To many people, the Keynesian Revolution is often associated with the rationalization of active government macroeconomic policy. Indeed, one of the major appeals of Keynes's General Theory was precisely that it seemed to lend theoretical guidance to policy-makers in an era when the Great Depression still had its grip on the industrialized world and Neoclassical economists offered no tools, if not quite the wrong tools, to address it.
During the early 1930s, in the depths of the depression, Neoclassical economists such as Gustav Cassel, Edwin Cannan, Arthur C. Pigou and Lionel Robbins were calling for further wage cuts to reduce unemployment and even for higher taxes to prevent people from "overconsuming":
"But in general it is true to say that a greater flexibility of wage rates would considerably reduce unemployment....If it had not been for the prevalance of the view that wage rates must at all costs be maintined in order to maintain the purchasing power of the consumer, the violence of the present depression and the magnitude of the unemployment that accompanied it would have been considerably less...[We must] realize that a policy which holds wage rates rigid when the equilibrium rate has altered is a policy which creates unemployment."
(L. Robbins , 1935)
Their logic, however, seemed counterintuitive: as Richard Kahn is reported to have asked Friedrich Hayek, "Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?", to which the famous Neoclassical macroeconomist reputedly replied, "Yes, but it would take a very long mathematical argument to explain why". (Kahn, 1984: p.182). To the more practically-minded, it seemed as if Neoclassical theory was out of touch with common sense.
Keynes's theory, in contrast, was simple, intuitive and practical: firms will hire more labor only if they believe they can sell the extra output; consequently, if demand as a whole declines, they will cut back production and lay workers off . However, by laying workers off, the income of potential customers decreases and thus demand as a whole will be even lower. Thus, as firms do not see demand rise again, they have no incentive to rehire. The economy, in short, is caught in a vicious circle of high unemployment and low demand. This is where an exogenous agency, such as a government, can step in and, by increasing demand, push the economy into a virtuous cycle of high demand and high employment.
Nonetheless, despite some occasional mutterings and nods, the General Theory did not have much of a direct impact on government policy during the Great Depression itself, particularly in its early phases. If anything, it was mostly used to rationalize existing "pump-priming" programs and policies already underway well before 1936 -- such as Franklin D. Roosevelt's "New Deal" in the United States, Hjalmar Schacht's policies in Nazi Germany, Britain's withdrawal from the gold standard, etc.
Even so, many of these policies did not always exhibit clear "Keynesian" features. For instance, it can be argued that the New Deal banking reform and output quotas were precisely contrary to Keynesian recommendations. Similarly, the deficit spending undertaken during this period was regarded by its advocates as a "necessary evil" to conduct the programs and policies. Promises were repeatedly made to eventually balance the budget -- indeed, Roosevelt won the election of the 1932 by promising to eliminate Hoover's deficits! At any rate, several Neoclassical economists, such as Jacob Viner and Dennis H. Robertson, had supported many aspects of "pump-priming" entirely on the basis of non-Keynesian arguments.
Of course, Keynes himself was not too clear about the implications of his theory on public policy -- the clarification was performed largely by Abba Lerner, Lorie Tarshis, Dudley Dillard, Alvin Hansen, Seymour Harris and others in later years. Nonetheless, the identification of such public policies and "Keynesianism" seemed natural - and thus many intellectuals, businessmen and politicians who disapproved of these policies likewise resisted the General Theory. From the economic vantage point, many Neoclassicals accused these policies and programs of further distorting markets and prolonging what otherwise would have been a market-led recovery, if not being wholly inflationary; the more radical economists, on the other hand, regarded them as futile "bandage work" -- anything less than the full socialization of the means of production would not be sustainable in the longer run. Similarly, from a more political perspective, the conservative right saw them as the first step towards full-blown Bolshevism; in contrast, the radical left saw them as pre-emptory attempts by the ruling classes to save capitalism.
With the appearance of the General Theory, these feelings were immediately redirected against the Keynesians and their system was regarded as either dangerous or pointless. However, Keynesianism actually achieved a middle ground that conceded little to its political critics: markets work, it claimed, provided there is full employment, but the market itself cannot guarantee that on its own; furthermore, government efforts are not futile but, tended carefully and continuously, they can in fact help sustain a permanently high level of employment and stability. By appealing for moderation on both the right and left sides of the aisle, Keynesianism was able to draw the debate on the role of government away from ideological extremes. Socialists, such as William Beveridge (1944, 1945), might see a large active role for governments, while conservatives, such as Michael Polanyi (1945) and John Jewkes (1948), would recommend a far smaller sphere, but both their messages could be couched in a common Keynesian language.
Of particular importance in the early years was in regarding the role of fiscal policy. Michael Polanyi (1945) concluded that the policy conclusions of the General Theory simply amounted to claiming that monetary expansion, by lowering interest rates, would be sufficient to increase output and employment. However, many of the early Keynesians (including Keynes himself), objected to the assertion that monetary policy was, in itself, sufficient to guarantee full employment. During the 1930s, interest rates had fallen considerably, yet it did not seem as if private investment was instigated into action. This was understandable: with so much excess capacity, the incentives to build even more capacity would be very little, even if financing was very cheap. As a result, many Keynesians recommended that fiscal policy, i.e. increasing government spending or lowering taxes, would have to come in and fill the gap.
Alvin H. Hansen (1939, 1941, 1946) ran with the idea to his famous "stagnation thesis". Loosely speaking, Hansen argued that the 1930s represented the "closing of the American frontier" and that, henceforth, there would be far fewer investment opportunities available than before. With the amount of profitable investment projects reduced permanently, Hansen concluded, the economy could no longer rely on private investment to increase employment, output and growth. The government, Hansen noted, did not require "profitability" to initiate building projects. Consequently, government fiscal policy will (and ought to) be henceforth responsible for a permanently larger portion of economic activity.
Hansen's "stagnation thesis", shared to a good extent across the Atlantic by Sir William Beveridge (1945), was not exactly welcomed in conservative circles. They received particularly sharp critiques Michael Polanyi (1945) and John Jewkes (1948), who argued that the entrepreneur and the profit motive could be relied upon to keep boosting investment and thus employment and output. A similar position was taken by Abba P. Lerner (1941, 1943, 1944) in his theory of "functional finance". In his famous "steering wheel" analogy, Lerner saw the role of the government limited to "steering" the private economy, driven by its own private motors, away from the "curbs" of depression and inflation:
"What is needed more than anything else is a mechanism which would enable us to regulate our economy so as to maintain a reasonable degree of economic activity: on the one hand to prevent any considerable unemployment of resources and on the other hand to prevent the stresses of the overemployment of resources and the disorganization we know as inflation." (A. Lerner, 1941: p.3).
The impact of Keynesianism on public policy began to be felt during and after the gestation period of the late 1930s and early 1940s. The recovery generated by pump-priming and a government-led war economy had lent credence to Keynesian claims about the ability of governments to achieve and maintain full employment. And the young Keynesians, educated in the late 1930s, were now beginning to reach positions of power. In 1943, the "Beveridge Report" was published - much of it reputedly written by the young Keynesian blade, Nicholas Kaldor - advocating the setting up of a "welfare state" in the United Kingdom. In 1944, the British government published its White Paper on Employment Policy, which committed the government to organize its budget policies with an eye on Keynesian full employment objectives.
In the United States, in 1946, the U.S. Congress passed the "Employment Act" emphasizing government's responsibility to seek and maintain "maximum employment" (the word "full" was deleted by some nervous congressmen, and the final text was littered with conservative escape clauses). The Council of Economic Advisors (CEA) was set up around the same time. Even in its early years, it was composed and staffed by economists somewhat sympathetic with the Keynesian Revolution such as Edwin Nourse, Leon Keyserling and Gerhard Colm. By the time the Kennedy administration took office, the CEA was composed of prominent Keynesians outright, with Walter Heller, Kermit Gordon and James Tobin in the CEA seats and Paul Samuelson, John Kenneth Galbraith, Arthur Okun and Seymour Harris in the background.
Fiscal policy reigned supreme in the post-war Western world. Monetary policy, dedicated exclusively to maintaining the Gold Standard before the war, was gradually revealed as being an important influence on output and thus a potentially effective policy tool. Calls for the resumption of the Gold Standard were abandoned altogether and, under Lord Keynes's direct influence, a new international monetary order was set up at Bretton Woods in 1946.
For the next few decades, political consensus on economic policy was remarkably uniform. By 1970, even Richard Nixon would declare "I am now a Keynesian". The violent business cycle, it was thought, had been tamed - and, in many ways, it actually was. During this period, the Western world achieved an unprecedented period of prosperity and the developing nations of Latin America, Africa and Asia looked forward with confidence. It seemed as if the vision Keynes laid out in his "Economic Possibilities for Our Grandchildren" (1930, Nation and Atheneum) was approaching even faster than he had anticipated. Of course, few predicted the unravelling that would happen in the 1970s.