The Return of the Master


By Robert Skidelsky

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In the debris of the financial crash of 2008, the principles of John Maynard Keynes — that economic storms are a normal part of the market system, that governments need to step in and use fiscal ammunition to prevent these storms from becoming depressions, and that societies that value the pursuit of money should reprioritize — are more pertinent and applicable than ever. In Keynes: The Return of the Master, Robert Skidelsky brilliantly synthesizes Keynes career and life, and offers nervous capitalists a positive answer to the question we now face: When unbridled capitalism falters, is there an alternative?


To Mikhail Gutseriev

The economist John Maynard Keynes is back in fashion. That guardian of free-market orthodoxy, the Wall Street Journal, devoted a full page spread to him on 8 January 2009. The reason is obvious. The global economy is slumping; ‘stimulus packages’ are all the rage. But Keynes’s importance is not just as a progenitor of ‘stimulus’ policies. Governments have known how to ‘stimulate’ sickly economies — usually by war — as long as they have known anything. Keynes’s importance was to provide a ‘general theory’ which explains how economies fall into slumps, and to indicate the policies and institutions needed to avoid them. In the current situation no theory is better than bad theory, but good theory is better than no theory. Good theory can help us avoid panic responses, and give us insight into the limitations of both markets and governments. Keynes, in my view, provides the right kind of theory, even though his is clearly not the last word on events happening sixty-three years after his death.
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.
Robert Skidelsky
JULY 2009

We have been living through one of the most violent collapses in economic life seen in the last hundred years. Yet economics — the scientific study of economic life — has done an exceptionally poor job in explaining it. For, according to mainstream economic theories, a downturn on this scale should not have happened. And we also have precious little idea about how to stop a succession of such crises bearing down on us in future. To get a handle on these issues we need John Maynard Keynes.
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.

The Crisis

What Went Wrong?


What Needs to Be Explained

All epoch-defining events are the result of conjunctures — the correlation of normally unconnected happenings which jolts humanity out of its existing rut and sets it on a new course. Such fortuitous conjunctures create what Nassim Taleb called Black Swans — unexpected events carrying huge impacts. A small number of Black Swans, Taleb believes, ‘explain almost everything in our world’.1 The economic crisis today is a Black Swan — a storm out of an almost cloudless sky, unexpected, unpredicted, falling on a world thinking and acting on the assumption that such extreme events were things of the past, and that another Great Depression could not occur.
How and why did it happen? It originated, as we all know, in a banking crisis, and the first attempts to understand the crisis focused on the sources of banking failure.
The most popular explanation was the failure of banks to ‘manage’ the new ‘risks’ posed by ‘financial innovation’. Alan Greenspan’s statement that the cause of the crisis was ‘the underpricing of risk worldwide’ was the most succinct expression of this view.2 In this interpretation, the banking crisis — and hence the world slump to which it has led — was caused by the technical failure of risk-management models, and especially their inability to manage the risk of the entire financial system breaking down. Particular attention was paid to the role of the American sub-prime mortgage market as the originator of the so-called ‘toxic assets’ which came to dominate bank balance sheets. Early remedies for the slump focused on ‘bailing out’ or refinancing the banks, so they could start lending again. These were followed by ‘stimulus’ packages — both monetary and financial — to revive the declining real economy.
Now that we are — or may be — over the worst of the crisis, attempts have been made to try to understand its deeper causes. Two theories may be distinguished: ‘money glut’ and ‘saving glut’. Conservative economists blame the crisis on loose fiscal and monetary policy which enabled Americans to live beyond their means. In particular, Alan Greenspan, chairman of the US Federal Reserve in the critical years leading up to 2005, is said to have kept money too cheap for too long, thus allowing an asset bubble to get pumped up till it burst. The Keynesian view sees cheap money in the US as a response to a ‘global saving glut’ originating in East Asia and the Middle East. It was the rise in US interest rates in 2005, bringing the housing boom to an end, which caused the American economy to collapse. As we shall see, these are a rerun of the debates between conservative and Keynesian economists about the causes of the Great Depression.

The Crisis: A Thumbnail Sketch

Complex in its detailed unfolding, the economic crisis which struck in 2007-8 is easy enough to grasp in outline. A global inverted pyramid of household and bank debt was built on a narrow range of underlying assets — American house prices. When they started to fall, the debt balloon started to deflate, at first slowly, ultimately with devastating speed. Many of the bank loans had been made to ‘subprime’ mortgage borrowers — borrowers with poor prospects of repayment. Securities based on sub-prime debt entered the balance sheets of banks all round the world. When house prices started to fall, the banks suddenly found these securities falling in value; fearing insolvency, with their investments impaired by an unknown amount, they stopped lending to each other and to their customers. This caused a ‘credit crunch’.
It all developed with astonishing speed. Commodity prices started to fall from July 2008. Collapsing confidence, precipitated by the bankruptcy of Lehman Brothers in September, caused the stock markets to plunge. Once banks began to fail and stock markets to fall, the economy started to slide. This has brought about generalized conditions of slump throughout the world, which have deepened throughout 2009. Unlike in the Great Depression, governments have introduced reflationary packages, which at least promise that the slump will not spiral all the way down into a deep depression as in the 1930s. But most analysts expect the fall in output to continue through 2009. Here are the main landmarks on the road to ruin.

The Collapse of the Housing Bubble

American house prices rose 124% between 1997 and 2006, while the Standard & Poor’s 500 index fell by 8%: half of US growth in 2005 was house-related. In the UK, house prices increased by 97% in the same period, while the FTSE 100 fell by 10%. Between 1994 and 2005, US home ownership rose from 64% to 69%. The average price of an American home, which had long hovered around three times the average wage, was, by 2006, 4.6 times the average wage.
Two forces were behind the housing boom. First, the Clinton administration encouraged government-backed institutions like Fannie Mae — set up in 1938 to make home loans affordable to low-income groups — to expand their lending activities. Second, private mortgage lenders, having exhausted the middle-class demand for mortgages, started vacuuming up ‘Ninjas’ — borrowers with no income, no job, no assets. Borrowers were enticed by ‘teaser’ rates: very low, almost zero, introductory interest rates on an adjustable-rate mortgage (ARM), which then went up sharply after a year or two. With defaults at a historic low between 2003 and 2005, there seemed little risk in this extension of mortgage lending, even though a third of the ‘sub-prime’ loans were for 100% or more of the home value, and six times the annual earnings of the borrower. By 2006, more than a fifth of all new mortgages — some $600 million worth — were sub-prime. The ease of refinancing magnified consumer indebtedness. Mortgage equity withdrawals to buy consumer durables and second homes shot up from $20 billion in the early 1990s, or 1% of personal consumption, to between $600 billion and $700 billion in the mid-2000s, or 8-10% of personal-consumption expenditure. There were similar housing booms in Spain, France and Australia, but the US and the UK stand out by their reliance on debt financing. By the end of 2007, UK household debt had reached 177% of disposable income, mortgage debt 132%. Martin Wolf wrote in the Financial Times in September 2008 that the monetary authorities of the United States and Britain had turned their populations into ‘highly leveraged speculators in a fixed asset’.3 Wolf ’s remark is given point by the fact that the ratio of new builds to house sales fell from almost 50% in 1999-2000 to just over 20% in 2007-8. Most house purchasers, that is, were engaged in swapping titles to existing properties rather than investing in new properties.
In 2005-6 two blows hit the housing market: a rise in the cost of borrowing and a downturn in house prices. Between June 2004 and July 2006 the Federal Reserve, seeking to dampen inflation and return short-term interest rates to a more normal level, raised the federal funds rate from 1% to 5.25%, and it kept it there until August 2007. US house prices declined by 26.6% between 2006 and 2008. By August 2007, 16% of sub-prime mortgages with adjustable rates had defaulted. The sub-prime losses of 2007 were ‘a bullet that fatally wounded the banks’.4 They demolished their risk models. David Viniar, chief financial officer of the smartest investment bank on Wall Street, Goldman Sachs, told the Financial Times in August 2007 that his team were ‘seeing things that were 25-standard deviation moves, several days in a row’,5


  • Foreign Affairs
    “The book offers clear and cogent critiques of modern macroeconomic thought, along with a brief but useful summary of what went wrong in 2007-9.”

Financial Times, October 18, 2010
“Skidelsky’s succinct, lively, unashamed paean analyses Keynes’s core values and offers a persuasive pitch for the contemporary relevance (and necessity) of his ideas.”

On Sale
Oct 26, 2010
Page Count
256 pages

Robert Skidelsky

About the Author

Robert Skidelsky is the Emeritus Professor of Political Economy at the University of Warwick. His three volume biography of the economist John Maynard Keynes (1983, 1992, 2000) received numerous prizes, including the Lionel Gelber Prize for International Relations and the Council on Foreign Relations Arthur Ross Book Award. He is the author of The World After Communism. He was made a life peer in 1991, and was elected Fellow of the British Academy in 1994.

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