Lecture on classic economics

The next lecture focused around classic economics and the theories of John Maynard Keynes, who can be regarded as a modern economist as his works were viewed as radical and different.  Keynes published a book in 1936 named The General Theory of Employment, Interest and Money, following the beginning of the Great Depression of the 1930’s.The book outlined why it is demand, not supply, which controls the overall level of economic activity. The General Theory can be summarised in four main points as outlined by Paul Krugman in his introduction.

John Maynard Keynes
( 5 June 1883 – 21 April 1946)

·        Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment. People are not buying goods; therefore less profit is being made which ultimately leads to job cuts as companies are unable to afford workers.

·        The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates painfully and slowly.

·       Government policies to increase demand, by contrast can reduce unemployment quickly. The solution is to employ a large number of people to build roads and infrastructure.

·       Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending steps into the breach.  The government’s money must be spent on buildings and infrastructure that do not compete with the private sector. The best way to spend money is to have a war as even though this is expensive, countries can gain wealth from resources.

These theories by Keynes are in stark contrast to those of classical economists such as Adam Smith who founded the phrase “hidden hand of the market”. Smith believed that the economic market will do its own thing whether that will be an increase or decrease and the government does not need to intervene. If people have money, they have the choice to spend it on whatever they need or want. Freud argues against this theory as he suggests that when people gain wealth they make irrational choices with their money, eventually spending all of it.

Freud’s theory of irrational decisions can be applied today in the case of Italy. The prime minister, Silvio Berlusconi led the country into a state of enormous debt and corruption by making irrational choices. He asked the Central Bank for a bond in order to borrow a sum of money to help the economy, which the bank agreed to as long as he paid interest on the bond. The bond had no monetary value; it was just a piece of paper that had a sum written on it. However, Italy is corrupt and people are not paying taxes like they should do, so the interest on the bond could not be paid using tax money. The country is unable to pay the interest back to the bank so the interest rates increase even further meaning cuts have to be made in order to pay the larger interest rates. As a result the economy begins to collapse meaning high levels of unemployment as companies cannot afford to employ workers. The economy becomes static as no money is moving around as people cannot afford to buy goods, leaving an even worse situation. Italy is unable to pay the higher interest rates back to the Bank; therefore the Bank refuses to give anymore Bonds to the country.  This is known as the Bond Market.