John Maynard Keynes corresponded with George Bernard Shaw for decades after meeting him at Cambridge. Shaw was not only a famous play-wright, but also an amateur economist (see Chapter 7). In January 1935 Keynes wrote to Shaw:
To understand my state of mind, however, you have to know that I believe myself to be writing a book on economic theory which will largely revolu-tionize – not, I suppose, at once but in the course of the next ten years – the way the world thinks about economic problems.1
Keynes’s forecast was remarkably accurate. His characterization of his project as “a book on economic theory,” however, was a slightly misleading.
Despite the eventual publication title of The General Theory of Employment, Interest, and Money, he was – as many commentators have noted – very much writing a tract for the times.
Keynes considered it his duty to tackle current issues. In a memorial for Alfred Marshall written in 1924, Keynes declared that the day of the the-oretical economic treatise had passed. The modern economist must aim for current policy relevance: “Economists must leave to Adam Smith the glory of the quarto, must pluck the day, fling pamphlets into the wind, write always sub specie temporis and achieve immortality by accident, if at all.”
In much the same spirit his biographer Roy Harrod attributed to Keynes the belief that “progress in economics would lie in the application of theory to practical problems. His recipe for the young economist was to know his Marshall thoroughly and read his Times every day carefully.”2
1 John Maynard Keynes, The Collected Writings of J. M. Keynes, vol. XIV, ed. Donald Moggeridge (Cambridge: Cambridge University Press, 1973), p. 492.
2 Keynes, “Alfred Marshall, 1842–1924,” Economic Journal (1924), in Keynes, Collected Writings, vol. X, p. 199; R. F. Harrod, The Life of John Maynard Keynes (London: Macmillan, 1951), p. 324.
Keynes’s success over the next three decades at revolutionizing the way the world thinks was celebrated by Time magazine in 1965, when it put Keynes’s portrait on the cover and titled its cover story “The Economy: We Are All Keynesians Now.”3 The story applauded the apparently successful use of Keynesian macroeconomic thinking by the economists, on leave from academia, who were then formulating policy for the administration of Lyndon Johnson:
Keynes and his ideas, though they still make some people nervous, have been so widely accepted that they constitute both the new orthodoxy in the uni-versities and the touchstone of economic management in Washington. . . . In Washington the men who formulate the nation’s economic policies have used Keynesian principles not only to avoid the violent cycles of prewar days but to produce a phenomenal economic growth and to achieve remarkably stable prices. . . . Basically, Washington’s economic managers scaled these heights by their adherence to Keynes’s central theme: the modern capital-ist economy does not automatically work at top efficiency, but can be raised to that level by the intervention and influence of the government. . . . In Washington the ideas of Keynes have been carried into the White House by such activist economists as Gardner Ackley, Arthur Okun, Otto Eckstein (all members of the President’s Council of Economic Advisers), Walter Heller (its former chairman), M.I.T.’s Paul Samuelson, Yale’s James Tobin and Seymour Harris of the University of California at San Diego.4
Keynes’s influence on policy was most famously confirmed when the next U.S. President, Richard Nixon, told an interviewer in 1971: “I am now a Keynesian in economics.”5
THE DEPTHS OF THE DEPRESSION
After nearly four years of sharp decline, with industrial production falling by more than half, the U.S. economy hit bottom in early 1933. It struggled upward for the next four years, but in 1937 began to decline sharply again.
From May 1937 to May 1938 industrial production fell by one-third. A sec-ond recovery then began. By September 1939 production was back to its September 1929 level – but had lost a decade of normal growth. Economists Harold L. Cole and Lee E. Ohanian have reported: “Real gross domestic
3 Available online at http://www.time.com/time/covers/0,16641,19651231,00.html.
4 “The Economy: We Are All Keynesians Now,” Time (31 December 1965), available online at http://www.time.com/time/magazine/article/0,9171,842353–1,00.html. For more on the influence of Keynesian fiscal policy advice see Chapter 15.
5 Richard Reeves, President Nixon: Alone in the White House (New York: Simon & Schuster Paperbacks, 2001), p. 295.
product per adult, which was 39 percent below trend at the trough of the Depression in 1933, remained 27 percent below trend in 1939.” Not until 1942 did real output finally return to its pre-Depression trend line.6
Why was the economy languishing through the 1930s? A number of eco-nomic historians have cited government policies that hampered market adjustments and thereby delayed recovery. Thomas E. Hall and J. David Ferguson’s 1998 account of “perverse economic policies” included the Smoot-Hawley tariff of 1930 and the tax hike of 1932 under the Hoover administration; followed by the National Industrial Recovery Act (NIRA) and the Agricultural Adjustment Act (AAA) of 1933–5, the payroll tax of the Social Security Act of 1935, and other tax hikes in 1933, 1934, 1935, and 1936 under Roosevelt.7 Other authors have emphasized that Hoover tried to prop up nominal wages in the face of shrinking nominal demand, and Roosevelt redoubled the effort in the National Labor Relations Act (NLRA) of 1935, policies that priced workers out of jobs.8 Cole and Ohanian, study-ing the NIRA and the NLRA, have found that “New Deal cartelization poli-cies are an important factor in accounting for the failure of the economy to recover back to trend.”9
Milton Friedman and Anna J. Schwartz famously emphasized perverse monetary policy in explaining the depth and persistence of the Great Depression. In their account, the initial decline was so deep because the money supply contracted by one-third between 1930 and 1933. Prices and wages that did not immediately decline in the same proportion, because of natural or policy-enhanced “stickiness,” were now too high to clear product and labor markets, creating unsold inventories and unemployment. They pointed out that the Federal Reserve, having taken over superintendence of the banking system from private clearinghouse associations, failed to do what the clearinghouses had done in previous crises to shore up the banks, stem bank runs, and prevent such a large monetary contraction. Later Fed policy, in their account, actively stifled the recovery. In 1936 and 1937
6 Frank G. Steindl, “What Ended the Great Depression? It Was Not World War II,”
Independent Review 12 (Fall 2007), pp. 180–1; Harold L. Cole and Lee E. Ohanian,
“New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112 (August 2004), pp. 779–81.
7 Thomas E. Hall and J. David Ferguson, The Great Depression: An International Disaster of Perverse Economic Policies (Ann Arbor: University of Michigan Press, 1998), pp. 71–3, 105, 122–6, 128–9, 144–5, 147.
8 Lowell Gallaway and Richard Vedder, Out of Work: Unemployment and Government in Twentieth-Century America (New York: Holmes and Meier, 1993).
9 Cole and Ohanian, “New Deal Policies,” p. 779.
the Fed, observing commercial banks’ large excess reserves (which banks chose to hold so as to be prepared to meet runs and other deposit out-flows), imposed higher required reserve ratios on bank deposits to “mop up liquidity.” To reestablish their desired free reserves (required reserves being largely useless for meeting deposit outflows), banks reduced the amount of deposits they created per dollar of reserves. At about the same time, in 1936–8, the U.S. Treasury and Fed together were “sterilizing” gold inflows from abroad, that is, offsetting the expansionary effect the inflows would normally have on bank reserves. Together these policies shrank the U.S.
money supply again, causing the recovery to go into reverse.10
KEYNES’S DIAGNOSIS
These retrospective accounts by economic historians emphasize gov-ernment policy mistakes that deepened the initial decline and hindered recovery. Keynes offered a very different account: The market economy had collapsed on its own, had become trapped in a vicious circle, and could not free itself. It needed government help. Keynes’s biographer Robert Skidelsky has commented: “It was the collapse of America which started him thinking that perhaps there was a fundamental flaw in the capitalist system, which meant that even very successful economies could suddenly collapse.”11
Keynes sketched out a “vicious circle” argument in his December 1930 essay “The Great Slump of 1930.” If a nervous public saves its income by hoarding money, rather than spending it on consumption goods or saving it in a form that finances capital investment, he argued, then both consumer-goods industries and capital-consumer-goods industries (factory and housing con-struction, machine-making, mineral extraction) will suffer losses. Banks will become reluctant to lend and businesses will become reluctant to invest.
The problem will snowball:
If the public are reluctant to buy [consumption goods, or to finance invest-ment] . . ., then . . . all classes of producers will tend to make a loss; and general unemployment will ensue. By this time a vicious circle will be set up, and, as a result of actions and reactions, matters will get worse and worse until some-thing happens to turn the tide. . . . If, then, I am right, the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for
10 Milton Friedman and Anna J. Schwartz, A Monetary History of the United States (Princeton, NJ: Princeton University Press, 1963), chs. 7, 9.
11 Commanding Heights, Lord Robert Skidelsky interview. Available online at http://www.
pbs.org/wgbh/commandingheights/shared/minitext/int_robertskidelsky.html.
capital investment . . . [T]he reluctant attitude of lenders has become matched by a hardly less reluctant attitude on the part of borrowers.12
Keynes went on to advise that a change in monetary policy could jump-start the world economy, although instead of “jump-jump-start” he used a dif-ferent automotive metaphor. He suggested that the capitalist economy was having “magneto” (alternator) trouble, as against the socialist idea that the entire automobile should be replaced.13 He proposed that the Federal Reserve, the Bank of England, and the Bank of France “should join together in a bold scheme to restore confidence to the international long-term loan market; which would serve to revive enterprise and activity everywhere, and to restore prices and profits, so that in due course the wheels of the world’s commerce would go round again.”14
In an essay published a month later, Keynes omitted the distinction between troublesome hoarding and the helpful kind of saving that finances capital investment. Now saving as such was a problem:
There are to-day many well-wishers of their country who believe that the most useful thing which they and their neighbors can do to mend the situation is to save more than usual. . . . Now, in certain circumstances all this would be quite right, but in the present circumstances, unluckily, it is quite wrong. It is utterly harmful and misguided – the very opposite of the truth. For the object of saving is to release labour for employment on producing capital-goods such as houses, factories, roads, machines, and the like. But if there is a large unem-ployed surplus already available for such purposes, then the effect of saving is merely to add to this surplus and therefore to increase the number of the unemployed. Moreover, when a man is thrown out of work in this way or any other way, his diminished spending power causes further unemployment amongst those who would have produced what he can no longer afford to buy.
And so the position gets worse and worse in a vicious circle.
To underscore his argument about how saving would reduce employ-ment, Keynes put a number on the size of the effect:
The best guess I can make is that whenever you save five shillings, you put a man out of work for a day. . . . After all, this is only the plainest common sense. For if you buy goods, someone will have to make them. And if you do not buy goods, the shops will not clear their stocks, they will not give repeat orders, and some one will be thrown out of work.15
12 Keynes, “The Great Slump of 1930,” in Keynes, Essays in Persuasion (New York: W. W.
Norton, 1973), pp. 142–4. Keynes made the argument in more technical terms in his Treatise on Money (London: Macmillan, 1930), published the same month.
13 Keynes, “Great Slump,” p. 139.
14 Ibid., p. 146.
15 Keynes, “Economy: (i) Saving and Spending [January 1931],” in Keynes, Essays in Persuasion, pp. 151–2. Nowhere in the essay did Keynes spell out any statistical estimates or calculations to support the “five shillings” number.
As he had before, Keynes recommended public works spending to boost demand for labor and goods.16 Note that, in Keynes’s account here, addi-tional saving does nothing to promote addiaddi-tional investment spending by reducing the interest rate facing investment borrowers.
Paul Krugman, in his Introduction to a recent edition of The General Theory, has usefully summarized its diagnosis of depression and policy message in four bullet points. To quote them:
Economies can and often do suffer from an overall lack of demand, which
• leads to involuntary unemployment.
The economy’s automatic tendency to correct shortfalls in demand, if it
• exists at all, operates slowly and painfully.
Government policies to increase demand, by contrast, can reduce
unem-• ployment quickly.
Sometimes increasing the money supply won’t be enough to persuade the
• private sector to spend more, and government spending must step into the breach.
Krugman commented that “these ideas weren’t just radical when Keynes proposed them; they were very nearly unthinkable,”17 but in fact by 1936 many leading and nonradical economists, even relatively free-market econ-omists at the University of Chicago, had proposed government spending on public works programs to relieve the unemployment of the early Great Depression.18
Keynes’s views that the collapse and nonrecovery reflected a flaw in the market economy, and that government spending to boost demand was needed for recovery, stood in sharp contrast to F. A. Hayek’s contempora-neous views that the collapse reflected a flaw in previous (overly expansive) monetary policy, and that the economy would best recover left alone (given a monetary policy framework to prevent excessive shrinkage of the money stream). In Hayek’s theory the crisis was the result of credit expansion
16 Ibid., p. 153. Keynes likewise advocated public works, financed by deficit spending, in a series of four newspaper essays reprinted as John Maynard Keynes, The Means to Prosperity (London: Macmillan, 1933).
17 Paul Krugman, “Introduction,” in John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Palgrave Macmillan, 2007).
18 See J. Ronnie Davis, The New Economics and the Old Economists (Ames: Iowa State University Press, 1971), and William J. Barber, From New Era to New Deal: Herbert Hoover, the Economists, and American Economic Policy, 1921–1933 (New York:
Cambridge University Press, 1985). For a brief review of the deficit-spending pro-posals by Chicago economists in the early 1930s see Richard M. Ebeling, “Monetary Central Planning and the State, Part 22: The Chicago School Economists and the Great Depression,” Freedom Daily (October 1998), available online at http://www.fff.org/
freedom/1098c.asp.
having allowed investment to outrun voluntary saving, so government pol-icies to augment consumption demand at the expense of saving would only deepen the crisis. Friedman and Schwartz later offered a third diagnosis, namely that the recession would have been routine except for the collapse of the money stock after 1929. Their retrospective recovery prescription focused on restoring the level of the money stock.
DID KEYNES “INVENT MACROECONOMICS”?
Keynes’s approach to explaining the Depression introduced novel con-cepts to the study of the aggregate economy. But it is an exaggeration to say, as Skidelsky has said, that “Keynes was the real inventor of macroeconom-ics. Concepts we take for granted today, like gross domestic product, the level of unemployment, the rate of inflation, all to do with general features of the economy, were invented by him.” In fact Irving Fisher at the turn of the century had developed the Quantity Theory of Money, based on work by Simon Newcomb and earlier economists.19 Fisher’s theory included a broad concept of the economy’s aggregate real transactions, for which real gross domestic product is a more readily measured proxy. Fisher sought to explain the rate of inflation and the effect of inflation on nominal interest rates. Keynes did not invent these concepts. Later in his interview Skidelsky acknowledged the point: “Before Keynes, there was a theory of money, the quantity theory of money, which maybe you could say is the start of macroeconomics.”20 Years before Fisher, as we noted in Chapter 3, there were the British theorists of the mid-nineteenth century – the Banking, Currency, and Free Banking schools – who sought to account for fluctua-tions in the levels of aggregate output and unemployment. Still earlier there were discussions of output as a whole by Malthus, Ricardo, and Say, consid-ered later in the present chapter.
Skidelsky continued: “Keynes’s was a monetary theory of production. He incorporated the theory of money into a theory of production and showed how what people did with their money could affect the level of production.”
There was in the General Theory, however, no theory of production in the usual sense of an analysis of how the economy transforms raw materials and labor into final goods and services. That monetary disturbances – shocks to money supply or demand – could cause fluctuations in the level of pro-duction was not a new idea. Fisher emphasized it, as did Hayek and Mises,
19 We discuss Newcomb, Fisher, and the quantity theory in Chapter 12.
20 Commanding Heights, Skidelsky interview.
as did other monetary theorists in the 1920s and early 1930s like Dennis Robertson and Ralph Hawtrey, as did the mid-nineteenth-century writers.
WHAT WAS NEW IN KEYNES
What was new in The General Theory was the disappearance of inherited past investment (working through multiperiod production as analyzed by Jevons, Böhm-Bawerk, and Wicksell) from the theory of what determines the volume of consumable output. All focus was now on current-period investment and other current expenditures (consumption, government spending, net purchases by the rest of the world) as determinants of current output. As Keynes summarized his new conception in the preface to the 1939 French edition:
It is shown that, generally speaking, the actual level of output and employ-ment depends, not on the capacity to produce or on the pre-existing level of incomes, but on the current decisions to produce which depend in turn on current decisions to invest and on present expectations of current and pro-spective consumption.21
In place of the intertemporal Hayekian triangle, the textbook rendering of Keynes’s view of the determination of current income in a closed national economy is a “circular flow” as in Figure 5.1.
In the textbook Keynesian income-expenditure model based on the cir-cular flow concept, current expenditure E (the sum of household purchases C + business investment purchases I + government purchases G) determines the equilibrium current output of goods and services Y. The level of expen-diture (and thus equilibrium income) depends on the share of income that goes to consumption spending, what Keynes called the “propensity to con-sume.” In Keynes’s own summary:
Moreover, as soon as we know the propensity to consume and to save (as I call it), that is to say the result for the community as a whole of the individual
Moreover, as soon as we know the propensity to consume and to save (as I call it), that is to say the result for the community as a whole of the individual