“It was here [The General Theory] that Keynes invented Keynesianism, disproving the classical laissez-faire theory of the self-adjusting, self-regulating, self-sufficient market . . .”
—Arthur Schlesinger, Jr.
New York Times Book Review
(January 23, 1994)
Keynesian economics should have died long ago. Ludwig von Mises, one of Keynes’s chief critics, thought it was already dying out in 1948. “What is going on today in the United States is the final failure of Keynesianism. There is no doubt that the American public is moving away from the Keynesian notions and slogans.” Mises, Hayek, and other free-market economists thought The General Theory was a “tract of the times,” not anything revolutionary or permanent. Hence many conservative economists miscalculated the persistence of Keynesianism.
What’s even more strange is that every theoretical tenet of Keynesianism has now been disproven. The process took decades. Arthur Pigou first refuted the “liquidity trap” hypothesis by demonstrating that deflation increases the real value of cash holdings, thus boosting potential demand during a depression. Friedrich Hayek showed that Keynesian economics is based on a “critical error,” namely, that economic activity is solely a function of final aggregate demand, when the truth is that employment and production are based on a delicate balance between investment and consumption, where interest rates and entrepreneurship play a vital role. W. H. Hutt offered a devastating attack on the accelerator principle and also demonstrated that a government-induced high-wage policy generates significant joblessness.
Henry Hazlitt proved that cutting wages during a slump, a Keynesian bugaboo, could actually increase wage income and end the recession if, as a result of a wage cut, more workers are hired or employees work more hours. Murray Rothbard criticized the multiplier, the stagnation thesis, and demonstrated the inherent instability of inflationary measures by government.
Milton Friedman effectively destroyed the Keynesian argument that monetary policy is not effective during a slump. With painstaking research, he showed that the Federal Reserve allowed the money supply to decline by a third during 1929-32, proving conclusively that government, not the free market, was largely responsible for the Great Depression. Friedman also demolished Keynes’s “consumption function,” which gave theoretical support for progressive taxation, and raised serious doubts about the Phillips curve.
Robert Higgs, in a brilliantly researched study of the American economy during World War II, showed that deficit spending did not have the beneficial effects commonly believed, and that it was only after the war that genuine prosperity returned.
A Persistent Virus
Yet, despite all these attempts to dislodge the “New Economics,” Keynesianism survives. Today in academia there are post-Keynesians, neo-Keynesians, and New Keynesians. Most economists and government leaders in the West still maintain that deficit spending is necessary and beneficial during a recession. The media persists in its mistaken notion that consumer spending drives the economy and efforts to save can be debilitating. (The February 14, 1994, issue of Business Week contained this comment on the proposed tax cuts in Japan: “The risk is that consumers, still hung over from the go-go-1980s, will just dump their new money into savings accounts and so torpedo a recovery.”) The Old Guard, as represented by the statement made by Arthur Schlesinger, Jr., at the beginning of this article, continues to sway the public into believing that big government is essential to stabilize free-market capitalism. They believe that Keynesianism constitutes a “permanent revolution,” as Mark Blaug calls it.
The Stability of the Free-Market Economy
But Schlesinger—and Keynes—have been proven wrong. The best and the brightest of economists have demonstrated quite clearly that an economy can function, thrive, and progress without serious unemployment, inflation, and recession if (a) monetary policy is stable and sound, (b) government’s role is fiscally responsible and limited to being a referee, not a player, (c) taxes, controls, and regulations are kept to a minimum and (d) people are free to pursue their own self-interest. This free-market counterrevolution has been most popular in emerging markets in Latin America, Asia, Africa, and Europe, where governments are downsizing, privatizing, cutting taxes, and adopting fiscal and monetary restraint. As a result, they are expanding like never before.
Robert Lucas, Jr., sums it up neatly: “The central lesson of economic theory is the proposition that a competitive economy, left to its own devices, will do a good job of allocating resources.”
Unfortunately, the Keynesian mystique is an overwhelming temptation to the seekers of power and the politicians of envy. The foundations of the House That Keynes Built are crumbling, but workers are determined to fix it rather than demolish it and replace it with the House That Mises Built. Therefore, I suspect that Keynesianism will be around for many years to come.
Nevertheless, let us not give up. In this new era of political freedom and global markets, there will never be a better opportunity to promote the virtues of free enterprise and to instruct the coming generation that free markets work and big government doesn’t. We will know we have won when the Keynesian Cross is replaced with Hayekian Triangles in Econ 101. 
- Ludwig von Mises, “Stones into Bread, the Keynesian Miracle,” Planning for Freedom, 4th ed. (Spring Mills, Pa.: Libertarian Press, 1980 ), p. 62.
- Out of Work, by Richard K. Vedder and Lowell E. Gallaway (New York: Holmes & Meier, 1993), confirms Hutt’s thesis in the Great Depression and beyond: Minimum wages, legal privileges for unions, civil rights legislation, unemployment compensation, and welfare have all played significant roles in generating unemployment. See also Hans F. Sennholz, The Politics of Unemployment (Spring Mills, Pa.: Libertarian Press, 1987).
- Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” The Journal of Economic History (March, 1992), pp. 41-60. For a review of all the anti- Keynesian arguments, see my edited volume, Dissent on Keynes: A Critical Appraisal of Keynesian Economics (New York: Praeger, 1992).
- Robert E. Lucas, Jr., “The Death of Keynes,” in Halistones, ed., Viewpoints on Supply-Side Economics (Richmond: Robert F. Dames, 1982), p. 4.