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ОглавлениеThe Keynesian Revolution in Political Economy
Keynes attacked the Treaty of Versailles on political grounds, bluntly asserting that the negotiators addressed the wrong problems and held a mistaken vision of the postwar order. A consistent theme in his career as an economist is that he was a political economist. This was true in at least three senses: first, he understood that economic ideas had to be communicated to the public in a manner designed to persuade; second, he saw that the policies of the state had to be grounded in sound economics; third, he knew that the organization of the economy could not in the end be separated from the institutions of the state.
From this arises a central irony of the Keynesian revolution in economic policy: while Keynes was a political economist, assigning new responsibilities to the state to stabilize the economy, academic economists who followed his lead turned their discipline into a technical enterprise entirely separate from politics. The distinguished tradition of political economy largely faded away as Keynes’s revolution unfolded in the postwar era. This development has served to conceal an intriguing possibility—that Keynes’s enterprise is vulnerable not primarily because the economic theory is flawed, but because it cannot be made to work from a political point of view.
In The Economic Consequences of the Peace, Keynes declared that the old order of political economy in Europe had come to an end with the First World War. He took this theme further in The General Theory of Employment, Interest, and Money, where he argued, against the backdrop of the Great Depression, that the nineteenth-century theory of free markets and limited government was inadequate to modern conditions. His prescriptions for setting capitalism on a new foundation launched the “Keynesian revolution.” A key question today is whether evolving conditions in the political economy of capitalism are in the process of making the Keynesian synthesis ineffective and obsolete in its turn.
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The Great Depression, more than any previous economic crisis, ignited a fundamental rethinking of the future of capitalism. What had gone wrong with the market system to cause such an unprecedented collapse? Was there a way to tame its “boom and bust” cycles? Could the capitalist system survive? Did it even deserve to survive; and if so, on what terms? The victories of communism in Russia and fascism in Germany suggested that capitalism would soon give way to one or the other of these extreme alternatives.
The Depression era produced three influential but widely diverging statements about the future of capitalism: Keynes’s General Theory (1936), Joseph Schumpeter’s Capitalism, Socialism, and Democracy (1942), and Friedrich Hayek’s The Road to Serfdom (1944). Each was a work of political economy in the broad sense, weaving together the interconnected subjects of politics, culture, institutions, and economic theory. Each had long been gestating in the mind of its author and expressed his considered reflections on the world crisis of the time. All three of these economists were well known in academic and policy circles long before these particular works appeared. To some extent, then, each developed his ideas in answer to theoretical challenges posed by the others.
Today, more than seventy years since they were first published, these three works continue to stand as seminal statements of influential public doctrines: Keynes’s General Theory for orthodox liberalism, The Road to Serfdom for market liberalism, and Capitalism, Socialism, and Democracy for conservatism and neoconservatism, or for the belief that culture is decisive for the survival of capitalism. For this reason, some have called their authors the “political philosophers” of the twentieth century. Among them, Keynes exercised by far the greatest influence in the post-Depression and postwar era. More than Hayek, Schumpeter, or any other economist of the time, Keynes went beyond diagnosis to offer practical remedies for the economic crisis of the 1930s. His General Theory did not arrive in time to be of much use during the Depression, but his insights revolutionized economic policymaking and the study of economics in the postwar era.
The evolution of “managed economies” in the postwar era owed a great deal to the writings of Keynes in which he assigned responsibility to governments for stabilizing economies. For Keynes, achieving full employment was the principal goal of economic policy, and he provided policymakers with a set of fiscal tools for smoothing out the booms and busts of the business cycle. This was the “middle way” that he tried to steer between the extremes of communism and fascism, and between state planning and free-market capitalism. From a political point of view, Keynes was among the liberal reformers of that time who sought to “tame” capitalism by giving new managerial duties to national governments.
Many attributed the rapid growth in America’s postwar economy to the application of Keynes’s theories. One economist called the postwar era “the age of Keynes.”1 Time magazine took note of his vast influence by publishing a cover story in 1965 under the title “We Are All Keynesians Now.” As the magazine acknowledged, “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 universities and the touchstone of economic management in Washington.” Though Keynes’s theories were temporarily in retreat in Washington and London during the 1980s and 1990s, they never really lost currency among academic economists, and the recent financial crisis provided a new occasion for their application. We have not yet evolved beyond “the age of Keynes.”
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In The General Theory, Keynes worked out the premises for a conclusion he had already reached. This is evident in a series of essays that he wrote during the 1920s and into 1930, which are collected into a single volume under the title Essays in Persuasion (1931). Here he reflected on the evolution of the capitalist order from its origins in the eighteenth century and on the significant changes in the international system brought on by the war. He maintained that rapid changes in the economic order required parallel changes in political and economic institutions, and corresponding adjustments in political and economic theory.
“The End of Laissez-Faire” (1926) is an essay in which Keynes rejected the principles of natural liberty and enlightened self-interest that lay at the heart of Adam Smith’s economics of free markets. “The world is not so governed from above that private and social interest always coincide,” he wrote. “It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened.”2 This was rather a caricature of the foundational assumptions of market economics, which did not insist that enlightened self-interest always operates in the general interest, but that it will do so more reliably than other forms of economic organization. Nevertheless, Keynes rejected these principles for two reasons: first, he considered them to be far too abstract to offer solutions to practical problems; second, he judged them to be increasingly obsolete in the modern world of institutional capitalism shaped by large corporations, labor unions, and not-for-profit institutions. At this time he began to consider (as he wrote) “possible improvements in the technique of modern capitalism by means of collective action.”
In that essay, Keynes focused on the organizational evolution of capitalist economies as a factor that altered or undermined the operation of free and competitive markets. An important phenomenon of modern life, he wrote, is the tendency for large enterprises to socialize themselves—or, in other words, to pursue social as opposed to purely private objectives. He suggested that “A point arrives in the growth of a big institution—a big railway or public utility enterprise but also a bank or insurance company—at which the owners of capital are almost entirely dissociated from the management, with the result that the direct personal interest of the owners (the shareholders) becomes quite secondary.”3 As organizations reach a certain size, managers become interested in other goals besides profit, such as stability, security of employment, reputation, and independence. Keynes also welcomed the development of semiautonomous not-for-profit institutions such as universities and scientific societies that promote the general interest in different spheres of activity.
Keynes envisioned an emerging system of capitalism in which large business enterprises and not-for profit institutions operated alongside government in common efforts to promote the public interest. The friction between the public and private spheres, so much an aspect of the old order of liberalism, was giving way to a new order of cooperation among large institutions. Keynes’s corporatist vision of the capitalist order represented an evolution of liberalism beyond its nineteenth-century emphasis on individuals, competition, and suspicion of the state.
The separation of ownership and control in large organizations implied that expert managers might assume new powers in the direction of political institutions and of private corporations, a concept that Keynes first broached in The Economic Consequences of the Peace. While this seems like a modern technocratic concept, it also had a traditional aristocratic pedigree, at least for Keynes. Roy Harrod, his friend and biographer, suggested that Keynes assumed that important economic decisions would always be in the hands of experts operating in the public interest, much in the way that central bankers are allowed to control interest rates and the supply of money without close political supervision. As a member of his country’s intellectual aristocracy, Keynes “tended to think of the really important decisions being reached by a small group of intelligent people, like the group that [later] fashioned the Bretton Woods plan.”4 Keynes, according to Harrod, approved of this as a normative matter; he also thought it to be an element in the evolution of modern capitalism as experts inherited control of the system from entrepreneurs.
Keynes pointed out two areas where the state could and should intervene to improve the operation of the capitalist order. The first was in the area of money and credit, where he called for deliberate control and planning by a central institution—that is, by a central bank with powers sufficient to regulate the supply of currency and credit toward the goal of full employment and stable prices. This was an implicit attack on the gold standard, which Keynes regarded as an archaic inheritance from the nineteenth century, and as an ineffective instrument for regulating money and credit in the wake of the war.
He had several longstanding objections to the gold standard. The main problem was that it required nations to expand or contract money and credit in order to maintain the exchange value of their currencies, while Keynes believed that monetary policy should assign priority to domestic employment and stable internal prices. His second objection was that the United States now held the lion’s share of the world’s gold reserves, mainly due to wartime loans, and this circumstance allowed the U.S. central bank to dictate interest-rate policy to the rest of the world. Keynes vehemently opposed Britain’s return to the gold standard in 1926, predicting that it would lead to deflation, rising real interest rates, added burdens to debtors, and domestic unemployment. He cheered when Britain abandoned the gold standard in 1931, after his forecasts were borne out, in favor of central bank management of monetary policy. On this subject, Keynes proved to be farsighted. After many fits and starts during the 1930s and in the postwar era, the world abandoned the gold standard for good in the 1970s in favor of a system of fiat currencies managed by central banks.
Keynes’s second innovation was to call for public control over investment such that the state would replace banks, investment houses, and wealthy individuals as the major supplier of investment capital. In the modern world, he pointed out, “savers” and “investors” were now different people and institutions; their decisions had to be coordinated by private intermediaries that took in savings and directed them toward new and hopefully profitable enterprises. Keynes had little faith that this process could be carried out seamlessly in the public interest, and so he looked to the state as the institution where the investment function could be carried out rationally in the interests of society as a whole. He returned to this theme again and again in the 1930s, and in The General Theory he argued in great detail for public investment as a means of rescuing the world from the Depression.
This is an area in which (fortunately) the Keynesian revolution never fully took hold, despite Keynes’s great influence and the growth of state spending in the postwar era. Banks and investment houses are still in private hands and our stock markets still allocate capital through private channels. Today we understand something that Keynes did not—namely, that modern governments, because they respond to constituent pressures, lobbyists, and campaign donors, are incapable of allocating capital on a rational or disinterested basis; they allocate funds on the basis of political rather than economic signals. Private investors, whatever their flaws, do a far better job of allocating capital than modern governments could ever do. Yet Keynes, writing in the midst of the Depression, focused far more on the failures of private markets than on the possible defects of democratic governments.
In 1930 he was still optimistic that the economic slump was but a temporary lapse in the onward march of capitalist development; he dismissed claims that it marked the end of prosperity or the collapse of capitalism. The system had “magneto trouble,” he wrote in “The Great Slump of 1930,” suggesting thereby that something had gone wrong with the starting mechanism of the capitalist machine. The system was not corrupt or fundamentally broken, as socialists and communists claimed; the machine only required a fix to make it run more smoothly and reliably. Keynes went on in that essay to identify the problem, writing, “If I am right, the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for capital investment.”5 Investors and entrepreneurs were not putting capital to work because, in the midst of the slump, they saw no market for machines, factories, new employees, and the like. At that moment, Keynes thought the slump could be reversed if the central banks in Britain, France, and the United States could coordinate monetary policy to increase the flow of credit internationally. Such a play might have worked, but it was never seriously attempted.
The tone is even more optimistic in “Economic Possibilities for Our Grandchildren” (1930), an essay in which Keynes characterized the current economic difficulties as a transitional period from the age of laissez-faire to the age of institutional capitalism. “We are suffering, not from the rheumatics of old age,” he wrote, “but from the growing pains of over-rapid changes, from the painfulness of readjustment between one economic period and another.”6 Keynes calculated that over the previous one hundred years the standard of living of the average European and American had grown at least fourfold, and predicted that over the next one hundred years it would improve between fourfold and eightfold again.a Within two or three generations, he suggested, the necessities of a comfortable life would be available to all, and mankind’s long struggle for survival in the face of scarcity would be near an end.
Keynes thought that the values of work, thrift, and moneymaking were erroneously associated with capitalism; he believed they are instead called forth by scarcity, poverty, and need. He speculated that these values would be rendered obsolete when, through capitalist enterprise, scarcity was eventually overcome, at which point mankind would be able to turn its attention to activities that make life worthwhile: art, music, literature, and philosophy. This, according to Keynes, would establish the final stage of capitalism—an end of history—when advanced societies would be able to live off their accumulated capital. Capitalism, with its moneymaking preoccupations, would then “wither away,” much as Karl Marx had predicted, but through a peaceful and evolutionary process.
Like many other thinkers of his time, Keynes regarded the political and moral principles associated with market capitalism as degrading and in need of replacement by a more humane set of ideals. There was an evolutionary or historical element in his thought: he claimed that capitalism developed in historical stages and also in a morally favorable direction. Institutional capitalism was an improvement over the “classical” system of the nineteenth century, but still a stepping-stone on a path to the final phase of capitalist development, when the “economic problem” would be solved once and for all.
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Keynes published his collected Essays in Persuasion during an economic slump that he thought would soon end. Like everyone else, he expected the world’s economies to bounce back quickly from the crash in the United States, just as it had done on many occasions in the past, most recently in 1920 and 1921. Keynes was as surprised as anyone by the severity of the slump, and in fact he lost a fair amount of money in the crash of the world’s stock markets.
The industrial economies had gone through recessions and even depressions in the past, but none as deep and prolonged as the collapse in the 1930s. In the United States, where the slump began, industrial production declined by a third between 1929 and 1933 and unemployment exploded from 3 percent to 25 percent of the workforce. More than a third of the country’s banks failed between 1931 and 1933, leaving depositors broke and the credit system badly damaged. In Great Britain the decline was not as steep, in part because the country’s economy had never fully recovered from the war. Nevertheless, economic output declined by a third there as well, exports declined by more than half, and unemployment rose to about 20 percent of the workforce in 1932. It was a global catastrophe that bottomed out only when the world’s economic machinery ground to a halt in 1933.
Disasters of this magnitude were not supposed to happen in market economies, which were thought to possess self-correcting features. When the slump dragged on, Keynes concluded that there was something wrong with the adjustment mechanisms of the market that was not accounted for in the standard economic theories. Much like the Great War, for Keynes the Great Depression called into question the received wisdom of the time.
This was the background for his General Theory, where he laid out the theoretical case for countercyclical government spending policies that proved to be so influential in the postwar era. Like The Economic Consequences of the Peace, this book too was widely discussed and reviewed when it first appeared, frequently in newspapers and magazines that catered to policymakers and intelligent laymen. But whereas the former set out a lucid argument that no one could misunderstand, The General Theory contained a bewildering mix of new concepts and arguments, critiques of old theories, and loosely related excursions into subjects like stock market speculation and mercantilist theories, all of which led to confusion among readers as to what the central point actually was. Paul Samuelson, one of Keynes’s American expositors, found it to be “a badly written book,” full of “mares’ nests of confusions,” where flashes of insight were interspersed with arguments that seemed to lead nowhere.7 Keynes developed a meandering argument in his tour de force and left it to others to work out the implications.
In The General Theory, Keynes mounted an attack on what he called the “classical” school of economics, the doctrine of free and self-adjusting markets developed by the political economists of the previous century. The classical theory, he suggested, is not a general theory but rather a special theory applicable to a condition of full employment and to an economy of small producers, independent workers, and competitive markets—circumstances that no longer obtained in modern economies, increasingly dominated by large institutions and by labor unions. A central theme of Keynes’s theory, and of Keynesian economics in general, is that market economies do not automatically adjust to systemic shocks like stock market crashes, widespread bank failures, famines, and wars. A second is that the market system, left on its own, will operate most of the time at levels below full employment and potential output.
In an early chapter, he set down and rejected three postulates of “classical” political economy that (he claimed) were central to the theory of self-correcting markets. The first was Say’s Law, named for Jean-Baptiste Say, a nineteenth-century economist who held that aggregate supply creates its own aggregate demand, or as Say put it, “The general demand for products is brisk in proportion to the activity of production.” Thus, a general glut across the entire economy ought never to occur because demand should always be sufficient to soak up the goods produced. The second principle, and one related to Say’s Law, was that widespread unemployment should never occur because workers, even during slumps, should find employment by adjusting their wage demands downward to levels where employers will hire them. A third was that savings are a form of deferred consumption that are put to work in the form of investment for the production of future goods, with the interest rate regulating the general volume of savings and investment at any particular moment. The flexible movement of prices, wages, and interest rates allows the market to adjust quickly to changes in production, the demand for labor, and increases or decreases in saving.
Keynes rejected these postulates as either wrong or inapplicable to the new world of institutional capitalism in which corporate managers had replaced entrepreneurs, labor unions now intervened to negotiate on behalf of workers, and banks and investment houses emerged to act as intermediaries between savers and investors. As for Say’s Law, Keynes thought that the existence of widespread unemployment contradicted the hypothesis that supply creates its own demand. He pointed out that producers and consumers act independently and not necessarily according to the same calculations. For these reasons, Keynes rejected Say’s Law and asserted the reverse: that it is consumer demand that calls producers into action. As for wages, he observed that there were unemployed laborers more than willing to work for prevailing wages, which meant that they were not “voluntarily” unemployed but were out of work because they had no offers of employment. To complicate matters, Keynes rejected the assumption that employers could easily reduce wage rates during slumps. Wage rates, he argued, were “sticky” rather than fluid (as the classical economists supposed) in a downward direction. The existence of labor unions ready to defend labor contracts or to call worker strikes made it even more difficult for employers to cut wages during slumps. (They typically cut production and employment instead.) In addition, wage cutting across the economy has deflationary effects, so it is possible for the price level to fall faster than wages, leaving the real wage as high or higher than when the process started.
As for saving and investment, Keynes again emphasized that savers and investors were no longer the same parties as they may have been in the previous century, but rather independent actors in the economy, operating on different views of the future. Now, savings and investment had to be brought together by financial intermediaries. He went further to argue that savings are a “leakage” from consumer demand and therefore tend to draw down investment as well, since investors respond to the ups and downs of consumer demand. Consumers change their rate of saving, and businesses and entrepreneurs their level of investment, for reasons largely independent of the interest rate. This means that there is no automatic mechanism to direct the flow of savings into investment and to maintain the two quantities at roughly equal levels.
Keynes concluded that there was no obvious process of adjustment in wages, prices, and interest rates that would correct the slide in employment and output. Under certain circumstances, there could be a general overproduction of goods, widespread unemployment, hoarding of money by consumers, and a collapse of investment—all occurring at the same time and in response to one another. This meant that the market might reach equilibrium at levels well below full employment; and Keynes argued that this was in fact what had happened in the 1930s. Wage demands could remain above the level where businesses are prepared to hire, especially in times of deflation. There might be times when low or even negative interest rates would prove insufficient to induce people to spend and invest. As incomes fall, so also do savings and the purchasing power of consumers. Those with jobs and incomes, seeing what is happening around them, hold back on purchases, further worsening the situation. Where there is weak consumer demand, there will be little investment, and thus no expansion in employment and incomes, and no progress in society. For all these reasons, slumps can be self-perpetuating and need not correct themselves by the natural operation of market processes. In that case, some external intervention is required to restore consumer demand, investment, and employment.
Having rejected the economic principles of the “classical” school, Keynes went on to attack its moral postulates as well. The virtue of thrift, for example, was not as socially beneficial as many claimed. Thrift, which might make sense for individuals, results in general harm when it is too widely practiced because it leads to the withdrawal of consumption from the marketplace and a consequent reduction in consumer demand. Since savings are not automatically used up in investment in times of slack consumer demand, increased savings can lead to a reduction in the wealth of the community and an acceleration of the downward economic spiral. This was his “paradox of thrift,” a not-so-subtle attack on the nineteenth-century proposition that thrift and deferred consumption are the foundations for order and progress.b Keynes reversed the traditional formula, insisting that consumption and debt, rather than thrift and saving, are the keys to prosperity.
The basic problem according to Keynes, and the reason that market economies so often fall short of potential output and “overshoot” on both the up and down sides, is that investors and businesses must make calculations about spending and hiring in the face of a fundamentally uncertain future. Investors are the “prime movers” of the economy, and also the source of market volatility. Consumers, by contrast, behave fairly predictably, spending a stable percentage of their incomes on goods and services of various kinds, except on occasions when fear and panic lead them to reduce expenditures and increase savings. Investors, on the other hand, must allocate funds based upon uncertain assessments of conditions many years into the future. “Our knowledge of the factors that will govern the yield of an investment some years hence is usually very slight and often negligible,” Keynes wrote in The General Theory. To complicate matters further, the evolution of stock markets requires investors to make judgments about how other investors assess the future—since those assessments, when added up, determine the value of stocks.
Keynes pointed to the distinction between risk and uncertainty. Risks are subject to calculation but uncertainties are not. Investors, Keynes argued, confront an unknowable future—that is, an uncertain future—when they commit funds for five, ten, or thirty years. They cannot know if a war, inflation, a natural disaster or some other unpredictable event will intervene to undermine their investments. In a rational universe, investors might keep their funds on the sidelines permanently due to the impossibility of knowing what the future holds. In the world as it is, Keynes suggested, investors are moved not by calculations of risk but by alternating moods of confidence and pessimism that are socially contagious but loosely grounded in real conditions. These are the “animal spirits” that at bottom drive the market economy. Keynes thought that investor uncertainty was a factor that kept interest rates too high because it required lenders to demand a premium on loans. Uncertainty also cut in the other direction: from the standpoint of businessmen, future profits may appear too uncertain to justify the loans required to expand or start their enterprises. In times of pessimism, uncertainty was one of the factors that drove the economy along in a downward spiral. This element of Keynes’s theory pointed in the direction of central bank policy to maintain interest rates at low levels to eliminate the “uncertainty premium,” even if such a policy risked inflation or weakening of the currency.
Keynes thus drew a portrait of the market economy that was very close to the opposite of that drawn by his eighteenth- and nineteenth-century predecessors. They saw a system that operated like a machine with its various parts working together to keep it moving forward even in the face of external shocks, which might slow it down but could not knock it off course for very long. In their view, entrepreneurs and investors were the rational and calculating participants that kept the economic machine moving. Keynes described a system that was inherently prone to booms and busts because its various parts did not work in harmony and because it was greatly influenced by shifting investor moods. In his theory, investors and entrepreneurs were the dynamic but capricious elements, putting their funds into play and withdrawing them according to those shifting moods about future prospects and in response to the spending and saving decisions of consumers.
Thus, consumers and investors increased or reduced their spending in a reciprocal dynamic, creating a “pro-cyclical” bias in the system and giving the market its boom-and-bust character. Keynes looked to government spending and borrowing as a countercyclical factor that might stabilize the system, particularly during slumps when consumer hoarding and investor pessimism sent the economy into a downward spiral. This new role for government may have represented his most radical departure from his nineteenth-century predecessors.
Keynes was by no means the first economist or public figure to call for public spending or public works projects to reduce unemployment during slumps. Spending on public works was a common theme in political platforms in the United States and Great Britain during the 1920s and 1930s, though the proposals were generally set forth as emergency measures, not as a systemic means of stabilizing the economy over the long term. Keynes recommended public works projects to President Roosevelt when the two met in Washington in 1933, before Keynes worked out the details of his general theory. Keynes had also called for a larger role for the state in the management of the economy during the 1920s when there was no immediate crisis of unemployment. In 1925, for example, he urged the Liberal Party to adopt a platform in which the state would take a large role in “directing economic forces in the interests of justice and social stability.”8 Like many other liberals of the time, Keynes wanted the state to take on greater powers over the economy, with or without a broad theoretical rationale.
What was novel about his call for public spending in The General Theory was the broad theoretical case that he advanced for it, with public spending used as an antidote to the failure of the marketplace and as a means to restimulate private economic activity. In effect, Keynes developed a technical or instrumental case for the expansion of state powers, rather than a political or ideological one. This was another way in which he saw the state as a potential partner with the business sector instead of a rival or competitor. Keynes envisioned a new order of capitalism in which the state would act to reduce the uncertainty that he felt was a source of instability in the marketplace.
The state could manage its spending and borrowing policies toward the goal of stabilizing consumer demand, which would reduce the uncertainty faced by investors and thereby smooth out the boom-and-bust cycle of the capitalist order. Keynes pointed out that when individuals hold back on consumption or cannot spend because they lose income during slumps, and when investors defer spending because they lose confidence, government can step in to borrow and spend as a means of maintaining demand and generating investment, instead of waiting for the market to make adjustments that may take a long time to occur. Every dollar or pound spent by governments in times of slack demand would be multiplied by some fraction as it is spent and passed through the economy by consumers. In Keynes’s simplified model, domestic output is determined by these three factors: consumption plus investment plus government spending (plus net exports).
While in recessions or depressions it would be preferable for governments to spend on useful and needed projects, Keynes said that any form of spending would be preferable to a policy of inaction. As recovery takes place, government budgets might be brought back into balance and debts incurred during slumps can be paid down. Keynes argued that his approach represented a middle path, or a third way, between the failures of laissez-faire and the excesses of socialism because it was a policy of gradualism that left intact the institutions of private property and representative government.
In terms of short-term policy, there were several attractive features to the approach he outlined. First, there was the proposal to balance public spending over the business cycle in order to bring public budgets into phase with the natural ups and downs of the market economy, which meant that Keynes was not departing all that far from the principles of fiscal rectitude. In addition, he called for public borrowing mainly when interest rates were at their lowest point during the business cycle. Second, he provided policymakers with new tools to deal with slumps as alternatives to beggar-thy-neighbor trade policies like tariffs and currency devaluations, and also as alternatives to central bank credit policies that he judged to be ineffective during slumps. Third, his recommendations involved (at least from his point of view) only limited interventions into the market system. He wrote, “Apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialize economic life than there was before. . . . It is in determining the volume, not the direction, of actual employment that the existing system has broken down.”9 Policymakers need not direct spending into this or that area of the marketplace, but simply control the general volume of spending to support consumer demand and maintain full employment. (What Keynes overlooked is that officials cannot help but direct money to particular areas of the economy when they allocate funds.)
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So far, this is the “conservative” Keynes who called for modest government interventions into the economy in order to reverse slumps and to maintain full employment. He did not mount a moral attack on the market system but rather recommended adjustments to make it run more efficiently. He did not advocate nationalization of industry, the redistribution of incomes, or even the vast accumulation of government debt. He cautioned against government interventions that undermined investor confidence or interfered with investors’ willingness to put money to work. He criticized President Roosevelt’s National Industrial Recovery Act because he saw it as a bureaucratic interference into wage and price decisions that was likely to scare off investors. Keynes urged FDR instead to emphasize policies that stimulated consumer demand. When he was first presented with the Beveridge Report in 1942, Keynes worried about how the costly pension and welfare programs it advocated would be paid for. Surprisingly, Keynes was not a “big spender” or an advocate of expensive welfare programs. He did not immediately see that his calls for activist fiscal policy might be paired with calls coming from other directions for public spending on old-age pensions, relief for the poor, and more public services. He saw fiscal policy as an instrument to stabilize the economy and to promote full employment, but not much more.
On the other hand, The General Theory also contained a more radical message in regard to the relationship between the state and the private market. Keynes was already on record in earlier writings as criticizing the “moneymaking” preoccupations of investors and entrepreneurs and the moral values of thrift and work associated with market capitalism. In The General Theory, he might have stopped with his short-run prescriptions for dealing with business-cycle slumps. But he went from there to suggest that the state should maintain a continuously active fiscal policy to prevent slumps from happening in the first place. He went even further to argue that the state should take control of investment in order to rectify the shortage of capital that he identified as an endemic weakness of market capitalism. In his view, uncertainty would always be too great and likely returns too low to induce private investors to part with their funds at levels needed to sustain robust growth and full employment. Thus he believed that “a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.” Keynes looked forward to “the death of the rentier,” the private investor, and he saw the state, unlike individual investors or businessmen, as being in a position “to calculate the marginal efficiency of capital goods on long views and on general social advantage.”10 The state could act (he thought) as both the “saver” and the “investor” at one and the same time, much as the wealthy entrepreneurs acted in the prewar era, thereby eliminating the need for financial intermediaries and the intricate process of translating savings into investment.
These speculations were at odds with the overall tenor of his theory, which he tried to cast as a moderate approach for correcting endemic problems in the capitalist system. Some have suggested that Keynes viewed this as an end state that would gradually be reached through systematic efforts to apply his theory. That may have been true. In any case, his statement that the state can act on the basis of “long views and the general social advantage” revealed how little he understood about the operations of democratic governments and the short-term outlook of most popularly elected politicians.
By and large, in the United States at least, it was the “conservative” Keynes that carried the day in postwar economic policy and the practice of economics in colleges and universities. Robert Lekachman called it “commercial” Keynesianism because it emphasized growth over redistribution, and he distinguished it from “liberal” Keynesianism as advanced by economists like John Kenneth Galbraith who saw Keynes’s doctrine as an opportunity to expand the welfare state and tame the business sector. In the 1960s, Lekachman could write that, “In the calm which has followed a new national consensus, it is possible to see that Keynesian economics is not conservative, liberal, or radical. The techniques of economic stimulation and stabilization are simply neutral administrative tools. Keynes’s personal history and the early affiliation of liberals and radicals with Keynesian doctrine have obscured this vital point.”11 This was undoubtedly an overstatement and an oversimplification, particularly in view of what happened later, but it was a sound expression of the intellectual and political consensus of the time.
The postwar boom in the United States contributed immensely to the momentum behind the “Keynesian revolution” both in public policy and in academic economics. Partly for this reason, Keynes achieved greater influence in the United States in the postwar period than in any other Western nation.12 Keynesian ideas spread first through the economics profession in the 1940s and 1950s before fully taking hold in the political world when John F. Kennedy entered the presidency in 1961. It was a fortuitous juxtaposition of circumstances that allowed economists to work out the macro-economic details and implications of Keynes’s treatise at the same time that policymakers had the resources at their disposal to put his policies into action. Economists and policymakers facilitated the revolution by emphasizing goals about which everyone agreed: economic growth and full employment. This is one reason why many economists could claim that Keynesianism was a neutral administrative tool.
By the mid-1960s, when the editors of Time wrote that “We are all Keynesians now,” the revolution was essentially complete. Keynesians had largely taken over the economics profession, and the Kennedy-Johnson administration was busy putting Keynesian policies into operation at the national level. Even Richard Nixon could announce that he was “a Keynesian in economics” as he slapped wage and price controls on the U.S. economy in 1971.
The Keynesian consensus began to come apart in the 1960s, first when some influential liberals (Galbraith most prominently among them) began to question growth and production for their own sake, and then more dramatically in the 1970s when inflation and unemployment provided openings for conservatives and market-oriented economists to question the effectiveness of Keynesian policies and point to “big government” as a cause of the nation’s economic troubles. In that decade, both Friedrich Hayek and Milton Friedman won Nobel Prizes in economics for work that challenged Keynes’s theories and the consensus that had formed around them. Margaret Thatcher and Ronald Reagan moved that debate to a higher plane in the 1980s as they implemented policies to reduce marginal tax rates and free up the British and American economies from regulatory burdens. During that period, Keynesian advisers were largely absent from influential government posts in the United States.
The success of those measures tended to polarize the economic debate, as advocates of Keynesian and “classical” free-market theories moved into rival political parties, think tanks, and academic departments. This is one of the elements of the polarized politics of the present time. The so-called “classical” theory, which many thought Keynes had buried in the 1930s, returned in full force in the 1980s as an alternative to the Keynesian consensus. As things turned out, the financial crisis of 2008 did not end the debate, as many thought it should have, but rather intensified it by providing a new occasion for quarrels over stimulus packages, taxes, and regulation. The financial crisis and the policy response to it proved that the “age of Keynes” had not yet run its course, in large part because Keynes’s ideas were now woven into the fabric of national politics and the American state. At this point, extricating them would probably require a “revolution” similar to that which occurred in the 1930s and 1940s.
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In making his economic case, Keynes meant to overturn not just the “classical” theory of economics but also the doctrine of limited government linked to it. In economics and economic policy he emphasized consumption, debt, and public spending as foundations for growth, rather than thrift, saving, and laissez-faire. In opposition to Schumpeter, he argued that if capitalism was to be saved, it had to be placed on a modern moral foundation in which spending, consumption, and debt were no longer seen as vices. He looked forward to a stage of capitalism when scarcity would be overcome, along with the harsh moral principles associated with it. Keynes understood that the revolution he proposed in economics had to be accompanied by corresponding breakthroughs in morality, culture, and political institutions.
The political economists of the eighteenth and nineteenth centuries saw a strictly limited state as an elemental feature of an efficiently operating market system. It was for this purpose that they devised the constitutional rules and institutional checks that we associate with the liberal states of that time. The architects of this classical liberal order saw the state as a threat to liberty and therefore tried to tie it down through various constitutional, legal, and political constraints. The new roles that Keynes assigned to the state were precisely the kind that liberal constitutions were designed to preclude: large public expenditures, public borrowing, and political management of economic affairs. In challenging the classical theory of economics, Keynes also challenged the political doctrine of classical liberalism to which it was attached.
Keynes never spelled out a theory of the state to correspond to his economic theory of public spending and investment. He did acknowledge in the final chapter of The General Theory that in order to maintain full employment the state would have to take on functions never envisioned by those earlier proponents of liberal government. These would include setting tax rates to promote consumption and directing investment to productive and socially useful goals. Yet he was never specific about how the state should organize itself to carry out these functions.
There is one obvious requirement for a Keynesian-style system: the state must command resources at a level commensurate with its responsibility to stabilize the economy. This condition was never met through most of the history of the United States. From 1800 to 1932, the U.S. federal government never had a budget that exceeded 3 percent of GDP except in times of war, when it exceeded that percentage for brief periods. During that long period, the federal government had few responsibilities beyond national defense and running the postal service, and relied mainly on the tariff to fund its operations. In 1930, at the onset of the Depression, the federal government spent about 2.5 percent of GDP, a proportion far too small to enable it to leverage enough debt to stimulate consumer demand across the economy. Federal spending increased to 10 percent of GDP by 1940, on the eve of World War II, then increased four- or fivefold during the war years, before stabilizing throughout the postwar era at around 20 percent of GDP—or at a level large enough to finance Keynesian-style policies.
The Keynesian revolution, in order to succeed, also had to push back against inherited suspicions about government debt. In 1932, both President Hoover and FDR campaigned for the presidency in favor of a balanced federal budget. Throughout the nineteenth century, leaders of both political parties in the United States expressed horror at the prospect of a permanent public debt. After the Civil War, Republican Party platforms consistently inveighed against government debt and in favor of the tariff to finance limited federal operations. From 1800 to 1932, total U.S. government debt never surpassed 20 percent of national GDP except during wars, after which the debts were rapidly paid off. But by 1940, total federal debt approached 40 percent of GDP and then increased to more than 100 percent of GDP by the end of the war. Rapid growth in the postwar period enabled the government to reduce that total back to about 40 percent of GDP by the late 1960s, after which time it began to grow again as a result of slowing economic growth and the burdens of increasing expenditures to pay for Great Society programs. From the late 1960s to the present, the U.S. government has achieved budget surpluses on only two occasions, notwithstanding the general prosperity of the period. Today, total federal debt (public and private) exceeds 100 percent of annual GDP and continues to grow steadily in the aftermath of the financial crisis. In 2009 and 2010, due to efforts by the Obama administration to engineer a Keynesian-style recovery from the crisis, the federal government ran budget deficits that amounted to more than 10 percent of GDP.
The most problematic element of the Keynesian state turns on the forms of political organization required to sustain it. Here, too, it stands in contrast to the classical liberal state. The dominant political parties in the United States from 1800 to the 1930s—the Democratic Party before the Civil War and the Republican Party afterward—were organized around the dispersion of political power in order to protect local or private interests. State and local governments jealously guarded their rights and privileges under the federal system. In the modern age, the fiscal power of the federal government has drawn all major interests into a national orbit, including state and local governments, whose representatives make routine pilgrimages to Washington in search of funds to cover their budgets. Both political parties—but especially the Democratic Party—organize constituent groups with interests in the federal budget, and enterprising politicians learned long ago that they could organize new voting blocs with promises of federal funds. This kind of politics—“Keynesian politics”—maintains a continuous demand for federal spending that facilitates Keynesian-style economic policies.
Yet this kind of politics also creates inflexibilities in public budgets that make it difficult to adjust fiscal policy to movements in the business cycle. Politicians have found it all too easy to increase spending and to approve stimulus programs during slumps; but those expenditures, once made, are difficult to scale back during subsequent recoveries. Every item of expenditure on the public budget develops an interest group whose main purpose is to keep it going. Under those circumstances, it is not hard to understand how and why political leaders can gradually lose control of public budgets.
Nearly eighty years after the publication of The General Theory, the problems that Keynes diagnosed of too much saving and obsessive thrift have given way to the opposite problems of exploding debt and uncontrolled spending. With the United States and the developed world facing new challenges of public debt and insolvent governments, the question arises as to how and on what terms the system of political economy that Keynes helped to design can be maintained in political and economic circumstances that superficially resemble those of the 1930s but in fact are far different.
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There have not been all that many clear-cut cases in which efforts to apply Keynesian fiscal policies have rescued modern economies from recession or depression. FDR’s spending policies during the 1930s are sometimes cited in this connection, but those policies were too inconsistent, quixotic, and uncertain in their effects to be judged as Keynesian successes. The Kennedy tax cut of 1964 is more plausibly cited as a triumph of Keynesian policy, since it was explicitly crafted by Kennedy’s advisers as a demand-side stimulus and it did produce a boom, at least for a short time. It is of special interest that this effect was achieved by cutting taxes rather than by increasing expenditures. There is also the argument that our modern political economy incorporates built-in stabilizers such that recessions create automatic and self-correcting deficits; in other words, we have constructed a Keynesian system that automatically prevents or corrects for slumps. From this point of view, Keynes no longer stands for a set of policy prescriptions but rather for a fiscal system that is built into the structure of governance.
On the other hand, there are several contrary cases that must be considered, such as the British experience in the 1960s, when Keynesian policies led to a major devaluation, and the American experience in the 1970s, when similar policies resulted in “stagflation.” For the past twenty-five years, since the collapse of its real estate and stock markets, Japan has tried various Keynesian-type policies, including major stimulus packages and public works programs, with little success in producing sustained growth but leaving a public debt roughly twice the size of the annual gross domestic product. The United States also enacted a Keynesian stimulus package in 2009 to deal with a major recession, but the results were disappointing. Once the funds were spent, the expansion slowed and unemployment rates began to creep up again, provoking calls for further stimulus spending. Meanwhile, government debt levels in the United States now exceed annual GDP, a condition that is manageable only so long as the nation’s central bank can maintain interest rates at low levels. In the United States, Japan, and several European countries, governments have come close to expending whatever Keynesian ammunition they once had.
For a theory of such longstanding influence, this one has had decidedly mixed results when applied to real-world economies.13 Of course, there are many economists who claim that his approach does not work at all or that the market economy adjusts much more smoothly to shocks than Keynes or his followers contend. There are others who suggest that recent experiences in Japan and the United States show the growth effects of Keynesian policies to be getting weaker with the passage of time.
One possible reason for this weakening may be that political processes in Western democracies lead gradually to an allocation of public resources that does not contribute to economic expansion but may instead hinder it. In such a situation, Keynesian spending policies might actually interfere with necessary adjustments in the economy, thereby slowing down rather than speeding up economic growth. If this is so, then the problem lies more with the political economy of Keynes than with the economics of Keynes.
This case was first advanced in 1982 by Mancur Olson in The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities.14 In this insightful book, Olson tried to account for the “stagflation” of the 1970s and the failure of Keynesian theories to explain it. He argued that democratic nations over time develop political rigidities that permit strategically placed interest groups to block breakthroughs in policy and to exploit political influence in order to seize shares of national income that they have neither earned nor produced. These “distributional coalitions,” in Olson’s terminology, are organized around struggles over “the distribution of income and wealth rather than over the production of additional output.”15 Often called “rent-seeking” coalitions, they include cartels or special-interest groups like trade or industrial unions, public employee unions, trade associations, advocacy organizations, or corporations that try to increase the incomes of their members by lobbying for legislation “to raise some price or wage or to tax some types of income at lower rates than other types of income.”16
As rent-seeking groups accumulate and multiply their influence, they win more advantages for themselves but impose ever-greater burdens on the private economy, by blocking change or disinvestment in old industries and by diverting resources from wealth-creating to wealth-consuming uses. When an economy reaches a point where distributional coalitions are pervasive, it loses the flexibility to respond to shocks, recessions, or unanticipated changes in price levels. “The economy that has a dense network of narrow special-interest organizations will be susceptible during periods of deflation or disinflation to depression or stagflation,” Olson writes.17 The reason for this is that an unexpected deflation will expose above-market incomes and prices in the “fixed-price” sector, forcing movement out of that sector and into the “flexprice” sector where incomes, wages, and prices are set by market competition. Many will resist such moves, or not know how to accomplish them; queuing and searching costs will be high; the adjustments will force prices to fall further in the flexprice sector, reducing overall demand in the economy. An extended period of stagnation will follow as the marketplace adjusts to the distortions caused by distributional coalitions.
One might suggest that the government should then step in with the standard Keynesian remedy, borrowing money and incurring debt to arrest the deflation and to allocate funds to maintain the above-market prices and incomes in the fixed-price sector. This in fact looks very much like what the U.S. government tried to accomplish with its $800 billion stimulus package in 2009, which was allocated disproportionately to public employee unions, university research programs, energy companies that could not get loans from banks, and bankrupt auto companies and their labor unions.c Olson’s reply might be that such remedies will have only a temporary effect because they empower distributional coalitions that do not produce wealth and growth but seek to maintain their advantages at the expense of the economy as a whole. Keynesian spending policies run up debt that everyone is obliged to repay in order to underwrite above-market incomes and prices for groups whose activities impede economic growth.
This is the reason, Olson suggests, that new states grow more rapidly than long-established ones: because new states have yet to develop rent-seeking coalitions. Thus, the United States economy grew rapidly during the nineteenth century, and the economies of Japan and West Germany similarly expanded in the two or three decades after World War II. These economies all had extended periods in which markets were free to operate and interest groups had not organized to obstruct change or to claim rents; they were open to investment and entrepreneurship, and as a consequence they enjoyed historically high rates of growth. Olson emphasizes that all three countries had gone through traumatic wars and revolutions that had the salutary effect of cleaning out existing rent-seeking groups. In the United States, such groups were wiped out by revolution and then restrained by constitutional rules that limited the power of the central government; in Germany and Japan, they were eliminated by war, so that these countries started over with clean political slates. But growth and affluence led over time to the formation of rent-seeking groups that created obstacles to further expansion.
Olson has been criticized for suggesting that such rigidities are usually cleaned out by wars and revolutions—upheavals that are far worse than the problem they would solve. In the modern age, these are obviously off the table as solutions to this economic problem. Of course, the business cycle might operate in market economies to disperse at least some distributional coalitions by making above-market prices and wages more expensive for others to bear. Yet the objective of Keynes’s approach was to “smooth out” the business cycle, which allows distributional coalitions to persist over the long run, even as new ones are forming. The fact that some governments (like that of the United States) can incur debt almost without limit means that this process of underwriting distributional coalitions by government spending can be extended well into the future, or at least until that borrowing capacity is called into question. But the distributional coalitions and the debt are both burdens on future growth.
Thus, in an economy where distributional coalitions are numerous and powerful, the Keynesian remedies (or at least spending remedies) may be ineffectual in restoring consumer demand, private sector investment, and economic growth. Keynesian spending policies may in fact encourage the formation of distributional coalitions that eventually render those policies less effective. In the process, political friction builds between influential rent-seeking groups and those who are compelled to fund their benefits. This is the political flaw hidden within Keynes’s theory.d
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The “age of Keynes” has now lasted about seventy-five years, or roughly as long as the “age of laissez-faire” that preceded it. Is this era approaching an end under the pressures of the long recession, the financial crisis, accumulating public debt, the demands of distributional coalitions and the political tensions they generate? Keynes himself argued that the capitalist system evolves through stages by the development of new organizational forms and by its dynamic process of invention and destruction. There is thus no reason to assume that the “age of Keynes” represents a permanent or final stage in the evolution of capitalism. One prospect is likely: the United States, and advanced economies in general, are in the early stages of an upheaval that will test the Keynesian system to its limits.
a As things turned out, Keynes was not far off in this prediction. In the United States, per capita income increased about sevenfold from 1945 to the present time. Yet there is no thought today that the “economic problem” has been solved.
b In an addendum to The General Theory (chap. 23), Keynes approvingly cited Mandeville’s Fable of the Bees, which suggested that frugality and virtue carried to excess lead to general impoverishment. Keynes’s point was that his theory about consumer spending and consumer demand was not novel but had an ancient pedigree in the history of economic thought.
c The General Motors (and United Auto Workers) bailout was paid for out of the Troubled Asset Relief Program, the $750 billion program adopted to allow the federal government to recapitalize banks and insurance companies by purchasing “troubled” assets.
d The consequences for party politics are further discussed in Chapter 5 below.
