Chapter 13: The Keynesian Synthesis

In 1936, with capitalism on the ropes, John Maynard Keynes published The General Theory of Employment, Interest and Money. The book was dense, often obscure, and would be debated for decades. But its core message was revolutionary: markets do not automatically produce full employment. Without intervention, an economy can settle into equilibrium with millions unemployed, factories idle, potential wasted. The invisible hand, left to itself, can fail catastrophically.

This was heresy. Classical economics taught that markets cleared: if there was unemployment, wages would fall until employers hired more workers; if there was excess production, prices would fall until consumers bought more goods. The Great Depression, with its persistent unemployment and unused capacity, should have been impossible. Yet there it was—a decade of misery that market forces seemed unable to correct.

Keynes didn't want to destroy capitalism. He wanted to save it from itself.

The Revolution in Thought

The classical economists believed in Say's Law: supply creates its own demand. When you produce goods, you earn income; when you earn income, you spend it; spending becomes someone else's income; and so the circuit closes. There can be temporary imbalances, but the system tends toward equilibrium at full employment.

Keynes saw a gap in this logic. What if people don't spend all their income? What if they save—hold money rather than buying goods? Then demand falls short of supply. Businesses, facing weak sales, cut production. Cutting production means laying off workers. Unemployed workers spend less. Demand falls further. The economy spirals downward not toward equilibrium but toward depression.

This was the paradox of thrift: saving, virtuous for individuals, could be disastrous for the economy as a whole. If everyone tried to save more during a downturn, spending would collapse and the downturn would deepen. Individual rationality produced collective catastrophe.

The solution, Keynes argued, was government intervention. When private spending fell short, government could fill the gap. Public investment—roads, bridges, schools—would employ workers who would spend their wages, stimulating further demand. Deficit spending during downturns wasn't fiscal irresponsibility; it was economic common sense. The government could do what private actors could not: spend when everyone else was saving.

The Postwar Consensus

The Keynesian revolution transformed economic policy across the developed world. After World War II, governments committed to maintaining full employment through active fiscal management. The tools were straightforward: spend more during recessions to boost demand; spend less during booms to prevent overheating. The business cycle, which had brought periodic devastation, would be tamed.

The Bretton Woods system, negotiated in 1944, provided the international framework. Exchange rates were fixed but adjustable, anchored to the U.S. dollar, which was itself convertible to gold at $35 per ounce. If a country ran persistent trade deficits, it could devalue its currency by adjusting the peg—but only with IMF approval, and only to correct "fundamental disequilibrium." Capital controls limited destabilizing financial flows; you couldn't simply move money across borders at will. The International Monetary Fund would provide short-term lending to countries facing balance-of-payments difficulties. The World Bank would finance development.

For three decades, the system seemed to work. From 1945 to 1973, growth across the developed world was unprecedented—les trente glorieuses, the thirty glorious years. Unemployment remained low. Inflation stayed moderate. Living standards rose steadily. The welfare state expanded: social security, health care, education, housing supports. Capitalism and democracy seemed compatible at last.

Consider what this meant for an ordinary American family in 1965. A single income—the father working in a factory or an office—could buy a house, a car, annual vacations, and send children to college. Health insurance came through the job. A pension waited at the end. The future seemed secure. This was not universal; racial exclusions and gender inequality meant the prosperity was unevenly shared. But for the white working and middle class, the postwar economy delivered.

The mixed economy emerged as the synthesis: private ownership and market allocation for most goods and services, but government intervention to correct market failures, stabilize the economy, and provide social insurance. Neither pure capitalism nor socialism, but a compromise that seemed to capture the best of both.

Minsky's Warning

Not everyone was satisfied with the synthesis. Hyman Minsky, working in relative obscurity at Washington University in St. Louis, saw something the mainstream missed: the Keynesian consensus was unstable.

Minsky's insight was paradoxical: stability breeds instability. When the economy is growing, when employment is high, when businesses are profitable, people become confident. Confident people take more risks. Banks lend more freely. Borrowers take on more debt. The memory of past crises fades; this time seems different.

Minsky identified three types of finance:

Hedge finance: Borrowers can cover both interest and principal from their income. This is the stable configuration—debts can be paid as they come due.

Speculative finance: Borrowers can cover interest but must roll over principal. They're betting that when the loan matures, they can refinance. This works as long as credit markets stay friendly.

Ponzi finance: Borrowers can't cover even interest from income. They're betting on asset appreciation—the value of what they bought will rise enough to cover their obligations. This is inherently fragile.

Over time, Minsky observed, successful economies drift from hedge to speculative to Ponzi finance. Success validates risk-taking. Each wave of borrowing that works out encourages more borrowing. Financial innovation creates new instruments that seem safe but embed hidden risks. The system becomes increasingly fragile, until some shock—an unexpected default, a drop in asset prices, a sudden loss of confidence—triggers a cascade of failures.

The "Minsky moment" is when the illusion breaks. Suddenly everyone tries to deleverage at once. Asset prices crash. Credit freezes. The crisis that seemed impossible becomes inevitable.

Minsky was largely ignored during his lifetime. The mainstream had concluded that Keynesian management had solved the problem of economic instability. But Minsky understood something they didn't: the solution was creating conditions for the next problem. The stability of the postwar consensus was sowing the seeds of its own destruction.

The Legitimacy of the Compromise

The mixed economy represented a particular answer to the legitimacy question: how does an economic system earn the consent of those it coordinates?

Markets claimed legitimacy through choice. You participate voluntarily; you exchange when both parties benefit; outcomes reflect the sum of free decisions. This was never fully true—market power, information asymmetry, and desperation constrained choices—but the rhetoric of voluntary exchange provided ideological support.

Planning claimed legitimacy through results. The planner acts in the common interest; the plan delivers outcomes superior to market chaos. This too was contestable—who defines the common interest? who holds planners accountable?—but the promise of rational coordination provided its own appeal.

The mixed economy claimed legitimacy through democracy. Governments elected by citizens would manage the economy for the common good. Markets would operate within politically determined constraints. The losers of market competition would be protected by democratically enacted safety nets. Consent was channeled through the ballot box.

For three decades, this formula held. Growth was broadly shared. The middle class expanded. Inequality, which had been extreme before the war, compressed. Union membership was high, providing workers voice in their workplaces. Social mobility seemed possible. The legitimacy of the system rested on its performance: it was delivering for most people, most of the time.

Then the 1970s arrived, and the consensus began to fray.

The Thread Forward

Stagflation—stagnation and inflation arriving together—shattered Keynesian confidence. The 1973 oil shock quadrupled energy prices; inflation surged; yet unemployment rose alongside it. The standard tools seemed to stop working. Stimulating demand to reduce unemployment fueled inflation. Restraining demand to control inflation deepened recession. The Phillips curve trade-off, which had promised a stable relationship between inflation and unemployment, broke down.

By 1979, U.S. inflation exceeded 13 percent. Interest rates hit 20 percent. The misery index—unemployment plus inflation—reached levels that made a mockery of the promise of managed prosperity.

Into this crisis stepped a different set of ideas: monetarism, supply-side economics, the Chicago School's faith in markets. The neoliberal turn would reshape global economics for the next four decades. But Minsky's warning would prove prophetic. The stability that neoliberalism created—or that it claimed to create—would breed its own instabilities.