(This paper was presented as the keynote address at the Seventh Annual Moral Foundations of Capitalism Conference hosted by the Clemson Institute for the Study of Capitalism in Clemson, South Carolina, on May 30, 2012)
The current economic crisis that has engulfed the United States and much of the rest of the world over the last few years, has seen a dramatic revival in the economic ideas and policy prescriptions of the most famous British economist of the 20th century, John Maynard Keynes. This has seemed surprising to some, since it was presumed that traditional Keynesian Economics was more or less relegated (to use Karl Marx's phrase) to "the dustbin of history."
After dominating the economics profession for more than a quarter of a century following the Second World War, Keynesianism had been challenged by various "counter-revolutions" in Macroeconomics beginning in the late 1960s and 1970s. They had taken the forms of Monetarism, Supply-Side Economics, New Classical or Rational Expectations Theory, New Keynesianism, and even Austrian Economics, following the awarding of the Nobel Prize to F. A. Hayek in the 1974.
The fact is, however, that neither Keynes nor his economics have ever been gone or replaced. Keynesian Economics has continued to dominate and hold sway over the way the vast majority of economists think about and analyze the nature of economy-wide fluctuations in employment and output.
The Legacy of Keynes's "Demand Management" Economics
It is the idea that government must manage and guide monetary and fiscal policy to assure full employment, a stable price level and to foster economic growth. Some of the terms of the debate may have changed over the last half-century or so, but the belief that it is the responsibility of government to control the supply of money and aggregate spending in the economy persist-s today just as much as it did in the 1940s.
The modern conception of "demand management" is a legacy of John Maynard Keynes's 1936 book The General Theory of Employment, Interest and Money. The impact of Keynes's book and its message should not be underestimated. Its two central tenets are the claim that the market economy is inherently unstable and likely to generate prolonged periods of unemployment and underutilized productive capacity, and the argument that governments should take responsibility to counteract these periods of economic depression with the various monetary and fiscal policy tools at their disposal. This was bolstered by Keynes's belief that policy managers guided by the economic theory developed in his book could have the knowledge and ability to do so successfully.
No less important in propagating his idea of demand management economic policy was Keynes's literary ability to persuade. As Leland Yeager expressed it, "Keynes saw and provided what would gain attention − harsh polemics, sardonic passages, bits of esoteric and shocking doctrine." Keynes possessed an arrogant amount of self-confidence and belief in his ability to influence public opinion and policy.
Austrian economist Friedrich A. Hayek, who knew Keynes fairly well, referred to his "supreme confidence . . . in his power to play on public opinion as a supreme master plays his instrument." On the last occasion he saw Keynes in early 1946 (shortly before Keynes' death from a heart attack), Hayek asked him if he wasn't concerned that some of his followers were taking his ideas to extremes. Keynes replied that Hayek did not need to be worried. If it became necessary, Hayek could "rely upon him again quickly to swing round pubic opinion—and he indicated by a quick movement of his hand how rapidly that would be done. But three months later he was dead."
Even today, respected economists argue that Keynesian-style macroeconomic intervention is needed as a balancing rod against instability in the market economy. One example is Robert Skidelsky, the author of a widely acclaimed multi-volume biography of Keynes and the recently published, Keynes: The Return of the Master (2009)?.
A few years ago Professor Skidelsky argued that capitalism has at its heart an instability of financial institutions and, "This insight by Keynes into the causes and consequences of financial crises remains supremely valuable." In any significant economic downturn, government should begin "pumping money into the economy, like pumping air into a deflating balloon."
Keynes first established his reputation as a public figure in the immediate aftermath of the First World War. During war, he had worked in the British Treasury. In 1919 he served as an adviser to the British delegation in Versailles. But frustrated with the attitude of the Allied powers toward Germany in setting the terms of the peace, Keynes returned to Britain and published The Economic Consequences of the Peace, in which he severely criticized the peace settlement.
In 1923, he published A Tract on Monetary Reform, in which he called for the end of the gold standard, suggesting a national man-aged paper currency in its place. He strongly opposed Great Britain's return to the gold standard in the mid-1920s at the prewar gold parity. He argued that governments should have discretionary power over the management of a nation's monetary system to as-sure a desired target level of employment, output, and prices.
In 1930 Keynes published A Treatise on Money, a two-volume work that he hoped would establish his reputation as a leading monetary theorist of his time instead of only an influential economic policy analyst. However, over the next two years a series of critical reviews appeared, written by some of the most respected economists of the day. The majority of them demonstrated serious problems with either the premises or the reasoning with which Keynes attempted to build his theory on the relationships between savings, investment, the interest rate, and the aggregate levels of output and prices. But the most devastating criticisms were made by a young Friedrich A. Hayek in a two-part review essay that appeared in 1931-1932.
Hayek argued that Keynes seemed to understood neither the nature of a market economy in general nor the significance and role of the rate of interest in maintaining a proper balance between savings and investment for economic stability. At the most fundamental level Hayek argued that Keynes's method of aggregating the individual supplies and demands for a multitude of goods into a small number of macroeconomic "totals" distorted any real understanding of the relative price and production relationships in and between actual markets. "Mr. Keynes's aggregates conceal the most fundamental mechanisms of change," Hayek said.
Keynes devoted the next five years to reconstructing his argument, the re-sult being his most famous and influential work, The General Theory of Employment, Interest and Money, published in 1936.
Keynes argued that the Great Depression was caused by inescapable irrationalities in the market economy that not only created the conditions for the severity of the economic downturn, but necessitated activist monetary and fiscal policies by government to restore and maintain full employment and maximum utilization of resource and output capabilities. For the next half-century Keynes's ideas, as presented in The General Theory, became the cornerstone of macroeconomic theorizing and policy-making throughout the Western world, and continue to dominate public policy thinking today.
John Maynard Keynes and the "New Liberalism"
What where the wider philosophical principles and ideas behind Keynes views about a market society? In 1925, John Maynard Keynes delivered a lecture at Cambridge titled "Am I a Liberal?" He rejected any thought of considering himself a conservative because conservatism "leads nowhere; it satisfies no ideal; it conforms to no intellectual standard; it is not even safe, or calculated to preserve from spoilers that degree of civilization which we have already attained."
Keynes then asked whether he should consider joining the Labor Party. He admitted, "Superficially that is more attractive," but rejected it as well. "To begin with, it is a class party, and the class is not my class," Keynes argued. Furthermore, he doubted the intellectual ability of those controlling the Labor Party, believing that it was dominated by "those who do not know at all what they are talking about."
This led Keynes to conclude that all things considered, "the Liberal Party is still the best instrument of future progress—if only it has strong leadership and the right program." But the Liberal Party of Great Britain could serve a positive role in society only if it gave up "old-fashioned individualism and laissez-faire," which he considered "the dead-wood of the past." Instead, what was needed was a "New Liberalism" that would involve "new wisdom for a new age." What this entailed, in Keynes's view, was "the transition from economic anarchy to a regime which deliberately aims at control-ling and directing economic forces in the interests of social justice and social stability."
A year later, in 1926, Keynes delivered a lecture in Berlin, Germany on, "The End of Laissez-Faire," in which he argued, "It is not true that individuals possess a prescriptive 'natural liberty' in their economic activities. There is no compact conferring perpetual rights on those who Have or on those who Acquire." Nor could it be presumed that private individuals pursuing their enlightened self-interest would always serve the common good.
In a world of "uncertainty and ignorance" that sometimes resulted in periods of unemployment, Keynes suggested "the cure for these things is partly to be sought in the deliberate control of the currency and of credit by a central institution." And he believed that "some coordinated act of intelligent judgment" by the government was required to determine the amount of savings in the society and how much of the nation's savings should be permitted to be invested in foreign markets as well as the relative distribution of that domestic savings among "the most nationally productive channels."
Finally, Keynes argued that government had to undertake a "national policy" concerning the most appropriate size of the country's population, "and having settled this policy, we must take steps to carry it into operation." Furthermore, Keynes pro-posed serious consideration of adopting a policy of eugenics: "The time may arrive a little later when the community as a whole must pay attention to the innate quality as well as to the mere numbers of its future members."
This agenda for an activist and planning government did not make Keynes a socialist or a communist in any strict sense of these words. Indeed, after a visit to Soviet Russia he published an essay in 1925 strongly critical of the Bolshevik regime. "For me, brought up in a free air undarkened by the horrors of religion, with nothing to be afraid of, Red Russia holds too much which is detestable . . . I am not ready for a creed which does not care how much it destroys the liberty and security of daily life, which uses deliberately the weapons of persecution, destruction, and international strife . . . It is hard for an educated, decent, intelligent son of Western Europe to find his ideals here."
But where Soviet Russia had an advantage over the West, Keynes argued, was in its almost religious revolutionary fervor, in its romanticism of the common working man, and its condemnation of money-making. Indeed, the Soviet attempt to stamp out the "money-making mentality" was, in Keynes's mind, "a tremendous innovation." Capitalist society, too, in Keynes's view, had to find a moral foundation above self-interested "love of money."
What Keynes considered Soviet Russia's superiority over capitalist society, therefore, was its moral high ground in opposition to capitalist individualism. And he also believed that "any piece of useful economic technique" developed in Soviet Russia could easily be grafted onto a Western economy following his model of a New Liberalism "with equal or greater success" than in the Soviet Union.
That Keynes had great confidence in an a state-managed system of "useful economic technique" was clearly seen in the following comparison he made, also in the mid-1920s, between a regulated wage system in the name of "fairness" between social classes and market-determined wages, which he condemned as "the economic juggernaut." Said Keynes:
"The truth is that we stand mid-way between two theories of economic society. The one theory maintains that wages should be fixed by reference to what is "fair" and "reasonable" as between classes. The other theory – the theory of the economic juggernaut – is that wages should be settled by economic pressure, otherwise called "hard facts," and that our vast machine should crash along, with regard only to its equilibrium as a whole, and without attention to the change in consequences of the journey to individual groups."
With the coming of the Great Depression, however, Keynes once again rejected the idea of a free market solution to the rising unemployment and idled industry that intensified following the crash of 1929. In his writings of the 1920s and early 1930s, advocating a "New Liberalism" and a deficit-spending government to "solve" the Great Depression, were the premises for the Keynesian Revolution that would be officially inaugurated with the publication of The General Theory of Employment, Interest and Money. With those ideas, Keynes produced one of the greatest challenges to the free market economy in the twentieth century.
Keynes and Keynesian Economics
The General Theory of Employment, Interest and Money was published on February 4, 1936. The essence of Keynes's theory was to show that a market economy, when left to its own devices, possessed no inherent self-correcting mechanism to return to "full employment" once the economic system has fallen into a depression.
At the heart of his approach was the belief that he had demonstrated an error in Say's Law. Named after the nineteenth-century French economist Jean-Baptiste Say, the fundamental idea is that individuals produce so they can consume. An individual produces either to consume what he has manufactured himself or to sell it on the market to acquire the means to purchase what others have for sale.
Or as the classical economist David Ricardo expressed it, "By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person . . . Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected."
Keynes argued that there was no certainty that those who had sold goods or their labor services on the market will necessarily turn around and spend the full amount that they had earned on the goods and services offered by others. Hence, total expenditures on goods could be less than total income previously earned in the manufacture of those goods. This, in turn, meant that the total receipts received by firms selling goods in the market could be less than the expenses incurred in bringing those goods to market. With total sales receipts being less than total business expenses, businessmen would have no recourse other than to cut back on both output and the number of workers employed to minimize losses during this period of "bad business."
But, Keynes argued, this would merely intensify the problem of unemployment and falling output. As workers were laid off, their incomes would necessarily go down. With less income to spend, the unemployed would cut back on their consumption expenditures. This would result in an additional falling off of demand for goods and services offered on the market, widening the circle of businesses that find their sales receipts declining relative to their costs of production. And this would set off a new round of cuts in output and employment, setting in motion a cumulative contraction in production and jobs.
Why wouldn't workers accept lower money wages to make themselves more attractive to rehire when market demand falls? Because, Keynes said, workers suffer from "money illusion." If prices for goods and services decrease because consumer demand is falling off, then workers could accept a lower money wage and be no worse off in real buying terms (that is, if the cut in wages was on average no greater than the decrease in the average level of prices). But workers, Keynes argued, generally think only in terms of money wages, not real wages (that is, what their money income represents in real purchasing power on the market). Thus, workers often would rather accept unemployment than a cut in their money wage.
If consumers demand fewer final goods and services on the market, this necessarily means that they are saving more. Why wouldn't this unconsumed income merely be spent hiring labor and purchasing resources in a different way, in the form of greater investment, as savers have more to lend to potential borrowers at a lower rate of interest? Keynes's response was to insist that the motives of savers and investors were not the same. Income-earners might very well desire to consume a smaller fraction of their income, save more, and offer it out to borrowers at interest. But there was no certainty, he insisted, that businessmen would be willing to borrow that greater savings and use it to hire labor to make goods for sale in the future.
Since the future is uncertain and tomorrow can be radically different from today, Keynes stated, businessmen easily fall under the spell of unpredictable waves of optimism and pessimism that raise and lower their interest and willingness to borrow and invest. A decrease in the demand to consume today by income-earners may be motivated by a desire to increase their consumption in the future out of their savings. But businessmen cannot know when in the future those income-earners will want to increase their consumption, nor what particular goods will be in greater demand when that day comes. As a result, the decrease in consumer demand for present production merely serves to decrease the business-man's current incentives for investment activity today as well.
If for some reason there were to be a wave of business pessimism resulting in a decrease in the demand for investment borrowing, this should result in a decrease in the rate of interest. Such a decrease because of a fall in investment demand should make savings less attractive, since less interest income is now to be earned by lending a part of one's income. As a result, consumer spending should rise as savings goes down. Thus, while investment spending may be slackening off, greater consumer spending should make up the difference to assure a "full employment" demand for society's labor and resources.
But Keynes doesn't allow this to happen because of what he calls the "fundamental psychological law" of the "propensity to consume." As income rises, he says, consumption spending out of income also tends to rise, but less than the increase in income. Over time, therefore, as incomes rise a larger and larger percentage is saved.
In The General Theory, Keynes listed a variety of what he called the "objective" and "subjective" factors that he thought influenced people's decisions to consume out of income. On the "objective" side: a windfall profit; a change in the rate of interest; a change in expectations about future income. On the "subjective" side, he listed "Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance." He merely asserts that the "objective" factors have little influence on how much to consume out of a given amount of income—including a change in the rate of interest. And the "subjective" factors are basically invariant, being "habits formed by race, education, convention, religion and current morals . . . and the established standards of life."
Indeed, Keynes reaches the peculiar conclusion that because men's wants are basically determined and fixed by their social and cultural environment and only change very slowly, "The greater . . . the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance." That is, men run out of wants for which they would wish investment to be undertaken; the resources in the society − including labor − are threatening to become greater than the demand for their employment.
Keynes, in other words, turns the most fundamental concept in economics on its head. Instead of our wants and desires always tending to exceed the means at our disposal to satisfy them, man is confronting a "post-scarcity" world in which the means at our disposal are becoming greater than the ends for which they could be applied. The crisis of society is a crisis of abundance! The richer we become, the less work we have for people to do because, in Keynes's vision, man's capacity and desire for imagining new and different ways to improve his life is finite. The economic problem is that we are too well-off.
As a consequence, unspent income can pile up as unused and uninvested savings; and what investment is undertaken can erratically fluctuate due to what Keynes called the "animal spirits" of businessmen's irrational psychology concerning an uncertain future. The free market economy, therefore, is plagued with the constant danger of waves of booms and busts, with prolonged periods of high unemployment and idle factories. The society's problem stems from the fact that people consume too little and save too much to assure jobs for all who desire to work at the money wages that have come to prevail in the market, and which workers refuse to adjust downward in the face of any decline in the demand for their services.
Only one institution can step in and serve as the stabilizing mechanism to maintain full employment and steady production: the government, through various activist monetary and fiscal policies.
In Keynes's mind the only remedy was for government to step in and put those unused savings to work through deficit spending to stimulate investment activity. How the government spent those borrowed funds did not matter. Even "public works of doubtful utility," Keynes said, were useful: "Pyramid-building, earthquakes, even wars may serve to increase wealth," as long as they create employment. "It would, indeed, be more sensible to build houses and the like," said Keynes, "but if there are political or practical difficulties in the way of this, the above would be better than nothing."
Nor could the private sector be trusted to maintain any reasonable level of investment activity to provide employment. The uncertainties of the future, as we saw, created "animal spirits" among businessmen that produced unpredictable waves of optimism and pessimism that generated fluctuations in the level of production and employment. Luckily, government could fill the gap. Furthermore, while businessmen were emotional and shortsighted, the State had the ability to calmly calculate the long run, true value and worth of investment opportunities "on the basis of the general social advantage."
Indeed, Keynes expected the government would "take on ever greater responsibility for directly organizing investment." In the future, said Keynes, "I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment." As the profitability of private investment dried up over time, society would see "the euthanasia of the rentier" and "the euthanasia of the cumulative oppressive power of the capitalist" to exploit for his own benefit the scarcity of capital. This "assisted suicide" of the interest-earning and capitalist groups would not require any revolutionary upheaval. No, "the necessary measures of socialization can be introduced gradually and without a break in the general traditions of the society."
This is the essence of Keynes' economics.
Continue reading (Long Read) - John Maynard Keynes: A Vision for the Future or a Ghost from the Past?