Keynes

Keynes is relevant for another reason. The crisis has brought to a head wider issues concerning the explanation of human behaviour and the role of moral judgements in economics. These touch on attitudes to economic growth, globalization, justice, the environment and so on. Keynes had important things to say about these matters. To take just one: If growth is a means to an end, what is the end, how much growth is ‘enough’, and what other valuable human purposes may be pre-empted by a single-minded concentration on economic growth?

The economic hurricane now raging gives us an immense opportunity to reorient economic life towards what is sensible, just and good. Keynes remains an indispensable guide to that future.

My own stimulus for writing this short book was given by my agent, Michael Sissons, to whom I owe an enormous debt of gratitude over forty years of association and friendship. I have also benefited enormously from the encouragement and advice of my publisher, Stuart Proffitt.

Although the historical Keynes is familiar territory to me, my three researchers at the Centre for Global Studies — Pavel Erochkine, Louis Mosley and Christian Westerlind Wigstrom — have given me invaluable help in transforming him into a figure relevant to the contemporary world. Christian Westerlind Wigstrom has helped clarify numerous points of theory, and is responsible for the statistical analysis in Chapter 5.

I would also like to thank Andrew Cox, Paul Davidson, Meghnad Desai, V. R. Joshi, Geoff Miller, Landon Rowland and my sons, Edward and William, for reading the manuscript, in whole or part, and making helpful suggestions. Edward in particular has sharpened my understanding of Keynes as a moralist. The House of Lords Library has been a valuable research resource. Any mistakes of fact or interpretation are my responsibility alone.

An important advantage I would claim for this book is that, although its subject matter is mainly economics, it is written from a vantage point outside that of the economics profession. My first academic study — and love — was history, and though I studied economics later, and was indeed a member of the economics department at the University of Warwick, I am not a professional economist. I would describe myself as an economically literate historian. The advantage I would claim is that of not having been brainwashed to see the world as most economists view it: I have always regarded their assumptions about human behaviour as absurdly narrow. For reasons which will become clearer as the book goes on, I have come to see economics as a fundamentally regressive discipline, its regressive nature disguised by increasingly sophisticated mathematics and statistics.

Not having been trained formally as an economist has an important drawback: I find mathematics and statistics ‘challenging’, as they say, and it is too late to improve. This has, I believed, saved me from important errors of thinking — like imagining the world to be an urn, or believing in induction as the source of knowledge. On the other hand, it has no doubt led me to underestimate the contribution of mathematics as an aid to rigorous thinking, and statistics as a check on our fancy. History, politics, sociology, psychology and anthropology are suggestive, not conclusive, disciplines: they cannot prove (or more importantly disprove) any hypothesis. They should perhaps be more like economics, and economics should be more like them. That is why I was drawn to Keynes: he was a man of many parts. I have heard economists say he was a brilliant thinker, but a bad theorist. They objected to his ‘ad-hoc’ theorizing — inventing bits of theory to explain unusual events, rather than building up his theory from secure micro-foundations. His wife called him ‘more than an economist’. I am less than an economist, but perhaps this makes me better able to appreciate his greatness.

Keynes, of course, is no one’s property; and, while economists may disagree with some of my interpretations, this book will have achieved its purpose if it brings Keynes to life for a world struggling once again with the riddles of economies and the perplexities of moral life in an age of actual and potential abundance.

Once I started writing this book, on 1 January 2009, I stopped reading the newspapers on a daily basis to avoid filling up my mind with ‘noise’. Any coherence my argument may have stems from this act of self-denial.

In a way, this is to be expected. For twenty years or so, mainstream economics has taught that markets “clear” continuously. The big idea was that if wages and prices are completely flexible, resources will be fully employed. Any shock to the system will result in instantaneous adjustment of wages and prices to the new situation.

Admittedly, this system-wide responsiveness depended on economic agents having perfect information about the future. This is manifestly absurd. Nevertheless, most mainstream economists believed that economic actors possess enough information to lend their theorizing a sufficient dose of reality. This so-called “efficient market theory,” should have been blown sky-high by last autumn’s financial breakdown. But I doubt that it has been. Seventy years ago, John Maynard Keynes pointed out its fallacy. When shocks to the system occur, agents do not know what will happen next. In the face of this uncertainty, they do not readjust their spending; instead, they refrain from spending until the mists clear, sending the economy into a tailspin.

It is the shock, not the adjustments to it, that spreads throughout the system. The inescapable information deficit obstructs all those smoothly working adjustment mechanisms — i.e., flexible wages and flexible interest rates — posited by mainstream economic theory. An economy hit by a shock does not maintain its buoyancy; rather, it becomes a leaky balloon. Hence Keynes gave governments two tasks: to pump up the economy with air when it starts to deflate, and to minimize the chances of serious shocks happening in the first place.

Today, the first lesson appears to have sunk in: various bailout and stimulus packages have stimulated depressed economies sufficiently to give us a reasonable expectation that the worst of the slump is over. But, judging from recent proposals in the United States, the United Kingdom, and the European Union to reform the financial system, it is far from clear that the second lesson has been learned. A few cosmetic reforms, it now seems to be agreed, are all that is needed. This is to set the scene for the next crisis.

For thirty years or so after the Second World War, Keynesian economics ruled the roost, at least in the sense that Keynesian policy — trying to keep economies fully employed and growing on an even keel — was part of the normal toolkit of governments. Then it was thrown out, as economics reverted to its older doctrine that market economies were internally self-correcting and that it was government intervention which made them behave badly. The free-market era of Reagan and Thatcher dawned.

The story of the decline and fall of the Keynesian revolution, and what has happened to economics generally, is a fascinating intellectual detective story in its own right, which charts the trajectory from President Nixon’s ‘We are all Keynesians now’ in 1971 to Robert Lucas’s 2009 remark ‘I guess everyone is a Keynesian in the foxhole.’¹

The decline of Keynesianism is a key theme of this book, because I believe with Keynes that ideas matter profoundly, ‘indeed the world is ruled by little else’.² I therefore believe that the root cause of the present crisis lies in the intellectual failure of economics. It was the wrong ideas of economists which legitimized the deregulation of finance, and it was the deregulation of finance which led to the credit explosion which collapsed into the credit crunch. It is hard to convey the harm done by the recently dominant school of New Classical economics. Rarely in history can such powerful minds have devoted themselves to such strange ideas. The maddest of these is the proposition that market participants have correct beliefs on average about what will happen to prices over an infinite future. I am naturally much less critical of the New Keynesian school, which disputes the terrain of macroeconomics with the New Classicals, but I am still quite critical, because I believe that in accepting the theory of rational expectations, which revives in mathematical form the classical theory which Keynes rejected, they have sold the pass to the New Classicals. Having swallowed the elephant of rational expectations, they strained at the gnat of the continuous full employment implied by it, and developed theories of market failure to allow a role for government.

The centrepiece of Keynes’s theory is the existence of inescapable uncertainty about the future, and this is the main subject of Chapter 4, with Chapter 3 being an account of the influence in developing it of his experience as an investor during the turbulent period of the Great Depression. Taking uncertainty seriously — which few economists today do — has profound implications not just for how one does economics and how one applies it, but for one’s understanding of practically all aspects of human activity. It helps explain the rules and conventions by which people live. I lay particular emphasis on its implications for how the social sciences should use language. Keynes always tried to present his essential thoughts — which he called ‘simple and . . . obvious’ — in what may loosely be called high-class ordinary language. This was not just to amplify his persuasive appeal, but because he thought that economics should be intuitive, not counter-intuitive: it should present the world in a language which most people understand. This is one reason why he opposed the excessive mathematicization of economics, which separated it from ordinary understanding. He would have been very hostile to the linguistic imperialism of economics, which appropriates important words in the common lexicon, like ‘rational’, and gives them technical meanings which over time change their ordinary meanings and the understandings which they express. The economists’ definition of rational behaviour as behaviour consistent with their own models, with all other behaviour dubbed irrational, amounts to a huge project to reshape humanity into people who believe the things economists believe about them. It was consistent with Keynes’s attitude to language to prefer simple to complex financial systems. He would have been utterly opposed to financial innovation beyond the bounds of ordinary understanding, and therefore control. Complexity for its own sake had no appeal for him.

My hope is that the current slump will cause the New Keynesians and others to take uncertainty seriously. But that probably requires a major institutional change in the way in which economics is taught and transmitted. This book ends with a proposal to reform the teaching of economics to encourage economists to think of it as a moral, not natural, science.

Keynes, of course, did not have the last word to say about the causes of economic malfunctions. His theories have to be adapted to a crisis precipitated by banking, rather than stock-market, failure. But my contention is that he provided the right kind of theory to explain what is now happening; and since, in my view, financial crises which lead to failures in the ‘real’ economy are a normal part of the operation of unmanaged markets, he can claim to have produced a ‘general theory’ which directs us to how to make markets safe for the world, as well as making the world safe for markets.

But let’s get Keynes — and Keynesianism — right. In the US, more than in Britain, he is considered a kind of socialist. This is wrong. Keynes was not a nationalizer, nor even much of a regulator. He came not exactly to praise capitalism, but certainly not to bury it. He thought that, for all its defects, it was the best economic system on offer, a necessary stage in the passage from scarcity to abundance, from toil to the good life.

Keynes is also considered to be the apostle of permanent budget deficits. ‘Deficits don’t matter.’ This was not Keynes: it was Glen Hubbard, chairman of George W. Bush’s Council of Economic Advisers in 2003. It may surprise readers to learn that Keynes thought that government budgets should normally be in surplus. The greatest splurgers in US history have been Republican presidents preaching free-market, anti-Keynesian doctrines: the one fiscal conservative in the last thirty years has been Democratic president Bill Clinton.

Nor was Keynes a tax-and-spend fanatic. At the end of his life he wondered whether a government take of more than 25% of the national income was a good thing.

Nor did Keynes believe that all unemployment was caused by failure of aggregate demand. He was close to Milton Friedman in viewing a lot of it as due to inflexible wages and prices. But he did not believe that that was the problem in the 1930s. And he believed that, except in moments of excitement, there would always be ‘demanddeficient’ unemployment, which would yield to government policies of demand expansion.

Keynes was not an inflationist. He believed in stable prices, and for much of his career he thought that central governments could achieve price stability by limiting money growth — another link with Friedman. But he thought it was idiotic to worry about inflation when prices and output were in free fall.

It makes some sense to think of Keynes as an economist for depressions — that is, for one kind of situation. He has been criticized for offering not a ‘general theory’, as he claimed, but a depression theory. I think this is wrong, for two reasons.

First, Keynes believed that deep slumps were always possible in a market system left to itself, and that there was therefore a continuous role for government in ensuring that they did not happen. His demonstration that they were not ‘one in a century events’, but an ever-present possibility, is at the heart of his economic theory.

Second, Keynes was a moralist. There was always, at the back of his mind, the question: What is economics for? How does economic activity relate to the ‘good life’? How much prosperity do we need to live ‘wisely, agreeably, and well’? This concern was grounded in the ethics of G. E. Moore, and the shared life of the Bloomsbury Group. Broadly, Keynes saw economic progress as freeing people from physical toil, so they could learn to live like the ‘lilies of the field’, valuing today over tomorrow, taking pleasure in the fleeting moment. I give an account of his ethical ideas in Chapter 6.

This book shifts the accepted interpretation of what was important in Keynes’s theory. The early interpretations of Keynes centred not on his view of why things went wrong, but on why they stayed wrong. He established, as economists say, the possibility of ‘underemployment equilibrium’. This was the important message for policymakers at the time: it suggested that policy intervention could achieve a superior equilibrium. Today — and understandably at this stage in the economic meltdown — we are more interested in the causes of the instability of the financial system. This was not the main topic of the General Theory of Employment, Interest and Money (1936), which was written at or near the bottom of the Great Depression. Nevertheless, Keynes did write a crucial chapter — Chapter 12 — which explained why financial markets are unstable, and a year later, in summing up the main ideas of the General Theory, he put financial instability at the centre of his theory. In this Keynes it is ‘radical uncertainty’ which both makes economies unstable and prevents rapid recovery from ‘shocks’. The shift in focus from the Keynes of ‘underemployment equilibrium’ to the Keynes of ‘uncertain expectations’ allows for a direct confrontation between contemporary theories of risk and risk management and Keynes’s theory of uncertainty and uncertainty reduction.

Keynes had a political objective. Unless governments took steps to stabilize market economies at full employment, the undoubted benefit of markets would be lost and political space would be opened up for extremists who would offer to solve the economic problem by abolishing markets, peace and liberty. This in a nutshell was the Keynesian ‘political economy’. Keynes offers an immensely fruitful way of making sense of the deep slump now in progress, for suggesting policies to get us out of the slump, for ensuring, as far as is humanly possible, that we don’t continue to fall into pits like the present one, and for understanding the human condition. These are the things which make Keynes fresh today. That is why I have written this book.