Back by Popular Demand

Is Keynes staging a comeback? The recent experiment in free market economics whose falsities Keynes exposed has not proved notably successful. As our economies have become more marketized, growth has slowed and unemployment has risen. The search is on for a theory and policy that might produce better results. But if Keynes is being rediscovered, please God let it be the real Keynes--not the bastardized version that betrayed his revolution and allowed the barbarians back.

Many self-described Keynesians, as well as his critics, understand only the distorted version of Keynes: the doctrine that governments can spend and borrow their way to full employment. Critics typically concede that this approach worked passably well for a short time in the 1950s, but like a drug, they say, its efficacy diminished until finally it collapsed in inflation and excessive union power. Defenders--"neo-Keynesians"--insist the old verities stand, and some recommend government pump priming almost indiscriminately.

Yet this debate is sterile and misleading and offers only a caricature of the man and his ideas. Keynes was more than the advocate of actively managing the overall level of demand in the economy by government borrowing, although that is part of the story. He also offered a revolution in the way the capitalist economy should be conceptualized, and that should be the inspiration for revisiting his ideas.

Let's begin at the beginning: Keynes's assault on the intellectual tradition in economics that free markets, if left to their own devices, must necessarily deliver the best results. Keynes saw as a fiction the settled world imagined by the so-called classical economists in which supply and demand can always be reckoned to balance or tending to balance. In the Keynesian universe, the market is unstable and inefficient; it is in a permanent process of experimentation in which malfunction and waste is systemic. It can alternate between boom and bust; it can get trapped in perversely low output. The capitalist system, left to its own devices, does not work.

As the British economic historian, Robert Skidelsky, shows brilliantly in the just-published second volume of his three-part biography, The Economist as Saviour, Keynes resisted attempts to overly mathematize his insights--the "grey, fuzzy, woolly monster" inside his head. A vision of how the economy functioned was the heart of his message, and the real economy that Keynes understood so well was anything but mechanically precise. (See "Citizen Keynes," page 115.)

Money Matters

The key to his difference with the classical school is an understanding of how the existence of money transforms the way we should conceive buying and selling as a system for organizing the economy. Free market economics imagines exchange in a Robinson Crusoe world of hunter-gatherers who must necessarily barter what they have today because otherwise it would perish. Thus on the day when all the perishable produce is brought to market, either it is exchanged for other goods or, because the terms of exchange are not attractive enough, left in the possession of the original holder. The process cannot fail to produce a stable outcome. Obviously, at the end of trading, everyone has exactly the fish, fruit, or whatever that they want because otherwise they would have traded it. Everybody is perfectly happy, and the system is perfectly efficient. But introduce money and everything changes.

Suddenly marketplace agents--entrepreneurs, consumers, and savers--have the capacity to make bets about the future through saving or borrowing, which the free market's hunter-gatherers do not; and the future is uncertain. Instead of trading perishable goods, market agents hold money. They can withhold their buying power because they think they might get a better bargain tomorrow; or they can borrow and spend today because they think the opposite. The market starts to be driven by expectations of the future, and producers have to decide whether the changing pattern of demand for their product is real or just the reflection of a series of bets that will unwind themselves.

Since Keynes's death, neoclassical economics has cannibalized Keynes's vision, attempting to reconcile the unreconcilable in order to save the classical paradigm. Although the "neoclassical synthesis" (classical economics plus emasculated Keynes) concedes the need for management of aggregate demand at the macroeconomic level, the rest of the model is resolutely pre-Keynesian. Modern neoclassical economics is no more than a vast intellectual game to prove the rules that apply to hunter-gatherers also apply in a complex industrial economy. Robinson Crusoe and General Motors play the same game.

Central to this exercise is an assumption of economic rationality: market agents, whoever they are, can be trusted to do no more than always want to maximize their advantage; prices contain all the information they could ever want to know; and even though the future is uncertain they make bets that, on average, reflect a mathematical calculus of the chances of success_-- even though they do not know this is what they are doing. The famous analogy is with the flight of a ball. The catcher does not know the physics of aerodynamics but can still successfully catch a ball.

But Keynes all his life distrusted the notion of mathematical probability applied to economics. He insisted that the future is not reducible to a series of outcomes to which economic agents can attach calculable probabilities. The future is not like a ball in flight because the catcher is blind; he or she can only make guesses about where the ball might land because the flight cannot be seen. It is in the future.

For Keynes, the future is simply incalculable, and that is what gives the money-exchange economy its unstable character. That is why inflation, unemployment, and booms and busts exist. Once the snowball of expectations, hopes, and fears is loosed and is fueled by excessive saving or borrowing, the unregulated market system cannot deliver any pattern of prices that can check the subsequent swings in economic activity until they have run their course.

Indeed this may take not just years but decades, for economies can get locked in a pattern of behavior that prices alone can do nothing about. Classical economists--like their new-right descendants today--argue that unemployment, for example, is essentially voluntary. If unemployed workers lower the price of their labor sufficiently, they must eventually price themselves into work; not to do so means unemployed workers are choosing to stay jobless. Essentially, the firm and the worker behave like hunter-gatherers over work-time: the worker wants to sell it and the firm to buy it, and if they haggle freely, there must ultimately be a price--the wage--that will allow the worker to sell his time.

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But according to Keynes, this bargain does not realistically capture what happens in an economy with money and uncertainty. If the firm hires a worker, it encounters a certain rise in its costs, with no compensating certainty that the extra output the worker produces can be sold. Thus, even if the wage is very low, it may still not be worthwhile hiring the additional worker--unless all firms could be told that if they hired workers simultaneously, those workers' wages would provide the demand that justified the increased production. But that is what they do not know, and in the absence of a benevolent angel telling them, they act prudently and hire nobody. Unemployment, in short, can be involuntary.

Keynes was not describing the special circumstances of the 1920s and 1930s, as his critics patronizingly claim, when analyzing involuntary unemployment and so-called "wage inflexibility." He was making a statement about how the price mechanism works at all times. The hunter-gatherer model cannot be bolted on to the modern money-exchange economy by some sleight of hand about rational economic behavior; with money and uncertainty, the motion of the capitalist economy is fundamentally different. There are credit booms and persistent unemployment, and they characterize our times as much as they did his.

If money destabilizes the economy, the counterpart of that destabilization will be in financial flows. If there is too much hoarding, then there will be oversupply of liquidity; if there is too much spending, there will be an excessive buildup of debt.

Stabilizing a market economy, therefore, requires that governments have influence over financial flows, domestically and internationally.

This is the unifying theme in all of Keynes's work. In his Treatise of Money, he is preoccupied with how the central bank can manipulate financial flows by altering bond sales and interest rates to change the overall price level. In the General Theory, his target is the larger one of mobilizing idle funds for investment by manipulating business expectations about future returns. If the government can assure private businesses that demand will be rising in the future, they can be more confident about borrowing for investment-- the idle finance can be utilized after all. Low interest rates cannot do this by themselves; there needs to be the promise of demand in the future.

Keynes Saves

Keynes famously turns the free market chain of causation on its head; it is not higher saving that leads to higher investment and thus higher income, but higher investment that produces higher income and thus higher saving. In a depressed economy, increasing saving in order to increase investment will boomerang. Higher private or government saving will only depress demand, leading businesses to anticipate fewer customers and hence to invest less. Moreover, investment has a snowball effect on income and output, the so-called multiplier.

This is a much forgotten element in Keynesian thinking, because again his proposition rests upon the view that the market economy systematically malfunctions. For a classical economist, the economy is always at some best point of balance--the famous "equilibrium"--so that if there is unemployment it is because it has been chosen by prospective workers who refuse to work for prevailing wages. Resources are allocated the way they are because that is how market agents want it, and external government stimulus will only upset that balance. As a result, either there will be no effect or it will be self-defeating. Government borrowing will push up interest rates, choking off private investment by the exact degree government investment has risen. The two effects cancel each other out. (Curiously, in the years since Keynes's death, the "neoclassical" synthesis has become less and less Keynesian; today many self-described neo-Keynesians commend budget balance and expect the economy to return to a natural, and hence optimal, presumed equilibrium path.)

Keynes, in contrast, pointed to the dynamic consequences of investment, both government and private. Investment purchased the "lumpy" part of national output_--the machines and factories that had long lives and that raised future productive capacity. In the process of raising capacity, investment so lifted employment and demand in the present that the process became self-justifying. When, for example, investment created jobs in the construction or machine-tool industries, that created demand; and that created more investment. As output grew, so savings grew--but after investment. There were no "crowding-out" effects of public deficits displacing private investment, because the whole system was in a state of permanent movement.

Thus the aim of policy is to find ways of acting upon the financial system--the true commanding heights of a market economy_--so that the real economy functions efficiently. Monetary and fiscal policy, and active direction and control of the financial markets, are a continuum. The Keynes who designed an international financial system in 1944 is the same Keynes who 10 years earlier wanted Roosevelt to borrow to pay for public works and who inveighed against Britain's deflationary return to the gold standard in 1926. The means might be interest rate manipulation, changing taxes and spending, or even directing private lending; but the end game was influencing financial flows and acting upon expectations.

What is so refreshing about Keynes is his belief that the best form of economic policy is attack--and his willingness to find the theoretical justification for initiatives to boost growth and employment that turned the free market orthodoxies upside down. This required, as it does today, colossal self-confidence, for the guardians of the orthodox view occupy the very pinnacles of the social and economic pyramid.

For all of Keynes's optimism that capitalism could be fixed, there is a political conundrum at the heart of the Keynesian project. Capitalism may need to be managed and regulated to give its best; but that implies that the business and financial elite give up some of their autonomy of action--the very autonomy that their economic power and personal inclination demands should remain unimpaired. In addition, policies that produce more output and stability of employment benefit the labor interest--and so again directly constrain business power. From the elite's point of view, it may actually be preferable to run the economy more unstably and inefficiently if the alternative is any reduction in its autonomy of action. In effect there is a trade-off between the larger welfare in which, although there is a business gain, it is uncertain and qualified by the certain loss of autonomy to reach that uncertain destination. An abiding attraction of laissez-faire is that it demands no such trade-off; rather it celebrates the current balance of economic power and requires the state to leave the business cycle alone.

Thus Keynesianism works best in those states that have democratic constitutions capable of best expressing a general or common interest over time, as well as institutions that mobilize wage earners to participate coherently in politics. There needs to be some combination of constitutional machinery that permits clear-cut executive action while respecting democratic disciplines, together with strong mass parties that can dynamise the system if Keynesian policies are to succeed; but few constitutions possess such qualities. Britain in the immediate postwar period, Sweden from the 1940s to the 1980s, and the United States around the New Deal threw up circumstances that permitted successful Keynesianism. But interest group politics and weak parties in the United States, and the demise of the Labor Party in Britain, undercut the capacity of both countries' political arrangements to express common interests. The vacuum was filled by the new right. These political exigencies have forced Keynes's interpreters to water down the Keynesian message in an attempt to rebuild support for at least a watered-down Keynesian program; half a loaf is better than no loaf at all.

Professor Skidelsky, for example, wants to rescue his hero from the stigma of being a liberal and to show that Keynes was as attached to sound money and free enterprise as any good conservative. But in so doing Keynes's more conservative interpreters are in danger of betraying Keynes's central insight. Keynes, a lifelong mocker of the conservative establishment in Britain and the United States, would not be falling in line today with proponents of price stability, deregulation, and balanced budgets as the precursor for growth; rather, they would be the objects of his coruscating scorn.

Those who counsel deficit reduction and tight monetary targets before the demands of the productive part of the economy would have been parodied as suffering from Freudian anal retention--in effect arguing that to do anything so disturbs the markets' natural processes that we must do nothing. The defenders of the Reagan and Thatcher economic miracles would be exposed for what they are: self-interested promoters of the rentier financial interest who like tight money and high financial yields and hence argue that the hollowing-out of the British and U.S. industrial sectors benefited everybody.

Keynes Lives

A Keynesian response today would have a number of strands ranging from implementing public works programs to recapitalizing chronically enfeebled banks. But his starting point would be an acknowledgement of the febrile condition of the national and international finance system. Global financial deregulation has established a new financial regime that not only has begun to exert a permanent veto over individual states' expansionary economic policies but also is acting as a wedge for dismantling all forms of market regulation. The destabilizing buildup of private debt in the United States, Japan, Britain, and the Nordic countries in the 1980s, for example, was prompted everywhere by the new deregulated offshore markets forcing the dismantling of national systems of financial regulation. The consequent credit booms left a debt overhang that is inhibiting a balanced and sustained recovery; and there is no certainty that once recovery gets under way the same forces will not reassert themselves--and the boom-bust cycle will repeat itself.

So Keynes would be increasingly interested in the interrelationship between domestic policy options and the new international financial system--because that is the new deregulated locus of the unstable, inefficient market system. He would be exploring ways of stabilizing and reducing the vast movement of short-term capital that, because of the capacity to move so quickly and in such size, terrorizes governments into economic minimalism and public inactivity; turnover taxes in the foreign exchange markets and new tougher requirements on international banks' capital adequacy ratios so biasing them to behave more cautiously would interest him.

But he would go further. Capital flows from currency to currency in the expectation of capital profits, and with a system of floating exchange rates the possibility for making such profits is embedded in the system. Floating exchange rates are central to the system's functioning, because they facilitate capital movement; it is no accident that the explosion of capital movement has accompanied floating exchange rates. Thus if countries could find a way of reestablishing a means of pegging their currencies and adjusting parities to diminish the expectation of speculative profits and losses, that would reinforce the bias to stability--and give states a greater chance of running expansionary economic policies.

And for a man who lived through the financial consequences of 1929, the parallels with the world capital markets in 1993 would seem eerie. In the late 1920s buying on margin helped fuel a stock market boom, providing the collateral for the banks to lend more against not only rising stock market prices but real estate values. When prices fell the whole system unraveled, leaving banks with such capital losses that their capacity to lend was mortally impaired--the proximate cause of the U.S. depression.

Today the markets in financial derivatives, instruments that allow investors to bet on future financial prices by investing just a fraction of the value of the underlying asset--de facto margin trading--have proliferated wildly on a global scale that makes 1920s Wall Street margin trading look like child's play. Now, as then, the great international banks are accepting risks they scarcely understand by underwriting financial derivatives and buoying up stock markets and capital values; but if prices cracked the knock-on impact on bank balance sheets and their capacity to lend would be as severe as in the early 1930s.

The idea is that individual investors can use the derivative markets to gain protection against risk, but as Keynes would surely point out, by definition there can be no protection for the system as a whole. Keynes would be lobbying hard for proper supervision and regulation of a market that has gone mad. Banks do not know what risks they are running, and if the markets ever move unexpectedly, one bank will find itself with colossal exposure for which it is uncovered. It will renege on its obligations, and the system will crack. Keynes would be ridiculing bankers' protestations about the system's soundness for what they are: self-interested bleating.

Keynes's continual concern was the real economy--of employment, investment, and output. He would be increasingly disturbed at the intensity of international competition and the way countries find themselves having to make astonishing economic adjustments in a matter of months and years. Although he was a convinced free trader, he would insist that the system can be kept open and liberal only if states can regain the possibility of pursuing full-employment policies to counteract the resulting dislocations. Free trade, as he argued during the Bretton Woods negotiations establishing the postwar financial order, the International Monetary Fund and World Bank, requires regulated international finance to allow expansionary domestic economic policies. Nor is free trade an absolute imperative. If the dislocation is too intense, then free trade too may need to be regulated.

With unemployment in the industrialized West standing at 36 million and rising-- and with inflation at a 30-year low--there is little doubt that Keynes would now be urging economic expansion led by governments. In economic management as in war, offense is the best means of attack. As a believer in the multiplier, he would urge debt-financed public works programs, scorning the paranoia about budget deficits. He would again and again stress the difference between current and capital government spending, mocking the classical economists' preference to pay to keep men and women on unemployment benefits. He would call for government accounts everywhere to be organized into current and capital components, thus highlighting scope for borrowing more, given the lack of debt in relation to government assets. And taxes, he would urge, should be lifted only once the economy was growing--and be targeted on the incomes of the well-off.

To the American right he would endlessly and patiently explain the economic benefit of state and federal debt. Highways, bridges, and education, for example, have yields that cannot be captured through the price mechanism and thus cannot be left to private initiative. A new road, for example, improves journey times not only for those who use it but for those who use the old roads from which traffic has been diverted. Real estate values improve along the road. Business turnover rises. The only economic agent that can capture the benefit is the state through taxes and reduced social security spending; it is thus the state that must finance the construction of the road--and if the returns are demonstrable there is no reason why the money should not be borrowed. Indeed, the spending on the road will snowball around the economy--the multiplier.

Nor would he allow fear of inflation to stymie his expansionary recommendations. Although aware of the destructive impact of inflation on democratic societies, he would have mocked the fear that inflation of 3 percent or 4 percent presaged hyperinflation and the end of democracy. Indeed, he would be the first to see that a rise in the price level would have the advantage of reducing the real debt overhang and restoring the viability of the banking system--and he would have drawn a distinction between a once-and-for-all increase in the price level and inflation.

Indeed, given the centrality of the financial flows in his thinking, he would be anxious to get the banking system back on its feet. He would be championing government-led schemes for retiring mortgage debt from distressed borrowers. Initiatives to recapitalize the banking system so it could undertake long-term lending would pour from his pen--while the case for taxing the over-rich, redistributing to the poor to boost consumption, would seem overwhelming.

The operation of the financial system on investment, particularly in Britain and the United States, would be a major preoccupation. Keynes was always critical about the stock market principle of buying and selling enterprise freely from day to day--as if the farmer can sell in the morning when it is raining and buy back in the afternoon when the sun is shining. The explosion of turnover in the capital markets would profoundly trouble him. Wall Street is becoming increasingly disengaged with the enterprises that it finances, and wealth creation is more and more a question of short-term financial engineering and paper entrepreneurship.

Indeed, the hollowing out of the U.S. economy has less to do with low-cost international competition than with the incessant demand for dividends from the institutional holders of most of the nation's equity. Under permanent pressure to beat the average performance indices, pension funds, insurance companies, and mutual funds have begun to regard dividends not as the return for risk--but as an income stream that should be as secure as interest payments on risk-free debt. As a result, company managements are compelled to make current assets work harder to deliver the required dividend stream, while using cash flow to support future investment risks the disapproval of the dividend-hungry institutions. Required real rates of return in the United States are spectacularly high in comparison with Japan and Germany; but that is the price managements must pay to persuade uncommitted and footloose institutions not to sell their shares. Wall Street has become the prime cause of U.S. deindustrialization.

After the end of the Cold War, Keynes would feel the necessity for magnanimity by the Western victors. The condition of the former Soviet Union and Eastern Europe would alarm him immensely, with unemployment and despair potentially fueling ugly political movements with an arsenal of nuclear weapons at hand. Turning around these depressed economies would not only alleviate a security threat, it would create an expanding market for Western goods. He would be ceaselessly traveling the West's capitals trying to drum up support for a Marshall aid plan for the former communist world. Defense spending in the West should be slashed and the money spent instead on supporting the growth of Russian capitalism--and he would be careful to support the social market variant of western capitalism rather than its pitiless Anglo-Saxon strain.

And Keynes being Keynes, he would have access to Clinton, Hosokawa, and Yeltsin. His books and pamphlets would be selling worldwide, and at home he would be busy sponsoring new drama and dance. The spirit of optimism and action he craved could not take place in a cultural vacuum; it needed counterparts in the world of art and architecture. Confidence about the future and the capacity of the commonweal to act in the public good is an attitude of mind; it needs buttressing from every quarter.

But we do not have such a man, nor is one on the horizon. Yet the least we can do is to understand what he stood for and why. Part of his effectiveness was that he was able to terrorize the Anglo-Saxon establishment with the prospect of communism if the capitalist economy failed. But that terror has gone.

Instead, Keynesians have now to point not to the prospect of a communist revolution but rather to the slow and pervasive decay of Western society brought about by running economies with millions of jobless and semi-economically active people. The collapse of employment for unskilled men is a major cause of U.S. violence; and as expression through work becomes remoter for millions throughout the West, so they turn to nationalism and religious fundamentalism. Protection and confrontation start to characterize international relations, and who can know where that will lead?

But the gains from public initiative are diffuse while the costs are certain and concentrated; and in any case the linkages between economic failure, social distress, and political calamity, while obvious, cannot be proven. For the moment the classical economists and their political allies continue to dictate the agenda. They have failed this century before with disastrous consequences; they will fail again. We need a Keynes. Without him, we need to revisit the extraordinary power of his ideas.

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