The Great Economists Read online

  His father was the Cambridge economist John Neville Keynes, which is why he is often referred to as Maynard Keynes. Describing John Neville Keynes, his son’s noted biographer, Robert Skidelsky, wrote: ‘the real barrier to a successful academic career was not lack of originality, but anxiety’.7 Neville Keynes had turned down a professorship at the University of Chicago in 1894, perhaps reluctant to leave the familiarity of Cambridge, where he had a comfortable existence as Registrary – the college’s top and well-compensated administrator. He wrote two books in his career, the second of which accorded him a doctorate when he was thirty-eight. He lived another sixty years but rarely wrote again. Still, Alfred Marshall considered Neville Keynes his best student and asked him to edit the prestigious Economic Journal, founded in 1890. He declined, though his son Maynard Keynes took it on when he became a fellow at King’s. Maynard Keynes exceeded his father’s academic legacy in other respects too.

  As his great-grandmother reminded him, ‘You will be expected to be very clever, having lived always in Cambridge.’ Maynard Keynes did not let her down, and excelled from a young age.8 He has been described as standing ‘head and shoulders above all the other boys’ in his prep school, both physically and mentally.9 At Eton, he won thirty-nine prizes, including the top awards for history and English, all of the main mathematical prizes, and even one in chemistry. He worked diligently and followed his father’s habit of monitoring closely how his time was spent. In a letter to his parents he wrote: ‘In a minute and a quarter my light has to be put out and I have many things to do before then.’10

  After graduation, Keynes spent two years in the India Office as a civil servant. Keynes sat the civil service entrance exam and ironically did poorly in economics. He would have come top had it not been for the economics mark, but had to be content with second. This was important because the successful candidates could choose from the available posts in the different civil service departments in order of their rank in the exam. The Treasury was the plum job, but there was only one post available that year and the top candidate, a bright classicist from Oxford University called Otto Niemeyer, took it. Keynes, therefore, had to settle for the India Office. Had Keynes come top and got into the Treasury, he might have stayed. We might never have had the Keynesian revolution in economics.

  Coming full circle, in the 1920s and 30s, when struggling to push his unorthodox policies arguing for government spending against the orthodox ‘Treasury view’, Keynes’s principal opponent in the Treasury, and later in the Bank of England, was none other than Sir Otto Niemeyer, GBE, KCB. According to the Oxford Dictionary of National Biography, he was ‘the outstanding Treasury official of the post-war years’. Keynes subsequently wrote in the Preface to his General Theory: ‘The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.’11

  During his time at the India Office, he did impress his immediate boss, Basil Blackett. Blackett later moved to the Treasury; and in the financial chaos of August 1914 remembered Keynes and called him in to help out temporarily. He ended up staying for the whole war. Thus, Keynes entered the Treasury in a rather more privileged and somewhat freelance position: he had a commanding role in the financing of the war, rubbed shoulders with all the top politicians and became the Treasury’s chief representative at the Paris Peace Conference.

  The aftermath of the First World War provided the context for some of Keynes’s most lasting ideas. It led to The Economic Consequences of the Peace, and that conditioned the rest of his career. In the book, John Maynard Keynes argued that Germany could not afford the post-war reparations demanded in 1919. Sales broke records in England and the US; this book made Keynes’s name.

  Keynes found the work at the India Office easy but uninspiring, which is likely to have contributed to his decision to return to Cambridge after a short spell to become an academic. His time in government proved to be a valuable link, as he was to contribute actively to economic policy during both world wars.

  He returned to Cambridge to take up a lectureship after being encouraged to do so by Alfred Marshall, with whom an earlier term of postgraduate work comprised Keynes’s entire formal training in economics. Keynes had remarked at the time in a letter to his friend, the writer Lytton Strachey: ‘Marshall is continually pestering me to turn professional Economist … Do you think there is anything in it? I doubt it.’12

  Keynes had frequent occasion to return to London as he was part of the Bloomsbury Group, an intellectual collective who took their name from the district in London where many of them lived and whose membership included Strachey as well as Virginia Woolf and E. M. Forster. All enjoyed the arts, including ballet and after years of homosexual dalliances Keynes fell in love with the Russian ballerina Lydia Lopokova after watching her perform in 1921. They embarked on an affair and married four years later after she obtained a divorce from her husband, when Keynes was forty-two and she was thirty-three. It was a marriage that lasted for the rest of his life.

  Rather unusually for an academic, Keynes – like Ricardo and Fisher before him – was also an investor. He made a fortune, but was nearly bankrupted several times. In 1936 he was worth over £500,000, or an eye-watering £27 million in today’s money. Then he nearly lost it all in the 1937–38 recession when he was heavily leveraged, having borrowed to invest in the stock market. Still, at his death in 1946 he had an investment portfolio of £400,000 (£12 million today) and an art and book collection worth £80,000 (£2.5 million today).13

  His experiences in the post-war boom and ensuing economic stagnation shaped his world-view. Unlike the classical economists, who believed that economies reacted quickly to shocks, Keynes believed the effect to be much more sluggish. For instance, savings were not used for investment, such as buying new equipment. Instead, Keynes saw at first hand that savings were used to fuel speculation. At that time investors had to deposit only 15 per cent when buying shares, and this high degree of leverage increased the speculative frenzy which prompted investors to keep betting.

  This experience shaped his famous ‘animal spirits’ description of investment and the role of investors. He defined ‘animal spirits’ as ‘a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities’.14 It framed his view of investors:

  professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole, so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, in the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.15

  As Keynes once wryly observed, ‘Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.’16

  The Keynesian revolution

  It was the time of the Great Depression and a sluggish economic recovery between the two world wars that saw the launch of the Keynesian revolution. Keynes’s seminal work grew out of the Depression. It wasn’t the first time that unemployment was an issue. The economic woes of the late nineteenth century during the Long Depression led to the term ‘unemployment’ appearing for the first time in the Oxford English Dictionary in 1888. But it was of a different magnitude in the Great Depression. From 1929–33, the US unemployment rate rose from 3 per cent to 25 per cent. Income in 1933 was
lower than in 1922. The UK also entered a prolonged depression and saw unemployment double to 20 per cent.

  Keynes was critical of the Treasury’s classical view, which was to await the recovery passively, since they believed that economies self-corrected in the long run. The long run for classical economists was long indeed. Modern economists are inclined to think that the long run is the amount of time needed for fixed capital to adjust, whereas the classical economists of that time thought that population had to adjust, so birth and death were also part of the long-run adjustment.

  Undoubtedly, Keynes’s legacy was to switch the focus from the long run to the short run, where adjustments were sluggish and governments could thus play a role. He famously observed: ‘But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.’17

  In The General Theory of Employment, Interest and Money, published in 1936, Keynes focused on the short run. He homed in on deficient demand, which included weak household consumption and low firm investment, as determinants of the Great Depression. He argued that, even in normal times, the incentive to invest is too weak and the propensity to hoard cash is too strong. Without the necessary investment, the economy tends to operate at less than full employment, where all labour is deployed productively. If there were also a ‘shock’ to investment demand, such as a stock market crash, output and employment would decline, resulting in economic slumps. So, Keynes proposed that governments should incur debt to move the economy back to full employment. He stressed that government borrowing to spend need not be inflationary if the economy was operating below its potential, and advocated deficit spending, where the government borrowed to spend during downturns and repaid debt during the good times: ‘The boom not the slump is the right time for austerity.’18 A practical economist, he proposed a board of public investment to plan to have a stock of projects ready for when other types of investments started to decline.

  Keynes saw some of his ideas put into action, albeit not entirely to his liking. He believed President Franklin D. Roosevelt’s US National Industrial Recovery Act of 1933, commonly known as the New Deal, would improve the banking system and transport infrastructure of America, but the amount of government spending or fiscal stimulus injected under FDR’s plan was much smaller than the 11 per cent of GDP or national output Keynes believed was needed. Thus, he was critical of the legislation for putting reform before recovery. Britain was even worse in Keynes’s view. The UK government balanced the budget. Despite the lack of government support, a combination of exchange depreciation and low interest rates brought about a recovery. But it was temporary. In 1937–38, both economies once again fell into sharp recession.

  Like now, there was a heated debate over what more spending would mean for the budget deficit and high levels of government debt. A budget deficit arises if the government spends more than it receives in a given year. Government debt is the total accumulated deficit over time. Keynes criticized the UK Treasury for confusing capital spending with government ‘deficit finance’. Keynes argued that public investment was a tool for correcting an economy that was operating below its full potential but which his critics thought would lead to even bigger budget deficits.

  Keynes was also concerned about uncertainty dampening investment and disagreed with neoclassical economists over the role of the interest rate.19 They viewed the interest rate as the price which balanced savings and investment. Keynes argued instead that savings rose and fell with income. Keynes believed that uncertainty was why people held on to money, even if it was not the most sensible investment decision: ‘For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit. Why should anyone outside a lunatic asylum wish to use money as a store of wealth?’20

  He continues: ‘Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.’21

  The implication was that deficit spending would lead to higher levels of national income, which would generate more savings that would in turn pay for the greater amounts of accumulated government debt.

  It wasn’t Keynes’s only involvement in government policy. During the Second World War Keynes became involved in the Beveridge Report that was published in 1942 and which was the foundation of the British welfare state, introducing a comprehensive social insurance system covering individuals ‘from cradle to grave’. It fitted into his theories of how fiscal policy can influence the economy. In other words, unemployment benefits act as ‘automatic stabilizers’ that increase government spending during downturns without the government having to choose to act.

  In sum, the Keynesian revolution altered the face of economics in proposing that economies were frequently not at full employment and output. As demand could fall short, and not all of what was produced would be bought, there was a role for government spending in righting the economy.

  Keynesian economics held sway until the 1970s, which was a decade of high inflation, propelled by two oil price shocks that led to dramatic price rises. The British economy was in the doldrums but suffered from inflation and a weak currency, which raised import prices of oil and other goods. By the autumn of 1976, the UK required bailing out by the International Monetary Fund (IMF), which lent it $4 billion and demanded deep cuts in government spending to reduce Britain’s indebtedness. The demonstrable end of the Keynesian era in the UK was when the British prime minister, James Callaghan, in 1976 remarked that the country could no longer spend its way out of recession and even added that it had only worked before by ‘injecting bigger and bigger doses of inflation into the economy’.22

  Unusually, the 1970s was also a period of high unemployment. This combination of high inflation and high unemployment, known as stagflation, contradicted the standard relationships. That era saw the rise of New Classicists and monetarists like Milton Friedman, whose theories explained stagflation and propelled him onto the stage. Keynes’s ideas fell out of favour. There is a parallel in that Keynes’s ideas were in vogue during the 1930s because they could explain the pressing issue of the time, which was unemployment.

  By 1980, laissez-faire had become the dominant theory in the US with the election of President Ronald Reagan. When he was the Republican candidate for the presidency against the incumbent Democrat, Jimmy Carter, he quipped: ‘Recession is when your neighbour loses his job. Depression is when you lose your job. Recovery is when Jimmy Carter loses his job.’ Reagan won.

  Still, that decade also saw the emergence of the New Keynesians, such as Nobel laureate Joseph Stiglitz, because unemployment was once again an issue in the aftermath of the economic revolutions that took place under both Reagan and Callaghan’s Tory successor, Margaret Thatcher. New Keynesians justified limited government intervention since unemployment can remain high for a long time, but incorporated New Classical theories about how people behave to explain why it takes time for economies to return to equilibrium.

  By the end of the twentieth century, the New Neoclassical Synthesis emerged, which was similar to the movement in the 1950s during which the Neoclassical Synthesis approach had appeared. The New Neoclassical Synthesis incorporated the New Keynesians, New Classicists and monetarists into one framework that incorporated parts of each theory to explain how the economy works.

  The New Neoclassical Synthesis thus includes New Classical theories of how consumers make decisions across time periods as well as incorporating ‘rational expectations’ theory. Rational expectations posits that consumers know that a tax cut today will mean tax rises in the future, so they don’t change their behaviour, thus a tax cut would not raise consumption and boost growth. Intriguingly, only a surprise government polic
y would work. The concept of rational expectations has been challenged owing to its assumption that consumers behave completely rationally and can process huge amounts of information. Indeed, government fiscal policies such as those advocated by Keynes which are not ‘surprises’ have impact, though the evidence is that consumers behave somewhat, though not completely, rationally in response to tax cuts.

  At the start of the twenty-first century, Keynes was back in the spotlight as deficits and public spending re-emerged as contentious issues after the 2009 Great Recession.

  Budget deficits and austerity

  Britain’s budget deficit may have been halved since the 2008 financial crisis, but it was still around 5 per cent of GDP at the end of the 2014/15 Parliament. It’s worth recalling that, when Britain was rescued by the IMF in 1976, its budget deficit was 6.9 per cent of GDP. But the deficit wasn’t as much a concern this time, or indeed in 1993 when its previous post-war high of 7.8 per cent was reached. That’s because Britain was affected by the global financial crisis that had increased the level of government debt in the world’s major economies.

  Following the 2008 crash, Britain’s debt had increased to around 90 per cent of GDP, substantially above the 60 per cent level obliged by the EU Maastricht Treaty. Two of the three major credit rating agencies didn’t see that level of debt as compatible with the AAA top credit rating. After the EU referendum vote to leave the European Union in 2016, Britain was downgraded from its last remaining AAA rating.

  The UK government has cut the rate of increase in government spending in order to reduce the yearly deficits and stabilize the overall debt level. Was austerity the right thing to do? The IMF had urged Britain to reconsider imposing austerity before the economy had fully recovered. And not just Britain. The initial years of the recovery saw governments from Europe to America cutting public expenditure while private demand was weak. In the UK, the recovery was tepid and output even contracted at times. In fact, 2012 saw two non-consecutive quarters of negative GDP growth, although that’s not a recession since the formal definition requires two such consecutive quarters.