Policy Research in Macroeconomics

Time to restore the revolutionary Keynes


John Maynard Keynes – for the Times Literary Supplement

It was his internationalism, together with his insights into the functioning of the world’s financial architecture that first drew me to the work of John Maynard Keynes.  His genius is, perhaps, most comparable to that of Charles Darwin. But whereas Darwin is widely recognized for developing the science of evolution, Keynes’s development of the science of macroeconomics goes largely unacknowledged by a profession still steeped in classical microeconomics. Both of these very British geniuses met with extraordinary resistance to their ideas –  as the persistence of creationism in some circles shows; and by the restoration of the classical school of microeconomics at Keynes’s alma mater, Cambridge University.

The international and financial dimensions of his work are today neglected in favour of the laissez-faire economics that Keynes had so vigorously contested. His profession is dominated by economists concerned overwhelmingly with the activities of individuals, households and firms. Management of the macroeconomy and of financial globalization is left largely to investors and speculators in capital markets, with central bankers playing a supportive, interventionist role.  This has led to a form of financial anarchy, backed and guaranteed by public institutions and their taxpayers. Worse, it has led to increasingly frequent financial crises. These began first on the fringes of the global economy (in the 1970s and 80s), but in 2007–9 moved to its core, the US and Europe.

Without serious acknowledgement by the profession of Keynes’s insights and of the substance of his contribution – his monetary theory and advances in macroeconomics – we may be sure of more severe crises to come.

Keynes was born in Cambridge in 1883, and though his preoccupations lay mainly with the international economy, he spent most of his happiest years in his hometown. He studied classics and mathematics at King’s College, Cambridge, and only came to economics at the end of his undergraduate studies. He never did a PhD. His parents doted on him. His mother, proud of her eldest son’s growing international reputation, faithfully gathered his press articles in her scrapbook, displayed today in the library of King’s College. They are a record of Keynes’s indefatigable efforts to conduct a dialogue with Britain’s citizens on economic issues, and to spread understanding of economic policies and processes, both at home and internationally.

Today Keynes is routinely derided by his enemies and “friends” on both the Left and the Right as a state interventionist, soft on government deficit spending.  These charges are false. He was chary about government deficits, and sensitive to public anxiety about government imbalances.  In his view, government spending was a prudent course of action in a slump because it would foster recovery, thereby improving the public finances. He understood that politicians could not cut deficits and debt. Only a prosperous economy can balance the government’s books.  But he was mainly concerned with that which made fiscal policy necessary – namely monetary failure. He was concerned with preventing, not just resolving crises. Like Darwin, he was intellectually cautious (witness the sometimes dense and difficult prose of The General Theory) and spent much of his career exhaustively rebutting arguments set against his theories by colleagues.

Money and the rate of interest

His theoretical focus was, above all, on money, monetary theory and practical policies, and the necessity of sound monetary policies for the creation of employment. Chapters thirteen-fifteen of the General Theory outline his theory of money and interest – today largely ignored or scorned. The man himself would not be surprised.  As Professor Victoria Chick and Dr. Geoff Tily note in, “Whatever happened to Keynes’s monetary theory?”:

Resistance to the book’s content came immediately drafts began to circulate. Keynes, after all, was trying to effect ‘a revolution . . . in the way the world thinks about economic problems’ and it is natural for the mind to mount a defence of its established contents and processes.

Keynes placed money and interest at the centre of his theory. He turned classical analysis on its head, and argued that when unemployment is high, it is not because wages are too high, but because the rate of interest is too high. The rate of interest was the cause, he explained, not the passive consequence, of the level of economic activity and in particular of the level of employment.

He understood that money originates as credit and not as savings, which are a consequence of credit creation, not a source of income.  As the Austrian economist Joseph Schumpeter explained, money is nothing more than “a promise to pay” – a social construct made up of promises upheld institutionally (think of contract law) by trust. As such money or credit is not subject to the limits imposed on finite commodities such as gold or bitcoin.  Because its creation is so effortless, it has to be managed, to avoid both inflation and deflation.  But “bank money” created almost effortlessly through lending has great virtues. It  is not just a way of creating purchasing power for the purposes of exchange; it also becomes a store of value.

Keynes’s most important breakthrough was the realization that the “price” of money, or rate of interest, was determined not as the classical theory dictated, by the demand for savings, but by the demand for assets – safe, secure or risky assets. This revolutionary theory – his Liquidity Preference Theory– is still considered too radical to be acceptable today. Keynes understood that those with a surplus savings, capital gains or profits– can decide whether to store those savings short-term as cash; long-term for security; or to use them for speculative purposes. He argued that by managing the supply of safe assets (bonds or gilts) to financial markets, central bankers could meet savers’ demand for assets in which to store their savings for these three purposes: as cash, for security, or for speculation. By providing these assets at different rates of interest, central bankers could effectively manage and influence interest rates on all borrowing– across the spectrum of lending – short- or long-term, safe or risky, and in real terms. (Central bankers currently only manage the Bank Rate, which has little influence over market rates fixed by commercial bankers for loans over different terms, and at different risk rates.)

Many economists continue to regard the rate of interest as almost irrelevant to the level of economic activity. But it was this Keynesian insight that led me and others to predict in 2006 that the Federal Reserve’s steady ratcheting up of interest rates after 2003–4 would have a disastrous impact on the world’s debtors – public and private, rich and poor.  

The decision by public authorities the world over to abandon the regulation of credit creation and capital mobility after the 1960s and early 70s, led to the inflation of a vast bubble of “easy” but expensive credit. With each ratcheting up of interest rates the governors of the US Federal Reserve sharpened the “dagger” of interest rates that, we predicted, was to puncture the vast bubble of American, but also global, debt. The defaults of sub-primers at the end of 2005 began the process, and led, in the early months of 2006 soon to a fall in US house prices, against which vast volumes of debt was leveraged.  The fall in housing and other asset values then led to a loss of confidence in valuations overall, which in turn led bankers to lose confidence in assets held by their peers. On August 9, 2007, inter-bank lending froze, and the Global Financial Crisis began to unfold in earnest.

Without Keynes’s theory of the rate of interest, my colleagues and I would have been in the same predicament as economists at the LSE, who were asked by the Queen why the crisis had not been predicted?

Keynes and the international financial system

In 1919 Keynes was a delegate at the Paris Peace Conference that concluded the First World War. As Eric Rauchway explains in an excellent account of the relationship between Keynes and President Roosevelt, The Money Makers (2015), Keynes quickly understood that the treaty negotiated by Woodrow Wilson and David Lloyd George imposed “unbearable economic burdens on Germany . . . and also lacked provisions to restart normal economic and financial relations among nations after war”. On May 1, 1919, as he walked the streets of Paris, Keynes encountered French workers engaged in a general strike, who then rioted. “From around the city came the sounds of gunshots and ambulances. After the fighting stopped, diplomats who ventured into the streets had to step over, or around bodies”, writes Rauchway.

These were the alarming and febrile conditions under which Keynes drew up a rough plan for the international resolution of economic conflicts between erstwhile enemies:

…working through his drafts [Keynes] scratched out and changed numbers, penciled estimates on separate sheets of paper, and let them shift according to whatever political considerations he gathered were important. The sums did not signify so much as the relationships they defined.

Keynes’s called it “Scheme for the Rehabilitation of European Credit and for Financing Relief and Reconstruction.” It ensured that “the prostrate Reich could use the bond market to raise funds, to pay a large chunk of what it might owe as reparations and debt”. The aid provided by victors could be used to buy food and raw materials for reconstruction – most likely from Germany’s former enemies. The funds raised would, he believed, rebuild the economies of both victors and the vanquished.  His scheme involved winners and losers in ensuring that sovereign borrowers would pay down their loans. But it went further, proposing that the bonds could become a kind of international or “reserve” currency, acceptable “as payment of all indebtedness between any of the Allied and Associated Governments”.

In other words, by 1919 Keynes was already thinking about the construction of an international financial architecture or system that would restore prosperity and stability to individual countries, and also to the international economy. The British government was supportive, with Austen Chamberlain endorsing it emphatically. Prime Minister Lloyd George sent the Scheme to President Wilson with a supportive memorandum.

Wilson took very little time to reject the proposal outright[MOU1] .  In his replay to Lloyd George he explained that Keynes’s scheme was not “feasible from the American point of view.” The US had already shouldered a heavy financial load “for our well-to-do commonwealth” and he did not think that Congress would be willing “to place a Federal guarantee upon bonds of European origin.”  He expressed the view that “the usual private channels would be able to fund reconstruction.” [Did he give a reason? Could he be quoted, if so?];  Keynes did not know, but Rauchway reveals that Wilson’s letter was drafted by a J. P. Morgan banker, Thomas Lamont – “the voice of the usual private channels speaking about its own desirability.”

The repudiation of his policies by politicians and bankers in 1919 was a blow, not just to Keynes, but to the millions that were to suffer the impact of preferred policies – those “private channels’  favoured by bankers, and derived from flawed “classical” economic theory. However, while Keynes was beaten, he was not down. He transformed the bankers’ rebuff into a powerful polemic, The Economic Consequences of the Peace – a legendary text that took aim at the feeble and spineless victors of war, the four leaders of the Western world.

The Treaty includes no provisions for the economic rehabilitation of Europe . . . no arrangement was reached at Paris for restoring the disordered finances of France and Italy, or to adjust the systems of the Old World and the New. . . . It is an extraordinary fact that the fundamental economic problems of a Europe starving and disintegrating before their eyes, was the one question in which it was impossible to arouse the interest of the (the Council of) Four.

Today  his The Economic Consequences of the Peace lives on as a stunning legacy, and has not been out of print since 1919.

The Versailles Peace negotiations fixed Keynes’s attention on international economic and financial relations for the rest of his life. The experience laid the foundation for his invention and development of the theory of macroeconomics: theory that led to the construction of the international financial architecture at Bretton Woods in 1944. Politicians and economists (if not bankers) had finally come round and endorsed his theory and policies. They did so only after tens of millions suffered and died through the 1929 financial crash, the Great Depression and a catastrophic Second World War.

His impact on economics was profound; it led to a transformation of the post-war international economy and to the launch of what all economists – both friend and foe – define as “the golden age” of economics, from 1945–71. Keynes understood why:

The decadent international but individualistic capitalism, in the hands of which we found ourselves after the war, is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous – and it doesn’t deliver the goods. In short, we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed.

Now that decadent capitalism is back with a vengeance, as is the public’s distaste for it. But whereas in 1933 society was “perplexed” about what to put in its place, that cannot be argued today. We have the experience of the ‘golden age’ and knowledge of the monetary theory and macroeconomic policies that  “delivered the goods”: by stabilizing the global economy, and helping to build periods of social and political stability.

Neglect of Keynes’s monetary theory and policies since then has come at the price of increasingly frequent international financial crises.. It is time to restore the revolutionary Keynes.

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