Keynes's Vision: Why the Great Depression Did Not Return (Routledge Studies in the History of Economics)

Keynes’s Vision

John Maynard Keynes was the most influential economist of the twentieth century, whose doctrines had a huge impact on American prosperity in the years following World War Two. This new book by John Philip Jones describes the main features of Keynes’s work, including the fiscal and monetary policies he recommended, together with a detailed tracking of how his theories played out in the American economy. The book focuses on each individual aspect of Keynes’s doctrines: his revolutionary emphasis on the economy as a whole (the concept that would later become known as macroeconomics); consumer demand and where it leads; investment demand and where it leads; interest rates and the influence of monetary policy; the role of government in controlling fiscal policy; and the overarching importance of expectations, optimism and pessimism. The book concludes with the seven major lessons drawn from the American economy in the latter half of the twentieth century and how these lessons were forecast by Keynes. This book also describes Keynes’s personality and the extraordinary panorama of his life. It is an excellent introduction to Keynes and his legacy, and is directed at students and also at nonspecialist members of the public who want to know more about how the economy is controlled and stimulated. It will also be of considerable interest to students of modern economic history. John Philip Jones is a professor at Syracuse University, New York.

Routledge studies in the history of economics

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19 Studies in the History of French Political Economy From Bodin to Walras Edited by Gilbert Faccarello

30 The Social Economics of JeanBaptiste Say Markets and virtue Evelyn L. Forget

20 The Economics of John Rae Edited by O.F. Hamouda, C. Lee and D. Mair

31 The Foundations of Laissez-Faire The economics of Pierre de Boisguilbert Gilbert Faccarello

21 Keynes and the Neoclassical Synthesis Einsteinian versus Newtonian macroeconomics Teodoro Dario Togati 22 Historical Perspectives on Macroeconomics Sixty years after the ‘General Theory’ Edited by Philippe Fontaine and Albert Jolink 23 The Founding of Institutional Economics The leisure class and sovereignty Edited by Warren J. Samuels 24 Evolution of Austrian Economics From Menger to Lachmann Sandye Gloria-Palermo 25 Marx’s Concept of Money The God of Commodities Anitra Nelson 26 The Economics of James Steuart Edited by Ramón Tortajada 27 The Development of Economics in Western Europe since 1945 Edited by A.W. (Bob) Coats 28 The Canon in the History of Economics Critical essays Edited by Michalis Psalidopoulos 29 Money and Growth Selected papers of Allyn Abbott Young Edited by Perry G. Mehrling and Roger J. Sandilands

32 John Ruskin’s Political Economy Willie Henderson 33 Contributions to the History of Economic Thought Essays in honour of R.D.C. Black Edited by Antoin E. Murphy and Renee Prendergast 34 Towards an Unknown Marx A commentary on the manuscripts of 1861–63 Enrique Dussel 35 Economics and Interdisciplinary Exchange Edited by Guido Erreygers 36 Economics of an Art of Thought Essays in memory of G.L.S. Shackle Edited by Stephen F. Frowen and Peter Earl 37 The Decline of Ricardian Economics Politics and economics in postRicardian theory Susan Pashkoff 38 Piero Sraffa His life, thought and cultural heritage Alessandro Roncaglia 39 Equilibrium and Disequilibrium in Economic Theory The Marshall–Walras divide Michel de Vroey 40 The German Historical School The historical and ethical approach to economics Edited by Yuichi Shionoya

41 Reflections on the Classical Canon in Economics Essays in honour of Samuel Hollander Edited by Sandra Peart and Evelyn Forget 42 Piero Sraffa’s Political Economy A centenary estimate Edited by Terenzio Cozzi and Roberto Marchionatti 43 The Contribution of Joseph Schumpeter to Economics Economic development and institutional change Richard Arena and Cécile Dangel-Hagnaver 44 The Long Run in Neoclassical Economics Tom Kompas 45 F.A. Hayek as a Political Economist Economic analysis and values Edited by Jack Birner, Pierre Garrouste and Thierry Aimar 46 Pareto, Economics and Society The mechanical analogy Michael McLure 47 The Cambridge Controversies in Capital Theory A study in the logic of theory development Jack Birner 48 Economics Broadly Considered Essays in honour of Warren J. Samuels Edited by Steven G. Medema, Jeff Biddle and John B. Davis 49 Physicians and Political Economy Six studies of the work of doctoreconomists Edited by Peter Groenewegen

50 The Spread of Political Economy and the Professionalisation of Economists Economic societies in Europe, America and Japan in the nineteenth century Massimo Augello and Marco Guidi 51 Historians of Economics and Economic Thought The construction of disciplinary memory Steven G. Medema and Warren J. Samuels 52 Competing Economic Theories Essays in memory of Giovanni Caravale Sergio Nisticò and Domenico Tosato 53 Economic Thought and Policy in Less Developed Europe The nineteenth century Edited by Michalis Psalidopoulos and Maria-Eugenia Almedia Mata 54 Family Fictions and Family Facts Harriet Martineau, Adolphe Quetelet and the population question in England 1798–1859 Brian Cooper 55 Eighteenth-Century Economics Peter Groenewegen 56 The Rise of Political Economy in the Scottish Enlightenment Edited by Tatsuya Sakamoto and Hideo Tanaka 57 Classics and Moderns in Economics, Volume I Essays on nineteenth and twentieth century economic thought Peter Groenewegen 58 Classics and Moderns in Economics, Volume II Essays on nineteenth and twentieth century economic thought Peter Groenewegen

59 Marshall’s Evolutionary Economics Tiziano Raffaelli

69 The Tradition of Free Trade Lars Magnusson

60 Money, Time and Rationality in Max Weber Austrian Connections Stephen D. Parsons

70 Evolution of the Market Process Austrian and Swedish economics Edited by Michel Bellet, Sandye Gloria-Palermo and Abdallah Zouache

61 Classical Macroeconomics Some modern variations and distortions James C.W. Ahiakpor

71 Consumption as an Investment The fear of goods from Hesiod to Adam Smith Cosimo Perrotta

62 The Historical School of Economics in England and Japan Tamotsu Nishizawa

72 Jean-Baptiste Say and the Classical Canon in Economics The British connection in French classicism Samuel Hollander

63 Classical Economics and Modern Theory Studies in long-period analysis Heinz D. Kurz and Neri Salvadori 64 A Bibliography of Female Economic Thought to 1940 Kirsten K. Madden, Janet A. Sietz and Michele Pujol 65 Economics, Economists and Expectations From microfoundations to macroeconomics Warren Young, Robert Leeson and William Darity Jnr 66 The Political Economy of Public Finance in Britain, 1767–1873 Takuo Dome 67 Essays in the History of Economics Warren J. Samuels, Willie Henderson, Kirk D. Johnson and Marianne Johnson 68 History and Political Economy Essays in honour of P.D. Groenewegen Edited by Tony Aspromourgos and John Lodewijks

73 Knut Wicksell on Poverty No place is too exalted for the preaching of these doctrines Mats Lundahl 74 Economists in Cambridge A study through their correspondence 1907–1946 Edited by M.C. Marcuzzo and A. Rosselli 75 The Experiment in the History of Economics Edited by Philippe Fontaine and Robert Leonard 76 At the Origins of Mathematical Economics The economics of A.N. Isnard (1748–1803) Richard van den Berg 77 Money and Exchange Folktales and reality Sasan Fayazmanesh 78 Economic Development and Social Change Historical roots and modern perspectives George Stathakis and Gianni Vaggi

79 Ethical Codes and Income Distribution A study of John Bates Clark and Thorstein Veblen Guglielmo Forges Davanzati 80 Evaluating Adam Smith Creating the Wealth of Nations Willie Henderson 81 Civil Happiness Economics and human flourishing in historical perspective Luigino Bruni 82 New Voices on Adam Smith Edited by Leonidas Montes and Eric Schliesser 83 Making Chicago Price Theory Friedman–Stigler correspondence 1945–1957 Edited by J. Daniel Hammond and Claire H. Hammond 84 William Stanley Jevons and the Cutting Edge of Economics Bert Mosselmans 85 A History of Econometrics in France From nature to models Philippe Le Gall

86 Money and Markets A doctrinal approach Edited by Alberto Giacomin and Maria Cristina Marcuzzo 87 Considerations on the Fundamental Principles of Pure Political Economy Vilfredo Pareto (edited by Roberto Marchionatti and Fiorenzo Mornati) 88 The Years of High Econometrics A short history of the generation that reinvented economics Francisco Louçã 89 David Hume’s Political Economy Edited by Carl Wennerlind and Margaret Schabas 90 Keynes’s Vision Why the Great Depression did not return John Philip Jones

Keynes’s Vision Why the Great Depression did not return

John Philip Jones

First published 2008 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 This edition published in the Taylor & Francis e-Library, 2007. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” Routledge is an imprint of the Taylor & Francis Group, an informa business © 2008 John Philip Jones All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0-203-93981-6 Master e-book ISBN

ISBN10: 0-415-77302-4 (hbk) ISBN10: 0-203-93981-6 (ebk) ISBN13: 978-0-415-77302-7 (hbk) ISBN13: 978-0-203-93981-9 (ebk)

For W.M.H.J.

Contents

List of illustrations About the author Acknowledgments Introduction: Why Keynes matters 1 Keynes’s legacy, 70 years later

xiii xvi xvii 1 5

The three pillars of Keynes’s doctrines 9 Keynes under attack 15 An education in economics 20 2 Three signposts

24

Fault lines in the American economy 27 A half-century of aggregate demand and output 28 The third signpost – employment and unemployment 32 Types of unemployment 38 3 Consumer demand and where it leads

42

Connections 43 The propensity to consume 45 Money and liquidity-preference 48 A web of relationships 54 Trends 56 Footnote on the spectrum of interest rates 60 4 Investment demand and where it leads Investment supply – where the money comes from 65 Investment demand – putting the money to work 68 Expectations 71

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Contents

5 The rate of interest

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A digression on three types of price 78 Four periods of economic activity 88 6 What should the government be doing?

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American economic policy during the 1930s 101 The travails of understanding government statistics 103 External trade and its complications 107 Did the deficits have any effect? 108 Did Keynes get it right? 114 7 Floating on an ocean of expectations

117

The psychology of recession 121 How do businesses grow? 122 The psychology of recovery 126 The prosperous years since 1945 127 8 Keynes the man

134

Social class and the British: a digression 135 The leap into the top 5 percent 139 Act I: Early promise, early fulfillment 140 Act II: A continuous process of intellectual development 142 Versailles and after 147 9 Twenty years of guerrilla infighting

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The troubles of the 1920s 158 The Gold Standard and the forces of financial conservatism 160 The Great Depression 165 10 Keynes, England and the world

172

An intimation of mortality 173 The approach of World War Two 173 Guru becomes man of action 174 Keynes as Treasury ambassador 177 Bringing an end to economic warfare 182 The Employment Policy White Paper 192 Keynes’s last contribution 194 11 Keynes the prophet Index

203 216

Illustrations

Figures 2.1 3.1 3.2 3.3 3.4 3.5 4.1 4.2 5.1 5.2 5.3 7.1 7.2

How price is determined in a single industry Aggregate demand The propensity to consume (schematic) Effect of higher income from increased money supply on an economy with spare capacity Effect of higher income from increased money supply on an economy working at full capacity Consumer demand Investment-demand schedule (or the marginal efficiency of capital) Investment demand The LM curve – the rate of interest and liquidity-preference The IS curve – the rate of interest and demand and income Hicks’s analysis of income and the rate of interest The psychology of recession The psychology of recovery

25 43 47 52 52 55 70 73 84 85 86 119 120

Tables 2.1 2.2 2.3 2.4 2.5 2.6

United States GNP/GDP, population, and employment, 1950–2000 United States labor productivity, 1950–2000 United States – changes in GNP/GDP and employment, 1968–2002 United States – comparison between changes in GNP/GDP and changes in unemployment, 1968–2000 United States – the three main components of aggregate demand (based on GNP/GDP), 1950–2000 United States – year-on-year changes in the three main components of aggregate demand (at constant prices) and unemployment, 1968–2002

30 31 33 34 35

36

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List of illustrations

2.7

United States – year-on-year changes in private investment (at constant prices) and unemployment, 1968–2000 2.8 United States – average unemployment per decade, 1950–1999 3.1 United States – annual changes in real GNP/GDP and savings as proportion of personal income, 1968–2002 3.2 United States typical spectrum of interest rates (%), 1993–2002 5.1 United States – economic performance during four separate periods (unweighted averages), 1968–2002 5.2 United States – interest rates and unemployment, 1968–2002 5.3 United States – changes in consumer prices and unemployment, 1968–2002 5.4 United States – unemployment related to interest rates, 1968–2002 5.5 United States – changes in real GNP/GDP related to interest rates, 1968–2002 5.6 United States – changes in personal consumption related to interest rates, 1968–2002 5.7 United States – changes in private investment related to interest rates, 1968–2002 5.8 United States – changes in consumer prices related to interest rates, 1968–2002 5.9 United States – changes in money supply (M3) related to interest rates, 1968–2002 5.10 United States – average personal saving related to interest rates, 1968–2002 5.11 United States – interest rates and changes in current account trade balance, 1968–2002 5.12 United States – wholesale prices of crude petroleum related to changes in consumer prices, 1968–2002 6.1 United States – three components of aggregate demand ($bn. at current prices), 1968–2002 6.2 United States – four separate periods – components of aggregate demand (expenditure in $bn. at current prices), 1968–2002 6.3 United States aggregate and federal government finances, 2002 ($bn.) 6.4 United States defense, federal government fiscal balance and current account trade balance ($bn. at current prices), 1968–2002 6.5 United States: Nixon, Ford and Carter administrations – GNP/GDP, unemployment, fiscal balance and current account trade balance (both at current prices in $bn.), 1968–1980 6.6 United States: Reagan and Elder Bush administrations – GNP/GDP, unemployment, fiscal balance and current account trade balance (both at current prices in $bn.), 1981–1992

37 39 57 61 89 91 92 93 93 93 93 94 94 94 95 96 105 106 106

109

110

111

List of illustrations 6.7

United States: Clinton and the early years of the Younger Bush administrations – GNP/GDP, unemployment, fiscal balance and current account trade balance (both a current prices in $bn.), 1993–2002

xv

111

About the author

John Philip Jones is a professor at Syracuse University, New York. He was born in Britain, and took the Economics Tripos from Cambridge University (Honours BA and MA). He spent 27 years in Europe as an applied economist and market researcher; and also as a manager of advertising accounts on an international basis. He spent 25 years with the J. Walter Thompson Company. His work was focused on the evaluation of advertising effects, and he has continued this activity since he entered academia. He has worked for 27 years at the Newhouse School of Public Communications, Syracuse University, where he is a tenured full professor. He was an adjunct professor at the Royal Melbourne Institute of Technology, Australia; and he is a visiting professor at the Copenhagen Business School, Denmark. He is the author of more than 70 articles in major journals, both professional and general. He has published seven books, mainly devoted to advertising effects. These include The Ultimate Secrets of Advertising (2001), which is concentrated on the econometric evaluation of advertising. He was the editor and part-author of a series of five books covering all aspects of professional advertising practice (the largest single collection of professional and academic papers ever published in the field); these were published by Sage Publications Inc. in 1998–2000. His books have been translated into ten foreign languages. He is a consultant to numerous first-rank national and international organizations, and travels all over the world in connection with this work. He is well known in the academic community worldwide, especially in marketing education. He has been the recipient of a number of national awards, from the American Advertising Federation and other bodies. In 2001, he received the Syracuse University Chancellor’s Citation for Exceptional Academic Achievement. He was nominated in 2003 by the professional journal, American Demographics, as one of the “25 most influential people on the demographic landscape over the past two-and-a-half decades.”

Acknowledgments

As always, my first thanks go to my wife Wendy, who has prepared this manuscript with her usual skill, meticulous care and cheerfulness. She has also managed to sustain my enthusiasm and morale during this book’s four-year gestation. I am also extremely grateful to Jerry Miner, Professor Emeritus in Economics at Syracuse University. I have discussed all parts of the manuscript with him and he has given me the benefit of his rich knowledge of the advances in macroeconomic thinking since Keynes’s time. However, since my initial and continued plan for this book has been to examine how Keynes’s own doctrines were actually illuminated by the American economy during the second half of the twentieth century, I have sharply restricted my discussion of new theoretical work in macroeconomics since Keynes’s General Theory was published. I examine only four developments: Hicks’s IS:LM analysis published in 1937 (discussed in Chapter 5); the rise and fall during the 1960s and 1970s of the explanatory usefulness of the Phillips Curve (also in Chapter 5); Friedman’s “Permanent Income Hypothesis” (in Chapter 3); and the stagflation of the 1970s (in Chapter 1). I greatly appreciate thoughtful comments on parts of my manuscript from the following American friends: Bud Carey, Goodwin Cooke, Robert and Elizabeth Daly, Jerry Evensky, Samuel and Judie Gorovitz, Rosanna Grassi, Kevin Holmquist, Philip and Mary Jones (my son and daughter-in-law), Eugene and Sandra Kaplan, Johanna Keller, Dennis Kinsey, Tina Press, Roger Sharp, and David Sutherland; and from the following British friends: Judie Lannon (who was born in the United States), Cherry Lewis (James Meade’s daughter), Colin McDonald, Martyn and Wendy Seekings, Anthony Simpson, and David Wheeler. Finally, I am grateful to another British friend Jeremy Bullmore who encouraged me to write this book when, despite my keen ambition to embark on it, I had little idea of what would be involved and I had certainly not come to grips with the size and complexity of the enterprise. It has been a tough piece of writing, but I have enjoyed my struggle with the challenge.

John Maynard Keynes, 1933 Cartoon by David Low that appeared in the New Statesman. Published by permission of the Centre for the Study of Cartoons and Caricature, University of Kent.

Introduction Why Keynes matters

I am a book collector (and also a book reader). On my shelves I have a work that I bought when I was young and could ill-afford it: a beautiful 1799 calf-bound three-volume edition of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations. This particular copy, which has been a source of continuous intellectual and aesthetic pleasure over the years, has a history. It once belonged to Richard Brinsley Sheridan, not only one of the most important dramatists in the British pantheon but also a prominent politician who sat for many years in the House of Commons. The fact that Sheridan immersed himself in this new field of study demonstrates that economics, or political economy – an academic pursuit that Thomas Carlyle was later unforgettably to call the dismal science – was on the agenda of public policy makers soon after 1776, when Adam Smith’s book first appeared. (My copy is from the third edition.) Public interest in economics accelerated during the nineteenth century. This had much to do with the enormous changes that were taking place in most parts of the world at that time: the intensification of national rivalries, colonialism, the vast increase in domestic and international trade, mass emigration from the old world to the new, seminal scientific discoveries and – most important of all – an unparalleled growth in wealth in the economically most developed countries: Britain, Germany, the United States and Japan. Industrial efficiency through economies of scale was making its presence felt for the first time. Such an outpouring of wealth had never been seen before during the long march of human civilization. It was the result of a spark ignited during the eighteenth century by the coming together of a number of unconnected happenings: technical inventions, new manufacturing methods, capital accumulation through the expansion of joint-stock companies, growth in population, domestic and foreign trade, and entrepreneurship that combined an instinctive feel for market opportunities with a zeal for exploiting them. This spark and the subsequent explosion of production were powerful enough to lift the world out of Malthusian deprivation and set it on a path that during the twenty-first century is likely to end world poverty, despite relentless increases in the numbers of mouths to feed. One result of this first surge in economic growth – and also a contributor to it – was the gradual flowering of strong optimism about the future on the part of

2

Introduction

most politicians and business people. This was a striking characteristic of economically advanced societies during the nineteenth century. This optimism was to fade during much of the twentieth century, with dire consequences, because the economic expansion of the preceding century was sharply interrupted. Intensifying national rivalries led inexorably and almost expectedly to World War One, although that conflict’s suicidal destructiveness, long duration and terrible aftermath were not anticipated by any of the European leaders who had led their countries to war in 1914. Keynes was one of the first prophets who as early as 1919 predicted what was to come frighteningly soon. During the two decades following 1918, a blight afflicted all capitalist societies. Growth had traditionally followed a cyclical path, but the trough that was entered in 1929 became deeper and more prolonged and the subsequent peak more hesitant than had ever happened before. This setback was a cause of great and widespread hardship and, in the case of Germany, of political instability that had disastrous consequences. What nineteenth-century economists had seen as a self-correcting mechanism, by which economic activity would move toward equilibrium by gradually rising during troughs and falling during peaks, seemed no longer to be functioning. In more precise terms, capitalist societies were now moving toward a different type of equilibrium, one characterized by large pockets of idle capacity: both unemployed labor and unused capital equipment. Capitalist economies were obviously capable of generating greater quantities of wealth, but no politician or economist had the breadth of imagination to understand why this did not happen; nor could they think of any effective stimulus to cause the wheels to turn again at full speed. The remedies that were actually implemented were derived from the article of faith that governments must play a neutral role in economic affairs. This meant that government budgets should be balanced and finance had to be “sound”: measures that did nothing but make a bad situation worse. And the resulting erosion of optimism and confidence made the situation worse still. It took an academic (albeit one with a worldwide reputation among the governing and intellectual classes) to work out with relentless logic what was going wrong and to propose remedies: remedies that were mostly unwelcome to policy makers. That academic, whose mind had the penetrating power of an electric drill and whose vision reached out to fields far beyond the sight of any other economists or even leading politicians, was John Maynard Keynes. It is not surprising, in view of the faults in the conventional diagnoses (which he uncovered) and the lack of success of the resulting remedies (which he skewered), that Keynes’s thinking shook the foundations of traditional economics and stood conventional economic policy on its head. The fact that the economic catastrophes of the period 1920–1940 have not recurred is the strongest proof that Keynes did indeed get it right, or at least got it far more right than wrong. But his work is of more than historic interest for two reasons. First, the fiscal and monetary measures that Keynes pioneered are parts of the tool kit of economic planners today and are used to keep severe economic depression at bay. Governments and central bankers have gained

Introduction

3

experience of opening and closing the fiscal and monetary control mechanisms to maintain economic activity while at the same time keeping a grip on inflation. There is a second point that is even more important. Keynes believed that the discipline of economics is a mindset, a way of looking at things; it is, in his words, “an apparatus of the mind.” This type of mental apparatus is used today by politicians and economists to address different problems from those that Keynes attempted to solve. Today’s economic challenges are no less important than the earlier ones, although they may not have the same pressing urgency. In advanced countries like those in North America, Western Europe and parts of the Pacific Rim, how many members of the general public who are instructed by the financial pages of the press and entertained by popular television programs about business realize that they are being confronted by Keynesian concepts, and that these are being expressed in rather special language, either Keynes’s own or that of economists who have followed his path? All people with enough savings to care about quickly become familiar with such abstract notions as how a low rate of interest can stimulate economic activity and boost the prices of common stock, and how a high interest rate can do the opposite. No one is any longer puzzled by such ideas as economic growth and recession, inflationary pressure, cyclical trends, hard and soft landings, seasonal and secular unemployment, deficient and excessive demand, variations in the rate of growth of the Gross Domestic Product, discretionary purchasing power and other once-recherché ideas that were formerly the exclusive concern of economists. Keynes has indeed entered the bloodstream of the general public, or at least the bloodstream of reasonably well-off people: a large and increasing proportion of the population. This book repeatedly emphasizes that Keynes was a figure of wide-reaching importance. Many who know nothing about his work recognize his name, and may even unconsciously use his language. Such is the fate of many eminent people. Although I shall try to explain why Keynes is known but not understood, this book is not an uncritical description of how the complex doctrines associated with his name became recognized, accepted and propagated. I plan instead to examine the doctrines themselves, with the rather bold ambition of testing their validity. My plan is to make simple comparisons between what Keynes said would happen in certain circumstances, and what actually happened when these circumstances occurred in the United States during the second half of the twentieth century. Generations of economists have approached Keynes differently. His doctrines have been scrutinized repeatedly and exhaustively, and in the main evaluated on logical grounds. The question addressed has been: “How well do the doctrines hold up intellectually?” Some economists, in works targeted at other economists, have calculated statistical correlations between various series of figures used to describe parts of Keynes’s economic landscape. My approach is simpler and is governed both by my professional experience as a market researcher and by the intended audience for this book. It is written for people of all ages who are interested in ideas. My audience includes – it is not confined to – faculty and students

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Introduction

in universities who have been properly baptized with a spirit of inquiry. All my readers will recognize Keynes’s name, and may be interested to learn more about the extraordinary things that he accomplished. And he did this in the face of no small amount of unrelenting opposition from politicians, government officials, bankers and fellow economists.

1

Keynes’s legacy, 70 years later

Keynes was the most influential economist of the twentieth century, and his doctrines reached out into the Ivory Towers and – less expectedly – also into the corridors of political power in most countries around the globe. It is difficult to find a book on the history of the period 1918–1945 published on either side of the Atlantic that does not contain some reference to his work, but he did not convert his many skeptics and make an impact on public policy overnight. Chapter 9 describes the prolonged warfare between Keynes and the traditionally minded Bank of England and the Treasury (the British government department that finances all the others), but by 1944, Keynes’s doctrines were widely enough believed to be embodied in British government policy; and many other countries followed. How was this accomplished? I shall look at three causes: 1

2

3

The inherent soundness of the doctrines themselves: the degree to which they diagnosed accurately and fully the causes of the world’s economic and social problems at the time and, if the ensuing policy prescriptions were effective, without producing toxic side effects. These problems were rooted in the painful amount of unemployment in most countries during the 1930s that most people thought to be a chronic characteristic of peacetime conditions in economically developed countries. Keynes as an analyst was concerned with diagnosis; then as a practical and humanitarian man, he wanted action. The desperate need for a solution to these disheartening problems: a need that eventually (although certainly not at first) prompted politicians and their economic advisers to cling to Keynes as if to a life raft. Keynes’s own persuasive powers, allied to his ability to ignite the enthusiasm of many highly intelligent and influential disciples, who used Keynes’s doctrines in the way he recommended: as “an apparatus of the mind.”1 Keynes had an extraordinary ability to speak to a wide general audience as well as to professional economists, and he was so well known that his journalism was widely published and his spoken words extensively reported.

Each of these three causes goes some way to explaining the great influence that Keynes eventually wielded. Chapter 11 will summarize the many things this

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Keynes’s legacy, 70 years later

book says about these three issues, but throughout the book I intend to go much further and examine how much the prosperity of the United States since 1945 can be attributed to Keynesian policies. In fact the most important practical question I address is why, during the period since 1945, we have not seen a repetition of the economic horrors of the 1920s and (especially) the 1930s. Chapter 11 also summarizes my answer to this question. As readers will discover in this book, the 30 years after the end of World War Two witnessed economic policies derived from Keynes’s doctrines: policies that were demonstrably beneficial. However, after 1973, a sudden and unexpected increase in the world price of oil – the first of many such increases – created an inflationary problem that was apparently not treatable by Keynesian remedies. As a result Keynes lost favor to a startling degree, and his reputation has still not recovered. Yet his policies during that time were working more effectively than appeared on the surface. And during the 1980s and 1990s, Keynes came again into his own – without anyone noticing what was happening – when his doctrines contributed very substantially to dramatic increases in economic prosperity. This book will examine the facts. In describing Keynes’s doctrines, I shall devote most attention to what he himself wrote, in particular what he said in his most important book, The General Theory of Employment, Interest and Money, published in 1936 when Keynes was in his early fifties. This work was directed at economists and therefore made no excuses for being technical. Keynes’s own published output was very large. It included major contributions to economic theory, a few interesting biographical essays and a huge output of journalism. His writings on economics culminated in the General Theory, the definitive expression of his doctrines. He published no more major works after this. A year after the General Theory came out, Keynes began to suffer from the debilitating disease that was to kill him in 1946. Nevertheless, during World War Two he was desperately committed to the work he was doing for the British government and this left him with no free time at all. In concentrating on Keynes’s writings, I have undertaken a difficult task for two reasons. The first concerns Keynes’s writing itself; the second is because of the secondary literature it has spawned. I must spell out the first at some length. Although Keynes’s writing on economic theory gives us many flashes of enlightenment, it is rather opaque because of the density and compression of the arguments. Some economists have actually called the General Theory a badly written work. An important point is that Keynes’s arguments are based on logic much more than on facts, and questionable reasoning is much more common than a misinterpretation of facts. In writing the way he did, Keynes followed the practice of other economists and indeed all social scientists (e.g. writers on sociology, psychology, anthropology, political science and history). In Keynes’s day, the approach of all such authors was philosophical: relying on logical reasoning, sometimes adventurous speculation and common sense (which also has its dangers).2 These authors often cited many isolated facts, but it was rare for them to base their arguments on large tranches of robust statistical data. (Things have changed to some extent since the 1930s.)

Keynes’s legacy, 70 years later

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Keynes’s approach is certainly understandable, since he was a quintessentially Cambridge figure, and economics in that university had during the nineteenth century splintered off from the study of philosophy (described there as Moral Sciences, causing the facetious to describe economics as Immoral Science!). Keynes’s approach, as described by Skidelsky, his best and most comprehensive biographer, was based on the idea that: “the foundational truths of ethics, mathematics and science were self-evident logical propositions, incapable of proof or disproof, but intuitively perceived to be true or false.”3 This method certainly contributes to the assurance of Keynes’s arguments, but his reluctance to use data led him astray over at least one important issue. This is described in detail in Chapter 3. The fact that Keynes and other economists traditionally relied on logic is a curious anomaly, although it followed a hallowed tradition. Economics – alone among the social sciences – has access to a formidable battery of carefully compiled statistical estimates collected at regular intervals. Such statistics are often called “hard” longitudinal data, and they measure the most important economic indicators, e.g. the Gross Domestic Product, employment, prices, money supply, budget surpluses and deficits, rates of interest, saving, investment, etc. My book is based on such data, which I use as a yardstick to measure the validity of Keynes’s doctrines and the truth of his predictions. Naturally, I have had to be careful, especially to avoid unexpected contaminations between different series of figures. The basic precept of all economists is ceteris paribus: all things being equal. And the larger the number of different sets of data (as in Chapter 6), the greater the danger of confusion and, as a result, drawing misleading conclusions. It is not easy to understand why Keynes turned so far away from empiricism that he used statistics extremely sparingly in the General Theory (although a little less so in the important theoretical work that preceded it, A Treatise on Money, published in 1930). I believe that there are three explanations. The first is the point I have already made, that Keynes was nurtured in a philosophical tradition and was accustomed to teasing out “self-evident logical propositions.” Skidelsky believes that Keynes’s skepticism about the value of data was because observation takes place through the prism of personal perceptions and is consequently not objective. The second explanation is provided very simply by Keynes himself: The statistics he could find were few and unreliable. He was especially worried about data on the quantity of output and on the price level.4 I do not think that the figures were quite so unsatisfactory even at that time; and World War Two witnessed serious attempts to estimate accurately and fully the size of the British national income.5 Even in the 1930s American data on the economy were reasonably plentiful, and Keynes himself recognized this.6 The problem hardly exists today, when governments and other organizations publish large quantities of information, including many complex types of analysis, all the work of highly qualified data specialists. Such data are the tools I use to examine how Keynes’s doctrines have actually played out in practice over the second half of the twentieth century.

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As early as 1923 Keynes was intrigued with the idea of collecting business statistics, and he helped start the London and Cambridge Economic Service. As mentioned, he used a limited amount of statistical information in A Treatise on Money, published six years before the General Theory. But the important point about Keynes’s view of economic statistics was that they are not like the tides and the temperature, with a life of their own with patterns of fairly regular and predictable change. For this reason he thought it impossible to use such statistics for forecasting the future, but they could be used as a source of operational intelligence, e.g. to provide a snapshot of parts of the economy, thus making it possible to use science to plan policy. One obvious example of the technique in action would be control of the money supply.7 The third – and rather surprising – explanation for why Keynes did not favor empiricism is that he had something like an aesthetic objection to it. He hinted, in his short biography of Robert Malthus, that empiricism weakens arguments and even emasculates vigorous writing.8 Keynes’s suspicion of empiricism stretched to his reluctance to support the “planning” movement: systematized programs to manage the economy. As we shall see in Chapter 6, he believed that the government has to play a part in correcting shortfalls in total demand, which is the main factor causing unemployment and inhibiting growth, but the way in which this should be done should not be through relying on automatic systems: “action standards,” based on plans and targets derived from statistics. He was convinced that such systems could never work because they would be used as a substitute for ideas to animate them.9 Keynes thought that the economist had to be a thinking individual, and not a person who pulled metaphorical levers on statistical models. I strongly believe that he constantly had in mind the idea of the statistician as a plodder: a person described irreverently and entertainingly in an essay published during the 1960s by a Harvard academic called Perry.10 Perry draws a delightful distinction between “cow – data without relevancies” and “bull – relevancies without data.” Both are deplorable, but in Perry’s view, the former is worse than the latter. Keynes would probably have agreed. People who write about economics (including Keynes) make plentiful use of geometrical diagrams and algebraic formulae, but these artifacts are used to describe models: quantitative relationships based on hypothetical numbers. These may be useful devices to describe theories, but readers should not get carried away. Some models are more relevant than others to the complexities of the world we live in, and explanatory power is always more important than elegance. As a prominent market researcher once said, as he inserted his knife into the jugular: “What is a model but a myth with numbers?”11 Keynes himself was even more robust when he discussed economists’ over-reliance on mathematics, “which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.”12 Keynes’s approach to the study of economics was purposeful. He had a clear idea of how he wished to employ the tool of economic analysis, but to him it was the tool of logic. As a market researcher regularly engaged in quantitative investigations of business problems, I find Keynes’s attitude to empiricism difficult to swallow.

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My day-to-day work describes consumer behavior. The technique used is relentlessly empirical: Although good research also depends on experience and judgment in drawing up the plans and interpreting the conclusions. It is not a matter of dispute that good research is able to illuminate behavior by providing batteries of factual data collected both once and repeatedly. It is also possible to infer the reasons for changes, and with more difficulty to find realistic pointers to the future. The industry is long established and is universally respected (except perhaps among philosophers!). I am by no means persuaded that the approach is irrelevant to the study of the more complicated problems of Keynes’s world, and in view of my professional experience the task I have set myself in this book is to scrutinize Keynes’s doctrines with the help of facts. So much for the important question of empiricism, and how Keynes’s work avoided being contaminated with it. The second reason for my difficulty in studying Keynes’s work is the gigantic quantity of secondary literature on the subject. His doctrines have spawned a body of writing as rich and fertile as the theories of Darwin and Einstein (to pick two thinkers who can be compared with Keynes in both the dazzling originality of their ideas and the permanent glow that these ideas generated), but the majority of economists today do not write about Keynes, although graduate and undergraduate courses based either directly or indirectly on his work are taught at most universities in the world. Economists today write about other economists who have written about Keynes, or even about economists who have written about other economists who have written about Keynes. It is as if, in the world of religious studies, biblical commentators discuss exclusively the work of other biblical commentators, while the Bible itself remains on the shelf. It is therefore sometimes difficult to separate what Keynes said from what other people have said about him. No matter how hard one tries to concentrate on Keynes alone, some of his ideas will inevitably be clouded by what one has learned about the interpretations of others. Over the years, Keynes’s doctrines have been taught in an increasingly modified form because of the work of many economists who have followed different paths. The first path led to a mathematical explanation and amplification of Keynes’s doctrines, and a pioneer paper was published a year after the General Theory: the work of an Englishman, John Hicks.13 Although Keynes was less than enthusiastic about this interpretation, it nevertheless became an important catalyst for the propagation of his ideas. (Hicks will be discussed in Chapter 5.)

The three pillars of Keynes’s doctrines The three most important concepts on which Keynes’s doctrines are based are: (a) the study of aggregates, the activity of the economy as a whole; (b) total demand, because of its bearing on employment; and (c) expectations, similarly for their relevance to employment. These three topics are intimately connected with one another, but will be described separately. First, the study of aggregates.

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Keynes’s most obvious and striking theoretical contribution is that he opened up economic theory in a most sweeping and powerful way to the study of the total economy. This field of investigation became known as “macroeconomics,” although Keynes did not use this word. Macroeconomics is different from traditional economics (or microeconomics), which concentrates on the study of individual firms and industries. In the study of firms and industries, business people’s self-interest corrects excesses through the process of competition, e.g. shortages mean high prices and profits, which encourage greater production by existing and new manufacturers, which in turn brings down prices and profits again. This process is what Adam Smith described graphically as the working of an invisible hand.14 Keynes did not originate the inquiries into aggregates, but he single-handedly and radically changed the emphasis of the whole field of economic studies. He saw his general theory as embracing both the well-understood principles of microeconomics – which assume that imbalances in economic life will correct themselves – and the new principles of macroeconomics, where imbalances are not necessarily self-correcting. This view goes to the heart of the problem of widespread unemployment and the difficulty of finding a cure. Unemployment was not a very important economic and social issue until after World War One. Unemployment was invariably cyclical and ultimately self-correcting, with the result that economists before Keynes did not study it as a pressing problem. For example, it is hardly discussed at all in the writings of Alfred Marshall, the most important economist of the last part of the nineteenth century.15 Consider the following arguments, which were all put forward intermittently by various writers: •

•

•

•

Although unemployment occurs in the trough of the business cycle, this is a temporary phenomenon. Unemployment will pick up again with the normal cyclical recovery of the economy. A major source of unemployment is that triggered by a fall in the demand for the products of a particular industry. When this happens, the workers who are put out of work will be absorbed by the demand for labor in expanding industries. (Keynes referred to this type of short-term unemployment as “frictional.”) An example of frictional unemployment in the United States is that caused by the decline of old manufacturing industries, and how the labor from these is only gradually being absorbed by the service industries. Some unemployment is caused by workers who will not make the effort to work. Marshall discussed this briefly, and Keynes gave it the name of “voluntary unemployment.” A current example in the United States is the willingness of unregistered aliens to work for below the minimum wage doing farm work, while American-born workers and legal immigrants are reluctant to do this. If there is ever a widespread fall in the demand for consumer goods, the population will save the money they would otherwise have spent. The

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supply of loanable funds will therefore go up, depressing the rate of interest. This in turn will encourage investment, so that the increased demand for investment goods (discussed below) will compensate for the decline in the demand for consumer goods. Equilibrium is achieved with no reduction in total demand and therefore no permanent fall in employment. Such widespread (but ultimately self-correcting) unemployment can best be described as involuntary. Keynes’s description of this theory appears in his comments on the work of two early economists, the Frenchman Say and the Englishman Ricardo: . . . it has been supposed that any individual act of abstaining from consumption leads to, and amounts to the same thing as, causing labor and commodities thus released from supplying consumption to be invested in the production of capital wealth.16 Note that these arguments are all philosophical, i.e. based substantially on logic; also that there is a fairly widespread assumption that the economic system is self-correcting, with the invisible hand continuing to be at work. However, the most striking point relates to involuntary unemployment, which is supposedly eliminated by natural forces after the passage of time. This is palpably a fallacy, as economists discovered when they were confronted with the massive, widespread and persistent unemployment of the 1930s. To Keynes, such unemployment did not correct itself, and he preferred to call it “structural.” The problem has not totally disappeared even in the twenty-first century, in some countries at least. In October 2006, the average unemployment in the countries of the Euro zone was 7.7 percent (much above the United States but admittedly much less than during the Great Depression).17 This brings us to the study of demand. Since economics is the study of the price mechanism, it is concerned with demand and supply, which together determine price. Demand is a familiar enough concept in microeconomics. Adam Smith’s aphorism, “The Division of Labor is limited by the extent of the market,” conveys the simple thought that the advantages of large-scale output cannot be realized unless this can be sold in the market place.18 Demand must drive production: a concept that is the genesis of the large and sophisticated industry of marketing, as distinct from what many people consider the anachronistic pursuit of mere selling. In economics, demand does not just mean people wanting things. It means that they also have the purchasing power to buy them. Thus the economist’s normal description of demand, the demand schedule or demand curve, describes the quantity of a product or service that will be purchased at different prices. These schedules are usually – although not always – hypothetical. When attempts have been made to construct real demand curves, the expected pattern appears although some interesting quirks have been uncovered: e.g. occasional circumstances when higher prices lead to higher rather than lower sales. Such eccentricities can be delightfully serendipitous to manufacturers and sellers of luxury products.

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As far as individual industries are concerned demand depends on the public’s wish to buy the products of that industry, as opposed to buying the products of quite different industries, or investing the money to earn something from it, or putting it under the mattress for safety but no return. It also depends on whether the public has the necessary cash, which is in turn related to the amount of employment and the level of wages. Keynes’s examination of aggregates places most emphasis on demand because of its influence on the level of employment. His theories – and the public policies to correct shortfalls that stemmed from them – were derived essentially from vicissitudes in demand in the total economy (or rather in all economies because we must take international trade into account). Effective demand defines the volume that will keep the wheels of industry rolling in conditions of equilibrium: where aggregate demand balances aggregate supply as business is currently organized: Effective demand is simply the aggregate income (or proceeds) which the entrepreneurs expect to receive, inclusive of the incomes which they will hand on to the other factors of production, from the amount of current employment which they decide to give.19 But there is no reason to expect the level of production to be what is necessary to maintain full employment. It all depends on supply and demand, and demand can of course go up or down in response to a variety of causes. If it falls, this increases unemployment because such a reduction shrinks business receipts. This result requires that costs should be brought down if businesses are to maintain their current operations, but money wages – one of the main elements (and sometimes the most important single component) – of costs stubbornly block any downward pressure because of resistance from workers and their trade unions. Thus the only way businesses can reduce their wage bill is to lay off workers: a process that will be discussed from a historical point of view in Chapter 9. Keynes introduced a new idea when he examined aggregate demand. Such demand is not limited to razor blades and breakfast cereals and air travel and all other types of consumer goods and services. Aggregate demand also includes the demand for blast furnaces and robotic equipment and industrial computers and all other types of capital goods. These will be used substantially to manufacture consumer products. The demand for consumer goods is therefore connected with that for capital goods, as I shall shortly demonstrate. The three ingredients on the title page of the General Theory – employment, interest and money – all revolve around demand. The rate of interest influences the supply of money and aggregate demand, and in most circumstances demand has a direct connection with employment. Chapter 2 is devoted to describing this connection by examining three signposts: aggregate demand; output (the mirrorimage of demand); and employment and unemployment. Keynes saw a role for the government in maintaining the economic health of the country. Monetary policy should be exercised through the rate of interest,

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which is normally controlled by the Central Bank. Fiscal policy means manipulating public spending, e.g. money devoted to public works, armaments, etc., to make up for the shortfall of demand in the private sector. This of course carries the danger of budget deficits, a typical complication associated with Keynes’s work. The inflationary danger from budget deficits remains a concern of many economists. As a general rule fiscal policy, if it is applied boldly, is more effective than monetary policy in stimulating aggregate demand: lower rates of interest are usually ineffective in pumping demand into the economy. However, monetary policy is faster acting than fiscal policy and has a more immediate effect on cooling demand. Increases in the interest rate are therefore constantly used to relax inflationary pressure. The use of the rate of interest as the main tool of monetary management demands a light hand on the controls, in order to steer a path between two unattractive alternatives. The central bank must nudge the interest rate high enough to avoid inflation, but at the same time it must be kept low enough to avoid inhibiting the stability and growth of the national income. One overall influence on the economy is business and personal expectations. I believe that the strongest link between interest, money and employment is psychological. Low interest rates and buoyant bank lending are signals of optimism that positively influence both consumer and investment demand and hence employment. High interest rates and tight credit have the opposite effect by engendering pessimism that causes a cooling of economic activity. One of the most important aspects of this psychology is that it connects the demand for capital goods and that for consumer goods. This is because any decision to invest in capital goods depends on whether the anticipated market for the consumer goods eventually produced will justify the capital expenditures needed to manufacture them. (Remember Adam Smith’s aphorism that the Division of Labor is limited by the extent of the market.) Business in the twentieth and twenty-first centuries has floated and continues to float on an ocean of expectations: at one extreme, positive feelings about the future and, at the other, pessimism about it (with varying stages of uncertainty in between). These expectations exaggerate and prolong both booms and slumps. Expectations make for so many hazards that it is impossible to regard business as in any way a scientific enterprise, despite the inflated claims that are so often made for it. Here are three instructive examples: •

Loudly trumpeted plans for the future turn out to be disappointing on many – perhaps the majority of – occasions. A fairly recent instance (from many I could have chosen) is Unilever’s scheme to reduce the number of its worldwide brands by more than 70 percent (sic), in order to concentrate on those thought to have the greatest potential.20 This policy led to a decline in the total sales volume and profitability of the company, because unexpected competition arrived, and the host of abandoned brands had anyway all been making small contributions to total sales and to the general overhead. What is surprising about this outcome is that the firm did not anticipate it.

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•

Disaster awaits the majority – some analysts say the vast majority – of new brand ventures. In major firms, every new brand is developed through a punctilious process of forward planning with a lavish use of the time of highly paid managers and the heroic investment of resources: investment that would not be committed without a firm belief that the new brand was going to succeed. The launch of new brands is in reality less productive than a crapshoot.21 A fascinating study can be made of the reasons why manufacturers continue to launch new brands. These reasons are intimately connected with the ferocity of competition between companies operating in mature product categories in developed economies. There is a compulsion to launch new brands for both aggressive and defensive reasons. The result is a massive waste of resources. The value of a company’s stock on the exchanges is important to that company. This is not only because a shrunken stock price will impoverish stockholders and managers (most of whom own stock), but also because it will make the company vulnerable to predators who will in most cases strip its assets and reduce its capabilities. The market valuation of a company is the product of a double uncertainty. First, there is the uncertainty involved in interpreting the “fundamentals,” i.e. the future demand for the company’s products, the state of the competition, glitches in the production of the company’s goods, unexpected changes in the prices of raw materials (e.g. oil), the rate of interest and trends in personal incomes, besides of course the company’s own tangible and intangible assets. These all make for difficulties in forecasting the future of the company’s business. Overlaying this difficulty is a second influence: the effect on stock prices of other investors’ responses to those same fundamentals. This effect is essentially nonrational, and it means that an investor must second-guess and – most importantly – move into or out of the market five minutes ahead of other investors. The naive and forlorn individual who buys and sells on the basis of rational expectations alone or on the advice of “experts” is courting danger.

•

Keynes was both perceptive and entertaining when he wrote on this topic.22 He had a cunning understanding of irrationality and was consequently a very successful speculator on his own behalf and on that of King’s College, Cambridge (whose investments he partly controlled as the college’s bursar). His feel for market psychology led him to his own unorthodox (although sensible) strategy of selecting only the companies he thought had long-term potential and buying their stock in a falling market. Nevertheless, despite his general success, there were three dramatic occasions during the 1920s and 1930s when his speculations almost sank him.23 Keynes’s doctrines lay great stress on the contribution to the fabric of economic life that is made by expectations: forecasts of the future, with their obvious uncertainties. Their role will also be discussed in some detail in this book, and Chapter 7 is devoted to it.

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Keynes under attack Keynes’s doctrines became widely and increasingly (although not universally) accepted during the period between the publication of the General Theory and the mid-1970s. During the 1930s and 1940s, the American interest rate had been kept very low with the general aim of stimulating demand and reducing the cost of government debt. However, in March 1951, the Treasury and the Federal Reserve agreed to use the rate of interest – the Keynesian tool of monetary management – to keep inflation and unemployment in check. This was done through modest increases in the rate. The 1960s were fairly prosperous times in the United States, and the chairman of the Federal Reserve, William McChesney Martin Jr., who was a Keynesian, also employed fiscal policies for macroeconomic management. In particular, he monitored the growth in public expenditure and pressed (without much success) for increases in federal taxes to contain inflation.24 The sixties actually saw an erosion of Keynes’s influence because the Kennedy and Johnson administrations focused increasingly on social and defense policies: the “Great Society” programs and then the Vietnam War.25 This change of government priorities contributed to the suddenness with which Keynes fell out of favor following the oil price shock after the end of 1973. This shock was a jolt that brought general inflation driven by increases in producer prices. Looked at year by year, the traditionally low inflation and unemployment figures edged sharply upward. (See Table 5.3 in Chapter 5.) Inflation was 6.2 percent in 1973, 10.9 percent in 1974 and 9.1 percent in 1975; unemployment was 4.9 percent in 1973, 5.6 percent in 1974 and 8.5 percent in 1975. These increases were serious enough to rattle the academic establishment. Before the mid-1970s, there had been an inverse statistical relationship between inflation and employment (also discussed in Chapter 5): if an increase in prices could be accepted, inflation would come down. By the mid-1970s this was no longer happening, and the unfavorable movement in both inflation and unemployment was given the picturesque name stagflation. Many economists, politicians and journalists began to shiver with apprehension that the negative figures they were seeing were the first signs of disaster. In fact, the experts over-reacted, perhaps because most of them still had traditional orthodoxy embedded in their psyche. Many abandoned Keynes with lightning rapidity and rallied to the standard of the monetarists. This standard was carried into battle by Milton Friedman, who offered an up-to-date and operational version of conventional financial conservatism. The central beliefs of the monetarists are (a) that if the money supply does not get out of hand inflation will be contained; and (b) unemployment is the price paid for interference with the free working of competitive forces. (In contrast to Friedman’s theory about unemployment, the application of Keynes’s policies and the fact that the Great Depression did not return are established facts.) Very many economists accepted this archaic libertarian doctrine. Nevertheless a few remained loyal to Keynes. Joan Robinson, one of his earliest

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disciples, never lost her belief in the essence of his theories, nor was there any weakening in the directness and vigor of her arguments. (An economist with a first-rank international reputation, she was surprisingly – and disgracefully – never awarded a Nobel Prize. She will appear again in Endnotes 1 and 37.): “By advocating the adjustment of the money supply as the answer to inflation and by offering ‘market’ solutions to unemployment, the economics profession has progressively abandoned logic for ideology and set us back precisely where we started.”26 A sharp increase in producer prices when the economy was working near to full capacity was not a problem that Keynes had ever faced, and he was not of course around during the 1970s when the shock was felt. Excluding the possibility – unlikely but not impossible – that Keynes might have conjured up a totally original solution like a rabbit out of a hat, he would probably have recommended the anti-inflationary policies that were actually followed: raising the rate of interest and restraining government expenditure. This naturally increased unemployment and slowed the growth of output. Despite the fears of so many economists, politicians and journalists, the American economy did not receive an immediate body blow in 1974, the year that heralded ten years of recession.27 The unfortunate feature of this period was not so much its severity as its duration; it was a decade during which economic conditions demonstrated stagnation rather than a slide into the abyss. Here are its main features: •

•

•

The economic indicator that moved consistently in the most negative direction was the price of petroleum. It worsened every year for eight years, and from an average of $3.31 per barrel during the period 1968 through 1973, the price quintupled to an average of $16.10 per barrel during the decade as a whole, with figures above $20 for the four years 1980 through 1983. This oil price shock had a “knock-on” effect throughout the economy since petroleum accounts for part of the cost of all goods and services. The massive size and the unrelenting nature of the oil price rises were obviously the main causes of the persistence of the recession. (See Table 5.12 in Chapter 5.) Inflation went up in a rather patchy way. The largest increases were in 1974, 1979, 1980 and 1981: rises driven by increases in the price of oil. After 1981 inflation started to go down again. In an effort to control this inflation, the rate of interest was moved up from the previous average of 5.8 percent to 9.7 percent during the recession, reaching its highest levels during the four years 1979 through 1982. The inflation was not the result of increased government expenditure, because this did not rise above its normal annual increase; the figures during the recession ranged from zero change to +2.2 percent. In response to the higher interest rate, the growth in private investment began to decelerate, and such investment actually fell in 1980 and 1982. This fall had a direct influence on the real GDP: the annual increase in GDP

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fell from +3.5 percent before the recession to an average of +1.8 percent during it, and there were actual declines in 1974 and 1982. These changes in GDP were both a cause and a result of unemployment. Average annual unemployment rose from 4.7 percent before the recession to 7.5 percent during its course; but annual changes were small and the peak level of 9.7 percent was reached in 1982. What is clear from these figures (and the fuller data in Chapter 5), is that the recession of 1974–1983 was nowhere near the Great Depression in its severity. The 1982 unemployment peak of 9.7 percent was not of the same order of magnitude as the 24.9 percent that was suffered in 1933. There is also little support for the exaggerated view of stagflation held by many economists, even one as eminent as Friedman: “It seemed to take larger and larger doses of inflation to keep down the level of unemployment.”28 There was in fact no upward progression (“larger and larger doses”) of either inflation or unemployment. They both moved in a relatively random fashion. As explained, the annual increases in the cost of oil and the consequent inflation caused the Federal Reserve to increase the interest rate in order to restrict the money supply, and also encouraged the Ford administration to hold back government expenditure. This policy had some success in preventing the economy from degenerating too far. The fact that other countries suffered greater damage from the oil price shock demonstrated that the Keynesian remedies that were applied in the United States managed to prevent a bad situation from getting worse. The problem was that no one yet had wide experience of the sensitivity of response of the dependent variables, inflation and national income, to changes in the independent variable, the rate of interest. The policy was flawed in its execution, but the results were far short of disastrous. By the time the price of oil surged upward again, in 2005, the Federal Reserve had moved higher along the learning curve. As a result it has been strikingly successful in steering the economy along the narrow path between two perils: inflation (with its overall illeffects) and deflation (with its dangers to the preservation and growth of the GDP). Stagflation became a particularly alarming problem in Britain, where inflation triggered dangerously high wage demands from trade unions whose power at the time was unfettered: “By 1975 . . . demands for wage increases of no less than 30 per cent were not uncommon.”29 These were crisis years for the reigning Labour Party government, whose main support actually came from the trade unions. The political and economic atmosphere was not one that encouraged fiscal stringency. It took a change of administration, with Margaret Thatcher as prime minister, to reduce the power of trade unions and consequently modify their influence on wages. Stagflation in Britain was far worse than in the United States, because there was less “give” in the British labor market; there was much more flexibility in the United States.

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The American economy was in any event restored to health during the 1980s as a result of governmental fiscal policy that was totally Keynesian in its effect (although this was not its explicit intention). The technique was budget deficits representing gigantic dollar sums to fund expenditure on armaments. The fiscal deficit reached $290 billion in 1992 to finance a defense expenditure of $298 billion: a higher sum than had been incurred even at the height of the Vietnam War. And the increased demand did not push the economy to the limits of capacity, because the average rate of inflation for the eight years 1984–1991 came down to 4.0 percent. These facts provide a robust endorsement of Keynesian policies and reveal the fallacy of the widely expressed criticism that inflation is built into his prescriptions, “because of the inflationary bias in the politicians’ fondness for public spending and deficits rather than for taxation and budgetary surpluses.”30 The defense expenditures of the Reagan era had the astonishing effects of ending the Cold War and restoring the American economy. And they quite obviously rehabilitated Keynes, although by that time many economists had dug themselves into deep trenches at the other side of no-man’s land, or at least half way across it, and were unable or unwilling to abandon them. The years after 1945, and especially the more difficult economic conditions of the 1970s, led to the birth of different schools of economic thought: schools often referred to as the “New Classical,” “Gradualist Monetarist,” “Moderate Keynesian” and “Extreme Keynesian.” These differ essentially on their estimates of how quickly the economy adjusts to changes: from very quickly at the “New Classical” end of the continuum to very slowly at the opposite extreme. And only the “Moderate Keynesians” and the minority of “Extreme Keynesians” see any value in demand management, the policy that lay at the heart of Keynes’s doctrines.31 This book does not reflect the thinking of any of these schools. As explained, it is devoted exclusively to examining Keynes’s theories in action. There is today much emphasis on the long term and what this means for economic growth. Keynes himself was apprehensive about long-term stagnation resulting from a falling yield from capital assets that would reduce investment demand, accompanied by a rising propensity to save that would slow the growth in consumer demand. As a consequence of the psychological uncertainties that govern demand, he was reluctant to formulate any rationally based theory covering the long term. One of his best-known aphorisms was: “In the long run we are all dead.”32 The General Theory focused on a relatively short period. The book was concerned with equilibrium at less than full employment, and the remedies propounded meant a fairly quick reaction within the economy to changes in the rate of interest and in the volume of government expenditure. Economic problems since the end of World War Two are different from those faced by Keynes, because the economic horrors of the 1920s and 1930s have not reappeared. Keynes had a good deal to do with this. Today’s problems are less urgent than those confronted by Keynes, and are concerned with broader social problems than unemployment alone:

Keynes’s legacy, 70 years later

19

There is in fact an obvious disagreement between first-generation and second-generation Keynesians on the issue of the importance of economic growth, reflecting a basic difference between aristocratic and democratic attitudes to the desire of the lower order for improvement in their material standard of life.33 This paragraph is sharply pointed because the word “aristocratic” refers to Keynes. The words were written by the engaging and perceptive Canadian economist Harry Johnson. And like all economists who made their reputation during the prosperous years after World War Two, much of his work focused on the way the vast increases in wealth had transformed the living standard of the mass of the population. Maintaining the impetus of this growth remains a leading – often the leading – objective of modern economists. The world before the war was totally different and Keynes cannot be faulted for concentrating on the intractable troubles of his time, because solving them had to be a precondition for any future progress. The long term was not on Keynes’s agenda because all his time and energy were needed to solve the crushing problems of the short term. Today’s problems of maintaining growth are often treated as essentially technical, and there are so many variables that are considered to influence growth that mathematical models are usually used to identify the independent variables that govern it, and to quantify their relative importance. The concepts and the language of modern macroeconomists – mostly the language of algebraic symbols – are therefore meant for their fellow acolytes who have been baptized into the same mysteries. An important difference between Keynes himself and later economists who accepted his doctrines with varying degrees of agreement or disagreement is that Keynes confined his most sophisticated and complex arguments to debates with fellow economists. But his activities went much beyond such debates. In the words of Jock Colville, an insider at the highest level of the British government, Keynes’s writing was considered “pungent and comprehensible to the inexpert.”34 Keynes’s nontechnical writing was directed at demonstrating the totally practical value of his thinking: We even get occasional flashes of this in the General Theory. It was Keynes’s effective way of speaking both to political leaders and to a mass audience that distinguished him from all other economists before or since: The style of Keynes is at its best not in his theoretical work but when he writes on economic policy. His power to reduce an analysis to its essentials, to give concrete shape to abstract considerations so that you feel you can touch and hold them is superb. He gives his best when he tries to speak to the general public.35 His writing was ignited by his burning belief that theory should lead to public policy and that public policy really matters to society. His doctrines had a greater practical impact on the management of the economy than those of any

20

Keynes’s legacy, 70 years later

other economist, despite a great deal of relentless opposition from many influential figures: opposition that Keynes confronted immediately and directly. His unique combination of brains, focus, drive and intellectual toughness insured that his ideas were acted on by top political decision-makers, and this is why he developed such an enormous worldwide reputation. The extent of Keynes’s influence was noted with elegant understatement by John Kenneth Galbraith, one of the first of his American disciples: “Conservatives worry about universities being centers of disquieting innovation. Their worries may be exaggerated but it has occurred.”36 The work of the generations of economists who followed Keynes has been so prolific that many students of macroeconomics try and learn about theoretical extensions of Keynes’s work without learning about Keynes’s doctrines first. They are therefore handicapped, and this book is intended to help those of them who are intimidated by the General Theory itself. Also, as stated earlier, I am trying to take a further step by examining the extent to which Keynes’s policy prescriptions were beneficial to the American economy during the latter half of the twentieth century. Because of the success of these prescriptions, if for no other reason, Keynes’s own work – unmodified by later interpretations – deserves to be studied seriously.

An education in economics In my youth I studied economics and took the Tripos: the Honours Degree and for the vast majority of students the terminal qualification awarded by Cambridge University. (Surprisingly, Keynes did not study for this Tripos. He was a mathematician, and only studied economics for a few months under Marshall before he became a much cleverer economist than most.) I studied under a number of Keynes’s closest friends and followers and others who knew him but were less enthusiastic about his work.37 These people gave me insights that have been particularly valuable for this book. By profession, I am an applied economist and market researcher with long professional experience, mainly devoted to studying consumer behavior. For half my career I worked with advertisers engaged in influencing this. The other half has been spent at Syracuse University where, with the cooperation of a number of outside research companies, I have helped to develop some empirically based devices to measure consumer demand and in particular to evaluate advertising’s (often inadequate) ability to boost it. In these activities I have relied daily on the intellectual apparatus I acquired as an undergraduate, but my work as a market researcher has of course also contributed to my ambition to test Keynes’s theories empirically. This is what this book is all about.

Notes 1 This point was always expressed by Keynes and his disciples. Joan Robinson, one of his most productive followers, was a vigorously engaging speaker who conducted her university lectures like debates. I remember her asking a large audience their views of

Keynes’s legacy, 70 years later

2 3

4

5

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

21

the major problem confronting the capitalist system. We had all been programmed to understand and appreciate Keynes’s doctrines and the reply we gave was “secular unemployment.” On the contrary, said Joan Robinson, the problem was inflation. This was during the 1950s. Her explanation of how inflation occurs will appear in Chapter 3. Her view on postwar inflation echoed Keynes’s own: “. . . he was now convinced that the problem of the post-war world was going to be dealing with inflation.” Robert P. Bremner, Chairman of the Fed: William McChesney Martin Jr. and the Creation of the Modern American Financial System, New Haven, CT: Yale University Press, 2004, p. 229. Albert Einstein is supposed to have claimed that a person’s common sense is the sum of the prejudices that he or she had acquired before the age of 18. Anon., “Circles of Friends,” The Economist, October 2, 2004, p. 79. Robert Skidelsky, John Maynard Keynes, Vol. 2: The Economist as Saviour, 1920–1937, London: Macmillan, 1992, p. 74. I am most grateful to a prominent philosopher, Professor Samuel Gorovitz of Syracuse University, for a number of perceptive comments on this chapter, especially on Keynes’s philosophical approach to economics. John Maynard Keynes, The General Theory of Employment, Interest and Money, New York: Harcourt Brace Jovanovich, 1964, pp. 37–40. Each chapter in my book contains references to points in the General Theory. These references are supported by endnotes which detail the relevant pages in the General Theory, but it is superfluous to repeat the publication data. Good although limited data were available during the 1920s and 1930s. See for instance J.R. Hicks, The Social Framework, Oxford, UK: Oxford University Press, 1942; also Lionel Robbins, The Great Depression, London: Macmillan, 1934. For guidance on Keynes’s use of data, and also for other valuable observations on this chapter, I am very grateful to Professor Jerry Evensky of Syracuse University, a prominent specialist in the history of economic thought. Keynes, General Theory, p. 332. Skidelsky, John Maynard Keynes, Vol. 2, p. 106. John Maynard Keynes, Essays in Biography, London: Macmillan, 1933, p. 117. Skidelsky, John Maynard Keynes, Vol. 2, p. 519. William G. Perry, Jr., “Examsmanship and the Liberal Arts,” in Persuasive Writing, Karl Zender and Linda Morris (eds), New York: Harcourt Brace Jovanovich, 1981, pp. 170–180. Colin McDonald, “Myths, Evidence and Evaluation,” Admap, November 1980, pp. 546–555. Keynes, General Theory, p. 298. J.R. Hicks, “Mr. Keynes and the ‘Classics’; a Suggested Interpretation,” Econometrica, 1937, pp. 147–159. Adam Smith, The Wealth of Nations (first four books), New York: Alfred A. Knopf – Everyman’s Library, 1991, p. 399. With the exception of his last major book, Industry and Trade, published in 1919 when Marshall was in his late seventies, and certainly past his best. Keynes, General Theory, p. 19. “Economic and Financial Indicators,” Economist, January 6, 2007, p. 81. Smith, The Wealth of Nations, p. 15. Keynes, General Theory, p. 55. See for instance Anon., “Unilever: Path to No Growth,” Economist, September 25, 2004; also Jack Neff, “Unilever, C-P spend even as they warn,” Advertising Age, September 27, 2004, pp. 1 and 78. John Philip Jones and Jan S. Slater, What’s In a Name? Advertising and the Concept of Brands, 2nd Edition, Armonk, NY: M.E. Sharpe, 2003, pp. 67–69. Keynes, General Theory, pp. 158–163.

22

Keynes’s legacy, 70 years later

23 Skidelsky, John Maynard Keynes, Vol. 2, pp. 524–525. 24 Milton Friedman and Anna Jacobson Schwartz, for the National Bureau of Economic Research, A Monetary History of the United States, 1867–1960, Princeton, NJ: Princeton University Press, 1963 and 1971, pp. 612, 620–638; Bremner, Chairman of the Fed, p. 241. 25 Robert Skidelsky, John Maynard Keynes, Vol. 3: Fighting for Britain, 1937–1946, London: Macmillan, 2000, pp. 505–506. 26 Joan Robinson with Frank Wilkinson, “Ideology and Logic,” in Keynes’s Relevance Today, Fausto Vicarelli (ed.), London: Macmillan, 1985, p. 98. 27 Supporting data can be found in Chapter 2 (Tables 2.3 and 2.6), and Chapter 5 (Tables 5.1, 5.2, 5.3 and 5.12). 28 Kurt R. Leube (ed.), The Essence of Friedman, Stanford, CA: Hoover Institution Press, 1987, p. 366. 29 Susan Howson (ed.), The Collected Papers of James Meade,Vol. 1: Employment and Inflation, London: Unwin Hyman, 1988, p. 365. Also Gottfried Haberler, The Problem of Stagflation, Washington, DC: American Enterprise Institute for Public Policy Research, 1985, pp. 46–47. 30 Charles H. Hession, John Maynard Keynes. A Personal Biography of the Man Who Revolutionized Capitalism and the Way We Live, New York: Macmillan, 1984, p. 73. 31 Ric Holt, “What is Post Keynesian Economics?” http://cc.shu.edu.tw/twungwu/holt.htm. Also David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, London: The McGraw-Hill Companies, 2000, pp. 541–545. I am very grateful to Professor Emeritus Jerry Miner of Syracuse University for valuable comments on this and other parts of this chapter. Jerry Miner spent a great deal of time bringing me up-to-date with the many and complex developments in macroeconomic analysis since Keynes’s death. Although I am now au fait with the most important developments, the only ones discussed in this book are the concept of stagflation, which appears in this chapter, and the work of Hicks and Phillips, described in Chapter 5. Let me reiterate that my main focus in this book is on Keynes’s own work and not the extensions of his doctrines by other analysts. 32 John Maynard Keynes, “A Tract on Monetary Reform,” 1924, The Collected Writings of John Maynard Keynes, Vol. IV, Austin Robinson and Donald Moggridge (eds), London: Macmillan, 1971, p. 65. 33 Elizabeth S. Johnson and Harry G. Johnson, The Shadow of Keynes. Understanding Keynes, Cambridge and Keynesian Economics, Chicago: University of Chicago Press, 1978, p. 218. 34 John Colville, The Fringes of Power. Downing Street Diaries, 1939–1955, London: Hodder & Stoughton, 1985, p. 353. 35 Josef Steindl, “J. M. Keynes: Society and the Economist,” in Keynes’s Relevance Today, Fausto Vicarelli (ed.), London: Macmillan, 1985, p. 109. 36 John Kenneth Galbraith, Economics, Peace and Laughter, Harmondsworth, Middlesex, UK: Penguin Books, 1979, p. 40. 37 I studied under three of Keynes’s closest and most devoted disciples: Joan Robinson, Nicholas Kaldor and Richard Kahn. I also knew Dennis Robertson, who throughout his life was on the closest terms with Keynes, although they differed substantially in their beliefs about economics. Robertson eventually took over the running of the Political Economy Club, which at that time met on Monday evenings in Robertson’s own rooms (as it had met earlier in Keynes’s). The purpose of the club was to read and discuss papers written by students on various wide-ranging aspects of economics. Its members were the Cambridge University economics faculty (whether or not they were sympathetic with Keynes’s views), plus a handful of selected graduate and undergraduate students, who drew lots to comment on the papers. It was an intimate and rather intimidating organization, and it had been very close to Keynes’s heart. He read a paper to the Political Economy Club a few months before his death in 1946.

Keynes’s legacy, 70 years later

23

This was the only occasion on which the talented Canadian Harry Johnson met Keynes, and his description of the paper read by the dying Keynes is memorable because it recorded his last appearance at the Political Economy Club, and probably his last participation in any Cambridge University activity: “He gave a very elegant talk, beautifully constructed, every sentence a piece of good English prose and every paragraph cadenced – just a wonderful performance.” (See Johnson and Johnson, The Shadow of Keynes, p. 133.) Note that Johnson talked about Keynes’s speaking style rather than the content of his paper. This provides a hint that Johnson, even as a student, was not totally comfortable with Keynesian doctrines as they were followed at Cambridge by the most influential members of the faculty, notably Richard Kahn, Joan Robinson and Nicholas Kaldor, who had a left-wing political agenda. As a member of this club, I rubbed shoulders with many of the legendary figures in economics from both inside and outside Cambridge, and I feel privileged to have done so. They included Harry Johnson, who in my day was a young don at King’s but was soon to leave Cambridge and become a follower of Milton Friedman.

2

Three signposts

Authors do not always follow the most obvious rule: “Begin at the beginning, and go on till you come to the end: then stop.” (This advice comes from Lewis Carroll, the Victorian clergyman who wrote Alice’s Adventures in Wonderland.) In particular, writers on macroeconomics tend to stray from this wise counsel by fast-forwarding to advanced and complex concepts (of which there is no shortage). Then, basing their descriptions on mathematics rather than on verbal logic, such writers construct models adorned with hypothetical numbers. These models are the framework used to give quantitative values to the models’ individual components and – even more importantly – to show the connections between them. Modern macroeconomists write the way they do for two reasons. First, they assume that their readers will already know something about the basic concepts of economics; second, the point already made that there are connections between the various elements from which the models are built. All economic models provide a picture of the world frozen in time, and the various elements of each model are stable and in balance: in a state of equilibrium (a word borrowed from the natural sciences). Models are usually illustrated with diagrams, and are in equilibrium at the location on the diagram where the curves representing different forces intersect. A simple example will be used here and illustrated in Figure 2.1. This example is the most basic of all microeconomic models: price determination in a single industry, in which equilibrium represents the point at which the quantity of goods demanded matches the quantity supplied. This is at the crossing point of the two curves, falling demand (D) and rising supply (S). The initial price is shown as P1. Equilibrium operates as a lodestone: an attractive force. Our example describes two separate forces, demand and supply, but an immediate imbalance can occur: Demand can exceed or fall short of supply, and supply can exceed or fall short of demand. An increase in demand for the products of a single industry (e.g. following a big reduction in direct taxation) causes price to rise: the demand curve in the diagram shifting bodily to the right (from D1 to D2). This higher price attracts an increase in supply, shown by a movement up the existing supply schedule. This movement occurs because the higher ruling price will encourage existing manufacturers to work overtime, and higher-cost producers

Three signposts

D1

25

S1

D2

S2

Price

P2 P1

P3

Output

Figure 2.1 How price is determined in a single industry.

to come into the market. The response of supply is usually rapid. The new price is shown as P2. Although equilibrium is universally accepted as an analytical device, equilibrium itself is rarely achieved. Supply can respond to changes in demand and demand can respond to changes in supply, but before equilibrium is reached further changes can supervene. These generate more flux that impedes, or at least postpones, the initial attraction toward equilibrium. Despite the fact that the final result is often indeterminate, the internal forces of the market will always be drawing the system toward stability. Economists are reluctant to make guesses of the time needed to reach equilibrium after any market disturbance, because it is impossible to generalize. The process has been neatly described as “comparative statics,” with an evolution resembling “a show of photographic slides.”1 The images of a changing market captured as a series of photographic slides reveal unerringly how changes will work themselves out. Although the assumptions on which models are based may be essentially correct, they often need a good deal more careful verbal explanation than they normally receive. When the models incorporate hypothetical estimates of quantities, is the precision with which they are presented fully justified empirically? Real forces may be fuzzy.

26

Three signposts

volatile and not too easy to understand. I believe that these uncertainties help us to understand why Keynes followed the tradition of British economists and described his doctrines by using extended verbal argument. This practice does not make for easy reading, but I believe instinctively that Keynes touches reality. Logic provided the building blocks for the General Theory. The changes and readjustments described so far are always defined as short-term movements. Keynes was concerned essentially with the short term, so that his time span includes the period taken for market forces to respond to initial changes (price moving from P1 to P2 in Figure 2.1). Keynes accepted that most individual markets have self-correcting mechanisms, but the whole point of the General Theory is that a shortfall in aggregate demand is not self-correcting (unlike the demand for the products of an individual firm). For the economy as a whole equilibrium can be achieved at less than full employment of labor and capital. Even when the short term mutates into the long term, no correcting forces spontaneously appear. The market can of course change in the long as well as the short term, and this can be explained with our original example of a single industry in Figure 2.1. An increase in demand will cause prices to rise and draw out increased supply in the way already described, but the second and higher equilibrium price P2 is likely to cause new and more efficient systems of production to be invented and put to work, and this takes time. This process is expressed by a bodily shift of the supply schedule to the right (from S1 to S2). The eventual result is a third equilibrium, producing greater supply than before and a reduction in price, to P3, below the second (and often also below the first) equilibrium.2 The analysis of John Hicks, whose 1937 paper is mentioned briefly in Chapter 1, is often used as the starting point for modern works on macroeconomic principles. His concepts are complicated and not easy to grasp, although they are pregnant with meaning. Hicks described mathematically the two elements he considered of cardinal importance in the General Theory: the rate of interest and the national income. His model is based on two schedules, which later became known as the Investment/Saving (IS) curve, and the Money Market Equilibrium (LM) curve. The relationships between the rate of interest and the national income are much more subtle than they appear at first glance. Each of the two curves separately describes a range of states of equilibrium; and where the two curves intersect can be described as a position of ultimate stability. Hicks’s model encompasses eight different variables within the framework of a single diagram, which has of course only two dimensions. This is a considerable feat of intellectual dexterity. The reader will be confronted with Hicks’s analysis in Chapter 5, which is devoted to the rate of interest. Despite the temptation to follow the lead of most macroeconomists and start with Hicks, I prefer to be guided by Lewis Carroll. Keynes pursued a relatively direct path in his writing, despite the compression and abstraction of his arguments.He was also therefore a follower of Lewis Carroll (and this was even more true of Dennis Robertson, who was a devoted reader of Alice). I now turn to my first three measures of economic activity: what I call “the three signposts.” These are aggregate demand; output; and employment and

Three signposts

27

unemployment. The paths leading from these signposts overlap, e.g. decreases in aggregate demand create unemployment, and increases in unemployment reduce aggregate demand. Anticipating such complications, the best place to start is with the most pressing problem addressed by Keynes, mass unemployment.

Fault lines in the American economy In 1933, almost 13 million Americans were out of work: just under one-quarter of the labor force. And the number was at least eight million every year from 1930 to 1940, with the exception of a period of a year starting in December 1936. In 1933, the volume of output in the United States was one-third less than in 1929, the year of the Wall Street Crash; and the 1929 level was only regained in 1937, after which it dropped again.3 No single year since the end of World War Two has come close to any of the years of the 1930s in their depth of economic despair. And even during the relatively depressed decade 1974 through 1983, U.S. unemployment was at an average of 7.5 percent, which, although high, was much less intolerable than the unemployment that the country had suffered through the course of the 1930s. Nevertheless, the United States has developed four semipermanent fault lines since the end of World War Two. First, there is inflation, which has been continuous although mostly fairly low. Only for 12 years (1970 through 1981) did it become serious enough to cause distortions in the economy and hardship to people living on fixed incomes, but the erosion in the value of money (the definition of inflation) was far short of what had happened in Germany during the 1920s, or even of the conditions endemic in many Latin-American countries today. Second, there has been considerable change in the structure of American business. Manufacture has declined and service industries have increased in importance. Large numbers of the population have moved from the rustbelt to the sunbelt. And skilled service jobs have moved overseas. Generally speaking, the American economy has shown its traditional resilience, although a price has been paid in frictional unemployment: unemployment caused by the decline of old industries and the slowness of new industries to absorb the unemployed workers. The third problem is that the United States traditionally imports more than it exports, and since 1998 the balance has become exceptionally and progressively negative. The country is a net importer of oil: a commodity used in all industries, which means that increased oil prices have a “knock-on” effect. A consequence of the imbalance of imports over exports has been a fall in the exchange value of the dollar. This is something that offers advantages as well as disadvantages, although it means that the price of all imports – including raw materials – goes up. Americans now feel much less rich than they used to when they travel abroad. The fourth affliction is that, during recent years, the deficit in the federal budget has reached colossal proportions, even bearing in mind the great wealth of the United States. This deficit has been caused to a large degree by tax

28

Three signposts

reductions. The situation is stubbornly persisting, with dangers for the future of the economy which are as yet not clearly understood. The present Republican administration hopes that tax reductions will stimulate substantial growth, which will generate increased tax revenues that will in turn reduce the deficit. (This may sound utopian, but it has actually happened before.) All these phenomena are territories marked on Keynes’s big macroeconomic map. In this book I shall try and describe why unemployment has proven a far less serious problem than during the 1930s. There is no obvious single explanation for this. The overarching factor is business confidence: a culture of positive expectations since World War Two that has rarely weakened and never withered. (This point will be picked up in Chapter 7.) There has also been the positive influence of government investment: an unconsciously Keynesian strategy that was carried out for broad policy objectives unconnected with any intention to compensate for a softening of aggregate demand.

A half-century of aggregate demand and output Our first two signposts, demand and output, will now be described from a historical point of view, reviewing 51 years in the American economy, 1950 through 2000. To simplify the analysis, I have looked at the figures at five- or ten-year intervals. (See Tables 2.1, 2.2, 2.5 and 2.8.) I have also examined in more detail a shorter period, the 35 years, 1968 through 2002, and here I have calculated year-on-year increases and decreases. (See Tables 2.3, 2.4, 2.6 and 2.7.) The second half of the twentieth century provides a meaty quantity of data, and this period is also long enough to illustrate different levels of economic activity (although nothing approaching the swings that occurred between the two World Wars). All the information in the tables comes from the best of the available sources, the U.S. Census Bureau, and was published in the various annual editions of the Statistical Abstract of the United States.4 The figures are highly robust, and differences as small as a single percentage point or less are significant. As discussed in Chapter 1, aggregate demand represents the total demand for personal consumption and also for investment. The official statistics quantify these items in the simplest way possible. Remembering that demand is the result of the intention and the ability to buy or to invest, it can be measured by the money actually spent. Consumer demand is measured by estimates of personal consumer expenditure. This includes the demand for home-produced products and also for imports, which do not stimulate employment at home (at least directly). Traditionally this has not generated many problems for the United States. However, during the past 20 years, and the past ten years in particular, the overseas trade balance (i.e. imports minus exports) has become unfavorable and is getting worse. Investment demand is measured by estimates of actual gross private domestic investment (which covers spending on capital goods: the large amount of nonresidential spending plus the smaller amount of housingrelated expenditure).

Three signposts

29

The official data also include a third important component of total demand: government expenditure. This covers both consumption expenditure (e.g. the regular supplies of goods that are used up more or less as they are issued, like army rations and ammunition) and a wide range of investment expenditure: everything from military weapons to government offices to highways. (As will be explained in Chapter 6, the figures of U.S. government expenditure actually understate reality, which means that they must be treated cautiously.) Keynes did not isolate government expenditure as a component of effective demand, but we can assume that he would have added government consumption to private consumption, and government investment to private investment. The additional analysis in the official figures is worth having as a separate item. In the official statistics, the total of personal consumption expenditure, gross private domestic investment and government expenditure accounts for the lion’s share of national income. This is a portmanteau phrase to describe the wealth created by a National Economy in any given year. More precise measures, which add a figure for estimated net exports (i.e. exports minus imports) are called Gross National Product (GNP) and Gross Domestic Product (GDP). There are technical differences between these two, but in any year the variation between them is rarely more than 1 percent, so that I generally use the figures from the two measures interchangeably.5 It is necessary to do this because the U.S. Census Bureau stopped using GNP in favor of GDP in 1991. For this reason, when I talk about the National Income in different periods, I must use the clumsy phrase GNP/GDP. Readers will see immediately that when we measure aggregate demand in terms of the value of production to satisfy that demand, demand and output are mirror images of one another. Keynes’s hypothesis that a deficiency in demand causes unemployment therefore means that this inadequacy produces two illeffects: on people who have no work and no wages, and also on the aggregate level of output. The aggregate level of output is the best (although not the only) indicator of the health of an economy. The first column in Table 2.1 does not take inflation into account. The third column, which is inflation proof and therefore provides a more realistic picture, shows a continuous upward progression in total demand/output over the 50-year period. The rate of growth was not uniform from each five-year period to the next, but the whole half-century shows an average compound rate of growth of more than 3 percent annually. Is this a lot or a little? To judge this question, we must bear in mind the enormous size of the American GDP. In comparison with the United States, a rapidly growing yet still undeveloped country like India has a GDP below $500 billion. And an annual growth rate of 6 percent (the minimum that India is achieving at the moment) means an annual addition of $30 billion: a sum within the compass of an economy that has a good deal of room for growth. But the United States has a GDP that is 20 times the size of India’s. A 6 percent increase in the American GDP would therefore mean an annual growth of about $590 billion: a sum larger than the total GDP of India.

30

Three signposts

Table 2.1 United States GNP/GDP, population and employment, 1950–2000 Year

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

GNP/GDP at current prices

GNP/GDP* at 2000 prices

Resident Employed civilian Unempopula- labor force ployment tion

$ Billion Index

$ Billion Index

Million

Million

Index

%

288 406 515 705 1,016 1,598 2,732 4,015 5,832 7,421 9,848*

1,841 2,259 2.541 3,191 3,824 4,241 5,239 6,112 7,171 8,064 9,826**

151.9 165.1 180.0 193.5 204.0 215.5 227.2 237.9 249.6 266.3 282.2

58.9 62.2 65.8 71.1 78.7 84.8 99.3 107.2 118.8 124.9 136.9

100 106 118 121 134 144 169 182 202 212 232

5.3 4.4 5.5 4.5 4.9 8.5 7.1 7.2 5.6 5.6 4.0

100 141 179 245 353 555 949 1,394 2,025 2,577 3,419

100 123 138 173 208 230 285 332 390 438 534

Notes GNP – Gross National Product. See endnote 4. GDP – Gross Domestic Product. See endnote 4. * GNP up to 1991; GDP in 1991 and subsequent years. ** The difference between these two figures is explained in endnote 4.

As an economy expands, a uniform percentage increase in GDP means a progressively larger sum when measured in absolute terms; and there comes a time when a percentage increase even as small as 2 percent or 3 percent means a boost in dollar value that becomes very difficult and eventually almost impossible to achieve. Huge new factories have to be opened to manufacture the extra goods. And the market for most consumer goods is anyway nearing saturation.6 If we consider these problems, the American compound annual increase of 3 percent over a 50-year period is a remarkable achievement. Many advanced economies smaller than the United States have achieved much less, despite the fact that, as in India, a large percentage increase would be practicable every year. America’s economic growth was mainly the result of productive efficiency, but it was also partly due to substantial immigration since the mid-1960s. Immigration had been a powerful driving force in the United States economy when it was growing at its fastest rate: during the latter part of the nineteenth century. The American economic performance is also remarkable for another reason: labor productivity. During the fifty-year period, the civilian population grew by 86 percent, partly because of natural growth and also to some extent because of immigration, but the civilian labor force more than doubled, growing in fact by 132 percent. The increase in the proportion of the population at work was the outcome of more women and more part-time workers coming into the labor force. Since the GNP/GDP has gone up more than five times in real terms – far more than the growth in the civilian labor force – the output per worker has pro-

Three signposts

31

gressively increased. In 2002, this was 130 percent higher than in 1950. (See Table 2.2.) This outcome was the classic result of economies of scale, especially those derived from increased capital resources and improved systems, notably the development of information technology. In all events, such growth – with its obvious implications for the increase in personal incomes – is another sign of a healthy economy. But the economy did not develop at an even rate. Table 2.3 shows a rocky journey during the years 1974 through 1983, during which there was an actual decline in GNP/GDP in four separate years. Average growth over the decade fell below the traditional compound average of 3 percent annually, and average unemployment shot up to 7.5 percent (and remained high during 1984, 1985 and 1986, when recovery was under way). The years before 1974 demonstrated relatively steady growth, which was resumed in 1984. In between there was a decade of recession, although this could not be compared with what had happened during the period between the two World Wars. The most obvious cause of the trouble was the sharp increase in oil prices after 1973, that led to economic problems worldwide because it triggered a sharp boost in inflation through its effect on the production costs of all types of goods manufactured all over the world. Inflation tends to depress aggregate demand since prices always increase ahead of incomes. The years before 1974 were characterized by an unprecedented period of growth and prosperity that started at the end of World War Two: a total of 28 years. After 1983, there was a further period of good GDP growth that lasted for 19 years (although there was a good deal of stubborn unemployment which did not fall until the late 1990s). The recession therefore represented a ten-year hiatus between two much longer periods of strong income growth. There were no regular and evenly spaced booms and busts. Recession was merely a protracted pause in a generally expanding total economy.

Table 2.2 United States labor productivity, 1950–2000 Year

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

GNP/GDP at 2000 prices per employed civilian worker $

Index

31,260 36,320 38,620 44,880 48,590 50,010 52,760 57,010 60,360 64,560 71,780

100 116 124 144 155 160 169 182 193 207 230

32

Three signposts In summary: • Over the second half of the twentieth century, the American economy grew at an inflation-proof compound rate of more than 3 percent annually. This is a remarkable rate of increase bearing in mind the large size of the American economy; the larger an economy becomes, the more difficult it is to maintain a uniform percentage rate of expansion. • Net immigration and improved output per worker have contributed significantly to this economic growth. Higher per capita productivity is an unambiguous indication of increased economic efficiency. • Growth has been uneven. The depression of the decade 1974 through 1983 was a clear setback, but was small in comparison with the Great Depression of the 1930s.

The third signpost – employment and unemployment We are concerned here with the unemployment during the recession. Was the increase in unemployment from 1974 through 1986 a strictly cyclical phenomenon (defined in Chapter 1)? Or were there secular forces at work to prolong it? Finally, is there any evidence of the long-term involuntary unemployment that Keynes addressed in the General Theory? This chapter will look at these complex relationships, but it is merely a beginning of the discussion of them in this book. Table 2.3 measures employment and unemployment separately, using slightly different statistical devices. Employment is measured by the actual numbers of the civilian working population who were employed at the time; in 2002, the number was 136.5 million people. The unemployment figures are expressed as a percentage of the civilian working population; this was 5.8 percent in 2002 (the employed proportion making up the remaining 94.2 percent). I am using the two different measures because they help us explore different ways in which aggregate demand affects unemployment. The absolute employment figures moved slowly upward over the period 1968 through 2002, with only four small setbacks. This trend reflected the gradual growth in the GNP/GDP, since the rise in employment was a long-term, strategic response to the increases in consumer demand. In contrast, the unemployment percentages were more volatile, moving rather erratically within the range of 3.5 percent to 9.7 percent. These fluctuations represented tactical responses to flickers in aggregate demand: a short-term reduction in demand leading to an increase in unemployment, and an increase in demand causing a reduction. These variations represented zig-zags on either side of a long-term upward trend line. Table 2.3 throws light on the relationship between changes in GNP/GDP and changes in unemployment. During 29 of the 35 years we are looking at, the expected relationship held, with reductions in GNP/GDP having a negative

Three signposts

33

Table 2.3 United States – changes in GNP/GDP and employment, 1968–2002 Year

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

GNP/GDP at constant prices

Employed civilian labor force

Unemployment

Year-on-year change (%)

Million

Year-on% year change (%)

Year-onyear change (percentage points)

+4.7 +2.7 0.5 +2.7 +6.1 +5.5 1.7 1.8 +5.3 +5.5 +4.7 +3.2 0.2 +1.9 2.5 +3.6 +6.8 +3.4 +2.8 +3.4 +3.9 +2.5 +1.8 0.5 +3.0 +2.7 +4.0 +2.7 +3.6 +4.4 +4.3 +4.1 +3.8 +0.3 +2.4

75.9 77.9 78.6 79.1 81.7 84.4 85.9 84.8 87.5 90.5 94.4 96.9 99.3 100.4 99.5 100.8 105.0 107.2 109.6 112.4 115.0 117.3 118.8 117.7 118.5 120.3 123.1 124.9 126.7 129.6 131.5 133.5 136.9 136.9 136.5

+2.1 +2.6 +0.9 +0.6 +3.3 +3.3 +1.8 1.3 +3.2 +3.4 +4.3 +2.6 +2.5 +1.1 0.9 +1.3 +4.2 +2.1 +2.2 +2.6 +2.3 +2.0 +1.3 0.9 +0.7 +1.5 +2.3 +1.5 +1.4 +2.3 +1.5 +1.5 +2.5 n.c. 0.3

0.2* 0.1* +1.4* +1.0 0.3* 0.7* +0.7* +2.9* 0.8* 0.7* 1.0* 0.2* +1.3* +0.5 +2.1* 0.1* 2.1* 0.3* 0.2* 0.8* 0.7* 0.2* +0.3 +1.2* +0.7 0.6* 0.8* 0.5* 0.2* 0.5* 0.4* 0.3* 0.2* +0.7 +1.1

3.6 3.5 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.0 6.0 5.8 7.1 7.6 9.7 9.6 7.5 7.2 7.0 6.2 5.5 5.3 5.6 6.8 7.5 6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0 4.7 5.8

Notes * Years in which declines in GNP/GDP are accompanied by an increase in unemployment: or when increases in GNP/GDP are accompanied by a decline in unemployment. n.c. – no change.

34

Three signposts

effect by causing unemployment to rise, and with increases in the GNP/GDP having a positive effect by causing it to fall. This is what Keynes’s doctrines would lead us to expect. Table 2.4 averages the response of unemployment to changes in GNP/GDP. Two conclusions emerge from it, which are both compatible with Keynes’s doctrines: • •

Negative responses were much stronger than positive ones. Although the sample of negative responses is too small to examine different levels of reduction in the GNP/GDP, the sample of positive responses is bigger. Here there is a differential effect, with larger increases in the GNP/GDP triggering greater reductions in unemployment.

As explained earlier in this chapter, total demand is made up of personal consumption, private investment and government expenditure. Table 2.5 shows how this total was broken down over the course of the last half of the twentieth century. (Remember that personal consumption includes imports, which led to large trade imbalances during the 1990s and even before.) During this period, personal consumption accounted for a relatively steady two-thirds of the total. Private investment started with a share of 19 percent, then weakened before and during the recession of the late 1970s and early 1980s. The share of government expenditure (which was only 13 percent in 1950) increased when the share accounted for by private investment was falling. Then, during the recovery in the 1990s, private investment strengthened again and government expenditure weakened, but it should be remembered that the figures of U.S. government expenditure understate reality for reasons that will be explained in Chapter 6. In fact, there is good evidence that demand generated by government expenditure increased a good deal. Table 2.6 looks at the 35 years 1968 through 2002. It examines the year-byyear vicissitudes in the three elements on effective demand, and what influence these constant changes exercised on unemployment. Short-term movements of private consumption and government expenditure were relatively small. YearTable 2.4 United States – comparison between changes in GNP/GDP and changes in unemployment, 1968–2002 Year-by-year change in GNP/GDP (%)

Number of years

Average change in GNP/GDP (%)

Average change in unemployment (percentage points)

Negative Positive Less than +5.0 +5.0 or more

6 29

1.2 +3.6

+1.6 0.3

24 5

+3.2 +5.8

0.1 0.9

Note The figures in the last two columns can be expected to move in opposite directions.

Three signposts

35

Table 2.5 United States – the three main components of aggregate demand (based on GNP/GDP) 1950–2000 Year

Total of three items (%)

Personal Private consumption (%) investment (%)

Government expenditure (%)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

100 100 100 100 100 100 100 100 100 100 100

=67 =64 =65 =64 =63 =65 =63 =63 =65 =66 =66

=13 =19 =20 =20 =23 =20 =20 =20 =20 =18 =17

=19 =17 =15 =16 =14 =14 =17 =17 =15 =15 =17

by-year changes in private consumption range between the extremes of 1.2 percent and +6.2 percent; and the changes in government investment were in a similar range, from 1.2 percent to +6.1 percent (except for a freak figure of 4.5 percent in 1970). For private investment, the situation was different, with the variations ranging from 24.2 percent to +26.4 percent. These short-term changes, because they were so extreme, were important drivers of changes in unemployment: probably the single most important contribution. Keynes himself certainly thought private investment the most important one.7 Remember also the weakening of the share of private investment out of total demand before and during the period when the economy was experiencing its decade of recession. (See Table 2.5.) Table 2.7 examines in detail the relationship between changes in private investment and changes in unemployment. To make the data easier to interpret, I have ranked the annual changes in private investment from the most negative to the most positive. As we saw in Table 2.4, negative effects are much stronger than positive ones. Table 2.7 (which has a larger sample of negative effects than Table 2.4) shows that negative effects are clearly differential, with big reductions in private investment triggering substantial increases in unemployment. In contrast, increases in private investment generate weaker responses in reducing unemployment. With increases in private investment, there is some differential effect but this is not strong. What we see in brief is that a fall in aggregate demand produces a jolt in unemployment, while a rise generates only a muted effect. This demandunemployment trigger, stronger in the negative than in the positive direction, is one of the keys to understanding the effects of Keynesian policies. These findings certainly support Keynes’s contention that big reductions in investment demand are the major cause of unemployment. Remember also the conclusion

36

Three signposts

Table 2.6 United States – year-on-year changes in the three main components of aggregate demand (at constant prices) and unemployment, 1968–2002 Year

Personal consumption (%)

Private investment (%)

Government expenditure (%)

Unemployment year-on-year change (percentage points)

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

+5.2 +3.6 +1.8 +4.0 +6.2 +4.7 1.2 +1.4 +5.6 +4.9 +4.7 +2.9 0.1 +1.2 +1.1 +4.6 +4.8 +4.4 +3.6 +2.8 +3.6 +1.9 +1.2 0.1 +2.9 +3.4 +3.8 +3.0 +3.2 +3.6 +4.8 +4.9 +4.3 +2.5 +3.1

+4.4 +5.0 6.4 +7.4 +12.5 +10.5 12.1 24.2 +19.4 +15.7 +7.5 +1.3 11.2 +6.2 14.4 +10.9 +26.4 1.5 1.4 +1.9 +3.2 +2.0 5.7 9.5 +8.5 +8.7 +13.2 +3.0 +9.0 +12.1 +11.8 +6.6 +6.2 10.7 +1.0

+5.8 1.2 4.5 n.c. +2.7 +0.9 +1.2 +2.0 n.c. +1.9 +2.2 +1.4 +2.2 +1.3 +1.5 +2.8 +3.1 +6.1 +5.2 +3.1 +0.6 +1.5 +3.2 +0.9 +0.5 0.8 +0.1 +0.4 +1.1 +2.4 +1.9 +3.9 +2.7 +3.7 +4.4

0.2 0.1 +1.4 +1.0 0.3 0.7 +0.7 +2.9 0.8 0.7 1.0 0.2 +1.3 +0.5 +2.1 0.1 2.1 0.3 0.2 0.8 0.7 0.2 +0.3 +1.2 +0.7 0.6 0.8 0.5 0.2 0.5 0.4 0.3 0.2 +0.7 +1.1

Note n.c. – no change.

from Table 2.5 that the recession of the late 1970s and early 1980s was associated with a fall in the share of total demand accounted for by private investment. As stated earlier, increases in private or public investment do not have much effect in reducing unemployment. This was certainly true of American experience during the 1930s, when the (admittedly rather small) investment took

Three signposts

37

Table 2.7 United States – year-on-year changes in private investment (at constant prices) and unemployment, 1968–2002 Year

Change in private investment (%)

Change in unemployment (percentage points)

1975 1982 1974 1980 2001 1991 1970 1990 1985 1986 2002 1979 1987 1989 1995 1988 1968 1969 2000 1981 1999 1971 1978 1992 1993 1996 1973 1983 1998 1997 1972 1994 1977 1976 1984

24.2 14.4 12.1 11.2 10.7 9.5 6.4 5.7 1.5 1.4 +1.0 +1.3 +1.9 +2.0 +3.0 +3.2 +4.4 +5.0 +6.2 +6.2 +6.6 +7.4 +7.5 +8.5 +8.7 +9.0 +10.5 +10.9 +11.8 +12.1 +12.5 +13.2 +15.7 +19.4 +26.4

+2.9 +2.1 +0.7 +1.3 +0.7 +1.2 +1.4 +0.3 0.3 0.2 +1.1 0.2 0.8 0.2 0.5 0.7 0.2 0.1 0.2 +0.5 0.3 +1.0 1.0 +0.7 0.6 0.2 0.7 0.1 0.4 0.5 0.3 0.8 0.7 0.8 2.1

the form of public expenditure under the terms of the New Deal. This investment is reviewed in Chapter 6. An additional factor emphasizing the importance of private investment is that it is not only an important source of demand in its own right, but it also works through the economic system to boost personal incomes, which in turn increase consumer demand. The data in Table 2.6 are not refined enough to demonstrate this phenomenon, but the table does provide hints that increases in private consumption are connected with increases in private investment. The influence of

38

Three signposts

investment on personal incomes, described as the Multiplier, is discussed in Chapter 3. This interrelationship is an example of the intersecting paths to which Keynes’s signposts are pointing. In summary: • Total employment grew fairly steadily over the period 1968 through 2002, but the unemployment percentage was a more sensitive measure of economic vicissitudes. It represented temporary but often important flickers around an overall upward trend line. • In most individual years, changes in GNP/GDP and changes in employment were related, as predicted by Keynes. Reductions in GNP/GDP had a more dramatic effect in increasing unemployment than increases in GNP/GDP had in reducing it. The fall in the National Income was substantially the result of contractions in private investment.

Types of unemployment Four types of unemployment were identified in Chapter 1. To reprise how they were described: •

•

•

•

Cyclical unemployment occurs during the trough in the business cycle. It is a temporary state of affairs and employment will pick up when the economy improves. Frictional unemployment is the result of the decline of certain industries, because of the natural evolution of the economy. It makes itself felt because of the delay in new industries absorbing out-of-work people from old industries. Voluntary unemployment is caused by workers unwilling to take jobs at the ruling wage. The payment on offer is not enough to tempt workers to make the effort to work. Involuntary unemployment is due to a widespread loss of work, for whatever reason, including the decline of certain industries. Before Keynes, it was thought that the economic system would mobilize the purchasing power not used on consumption and generate new investment that would eventually absorb the people out of work. Keynes based his doctrines on the obvious fact that the economic system proved itself not to be self-correcting in this way during the 1930s. The serious endemic problem of involuntary unemployment can best be described as “structural” or, more vividly, as “Keynesian.”

In the United States the underlying level of unemployment during the first seven decades of the twentieth century was between 4 percent and 5 percent. This excludes exceptional periods: the Great Depression, World War Two and the

Three signposts

39

beginning of the postwar boom. The average figure for the 30 years 1900 to 1929 was 4.7 percent (although there was a good deal of variation from year to year).8 During the 1950s it was 4.5 percent, and during the 1960s, 4.8 percent. (Table 2.8.) During the decade of recession following the oil price shock, 1974 through 1983, the rise in unemployment was cyclical, at an average level of 7.5 percent. During this decade, government investment grew gradually every year, but there were declines in some years in both personal consumption and private investment (four big drops in the latter). In 1984 the GNP/GDP began to grow reasonably strongly, yet unemployment remained high: 7.5 percent in 1984, 7.2 percent in 1985 and 7.0 percent in 1986. (Table 2.3.) This is additional evidence that increases in demand (unlike reductions) have only a modest effect on unemployment. It was not until the late 1990s that unemployment came down to the underlying level of between 4 percent and 5 percent. A probable reason for this stickiness was the frictional effects of the changes that were taking place at the time in American business, in particular the shift to an information-based economy. The question that needs to be answered is whether the underlying level of 4 percent to 5 percent is higher than it needs to be. Does it contain an element of voluntary unemployment? This is caused partly by illegal immigration, and trade union wage bargains and even the legal minimum wage may result in workers pricing themselves out of employment. Even worse, is there an element of Keynesian unemployment, which means that the economy may be at equilibrium but working at below full capacity? This may be a real possibility but Keynes himself would probably not have accepted it. His own estimate of the bottom level to which unemployment would drop while remaining stable in the long term was 5 percent.9 To examine these questions we need to look at the factors that influence demand of all three types: personal consumption, private investment and government investment. The directions to which our signposts are pointing now begin to follow complicated paths. Chapter 3 and Chapter 4 discuss respectively consumer demand and investment demand. Government investment will be reviewed in Chapter 6, which is devoted to the long history of government attempts to stimulate aggregate demand by public investment.

Table 2.8 United States average unemployment per decade, 1950–1999 Years

Average annual rate of unemployment (%)

1950–1959 1960–1969 1970–1979 1980–1989 1990–1999

4.5 4.8 6.2 7.3 5.8

40

Three signposts In summary: • The underlying long-term rate of unemployment in the United States is a little under 5 percent. • During the depression of the decade beginning in 1974 there was a cyclical increase, to 7.5 percent, and it remained at a high level through 1987. By the late 1990s it came down to its underlying level of between 4 percent and 5 percent. • Keynes considered 5 percent to be the expected stable long-term level of unemployment, but this could possibly contain an element (at least) of involuntary unemployment. The optimum figure may be well below 5 percent.

Notes 1 Robert J.Gordon, Macroeconomics, 4th Edition. Boston: Little Brown, 1987, p. 169. 2 For a real-world example of short- and long-term adjustments of demand and supply, based on the market for California avocados, see John Philip Jones, How Much is Enough? Getting the Most from Your Advertising Dollar. New York: MacmillanLexington Books, 1992, pp. 309–313. 3 John Kenneth Galbraith, The Great Crash, 1929. Harmondsworth, Middlesex, UK: Penguin Books, 1954 and 1980, p. 186. 4 U.S. Department of Commerce, Statistical Abstract of the United States. Washington, DC: Economics and Statistics Administration, U.S. Census Bureau, published annually. In my writing, the National Income – the total annual output of goods and services – is described in the normal way, as the Gross National Product (GNP) and Gross Domestic Product (GDP). The differences between the two are minor, and are described by the U.S. Census Bureau as follows: Gross National Product measures the output attributable to all labor and property supplied by United States residents. GNP differs from national income mainly in that GNP includes allowances for depreciation and for indirect business taxes (sales and property taxes). Gross Domestic Product is the total output of goods and services produced by labor and property located in the United States, valued at market prices. GDP can be viewed in terms of the expenditure categories that comprise its major components – purchases of goods and services by consumers and government, gross private domestic investment, and net exports of goods and services. The goods and services included are largely those bought for final use (excluding illegal transactions) in the market economy. A number of inclusions, however, represent imputed values, the most important of which is rental value of owner-occupied housing. GDP, in this broad context, measures the output attributable to the factors of production located in the United States. In December 1991, the Bureau of Economic Analysis began featuring Gross Domestic Product rather that Gross National Produce as the primary measure of U.S. production. GDP is now the standard measure of growth because it is the appropriate measure for much of the short-term monitoring and analysis of the economy. In addition, the use of GDP facilitates comparisons of economic activity in the United States with that in other countries.

Three signposts

5

6 7 8

9

41

In Table 2.1, the 2000 figure of $9,848 billion under “GNP at current prices” is only 0.2 percent higher than the figure of $9,826 billion under “GDP at 2000 prices.” To avoid complications, I am using the two descriptions interchangeably. The U.S. Census Bureau calculates GNP (and during and after 1991, GDP) in terms of constant dollars, i.e. excluding the effects of inflation. These adjustments are made on the basis of careful weighting of the various components that add up to GNP/GDP. The problem is that the year used for the base period is changed every few years. In Table 2.1, I have myself extrapolated all the U.S. Census Bureau figures to provide a uniform series of estimates using 2000 as the base year. Ibid. Note also that, for many years, the volumes of the Statistical Abstract of the United States make small (mainly) upward adjustments in certain of the figures that had been published in earlier editions. As far as possible in this chapter I have used the most recently published figures. This problem was quantified as long ago as the 1980s. Jones, How Much is Enough?, pp. 22–27. Keynes, General Theory, pp. 313–315. Richard K. Vedder and Lowell E. Galloway, Out of Work. Unemployment and Government in Twentieth Century America. New York: New York University Press, 1997, p. 55. This book is unusual among studies of macroeconomics because it makes extensive use of hard data. Thomas Wilson, Churchill and the Prof. London: Cassell, 1995, p. 163.

3

Consumer demand and where it leads

Economics is the most mundane, although not the least important of the social sciences. It carries – or at least it should carry – a good deal of weight because of its influence both on public policy and on the individual strategies of business firms. Economics focuses on a firm’s profit, which is based in turn on its costs and the value of its sales. The most important decision influencing sales is whether the firm is in the business of making what it can sell, or alternatively whether it exists to sell what it is accustomed to making. The question is not easy to answer, and Toyota and General Motors (to pick two topical examples) are likely to answer it in different ways. Adam Smith would have said that success in a capitalist world depends on making what you can sell. And Keynes would have agreed. His mind was fixed relentlessly on demand, since the basic proposition of the General Theory is that aggregate demand is the fundamental economic driving force. This is what this chapter is all about. In the short term (where Keynes’s attention was focused) demand is composed of two parts: consumer demand and investment demand, and these together form the engine that produces employment. The overall level of employment drives the size of the national income (as illustrated in Figure 3.1), although the degree of influence of demand on employment and income depends on the economic infrastructure of a country: factors like the organization of industry, the quantity of capital employed, the amount of foreign trade and government fiscal and monetary policies. Differences of these types explain why business depression has different degrees of effect in different countries. The Great Depression hit the United States particularly hard because federal fiscal policy during the early 1930s was restrictive and was directed at balancing government expenditure and revenue. In the absence of any remedial policies, this caused demand to fall, thus making the ill-effects of depressed business even worse. Keynes wrote his book because he wanted to explain problems rather than dwell on the rosy prospects of economic progress. His aim was to address the strains on society caused by shortfalls below what employment and national income ought to be if the economic system were producing at its full potential. He understood that a weakening of employment and income both cast a blight.

Consumer demand and where it leads

Consumer demand

Multiplier

43

Investment demand

Aggregate demand

Employment

National income

Figure 3.1 Aggregate demand.

However, of the two, the loss of income is even more damaging than the psychological effects of loss of work. Unemployment is bad for the living standards of the unemployed, although social welfare schemes do something to compensate. It also corrodes their morale – something a number of people believe is more serious than loss of income – and this loss of morale gets progressively worse over time. The unemployed are, however, never more than a minority, although sometimes a substantial minority, of the population as a whole. On the other hand, a loss of national income is bad for everybody. It reduces the material comfort of many individuals, and it also shrinks the resources available for general benefits like education, health care and national defense – expenditures that are badly needed by society as a whole. The despair and fear caused by low and shrinking income are if anything worse than those caused by unemployment.

Connections This chapter focuses on consumer demand. Chapter 4 moves on to investment demand. The consumer and investment elements of aggregate demand are controlled substantially by different external forces. Of course Keynes’s doctrine is quite incomplete without a full consideration of investment demand. An

44

Consumer demand and where it leads

important complication is that consumer demand influences investment and investment influences consumer demand, in a mutual interaction that works at three levels. (These are suggested by the three dotted lines in Figure 3.1.) First, in equilibrium, private households are a source of investment funds. This is because consumers’ incomes are used for two separate purposes: consumption and saving, but saving is not equivalent to investment. This insight was one of Keynes’s most important discoveries.1 In all economically stable economies – as in all economically stable households – saving and investment must balance in the long term. Economists before Keynes assumed that this balance would be brought about automatically and quickly by movements in the rate of interest. They thought that an increase in saving would boost the supply of funds available for investment, reducing the rate of interest and in turn encouraging business people to invest. Keynes, conscious that this hypothesis failed to explain mass unemployment, provided a more subtle theory. If saving increases, then consumption goes down. This will inevitably reduce national income because even with low interest rates there will be no incentive to invest, so that investment will also come down. This will shrink aggregate income and reduce saving, so that investment and saving will become balanced again. On the other hand, an increase in investment will boost income, causing saving to increase to meet the extra investment. Despite this indirect connection between investment and saving, Keynes’s analysis does not contradict the basic idea that household incomes are one source of investment funds. This is a factor that provides a basic connection between consumer and investment demand. The second connection between investment and consumer demand is also subtle. The discovery was made by Keynes’s academic collaborator, Richard Kahn, also a Fellow of King’s College, Cambridge, and a member of the group of younger followers who became known as the “Cambridge Circus.” Kahn was a rather pessimistic bachelor who was referred to as “Keynes’s adjutant,” reflecting how their colleagues saw the large difference between the two men: the difference between the weight and authority of a commanding officer and the much more circumscribed weight and authority of his adjutant, a captain.2 In contrast to Keynes, Kahn’s published output was startlingly small. His reputation was based on a single article that appeared in the Economic Journal in 1931.3 (The Economic Journal is the leading British academic journal in the field and was for many years edited by Keynes.) Kahn’s insight was that capital investment generates consumer income because investment projects give work to wage earners. In turn these wage earners spend part of their incomes on goods and services provided by other workers, for which they receive wages and who in turn spend part of their income on further goods and services . . . and so the process continues in a continuous chain. If we attempt to aggregate the total personal consumption eventually generated by the original capital investment, we can see that the total increase in personal consumption is likely to be greater than – in fact a multiple of – the original investment; and the greater the propensity to consume (defined

Consumer demand and where it leads

45

below), the larger the eventual effect. This positive expansion of demand became known (appropriately enough) as the Investment Multiplier, and the principle applies to demand generated by both private and government investment. The third connection between consumer demand and investment demand follows from the working of the Investment Multiplier. The additional consumer income produced by the Multiplier in turn generates some increments of saving to add to the extra spending on personal consumption. This saving balances the increased investment. We should perhaps add a fourth long-term factor, which is purely a matter of presumption, a psychological factor. Investment is carried out because business people expect to make profits. Such expectations are driven directly by anticipations of consumer demand, so that high expected future levels of consumer demand will offer long-term returns to investment over future periods (and vice versa). Readers will remember that Chapter 2 discussed the year-by-year changes in private consumption and direct investment over the period 1968 through 2002. From the data in Table 2.6, it can be seen that these two types of expenditure moved in the same direction (plus-plus or minus-minus) for 28 of the 35 years covered. This demonstration of the connection between private consumption and private investment is unrefined, but we can certainly draw the simple conclusion that in most years they were related. In summary: • In equilibrium, consumer incomes are a source of investment funds; and this investment generates consumer income and demand. In turn this yields additional investment: a virtuous spiral when the figures are going up (but a vicious one when they are going down). • All the time investment decisions continue to be influenced by business people’s expectations of the state of future consumer demand.

The propensity to consume One feature of consumer demand is that, in contrast to investment demand, it is generated by large numbers of people, while it is satisfied by a much smaller number of suppliers. Each consumer accounts for only a small amount of purchasing; but each supplier usually delivers a large quantity of output (and employment). This circumstance means that to an individual entrepreneur an investment decision is a weighty matter and given the appropriate amount of consideration. However, it must not be thought that the process is totally, or even substantially, rational. Uncertainty and expectations are as important to business decisions as they are to personal ones. But what causes consumer demand? It is obviously based on people needing and wanting goods and services, but it also depends on their ability to pay: the

46

Consumer demand and where it leads

size of consumer incomes. These are influenced (as explained) by the Investment Multiplier. Given the size of consumer incomes, consumer demand is governed by the propensity to consume. Although the word propensity is not a concrete phrase and denotes a psychological preference, the phrase propensity to consume is translated by Keynes into something more specific: the proportion of income spent on consumption, rather broadly defined. The obverse of this, the propensity to save, is the proportion of income devoted to saving. Income is always limited, and there are many calls on it. The two categories of consumption and saving make calls on income from opposite directions: more of one, less of the other (although Keynes thought that the propensity to save was nothing more than a residual, and was therefore determined by the propensity to consume). Keynes believed that the propensity to consume is governed by a host of objective and subjective factors.4 He thought that this propensity did not change much in the short term, although gradual changes were to be expected in the long term. In his judgment, any changes in consumption, when measured in absolute terms, “depend on changes in the rate at which income . . . is being earned and not on changes in the propensity to consume out of given income.”5 For most people, wages do not change much from year to year. Among Keynes’s objective factors is an important matter of psychology, one aspect – but only one aspect – of which is described by Keynes as: “changes in expectations of the relation between the present and future level of income.”6 This can work in a positive as well as a negative direction. Although Keynes thought that the propensity to consume always tends to decline with rising income, expectations can drive it in a positive as well as a negative direction: e.g. the “feel good” factor of the 1980s and 1990s stimulated by a rising stock market that boosted the apparent value of money invested there. A strong optimism gradually replaced the pessimism of the years before World War Two. It is not only possible but indeed quite common for the propensity to consume to be gradually driven down or up by the psychological responses of consumers to changes in business conditions. Genuinely secular trends can be easily revealed by comparing countries at different stages of economic development. Consider a poor country like Bolivia, which has a per capita GDP of less than $2,000. Virtually 100 percent of household incomes are used for consumption (50 percent goes for food and beverages alone).7 In contrast, the United States, where per capita GDP is more than $35,000, 80 percent of income goes on consumption, with only 13 percent going for food. The American figure of 80 percent is considerably exaggerated when it is used to compare the items of consumption in both the United States and Bolivia. It includes consumption expenditure by the government financed out of taxation. In addition, many goods commonly bought in the United States would be unattainable luxuries in Bolivia. A more realistic figure for the United States would be 50 percent of income spent on personal consumption. The figure had been 32 percent in 1950.8 Two factors influence how people in Bolivia and the United States use their

Consumer demand and where it leads

47

money differently, and in particular why Bolivians use all their resources for consumption, while Americans use only perhaps 50 percent. •

•

American consumers buy a much larger and richer range of goods and services than people in Bolivia. This means that there is a very much larger expenditure on these things in the United States, and as mentioned they include many goods that most Bolivians would consider out of their reach. Despite this much more substantial expenditure on goods and services, there is a surplus in the United States of perhaps 50 percent of all income. And because of the vastly higher level of GDP per capita, the average American residual of $17,500 per capita is more than eight times the total size of the Bolivian GDP per capita.

This surplus, an important quantity of resources in developed countries, is used to pay for luxuries; for direct taxes (which provide government expenditure that is in turn used for investment and consumption); and money for speculation. It is also the ultimate source of saving, which can mean keeping money in cash and bank checking accounts as well as moving it into relatively illiquid assets. Remember also that the size of personal incomes varies very widely. Among the substantial numbers of Americans who earn much more than the average income, the absolute size of the surplus is very large indeed. The general point about the difference in the propensity to consume in rich and poor countries is illustrated in Figure 3.2.

Rich countries

Income

Poor countries 50% Propensity to consume

Figure 3.2 The propensity to consume (schematic).

48

Consumer demand and where it leads In summary: • The propensity to consume (the proportion of income spent on consumption) is governed by a number of factors, both subjective and objective. • The propensity to consume is relatively stable in the short term. But in the long term Keynes believed that it tends to decline as income rises. This is indeed true of the very long term and can be demonstrated by comparing countries at the opposite ends of the spectrum of economic development. • The propensity to save is a residual: the difference between income and propensity to consume. Keynes believed that the propensity to save will tend to rise in the long run, in step with the falling propensity to consume. Whether this actually happens depends on the definition of the long term. As will be discussed later in this chapter, Keynes was skating on thin ice here.

Money and liquidity-preference We now get to what is probably Keynes’s most deceptively simple but most pregnant concept, liquidity-preference. This describes the relationship between people and the money they possess: their income and their accumulated savings. Despite the fact that money is probably the most familiar commodity in the world, few people pause to think about what it really is. Money is only a concrete object when we see a suitcase full of hundred dollar bills in a gangster movie. Money is usually something much less tangible, and can be most accurately described as credit created by banks. Money is a measure of the value of goods and services and can be seen as a surrogate for this real wealth. Money’s extrinsic value is that of the goods and services it buys. Its only intrinsic value is a matter of psychology, when it is seen as a protection during bad times (the source of liquidity-preference). Although larger or smaller quantities of money do not affect directly the volume of goods and services produced – merely their apparent value – the money supply exercises an important indirect influence on the volume of production. The immediate effect of an increase in the money supply is a rise in prices. This means that the danger of increasing the quantity of money is inflation: a rise in prices large enough to disturb the fabric of society. If this price rise is moderate and well under control, it can stimulate output and employment (in a way that will shortly be described), and it can also have the long-term effect of encouraging investment demand. It does this because it signals the probability of better business through increasing profit, and entrepreneurs will gear up for this. Money is made up of three separate components. First, there are coins and banknotes – today all issued by the United States Treasury and the Federal Reserve – and to these are added traveler’s checks and checking accounts:

Consumer demand and where it leads

49

demand deposits at banks. These four different types of money represent assets instantly available and are entitled M1. M1 offers the maximum degree of liquidity. The second component of money is deposits with banks and other institutions that are available for use only at a few days’ notice. We add these to M1 and the result is M2. (Keynes himself used the abbreviations M1 and M2, although in a slightly different sense, as parts of a mathematical formula.9) Finally, there is M3, which starts with M2 and adds deposits that need longer notice to be withdrawn. These are relatively illiquid assets (although not as illiquid as real estate). M3 is therefore largely composed of deposits in banks and other financial institutions. Each deposit (minus a fixed proportion kept in reserve) can in turn be lent to customers, and thus it generates a large amount of credit. This is a continuous process, because the credit that has been created will be deposited by the borrower in his or her bank. In turn, a large amount of this second deposit will form the foundation for additional credit. And so the chain is extended until the initial deposit becomes inflated to perhaps six times its original value. As a control over this ballooning of credit, a firm ratio of loans to deposits is determined by law: a procedure aimed at protecting depositors from a “run” on any bank. An additional precaution is provided by the federal insurance of deposits up to a limit of $100,000 and sometimes more, and this applies to all banks regulated by the federal system.10 Controls over bank credit – which work effectively – were strengthened as a result of the widespread failure of banks at the beginning of the Great Depression. Of the three components of money, M1 in 2002 accounted for only 14 percent of the total; the extra amounts covered by M2 comprised another 54 percent; and the additional quantities included in M3 made up a further 32 percent. These individual percentages change to some extent year-by-year, but the main point to remember is that by far the most important type of money is bank deposits. Coins and banknotes on their own – the only type of money controlled directly by the government – accounted for only 7 percent of the total United States money supply in 2002. The remaining 93 percent was controlled indirectly (and sometimes imperfectly) by the central bank. The mechanism by which the amount of money is controlled is the rate of interest, set by the Federal Reserve, together with banks’ reserve ratio. (In some countries there are also direct regulations on the types of lending.) This control tends to be more effective when rises in interest rates are used to cool the economy than when interest rates are reduced in order to stimulate activity. In other words, interest rates work better in a negative than in a positive direction.11 This point will recur in this chapter. We now need to look at Keynes’s explanation of the rate of interest. In this he broke totally new ground, but we should remember that his thinking was molded by very close personal observation of the working of the London stock market during the early 1920s.12 To Keynes, people have a nonrational, even atavistic attitude toward the money they possess: “our desire to hold money as a

50

Consumer demand and where it leads

store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude.”13 The phrase he used to describe this fixation is liquiditypreference. Some people prefer the more forceful and less clinical phrase hoarding. Keynes saw three separate motives for liquidity-preference, the transactionsmotive, the precautionary-motive and the speculative-motive.14 The transactionsmotive is the only one of the three that is rational. It describes our need for liquid funds to conduct the ordinary business of life: to meet day-to-day expenses and to bridge the gap between the time when payments must be made and when fresh income arrives. This applies to both individuals and business firms, and the amount of our allocation of funds for the transactions-motive is governed by the size of our income, where there is of course great variation. In contrast to the transactions-motive, the precautionary-motive and speculative-motive are psychological phenomena, both concerned with how we regard and how we handle risk. The precautionary-motive calls for us to set aside sums that will be readily available for unexpected emergencies: in the words quoted above: “the possession of actual money lulls our disquietude.” The speculative-motive is an amalgam of a sporting instinct and greed; and a high income is not a necessary condition for it to operate. With all three motives, an incentive is therefore needed to make us part with liquidity, and this incentive is the rate of interest.15 People are willing to hoard money, i.e. to receive no earnings from it because of the peace of mind that it provides, so long as the risk of loss seems to them to be greater than the rate of interest they would receive from lending it. The rate of interest is therefore what is necessary to compensate people for parting with liquidity: the higher the uncertainty the higher the rate. To put the point more dramatically, the ruling rate of interest is the point of balance at which the bears are willing to lend the funds for investment and the bulls are willing to take them up. This is seen most dramatically with bonds. The demand for these is driven directly by the rate of interest, and changes in the rate of interest have an immediate effect on the demand for bonds, and also a slightly less direct – and inverse – influence on the demand for equities. High interest increases the demand for bonds and it lowers the prices of common stocks. The rate of interest is important because it controls the supply of bank credit. If the rate falls, borrowing will increase for consumption and investment spending; if it rises, demand will be reduced. In turn, bank credit – the main source of money supply – makes an important contribution to aggregate demand and therefore to employment and national income. Because the rate of interest can cool (and stimulate) the economy, it has been used for more than half a century as one of the main tools of macroeconomic management in developed economies. The rate of interest and the supply of money are determined in such countries by the central bank whose operations are supervised, with differing degrees of strictness, by the government. This means that interest rates and money supply

Consumer demand and where it leads

51

are manipulated with the aim of managing the macroeconomic health of the country. The money supply plays a role in macroeconomic management by acting as a catalyst, or enabler, by driving changes in more important economic forces, notably output and employment. An increase in the money supply will increase demand. But in some circumstances (explained in Figures 3.3 and 3.4) it can have the unfortunate consequence of boosting prices, which will in turn cause wages and other costs to increase, and this will counteract the benefit of the higher demand. An even more unfortunate consequence is that sharply higher prices can disturb the fabric of society. Indeed there can be a strongly negative effect on optimism and expectations which can immediately reduce investment and consumer demand, and hence output and employment. Control of the money supply as a macroeconomic tool is a direct outcome of Keynes’s doctrines, and such manipulation has had varying degrees of success. The matter is delicate, and central banks in different countries take a long time to learn how markets respond to the gentle – and sometimes less gentle – prods that they apply. In the United States, the actual rate of interest set by the central bank is the Federal Funds Rate (FFR), dictated by the Federal Reserve Bank. Since the various rates charged by commercial banks are based on the FFR, and also because all interest rates compete with one another to a greater or lesser degree, the Federal Funds Rate sets the pattern for American financial markets as a whole.16 (See the note on the Spectrum of Interest Rates, at the end of this chapter.) Total M3 – the aggregate supply of cash and all bank deposits – was $8,511 billion in 2002, having increased from $1,996 billion in 1980. Giving the 1980 figure an index number of 100, the 2002 figure was 430: a more than fourfold increase. It is important to compare this increase to the progress of prices. If we base the Consumer Price Index for 1980 similarly on a figure of 100, the figure for 2002 was 220, showing that prices had more than doubled (with an average annual increase of 3 percent, compounded). The question that now needs to be answered is: With the money supply rising fourfold, why did prices only double? We are talking about a two-to-one difference. The classic Quantity Theory of Money (which is the source of the policy of Monetarism) hypothesizes that prices are determined by the total amount of money that is washing around the economic system. If the quantity of money doubles, then prices will also double. This actually takes place because the extra money finds its way to consumers, e.g. from extra bank credit, and this will increase consumer demand and bid up prices. The theory is, however, based on a strict assumption: a condition that total output is unaffected by the increase in money supply. This is not true if there is spare capacity in labor and capital equipment. (These factors were a characteristic of the economic system during the 1930s.) In these circumstances, the increased demand from the larger quantity of money will cause some increase in prices, which will then stimulate a rise in output. This has also probably been true in the United States since 1980, and is illustrated in Figure 3.3. This concept is at the heart of the policy of using fiscal controls – tax rates and public

Effect of higher income from increased money supply on an economy with spare capacity

Aggregate demand

Aggregate output

2

Price

1

Quantity

Figure 3.3 Effect of higher income from increased money supply on an economy with spare capacity.

Effect of higher income from increased money supply on an economy working at full capacity Aggregate demand 2 1

Price

Aggregate output

Quantity

Figure 3.4 Effect of higher income from increased money supply on an economy working at full capacity.

Consumer demand and where it leads

53

expenditure – in order to influence the overall health of the economy. The first tocsin was sounded by President Roosevelt’s New Deal. Keynes believed that stable prices are an important condition for a healthy economy (as will be discussed in Chapter 5). The fact that the increased money supply during the last two decades of the twentieth century did not cause sharp inflation but was kept down to 3 percent per annum is a tribute to the efficiency of American macroeconomic management. A greatly more serious condition is when the economic system is working at full capacity. Increased demand is then physically incapable of stimulating additional output, and the outcome is felt exclusively as a rise in prices. This situation represents the Quantity Theory in its purest form. The point at which the system is working at full capacity is shown in Figures 3.3 and 3.4 by the supply function turning vertical, indicating that it has become inelastic, with supply unresponsive to increases in price. Full capacity does not mean that all the workers and every piece of machinery must be working flat out without interruption. Full capacity working can be impeded by permanent bottlenecks in part of the production process, e.g. those often imposed by trade union restrictions. Keynes explained the phenomenon of full capacity in the following words: When a further increase in the quantity of effective demand produces no further increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation.17 The implication of this conclusion, with its relevance to macroeconomic policy, can be expressed as follows: in conditions of full-capacity working, increases in money supply aimed at stimulating demand will generate inflation and nothing else. How this works is illustrated in Figure 3.4.18 A strange phenomenon associated with the 1970s was stagflation: an unfortunate combination of inflation and no growth in output. Stagflation is usually attributed to the inflation that resulted from the oil price shock after 1973. This was the first major economic disturbance since the end of World War Two and it had the expected outcome of seriously shaking confidence, quickly inhibiting both private investment and consumer expenditure, and therefore demand and output. (See Tables 2.6 and 2.3 in Chapter 2.) Hence the combination of inflation and stagnation: the toxic concoction that was not effectively removed from the economic menu until the 1980s. In summary: • Bank credit represents more than 90 percent of the total supply of money. • The demand for bank credit (and therefore the supply of money) is governed substantially by the rate of interest.

54

Consumer demand and where it leads •

•

The supply of money has a major influence on aggregate demand. A reduction in interest produces an increase in demand, and this can stimulate the economy in circumstances in which there is slack in the system (unused capacity): labor unemployment and idle equipment. However, in circumstances where the economy is bumping against maximum capacity, an increase in the money supply produces inflation: no increase in output but simply higher prices. This means that the rate of interest must be used with accurate market intelligence and great delicacy when it is employed as a tool of macroeconomic management.

A web of relationships The rather complex relationships described in this chapter are summarized in Figure 3.5. The most important points about this diagram are as follows: 1

2

3

4

5

The three key factors that determine consumer demand are the propensity to consume, the supply of money and, ultimately, the national income. Note that the national income influences the absolute volume of consumption and saving, but not the propensity to consume or the propensity to save. These represent proportions of total income and are assumed to remain fairly stable. The rate of interest plays a vital role. The force that drives it is liquiditypreference, but in developed economies it has been taken out of the hands of the market and is employed as an important tool of macroeconomic management. A reduction in interest increases the money supply, consumer demand and hence output, provided that there is slack in the economy. If the economy is working at full capacity, an increase in the money supply is inflationary. (With increases in the rate of interest, the effects show a mirror image of these movements.) In Figure 3.5, most of the boxes describe dependent variables. The arrowhead points to the dependent variable, and the place of origin of the arrow shows the factor that influences it. Uncertainty and expectations are important throughout. These represent people’s psychological responses to changing economic conditions.They impinge on liquidity-preference; on the propensity to consume; and on the supply of money (i.e. the demand for credit). In Figure 3.5, the symbol P stands for policy management. The rate of interest is one of the two tools of macroeconomic management, the other being taxation or, as it is more commonly called, fiscal policy. (These two tools are discussed in Chapter 5 and 6 respectively.) It is no coincidence that the rate of interest has been placed in Figure 3.5 in a place where its connections with the other factors can be shown diagrammatically.

Consumer demand and where it leads

55

Consumer uncertainty and expectations

Propensity to save

Propensity to consume

Liquiditypreference (hoarding)

Rate of interest p

Money supply

Consumer demand

Governs absolute volume of consumption saving and hoarding

p  policy management

Aggregate demand p

If spare capacity

If full capacity

Employment

Inflation

Governs liquidity-preference for transactions

National income

Figure 3.5 Consumer demand.

6

Finally, if we move to the longer term, further dependent relationships make themselves felt. Here are two examples: •

If national income is lifted as a result of the increases in consumer demand resulting from the stimuli shown in Figure 3.5, the higher income will positively influence liquidity-preference for transactions and also the absolute level of consumer demand. (This happens because the relatively constant propensities to consume and to save will now be applied to a higher total income.) This all provides an extra degree of impetus to the initial increases in consumer demand. And again, an initial reduction in income works in the same fashion but negatively rather than positively.

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Consumer demand and where it leads •

The increased demand that comes from a higher national income will give a shot in the arm to entrepreneurs’ expectations, boosting the demand for investment (discussed in Chapter 4) that will in turn employ the extra saving that will also be generated by the increased income.19

In summary: • The key factors influencing consumer demand are the propensity to consume, the supply of money, and ultimately the national income. • The rate of interest controls the money supply, which influences the level of consumer demand, but there are common circumstances where an increase in the money supply produces inflation and not additional output. • The rate of interest is used as a tool of macroeconomic management, but it needs careful handling to steer the economy on a cautious course to stimulate growth while at the same time holding back inflation.

Trends One of the most important ingredients of Keynes’s doctrine was his extrapolation of a single trend: a trend that points toward secular stagnation. This trend relates to the propensity to consume (the proportion of income spent on consumption) and its obverse, the propensity to save (the proportion of income that is saved). Keynes thought a great deal about these two linked concepts. He concluded that over time – provided that income was on a gradually upward path – the propensity to consume will slowly decline and the propensity to save will slowly increase. When describing these hypotheses, he used the economist’s adjective marginal (meaning incremental) to indicate the progression: reductions in the marginal propensity to consume and increases in the marginal propensity to save. This description reflects the common belief that the money we spend on consumer goods, especially necessaries, does not rise much as we become better off. The impact of this trend is obvious. A gradual transfer of the share of total income from consumption to saving will cause saving to rise faster than consumption, thus restraining effective demand – if we make the (realistic) assumption that increases in saving do not immediately translate into increases in investment. Keynes was emphatic about the likelihood of a gradual reduction in consumer demand caused by this trend. He made the point twice in the General Theory, and his meaning is unambiguous: “The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income.”20

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57

Here is something we can examine empirically, and I have done this in Table 3.1. I have looked at American data for the period 1968 through 2002. For each year I have related the annual changes in real GNP/GDP (data from Table 2.3) to official estimates of saving as a proportion of disposable personal income. The latter figures have been subject to constant small revisions, but as far as possible I have used the latest figures published in the annual editions of the Statistical Abstract of the United States. The first thing to look at is income. Each year’s estimate was calculated on a compound basis, and the GNP/GDP over the 35-year period moved Table 3.1 United States annual changes in real GNP/GDP and savings as proportion of personal income, 1968–2002 Year

GNP/GDP at constant prices year-on-year change (%)

Personal saving % of disposable personal income

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

+4.7 +2.7 0.5 +2.7 +6.1 +5.5 1.7 1.8 +5.3 +5.5 +4.7 +3.2 0.2 +1.9 2.5 +3.6 +6.8 +3.4 +2.8 +3.4 +3.9 +2.5 +1.8 0.5 +3.0 +2.7 +4.0 +2.7 +3.6 +4.4 +4.3 +4.1 +3.8 +0.3 +2.4

6.7 6.0 8.0 8.2 6.2 7.8 7.3 8.6 6.9 5.9 6.1 5.9 7.9 6.7 6.2 5.0 6.1 4.4 4.1 3.2 4.4 4.4 7.8 6.0 6.2 5.1 4.2 5.6 4.3 4.2 4.7 2.6 2.8 2.3 3.7

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Consumer demand and where it leads

progressively upward. In only six years (1970, 1974, 1975, 1980, 1982 and 1991) did the figures fall back slightly, and these reductions hardly impeded the healthy and substantially unbroken increases over the whole period. We now come to saving. Here it is impossible to tease out any trends from the figures, since the proportion of saving out of disposable personal income moved erratically between the extremes of 2.3 percent and 8.6 percent. (The unweighted average is 5.6 percent.) To these figures we ought to add what are sometimes called “forced” savings, e.g. amounts spent on repaying the principal of mortgage loans, and personal pension contributions. The latter two sums are more or less fixed, so that the amount of variable saving remains very small: an average (as explained) of 5.6 percent of disposable personal income. The only point that emerges clearly from these unimpressive and volatile figures is that there is no support for Keynes’s hypothesis that rising income is associated with an increasing marginal propensity to save. Insofar as the figures show anything at all, they demonstrate the opposite. The figures for the decade 1993 through 2002 are a good deal lower than those for the period 1968 through 1977.21 Currently, total personal savings in the United States are negative. International data published in 2005 showed that the decline in saving had not been confined to the United States. It had also happened during the 1990s in Australia, France, Germany, Italy and Japan.22 Why did Keynes get it wrong? One economist arrived at the answer. He was Milton Friedman, who had in 1957 published a remarkable book that described what he called the “Permanent Income Hypothesis.” This stated that the “relation between permanent income and permanent consumption . . . is independent of the size of permanent income but does depend on other variables” (which Friedman spelt out in detail).23 In contrast, Keynes’s propensity to consume varies according to income. Friedman’s book was empirical as well as theoretical, and he made a case that refuted Keynes, that also holds true for my data in Table 3.1. There are a few further specifics related to my own analysis. These are described below, although readers must not think that I have made major discoveries that Friedman had not already made half a century ago. First, although Keynes’s hypothesis was not supported by American conditions during the last third of the twentieth century, the comparison made earlier in this chapter between the United States and Bolivia will support Keynes’s view, but these countries are in practice separated by centuries of economic development. The operational lessons from the comparison between them are therefore not too relevant to macroeconomic policy in developed economies. Second, Keynes’s work was rooted in the conditions of economic life in developed countries before World War Two. During that more austere time, people were much more circumspect about how they spent their incomes than they are today. There was less margin for error, and bourgeois attitudes to credit were skeptical. Views about credit changed during the second half of the twentieth century. This brings us to my third point.

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The stock markets were unusually buoyant over the course of the 1970s, 1980s and 1990s, especially during the latter decade, when saving sank to very low levels (and is now negative). When the stock market indexes are climbing at a sometimes heated pace, the effect on people is to make them feel an increasing degree of optimism: “irrational exuberance”, in the words of the Yale economist Robert Shiller popularized by Alan Greenspan, former head of the Federal Reserve. This frame of mind prompts consumers to spend both on consumer goods and on more speculative ventures, a process that was greatly facilitated by my fourth factor, the mushrooming of consumer credit. Credit cards came into widespread use during the 1970s, and they were virtually ubiquitous by 1990. In 2002, the total value of credit card debt had climbed to $1,361 billion (compared with M3 of $8,511 billion). Credit cards represent a huge incentive to spend today and pay (much more) tomorrow; and they are here to stay.24 Keynes stated explicitly that his doctrine was based on the assumption of no change in the tastes and habits of consumers. This assumption seems not to hold in the United States since the 1970s or even earlier.25 One additional point stems from my own professional experience in the advertising field. I have published data from my own and other sources on the possibility that substantial regular expenditures on advertising might cause an expansion of aggregate consumer demand in specific product categories. The results of this research are negative. Advertising has no macro effect although it can influence the sales of some brands, that expand at the expense of others. Advertising can therefore take no credit (or blame) for how total consumer demand has been sustained and indeed boosted.26 To explain this, we need to look at more deep-seated causes, such as those I have explored in the paragraphs above. In comparison with the 1930s, there is today far more business confidence than business pessimism in the developed world. This has unquestionably kept consumer demand at a high level and has sustained employment in most years. The economic system has shed some fat, but the muscle has retained its strength and resilience. The American economy has behaved remarkably well during the second half of the twentieth century. It would be surprising if this is not connected with the high propensity to consume. And in turn it has probably contributed to maintaining this high propensity. It can also be argued that macroeconomic management has paid some dividends. However, we cannot estimate this accurately from the analysis so far. We need first to look at investment demand and then at the specific tools available for fiscal and monetary management. These have been employed with varying degrees of efficiency, as will be discussed later in this book. In summary: • Keynes believed emphatically that as incomes increase over time, the propensity to consume will fall and the propensity to save will rise; and the result will be secular stagnation.

60

Consumer demand and where it leads •

•

•

The experience of the United States during the second half of the twentieth century proved Keynes’s prognosis to be wrong, but Friedman got it right. A number of reasons can be suggested for this, but the most important is the strong and increasing degree of consumer and business confidence that characterized the United States and other developed countries during this period. There was less concern than there had been during the 1930s about making provision for future loss of income and other emergencies while present wealth and the prospect of future wealth were both on the rise. The buoyancy of consumer attitudes maintained a high propensity to consume, and this in turn unquestionably contributed to keeping up high levels of economic activity.

Footnote on the spectrum of interest rates At any time there is a spectrum of different interest rates, depending on how simple it is for the lender to reclaim his funds: a process governed, in other words, by the liquidity of the loan. Specimens of the range of rates appear in Table 3.2, which shows that these rates move up and down in general harmony if not in lockstep. The reason for this harmony is that ultimately all these assets are competing indirectly for loanable funds, so that the price of lending them (i.e. interest rates) will move toward equality through normal competition. For cautious individuals, the first step away from the atavistic attraction of liquidity will lead them to buy “safe” interest-bearing assets issued by the government, banks and commercial companies: securities commonly known as bonds. Because the return from these assets is guaranteed, they are more immediately attractive to liquid funds than are company stocks, the return from which is less predictable. Bonds themselves have different lengths of maturity. Those with long maturity usually carry a higher rate of interest than shorter ones: a reflection of the higher degree of liquidity provided by the short maturity. On the rare occasions when long-maturity bonds show a lower rate of interest than the short ones, this can spell trouble because this is a signal that the market is anticipating a lower interest rate in the future because a recession might be on the horizon.27 The bond and stock markets are also not separate and self-contained. As mentioned, interest rates must be high enough to persuade potential investors to forgo the safety of liquidity. A wave of uncertainty in the market causing liquidity-preference to increase will result in some switch in demand from stocks to bonds. The result will be an increase in the price of bonds and a fall in common stocks – a phenomenon readily observable by stock watchers. Lower prices of equities mean an increased yield, which will tend to cause all interest rates to be brought approximately into line with one another.

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Table 3.2 United States typical spectrum of interest rates (%), 1993–2002

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Federal funds effective rate

6-month treasury bills

5-year certificates of deposit

New home mortgages

3.02 4.21 5.83 5.30 5.46 5.35 4.97 6.24 3.88 1.67

3.12 4.64 5.56 5.08 5.18 4.83 4.75 5.90 3.34 1.68

4.98 5.42 6.00 6.46 5.66 5.08 4.93 5.97 4.58 3.96

7.20 7.49 7.87 7.80 7.71 7.07 7.04 7.52 7.00 6.43

The effect of this shift between stocks and bonds may be to move interest rates above what they should be in order to maintain full employment.28 On the other hand, if interest rates are brought down very low by the monetary authorities in order to encourage investment, and if this coincides with a serious loss of confidence, the result will be the “Liquidity-Trap.” Potential investors will keep their assets in a liquid form and there will be too few savings to support the investment that normally ought to be encouraged by the low interest rates. This analysis does not modify the basic mechanism by which interest rates are set by the FFR, a rate fixed by the Federal Reserve Bank to serve as a tool of macroeconomic management. Chapter 5 discusses the actual effectiveness of this device in the hands of the Fed.

Notes 1 Keynes, General Theory, pp. 78, 161, 210–211. 2 Noel Annan, The Dons, London: HarperCollins, 1999, p. 209. 3 Richard Kahn, “The Relation of Home Investment to Unemployment”, Economic Journal, June 1931, pp. 173–198. 4 Keynes, General Theory, pp. 91–95, 107–109. 5 Ibid., p. 110. 6 Ibid., p. 95. 7 International Monetary Fund, General Data Dissemination System, http: //dssbb.imf.org/Applications/web/ggds/gddshome/, January 2005. 8 U.S. Department of Commerce, Statistical Abstract, 2003, pp. 443–444. Also Bradley Johnson, “American Demographics”, Advertising Age, February 7, 2005, p. 34. 9 Keynes, General Theory, p. 199. 10 I have received helpful information on this matter from Kevin Holmquist, of the Nottingham, Syracuse, branch of the Key Bank of New York. 11 Keynes, General Theory, pp. 321–322. 12 Robert Skidelsky, John Maynard Keynes, Vol. 2: The Economist as Saviour, London: Macmillan, 1992, p. 25. 13 Ibid., p. 561. Skidelsky is quoting from an article that Keynes published in the Quarterly Journal of Economics, February 1937.

62 14 15 16 17 18

19 20 21 22 23 24 25 26 27 28

Consumer demand and where it leads Keynes, General Theory, pp. 194–199. Skidelsky, John Maynard Keynes, Vol. 2, p. 561. U.S. Department of Commerce, Statistical Abstract, 2003, p. 753. Keynes, General Theory, p. 303. As far as I know, the specific analyses illustrated by Figures 3.3 and 3.4 have never been published. However, I remember Joan Robinson explaining them to me by sketching the diagram on a piece of paper with a red pencil, during a supervision (the Cambridge word for tutorial). Keynes, General Theory, pp. 110–111. Ibid., p. 27. U.S. Department of Commerce, Statistical Abstracts, various years. “Special Report: The Economics of Saving,” Economist, April 9, 2005, pp. 58–60. Milton Friedman, A Theory of the Consumption Function, Princeton: Princeton University Press, 1957, pp. 25–37, 126. U.S. Department of Commerce, Statistical Abstract, 2003, pp. 750, 752. Keynes, General Theory, pp. 110, 245. John Philip Jones, “Macroeconomic Effects: The Influence of Advertising on Overall Sales Levels,” in How Advertising Works: The Role of Research, John Philip Jones (ed.), Thousand Oaks, CA: Sage Publications, 1998, pp. 326–335. Anon., “Economics Focus: The Long and Short of It,” The Economist, January 7, 2006, p. 69. Skidelsky, John Maynard Keynes, Vol. 2, pp. 559–560.

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Investment demand and where it leads

Only one in four people are very confident they have saved enough for retirement. Be the one. Prepare to live the future the way you always saw it. With the latest investment products and solutions from the Hartford . . .1

This professionally written argument is typical of the many advertisements that adorn the pages of American magazines, especially those directed at the very large group of comfortably prosperous people. The Hartford is a financial services company that sells a range of savings-related products. There are many such companies, plus specialist firms like stockbrokers. Financial organizations vary greatly in size and the biggest are not necessarily the best. In addition to the savings that individuals put into the hands of such financial managers, large numbers of people – probably a majority of the population – make “forced savings,” e.g. income reductions to pay for pension plans and automatic payments from bank accounts to meet mortgage loans. In the United States, as in all economically developed countries, savings is a large industry. And although (as demonstrated in Chapter 3) the marginal propensity to save is not creeping up over time as Keynes thought it would, regular saving out of income is still a deeply ingrained habit with vast numbers of American people. Note that the advertisement for the Hartford contains the word investment. This actually has two distinct meanings. The business person (entrepreneur in Keynes’s language) who is building a new factory is investing, but what is really happening is that investment demand is being created, and it is this that produces income and employment. The individual who is buying newly issued stock in a company is investing, but what is happening is that he or she is providing funds for investment, and it is this investment supply that is used to satisfy investment demand. Note the difference between buying newly issued stock (which provides funds for new investment) as opposed to trading in existing shares (which just means the transfer of ownership of existing assets). To fill out this picture, we need to revisit what was discussed in Chapter 3, consumer demand. Consumer demand means individual households buying goods and services. This practice has an important although obvious feature. It is

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generated by large numbers of buyers, while it is usually satisfied by a much smaller number of suppliers. Each consumer accounts for only a modest amount of purchasing in proportion to the total volume of buying by the population as a whole. In contrast, each supplier usually delivers a large quantity of output (and hence employment). The situation is different with investment demand, where the numbers are reversed. Investment demand comes from business people who wish to use funds to build plant and machinery, employ workers and accumulate inventories of materials; and also from households that wish to buy houses or other capital assets. The organizations that create the largest quantity of investment demand are few in number and each substantial in size. Many parties supply the funds, and the contributions of the individual investors are usually small in comparison with the total size of the investment supply put to work by entrepreneurs. In practice, most (although not all) individual investments are channeled into mutual funds and pension accounts, where they are controlled by professional managers, and much of this money is eventually used to fund physical investments. Such accumulations are nothing more than an aggregation of small individual sums that come from separate people. An investment decision by an entrepreneur (e.g. to build a blast furnace or to develop a new brand of consumer goods) is a much weightier and more uncertain matter than either a household investment decision (e.g. to buy property or a car), or a private consumption decision, even when very large sums of money are involved, e.g. in buying a luxury vacation. When we make personal buying decisions, even about “high-ticket” purchases, we have a clear idea of what we are getting: indeed we get some of the reward immediately after we buy. Making such a buying decision is therefore not especially difficult, so long as we have the resources to implement it. Making a decision about business investment is a much less predictable affair. It calls for a reliance on judgment to make projections for the future, with the real possibilities of either large profit or large loss (and other alternatives in between). The business person who makes the investment decision is living in a world of uncertainty because he or she is forecasting future income, and although the most advanced forecasting techniques may be used, the whole process is often merely educated guesswork. Expectations are at the heart of investment demand. Nevertheless all economic progress is the result of expectations that were eventually fulfilled, and this means that there is no shortage of business people who are prepared to take the risk. Entrepreneurial flair differs widely between individuals, with success due much more to “feel” than to the entrepreneur’s personality, dedication and analytical ability. There is less risk involved with investment to replace existing plant, since we know the volume of sales produced by an existing business; and new investment will, it is hoped, make this production more efficient. However, in Keynes’s definition, investment means net investment. Replacement does not therefore come into the category of investment as he saw it.2

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In summary: • Private business investment demand comes from a small number of organizations, each of which accounts for large amounts of investment. An investment decision is a weighty matter because of the financial risk. • Private business investment decisions are based on an anticipation of consumer demand for the final products of the business. The process is little better than educated guesswork. • The factor that determines an entrepreneur’s success is his or her “feel” rather than more rational qualities that education and experience can develop.

Investment supply – where the money comes from Before we look in detail at where the money comes from, we need a reminder of the total size of investment demand compared with consumer demand. This was described in Chapter 2, and the tables mentioned below appear in the text of that chapter. •

•

•

In most years, consumer demand, i.e. personal consumption, accounts for two-thirds of total consumption. The remaining one-third is split between private investment and what the government spends. Government expenditure in turn is used for both consumption and investment. This means that personal consumption in total accounts for the lion’s share (perhaps near 80 percent) of total consumption demand. (See Table 2.5.) But the share of total demand accounted for by private consumption does not change much from year to year. In contrast, business investment is much more volatile. (See Table 2.6.) And changes in such investment yearby-year generate direct changes in unemployment in the opposite direction, with the biggest reductions in investment causing the largest increases in unemployment, and vice versa. (See Tables 2.6 and 2.7.) It follows that, while consumer demand remains reasonably stable, there are ups and downs in investment demand, and it is these that have the most direct influence on employment. The chain of signposts therefore points from investment demand to employment and employment points to output. (Remember also that output also points back to consumer demand and also employment through the Investment Multiplier; and all this in turn points back to consumption.) The supply of investment funds comes from six different sources:

1 2

Business firms’ own reserves. Different types of government organization.

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3 4 5 6

Banks. A variety of sources of venture capital. Overseas sources, a process known as foreign direct investment (FDI). The open market, which means (as explained) the resources of individuals which in most circumstances are controlled by the managers of mutual funds and pensions schemes. There are also some substantial (and wellknown) individual investors, but these are few in number, although not in the money they provide to satisfy investment demand. With good judgment and exceptional luck, fortunes are sometimes made.

Successful business firms accumulate substantial reserves because they normally behave very conservatively in distributing profit to stockholders as dividends. Large resources are accumulated and are added to every year; almost $140 billion were generated in 2002 alone. These funds are not usually left in a bank to earn modest interest. They are more often used for three purposes. The first is to make business acquisitions, which do not represent net investment but are merely a change of ownership of existing capital assets. Most such acquisitions are made by a combination of cash and newly issued stock in the buying company. This does not represent a dilution of the firm’s equity because the larger number of shares now covers the ownership of more assets. The second use of a company’s reserves is to buy back the firm’s own stock in the open market, thus theoretically boosting the value of all the remaining stock that is in public hands. The third use for a company’s reserves – and our concern here – is to make net investment in new plant and inventories and to employ workers to get the production process going. The next source of investment funds is the various federal and other government agencies, that accounted for a total of $1,970 billion in 2002.3 Much is used for consumption, but a good deal also goes into investment for public projects. However, the amount of government money used for private investment is very small in the United States.4 It totaled only $4.3 billion in 2002, and represented loans to small businesses. In many other countries, however, there is a much more serious participation by government in private enterprises, usually an expression of political policy rather than a matter of economics. In the United States, the only type of public investment that is driven by an explicit political motivation is the array of widely publicized “pork barrel” projects that regularly arrive on the floor of the Congress. This is a price we pay for representative government. Yet all decisions about government investment are made – if not with politics in mind – at least with broader objectives than a strictly economic return. Investments are made to fulfill objectives concerned with government policy regarding defense, social improvement et al. The third source of funds for investment is banks. They often make temporary loans for working capital, e.g. to pay for raw materials; but banks do not play much part in supplying investment resources for fixed capital assets like plant and machinery. Banks do this to some degree in a number of foreign countries, e.g. Japan and Germany. American banks are in the business of borrowing

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“short”, i.e. accepting deposits that can be redeemed either immediately or at fairly short notice. They are only too conscious of the danger of borrowing “short” and lending “long,” i.e. locking themselves into long-term lending contracts. The only common type of “long” loan made by banks is real estate mortgages, and banks usually set up separate operating divisions to handle these. Venture capital is the next category of investment funds. The total volume is again relatively small: $7.7 billion in 2002.5 The money comes from pension funds, financial and insurance organizations, and endowments/foundations. With the latter, there is often a quasi-charitable incentive to providing funds. And in all circumstances, venture capital is a field of exceptional uncertainty, where expectations play an even larger role than with other investment decisions. The fifth source of investment funds is money that comes from overseas. There is a confusion about this because of the large trade imbalance that is such a striking characteristic of the American economy. Each year this imbalance can be carried because of transfers of money from creditor countries, known as foreign direct investment (FDI). Funds invested in American industry are large: $25.7 billion in 2002.6 These create employment in the United States through the operation of the Investment Multiplier, but this type of investment does not come close to accommodating the total trade imbalance, and much larger sums are provided by overseas investment in United States government funds. These have a more oblique influence on American employment, but they make possible much U.S. government investment, which does in turn create jobs. In any year when the United States imports more than it exports, the value of the dollar will tend to sink. (This is most emphatically the experience of the first years of the twenty-first century.) The dollar would sink even lower in the absence of overseas investors who are prepared to invest in the United States. They do not make such investments on altruistic grounds. Overseas investors have confidence in the United States, and they put money into the country because of the likely growth in the value of their investment, not to speak of the money they will earn and which will be repatriated. We are left with a sixth source of investment funds: the open market, which mostly means (as explained) the money put up by large numbers of small investors. This supply is also to a major extent driven by expectations of future earnings and capital appreciation. Of the six sources of investment funds, those that are most relevant to this discussion – in view of both their size and the fact that they are driven by economic motives – are the first, fifth, and sixth. These are business firms’ own reserves, overseas sources of funds and the open market. We must now see how these sources are used to meet the investment demand created by entrepreneurs: or more specifically what measures of performance (if any) are used to bring investment supply and investment demand into balance. As explained in Chapter 3, individuals’ propensity to save is controlled by their propensity to consume, saving being a mere residual: the difference between consumption and income. However, their willingness to commit their saving to investment, i.e. to sacrifice the supposed safety of liquidity, is

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influenced by a factor stronger than the rate of interest, the likelihood of capital gains. An individual who is thinking of deploying his or her funds will weigh the contrasting possibilities of a large killing or a total loss (or various alternatives in between).Only too often the decision is a leap in the semidarkness; sometimes a totally blind leap. We return then to a theme that has already appeared many times in this book: the prime role of expectations. In summary: • Private business investment demand is volatile because it is based on frequently changing estimates of future consumer demand for a company’s end products. • Private business investment demand exercises the greatest single influence on employment. • The supply of private business investment funds comes from six sources. The most important are firms’ own reserves, FDI and the open market. The open market is a mechanism that assembles large numbers of small savings by individuals, with professional financial managers deploying these funds to generate a profitable return. • Individual savings are invested with security in mind but also in many cases with the objective of capital gains. The importance of these underscores the crucial role of psychological factors: forecasts (or guesses) of the future.

Investment demand – putting the money to work From now on the word investment will be used to describe entrepreneurs’ decisions to use the supply of funds to grow their businesses. These decisions are based on projections of future returns, since investment means trading the value of assets today in return for future income and an eventually enhanced value of those assets. Projections differ according to how likely they are to be fulfilled, and to help to bring some order into an uncertain world, business people usually draw up practical plans – payout projections – which detail their forecasts of returns year-by-year. These sometimes work in practice, but not consistently enough for us to regard business planning as anything approaching a scientific enterprise. What matters most is the degree of certainty that the plans will turn out as anticipated, and this is the thing we know least about. It is theoretically possible to draw up some sort of continuum describing the extent to which plans will be realized. At one end it is labeled “reasonably safe” and at the other, “extremely hazardous.” I believe that most cases are weighted toward the latter extreme. It is indeed rare for forecasts to work out precisely as planned, although organic extensions of an entrepreneur’s business have the best chance of being at the safer end of the continuum. With these activities, business people have a

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better grasp of market trends than in the case of completely new ventures. In the field of consumer goods a huge proportion of new brand introductions (with some categories of goods, as many as 90 percent) end up as failures.7 Nevertheless, despite all the uncertainties, investment is the most important job an entrepreneur carries out. His or her future income is the reward for calculation, intuition and – most importantly – risk-taking, and the size of this reward is usually disproportionate to the actual amount of labor that the entrepreneur contributes to the business. In making investment decisions, flair is far more important than hard work. Keynes analyzed the investment process in the following way, and readers should note that the concept is totally theoretical and that there is no way in which it can be demonstrated empirically. However, the underlying principles are valid and the analysis helps us to understand the forces at work, although we shall need to discuss in some detail the limitations in our ability to measure these forces. •

•

•

Increasing amounts of investment produce a progressively diminishing yield. Keynes gave two reasons for this: first, “the prospective yield will fall as the supply of that type of asset is increased” (this is a claim not a proof); and second, as a result of the pressure on production facilities, the supply price of the asset will rise as more is bought.8 This is a parallel concept to the rising supply schedule which is used to illustrate how prices are determined: we see output increasing as a result of progressively less efficient (i.e. higher-cost) production being brought onto the market. In this way, investment produces a falling schedule, showing how one-at-atime increases are associated with a progressively falling yield. The actual amount of investment is governed by the supply price of the asset, which is a concrete sum, but the yield is based on entrepreneurs’ expectations, which are anything but concrete. This Investment-Demand schedule is also known as the Marginal Efficiency of Capital, and it plays a central role in the General Theory. (It would be better described as the Marginal Efficiency of Investment, but Keynes’s more familiar description will be used here.) It is shown in Figure 4.1. The business person will determine his or her actual investment at the point where the prospective yield (determined, as explained, by expectations) is in line with the ruling rate of interest, which is the price that the entrepreneur theoretically pays for borrowing the money. This is the point of equilibrium.

There is no dispute about Keynes’s claim that the Marginal Efficiency of Capital follows a path of diminishing returns. There is always a top limit to the investment made by any firm. If increasing returns were ever to operate, there would be a constant and indeed progressive incentive to make more investment, with a certain outcome of ever-greater yield. This obviously never happens. And although it does not provide decisive evidence that the Marginal Efficiency of Capital produces diminishing returns, it is certainly proof that business people believe this to be so.

Investment demand and where it leads

Rate of interest at different times

Yield percentage

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Capital asset formation

Figure 4.1 Investment-demand schedule (or the marginal efficiency of capital).

The argument that extra demand for capital goods will cause their prices to rise only applies if the investing firm is large enough to influence the market in this way, but not all firms that are investing are powerful enough to exercise such influence. I have therefore drawn the schedule in Figure 4.1 to show a gradual rather than a steep pattern of diminishing returns. In the long term – a period normally defined as providing enough time for radical changes to be made in production methods – enormous improvements are possible in investment yields. We are talking here about years rather than weeks, and the effect of massive evolutions such as these are best described by a shift to the right of the Investment-Demand schedule.

In summary: • Keynes used the Marginal Efficiency of Capital as an analytical device to explain investment demand, demonstrating that increases in capital assets are associated with a progressively falling yield. This is the normal pattern of diminishing returns. • Keynes hypothesized that the precise level of investment would be determined at the point where the yield from the Marginal Efficiency of Capital matches the rate of interest ruling in the marketplace. • There are problems with the practical application of this model because it has no metrics to measure it.

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Expectations The role of expectations has been mentioned repeatedly in this book. They make the most crucial contribution to investment decisions, and this is a point that will now be looked into in more detail. In the various fields of consumer goods, most manufacturers are already operating in the product category in which they may be planning to invest. There are reliable facts to demonstrate this, and the exclusion of outsiders is due to barriers to entry that have been effectively erected by established players in the field.9 They usually do this by fair means rather than foul, in particular by their sheer scale of operations and their efficiency. Not the least important of these barriers is knowledge and expertise in the product category: advantages which are obviously helpful to manufacturers who are making projections of the future. The facts that are most immediately relevant are data on overall economic trends, e.g. the rate of growth of incomes. If this is high, it points the way to opportunities for luxury brands; business depression and a loss of jobs stimulate the sales of products that offer good value for money. Another example is the growing concentration of the retail trade (a most important development during the last two decades). This concentration will drive manufacturers to reduce prices through the medium of sales promotions, which normally means a loss of net earnings. In parallel with these general trends are shifts of demographics, e.g. an increase in the birthrate will provide opportunities for brands of diapers, and as these children grow there will be increasing demand for pre-sweetened breakfast cereals. There are also changes in psychographics which often bring about permanent shifts in purchasing patterns, e.g. health conscious lifestyles that provide a great stimulus to light and “low-carb” products; and changing hairstyles that give opportunities for new types of shampoo. Manufacturers usually have a good understanding of trends such as these, insofar as they relate to the fields in which they operate. Entrepreneurs can therefore make rational projections of the likely outcome of investment in new plant and equipment when such estimates are measured in sales volume, and the outcome often arrives in the same ballpark, but from then on the problems multiply. Although it is difficult but not impossible to forecast sales volume, measuring in advance the profit that comes from these sales, i.e. the effective yield of the investment, is a much harder task. The reason for this is that extra volume will often produce unexpected effects: it may depress consumer prices because of the bargaining power of the retail trade, and it will almost certainly invite retaliation from competitors in the marketplace. To complicate matters even further, much of the incentive for a business person to invest is not the regular earnings from the extra capital employed, but rather from an overall increase in the value of the company’s equity that will boost the price of its stock. These factors are simply not susceptible to accurate or even rational estimation. An equally difficult consideration stems from that point on the InvestmentDemand schedule where the yield of the investment equals the rate of interest,

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which (supposedly) represents the price an entrepreneur pays for his or her funds. The rate of interest actually plays a subtle and rather indirect role in determining the total volume of investment. It affects both investment supply and investment demand to a limited extent. A rise in the rate of interest will reduce liquidity-preference, but it will also encourage savers to put their money into fixed-interest assets rather than into industrial equities whose long returns (if any) will mostly come from capital gains. Real estate investment is directly influenced by the rate of interest, because such investment (particularly that made by individuals to buy houses) is financed by loans from banks and mortgage companies. There is an inevitable trade-off between the alternatives of putting their money into real estate and putting it into industrial investment. Real estate provides a roof over the individual’s head, but it is often also seen as the better bet to provide capital growth. This factor alone drove – and continues to drive – the real estate boom in Britain that has now lasted for 35 years. The rate of interest is not a matter of direct operational importance to entrepreneurs, telling them precisely when to invest in specific projects, except in the rare circumstances when they are borrowing investment funds from a bank. The main way in which business people are influenced by the rate of interest comes from how interest rates impregnate the atmosphere surrounding investment in general, leading to optimism or pessimism. An environment of high interest rates will tend to make the entrepreneur look for higher returns from his or her investment than would have been the case with low interest rates. It is a matter of psychological pressure. It is in this sense that the level of investment can be seen to be determined by the rate of interest working in cooperation with the Marginal Efficiency of Capital. However, the whole process is extremely rough and ready. Keynes was perfectly well aware that (to quote Skidelsky), “Investment demand is the most unruly element in the capitalist universe.” He did not emphasize this in the General Theory, but the point was made strongly in the lectures he delivered at Cambridge before the publication of that work.10 Because of these objections, does the concept of the Marginal Efficiency of Capital collapse because it is not susceptible to measurement of even the most approximate kind? In my opinion, it does not. The two basic ideas are useful explanations of the real world. First, capital formation does follow a path of diminishing returns. Second, an entrepreneur will decide the volume of investment from a gut feeling for the likely contribution of the investment to the business, and the decision will be made in an investment environment that is conditioned by the general level of interest rates. There are also retrospective measures. The progress of firms is always monitored in some detail every year, and this gives a clear enough idea of the wisdom of the entrepreneur’s past investment decisions. However, as I must reiterate yet again, in investment decisions virtually everything depends on the accuracy of the entrepreneur’s expectations, or more precisely on the soundness of his or her instinctive judgment. The rate of interest plays a role, but as I have argued, this is of secondary importance.

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In this context we should also remember the points made earlier in this chapter that (a) investment demand is more volatile than consumer demand, and (b) it therefore has a more direct influence on the ups and downs of unemployment than consumer demand does. The largest element of consumer demand for most people – income used for necessaries – is driven by the humdrum realities of everyday life. Investment demand is almost exclusively driven by the entrepreneur’s view of the future. This is the most persuasive proof available that expectations are the root cause of variations in employment and output. Figure 4.2 illustrates the factors that contribute to investment demand, and should be compared with Figure 3.5, which provides a similar picture of consumer demand. When the boxes are connected, the dependent factor is shown by the arrowhead, and what causes it by the box at the starting point of the arrow. Consumer uncertainty and expectations

Propensity to save

Supply price of capital assets

Propensity to consume

Entrepreneurial uncertainty and expectations

Liquidity preference

Rate of interest p

Marginal efficiency of capital

Investment demand Governs absolute amount of consumption and saving

Influences marginal efficiency of capital

Aggregate demand p

Employment

National income

Figure 4.2 Investment demand.

p  policy management

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Figure 4.2 demonstrates the Marginal Efficiency of Capital to be the essential driver of investment demand. The Marginal Efficiency is controlled directly by entrepreneurial expectations and also by the cost of the capital equipment that is brought into use. In the background is the national income, the ultimate source of investment funds. Keynes’s theoretical analysis shows the actual volume of investment as determined by the point at which the level of yield – as anticipated by the entrepreneur – matches the ruling rate of interest, which supposedly determines the price at which investment funds will be provided. However, as explained in this chapter, the ruling rate of interest is not often the metric directly used to quantify the resources that will actually be used for investment. Therefore, interest rates are not usually in the forefront of the entrepreneur’s mind, although they are a background factor which entrepreneurs are conscious of when they are deploying investment funds. It is expectations that are central to investment. They are essentially an expression of calculated optimism, and the entrepreneur’s profit is to a large degree the reward for successful risk-taking: expectations that have been fulfilled in the marketplace. Decisions based on expectations are not in any way the same as speculation. Despite the inefficiency of the tools available to predict the future, business plans are always based on rational rather than blind expectations. Speculation on the other hand is not a matter of rationality, but is based essentially on a feel for the psychology of crowd behavior. This valuable mental attribute is not normally part of the tool kit of educated business people. It is not developed by study in business schools. Keynes, who had received an exclusively liberal education, possessed it to a remarkable degree. If a business is operating in the field of consumer goods, entrepreneurial expectations will inevitably be influenced by the propensity to consume. Indeed, investment decisions in any field are likely to be taken more optimistically if consumer goods’ markets are in general thriving: something usually signaled by a rising stock market. And low interest rates tend to boost the price of equities, which adds to entrepreneurial optimism. A rise in interest rates will reduce liquidity-preference. It will also depress entrepreneurs’ expectations; and (theoretically) nudge the level of investment to a higher point on the Investment-Demand schedule, which means less investment. This will in due course depress demand, income and employment. (A reduction in the rate of interest will of course produce the opposite effects.) Not surprisingly, there is yet another complication. A rise in the rate of interest will increase the supply of funds potentially available for investment. However, as Keynes repeatedly pointed out, saving and investment are not the same things. An increase in the rate of interest is therefore likely to end up with a doubly negative effect: less investment demand, accompanied by less consumer demand. This is a situation that happened often before World War Two. Figure 4.2 shows some of the complicated ways in which the economy works. One factor that exercises a considerable influence on both consumer demand and investment demand is the rate of interest. Chapter 5 attempts to

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describe this influence in more detail. Richard Kahn, “Keynes’s adjutant,” devoted a whole course of lectures to the rate of interest when I was a student. I can only remember two things about what he said. First, he made it clear at the beginning that students who wanted investment tips had come to the wrong place. Second, the content of the course was in most respects incomprehensible to my untutored ear. In Chapter 5, I shall try and do better. This chapter ends with an extremely important final point. Since saving is not synonymous with investment, it can often be greater (as we shall see in Chapter 5). When this happens, total effective demand – and therefore national income – will drop because the loss of consumer demand will not be compensated by any increase in investment demand. This reduction in national income will eventually result in a new balance between saving and investment, but with saving shrinking because of the smaller national income. It is also possible for investment to exceed saving, and this will act as a force to boost national income, producing eventually another new balance, with a higher level of saving to match the increased investment. When saving exceeds investment, the likely result will be recession; when investment exceeds saving, conditions are ripe for a boom, although this is not a certain outcome. This uncertainty makes for problems when investment is used as a tool of macroeconomic management, a tool that can be employed in two ways – through direct government investment or through government monetary policy to encourage private investment. The cover story in Business Week, July 11, 2005, was devoted to the “global savings glut . . . roughly $11 trillion in 2005, almost the size of the whole U.S. economy.” The authors of this article pointed out that sums as large as these have put pressure on central banks in all countries to reduce interest rates: a “cheap money” policy that has had only a patchy record of success in stimulating growth. Despite this qualification, the general tone of the article was optimistic about the economic opportunities provided by the huge pool of savings. Yet in comparing the sluggish economic performance of Japan (which has the highest saving rate among the major developed economies) with the much more dynamic recent record of the United States (where saving is lowest), the article did not draw the obvious inference that in Japan consumer demand is being depressed while in America it is being stimulated. After more than 70 years, Keynes’s basic lessons are still not being understood.11 In summary: • Good background data exist to help investment decisions. These data relate both to a firm’s own business and to the economy as a whole. • Nevertheless, good decision-making depends on entrepreneurial “feel.” This should be guided but not governed by the market data. Entrepreneurial “feel” varies widely among business executives. • Forecasting sales of the end product of a company is difficult but not impossible, but it is much harder to forecast profit, and the concept of

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•

the Marginal Efficiency of Capital depends totally on the ability to forecast profit. The Marginal Efficiency of Capital cannot be calculated with any precision. And the rate of interest does not usually control investment funds directly because the money does not come from banks. But both the Marginal Efficiency and the rate of interest have a strong influence on entrepreneurial expectations. They operate at a psychological level and in this way they influence investment decisions indirectly but powerfully.

Notes 1 2 3 4 5 6 7 8 9 10 11

Smithsonian, May 2006, inside front cover. Keynes, General Theory, p. 75. U.S. Department of Commerce, Statistical Abstract, 2003, p. 438. Ibid., p. 512. Ibid. Ibid., p. 757. Jan S. Slater, “New Brands: Success Rate and Criteria for Success,” John Philip Jones (ed.), How to Using Advertising to Build Strong Brands, Thousand Oaks, CA: Sage Publications, 1999, pp. 147–155. Keynes, General Theory, p. 136. John Philip Jones, How Much is Enough? Getting the Most from Your Advertising Dollar, New York: Macmillan – Lexington Books, 1992, pp. 320–323. Robert Skidelsky, John Maynard Keynes, Vol. 2: The Economist as Savior, 1920–1937, London: Macmillan, 1992, p. 499. Rich Miller, Jack Ewing, Stanley Reed, Laura Cohn, Frederick Balfour and David Henry, “Too Much Growth. A Global Savings Glut is Good for Growth – But Risks are Mounting,” Business Week, July 11, 2005, pp. 58–66.

5

The rate of interest

During the 1950s, one of the rooms on the top floor of the old Marshall Library in Cambridge University held a most unusual apparatus. It was a large metal chest, taller than a man and three times as broad. Its front face was a maze of interconnected transparent tubes containing colored liquid, with a wide, vertical central tube and a number of side tubes feeding into it. The liquid in the side tubes was controlled by faucets. The main tube fed by the others represented the national income, and the side tubes demonstrated the various influences on it: the rate of interest, money supply, consumer prices, etc. This ingenious although rather ramshackle contraption was called the National Income Machine. It was the plaything of a talented and popular faculty member, Harry Johnson, whom we met in Chapter 1. He was in his early thirties and had come to Cambridge from the University of Toronto. He subsequently moved on to build a notable career and became a prolific author. He was at the University of Chicago when he died at the age of 53, before he could be nominated for a Nobel Prize for which he was well qualified (although not for his work with the National Income Machine). The most interesting feature of the machine was that it described a dynamic world, by showing how some inputs influenced others, and how the end result of varying quantities of inputs determined the national income. The faucets themselves were not just clicked on and off: they could be partially opened, like a tap in a bathroom or kitchen, to represent marginal adjustments in the rate of interest and the other variables. The National Income Machine must have been the only multivariate model that had been constructed by a plumber! Like all mathematical models, everything depended on the judgment of the person who controlled the faucets to alter the volume of the inputs. All the machine could do was to illustrate the outcomes, and in doing this the degree of influence of each input had of course been determined by the person who gave the plumber his instructions about the diameter of the tubes. The machine was nothing but a complicated mechanical slave, although it was useful as a means of describing to students how the various inputs were likely to affect the growth or decline of the economy. I was a student at the time and I remember it well enough. I am being less ambitious in this book. Figures 3.5 and 4.2, which appeared

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The rate of interest

in earlier chapters, both feature the rate of interest. They attempt to show how this is connected with personal consumption and private investment: two of the three main influences on aggregate demand. (The third component, government expenditure, is discussed in Chapter 6.) The purpose of this present chapter is to estimate with the help of data how much influence the rate of interest actually exerts in comparison with the influence of the other macroeconomic contributors to economic progress. The Hicks analysis described later in this chapter covers eight separate inputs (including the rate of interest). A further factor – the psychology of consumer and business confidence, with its connected uncertainty and expectations – will also be discussed later, although there is no way it can be quantified.

A digression on three types of price According to the doctrines of classical economics, all types of price are determined in the same way, with equilibrium price holding the balance between supply and demand. I shall now describe very briefly three types of price, and how the tenets of classical economics may need to be modified to explain the reality of contemporary economic life. The three types of price are first, the price of goods and services; second, the price of labor, i.e. wages; and third, the price of investment capital, i.e. the rate of interest. The supply and demand mechanism describes the prices of goods and services very realistically. This is a microeconomic analysis: both supply and demand are specific to the product category in which prices are being determined. Classical economics is less good at explaining wages, and even less good at explaining the rate of interest. These last two are macro rather than micro analyses, because supply and demand are determined by inputs from the economy as a whole. The prices of goods and services The most familiar concept in microeconomics describes how the prices of goods and services are determined. These are flows, involving a repetition of buying and selling. As shown in Figure 2.1 in Chapter 2, a diagram is normally used, with price measured on the vertical axis, and the quantity of goods on the horizontal one. The demand schedule falls from northwest to southeast, demonstrating that at high prices the amount bought will be small, but at progressively lower prices, the quantity bought will become larger. The supply schedule rises from southwest to northeast, showing that at low prices only a small volume is produced: the output of the most efficient organizations. As prices rise, supply goes up as less efficient production is drawn in: from higher-cost producers and from overtime working. Price is determined at the point where the two schedules intersect. Within the limit set by price, there is no unsatisfied demand or over- or undersupply. The market describes total sales in any industry: soap or computers or air travel. Demand is virtually always responsive to a change in price, and the per-

The rate of interest

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centage response of demand to a 1 percent change in price is called the price elasticity. If demand is very elastic, the demand schedule will be relatively flat; if inelastic, it will be steep. These alternatives show that changes in price produce a large effect if demand is elastic, and a small effect if it is inelastic. The way demand is described for individual manufacturers is quite different. In conditions of pure competition, each manufacturer is a minor player and can sell all he wishes to at the prevailing price. For a single manufacturer the demand schedule is horizontal, describing extreme elasticity. It is assumed that every manufacturer is small, that his product is the same as everybody else’s and that one manufacturer’s goods can therefore be easily substituted for those made by his competitors. As a result of this high degree of competition, such markets did not provoke any moral disapproval because manufacturers could not reap extra profit by restricting their output and increasing their prices. Each market had a single ruling price, which disciplined manufacturers and restricted their ability to exploit market power. However, about a century ago economists began to agree that the description of pure competition does not apply to most real-world markets, and during the 1930s imperfectly competitive markets became a fashionable subject of study.1 These studies concluded that manufacturers had grown so large and their products so differentiated, that such oligopolists (an unattractive word coined at that time) were capable of boosting their profits by exploiting their size and the uniqueness of their products. This behavior was widely questioned on ethical grounds, and many manufacturers were brought before government regulatory agencies that had been set up to maintain competition. Oligopolists do indeed manufacture differentiated products, using advertising to develop brands, which are the most important device available to manufacturers to underscore their claims that their products have no substitutes. If they are successful, such manufacturers can reduce the elasticity of demand for their goods, and evidence exists that advertising can indeed make this possible.2 There were limits to the growth of market power for the obvious reason that oligopolists are in ferocious competition with one another. Nevertheless, most analysts during the 1930s accepted that the majority of markets were oligopolies, with the result that prices were relatively much higher than they might have been under pure competition, although there was of course no way of moving (or returning) to that situation. An important change has taken place during the past 40 years, a change that has gone substantially unnoticed, except by the Federal Trade Commission (FTC). The key feature of this has been described as the Steiner Effect (named for Robert Steiner, the FTC economist who first isolated it).3 The Steiner Effect, which can be demonstrated empirically, shows that demand is indeed relatively inelastic at the manufacturer level because of the effect of advertising in making the advertised brand unique in the minds of its buyers, thus impeding substitution if the advertised brand’s price goes up. Nevertheless, it is highly elastic at the retail level (as will shortly be explained). Consequently, retail margins tend to shrink in markets characterized by oligopoly, and this has a demonstrable

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The rate of interest

effect in reducing consumer prices. Price competition has returned with a vengeance. If any retailer tries to charge a higher price than his direct competitors, he will lose business. In economically developed countries, prices of consumer goods are usually expressions of Temporary Price Reductions (TPRs). In reality these are so continuous that they become semipermanent. As any observer can see, TPRs for specific named brands are widely advertised by the three or four largest retailers in every city, and competition between them brings down the ruling price to the lowest. Advertising and indoor displays show clearly and forcefully where the lowest price for any brand is to be found. This of course causes competitors to follow. Naturally, retailers are unhappy to see their margins squeezed. They therefore exercise their own market power with manufacturers. The size and bargaining power of retailers is understood by relatively few individuals, but it is a simple fact that the largest retailers are much bigger than the weightiest manufacturers. Wal-Mart’s sales volume in the United States is six times that of Procter & Gamble, the largest marketer of consumer goods in the world, so that it is easy to see which party has the upper hand.4 Retail bargaining power imposes uncomfortable pressure on manufacturers, who are forced to concede large and everincreasing discounts to their retail customers. Because of the competition between retailers, most of these price reductions are passed in turn to their customers: the population as a whole. Out of manufacturers’ combined advertising-plus-promotional budgets, 75 percent now goes on promotions – which essentially mean price-cutting – and only 25 percent goes on consumer advertising. (In the 1970s, the ratios were 60 percent promotions to 40 percent advertising.)5 In this rather convoluted way, consumer goods markets are highly competitive, to the ultimate benefit of the consumer. The conditions of pure competition described by the classical economists in their analysis of the price mechanism have to a large degree been restored. Paradoxically pure competition per se does not exist; and it probably never did. The important fact is that the free market has learned how to impose large restraints on oligopoly profits, and the consumer is offered goods at low prices, and prices that in real terms generally go down gradually over time.6 The price of labor Wages are determined by the same forces of supply and demand that fix the prices of other goods and services; and the way in which wages are theoretically arrived at is illustrated with the same type of diagram. On this, wages (real or money) are measured on the vertical axis and employment on the horizontal. According to the well-established doctrine of classical economics, the demand for labor depends on its marginal productivity. This demand declines as more workers are employed because diminishing returns operate through all parts of the economic system. The fall in the demand schedule from northwest to

The rate of interest

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southeast shows that high wages mean low employment (usually the workers are highly skilled and therefore very productive); and low wages mean high employment (often a reflection of an unskilled and relatively unproductive workforce). The supply of labor is determined by workers’ natural reluctance to work: something described technically although not very beautifully as the marginal disutility of labor. The higher the wages, the greater the extent to which workers will make the necessary effort, hence the rise in the supply schedule from southwest to northeast. The point of equilibrium is where the two lines intersect. This is where the prevailing wage equals the marginal productivity of the last worker employed, and where this last worker chooses to exchange leisure for wages. This place of balance is not necessarily the point at which all members of the workforce are employed: merely the point where the number of jobs on offer is equal to the number of workers who are willing to work at the prevailing wage. The theory therefore accepts the likelihood of voluntary unemployment, certainly in societies where social welfare alleviates the hardship of poverty. The theory is based on good logic, but it is not a realistic description of how wages are actually settled. There are three large impediments that block the fundamental market forces as these are played out. The first is that business people have a most inadequate idea of how to measure the marginal productivity of the workers they employ, let alone new additions to the payroll. Businesses expand by introducing innovative methods and new equipment, which usually bring substantial numbers of new men and women into employment. This is a quite different process from making marginal additions – hiring extra workers one at a time – although this may still be the norm in cottage industries in developing countries. However, in all circumstances, in both developed and underdeveloped economies, the decision to employ extra workers is based on the entrepreneur’s broad judgment of future business opportunities. Any meticulous calculation of small increments of labor productivity is, and probably always was, something that happened only rarely. The second problem with the classical theory of wages is that the free working of the labor market is constantly impeded by market concentration on the supply side caused by the bargaining power of trade unions. There is a relentless upward pressure on wages wherever strong unions exist (although with prolonged periods of prosperity, workers’ overall support for unions tends to ebb).7 The all too common consequence is that business people restrain their wage bill by refusing to increase employment or even to let people go. High wages tend therefore to be paid for by a reduction in the size of the workforce. The third obstruction to the working of the classical theory is also related to the power of trade unions. As a universal rule, wages move upward much more easily than they move downward. This is certainly true of money wages, which normally (although not always) lag behind real wages. In unionized industry, the threat to real wages from inflation normally galvanizes trade unions into action

82

The rate of interest

to push money wages up in order to resist the erosion in workers’ purchasing power. In the rare circumstances when prices are coming down, it is very unusual for money wages actually to be reduced in line. The theoretical description of wages and how the market place determines them is therefore seriously incomplete despite its logical soundness. The roadblocks just described are directly relevant to this book because they focus on the trade-off between wages and unemployment. If real or money wages remain sticky (which they normally do), unemployment is the price paid for their lack of flexibility. Underlying all matters of entrepreneurial judgment – an activity in which the entrepreneur is all too often handicapped by incomplete knowledge of his marginal costs – there are the underlying forces of uncertainty and expectation: forces that appear as a leitmotiv throughout this book. The price of investment We now return to the main topic of this chapter: capital investment that represents a stock and not a continuous flow; each investment is once and for all, with short-term and long-term consequences. Keynes differed fundamentally from the classical economists in his explanation of how the rate of interest is actually arrived at. The doctrine of classical economics explained the rate of interest, as with all other prices, by the working of supply and demand: supply representing the flow of investment funds and demand, the use of those funds by entrepreneurs to buy plant and equipment. On the supply-demand diagram, the amounts of saving and investment are set out on the vertical axis, and the rate of interest on the horizontal one. The rate of interest is seen as the mechanism to move the market to a point of natural equilibrium. The demand schedule descends from northwest to southeast, because a low rate of interest was thought to stimulate a high volume of investment, and this falls as the rate of interest rises. On the other side of the equation, the supply schedule rises from southwest to northeast, because a low rate of interest could (according to the theory) stimulate little saving, while the volume of saving increases as the rate of interest rises. The intersection of the two lines establishes the interest rate at which the funds available for investment are balanced by the actual funds that will be put to work by entrepreneurs. Keynes’s problem with this analysis is that it ignores extended consequences. At the macro level, which is Keynes’s concern, national income will soon be affected by changes in the demand for investment funds. Consider a substantial disequilibrium, such as one driven by a major increase in demand for investment funds (e.g. one caused by an across the board reduction in corporate taxes). This boost will be demonstrated by a bodily shift in the demand schedule. Keynes argued that such a shift will influence the aggregate supply schedule directly, and movements in the supply schedule will similarly influence the aggregate demand schedule.8 The reason is that both schedules drive the total amount of income, and if

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either changes, then income will also change. An increase in investment demand will cause income to rise, and vice versa, and these changes will in turn affect the sums available for saving. An increase in the supply of saving will cause income to fall because of the reduction in consumer demand (the opposite again true), and any such change will also affect the income available for savings. The result of all this activity – the final effect of shifts in the demand and supply schedules – will lack the neatness and simplicity of the classical analysis of interest, and there will be a new equilibrium based on the adjusted level of income and saving. As explained in Chapter 3, Keynes visualized the rate of interest as an element in the world of psychology rather than the world of mathematical hypotheses. The rate of interest is the sum necessary to tempt owners of money to part with its instant liquidity. A lowering of the rate of interest below a certain level and resulting increase in the amount of credit will not necessarily lead to increased investment, because of the so-called “Liquidity Trap,” which acts as a brake on reductions on the rate of interest: “The new money would just pile up unspent and uninvested because of liquidity-preference, the drive to hold cash during a severe depression.”9 At what level of interest will people be prepared to forget their fears and give up their sheet anchor? Everything depends on the circumstances of the time. More uncertain periods will call for a higher rate of interest than periods of economic stability. It is the overall level of activity and confidence that causes the rate of interest to rise or fall, with its indirect effect on liquidity-preference. Expectations of future reductions in the interest rate keep money in the “Liquidity Trap.” Shortly after the publication of the General Theory, John Hicks presented an important paper on the rate of interest. This was published in 1937.10 Hicks was at that time teaching in Cambridge, but he was later to become the leading Oxford economist. Hicks’s specific contribution is that he related financial demand, i.e. liquidity-preference, to “real” demand, i.e. that for goods, services and investment. The main points of Hicks’s substantially mathematical paper are as follows: • •

Two separate relationships exist between income and rate of interest.11 The first of these controls the demand for money (i.e. liquidity-preference) in the following ways: 1

2

In Figure 5.1A, the demand for liquidity follows a falling curve (D1/D2/D3).The higher the rate of interest the lower the demand, and the lower the rate of interest the higher the demand. The monetary equilibrium is where the demand curve cuts the supply curve (which is vertical because it is assumed that the supply of money is fixed). If the demand for liquidity increases (from D1 to D2), this causes the rate of interest to rise; if it falls (from D1 to D3), the rate of interest will come down.

84

The rate of interest A

B s LM

Rate of interest

Rate of interest

D3 D1 D2

Liquidity supply and demand

Real national income

Figure 5.1 The LM curve – the rate of interest and liquidity-preference.

3

4

5

•

Increases and decreases in liquidity-preference for transactions are governed by real national income. If this goes up, the demand for liquidity moves up (from D1 to D2), thus raising the rate of interest. If it falls (from D2 to D3), the demand for liquidity goes down thus causing the rate of interest to drop. The various points of equilibrium on Figure 5.1A are plotted on Figure 5.1B. This is the LM curve, which compresses together four different variables: the rate of interest, the demand for liquidity, the supply of money and the real national income. The slope of the LM curve (from southwest to northeast) shows a direct relationship between the two variables. This is because of the direct correlation between real national income and liquidity-preference for transactions (high-high and low-low). If real national income goes up, liquidity-preference for transactions also goes up (and vice versa). If liquidity-preference increases, this will raise the rate of interest (and vice versa). Therefore “real” national income is directly related to the rate of interest.

The second relationship – that concerning the relationship between the rate of interest, and demand and income – is rather more complex: 1

2

Figure 5.2a describes the relationship between the rate of interest and “real” demand: planned spending on both consumption and investment. Planned spending increases as the rate of interest falls, and it falls as the interest rate rises. Increased spending causes the national income to rise, inducing additional saving, and reduced spending has the opposite effect. Therefore

The rate of interest

85

B

Demand induced saving Real national income A

C

Rate of interest

Rate of interest

IS

“Real” demand for goods, services and investment

Real national income

Figure 5.2 The IS curve – the rate of interest and demand and income.

3

4

•

the curve of induced saving (Figure 5.2B) rises from southwest to northeast. The steepness of the slope is governed by the marginal propensity to save and by the Investment Multiplier. Figure 5.2C plots the various points of equilibrium in Figures 5.2A and 5.2B. This is the IS curve, which compresses together six different variables: the rate of interest, planned spending, the propensity to save, the Investment Multiplier, induced saving and the national income. The slope of the IS curve (from northwest to southeast) shows an inverse correlation between the two variables. This is because of the inverse relationship between the interest rate and “real” demand (highlow and low-high). Since there is a direct relationship between the level of national income and “real” demand, the rate of interest and the national income are correlated inversely.

Income and interest rate are determined where the two curves intersect (Figure 5.3), which is where equilibrium has been established in both the money market (LM) and the commodity market (IS).

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The rate of interest

IS

Rate of interest

LM

Real national income

Figure 5.3 Hicks’s analysis of income and the rate of interest.

•

•

The Marginal Efficiency of Capital (described in Figure 4.1) shows the level of investment stimulated by a given rate of interest; and the Investment Multiplier tells us what level of income will be necessary for saving to match investment. The rate of interest is an important factor determining liquidity-preference, which is a leading influence on the supply of investment funds. It also substantially determines the income necessary to provide these funds.

Although Hicks provided a important extension to Keynes’s doctrine, and in so doing widened the acceptance of the General Theory in the academic community, the debate about the drivers of the rate of interest is now less urgent than it once was. It has to some extent given way to a debate about what effect changes in the rate of interest will have on the overall prosperity of the economy. The reason for this change of emphasis is that the people and organizations charged with running the economy (in economically developed countries at least) manipulate the rate of interest via the central bank. And these adjustments are used as a mechanism to control the economy’s responses to economic fluctuations. The rate of interest is no longer left to the vagaries of the marketplace. In most countries, a person or persons with the authority of Alan Greenspan (Chairman of the Federal Reserve until he retired in January 2006) fixes it and

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announces changes following regular meetings with colleagues. This procedure is a direct legacy of Keynes. Not only did Keynes bequeath the interest rate as a tool of economic management, but in a broader fashion he also left the legacy of the government’s role in pulling the macroeconomic levers. In this, he made two bequests: monetary policy and fiscal policy (the latter is discussed in Chapter 6). At the center of monetary management is the rate of interest, and the discussion in the rest of this chapter will therefore be concentrated, not on its causes, but rather with the effects of interest rate changes on the American economy during the last third of the twentieth century. In summary: • Classical economic theory explains well how supply and demand determine the prices of goods and services at a micro level. Developments in the marketplace during the last 40 years have restored much of the vigor of competition that was beginning to be lost as markets gradually became concentrated over the course of the previous century. • Wages – the price of labor – are not satisfactorily explained by the traditional analysis of supply and demand. From a macro point of view, wages are sticky in the downward direction partly because of the bargaining power of labor unions and also because of legal restrictions. A fall in demand for labor results in unemployment rather than lower wages: the starting point of the General Theory. • The rate of interest – the price of investment, which is a macro analysis and measures stocks not flows – is not satisfactorily explained by the forces of supply and demand because they fail to take into account the effect of these forces on the size of the national income. Changes in investment demand directly influence the size of the national income. The saving generated to balance the investment demand goes up or down in accordance with how much national income rises or falls. • Keynes’s theory of liquidity-preference provides an improved explanation. Liquidity-preference and other important variables are explained elegantly and with great economy by Hicks’s interpretation of Keynes. In this, Hicks succeeded in compressing the effects of eight different variables. • Because the rate of interest is now used as a tool of macroeconomic management, the study of the rate of interest has moved from an analysis of its causes to an examination of its effects on the economy.

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The rate of interest

Four periods of economic activity As in Chapters 2 and 3, I focus on the 35 years from 1968 through 2002. I am going to look at the two main indicators of the health of the economy: average annual unemployment and average change in real GNP/GDP. I also examine seven explanatory indicators: the various influences on that health, listed in Table 5.1. The best way to look at the relationships between these macroeconomic factors is to cluster the 35 years into self-contained periods during which we can average the measures and show differences: sometimes rather sharp ones. The analyses in this chapter are again all based on information published in the various annual editions of the Statistical Abstract of the United States. The U.S. Census Bureau collects most of its figures by pulling together information covering in its entirety each macroeconomic field (e.g. private consumption) in the same way as the population census is counted. This is a laborious process, but it avoids the inaccuracy of sampling and we do not need to look upon the figures as mere approximations because of sampling error. Some data are collected from sample surveys, although the samples are very large so that the sampling error is minimal. The figures that appear in the tables in this chapter are all reasonably precise, or at least as accurate as the U.S. Census Bureau statisticians can make them (although in some series of statistics, discrepancies occasionally occur; these are corrected in the Statistical Abstracts published in later years). As a general rule small differences in the figures are significant. Table 5.1 looks separately at four self-contained periods: • • • •

1968–1973, six prosperous years before the downturn 1974–1983, ten years of recession (although a modest reduction in activity compared with the depression of the 1930s) 1984–1991, eight prosperous postrecession years 1992–2002, 11 years of high prosperity

As explained, for each period the annual figures are averaged. In the cases of changes in GNP/GDP, changes in personal consumption and changes in private investment, the figures have been inflation-proofed, i.e. the declining value of the dollar has been factored into the calculations. The period on which it is most worthwhile to focus is the ten years of recession, 1974–1983. At this time all the measures of American economic performance moved in a negative direction, and most of the discussion that follows concentrates on that time: a period during which the rate of interest played a pivotal role. The central bank manipulated the interest rate in order to control inflation, and this was not a total success. What was even worse was that the use of this tool also led to a slackening of economic growth because it kept the economy working at below its full capacity. We therefore see a double problem with the interest rate: the crudity of its effect in controlling inflation, and the seemingly inevitable side effect of reducing growth. The basic cause of the troubles was an exogenous factor (i.e. one outside the

The rate of interest

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Table 5.1 United States economic performance during four separate periods (unweighted averages) 1968–1973 1974–1983 1984–1991 1992–2002 Number of years Average unemployment (%) Average change in real GNP/GDP (%) Average federal funds discount rate (%) Average change in real personal consumption (%) Average change in real private investment (%) Number of years Average change in consumer prices (%) Average change in money supply (%) Average personal saving as percentage of disposable personal income (%) Average current account trade balance ($ Bn.)

6 4.7 +3.5

10 7.5 +1.8

8 6.4 +3.0

11 5.4 +3.2

5.8

9.7

7.2

6.0

+4.3

+2.5

+2.8

+3.6

+5.6

0.9

+1.9

+6.3

6 +4.9

10 +8.5

8 +4.0

11 +2.5

+6

+7

+9

+11

7.2

6.7

5.1

4.2

+0.5

5.3

106.4

217.6

features of the economic landscape that have been discussed so far in this book). This factor was changes in the wholesale price of petroleum (detailed in Table 5.12). It will be no surprise to readers that the problems of the decade began with a sharp spike in petroleum prices after 1973, to a level in 1974 107 percent higher than the average for the six preceding years. This more than doubling of prices was not the outcome of any absolute shortage of supply. It was the result of a deliberate restriction of output by the Organization of Petroleum Exporting Countries (OPEC), with the explicit aim of boosting prices, and it clearly succeeded in doing this. The Austrian economist Josef Steindl explains this as follows: the case of oil demonstrates the consequence of laissez-faire: the excessively low prices of the pre-OPEC times made the industrial world wasteful of oil and drove it into an extreme dependence on oil producers who then took revenge on their former exploiters.12 Petroleum prices affect the costs of all goods and services, since petroleum is used universally to produce them and/or to bring them to market. The result of the petroleum price rise was therefore a corresponding increase in overall inflation, which also doubled in 1974 in comparison with the six years before. Similar surges in petroleum prices accompanied by increases in inflation continued over the decade of recession, with very substantial spurts in 1979, 1980

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and 1981. During these three years, the exporting countries edged their supplies of petroleum upward more quickly than had happened in 1974, which meant that the relative jump in petroleum prices in 1979, 1980 and 1981 was more gradual. To some extent this practice tamed the effect on inflation.13 Despite this, the increases in overall prices had a disruptive effect on the economy, particularly on unemployment, for a number of years. During the whole ten-year period, the money supply grew in response to the increase in prices. The reason why the Federal Reserve took four years to increase the interest rate significantly was the need to keep some buoyancy in GNP/GDP, and at the same time restrain unemployment growth. After some delay, this policy showed some success. In the end, the inevitable effect of the increases in the rate of interest was to slow the rate of economic progress, as can be demonstrated by comparing the years 1974–1983 with the six preceding years 1968–1973. •

•

• • • •

•

•

Over the ten-year period consumer prices rose to almost twice their normal annual rate, but the situation would almost certainly have been worse without the dampening effect of the higher interest rates. Unemployment moved sharply upward, from 4.7 percent to 7.5 percent, mainly due to the cooling of the economy. In the background was a gradual increase in labor productivity (described in Table 2.2) that was continuously holding back the demand for workers. (This factor also accounts for some of the stickiness in unemployment after 1983.) The average rate of inflation went up from 4.9 percent to 8.5 percent. The annual growth rate in GNP/GDP fell by almost a half. The annual growth in real personal consumption fell by more than 40 percent. The average change in real personal investment fell in a most pronounced way, from an average annual growth of 5.6 percent to an average annual decline of 0.9 percent. Average saving as a proportion of disposable person income fell modestly, from 7.2 percent to 6.7 percent (but readers will remember that relatively high saving accompanied by relatively low investment acts as a drag on the economy by stifling personal consumption). A negative current account trade balance became the norm. This was the start of a secular trend. (See Table 5.11.) Between 1974 and 1983 the high rate of interest encouraged the movement of overseas funds to the United States, and this improved the foreign exchange value of the dollar. The higher-valued dollar encouraged imports, but the impetus of this growth of imports continued long after the rate of interest had come down again. The growth of imports became a genuinely long-term problem, reflecting structural changes in the American economy.

The first two of these factors – unemployment and inflation – have been shown to be inversely related in certain circumstances. A.W.H. Phillips, a New

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Table 5.2 United States interest rates and unemployment, 1968–2002 Year

Federal funds discount rate (rounded)

Unemployment % of civilian labor force

Year

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

5.50 6.00 6.00 5.25 4.50 7.50 8.00 7.75 6.00 6.00 9.50 12.00 13.00 14.00 12.00 8.50 9.00 8.00

3.6 3.5 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.0 6.0 5.8 7.1 7.6 9.7 9.6 7.5 7.2

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Federal funds discount rate (rounded) 7.50 6.00 6.50 7.00 8.10 5.70 3.50 3.00 4.20 5.80 5.30 5.50 5.40 5.00 6.20 3.90 1.70

Unemployment % of civilian labor force 7.0 6.2 5.5 5.3 5.6 6.8 7.5 6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0 4.7 5.8

Notes When a range of interest rates is published for any year, I have selected the top end of the range. Beginning in 1990, the rate of interest is classified as the Federal Funds Effective Rate.

Zealand-born economist, carried out in 1958 a wide-range empirical study and plotted a regression that became known as the Phillips Curve. This curve shows a clear relationship between low unemployment and high inflation and, proceeding in steps, to a relationship between high unemployment and low inflation. Note that this contradicts American experience during the period 1974–1983. The commonsense logic behind the Phillips Curve is that when unemployment is low, the labor market is tight and higher wages must be offered to attract workers; and vice versa when unemployment is high. Phillips had an operational importance that was comforting to Keynesians: if moderate inflation could be accepted, unemployment would be contained and even reduced. The Phillips Curve describes reality when prices are increasing at an average rate, but with high inflation the user of the Phillips Curve should be guided by the precept caveat emptor. With high inflation (or even moderately high inflation, as in the period 1974–1983) different, longer-term forces come into play, in particular expectations. These forces turned Phillips on its head. The Americans Milton Friedman and Edmund Phelps demonstrated that high inflation is usually associated with higher rather than lower unemployment. They developed a

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Table 5.3 United States changes in consumer prices and unemployment, 1968–2002 Year

Change in consumer prices

Unemployment % of civilian labor force

Year

Change in consumer prices

Unemployment % of civilian labor force

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

+4.2 +5.4 +5.9 +4.4 +3.1 +6.2 +10.9 +9.1 +5.8 +6.5 +7.6 +11.0 +13.6 +10.7 +6.1 +3.2 +4.4 +3.6

3.6 3.5 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.0 6.0 5.8 7.1 7.6 9.7 9.6 7.5 7.2

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

+1.6 +3.6 +4.1 +4.8 +5.4 +4.2 +3.0 +3.0 +2.6 +2.8 +3.0 +2.3 +1.6 +2.2 +3.4 +2.8 +1.6

7.0 6.2 5.5 5.3 5.6 6.8 7.5 6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0 4.7 5.8

Notes When a range of interest rates is published for any year, I have selected the top end of the range. Beginning in 1990, the rate of interest is classified as the Federal Funds.

model more complex but more reliable than the Phillips Curve, called (rather clumsily) the Expectations-Augmented Curve, and this has its uses for macroeconomic management.14 Since 1997, the Expectations-Augmented Curve has been modified. During this period, unemployment has been low but – surprisingly – so has inflation. A tight labor market has not generated high inflation. It has been suggested that this has been caused by competition from unskilled workers overseas who produce goods for the American market, and which has discouraged American workers from seeking higher wages. The Phillips curve has flattened, but this is closer to present-day reality than the Expectations-Augmented Curve.15 To return to the 1974–1983 period, the increases in the rate of interest moved relentlessly to turn an inflationary situation into recession. In doing this, they played an intermediary – linking – role. Was the resultant recession inevitable? Was the degree by which inflation was controlled justified by the price paid in increased unemployment and reduced growth? These are variables that cannot be quantified and must therefore remain hypothetical; our judgment of this matter depends on how worried we should be about inflation. Is it indeed the worst of all available alternatives? This is a point to which we shall return.

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One way to get closer to the influence of interest rates on the main economic indicators is to compare the effects on these indicators of low interest with the effects of high interest. This is done in Tables 5.4, 5.5, 5.6, 5.7, 5.8, 5.9 and 5.10. By all these measures, low interest rates had a more benevolent effect than high ones, but with a single exception (discussed in the next paragraph), the effect was rather small and the direction of causality unclear. In one case (described in Table 5.8), high interest rates were clearly associated with high inflation. This came about because high interest rates were imposed to control inflation, as explained earlier. It is therefore futile to look for any causal relationship from interest rates to inflation. Table 5.4 United States unemployment related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

Average unemployment %

Up to 6.0 Over 6.0

19 16

5.0 9.0

5.6 6.7

Table 5.5 United States changes in real GNP/GDP related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

GNP/GDP at constant prices average year-onyear change %

Up to 6.0 Over 6.0

19 16

5.0 9.0

+3.2 +2.4

Table 5.6 United States changes in personal consumption related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

Personal consumption at constant prices average year-on-year change %

Up to 6.0 Over 6.0

19 16

5.0 9.0

+3.6 +2.7

Table 5.7 United States changes in private investment related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

Private investment at constant prices average year-on-year change %

Up to 6.0 Over 6.0

19 16

5.0 9.0

+6.0 +0.2

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The rate of interest

Table 5.8 United States changes in consumer prices related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

Consumer prices year-on-year change %

Up to 6.0 Over 6.0

19 16

5.0 9.0

3.6 6.6

Table 5.9 United States changes in money supply (M3) related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

Money supply year-on-year change %

Up to 6.0 Over 6.0

19 16

5.0 9.0

+7 +9

Table 5.10 United States average personal saving related to interest rates, 1968–2002 Federal funds discount rate %

Number of years

Average federal funds discount rate %

Personal saving as % of disposable personal income

Up to 6.0 Over 6.0

19 16

5.0 9.0

5.3 6.0

The single striking correlation is that between low interest rates and high private investment and vice versa (illustrated in Table 5.7). This echoes the point made in Chapter 2 about the central importance of private investment, and it will help us to map out directly the chain of causes between the various economic factors and how they contributed to the economy in recession during the period 1974–1983. First, a high interest rate was imposed to tackle inflation, but inflation remained fairly high, and worse consequences were to come. The policy of increasing interest was nevertheless correct because it is virtually certain that without a high rate of interest, the degree of inflation would have been greater, perhaps much greater than it actually was. The second thing that happened was that, because of the high interest rate, private investment started to shrink. This in turn increased unemployment and reduced the growth in GNP/GDP. These negative changes caused a reduction in personal consumption which also in due course reduced unemployment and inhibited the growth of income. At the end of the 1970s, the Federal Reserve also took the advice of Milton Friedman and his followers and controlled the money supply, allowing it to grow only gradually because it was thought that this would restrain inflation.

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Table 5.11 United States interest rates and changes in current account trade balance, 1968–2002 Year

Federal funds discount rate (rounded)

Current account trade balance $Bn.

Year

Federal funds discount rate (rounded)

Current account trade balance $Bn.

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

5.50 6.00 6.00 5.25 4.50 7.50 8.00 7.75 6.00 6.00 9.50 12.00 13.00 14.00 12.00 8.50 9.00 8.00

+0.6 +0.4 +2.3 1.4 5.8 +7.1 +2.0 +18.1 +4.3 14.3 15.1 0.3 +2.3 +5.0 11.4 43.6 96.8 121.7

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

7.50 6.00 6.50 7.00 8.10 5.70 3.50 3.00 4.20 5.80 5.30 5.50 5.40 5.00 6.20 3.90 1.70

147.5 163.5 126.7 101.1 90.4 3.7 62.4 82.0 117.7 105.2 117.2 127.7 204.7 290.8 411.5 393.7 480.9

Notes When a range of interest rates is published for any year, I have selected the top end of the range. Beginning in 1990, the rate of interest is classified as the Federal Funds Effective Rate.

This policy effectively came to an end in 1982, because inflation remained high and unemployment was actually increasing. “Since then the Fed has engaged in precisely the sort of discretionary fine-tuning that Friedman decried.”16 (Keynes was also opposed to fine-tuning, but both Keynes and Friedman were wrong.) Tight control of the money supply was shown not to work. And the interest rate mechanism was shown to be an imprecise and rather dangerous tool, although there are no realistic alternatives. We should however ask the question: Does inflation represent a real disaster? Is it vital to suppress inflation, or at least keep it at a low level? The answer is yes. Inflation produces two vicious effects: serious hardship to people on fixed incomes, and an endemic instability to all parts of the economic system. Keynes certainly worried about the latter. He had observed what had happened in Russia and Central Europe during the 1920s, a time when: “. . . a currency crisis or flight from the currency was experienced, when no one could be induced to retain holdings either of money or of debts on any terms whatever.”17

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Table 5.12 United States wholesale prices of crude petroleum related to changes in consumer prices, 1968–2002

1968–1973 (average) 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984–1991 (average) 1992–2002 (average)

Wholesale price of crude petroleum $ per barrel

Consumer prices year-onyear change (%)

3.31 6.87 7.67 8.19 8.57 9.00 12.64 21.59 31.77 28.52 26.19 17.86 17.38

+4.9 +10.9 +9.1 +5.8 +6.5 +7.6 +11.0 +13.6 +10.7 +6.1 +3.2 +4.0 +2.5

The effect of changes in the interest rate on private investment is difficult to predict. As I argued in Chapter 4, the rate of interest influences entrepreneurs’ investment policy through its effect on expectations. It does this to a far greater degree than through its ability to manipulate investment by prompting entrepreneurs to move up and down their schedules of the Marginal Efficiency of Capital: a concept far distant from reality. A secondary factor is the influence of a low or high rate of interest on stock prices. Low interest reduces the demand for fixed-interest securities and boosts the demand for equities. This situation leads to a bullish stock market, which tends to improve personal and business expectations. These are of course favorable for investment. A further – and even larger – problem with the rate of interest is its greater ability to dampen a high level of economic activity than to stimulate the economy to grow from a low one. It has a sledgehammer effect, which is apparent from Table 5.1, where we see that it took eight years to climb out of the ten years of recession. Keynes had a word to describe this: “. . . the phenomenon of the crisis – the fact that the substitution of a downward for a upward tendency often takes place suddenly and violently.”18 It was only in 1992 that strong growth was resumed again. Even then, extra demand was being pumped into the economy by budgetary and trade deficits (discussed in Chapter 6). We can conclude from this chapter that Keynes’s basic analysis of the problems is generally supported by American data from the last third of the twentieth century, but the first of Keynes’s prescriptions to solve economic difficulties, manipulation of the interest rate, is imperfect. It can be both clumsy and painful in its effects during tough economic times, although it must still be used during depression, faute de mieux. However, experience is making the rate of interest an increasingly practicable tool for use when the economy is reasonably stable.

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For many years, the Federal Reserve has been limiting its changes in interest to tiny adjustments of 25 Basis Points (i.e. one quarter of 1 percent). In fact, since the beginning of the 1990s, the vigilance and improved skills of the Fed have done a good job of controlling inflation without greatly inhibiting economic growth. In comparison with the rate of interest, how efficient is Keynes’s second bequest: direct demand management through government fiscal policy? This is discussed in Chapter 6, and as in the other chapters in this book, it deals with facts. We should however remember that fiscal policy is not always – or even often – carried out in order to manage consumer demand. The traditional objective is to balance the government’s books. Keynes opened it up for a different purpose, and we shall look at the evidence of its effects as Keynes intended. In summary: • United States experience over the 35 years from 1968 to 2002 reveals ten years of recession, 1974 to 1983, which were an interruption between periods of generally unbroken economic growth. • This recession was triggered by a substantial increase in the price of petroleum after 1973, followed by further rises each year up to 1983. There was an unsuccessful attempt to apply tight controls on the money supply at the end of the 1970s. • The American monetary authorities also began to increase the rate of interest to a serious degree in 1978, with the objective of curbing general inflation. The extent to which inflation was restrained, and also how much the higher interest rates influenced national income and unemployment, will be summarized at the end of Chapter 6 (an extended summary because it covers the effects of both monetary and fiscal policy on the health of the American economy).

Notes 1 Edward Hastings Chamberlin, The Theory of Monopolistic Competition, Cambridge, MA: Harvard University Press, 1933, reprinted 1948; Joan Robinson, The Economics of Imperfect Competition, London: Macmillan, 1933, reprinted 1950. 2 John Philip Jones, The Ultimate Secrets of Advertising, Thousand Oaks, CA: Sage Publications, 2002, p. 165. 3 Robert L. Steiner, “Does Advertising Lower Consumer Prices?,” Journal of Marketing, 37, October 1973, pp. 10–27; Michael Lynch, The “Steiner Effect”: A Prediction from a Monopolistically Competitive Model Inconsistent with Any Combination of Pure Monopoly or Competition, Washington, DC: Bureau of Economics, Federal Trade Commission, 1986, unpublished. 4 The six-to-one ratio is my own estimate. The aggregate annual value of Wal-Mart sales is more than three times that of Procter & Gamble and Gillette combined. However, the vast preponderance of Wal-Mart sales is made in the United States. For Procter & Gamble and Gillette, the proportion is about 50 percent.

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The rate of interest

5 John Philip Jones, “Trends in Promotions,” in The Advertising Business, John Philip Jones (ed.), Thousand Oaks, CA: Sage Publications, 1999, Chapter 31. 6 See for example Lord Heyworth, Advertising, Chairman’s Annual Speech to stockholders, London: Unilever Limited, 1958. This is a very authoritative source, based on an examination of a range of Unilever brands. One of the points that Heyworth makes is that over time the quality of goods improves as a result of technical innovation. This means that any reduction in price is de facto greater than it appears. Most price reductions are in fact now connected with the reduction in retail margins caused by the Steiner effect. See endnote 3. 7 See for instance Anon., “America’s Labor Federation: Losing Its Grip,” The Economist, July 30, 2005, pp. 25–26. 8 Keynes, General Theory, pp. 180–182. 9 Mark Skousen, The Making of Modern Economics. The Lives and Ideas of the Great Thinkers, Armonk, NY: M.E. Sharpe, 2001, p. 346. 10 J.R. Hicks, “Mr. Keynes and the ‘Classics’; A Suggested Interpretation,” Econometrica, 1937, pp. 147–159. 11 The analysis in Figures 5.1, 5.2 and 5.3 are based on the explanations provided by Robert J. Gordon, Macroeconomics, 4th Edition, Boston: Little Brown, 1987, pp. 95–112. 12 Josef Steindl, “J. M. Keynes: Society and the Economist,” in Keynes’s Relevance Today, Fausto Vicarelli (ed.), London: Macmillan, 1985, pp. 122–123. 13 Jeremy Leggett and David Jenkins, “When Will Oil Run Out? And What Happens Then?” Prospect, December 2005, pp. 22–25. 14 Kevin D. Hoover, “Phillips Curve,” in The Fortune Encyclopedia of Economics (David R. Henderson, ed.), New York: Warner Books, 1993, pp. 279–284. 15 “Economics Focus – Curve Ball,” The Economist, September 30, 2006, p. 88. 16 Paul Krugman, “Who Was Milton Friedman?” New York Review of Books, February 15, 2007, p. 29. 17 Keynes, General Theory, p. 207. 18 Ibid., p. 313.

6

What should the government be doing?

What role should the government be playing in managing the macro economy? This is a debate that has continued – inconclusively – for more than a century. Here are the views of three Britons (or to be precise a Scotsman, an Englishman and a Welshman), all figures of major importance: Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole, or almost the whole public revenue, is in most countries employed in maintaining unproductive hands. Adam Smith1 The important thing for Government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all. John Maynard Keynes2 Parliamentary government is being asked to solve the problem which so far it has failed to solve: that is how to reconcile parliamentary popularity with sound economic planning . . . how to persuade the people to forgo immediate satisfactions in order to build up the economic resources of the country. Aneurin Bevan3 At one extreme, Adam Smith describes the basic libertarian argument that the less that government is involved, the better this will be for society. To the classical economists, the activity of government should be minimized and mainly confined to three (later four) basic tasks: • • •

to provide legal protection for private property and to enforce contracts; to maintain national defense and public safety, and to protect people from crime; to mitigate the worst effects of poverty (although there was a good deal of flexibility in interpreting this);

100 •

What should the government be doing? and (as economies developed), to control economic abuses, in particular by maintaining healthy competition: hence the 1890 Sherman Anti-Trust Act and the founding of the Federal Trade Commission in 1914.

At the opposite extreme we have the view of the pioneering socialist politician Aneurin Bevan, who is clearly concerned with the practical difficulty of persuading the electorate to accept the wisdom of allowing politicians to make their economic decisions for them. Running through his words is his belief in dirigisme: that the government’s job is to plan economic development and enforce priorities, which will of course dictate how resources are to be allocated. Bevan brings to mind the world of Five-Year Plans, state control of the “commanding heights” of the economy, production targets and Incomes Policies. These ideas go far beyond Keynes, and fortunately they have become anachronisms (except perhaps in Brussels, where there is a faint echo of these things in the pronouncements of the European Union, a highly bureaucratic organization that carries out its business in a palace of spectacular size and vulgarity). Keynes defines his position precisely. This was derived from his conclusion – which is questioned by very few people – that at a macro level, the problems of competitive capitalism are not self-correcting; unemployment is not eliminated by the natural forces of the market. When this happens, Keynes believed that the government must step in and take measures to correct the situation. Keynes was sensitive to possible attacks from people who saw his prescriptions as advances toward socialism. He was therefore slightly defensive in describing what he thought should be done (my comments are in italics): In some other respects the foregoing theory is moderately Conservative in its implications. (The Conservative party – spelt with a capital C – is on the right of the British political spectrum. In many respects it resembles the American Republican party.) For whilst it indicates the vital importance of establishing certain central controls in matters which are now (i.e. in 1936) left in the main to individual initiative, there are wide fields of activity which are unaffected. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways.4 This chapter is concerned with the extent to which governments have succeeded in managing aggregate demand and unemployment through what has become known as fiscal policy. (Monetary policy was discussed in Chapter 5.) Fiscal policy embraces (a) changes in taxation and (b) changes in government spending. Such changes have been plentiful over the years, so that there should be a good deal of information to help us judge their effects, but there is a problem to bear in mind when we judge their influence on National Income and unemployment. The problem is because changes in taxation and government spending since the early 1980s have mostly been carried out for purposes uncon-

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nected with the problems of stagnating income and high unemployment that were Keynes’s concerns. Taxes (federal taxes at least) have almost always been moved up and down for reasons of broad social and economic policy, e.g. to raise money to pay for government programs, to correct inequities and to provide incentives for effort and risk-taking. Similarly, government expenditures have been manipulated (mostly increased) with a range of general objectives in mind, e.g. to boost defense expenditure and welfare subsidies. Nevertheless, despite the fact that the purpose of the changes may have been different from Keynes’s, it is perfectly appropriate to examine their effects on what Keynes was looking for. This is what I shall try and do in this chapter. In summary: • Keynes believed that the government should play a role in macroeconomic management, in particular to sustain aggregate demand in the economy. The government’s role should be confined to this. • He did not support the broader aims of the British Socialist Party, notably the state ownership of industry: aims increasingly endorsed by public opinion during World War Two and which became government policy in 1945.

American economic policy during the 1930s The first important example of the government’s use of taxation and public expenditure to inject life into the economic system was Franklin Roosevelt’s New Deal, which dates from 1933. The wide-ranging measures that were carried out were intended partly to increase national income and reduce unemployment, but although the outcome was not total failure, it was certainly close to it. The main reason is that the schemes set in motion were not funded by much “new” money: there was little net additional investment.5 The most important parts of the New Deal mobilized government money (financed by taxation) to pump up the economy: money that came in most cases from both federal and state coffers. There was a total of 38 major New Deal projects between 1933 and 1941, and the main ones involving public expenditure were: • •

•

the Civilian Conservation Corps (CCC), to mobilize young men to do manual work in wilderness areas; the Public Works Administration (PWA), to carry out major building projects, mainly roads and bridges but also to build two aircraft carriers that performed noble service in World War Two; the Civil Works Administration (CWA), which provided 800,000 jobs for a variety of public projects including some related to the arts;

102 • • •

What should the government be doing? the Works Progress Administration (WPA), again for a range of public enterprises; the Reconstruction Finance Corporation (RFC), to provide funds for the above activities; the Federal Emergency Relief Act (FERA), which also provided banking services for public projects.

This is a formidable and imaginative list of programs. They are usually put on the credit side of the balance sheet when President Roosevelt’s achievements are measured. Yet their final outcome was disappointing because the New Deal had very little effect in boosting the national income and reducing unemployment, except by a relatively small amount and for a short period. The amount of money spent on all these schemes was in fact fairly small, e.g. $2 billion on the CCC, and another $2 billion on the RFC (which funded many programs, including the WPA). Even worse, these funds did not represent real additional investment. Between 1933 and 1939, 43 percent of federal relief and public works expenditures were paid for by tax increases, and 57 percent by borrowing funds, nearly all from the banks. This meant that the banks bought government bonds with money that they might otherwise have used to lend for investment in private projects. The New Deal was also characterized by heavy bureaucracy, much inefficiency and some corruption. The result of all this economic activity was that the New Deal provided very few additional resources to boost aggregate demand. For this reason, it is not surprising that it did not do much to tackle the fundamental problems that Keynes described. The avowed purposes of the New Deal were “relief, recovery and reform.” There is a powerful social agenda here, and it is obvious that some of the programs had a much more left-wing orientation than Keynes intended. The New Deal was in other words as much about redistributing income as increasing it. Hence the importance of the tax increases which paid for almost half the total range of programs. It must also be remembered that the Social Security Act was passed into law in 1935. This piece of legislation with a clear social purpose is even more important today than it was during the 1930s. What happened after the end of the 1930s provides a striking contrast to the history of the New Deal.6 The unemployment rate was 23.3 percent in July 1933; 21.3 percent in July 1935; 15.3 percent in December 1936 (a promising reduction); but it was up again to 20.1 percent in May 1938. A second depression had hit the country, and this was caused by a financial factor: a restriction of the money supply, allied to an increase in labor costs because of higher taxes, including the new ones to fund social security. It was obvious that the various programs of the New Deal were able to do very little to correct the problems. The big change took place in 1940, when spending on rearmament was boosted very substantially. Federal government purchases increased from $15 billion in 1940 to $36 billion in 1941; to $99 billion in 1942; and to $148 billion in 1943. As a direct consequence, unemployment came down to 14.6 percent in 1940; 9.9 percent in 1941; 4.7 percent in 1942; and 1.9 percent in 1943. Over

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the period, GNP per capita increased by 43.3 percent. Between 1940 and 1943, real federal expenditures increased almost nine times while taxation did not quite double. It was “new” money that was being spent; the federal government was running at a deficit. The lesson from comparing the periods 1933–1939 and 1940–1943 is clear. The ability of government to boost national income and reduce unemployment is a direct outcome of the amount of money spent. If unemployment is sticky, government spending must increase quite dramatically if it is to have an effect. If there is plenty of slack in the economic system, the result will mainly be seen in increased output, with little increase in prices. If the economy is working close to full capacity, or if there are bottlenecks, the specters of inflation and stagnation will all the time confront the people who are pulling the macroeconomic levers. This danger is always present in government attempts to spend its way out of depression, although (as we shall shortly see) it was remarkable how this danger was avoided during the period 1984–2002. In summary: • The New Deal was undertaken for both social and economic reasons. Although the social effects have been applauded, the program was not successful in boosting national income and reducing unemployment because it was funded by an inadequate net increase in government investment. • With the approach of World War Two, rearmament was financed by a much more serious increase in government spending. This had a direct effect on reducing unemployment. This experience reveals a crude correlation between the size of government investment and the extent to which unemployment is reduced. However, the starting point in boosting investment must be higher than might have been originally thought, but it is a dangerous remedy if the economy is working close to full capacity, because the direct result will be inflation.

The travails of understanding government statistics For decades I have worked as a professional user of statistics, mainly those generated by large-scale quantitative studies of consumers. The first task of any person who relies on statistical data must be to be reassured that the figures are reliable. As part of this process I have long applied what the A.C. Nielsen research organization used to call the test of “reasonability.” This is nothing but applied common sense allied to some skepticism. With experience, the user of statistics learns to compare, almost instinctively, different tranches of data: series of figures that may not necessarily be connected directly although they may overlap slightly.

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What should the government be doing?

The questions one asks oneself include the following: Are the different series of figures self-supporting? Are there harmonies – sometimes rather subtle ones – between them? Do all trends point in the same direction? If any of these answers is negative, one must keep on chewing over the discrepancies to try and explain them. Are there elements in some sets of figures that are not included in others? (In which case, one series of data may be the most reliable.) And if surveys based on samples of the population are used, were respondents asked the same or different questions? And what were the sample sizes? This chapter is devoted to government expenditure (including investment). Figures on US government expenditure appear in Chapter 2 (Tables 2.5 and 2.6) and also in this chapter (Table 6.1). These data do not appear to be increasing: a matter that has not been discussed so far. One reason is that I am not happy with the “reasonability” of the statistics. Did they cover everything that should be covered, especially during the past 20 years? To anybody who has lived in the United States during the last two decades of the twentieth century, a striking feature of government is that its expenditure is constantly on the increase. This is especially true if one examines spending on defense and social programs. To explain this rather strange discrepancy between the government figures and one’s personal observation, I have had to dig into the government statistics in order to deconstruct the various components from which they are built. For purposes of explanation, I have looked initially at one year, 2002, and my analysis will be found in Table 6.3. The best place to start is by looking at total receipts and expenditures by all levels of government in the United States.7 Current receipts, which come mainly from taxes, totaled $2,872 billion in 2002. Total expenditure came to $3,126 billion. This left a deficit of $254 billion: the equivalent of almost $1,000 for every person living in the United States. On the expenditure side, the amounts on current account were money spent on national defense ($387 billion); nondefense federal spending ($200 billion); and state and local expenditures ($1,035 billion). Total government consumption therefore came (with rounding) to $1,621 billion. This is an important sum and I shall build on it. Overall government expenditure on consumption starts with this basic total of $1,621 billion. We must then add two very large sums: transfer payments ($1,267 billion) and net interest paid ($206 billion). There is also a collection of small sums totaling $32 billion. Adding together the four amounts listed in this paragraph, we get to the aggregate government expenditure of $3,126 billion. This is the total amount of money spent on current account on behalf of society by the federal, state and local governments. It comes to more than $11,000 per capita. We now have an additional complication. The official figures of U.S. government expenditure that we see in Tables 2.5, 2.6, 6.1 and 6.2 include sums on both current account and investment account. These are made up of the consumption expenditure of $1,621 billion (described above), plus the sum of $352 billion for investment. These two sums total the $1,973 billion that we see in Table 6.1.

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Table 6.1 United States three components of aggregate demand ($ bn. at current prices), 1968–2002

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Personal consumption

Private investment

Government expenditure

536 580 649 667 729 805 888 976 1,084 1,206 1,349 1,511 1,763 1,926 2,059 2,258 2,460 2,713 2,851 3,052 3,296 3,597 3,832 3,971 4,210 4,455 4,716 4,969 5,238 5,529 5,856 6,247 6,684 6,987 7,304

127 139 152 154 179 209 215 206 258 322 375 416 478 558 503 547 719 736 718 749 794 873 862 800 867 955 1,097 1,144 1,243 1,391 1,539 1,637 1,755 1,586 1,593

200 210 237 234 256 276 303 340 362 395 433 474 570 561 608 652 701 878 833 882 919 1,100 1,181 1,236 1,271 1,293 1,328 1,372 1,422 1,488 1,539 1,641 1,751 1,858 1,973

Is there anything wrong with this estimate? I believe that it is both incorrect and misleading, because it grossly underestimates the reality of government expenditure, which should also include the vast sums of $1,267 billion for transfer payments and $206 billion for net interest paid. The relevance of these sums for this book is that they both represent income to individuals and organizations and are therefore sources of aggregate demand. Government transfer payments mostly represent social security benefits, which are direct supplements to personal income. Net interest is paid to people and organizations that hold government debt, and these again are additions to income.

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What should the government be doing?

Table 6.2 United States – four separate periods –components of aggregate demand (expenditure in $ bn. at current prices) 1968–1973 1974–1983 1984–1991 1992–2002 Total Average personal consumption Average private investment Average government expenditure Average unemployment % of civilian labor force

1,057 661 160 236

100% 2,360 100% 4,969 100% 8,540 100% 63% 1,502 64% 3,222 65% 5,654 66% 15% 388 16% 781 16% 1,346 16% 22% 470 20% 966 19% 1,540 18%

4.7

7.5

6.4

5.4

Table 6.3 United States aggregate and federal government finances, 2002 ($ bn.) A

B

C

Budget Balance

Aggregate

Federal

Current receipts Current expenditure Deficit Current Expenditure Current expenditure Consumption expenditure Transfer payments Net interest paid Other items Consumption and Investment Consumption and investment Consumption Investment

2,872 3,126 254

2,011 1,853 158**

Total

3,126 1,621 1,267 206 32 1,973* 1,621 352

Notes * This figure appears in Table 6.1. ** This figure appears in Table 6.4.

Is there any simple way of including the effect of these large additional expenditures on output and employment? With such large sums of money from multiple sources, it becomes increasingly likely that aggregate government expenditure will change a good deal from year to year. Since federal spending represents the lion’s share of total government spending, I believe that it is helpful to use the size of the federal government’s budgetary surplus/deficit as an indication of changes in the absolute amounts of government expenditure. This is because such a fiscal balance represents differences at the margin, and therefore shows directly the year-by-year ups and downs in the total volume of federal government spending. I shall therefore try and tease out whether these fluctuations – and any accompanying long-term trends – in the budget surpluses/deficits have had any influence on total demand and on national income and employment over the period 1968–2002.

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In summary; • Official United States statistics on current expenditure understate the true amount. An accurate figure is important to establish the influence of government expenditure on aggregate demand. The reason for the underestimate is the omission of two substantial items from the government figures: transfer payments and net interest paid, both of which influence total demand. • The analysis in this chapter relies on a measure of net additional government expenditure. This is the government fiscal deficit (i.e. current expenditure minus current receipts), which is a calculation of the demand generated over a year by government expenditure over and beyond what is covered by taxation. Government expenditure is therefore the sum covered by taxation plus the deficit.

External trade and its complications One of the most obvious and disturbing features of the U.S. national accounts during the past two decades has been the size and growth of the external trade deficit. As we see in Table 6.4, this has climbed steadily (although with some pauses) from a negative sum of $97 billion in 1984 to $481 billion in 2002, and the deficit is still increasing. What this means is that the dollar value of imports is becoming increasingly larger than the dollar value of exports. With a negative balance, the country is not paying its way internationally. The cause of this deficit is the virtually uninterrupted growth in American personal consumption, which has led to increases in the imports of petroleum (used in all manufacturing and in the delivery of all services). And growing numbers of cars have been imported because many buyers believe that imported automobiles are better designed, more reliable and more economical than American ones. There are also large and growing imports of many other consumer products, especially electronics and clothing and footwear. To a large extent, such consumer goods are manufactured more efficiently outside the United States than within it, mainly because of cheaper labor costs. This has led over time to a change in the balance of the American economy toward “high tech” and service enterprises, accompanied by shifts of population within the country. We should normally expect such a strong negative trade balance to lead to a weakening of the dollar: a response to a lack of foreign demand for American products. This has happened, but not to a dramatic degree. The reason why the dollar has maintained its value so well is quite simple. The trade deficit has been financed by foreigners’ willingness to invest money in the United States: in U.S. government debt and (and to a small but increasing extent) by buying equity in American business firms. One’s instinctive reaction to a large trade deficit is horror rather than optimism, because of the ever-present danger of a collapse of the dollar which might

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cause the price of imports into the United States to increase to uncomfortably high levels, which would also trigger a serious rise in the rate of interest. The imports will include raw materials, and such price increases will have a “knockon” effect throughout American industry. Such a chain of disasters depends totally on the underlying strength of the American economy. If this is real, substantial and durable, overseas creditors will continue to invest their credit balances in the United States. This indeed describes the experience of the last two decades. It should also be remembered that the growth of most backward but developing economies has been and is being sustained by the American consumer. It is therefore very much in the interest of America’s creditors to keep the American economy buoyant so that the demand for their products will be maintained into the long-term future. In the early twenty-first century, 60,000 Chinese students are being educated in American universities. This is a doubly constructive way in which China is contributing to closing America’s trade deficit. There is however a powerful downside to overseas trade deficits. Imported goods mean that domestic demand is being satisfied by overseas, rather than home-based, manufacturers. This situation greatly discourages American manufacturing industry, although by this process foreign countries invest substantially in United States government securities, and this in turn makes it easier for the government to carry budget deficits which can contribute to employment. As a result, the United States becomes increasingly beholden to foreign investors to sustain its government operations. In summary: • Since 1983, and especially since 1993, there has been a progressive widening of the United States overseas trade deficit. This has been driven by continuous increases in the volume of imports of consumer goods. • The deficit has been supported to a considerable degree by overseas investment in United States government securities and also in American business enterprises: practical expressions of overseas confidence in the strength of the American economy. • Overseas trade deficits have little effect on sustaining demand within the United States. And long-term ill-effects are more than likely.

Did the deficits have any effect? The fiscal and trade balances are shown year-by-year in Table 6.4. Here, and also in Tables 6.5, 6.6 and 6.7, I am taking the unorthodox step of putting the two balances alongside one another. This juxtaposition makes it possible to compare the aggregate demand stimulated by budget deficits and the amount that is being siphoned off overseas.

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Table 6.4 United States defense, federal government fiscal balance and current account trade balance $ bn. at current prices, 1968–1982

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Defense

Federal government fiscal balance

Current account trade balance

82 83 82 79 79 77 79 87 90 97 105 116 134 158 185 210 227 253 273 282 290 304 299 273 298 291 282 272 266 271 269 275 295 306 349

25 +3 3 20 20 16 7 53 74 54 59 41 74 79 128 208 185 212 221 150 155 153 221 269 290 255 203 164 108 22 +69 +126 +236 +127 158

+1 n.d. +2 1 6 +7 +2 +18 +4 14 15 n.d. +2 +5 11 44 97 122 148 164 127 101 90 4 62 82 118 105 117 128 205 291 412 394 481

Note n.d. = no difference.

We can therefore take a bird’s-eye view of important marginal changes in total demand. I must, however, reiterate that the deficits were in no way engineered with Keynesian objectives in mind. The government deficit that stimulated demand was the result of reduced taxes and increased government expenditure, notably on defense which reached $349 billion in 2002 and was, in real, inflation-proofed terms, about what had been spent at the height of the Vietnam War in 1968. The growth in the negative trade balance, which signaled

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a diversion of demand to overseas sources of supply, was the outcome of the long-term trend toward increasing imports. Since the government fiscal balance is au fond determined by public policy, I have also analyzed the data into periods covering different presidential administrations: • • •

Table 6.5, the administrations of Nixon, Ford and Carter; Table 6.6, the administrations of Reagan and the Elder Bush; Table 6.7, the administration of Clinton and the first years of the Younger Bush.

We can draw three strong overall conclusions from these figures. The first and most important point to note is the sharp boost in the government’s fiscal deficit in 1982. After 1982, this continued the trend upward, although with some reductions in the amount of red ink, but for four years, the trend was reversed; this is the second point that emerges from the data. From 1998 through 2001, the government accounts returned to a positive balance: the direct result of a prospering economy during the latter part of the Clinton administration. A growing GDP and a relatively low level of unemployment generated increased tax revenues, which extinguished the deficit, but the surplus began to erode after three years and it disappeared after four. The third conclusion we can draw from Tables 6.4, 6.5, 6.6 and 6.7 is the seemingly irreversible ballooning of the current account trade balance, caused by the factors already discussed in this chapter: the increasing imports of Table 6.5 United States: Nixon, Ford and Carter administrations GNP/GDP, unemployment, fiscal balance and current account trade balance (both at current prices in $ bn.), 1968–1980

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

GNP/GDP at constant prices year-on-year change %

Unemployment %

Federal government fiscal balance

Current account trade balance

+4.7 +2.7 0.5 +2.7 +6.1 +5.5 1.7 1.8 +5.3 +5.5 +4.7 +3.2 0.2

3.6 3.5 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.0 6.0 5.8 7.1

25 +3 3 20 20 16 7 53 74 54 59 41 74

+1 n.d. +2 1 6 +7 +2 +18 +4 14 15 n.d. +2

Note n.d. = no difference.

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Table 6.6 United States: Reagan and the Elder Bush administrations GNP/GDP, unemployment, fiscal balance and current account trade balance (both at current prices in $ bn.), 1981–1992

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

GNP/GDP at constant prices year-on-year change %

Unemployment %

+1.9 2.5 +3.6 +6.8 +3.4 +2.8 +3.4 +3.9 +2.5 +1.8 0.5 +3.0

7.6 9.7 9.6 7.5 7.2 7.0 6.2 5.5 5.3 5.6 6.8 7.5

Federal government fiscal balance 79 128 208 185 212 221 150 155 153 221 269 290

Current account trade balance

+5 11 44 97 122 148 164 127 101 90 4 62

Table 6.7 United States: Clinton and the early years of the Younger Bush administrations GNP/GDP, unemployment, fiscal balance and current account trade balance (both at current prices in $ bn.), 1993–2002

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

GNP/GDP at constant prices year-on-year change %

Unemployment %

+2.7 +4.0 +2.7 +3.6 +4.4 +4.3 +4.1 +3.8 +0.3 +2.4

6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0 4.7 5.8

Federal government fiscal balance 255 203 164 108 22 +69 +126 +236 +127 158

Current account trade balance

82 118 105 117 128 205 291 412 394 481

petroleum, cars, electronics and footwear. This ballooning is the continuation of a secular trend, and there are no obvious signs that it will be reversed. We now look at the three presidential periods described earlier. The administrations of Nixon, Ford and Carter During the period 1968–1973 the economy was on a reasonably even keel, with an annual real growth in GNP averaging 3.5 percent and unemployment

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4.7 percent, which was approximately its long-term stable rate. (See Table 5.1 in Chapter 5.) Public expenditure, despite what was committed to defense, was well within the compass of a growing economy. And consumer demand had not yet been redirected overseas. The government fiscal deficit and the overseas trade deficit were therefore small by the standards of later years. In 1974 there was the oil price shock, which increased producer prices throughout the economy. This price increase was met by a boost in interest rates to control inflation, the side effects of which were a reduction of real personal consumption and an even greater fall in private investment. In the recessionary conditions that resulted, the shortfall in tax revenue caused the government federal deficit to shoot up: to $74 billion in 1976 and still remaining quite high during the rest of the Carter administration. (See Table 6.5 in this chapter.) This serendipitous injection of demand restored some growth to the GNP, although unemployment remained high. However, it is likely that without the additional demand, GNP growth would have been lower and unemployment even higher. The intervention of the government was unplanned but it had a positive and benevolent effect. Annual inflation was 4.9 percent during the period 1968–1973, and 8.5 percent during 1974–1983. (See Table 5.1 in Chapter 5.) This increase was obviously not caused by the force of demand, which was clearly weakening. Nor was it brought about by demand pressing against the economy’s absolute productive capacity, since with labor unemployment at 7.5 percent, there was clearly much slack in the system. The administrations of Reagan and the Elder Bush With the Republican administrations of the 1980s and early 1990s, the deficit in the fiscal budget remained extremely high, peaking at $290 billion in 1992. During this time the deficit in the overseas trade balance first made itself felt, reaching a high point of $164 billion in 1987. During each year, the current account trade deficit took a large bite out of the domestic demand stimulated by the federal fiscal deficit (although only in 1987 was the overseas deficit the larger of the two). During every other year there was at least some net increase in aggregate demand from the fiscal deficit and these marginal increments were on top of the expenditures on personal consumption and private investment which were both showing signs of recovery. (See Table 5.1 in Chapter 5 and Table 6.6 in this chapter.) The GNP/GDP was soon recovering, and growth showed a sharp boost to 6.8 percent in 1984 (coinciding with a federal fiscal deficit of $185 billion), but unemployment was slow to pick up, and the lower figures during the three years 1988–1990 were merely a remission. The stubbornly high level of unemployment was almost certainly related to the gradually increasing productivity of the American workforce (shown in Table 2.2). After 1982, inflation came down to a level lower than that before 1974 (see Tables 5.1 and 5.3), so that the demand-led recovery carried no danger of

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bumping against the overall capacity of the economy (clearly evident from the higher than average unemployment). The economy was quite evidently being restored to health, and the totally unplanned contribution of the federal budget deficit was making a significant contribution to this. The administration of Clinton and the early years of the Younger Bush From 1993, we see GDP growth healthily maintained (at an average annual increase of 3.2 percent over the ten-year period), accompanied by a slackening of unemployment. This was down to 4.0 percent in 2000, although it crept up again in 2001and 2002. There was a reasonable increase in personal consumption and a large lift in private investment, both of which boosted total demand. (See Tables 5.1 in Chapter 5, and 6.7 in this chapter.) A remarkable feature of the period was that the (now traditional) budget deficit was turned into a surplus for four years, 1998–2001. The main cause of this was the surprisingly small rise in federal spending by the Clinton administration. Clinton’s first five years saw an increase of 8.2 percent, compared with 11.9 percent for Reagan, 16.5 percent for Nixon, 25.2 percent for Johnson and 35.2 percent for the Younger Bush.8 Clinton’s prudence had a good psychological effect in bringing the economy back on an even keel. Throughout this period the overseas trade deficit was moving up fast, although very surprisingly this did not depress the economy. After 2001, the fiscal deficit started ballooning again and the overseas trade deficit reached unparalleled levels. (See Table 6.7.) To date, these deficits have not led to inflation: evidence of spare capacity in the United States economy. I also think it likely that the Federal Reserve’s increasing skill in manipulating interest rates has kept the economy balanced between the unacceptable extremes of inadequate growth and unacceptable inflation. The uncertainty of the world economy after the terrorist attacks in September 2001 provided a sharp shock to all stock exchanges. Since then they remained essentially stagnant, with only small improvements until a more general recovery in 2006. However, this sluggishness does not seem to have inhibited business and personal confidence, and growth in aggregate demand has not been undermined. In summary: • Government fiscal deficits since the late 1970s (like the overseas trade deficits since the early 1990s) were in no way the outcome of Keynesian policies of demand management. Nevertheless, the outcomes of budget deficits provide evidence of effectiveness of Keynes’s policy prescriptions. • The increase in the fiscal deficit during the late 1970s had only a modest effect in boosting GNP/GDP and in reducing unemployment. But the economic indicators following the oil price shock after 1973

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•

•

What should the government be doing? were so negative that it is extremely likely that the GNP/GDP would have grown less and unemployment would have been higher than it was if the deficit had not occurred. During the 1980s, GNP/GDP growth was restored to a more normal level and unemployment started to come down. These improvements are directly related to the demand that was being pumped into the economy every year by the fiscal deficits, which were substantially driven by defense spending and tax cuts. During the 1990s, GDP growth continued and unemployment started falling (after the temporary increases in 1991 and 1992). The growth of national income had the effect of shrinking and then eliminating the fiscal deficit during the period 1998 through 2001.

Did Keynes get it right? To a substantial degree he did. For a start, there is no serious dispute about his central diagnosis that a lack of aggregate demand was the root cause of depression and recession and involuntary unemployment. I shall, however, now concentrate not on his diagnosis but on his remedies. These are more controversial. The argument is mainly based on Chapters 5 and 6, which cover United States monetary policy and government fiscal policy during the years 1968–2002. Before summarizing the effectiveness of monetary and fiscal policies, it is worth mentioning that Milton Friedman – a distinguished and perceptive analyst but not one renowned for his enthusiasm for macroeconomic management – has endorsed the success of the Federal Reserve in manipulating the rate of interest to restrain potential inflation and support controlled growth.9 In summary: • The interest rate is a less than perfect tool of economic management. • It is not very effective at breathing life into a depressed or flagging economy, because it lacks the ability to stimulate positive expectations and thereby encourage investment. Keynes had predicted this eventuality with great precision: “. . . a high rate of interest is much more effective against a boom than a low rate of interest against a slump.”10 The inability of a low rate of interest to stimulate investment is due to the “Liquidity Trap” and – in particular – to the persuasive influence of negative expectations. • It is more effective at cooling an over-heated economy: what Keynes called the “crisis” effect.11 In other words it is better at planting uncertainties than nurturing positive expectations. And a serious impediment is that its influence on inflation has the side-effect of

What should the government be doing?

•

•

•

•

•

115

depressing personal consumption and (even more seriously) private investment. The overall results are reductions in the growth of GNP/GDP and increases in unemployment. In the circumstances when the economy is free of rocks and shoals, the Federal Reserve has sharpened its ability to manipulate the rate of interest with the aim of scotching potential inflation and maintaining controlled growth. When the rate of interest is kept low, this tends to reduce the demand for bonds and increase the demand for equities, thus boosting their price. This has a substantial influence on personal and business confidence, which in turn stimulates total demand. Fiscal deficits also boost aggregate demand, but it should be emphasized that during the 1968–2002 period such deficits were in no way engineered with the intention of managing demand in the Keynesian sense. They happened for other reasons, but they nevertheless helped propel the economy forward. It is totally reasonable to read the effects of any increase in government investment, although this may not have been carried out to meet Keynesian objectives. The current account trade balance is in most circumstances outside the government’s hands. The government needs to monitor it carefully and continuously because a trade deficit has little effect on the creation of domestic demand, but it carries large and as yet undefined long-term dangers for the economy. What governments simply do not know is how much deficit is needed to produce an effect. We learned from Franklin Roosevelt’s experience that the net increase in aggregate demand stimulated by the New Deal was too little to make a difference. Substantial spending on rearmament before and during World War Two had a very positive effect on income and employment, but the sums of money were very large indeed. The total of government purchases in 1943, which brought unemployment down to 1.9 percent, was $148 billion at 1943 prices. This is the equivalent of $1,500 billion in 2002 dollars (a figure approximately the same as the total private investment in the United States). This is not a deficit that any rational and prudent government can consider for planning purposes. The dangers are simply too great. In the background is a constant specter of inflation. Roosevelt was compelled to spend gigantic sums on armaments because his first priority was to fight a war. With the unemployment rate at 20.1 percent in 1938 and still as high as 14.6 percent in 1940, he had more “wiggle room” than anybody possesses today. A modern government is faced with the tremendous problem of measuring, or at least judging with some accuracy, the amount of slack in the American economy. One of the difficulties is that prosperous times lead to new equipment

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•

being installed, thus expanding the capital stock. And with labor productivity continuing to improve, employment bottlenecks will also not immediately occur. To do the difficult job of evaluating the capacity of the economy, the only useful way to work is pragmatically and experimentally, following the method used by the Federal Reserve. By this means there might be a reasonable chance that governments can learn the degree to which they can safely open the faucets of aggregate demand. Every action should be expected to yield two rewards: first, some contribution to solving a current economic problem; and second, more knowledge of the limits of effectiveness, which will eventually help to get improving results from future actions.

Notes 1 Adam Smith, The Wealth of Nations (first four books), New York: Alfred A. Knopf – Everyman’s Library, 1991, pp. 305–306. 2 John Maynard Keynes, “The End of Laissez-Faire” (1924 lecture), in The Collected Writings of John Maynard Keynes, Vol. IX, Austin Robinson and Donald Moggridge (eds), London: Macmillan, 1972, p. 291. 3 Aneurin Bevan, quoted by the prominent socialist politician Denis Healey, The Times, London, April 17, 1975. 4 Keynes, General Theory, pp. 377–378. After Keynes’s death, his disciples at Cambridge University, Joan Robinson, Richard Kahn and Nicholas Kaldor, used his work to support their own socialist agenda. This alienated a number of more conservative economists such as Dennis Robertson, who believed that they had hijacked Keynes for their own political purposes. See Noel Annan, The Dons, London: HarperCollins, 1990, p. 269. 5 The data come from Jim Powell, FDR’s Folly. How Roosevelt and His New Deal Prolonged the Great Depression, New York: Three Rivers Press, 2003, Chapters 7 and 8. This is a trenchant and tendentious book, but the facts it quotes cannot be disputed. 6 Gene Smiley, Rethinking the Great Depression, Chicago: Ivan R. Dee, 2002, pp. 106, 111, 117, 137. 7 U.S. Department of Commerce, Statistical Abstract, 2005, pp. 278, 534. 8 Anon., “In Fact,” Prospect, December 2005, p. 7. 9 Robert Kuttner, “No Sainthood for Greenspan,” Business Week, August 1, 2005, p. 106. 10 Keynes, General Theory, p. 320. 11 Ibid., p. 314.

7

Floating on an ocean of expectations

A big idea that is woven like a red thread through Keynes’s doctrines is the part played by psychology in all economic matters – investing, buying, selling, planning for the immediate future, planning for the long term – everyday concerns of both entrepreneurs and members of the public (at least those in relatively affluent countries). The following quotations from the General Theory make the point. 1

2

3

4

5

6

7

On the instability of personal decisions: “a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic.”1 On the uncertainties of personal investment: “when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favorable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator.”2 On short-term business planning: “the behavior of each individual firm in deciding its daily output will be determined by its short-term expectations as to the cost of output on various possible scales and expectations as to the sale-proceeds of this output.”3 On long-term business planning: “If human nature felt no temptation to take a chance, no such satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.”4 On the lagged effect of psychological influences: “the economic machine is occupied at any given time with a number of overlapping activities, the existence of which is due to various past states of expectation.”5 On the volatility of expectations: “A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as a result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield.”6 On the extent to which psychology impregnates the economic system, and how it highlights: “the three fundamental psychological factors, namely the psychological propensity to consume, the psychological attitude to liquidity and the psychological expectation of future yield from capital-assets.”7

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Keynes was not especially original in his emphasis on psychology, but the way in which he used it as a leitmotif throughout the General Theory pushed the role of psychology further than it had been taken by any other analyst. This was despite the appearance, during the early 1920s, of an influential book entitled Risk, Uncertainty and Profit, which developed the point that risk can to some degree be managed while uncertainty has a life of its own. Keynes’s stress on psychology has an obvious harmony with uncertainty, as it was described in this book.8 The author was Frank Hyneman Knight, the first economist of international stature to teach at the University of Chicago. Many of today’s economists believe this prestigious and well-funded institution to be the world’s outstanding center for the study of their subject, although most of its faculty are politically to the right of Keynes and do not take kindly to the practice of macroeconomic management. Milton Friedman (whose name appears later in this chapter and also in Chapters 1, 3, 5, 6 and 11) made his reputation and won his Nobel Prize as a result of his work in Chicago. Psychology can exercise both a positive and negative influence on market behavior. This chapter discusses both. We start with the negative – the psychology of recession – because this was Keynes’s starting point. Figures 7.1 and 7.2 map the main influences on the psychology of individuals and entrepreneurs, as these topics have been discussed in earlier chapters. Synergy is everywhere at work, in that psychology heightens the effect of all other influences. Psychology describes the mindset of individuals and entrepreneurs, but it also describes those qualities that business people need to turn plans into action. It means vision, but it also means resolution and drive. Figure 7.1 is based on two clusters of factors: the psychology of consumer pessimism and the psychology of entrepreneurial pessimism. Figure 7.2 looks at the opposite picture: the clusters surrounding the psychology of consumer and entrepreneurial optimism. Within each of these four clusters there are many interconnections, all enhanced (as explained) by the added impetus of psychology. An additional and very important point is that consumer pessimism influences entrepreneurial pessimism very strongly, and the same holds true of consumer and entrepreneurial optimism. Most entrepreneurs are in the business of selling their goods and services to a wide market, and before any other consideration they will make a good estimate of, or at least get a feel for, the state of consumer demand for their products. We are reminded again of Adam Smith’s aphorism that the Division of Labor is limited by the extent of the market. However, estimates of business opportunities are little more than different orders of guesswork, as will be obvious from examples described later in this chapter. An additional general point must be made before looking further into expectations. Pessimism moves quickly; optimism much less so. Markets, employment and national income move down much more speedily than they move up. This is a development of points made in Chapters 2, 5 and 6. The data in Chapter 2 show that reductions in GNP/GDP have a greater effect in increasing unemployment than increases in GNP/GDP have in reducing it. (See Table 2.4.) A further

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Consumer pessimism – Falling expectations for future income – Gradually falling propensity to consume – Increased liquidity-preference for precautions – Rising rate of interest (Central Bank) – Falling stock market – Reduced demand for credit – Stagnant prices – Irrational doubts

Reduced consumer demand

Entrepreneurial pessimism – Doubts about market opportunities – Rising rate of interest – Falling stock market – Stagnant prices – Irrational doubts

Reduced investment demand

Reduced aggregate demand

Figure 7.1 The psychology of recession.

point is that reductions – especially large reductions – in private investment have a substantial effect in boosting unemployment, while increases – even large increases – in private investment do little to lower it. (See Table 2.7.) In summary, a fall in aggregate demand produces a jolt in unemployment while a rise produces an effect that is both modest and delayed. The discussion of the rate of interest in Chapter 5 shows that high rates of interest, although they may tame inflation, have a dramatic effect on reducing private investment on housing, plant and equipment, and inventories, with the inevitable outcome of shrinking aggregate demand and employment. (See Table 5.6.) Low rates of interest are slow to work in the opposite direction. Chapter 6 tracks the effects on demand and unemployment that resulted from fiscal deficits and current account trade deficits. In both cases the national

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Consumer optimism – Improving expectation for future income – Gradually rising propensity to consume – Increased liquidity-preference for transactions – Increased liquidity-preference for speculation – Falling rate of interest (Central Bank) – Bouyant stock market – Increasing demand for credit – Bouyant prices – Irrational “feel-good”

Increased consumer demand

Entrepreneurial optimism – Optimism about market opportunities – Falling rate of interest – Buoyant stock market – Bouyant prices – Irrational “feel-good”

Increased investment demand Increased aggregate demand

Figure 7.2 The psychology of recovery.

income responded without too much delay, but there was an immensely long time lag before unemployment came down. Only in 1997, after 15 years of one type of deficit or the other (or more commonly both), did unemployment fall below 5 percent. (See Tables 6.6 and 6.7.) One reason for this slowness was increased labor productivity: the extra output was being produced by a workforce that was growing less fast than the increase in output. (See Table 2.2.)

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In summary: • Two important psychological forces constantly appear in the General Theory: the negative and positive effects of psychology that predominate at different times. Because of Keynes’s focus on explaining and remedying unemployment, he gave greater prominence to the psychology of recession than to the psychology of recovery. • The psychological drive behind pessimism is stronger and is more rapidly diffused within markets than the drive behind optimism. This goes a long way to explain the depth and stubborn duration of the Great Depression. • Evidence that pessimism has greater force and is more fast-acting than optimism is provided by data on unemployment, and how this is influenced by ups and downs in the GNP/GDP; by changes in private investment; variations in the rate of interest; and by swings in the federal fiscal balance (i.e. changes in demand engineered by government expenditure).

The psychology of recession We now come to some of the details of consumer and entrepreneurial pessimism. These are illustrated in Figure 7.1. The most serious causes of pessimism from among the factors listed in Figure 7.1 are falling expectations of future personal income and, related to these, doubts about market opportunities for businesses. As an economy tips from expansion into contraction, falling expectations of future income are most commonly driven by fears about job security (less usually because of an erosion of purchasing power due to inflation – a phenomenon of the 1970s – and which will not be discussed further). The specter of job loss gradually reduces the propensity to consume as people batten down the hatches, lop off discretionary spending and even cut back on living expenses, all for the purpose of building a reserve. This process naturally depresses aggregate demand. Liquidity preference for the precautionary motive will increase, and this will apply pressure to raise the rate of interest. This may anyway be moving upward as a result of monetary management by the central bank, in the (by now incorrect) belief that the economy still needs to be cooled. Higher interest rates, in conjunction with depressed consumer demand, will lift the demand for bonds and cause the price of equities to fall, spreading pessimism even further. Because of stagnant consumer demand, prices will also stick in a groove. All these factors – a reduced propensity to consume, an increased liquidity preference, higher rates of interest, a depressed stock market and stagnant prices – will rapidly work to cast doubts about future market opportunities in the minds of business people. They will tend to put future plans on hold and reduce all

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controllable expenses connected with their existing operations, e.g. they will stop hiring new staff, and they will thin down bookings for future advertising and anything else they can turn into cash. The last two paragraphs have certainly not described the world during the past 60 years. However, they portray accurately the world that Keynes knew and whose problems he addressed in the General Theory. In summary: • Consumer pessimism has a number of related causes, the most important of which is falling expectations of future income. The result of such pessimism is a fall in consumer demand. • Consumer pessimism directly drives entrepreneurial pessimism, because most businesses operate with the end consumer in mind. • The result of such pessimism is a fall in entrepreneurial demand, which is now added to the fall in consumer demand. • Pessimism at all levels spreads very quickly and it directly increases unemployment.

How do businesses grow? A matter of considerable importance is whether, since the end of World War Two, government decision-makers from different countries had known about, studied and absorbed Keynes’s doctrines. As a result, did these people’s actions manage to extinguish the latent macroeconomic problems of the world since 1945? I shall refer to this possibility later in this chapter. Before I do so, it is important to look into the specifics of business expectations. Where do innovative ideas come from? What steps do entrepreneurs take to test them and evaluate their viability before substantial investments are made? How can the risks be minimized? Most importantly, why do entrepreneurs continue to launch new ventures when, as is widely known, most such enterprises end in failure? Every business becomes established because of some type of innovation, either a real one or something perceived by its customers. (The latter is not as irrational as some analysts may believe it to be.) Such an innovation gives the business its differentiation and opens up its niche in the market. Continued innovation helps to maintain and improve the business’s progress, and the strongest companies tend to be those with the best records of innovation. The big innovations that improved the lives of the public during the twentieth century (although some were actually a little older) were all driven by scientific and engineering advances. I am thinking of the telephone, the automobile, airline travel, household appliances, radio, television, personal computers, cellular telephones, credit cards and electronic banking, and the revolutionary prescription drugs that have transformed the practice of medicine. Prescription drugs were developed differently from the other innovations, in that they were

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and are the outcome of vastly expensive programs of clinical research put in train to try and find treatments for particular illnesses. In contrast, none of the other discoveries emerged from formal studies of the market. They were the result of unplanned breakthroughs (although rarely sudden flashes), and each breakthrough was invariably something that emerged from the imagination of an inventor or group of competing inventors. Each major new product defined above became astoundingly successful. This usually happened very quickly, for two reasons: •

•

It tapped into a hidden and unarticulated need or else it struck a chord in the public imagination; but for whatever reason, people wanted it as soon as they saw it. It was accompanied by a large and continuous growth of personal income during the twentieth century that eventually put even expensive new goods within the reach of large numbers of consumers.

The investment to manufacture and market such inventions was based on nothing more than an optimistic and totally instinctive anticipation of large market potential; and in every one of the above cases (all acknowledged successes) the bullish instinct of the inventor undershot rather than overshot the eventual reality. Market research played little or no role. Nor would it have been helpful if it had been employed widely. Market research is mainly conducted by interviewing people. It is rooted in the status quo because people’s experience substantially governs their ability to describe their needs and preferences. If such research is used to evaluate the prospects of totally new ideas for goods and services, the people interviewed for their opinions need to be shown the concept in some concrete form. And even then, it is impossible to take at face value people’s statements of interest or lack of interest. If there are no concrete prompts and new ideas are only described impressionistically (all that is possible until money is spent on product development), members of the public are able to contribute very little of value. Market research became much more important to the process of innovation when markets became established but still had room to grow. Entrepreneurs in existing businesses and – even more importantly – new entrants into the market, were now given some guidance because potential buyers whose views were being solicited had a point of reference. Entrepreneurs were now able to discover, tentatively at least, whether the public wanted the same as, or something partly different or something substantially different from what was available already. Market research is a device that was developed to contribute science to marketing, one aspect of which is the difficult process of projecting future sales. To describe it more realistically, market research is used to reduce doubts about market opportunities, but such research is actually not very good at this job. As described in Chapter 1, my own professional background is in market research, and it has become a substantial industry in all economically developed countries.

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While it can do some things well, it does other things badly, and some things not at all. One job that market research can address reasonably efficiently, in sophisticated markets at least, is to reveal market opportunities in general terms. The word general must be emphasized. Here is an example. It has been known for more than 20 years that a substantial minority of the American public is interested in healthy lifestyles. The reasons are, or are related to, the pace of business life, public awareness of a polluted environment, the widely reported opinions of the medical profession about diet and exercise, scare stories in the media about obesity and a deep-seated desire to go back to nature. Vast research plus the appearance of large numbers of brands marketed to health-conscious people provide clear evidence that this phenomenon is real. When I was writing the first draft of this chapter, I visited a typical American supermarket and inspected six product categories: carbonated soft drinks, beer, ready-to-eat breakfast cereals, bottled salad dressings, margarines and processed cheese.9 In these categories alone, I had no difficulty in locating more than 70 “healthy” brands, identified by such claims on the packaging as “fat free,” “caffeine free,” “light” (or “lite”), “diet,” “low cholesterol” and “low calories.” Of all these brands, six (or perhaps seven or eight) have become nationally important; these include Diet Coke, Diet Pepsi, Kellogg’s Special K and Miller Lite, now a failing brand. (I may have missed one or two of the other successful ones.) As explained in Chapter 1, the large majority of new brand introductions fail. I shall now explain this in more detail. The calculation of success and failure depends on the criteria used. What is a success? What is a failure? I count as a clear success a brand that maintains a significant share (at least 5 percent) of its category sales, five years after its launch. The six (or so) successes I noted in my supermarket visit fall into this group. The remaining brands I saw are in the middle, being partial successes/partial failures, and many of these will stumble along for years until many, perhaps the majority, will be withdrawn from the market. Looking then at an overall success rate estimated during my supermarket visit, I can say that I located about six successes and maybe 60 or more partial successes/partial failures. To this total we must add the large numbers of further brands that arrived over the last 20 years, and were withdrawn and sank without trace. The overall conclusion about the success rate of new brand introductions confirms the pessimism expressed in Chapter 1. How does all this affect our views of entrepreneurial psychology? Market research is certainly able to paint a broad picture; it can help define the field in which an entrepreneur might be able to operate successfully. Whether his or her operations are actually going to be successful – whether success comes early and doubts about market opportunities will be substantially removed – depends totally on the entrepreneur’s brains, vision, imagination, practiced marketing skill, willingness to take risks and, not least, luck. In other words, success and failure are the direct outcomes of the psychology of the entrepreneur. This was

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the case when markets were totally undeveloped, and it is substantially true in the United States today, despite the size of the market research industry. These qualities are rather less important in the cases where a business person is following a competitor’s lead, a strategy defined technically (although not very elegantly) as “me-too.” There is, however, a substantial penalty in doing this. It is rare for “me too” brands to achieve more than half the market share of innovative brands; and third brands will usually only manage to win a quarter of the innovator’s share.10 Hence the importance of getting in first with new ideas. This can only be done by exercising entrepreneurial skills and flair. The lure of a killing as the result of being number one with a successful new brand concept – but, even worse, the fear that a competitive company will come out with such a concept before you – provides the drive within marketing companies to innovate constantly and aggressively, despite the widely known odds against success. I could give many more examples to illustrate the points I am trying to make here, but shall only mention one important one: brands sold in supermarkets. It has been known for decades that the demand for everyday consumer goods sold in supermarkets is elastic, which means that lower prices lead to higher sales, and the ratio of price reduction to sales increase can be quantified and averaged across brands and product categories.11 The gigantic success of Wal-Mart is the direct result of responding to high price elasticity. Wal-Mart builds its sales by charging very low prices to the consumer, and the vast sales volume generates enough profit to compensate for the reduced revenue from each pack sold. WalMart and the consumer both benefit: but at the expense of the manufacturer, whose margins are squeezed. The same way of conducting business is true of all major supermarket chains. However, the degree to which low prices can be dramatized and made appealing to customers depends on the supermarkets themselves. In Germany Aldi was greatly more successful than Wal-Mart (which eventually withdrew from the market), although in America Aldi has never done well. In Britain, Tesco is significantly more successful than Wal-Mart. And in France, Carrefour is in a class of its own in the supermarket field. Wal-Mart, Aldi, Tesco and Carrefour were all developed with considerable skill and built into businesses that generate huge sales and profits. They all responded to the same marketing trend: the increasing demand for low-price everyday goods. Yet the individual personalities of these four stores – the unique bundle of functional benefits and nonfunctional attributes that each offers to the buyers it targets – is the direct outcome of the talent of the person or group of people who created it. Each is, in other words, an expression of psychological sensitivity on the part of the entrepreneur, an art as much as a science. It is no surprise that in all four countries, there are large numbers of much less successful low-price supermarkets. The four stores I have mentioned are the market leaders in their countries because they represent what their founders instinctively believed consumers wanted. Each of these founders had a clear national identity and (despite fanciful notions of the “Global Village”) different countries still maintain their own individual identities.

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In summary: • It is rare for businesses to grow organically by remaining within the status quo: operating continuously in the same way. In a competitive market place, growth demands some type of innovation. • The big innovations of the past were usually the results of unplanned breakthroughs and were not introduced to satisfy any identified market need. Great innovations were rare, and they were essentially the product of an inventor’s intuition, imagination and single-minded commitment. These are characteristics of the inventor’s psychological make-up. • The development and widespread use of market research have merely modified, not changed, the process of innovation. Market research can only define the field where success might be possible. In exploring this field, actual success must come from the innovator’s own flair: his or her innate ability to leap into the unknown. • The high failure rate of new brand introductions demonstrates that innovation is an enterprise in which science plays a merely subsidiary and not a primary role.

The psychology of recovery After the analysis of the factors influencing economic recession, it is not too difficult to map those contributing to economic recovery. These are shown in Figure 7.2, and each of the factors is the obverse of its opposite number in Figure 7.1 (which describes the psychology of recession). During a time when business begins to tick over without too many interruptions, employment begins to pick up, and as members of the public begin to receive gradually rising incomes from stable jobs, they will feel increasingly optimistic about the prospects for future income. This will increase gradually their propensity to consume and hence total demand. Liquidity-preference for the precautionary motive will fall, although that for the transactions and speculative motives will go up. Although these two sources of liquidity-preference could be expected to boost the rate of interest, interest is likely to be brought down by the monetary policy of the central bank with the aim of stimulating recovery. A lower rate of interest will reduce the demand for bonds; and it will increase the demand for and price of equities. The low rate of interest will also increase bank lending to consumers and businesses and will boost the growth in the money supply. If the central bank does its job properly, this will not lead to inflation, although prices are likely to rise slightly, which will contribute to business optimism. Entrepreneurs will increase their investment because of the stimulus provided by the greater propensity to consume; and also by the atmosphere of optimism generated by the low rate of interest and the rising stock market indices. I

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believe that this is the actual mechanism by which investment is increased; in Keynes’s own words, it is driven by “the psychological expectation of future yield from capital assets.”12 This boost in investment is the most important of the factors discussed here. As a result of the total demand it generates, it makes the greatest single contribution to reducing unemployment and raising the National Income, although it may be better to say that these benefits come from substantial investment-related demand on top of the consumer-related demand that stimulated the investment in the first place. Sometimes investment demand will lead the way, in response to entrepreneurs’ anticipation of future rises in consumer demand. During this process, members of the public will feel increasingly happy about the present and future, and this will cause consumer demand to keep growing. The business community will also feel optimistic (sometimes irrationally so), which will continue the process of stimulating investment. Two organizations, the Conference Board and the University of Michigan, track public confidence through regularly repeated sample surveys. These make interesting reading, but they are concerned most with short-term fluctuations which cannot be projected into the long term. For this reason it is unlikely that they are used much by business to influence investment decisions. In summary: • The first driver of consumer optimism is improved prospects of future personal income. These will be accompanied by a number of signals that also act positively on consumer psychology and which all boost consumer demand. • Improved consumer optimism will transfer to entrepreneurs’ attitudes. Business optimism can occasionally lead the way because it is often triggered by entrepreneurs’ anticipation of future improvements in consumer demand. • The positive effect of optimism is often weaker and more slowly diffused throughout the economy than the negative effects of pessimism. Macroeconomic management faces a difficult initial job when its objective is to shake an economy out of recession.

The prosperous years since 1945 This discussion of consumer and business confidence brings us logically to the most important practical topic addressed by this book. Why did the American economy manage to sustain strong positive growth during the period since 1945, with very few setbacks? This growth effectively transformed the business climate of the United States and also brought prosperity to most of the rest of the world. Did Keynes have anything to do with this? The basic facts are clear. Over the course of the half-century from 1950 to

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2000, the American GNP/GDP grew more than fivefold, measured in constant (i.e. inflation-proofed) dollars. This represents an average annual increase of 3 percent (again inflation-proofed). (See Table 2.1 in Chapter 2.) During this time, the American labor force grew, but the average per capita productivity of American workers more than doubled. (See Table 2.2.) During the five decades, average unemployment was 4.5 percent in 1950–1959; 4.8 percent in 1960–1969; 6.2 percent in 1970–1979; 7.3 percent in 1980–1989; and 5.8 percent in 1990–1999. (See Table 2.8.) These levels were vastly below those experienced during the 1930s. There was one period of recession, 1974–1983, when the average annual growth in the GNP/GDP slackened to 1.8 percent, and average unemployment was 7.5 percent. (See Table 5.1.) If this represented a “natural” cyclical pattern, the decade of recession was only one-fifth of the period of 50 years that we are looking at. This duration is well below the historical average. During the two decades of the 1920s and 1930s, the United States was mired in depression for ten or more years, and this depression was far more serious in its effect on national income and unemployment than anything we have seen since the end of World War Two. Business cycles have been widely discussed in the literature of economics, and Keynes made important contributions. The characteristics of the business cycle are that, at the peak, the upward forces lose momentum and eventually go into reverse; and at the trough, the downward forces lose impetus and similarly go into reverse. In Keynes’s view, the loss of momentum at the top of the cycle is due to a reduction in investment. This effect is not because of the high rate of interest caused by “the increased demand for money both for trade and speculative purposes.”13 A much more important factor causing the reduction in investment is a collapse in the marginal efficiency of investment due to a steep fall in entrepreneurial confidence. “The disillusion comes because doubts suddenly arise concerning the reliability of the prospective yield.”14 During the period 1974–1983, the strongest signal of recession was indeed the sharp reduction in private investment. This shrank by an annual average of 0.9 percent of GNP/GDP. (Table 5.1 in Chapter 5.) This strongly confirms Keynes’s diagnosis, especially since the rate of interest only started to climb substantially in 1978. (See Table 5.2.) There is not then much doubt about the American economy’s vital signs during the half-century since the end of World War Two. There were long periods of prosperity, with only a single decade of fairly serious but not disastrous recession. It was an altogether remarkable performance. But the fascinating question is why? How did it happen that the United States at last got its economy approximately right, while everything that happened between the two world wars was substantially wrong? I am going to suggest five major reasons to explain the performance of the American economy since 1945. These are not in any particular order, but I believe that the last reason is the most important one, since it enhances the effects of all the other factors.

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The legacy of World War Two In 1945, there was a great accumulation of pent-up demand for consumer goods both in the United States and many other countries. Many American civilians had earned high wages during the war and they were now anxious to buy highticket items, notably houses, household appliances and cars. During the war, a number of industries, notably those manufacturing motor vehicles and airplanes, had received massive injections of capital and they were geared for high levels of peacetime production. The postwar boom continued, with modest interruptions, until 1974. American exports were also high during the period, not least because of the substantial aid to Europe under the aegis of the Marshall Plan. This of course created many American jobs. Consumers With lower unemployment and gradually growing wages, expenditure on consumption gradually but continuously increased, and the arrival of plastic cards during the 1970s boosted consumer buying to a considerable degree. Because of all this, the propensity to consume (i.e. the proportion of income spent on consumption) did not decline as incomes increased, as Keynes’s writings would have led us to expect, but was in line with Milton Friedman’s “Permanent Income Hypothesis” (discussed in Chapter 5). There is no evidence of an increase in liquidity-preference even during the decade of recession, 1974–1983. The interest rate increased during that decade because the Federal Reserve was trying to rein back the increase in the money supply that was stimulated by the increased producer prices, especially the rapidly rising price of oil. The high rate of interest checked both consumer demand and private investment without savagely depressing them, but by the end of the 1970s, the Fed had learned how to manage its affairs more efficiently. Investment Private investment, stimulated by healthy consumer demand, remained high except during the decade of recession. It was the single factor that contributed most to boosting output and reducing unemployment. However, large amounts of extra demand were pumped into the economy during the 1980s and 1990s as a result of the government fiscal deficit, which was driven by tax reductions and by the amount of money spent on defense. This enabled the United States to win the Cold War, an astonishing and unexpected achievement. It also yielded the considerable additional benefit of boosting aggregate demand and can therefore be compared directly with the policy of the Roosevelt administration before and during World War Two. The policy of heavy public expenditure financed (if absolutely necessary) by budget deficits was essentially Keynesian, although no American politicians have been brave enough (or perhaps knowledgeable enough) to call the policy by this name.

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The apparently alarming overseas trade deficits that occurred between 1985 and 1990, and which reappeared – seemingly irreversibly – in 1993 had the effect of generating domestic demand from overseas creditors. Although there are great dangers, this situation appears not to be disastrous, at least in the short term, because of the confidence felt by the rest of the world in the strength and stability of the United States. Monetary policy The role of the Federal Reserve during the last 15 years or so has been effective enough to surprise many people. It is a remarkable achievement that the American economy has shown controlled growth, while at the same time demand has been held to a level at which the economy has not been forced to work over capacity. This has meant that inflation has been kept well under control. This control is a direct result of the monetary policy of the Federal Reserve. Monetary policy is one of the most important pieces of apparatus in Keynes’s tool kit. Although Keynes laid down the principles, he did not give much guidance about the precise degree to which the interest rate faucet must be opened or closed in order to produce specific results. The Fed has managed to operate pragmatically and has learned how to use the tool kit effectively. There is also another benefit. The reassurance provided by the foresight and practiced skills of the Federal Reserve has contributed significantly to business confidence. This brings me to the last of the five factors that explain the present overall health of the American economy. An ocean of expectations This chapter has been devoted to expectations: unfavorable if the economy is going south, but favorable if it is going the other way. As already mentioned, expectations are not simply a matter of gazing into a crystal ball. They also embrace two of the qualities most esteemed in business, vision and drive: drive to turn plans into action. Everything that we read about the world economy between the two world wars demonstrates that the word “depression” has two meanings. It describes the catastrophic dip in the graph of output. It also describes the mindset of individuals, both consumers and entrepreneurs. People without jobs were without hope; people with jobs were fearful of losing them. Entrepreneurs saw no prospect of growing their way out of their difficulties. Franklin Roosevelt’s inspired call to action that “the only thing we have to fear is fear itself” may have cheered people up, but the effect was only temporary. As Keynes saw so clearly, the economic engine of competitive capitalism was faltering badly. What is totally astonishing is that at the end of World War Two and during the years that followed the engine was repaired. Progress after that date was maintained without too many setbacks by the four factors just discussed. But each one was underscored – its effect inflated – by an overall feeling of confi-

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dence on the part of both consumers and business people. This growth of confidence became virtually unstoppable. By the mid-1970s, confidence was so solid that the massive oil price shock caused nothing more serious than a setback, although the economy took time to recover from it. And the effect of the less violent increase in the price of oil in 1990 was kept under control even more efficiently. The serious but gradual increases in oil prices in 2004–2006 have not produced any economic disasters as this chapter is being written, in the summer of 2006. Nevertheless, the future depends on how the oil industry chooses to respond to the pressure of increased demand, much of it coming from China and India.15 (More recently prices have crept up again, but with no really serious ill-effects.) This does not mean that the economy should be allowed to run itself unchecked in perpetuity. It needs to be looked at by political leaders and by the central bank with ever watchful eyes. The mechanism is sensitive and the controls that are manipulated can have a sharp effect, meaning that they must be applied lightly. There are still major transitional problems with the world economy, although we should all welcome the fact that China and India, with a combined population of 2.4 billion people, are on the brink of becoming economic powerhouses. Their growth benefits the world because the wealth they generate goes some way to meet a necessary (although perhaps not sufficient) condition for the elimination of poverty. The American economy will continue to adjust to a changing environment of international competition. Even if, during the next half-century or even less, the economy becomes totally transformed, there is no reason at all to think that the roles of the government and central bank will be less important than they are today. These bodies will still need to keep their fingers on the macroeconomic pulse of the economy, looking carefully at total demand and remaining watchful for signs of inflation. Remedies will have to be applied if they are needed. I am convinced that Keynes’s diagnoses will still remain valid; and if these remedies are applied with finesse and increasing knowledge of their effectiveness, they should continue to work. The General Theory is not just an academic treatise. It was written for a public purpose. Psychology is central to Keynes’s doctrines, but it is only a part, albeit an important part, of the whole. To Alfred Marshall, Keynes’s mentor, psychology was not only high on his list, but its position was even more dominant. To Marshall, economics is rooted in austere materialism, and he regretted that there was no room for idealism within the framework of economic analysis. For this reason, Marshall stated that he would have preferred to have devoted his life to psychology, which he considered better able to improve society: an arduous and long-term endeavor.16 Although psychology was important to both Marshall and Keynes, they looked at it from different angles. What united them was something else: their goal of improving the lot of mankind. This is what really gives their work its importance and distinctiveness. While Marshall only succeeded in influencing

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other economists, Keynes made an impact on politicians and bankers in many countries, and for this reason his legacy was by far the more powerful. This is now therefore an appropriate place to look at Keynes’s background and unusually complex personality. These form the substance of Chapters 8, 9 and 10. In summary: • The United States economy grew at a remarkable rate during the last half of the twentieth century. This transformed the standard of living of the large and growing American population. • The positive performance of the economy was caused by five factors: 1

2

3

4

5

The pent-up consumer demand from World War Two was accompanied by relatively high personal incomes. The personal savings accumulated during the war could now be spent on consumer goods, especially durables. Consumer credit became widely available. Improved expectations and confidence encouraged the public to accept credit liabilities. Growing consumer markets stimulated increases in private investment, which were continuous with very few interruptions. At the same time, large volumes of public investment were made through substantial government fiscal deficits. The two sources of investment stimulated employment directly. Government deficits were in reality Keynesian fiscal policies, although they were not undertaken with any Keynesian objectives explicitly in mind. Monetary policy began to play a part in stimulating growth while at the same time restraining inflation. This had its direct origin in Keynes’s doctrines. What was happening in the United States was that the increases in demand were operating in an economy that was working at a little below full capacity, and this is what kept inflation at bay. As Keynes constantly emphasized, the over-arching importance of optimism and confidence affected both consumers and the business community. This also contributed to taming the worst ill-effects of the ten-year recession between 1974 and 1983.

Notes 1 2 3 4 5 6 7

Keynes, General Theory, p. 161. Ibid., p. 159. Ibid., p. 47. Ibid., p. 150. Ibid., p. 50. Ibid., p. 154. Ibid., pp. 246–247.

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8 Frank Hyneman Knight, Risk, Uncertainty, and Profit, New York: Houghton Mifflin Company, 1921. 9 I visited the P&C supermarket, Nottingham, Syracuse, NY 13210, on August 23, 2005. 10 This estimate is based on my direct personal observation of many product categories. See also John Philip Jones and Jan S. Slater, What’s in a Name? Advertising and the Concept of Brands, 2nd Edition, Armonk, NY: M.E. Sharpe, 2003, pp. 47–48. 11 Gerard J. Tellis, “The Price Elasticity of Selective Demand: a Meta-Analysis of Econometric Models of Sales,” Journal of Marketing Research, November 1988, pp. 331–341. 12 Keynes, General Theory, p. 247. 13 Ibid., p. 315. 14 Ibid., p. 317. 15 Anon., “Counting the Cost. Oil and the Global Economy,” The Economist, August 27, 2005, pp. 55–56. 16 John Maynard Keynes, “Alfred Marshall,” Essays in Biography, London: Macmillan, 1933, p. 214.

8

Keynes the man

This book has been all about Keynes’s doctrines, and what American experience during the second half of the twentieth century has revealed about the accuracy of his diagnoses and the effectiveness of his remedies. This has meant jumping ahead in time. I shall now backtrack to the period before World War Two, when many people – academics, bankers, Treasury bureaucrats and politicians in Britain and other countries – first confronted Keynes’s unorthodoxy. What sort of person was the economist who produced these startling ideas? How did he persuade important people to take him seriously? Maynard Keynes’s education was punctuated by glittering achievements.When he graduated from Cambridge with first-class honours (in American terms, summa cum laude), he was one of a relatively small group of high achievers from the most prestigious British universities. His contemporaries – those in his own year and two or three years on either side – numbered only a few hundred, a minuscule fraction of the British population as a whole. Keynes was eventually to make a greater mark than any of the other men; his contemporaries in the top echelon were nearly all men, with depressingly few women. During the years when Keynes was at school up to the age of 18, boys were specially favored; their sisters received a more perfunctory education. There were a number of good schools for girls, but very few of their pupils went to university. Well-bred young women were encouraged to marry well. The thing that caused Keynes to advance ahead of most of the others in his group of academic stars was an inner compulsion throughout his life to spend long hours thinking and writing. He treated his formal education as the beginning and not the conclusion of a never-ending process of acquiring knowledge, particularly knowledge of things that were totally unknown before. This was the result of his psychological make-up. He did many different things during his life and he had the ability to learn from them and to make the different experiences interact to the benefit of them all. Keynes’s social class also had something to do with all this, mainly because it determined how he was educated. This is where his intellectual growth began. A small number of other people from the same background as Keynes also continued to develop their abilities after their formal education had finished. Eric

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Blair, to whom we are introduced in the next paragraph, is an example. He was a man different from Keynes in most – but not all – respects.

Social class and the British: a digression In May 1917, just before his 14th birthday, Eric Blair entered Eton College, the most distinguished of the British public schools. The adjective “public” is an anachronism, because such schools are private, exclusive and expensive. In most of them the pupils live in the school (except for vacations) and they are there between the ages of 13 and 18. Britain has about 200 public schools of varying quality today, but there were rather fewer 100 years ago. The pattern and standard of excellence were (and still are) set by the top 20, most of which are the oldest. Eton was founded by King Henry VI in 1440, and is located in Windsor, in the shadow of the royal residence Windsor Castle. The royal connection continues. Before he went to Eton, Eric Blair had spent five years living in an austere preparatory (prep) school. British prep schools, which educate boys from the richer strata of society before they go to public schools at the age of 13, are different from American prep schools, which prepare students for universities. Blair was very unhappy at this school, but he was so well educated there that he entered Eton as a King’s Scholar, a highly prestigious achievement that relieved his parents of most of the substantial cost of his public school education. Public schools were snobbish and in many cases unhappy places for the boys, but a superb education was on offer at the better ones, mainly because the teachers were well qualified, the classes were small and there was an ethos steeped in the values of scholarship and service to the community. Even today, half the new students accepted at Oxford and Cambridge come from public schools, although these students represent only a tiny proportion – 7 percent – of the British school population. Places at Oxford and Cambridge today are offered exclusively on the basis of academic achievement and potential, as measured by rigorous public examinations, and the competition is ferocious. Today, many pupils leaving a top public school in Britain are as well equipped educationally as an average student finishing the sophomore year in a good American university.1 The best public schools have always provided an admirable education, despite the great attention given to vigorous sports, which were thought by many traditional schoolmasters to be a way of suppressing sexual urges! In the last paragraph I use the phrase a superb education was on offer. Whether a boy at a public school actually received a good education depended largely on his own motivation and basic abilities, but on balance the majority of boys benefited academically. Such schools fostered self-motivation and leadership since the boys lived in a substantially self-governing community. This meant that they were encouraged to be self-reliant in all things, including their education. (Winston Churchill was a good example; his school days were unpromising to say the least, yet he taught himself to write well when he was on his own in the school library, with some guidance from a sympathetic schoolmaster.)

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Blair did not go to university, but his abilities were so well nurtured at Eton that by constantly applying himself to his thinking and writing, he blossomed into one of the most important British writers of the twentieth century, using the name George Orwell. He was a passionate and progressive egalitarian, a man of wide interests, but not an internationalist although he had lived for years outside Britain, in Burma, France and Spain. He identified totally with England, and in one respect his Englishness was even stronger than his egalitarianism: he had the customary English fixation on social class. He had little sympathy with class distinctions, but they are a theme that (perhaps unconsciously) runs through his journalism and essays. He described himself as “lower-upper-middle class.”2 He may not have been too serious when he portrayed the seemingly Byzantine complexity of the British class system in this way, but if he meant it he was wrong because he was over-complicating the subject. The reality of British class is much simpler than it appears. A century ago, there were only two important classes. Within each of these, the similarities were far greater than the differences, although there were many relatively unimportant points of distinction defining subgroups, like Orwell’s “lower-upper-middle class”.To simplify the definition, I shall call these two classes the upper 5 percent and the lower 95 percent. These percentages are no more than informed guesses, but they are correct orders of magnitude. A hundred years ago, these proportions represented about 400,000 families in the upper 5 percent and 7,600,000 in the lower 95 percent (assuming an average of five people per household and a British population of 40 million.) At the beginning of the twenty-first century there are still two classes, but today the proportions have changed. There is a higher percentage in the upper group, perhaps 10 percent of the total, and the border between the upper and the lower has become very porous, so that differences matter much less than before, but in reality the two groups have never been hermetically sealed from one another.3 A few outstanding people always managed to jump the barrier; in the early twentieth century they included a prime minister and a field marshal. As the nineteenth century turned into the twentieth, by far the most important factors that divided the top 5 percent from the lower 95 percent were education and occupation: specifically whether the head of the household had been to a public school. This more than anything else determined his job and hence his income. Most boys who went to public schools had also been to prep. schools, but relatively few went to universities. British universities were few and small by today’s standards. The best and most important were Oxford and Cambridge (in a class of their own), but there were also a few other good ones. A century ago, the proportion of public school boys who went to university was much smaller than it is today, probably less than 20 percent. In addition, the relatively small numbers who went to prestigious universities from schools other than the major public schools often built excellent careers and therefore entered the ranks of the upper 5 percent. Maynard Keynes’s father was an example. The top 5 percent comprised the tiny proportion of families in the aristocracy and land-owning gentry who were generally people of independent means;

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members of the learned professions; national politicians and those who aspired to join their ranks; senior government bureaucrats in the home civil service and in the diplomatic and colonial services; most (but not all) officers in the armed forces4; substantial farmers; and those at the top levels in major companies in industry and finance, plus younger men who had entered their firms in “fasttrack” jobs, often with family connections. The southeast of England had an above-average concentration of families in the top tier because of the number of career opportunities in London.5 The jobs held by the top 5 percent were usually well paid and offered opportunities for promotion and increased incomes, and some people made considerable fortunes. Many had also received legacies, because a hundred years ago there were no punitive estate taxes (death duties) in Britain. Since the top 5 percent could afford to educate their boys at public schools, the system became self-perpetuating. It was also very common for the upper 5 percent to give something back to society, as they had been taught in their schools. Although there was usually an element of de haut en bas, this help took many forms. Much was connected with the activities of the established church, the Church of England, and many of the upper 5 percent were faithful churchgoers and widely involved in charity work. Some industrialists, the Cadburys and William Hesketh Lever in particular, built model villages for their workers. Keynes was born into the top 5 percent. His education at school and university developed his considerable latent abilities and sharpened his intellect. It taught him how to think in a disciplined and imaginative way, and how to write lucidly and unambiguously. Most importantly, it taught him how to develop his abilities on his own and provided the inner drive for him to do so. His education gave him a secure foundation for a very successful career. His social class – the outcome of his education – determined his friends and his interests, and it deepened his artistic sensibility, in particular his love for the theater, books and – surprisingly – avant garde art. It governed his manners and attitudes to other people, it defined how he dressed, the topics of his conversation and his accent (which was and to some extent still is an indication of social class in Britain). Keynes’s education in an all-male boarding school also nurtured his homosexuality, something that was common in both prominent and obscure public schools, and which obviously caused great problems for many individuals during the years when homosexuality was a criminal offense. What I have said about class recognizes reality, but this reality conceals a stubborn problem. At the beginning of the twentieth century, the lower 95 percent knew little about the lives of the upper 5 percent, and the upper 5 percent knew very little about the lives of the lower 95 percent. This lack of first-hand knowledge of the population as a whole was a considerable handicap to social scientists, economists included, who came from the top 5 percent of society. There was a special exception in the work of three late Victorian and Edwardian philanthropists and academics, Booth, Seebohm Rowntree and Bowley, who studied the lower 95 percent statistically, but their analyses fell short of any qualitative understanding of the lives of the poor.

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The reason why George Orwell appears early in this chapter is because he was a journalist with a conscience who made a real effort to live among the poorest people. This gives his work a startling immediacy. He was the only well-known member of the upper 5 percent since Henry Mayhew to have done this. Mayhew had carried out personal investigations of the London poor during the mid-nineteenth century.6 The fact that Orwell learned directly about the lower 95 percent is so unusual that it is the exception that proves the rule. The rule is of course that the upper 5 percent and the lower 95 percent remain apart except for the individuals (few in 1900 but many more in the twenty-first century) who succeed in filtering from the lower to the upper. Keynes was the product of his class and his time, and this raises a point first discussed in Chapter 1. Harry Johnson (the engaging and clever Canadian economist who appeared in Chapter 1 and also in Chapter 5) makes a subtle but rather devastating point about Keynes’s lack of knowledge of the lower 95 percent of society. Johnson does this when he discusses Keynes’s fixation on full employment, which (in Johnson’s view) represented an: essentially aristocratic Victorian view of the economic requirements of a happy society. In that view, social happiness consisted of a job for everyone in his appointed place in life – Keynes was very little concerned about providing more equal opportunities for advancement within the ordered hierarchy of employment.7 Johnson was an Apostle, a member of a small, semisecret society of Cambridge intellectuals (which will shortly be described); Keynes had been a member. Johnson eventually became the president of the society, and made his attitude to Keynes perfectly clear in his 1971 presidential address. Johnson was referring specifically to an essay by Keynes entitled “My Early Beliefs”: I was struck by the supreme arrogance it displayed – it was a small group of gilded youth in Cambridge shielded by inherited social position from the expediencies of the phenomenal world that confronted everyone else, when virtually everyone else was preoccupied with the struggle to stay alive.8 This perception of Keynes, whether or not it was based on reality, was to damage his reputation among later economists. Since World War Two, the dynamism of the capitalist system, with the glitches removed, has shown itself able to generate unparalleled amounts of wealth, to the unanticipated benefit of the descendants of the unemployed of the interwar period. Modern economists believe that keeping up the impetus of this growth is what matters most today, and they feel that Keynes made no contribution to addressing the opportunities of long-term progress. But such economists take too broad a view of history. The hardship and frustration caused by the Great Depression may have been far less severe than, for instance, the horrors of the genocide of the European Jews and the universal

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destruction of life and property in World War Two. This does not mean that the Great Depression was merely an uncomfortable and temporary problem. The experience of that time has been richly documented, and the despair was probably greater than the deprivation itself: the hopelessness of a situation for which there seemed to be no cure – until Keynes made his appearance. Remedying the ills of the Great Depression was a precondition for the prosperity of later decades and Keynes was therefore totally right in concentrating on those ills. He was working in the 1930s, not the 1960s. Whether or not his “aristocratic” inclinations would have prevented him from addressing the impediments to economic growth that emerged during the prosperous years following World War Two can never be known. I strongly suspect that the searchlight he projected would have illuminated the later problems in the same way as it had illuminated the earlier ones. And different economic circumstances may well have modified the pessimism that Keynes felt during the 1930s.9 A point also related to Keynes’s background – something whose importance will become more evident in Chapter 10 – is that his personality, education and culture did not make him especially sympathetic to foreigners, particularly people from the United States. This was not to make for the smoothest of relationships when he found himself working closely with Americans during World War Two.

The leap into the top 5 percent An understanding of British education and social class is important in helping us appreciate Keynes in his many roles: as a thinker and writer, a teacher of talented students, a successful financial adviser and speculator, a tough and rather intolerant dialectician, an individual with foibles, a man with a very wide range of serious interests, a person with the strength of personality to influence other people, but above all someone who wanted to improve society in a practical way. Keynes’s family was almost certainly founded by a soldier called de Cahagnes who had accompanied William of Normandy when he invaded England in 1066 and became King William I.10 Keynes’s descent from the Norman warrior is probable, although there is no final documentary proof. The fortunes of the warrior’s family decayed after the British Civil War during the mid-seventeenth century, after which gaps appear in the family records. In the nineteenth century a Keynes emerged who rose to local prominence. He was John Keynes, Maynard Keynes’s grandfather, who was a successful self-made businessman in Salisbury, an ancient cathedral city in the West of England. John Keynes built a business growing and marketing flowers, fruit and vegetables, and when he died in 1878 he left the considerable fortune of £40,000 (probably more than $3 million in today’s money). John Keynes himself was probably not in the top 5 percent of British society, because of his relatively modest background. Another impediment was that the Keynes family were Baptists. This Protestant, Non-Conformist sect was quite separate from the Church of England, which dominated the top class of British society.

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John Neville Keynes, John Keynes’s son and Maynard Keynes’s father, made the upward leap. John Neville Keynes went to a small public school for boys from Non-Conformist families. From there he went to the University of London and then to Cambridge. At Cambridge, he took top honors in Moral Sciences (i.e. philosophy), and seemed set for an academic career. He subsequently became a fellow of Pembroke College, which meant that he was on the teaching staff and also on the governing body. It was at Pembroke that his intellectual interests moved from philosophy to economics (at that time in the process of splintering off Moral Sciences to become a subject of study in its own right). Although he published two rather formidable books, his academic career faltered and he became instead a university administrator, eventually being appointed the Registrary of Cambridge University. In Oxford and Cambridge, the individual colleges are independent and in some respects more important than the university itself. They have their own endowments that enable them to pay their own way. They elect their own teaching fellows, generally known as “dons,” and they select their own students who are taught to a large degree within the college. There is also a central organization, the university, which makes academic appointments. These are filled by college dons, who also run the programs of study, deliver the university lectures and set and grade the university examinations. As a result of these, degrees are awarded. It is the job of the Registrary to supervise all this activity, and he does this mainly by sitting on all the appropriate committees. In military language the Registrary is the chief of staff, but not the commanding general. Until recently, there was no commanding general at either Oxford or Cambridge because these universities like it that way, but there are now ominous signs of change. John Neville Keynes had received a comfortable legacy from his father. When he established himself at Cambridge University, he married and settled in a large and exceptionally ugly house about twenty minutes’ walking distance from the center of the city, where the older colleges repose, each in its uniquely splendid setting.11 Maynard Keynes, the oldest of three siblings, was born in 1883. I shall describe his life very briefly, and as in a play I shall divide it into three acts. This chapter covers two short acts: the period when he was preparing himself for his later achievements. Act I follows Keynes from his birth to his graduation from Cambridge; Act II describes his activities up to the age of 42. His remaining years up to his death at the age of 62 are the subject of Act III (and Chapters 9 and 10).

Act I: Early promise, early fufillment Unusually, the young Maynard Keynes was sent to a prep school in Cambridge as a day-boy; this meant that he lived at home. He soon showed unusual intellectual promise, and this was developed by coaching from his father, who continued to help him during his years at public school and university. His potential showed itself early when he was elected a King’s Scholar at Eton, and he entered the school in 1897, 20 years before Eric Blair. Keynes did very well

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within the intellectual culture of Eton, particularly among the rarified group of scholars, but he also played some sport, led an active social life as a member of Eton’s most select societies and even did some acting. There is no evidence that he was a practicing homosexual there, but he was fond of sexual gossip and he was attracted to other boys in a poetic way. However, Eton made him ripe for the more active homosexuality that he was to encounter at Cambridge. When he was 18 he won Eton’s most important prize in mathematics. And, as might have been expected, he won a top scholarship to King’s College, Cambridge, based on his work in mathematics and also in classics. The scholarship, like the one he had received at Eton, relieved his parents of much of the cost of his education. King’s is a sister foundation to Eton and was established in 1441, also by King Henry VI. Keynes entered the college in October 1902. His main subject of study was mathematics, but he was very soon deeply involved in philosophy, which in due course led him to economics. In his first year he was invited to join the Apostles, the semisecret society whose fame extended far beyond Cambridge, and which had existed continuously since 1820. Recruited from handpicked men of considerable intellectual ability, the Apostles was founded for a serious purpose: to read and debate papers on wide-ranging subjects. It was always a tiny group of people and had fewer than 400 members in total over the almost two centuries of its existence.12 The Apostles became important to Keynes for two reasons. First, his social horizon was extended. He was introduced to the Apostles by two undergraduates from Trinity College, another royal foundation. They were Lytton Strachey and Leonard Woolf (later husband of Virginia Woolf), who were shortly to become founding members of what became known as the Bloomsbury Group of writers and artists. It was through the Apostles that Keynes became a member of this group when he went to live in London. The second reason why the Apostles played an important role in Keynes’s life is that among its members in Cambridge he found his first homosexual lover. Keynes had a number of male lovers over the years 1905–1922, but they were all rather short-lived affairs. In 1925, Keynes, surprisingly, reversed his sexual preference and married. As mentioned, the Apostles were chosen from people in the first flight of academic ability. Keynes soon came to dominate their proceedings. Regrettably he developed a reputation as an intellectual bully, and his strong impact was resented by some people. In his personal correspondence, Leonard Woolf showed how much he disliked Keynes (although this also says something about Woolf who was notoriously misanthropic, at least until he married).13 Because of Keynes’s obvious talent, it is no surprise that he was in the top honors group in 1905 when he passed the Tripos (i.e. graduated) in mathematics, although there were a few men ahead of him on the list of Wranglers (the Cambridge name for graduates in mathematics with first-class degrees).14 Readers may be puzzled why Keynes took no further degrees. Oxford and Cambridge traditionally regarded such degrees with disdain and considered that they added little knowledge or intellectual rigor to a baccalaureate degree from those ancient

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institutions. Such a degree anyway translates upon application into a Master’s degree after a period of a few years. Oxford and Cambridge are less immodest today about graduate education. We have now come to the end of Act I of the three acts of Keynes’ life. Here is a young man of 22, whose early talent and education have placed him among those Britons of his age who were in the top echelon of the most select group in the country. There were probably about a hundred who took first-class Cambridge degrees in various subjects at the same time as Keynes, plus about the same number at Oxford. These represented approximately 10 percent of the Oxford and Cambridge graduates of that year, but (as mentioned at the beginning of this chapter) in comparison with the total population of Britain the proportion was almost too small to measure. Any career was now open to Keynes. He could have become a don or a senior civil servant. He had survived cut-throat competition to be elected president of the Cambridge Union, the university debating society run on the lines of the House of Commons and which was widely seen as a training ground for future prime ministers. Keynes could therefore have become a politician; or a diplomat, a colonial ruler, a lawyer, a clergyman, a journalist, even a physician (not easy because he had not studied Natural Sciences, but not impossible; Robert Bridges the future Poet Laureate took this path). Keynes would have been less likely to have gone into business. Most of his contemporaries in the top group went into professional or government jobs. But despite the dazzling careers that many of them built, they are all today forgotten men. (Many appear, alas, on war memorials.) In contrast, Keynes has a worldwide fame 60 years after his death. The names of none of his contemporaries have become adjectives, but we talk today of Keynesian economics. The interesting question is why? How did Keynes manage to forge ahead? His progress between the time of his graduation in 1905 and the period shortly after the end of World War One provides some clues. It was a period of considerable and varied activities, and Keynes learned from them all and each activity helped his effectiveness in the others. Unlike the vast majority of academics, Keynes kept only one foot in academe and even then it was not permanently fixed there, although he had some administrative responsibilities, eventually becoming the Bursar of King’s, substantially responsible for the college’s finances.

Act II: A continuous process of intellectual development After he had graduated in 1905, Keynes began to study economics with Alfred Marshall, who appears in Chapter 1 of this book. Keynes took to it with enthusiasm and flair. He grasped the principles within about two months, and resisted persuasion to take a degree in the subject despite Marshall’s prediction of firstclass honors.15 Marshall was due to retire in 1908. Before that, it was becoming clear that economics was where Keynes’s interests and greatest talents lay. On his graduation in 1905, however, he started preparing for the public examination for entry into the senior branch of the home civil service, a popular career for

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someone of his caliber. He had no difficulty at all in passing the examination, taking second place in the order of merit. Keynes started his civil service career in 1906 in the India Office, and moved to London. The job was not arduous, and he managed to plan and begin writing his first book when he was working there. This was a work of philosophy called A Treatise on Probability, and it had an exceptionally long gestation. Cambridge beckoned, and a fellowship at King’s materialized in 1908. He now began his long career as a teacher of economics. He had been reading about the subject for some time in preparation. But Keynes’s connection with the civil service was by no means broken, and he worked either as an official or as an adviser to government departments right up to his death in 1946. He made many important contributions to government policy, especially during the last decade of his life. (The year 1944 was especially important because of the publication of the Employment Policy White Paper, whose significance will be discussed in Chapter 10.) In 1911 he was appointed editor of the Economic Journal, the first British learned journal in the field of economics and a publication that was already internationally important. This occasionally time-consuming activity caused him to spend a few days every week in London, and he found a place to live near University of London buildings, in Bloomsbury, where he already had close friends. His membership of the Bloomsbury Group became an increasingly important part of his life. Like all Keynes’s other intimates, these writers and artists were from the top 5 percent of British society. A vast amount has been written about the Bloomsbury Group: rather more than their combined talent justifies. On the positive side, the members were both bright and versatile; and by shedding some of the rigidities they had been taught when they were educated, they succeeded in breaking new ground in their writing and their art, but there were negatives too. Their personalities were often less than admirable: their diaries and letters often show them to be superior, snobbish and bitchy. And they were not uniformly clever. Keynes and Virginia Woolf were both in the top class in their different fields. Lytton Strachey had a talent for entertaining and iconoclastic biography, but there was less ability and originality among the others, writers and artists alike. Their unorthodoxy was also expressed in their rotating relationships with one another, in sometimes heterosexual and sometimes homosexual ways (while some members of the group had rather confused sexual inclinations). Keynes was especially influenced by Bloomsbury because it stimulated his imagination and prompted him to take a serious interest in the arts, in particular the theater, ballet and picture collecting. He started to buy modern paintings and eventually put together an important private collection, including works by the Impressionists and Post Impressionists. These turned out to be fabulous investments, although Keynes acquired the paintings because he liked them and not because they might possibly have made him a millionaire. His collection, which eventually numbered 18 first-class works, by Braque, Cézanne, Delacroix, Derain, Matisse, Picasso, Renoir, Seurat and Sickert, is now in the Fitzwilliam Museum, Cambridge.16

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While Keynes was influenced by Bloomsbury, he in turn made a striking impression on these sharp, intelligent but bizarre people. Virginia Woolf – whose views are always worth listening to – sensed that he radiated power. She noted that he had dined with Asquith two days after the latter had resigned as prime minister in December 1916; on a later occasion she automatically assumed that he would one day join the British Cabinet; and she casually noted that when Keynes resigned from his wartime job in the British Treasury, he had received multiple job offers with astronomical salaries for part-time work in the City of London, all of which he rejected.17 She described the rapidity of his thought using a dramatic metaphor: “He is like quicksilver on a sloping board – a little inhuman but very kindly, as inhuman people are.”18 Keynes was always close to Virginia Woolf, and he was shattered by her suicide on March 28, 1941. This was a week before the public presentation of the 1941 Budget. Keynes’s role in guiding the strategy for this was his first major contribution to British government policy during World War Two. Perhaps surprisingly, younger people were unqualified in their admiration. To Quentin Bell, Virginia Woolf’s nephew, Keynes was “amiable, communicative and amusing,” and “as always, charming, brilliant, impressive and very persuasive.”19 Later in his life, many people enjoyed his warmth and quirkiness, despite his hard intellectual exterior. During these first years of his professional life, Keynes started his practice of doing a number of jobs at once. Shortly after he was appointed editor of the Economic Journal, he also became immersed in a detached and disinterested way with the problems of public finance in India. This was the delayed outcome of his experience in the India Office, and it led him in 1913 to publish his first book, Indian Currency and Finance. (A Treatise on Probability was still in progress.) A first book is always an event of enormous significance to an author because it gives him confidence. Thereafter, Keynes became increasingly surefooted, and this was to pay a real dividend when in 1919 he began writing a work that was to spread his fame far beyond the boundaries of Cambridge University. Keynes’s life was becoming intellectually and culturally very rich, with his teaching and college administration at Cambridge, his quasi-official work on Indian finance, his editorship of the Economic Journal and his burgeoning fascination with the arts. Playing an important role in the background, there was the Bloomsbury Group, with its addictive but often barbed and inconsequential gossip and its opportunities for homosexual affairs. This part of Keynes’s private life calls for a brief digression. Among his Bloomsbury friends, Keynes met the man with whom he had his longest-lasting homosexual relationship, the painter Duncan Grant. They were lovers for three years; Keynes’s other affairs had been and would be much shorter-lasting. I have mentioned Keynes’s homosexuality a number of times already. Readers must not think me prurient, and I am certainly not making any value judgment about his private conduct. But the fact that he had a long series of lovers may have been a sign of emotional instability or immaturity. Who can

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tell whether or not this reduced the effectiveness of his professional activities? Remember that A Treatise on Probability, on which Keynes had been working for many years, was not published until 1921. From the mid-1920s, he seems to have gained renewed zest and focus. He did a greater number of different things than any of his contemporaries, and he did them all wonderfully well. His life was a confluence of ability, mental energy and continuous and unswerving aim.20 By then Keynes had become much more stable emotionally because of a new – and permanent – personal relationship. Remarkably, his sexual orientation had changed and he had married a woman who was quite different from him in background and character and with whom he was to live in total happiness until he died. The explanation for the increasing panache with which he attacked his professional activities was mental stability. In the view of present-day psychiatrists, Keynes’s focus on and enthusiasm for his professional work was probably due more to his growing emotional maturity than to the actual change in his sexual preference.21 Returning to the situation when World War One broke out, Bloomsbury studiously refused to get involved, although the vast majority of people in the top 5 percent of society rushed to play their part. Many of Keynes’s school and university contemporaries immediately joined the army, but he was disinclined to do so since he could not see himself leading a weary platoon to almost certain destruction. He nevertheless did something important for Britain: something he was particularly well qualified to do. He left Cambridge in early 1915 and became a full-time official at the Treasury, one of the key departments of state whose special importance is because it finances all the other departments. His four years at the Treasury were enormously important to Keynes, for two reasons. First, he began to think in what are now called macroeconomic terms. He began to be concerned with war finance, Britain’s subsidies to her allies, the domestic fiscal balance, inflation, the British balance of payments, the strength of sterling, and (not least) the danger of financial crises. The language describing these issues was the one he used with increasing confidence and force throughout his life, and it is of course the language of the General Theory. The second reason is that his government experience led him to write a book that gave him a greater fame than most dons ever achieved during their lifetimes. When Keynes became a civil servant again he re-entered the Administrative branch. There are three separate echelons in the British civil service, and much the smallest is the top one, the Administrative branch. In Keynes’s day, there were 33 officials at this level in the Treasury, virtually all men who had graduated from Oxford and Cambridge.22 Keynes entered, not at the bottom of the Administrative grade list, but about half way up the ranking. This was because of his previous civil service experience and his growing fame as an economist. His position was senior enough for him to be noticed by the political heads of the Treasury and he soon made his presence felt and began to climb the totem pole. Within months, he was a close adviser to the Chancellor of the Exchequer (i.e. the minister of finance), Reginald McKenna, who was usually happy to

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accept Keynes’s counsel. But David Lloyd George, then minister of munitions, subsequently minister for war and before too long prime minister, considered Keynes dangerously impulsive in his judgments.23 The really important point was that Britain was fighting a massive world war, and Keynes was learning a job than no one had even done before. (He was also continuing to do other work: as editor of the Economic Journal, and giving public lectures at London University.) Keynes learned the concepts of macroeconomics “on the job.” He had earlier predicted that Britain was better able than Germany to carry the economic burden of a long war, and in September 1915 he wrote the following (with concluding observation by the historian Hew Strachan): As long as there are goods and labor in the country the government can buy them with banknotes; and if the people try to spend the notes, an increase in their real consumption is immediately checked by a corresponding rise of prices. (What would determine Germany’s eventual economic exhaustion, therefore, was not financial catastrophe but the depletion of commodity stocks.)24 Because Britain was buying food and munitions from abroad and at the same time subsidizing her allies, large amounts of sterling were departing the country and there was a danger in 1917 that the British pound would rapidly decline in value. Keynes went to the United States in the fall of that year as a senior member of a team sent to persuade the American financial establishment to grant loans to Britain. He did not take kindly to the Americans, and the feelings were reciprocated. However, the negotiations were successful. They were a forerunner of even more important negotiations that Keynes himself conducted at the end of World War Two to secure an American loan to an impoverished Britain. This was the last thing he did before he died. Earlier in 1917, Keynes had been made a Companion of the Order of the Bath, which meant that he could put the letters C.B. after his name. The British orders of knighthood are highly esteemed and are intended to reward excellence (although in effect often routine performance) in all senior branches of government service, civil and military. (Cynics say that they are used as substitutes for respectable salaries for government servants and are therefore a device to keep taxes down.) Excluding certain exalted titles usually conferred on the British and foreign royal families, there are four orders of knighthood which go to small numbers of people among the top 5 percent of British society. The Bath, which dates from the middle ages, is normally the preserve of senior officers in the armed forces rather than civil servants, whose awards are normally a shade less prestigious. Keynes’s admission to the Order of the Bath was a clear recognition that he was a coming man. During the last months of World War One, Keynes was closely involved in financial negotiations with Britain’s allies. In a short while he became well known on the international scene. One of his small but interesting achievements

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was to find the money from British government funds to buy the paintings in the Paris studio of Edgar Degas for the National Gallery in London.25 Keynes’s international responsibilities led him to be nominated in January 1919 as the Treasury representative at the Peace Conference at Versailles. This was to take place in the massive palace outside Paris constructed during the seventeenth entury by King Louis XIV, the Sun King. Keynes’s job was to advise on the financial aspects of the Peace Treaty, particularly on the reparation payments that the Allies were determined to demand from Germany. Keynes’s role was to stay in the background during the negotiations and feed advice to the more senior delegates, but his close observation of the statesmen whose decisions altered the map of the world changed Keynes’s life.

Versailles and after The Versailles Conference lasted six months, January through June 1919. There were large numbers of delegates from the victorious and vanquished nations, but most of the work was carried out in small meetings. In these, the winners and losers were kept carefully apart.26 Three men dominated the Conference: Georges Clemenceau, the prime minister of France and the man who exerted the greatest influence on the final outcome; David Lloyd George, the British prime minister; and Woodrow Wilson, president of the United States. Keynes was extremely perceptive in his analyses of their individual characters, as will be seen later in this chapter. Keynes’s professional responsibility was to estimate the amount of reparations that Germany should be forced to pay to the victorious powers. Before the Conference, he and his Treasury colleagues had come up with a sum of £3 billion, a sum considered to be within Germany’s capacity to pay. After careful thought, Keynes brought this down to £2 billion (about $9 billion at the 1919 rate of exchange, and the equivalent of perhaps $400 billion in the twenty-first century).27 Although Wilson originally proposed no reparations at all, Lloyd George wanted a much larger sum, and Clemenceau a larger sum still. Keynes was temporarily sidelined by Lloyd George, but he soon returned to his advisory role as the Conference proceeded in stages, which were in effect intricate rounds of horse trading. The victorious delegates were in the business of setting rigorous terms for the defeated nations, while the latter were in the more arduous (and less successful) business of softening the treatment they would receive. The sum for reparations eventually exacted from Germany was almost four times the amount of Keynes’s original proposal. Appropriately enough, it was never paid in full. The book Keynes wrote soon after the Conference, The Economic Consequences of the Peace, provides vivid insights into the personalities of the three statesmen who dominated Versailles. These descriptions also give us an unimpeded glimpse into Keynes’s own mind. Readers will note three characteristics of what Keynes had to say about his subjects: first, his portrayals were totally honest and were not softened in any way to avoid bruised feelings. The second

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characteristic is Keynes’s extraordinary eye for detail, but in every case detail that was relevant to the story he was telling. The third and most important feature of the descriptions is Keynes’s ability to get to the core of an issue and describe what he found in language that leaps out of the page. When Keynes described Clemenceau, he dwelt on seemingly inconsequential details, as in the following brief extracts: a square-tailed coat of very good, thick black broadcloth, and on his hands, which were never uncovered, gray suede gloves; his boots were of thick black leather, very good, but of a country style, and sometimes fastened in front, curiously, by a buckle instead of laces.28 He spoke seldom, leaving the initial statement of the French case to his ministers or officials; he closed his eyes often with an impassive face of parchment, his gray gloved hands clasped in front of him.29 He was a foremost believer in the view of German psychology that the German understands and can understand nothing but intimidation.30 Keynes instinctively realized that Clemenceau could only be understood by setting him in his historical context. Clemenceau was 78 years old at the time of Versailles and he was therefore a genuinely nineteenth-century figure. He was unyieldingly vindictive toward Germany, whom he held responsible for the Franco-Prussian war of 1870–1871, a conflict that had caused the most painful loss of French life, treasure and amour-propre, not to speak of the rich provinces of Alsace and Lorraine. The negotiations that ended that war, together with the equally humiliating declaration of the German Empire that followed the German triumph, took place in the same Palace of Versailles that was being used in 1919 to conclude the greatly more punishing war of 1914–1918. Clemenceau had a cultivated and subtle mind, but he was basically an autocrat who represented the France of the years before 1870, and it was this era to which he was determined that France should return. This is what Keynes’s pen portrait managed to capture. Clemenceau got the best deal in most of the horse trading. Tragically, he did not have the foresight to imagine the price that France would pay in 1940 for his intransigence in 1919: an intransigence that was perhaps not his own fault because – like most successful French politicians before and since – his personality was a distillation of the spirit of France. Keynes showed Lloyd George as a total contrast to Clemenceau. The British prime minister was a Celt – a member of a more emotional race than most Britons, who are Anglo-Saxon – and a man who possessed: unerring, almost medium-like sensibility to everyone immediately round him . . . watching the company, with six or seven senses not available to ordinary men, judging character, motive, and subconscious impulse, perceiving what each was thinking and even what each was going to say next,

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and compounding with telepathic instinct the argument or appeal best suited to the vanity, weakness, or self-interest of his immediate auditor.31 Lloyd George was a figure of astonishing tactical brilliance: the result of his intuition and imagination rather than his intellect. When he tried to act as an intermediary between the contrasting but equally extreme positions of Clemenceau and Wilson, he had no real success. Despite superficial appearances, Lloyd George was a man of principle, but he was torn between his own basically benevolent instincts and the demands for revenge against Germany from his political supporters at home and the leaders of the British Dominions which had contributed so greatly to the British war effort. In the last analysis, Lloyd George’s actions revealed a streak of moral weakness, and Keynes hinted at this in his verbal portrait. This defect in Lloyd George’s makeup was manifested during the war itself, when Lloyd George had become certain that Haig, the commander of the British army in France, was unsuited to his great responsibilities, yet Lloyd George lacked the confidence and resolution to fire him. The epic figure in Keynes’s pantheon was Woodrow Wilson, a man doomed, like a Shakespearian tragic hero, by the deficiencies of his own character. Wilson had not spent many years in politics, but he developed high and rigid principles, and he came across as: a generously intentioned man, with many of the weaknesses of other human beings, and lacking that dominating intellectual equipment which would have been necessary to cope with the subtle and dangerous spellbinders whom a tremendous clash of forces and personalities had brought to the top as triumphant masters in the swift game of give and take, face to face in Council – a game of which he had no experience at all.32 Keynes saw Wilson as a man from whom so much was expected yet who was outclassed by the other two members of the triumvirate. He considered him a theologian and not an intellectual at all. The famous Fourteen Points were, in Keynes’s words “nebulous and incomplete.”33 To make matters worse, Wilson had no effective help from the American officials who accompanied him. At Versailles he was a lost soul. Clemenceau’s combination of finesse and iron resolve trumped Wilson’s moral rigidity. And Lloyd George’s complex maneuverings did not manage to achieve any sort of compromise. Wilson’s greatest disappointment was of course yet to come. He became a martyr to the Separation of Powers, his high ideals unable to earn the support of the Congress of the United States. Keynes became bitterly disillusioned by the Versailles negotiations: by the crude dismemberment of the defeated countries and, even worse, by the headstrong and vindictive policy of squeezing the economic life out of Germany by the amount of reparations demanded. Keynes saw, with penetrating prescience, that the German economy would collapse and that this would imperil the

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economic stability of Europe, although even he was unable to predict fully the horrific consequences of that collapse. Keynes’s description of the final outcome of the Conference provides some idea of the depth of his feelings. It is an arresting amalgam of uncompromising and acid criticism, and logical elegance: Clemenceau, aesthetically the noblest; the President, morally the most admirable; Lloyd George, intellectually the subtlest. Out of their disparities and weaknesses the Treaty was born, child of the least worthy attributes of each of its parents, without nobility, without morality, without intellect.34 In June 1919, Keynes in disgust resigned from the Treasury and began to put his disillusionment onto paper. Within months, The Economic Consequences of the Peace was published, and Keynes became famous within the top 5 percent of society in Britain. More interestingly, his fame began also to eddy out into other countries. The pen portrait of Keynes at this time by Walter Lippmann, an unusually well-informed and influential American observer, was anything but a description of a normal Cambridge don and senior official in the most important British department of state: . . . “charming, cunning, versatile, with tastes that ran the gamut from mountain climbing to practical jokes.” Others found him . . . “rather mad and perverse, given to wearing strange costumes, practicing elaborate jokes, and speaking in riddles.”35 Many people attest to Keynes’s mischievousness, his impishness, a character twist that he retained almost to the end of his life. It only flagged during his last year as a result of the strain of his work, the weakening of his morale and his worsening health. Keynes was always a confident man. He was not vain: indeed he was unjustifiably embarrassed by his personal appearance. He was actually tall and rather elegant; the frontispiece of this book, the cartoon by David Low, captures his appearance wonderfully well. He was not diffident, however, about his mental abilities. There was a story that circulated in Cambridge that he used to explain light-heartedly how to pronounce his name: “Keynes, to rhyme with brains.” His Treasury experience, which meant his participation in high-level decisions affecting the economy, now gave him a special authority that was possessed by no other don. This greatly strengthened his contribution when he returned to his teaching in October 1919. As usual, many activities soon filled Keynes’s life; the most time-consuming of these was journalism.36 The British government had invited him to go to India to help solve the problems of Indian taxation, but he turned down the opportunity because he had become increasingly caught up with the Liberals. This party had traditionally been on the left of British politics, but its position there was becoming increasingly tenuous because of the emergence of the Labour Party (often called – slightly disapprovingly – the Socialist Party). The Liberals were about to occupy a shaky position in the center. Lloyd George was leader of the Liberals, but when he lost office as prime minister in 1922, the party received a blow from which it never recovered, although Keynes had no way of knowing

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this. Keynes was growing to respect Lloyd George, although he had been very suspicious of him during World War One (Lloyd George had felt the same way about Keynes), but Lloyd George certainly made an impression on Keynes at Versailles. The daily newspaper most closely associated with the Liberals was the Manchester Guardian, and Keynes edited 12 supplements, each the size of a magazine, devoted to the reconstruction of Europe. They also included a number of articles written by him. At the same time, he also published another book on the disastrous Peace Treaty. In addition, between 1923 and 1931, Keynes was chairman of the official Liberal Party journal, the Nation and Athenaeum, which provided a platform for his trenchant views.37 And of course he continued as editor of the Economic Journal. Because he had become a national figure, Keynes became a director of a number of companies in the City of London.38 He gave good value for his fees, but he in turn gained more than the money alone. The insights he gained into the operation of financial markets began to open his eyes to the world of expectations that was to be become such an important part of his doctrines. He also acquired – or perhaps continued the process of acquiring – a feel for the irrationality of the stock market, an understanding that was to bring him financial benefits and risks (the former greater than the latter). In 1920 the British economy had fallen into a depression after the postwar boom, and recovery was sluggish. At all times of his life, Keynes’s most important activity was thinking, and it was at this time that he began to address the problem of involuntary unemployment. Thus began the chain of intellectual activity that was to continue with some interruptions for years and was to culminate in the publication of the General Theory in 1936. Despite everything else that was going on, something astonishing was happening to Keynes. As early as 1918, he had begun to admire the performances of an émigrée Russian ballerina called Lydia Lopokova, and he started to meet her regularly in 1921.39 She had a husband already, but her marriage was in dissolution and was soon to come to an end. The courtship between Keynes and Lopokova was interrupted but it was serious, and in 1925 they married. (The delay was caused by Lopokova’s divorce.) This meant that by this time Keynes had changed his sexual preference. This is unusual although not as uncommon as many people believe.40 The national press reported the news of the marriage, but Bloomsbury disapproved; but by this time Bloomsbury had become less important to Keynes than it had been before 1914. Lopokova was artistic, impulsive, unconventional and charming, and spoke a uniquely fractured style of English. In contrast, Keynes was focused, articulate, with great intellectual depth, but he was in many ways conventional. Their marriage was a love match and was wonderful for them both. They had no children and they were together for only 21 years, because he died in 1946 when he was two months short of 63. The Keynes/Lopokova union provides an appropriate conclusion to the second act of Keynes’s life. His first 42 years were a preparation for what was to

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come. During the third act, he was to be a man of many parts – even more parts than before – and he was to prove himself to be yet more formidable as a thinker, dialectician and éminence grise, but also as a man who wanted to solve the most pressing economic problems of the world.

Notes 1 This conclusion is based on my direct personal experience of the British educational system, and 27 years as a professor at a large, selective, private university in the United States. My son Philip has made a number of valuable contributions to this chapter. He was educated on two continents, attending a British prep school and public school, and an American university. He is by profession an editor and publishing executive, and he has done a great deal to tighten the writing in this and other chapters of this book. 2 Peter Stansky and William Abrahams, The Unknown Orwell, St. Albans, Herts, UK: Paladin, 1974, p. 22. 3 An important British economist, Peter (later Lord) Bauer wrote an entertaining essay on the British class system, based on what he had observed during the 50 years he had lived in Britain. He had been born in Hungary and lived there until the end of his teens. He was therefore able to look objectively at British people’s irrational interest in social class. The subject amused him although the tone of his essay is serious. In it he demonstrates that throughout the twentieth century, the door into the top echelon was always open to talent. Peter Bauer, “Class on the Brain,” in Subsistence to Exchange and Other Essays, Princeton, NJ: Princeton University Press, a Cato Institute Book, 2000, pp. 125–138. Peter Bauer was my Director of Studies at Cambridge. 4 A neat description of the most important division between classes in the British army before World War One is given in a book written by an articulate private soldier: “The gulf between the Regimental Sergeant-Major and the youngest officer in the battalion was equally great, if not greater than the gulf between the Regimental SergeantMajor and the youngest recruit.” Frank Richards, Old Soldier Sahib, London: Faber & Faber, 1936, p. 156. It is difficult to think of an organization with a more finely shaded hierarchy than the British army during the early twentieth century. Yet as Richards points out, one distinction mattered more than any other: one bridge that could be crossed only in the most exceptional cases. In a British infantry battalion before 1914, the officers accounted for 3 percent of the total strength. Today, the proportion is slightly higher, generally about 5 percent. This part of the book has been scrutinized by a well-informed English friend, Anthony Simpson, formerly of the European Commission, Brussels. I am most grateful to him for this and other contributions. I am equally grateful for the contribution of another British friend, Colin McDonald, who takes the more traditional view that British society is sliced into more segments than appears to me when I look at it from my American perspective. 5 In commercial survey research carried out in Britain, the population is classified into six socio-economic groups, defined by the occupation and income of the head of the household. These are A (the top group); B (the upper-middle class); C1 (white-collar workers); C2 (skilled blue-collar workers and factory supervisors); D (the bulk of the working class); and E (the poor who live on social security). Because of the very small numbers in Groups A and E, they are always collapsed into B and D respectively, so that only four classes remain: AB, C1, C2 and DE. AB is an approximation of what I mean by the top group, which numbered 5 percent in Keynes’s youth, but probably 10 percent today. Putting the A and B classes together means that there is little to choose, in income, background and tastes,

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6 7 8 9 10

11 12 13

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between a peer of the realm, an ambassador or a top businessman (Class A) and a physician, a lawyer or the owner of a prosperous local business (Class B). The practice of British market research elevates the upper-middle class into the aristocratic group. On the other hand the British middle class (e.g. school teachers and office workers) would be considered C1. AB and C1 together form the top 25 percent of the population. Note the strange use of the adjectives “upper-middle” and “middle” to describe most of the people in the highest one-fourth of British society. In the United States, there is a more logical use of the phrase “middle class.” It means middle income, and would include a salesman (British Class C1), a factory foreman (Class C2) and a mail carrier (Class D). Many of Mayhew’s investigations have been republished in a beautifully produced edition: Henry Mayhew, London Characters and Crooks, Christopher Hibbert (ed.), London: The Folio Society, 1996. Elizabeth S. Johnson and Harry G. Johnson, The Shadow of Keynes. Understanding Keynes, Cambridge and Keynesian Economics, Chicago: University of Chicago Press, 1978, p. 217. Richard Deacon, The Cambridge Apostles: A History of Cambridge University’s Elite Intellectual Secret Society, New York: Farrar, Straus & Giroux, 1986, p. 175. See the section of Chapter 1 entitled “Keynes Under Attack.” Although I take responsibility for my interpretation of Keynes’s life, I have relied heavily on the rich mine of facts published in the various biographies of Keynes. These are: R.F. Harrod, The Life of John Maynard Keynes, London: Macmillan, 1951; (Harrod’s book appeared five years after Keynes’s death, and was the first biography of its subject; since Harrod knew Keynes well, the book has some uniquely interesting features); Charles H. Hession, John Maynard Keynes: A Personal Biography of the Man Who Revolutionized Capitalism and the Way We Live, New York: Macmillan, 1984; D.E. Moggridge, Maynard Keynes: An Economist’s Biography, London: Routledge, 1992; Robert Skidelsky, John Maynard Keynes, London: Macmillan, Vol. 1, 1983; Vol. 2, 1992; Vol. 3, 2000. The titles of the three volumes are: Hopes Betrayed, 1883–1920; The Economist as Saviour, 1922–1937; and Fighting for Britain, 1937–1946. Skidelsky’s work is very comprehensive: more than 1,700 pages. It is an outstandingly enlightening and readable work. There is also a fascinating collection of 28 freestanding papers, mostly written by people who knew Keynes personally. This was edited by Keynes’s nephew, Milo Keynes, Essays on John Maynard Keynes, Cambridge, UK: Cambridge University Press, 1975. In this chapter, the history of the Keynes family and Keynes’s early years is based on Harrod, pp. 1–54; Hession, pp. 1–36; Moggridge, pp. 1–51; Skidelsky, Vol. 1, pp. 1–25, 93–105. There is also a personal memoir written by Keynes’s brother Geoffrey, published in the essays edited by Milo Keynes (who was Geoffrey Keynes’s son), pp. 26–35. I am grateful to my friends Martyn and Wendy Seekings for refreshing my memory of the geography of Cambridge. Deacon, The Cambridge Apostles, pp. 200–205. Douglas Blair Turnbaugh, Duncan Grant and the Bloomsbury Group, Secaucus, NJ: Lyle Stuart, 1987, p. 29; Deacon, The Cambridge Apostles, pp. 78–79; Frederic Spotts (ed.), Letters of Leonard Woolf, New York: Harcourt Brace Jovanovich, 1989, pp. 32, 73, 140. In my discussion of the impact of Keynes on the Bloomsbury Group, I am very grateful for the comments of Ambassador Goodwin Cooke, a colleague at Syracuse University. Harrod, The Life of John Maynard Keynes, pp. 69–75; Hession, John Maynard Keynes, pp. 43–47; Moggridge, Maynard Keynes, pp. 52–81; Skidelsky, John Maynard Keynes, Vol. 1, pp. 115–132. Skidelsky, John Maynard Keynes, Vol. 1, p. 166. Richard Shone with Duncan Grant, “The Picture Collector,” Essays on John Maynard Keynes, M. Keynes (ed.), pp. 280–289.

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17 Nigel Nicolson and Joanne Trautmann (eds), The Letters of Virginia Woolf, Vol. 2, New York: Harcourt Brace Jovanovich, 1976, pp. 133, 595; Anne Olivier Bell (ed.), The Diary of Virginia Woolf, Vol. 1, Harmondsworth, Middlesex, UK: Penguin Books, 1979, p. 288. 18 Bell (ed.), Diary of Virginia Woolf, Vol. 1, p. 24. 19 Quentin Bell, Bloomsbury Recalled, New York: Columbia University Press, 1995, pp. 87, 221. 20 There is an aphorism associated with the Great General Staff of the Prussian army: the most valuable people combine high energy with high ability; but the least valuable – in fact the most dangerous – are those who combine high energy with low ability. 21 During the years 1901 through 1915 alone, Keynes had 26 identified male lovers (Moggridge, Maynard Keynes, pp. 838–839). Hession, Moggridge and Skidelsky all discussed Keynes’s homosexuality, but Harrod did not. This was because his book, The Life of John Maynard Keynes, was published in 1952, a time when homosexuality was a criminal offense in Britain and Harrod wished to avoid embarrassment to the Keynes family. I have discussed the change in Keynes’s sexual preference with two prominent psychiatrists, Dr Robert Daly and Dr Eugene Kaplan, both of the University Hospital, Syracuse, New York. I have also discussed this and other aspects of Keynes’s life with a well-known historian, Professor Roger Sharp of Syracuse University, New York, and I am very grateful to him, as I am to Bob Daly and Gene Kaplan. 22 Hew Strachan, The First World War, Vol. 1: To Arms, Oxford: Oxford University Press, 2001, p. 859. 23 Skidelsky, John Maynard Keynes, Vol. 1, pp. 312–313. The full story of Keynes’s work at the Treasury before the Versailles Conference is told in Harrod, The Life of John Maynard Keynes, pp. 201–253; Hession, John Maynard Keynes, pp. 115–134; Moggridge, Maynard Keynes, pp. 232–287; Skidelsky, Vol. 1, pp. 305–353. 24 Strachan, The First World War, Vol. 1, p. 817. 25 Skidelsky, John Maynard Keynes, Vol. 1, p. 349. 26 Ibid., pp. 354–375. 27 I am using a billion in the American sense (i.e. a thousand million). Keynes proposed a sum that he spelled out as £2,000 million. (A British billion is a million million.) 28 John Maynard Keynes, The Economic Consequences of the Peace, New York: Harcourt, Brace and Howe, 1920, pp. 29–30. 29 Ibid., p. 30. 30 Ibid., p. 32. 31 Ibid., p. 41. 32 Ibid., p. 39. 33 Ibid., p. 43. 34 John Maynard Keynes, Essays in Biography, London: Macmillan, 1933, pp. 40–41. 35 Ronald Steel, Walter Lippmann and the American Century, Boston: Little, Brown and Company, 1980, p. 306. 36 This part of Keynes’s life is recounted by Harrod, The Life of John Maynard Keynes, pp. 285–330; Hession, John Maynard Keynes, pp. 173–200; Moggridge, Maynard Keynes, pp. 348–394; Skidelsky, John Maynard Keynes, Vol. 2, pp. 3–18, 91–91, 134–139. 37 Skidelsky, John Maynard Keynes, Vol. 2, pp. 102–139. 38 Ibid., pp. 26–27. 39 Harrod, The Life of John Maynard Keynes, pp. 364–370; Hession, John Maynard Keynes, pp. 178–182, 222–224; Moggridge, Maynard Keynes, pp. 395–413; Skidelsky, John Maynard Keynes, Vol. 2, pp. 140–146. 40 The views of Dr Daly and Dr Kaplan. See note 21 above.

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The Roaring Twenties were an interval of highly charged activity between two depressions. One was brief, the other prolonged; but both were unpleasant. The depression of 1919–1922 soon gave way to the boom of the mid-1920s, which in turn produced excesses in the United States that led to a greater depression than has ever been seen before or since. It was into the dark recesses of the twenties and thirties that Keynes directed a penetrating searchlight.1 He did this through his serious writing and his more popular journalism and radio broadcasts. He did it even more energetically through the continuous guerrilla warfare he waged against the financial establishment. This phrase was not used in Keynes’s day, but it describes well the notion of a club of policy-making insiders. The title of this chapter describes Keynes’s battles as guerrilla infighting, a reminder that he was personally a member of this club and fought from a secure position as an insider himself. His marriage in 1925 coincided approximately with the beginning of his battles with the financial establishment, and these events marked the start of the third act of Keynes’s life. He had spent four years, 1915–1919, as a senior official at the Treasury where he had made a considerable impact, and he was developing a growing national and international reputation as an economist, so that Keynes was always “one of us” not “one of them.” This recognition contributed greatly to how his views were regarded; there may have been disagreements, but he was always taken seriously. It was also important that the men (no women, alas) with whom Keynes locked horns – the government officials, bankers and politicians – were, like Keynes, all from the upper 5 percent of British society. Most of them had arrived there after a public school and an Oxford or Cambridge education. (The two notable exceptions were prime ministers David Lloyd George and Ramsay MacDonald, who both rose from humble beginnings as a result of their outstanding natural ability and the support of the voting public.) Keynes continued to operate in a society with which he was totally familiar. Three groups of men made up the financial establishment. The first was the top permanent officials of the Treasury. Most of these had graduated in the liberal arts rather than economics; only Ralph Hawtrey (who will reappear in this chapter) could claim to be an economist. Top civil servants in Britain were and are popularly known as “Mandarins,” the government equivalent of Oxford

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and Cambridge dons. The job of the Treasury is to find the money from taxation to pay for the activities of all the other government departments. This gives it its importance, and as a reminder of this, the full title of the prime minister has always been First Lord of the Treasury. The Treasury’s traditional policy was synonymous with sound finance. This meant balanced budgets, freedom from political interference (because the different departments of state fought their battles over funding within the Cabinet), and an overall objective of not interfering with the healthy working of business competition.2 The second group comprised the highest decision-makers at the central bank, the Bank of England. This was a private institution. It was nationalized shortly after World War Two and returned to private ownership at the end of the 1990s. Its main function was and is monetary policy. This means controlling the quantity of money created by the banking system and managing the national debt. It carries out this work mainly by manipulating the short-term discount rate (then called the Bank Rate), which directly influences all other interest rates. The Bank of England works in close cooperation with the Treasury, although this does not preclude the two bodies from following different policies occasionally.3 For most of the two decades I am talking about, the political head of the Treasury was not consulted about the Bank Rate. The third – and smallest – group was the political leadership of the country, in particular the Chancellor of the Exchequer, the parliamentary head of the Treasury. His main task was and is to scrutinize carefully and evaluate the advice of his permanent officials and to make decisions, which means taking responsibility for them and defending them on the floor of the House of Commons. In addition to these three groups, Keynes was also closely connected with the City of London through his directorships of a number of major companies. Significantly his knowledge of business was confined to finance. He never gained any first-hand experience of manufacturing industry and how plans for capital investment are actually drawn up. When an entrepreneur replaces old capital equipment with new, it is possible to make a rational calculation of what this will mean for output and profit. The principles that Keynes described as governing capital formation therefore apply, but in Keynes’s definition this is not net investment at all and it is therefore excluded as a source of demand and employment.4 It is quite different with investment for totally new ventures, whether or not these are undertaken by businesses already operating in the field. This is what Keynes meant by net investment. And it is a much more problematical endeavor. My personal observation has shown me that such investment plans are made on the basis of entrepreneurial “feel”: a compound of opportunism, optimism and guesswork, supported by tenuous projections of future sales volume and profit that might be generated by the capital project that is being planned. It sometimes works, but it is not easy to explain why. This is all very different from Keynes’s neat analysis based on the Marginal Efficiency of Capital. Keynes also published a formidable amount of journalism, which meant that his name became familiar to the broad mass of the British population, although

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not quite so many people understood fully the meaning of his doctrines. The communication was very much one-way. His spoke to the public, but the public did not speak to Keynes. This meant that he did not have the first-hand knowledge to ratchet up his arguments against unemployment and the lack of flexibility of money wages. Unemployment as an abstract concept was always on Keynes’s mind, but he knew little about the plight of the poor. The stickiness of money wages – the way they did not move down as prices fell – was an important but theoretical topic during the mid-1920s when Keynes was devoting a huge amount of attention to the Gold Standard and Britain’s overvalued currency: policies he thought were grievously mistaken. George Orwell’s condemnation of the plight of the poor was more personal and powerful. Keynes’s journalism was packed with ideas, partly because it reflected the constant evolution of his doctrines. He was not a person who formulated a single all-encompassing view at the beginning of the 1920s: one which he would stick to throughout the whole period. His doctrines emerged rather slowly, with much backtracking and redrafting, until the publication of the General Theory in 1936. The infighting with the Treasury, the Bank of England and the politicians unquestionably contributed to the development of his thinking. I believe strongly that synergy is more often the product of abrasiveness than of smooth partnership. Most of Keynes’s work was done in committee and he managed to dominate most of the committees on which he sat. Not only was he cleverer than most of the other members, but he was unusually conscientious and invariably prepared a “position paper” for each meeting. This tended to catch the other members on the wrong foot.5 Although members of the cosmopolitan moneyed elite – people sometimes known as café society – thought Keynes was a “dull dog”6 who was fond of argument, he was not considered dull by people who knew him well. All his friends and colleagues were members of the top 5 percent of British society, but they were all either intellectuals or devoted to the arts. Some were both. With such people he was a most engaging conversationalist in matters both serious and less consequential. Dennis Robertson remembered his impish humor. In serious debate, Keynes was a tough dialectician and became a formidable one. Although he was gentle to his students and was never rude to those who made fools of themselves at meetings of the Political Economy Club, he could be pretty direct to junior dons, and even more so to senior people in Cambridge and to those within the financial establishment in London. He had charm, but he could on occasion be a verbal bruiser and would have been at home in the House of Commons where debate is nothing if not robust. On one occasion, Keynes told a senior Treasury official to his face that he was “intellectually contemptible.”7 Since he did not confine his fisticuffs to the government bureaucracy, a board meeting of a major insurance company once witnessed Keynes explaining to a co-director who happened to be the brother of Lord Curzon, onetime Viceroy of India: “You have all the pomposity of your brother and none of his intelligence.”8

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Did this occasional verbal pugilism cause resentment? Unquestionably it did. More importantly, was it counter-productive? I do not believe it was. Keynes was concerned with very big issues indeed: nothing less than the lives of the most disadvantaged people in society, and even the future of competitive capitalism. He was not playing an academic game. He was devoting his life to matters over which he could not afford to be too tactful, delicate or subtle. If he was to influence public policy, he had to advance his doctrines relentlessly, and with all the force of his formidable intellect. He was also matched – particularly in the Treasury – with minds of a caliber not far short of his own.

The troubles of the 1920s The end of World War One in 1918 brought a boom to Britain that was driven by pent-up consumer demand, to which was added the stimulus of government expenditure that continued at a rate not much lower than what had been spent during the war. This boom was soon followed by a sharp depression during the years 1919–1922, brought about by two shocks. The first was a rise in real wages due to a reduction in the working week caused by trade union pressure. The second was a government-induced deflation triggered by the inevitable fall in government expenditure and which was made much worse by an increase in the rate of interest. The collapse in prices, output and employment was greater than at any time since the end of the Napoleonic war. Stability was finally restored with unemployment at 10 percent and it continued at this high level throughout the rest of the decade.9 In the United States, the pattern was similar but the recovery was better. The downturn in incomes that began in mid-1920 was characterized by falling prices and business liquidations. Unemployment, which had been as low as 1.4 percent in 1919, rose to 5.2 percent in 1920 and then to 11.7 percent in 1921 (a level never reached before during the twentieth century). Unemployment sank to 6.7 percent in 1922, and then fell to low levels during the rest of the 1920s.10 The 1920s were a boom time in America. The important question bearing on the development of Keynes’s doctrines was why the recession of the early 1920s left a legacy of high unemployment in Britain, while the United States recovered much more completely. In the opinion of Skidelsky, Keynes’s best biographer, it was the shock of this recession to the British economic system that started Keynes down the path that led to the writing of the General Theory more than ten years later. A problem that compounded the special difficulties of the British economy – and something that was to become even worse over time – was what Keynes later described as “frictional” unemployment. This was unemployment in declining firms with out-of-date capital equipment, mostly in mature industries that did not have much future in Britain because other countries were becoming more efficient. Unemployment in these firms and industries was not easily absorbed by the relatively small number of growing industries. Britain was the first indus-

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trial country, and it is not surprising that she relied heavily on such ancient enterprises as shipbuilding, iron and steel, coal and cotton. The first three of these are heavy industries where output and employment are related in a geared fashion to other types of business. Ultimately, the products of heavy industries are used to manufacture and transport consumer goods, and any decline in the demand for consumer goods is felt in an exaggerated form by the heavy industries supplying them. Hence the 1929 unemployment levels of 23.2 percent in shipbuilding; 19.9 percent in iron and steel; 18.2 percent in coal; and 14.5 percent in cotton: figures that climbed much higher during the Great Depression.11 What made the situation in Britain even worse was the fact that these heavy industries were concentrated in limited regions of the country: the north of England, Scotland, Wales and Northern Ireland. New industries, e.g. automobiles, airplanes, radio (popularly known in Britain as “the wireless”) and many packaged consumer goods, were being established mainly in the midlands and the south. This meant that a shift of workers from regions where there was no work to the places where there were at least limited opportunities to get jobs meant that people had to move home to new localities. Despite the difficulties and expense, an unexpectedly high number – perhaps as many as one million families – made the move between the end of World War One and the beginning of World War Two. The United States, with its traditionally greater degree of geographical mobility, was and is better able to handle frictional unemployment. There were two further factors that influenced Britain’s poor economic performance during the 1920s. The first of these was Britain’s return in 1925 to the Gold Standard for its foreign exchange, but with the pound sterling disastrously overvalued. (This factor is discussed in the next section of this chapter.) The second factor was something that became the central element in Keynes’s doctrines. He came to believe increasingly that there was an underlying impediment to the healthy working of the British economy: what he later described as a weakness in aggregate demand. The incomplete recovery from the slump of 1919–1922 provided the soil in which a seed was planted that later germinated in Keynes’s mind. This seed was planted by Robert Malthus, whose work had long fascinated Keynes. Keynes described Malthus, who was a Cambridge don at the turn of the eighteenth and nineteenth centuries, as the first Cambridge economist. (He was the author of the widely known and pessimistic work An Essay on the Principle of Population.) Malthus was the first to articulate the concept of total demand, an idea that he had developed during a long journey on horseback. He was pondering why the price of provisions should have risen by so much more than could be accounted for by any deficiency in the harvest. He did not, like Ricardo a few years later, invoke the quantity of money. He found the cause of the increase in working-class incomes as a consequence of parish allowances being raised in proportion to the cost of living.12 [Parish allowances were a primitive type of social security.]

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There is some dispute about when the idea of a lack of overall demand first dawned on Keynes. Skidelsky shows that Keynes’s interest in Malthus dated back to 1914, and the first draft of his essay on Malthus was written in 1922.13 The final version of this was eventually published in 1933 (and is the source of the quotation in the previous paragraph). This all strongly suggests that Malthus had a seminal influence on the General Theory. Even more importantly, it is fairly clear that the idea of unemployment being caused by a shortfall in aggregate demand first entered Keynes’s consciousness just as the country was recovering rather painfully from the recession of 1919–1922.

The Gold Standard and the forces of financial conservatism World War One, like all other wars, was responsible for inflation. The cause was increased government expenditure, financed partly by taxation and partly also by increasing the money supply (i.e. the equivalent of printing more money). At the same time, the supply of consumer goods was reduced because of the diversion of the economy to war production. All workers – including those employed directly or indirectly as a result of government spending – had to pay higher prices for goods and services. British wholesale prices increased by 139 percent between 1914 and 1918, but they had fallen by 1924 to a level 60 percent above 1914. This was because of the depression of 1919–1922.14 In the United States, prices followed the same route although to a less extreme degree. Wholesale prices in 1924 were about 50 percent higher than in 1914.15 At the beginning of World War One, the British government decided that the pound sterling would no longer be convertible into gold, in order to control directly the amount of foreign exchange. Foreign currency was going to be needed to buy war matériel. During the mid-1920s, the Chancellor of the Exchequer, Winston Churchill, took the advice of his Treasury officials and decided to return Britain to the Gold Standard. This meant that the value of the pound sterling would be pegged to the price of gold, so that the government and monetary authorities would no longer have any control over the exchange rate. This change also applied to the money supply, which was determined by the amount of gold in the Bank of England. These were serious restrictions to the government’s powers of maneuver. What made the situation even worse was that the exchange rate was fixed at its 1914 parity with the dollar (with the pound sterling equivalent to $4.86). Sterling was as a result substantially overvalued on the foreign exchanges since the British price level had climbed higher than that in the United States. The return to the Gold Standard made macroeconomic management of the economy all but impossible. The return to the Gold Standard was intended to provide a psychological boost to the British economy by re-creating – so it was hoped – the certainties of the years before World War One. The rate of exchange and the money supply would be taken out of the hands of potential meddlers with dangerous ideas or who might have a political agenda. It meant a sharp and welcome reduction in the price of imports as a result of the inflated value of sterling. Perhaps it was

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thought that the return to the Gold Standard would recapture the era of Victorian free trade, when Britain was the workshop of the world, and the working class enjoyed the enormous benefit of cheap imported food. This had been a result of the sheer efficiency of agriculture and livestock rearing in the United States, Canada, Australia, New Zealand and Argentina, but this policy depended for its success on Britain’s ability to manufacture cheap, high-quality goods for export. However, the return to the Gold Standard at the 1914 parity guaranteed that exports would be handicapped rather than benefited, since their prices would be artificially lifted because of the high value of the British currency. There was therefore an immediate blight on the British export trade. Prices in the export industries had to be forced down to be competitive, and the whole economy was soon affected, with a continuous fall in domestic prices starting in May 1925.16 Such price reductions could only be engineered by shrinking the wage bill. It was hoped that lower money wages would be compensated for by lower prices, leaving real wages intact, but powerful trade unions resisted any fall in money wages. The inevitable outcome was a reduction in the wage bill brought about by unemployment; and followed by depressed trade because of the fall in consumer demand. The return to the Gold Standard also meant a rise in the rate of interest as the Bank of England attempted to increase the demand for sterling despite its overvaluation vis-à-vis many other currencies. And of course a high rate of interest also discouraged investment demand within Britain. A government committee that met during 1918–1919 had recommended a return to the Gold Standard; and the Bank of England, the main proponent of “sound finance,” was strongly in favor. This view coincided with the Treasury’s. The Treasury’s recommendation to return to the Gold Standard at the 1914 parity was described in a memorandum, dated February 9, 1925, by a Mandarin called Sir Otto Niemeyer, the head of financial policy and the official who managed to persuade Churchill to accept the Treasury’s advice.17 Besides engaging in a good deal of speculation, this memorandum looked into technical questions, e.g. estimates of the stocks of gold and the price levels in different countries. In essence, Niemeyer’s case rested on two very large value judgments clothed in ex cathedra language: everyone upholds the Gold Standard, because they believe it to be proved by experience to be the best for trade. If it is agreed that we must have the Gold Standard, is it not better to get over any discomforts at once and then proceed on an even keel? The most serious argument against the return of the Gold Standard is the feared effect on trade and employment. No one would advocate such a return if he believed that in the long run the effect on trade would be adverse.18 The “everyone” who supposedly endorsed the Gold Standard did not include Keynes, who stated clearly, in a pamphlet published in 1925, and entitled The

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Economic Consequences of Mr. Churchill: “The policy of improving the exchange by 10 per cent involves a reduction of 10 per cent in the sterling receipts of our export industries.” He then argued that this policy would inevitably lead to a reduction in wages; and with credit restriction, this would equally inevitably lead to increased unemployment.19 Rentiers – people with above-average fixed incomes – naturally benefited from lower prices. This meant that the return of the Gold Standard did little to ease the tension between the social classes: rentiers were becoming better off at the expense of wage earners. Keynes’s disagreement with the Treasury was, naturally enough, over the second paragraph quoted from Niemeyer’s memorandum. This led to a constant battle between Keynes and the Treasury that lasted for some years. His personal relations with Winston Churchill remained friendly, and Churchill even wrote a trenchant note to the Treasury supporting Keynes’s point of view,20 but Keynes never got on with Niemeyer, and made no progress in advancing his views until 1927, when Niemeyer left the Treasury and joined the Bank of England.21 History was to prove Keynes right. The misjudgment of the Treasury and the Bank of England goes a long way to explain the pains suffered by Britain during the 1920s. In comparison with the United States, the British economy was weaker and unemployment higher: also a reflection of Britain’s much greater reliance on foreign trade. The return to the Gold Standard tightened the screws on the British economy. Since the ill-effects stemmed specifically from flawed monetary strategy – the overvalued currency, the downward pressure on prices and the high rate of interest that restricted credit – Keynes focused most of his attention on these policies. Readers will remember from Chapters 5 and 6 that two lines of attack were eventually developed from Keynes’s doctrines: monetary policy (mainly via the rate of interest) and fiscal policy (mainly via government expenditure to stimulate total demand, and ideally financed by borrowing). The problems following the return to the Gold Standard directed Keynes to monetary policy, and in turn to his first major book on economic theory, A Treatise on Money, published in two volumes in 1930.22 It was a precursor to the General Theory, but was based on a theory of prices while the General Theory moved the field of analysis to income and expenditure. During the 1920s Keynes had also been involved directly in politics, as the economic adviser to the Liberal Party. As mentioned in Chapter 8, the Liberal Party, led by David Lloyd George, had been marginalized by the much more radical Labour Party, which formed a government in 1924 and again in 1929. Lloyd George was conducting a losing battle for public support. During and after the Versailles Conference, Keynes had developed considerable respect for Lloyd George, and one of the main planks of the Liberal Party platform was the policy recommendation, articulated by Keynes, to boost public expenditure to reduce unemployment.23 Unlike Lloyd George, Keynes was not a populist. He represented the cool, intellectual approach and style of Asquith, the Liberal prime minister who held office before and during World War One, until he was

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forced to hand power to Lloyd George at the end of 1916. During the 1920s the Liberal Party policies did not get much response from the electorate, and it took the economic horrors of the 1930s for public investment to return to the political agenda. By that time, Keynes had very little connection with the Liberal Party. The more immediate problem was the Gold Standard, which Keynes continued to attack in the press, but he was stonewalled by the Treasury, where the Mandarins remained convinced that Keynes was exaggerating the extent to which wages refused to follow prices in a downward direction. He was criticized in particular for using statistics that the Treasury considered inadequate.24 Keynes’s figures may have been weak, but his diagnosis was correct. He was also fighting the Treasury from another direction: from the inside. Following the election of a new Labour government in 1929, Keynes was appointed a member of a major government committee to examine British finance and industry, chaired by a judge called Macmillan. Keynes was soon in his element and began to dominate the proceedings, basing his arguments on those that he was crystallizing for publication in A Treatise on Money.25 At last his ideas could make some progress, especially since 1929 was a very inauspicious year because of what was happening in New York. The Macmillan Committee was concerned with the long-term problems of the British economy as much with the looming depression. The committee was therefore able to consider questions of strategy rather than tactics. The prime minister, Ramsay MacDonald, also set up an Economic Advisory Council (EAC) to give advice on immediate policy. Keynes became a member of this also. Although the EAC actually accomplished little, Keynes’s membership of the body was a further recognition of his position at the heart of the financial and economic establishment.26 Keynes analyzed very clearly the twin roles of the Bank Rate, showing how a high Bank Rate attracts foreign funds to London, and in the long run also lowers domestic costs. It does this by increasing the expense of borrowing and reducing profit. And if – a big if – money wages could be brought down, domestic prices would be lowered and British exports would become more competitive. This would lead to a fall in the Bank Rate and the system achieving equilibrium again. But if money wages are sticky, it is unemployment that causes prices to fall. How well the Bank Rate can bring about equilibrium in export industries depends totally on the flexibility of money wages, but they are anything but flexible, and this turned out to be a major cause of unemployment. (It should be remembered that both sides of the trade-off between lower wages and more unemployment are pernicious; they both depress consumer demand because of the negative effect of both lower wages and fewer employed workers.) Keynes said that wages had not moved down to any great extent since 1924 (although as we have seen the Treasury disputed his figures). He thought that this lack of flexibility was partly a result of the small social security dole paid to unemployed workers. Keynes thought that this tiny minimum income cushioned the effect of unemployment, because workers were prepared to accept no work

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and the dole, in exchange for maximum work and some reduction in their wages. Keynes was seriously out of touch when he tried to describe in this way the motives of the working classes: those people who were the victims of structural unemployment. He did not – or could not – imagine what it was like to live on the dole, with less than £1 per week, the twenty-first century equivalent of about $100. George Orwell, with his first-hand knowledge of the poor, knew that the dole was much below what was needed to pay for the minimum expenses of living. To a person of Keynes’s education, no work meant leisure, but to the uneducated poor, it meant long days standing on street corners and reading newspapers in public libraries. The average wage for a man at work was little enough – about £3 per week, or approximately $300 at today’s wages and prices – but it meant activity and self-respect, and enough surplus for him to afford some tiny luxuries to compensate for a life whose arduousness and uncertainty were so extreme that they are difficult for us to comprehend today.27 The past is indeed a different country. Keynes was not exclusively concerned with monetary issues. He also pursued his support for public investment that he had persuaded the Liberal Party to promote. Perhaps his move in this second direction was because he was now realizing that a reduction in the interest rate did not do as much to boost investment as he had previously thought. This became clear when the Bank Rate was reduced to 2 percent in 1931, with very little effect. And in 1932 Keynes was coming to believe that “It was not enough . . . to lower interest rates, it was too slow a process.”28 Keynes also developed the theory that a high Bank Rate is likely to lead to a surplus of saving over investment, which will directly reduce employment because of the cutback in consumer demand. This was the path that was to lead him to the General Theory. The natural outcome of this idea was Keynes’s proposal that the state should step in to bridge the gap between saving and private investment by boosting public investment. The Treasury objected. Keynes rejected the Treasury’s central point that state investment would inevitably mean a corresponding reduction in private investment (an argument that was dramatized with the phrase “crowding out”) because this is only valid if the economy is working at full capacity. In such circumstances, a given value of saving can finance either public or private investment. The situation is different when there is slack in the economy. New government investment can then generate additional income, that will in turn boost consumer demand as well as saving. This was a new language that roundly contradicted the language of financial orthodoxy. The Treasury had not given up its opposition to public investment, and Keynes was for a while locked in combat with a highly intelligent and articulate Mandarin, Sir Richard Hopkins. Nevertheless, Keynes’s views throughout the committee meetings had made a considerable impression, and they certainly prepared the way for Britain’s abandonment of the Gold Standard in 1931, when the blizzard of the Great Depression struck the British economy. In turn, Keynes had learned from his opponents. (Readers may remember the point made earlier

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in this chapter – my own belief – that synergy is more often the outcome of abrasiveness than smooth cooperation.) As Keynes gradually worked toward the arguments on which the General Theory was based, the infighting within the Macmillan Committee remained in his mind.

The Great Depression Keynes was near the center of power when the Great Depression blew its fierce wind across the Atlantic. He was respected by the prime minister, Ramsay MacDonald, and the Treasury and the Bank of England were paying serious attention to his views. By late September 1931, a Treasury official called Sir Frederick Phillips calculated that, in comparison with 1914, the wholesale price level was unchanged, but the cost of living had advanced by 45 percent and wages had gone up by 75 percent. He concluded, in a sentence that Keynes himself could not have written more powerfully: This is what was crushing our farmers and manufacturers for the benefit of the rentier, the distributive trades and the fixed income men, while the working classes were losing as much from unemployment as they were gaining from an increase in real wages.29 In January of that year, Ralph Hawtrey, the only senior official in the Treasury who had been educated as an economist and had a considerable reputation as an expert, was clearly echoing the idea of the Multiplier when he wrote: “If the output of consumption goods can be quickly increased . . . (this) represents additional income to the factors of production, and therefore a further expansion of the consumers’ income. A part again will be spent on consumption.”30 It must not be thought that Keynes was carrying the day. The weight of opinion within the Treasury was still against him, although he was garnering some influential support. However, by the time these two memoranda were written, the blizzard had struck. The Great Depression was the direct outcome of faulty monetary policy following the 1920s boom in the United States: a boom that had not spread to Britain because of the unemployment caused directly by Britain’s return to the Gold Standard with an overvalued currency. In the United States, the years of prosperity generated a great deal of discretionary income that led people from all ranks of society to speculate on the stock exchanges. During the first nine months of 1929 this speculation became frenzied. The factor that fueled this intense activity was margin trading: the practice of borrowing money to buy stock and using the inflated value of the stock that an individual had already purchased as collateral for the loan. This practice naturally injected adrenaline into a rising market. Margin trading caught on very fast, and what was naively and optimistically judged to be “investment,” became the everyday habit of people of very modest means. Speculators were not discouraged by brokers who were receiving commissions that were soon increasing at a spectacular rate. The people playing the

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market were not traditional operators, and the pain when stock prices eventually collapsed was therefore felt over a wide swath of the population. When the market started its inevitable fall, margin trading turned a market decline into a catastrophe for large numbers of people who had put money into the market as the value of their collateral shrank. This left them with few resources to cover their debts when stockbrokers called in their loans to protect themselves in the falling market. Bernard Baruch, one of the few financiers who kept his judgment when the climate of the market was encouraging almost every one else to lose theirs, realized that when his shoeshiner was giving him stock tips, it was time for him to sell out and liquidate his assets, but people like Baruch were in a small minority, and Wall Street’s Black Day, October 29, 1929, brought widespread ruin. There was truth in the folktales of financiers committing suicide by jumping off the top of high-rise buildings. By 1929, the production of consumer goods was already outrunning demand; and although this was not widely recognized at the time, it signaled a natural end to the boom of the 1920s. The weeks following the Wall Street Crash saw a sharp reduction in the demand for durable goods, notably cars. Bank failures caused by defaults on loans led to many firms running out of cash, with the predictable effect on unemployment.31 Because of the collapse in total demand, stock prices and – worst of all – business confidence, industrial production in the United States fell to dismal levels. As measured by a 1928 index of 100, production peaked at 114 in June 1929; fell to 90 in June 1930; 76 in June 1931; and 53 in June 1932. But unemployment took some time before it became a desperate problem. The number of unemployed workers was 3.0 million in March 1930, but it inexorably climbed to 13.6 million (28 percent of the workforce) in March 1933.32 It only declined once and then only temporarily during the whole of the 1930s. The government meanwhile balanced its budgets. The slump soon spread worldwide. It hit Britain seriously because of the country’s reliance on overseas trade. The percentage of unemployed workers had been higher in Britain than in the United States during the 1920s: the actual numbers of unemployed in Britain were 1.2 million in 1929, a figure that rose to 2.7 million in 1931, and this level did not fall much until the approach of World War Two.33 The figure of 2.7 million unemployed represented 22 percent of the workforce: a proportion that was much higher in large regions of Britain where the old, traditional industries were located.34 These soon became known as the Depressed Areas (later renamed euphemistically the “Special Areas”). The economic crisis in Britain led in 1931 to the fall of the Labour government and its replacement by a National (i.e. all-party) administration, led by the same prime minister, Ramsay MacDonald. Many members of the Labour Party refused to follow MacDonald and formed the opposition party in the House of Commons. The National government in turn adopted substantially right-wing policies as a result of the number of Conservative Party leaders who joined it, and also because of the Treasury’s arguments for sound finance. The Great Depression hit much harder and lasted much longer than the slump

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of 1919–1922. The government was forced – perhaps inevitably – into a position of being controlled by events and not vice versa. Their approach was strikingly different from that of Franklin Roosevelt, although (as we saw in Chapter 6) Roosevelt’s actual policies turned out to be very disappointing. In the last analysis, Roosevelt’s remedies were not daring enough, but he was not to know the amount of new spending that would be needed to stimulate enough aggregate demand to get the economy moving. This had to wait until the period leading up to World War Two. The Depression caused tax receipts to fall, and Ramsay MacDonald’s National government attempted to make good this shortfall by reducing government expenditure, e.g. by cutting both the pitiful dole paid to unemployed workers and the extremely low pay of the armed forces (which in turn triggered a mutiny in the Royal Navy). This policy had the expected effect in reducing demand further, making a bad situation even worse. The government also moved toward tariff protection in order to restrict imports: a policy that led to the Ottawa agreement of 1932 that gave preferential tariffs to countries in the British Commonwealth while maintaining tariff barriers against imports from other countries. The virtual abandonment of free trade represented a decisive step away from the economic tenets of the Victorian age. Britain was forced to abandon the Gold Standard in 1931, a process in which Keynes was much involved. Although the value of the pound quickly sank from its former level of $4.86 to $3.50,35 the depression was too far advanced for the revalued pound to have much positive influence on the British export trade. The Bank Rate was also brought down to 2 percent, but this had little effect on private investment, thus reinforcing the lesson that monetary policy is not very effective as a positive stimulus to growth, although (working in the opposite direction) it can be useful in cooling an overheated economy by reducing inflationary pressure. Although the Labour government had carried out a modest program of public works – too small an effort to have any effect on the economy as a whole – the National administration that followed it shied away from an expansionist fiscal policy aimed at pumping demand into the economy. In this, they were of course following the advice of the Treasury. The benefits of such a stimulus were thought to be dubious, and the dangers (in the Treasury’s view) unacceptably great. Readers will not be surprised to learn that such a stimulus was the precise direction in which Keynes’s thinking was leading him. Keynes’s thoughts, as they were developing, were expounded in eight lectures at Cambridge in the summer term of 1932 and eight more in the autumn; and these were repeated in subsequent years. Keynes’s disciples in Cambridge soon realized that these lectures were of seminal importance.36 He also developed his views in four articles published in The Times in March 1933, which were reprinted in a pamphlet entitled The Means of Prosperity. This exposition of Keynes’s doctrines made a “sensational impact.”37 The Times, published in London, was at the time the voice of the British social and financial establishment and was closely associated with the Conservative viewpoint:

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meaning the views of the Conservative Party as well as a general belief in the status quo (conservatism with a small “c”). In these articles, Keynes described the Investment Multiplier for the first time in the public media. By using it (with some caution), Keynes estimated that if the government borrowed £100 million and devoted the money to public works, the result would be 500,000 new jobs. This total would soon be boosted to 1,000,000 because of the extra demand generated by the first half million new jobs. In addition, £50 million would be returned to the government both in taxation and in a reduction in unemployment relief. Keynes therefore calculated that a net investment of £50 million would increase employment by 1,000,000: £50 per job, which many people would consider a modest price to pay. The Treasury, howwever, was unimpressed, and a number of memoranda criticizing Keynes’s articles circulated among the top Mandarins and politicians. These expressed a variety of imaginative objections to Keynes’s doctrines, but in their essentials they were rooted in the sanctity of balanced government budgets. The Treasury view was expressed by Sir Frederick Phillips in April 1933: “Uncertainty and apprehension as to the future would very quickly cancel out any immediate psychological benefit which the reduction of taxation by unbalancing the budget would promote. A balanced budget gives us solid advantages.”38 The emphasis in these words on uncertainty and apprehension certainly sheds light on the main factors blocking the recovery: an impediment that reduced or even perhaps destroyed the effect of the lower value of the British currency and the 2 percent Bank Rate which might otherwise have been expected to stimulate investment demand. To say the least, it is very doubtful whether a positive fiscal balance could have restored entrepreneurial confidence in the absence of any significant boost to aggregate demand aimed at restoring economic growth. Entrepreneurs were and are mainly interested in the expansion of their businesses, and before they embark on investment plans they rely on clear indications of buoyancy in the economy: signals that reveal a growing spirit of optimism. During the years up to 1936, Keynes devoted a substantial and increasing amount of time to thinking through and discussing with colleagues the arguments that were eventually worked out in the General Theory. This was his second and vastly more important book on economic theory. When this work was being planned, he resolved to make his doctrines as bulletproof as his formidable abilities could make them, because this would naturally enhance the credibility of his subsequent policy recommendations. The General Theory was therefore addressed to Keynes’s fellow economists. The theory came first, but there were clear hints of how they could be put into operation by fiscal and monetary policies.39 Keynes worked closely with his young academic disciples, the group who became known as the “Cambridge Circus” (a pun on the familiar landmark in Soho, the theatrical district of London). They were Richard Kahn, Joan Robinson, Austin Robinson, Piero Sraffa and James Meade, but these young academics were as yet more full of promise than achievement. When they reached

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maturity they became powerful and influential protagonists of Keynes, both in Cambridge and throughout the academic world. Keynes had a less happy association with many other economists, not only the older ones. Arthur Cecil Pigou (known by his initials A.C. Pigou), who had become the chief Cambridge economist as professor of political economy on Marshall’s retirement in 1908, did not see eye to eye with Keynes in any way. And Dennis Robertson, who succeeded Pigou in 1944, differed from Keynes in many ways although they agreed on some issues. Until he returned to Cambridge, Robertson was at the London School of Economics (LSE), where two leading figures, Friedrich von Hayek and Lionel Robbins were opponents of Keynes, although some powerful thinkers at the LSE were on Keynes’s side: Abba Lerner, Nicholas Kaldor and (with less enthusiasm) John Hicks, who soon moved to Cambridge and then to Oxford. Another important figure, Roy Harrod, of Oxford University, became a noted Keynesian and Keynes’s first biographer. Interestingly, Keynes’s doctrines also soon began to make waves in the United States (as we shall see in Chapter 10). In his relations with other economists, Keynes committed the sin of being cleverer than they and demonstrating this cleverness quite openly; and it is a sad fact of nature that this often creates an insurmountable psychological barrier. The only Mandarin who was consulted by Keynes as his doctrines were being developed was Ralph Hawtrey, the Treasury economist who has appeared twice in this chapter. Although Keynes had discussed with him all parts of the General Theory when the book was in proof form, Hawtrey began to depart substantially from Keynes. As early as March 1936, he circulated a long memorandum within the Treasury, which influenced its policy negatively from Keynes’s point of view.40 The Treasury did, however, recommend public investment in the Special Areas, where unemployment remained appalling, although there would be no such investment in other parts of the country.41 The Conservative Party had been returned at the 1935 General Election, and neither the prime minister, Stanley Baldwin, nor his eventual successor, Neville Chamberlain, were prepared to boost aggregate demand by fiscal policy. They were conservatives of the most extreme type, and budgetary deficits were anathema to them. However, from the moment of publication of the General Theory in February 1936, the tide began to flow slowly but inexorably with Keynes. He had been a public figure since 1919, and although few people actually read the General Theory, Keynes’s public profile was raised: “It must be realized that Keynes was surrounded by complete incomprehension of a public stunned by the novelty of his ideas.”42 Many people, economists and noneconomists alike, realized that he had a grasp of economic matters that enabled him to predict events. His Cassandra-like forecasts of the economic consequences of the Versailles Treaty had been shown to come frighteningly true. His prognoses of the effects of the return to the Gold Standard in 1925 had been painfully correct. No government remedies imposed during the 1930s had cured unemployment, while Keynes’s pleas for an expansionist economic policy had received little political support. However, as World War Two approached, events were to reveal their wisdom.

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From 1938 onward, the governments of both Britain and United States were compelled to spend large sums on rearmament, and these had the striking effect (unexpected by many people) of eliminating unemployment without causing excessive inflation. The remedies were working, although the extent of the public investment that was necessary for an effect was greater than anyone – even Keynes – might have expected. This experience provided guidance on how the British and American economies were to be managed after the end of World War Two. There was indeed no recurrence of the Great Depression. The war itself was to confirm Keynes’s personal position as the leading economic guru in the world (although the word “guru” was not then used). Like Winston Churchill, he had the luck to attain his highest powers at precisely the time when they were most needed: in Keynes’s case, during the 1930s and during the course of World War Two. Also, like Churchill, his influence spread throughout the world, as we shall discover in Chapter 10.

Notes 1 The metaphor is Dennis Robertson’s, when he compared Keynes’s mind with his own. Keynes’s intellect was like a searchlight whose mighty power was narrowly focused in one direction, leaving the rest of the world in darkness. Robertson saw his own mind as a glowworm: something that does not throw much light but nevertheless one that illuminates in all directions. I heard Robertson make this point in personal conversation. See also Robert Skidelsky, John Maynard Keynes, Vol. 2: The Economist as Saviour, 1920–1937, London: Macmillan, 1992, p. 560. 2 G.C. Peden (ed.), Keynes and His Critics. Treasury Responses to the Keynesian Revolution, 1925–1946, Oxford, UK: Oxford University Press, 2004, p. 3. 3 Ibid., p. 6. 4 Keynes, General Theory, pp. 74–75. 5 Skidelsky, John Maynard Keynes, Vol. 2, pp. 428, 425. 6 John Julius Norwich (ed.), The Duff Cooper Diaries, 1915–1951, London: Weidenfeld and Nicolson, 2005, p. 132. 7 Peden (ed.), Keynes and His Critics, p. 12. 8 Skidelsky, John Maynard Keynes, Vol. 2, p. 426. 9 Ibid., pp. 130–131. Also Peter Clarke, Hope and Glory: Britain 1900–1990, London: Allen Lane, The Penguin Press, 1996, p. 108. 10 Broadus Mitchell and Louise Pearson Mitchell, American Economic History, Boston, MA: Houghton Mifflin, 1947, p. 787; Richard K. Vedder and Lowell E. Galloway, Out of Work: Unemployment and Government in Twentieth-Century America, New York: New York University Press, 1997, p. 55. 11 John Stevenson and Chris Cook, The Slump: Society and Politics During the Depression, London: Quartet Books, 1977, p. 286. 12 John Maynard Keynes, Essays in Biography, London: Macmillan, 1933, pp. 123–124. 13 Skidelsky, John Maynard Keynes, Vol. 2, pp. 416–417. 14 Lionel Robbins, The Great Depression, London: Macmillan, 1934, p. 207. 15 Milton Friedman and Anna Jacobson Schwartz, for the National Bureau of Economic Research, A Monetary History of the United States, 1867–1960, Princeton, NJ: Princeton University Press, 1963 and 1971, p. 197. 16 Robbins, The Great Depression, p. 207. 17 Skidelsky, John Maynard Keynes, Vol. 2, p. 197. 18 Peden (ed.), Keynes and His Critics, pp. 27–33.

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19 R.F. Harrod, The Life of John Maynard Keynes, London: Macmillan, 1951, pp. 358–362; Charles H. Hession, John Maynard Keynes: A Personal biography of the Man Who Revolutionized Capitalism and the Way We Live, New York: Macmillan, 1984, pp. 215–220; D.E. Moggridge, Maynard Keynes: An Economist’s Biography, London: Routledge, 1992, pp. 430–433; Skidelsky, John Maynard Keynes, Vol. 2, pp. 198, 203. 20 Skidelsky, John Maynard Keynes, p. 198. 21 Peden (ed.), Keynes and His Critics, p. 356. 22 John Maynard Keynes, A Treatise on Money, London: Macmillan, 1930. 23 Harrod, The Life of John Maynard Keynes, pp. 375–379; Skidelsky, John Maynard Keynes, Vol. 2, pp. 222–224, 297–306. 24 Peden (ed.), Keynes and His Critics, p. 64. 25 Ibid., pp. 93–101. 26 Harrod, The Life of John Maynard Keynes, pp. 413–427; Moggridge, Maynard Keynes, pp. 452–461; Skidelsky, John Maynard Keynes, Vol. 2, pp. 343–362. 27 There are many published accounts of how the poor lived during the 1920s and 1930s. The most graphic one, first published in 1937, is in George Orwell, The Road to Wigan Pier, London: The Folio Society, 1998, especially Chapter 1. 28 These are the words of a Swedish economist Per Jacobsson, who visited Keynes at the time. Skidelsky, John Maynard Keynes, Vol. 2, p. 460. 29 Peden (ed.), Keynes and His Critics, p. 117. 30 Ibid., p. 112. 31 John Kenneth Galbraith, “Financial Genius is Before the Fall,” Economics, Peace and Laughter, Harmondsworth, Middlesex, UK: Penguin Books, 1971 and 1979, p. 124. 32 Robbins, The Great Depression, pp. 210, 213; Vedder and Galloway, Out of Work, p. 77. 33 Robbins, The Great Depression, p. 213. 34 Stevenson and Cook, The Slump, p. 286. 35 Peden (ed.), Keynes and His Critics, p. 120. 36 Skidelsky, John Maynard Keynes, Vol. 2, pp. 460–466. 37 Ibid., p. 470. 38 Peden (ed.), Keynes and His Critics, p. 148. 39 Keynes, General Theory, p. 377. 40 Peden (ed.), Keynes and His Critics, pp. 154–174. 41 Ibid., p. 174. 42 Josef Steindl, “J. M. Keynes: Society and the Economist,” Keynes’s Relevance Today, Fausto Vicarelli (ed.), London: Macmillan, 1985, p. 115.

10 Keynes, England and the world

The General Theory is not a piece of writing to be dipped into and read casually. It is full of enlightenment, but its closely woven argument must be approached with a good deal of intellectual effort. Some of the early reviews of the book, both in Britain and the United States, showed considerable misunderstanding of Keynes’s meaning.1 (When this happens, the author is usually to blame!) However, despite such problems, the General Theory gives us a sharp insight into Keynes’s mind when, within the dense and sinewy prose, there is a sudden flash of imagination that illuminates dramatically the serious point that he is making. Here is one of the best-known examples: even a diversion of the desire to hold wealth towards assets, which will in fact yield no economic fruits whatever, will increase economic well-being. In so far as millionaires find their satisfaction in building mighty mansions to contain their bodies when alive and pyramids to shelter them after death, or, repenting of their sins, erect cathedrals and endow monasteries or foreign missions, the day when abundance of capital will interfere with abundance of output may be postponed. “To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.2 Keynes was of course talking about the Investment Multiplier. Initial investment to trigger growth is obviously more valuable if it provides an economic or social benefit. Bridges are more useful than pyramids. But even building pyramids will spark the engine of demand that will cause unemployment to fall. This goes to the heart of Keynes’s doctrines, a point that we must bear in mind when we examine how the growth of the armaments industry lifted both Britain and the United States out of depression. We should not forget that Japan and Germany had discovered the same secret some years before. Unemployment in Germany began to fall as soon as Hitler came to power in 1934, when he began to spend money on rearmament and on various public construction projects.3 Chapter 8 was devoted to the first two acts of Keynes’s life: the periods of preparation for what was to come. Chapter 9 described the first part of Act III, the years of intellectual achievement, when Keynes was writing his most import-

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ant books and most trenchant journalism. With the publication of the General Theory in 1936, the bridge from Chapter 9 to Chapter 10 marks a transformation in Keynes’s life, from the period of thought to the period of action. His last decade, 1936–1946, saw his appearance on the world stage and his emergence as a figure of historical importance.

An intimation of mortality Before proceeding with the main course of this chapter I must make a painful digression. In June 1937, the General Theory was becoming an important talking point in academic circles and also among influential men of affairs: politicians, bankers and civil servants alike. At this point Keynes’s health failed him. The first symptom was a throat infection that moved rapidly through his bloodstream and attacked the valves of the heart, causing chest pains and breathlessness. It was debilitating and the long-term prognosis was not good. The condition – which is rare, difficult to diagnose and usually fatal in the end – is described technically as subacute bacterial endocarditis.4 The genesis of the infection dated from an illness that Keynes had suffered in 1931, but by 1937 it had become very serious indeed. Keynes spent more than three months in a nursing home in a feeble state. In the months that followed his work was constantly interrupted, and bouts of intense thinking and writing – his normal pattern of activity – were followed by relapses, sometimes accompanied by heart attacks. Medical science in the 1930s had not discovered the drugs to cure many diseases, including this one. (The situation is different today because of antibiotics, which were not used widely until after Keynes’s death.)5 Keynes’s doctors did what they could do. They coated his tonsils with antiseptic lotions and imposed a regime of rest: policies that did some good although he did not feel significantly better until March 1939, when he began to be treated by Janos Plesch, an émigré Hungarian physician practicing in London, who used a little-known drug that bore a faint but remarkable resemblance to modern antibiotics. However, despite Plesch’s ministrations, Keynes remained in poor health until he died in 1946; we should evaluate his enormous contributions during those years with this point in mind. When he was negotiating the Bretton Woods agreement in the United States in July 1944, “it was obvious to those around him that Keynes was living on borrowed time.”6 It is with good reason that Skidelsky named the third volume of his magisterial biography of Keynes, Fighting for Britain.

The approach of World War Two It was good fortune for Keynes that he was reasonably fit when the General Theory was published in February 1936. As he and his closest colleagues expected, the book made an immediate impact on the economics profession and on the political and financial establishment. At the same time – although unconnected with Keynes’s book – the threat of Hitler’s Germany was forcing a

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reluctant British government to begin a serious process of rearmament. Thus began an accelerated but belated program to repair the neglect from which the British armed services had suffered since the end of World War One. In February 1937, the government announced a five-year plan for rearmament to be financed by borrowing £400 million.7 The eventual price of rearmament was much higher than this.8 British government revenue had to rise steeply to provide most of the money that armaments were going to swallow. The revenue figure for the fiscal year 1940/41 (the first full year of war) was 57 percent above that for 1937/38. It reached its highest level in the last year of the war, 1944/45, when government receipts were 54 percent above 1940/41. In real (inflation-proofed) terms, government revenue at the end of the war was about twice what it had been in 1937/38. In addition, during the period of hostilities, Britain had received enormous supplies of war matériel and food from the United States under the terms of the Lend-Lease Act. Without these, Britain would have been quite unable to continue the war. The overall result of the huge boost in public expenditure, although a large proportion had been funded from increased taxation, was the virtual elimination of unemployment. The number of the unemployed was 1,710,000 in 1938 (8.7 percent of the working population), but this was down to a mere 54,000 in 1944. Workers were directed to where they were needed, by government departments with temporary legal powers. This meant that controls with the force of law were used to eliminate frictional unemployment: a course that would never have been accepted in peacetime. Boosted public expenditure had an unambiguous effect in reducing unemployment, but it should be remembered that the increased public spending was carried out for purposes totally unrelated to any that Keynes had in mind. The government was reluctantly in the business of building metaphorical pyramids and digging symbolic holes and filling them in again, rather than constructing capital goods of long-term value or (as Roosevelt favored), providing welfare benefits for the poor.

Guru becomes man of action In 1939, when Britain went to war, Keynes was a known quantity. Not only had his role in World War One been recognized and remembered by the official establishment, but throughout the interwar period his reputation had never ceased to grow. After the publication of the General Theory in 1936, he was widely recognized as the most prominent economist in the world. Nevertheless, during the first months of World War Two, Keynes had no official role in managing the British economy. This was partly because of his ill-health, and partly because he was considered too much of a “loose cannon.”He was openly antagonistic to many aspects of British government policy: an attitude colored by his dislike of the prime minister, Neville Chamberlain.9 Besides lobbying energetically for the release of enemy aliens who had been interned, a group that included his disciple Piero Sraffa, Keynes did some extremely important work

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on economic policy from his independent position: work that made waves because of his unquestioned authority.10 While Keynes was sitting on the sidelines, a single issue began to dominate his thinking. From his experience from World War One, he knew the realistic cost of modern war and this drove him to focus on how Britain was going to pay for the probably even more expensive conflict ahead. The methods he chewed over and rejected were (1) to allow inflation to finance the additional war expenditure, and/or (2) to make major increases in taxation of various types. Relying on inflation was the system adopted to a large degree during World War One and it had the advantage of involving only the smallest degree of macroeconomic management. It worked in the following way. The increased demand from public expenditure would bring the economy close to full-capacity working. This would raise prices; such increases would keep a step ahead of rises in money wages; and the result would be a reduction in real wages. The cost of the increased government expenditure would therefore be paid by the mass of the working class because their standard of living would be forced down. Keynes did not like this solution because of its crudity and unfairness, and – not least – because he had a horror of the perils of inflation.11 Before World War Two, the large majority of the working class, blue- and white-collar – those earning less than £500 (then about $2,500) per annum – had been virtually exempt from direct taxation. Keynes shied away from an acrossthe-board tax increase without the smallest compensation to taxpayers, because of his belief that this would mean hardship, even if it was steeply progressive, i.e. with tax rates rising rapidly with each upward step in income. Keynes also thought that tax on expenditure (e.g. a universal sales tax) would be unduly regressive, because its effects would be felt more sharply by lower-paid than by higher-paid workers. These methods were all eventually applied during the course of the war, but in 1939 and 1940 Keynes did his best to avoid them by proposing an ingenious system to raise revenue while at the same time minimizing the pain. In addition, his scheme had the remarkable effect of promising positive long-term benefits. The idea that Keynes put forward was based on “forced saving.” He proposed a progressive income tax applied widely, but part of the revenue would be repaid to taxpayers much later, with interest paid on what were effectively loans to the government. A large proportion would be repaid to lower-income taxpayers, but progressively less would be returned to those receiving higher incomes. The long-term benefit was that the repayment could be made after the end of the war, when the effects of any slump could be countered by a release of the forced savings to pump demand into the economy. Keynes argued his case in memoranda to civil servants and politicians, in the pages of leading newspapers and on radio, and also in a small book called How to Pay for the War. This could be described as a “broadside”: an archaic British word to describe an essay intended to stir up action. It sold for a shilling (about 25 cents). Although the plan intrigued and won the support of many academics and permanent government officials, it had no realistic chance of being accepted

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as policy. This was because the Labour Party, which formed the Parliamentary opposition, was totally opposed to the scheme because they viewed it as a swingeing tax on the lowest paid, irrespective of its supposed long-term benefit. Some people perhaps remembered Keynes’s own aphorism that “in the long run we are all dead.” The Labour attitude to Keynes’s proposal provided a taste of the party’s influence on public policy when it became part of Winston Churchill’s coalition government. Leaders of the Labour Party made a crucial contribution to Britain’s war effort, but they were always sensitive to the source of the Labour Party’s power. During their period in office, they were never disloyal to what they saw as the interests of the British working class. In addition to the “forced saving” proposal, Keynes had a sharp tussle with the Treasury over the latter’s inability to control the international movements of the pound sterling. By this time, the life of Chamberlain’s increasingly unpopular government was coming to an end. In May 1940, with Winston Churchill as prime minister heading a coalition administration – a government of all the talents – it was not going to be long before Keynes was invited to come on board. He actually spent two hours with Churchill on September 6, after dinner at a small dining club of which they were both members. Keynes was impressed with Churchill’s calmness and lack of ego: “Perhaps this moment is the height of his power and glory, but I have never seen anyone less infected with dictatorial airs or hubris.”12 The small amount of free time that Churchill enjoyed at this time can readily be imagined, and his conversation with Keynes was unusual, to say the least, in view of Churchill’s indifference to economic and financial affairs; but perhaps he dissociated Keynes from the Treasury, whose views he always suspected since the time during the 1920s when Churchill was Chancellor of the Exchequer (the British finance minister).13 On June 28, 1940, the Chancellor of the Exchequer, Sir Kingsley Wood, invited Keynes to join the Treasury as an adviser, with no pay but with an office and secretarial help: hardly a generous offer but one that Keynes did not hesitate to accept. He was not employed on many problems at first. He had no departmental responsibility and acted as a freelance. He knew what was going on and he contributed energetically and zestfully to debates and dialogues on the subjects that interested him. Before too long he was regarded both within and outside the Treasury as its most important asset.14 In October 1940 Keynes was put on the Treasury’s Budget Committee, which advised the Chancellor on his most important task, formulating his annual national budget: a plan that determined tax rates and which acted as a blueprint for the national accounts. This meant that at last Keynes could put his imprint on British government policy. There was a good deal of negotiation within the committee about alternative plans before the Chancellor presented his first major budget to Parliament on April 7, 1941. Its content was strongly influenced by Keynes. For one thing, alongside large increases in direct taxation at sharply progressive rates, Keynes’s “forced saving” plan was at last introduced as public policy. The personal credits for taxpayers were going to account for about half the estimated yield of the additional taxes: a good deal less than in Keynes’s ori-

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ginal proposal. But the budget as a whole was nothing less than a massive public endorsement of Keynes’s role in formulating it. Skidelsky summarizes five major contributions by Keynes in addition to the “forced saving” scheme. Of these the most striking was Keynes’s influence on the strategy to avoid inflation by eliminating “excess private purchasing power.” As a result, British inflation during the six years of World War Two was half of what it had been during the four years of World War One.15 Subsequent wartime budgets differed in detail from that of 1941, but they did not vary much in principle. Keynes therefore helped to set the pattern: a pattern based on what Skidelsky has described as “Keynes’s budget triumph.”16 From now on, Keynes would be involved in a number of other affairs of great national and (particularly) international importance.

Keynes as Treasury ambassador Despite the increases in government revenue engineered by the 1941 budget, Britain still faced huge problems in how to pay for the war. Her effectiveness as a fighting nation, and even her very existence, depended on imports of food, petroleum and armaments. Consumption of food was controlled tightly but extremely fairly by a universal system of rationing. Supplies of petroleum were restricted to the armed forces and those civilians judged to be in real need; leisure motoring was banned, and most private cars were taken off the road. The demand for armaments was enormous and growing. Britain was fighting a bitter war on sea and in the air. The army had lost most of its equipment when it was evicted from France, and in late 1941 a substantial British military force began to wage campaigns against the Italians in Africa. The only country capable of providing large enough supplies to enable Britain to continue to wage war was the United States, despite the fact that at this time the American armaments industry was undeveloped. The problem that Britain faced with the United States was a financial one. There were four possible sources of funds: exports of British goods and services; credit from suppliers in the United States; British reserves of gold and dollars; and overseas assets: equity in enterprises of different types owned by British individuals and business firms. The British government had the option of nationalizing these overseas assets – which were capital sums – and using the proceeds for food, petroleum and armaments, i.e. spending the money for ongoing expenses, which was not the best thing to do. All these sources provided funds during the war, but there were major problems in raising money to pay for American goods in 1940. British exports could only make a limited contribution because much of Britain’s domestic industry was not producing exports: it was being turned over to war production. Buying supplies on credit was forbidden by American law because in 1933 Britain had frozen her repayment of debts incurred during World War One. The capital value of the gold and dollar reserves plus the value

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of the overseas investments, if they were liquidated, would only enable Britain to fight on for a finite period, probably not much more than a year, after which time the cupboard would be bare. Britain was in peril not only in military terms but in financial ones too. The British government, which had no real alternative, did not reduce its demand for American help and even contemplated confiscating British wedding rings to provide gold to pay for armaments.17 The Americans were willing to help, but their attitude was influenced by business considerations more than by sympathy for Britain’s plight. There was widespread horror at the prospect of going to war. However, most Americans understood the threat of Nazism only too well, and this eventually had an effect that greatly benefited Britain. The sentiment gradually grew throughout the United States – a sentiment encouraged by the British Embassy in Washington – that the sacrifices made by Britain were keeping war from American shores. Help for Britain was therefore increasingly seen to be in the interest of the United States. President Roosevelt, a very complex character, was an ally of Britain although – in common with most Americans – he detested imperialism. For a mixture of reasons of which idealism was certainly one, Roosevelt used his practiced skills in manipulating the Congress to provide two spectacular gifts to Britain. These were disguised as deals, with an element of quid pro quo, in order to placate the Isolationists and those who had little sympathy with Britain, but they were gifts nevertheless. The first of these, in 1940, provided Britain with a large supply of old-pattern rifles, plus 50 obsolescent fighting ships: destroyers that made a major contribution to fighting the Battle of the Atlantic, and which were handed over in exchange for leases to British bases in the Western Hemisphere. Roosevelt’s second gift was of much greater and more durable importance, and it became one of the major keys to achieving eventual victory. It was the Lend-Lease program, passed into law on March 11, 1941. This unparalleled act of political vision and generosity guaranteed that Britain would in future receive all the aid that she was going to need to fight the war. As an aside that is important to this book, we should also remember that the additional public expenditure on armaments had a very positive effect on the American economy: unemployment was virtually eliminated. As in Britain, this was Keynesian policy, although the investment was not made with Keynesian objectives specifically in mind. The United States had provided large quantities of matériel during the period of more than a year before the Lend-Lease supplies began to roll across the Atlantic, and the British Treasury had senior representatives in Washington engaged in negotiating how to use British reserves and assets to pay for these. The American point man in the negotiations was the Secretary of the Treasury, Henry Morgenthau, who was passionately anti-Nazi although also (much less passionately) anti-British. As 1941 progressed, the British government began to feel that too little pressure was being applied on the Americans, and it therefore decided to send Keynes to visit Washington to take a firm grip on the proceed-

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ings. Maynard and Lydia traveled by air. After a tedious journey not devoid of danger, on May 8, 1941 they arrived in New York City, where Keynes was to hold his first meetings.18 Keynes was not a household name in the United States, but he had an influential following there. His ideas had been picked up during the 1930s at Harvard, and after the publication of the General Theory, a number of academics at that university, notably Alvin Hansen, Paul Samuelson and John Kenneth Galbraith, began to spread Keynes’s doctrines with single-minded dedication. The message soon eddied out to Washington, and Keynes’s economics attracted followers in a number of government agencies and in the Federal Reserve Bank.19 Keynes spent a part of his time during the three months he spent in the United States in talking to his disciples, most of whom were young thrusters. The prophet was speaking to the converted. However, Keynes’s relationship with Morgenthau was less happy. This was partly due to misunderstanding. Morgenthau had a comfortable working relationship with the British Treasury representatives already in Washington, and he was not too sure about how Keynes fitted into the picture. Morgenthau also needed a simpler explanation of the issues than Keynes could – or was happy – to provide. In addition, as had happened during Keynes’s earlier visits to the United States, there were many features of the country that he disliked. As before, the feelings were reciprocated.20 This situation did not auger well for the future. Keynes was a product of his time and his class. He had little or no first-hand knowledge or understanding of the 95 percent of the British population who ranked lower than the elite 5 percent to which he himself belonged, although he dedicated his life to benefiting the 95 percent that comprised the vast majority of wage and salary earners. In the same way, Keynes had little understanding of people who lived in overseas countries, except for those who became domiciled in Britain. Since his most important activities during his remaining years revolved around the United States, the cultural differences between educated people in the United States and Britain were to erect the occasional roadblock against the smooth flow of negotiations. I shall discuss these differences later in this chapter, but we should also remember that Keynes was rather a polarizing personality because of his intellectual power. The British objective in the 1941 talks was to preserve intact as many British assets as possible, if necessary by borrowing money and using these assets as collateral. The negotiations were tortuous, but the worse disagreements were postponed until a later date. The aim of the Americans was to gain some recompense for Lend-Lease. They therefore attacked Imperial Preference (the system introduced in 1932 to establish a customs union between Britain and her overseas possessions, and excluding outsiders). The American attitude immediately proved “unacceptable to several British ministers, who saw Imperial Preference as a means of strengthening links between Empire countries.” The British position “was based on a desire to retain the right to use any policy instrument, including import controls and exchange controls, which might be necessary to

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deal with post-war balance-of-payments problems.” Talks to resolve the differences did not begin in earnest until September 1943.21 In the meantime, as LendLease supplies grew into a flood, British reserves of gold and dollars actually grew: from £141 million in December 1941 to £624 million at the end of the war.22 In Skidelsky’s opinion, the British Treasury might have done equally well without Keynes’s participation. He did however add weight to the British side. And this first wartime visit established his official British position in the inner circles of American finance and politics, a closed world in important respects. It of course included the president, whom he met twice during his trip. Keynes’s role as a spokesman for Britain paved his way for the more wide-ranging negotiations that he was to undertake later in the war and one year after, a period when America was to become the center of Keynes’s activities. This raises an immediate and important question: how well was Keynes attuned to working with Americans on an equal basis? It is difficult to describe the cultural differences between educated Americans and educated British people because there are so many exceptions, but I am convinced (having spent two-thirds of my life in Europe and one-third in the United States) that such differences exist. Here is the bird’s-eye view from my perch. American minds and interests tend to be more concentrated and focused; British minds are more wide-ranging and speculative. Equality is in the bloodstream of Americans, although there is no lack of residual racism in certain parts of the country. Educated British people are more conscious of educational and class gradations within society. Americans are much more commercially minded than the British: more sensitive to opportunities for making money. In contrast to a number of European countries, in the United States, “a majority of citizens believe that commercialism and consumerism are not a threat to their culture.”23 Yet Americans are far more anxious to pay something back to society. This is shown by their regular attendance at religious worship, by the pledges they make to charities, especially the churches and temples where they worship and the universities where they were educated and by the amount of time they devote to pro bono work. Do Americans work harder? They certainly work longer hours than most people in Britain, and British people find it difficult to understand why Americans make such an effort to start work as dawn is breaking. However, one wonders whether such long hours are productive; in my judgment they soon hit the inevitable stage of diminishing returns. An anecdote that has circulated in London (partly based on fact) is that many Americans are entitled to take four weeks’ vacation and actually take three, while the British and most Europeans are entitled to four and actually take six. There is an underlying Puritanism in the make-up of many Americans. People in both countries tend to be ambitious, but most British people focus their ambitions on the organizations to which they belong. Americans are keener to strike out on their own. Not surprisingly, the United States has produced more inventions of practical use than any other nation, because Americans seek to make their fortunes as their own masters.

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Above all, American people are active and rather restless; as a result they are great doers and tend to be personally very outgoing. The cliché “can-do attitude” expresses much truth. “The percentage of Americans who believe that ‘success in life is pretty much determined by forces outside our control’ is 32 per cent, compared, for example, with the German figure of 68 per cent.”24 And I am always surprised at how well many Americans, not just manual workers, can use their hands to build and repair things. Educated British people are more contemplative, and have the habit of standing back and weighing the merits of alternative courses before taking action. The British, in common with other Europeans, tend to dwell comfortably and nostalgically on the past. The Americans, being more impatient, believe that the future offers more excitement and opportunity. Conversation is important to the British; it can be serious or inconsequential but it must be engaging; light-heartedness helps. At an early age educated British people are taught to write accurately and with some sense of style, and throughout their lives they take pleasure in reading elegant and economical prose. Although American English has a richer vocabulary than British English, the British work with more intense persistence in the search for lucidity and persuasiveness. American writing tends to be more businesslike, with fewer frills; it is generally duller and richer in jargon. If British people are more reserved than the Americans, the weapon they use to veil the strength of their feelings is the English language; circumlocutions and evasions are sometimes developed into an art form. In contrast, Americans are more confrontational. Readers will learn later (on page 189) about a sharp and revealing face-to-face disagreement between Keynes and his American opposite number during a meeting in Washington. Are the British or the Americans more susceptible to people with powerful personalities and trenchant opinions? The rather iconoclastic British sense of humor protects them from being too seriously manipulated. The examples of William Jennings Bryan, Huey Long, Walter Winchell, Joe McCarthy and (among more significant public figures) the two Roosevelt presidents and the half-American Winston Churchill suggest that Americans can fall for people who radiate confidence and power, if the messages projected are simple enough to resonate with them. Keynes had a hypnotic personality, but he was also an intellectual who dealt with rarified concepts. This quality aroused the suspicions of some members of the American establishment, such as Roosevelt’s confidant and legman Harry Hopkins, Treasury Secretary Henry Morgenthau and Morgenthau’s deputy Harry Dexter White (whom readers will shortly meet).25 Moreover there is never a whiff of bohemianism in the lives of Americans in the top echelons of society, but this characteristic is not too rare in Britain and Keynes carried it. Because of their respect for his professional contributions, Keynes was a hit with many economists. But he was now about to work in close contact with heavyweight American politicians, government officials and financiers who probably anticipated a difficult time ahead in working with someone as formidable as Keynes. Both they and he put national interests first, but another

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difference was that Keynes had a broader worldwide vision. Keynes was of course born in a country that possessed an empire. Many Americans were and still are passionately anti-imperialist, at least as this applies to political imperialism, although many foreigners would regard the export of the American way of life as imperialism in a disguised form. American antipathy to Britain is rather rare but it still exists; the Irish Potato Famine retains its legendary power in some parts of the United States. Whatever the root causes might have been, Keynes was respected by the Americans, but this respect was not accompanied by much personal affection from the more senior policy-makers. There were occasional exceptions, such as Dean Acheson, the assistant secretary of state, who was then in his late forties. He got on very well with Keynes, partly perhaps because Acheson’s father was Canadian and his grandfather British. The problem with Keynes was that he was much too English and, worse still, much too clever: a combination that made him intimidating. A final insight into the differences between the cultures of the United States and Britain is provided by Keynes’s prolonged and sometimes antagonistic relationship with the top British Treasury officials – the Mandarins – whose views on Keynes’s proposals have been fully documented.26 The point is that both Keynes and the Mandarins came from the same educational and social milieu. Treasury business was conducted in a rational and rather academic fashion, through lucidly written and well-argued memoranda that were circulated and which collected comments. Keynes and the Treasury followed the same unwritten rules – obeyed the same disciplines – in how they moved recommendations forward to reach consensus. It was not a rapid process. In contrast, as we shall see, the relationship between Keynes and his American opposite numbers followed different conventions.27

Bringing an end to economic warfare The Great Depression had a crushing effect on the prosperity of vast numbers of people around the world. It was also a destructive force in the field of international economic cooperation. This was a direct result of various countries’ efforts to reduce the ill-effects of the depression itself. When a country is hit by depression, one obvious way to stimulate the economy is to boost its exports. This policy depends on the prices of the exported goods and services in the country that imports them, which in turn depends on the exchange rate between the currencies of the exporting and importing countries. Chapter 9 showed how, during the 1920s, the pound sterling was pegged to the price of gold: the British Treasury paid a fixed amount per ounce of gold, and this fixed price caused that currency to be heavily overvalued. This naturally depressed the British export trade (although the overvalued pound greatly reduced the prices of British imports). When the pound was released from the Gold Standard in 1931, it found its own exchange rate value, which depended on the balance between British exports and imports. As expected, this value moved down significantly – to the

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perceptible benefit of British exporters, causing, however, a sudden problem for the United States, since the dollar was now overvalued compared with sterling because of the dollar’s continued link with gold. As a result, American exports were immediately hit. In 1933, the United States also came off the Gold Standard (i.e. the dollar was no longer traded for gold at a fixed rate), but the American monetary authorities still managed to use that metal as a tool for devaluation. They did this by buying gold in the open market, thus pushing up its price, and as its price moved up the value of the dollar automatically moved down. This process degenerated into a competitive struggle between the United States and Britain to devalue their currencies, with the aim of gaining and maintaining export business. The eventual result was the formation of what became known as the “sterling bloc” (26 countries that were tied to sterling): a group that confronted most of the rest of the world: countries tied to the dollar.28 This currency alignment was underscored by a trade alignment. Britain, a country that for two centuries had exploited the advantages of free trade, in 1932 implemented a policy that was substantially protectionist. This policy was based on Imperial Preference, which aimed at reinforcing trade links with the countries of the British Empire and Commonwealth. There was to be free trade between them but tariff barriers against all outsiders. The countries colored red on the map of the world – the color that identified the British Empire – were now to be more than an (increasingly unruly) family of nations, but were also to become a customs union held together with financial strings. The United States had developed its industries into the most powerful engines of production in the world during the half-century before World War One. This process had been made easier by American tariffs that put imports at a disadvantage. After World War One, when American business grew increasingly anxious to sell its goods and services all over the world, American trade philosophy changed in the direction of free trade. American industry was now strong enough to be free of tariff protection, but other countries’ tariffs were a clear impediment to American exports. As mentioned earlier, Imperial Preference therefore emerged as a problem for the United States; hence the pressure on Britain to abandon it as some recompense for the generosity of the Lend-Lease program. Imperial Preference was to remain a “no-go” area for the British because of its political importance, but other means of extracting trade concessions from the British remained on the agenda. Keynes had returned to Britain from the United States in late summer 1941. Back in England, he followed his usual practice of spending most of his time thinking, on this occasion addressing the multiple problems of world trade as these had been revealed during the 1930s: a topic that was also moving to the top of the Americans’ agenda. The classic advantage of freedom of trade is that it helps every country to specialize in what it is good at: a policy that maximizes total wealth and, ceteris paribus, the welfare of everybody in the world. The two main impediments were, first, monetary problems and, second, tariffs and other trade restrictions; Keynes considered monetary problems to be less intractable than the others. He therefore concentrated on the lack of stability in exchange

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rates and – an even greater impediment to freedom – the artificial valuation of some currencies; some were artificially low and others artificially high. He had to find a way to create stability without sacrificing flexibility. A month after Keynes returned from the United States – and in total tranquility – he wrote two papers. The first of these analyzed the Gold Standard; the second, which became known in the Treasury as the Keynes Plan, took a broad strategic look at international trade, focusing on the long term and not just on the problems that Britain was expected to face at the end of the war. It was a building block for an organization that was going to be formed to ease the strains of international trade and help with economic development. Because of the imaginative ideas it contained and the frame for operational policy that it provided, the Keynes Plan was to make a contribution to solving economic problems second in importance only to the General Theory. The two were indirectly related: There is no denying that Keynesian policies meet their greatest difficulty at the point where the system is open, in the balance of payments. There are two ways of confronting these difficulties: the one is to close the country more or less by suitable protectionist measures. The other is to unite all countries in a common international order which will safeguard their interests by the establishment of suitable rules.29 Keynes addressed the deep problem of keeping world trade more or less in equilibrium, with no wide discrepancies between the negative balances of debtor countries and the positive balances of creditors. Such equilibrium had been grievously lacking during the interwar period. The Gold Standard, which had brought stability before World War One, had degenerated through its rigidity into a hopelessly inefficient system after that war. It brought depression directly to Britain during the 1920s and had a baleful influence on the economic warfare between many countries during the 1930s. Keynes’s central idea was to focus on the financing of international trade, by forming an international organization – a currency clearing system – to regulate it. He called this an International Currency Union, later renamed the International Clearing Union (ICU), an organization to be funded by all central banks and run by an independent international board. The ICU would not conduct transactions in individual currencies or in gold, but would have a currency of its own, which Keynes named Bancor. (Individual currencies and gold would be used to make deposits in the new currency.) Each country would make substantial deposits into this bank and could overdraw its account. In general terms, the ICU would operate like a normal bank, by balancing total debts and total credits, a process described (in Keynes’s words) as follows: when a chap wants to leave his resources idle, those resources are not therefore withdrawn from circulation but are made available to another chap who is prepared to use them – and to make this possible without the former losing his liquidity.30

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A country could also – very importantly – alter the value of its own currency against Bancor, depending on how much it was in debit or credit. If it was overdrawn by a determined amount, it could devalue. If it was in a strong credit position (with substantial assets in the ICU), it would have to boost the value of its currency, again within limits. This was the ingenious method by which individual countries could control their own financial affairs, while at the same time having flexibility in adjusting the value of their currencies to balance their international books. This plan enabled rates of exchange to be kept as stable as they had been under the Gold Standard, but without its pernicious rigidity.31 The Keynes Plan moved through the senior ranks of the Treasury, through the economists who had been brought into government service and through the Bank of England. It collected many comments, criticisms and points of agreement on the way. Keynes produced three further drafts that managed to maintain the integrity of the original and at the same time incorporate important improvements. Roy Harrod, from the War Cabinet Offices, who was a prewar Oxford don and was to be Keynes’s first biographer, made a notable contribution. So did two Americans, Keynes’s disciple Alvin Hansen and the public administrator Luther Gulick, who were spending time in London developing plans for an International Development Corporation and an International Economic Board (to work toward full employment). Harrod described Keynes’s work at this time as follows: In all the discussions of his various schemes Keynes showed himself extraordinarily open-minded and ready to receive suggestions, however tentative. He drafted and re-drafted in an attempt to satisfy every point of view. He was entirely lacking in the kind of obstinacy which so often results from pride of authorship.32 Keynes’s plan, having gone through its various hurdles, was passed by the Treasury to the British War Cabinet, and approved on May 7, 1942, eight months after Keynes had first drafted it. The plan was to form the British “position paper,” the platform for lengthy and important discussions that were to take place with the Americans. Note that everyone viewed the negotiating process as the concern of two countries only, although the implications of the negotiations were going to apply to the whole world. If anything was going to happen, this depended on Britain and (to a much greater degree) on the Americans. A hiatus now occurred. The Americans were still anxious to resolve the differences in trade policy by persuading the British to make it easier for American exporters. The Board of Trade, the British government department most concerned with tariff policy, was not yet ready to open international talks, although the Treasury embarked on economic investigations that were in some ways relevant to trade. The first of these was made by Keynes himself, who addressed the controversial issue of stabilizing the international prices of agricultural and other primary products. He developed a scheme based on “Buffer Stocks”: inventories that

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could be used to cushion the effects of extreme highs and lows in the prices of primary products in order to smooth demand and hence producers’ incomes; but Keynes’s scheme was never fully developed because the Treasury had other priorities. The second plan was the work of James Meade, an Oxford economist who had been a member of Keynes’s “Cambridge Circus” and who, like Harrod, was now working in the War Cabinet Offices. His ambitious scheme envisaged an “International Commercial Union,” a framework for regulating and liberalizing international trade. Like Keynes’s “Buffer Stocks,” and for the same reason, Meade’s plan was also never fully worked out.33 Although the Americans were anxious to start trade talks and were frustrated by the slowness of the British, Washington was not yet ready to begin negotiations over the ICU. The reason was that the United States Treasury was drawing up its own plans. The work was delegated by Morgenthau to Harry Dexter White, whose job was director of monetary research at the United States Treasury, but who soon became de facto the Assistant Secretary of the Treasury. White was a second-generation American and was 50 years old in 1942. He had been educated as an economist at Columbia, Stanford and Harvard (where he had earned a Ph.D.). Harvard normally makes its tenured appointments from people with established reputations in other universities. White was therefore denied tenure at Harvard, and taught for some time at a small college before he joined the Treasury. It was here that his career took a rapidly upward trajectory, partly because he was able to explain complicated concepts in terms that Morgenthau was able to understand. He had been an early believer in Keynes’s doctrines. Although Keynes obviously carried much more authority because of his established reputation, White had a sharp mind and could stand up to Keynes in argument, but there was not much affection, and the fact that White, like Morgenthau, was anti-British did not help matters: Their modes of debate were diametrically opposed. White was full of vigor and manful thrust. . . . His earnestness carried him forward in a torrent of words, which sometimes outstripped his grammatical powers . . . (Keynes) detected any inconsistency in the opposition, even in the most abstruse matter, with lightning celerity, and pointed out with seeming gentleness in barbed and sometimes offensive sentences.34 Surprisingly, White was also a communist fellow traveler, which meant that the recommendations he developed were influenced by a political agenda: to give economic support to the Soviet Union and to bring that country into the club of nations that would dominate the world economic scene after the end of the war.35 In late 1941 and early in 1942 White was working on a more ambitious plan than Keynes. It envisaged an International Stabilization Fund (roughly parallel to the ICU), and an even more major innovation, a Bank for Reconstruction. White’s plans filtered to London, and in July 1942 Keynes’s plan reached Washington. With this exchange of proposals, the battle lines were being drawn up.36

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Keynes viewed White’s ideas as more traditional and orthodox than his own. White’s fund was planned “to make loans out of subscribed capital,” loans that would be much more limited in size than the ICU’s overdrafts (which would have the effect of creating new money). In White’s plan, the fund would approach the individual central banks for financial support. With the ICU, the situation would be reversed, with the Clearing Union acting as central bank to the individual countries’ central banks. However, to Keynes the really important matter was that the Americans were prepared to participate in a scheme to stabilize international currencies. Harrod has left a wonderful picture of the moment he first read Keynes’s plan. Harrod was in a crowded British railway carriage full of disheveled soldiers sprawling over one another in sleep, [when he] felt an exhilaration such as only comes once or twice in a lifetime. . . . Here is the real thing, because it will save us from a slump . . . the Americans were admitting the principle of joint responsibility for disequilibrium.37 Keynes was totally realistic about the difference in the resources possessed by the two countries, and the gap between them that was widening every day. He greatly favored the ICU plan because of the breadth of its concept, but he foresaw the strong likelihood that the United States would eventually win the day. His job, as he saw it, was to achieve the best compromise possible. Morgenthau and White came to London in October 1942 to inspect armament factories. It was at this time therefore that the Americans and British began to open up a face-to-face dialogue on their two plans. During the months that followed, revised drafts crossed the Atlantic in both directions, in the course of which White’s Reconstruction Bank temporarily disappeared from view. Russia, China and various Latin American countries were also brought into the picture although not into the discussion. During this process, the contents of the plans became so widely known that there was no point in holding back publication, and this happened in April 1943. Keynes became Lord Keynes in 1942 and entered the House of Lords. This was not so much a promotion as a recognition that he was a member of the group of people sometimes known in Britain as the “great and the good.” It was a lifetime appointment. At the time he was ennobled the title was hereditary, but since Keynes had no children the title died with him. Debates in the House of Lords are neither as important nor as hard-hitting as those in the House of Commons. The Lords is one of the three branches of the British constitution (the others being the Monarchy and the Commons), but it is certainly a less significant body than the United States Senate. Nevertheless the Lords provided Keynes with a forum to state his views publicly, with a good chance that his speeches would be reported. He devoted his first speech in the Lords, on May 18, 1943, to the ICU. It was very well received. This was much less true of the reception of the two plans by the American financial establishment, which expressed its expected opposition to any type of supranational organization with dangerous powers (at least in the estimation of many Americans).38 This suspicion may

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have had something to do with the unfavorable reception of Keynes’s plan in the United States because of its adventurousness. White’s plan contained fewer obvious dangers. It was at about this time that Keynes’s position vis-à-vis the Americans began to change increasingly for the worse. In all types of face-to-face confrontation, one party must take the initiative if disagreements are to be resolved. This holds for the most extreme type of confrontation, armed conflict, but it is also true of political and business debates and even differences of opinion about unimportant issues. The party that holds the initiative dictates the tactics and has therefore a significant advantage; his opponent is forced to respond and to take a more passive role. Generals talk about one side being balanced and the other side unbalanced or “wrong-footed”: a metaphor that illuminates the meaning of Bonaparte’s aphorism that in war the moral is three times as important as the material. He should have added that the moral is often accompanied by greater material, and that greater resources provide increased confidence, together with the likelihood that the plans of the initiator will have received more time and thought than the plans of the responder. From 1943 until Keynes died in 1946, the Americans possessed, to an increasing degree, superior resources, better balance, greater confidence and were able to take the initiative in negotiations that were mostly held on their home territory. In view of the disadvantages of the British position, it is a tribute to Keynes’s brains and force of character that he was able to make such an impact, but inevitably he was not going to win. The American resistance to the ICU rose to the surface during discussions between American and British Treasury representatives held in Washington during the summer of 1943. Other allied nations who had also been consulted favored the White plan: a preference that was probably connected with their appreciation of where the greatest power lay. At the suggestion of Lord Halifax, the British ambassador to Washington, the British government in September 1943 sent a large delegation to talk to the Americans. Maynard and Lydia were of course included. She had looked after Maynard’s health with extraordinary care and efficiency during the early part of the war, but there were now signals that his problems were returning. Within months, Keynes’s health became much worse as a result of the responsibility he was carrying, in addition to the intense effort expected of him in conducting difficult high-level negotiations. It was to break down badly in March/April 1944. The meetings between the Americans and British were to be advisory and nonbinding, and largely confined to the two monetary plans. By this time, White’s plan had been circulated to the Congress. Subcommittees of delegates from both sides were put to work to “devil,” i.e. prepare the ground for the discussions at the plenary meetings. The main unresolved issues were “the size of the Fund’s resources, the conditions of access to them, determination of exchange rates and the monetary valuation of Unitas.”39 (Unitas was White’s invented currency, his equivalent of Keynes’s Bancor. In the event it was to suffer the same fate.)

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There was a dense program of subcommittee and plenary meetings, and the gloves were removed surprisingly often. The level of the discussion was both rarified and sharp because the participants were specialists with wide experience and they all possessed first-class intellectual equipment. The latter did not get in the way of schoolroom antics, such as this one, described by James Meade. White insisted on rather large meetings, and Meade portrayed Keynes and White sitting side-by-side, with British colleagues and advisers lined up beside Keynes and their American opposite numbers lined up beside White, while the two principals . . . “go for each other in a strident duet of discord which after a crescendo of abuse on either side leads up to a chaotic adjournment.”40 This is a richly comical scene, and not the sort of confrontation seen in a Cambridge Senior Combination Room, where differences – sometimes profound and sometimes trivial – are much more subtly concealed and never reconciled. The Washington harangue also contains a serious lesson. Real progress in debates between parties with competing interests is more often the outcome of differences that have to be reconciled in acrimonious discussion, than through a smooth progression of mutual agreement on issues that may not have been thought about very deeply. Keynes was anyway unwilling to “trim” his arguments to his audience and this perversely saved time in reaching compromises.41 The final result of the meetings was inevitable. White’s plan was substantially agreed, although Keynes secured some important concessions, including an increase in the size of the fund (although still to a level much below the British ICU plan). Less progress was made with trade policy. Keynes was not much involved with this, and the main issue was whether Britain was to be allowed to keep its gold and dollar reserves while it was receiving Lend-Lease. This matter was not eventually resolved until the end of 1944, when Morgenthau and Keynes engineered an agreement. Was the whole exercise a crushing failure for Keynes? It was very much the opposite. For the first time in history – an event whose importance was underscored by Keynes’s personal memory of Woodrow Wilson’s failure – the United States was committed to lead an important international organization: one geared to solving one of the most important of all economic problems. Keynes’s original initiative certainly stirred Morgenthau and White to develop the plan that eventually carried the day. The defeat of the British proposals was the outcome of the inexorable shift of economic power to an increasing dominant America. Keynes and White were not talking as equal partners, and this is a problem that was to become even greater for Keynes immediately after the end of the war: a period when Britain demanded his brains and persuasive power more than ever before, but when his health was breaking down fast. The resolution of the Washington discussions was not received well in London, where xenophobia was increasing in parallel with America’s growing ascendancy within the counsels of the wartime allies.42 Keynes, through his grit and determination, kept the agreement on the rails, and it was published in Washington, London, Moscow and Chungking on April 22, 1944.

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A jointly agreed plan was not the same as a treaty between sovereign states. This was what led to the celebrated conference at Bretton Woods in June/July 1944. The venue for this conference was a large hotel, formerly a millionaire’s country home, in the rural retreat of New Hampshire. It was, however, preceded by smaller meetings in a less agreeable location, Atlantic City, New Jersey. The purpose of the Atlantic City meetings was for White and Keynes to make preparations to sing from the same song sheet: to reach agreement on their ideas and to make plans to bring some organization to the very much larger and potentially unfocused conference at Bretton Woods, where 44 different countries were to be represented by 750 delegates. By this time, White’s fund had become known by its permanent title of the International Monetary Fund (IMF), and his proposal for an international bank was revived and put on the agenda, under the name of the International Bank for Reconstruction and Development (IBRD), soon to become known as the World Bank. As the name implies, the IBRD was planned as a source of funds for reconstruction of the most battered economies after World War Two, eventually moving into the business of making loans (with strings attached) for economic development in developing countries. Morgenthau presided over Bretton Woods, but Keynes represented the intellectual center of the proceedings – and he was recognized by the delegates as such – despite the fact that he attended relatively few meetings.43 Keynes was looked upon by everybody with the greatest awe, although his personality and Englishness did not make him a cheerleader. Many detailed agreements were made after considerable wrangling: in particular the levels of financial participation by the larger (although not necessarily richer) countries. One point of great importance was that the dollar was to be recognized as the all-important international currency. The United States, the future home of the IMF and the World Bank, would become de jure as well as de facto the financial center of the world. Under the Bretton Woods system, the dollar could be exchanged against gold at a fixed rate, but other countries could stabilize their currencies against the dollar by a number of means, including borrowing from the IMF. The system had to deal with great difficulties, largely because of the battered state of the European economies. Nevertheless Bretton Woods remained effective until 1971, when the United States stopped the convertibility of the dollar against gold. After this, the fund became more involved in making development loans to Third World countries. Ominously, at the conference, there was much less discussion of trade matters, and there was no agreement about tariffs. Keynes was out of action for so much of the time that it is surprising that he made such an impact on the proceedings. On a positive note, Keynes’s relationship with Morgenthau and White grew a little warmer, and this was to pay a dividend during the next round of negotiations in the following December. But on July 20, Lionel Robbins, from the London School of Economics and the senior academic on Keynes’s team, noted that Keynes spent . . . “one evening of prostration at Atlantic City, two the first week here, three last week; and I now feel that it is a race between the exhaustion of his powers and the termination of the conference.”44

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One important matter still remained on ice: trade talks. These now became so important for the Americans that, a month after Keynes had returned to Britain after Bretton Woods, he was on his way back to Washington. For reasons that are still not clear, Roosevelt appointed Morgenthau rather than the State Department to speak for the United States. Morgenthau’s opposite number, the British Chancellor of the Exchequer, should have been the British representative, but he – perhaps thankfully – delegated the job to Keynes because of his greater expert knowledge and deeper experience of working with the Americans. Perhaps surprisingly, the talks went well. The main point of discussion was Lend-Lease, in particular what was to happen after the end of the European war, which was clearly on the horizon. For how much longer would American generosity be extended? Britain would be playing a major part in the war against Japan (something that Roosevelt had agreed against the advice of the Joint Chiefs of Staff), and Lend-Lease supplies would continue to flow during this period. With the end of the European war, it was hoped that the Lend-Lease supplies to fight the Japanese war would take pressure off British industry and allow it some slack to refurbish and reequip. If this happened, it would strengthen Britain’s hand vis-à-vis the United States in the future competition for exports: a situation that would not be too popular in Washington. Many people, Keynes included, believed that this additional help was the repayment of a moral debt: some recognition of Britain’s vastly greater sacrifices in fighting the war. Not surprisingly, Churchill had the same opinion.45 Morgenthau was cooperative, partly because he expected British support for his vindictive and impractical scheme for emasculating German industry and turning Germany into an agricultural country. This plan did not get very far, and it was not too realistic to expect support from the author of The Economic Consequences of the Peace! Morgenthau’s opinion of Keynes had certainly mellowed; the following comment was, I believe, totally honest: [Keynes] “was a very fine and pertinacious negotiator . . . He had a very fine intellect, but, unlike most intellectuals, was never cold, so that one always had a feeling of intimacy with him.”46 The trade talks were eventually concluded amicably. Substantial Lend-Lease funds would be made available for a finite period, originally set at 12 months after victory in Europe (although this period was subsequently shortened because of the early end of the Pacific war). Britain was to be allowed to keep her gold and dollar reserves. There was to be some restriction on British exports, because the Americans believed, quite reasonably, that it was unfair for LendLease goods to reach Britain while Britain at the same time was benefiting from exports of similar products. This had been a worry as early as 1941.47 Despite all the optimism, the Morgenthau/Keynes talks did not finally settle financial affairs between the two countries. In particular, the arrangements to pay for supplies received before Lend-Lease were postponed yet again, and this problem was to reappear in 1945.48

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The Employment Policy White Paper While Keynes was addressing such complex international problems as the payment for American war materials supplied before Lend-Lease, and his plan for an International Clearing Union with its long gestation and endless debates on both sides of the Atlantic, important developments were taking place on the home front in Britain. The British population had by then become accustomed to a dirigiste state. Life in Britain during World War Two was astonishingly austere by present-day standards, with conscription of men and women into the armed forces, direction of labor between industries, restrictions on press freedom, stringent rationing of food, clothing and newsprint, a ban on the importation of wine, fruit and all luxury products, the requisitioning of large tracts of the countryside for military training, abolition of pleasure motoring and all overseas travel, high direct and indirect taxation, the virtual elimination of street lighting and regulations that required blackout curtains in houses and offices. The population accepted such sacrifices because they were seen to be temporary and – an even more important point – the people were single-mindedly determined to win the war. Nevertheless, everyone was immensely encouraged when a plan was unveiled in December 1942 that promised a more comfortable tomorrow. This was the Beveridge Plan, an essentially freelance effort by the social scientist and university administrator William Beveridge. It was a blueprint for a “cradle-tograve” welfare system that tied together the existing patchwork of schemes (mostly applying to only parts of the population), that covered unemployment and disability assistance and old-age pensions; it also proposed subsidies to families with children. Half the cost would come from individuals and the rest from the state. Beveridge was rather humorless and immodest and he had strong authoritarian inclinations, but his plan was practicable albeit utopian. Keynes actually helped Beveridge with the costing in order to ensure its feasibility. The Churchill government refused to commit itself to Beveridge despite a popular clamor for the plan. Not surprisingly, it was eventually turned into practical policy by the Labour government that took office in 1945. It became part of what is often referred to as the creation of a “New Jerusalem.” Beveridge’s plan envisaged “full employment,” which he originally interpreted as 8 percent of the work force. In subsequent discussions this came down to 5 percent (Keynes’s best estimate) and eventually to 3 percent (Beveridge’s more optimistic one). Unemployment is never zero except in totally autocratic societies. In free societies there is invariably some unemployment – cyclical, frictional or voluntary – even if structural unemployment is eliminated. A realistic estimate was important to the financing of the plan, because high unemployment would force up the total amount of welfare benefit payable, while at the same time acting as a drag on the National Income. Full employment was of course what the General Theory was all about. James Meade, working in the Offices of the War Cabinet, had for some time been developing ideas for turning the General Theory into practical government policy. Meade had been doing pioneering work on drawing up statistical meas-

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ures of the British economy as a whole, e.g. output, investment, consumption etc. He saw these as an important first step in managing demand and employment; and history was to prove him right.49 Meade produced his first paper on means of preventing general unemployment as early as 1941. This and further documents made their leisurely way through the corridors of power until 1943, when the government set up a high-level Steering Committee on Post-War Employment: a committee mainly concerned with steering aggregate demand and boosting it if necessary. The main problem was of course how to pay for the state subsidies that would be necessary to stimulate demand. Meade favored a system of flexible National Insurance contributions (taxes to fund the various social security schemes). Unlike income tax, these were paid by all employed workers: Both employers’ and employees’ contributions should administratively be capable of prompt variation. Moreover . . . the total of post-war social security contributions is likely to be sufficiently large to make their variations a very significant weapon for the purpose of stabilization. [Shortfalls could be met by] the reserves (or the debt) of the fund.50 Keynes, who was peripherally involved, favored a radically different scheme. At an earlier stage in his career, he had been in favor of finding ways of diverting Britain’s overseas investment to home use, but nothing much came of this. Keynes was always anxious to balance the national accounts, so that he did not wish to consider budgetary deficits. He therefore preferred increased borrowing from the capital account, which would mean increasing the size of the National Debt. Keynes’s approach was broader than Meade’s, and did not rely on making minor adjustments to the controls in response to small variations in the economic indicators, notably the statistical estimates of unemployment and government income. Keynes was suspicious of the effectiveness of using statistics for “fine-tuning.” As discussed in Chapter 1, his approach to statistics was philosophical, and he described it as follows: the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical and social curiosity, a purpose for which perfect precision – such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact – is neither usual nor necessary (my italics).51 Keynes made this point trenchantly, but he was not to live to see the increasing skills of the Federal Reserve during recent years. It has learned to “tweak” the rate of interest with great efficiency and has succeeded in using this to manage the health of the American economy. Keynes was not a member of the Steering Committee on Post-War Employment because he was ill in March and April 1944, and he was anyway

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concentrating his energy on his ICU scheme. The financial measures proposed by Meade were therefore embodied in the Committee’s report, which formed the basis of the famous Employment Policy White Paper that was published in May 1944. (A White Paper describes official British government policy.) This particular paper took a “broad church” view of Keynes’s doctrines, by accepting the traditional Treasury position of not sanctioning budget deficits or additions to the National Debt and at the same time moving into a wider field than Keynes by embracing both the supply side of the economy and foreign trade. Keynes expressed some reservations on the White Paper, but he endorsed it in general. There was serious opposition within the Treasury, and Keynes responded to this effectively. As mentioned, the final document covered a rather wider field than the General Theory, but au fond the White Paper was unmistakably Keynesian, and its policy prescriptions included the use of the rate of interest to influence investment, and Meade-inspired methods of funding schemes to boost demand directly. The really important point about the paper – something recognized by Keynes – was its opening sentence: “The Government accept as one of their primary aims and responsibilities the maintenance of a high and stable level of employment after the war.”52 The White Paper was published eight years after the General Theory. It is difficult if not impossible to think of another academic work, no matter what field it is in, that has made such an impact on public policy. And this was not the end of it. The United States Congress passed an employment act in 1946, and similar legislation was enacted into law in Canada, New Zealand, Australia, Sweden and South Africa.53

Keynes’s last contribution The European war ended in May and the Japanese conflict three months later, in August 1945. It is difficult to recapture the relief and satisfaction that these events brought to the victorious powers. In Britain the pleasure was much modified by a realization that the country had an economically difficult future, with mounting financial problems. Supplies from Lend-Lease only continued for three months after the end of the war in Europe, and this meant that there was no hope for Britain to be able to divert substantial domestic funds from armaments to repairing the industries that had been working at full capacity for six years. Keynes addressed this major financial problem shortly after the end of the European war. Lord Cherwell, Churchill’s scientific adviser, referred to Britain’s situation as “Economic Dunkirk.”54 Britain needed a substantial subsidy to tide its economy over the next three years, and Keynes thought that more than $7 billion was needed, mostly to cancel debt. This debt included $3 billion owed to the United States for supplies received before Lend-Lease, and even greater sums to the British Commonwealth for the cancellation of sterling debts that Britain had accumulated during the war. In addition, Keynes proposed a $5 billion loan from the United States at a low rate of interest and repayable over ten years. (In the event, Britain was to receive only $4.4 billion to cover all these

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needs, and then as an interest-bearing loan.) An important quid pro quo was that Britain would now commit herself to liberalizing international trade. Britain’s debts to the sterling area, the so-called sterling balances, were a grumbling problem for the United States. While these debts remained so high, they perpetuated the sterling bloc which the Americans saw as a permanent impediment to free international trade. In addition, Britain’s payments to service these sterling debts syphoned off funds that would otherwise be available to pay the interest and repay the principal on loans from the United States. A sum of $7 billion or even more was a hefty amount, but Keynes continued to claim justice. He felt very strongly that Britain was entitled to receive the money in compensation for the sacrifices she had made during the war. The physical burdens and reduction in the standard of living had been far greater in Britain than in America. Unfortunately, a number of signals came in from people who were au courant with political feeling in the United States that Keynes’s “justice” argument would have little traction on the other side of the Atlantic. There was anyway a change in the dramatis personae. Roosevelt was dead, Morgenthau and White had moved on and Churchill had lost office. Keynes, now faced with a new cast of characters, was likely to meet the same problems he had encountered when he first worked with Morgenthau and White. In the Truman administration, Morgenthau’s successor as Secretary of the Treasury was Frederick Vinson. The Assistant Secretary of State, William Clayton, became immediately involved in economic relations with Britain. Help for Britain was on their agenda, but Clayton, who made up his own mind on the question, visualized much tougher terms than Keynes was aiming for. Vinson was pro-British, but he did not take to Keynes. Clayton was also pro-British but was a strong free trader, which made for difficulties for the British since he insisted on a trade agreement to accompany any financial one. In Britain, the Chancellor of the Exchequer in the new Labour government was Hugh Dalton, a forceful politician who had once been Keynes’s student. Dalton appointed Keynes as his chief economic adviser, but this was a tribute to Dalton’s respect rather than affection for Keynes. Dalton was to prove a troublesome political chief. With the end of the Japanese war and the halt of Lend-Lease (a decision that Truman was later to regret), the British became immediately conscious of the urgency of starting talks with Washington. The British government therefore assembled a delegation to open discussions. This was to be led by Lord Halifax, the British ambassador to the United States, although the point man was to be Keynes.55 A preliminary meeting was held on August 23, 1945, chaired by Prime Minister Clement Attlee and including the senior members of his administration. Keynes was instructed not to finalize any deal with the Americans, but his brief was obviously to secure the best terms possible to avoid the financial disaster that Keynes agreed was facing Britain. The point was that Britain still needed substantial imports of food, raw materials and petroleum, but it would be impossible to pay for these because Britain had lost two-thirds of her export trade. The result would be a sharp deterioration

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in Britain’s overseas trade balance, which would result either in the country defaulting on her obligations, and/or a shrinkage of imports that would mean great hardship, and/or a substantial devaluation of sterling which would cause a large increase in the price of imports that would make a bad situation even worse. Keynes was confident and even optimistic about his ability to agree favorable terms with the Americans. He did not include anyone from the Board of Trade on his team, in the hope that this would discourage Washington from putting trade talks on the agenda. (As an afterthought he did include a Board of Trade official as an observer: a fortunate decision since the Americans were emphatic about including trade talks.) By this time Keynes’s ill-health was taking a visible toll on his energy and appearance, but his voyage with Lydia across the Atlantic restored him temporarily to physical health and recharged his mental batteries. His first meetings were in Canada, where he made a favorable deal about the termination of Canadian Mutual Aid (a smaller scheme than American LendLease but one that had been set up on similar lines). He then went to Washington. The first meeting with the Americans was held on September 11, 1945, during which Keynes was not able to dissuade them from including trade talks on the agenda. This was a replay of the debates on the IMF and the World Bank; the Americans had the greatest economic power on the planet and Keynes was negotiating from a position of weakness, a situation that was getting worse every day. The first three days of the talks in Washington saw long and well-argued presentations of the British position by Keynes, but it quickly became clear that a grant or an interest-free loan were not practical possibilities because they would not be approved by a skeptical Congress. This left an interest-bearing loan as the sole option. Keynes’s political masters in London were puzzled and extremely disturbed by this development, since Keynes’s earlier optimism had led them to expect something much better. Eventually, the Americans offered a loan of $5 billion at 2 percent interest, with some softening of the terms of payment. Dalton said no, because the British government believed the interest payments to be beyond the country’s capacity. The Labour administration was unwilling to find a way of raising the money, and therefore preferred to wear the hair shirt of austerity. The fact that the British now had a left-wing government may have accounted for a hardening of American attitudes. The trade talks were still on the agenda, and to conduct them Robbins arrived at the end of September with a team from the Board of Trade. The Americans were unwavering in their goal of liberalizing world trade and this meant that sterling would have to participate in the process. Although Robbins made some progress, Imperial Preference remained a sticking point. In the meantime, the Americans were having second thoughts about a loan as high as $5 billion. Harry Dexter White, in the background and out of favor, calculated that Britain would not need such a large sum of money. Not surprisingly, Clayton was influenced by this view. Various proposals and counter-proposals crossed the Atlantic, and the negotiations were held up for three weeks until the

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dust had settled. It was clear by now that Britain was not going to receive anything like the financial support that Keynes had originally envisaged. When the talks started again, they were characterized by abrasiveness. As might have been expected, the stress from this atmosphere aggravated Keynes’s heart problems. On one occasion, Halifax and Keynes even threatened to withdraw from the negotiations, and this would have meant that Britain would not ratify the Bretton Woods agreement. The Labour government had planned to pass the American loan and Bretton Woods into law at the same time, so that the withdrawal of Britain would have meant the collapse of the Bretton Woods edifice, and Vinson and Clayton were not willing to take this risk. The talks therefore lurched forward. Keynes was being subjected to a double pressure: both from the Americans and from Dalton and the British government. British insiders in Washington had a view of Keynes as a negotiator rather different from how he was seen in London. This is how Halifax described Keynes’s difficulties in reaching agreement with the Americans: there were many minor storms, when Keynes was unable to resist temptation and allowed the flash and thrust of a sardonic humor, never far below the surface, to peep through. But transitory irritations soon gave way to the lure of watching the performance of so fresh and unconventional an instrument as his mind was.56 London, however, was not willing to give Keynes the benefit of the doubt. Dalton recorded in his diary: Keynes is becoming rather sulky and it is clear that, as must always be the case, following these long negotiations, those who represent us out there and we here at home have drifted into a condition of mutual incomprehension.57 With Dalton holding such an opinion, it is not surprising that the Labour cabinet lost confidence in Keynes and sent out Edward Bridges, the most senior official in the British civil service, to take over from him. Bridges soon realized (echoing Halifax) that Keynes was the better qualified negotiator and there was no interference with Keynes’s work. To make matters worse, there was continued confusion as lawyers were brought in to draft proposals that they did not fully understand. However, the talks were eventually settled on American terms: a loan of $3.75 billion of “new money,” plus $650 million (a relatively nominal sum) to pay off the existing Lend-Lease obligations. These loans were subject to 2 percent interest and were payable over 50 years. In Britain the loan and the Bretton Woods agreement were speedily passed into law. There was no shortage of unfavorable comment in Britain about the ingratitude of the Americans for Britain’s earlier sacrifices. Nor was there much enthusiasm for Bretton Woods itself in certain influential circles. There was a feeling

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that Keynes was being extremely inconsistent in forgetting his early antagonism to the Gold Standard: To me there is something ironical but pathetic in the thought of Keynes at Bretton Woods taking a leading part in producing a scheme for getting as near as he dared to an International Gold Standard, and later, in the House of Lords, pressing it on a more than slightly sceptical country.58 These were the words of the able and businesslike War Minister, P.J. Grigg, who was almost unique in Britain in having moved from being a senior departmental official to an appointment as minister of the Crown with a seat in Parliament, but Grigg was not subtle enough to see the difference between the rigidity of the Gold Standard and the more flexible Bretton Woods mechanism. He also overlooked the fact that Bretton Woods was a cooperative endeavor, because international currency stability was seen – at last – to be in everybody’s interest. The loan was far less than Keynes and the Labour government (who had listened to Keynes) had originally expected, but it was just enough, despite the fact that much of its value was soon eaten by inflation. By imposing stringent controls over foreign exchange, including a £50 ($200) annual limit on the money British people were allowed to spend on foreign vacations, the British government averted financial disaster and survived two difficult years. (Keynes was not to realize that salvation would arrive in 1948 as a result of a gift of massive generosity – and political self-interest – from the Truman administration: a plan that took its name from Truman’s Secretary of State, George Marshall.) Even after Marshall Aid, the pound sterling was devalued in 1949. The loan agreement also called on Britain to clear up within a year the lingering problem of the sterling balances, although Britain was allowed some room for maneuver in this matter. However, Britain did not finally abandon Imperial Preference until she entered the European Union during the early 1970s. Keynes returned to Britain in December 1945, prostrate with ill-health, and his disappointment with the American negotiations was an additional burden. He recovered over Christmas, and in the New Year returned to his favorite pursuit of thinking and writing. He also worked at the Treasury, where he concentrated his efforts on making the best use of the American loan. He realized that this sum of money was only large enough to buy a limited amount of time for the British economy, and he planned accordingly. Keynes’s last speech in the House of Lords defended Bretton Woods and the American loan.59 In March, Keynes went back to the United States for what he hoped would be a semivacation in Savannah, Georgia, where a multinational meeting was being held to establish the IMF and the World Bank, but there were disagreements between Keynes and the Americans over where the two bodies were to be located – Washington (favored by the Americans) rather than New York (which Keynes for good reason preferred) – and also about the basic structure of the two organizations. There was much heated discussion, but again it was inevitable that the American proposals would win the day. This was accomplished because

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the United States was able to win a decisive number of votes from the small nations, which were all impressed by America’s economic dominance. Keynes passed out unconscious on the train journey from Savannah to Washington. He got to New York with difficulty, and returned home by sea. His Treasury colleagues were shocked by his appearance when he returned to London. Some of his old vigor soon revived, but his recoveries were now temporary and were merely intervals of good health punctuating longer periods of illness. The strain he had suffered during the previous two years was too much for him, and he died on Easter Sunday, April 21, 1946, two months short of his 63rd birthday and ten years after the publication of the General Theory.60 Those ten years had seen the propagation of his ideas and also his permanent move out of academia into the field of national and international policy making. It was the intensity and responsibility of this work for the British government that strained his already fragile health and led to his death within months of the end of the war.61 Shortly before he died he heard that he was to be given the Order of Merit. Except for a few ancient orders of chivalry that go to British and Foreign royalty and a few aristocrats, the Order of Merit is the most rarely awarded of all British honors, bestowed on the 24 most distinguished living men and women in Britain on the basis of their artistic or intellectual achievements rather than the accident of their birth; but Keynes was to die before he was able to visit Buckingham Palace to receive the modest cross worn around the neck.62 It is a fascinating although ultimately fruitless exercise to speculate about what Keynes would have made of the world of the twenty-first century, 60 years after his death. He would certainly have been gratified by the conquest of structural, secular unemployment, considering his own direct contribution to this magnificent outcome. He would also have been impressed (although probably not dazzled) by the unparalleled growth of wealth, especially in the most economically developed countries: something that was largely the result of the conquest of unemployment. He would also have been excited about the revolutionary and totally beneficial advances in medical science which might have prolonged his own life if he had been fortunate enough to have lasted just a few more years. (Antibiotics came into common use at the end of the 1940s.) It is moot whether Keynes would have agreed that the vast and continuous growth in personal incomes has led pari passu to increases in happiness. He probably shared the view of Keir Hardie, the founder of the British Labour Party, that the tragedy of the working classes is the poverty of their aspirations. Wealth is a necessary but not a sufficient condition for the greater good of the greatest number. As far as Keynes’s own field is concerned, he would have been amused and perhaps pleased by how the language of macroeconomics is now used every day by politicians and journalists and how it has even become part of the dialogue of the “chattering classes.” What about the economic problems that have occupied so much of the world’s attention since World War Two? What would Keynes have said and done about maintaining growth in developed countries and generating it in developing countries? What would he have had to say about how to

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handle shock increases in the prices of primary products? Would he have believed that the long-term allocation of scarce and finite resources should be left to the price mechanism, when supply is restricted by market concentration? And how would he have dealt with vast budget deficits and the ballooning of debit balances in international trade? It is impossible to guess whether Keynes would have made substantive contributions to solving these problems. We have no clues in his own writing. But in view of what he accomplished in lifting the even greater incubus of persistent unemployment, I believe that he would have done a better job than the economists who have actually tackled these more recent challenges. Good though many of these people are, Keynes had the edge in intellectual horsepower, flair and force of character. He would unquestionably have been awarded the first Nobel Prize for the dismal science if he had lived until his late eighties, when the prize was extended to economists, but this great recognition would not have done much to burnish his existing reputation. It is by his work that he should be judged.

Notes 1 Robert Skidelsky, John Maynard Keynes, Vol. 2: The Economist as Saviour, 1920–1937, London: Macmillan, 1992, pp. 572–579. 2 Keynes, General Theory, p. 220. 3 Skidelsky, John Maynard Keynes, Vol. 2, p. 486. 4 Robert Skidelsky, John Maynard Keynes, Vol. 3: Fighting for Britain, 1937–1946, London: Macmillan, 2000, p. 6; D.E. Moggridge, Maynard Keynes: An Economist’s Biography, London: Routledge, 1992, pp. 607–608. 5 I am very grateful to Dr Eugene Kaplan of University Hospital, Syracuse, for his gift of translating the technical language of medicine into words that a layman can understand. 6 Skidelsky, John Maynard Keynes, Vol. 3, p. xvi. 7 Skidelsky, John Maynard Keynes, Vol. 2, p. 630. 8 Annual Abstract of Statistics, London: Central Statistical Office, 1948, pp. 93, 204, 220, 244–245. 9 Skidelsky, John Maynard Keynes, Vol. 3, pp. 30, 49. 10 R.F. Harrod, The Life of John Maynard Keynes, London: Macmillan, 1951, p. 497. 11 Keynes, General Theory, p. 207; Harrod, The Life of John Maynard Keynes, pp. 272–273. 12 Harrod, The Life of John Maynard Keynes, p. 500. 13 Keynes’s role during the period 1939–1941 is described in Harrod, The Life of John Maynard Keynes, pp. 487–506; Charles H. Hession, John Maynard Keynes: A Personal Biography of the Man Who Revolutionized Capitalism and the Way We Live, New York: Macmillan, 1984, pp. 314–323; Moggridge, Maynard Keynes, pp. 627–649; and Skidelsky, John Maynard Keynes, Vol. 3, pp. 54–55, 77–87. 14 Skidelsky, John Maynard Keynes, Vol. 3, pp. 152–154, 296. 15 Ibid., p. 88. 16 Ibid., p. 86. 17 John Colville, The Fringes of Power. Downing Street Diaries, 1939–1955, London: Hodder and Stoughton, 1985, p. 229. 18 The details of the relations between Britain and the United States during the period before May 1941 are described in Harrod, The Life of John Maynard Keynes, pp.

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505–512; Hession, John Maynard Keynes, pp. 323–327; Moggridge, Maynard Keynes, pp. 650–655; and Skidelsky, John Maynard Keynes, Vol. 3, pp. 91–108. John Kenneth Galbraith, “How Keynes Came to America,” Economics, Peace and Laughter, Harmondsworth, Middlesex, UK: Penguin Books, 1971, pp. 36–49. Skidelsky, John Maynard Keynes, Vol. 3, pp. 108–121. G.C. Peden (ed.), Keynes and His Critics. Treasury Responses to the Keynesian Revolution, 1925–46, Oxford, UK: Oxford University Press, 2004, pp. 242–243. Skidelsky, John Maynard Keynes, Vol. 3, pp. 121–127, 134. John Brewer, “Selling the American Way,” New York Review of Books, November 30, 2006, p. 61. Ibid. Skidelsky, John Maynard Keynes, Vol. 3, p. 122. Peden (ed.), Keynes and His Critics. I have received valuable comments on the differences between American and British culture from American friends who have spent long periods of time in Britain. They are Gene Kaplan (who was at the Tavistock Institute) and his wife Sandy; Sam Gorovitz (who was at Oxford University) and his wife Judie; and Bob Daly (who taught at King’s College, Cambridge, where he learned a good deal about Maynard Keynes from dons who knew him) and his wife Liz. I am grateful for the comments of a London friend and former colleague from J. Walter Thompson, London, Judie Lannon, who was born and educated in the United States. Valuable comments have also come from colleagues at the Newhouse School of Public Communications, Syracuse University: Bud Carey, Rosanna Grassi, Johanna Keller, Dennis Kinsey, Tina Press and David Sutherland. Skidelsky, John Maynard Keynes, Vol. 3, p. 186. Josef Steindl, “J. M. Keynes: Society and the Economist,” Keynes’s Relevance Today, Fausto Vicarelli (ed.), London: Macmillan, 1985, p. 101. Skidelsky, John Maynard Keynes, Vol. 3, p. 222. Note Keynes’s use of the word “chap.” This was the argot of the “Cambridge Circus”. It was Joan Robinson’s favorite word to describe a member of the general public who earns, spends and saves income. Ibid., pp. 203–209. Roy Harrod, The Life of John Maynard Keynes, London: Macmillan, 1952, p. 533. Skidelsky, John Maynard Keynes, Vol. 3, pp. 233–238. I am also grateful for a number of comments on this chapter by Cherry Lewis, James Meade’s daughter. Harrod, The Life of John Maynard Keynes, p. 558. Skidelsky, John Maynard Keynes, Vol. 3, pp. 239–243. Ibid., pp. 243–247. Harrod, The Life of John Maynard Keynes, p. 545. Harrod, The Life of John Maynard Keynes, pp. 512–529; Hession, John Maynard Keynes, pp. 331–340; Moggridge, Maynard Keynes, pp. 688–694; Skidelsky, John Maynard Keynes, Vol. 3, pp. 247–256. Skidelsky, John Maynard Keynes, Vol. 3, p. 310. Ibid., p. 318. Ibid., p. 394. Harrod, The Life of John Maynard Keynes, pp. 569–575; Hession, John Maynard Keynes, pp. 340–341; Moggridge, Maynard Keynes, pp. 731–741; Skidelsky, John Maynard Keynes, Vol. 3, pp. 325–336. Skidelsky, John Maynard Keynes, Vol. 3, pp. 339–360. Ibid., p. 355. Colville, The Fringes of Power, p. 515. Harrod, The Life of John Maynard Keynes, p. 508. Colville, The Fringes of Power, p. 417. Skidelsky, John Maynard Keynes, Vol. 3, pp. 361–372. Steindl, “J. M. Keynes: Society and the Economist,” pp. 100, 103.

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50 Susan Howson (ed.), The Collected Papers of James Meade, Vol. 1: Employment and Inflation, London: Unwin Hyman, 1988, pp. 186, 190. 51 Keynes, General Theory, p. 40. 52 Skidelsky, John Maynard Keynes, Vol. 3, pp. 266–286. 53 Hession, John Maynard Keynes, pp. 366–367. 54 Colville, The Fringes of Power, p. 559. 55 Skidelsky, John Maynard Keynes, Vol. 3‚ pp. 396–402. 56 Lord Halifax, Fullness of Days, New York: Dodd, Mead & Company, 1957, p. 273. 57 Ben Pimlott (ed.), The Political Diary of Hugh Dalton, 1918–1940; 1945–1960, London: Jonathon Cape, 1986, p. 365. 58 P.J. Grigg, Prejudice and Judgment, London, Jonathan Cape, 1948, pp. 260–261. 59 As another token of Keynes’s membership of the British establishment, on February 20, 1946 he attended the reopening of the Royal Opera House, Covent Garden, as the Chairman of its Trustees. The house had been closed during the war and converted into a dance hall. It opened its doors again with a dance performance of a totally different type: a gala evening of ballet, something that was close to Lydia’s heart. Keynes attended the performance, but was too exhausted and ill after a heavy day at the Treasury even to greet the king and queen. 60 Skidelsky, John Maynard Keynes, Vol. 3, pp. 403–458. 61 Ibid., pp. 459–471. 62 Harrod, The Life of John Maynard Keynes, p. 97.

11 Keynes the prophet

At the beginning of the twenty-first century, only about 5 percent of Americans have any direct memory – and then mostly from their childhood – of the Great Depression. The proportion is similar in the countries of Western Europe and in other parts of the economically developed world. To the remaining 95 percent of the population of these countries, the 1930s are history. The decade is as remote for them as the American Revolutionary War or the battles of Trafalgar and Waterloo. The more distant we are from the Great Depression, the less relevant seems the contribution made by Maynard Keynes. His legacy is still with us today, but the vast majority of us are unconscious of it because we have forgotten the disease from which the world economy had suffered during the 1930s. The subject of this book – Keynes’s revolutionary and substantially effective solutions to an intractable problem – is more than a subject of historical interest. Keynes developed a pair of techniques, monetary controls and demand management, that continue to be used today, and it is these very tools that still help national economies overcome secular stagnation and move forward to a more prosperous future. Paradoxically, many governments are unaware that their fiscal policies have a direct influence on aggregate demand. They are therefore Keynesians without actually knowing it. What are our main conclusions about Keynes’s contributions, especially about the effectiveness of the macroeconomic policies he developed? My conclusions will be summarized briefly in this chapter. I shall interleave my seven main deductions from American experience since World War Two with quotations from Keynes’s rather uncompromising prose, mostly taken directly from the General Theory which, as readers will remember, was published in 1936. Keynes had much more to say about these issues, but I have concentrated on his pithiest statements.1

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First Conclusion: • During the second half of the twentieth century, cyclical ups and downs in National Income and changes in employment moved in the same direction and the causality was two-way. • When income went up, so did demand and employment (and this then generated more demand). When income fell, so did demand and employment (which in turn caused demand to fall further). • There was an additional “crisis” effect, substantially psychological in origin: drops in income had a more dramatic effect in reducing demand and employment than increases in income had in boosting them. Reductions in income were mostly the outcome of contractions in private business investment demand, driven by reductions in the Marginal Efficiency of Capital: in effect another psychological phenomenon. Keynes’s hypotheses: The trade cycle is best regarded, I think, as being occasioned by a cyclical change in the Marginal Efficiency of Capital . . . another characteristic of what we call the trade cycle which our explanation must cover if it is to be adequate [is] the phenomenon of the crisis – the fact that the substitution of a downward for an upward tendency often takes place suddenly and violently, whereas there is, as a rule, no such sharp turning-point when an upward is substituted for a downward tendency . . . a high rate of interest is much more effective against a boom than a low rate of interest against a slump. . . . Any fluctuation in investment not offset by a corresponding change in the propensity to consume will, of course, result in a fluctuation in employment.2 Second Conclusion: • Private business investment demand, which calls for funds to pay for buildings, plant, machinery and inventories, is governed by the Marginal Efficiency of Capital, which is rooted in the entrepreneur’s judgment of the likely profitability of the investment. The most important influence on this is his or her estimate of the likely demand for the firm’s products when production comes on stream. Successful entrepreneurs make more correct than incorrect decisions, but even the most successful business people make many mistakes. • The psychological uncertainties of the decision-making process cause investment demand to be volatile, and influenced as much by overall factors – the “business climate” – as by the state of the specific market in which the business is operating. • American experience during the last half of the twentieth century showed clearly that private investment was the most important single

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influence on employment, to a large extent because it also stimulated consumer demand through the Multiplier. Keynes’s hypotheses: If human nature felt no temptation to take a chance, no satisfaction, profit apart, in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation. . . . The affair [is] partly a lottery, though with the ultimate result largely governed by whether the abilities and character of the managers were above or below the average. . . . Increased employment for investment must necessarily stimulate the industries producing for consumption and thus lead to a total increase of employment which is a multiple of the primary employment required by the investment itself.3 Third Conclusion: • The propensity to consume – the proportion of income devoted to consumption – tends to fall as income rises. The fall in the propensity to consume is a long-term phenomenon and can most easily be seen by comparing economies at different stages of development. The propensity in economically undeveloped countries is far higher than in developed countries. • The falling propensity to consume is more difficult to detect in shorter periods, and cannot be found in data from the United States covering the last part of the twentieth century. Milton Friedman could explain this. • During this period, the American economy changed in ways that Keynes did not anticipate. Consumer credit ballooned, driven by a general optimism that came from a “feel good” atmosphere signaled by a buoyant stock market and booming real estate prices. An unexpectedly healthy expansion of consumer demand maintained the forward thrust of economic activity and kept unemployment low. Keynes’s hypotheses: The fundamental psychological law, upon which we are entitled to depend with great confidence . . . is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. . . . Windfall changes in capital-values not allowed for in calculating net income [are important] in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.4

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Fourth Conclusion: • For 20 years after the end of World War Two and again during the whole period since 1978, the Federal Reserve has used the rate of interest as a tool of macroeconomic management. Although there are underlying market pressures on the rate of interest – the demand for liquidity to push it up and planned spending on consumption and investment to bring it down – the task of the Fed has been to steer a very delicate course, keeping interest high enough to discourage inflation yet low enough to nurture growth. The Fed’s skill has greatly improved over time. • Yet the rate of interest has been a less than perfect device to manage the economy, because low interest has been much less efficient in stimulating a depressed economy than high interest has been in cooling a potentially overheated one. It can therefore be efficient at scotching inflation at its first signs, and it has been and still is employed for this purpose. • An indirect policy of boosting aggregate demand, e.g. using a low interest rate to trigger business investment (and hence demand), has less effect than a direct policy, e.g. manipulating the national and local budgets to increase government investment (and hence demand). Keynes’s hypotheses: The duty of ordering the current volume of investment cannot safely be left in private hands. . . . There is, indeed, force in the argument that a high rate of interest is much more effective against a boom than a low rate of interest against a slump. . . . Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest. For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasiboom.5 Fifth Conclusion: • Since the end of World War Two, American government spending has been high and has increased significantly, even taking inflation into account. High expenditures were necessary to fund the Korean War in the 1950s; the Great Society programs and the Vietnam War in the 1960s and 1970s; and the Reagan arms race in the 1980s, which began a series of enormous fiscal deficits that in the twentyfirst century have become larger than ever. The early 1990s saw the Kuwait War; and the present War on Terror began later in that decade. • These government outlays were not committed with Keynesian

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objectives in mind, but they had a Keynesian effect in stimulating growth in the national income and reducing unemployment. They did this to a substantial degree through the working of the Investment Multiplier. Surprisingly, these deficits were not inflationary. By luck or judgment, the economy was usually working at below full capacity, and this meant that the extra demand pumped into the system stimulated additional output and did not cause prices to rise. Overall experience of the effects of government expenditure on output and employment emphasizes that these sums must be large enough to make an impact. They were insufficient during the 1930s, but were large enough to have a clear effect during World War Two and after. These expenditures helped to achieve victory during the war, and at the same time they conquered unemployment. Keynes’s hypotheses: The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government. . . . Whilst (it) would seem to a nineteenth century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative. . . . But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom. . . . When a further increase in the quantity of effective demand produces no further increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation.6

Sixth Conclusion: • Optimism and pessimism do not have a life of their own. They are the product of a host of individual guesses by both business people and consumers about an unknown future. These are largely governed by the climate of opinion within society and by the attitude and actions of the government. Optimism boosts the influence of the “real” factors affecting economic growth by adding enthusiasm and panache (“animal spirits”). Pessimism aggravates the effect of the “real” factors affecting its decline, emphasizing the risks and uncertainties. • Consumer optimism and pessimism have a strong parallel influence on entrepreneurial optimism and pessimism, because business plans

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Keynes the prophet are made to satisfy consumer demand. Consumer demand is a prime mover that drives private business investment. The influence of pessimism on the economy is greater and acts more quickly than optimism. The evidence for this comes from the last part of the twentieth century. During this time, reductions in national income, private business investment and government expenditure had a considerable influence in reducing employment: a much greater influence than increases in these inputs had in boosting it. Keynes’s hypotheses: It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death. This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man.7

Seventh Conclusion: • The Great Depression has never returned. This fact is undeniable, but the explanation for it is complex. There were a number of interconnected causes, most of which involved government action (or deliberate inaction in comparison with policies during the Great Depression). These causes all relate in some degree to points that Keynes discussed in the General Theory, and the most important ones are direct expressions of Keynes’s doctrines. • The boom after World War Two was more prolonged than that after World War One. This is because the destruction of the war zones and the reduction in living standards in the nations that fought the war had been much greater than during World War One. From 1948, the Marshall Plan made a significant contribution to European recovery, with the additional benefit of maintaining a high level of demand and employment within the United States. • For 40 years after World War Two, the American export trade was healthy. The dollar was in demand worldwide, but its value was not kept artificially high: something that would have inhibited American exports. The full effects of today’s large negative imbalance in international trade have not yet been felt or even fully understood. • American government policy has been generally benevolent. There have been no restrictive policies to balance the fiscal budget when

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•

•

•

•

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expenditures exceeded tax revenue, even when the deficit reached unprecedented amounts. Successive American governments have also moved generally to liberalize international trade. International trade is indeed much freer than in the 1930s, although poorer countries – those that are developing as well as those still mired in poverty – are still handicapped, particularly in their ability to find open markets for their agricultural products. After the end of World War Two, the American government began to use monetary controls through the manipulation of interest rates by the Federal Reserve. This mechanism was employed with good effect for 20 years. It then went into abeyance and was revived in 1978, since when it has been used effectively. With growing experience, the Federal Reserve has learned how to nudge interest rates upward to prevent inflation once its early signs have been detected. The most important single factor is that American public expenditure has been extraordinarily high by historic standards. As discussed earlier, the purposes of this expenditure have been totally nonKeynesian, but their effect has been totally Keynesian. The demand pumped into the economy by these government expenditures has managed to mop up spare capacity, but their growth has stopped short of overheating the economy. In this connection it is important to remember the precautionary role of the Federal Reserve in staving off inflation. During the long years of postwar prosperity, consumer confidence and entrepreneurial optimism have added their positive effects to the other influences on economic growth. The American economy was bruised by the oil price shock of 1974. The outcome was a decade of very low growth, but there was no hint of economic catastrophe. The decade of recession was in no way comparable to the Great Depression. The rises in the price of petroleum beginning in 2004 had very little serious effect, beyond muting the optimism of investors. The substantial and growing buoyancy of consumer confidence maintained the propensity to consume at a high level and staved off any secular tendency for it to fall. As incomes grew, so did spending on consumer goods. This was the fundamental driving force behind the power of the American economy. It was and is a spur to innovation and a stimulus to structural change, as well as the ultimate source of entrepreneurial optimism. Innovation in American industry is not only demonstrated in technical inventions, but also in “downstream” activity, particularly in the exploitation of original ideas through marketing. In this part of the enterprise, entrepreneurs must be closely attuned to the psychology of the end consumer.8

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Keynes the prophet Keynes’s Hypotheses: “To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services. It is not reasonable, however, that a sensible community should be content to remain dependent on such fortuitous and often wasteful mitigations when once we understand the influences upon which effective demand depends.9 The important thing for government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all.10

This last quotation (which also appears in Chapter 6) is clear and balanced, but too general a statement of Keynes’s view on the role of the state in macroeconomic management. The problem with this statement is that it is incomplete, because it does not specify which of Keynes’s “things which at present are not done at all” ought legitimately to be the concern of the government. This phrase can be interpreted quite differently in a country with a strong dirigiste tradition, from how it has actually been interpreted in the United States. In the years immediately after World War Two, the British government maintained a “cheap money” policy, with a rock-bottom rate of interest to encourage private business investment. This policy did not succeed and the British economy trod water for decades. The decision-makers of the time had not read Keynes carefully enough. (See my fourth conclusion in this chapter.) During the 1970s, the British government pumped demand into the economy despite its likely effect on inflation, and this in the event turned out to be disastrously high. Again this was because the policy-makers had not done their homework. (See my fifth conclusion.) The United States has a deeply rooted libertarian tradition, and not surprisingly the country has employed Keynesian policies with great circumspection. High government expenditure, although carried out for objectives unrelated to Keynesian policies, has had a positive effect in boosting demand, National Income and employment. Miraculously there were no inflationary consequences. The way in which the Federal Reserve has controlled the rate of interest, carefully nudging it upward when appropriate – a policy that has become increasingly effective with experience – has succeeded in restraining growth at a level below the full capacity of the economy, with the result that inflation has been kept relatively low. A given percentage increase in the National Income becomes progressively more difficult to achieve as an economy grows, because the base on which the percentage is calculated increases each year. It is therefore extraordinary that the United States – by a wide margin the largest economy in the world – should have achieved such a high annual growth since the end of World War Two. The average annual increase in the GDP is among the highest in the developed world, although all the other countries with which the United States is being

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compared have smaller economies. (In the fall of 2006, the United States’ average growth over the calendar year was higher than the average for all the countries of the European Union.)11 It is difficult to deny that the remarkable performance of the American economy since the end of World War Two has been due not only to its underlying and increasing power, but also to the way in which American macroeconomic management has applied Keynesian doctrines. It has been a model exercise, and it is astounding that in the eyes of many economists today, Keynes’s doctrines have become anachronisms. In a balanced and lucid appraisal of Milton Friedman’s life and work that Paul Krugman published shortly after Friedman’s death, Keynes is compared with Martin Luther, the driving force behind the Reformation, and Friedman becomes Ignatius Loyola, the powerful and devout general who led the CounterReformation.12 Krugman is a strong (although not unqualified) supporter of the Counter-Reformation, yet he admits that Friedman’s monetarist policies did not work when they were adopted after the oil price shock of the 1970s. (See Chapter 5.) But what Krugman does not examine is the fiscal deficits during the 1980s and after – de facto Keynesian policies – deficits that succeeded in sustaining the growth of the GDP and maintaining a high level of employment. In Chapter 1, I offered three reasons why Keynes made such an impact on the economic health of the twentieth century: (1) the inherent soundness of his doctrines and the policy prescriptions that flowed from them; (2) the desperate need for a solution to the economic problems of the 1930s; and (3) Keynes’s persuasive powers and his ability to ignite the enthusiasm of talented disciples. Although I said that all three reasons go some way to explain Keynes’s influence, it is now time to put them into perspective. The evidence in this book, which has been summarized in this chapter, shows that the first of these reasons was by far the most important one. Keynes did indeed get it substantially right and his prescriptions worked, to the incalculable benefit of workers and businesses in many countries, and the general welfare of society. Contrary to received wisdom, Keynesian policies did not become outdated with the arrival of stagflation in the 1970s; they were never more dramatically vindicated than by the government policies followed – quite unconsciously – during the 1980s and 1990s. These policies succeeded in pumping large volumes of demand into the American economy, and this boosted employment without inflationary consequences because there was slack in the economy. At about the same time, the interest rate was being developed as a tool of monetary policy by the skill of the Federal Reserve: a policy that demonstrated the greater effectiveness of a high interest rate in cooling a heated economy than low interest in stimulating economic activity. This difference had been precisely predicted by Keynes. During the 1930s, governments everywhere were at a loss about how to cure the blight of unemployment and this was the greatest single problem they faced, at least until the specter of war appeared on the horizon, but Keynes’s doctrines were too radical to be implemented. There may have been a desperate need for a

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cure for unemployment, but the need to avoid risks was even greater. However, the demonstrable effect of high government expenditure in maintaining full employment just before and during World War Two led – at very long last – to the official acceptance of Keynes’s policies. Britain took the lead in endorsing Keynes in 1944, and not long afterwards a number of other important countries followed. These included the United States. Keynes’s ability to address a highly influential, nonspecialist audience, through his personal contributions to policy and supported by his widely published journalism, kept his doctrines and policy recommendations prominently in the public eye. Keynes himself was always taken seriously. His many talented disciples in Britain and the United States gave academic support to the unorthodoxies he was propagating and spread the word widely, but there was a decisive difference between Keynes and his followers. After the beginning of World War Two, Keynes became an economic statesman esteemed worldwide, and a figure who – with the possible exception of Adam Smith – was the most influential thinker who has ever emerged from the field of economics. This was the result of his intellect, the weight of his personality and the reputation that he had developed over two decades. It is difficult to think of relatively modern parallels in other fields of activity. Consider another major thinker as eminent in his academic discipline as Keynes was in his. In the fall of 1939 this other figure, Albert Einstein, wrote to President Roosevelt a letter that was the genesis of the program to develop atomic energy. In doing this, Einstein was moving out of academia and entering the highest arena of public policy, and it was his eminence in theoretical physics that made this possible. Similarly, Keynes and only Keynes could have influenced economic policy in the way that he did during the 1940s and after, since his policy prescriptions outlived him. His role in government decision-making was not a single shot, like Einstein’s; indeed Keynes’s continuous influence over many decades was a more impressive achievement. During the four years it has taken me to write this book, my admiration for Keynes, which was high to begin with, has grown progressively. It is therefore appropriate that this chapter and this book should conclude with a last look at the astonishing figure who made such a contribution to the economic progress and welfare of the world. Chapters 8, 9 and 10 represent my best effort to describe the most important events of Keynes’s life and to explain how he managed to outstrip his most talented contemporaries. His life was rich in experience, variety and achievement. There was much that was unorthodox about him: his early explosive arrival on the public stage, his single-minded determination to shake the foundations of economics, the artistic and literary environment in which he flourished and – not least – the bizarre change in his sexual preference. His professional activities changed permanently in 1940, when he quit academia and started applying his high-level thinking to policy-making at the top level of government. The published histories of the period commemorate his contributions as a public servant: the imaginative part he played on the home

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front in demonstrating how to raise taxes to balance Britain’s wartime budgets while avoiding the high inflation that had occurred in World War One, and on the international front his battles with Washington over the postwar American loan. Bretton Woods is also a monument to him. He was the initial driving force behind the International Monetary Fund and World Bank, although these bodies were later molded much more by the Americans than by Keynes himself. In the event, the IMF was only effective in its original role for a quarter-century, because in 1971 the United States withdrew from her central position in stabilizing international currencies. The IMF then moved into making development loans to economically poor countries. For more than 60 years the World Bank has remained an important landmark on the international landscape, and has developed a massive “Knowledge Bank” of economic statistics that are available to macroeconomic decision-makers throughout the world. The tragedy of Keynes’s life was that his last three years ended in tears. This unfortunate outcome was not caused by any weakening of his brains, energy or dedication, or even his mortal illness. It was solely the product of the unshakable fact that the United States had by that time become the economic powerhouse of the world. It is very easy to appreciate Keynes’s frustration. I have mentioned before how appropriate it is that Skidelsky entitled the third volume of his monumental biography of Keynes, Fighting for Britain. It is a title that carries an alltoo-clear message about the weight of Keynes’s responsibilities, and also perhaps a hint of the price that he would pay for carrying them. Despite Keynes’s justifiable claim to fame for what he accomplished during and after World War Two, his most lasting contribution to the welfare of mankind remains the General Theory. The failure of capitalism during the Great Depression was not total, but it appeared to be irreversible. Before Keynes, all efforts to cure the affliction had failed. In all human activities – those carried out by individuals and organizations and nations – nothing is more difficult to handle than failure. Picking up the pieces and finding a new course of action calls, as might be expected, for courage and resolution, but these alone are not enough. More important is imagination to find a new way ahead. The problem with harnessing the imagination is that it depends on one’s morale: a frame of mind that is shaken by the failure itself. Failure breeds inertia and cynicism and an unwillingness to take risks for fear of things going wrong again. People cannot think of a way of digging themselves out of their hole and this inhibits their willingness to make the effort. The established sciences, including social science of which economics is a part, do not help. These disciplines program the thinking of their acolytes, and do not nurture an environment in which people are encouraged to stand existing doctrines on their heads. Paradigms are sometimes shifted, but not very often. But this is exactly what Keynes did. My capstone conclusion from this book is that Keynes’s theories (which were substantially correct) and the policies that stemmed from them (which were largely successful) were the outcome of two forces. The first was Keynes’s intellectual power, particularly his ability to push forward the frontiers during the whole of his life and his knack of making all his

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activities cross-fertilize each other. The second, which was scarcely less important, was his spiritual make-up: his confidence, persistence, drive and unwillingness to be discouraged, even by his failing health during the last two years of his life. As I have suggested in this book, his mind and spirit were molded by his education and social class, and this had disadvantages as well as advantages. Keynes had little direct knowledge of the vast majority of the population: the people whose incomes he dedicated his life to protecting. This lack of personal knowledge led at least one influential economist, Harry Johnson, to question – perhaps unjustly – Keynes’s dedication to the ambitions of the working class in a dynamic world. He devoted most of his energy to eradicating unemployment (i.e. maintaining jobs within the existing structure of industry), but Johnson thought him to be much less concerned with the growth in the incomes and the improvement of the broader welfare of the disadvantaged. Equally seriously, Keynes’s character and background made for difficulties in his negotiations with the Americans. With them, respect was not accompanied by much love. However, if we try and set on one side the unconscious prejudices inculcated by Keynes’s social background and concentrate exclusively on the influence of his spiritual make-up on his intellectual endeavors, I believe that in this respect his remarkable combination of inner strengths had a very positive effect in allowing his imagination free rein. Many other people had superb intellects. Many people – some clever but some stupid – had strong will and some of these also had imagination. As a result of the combination of the genetic endowment that he inherited and the legacy of his education and personal experience, Keynes had a personality that fused together great intellect and great imaginative power. The result was powerful synergy; and it was this synergy that drew Keynes so far ahead of most of his other contemporaries who also had first-class talent.13

Notes 1 Omissions of less important phrases are indicated by . . . Words in parentheses substitute for longer phrases, but I have been very careful to avoid any change in the meaning. 2 Keynes, General Theory, pp. 313–314, 320. 3 Ibid., pp. 150, 118. 4 Ibid., pp. 96, 92. 5 Ibid., pp. 320, 322. 6 Ibid., pp. 379–381, 303. 7 Ibid., pp. 162–163. 8 “Economics Focus – Venturesome Consumption,” The Economist, July 29, 2006, p. 70. 9 Keynes, General Theory, p. 220. 10 John Maynard Keynes, “The End of Laissez-Faire” (1924 lecture), The Collected Writings of John Maynard Keynes, Vol. IX, Austin Robinson and Donald Moggridge (eds), London: Macmillan, 1972, p. 291. 11 “Economic and Social Indicators,” The Economist, October 7, 2006, p. 112.

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12 Paul Krugman, “Who Was Milton Friedman?” New York Review of Books, February 15, 2007, pp. 27–30. 13 My conclusions about Keynes’s mental and spiritual make-up have been checked out by two prominent psychiatrists (who have also seen and commented on other parts of this manuscript), Dr Robert Daly and Dr Eugene Kaplan of the University Hospital, Syracuse, New York.

Index

Abrahams, William 152n Acheson, Dean 182 Advertising Age 21n, 61n advertising-plus-promotional budgets 80 Aldi stores 125 American antagonism to Britain/to Imperialism 182, 186 American Loan to Britain (1946) 146, 194–198 American Revolutionary War 203 Anglo-American differences in culture 180–182 “animal spirits” 207 Annan, Noel 61n, 116n antibiotics 173, 199 Asquith, H.H. 144, 162 Atlantic City (NJ) 190 Attlee, Clement 195 Australia 194 Baldwin, Stanley 169 Balfour, Frederick 76n “Bancor” 184–185, 188 Bank of England 4, 156, 157, 162, 165, 185 Baptist Church 139 Baruch, Bernard 166 Bauer, Peter 152n Begg, David 22n Bell, Quentin 144, 154n Bevan, Aneurin 99, 116n “Beveridge Plan” 192 Beveridge, William 192 Blair, Eric 135–138, 152n, 157, 164, 171n Bloomsbury Group 141, 143–145, 151, 153n, 154n Bolivia, compared with the U.S. 46–47, 58 Booth, Edwin 137 Bowley, Arthur 137

brands: health-oriented 124; new 14, 122–124 Braque, George 143 Bremner, Robert P. 21n Bretton Woods (NH)/Bretton Woods Agreement 173, 189–191, 196, 198 Brewer, John 201n Bridges, Edward 196 Bridges, Robert 142 Britain/British: army 152n; Board of Trade 185, 196; Cabinet/War Cabinet 144, 156, 185–186, 192; civilian population, wartime controls on 177,192; Commonwealth 194; Depressed Areas/Special Areas 159, 166; National Government (1931) 166; new industries 159; private education system 135, 152n; social class 134–139, 152n, 153n, 162, 214; unemployment 159, 166, 174, 192 Bryan, William Jennings 181 “Buffer Stocks” 185–186 Burma 136 Bush, George (elder) 110–113 Bush, George (younger) 110–114 business, innovation and growth 122–126 Business Week 75, 76, 116n Cadbury family 137 Cambridge University 22, 72, 77, 83, 116, 134, 140, 144–145, 153n, 155–156, 169, 189; Apostles 138, 141, 153n; “Cambridge Circus” 44, 168, 186, 201n; Fitzwilliam Museum 143; King’s College 14, 44, 141, 142–144, 201n; Pembroke College 140; Political Economy Club 22n, 23n, 157; Registrary 140; Trinity College 141; Union Society 142; Wranglers 141

Index 217 Canada 194, 196 Canadian Mutual Aid 196 Carey, Bud 201n Carlyle, Thomas 1 Carrefour stores 125 Carroll, Lewis: Alice’s Adventures in Wonderland 24, 26 Carter, Jimmy 110–113 Cézanne, Paul 143 Chamberlain, Neville 169, 174, 176 Chamberlin, Edward Hastings 97n “Chap” (argot of the “Cambridge Circus”) 184, 201n Cherwell, Lord 194 Chicago, University of 77 China 131, 187; Chungking 189; students from China in the U.S. 108 Churchill, Winston 135, 160–162, 170, 176, 181 Church of England 137, 139 Civil Conservation Corps (CCC) 101–102 Civil Work Administration (CWA) 101 Clarke, Peter 170n Clayton, William 195, 196 Clemenceau, Georges 147–150 Clinton, Bill 110–113 Cohn, Laura 76n Columbia University 186 Colville, Jock 19, 22n, 200n, 201n Commons (British), House of 1 The Conference Board 127 confidence see expectations, business; expectations, personal Conservative Party (British) 100, 166, 167–168, 169 consume, propensity to 45–48, 73, 205, 209 Consumer Credit 132, 205 consumption, personal 35–36, 78, 89, 93 Cook, Chris 170n, 171n Cooke, Goodwin 153n “crisis” effect (in economic downturn) 114, 204 “crowding out” 164 Curzon, Marquess of 157 Dalton, Hugh 195, 196 Daly, Elizabeth 201n Daly, Robert 154n, 201n, 214n Darwin, Charles 9 Deacon, Richard 153n Degas, Edgar 147 Delacroix, Eugène 143 demand: aggregate 12, 28–32, 35–36, 73,

78, 159, 202, 204, 206; consumer 54–56, 78, 129, 132; consumer and investment, connections between 43–44; curves 11, 24–25; effective 12; elasticity of 79 demographic shifts 71 Derain, André 143 Diet Coke 124 Diet Pepsi 124 “dole” (British Social Security) 163–165 Dornbusch, Rudiger 22n Econometrica 21n, 98n Economic Advisory Council (EAC) 163 Economic Journal 44, 143, 144, 146 economics as mental discipline 3 The Economist 21n, 62n, 98n, 133n, 214n Einstein, Albert 9, 21n, 212 Employment Policy (British White Paper) 143, 192–194, 212 Eton College, Windsor 134, 140–141 European Union 100, 198 Evensky, Jerry 21n Ewing, Jack 76n expectations: “Expectations-Augmented Curve” 92; business 13, 28, 56, 71–76, 78, 117, 119–120, 121–122, 124–125, 131, 132, 204, 206–208; personal 13, 78, 117, 119–120, 126–129, 131–132, 204, 206, 208–209 Federal Emergency Relief Act (FERA) 102 Federal Funds Discount Rate see Interest rate Federal Reserve Bank 15, 17, 51, 61, 97, 114, 129, 130, 179, 193, 206, 209, 211 Federal Trade Commission 79, 97n, 100 finance, “sound” 2, 166, 169 fiscal policy 100–101, 162, 164, 174, 203 Fischer, Stanley 22n Ford, Gerald 110–113 France 136 Friedman, Milton xvii, 15–17, 22n, 23n, 58, 62n, 98, 114, 118, 129, 170n, 205, 211, 214n; “Permanent Income Hypothesis” xvii, 58, 129 “fundamentals,” company 14 Galbraith, John Kenneth 20, 22n, 40n, 171n, 179, 201n Galloway, Lowell E. 41n, 170n, 171n General Motors 42

218

Index

Germany: Army Great General Staff 154n; recovery from the Great Depression 172; reparations after World War One 147 Gillette 97n the “Global Village” 125 Gold Standard 157, 159, 160–165, 167, 169, 182–183, 185, 198 goods: capital 12; consumer 12 Gordon, Robert J. 40n, 98n Gorovitz, Judith 201n Gorovitz, Samuel 21n, 201n government expenditure (including investment) 34–36, 78, 103–107, 164, 206–207 Grant, Duncan 144–145, 153n Grassi, Rosanna 201n the Great Depression 11, 15, 17, 27, 42, 102–103, 138–139, 163, 164, 165–167, 170, 182, 203, 208, 209, 212 “Great Society” programs 15 Greenspan, Alan 59, 86 Grigg, P.J. 198, 202n Gross National Product (GNP)/ Gross Domestic Product (GDP) 29–30, 32–34, 38, 40n, 41n, 73, 88–89, 93, 192, 204, 210 Gulick, Luther 185 Haberler, Gottfried 22n Halifax, Lord 188, 195–197, 202n Hansen, Alvin 179, 185 Hardie, Keir 199 Harrod, Roy 153n, 154n, 169, 171n, 185–186, 187, 200n, 201n, 202n The Hartford 63 Harvard University 8, 179, 186 Hawtrey, Ralph 155, 165, 169 Healey, Denis 116n Henderson, David R. 98n Henry, David 76n Henry VI of England 135 Hession, Charles H. 153n, 154n, 171n, 200n, 201n, 202n Heyworth, Lord 98n Hicks, John 9, 21n, 22n, 26, 78, 98n, 169; IS:LM analysis xvii, 83–87 hoarding, see Liquidity-Preference Holmquist, Kevin 61n Holt, Ric 22n Hoover, Kevin D. 98n Hopkins, Harry 181 Hopkins, Richard 164 Howson, Susan 22n, 202n

Imperial Preference 167, 179, 183, 195, 198 India 131 inflation 16, 27, 51–53 interest rate(s) 51, 73, 78, 89–94, 163, 167, 168, 206, 210; classical theory of 82–83; spectrum 60–61; trends 91, 95 International Bank for Reconstruction and Development see World Bank International Clearing Union (ICU) 184, 186–188, 189, 192 International Commercial Union 186 International Currency Union see International Clearing Union International Development Corporation 185 International Economic Board 185 International Monetary Fund (IMF) 61n, 186, 190, 196, 198, 212 International Stabilization Fund see International Monetary Fund inter-war period 2, 27 investment: demand 63–64, 68–70; foreign direct 66–68; government see government expenditure (including investment); Investment DemandSchedule see Marginal Efficiency of Capital; private 16–17, 35–37, 78, 89, 93, 129–130, 132, 204, 206; supply 63–64; supply, sources of funds for 65–68 Irish Potato Famine 182 Jacobsson, Per 171n Japan: recovery from the Great Depression 172; war against 191, 194 Jenkins, David 98n Johnson, Bradley 61n Johnson, Elizabeth S. 22n, 23n, 153n Johnson, Harry G. 19, 22n, 23n, 77, 138, 153n, 214 Johnson, Lyndon B. 15 Joint Chiefs of Staff 191 Jones, John Philip 21n, 40n, 41n, 62n, 76n, 97n, 98n, 133n Kahn, Richard 22n, 23n, 44, 61n, 75, 116n, 168 Kaldor, Nicholas 22n, 23n, 116n, 169 Kaplan, Eugene 154n, 200n, 201n, 214n Kaplan, Sandra 201n Keller, Johanna 201n Kellogg’s Special K 124 Kennedy, John F. 115

Index 219 Key Bank of New York 61n Keynes, Geoffrey 153n Keynes, John 139 Keynes, John Maynard frontispiece, 2, 14, 23, 99, 131, 150, 165, 169, 181, 203; abrasiveness 157–158, 164–165, 197; American loan (1946) 146, 194–198; Americans, negotiations about international finance with 186–192; Americans, relations with 139, 146, 179, 181–182, 188–189, 195, 196, 214; analyses of his work by other economists 3; antagonism toward 15, 211; art collector, as 137, 143, 153n; City of London activities 156; Civil Service, early career in 142–144; Companion of the Bath (CB) 146; compulsion to think and write 134, 145, 183; death of 199; dialectician, as 152, 157–158, 186, 197; education of 140–142, 213; Employment Policy White Paper 194; family origins 139–140; financial speculator, as 14; “Forced Saving” plan during World War Two 175–177; homosexuality of 141, 143–145, 146; House of Lords, entry into 187; illness (subacute bacterial endocarditis) 173–174, 188, 190, 196, 198, 199, 214; King’s College, Cambridge, Fellow and Bursar 142–144; language of macroeconomics 3, 145–146, 157, 199; Peace Conference (1919) 147–150; “position papers,” preparation of 157, 185; reputation of 4, 199, 212–214; social class 134–139, 155, 179, 182, 213; statistics, skepticism of their predictive value 8–9, 192–193; synergy between different activities 134, 142, 144, 214; Treasury, British, ambassador for during World War Two 177–180; Treasury, British, career in 145–147, 176–177; Treasury, British, “Keynes Plan” 185; writing style 19, 147–148, 149–150, 172, 185, 212 Keynes, John Maynard, publications etc: Cambridge lectures (1932) 167; The Economic Consequences of Mr. Churchill 161–162; The Economic Consequences of Peace 147–150, 154n, 191; The End of Laissez-faire (1924 lecture) 116n, 214n; Essays in Biography 21n, 133n, 154n; The General Theory of Employment, Interest, and Money 6–9, 21n, 35, 41n,

42n, 44, 46, 49, 50, 53, 56, 59, 61n, 62n, 64, 69, 76n, 82, 95, 96, 98n, 100, 114, 116n, 117, 127–128, 131, 132n, 133n, 145, 157–160, 162, 164, 168, 169, 170, 170n, 171n, 172, 173, 178, 192, 194, 199, 200n, 202n, 203, 204, 205, 206, 207, 208. 209, 213, 214n; How to Pay for the War (World War Two) 175; Indian Currency and Finance 143, 144; journalism 151, 156, 172; The Means of Prosperity 167; A Tract on Monetary Reform 22n; A Treatise on Money 7, 8, 162, 163; A Treatise on Probability 143, 144; Quarterly Journal of Economics, article in 61 Keynes, John Neville 136, 139–140 Keynes, Lydia see Lopokova, Lydia Keynes, Milo 153n Keynesians: “extreme” 18; “gradual monetarist” 18; “moderate” 18; “new classical” 18 Kinsey, Dennis 201n Knight, Frank Hyneman 118, 133n Krugman, Paul 98n, 211, 215n Kuttner, Robert 116n Labour/Socialist Party (British) 100–101, 116, 162–163, 166, 176, 195, 196, 198, 199 Lannon, Judie 201n Latin-America 46–47, 58, 187 Leggett, Jeremy 98n Lend-Lease Act 174, 177, 179, 189, 191, 192, 194, 195, 196 Lerner, Abba 169 Leube, Kurt R. 22n Lever, William Hesketh 137 Lewis, Cherry (née Meade) 201n Liberal Party (British) 151, 162–163, 176 Lippmann, Walter 150, 154n Liquidity: -Preference 48–50, 73, 83, 84; for precautions 50; for speculation 50; for transactions 50, 55; “Trap” 61, 83, 114 Lloyd George, David 146, 147–151, 155, 162–163 London 189; and Cambridge Economic Service 8; City of 144, 151, 156; School of Economics (LSE) 169, 190; University of 143, 146 Long, Huey 181 Lopokova, Lydia 145, 151–152, 155, 188, 196, 202n Lords, House of (British) 187, 198 Louis XIV of France 147

220

Index

Low, David frontispiece, 150 Loyola, Ignatius 211 Luther, Martin 211 Lynch, Michael 97n macroeconomics 9–10, 146 Malthus, Thomas 1, 159–160; Essay on the Principle of Population 159 MacDonald, Ramsey 155, 163, 165, 166 Macmillan Committee 163 Manchester Guardian 151 Marginal Efficiency of Capital 68–70, 72–76, 86, 156, 204 margin trading 165 Marshall, Alfred 10, 20, 21n, 131, 142 Marshall, George/Marshall Plan 129, 198 Martin, William McChesney 15, 21n Matisse, Henri 143 Mayhew, Henry 138, 153n McCarthy, Joseph 181 McDonald, Colin 21n, 152n McKenna, Reginald 145–146 Meade, James 22n, 168, 186, 189, 192–193, 194, 201n, 202n Michigan, University of 127 Miller Lite 124 Miller, Rich 76n Miner, Jerry 22n Mitchell, Broadus 170n Mitchell, Louise Pearson 170n models, economic 24 Moggridge, Donald 22n, 116n, 153n, 154n, 171n, 200n, 201n, 202n, 214n monetary policy 12–13, 130, 132, 162, 203, 209, 211 money: definition of 48–54; supply of 89, 94 Morgenthau, Henry 178–179, 181, 186–187, 189–191, 195; “Morgenthau Plan” (for Germany) 191 Morris, Linda 21n Moscow 189 Multiplier, Investment 38, 43–45, 85, 165, 168, 172 National Gallery, London 147 national income see Gross National Product (GNP)/Gross Domestic Product (GDP) “National Income Machine” 77 Nation and Athenaeum 151 Neff, Jack 21n New Deal (US during 1930s) 37, 101–103; “New Jerusalem” (Britain after 1945) 192

New York City 198 New York Review of Books 98n, 201n New Zealand 194 Nicolson, Nigel 154n Nielsen, A.C. 103 Niemeyer, Oscar 161–162 Nineteenth Century, economic progress during 1–2 Nixon, Richard 110–113 Nobel Prize 16, 77, 118, 200 oil see petroleum prices oligopoly 79–80 Order of Merit (OM) 199 Organization of Petroleum Exporting Countries (OPEC) 89 Orwell, George see Blair, Eric Ottawa Agreement see Imperial Preference Oxford University 83, 141–142, 145, 155–156, 169, 185, 201n P&C Supermarket, Nottingham, Syracuse, NY 133n Peden, G.C. 170n, 171n, 201n Perry, William 8, 21n petroleum prices 15–17, 39, 96, 131 Phillips, A.W.H./Phillips Curve xvii, 22n, 90–92, 98n Phillips, Frederick 165, 168 Picasso, Pablo 143 Pigou, A.C. 169 Pimlott, Ben 202n Plesch, Janos 173 Powell, Jim 116n Press, Tina 201n Procter & Gamble 80, 97n Prospect 116n psychology of recession see expectations, business; expectations, personal psychology of recovery see expectations, business; expectations, personal public works 167 Public Works Administration (PWA) 101 Quarterly Journal of Economics 61n Reagan, Ronald 18, 110–113 Reconstruction Finance Corporation (RFC) 102 Reed, Stanley 76n Renoir, Auguste 143 research, market 8–9, 123–124 retail concentration 80

Index 221 Ricardo, David 11 Richards, Frank 152n the “Roaring Twenties” 155 Robbins, Lionel 21n, 169, 170n, 171n, 190, 195–196 Robertson, Dennis 22n, 26, 116n, 157, 169, 170n Robinson, Austin 22n, 116n, 168, 214n Robinson, Joan 15–16, 20n, 21n, 22n, 23n, 62n, 97n, 116n, 168, 201n Roosevelt, Franklin Delano 101, 130, 167, 174, 178, 181, 191, 195, 212 Roosevelt, Theodore 181 Rowntree, Seebohm 137 Royal Navy 167 Royal Opera House, Covent Garden 202n Russia 186–187 Salisbury (Britain) 139 Samuelson, Paul 179 Savannah, GA 198–199 save, propensity to 46, 56–60, 73 saving, personal/“forced” 58, 63, 89, 94, 175–177 Say, Jean-Baptiste 11 Schwartz, Anna Jacobsen 22n, 170n Seekings, Martyn 153n Seekings, Wendy 153n Seurat, Georges 143 Sheridan, Richard Brinsley 1 Sherman Anti-Trust Act 100 Shiller, Robert 59 Shone, Richard 153n Sickert, Walter 143 Simpson, Anthony 152n Skidelsky, Robert 21n, 22n, 61n, 62n, 72, 76n, 153n, 154n, 158, 170n, 171n, 173, 177, 179, 200n, 201n, 202n, 212 Skousen, Mark 98n Slater, Jan. S. 21n, 76n, 133n Smiley, Gene 116n Smith, Adam 1, 10, 11, 13, 21n, 99, 116n, 212; An Inquiry into the Nature and Causes of the Wealth of Nations 1, 21n, 116n, 118 The Smithsonian 76 South Africa 194 Soviet Union see Russia Spain 136 speculation 14, 50, 165 Spotts, Frederic 153n Sraffa, Piero 168, 174 stagflation xvii, 15–17, 22n, 53, 211 Stanford University 186

Stansky, Peter 152n Statistical Abstract of the United States 28, 40n, 41n, 61n, 62n, 66, 67, 76n, 88, 102–107, 116n statistical data available to social scientists 6–9, 192–193 statistical “reasonability” 103–104 Statistics, Annual Abstract of (Britain) 200n Steel, Ronald 154n Steering Committee on Post-War Employment (Britain) 193–194 Steindl, Josef 22n, 98n, 171n, 201n Steiner, Robert/Steiner Effect 79, 97n, 98n “Sterling Bloc” 183 Stevenson, John 170n, 171n Strachan, Hew 146, 154n Strachey, Lytton 141, 143 Sutherland, David 201n Sweden 194 Syracuse, NY: Newhouse School of Public Communications, Syracuse University 201n; Syracuse University 20, 21n, 153n, 201n; University Hospital (State University of New York Upstate Medical University) 154n, 200n, 215n Tavistock Institute, London 201n Tellis, Gerard, J. 133n temporary price reductions (in retail trade) 80 Tesco stores 125 Thatcher, Margaret 17 Thompson, J. Walter 201n The Times (London) 116n, 167 Toronto, University of 77 Toyota 42 Trade, external 107–115, 184, 208 Trade Unions 81–82 Trafalgar, Battle of 203 Trautmann, Joanne 154n Treasury (Britain) 4, 144, 155–156, 157–158, 161–162, 165, 168, 169, 176, 179, 182, 185–186, 194, 198; Budget Committee 176 Treasury (US) 15, 178, 181, 186 Truman, Harry 196, 198 Turnbaugh, Douglas Blair 153n unemployment: “cyclical” 10, 38, 192; “frictional” 10, 38, 158–159, 192; “structural”/”involuntary”/”Keynesian” 11, 38, 164, 192, 199; “voluntary” 10, 38, 192

222

Index

Unilever 13, 21n, 98n “Unitas” 188 US Census Bureau: Economics and Statistics Division see Statistical Abstract of the United States US Congress 194 US economy: activity from 1964, four phases of 88; fiscal deficit 27–28, 109–116, 209; foreign trade balance 27, 89, 95; labor productivity 30–31, 90; problems during 1970s 6, 15, 17, 40; prices, consumer 89, 93–94; recovery during 1980s 18; structural changes 27; unemployment levels 32–34, 39, 89, 91–93, 158, 166, 204 US Department of Commerce see Statistical Abstract of the United States Vedder, Richard K. 41n, 170n, 171n Versailles 147–149, 162, 169 Vicarelli, Fausto 22n, 98n, 171n, 201n Vietnam War 15, Vinson, Frederick 195–196 Von Hayek, Friedrich 169 wages: determination 80–82; “stickiness” of 81–82, 163 Wall Street, “black day” on 165

Wal-Mart stores 80, 97n, 125 Washington, DC 178, 189, 196, 198–199 Waterloo, Battle of 203 White, Harry Dexter 181, 186–187, 189–190, 195, 196 Wilkinson, Frank 22n Wilson, Thomas 41n Wilson, Woodrow 147–150, 189 Winchell, Walter 181 Wood, Kingsley 176 Woolf, Leonard 141, 153n Woolf, Virginia 141, 143, 144, 154n Works Progress Administration (WPA) 102 World Bank 186, 190, 196, 198, 213 World War One 2, 142, 145, 160, 174, 177; British war finance 175–177; postwar boom 158; prices in US and Britain during and after 160 World War Two 6, 103, 129, 138, 169, 203, 206, 210–211; British war finance 175; post-war economic development 18, 127–132; rearmament before 170, 172, 173–174 Yale University 59 Zender, Karl 21n