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Financial Crisis and Great Recession: Why Keynesian Model Failed

Introduction

It would not be an overstatement to claim that the Great Depression era was one of the darkest pages in U.S. economic history. Causing the U.S. economy to suffer a tremendous collapse, Great Depression led to poverty rates spiraling out of control, while also affecting other countries such as Germany (Rauchway 2018). Therefore, when John M. Keynes, a British expert in economy, suggested a model that supposedly explained the nature of and control tools for the Great Depression, the framework was accepted mostly without questioning it (Congressional Research Service 2010). However, the failure of Keynesian economics should be attributed not only to its inherent flaws, primarily, the slackening of the government’s response to changes and the mismanagement of inflation but also to the profound misunderstanding of the model.

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Analysis

Implying that the market demand defines the efficacy of the market performance and that the extent of spending is correlated with the extent of economic well-being, Keynesian economics represented a rather flawed premise, to begin with. Despite being tailored specifically to fit the framework of the depression era, the Keynesian model could not suffice as a mechanism for controlling a healthy market, which was the primary cause of its eventual and inevitable downfall (Blyth 2013). By definition, the Keynesian economy implied that the increased investment in the state economy exceeding the rates of saving in it is correlated with the level of economic well-being within the state (Blyth 2013). The specified perspective, born out of the austere environment of the great depression, could be seen as a tolerable solution at the time, yet, when applied to the context of the post-Depression environment, it inevitably failed (Blyth 2013). When considering the essential contributors to Keynesian economics’ ultimate failure, one should mention three essential outcomes.

Slow Government

When considering the inherent flaws of Keynesian economics, one must mention its tendency to slow down the government’s response to market changes. Given the gradual development of the premises for globalization and, therefore, the need for a prompt response to global economic changes, a model that could encourage a prompt response from the state would be highly welcome (Rauchway 2018). However, the Keynesian framework, while being rooted in the analysis of the previous experience of recession, failed to capture the necessity to address current and emergent trends in the state and global market (Rauchway 2018). The impact that the Keynesian model had on the U.S. government indicates that the framework was imperfect, to say the least. Failing to prepare the state for economic changes and providing inadequate and insufficient grounds for a profound fiscal analysis, Keynesian economics proved to have several fatal flaws that could not justify its further application in the post-Depression U.S. environment. Thus, the effects that Keynesian economics had on the U.S. economy, particularly, the restrain that it placed on the economic development across the U.S.

The tragedy of the slow government response was exacerbated to a massive extent by the fact that the state authorities had been given significantly larger power over the management of key market processes. Rauchway (2018) explained that, partially, the failure of the program could be explained from the sociological perspective, namely, the fact that the New deal and the associated changes were planted into the social context where people were familiar with the challenges of being economically stranded. Therefore, the slow government response of the Obama administration as the force that was born in a comparatively affluent setting and could not embrace the power of negative economic circumstances becomes a crucial factor in the development of the crisis and the failure of implementing Keynesian economics properly. s

Inflation

The recession observed after the implementation of Keynesian economics in the U.S. setting was quite numerous, yet the tremendous rise in inflation rates was, perhaps, the most notorious and unmanageable one. The uncontrollable rise in inflation was inextricably connected to the problem of the state authorities exerting complete control over key economic processes and transactions, therefore, containing the natural development of the market and the relationships within it (Congressional Research Service, 2010). Thus, the rapidly building inflation rates defined the failure of the Keynesian approach applied to the context of the 2008 environment.

In retrospect, the described issue could have been prevented if the implementation of Keynesian economics during the Great Depression had been considered closer. The Congressional Research Service (2010) specifies that several crucial similarities between the 1920s situation and the crisis of 2008 should have prompted a more detailed analysis and a better understanding of the possible implications. In turn, in 2008, the U.S. government demonstrated the failure to conduct the necessary analysis and recognize the importance of amending the economic framework for fighting recession. Specifically, the inflated role of institutional governance that the model in question proposed suggested halting essential processes contributing to the market progress. Indeed, Lothian (2017, p. 36) speculates that “a market economy cannot be made more inclusive—and afford more access to more markets for more people—without being institutionally reordered.” Therefore, the intrusion of the state into the functions of the state economy was bound to be detrimental to the successful development thereof. Thus, the proponents of the Keynesian model being deployed without any changes being made to the 1940s framework was one of the main factors of failure. Specifically, the people promoting it lacked the understanding of the role that governance exerted by the state authorities had on the rise in inflation rates.

Inefficient Economy

Finally, the expansion of the 2008 crisis and the failure to contain it immediately with the help of the Keynesian model can be attributed to the fundamental misunderstanding of Keynes’ economics. Specifically, according to Prasad (2013, p. 2), “the United States has been in the vanguard in the argument for stimulating consumption as the way out of the crisis,” which, given the circumstances was an undeniably wrong choice. Namely, the proposed solution enhanced the extent and pace of poverty growth within the U.S. community by encouraging consumers to spend as opposed to saving financial resources for their further and more considerate allocation (Prasad, 2013). However, while attributing the described issue to the inherent problems within Keynesian economics is comparatively easy, the described issue appears to be rooted in the failure to grasp the concept of Keynesian economics as Keynes created it. Specifically, attributing the key role in locating the equilibrium within the Philips curve to the government, the proponents of Keynesian economics created a premise for the increasing inflation rates due to the constant and unmitigated intrusion of the government into all economic transactions.

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However, the issue described above could also be seen as the direct effect of Keynesian economics’ imperfections. If Keynes’ framework was functional and effective, the need for the government to be flexible in its management of economic processes would have been self-explanatory and could have been easily inferred from the key tenets of the theory. Instead, the model was used to distort the existing framework based on a false assumption that the state authorities failed to verify. Thus, the described issue, while also being explained by the human factor, could be seen as the direct effect of Keynesian economics’ flaws.

At the same time, it would be wrong to deem Keynesian economics as the framework that had solely negative implications on the U.S. economy. Specifically, considering its use during the great recession of 2008, one must admit that it supported U.S. citizens extensively by helping to manage unemployment and deflation at the countrywide rate (Prasad, 2013). However, the fact that the model itself failed to meet the needs of U.S. citizens in the context of the contemporary market is undeniable. Thus, a combination of unpreparedness, lack of insight, and the failure to introduce necessary changes to the Keynesian model could be deemed as the essential causes of its ultimate failure.

Conclusion

While the Keynesian economy model unmistakably had a broad range of flaws, including its tendency to slacken down the state’s response to market changes and its poor inflation control, its misunderstanding also contributed to the failure. Namely, the poor grasp of the Keynesian model’s theoretical premises, such as the Philipp’s curve, created a profound misunderstanding of how economic issues and processes should have been handled, which led to the ultimate aggravation of the economic situation. Therefore, while Keynesian economics was based on a rather dubious premise, to begin with, its mismanaged implementation exacerbated the outcomes, highlighting its flaws and making the market situation unmanageable.

References

Blyth, Mark. 2013. The Austerity Delusion: Why a Bad Idea Won over the West. Foreign Affairs, no. 92, 41-56.

Congressional Research Service. 2010. The 2007-2009 Recession: Similarities to and Differences from the Past. CRS.

Lothian, Tamara. 2018. “Chapter one The Past and Future of American Finance Seen Through the Lens of Crisis.” In Law and the Wealth of Nations, 33-68. Columbia University Press.

Prasad, Monica. 2013. The American Way of Welfare: Political-Economic Consequences of a Consumer-Oriented Growth Model 3. Demos, pp. 1-22.

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Rauchway, Eric. 2018. “Neither a Depression nor a New Deal: Bailout, Stimulus, and the Economy.” The Presidency of Barack Obama. Princeton University Press, 30-44. De Gruyter.

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StudyCorgi. 2022. "Financial Crisis and Great Recession: Why Keynesian Model Failed." September 29, 2022. https://studycorgi.com/financial-crisis-and-great-recession-why-keynesian-model-failed/.

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