In my narrative of 20th and now 21st century economics and public policy, the Keynesian hegemony resulted not due to superior analysis but because Keynes struck the right cord with the intellectual climate of his day. It is important to remember the historical context and the economic stagnation in which England was ensnared in coming out of WWI and lasting through the 1920s and 1930s, as well of course, the world-wide Great Depression that was triggered in the late 1920s and worsened in the 1930s.
For at least a generation, the intellectual climate of opinion in the West was concerned with monopoly power, the exploitation of the powerless, and the injustice of inequality. The biggest fear of modernity was mass unemployment. The biggest resentment of modernity was the idle rich. Keynes, more effectively than others, was able to link the biggest fear with the biggest resentment. To pull that argument off, he had to show that the link between savings and investments was broken. The savings of some did not, he argued, translate into investment funds for others, which in turn would have fueled economic progress. The idle rich somehow remain rich, but their funds are idle and thus the economic machinery of modern capitalism stalls.
Much has been written throughout the 20th century demonstrating the flaws of this mode of theorizing and revealing the empirical weaknesses in narratives constructed along these lines. But the staying power of the narrative persists, and in fact with the turbulent times we have faced at the beginning of the 21st century, this narrative has once again captured the imagination of the intellectual class. This is most evident in the stunning success of Thomas Piketty's Capital in the Twenty-First Century, but that came on the heels of a 20 year steady diet of popularizing of the basic Keynesian narrative by Paul Krugman in his books, articles, op-eds, and talks. And, of course, Krugman is not alone but simply the loudest voice in the crowd. Krugman often talks about the intellectual resistence he must endure, but from where I sit I would say that his difficulty in getting people to understand his ideas is analogous to opening a screen door that is unlocked, whereas the true free market liberal economist faces the challenging of opening up a steel vault that has been bolted shut.
Consider Greg Mankiw's recent NYT column about how inherited wealth works its way through the economy. As he says:
When a family saves for future generations, it provides resources to finance capital investments, like the start-up of new businesses and the expansion of old ones. Greater capital, in turn, affects the earnings of both existing capital and workers.
Because capital is subject to diminishing returns, an increase in its supply causes each unit of capital to earn less. And because increased capital raises labor productivity, workers enjoy higher wages. In other words, by saving rather than spending, those who leave an estate to their heirs induce an unintended redistribution of income from other owners of capital toward workers.
The bottom line is that inherited wealth is not an economic threat. Those who have earned extraordinary incomes naturally want to share their good fortune with their descendants. Those of us not lucky enough to be born into one of these families benefit as well, as their accumulation of capital raises our productivity, wages and living standards.
The idle rich are never really idle; their savings become investment funds for others, and that fuels economc progress. As Milton Friedman pointed out long ago, in a rising tide all ships rise.
Now consider, Paul Krugman's response -- opportunity cost of how government might have better spent those funds if it had confiscatory taxation; snide remark about the belief in "trickle down" economics; and the invoking of a public choice style argument about the wealthy capturing the aparatus of government and undermining democracy. Leave aside the the opportunity cost argument and the public choice style argument are in tension with each other!; but instead consider that the standard Keynesian narrative about the broken link between savings and investment and thus the critique of "trickle down" economics must be argued and not merely asserted. Where do those funds go if not into investments whose return is positive? If not positive, then wouldn't we simply see the old wisdom about a fool and his money are soon parted being manifested? In other words, if the idle rich were indeed idle, they wouldn't be rich.
Unless, of course, the wealth in society is determined not by value creation in the market economy, but by the political connections one has that results in privileges bestowed by authorities. So when Krugman invokes poltical economy considerations, as he often does, and they are indeed really important considerations to always consider, it should be recognized that the argument has shifted away from a consideration of laissez-faire capitalism, and into the realm of modern state capitalism and the rent-seeking state. Perhaps Krugman should re-read his old essay, "Is Free Trade Passe?" or his book, Peddling Prosperity -- where both left and right are taken to task for not understanding basic economics and the political economy of special interests.
Perhaps if government were run by Edwin Cannan's Inca Gods, then the opportunity cost argument would have some possibility of being sensible. But these benevolent, omnipotent and omniscient creatures on not in control of the positions of power. We live in an imperfect world populated by very imperfect individuals muddling through with the aid of various institutions, such as those of involved in financial intermediation. The system if based on the rule of law and freedom of contract, will be smarter than any of the individuals that utilize it. Property, prices and profit/loss incentivize, provide guiding signals, and the critical learning feedback so that savings of some will be allocated toward productive investment projects by others. There simply is no alternative to generalized prosperity than through a vibrant capital market.
The idle rich are never really idle is a free market economy.