John Maynard Keynes: The Man from Harvey Road

During the Great Depression of the 1930s, there was serious concern about the viability of the Western economies. Britain, France, and America were in trouble. As the years went by, the market economies did not spontaneously recover. The Depression persisted.

In the 1930s the nonmarket economies staged a grand revival. They exhibited impressive growth. The Soviet Union underwent industrialization and exported agricultural crops under Stalin's Bolshevik socialism (while millions starved in the Ukraine). Germany became wealthy again and militarized itself under Hitler's national socialism (while women were removed from the work force and intellectuals fled the country). Italy became orderly--even the trains ran on time under Mussolini's fascism (while poor African nations were conquered by force of arms). The Continental message seemed clear to many in the West--extensive government control and intervention brought about economic growth and prosperity.

During the 1930s, socialism in all its variants gained many supporters. The socialist parties had their strongest followings in the United States; the labor parties were politically powerful in Britain. Perhaps government intervention was the permanent solution to economic depression and stagnation.

In the midst of these troubling developments, John Maynard Keynes emerged as a pioneer of economic theory. In economic circles, the persistence of the Depression shook confidence in laissez-faire solutions. In political circles, socialism and greater government intervention became ever more acceptable. Keynes did not believe the market economy could take care of itself, and he also feared bolshevism and the rising interest in a socialist order. Seeking a middle way, Keynes hoped to save capitalism through government intervention.

In 1936 Keynes published The General theory of Employment, Interest, and Money. His concern was that the market economies, of Britain and America in particular, were not going to pull themselves out of the Depression. He realized that capitalism did not spontaneously guarantee an economic growth path that would maintain full employment of labor. His insight was the development of a macroeconomic model that showed this inherent weakness of capitalism and provided a solution that saved capitalism from the threat of national socialism.

Savings and Investment

Keynes rejected the classical model of market stability: The casual empirical evidence of the 1930s was proof enough of its fallibility. At the beginning of the General Theory he took on J.B. Say, John Stuart Mill, and his own teacher, Alfred Marshall. Keynes contended that savings and investment do not necessarily coordinate. Referring to the classical economists, he wrote:

They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives that determine the former. (p. 21)

In Keynes view, savings is a function of income, not the interest rate, and investment is a function of the interest rate, not income. The decision to save will not necessarily bring about investment. Say's famous law (Supply creates its own demand) states that market processes are stable. Full employment is, therefore, a normal feature of capitalism. If Say's law does not hold, then markets are unstable and full employment may not be obtainable. Keynes explained:

Thus Say's law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written. (p. 26)

If savings do not signal investment, then the flow of income may not maintain full employment. A rise in savings reduces national income, which in turn reduces the demand for labor to produce income. The "chapter of economic theory" to which Keynes refers is his General Theory. He sought to explain the possibility of a persistent unemployment equilibrium in a capitalist economy.

Keynes realized that investment may not respond to declining interest rates during a depression. The decision to invest may be influenced as much by the mood of the times, and by expectations about the future, as it is by the interest rate. He wrote:

[T]here is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive… can only be taken as a result of animal spirits--of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

…Thus if the animal spirits dim and the spontaneous optimism falters, enterprise will fade and die.

In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends. (pp. 161-162)

In short, economic depression brings about psychological depression. While a drop in the interest rate may make investment projects technically profitable, it will not, on its own, make investors more optimistic. Money kept in banks need not be invested.

Also, in a depression, interest rates may be so low that everyone prefers to hoard cash. Any new money injected into the economy by the central bank will be hoarded by individuals. The central bank is then unable to encourage more investment by lowering interest rates any further.

Thus, capitalist markets may not coordinate savings with investment. For savers, very low interest rates bring about a very high liquidity preference. Savers will choose to hold their savings in money, rather than in bonds or stocks. Any increase in the level of loanable funds in the money market will be hoarded as cash and not moved into investments. For investors, very low interest rates may not stimulate a demand for investment. Pessimistic expectations about future conditions inhibit investment in a depressed economy.

Wages and Unemployment

In the General Theory, Keynes contends that the product and money markets in a capitalist economy are inherently unstable. Therefore, unemployment is the rule rather than the exception. Near the end of the book, Keynes investigates the labor market, asking why unemployment persists in labor markets during a depression. If there is a surplus of labor, Keynes contended, the money wage will not undergo the needed decrease as required to bring about labor-market equilibrium. Money wages for labor are rigid in the downward direction. Therefore, if the demand for labor drops relative to the supply of labor, as it does during a depression, money-wage rigidity acts as a price floor and produces a surplus of labor. Unemployed labor persists because wages will not fall to bring about labor-market equilibrium.

Keynes posited a number of explanations for wages' downward rigidity. He believed that trade unions with mandatory collective bargaining power can demand wages about the equilibrium rate. The government can establish minimum-wage requirements that make downward money-wage flexibility illegal. In addition, the workers may suffer from "money illusion"--the mistaken notion that one's real income is measured in money terms and not real terms. If the price level falls, labor-market equilibrium requires a proportional decline in money wages. However, if workers suffer from money illusion, they think that a decrease in their money wage is also a decrease in their real wage, and they resist this reduction. However, should prices rise, workers will not withdraw their supply of labor if their money wages remain constant while their real wages decline. Keynes observed:

Now ordinary experience tells us, beyond doubt, that a situation where labor stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labor whenever there is a rise in the price of wage-goods. (p. 9)

In short, Keynes did not believe that a system of flexible wages exists in a market economy. In times of depression, money wages will not adjust downward to bring about labor-market equilibrium. Keynes went further to contend that such wage flexibility is undesirable:

It follows therefore, that if labor were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing money-wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. The chief result of this policy would be to cause a great instability of prices, so violent perhaps as to make business calculations futile in an economic society functioning after the manner in which we live. To suppose that a flexible wage policy is a right and proper adjunct of a system which is on the whole one of laissez-faire is the opposite of the truth. (p. 269)

Kenyes' theory of the labor market is very interesting in light of the economic developments in the 1930s. On the one hand, he says that the capitalist economies will face serious problems of unemployment due to the rigidity of wages; on the other hand, he said that flexible wage rates cause serious problems for capitalist economies. In contrast to totalitarian regimes, Keynes saw capitalism as a system with flexible prices and rigid wages. He wrote:

Except in a socialized community where wage-policy is settled by decree, there is no means of securing uniform wage reductions for every class of labor. (p. 267)

It is only in a highly authoritarian society, where sudden substantial, all-around changes could be decreed that a flexible wage-policy could function with success. One can imagine it in operation in Italy, Germany or Russia, but not in France the United States or Great Britain. (p. 269)

In the General Theory, Keynes developed a model of capitalism radically different from that of classical economists. He saw capitalism as inherently unstable and incapable of spontaneously maintaining full employment. According to Keynes, a decline in national income will bring about a decline in the demand for labor. Because of downward wage rigidity, unemployment will persist. With people out of work, the demand for consumption will be low; with business depressed, the demand for investment will be low. As Keynes saw it, the free-market economies of Britain, America, and France could not escape the Depression unless they changed their fiscal policies.

Saving Capitalism

The General Theory does not merely develop a radical new macroeconomic model of capitalism. Keynes not only saw a problem, he recommended a solution. To save capitalism from socialism's threat, he proposed extensive government intervention to stimulate the depressed economies.

Ironically, Keynes was aware that his policies would be easier to apply in a dictatorial socialist system, than in a democratic capitalist system. He essentially recommended socialist prescriptions to save capitalism from socialism. The German edition of the General Theory, which appeared in September 1936, was a best-seller in National Socialist German. In its preface, Keynes wrote:

The theory of aggregate production that is the goal of the following book can be much more easily applied to the conditions of a totalitarian state than the theory of the production and distribution of a given output turned out under the conditions of free competition and of a considerable degree of laissez-faire. (Hazlitt, p. 277)

Keynes proposed discretionary fiscal policy to stimulate the depressed economy directly. In his view, since the private sector was not demanding enough consumption or investment to maintain full employment, the government had to run a deficit. Therefore, government spending had to rise or taxes must decline. In the words of President John Kennedy, Keynes called for "an unbalanced budget for a balanced economy."

Keynes' fiscal policy advocated increased government spending instead of reduced taxes, because government spending would impact immediately on aggregate demand, while tax reduction would have to wait until households decided to spend increased earnings as disposable income. Not particularly concerned about the exact nature of the government spending, Keynes' message was that government spending was necessary to eradicate unemployment. Any type of spending would do. He concluded:

Pyramid-building, earthquakes, even wars may serve to increase wealth….

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … , there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (p. 129)

In essence, Keynes proposed government intervention to maintain capitalist economies at full employment. He was interested in the macroeconomic results of this intervention. If expansionary monetary policy worked, fine. However, in a serious depression, monetary policy is weak. Fiscal policy would have to pull up the economy.

Keynes' proposals to build pyramids or to bury bank notes in abandoned mines were not adopted. Britain, America, and France did not experience earthquakes or other natural disasters. However, his suggestion of war fulfilled. Shortly after the release of the General Theory, Britain and France went to war against Nazi Germany. America joined soon thereafter.

Keynes advocated a full-scale program of central economic planning. According to his plan, the market should be guided or fine-tuned by government-employed experts. Government policies should be concerned with more than low interest rates and deficit spending--they should also directly influence the levels of private consumption and investment. On controlling consumption, Keynes wrote:

The state will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the interest rate and partly, perhaps, in others ways. (p. 378)

Believing that capitalism will not automatically turn savings into investment, Keynes contemplated a nationalization of investment. The idea of government control of investment appears throughout the General Theory. He explained:

I expect to see the State, which is in the position to calculate the marginal efficiency of capital-goods on long views and on the basis of general social advantage, taking an ever greater responsibility for directly organizing investment. (p. 164)

I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands. (p. 320)

I conceive, therefore, a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment. (p. 378)

In order to save capitalism from its own destruction and the threat of national socialism, Keynes proposed to give government control of all investment, give it the power to spend more than it took in as taxes, and give it the power to influence private consumption patterns. In short, to save capitalism from socialism, Keynes proposed to socialize capitalism!

At the end of the book, he defended his policies as necessary for individual freedom. He stated:

Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to investment, 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 a condition of the successful function of individual initiative. (p. 380)

Contradictory Conclusions

The General Theory is a complex and fascinating work. However, the message that capitalism can only be saved if it is socialized, and that freedom can only be guaranteed if it is taken away, is Orwellian doublespeak at its best. How could a person as brilliant as Keynes have reached such seemingly contradictory conclusions? The answer to this question can be found in what his first biographer and friend, Sir Roy Harrod, called "the presuppositions of Number 6 Harvey Road" (p. 192-93).

Kenyes was born in 1883 in Cambridge, England, in the twilight of the Victorian era, at his parents' home at Number 6 Harvey Road. He spent his formative years in Cambridge in a milieu dominated by the presuppositions of Number 6 Harvey Road. The presuppositions are three in number:

· The British Empire is stable and will continue for many years to come.
· Material progress, that is increasing economic output per worker, will continue without ceasing.
· The British government will always be in the hands of an intellectual aristocracy that uses methods of persuasion.

These presuppositions are the key to understanding Keynes' approach to economic policy. They were so much a part of Keynes' worldview that he did not realize what would happen if his ideas were applied within a democratic institutional framework. Harrod certainly realized this when he wrote of the economist five years after Keynes' death in 1946.

Keynes tended till the end to think of the really important decisions being reached by a small group of intelligent people, like the group that fashioned the Bretton Woods plan. But would not a democratic government having a wide multiplicity of duties tend to get out of control and act in a way of which the intelligent would not approve? This is another dilemma--how to reconcile the functioning of a planning and interfering democracy with the requirement that in the last resort the best considered judgment should prevail. It may be that the presuppositions of Harvey Road were so much of a second nature to Keynes that he did not give the dilemma the full consideration which it deserves. (p. 193)

As Milton Friedman has pointed out in his television series, Free to Choose, it was one of the great tragedies of the twentieth century that Keynes did not live another fifteen years. Had he done so, it is conceivable that he would have realized the shortcomings of the presuppositions of Harvey Road and taken action to correct the policy prescription errors of his overzealous disciples, both in Britain and the United States.