”

(Blinder 1987, 42).

Thus, Keynesian economics recovered from the 1970s crises and ASAD

diagrams filled the pages of modern textbooks. In the words of G.K.

Shaw, modern Keynesian theory “not only resisted the challenge but also

underwent a fundamental metamorphosis, emerging ever more convincing

and ever more resilient” (Shaw 1988, 5). The remaining Keynesian

precepts achieved a certain kind of “permanent revolution.”

Post-Keynesian Economics Today

What’s left of modern Keynesian theory? Was Keynesianism a “permanent”

revolution, as G.K. Shaw says, or an unfortunate interlude, as Leland

Yeager calls it, a temporary “diversion” from the neoclassical model?

Keynes and his disciples still hold fast to a central belief that the system

of Adam Smith is inherently precarious, especially under a laissez-faire

global financial system, and requires government intervention (expansionary

fiscal and monetary policy) to maintain a high level of “aggregate

effective demand” and full employment. Paul Krugman (2006) identifies

four Keynesian ideas that permeate today’s economics:

1. Economies often suffer from a lack of aggregate demand,

which leads to involuntary unemployment.

2. The market response to shortfalls in demand operates slowly

and painfully.

3. Government policies can make up for this shortfall in demand,

reducing unemployment.

4. Monetary policy may not always be sufficient to stimulate

private sector spending; government spending must at times

step into the breach.

Keynesianism still permeates our economic way of thinking, such

as when the media warns that falling consumer confidence poses a

threat to the economy, or when politicians promise that their tax cuts

will create jobs by putting spending money in people’s pockets, or

when they warn consumers that saving their tax cut won’t stimulate

the economy.

In our final chapter, we see how promarket economists have raised

serious objections to Keynesianism, both on a theoretical and empirical

level. As a result, the economics profession has witnessed a gradual

return to a “neoclassical” position. But clearly, after Keynes, the house

of Adam Smith will never be the same.