As if Keynes had never lived

Talk on 80th anniversary of publication of Keynes’s General Theory in King’s College Cambridge 

The 80th anniversary of the publication of Keynes’s General Theory was celebrated on Saturday 8th October 2016 at a conference in Kings College Cambridge. After sessions on Keynes’s wider involvement and engagement with the arts, in particular painting and book collecting, there was first a session on the German and French translations of his book and then a session on the ‘The impact of The General Theory on economic policies during the last thirty years (1886-2016)’. Geoff Tily presented on events and outcomes in the UK. His paper was headed ‘As if Keynes had never lived: the second UK and world crisis of financial globalization’ (available here). 

The conference website with papers for all sessions is here

Great honour to be part of this truly fitting celebration of Keynes’s life and work. I am immensely grateful to Hélène in particular and also indirectly to Dr Armin Haas.

Let me make some introductory remarks. 

I hope we all share a Keynes as a monetary economist, concerned with answering Hayek’s challenge, and devising a economics for systems based on money understood properly as a social technology rather than on ‘real exchange’.  

Up until this rather acrimonious debate with Hayek, he overlaid a theory of credit on the classical theory.

But the work we celebrate today was a wholly new theory of a monetary economy, with money and credit fully integrated. The practical upshot was of vast significance.

Written in the wake of the great depression, he argued that crisis was not endemic to market economies. 

Economic failure was instead a result of failures of the financial or monetary system.

The theory was then the means to an alternative system, with money deployed to foster productive activity, employment and stability.

Such a system required major institutional reform at both international and domestic levels. I have listed them in my paper: from the international clearing union and capital control, to keeping bank rate permanently unchanged and extensive changes to government debt management policy.

Across all these processes, the governing operational consideration was the paramount importance of maintaining permanently low interest rates. 

My judgement is that the relation between prosperity and interest was the most fundamental conclusion of The General Theory of Employment, Interest and Money. Though he was hardly the first to see this. As he put it, several milleniums of usury doctrine “deserved rehabilitation and honour”.

The political ramifications were no less fundamental.

His system did not set the market against the state, but cut across this common characterisation of right and left.

Ultimately we are led to the conclusion that the interests of finance and wealth are wholly opposed to the interests of society as a whole. A monetary environment conducive to wealth was contrary to production and so to employment. Marx’s class interests were repositioned, with labour and industry having common cause against finance.

As the world economy continues to convulse in the wake of the GFC, and with finance’s dominance damaged but undiminished, the relevance of this analysis should be obvious. 

The talk follows roughly the structure of the paper.

As the organisers requested, ahead of addressing events of the last 30 years, I set out a theoretical framework and also overview post-war policy and events – I also separate out the 1970s inflation in the middle and cover the 1930s at the start.

An annex has six charts of key macroeconomic variables over the past century.

I will close with remarks on finance, democracy and economics today.

The full story is complex and involved. For today, the thread through the talk is the rate of interest, with apologies to those who have heard it too often. 

Very brief remarks on the 1930s

So I begin when Keynes’s impact on policy begins: after Britain came off the gold standard in September 1931. 

His Treatise had just been published, where he had tentatively seen the key role of interest. As Roy Harrod would put it, “he had become convinced that the time was ripe for a large and permanent reduction through the world”.

Keynes devised the UK exchange management system that permitted the rapid reduction of Bank rate to 2 per cent. And the conversion operation on the 1917 war loan began action on the long-term rate.

In parallel, theoretical debate and thinking led from the Treatise to the General Theory.

Theoretical framework

In section 3 I outline how the central role of the rate of interest emerges from the General Theory.  

He set the scene in an article in The Listener magazine, just over a year before the publication of his book.

In the classical theory the rate of interest was a passive consequence of the dominant forces of productivity and thrift. And so was impervious to policy.

Keynes deconstructed the ‘classical doctrine’ to be based instead on three ‘psychological propensities’: liquidity preference; the badly named ‘marginal efficiency of capital’ (alternatively the demand for capital investment); and the ‘marginal propensity to consume’ (which isn’t really featuring today).

Diagrammatically the single system of the conventional theory is split into two separate theories of interest on the left and a theory of investment on the right, akin to two models of supply and demand. Notation:

On the left, r is the rate of interest; M is the money supply (carefully understood, see below).

On the right, r is again the rate of interest; I is the level of investment.

I cannot do justice to this in the time available: the fuller theory is in Victoria Chick’s Macroeconomics After Keynes and my Keynes Betrayed.

I want to explain the outcomes of interest today as the result of shifts in and movements along these curves. While I don’t believe that Keynes’s conceptions can be represented algebraically, for me these diagrams capture the essence of the theory, and perfectly well explain events of the past century and the associated policy choices. The relevant lines are highlighted in red, as the story unfolds.

I’m going to labour it because I am not sure that outcomes are usually understood in this way, even if the building blocks are familiar. (Familiar that is to the economics part of the audience; I hope it’s not too oblique for others.)

On the left, the liquidity preference theory looks like the LM of ISLM but is wholly different. The rate of interest is a monetary phenomenon, arising from the supply and demand for money as a store of value. ISLM is a loanable funds theory of credit, which Jörg Bibow has categorically refuted.

The long-term rate of interest was set according to the schedule of liquidity preference (LP) which shifts according to changed expectations about the future, and the supply of money as a store of value. 

His theory explained how policymakers could manipulate expectations (and hence shift the schedule of liquidity preference) to set rates of interest across the spectrum. In practise this was achieved with debt management policy. In this context money as a store of value is the supply of short term debt, Treasury bills in the UK.

The basic intuition is simple: the government can either set the price or quantity of its gilts.

If the government forces onto the public its own preference for certain maturities, the public sets the price. This is the norm: the government want to borrow long and restrict the short-term debt. But if the public’s preference for instruments of different maturities is met, the government can set the price.

In practice Keynes devised the ‘tap issue’ process for the issue of government debt and also Treasury deposit receipts to help accommodate the likely latent higher demand for short-term debt. Capital controls were in place from 1932 to prevent distortions from other countries offering higher rates.

Under Keynes’s theory of investment, the amount of investment carried out by firms then depends on the marginal efficiency of capital (MEC) schedule that reflects entrepreneurs’ expectation of the rates of return on undertaking capital expenditure.

These expectations are uncertain, and in the General Theory the schedule shifts according to the so-called animal spirits of the corporate sector.

The theory leads to a unique outcome. The MEC in a given state of expectation is a demand schedule for investment that is set against a supply of funds at ‘the’ rate of interest. This is wholly different from the IS arrangement. Here  the supply of funds, which includes credit, is endogenous at the prevailing rate of interest. The full analysis is in Paul Davidson’s masterful ‘Finance, funding, saving and investment’. 

This then is the key mechanism of the general theory. Liquidity preference manipulated. Supply of floating debt increased. Interest rate down. Investment up.

Investment then leads to output and employment in the familiar way. 

This chart shows the extent to which the long term rate of interest has conformed to this prescription over the past century or so. These are US real rates, but the corporate rate in orange is likely to underpin the rate of interest for the private sector throughout the world.

We see the two financial globalizations of the 1920s and from the 1980s underpinned by dear money. And in contrast, the cheap money of the post-war golden age.

Post-war ‘bastard golden age’

Though Richard Kahn called it the bastard golden age.

On one level, the post-war era was very different to anything that had ever been before, but on another level it fell far short of Keynes ideal.

The nationalisation of the Bank of England in 1945 was profoundly symbolic of the assertion of public agency over finance.

From a monetary point of view, the labour government were true to Keynes and held interest rates low. But their efforts were gradually undermined. They lost office by trying to do the right thing on fiscal policy, cutting spending back to offset the excess demand caused by Korean War obligations. 

Under the Tories, in 1951 Bank rate was raised for the first time in 20 years, and effectively handed back to Bank of England control. Though this came in parallel to a global shift, led by the US under the Federal Reserve–Treasury Accord.

Right through to Harold Wilson’s governments, Bank rate policy was set on an increasingly contractionary course.

This was exacerbated by exchange rate arrangements that were akin to gold in effect if not appearance; and through which the US imposed its will on the post-war world.

In contrast, Keynes’s clearing union scheme should have allowed no single country to dominate.

All that said, policy was allowed to operate so that aggregate demand was unprecedentedly vigorous.

In spite of undoing Keynes’s specific policies, as the earlier chart showed, the real rate was held low for more than three decades.

In parallel, aggregate demand was supported by a progressive approach to government expenditure. 

But as this expenditure breakdown of GDP growth rates by decade make clear, the primary driver of economic prosperity was investment growth.

The result was thirty years of unprecedentedly low unemployment, a narrowed distribution of income, as well as great social gains and creative advance.

It is to undermine wholly Keynes’s legacy by attributing these gains to fortunate supply-side conditions, and unfortunately all too common. 

The 1970s inflation

In section 5 I look at the means to a more realistic account of the 1970s than oil shocks and trade unions.  

A lesson of the bastard golden age was that there were diminishing returns to expansionary fiscal policy in countering contractionary monetary policy.

But other factors are important and rarely considered.  

Fundamentally the goalposts were moved from employment to growth; from the level of activity to rate of change.  Most strikingly with the OECD target for 50 per cent growth in the 1960s.

The 1970s then saw the chaotic liberalisation of domestic credit through the Bank of England’s competition and credit control regime, exacerbated by the ludicrously expansionary initiatives of the Heath government – the ‘Barber boom’.

Trade unions may not have helped, but their actions were symptoms and not cause.

Above all, the inflationary outcome did not reflect any flaws in the General Theory.

But obviously, regardless of reality, full financial globalization began.

Financial globalisation

To assess the latest thirty years in the UK, we must begin in 1979.

From that point Keynes’s monetary policies were set wholly in reverse.

Capital controls were removed; Bank rate was increased with unprecedented aggression, and debt management policy reverted to quantity rather than price. The supply of money was contracted through over-issuing long-term government debt and reducing greatly the issue of Treasury bills.  

Financial markets must have understood interest rates were on their way up; so their expectations of interest rates changed and hence liquidity preference shifted out. Expectations became reality. Higher interest meant lower investment.

Initially, as with the ‘Volker shock’ in the US, the impact on unemployment was brutal.

But eventually severe slump gave way to severe volatility. 

On the basis of Keynes’s theory, the effect of a dear rate of interest can be partly compensated by a rightwards shift in the demand for investment. Optimism about yields (temporarily) triumphs over a monetary environment at odds with private investment.

For Keynes this arrangement was deeply dangerous and ultimately unsustainable.

The intuition is very straightforward. There is a fundamental confusion that the rate of interest is inversely related to the amount of lending by the financial sector.

Policymakers think that dear money restrains lending: the real problem is that it doesn’t.

Dear money instead reduces the probability of repayment: as it is far easier to earn a low rather than a high rate of interest. 

Eventually those firms that were excessively optimistic about investment yields will be disappointed by inadequate revenues.

Keynes did not go there, but the inevitable consequence of these processes on a systemic basis is a ‘debt inflation’ – with aggregate corporate liabilities growing increasingly out of line with incomes.

Unsustainable by definition, the situation must end in severe collapse. 

Just as Keynes’s understanding of the great depression was centred on investment, I regard corporate excesses as the original cause of the processes that led to financial collapse in 2007. This unfolded especially over the 1990s, with the ‘’ ‘new economy’, accompanied by very rapid debt and asset inflations. 

This chart shows two measures of this sharp debt inflation from the mid-1980s on different time horizons. On the left a longer-run with debt as a share of GDP. On the right a shorter run with debt as a share of corporate disposable income.

The corporate excess initially stopped almost exactly at the turn of the millennium. This can be seen in capital investment data, but even more clearly in financial market data. 

For example the UK FTSE 100 has never materially exceeded the 7000 monthly peak it reached in December 1999.

Afterwards came the purely speculative phases over the 2000s: residential and commercial property inflations, a splurge on consumer credit and an explosion of complex financial products.  Each of these was fostered by continued liberalisations of finance. All had in common borrowing on the basis of future expectations that could not be met. And it all ended in the financial crisis which I have beginning in August 2007, and of which the housing expansion and Lehman Bros collapse were symptoms not cause. 

 The present

We arrive basically in the present, with events all too familiar.

Policymakers have seemingly operated only to restore business as usual. The job was done when the massive support to the financial sector was successful in arresting economic collapse. A timid fiscal stimulus was then followed by the social injustice and intellectual travesty of austerity.

The decline may have been arrested, but no dynamism has been restored to the economy, with falling real wages still the norm. To the extent there is expansion, it is primarily based on asset inflations. As is obvious on the walk from Cambridge station.

It is very simple to describe events in the Keynes framework. From the boom, to the bust.

From as early as the South Eastern Asia crisis in 1997 there has been an increased aversion to risk, widening the spread between government and corporate rates, but also a coincident increase in liquidity preference.

In spite of this, repeated and vast expansions to the money supply have pushed rates lower, first originating in the private financial sector. Then, since the depths of the financial crisis, public intervention has been required to restrain extreme increases in liquidity preference. The scale of QE is now beyond belief. Amounting to a stock of $13tn across the UK, Japan, euro area and US, 40% of global GDP. $½tn was added in the latest quarter alone.

But the effect on interest rates can be exaggerated if we focus solely on nominal rates for governments of rich countries, as seems to be the norm.  My 100 year chart included a projection into 2016 that is hardly a historical low.

So real rates are unlikely to be greatly lower and in parallel they are outweighed by a collapse in investment demand, reflecting a crisis in business confidence, undoubtedly exacerbated by a private debt overhang.

But there is worse.  Here’s the Financial Times on last week’s IMF forecast. 

At the global level, prolonged demand deficiency has meant in 2016 a collapse in world trade and new warnings about global deflation.

Whatever the limited extent of private deleveraging in advanced economies, emerging countries have taken up the slack. McKinsey continue to point out that in aggregate, global debt is higher than ever. Ongoing fragilities in the banking system are plain to see. (And incidentally, we have re-discovered that cutting public spending does not reduce the public debt ratio.)

Finance and democracy

The title of this talk reflects the idea that history has turned full circle.

The 1920s were much more than the failure of a technically flawed financial architecture. The Versailles conference had ensured financial interests were dominant in the construction of the post-war economic arrangements. Central banks were reconstituted or established as independent of political authority, but not so independent of financial authority. Alongside the gold standard, came the free movement of international capital.  Monetary policy kept interest dear and fiscal policy kept tight restraints on government expenditure.

It was dear money that caused the extreme instability and imbalance of the inter-war years. While Britain endured a decade of stagnation, in Germany and the United States, unparalleled excess gave way to debt deflation and catastrophic collapse. The Great Depression was the first international crisis of financial globalisation. 

I touched on very briefly how the UK authorities were swift to use Keynes’s diagnosis as the foundation of an alternative system. Under Roosevelt, the US moved next and moved furthest. Ferdinand Pecora’s Commission brought leading figures from the financial sector to account in the full gaze of the public, as well as giving us the word ‘banksters’.

The authorities had set about the most profound reordering of competing economic interests. At face value the scale of these reforms to finance and the changed role of the state in Roosevelt’s US, the British Empire and, briefly, Blum’s France, were unprecedented.

The totalitarian countries, of course, took a different approach.

But finance’s diminution was only temporary. Led by the United States under Truman, the world emerged from the Second World War unwilling to go as far as Keynes had envisaged. Slowly but surely, finance re-asserted itself.

From 1979, the second financial globalization conformed in great part to the first. Obviously the gold standard was dead and buried, but the system has been the same in practical effect. Real interest rates have been at an uncannily similar level to the 1920s.

It is unsurprising that undoing policies put in place as a result of the great depression and reverting to the arrangement that preceded the great depression has led to a crisis that has no precedent since the great depression.

Events have gone full circle to the point when Keynes was about to take over, but no further. This time, Britain has not ‘left the gold standard’. Financial globalization stands firm.

In the meantime, the academic economics establishment has nothing to offer. It has preached retrenchment as punishment for living beyond our means. The rate of interest on government bonds is merely regarded as indicating a dismal future that we had better get used to. Mainly the profession is preoccupied by self-justification and self-defence, in the wake of challenge that is not letting up. The student movement deserves great credit.

In the lecture theatre and in public discourse, Keynes remains confined to the state–market spectrum; assimilated to a failed algebraic model with no monetary content. 

The scale of the distortions of his work is almost beyond belief. New work on the General Theory is explicitly dismissed as scholastics, as being aloof from the practical realities of the world.

Post-Keynesian scholarship of course has struggled against these implacable forces and offers much more. I should concede that few go as far as I do on the rate of interest.

Why should the profession behave in this way? 

At the head of post war economics in Cambridge, Dennis Robertson’s remark from 1949 seems to me very telling. He urged academia to get back into line, as servant not master of conventional wisdom and the elite. Thus the narrow and simplistic IS-LM theory served the policy consensus after the war; thus the profession yielded to the monetarist challenge that ushered in liberalisation; thus the present, with economists figure-heading the calls for austerity.

Perhaps we are now seeing how dangerous this has been.

Keynes wrote the General Theory with the fear of totalitarianism uppermost. Via academia, he saw a way to arm political forces with a middle way between failed laissez-faire and fascist or communist doctrine. 

Maybe he saw the gains achieved in the US, France and the UK were far from secure. In other countries, his fears were a reality.

Today the elite may despair of the rise of reactionary and populist forces, but the public can see they have nothing to offer. The prolonged kow-tow of the economics profession to power has left progressive forces entirely unarmed. And perhaps an intellectual arrogance leaves progressive economists unable to see this. Some years ago a prominent game theorist told me, ‘we haven’t missed anything’.

Finally. If this interpretation is correct, there is no a priori reason why Keynes’s conclusions about the way forward in the 1930s are any less relevant today. And more than that, offer cause for the greatest possible optimism.

From the current position, this would restore Keynes. 

Monetary policy needs to revert to a sound means to set and maintain cheap money. A vigorous fiscal intervention is needed to revive aggregate demand and business confidence more generally. And confidence would feedback to reduced liquidity preference and re-enforced monetary policy. The scale of political initiative required on a domestic and international level is immense.

But the goal may be beyond compare. The differences between these two points [green circles] on this theoretical abstraction is a slight thing. But they reflect two different worlds. The difference between the present and that of Keynes’s General Theory is also immense

It seems to me that even the possibility this is right, is a matter of the highest importance.

While Keynes’s genius and greatness may be plain to most of us here, we desperately need to wake up the economics profession as a whole. What’s new? Thank you. 


This version of the blog was amended on 10th October.