Citizen Keynes




Robert Skidelsky, John Maynard Keynes, Volume Two: The Economist as Saviour, 1920-1937 (Viking Penguin, 1994).


I feel very possessive about John Maynard Keynes. He overshadowed the most formative years of my education. His General Theory shapes the way I think about economics.

Though he died in 1946, Keynes still dominated economics at Cambridge in the mid-1960s. It wasn't just that all the leading figures among the faculty, Richard Kahn, Joan Robinson, Brian Reddaway, David Champernowne, Nicholas Kaldor, and James Meade, had been his pupils and/or collaborators. It was the tone of the place. The study of economics, theoretical or empirical, was driven by the desire to improve the conduct of economic policy. This did not mean that pure theory was neglected. Indeed, in those years Robinson was fighting a stirring battle in the realms of high theory with Paul Samuelson and Robert Solow from the Massachusetts Institute of Technology. Nor was Cambridge innocent of the cutting edge of econometric technique. Richard Stone, who, following Keynes's suggestions, had created the first modern national income accounts, was still director of the Department of Applied Economics where much of modern econometrics was pioneered. Nonetheless, we were taught that theory and technique should serve the higher cause of rational economic policies, and to use our newly learned econometric expertise to write essays on unemployment, or inflation, or the balance of trade, or some other topic at the top of the current political agenda.

These reflections were evoked by Robert Skidelsky's description of Keynes the economist in his long-awaited John Maynard Keynes, Volume Two: The Economist as Saviour, 1920-1937:


His achievement was to align economics with changes taking place in ethics, in culture, in politics, and in society. . . . In his big books he was the pamphleteer trying to rein in his imagination, school himself to the demands of a formal treatise. He had powerful intuitions of logical and historical relationships. . . . As with all original minds, Keynes's intuitions were never fully captured by his analytical system. (pp. 424-425)


And, Skidelsky tells us, Keynes was also practical, absorbed in questions of economic policy, argumentative, benevolent and intolerant, often rude, and had an intellectual arrogance that would allow positions previously held with great passion to be calmly abandoned. Well, that is exactly what the Cambridge faculty was like in the 1960s. Not only did the ghost of Keynes dominate the content of economics education at Cambridge, it also dominated the style. That style could be sustained with substance only by the extraordinarily gifted. So it is not surprising that the Cambridge faculty, although still very "Keynesian," looks much more conventional these days.

A great achievement of the magnificent second volume of his biography of Keynes is the way Skidelsky conveys Keynes's character--what it was like to know him. I have always been somewhat puzzled by the 1930s newsreels in which Keynes pontificates on economic matters of the day. That awful upper-class voice and the patrician manner are distinctly off-putting today. Yet Keynes inspired great affection among his wide circle of friends. Many of my teachers had known him, and despite their diverse economic and political opinions, knowing Keynes had clearly been one of the most important aspects of their lives. Skidelsky makes it clear why. Keynes was enormously exciting to know. His mind was both precise and wide ranging. He was both practical and fanciful. He believed that the power of rational thought could secure freedom and the good life, not a common view in the 1930s. So in times of national and international economic crisis, he gave his friends hope. Economic disaster would not destroy civilization. Maynard would make sure of that.

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Any life of Keynes must be an intellectual biography. For despite his wide-ranging activities in politics, in business, and in the arts, Keynes was essentially an academic, albeit an extraordinary one. It was his ideas, and his ability to persuade others to accept them, that mattered. Skidelsky handles the intricacies of theoretical argument with remarkable skill. Still, readers must be prepared to put in some hard work on economic theory.

Woven into Skidelsky's intellectual and historical narrative is a beautiful love story: the relationship between Keynes and the Russian ballerina, Lydia Lopokova, whom he married in 1925. Lydia brought gaiety and unfailing emotional support, and she opened up for Keynes a new world of ballet and theater. Keynes helped fund the start of the Camargo Society in 1929 to assist Lydia's dancing career in Britain. In due course, and not without difficulty, the Camargo Society would evolve into the Royal Ballet. (Not, as Skidelsky writes, the English National Ballet. That is a quite different organization.) In the 1930s Keynes built the Arts Theatre in Cambridge to assist Lydia's moderately successful transition from dance to acting. It opened in the same month that The General Theory of Employment, Interest and Money was published, February 1936.

Ultimately, this volume of Skidelsky's biography must be judged by his presentation and analysis of the genesis, the argument, and the importance of that book. On the genesis of the General Theory, Skidelsky's narrative is excellent. From the achievement of international fame with his critique of the follies of the Paris peace conference in The Economic Consequences of the Peace in 1919, Keynes was always struggling to build the intellectual foundations of a rational economic policy from the tools of economic theory. Skidelsky's skill in blending together contemporary economics, politics, and ongoing intellectual controversy in a variety of disciplines, together with a cast of characters ranging from Asquith to Diaghilev, from FDR to Wittgenstein, from Lloyd George to Virginia Woolf, all in a beautifully written narrative, is simply superb.

As to the substance and importance of the economic argument, here Skidelsky is less convincing. For one thing, he is not entirely sympathetic with Keynes, and certainly not with "Keynesianism":


Has any major economist so affronted the method and style of his discipline? Only his genius and the desperate character of the times enabled him to get away with it--and then only to a minor extent. For today, in truth, there is little left of Keynes's vision, only some crumbling bones of scholasticism, disinterred for first-year macro-economics students. (p. 502)


There also are numerous references to the "dangers" arising from the application of Keynesian ideas in post-World War II policymaking. More important, Skidelsky's narrative fails to fully convey just why Keynes, clearly at odds with the policymakers of the day, was such a threat to economic theory. Consequently, the significance of Keynes's ideas for economics and economic policymaking today is left obscure.



Keynes' Theory of Employment


The proposition in standard economics that prices are determined by the relationship between supply and demand is at once a theory of value and distribution and a theory of output and employment. In the economist's equilibrium state, a rendezvous between supply and demand determines the correct price, as well as the equilibrium composition of output and the economy's total output. In equilibrium, the economy is supposed to absorb the available supply of labor, since wages are just another price balancing supply and demand. But if the claim that Keynes makes in the General Theory is true and the economy settles into a long-run equilibrium at less than full employment, if the market for labor does not clear, then it cannot at the same time be true that prices are determined by the relationship between supply and demand. The entire edifice of economic theory erected since the late nineteenth century and taught in every economics department throughout the world is false. That is the scale of the threat posed by the General Theory.

Today orthodox economics accepts Keynes's critique of the self-regulating market mainly by acknowledging that the market economy may deviate from its normal equilibrium in the short run, and so display Keynesian characteristics, while in the long run, normal, full-employment equilibrium will be restored as the prices eventually adjust to equilibrium levels.

This orthodox rendition of Keynes seems to accept his insights, while neatly preserving the basic elements of supply-and-demand theory. A centerpiece of this revisionism was the work of J.S. Hicks, familiar to students of macro-economics as the "IS-LM" model. Hicks's gloss on Keynes, first published in 1937, holds that the market economy fails to attain full employment mainly because money wages are "sticky." That is, they fail to adjust immediately to real changes in economic conditions. Since labor costs are a principal ingredient of product costs, sticky money wages keep up prices too, and so ensure a high demand for money for transactions purposes, in turn keeping interest rates high. If only money wages would fall, the demand for money would fall too, interest rates would come down, and the decline in interest rates would stimulate an increase in investment, raising output and moving the economy toward full employment.

This rescue of the classical model from the Keynesian challenge is the essence of the so called "neoclassical synthesis," ingeniously combining the practicality of Keynesian monetary and fiscal policy in the short run, while preserving the full-employment equilibrium of orthodox supply-and-demand theory in the long run, and thereby preserving the classical model. Keynes's message is reduced to the traditional case that unemployment is due only to a failure of prices--in this case wages--to adjust instantaneously to an equilibrium.

By the 1970s, when stagflation hit the world's advanced economies, the neoclassical version of Keynes opened the door to a full retreat and the resurgence of pre-Keynesian economists led by Milton Friedman-style monetarists. Active monetary or fiscal policy was, so the monetarists argued, doubly foolish. It not only ignored the fact that the economy under the normal workings of the market would in the long-run gravitate to a full-employment equilibrium. Activist macroeconomic policy also reinforced the imperfections that were the source of the problem in the first place.

For example, if sticky money wages were causing unemployment, fiscal or monetary policies designed to expand the economy would simply increase workers' bargaining power and make things worse. How much more rational to take steps to weaken workers' bargaining rights, thereby "unsticking" the money wage and garnering the fruits of an efficient free market. In the 1980s, so-called "supply-side" economists took further advantage of the theoretical weakness of the neoclassical synthesis, arguing for cuts in those taxes (taxes on the better off) and benefits (benefits to the poor) that were distorting the working of the free market.

In the face of these arguments, many Keynesians took refuge in a market imperfection noted by the master, "uncertainty," which could not be wished away (though the theory of rational expectations would soon attempt just that). If economic life is so riddled with uncertainty that the very notion of systematic laws of motion is simply absurd, then no "tendency" toward full employment is there to be found. This was certainly one strand of Keynes's own view, but hardly the most important one. Skidelsky, however, tends to favor this interpretation of the General Theory, resting his case strongly on Keynes's famous article in the Quarterly Journal of Economics of 1937, and the assertion there that:


we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. . . . Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of classical economic theory . . . I do not mean merely to distinguish what is known for certain from what is probable. . . . The sense in which I am using the term is that in which the prospects of a European war is uncertain, or the price of copper and the rate of interest twenty years hence. . . . About these matters there is no scientific basis on which to form any calculable probability whatever. (quoted by Skidelsky, pp. 616-617).


This reading of Keynes suits Skidelsky nicely, for it has a conveniently anti-interventionist double edge. If markets have less than perfect knowledge, so do governments. Unhappy with the possibility that the General Theory might make the case for active fiscal and monetary policy to secure full employment, Skidelsky persistently emphasizes the need to take only that action that secures and maintains the confidence of the markets and of business community--maintaining the stability of convention. Curiously, this was the case made by the British Treasury in 1930 against a Keynesian public works program to alleviate unemployment.

To be fair to Skidelsky, the diminution of the economics of the General Theory either to a catalog of market failures or to a world dominated by uncertainty is, it must be admitted, due in no small part to weaknesses in the structure of Keynes's original argument. Keynes's theory is seriously weakened by the inclusion in its core of a key relationship borrowed from orthodox theory he was attacking: the idea that the quantity of investment is determined by its price--the rate of interest.

The relationship between investment and the rate of interest (as the rate of interest falls and investment rises, and vice versa) was a fundamental part of the orthodox theory of output, known technically as the demand function of investment. Once Keynes had accepted that as the rate of interest falls, aggre gate investment increases, then his whole theory rested on the question: Why doesn't the rate of interest fall to a level that will induce enough investment to produce full employment?

Keynes's answer was that the rate of interest was determined in the financial markets, and there is no reason why it should necessarily gravitate to the requisite level. It was not a very convincing answer. This was the weakness Hicks would exploit. The demand function for investment (which Keynes called the marginal efficiency of capital schedule) was the Trojan horse that allowed the forces of his enemies to attack the very heart of Keynes's case for an under-employment equilibrium and hence for active government.

It was one of Keynes's closest collaborators who solved the dilemma. From 1936 on, Joan Robinson had argued that if Keynes was right about the determination of employment, then orthodox theory must be wrong about the determination of prices. In the mid-1960s she at last found a way of sustaining her argument. The high theory debates that she and others conducted with the more orthodox theorists of MIT reached an agreed conclusion when Paul Samuelson was forced to concede that there was no logically consistent way to construct a demand function for capital outside the artificial confines of a one-commodity world (see the symposium on paradoxes in capital theory, Quarterly Journal of Economics, 1966). This, in turn, means that it is not possible to formulate a logically consistent theory of the long-run normal rate of interest; hence no consistent theory of long-run prices or of output and employment is possible either. Building so-called Keynesian models on the basis of market failure no longer makes sense--there cannot be a short-run deviation from a long-run equilibrium that is not there in the first place! In one stroke the critical task in which Keynes had failed was accomplished, and the marginal efficiency of capital schedule was swept away too. What was left was the part of his theory that Keynes himself had regarded as his truly original contribution--the principle of effective demand.



Demand and Investment


The principle of effective demand states that output is determined by the combination of those expenditures that are relatively autonomous of the level of income and those expenditures that are induced by the level of income. At the simplest level investment is autonomous, set free from dependence on current income by the flexibility of modern financial institutions, which can provide entrepreneurs with the funds required to implement their investment plans (or can be a means of confining investment to financial assets, avoiding any commitment to real activity). For example, if an entrepreneur has a convincing prospect of profit he or she can borrow the funds to hire the workers needed to launch the project. An investment induces successive rounds of consumption spending until the injection of new spending leaks into savings. Investment, via this multiplier effect, determines total demand and hence determines the level of national income and of savings.

But what determines investment? Short of a mechanistic demand function for investment, the issue is open. It is clear that a satisfactory explanation of why Britain and the United States invest around 17 percent of gross domestic product, Germany and France around 22 percent, and Japan nearly 30 percent will rest on more than simplistic analyses of impact of differences in the rate of return. The role of the state, corporate organization, the relationship between finance and industry, industrial structure, the rate of technical progress, the pattern of labor relations, domestic and international competition, the confidence of the money markets, and perhaps as important as all of these, the stability of "convention," all have a part to play. In other words, the process of accumulation is a complex institutional, historical, and analytical problem. The "openness" of Keynes's theory at the point of the determination of investment enables the incorporation of these factors into the theory. Keynes himself excelled in the fusion of all such dimensions into his theoretical narrative.

Indeed, one vital element in his interpretation of the General Theory that Skidelsky gets spectacularly wrong is his assessment of the role of institutions in Keynes's theory of employment:


What is missing is history and sociology. . . . The psychological "propensities" are data. They are equipment which "agents" bring to their decisions. Their roots in events or social systems are unexplored. There is no mention of the Great War, political and currency disorders, the changing balance between capital and labour, all of which might plausibly be called causes of the clutch plague. The social system, as Keynes puts is, is 'given'--outside the model. Ethics and science have always given Anglo-Saxon economics its cutting edge: they are the two blades of its scissors. They are responsible for its greatest achievements and also its single biggest blindspot: neglect of the institutions through which people act. Keynes was in this tradition. (pp. 543-544)


Skidelsky is right about the orthodox Anglo-Saxon theory of prices, output and employment. He couldn't be more wrong about Keynes.

The institution-less world is a particular characteristic of the neoclassical theory that dominates academic economics and, indeed, virtually all present-day economic thinking. In the perfectly competitive model that stands at the very core of neoclassical theory, institutions are imperfections. The market there defined contains none of the institutions of which actual markets are necessarily composed: the structure of corporate and labor law, the conventions that dictate so much of market behavior, the relationship between finance and industry, and, most important of all, the monetary and fiscal institutions of the state.



Keynes the Institutionalist


All these are necessary elements at the core of Keynes's theory of employment. It is, for example, simply not possible to construct Keynes's principle of effective demand outside the institutional framework of a modern capitalist economy, with fully developed, flexible financial institutions and a government that issues monetary instruments. Moreover, all those elements that Skidelsky cites as "given" are themselves susceptible to separate determination by a variety of factors, historical and sociological, outside the formal structure. This stands in sharp contrast to orthodox theory in which "tastes" and "propensities" are necessarily embodied in the axiomatic specification of the model.

The application of Keynesian economics to policy in the post-World War II era has been accordingly an exercise in institution building, internationally and nationally. In the international economy the price mechanism, operating through either the classical gold standard or flexible exchange rates, was one of the factors Keynes identified as having created and perpetuated instability and depression in the 1930s. In its place, partially influenced by Keynes, the 1944 Bretton Woods conference constructed a framework of fixed exchange rates, hedged around with exchange controls, and added a variety of other measures designed to create an international environment supportive of national full-employment policies. In the domestic economies of what was to become the Organization for Economic Cooperation and Development (OECD) the state assumed responsibility for the pursuit of full employment. State activity in every economy increased to levels never before experienced in peacetime. Monetary and fiscal policies were now judged in terms of their impact on employment. Of course, the degree of Keynesian intervention and the new institutions varied from one country to another. But, strikingly, policymakers no longer perceived employment as reflecting the unrestricted operation of markets. Instead, the market had to operate within an institutional framework dedicated to securing full employment by the manipulation of effective demand.

The years from 1950 to 1970 were a golden age of modern capitalism. All the major capitalist countries grew faster for longer than ever before, or since. But in the last 20 years, the OECD countries have not been able to recover the performance of those years. In virtually all the major countries, trend growth rates have been at most half the rate of those enjoyed in the golden age. Average rates of unemployment in the major industrial countries have risen sharply, especially since 1979, and both national economies and the international economy have become far less stable. Today high levels of unemployment in America are contributing to the decline in the fabric of society. In Europe unemployment is threatening social stability, even democracy itself, in both the east and the west of the continent. In Japan rising unemployment is compounding the difficulties of reforming a corrupt political regime.

The commonality of the deflationary experience throughout the OECD overwhelms the particular circumstances of individual countries. This suggests that policies that focus on the national competitiveness, such as investments in training or research and development, while important, are not totally up to the task of securing full employment. For if the overall rate of growth of demand in the G7 countries does not increase, enhanced competitiveness in one country simply ends up "stealing" jobs from another country. What is needed is a general expansion that raises the rate of growth and levels of employment throughout the OECD.

The expansionary lead can only come from the United States. This claim may engender incredulity: Isn't the United States heavily in deficit and in debt? Isn't fiscal contraction the order of the day? In truth, the United States seems eminently capable of funding its domestic and foreign borrowing at current low interest rates and at the current exchange rate. In these circumstances it is possible to tackle the twin deficits by a mixture of expansion and policies designed to enhance competitiveness. Increased government investment, particularly that which encourages increases in private investment, could result in a higher level of activity, a current account deficit of roughly the same size as at present, and a sharply reduced fiscal deficit as the private sector moves toward balance. The alternative strategy of lowering spending could, by complementary falls in private sector spending, result in roughly the same deficits as there are now but with lower growth and higher unemployment.

Of course, as Skidelsky would no doubt argue, much depends on the impact of an expansionary strategy on private sector confidence and hence on private sector investment behavior. In his pamphlet The Means to Prosperity, published in 1933, Keynes urged that government spending should be divided into capital and income accounts. This eminently sensible proposal, which would require that funds raised should also be appropriately apportioned between the two accounts, is typical of the accounting procedures of any well-run business. It would be a sensible reform today. If nothing else, it would demonstrate financial prudence while at the same time fund necessary expansionary spending. Balancing the budget for current consumption, alongside borrowing on capital account to finance investment, is a rational and efficient strategy. So long as the social rate of return on public investment is higher than the net cost ("net" after taking account of taxes generated and reduction in unemployment rolls) of any borrowing used to finance it, then the ratio of debt to national income will not rise.

An expansionary policy pursued by the United States, and allied with institutional reforms in the international financial system to support expansionary policies within the other major industrial countries, could return the West to full employment, with all the attendant benefits that would bring, not just in real output but also in reduced poverty, crime, and ill health. It would also accelerate inflation.



Dealing with the Inflation Peril


It may seem perverse in these deflationary times to harp on the possibility of accelerating inflation. But there is no doubt that sustained expansions in the major industrial countries would increase inflationary pressures. Throughout the slow-growing 1980s, real wages have stagnated or even fallen in America, building unfulfilled consumption demands that would be unleashed in a tighter labor market. In addition, coordinated world expansion would inevitably set off an upward movement in world commodity prices that are now lower than at any time since the early 1970s. But the threat of inflation is no reason to accept permanent recession. It is rather a challenge to our ability to build suitable institutional arrangements that mediate the inflationary pressures--which, after all, stem from a desire of workers and commodity producers to gain a larger share of the cake that their efforts help to produce. It is in the interests of all that an effective non-inflationary framework is created. Surely, in the presence of clearly recognized mutual self-interest, there is a rational solution to even the most complex economic problem.

The same mutual self-interest exists between the newly industrializing countries of the Pacific Rim and the G7. Until the early 1980s the major industrial countries had balance-of-payments surpluses with the burgeoning economies of the Far East, indicating that trade was creating, not destroying, jobs. In the mid-1980s the G7 moved into deficit with the new industrial economies of the Far East, but even so, since growth in the G7 was constrained by internal policy decisions, not by balance of payments considerations, the competitiveness of the new Pacific Rim industries cannot be blamed for current unemployment. If there were to be a growing trade imbalance between the old and new industrial nations, then that could be a barrier to growth in both groups. Once again the accumulation of debt on one side of a trading partnership is in no one's interest. Suitable policy (that is, institutional) steps are required to boost the growth of trade in both directions, while sustaining broad multilateral balance.



Keynes and Employment Policy Today


Skidelsky's beautifully structured narrative paints a picture of a man seeking to fashion the intellectual and practical tools to rescue the market economy from its own vices. For Keynes unemployment could never be a "natural" disaster, like an earthquake or a flood. He knew that it is a failure of social and economic organization, a failure by society and social institutions to achieve a desirable goal. Quite simply, when millions of people are out of work, we have failed to organize our society so that full employment is secured. And being a problem of social organization, there must be a solution if only society is willing to take the steps necessary. This doesn't mean that either finding or implementing a solution will be easy. Our society and our economy are complicated institutions, linking a multitude of firms and people at home and abroad, each with their own goals and their ways of doing things. Moreover, achieving full employment may conflict with other goals we consider to be important. But it is irrational simply to accept unemployment, as if it were a fact of nature. Unemployment is our failure. At the very least, we must spell out clearly the choices that must be made if we are to attain full employment.

There never will be a single, neat "solution" good for all time. The very dynamism that is the success story of capitalism creates not only the potential for greater prosperity but also new problems that must be solved if that prosperity is to be attained. Keynes's extraordinary achievements derive not only from his intuitive genius but from the fact that he recognized the force of changing circumstances and focused on the ends of economic policy, never the means. He never allowed conventional theory or orthodox thinking or vested interests to stand in the way of his practical goals--freedom, civilization, and the good life.


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