The classicals wanted to balance the government budget through slashing expenditures or raising taxes. To Keynes, this would exacerbate the underlying problem: following either policy would raise saving and thus lower the demand for products and labor. Keynes saw H. Hoover’s June 1932 tax hike as making the Great Depression worse.

Keynes’s ideas influenced Franklin D. Roosevelt’s view that insufficient buying power caused the Depression. Something similar to Keynesian expansionary policies had been applied earlier by both social-democratic Sweden and Nazi Germany. But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s.

Keynes’s theory suggested that active government policy could be effective in managing the economy. Keynes advocated counter-cyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nation’s economy suffers from recession or when recovery is long-delayed and unemployment is persistently high – and the suppression of inflation in boom times by either increasing taxes or reducing government outlays. He argued that governments should solve short-term problems rather than waiting for market forces to do it.

This contrasted with the classical and neoclassical economic analysis of fiscal policy. Deficit spending could stimulate production. But to these schools, there was no reason to believe that this stimulation would outrun the side-effects that «crowd out» private investment: first, it would increase the demand for labor and raise wages, hurting profitability. Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating. Worse, it would be shifting resources away from productive use by the private sector to wasteful use by the government.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is persistently high. In that case, crowding out is minimal. Further, private investment can be «crowded in»: fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation. Second, as the stimulus occurs, GDP rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector’s growth. That is, government spending on basic research, public health, education, and infrastructure could help the long-term growth of potential output.

In Keynes’ theory, there must be significant slack in the labor market before fiscal expansion is justified. It is important to distinguish between mere deficit spending and Keynesianism. Governments had long used deficits to finance wars. But Keynesian policy is not merely spending: it is the proposition that sometimes the economy needs active fiscal policy. Keynesianism recommends counter-cyclical policies, for example raising taxes when there is abundant demand-side growth to cool the economy and to prevent inflation, even if there is a budget surplus. Classical economics argues that one should cut taxes when there are budget surpluses, to return money to private hands. Because deficits grow during recessions, classicals call for cuts in outlays. Keynes encourages increased deficits during downturns. In the Keynesian view, the classical policy exacerbates the business cycle. In the classical view, Keynesianism is almost literally fiscal madness.