Simply stated, the part of the John Maynard Keynes theory that is pertinent to this discussion is where he says that when the economy slows down for any reason, the government should inject liquidity into the economy by, for example, launching a program of public works to upgrade the infrastructure of the nation in order to offset the reduction in demand that the slowdown has caused. In fact, the Keynes idea was tried in several places around the world over many decades and was proven to work well. It also seems to be working in America at this point, having hesitated for a period of time. It is, however, moving at a slow rate which is puzzling given that huge amounts of money were injected into the economy by the central bank and by the treasury. And so the question is this: Why the slow response in America?
The best way to answer this question is to pay a visit to the “Island of Prosperity” of our imagination and see what is going on in there. This is an island where a million people live, having all the institutions of the modern world and enjoying the amenities of modern life. The island is governed by flexible rules implemented by volunteer politicians who freely donate an hour of their time every day to do the job. No tax is collected on the island unless public works are called for in which case enough taxes are levied to pay for the work and no more. Also, there is the rule that no one is allowed to keep money overnight. Thus, the economic system works like this: Every morning the heads of enterprise estimate how much money they will need on that day and they go to the central bank where they borrow as much. They hire people and pay them to produce goods and services which they sell to customers who are their own employees and the employees of the other enterprises. The expectation is that the employers will make sure at the end of the day that they paid out all the money they borrowed in wages and salaries. Also, all employees are expected to make sure that they or their loved ones have spent all the money they earned to buy goods and services.
Consequently, it can be seen that the producers of goods and services who are the employers are also the merchants that get the money back when the employees and their loved ones go shopping because these people are also the consumers of the island. Thus, the money leaves the bank in the morning; it is circulated through the economy all day long only to be returned to the bank at the end of the day. But going through its normal cycle, the money will have done its job which is to be the medium of exchange that makes possible the creation of wealth by transforming the creativity and physical labor of the island's workforce into useful products such as the durable and non durable goods and all the services. For example, thanks to the money cycle, families will have food on the table; kids will go to school; people will buy clothes or have a haircut and so on. Also, manufacturers will buy a new building or repair old machines; transport companies will get new buses; farmers will get new tractors and so on. As for the retailers and the wholesalers, they will add to their inventory, will open a new store or a storage facility and so on.
But each day on the island is not the same as any other day. This is because short term and long term changes occur all the time. In the short term category, people get ideas for new gadgets or new services; some of which will succeed when tried on the public and some of which will fail. In the long term category, older people will retire and younger ones will replace them, coming onto the scene with different approaches for doing business. All of this has a direct effect on the economy because in response to it, the amount of money that the heads of enterprise borrow will differ from one day to the other. That is, the heads of enterprise may borrow a hundred million dollars today in which case the island will produce a hundred million dollars worth of goods and services during the day. And they may borrow a hundred and twenty million dollars tomorrow in which case the island will produce a hundred and twenty million dollars worth of goods and services then.
The main point to retain here is that all the money which is given out in wages and salaries will eventually go to buy all the goods and services that will be produced on that day. In effect then, the quest to balance the economic cycle of the day begins with each head of enterprise estimating how much demand there will be for the products that he or she makes. To be efficient, they will have to produce the exact quantity of goods and services that will be in demand on this day which means they will have to borrow the exact amount of money that will be needed lest they be short of it at the end of the day or discover that they have a surplus of cash that sat idle and did not contribute to the production. In fact, it happens all the time that a number of heads of enterprise discover at some point during the day that their estimates were off the mark. Unable to return to the bank to do the necessary adjustment because the rule prohibits it, those who have a shortfall borrow from those who have a surplus and pay a penalty called interest. And this interest comes out of their profit which is hurtful enough that they try to avoid falling into a situation like this.
What this says is that the estimates made by the heads of enterprise are based on intuition influenced by past performance and not on some supernatural clairvoyance. These people may want to believe they are affected by the dictates of the marketplace because they see the future and make the correct estimates but the reality is that they are the ones who affect the marketplace by the estimates they make and the decisions they take. In fact, what they borrow cumulatively is called the money supply which is what determines the size of the economy known as the Gross Domestic Product (GDP). Indeed, if you ignore the velocity of money -- which is the case on this island given that the business cycle runs its course on a daily basis – it has been established that the supply of goods and services will vary to more or less match the size of the money supply. And this means that a correlation does exist between the size of the money supply and the GDP. The truth is that the central bank and the treasury of a country manipulate the money supply in their quest to influence the performance of the economy and cause the GDP to grow at the rate they predetermine for it. This approach works reasonably well when things fall into place but there are always things that can go wrong, some of which are serious and some of which are of a lesser consequence.
Still, it remains true that to boost the economy or to slow its growth, the central bank and the treasury have at their disposal the tools to increase or decrease the money supply at will. In fact, what happened in the aftermath of the financial crisis of 2008 is that the American central bank and the treasury increased the money supply in a big way but the economy did not respond as well as expected. To see why this happened, we go back to the Island of Prosperity and see what may have happened there under apparently similar circumstances. It is that the government of the island decided one day it wanted a bigger economy and so it made use of the Keynesian method and increased the money supply by borrowing from the central bank and by spending the money on public works such as highways, waterworks and bridges. This put more money in the hands of more workers who increased the demand for goods and services which is what encouraged the businesses to produce more of what they make. The Keynesian method worked in this case but because the economy was already humming at a normal rate of growth, the effort created a side effect called overheating.
What happened was that the people bought goods and services at rates that were unprecedented and they quickly reached a level of saturation where they lost the appetite to buy more of anything. The economy slowed down considerably and the result was that the service industries began to suffer; and some of them were forced to close. As for the goods producing industries, they kept storing the products they did not sell until the cost of storage became prohibitive and so they stopped producing anymore but stayed in business by selling their inventories. By now, everyone on the island knew that something drastic had to be done to rescue the economy and so they all started thinking. After a short period of time, someone got the idea of opening a trade route to the next island (called Island of Bargain) to sell there the surpluses that the Island of Prosperity was equipped to produce. The idea looked promising and the two governments negotiated a deal in a hurry after which they built a causeway that physically and metaphorically joined the islands.
Commerce flourished between the two but alas, another reality came to spoil the party when it was discovered that the people on the Island of Bargain (also called B) did not have the purchasing power to buy all the surpluses that the Island of Prosperity (also called P) was able to produce. And so the heads of enterprise on P tried to find out why this was the case and they discovered that the people on B did not have the facilities to produce enough goods and services that would give them a high standard of living and the purchasing power that goes with it. And so the heads of enterprise dreamed up the idea of moving the factories they had on Island P to Island B where they hired cheaper labor and made goods and services they could sell at a cheaper price both on P and on B.
The result was that after a time, the purchasing power of the people on B started to increase, and the purchasing power of the people on P started to decrease. Unable to get used to the idea of a lower standard of living, the people on P borrowed to make up for the shortfall in their incomes. In the meantime, the people on B were unable to get used to the idea of living at a higher standard of living so they saved their money and created a big pool of savings. They lent the money to the people on P to help them pay for the goods and services they were selling to them. But a setup like this can only be considered the early stages of insanity and so to take advantage of it, unscrupulous characters always get into the act and create the get-rich-quick schemes whereby they engineer artificial bubbles, pump them to a colossal size and dump them just before they burst. This is what happened on the Island of Prosperity and the economy went into a deep slump.
To save the situation, the central bank and the treasury resorted to the Keynesian remedy once again by bankrolling new projects that allowed them to inject massive amounts of money into the economy. But the result was a painfully slow recovery; and no one could figure out why since the remedy was tried before and, in fact, proved to work too well. Then one day, something happened by chance that shed light on the matter. What happened was that a section of the causeway joining the two islands fell into the sea and trade came to a halt for a period of time between the islands. And it was during this time that business on the Island of Prosperity picked up as the local enterprises hired workers to produce the goods and services that were not coming from the Island of Bargain, and life looked like the good old days again. People were being paid for work they did and had no need to borrow just to live. Thus, to the delight of everyone, the mystery was solved. It is that Keynesian Economics does not work well in an artificial setup made of two parts where one part feeds the other with cheap products and feeds in turn on the illustrious legacy of that other.
Like the people on the Island of Prosperity, the American consumers do not spend the money they earn on American goods and services. Instead, they earn the money in America and spend it on cheap goods and services that are imported from abroad. What this situation does is starve the American producers who find themselves without a market where they could sell their products. What the situation also does is enrich the local distributors who import the products they sell in America. A strange sort of economy is created around these principles, one that does not respond too well to the stimuli envisaged for the kind of economy that Keynes had in mind. In fact, the Keynes model differs so markedly from the current American model, it was inevitable that the money pumped into the latter will not yield the result predicted by Keynes. The recovery has been and still is slow in coming but I say don't blame John Keynes for this; he is not responsible for what you see happen in America today.
Yet, the man is treated – perhaps for political purposes -- as if he were responsible for America's woes, but I say he is innocent of all charges and should not be so vilified.