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Keynesian v Austrian View of the Business Cycle

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Following World War I and during the Great Depression, John Maynard Keynes, often referred to as the “father of Modern Macroeconomics,” put forward a monetarist theory that claimed that government should take action, by controlling interest rates, to stabilize price levels. For example, the government’s central bank should “lower interest rates when prices tend to rise and raise them [interest rates] when prices tend to fall.”1 This is still the practice of the Federal Reserve to this day. As unemployment continued in the west up until World War II, Keynes expanded his theory to include government intervention to stimulate aggregate demand, a combination of “consumption, investment, and government spending,”2 by providing incentives for spending, investing, and higher wages while trying to create disincentives for saving or lowering wage rates. The theory also encouraged deficit spending in times of crisis since it would be the most direct way for government to quickly boost aggregate demand and revive the economy. These ideas were adopted by most Western governments from the 30s until the 60s when stagflation, high inflation and high unemployment, appeared to disprove the core of Keynes interventionary tactics. During this time the Austrian School of Economics, primarily Ludwig von Mises and F. A. Hayek repudiated the theories of Keynes, as well as Chicago School economist Milton Friedman. They ideas of the Austrians to some degree and the Chicago School influence the American government from the 80s all the way until our latest recession when both President George W. Bush, President Barack Obama and the Federal Reserve have re-instituted Keynesian ideas of deficit spending, intentional inflation by lowering interest rates and printing money, and trying to absorb unemployment in the public sector. However, similar to the 70s, we seem to again be facing stagflation as the dollar is continuously weakened and unemployment remains high. This has led to increased support for austerity measures in the United States, a more free market approach.

Macroeconomic theory could be considered a self-fulfilling prophecy. As policy shaped and applied to “aggregates” the repercussions will also be felt by the “aggregate.” However, in reality the aggregate, or any other amorphous entity, does not act, only individuals act. In “America’s Great Depression” by Murray Rothbard he explains that “this view holds that business cycles and depressions stem from disturbances generated in the market by monetary intervention. The monetary theory holds that money and credit-expansion, launched by the banking system, causes booms and busts.”3 Rothbard further explains that is absurd to assume that all entrepreneurs simultaneously make the same decisions leading to booms and busts that extend to all industries and areas of the economy, he says, “in the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time…In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange—money. Money forges the connecting link between all economic activities. If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if all prices move up or down together, some change must have occurred in the monetary sphere.”4

Further, Keynes in the introduction to “The General Theory of Employment, Interest, and Money,” makes the strong claim that “classical” or free market economic theory only applies in special cases while his own theory, which he boldly labels “general,” applies generally in all cases.5 However, throughout history the ideas of Keynes and his advocacy for strong government intervention only gain real support during times of crisis. It is during times of recession, depression, or natural disasters, such as the dust bowl that affected the “Okies,” famously portrayed in “The Grapes of Wrath.” The plight of those most affected by such disasters always tug at the heart strings of their fellow countrymen, and rightly so. However, our emotional response and desire to help those in need should not be used to justify a “general” theory. Those who suffered the most in “The Grapes of Wrath” were not suffering due to capitalism or greed, though the case can be made when the circumstances are created in a work of fiction, but were due to an “act of God” that made previous resources and land quickly lose their value and created a shift in labor that was difficult to absorb by the market due to abrupt and unpredictable nature of the disaster.


1. The Concise Encyclopedia of Economics. John Maynard Keynes. http://www.econlib.org/library/Enc/bios/Keynes.html. Accessed on 15 October 2011.
2. Ibid.
3. Rothbard, Murray. (2005). America’s Great Depression Fifth Edition. Auburn, Alabama: Ludwig von Mises Institute. pp. xxxvii
4. Ibid. pp. 6-9
5. Keynes, John M. (1997). The General Theory of Employment, Interest, and Money. Amherst, New York: Promethius Books. pp. 3

Filed under Economics
Oct 15, 2011