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CHAPTER ONE

John Maynard Keynes and the Collapse of the Old Order

John Maynard Keynes was a liberal revolutionary who aimed to place the capitalist order on new economic, political, and cultural foundations. Not solely an economic theorist, he was a political economist in the tradition of Adam Smith, John Stuart Mill, Schumpeter, and Hayek. His theories pointed toward a far-reaching revision in the relationship between the state and the economy in capitalist systems. While the institutions of government inherited from the eighteenth and nineteenth centuries had been designed to check the power of the state for the purpose of protecting liberty, Keynes assigned new power to the state in order to promote stable economic growth and full employment.

The Keynesian revolution in economics thus implied a second revolution in politics, to circumvent both the constitutional and the cultural barriers to state action that had been erected in the era of classical liberalism. The “Keynesian state” is larger and far more interventionist than the forms of government anticipated by Adam Smith, the authors of the U.S. Constitution, and nearly all of the influential statesmen and theorists of the nineteenth century. Many of the core conflicts of our time grow out of the friction between Keynes’s vision of a managed economy and the constitutional order crafted to achieve quite different and far more limited goals.

Keynes was sensitive to the historical nature of the capitalist system as it evolved through different phases, created new institutional forms, and adapted to crises and new challenges. He questioned whether it was still appropriate to use theories formulated in 1800 or 1850 to account for the economic realities of the 1920s and 1930s. The “age of laissez-faire,” he wrote in the 1920s, had been brought to an end first by the development of large corporations and labor unions, and then by the destructive effects of the world war. If the old order was dead, then a new one must be built on a different intellectual basis. This was the campaign that Keynes engaged in during his stints in public service and in the books and articles that he wrote between 1919 and his death in 1946.

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A thinker of the widest interests, Keynes wrote on subjects ranging from Isaac Newton to modern art, and interspersed his treatises on economics with sage references to history, politics, and psychology. His biographer Robert Skidelsky asserts that he was as much a moralist as an economist.¹ Keynes, he wrote, searched for a vision of capitalism that promoted both efficiency and justice in equal parts. In an essay on Alfred Marshall, his mentor at the University of Cambridge, Keynes wrote that the “master economist” must possess many gifts: “He must be a mathematician, historian, statesman, and philosopher, in some degree. No part of man’s nature or his institutions can be outside his regard.”² Nor was Keynes an “armchair” or merely academic theorist; he participated actively in every important political debate that took place in Great Britain during the tumultuous years from the outbreak of World War I through the close of World War II. Progress in economics, he maintained, must arise from the interplay between theory and urgent practical problems.

Keynes thus began working out his theories on the necessity of refashioning the capitalist order while he served as a member of the British delegation to the Paris Peace Conference in 1919. For Keynes and his generation, the Great War of 1914–1918 demolished the foundations of European civilization. The old order in Europe had been built upon a network of interlocking principles and ideals: Protestantism and Victorian morals in culture; nationalism, empire, and monarchy in politics; laissez-faire, free trade, and the gold standard in economics. The big question after the war was whether those principles and institutions could survive in a new era of sovereign debt, despair and dashed hopes, debauched currencies, and a permanently changed balance of world power.

Keynes set forth his reflections on the war and the damage it did to the social order in The Economic Consequences of the Peace, the no-holds-barred attack on the Treaty of Versailles that he wrote in a few months in 1919 after the peace conference had concluded.³ He predicted that unless the treaty was revised, it would lead to financial ruin across Europe and possibly to another, more destructive war. The book was an immediate bestseller, turning Keynes into an international celebrity. It ran through five editions and was translated into eleven languages within a few years. Today it is regarded as one of the more important and controversial books published in the twentieth century, for in it Keynes not only criticized the treaty but declared the obsolescence of the prewar order in Europe along with its associated institutions, ideals, and cultural assumptions.

He began the book with an insightful chapter titled “Europe before the War,” a melancholic reflection on a golden age blasted away on the battlefields of France and Belgium. “What an extraordinary episode in the economic progress of man that age was that came to an end in August, 1914,” he wrote.⁴ Keynes marveled at the progress made across the continent after Germany began to emerge as a world economic power following its unification in 1871. Before then, most states except for Great Britain were largely agricultural and self-sufficient. Trade was carried on mainly within local markets. After that time, industry and population grew steadily as trade quickened across Europe, widening the sphere of prosperity and the reach of modern comforts. The gold standard maintained stable currency values and facilitated trade and capital flows. By 1914, Keynes wrote, “the inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep.”⁵ The generation that grew up before the First World War saw the world remade by the explosion in capitalist enterprise. It was the first era of globalization. Europe, led by Great Britain, France, and Germany, was the center of the world’s economic order.

Germany played a leading role in this surge in trade and wealth. Its population increased from 40 million to nearly 70 million between 1870 and 1914, much faster than the populations of France and Great Britain. (In 1914, Britain had a population of 46 million, and France, 40 million.) German industrial output expanded at an even greater pace, spurred on by the speedy and efficient introduction of the factory system. By 1900, Germany was a main European supplier of pharmaceuticals, electrical equipment, steel, and coal. Germany quickly became an important trading partner for every other European nation, including Great Britain.

Keynes identified a cause of this rapid growth in a moral and psychological disposition among all classes to save and invest new wealth rather than to exhaust it in consumption. The wealthy, in particular, were responsible for the accumulation of capital because “they were not brought up to large expenditures, and preferred the power which investment gave to them to the pleasures of immediate consumption.”⁶ They had “the cake,” so to speak, but on the condition that they abstained from eating it, or at least from eating all of it. (After all, the wealthy of that era lived in lavish homes, usually several of them.)

One of the reasons the prewar economy worked as well as it did was that the wealthy classes were at once the “savers” and the “investors.” The founding entrepreneurs still owned and managed their enterprises. The laboring classes accepted this arrangement because the proceeds from their labor were continuously plowed back into the building of more factories and railroads. Much of this surplus was invested in the United States, which in turn sent back surplus foodstuffs to support Europe’s growing population. Yet rapid population growth both in Europe and in America put pressure on agricultural prices. Keynes saw this trend as a destabilizing factor in the economic affairs of Europe, since some nations (Germany in particular) began to think of conquest as an alternative to trade for guaranteeing food supplies.⁷

The war permanently disrupted the delicate balance among the various factors of trade, psychology, population, and investment upon which the prewar order was constructed, leaving millions on the continent starving and destitute when the war ended. Nearly 20 million people were killed during the war and many millions more wounded or displaced; factories and transportation grids were destroyed across large swaths of the continent; food and medicine were in short supply; all countries were in debt from heavy borrowing to pay for armaments; national currencies were of uncertain value in relation to one another due to wartime inflation; and the accumulated wealth of the continent was consumed in a few years of war. The suffering was magnified by comparison with the comfortable lives that Europeans had enjoyed before 1914 and with the optimism for the future that nearly everyone had entertained just a few years earlier.

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It was against this backdrop that European and American leaders gathered in Paris early in 1919 to hammer out a peace treaty. Many observers expected the French, British, and American leaders who controlled the Paris Peace Conference to craft a treaty that incorporated President Wilson’s Fourteen Points and his general principle that there should be “peace without victory.” In the months following the armistice, Wilson was by far the most popular political figure in the Western world—a leader who seemed to be carrying the hopes of the world on his shoulders. His program was one basis upon which Germany had agreed to lay down arms. Prior to the conference, Allied leaders made public declarations suggesting that the terms of the peace should be in accordance with Wilson’s various addresses on the subject.

Keynes avoided taking sides on the question of which country was to blame for starting the war. In Economic Consequences of the Peace, he stressed the various elements of Wilson’s program that pointed away from a punitive settlement. For example: “The removal so far as possible of all economic barriers and the establishment of an equality of trade conditions among all the nations consenting to the peace and associating themselves for its maintenance” (from the Fourteen Points); and, “There shall be no annexations, no contributions, and no punitive damages” (from an address before Congress), although Great Britain and France successfully demanded, as a rider to the president’s statements, compensation for damage done to civilians and their property by land, sea, and air during the war. There was also, of course, the League of Nations that, in Wilson’s mind, would treat all nations equally, arbitrate international differences, and enforce the peace.

Keynes viewed Wilson’s program as a solemn contract binding upon the parties to the Paris Peace Conference—as did Wilson himself, at least prior to the conference. It is far from clear that the other parties, especially the French and British representatives, saw the complex situation in the same light. In fact, despite some rhetorical declarations, they did not.

Like many who pinned their hopes on Wilson’s vision, Keynes was dismayed when, after six months of negotiations running from January to June (1919), the conference adopted a regime of reparations and territorial concessions designed to punish Germany by making her bear most of the costs of the war—including military losses that went well beyond compensation for civilian damages. By this time, Wilson had adjusted his position somewhat, declaring that Germany had to be punished for the crime of aggression.

The Treaty of Versailles assigned to Germany the major blame for the war, and forced her to disarm and to cede territories and raw materials to France. Article 231, the so-called “war guilt” clause, stated: “The Allied and Associated Governments affirm and Germany accepts the responsibility of Germany and her allies for causing all the loss and damage to which the Allied and Associated Governments and their nationals have been subjected as a consequence of the war imposed upon them by the aggression of Germany and her allies.” The Allied powers assessed $5 billion (22 billion gold marks at 1914 values) to be paid immediately in gold and raw materials, and “punted” calculations of the rest of the reparations to a commission of Allied representatives to be set up later. On the basis of Article 231, Keynes calculated that Germany might be assessed as much as $40 billion (170 billion gold marks) in reparations, which was about three times Germany’s prewar GDP and four times the amount he estimated that Germany could afford to pay from remaining resources and proceeds from future exports. He argued that the sum needed to be cut back substantially to avoid out-of-control inflation and some form of revolutionary backlash in Germany.

For understandable reasons, the French feared a revival of German power and a renewed military campaign to reverse the decision of the war. One of the goals of the conference (insisted upon by France) was to establish as far as possible a rough equality between Germany and France in military and economic power. Due to the rapid growth in German population and industry over the previous decades, such a goal could not be accomplished without extreme measures either to shrink Germany or to stretch France. This, according to Keynes, was a wrongheaded approach:

My purpose in this book is to show that the Carthaginian Peace is not practically right or possible. The clock cannot be set back. You cannot restore Central Europe to 1870 without setting up such strains in the European structure and letting loose such human and spiritual forces as will overwhelm not only you and your ‘guarantees,’ but your institutions and the existing order of your society.⁸

Here was Keynes’s central point: the old order in Europe could not be restored. Germany would henceforth be a major power on the continent. The treaty could not reverse that evolution, and any attempt to do so would end in failure—and possibly in a future attempt by Germany to reverse the decision of the war.

Keynes reserved his sharpest words for Wilson, the American president who might have used his prestige and popularity to craft a treaty more in keeping with the ideals of fairness, self-determination, free trade, and collective security that he enunciated during the course of the war. Wilson’s primary goal at the conference was to win European support for his League of Nations, an institution that he believed would secure the peace for future generations. European leaders dismissed this view as a delusion and had little difficulty in giving Wilson his League in return for his support for those elements of the treaty that they considered far more important: reparations and territorial concessions. Keynes portrayed Wilson as an American naïf, a “blind and deaf Don Quixote,” in the company of seasoned European negotiators. “There can seldom have been a statesman of the first rank,” Keynes wrote, “more incompetent than the President in the agilities of the council chamber.”⁹ According to Keynes, Wilson was so thoroughly “bamboozled” by the French and British leaders—Clemenceau and Lloyd-George—that he headed back to America comfortable in the illusion that the Treaty of Versailles established the foundations for true peace. Those hopes were formally dashed at home when the U.S. Senate rejected the treaty after Wilson refused to accept a compromise that would have limited the power of the League of Nations to take the United States into war without the consent of Congress.

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In pinning the blame for the treaty’s flaws on Wilson, Keynes realized that any solution to the European crisis would have to come about through the intervention of the United States. The war had shifted the balance of world power westward, as the United States emerged from the conflict with reserves of wealth that Europe would not be able to match for years or decades to come. Great Britain and France sought heavy reparations from Germany partly to pay for the war and to punish Germany, but also to use the proceeds to repay American banks for loans taken out to underwrite the war. The amount of these loans, some $4 billion owed by France and nearly $5 billion by Great Britain, represented nearly half of France’s prewar GDP and a third of Britain’s. The principal and interest (5 percent per year) due on the loans imposed a burden on their economies that would prove difficult to bear under conditions of postwar austerity. Keynes maintained that President Wilson could have marshaled the financial power of the United States to impose upon the European allies a treaty more in keeping with the requirements of postwar peace.

He reasoned, probably correctly, that Great Britain would be better off by renouncing reparations and gaining cancellation of the debts than by winning phantom reparations (that might not be paid) and paying real debts. If the United States would cancel inter-ally war debts in an “act of statesmanship and generosity,” he argued, then reparations imposed upon Germany might likewise be scaled back to a level that the Germans could afford to pay without bankrupting themselves. Keynes and several other aides floated this proposal behind the scenes at the peace conference.¹⁰ It went nowhere, for a host of very good reasons. The French were more worried about the military threat from Germany than about war debts. The Americans saw no reason why they should bear the costs of the war when they had played no role in starting it.

Keynes feared that the twin burdens of German reparations and inter-ally war debts would weigh heavily upon the international financial system for years to come. The transfer of vast amounts of gold to the United States in payment of debts would foster a boom in the creditor country at the expense of debtor economies. In the decades before the war, the automatic adjustment mechanisms of the gold standard prevented nations from running up large international debts. Now, after the war, the world was awash in debt, much of it owed to the United States, a nation with little experience as an international creditor and world economic power—and, to make matters worse, a country used to protecting its domestic markets from foreign competitors. Keynes understood (though he did not press the point in his book) that Great Britain stood to lose its financial preeminence due to its debt position with the United States. Thus, in pressing for a solution to the debt issue at the conference, he acted more as a representative of British interests than as a disinterested analyst of the treaty. In any case, he was right to worry that accumulated debts from the war might destabilize the international economy in the postwar period. In confirmation of these fears, the Allied powers—led by the United States—made continuous efforts during the 1920s to reduce or restructure war debts and reparations, with limited success. After the stock market crash in 1929, the issues of debt and reparations gave way to new and bigger problems.

In the broader message of the book, Keynes argued that the ideals and institutions of the prewar era could no longer serve as the foundations for progress. “The forces of the nineteenth century have run their course and are exhausted,” he wrote. “The economic motives and ideals of that generation no longer satisfy us. We must find a new way and must suffer again the malaise, and finally the pangs of a new industrial birth.”¹¹ From his point of view, the fundamental assumptions of Europe’s liberal civilization had been badly shaken. Faith in automatic progress via saving and self-discipline was crushed. National currencies and terms of trade were distorted by wartime inflation. Workers would henceforth demand a larger share of the fruits of capitalism than they were willing to accept prior to 1914. Governments would have to take the lead in feeding their populations, establishing stable currencies, and restarting commercial activity. Keynes concluded that all this pointed toward new roles for the state, labor unions, and corporations in the evolution of capitalism.

This was something that (according to Keynes) the statesmen at the time did not grasp as they negotiated over borders, reparations, and the League of Nations while the populations of Europe starved and established states were overturned in revolutions. They did not see “that the most serious of the problems that claimed their attention were not political or territorial but financial and economic, and that the perils of the future lay not in frontiers or sovereignties but in food, coal, and transport.”¹²

The Economic Consequences of the Peace was an early intervention of the academic expert into the practical world of international politics and finance. As some have written, it may be read as an extended lecture on the errors of politicians from the standpoint of the professional economist and intellectual. Keynes wrote in 1922, “The economist is not king; quite true. But he ought to be. He is a better governor than the general or the diplomatist or the oratorical lawyer.”¹³ This appears to be one of the lessons he took from the Paris Peace Conference: that it would be up to economists, experts, and intellectuals to step in where the politicians had failed to chart a path out of the European crisis.

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Keynes’s indictment of the Versailles Treaty, though widely popular in intellectual circles, was not so enthusiastically received in diplomatic quarters in Washington, Paris, or London. There, The Economic Consequences of the Peace was condemned as too pessimistic about the future course of world affairs, too sympathetic toward Germany, too negative about President Wilson’s role at the peace conference, and too heavily focused on the economic aspects of the treaty. One prominent reviewer branded it “an angry book,” which was undoubtedly true. Some later blamed Keynes for legitimizing German efforts to undermine the treaty in the 1920s and 1930s and for laying the groundwork for appeasement in the 1930s.¹⁴ This was partly true: German leaders took advantage of Keynes’s book in their campaign to discredit the treaty. Nevertheless, his critics have overstated the influence of the book. It did not wreck the treaty or create German resistance to it or cause the disorders of the 1920s and 1930s. More fundamental forces were at work; and farsighted though Keynes may have been, he could not have anticipated all of these outcomes. In any case, he wrote from a wish to see the treaty revised but not entirely discarded.¹⁵

But his critics had a point. Keynes’s manifesto was an exaggerated production in several important respects. Written in the form of an indictment, it was a one-sided brief against the treaty, focused excessively on the reparations issue. The central idea was that the reparations regime would cripple Germany financially and unleash forces that might set off a revolution or another war. While such events did unfold during the 1920s and 1930s, it is not true that reparations or the treaty was their primary cause.

To a significant degree, the Allied representatives in Paris presented Germany with a bill designed to placate anti-German sentiment at home, a point that Keynes did not fully appreciate.¹⁶ By 1921, the reparations commission set up by the Allies scaled back the levies to $33 billion (about 132 billion gold marks) to be paid at interest over thirty or so years, a sum that was lower than Keynes’s initial estimates but still much higher than he thought Germany could afford to pay. Nearly two-thirds of this sum was assessed in the form of “C bonds,” which carried no interest and would be due at an indeterminate date when the commission decreed that the Weimar government could pay it. The C bonds were, as many said at the time, a phantom assessment. Thus the commission, bowing to economic reality, effectively slashed the reparations down to a level close to what Keynes estimated that Germany could afford.

Even at these reduced rates, however, the German government balked at making payments because the German people regarded reparations as a national humiliation—although Germany had imposed a war indemnity upon France at the conclusion of the Franco-Prussian War only fifty years earlier. The payments were made erratically until they were deferred after the stock market crash and then canceled when Hitler took power in 1933.

Scholars estimate that between 1920 and 1930 Germany paid approximately 20 billion gold marks in reparations, a fraction of the amount assessed, and a figure that was dwarfed by loans that poured into Germany from primarily American sources.¹⁷ At these levels, the reparations could not have caused all of the problems attributed to them: the German hyperinflation in 1923, the stock market collapse, or Hitler’s rise to power. The reparations in the end were more of a throbbing political problem that discredited the Weimar government within Germany and impeded international economic cooperation across Europe. Economists who have looked at these figures generally agree that the Germans could have afforded to pay the levies—that is, the 50 billion gold marks—if they had wanted to do so.¹⁸ As events proved, the massive debts run up by the belligerent powers during the war were far more consequential than German reparations in destabilizing the international economy in the 1920s.

Nor was it accurate for Keynes to claim that the treaty imposed a “Carthaginian Peace” upon Germany, because while the German army collapsed in the field in the autumn of 1918 and the German government disintegrated into chaos at home, German territory was never occupied by Allied troops and the country suffered little actual war damage. The war ended in an armistice rather than in national capitulation. Most of the war damage was localized in areas of Belgium and northern France. This was the basic problem: Germany was never subjected to the tribulations of foreign occupation and plunder that usually accompany defeat in war. For this reason, Germans never fully accepted the fact that they had lost the war. The Allies imposed harsh terms on Germany but set up no mechanism to enforce them against a recalcitrant government and population. Once the United States rejected the treaty and Great Britain withdrew from continental affairs, France was left alone to enforce the treaty against a larger and potentially more powerful adversary. As the years passed, Germany felt free to ignore the terms of the treaty, secure in the belief that they could not be enforced.

Keynes’s grand solution—a reduction of reparations linked to the cancellation of inter-ally war debts—may be considered a statement of British financial interest as much as an expression of sympathy for the German position. He wrote that the payment of interest on those loans was an oppressive prospect for Great Britain and the other debtor countries. Nevertheless, the United States, given its history and its relationship to the European powers at that time, was not going to absorb the costs of a European war that it had no role in starting. Public opinion in America would have rebelled against any such solution. It was not a realistic proposal, nor was Keynes’s plea for another international loan from the United States after he had called for the cancellation of already existing debts. “Does he think we are financial simpletons?” asked one American reviewer of the book.

Keynes was also wrong to think that Wilson’s vision should or could have controlled the peace conference or that Germany would have accepted a treaty that fully incorporated his Fourteen Points. Here Keynes’s argument was more than a little illogical, for he wrote that “when it came to practice [Wilson’s] ideas were nebulous and incomplete. He had no plan, no scheme, no constructive ideas whatever for clothing with the flesh of life the commandments which he had thundered from the White House.” In that circumstance, it is hard to see why he thought that Wilson’s vision could have set the agenda for the conference. In addition, France and Great Britain had legitimate financial and security interests that could not be swept aside in the postwar negotiations, even by Wilson. The treaty that emerged from those negotiations was inevitably going to contain a bundle of compromises that gave each of the major powers some but not all of what it asked for.¹⁹ Public opinion in France and Great Britain would have recoiled against a “slap on the wrist” treaty in regard to German responsibility for the war. It is also probable that Germany would have recoiled against a thoroughly Wilsonian treaty, inasmuch as one of the Fourteen Points called for an independent Polish state to be carved out of the Polish populations on the eastern border of Germany, assured of free and secure access to the sea. That was a sore point for Germany, and one whose inclusion might have undermined any treaty that emerged from the Paris negotiations. Two decades later, the Second World War began on the day that Hitler moved to reverse that particular provision of the Treaty of Versailles.

In his own way, Keynes may have been as utopian as Wilson was in envisioning the postwar order. Wilson looked to transcend the balance-of-power politics that characterized the prewar regime in favor of a system of collective security as institutionalized in the League of Nations. That was judged by nearly everyone, including Keynes, to be a utopian vision and one that was unworkable under the conditions of the time. In much the same way, Keynes proposed a vision of European economic cooperation and integration that was equally implausible in a situation in which national rivalries and resentments had been inflamed by the deaths, damage, and overall suffering of the war. Keynes, in effect, was asking the warring parties of Europe to set aside their differences and forget past humiliations in the interests of mutual cooperation and economic progress, with the financial burden for that solution to be carried by the United States. None of the parties was willing to do that in 1919, and few people at the time thought that such a prospect was possible. The weight of history was still too great to allow for either the Wilsonian or the Keynesian solution.

It would take another war before such a vision could be seriously considered, this time under the supervision and patronage of the United States, motivated in large measure by the emergence of the Soviet Union as a potential adversary. As the Second World War approached an end, American and British planners sought to avoid the missteps of 1918 and 1919. This required in the first place the unconditional surrender of German forces and the Allied occupation of German territory. The remedies that Keynes proposed in 1919—relief, reconstruction, renewal of trade, cancellation of debts, limited reparations, stabilization of currencies, and integration of the vanquished into the postwar order—were generally accepted in 1945 as guideposts for the postwar order. Keynes, as the British representative at the Bretton Woods conference in 1944, played an important role in designing the institutional foundations of the postwar economic order: the World Bank, the International Monetary Fund, and an international currency regime pegged to the U.S. dollar. These policies and institutions, much in contrast to those adopted in 1919, established a basis for postwar security and prosperity across Western Europe and North America.