The Legacy of John Maynard Keynes
Keynesian policy recommendations are now the staple of governments around the world but it is hard to believe Keynes himself would endorse them
In most countries, balanced budgets are but a memory from days long past. All governments seem to be more or less Keynesian now but some, apparently, still not Keynesian enough. President Barack Obama recently declared that balancing the US budget was no longer a priority. The IMF and the OECD undermined the G20 meeting in Russia by warning that austerity programmes would be harmful. With his theoretical rationale for deficit spending, John Maynard Keynes, born 130 years ago next month, left a gigantic footprint. In the final chapter of his famous General Theory of Employment, Interest and Money, his magnum opus, Keynes writes: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” Keynes wasn’t necessarily talking about himself but this passage perfectly captures the power of his own ideas. Even in the public at large, almost everybody seems to know about him, which is rare for an economist. And hardly anybody is indifferent to him. Keynes is either deeply revered or violently rejected: some see in him the master, the saviour; others shiver in face of the devil incarnate.
It is true that Keynes turned economic science around. The publication of his General Theory in 1936 marks the birth of modern macroeconomics. It was nothing short of a revolution. Keynes changed the paradigm of his discipline. He dethroned the classical approach. He challenged the traditional view, according to which supply always creates its own demand (Say’s law). He replaced the wage rate as the ultimate determinant of employment with effective aggregate demand. For this reason also, he didn’t consider saving a virtue per se. He doubted that markets automatically return to equilibrium after a disturbance; he considered disequilibrium to be the rule rather than the exception.
He did not believe that people always behave rationally; on the contrary, “animal spirits” abound. Keynes also took fundamental uncertainty seriously, i.e. the kind of uncertainty about future events to which we cannot attach any numbered probabilities. And even though he was convinced that a market system is the best system we can possibly have, he did assign an active role to government, especially in the management of crises. In a situation in which at least the mainstream of economics was at a loss to explain why exactly the Great Depression had come about and what could be done to prevent a similar meltdown in the future, Keynes’s new theory was met with fascination. It was rapidly adopted and expanded.
But Keynes’s impact on theory was only the beginning. His legacy is also a political one. Keynes changed the way government behaved and was expected to behave. Keynes himself was active in government — not as a politician, but as a government official, as a delegate and as an adviser. He believed strongly that it was the duty of the enlightened bourgeois elite of his country to intervene and show the way. He was part of this elite, and he was an elitist. His friends describe him as patient and utterly charming if in good company, but impatient and easily disgusted by ignorant plebeian herds. For him, interventionism was fine as long as it was carried out by people with the right moral convictions. With this impossible caveat, Keynes endorsed interventionism and triggered the beginning of a more generalised trust in government, or state, activism.
In the political sphere, however, which is hardly ever able to deal with complicated models, conditions and nuances, Keynesianism was rapidly reduced to a set of core messages. Or to put it another way, Keynesianism rapidly degenerated into vulgar Keynesianism. Besides the general endorsement of state activism, this meant deficit spending as its major tool. In an economic downturn, government was expected to use fiscal policy in order artificially to increase consumption, which meant to run a deficit, and the Keynesian multiplier, according to which £1 of spending would generate more than £1 of revenue, would do wonders to boost the economy. Inflation is not a problem. The economic consequences — not of Mr Keynes directly, to quote James M. Buchanan, but of the use of his body of thought in politics — were an enormous rise in government activity and debt. In the Thirties, Keynes could never have imagined that government would ever eat up half of the gross domestic product.
The late Seventies and the Eighties looked like the demise of Keynesianism. The phenomenon of stagflation, triggered by the oil crisis, invalidated the Keynesian toolkit of politics. All of a sudden, the supply side was rediscovered. Economists learned to use both their eyes again, as Paul Samuelson famously remarked: “The Lord gave us two eyes to watch both demand and supply.” Keynes himself used to be a little blind in his supply eye. Politicians now began to accept that the corporate world needed to be treated as more than a simple cash cow for the Treasury.
But one thing remained relatively constant — the role attributed to government, and the deep conviction present in politics that government can reasonably and effectively direct the course of the economy without doing any harm. The growth of government slowed down in the Eighties, but the trend turned around again quite rapidly. Keynes’s personal belief in government as being able and entitled to steer the course of events seems to be everywhere nowadays. Government is full of “men of system”, as the Enlightenment philosopher Adam Smith called them. Let me quote a passage from Smith’s Theory of Moral Sentiments:
The man of system . . . seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it.
Keynes’s legacy in economics is an enlarged vision, taking uncertainty and disequilibrium seriously, and his legacy in politics is self-confidence, or self-conceit. He was not a hero, a master, a saviour-but a fascinating, intriguing, brilliant and witty man. He was born into a Cambridge family that had originally come from Normandy and belonged to the well-educated and wealthy bourgeoisie. His father, John Neville Keynes, was a well-known figure, who taught logic and political economy at Cambridge, published several books and was well connected in the intelligentsia of the time. Alfred Marshall, who was the first to establish economics as an academic discipline in its own right, was a close friend. Maynard Keynes’s mother Florence Ada was active in the movement for social reform and became the first woman mayor of Cambridge. Keynes had two younger siblings, a brother and a sister. He was a brilliant student at Eton, then went on to study mathematics and classical philology at King’s College, Cambridge, with which he would remain affiliated all his life.
Studying in Cambridge never meant just going to lectures, seminars and supervisions but participating in a host of events, ranging from concerts to debates. Keynes was admitted to the secretive Apostles, a club that was under the sway of the philosopher G.E. Moore. He had close ties with the cultural and literary world and later became a member of the Bloomsbury group, who had soaked up from Moore the belief that “one’s prime objects in life were love, the creation and enjoyment of aesthetic experience and the pursuit of knowledge”. Bloomsbury reacted against the conservative habits, traditions and conventions of the Victorian era and claimed nothing less than cultural superiority. In a 1938 essay looking back at his life, entitled “My early beliefs”, Keynes bluntly calls this attitude “immoralism” and recognises that its total rejection of traditional morality probably went too far; it wasn’t even faithful to Moore’s example. But Keynes was still frivolous enough to admit that it was now too late to change him.
At the end of his studies in 1904, he went on taking classes in Cambridge, especially in philosophy. He also tried out economics but didn’t like it. In the end, he decided to leave academia and applied for a government job. He was appointed to the India Office in 1906. However, he quickly grew so bored in the civil service that he began work on a PhD thesis on probability. This is the context in which he became aware of the difference between risk and uncertainty, between unknown future events that can be given numbered probabilities and those that cannot. Keynes used his dissertation to apply, unsuccessfully, for a fellowship at King’s. In the end, Alfred Marshall offered him a post as a lecturer in economics, funded out of his and John Neville Keynes’s own pockets. Luckily for Keynes, in those days economics wasn’t yet fully established at Cambridge, otherwise this act of nepotism wouldn’t have been possible. It was also hazardous: at this stage Keynes knew very little about economics.
In 1909, Keynes’s doctoral thesis on probability was finally accepted, but he had to make some corrections; it took him until 1921 to complete them. In 1911, he was nevertheless elected to a fellowship at King’s; he remained a fellow for the rest of his life.
But this way of life didn’t last. In 1915 he was called back into government, to the Treasury. Among his responsibilities were the design of terms of credit between Britain and its First World War continental allies, and the acquisition of scarce currencies.
What is more important, however, is the fact that after the war, Keynes was appointed financial representative to the 1919 Paris Peace Conference. With his unorthodox — and initially unpopular — views, which he set down in his book The Economic Consequences of the Peace later that year, he made enemies and gained notoriety. Keynes warned that crushing Germany financially was a bad idea, both for economic and political reasons. He found it inconsistent to demand high reparations and deprive the country of the means to earn the money necessary to be able to pay them, and he feared the germination of a desire for revenge. He was right, even if the rise of Hitler cannot be explained by the Treaty of Versailles alone.
At any rate, this book made him famous, and it enabled him to begin a career as a journalist and author. After the war, Keynes combined teaching a private seminar at Cambridge with his official life in London, where he sat on several government commissions and supervisory boards. He was a busy and much respected public figure. He speculated on the Stock Exchange, on his own account and for other people, with varying success. His first really theoretical work in economics came out only in 1930, in two volumes, written under the influence of the Great Depression: A Treatise on Money.
His most famous work, The General Theory of Employment, Interest and Money followed six years later. The book is non-technical. Paul Samuelson, one of the American scholars who spent a lot of time translating Keynes’s ideas into the language of traditional neoclassical economics, bringing about what he called the “neoclassical synthesis”, found it exasperating and inspiring at the same time:
It is a badly written book, poorly organized . . . it is arrogant, bad-tempered, polemical . . . it abounds in mare’s nests and confusions: involuntary unemployment, wage units, the equality of savings and investments, the timing of the multiplier, interactions of marginal efficiency upon the rate of interest and many others . . . flashes of insight and intuition intersperse tedious algebra. An awkward definition suddenly gives way to an unforgettable cadenza. When it is finally mastered, we find its analysis to be obvious and at the same time new. In short, it is a work of genius.
Meanwhile, Friedrich Hayek had joined the London School of Economics in 1931. The two men saw quite a lot of each other, and even though they disagreed on economics as much as on lifestyles, they became friends. Keynes was cool, Hayek was stern. Keynes liked to be a provocative and sometimes brutal nonconformist, while Hayek was polite in a very old-fashioned way and deeply respected tradition, including religion, as the condensed form of human experience passed on from generation to generation. But they were both erudite people who enjoyed each other’s conversation, and they were both bibliophiles. When the LSE was evacuated to Cambridge during the Blitz, Keynes helped Hayek find accommodation there.
In the intellectual dispute between Hayek and Keynes, their two very different temperaments came out very clearly at the beginning of the Thirties. Hayek wrote a scrupulous and precise review of Keynes’s Treatise on Money, criticising the lack of a well-argued capital theory, and providing Keynes with some insights into the Austrian theory of capital that he might want to consider in his work. When Keynes finally responded, he just shrugged and said that he no longer believed what he had written in that book.
This opportunism and nonchalance were typical. He changed his mind often and was proud of his mental flexibility in adapting to new facts and insights. He nevertheless did take a rather cheap revenge in trashing Hayek’s book Prices and Production, which came out in 1931. Hayek presented an over-investment theory of the business cycle, which ran contrary to the under-consumption theories that were in vogue in those days in the Anglo-Saxon world and which Keynes endorsed as well. Keynes ridiculed Hayek for having used an equilibrium position as a starting point for his argument. Given that the economy quite clearly seemed to be in disequilibrium, he found this beside the point.
But this wasn’t the core of their disagreement. Hayek argued that after an excessive boom, saving needs to increase and consumption has to drop in order for investment to maintain the capital stock in use. A reduction of consumption is inevitable in order to return to equilibrium, and any public intervention to try to prevent this is bound to prolong the crisis instead of curing it. Keynes, however, viewed under-consumption not over-investment as the cause of the boom. He was convinced that a rise in savings just wouldn’t do because savings don’t automatically feed into investment if the mood isn’t right. If people are pessimistic, they don’t invest and they don’t consume; they put their money under their pillows and leave it there. In his General Theory, which Hayek chose not to review, Keynes called this attitude the “liquidity preference”. To the well-known functions of money as a transaction device and as a standard of value, Keynes thus added the function of a store of value. If all goes wrong, this psychologically determined liquidity preference can increase and degenerate into a “liquidity trap” that soaks up all efforts by the central bank to float the market. When monetary policy becomes ineffective, fiscal policy — increased government spending — is the only instrument that government can use.
Keynes’s distinctive note was his intuition that psychology always plays a role. In his General Theory, he not only works with a “marginal propensity to consume”, a psychological element and at the same time something he claims to be an anthropological constant in the style of Adam Smith’s “natural propensity to truck, barter and trade”, but he also underscores very strongly that expectations matter. Given the fundamental uncertainty that is always present in social interaction, pessimism can spread and easily feed into a collective downward spiral. The difference between Hayek and Keynes was not just an empirical question about whether it was over-investment or under-consumption that had created a specific cycle; it was much more a fundamental disagreement between their views concerning the process of adaptation. Hayek understood Keynes’s point, but didn’t believe that government could, or even should, influence people’s expectations.
In modern economic theory, a whole branch of study focuses on the expectations problem: the rational expectations approach. It argues that all relevant future events are anticipated and all relevant information is therefore already present in the data underlying present action. The rational expectations argument against Keynesian deficit spending, for example, is that if government raises spending today expectations won’t improve because people know that they will have to pay it back in the future, either through taxes or inflation.
It is easy to refute this argument — correctly — with the benefit of experience, especially after the financial crisis which began in 2008. This crisis has shown very clearly that stock and futures prices by no means contain all relevant information and people don’t always anticipate value correctly. And when people choose to believe government, such as when the chancellor says that all private bank accounts will be guaranteed, which is totally unfeasible, the rationality assumption also seems less convincing. Keynes knew why — from personal bad experience. He lost and earned back a lot of money, both on his own account and for King’s College, whose investments he managed. He did, however, die a multimillionaire.
In his General Theory, Keynes describes the process that takes place in financial markets as a “beauty contest”. Just as you don’t win a beauty contest because you’re the most beautiful person by any objective standard, you don’t make money on the stock exchange because you identify the stocks of the most successful companies. It is not enough to scrutinise balance sheets and production technologies. If you manage to make a fortune, you do so because you have correctly anticipated the evaluation of stocks by others, and acted accordingly. This subjective valuation, Keynes thought, can be miles away from any objective standard, simply because people aren’t rational and there is such a thing as a herd effect. We tend to do what others do because we hope to profit from the “wisdom of crowds” and also because that’s what determines prices. But it can be misleading and destructive.
Hayek didn’t share Keynes’s mixed experience with the financial markets, but he would have agreed that there is no such thing as an objective value of a stock. Hayek was a subjectivist. And he would not have understood why a rationally expected price should be one that already incorporates all relevant information. In his view, the economic problem consisted not just of an optimal allocation of scarce resources, but was rather a more generalised problem of social interaction. In that sense, it has to do with dealing with the “knowledge problem”, our natural lack of all-encompassing knowledge, in such a way that a maximum of the bit of imperfect, decentralised, local knowledge that we individually possess could be gathered and communicated. In the marketplace, this happens as we react to prices. On the basis of our personal assessment of relative scarcity, we both take in and send out local information, and this action in itself becomes an element of newly-generated information for ourselves and for others. In short, Hayek’s point is that this interaction has to take place effectively in order to determine a price, which is thus a subjective and interactive matter. It cannot be avoided, it cannot be circumvented, there is no shortcut. There is no other way of knowing what its level should be.
Keynes did grasp this essential part of the Hayekian argument but couldn’t be bothered with it. Nothing reflects this more clearly than his famous statement about the long term. In his Tract on Monetary Reform, which came out in 1923, he writes: “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”
Like most gifted people, Keynes wanted to get something done, and he was optimistic about the success of well-intentioned political action. In his 1930 essay on the “Economic Possibilities of Our Grandchildren”, this optimism seems boundless. “The economic problem may be solved, or be at least within sight of solution, within a hundred years,” he writes. Only then will the real problems arise, those problems that the Bloomsbury group had their specific answers to: “For the first time since creation man will be faced with his real, his permanent problem — how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest have won for him, to live wisely and agreeably and well.”
At this point, according to Keynes, we will finally have time to think about the most essential part of human existence: the question as to what constitutes a good life. And now he becomes stunningly anti-capitalist: “The love of money as a possession — as distinguished from the love of money as a means to the enjoyments and realities of life — will be recognised for what it is, a somewhat disgusting morbidity . . . All kinds of social customs and economic practices, affecting the distribution of wealth and of economic rewards and penalties, which we now maintain at all costs, however distasteful and unjust they may be in themselves, because they are tremendously useful in promoting the accumulation of capital, we shall then be free, at last, to discard.” That time hasn’t come yet, but we had better be prepared mentally, he warns us, and begin asking ourselves questions. This curious view is a rejection of the ethics of capitalism from the standpoint of cultural superiority. Hayek could only turn away with a shudder from such pretentiousness.
The Second World War, however, saw Keynes and Hayek for once fight along similar lines. Both were afraid of the forms of totalitarianism they observed in Germany and in Russia, and both were worried that Britain, due to the enormous war effort, would end not only in excessive debt, but also with hyperinflation. Both advocated forced saving — given military expenditure, this was clearly not a situation of lack of demand. Even Keynes agreed on that. The war years were a time when Hayek suffered from isolation and Keynes’s star shone more brightly than ever. In 1941, Keynes was appointed an adviser to the Treasury, and in 1942 he not only joined the advisory board of the Bank of England but also became, at Winston Churchill’s instigation, Lord Keynes of Tilton. His mother was thrilled.
In 1944, Keynes travelled to Bretton Woods, a small mountain village in New Hampshire. He was head of the British delegation and chairman of the World Bank commission in the negotiations that established the Bretton Woods system, which lasted until the 1970s. He proposed an international clearing union for the management of currencies, the creation of a common world unit of currency, which he called the “Bancor”, and new global institutions managing an international trade and payments system with incentives for countries to avoid substantial trade deficits or surpluses. He wasn’t fully successful in persuading the Americans, but the World Bank and the IMF were founded as a compromise. Overworked and exhausted, Keynes succumbed to a second heart attack in 1946.
In the end, it seems that Keynes had grown wary of his own optimism concerning the possibilities of political action, admitting: “I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking 20 years ago.” The reason for this final volte-face might be that Keynes realised that not only did he never pay any attention to the supply side of the economy, but he also left government entirely out of the picture. He had spent his life in the political sphere. It seems inevitable that some day he would finally have woken up to the fact that politics isn’t neutral — and can’t be. But unfortunately for the present, in expounding his theory, he did not anticipate that the dynamics of the political process would be such that increased public spending in crisis situations would never be cut back in better times. He didn’t heed Hayek’s warnings.
In a fair and differentiated reading, Keynes’s theory has undeniable strengths: it takes disequilibrium, uncertainty and “animal spirits” into account. But Keynes did not foresee that there could and would be a political cycle, with the incumbent government doling out fiscal presents just before elections and cutting back right afterwards. He didn’t analyse what the multiplier depends on and therefore didn’t imagine that it could be below 1 or even negative. He didn’t expect that we would some day find ourselves in a situation where people save little and governments spend a lot — ideal conditions for the multiplier — while that pessimism would stifle the economy precisely for that reason. He didn’t take the time lags of political action into account. He ignored the fact that public spending tends to crowd out private investment.
These are not just minor flaws that he couldn’t foresee. These are serious shortcomings that are to be remembered and borne in mind as a caveat against the vulgar Keynesian policy recommendations that now seem to be the staple of governments around the globe. It is hard to believe that Keynes himself would ignore these caveats, were he still alive. While he would certainly have endorsed the immediate reaction of fiscal and monetary policy to the outbreak of the crisis in 2008, it is difficult to believe he would still be in favour of loose money and deficit spending today, five years on. He would urge governments to put on the brake. Crisis policies are for times of crisis. He would know about the bubbles that governments are creating anew. And he would take the risk of inflation seriously, as he always did. Keynes would be wiser than the Keynesians.