Keynesianism in America: An Examination of American Economics from Roosevelt to Reagan

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Keynesianism in America: An Examination of American Economics from Roosevelt to Reagan

Very rarely has an entire discipline been overhauled and completely changed by a single

piece of literature. Such was the case when John Maynard Keynes published The General Theory

of Employment, Interest, and Money in 1936. Keynes, an English born Cambridge professor

completely revolutionized the way economists thought about the government’s role in the global

economy, and ushered in the study of macroeconomics. Keynesian principles have been

implemented in the American experience since Franklin Roosevelt’s administration, affirming

the place of the government at the helm of the national economy. How some principles of

Keynesianism have been applied in America has varied wildly, and different economic trends

have changed how the government creates its policies. Lorie Tarshis, a student of Keynes at

Cambridge, and later the head of economics department at Stanford University said of Keynes:

Keynes himself was not aware of the fact; certainly not fully aware of the fact, what he was leading an intellectual revolution… I mean an intellectual revolution of the kind that Darwin initiated when he wrote the Origin of Species and Max Planck when he developed the quantum theory - a change in the way of thinking about something that people had taken as true, which had influenced all their thinking. It’s this that I call the revolution.1

Keynesian economic principles have been core to American fiscal and monetary policy since the

Roosevelt administration, and were both applied and refuted up to the Reagan Administration.

J. M. Keynes

Keynes was born in Cambridge, England on June 5th 1883, to an upper middle class family,

providing him with the resources he needed to flourish as a student and to pursue a career in

academia. Keynes had an early interest in philosophy while in college, specifically logic, which

would serve as a solid foundation to his future work. During his undergraduate studies, Keynes

gravitated towards economics with heavy influences by economists such as Alfred Marshall,

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who was his professor at Cambridge. Marshall was one of the most influential economists in the

world at the time, and like Keynes, he had crossed into economics after initially studying

philosophy.2 Marshall had been the head of the Cambridge economics department since 1885,

where he advanced his theories, eventually publishing them in his book Principles of Economics.

Keynes held Marshall in very high esteem, and wrote of him “As a scientist he was, within his

own field, the greatest in the world for a hundred years.”3

While studying, Keynes published his first work Indian Currency and Finance, in which he

addressed the use of the gold standard in India. Gold has traditionally been in huge demand in

India; it is used as a financial asset, a show of status, and for making into jewelry or decorating

religious idols. Keynes saw this as a weakness in the Indian economy; since the value of

currency was pinned to gold, and the demand for gold could fluctuate, the value of the currency

was subject to this demand. Keynes wrote that this was only a feasible model if there were

superfluous amounts of gold available and if the demand for gold remained stable.

Writing in the wake of the Great Depression, Keynes’s General Theory shook the foundation

of economics by challenging some of its most basic assumptions. Economists during the classical

era of economics generally agreed that in an economy, there are two basic types of domestic

expenditure: consumption and investment. It was also a commonly held belief that when people

earned money, they either spent it on consumption or investment. Therefore, whenever

consumption fell, it would be naturally met by an increase in investment. Keynes’s own

experience with investment gave him a unique insight; after trying his hand at investing he had

lost most of his personal wealth during the Great Depression. Keynes realized that people will

not always want to invest their money if they are unsure about their economy’s future, and that a

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fall in consumption does not necessarily be met with a rise in investment or vice versa. D.D.

Raphael, a professor at the University of Otago wrote of Keynes:

Keynes’ fundamental insight was that we do not know – cannot calculate – what the future will bring. In such a world money offers psychological security against uncertainty. When savers become pessimistic about future prospects they can decide to hoard their savings rather than invest them in businesses. Thus there is no guarantee that all income earned will be spent. This amounts to saying that there is no natural tendency for all available resources to be employed. ‘Men cannot be employed.’4

Keynes’s idea that people will not always spend their money directly contradicted classical

thinking, which held that all available resources will be employed, and explained how an

economy could become depressed. If people lose confidence in future prospects about the

economy, they will hold on to their money rather than spend it. This fall in expenditure will

cause prices to fall, because people are not willing to risk more money on an asset if they are not

confident about the future. Keynes generated the “propensity to save,” which is a ratio of money

spent to money earned, because he recognized that people will not spend every dollar that they

earn.5 The higher the propensity to save, the more saving there would be, and therefore spending

would fall, causing deflationary pressure.

During the Great Depression, Keynes saw firsthand that the combinations of the capital of

banks being lost and over production in industries such as the agricultural resulted in deflation.

To try and remedy this problem, Keynes selected one institution with both the resources and the

power to direct the entire economy. He derived “the belief that government and politicians are

competent to directly secure the material conditions that ‘general happiness’ or ‘the wide

dissemination of comfort.’”6 At the time, this shifted the entire focus of the study of economics.

Prior to the development of the idea that a government could create expenditure which could

directly increase the economy, theories on economics usually centered on the small scale: the

division which is now known as microeconomics. Macroeconomic theories before this time were

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limited in scope and nested in other ideologies. For instance, mercantilism drove much of the 18th

and century scrambles for colonies by the major European powers, such as the English

establishing colonies in the Americas. However, mercantilism was rooted in Machiavellian

philosophy, and largely ignored the interactions between markets and people, causing disconnect

between macro and micro economic theories.

The prevailing macroeconomic theory before Keynes was dubbed “classical economics.”

Classical economics continues to serve as the basis for our understanding of how economies

work today, and many of its concepts are still applied in modern economics. One of the main

aspects of classical economics that was applied in America is known as ‘laissez faire’ which

translates to ‘do nothing,’ named such because it was widely believed that government regulation

only slowed down entrepreneurs and impede on the growth of businesses.7 Laissez faire

economics made sense in America for several reasons, for instance the federal government could

not collect taxes until 1913 when the 16th amendment was passed. 8 Also, Americans had a strong

history of property rights, and government involvement in the economy was seen as arbitrary and

draconian. However, this view was flawed because it failed to account for the larger picture; a

government could take on projects that were less profitable to individuals, but equally important

to society as private enterprises, such as building roads and funding research. Also, Keynes

realized that a government will tend to spend every dollar which it collects in revenue, meaning

that money would continue to flow into the economy.

Keynes’s seminal work was The General Theory on Employment, Interest, and Money in

which he laid out the framework for macroeconomics. Most important in his works were the

rules of functional finance, which Keynes saw as the steps the government could take in order to

boost or dampen the business cycle. The rules would heavily influence the thinking of policy

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makers after the Great Depression, especially those people in FDR’s cabinet. The rules in basic

form included that the government should maintain a reasonable level of demand at all times to

prevent excessive unemployment, and that the government can achieve this by either increasing

spending or cutting taxes. Another basic rule is that the government can borrow money when it

wishes to raise the rate of interest, and can loan money or repays debt to lower the level of

interest. To maintain this system the government should print out appropriate amounts of

money.9

Franklin Roosevelt’s Administration

Franklin D. Roosevelt’s administration changed the face of American economics, and

ushered in the modern era of government involvement. In Roosevelt’s Administration,

Keynesian thinkers were prominent and Keynes’s influence was obvious. In fact a copy of An

Economic Program for American Democracy, which was a Keynesian influenced paper coming

out of Harvard that found its way onto FDR’s night stand in 1934.10 FDR’s New Deal contained

all of the rules of functional finance, and his actions to change the American fiscal system. One

such action was to take America off of the gold standard to achieve control over the value of the

dollar and to avoid the fluctuations that Keynes had written about in Indian Currency and

Finance. After the crash, European investment in American securities had risen through the

transfer of large quantities of gold; and at the same time Americans had been liquidating their

European holdings and investing in American properties.11 This made Europe a creditor to the

United States, and most of Europe’s assets were liquid whereas American assets were frozen.12

This will set up a movement of gold and goods toward Europe from America which would

greatly influence the value of the dollar. 13

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Roosevelt revoked the gold standard on April 5th 1933, with Executive Order 6102. The

presidential action made hoarding “all gold coin, gold bullion and gold certificates now owned

by” private individuals illegal and required people to give up gold to the Federal Reserve.14 This

action was very controversial because it made owning gold, which is an object containing both

physical and financial value, illegal except for those with a license to own it. FDR’s Democratic

controlled Congress followed his Executive order with the Gold Reserve Act of 1934 which

made the Federal Reserve give all of its gold to the Department of the Treasury, under direct

federal control. This act was challenged in court numerous times, so the Supreme Court decided

to hear the cases in what is collectively known as the Gold Clause Cases. The prosecution argued

that “the laws and regulations, under which those orders were issued, were unconstitutional as

constituting a deprivation of property without due process of law.”15 In the Court’s majority

decision, Chief Justice Hughes wrote that “the Congress has complete authority to regulate the

currency system of the country,”16 in the 5-4 decision in favor of the treasury. The Gold Clause

Cases defended the actions of the Roosevelt administration and solidified the end of the gold

standard in America.

Franklin Roosevelt looked to Keynesian ideas and practices when constructing other New

Deal legislation. It is well documented that FDR’s administration even established direct contact

with Keynes in order to seek his thoughts and advice on the best ways to move forwards. In a

letter to Roosevelt from Henry Wallace, who would later become Vice President, Wallace

presents the president with an abstract of a conversation that was held with Keynes. In the

abstract, Keynes advices “The problem of foreign trade, while important, is not the primary

economic problem. It is necessary first to increase the domestic demand.”17 This meant that he

wanted America to focus on making its domestic markets more competitive, rather than try to

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maintain an export driven economy. This advice is reflected on the isolationist sentiments which

arose in the wake of the Great Depression, and which likely prevented immediate US

involvement in the Second World War. Keynes continued in this conversation to say that

demand could increase through investing in the creation of new capital goods, and that this

would be advantageous for the US government to do because it would enable them to cooperate

with investors in the recovery.18 Keynes’s point here was that investing in the country, rather than

just handing out money, has numerous further benefits. Not only are people getting paid, putting

more money in the economy, but since the government can work with investors, they can help

set those investors and entrepreneurs up for future success and can contribute to the improvement

of the society.

Keynes saw that one way to achieve this goal was by building houses, an investment

which would yield returns through mortgages. In the letter to the President, Keynes is recorded

as saying that American attention should be turned to building houses and making them

affordable. He also urged the US to lower interest rates on long term loans, so that it would be

easier for banks to give out mortgages.19 FDR recognized the need for affordable housing in

America, and made building houses part of a larger framework as part of the new Deal. Grand

building projects were an important part of the recovery efforts led by FDR. In a newspaper

editorial, FDR conveyed his 5 point recovery plan to America about a year after Wallace’s letter

was sent to him; in his recovery program, Roosevelt called for “a boom in a large-scale house

building, designed to increase construction expenditures as well as to provide work for more

men.”20 Housing projects were also commenced through legislation such as the Federal Housing

Administration and the National Housing Act of 1934. Beyond housing, Roosevelt put

government revenue to work through numerous federal programs, such as the Civil Works

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Administration which provided work for those in the direst need of a paycheck. The

Administration employed approximately 4,000,000 people, built schools in rural townships, and

established a minimum wage for their workers.21

Another aspect in which the Roosevelt Administration implemented Keynes’s advice was

when he told the Administration that “It is vitally important not to relinquish the social services

and economic controls that have been developed during the depression,” elaborating by saying

“Wall Street and the bankers will probably say, when the brief recovery comes, that it came of

itself, and would have come more quickly had the government not interfered.”22 Keynes

communicated that he believed that the recovery had been led by government efforts, and that

further government action was necessary to ensure that the US would not fall into the same trap

again.23 This recognition of the need for government involvement in American economics and

life was a cornerstone of Keynes’s work, and one of the most important legacies that Franklin

Roosevelt would leave to the country. From this point forward, the US government would

dramatically increase its operations, and would help to launch America to the forefront of the

world.

The government bureaucracy under Roosevelt expanded through legislation, such as the

Civil Works Administration, the Tennessee Valley Authority (TVA), and the Worker’s Relief

Administration. The TVA is a federally owned corporation that was created in 1933 through

Congressional legislation. Its primary goal was to revitalize the economy in the South by

creating new infrastructure and public utilities. The TVA was a fulfillment of the commitment to

forwarding the growth of public utilities in America as stated in Roosevelt’s five point plan.24

Among the powers granted to the TVA by Roosevelt’s Administration was the “power to acquire

real estate for the construction of dams, reservoirs, transmission lines, power houses, and other

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structures, and navigation projects at any point along the Tennessee River, or any of its

tributaries.”25 This enabled the development of the Deep South which had historically been left

behind industrial and technological advances.

During this time, the federal government also sought to employ its citizens, setting up

Federal-State Employment services as part of the Worker’s Relief Administration all over the

country. These organizations helped people connect with employers; these programs still endure

today. Keynesian principles used by the Roosevelt Administration proved that government could

steer the economy out of the recession onto the road of recovery, and the programs instituted by

the New Deal could act as a bulwark to future depressions.

Keynes’s advice in this letter also pointed to the necessity of regulating the agricultural

industry in the United States. In the letter, Keynes is recounted as saying that the US needed to

re-approach the issue of the agricultural industry to try and adjust output produced to output

demanded, since the Supreme Court decided the federal government had no power to regulate

agriculture in United States v Butler.26 He pointed to Britain’s use of acreage quotas, barriers

against new competition, and subsidies for its farmers, and that most other countries had

developed similar devices.27 Franklin Roosevelt had previously tried to regulate the agricultural

industry through the Agricultural Adjustment Act (AAA), by attempting to reduce the output of

farms in the United States which were experiencing a resource glut. However, the Supreme

Court ruled against the constitutionality of the AAA in United States v Butler, limiting the

government’s ability to regulate the agricultural industry. However, Keynes advised that the US

would need to try and regulate the agricultural industry regardless of this setback.

The fast recovery that was happening in Europe was enabling investors on the Continent

to pour money into America in investments. Following this trend, Keynes advised that foreign

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investment should no longer be a major focus for Americans, like they had made it after WWI

with the Dawes Plan, which resulted in the US bringing down the German economy.28 In order to

further his point, Keynes supposed “It would be much better to invest at home, even at low rates

of interest; and the effect of that course is to increase the domestic demand and decrease the

relative importance of foreign trade.”29 This advice would further spurn the isolationist

sentiments in American politics until the Second World War. The Neutrality Acts, which were an

important part in shaping foreign policy in the 1930s, contained legislation dedicated to keeping

Americans from investing abroad. Roosevelt’s administration understood that it was essential to

keep money in America, and to invest within the country in order to realize a full recovery

One of the most recurring problems in the study of macroeconomics and difficult issues

in politics is that of taxes. During the mid-1930s, income inequality was back on the rise, and the

top 10% of income earners were holding similar concentrations of wealth as before the

Depression.30 In the letter to Roosevelt, Keynes was noted as saying: “The main defects in our

present society are its failure to provide full employment, and its inequitable distribution of

wealth and incomes.” 31 Keynes identifies excessive income inequality as one of the root

economic problems, and one that impedes upon growth in an economic system. He says that

though the success of American capitalism had been evident, the meteoric ascension to wealth

had benefitted a select few, and most Americans dwelled in poverty. With so many Americans

unable to either generate or spend income, the markets in America began to shrink again during

1937. Roosevelt decided that the most effective way to try and close the income gap, while not

creating a drag on the markets, would be a tax on the wealthiest Americans. In his five point

plan, Roosevelt called for “the submitting of a bill to Congress, calling for a revision of the tax

structure with probable emphasis on the so-called corporation profits tax.”32 This plan would tax

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the top earning Americans, and would use the money to fund programs to provide benefits to the

lowest earning citizens. By redistributing wealth, the government was able to focus on investing

in its people, and created a labor force that was skilled and ready to work and succeed. This

investment in infrastructure and the labor force would enable the US to turn the tide of the

biggest conflict the world had ever experienced: World War II.

World War II was a very distinctive time period in American history, because of the total

commitment of the country to one cause. The government made dramatic changes to the market

economy in order to support the war effort, which led to one of the most significant short term

increases in economic growth in the history of the U.S. economy.33 Roosevelt’s administration

coordinated the US economy through price controls and rations on natural resources. For

example it was difficult for households to purchase goods such as washing machines, irons or

water heaters because the raw resources and production capabilities needed to produce these

goods were needed for the war effort.34 This market restriction, combined with huge increases in

the purchase of war bonds led to a consumption expenditure flat-lining. However, increase in

government spending was so immense that the US experienced one of the fastest periods of

growth ever experienced in its history. In 1941, government spending represented approximately

30% of GDP, or almost $408 billion. At its peak in 1944, this had risen to over $1.6 trillion or

79% of total GDP.35 Government spending was funded by increases in government debt and

taxes, which increased five and six fold respectively.36 The war years saw the largest increase in

government powers and bureaucracy up until that point in history, and once that bureaucracy was

created, most of it endured far past the war and has expanded and evolved since. The war effort

and new government programs and jobs effectively ended the Great Depression; the

unemployment rate fell from 14.6% in 1940 to 1.9% in 1945.37

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The impact of World War II for Keynesian economics was significant. Up until the war,

the United States’ recovery had been faltering after consumer confidence had been obliterated by

the crash. FDR and the US showed that economic slowdown could be counteracted by an

increase in government spending, and provided a solid foundation for Keynesian economists to

teach a new generation of economic thinkers. Academics like Lorie Tarshis, who was directly

taught by Keynes, and Paul Samuelson, who was a neo-Keynesian thinker, wrote textbooks that

went into use in over 100 universities, including most of the Ivy League schools.38 Keynesian

philosophy became widely accepted, and was the standard for modern economics, solidifying the

newly established bureaucracy in America and making the government comfortable with the idea

of spending more money and having a larger role in the economy. In fact, after the war ended,

instead of government spending returning to pre-war levels, it remained much higher, and has

continually risen since. Keynesianism changed the way in which Americans think about

government acting on the economy. The government before Keynesianism was seen as a drag on

the economy that slowed down economic activity while natural market forces fueled the

economy. However, once Keynesianism took a firm hold in American economics, the

government altered itself to become a driver of economic forces and expanded its activities,

changing Americans’ mindsets and relationships with the government.

Eisenhower and the Recession of 1957

President Eisenhower’s administration was much more cautious in the use of government

power, and some of the ramifications of his economic policies became evident in the later years

of his administration. When Eisenhower first took office, he had a new generation of Keynesian

economic thinkers at his disposal, and an economy which had successfully recovered from the

Great Depression and the post-War slump. Eisenhower was very frugal about government

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spending, but nevertheless allowed the use of government expenditure to make impressive

changes in America. One of the main reasons that government involvement continued to rise,

even under the fiscally conservative Eisenhower’s Administration, was the Cold War. The Cold

War was unique in America’s history because never before had America been at the forefront

global power, and now they were at a standoff with the USSR. The threat of Communism was so

great in the minds of Americans that they felt as if they could not afford to fall behind the Soviet

Union, militarily, or economically. To ensure the country’s power on the world stage, Americans

had to become comfortable with the government taking on more power in order to ensure

domestic tranquility. The threat of nuclear war was so great that the military and government

bureaucracy began to take on more power than at any time in American history. This shift

towards government consolidation of power aligned perfectly with Keynesian theory, because it

put the government at the helm of the economy, able to steer it towards prosperity.

Keynesianism continued to be the core of modern economics through this time period, and was

translated into real legislation during the Eisenhower Administration.

One of the programs initiated under the Eisenhower Administration which was in line

with much of the New Deal and Keynesian thinking was the Federal-Aid Highway Act of 1956.

This piece of legislation appropriated about $2 billion to create the interstate highway system,

which drastically reduced transportation time within the US.39 This action was taken not as a

measure to boost the economy while it was experiencing a contraction, but instead as a measure

to provide for the defense of the country and to serve as an investment in transportation for the

good of the nation.

Even with the looming threat of nuclear war, and the past successes of Keynesianism

being incorporated in America, Eisenhower remained committed to fiscal conservatism, which

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was reflected in his contractionary fiscal policies. The Eisenhower Administration wanted to

avoid the hazards of inflation and promised not to "undermine our strength as a nation through

deficit.” In fact, his administration had budget surpluses during expansionary periods.40

Eisenhower’s Administration pursued contractionary fiscal policy through the government

purchase of goods, 41 and by keeping taxes high: the tax rate on top earners was over 90% during

his administration.42Eisenhower began his contractionary policies in 1954, the year after the

Korean War ended. That year, the government purchase of goods and the shrinking of the

peacetime military resulted in a drag on the economy totaling an estimated $25 billion, 43 which

represented over 6% of national output at the time.44 Eisenhower’s government continued to

pursue a contractionary policy to avoid inflation until the recession of 1957, referred to in some

circles as the “Eisenhower Recession.”

The recession of 1957 was the result of several factors, such as excess capacity in

industry, over-accumulation of inventories, and reduction in government orders for military

goods.45 The fiscal policy spearheaded by the Eisenhower Administration was not the sole reason

for the recession, but the policies implemented under Eisenhower compounded the problem. In

order to reverse the trends of recession, the Federal Reserve began to shift its monetary policy.

The Federal Reserve took action through steps such as increasing its holdings in US Government

securities so that they could increase the availability of bank reserves.46 The Federal Reserve also

lowered interest rates, so that banks may borrow more money in it and counteract the decrease in

business activity.47 The generous loans appropriated by the Federal Reserve enabled banks to

repay their debts, purchase government securities, and increase their own reserves, all of which

improved their liquidity.48 The Federal Reserve continued its policies into 1958, and progress

followed. By mid-1958, unemployment had declined, GNP rose, the agriculture industry made

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sizable gains, and industrial production was on the rise once more.49 The successful response by

the Fed to stop the recession was important to the evolving Keynesian philosophy in the political

and academic fields.

The response by the Federal Reserve to lower interest rates in the face of high

unemployment helped to solidify a theory which had been formulated by economist A.W.

Phillips in 1958. His ideas were that an inverse relationship existed in between unemployment

and inflation. This was especially interesting for Keynesian economic thinkers at this time,

because in The General Theory Keynes wrote that the amount of investment will depend on the

“inducement to invest,” which lied in the rate of interest.50 This relationship between interest and

investment rates could further be linked to another phenomenon Keynes wrote about: “When full

employment is reached, any attempt to increase investment still further will set up a tendency in

money-prices to rise without limit… i.e. we shall have reached a state of true inflation.”51 Thus,

Keynes had identified a link in between interest and investment, and also a link relating

investment, unemployment, and inflation. Phillip’s study formalized these into an inverse

relationship which Keynesian thinkers adapted this into their philosophies, and backed his theory

with real world data. The evidence backing Keynesianism was now so widely accepted that it

was launched into a sort of “golden age,” where it remained the undisputed center of modern

economics, and the field of economics now worked to reinforce and fit into Keynes’s framework.

Johnson’s Great Society

Unfortunately, many Americans live on the outskirts of hope—some because of their poverty, and some because of their color, and all too many because of both. Our task is to help replace their despair with opportunity. This administration today, here and now, declares unconditional war on poverty in America. I urge this Congress and all Americans to join with me in that effort.52

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With these words President Lyndon B. Johnson began the War on Poverty, a social program in

which Johnson planned to use Keynesian ideas and theory in order to alleviate desperate poverty

which existed in America. The Johnson Administration sought to create initiatives designed to

improve the education, health, worker skills, and access to economic resources for those

struggling to make ends meet. The first years of the Johnson Administration were extremely

productive in terms of passing legislation, much of which was proposed during the Kennedy

Administration. Among the myriad of legislation includes the Economics Opportunity Act, the

Job Corps, the Food Stamp Act, and the development of Medicare.

The Economic Opportunity Act contained programs such as the Jobs Corps which sought

to increase the employability of the poorest Americans in the face of a decline in the number of

unskilled wage jobs. The legislation was designed such that it would “eliminate the paradox of

poverty in the midst of plenty,” through government involvement in the labor force.53 The Jobs

Corp provided young men and women the opportunity to gain vocational and useful work

experience by working in rural and urban residential areas as well as with the conservation of

natural resources.54 This legislation harkened back to the Civilian Conservation Corps, part of

New Deal Legislation which helped to solidify Keynesian theory in the first place. Johnson’s

Administration was now trying to replicate the success of the New Deal by increasing

government involvement in the economy.

The Food Stamp Act formed a new welfare program, promoted American agriculture,

and provided for the poorest Americans. The Food Stamp Act provided eligible low income

households to obtain coupons which could be redeemed for food produced domestically.55 In

economic terms, the Food Stamp Act created an automatic stabilizer. The theory behind an

automatic stabilizer in the economy is that a safety net is made at some certain level, and once a

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person falls below that level they are provided with income so that they may continue to

consume. This would cause a drag on the economy while it is expanding, because the money that

could be directed towards investment or spending on durable goods is redirected to be spent on

non-durable goods.56 However, in the event of a contraction in the economy, the consumption

that is created by giving an income to the unemployed or otherwise disenfranchised can boost the

economy by increasing demand. This is a delicate political and economic paradox because while

it may be necessary for a government to support its most destitute financially, the government

must be sure to avoid dependency on its welfare programs, which would diminish motivation to

work and entrepreneurial ability.

One of the most successful yet scrutinized aspects of Johnson’s Great Society was the

introduction of Medicare, which provided subsidized healthcare to the elderly. Medicare was

added on to the Social Security Act as an amendment, and provided seniors with entitlements to

monthly insurance benefits. Before Medicare was passed the elderly incurred expensive medical

bills for healthcare that was vital to their well-being, and the poverty rate among the elderly was

over 35%.57 By subsidizing healthcare costs, which increase substantially for elderly citizens, the

government was able to effectively relieve the poverty rate among the elderly; today the poverty

rate for the elderly is below one in ten.58

The Advent of Stagflation

In the 1970’s a new economic phenomenon transpired that shook an essential pillar of

Keynesian theory. This phenomenon was stagflation: a combination of high inflation, a

stagnating business sector, and an increasing unemployment rate. This directly contradicted

Keynesian theory and the idea behind the Phillips curve; it showed that inflation and

unemployment were not always inversely related to each other. Stagnation was the result of

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several factors colliding in the 1970’s that would mount the biggest attack on Keynesian theory

up to this point.

When examining government policies of the 1970’s, it becomes evident that the

government itself instituted policies which helped to create the conditions for stagflation.

Richard Nixon was the first culprit for sowing the seeds of stagflation with the imposition of

wage and price controls in 1971. Nixon was weary of a weak economy, especially on the eve of

another election; he believed that he lost the 1960 election to Kennedy due to the poor state of

the economy at the end of the Eisenhower Administration.59 Fearing the possibility of high

inflation, Nixon instituted price controls as a political move, and successfully kept inflation

down for the 1972 election.60 However, since businesses couldn’t raise prices on their goods, and

the market was being flooded with cheap goods from overseas, American businesses had to cut

jobs in order to stay profitable. The wage and price controls, while temporarily holding down

inflation, did not offer a permanent solution, and inflation resumed its rise during the Ford

Administration. President Ford was very aggressive in trying to reduce inflation through fiscal

and monetary policy. His administration cut spending and tightened the money supply. However,

the contractionary fiscal policies pursued by Ford resulted in an increase of the unemployment

rate.

Some of the earliest factors that created the conditions for the perfect storm of stagnation

to exist pre-dated either the Nixon or Ford Administrations, and lay within the success of

Keynesianism itself. During the 1960’s the United States’ Government spending increased due to

new social programs and the war in Vietnam. This boost in aggregate expenditure meant that the

US enjoyed a very low unemployment rate for the decade, but also resulted in inflation rates that

were more than double what they had been in the previous decade.61 This fit into Keynesian

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theory, because the low unemployment and high inflation combination fit together on a Phillips

curve. This prolonged period of monetary expansion resulting in a long period of inflation can be

explained by an economic theory known as “sluggish inflation.”62 Sluggish inflation can be

characterized as a continuation of rise in price levels even after government spending increases

taper off, due to the expectation of continued increases in spending. In theory, this would not be

bad for the economy, because workers would still be employed, even if inflation was rising

quickly.

However, theory became hollow and worthless in the face of global crop failures and an

oil embargo in 1973. This sudden drop in supplies for the economy to run was disastrous for

America. Americans at this time were more dependent on imported goods than they had ever

been as the country was making a transition from an exporter economy to and importer economy.

The shortage of supplies from the oil embargo and the crop failures drove up prices, resulting in

increased inflation, and businesses had to compensate for higher operation costs by laying off

workers. The inflation rate went from 3.2% in 1972 to 11% just two years later,63 and by 1975

unemployment had risen to 8.5%. Keynes’s idea of inflation being a signal of economic growth

and a shield against unemployment had unraveled.64 The culmination of stagflation refuting

Keynesian theory, and the federal government’s inability to correct the problem through use of

the Keynesian measures it had utilized before, contributed to the rise of a new economic school

of thought that would dominate American economic policy and change the nature of modern

economics. Keynesianism had fallen out of favor in both academic and government circles.

The Reagan Administration and the Rejection of Keynesianism

The Reagan Administration was one of the most important and pivotal eras in American

economic history. Reagan rejected the use of government involvement in the economy, firmly

Bhutta 20

believing that private and unregulated enterprise was a core national value, and that it would

propel the American people towards economic dominance. The Reagan Administration’s

economic policies were a reversal of much of what had been done in the 50 years previous, and

were shaped by new economic theories such as Monetarism.

Milton Friedman was one of the most influential economists who led the movement

known as Monetarism. Friedman’s work centered on his theories that while Keynesian ideas

about inflation and unemployment might hold up in the short run, in the long term there is a

natural unemployment rate, which market forces automatically return to after fluctuations.65

Friedman theorized that since the natural unemployment rate did not change, the only way that

inflation could rise was if the government created money at a rate greater than the rate at which

the economy was growing.66 Friedman also refuted the Phillips curve through an analysis of

wage earners’ expectations. Friedman created the term “adaptive expectations,” to explain why

he believed a natural rate of unemployment exists.67 When workers, particularly unions of

workers, expect that there will be a rise in inflation, they may demand that their wages be higher

in order to compensate for that rise. In response, employers must raise the prices of their goods

to account for the higher production costs, and this resulting rise in price level is inflation. The

expectation of inflation therefore becomes a self-fulfilling prophecy and creates inflation in the

short, but in the long run employers will have to compensate for increases in costs by cutting

back the number of workers, therefore creating a balance between unemployment and inflation.

Friedman’s work on the long term economic cycle moved economics away from trying to use the

government to change the demand in an economy, and ushered in what is known as supply side

economics. The Reagan Administration’s acceptance of supply side economics was reflected in

significant tax cuts, deregulation, and dismantling unions during the 1980s. Friedman’s work

Bhutta 21

went on to enjoy the same influence and stature that Keynes’s work had during its own “golden

age,” and has significantly impacted modern economics. While Friedman’s work clearly built off

of the ideas and theories that Keynesianism is based upon, its difference lies in perspective. The

theories of Milton Friedman synthesized certain aspects of classical economics together with

some of Keynes’s ideas to create the modern understanding of economics.

Legacy

The move away from Keynesian principles was extremely significant; economists were

no longer focusing on fitting into the Keynesian framework and new schools of thought arose in

the academic field. While Keynes’s theories still make up much of modern economics, his

theories have been significantly altered and the influence of his work has waned as the nature of

the American economy has evolved. Keynes himself is still a central figure in economic history

however; he ranks among the titans of economic theory, among the likes of Adam Smith and

Thomas Malthus. His ideas of the importance of the government in an economy compelled

economists to think of the big picture, and every economist who worked after Keynes’s General

Theory was working on his shoulders. Keynes’s influence in economics and politics is

inescapable, from his philosophies came an immeasurable number of consequences. Today in the

United States, government price ceilings, subsidies, and bureaucracy all come from the

consequences of Keynes’s advocacy for broader government involvement in the economy.

Though Keynes was correct with his often quoted phrase “in the long run we are all dead,”

Keynesianism has found new life in its applicability all over the world, and retains significant

followings in the political and academic spheres.68 In the long run, the legacy and ideas of John

Maynard Keynes on economics has extended far beyond himself and has permanently changed

how people, government, and markets interact.

Bhutta 22

Notes

1. Colander, David C., and Harry Landreth. The Coming of Keynesianism to America: Conversations with the Founders of Keynesian Economics. Chelteenham, UK: E. Elgar, 1996. Print. Pg. 55,

2. J. M. Keynes. "Alfred Marshall, 1842-1924." The Economic Journal 34.135 (1924): 311. JSTOR. Web. 28 Apr. 2014. Pg. 319,

3. Ibid. Pg. 321,

4. D. D. Raphael, Donald Winch, and Robert Skidelsky. Three Great Economists. Oxford: Oxford UP, 1997. Print. Pg. 225,

5. William A McEachern. Econ Macro 2. Mason, OH: South-Western Cengage Learning, 2010. Print. Pg. 133,

6. Joseph T. Salerno. "The Development of Keynes's Economics: From Marshall to Millennialism." The Review of Austrian Economics 6.1 (1992): 3-64. Mises.org. Ludwig Von Mises Institute. Web. 23 Apr. 2014. Pg. 9,


8. The Constitution of the United States of America with the Declaration of Independence. China: Fall River Pr, 2013. Print,

9. David C. Colander. and Harry Landreth. The Coming of Keynesianism to America: Conversations with the Founders of Keynesian Economics. Chelteenham, UK: E. Elgar, 1996. Print. Pg. 16,17,

10. Colander, David C., and Harry Landreth. The Coming of Keynesianism to America: Conversations with the Founders of Keynesian Economics. Chelteenham, UK: E. Elgar, 1996. Print. Pg. 8-9,

11. Henry Wallace. "Abstract of Conversation with Mr. John Maynard Keynes." Letter to Franklin D. Roosevelt. 8 May 1936. New Deal Network. Franklin and Eleanor Roosevelt Institute. Web. 28 Apr. 2014,

Bhutta 23

12. William A McEachern. Econ Macro 2. Mason, OH: South-Western Cengage Learning, 2010. Print. Pg. 219. Liquidity refers to the ease with which an asset can be converted into cash without significant loss in value. If an asset is frozen then it cannot easily be converted into cash without loss of value.


14. Exec. Order No. 6102, 3 C.F.R. (1933). Print,

15. Nortz v. United States. US Supreme Court. 18 Feb. 1935. Legal Information Institute. Cornell University, n.d. Web. 30 Mar. 2014,

16. Ibid,


18. Ibid,

19. Ibid,

20. Franklin D Roosevelt. "Five-Point Recovery Program." Editorial. Fort Wayne Journal-Gazette [Fort Wayne, IN] 28 Nov. 1937: n. pag. New Deal Network. Franklin and Eleanor Roosevelt Institute. Web. 29 Apr. 2014,

21. Work Relief Administration. Civilian Works Administration. Press Conference, February 16, 1934. New Deal Network. Franklin and Eleanor Roosevelt Institute, n.d. Web. 6 May 2014,


23. Ibid,


25. Title 16 of the United States Code, § 831. Print,

26. United States v. Butler. Cornell University. US Supreme Court. 6 Jan. 1936.Legal Information Institute. Web. 29 Apr. 2014,

Bhutta 24


28. Sally Marks. "The Myths of Reparations." Central European History 11.3 (1978): 231-55. JSTOR. Web. 30 Apr. 2014. Pg. 246. The Dawes Plan was formulated by American bankers as a way to try and facilitate the payment of reparations by Germany. “The Dawes Plan of April 9, 1924, operated at two levels…The plan called for complete reorganization of German finances with foreign supervision, a large international loan to Germany, and an Agent-General for Reparations in Berlin to oversee a complex supervisory structure. To raise revenues toward reparations, the plan demanded mortgages on German industry and the state railways, reassumption of domestic indebtedness by the German government, and sweeping tax reform to end the anomaly (and Versailles Treaty violation) of much lower tax rates in Germany than in the victor powers.”


30. T. Piketty, and E. Saez. "Income Inequality in the United States, 1913-1998." The Quarterly Journal of Economics 118.1 (2003): 29. Print,



33. Economic Consequences of War on the U.S. Economy. Publication. Institute for Economics & Peace, 2011. Web. 8 May 2014. Pg. 7,

34. Ibid. Pg. 8,

35. Ibid Pg. 7,

36. Ibid,

37. Ibid,

38. Stanford University. Office of the President. Memorial Resolution Lorie Tarshis. Stanford Historical Society. Stanford University, n.d. Web. 13 May 2014,

Bhutta 25

39. Title 1 - Federal-Aid Highway Act of 1956, Pub. L. No. 84-627,

40. Ann Mari May. "President Eisenhower, Economic Policy, and the 1960 Presidential Election" (1990). CBA Faculty Publications, University of Nebraska. Paper. Pg. 419,

41. Ibid. Pg. 421,

42. Alvaredo, Facundo, Anthony B. Atkinson, Thomas Piketty, and Emmanuel Saez. 2013. "The Top 1 Percent in International and Historical Perspective." Journal of Economic Perspectives, 27(3): 320. Pg. 7,

43. Ann Mari May. "President Eisenhower, Economic Policy, and the 1960 Presidential Election" (1990). CBA Faculty Publications. Paper. Pg. 421,

44. "1954 United States Budget." 1954 United States Federal Budget. FindTheBest.com Inc., 2014. Web. 11 May 2014,

45. Geoffrey H. Moore. "Measuring the 1957-58 Recession." The Analysts Journal 15.1 (1959): 17-20. JSTOR. Web. 11 May 2014. Pg. 17,

46. Forty-Fourth Annual Report of the Board of Governors of the Federal Reserve System: Covering Operations for the Year 1957. Rep. Washington D.C.: Federal Reserve, 1957. Print. Pg. 32,

47. Ibid,

48. The 1957-1958 Recession: Recent or Current? Rep. no. 8. Vol. XXXX. St. Louis, MO: Federal Reserve Bank of Saint Louis, 1958. Print. Pg. 99,

49. Ibid,

50. Keynes, John Maynard. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace & World, 1965. Print. Pg. 26,

51. Ibid, Pg. 79-80,

52. The War on Poverty 50 Years Later: A Progress Report. Rep. Washington D.C.: Council of Economic Advisers, 2014. Print. Pg. 2,

53. "Economic Opportunity Act of 1964" (PL 88-452, 20 Aug. 1964), 78 United States Statutes at Large. 508,

54. Ibid,

Bhutta 26

55. Pub.L. 88−525, 78 Stat. 703, H.R. 10222, enacted August 31, 1964. The Food and Stamp Act only allows for American made food stuffs to be purchased at retailers who choose to comply with the program,

56. William A McEachern. Econ Macro 2. Mason, OH: South-Western Cengage Learning, 2010. Print. Pg. 101. Durable goods are goods that are expected to last at least three years; these include commodities such as furniture and kitchen appliances. Non-durable goods are products that are not expected to last at least three years. These include food, soap, and beverages. While durable goods tend to cost more, since they last long there are not as many purchases of durable goods as there are of non-durable goods,

57. The War on Poverty 50 Years Later: A Progress Report. Rep. Washington D.C.: Council of Economic Advisers, 2014. Print. Pg. 12,

58. Ibid,

59. Ann Mari May. "President Eisenhower, Economic Policy, and the 1960 Presidential Election" (1990). CBA Faculty Publications. Paper. Pg. 418,

60. William C. Berman. "Allen J. Matusow. Nixon's Economy: Booms, Busts, Dollars, and Votes." Rev. of Nixon's Economy: Booms, Busts, Dollars, and Votes. The American Historical Review 104.1 (1999): 227-28. JSTOR. Web. 18 May 2014. Pg. 228,


62. Robert B. Barsky, and Lutz Kilian. A Monetary Explanation of the Great Stagflation of the 1970s. Publication. Ann Arbor, MI: U of Michigan, 2000. Print,

63. "US Inflation Calculator." Historical Inflation Rates: 1914-2014, Annual and Monthly Tables. 15 May 2014. Web. 17 May 2014,

64. "Databases, Tables & Calculators by Subject." Bureau of Labor Statistics Data. Bureau of Labor Statistics. Web. 17 May 2014,

65. Özlen H. Birol. ““Adaptive Expectations” of Milton Friedman and Monetarists and Phillips Curve; And the Comparison of Them with Other Macroeconomic Schools." Journal on Business Review 3 (2013). GSTF. Web. 18 May 2014,

66. Ibid,

67. Ibid,

68. W. W. Houston. "In the Long Run, We'll Live to 300 and Work." The Economist (2013). 10 May 2013. Web. 18 May 2014.

Bhutta 27

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Bhutta 29

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Bhutta 30

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Bhutta 31

Outline

I. Introduction: Keynesian economic principles have been core to American fiscal and

monetary policy since the Roosevelt administration, and were applied both correctly

and incorrectly in through the turn of the century.

II. Keynes: The Man

A. Background

1. Cambridge professor

2. Indian Currency and Finance was in 1913

3. The End of Laissez-faire: The Economic Consequences of the Peace in 1926

B. Keynesian Literature & theories

1. A Tract on Monetary Reform in 1926

2. A Treatise on Money in 1930

3. The General Theory of Employment, Interest, and Money in 1936

4. Creation of Macroeconomics

5. Functional finance

a. The government shall maintain a reasonable level of demand at all

times (reasonable meaning that there is not excessive unemployment)

and shall achieve this by either increasing spending or cutting taxes.

b. The government borrows money when it wishes to raise the rate of

interest, and loans money or repays debt to lower the level of interest.

c. The government should print out appropriate amounts of money.

III. Roosevelt

A. An Economic Program for American Democracy

Bhutta 32

B. First New Deal

1. Social Security

2. Emergency Banking Act/FDIC

3. Federal Emergency Relief Administration, Civil Works Administration, and

Civilian Conservation Corps, Workers Progress Administration

4. National Industrial Recovery Act, Tennessee Valley Authority

C. Repeal of Gold Standard

1. Keynes on gold standard

2. Executive Order 6102 and Gold Reserve Act of 1934

3. Gold Clause Cases

D. WWII

IV. Truman and Eisenhower

A. Post War economy

1. Recessions caused by decrease in military spending

B. Contractionary Monetary Policy

C. Recession of 1957

V. Kennedy and Johnson

A. Recession of 1960/ Kennedy’s Stimulus Package

B. LBJ’s “Great Society”

1. Economic Opportunity Act of 1964

2. War on Poverty

3. Air and Water Quality Acts

C. Keynesian policy is dominant policy

VI. 1973-1975 Recession

Bhutta 33

A. Wage-price controls

B. Inflation

C. OPEC (shock on prices)

VII. 1980-1982 recession

A. Reaganomics

B. Rise in interest rates to combat inflation worsened problem

C. Tax cuts and boost in military spending end recession, increase debt

D. Deregulation

VIII. Bush Sr. and Clinton Administrations

A. 1990-91 Recession

B. Budget surplus

C. New regulations

IX. Examination of federal spending through time

A. Social Security/Medicare

B. Size of deficit

C. National budget

X. Conclusions

Documents

Keynesianism in America: An Examination of American Economics from Roosevelt to Reagan