Another entry in the debate begun by Paul Krugman as to whether the developments of the last 30 years - from the New Classical revolution to Real Business Cycles to New Keynesian macroeconomic theory - was all a waste of time. Here Mark Thoma presents an interview with Thomas Sargent, who defends "modern macro": The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised.6 These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.
But isn't that just Krugman's point? The profession has made tremendous progress on models of an economy where everything is going pretty well. But it is when markets break down and the world is hurtling toward depression that policymakers pick up the phone and ask macroeconomists what the hell is going on and how do we get out of this mess? And when they got that call in 2008, "modern" macroeconomists had no answer. The old fuddy-duddy Keynesians did.
The sentences following Keynes' most famous quote are relevant here: "Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."
(The preceding sentence: "In the long run, we are all dead.")
The riots are the result of a lot of different factors, but surely the global economic crisis has something to do with it. Small signs of the unraveling of our society under economic pressures brings John Maynard Keynes' 1938 essay My Early Beliefs to mind. In it Keynes reflected on how poorly his and his cohort's pre-war beliefs held up against the reality of World War I, the Great Depression, the rise of Communism, Nazism, and lesser Fascisms, and the looming menace of World War II:
"We were the last of the Utopians, or meliorists as they are sometimes called, who believe in a continuing moral progress by virtue of which the human race already consists of reliable, rational, decent people, influenced by truth and objective standards, who can be safely released from the outward restraints of convention and traditional standards and inflexible rules of conduct, and left, from now onwards, to their own sensible devices, pure motives and reliable intuitions of the good...
"In short, we repudiated all versions of the doctrine of original sin, of their being insane and irrational springs of wickedness in most men. We were not aware that civilisation was a thin and precarious crust erected by the personality and the will of a very few, and only maintained by rules and conventions skilfully put across and guilefully preserved. We had no respect for traditional wisdom or the restraints of custom. We lacked reverence, as [D.H.] Lawrence observed and as Ludwig [Wittgenstein] with justice also used to say - for everything and everyone. It did not occur to us to respect the extraordinary accomplishment of our predecessors in the ordering of life (as it now seems to me to have been) or the elaborate framework which they had devised to protect this order... As cause and consequence of our general state of mind we completely misunderstood human nature, including our own...
"And as the years wore on towards 1914, the thinness and superficiality, as well as the falsity, of our view of man's heart became, as it now seems to me, more obvious....
"If, therefore, I altogether ignore our merits - our charm, our intelligence, our unworldiness, our affection - I can see us as water-spiders, gracefully skimming, as light and reasonable as air, the surface of the stream without any contact at all with the eddies and currents underneath. And if I imagine us as coming under the observation of Lawrence's ignorant, jealous, irritable, hostile eyes, what a combination of qualities we offered to arouse his passionate distaste; this thin rationalism skipping on the crust of the lava, ignoring both the reality and the value of the vulgar passions, joined to a libertinism and comprehensive irreverence, too clever by half for such an earthy character as Bunny [David Garnett], seducing with its intellectual chic such a portent as [Lady] Ottoline [Morrell], a regular skin-poison. All this was very unfair to poor, silly, well-meaning us. But that is why I say that there may have been just a grain of truth when Lawrence said in 1914 that we were 'done for.'"
We could use a few good people skilfully to put across some rules and conventions and guilefully to preserve them right about now. More broadly (and somewhat apart from Keynes' point in this particular essay, but consistent with his other writings): Managing the economy is important. We need growth and economic opportunity to keep our social structure from becoming unhinged. Expect more of what we're seeing in the UK as long as this economic crisis continues.
Keynes begins his essay "The End of Laissez-Faire" in the version included in his Essays in Persuasion with the stirring passage:
Let us clear from the ground the metaphysical or general principles upon which, from time to time, laissez-faire has been founded. It is not true that individuals possess a prescriptive ‘natural liberty’ in their economic activities. There is no ‘compact’ conferring perpetual rights on those who Have or on those who Acquire. The world is not so governed from above that private and social interest always coincide. It is not so managed here below that in practice they coincide. 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; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these. Experience does not show that individuals, when they make up a social unit, are always less clear-sighted than when they act separately.
I have always been disappointed that Keynes did not support this claim with logical argument, he simply stated it as fact and drew its implications for policy. Now I learn that the Essays in Persuasion version of the essay is just an excerpt from a longer essay that was published as a pamphlet by Hogarth Press in 1926. The passage above opens Part IV of the longer essay: Parts I-III provide a fascinating account of the history of laissez-faire and a more comprehensive practical and philosophical critique. I regret now having assigned the Essays in Persuasion version to my History of Thought students rather than the complete version. I also vow to track down the originals of every essay in Essays in Persuasion to see what else I've been missing lo these many years.*
* Of course I know already that Economic Consequences of the Peace and Tract on Monetary Reform are worth reading in their entirety. Over and over again!
From his essay, "My Early Beliefs," 1938. It's especially poignant in light of Brad DeLong's series "liveblogging" from May 1940.
I can visualise very clearly the scene of my meeting with D. H. Lawrence in 1914…My memory is that he was morose from the outset and said very little, apart from indefinite expressions of irritable dissent, all the morning… We sat round the fireplace with the sofa drawn across. Lawrence sat on the right-hand side in rather a crouching position with his head down. Bertie stood up by the fireplace, as I think I did, too, from time to time. I came away feeling that the party had been a failure and that we had failed to establish contact, but with no other particular impression. You know the sort of situation when two familiar friends talk at a visitor. I had never seen him before, and I never saw him again. Many years later he recorded in a letter, which is printed in his published correspondence, that I was the only member of Bloomsbury who had supported him by subscribing for Lady Chatterley…
Bertie gave him what must have been, I think, his first glimpse of Cambridge. It overwhelmed, attracted and repulsed him – which was the other emotional disturbance. It was obviously a civilisation, and not less obviously uncomfortable and unattainable for him – very repulsive and very attractive. Now Bunny had come into his life quite independently, neither through Ottoline nor from Cambridge and Bloomsbury; he was evidently very fond of Bunny; and when he saw him being seduced by Cambridge, he was yet more jealous, just as he was jealous of Ottoline's new leanings that way. And jealousy apart, it is impossible to imagine moods more antagonistic than those of Lawrence and of pre-war Cambridge.
But when all that has been said, was there something true and right in what Lawrence felt? There generally was. His reactions were incomplete and unfair, but they were not usually baseless… So Bunny's memoir has thrown my mind back to reflections about our mental history in the dozen years before the war; and if it will not shock the club too much, I should like in this contribution to its proceedings to introduce for once, mental or spiritual, instead of sexual, adventures, to try and recall the principal impacts on one's virgin mind and to wonder how it has all turned out, and whether one still holds by that youthful religion.
I went up to Cambridge at Michaelmas 1902, and Moore's Principia Ethica came out at the end of my first year. I have never heard of the present generation having read it. But, of course, its effect on us, and the talk which preceded and followed it, dominated, and perhaps still dominate, everything else. We were at an age when our beliefs influenced our behaviour, a characteristic of the young which it is easy for the mIddle-aged to forget, and the habits of feeling formed then still persist in a recognisable degree…
It was only for us, those who were active in 1903, that Moore completely ousted McTaggart, Dickinson, Russell. The influence was not only overwhelming; but it was the extreme opposite of what Strachey used to call funeste; it was exciting, exhilarating, the beginning of a renaissance, the opening of a new heaven on a new earth, we were the forerunners of a new dispensation, we were not afraid of anything…
Now what we got from Moore was by no means entirely what he offered us. He had one foot on the threshold of the new heaven, but the other foot in Sidgwick and the Benthamite calculus and the general rules of correct behaviour. There was one chapter in the Principia of which we took not the slightest notice. We accepted Moore's religion, so to speak, and discarded his morals. Indeed, in our opinion, one of the greatest advantages of his religion, was that it made morals unnecessary – meaning by 'religion' one's attitude towards oneself and the ultimate and by 'morals' one's attitude towards the outside world and the intermediate. To the consequences of having a religion and no morals I return later…
Even if the new members of the Club know what the religion was (do they?), it will not do any of us any harm to try and recall the crude outlines. Nothing mattered except states of mind, our own and other people’s of course, but chiefly our own. These states of mind were not associated with action or achievement or with consequences. They consisted in timeless, passionate states of contemplation and communion, largely unattached to ‘before’ and ‘after’. Their value dependend, in accordance with the principle of organic unity, on the state of affairs as a whole which could not be usefully analysed into parts… The appropriate subjects of passionate contemplation and communion were a beloved person, beauty and truth, and one’s prime objects in life were love, the creation and enjoyment of aesthetic experience and the pursuit of knowledge.
How did we know what states of mind were good? This was a matter of direct inspection, of direct unanalysable intuition about which it was useless and impossible to argue… In practice, victory was with those who could speak with the greatest appearance of clear, undoubting conviction and could best use the accents of infallibility. Moore at this time was a master of this method – greeting one's remarks with a gasp of incredulity – Do you really think that, an expression of face as if to hear such a thing said reduced him to a state of wonder verging on imbecility, with his mouth wide open and wagging his head in the negative so violently that his hair shook. Oh! he would say, goggling at you as if either you or he must be mad; and no reply was possible. Strachey's methods were different: grim silence as if such a dreadful observation was beyond comment and the less said about it the better, but almost as effective for disposing of what he called death-packets. Woolf was fairly good at indicating a negative, but he was better at producing the effect that was useless to argue with him than at crushing you. Dickinson knew how to shrug his shoulders and retreat unconvinced, but it was retreat all the same. As for Sheppard and me we could only turn like worms, but worms who could eventually be goaded into voluble claims that worms have at least the right to turn…
I have called this faith a religion, and some sort of relation of neo-platonism it surely was. But we should have been very angry at the time with such a suggestion. We regarded all this as entirely rational and scientific in character. Like any other branch of science, it was nothing more than the application of logic and rational analysis to the material presented as sense-data. Our apprehension of good was exactly the same as our apprehension of green, and we purported to handle it with the same logical and analytIcal technique which was appropriate to the latter. Indeed we combined a dogmatic treatment as to the nature of experience with a method of handling it which was extravagantly scholastic…
Thus we were brought up – with Plato's absorption in the good in itself, with a scholasticism which outdid St. Thomas, in calvinistic withdrawal from the pleasures and successes of Vanity Fair, and oppressed with all the sorrows of Werther. It did not prevent us from laughing most of the tIme and we enjoyed supreme self-confidence, superiority and contempt towards all the rest of the unconverted world. But it was hardly a state of mind which a grown-up person in his senses could sustain literally. When MacCarthy came down for a week-end, he would smile affectionately, persuade moore to sing his German Lieder at the piano, to hear which we all agreed was a very good state of mind indeed, or incite Bob Trevy to deliver a broken oration which was a frantic travesty of the whole method, the charm of it lying in the impossibility of deciding whether Bob himself meant it, half at least, seriously or not.
It seems to me looking back, that this religion of ours was a very good one to grow up under. It remains nearer the truth than any other that I know… It was a purer, sweeter air by far than Freud cum Marx. It is still my religion under the surface. I read again last week Moore's famous chapter on 'The Ideal'. Itis remarkable how wholly oblivious he managed to be of the qualities of the life of action and also of the pattern of life as a whole. He was existing in a timeless ecstasy. His way of translating his own particular emotions of the moment into the language of generalised abstraction is a charming and beautiful comedy… The New Testament is a handbook for politicians compared with the unworldliness of Moore’s chapter on ‘The Ideal’…
I am still a long way off from D. H. Lawrence and what he might have been justified in meaning when he said that we were 'done for'. And even now I am not quite ready to approach that theme. First of all I must explain the other facet of our faith. So far it has been a question of our attitude to ourselves and one another. What was our understanding of the outside world and our relation to it?
It was an important object of Moore's book to distinguish between goodness as an attribute of states of mind and rightness as an attribute of actions… We were living in the specious present, nor had begun to play the game of consequences. We existed in the world of Plato's Dialogues; we had not reached the Republic, let alone the Laws.
This brought us one big advantage. As we had thrown hedonism out of the window and, discarding Moore's so highly problematical calculus, lived entirely in present experience, since social action as an end in itself and not merely as a lugubrious duty had dropped out of our Ideal, and not only social action but the life of action generally, power, politics, success, wealth, ambition, with the economic motive and the economic criterion }ess prominent in our philosophy than With St Francis of Assisi, who at least made collections for the birds, it follows that we were amongst the first of our generation, perhaps alone amongst our generation, to escape from the Benthamite tradition. In practice, of course, at least so far as I was concerned, the outside world was not forgotten or forsworn. But I am recalling what our Ideal was in those early days when the life of passionate contemplation and communion was supposed to oust all other purposes whatever. It can be no part of this memoir for me to try to explain why it was such a big advantage for us to have escaped from the Benthamite tradition. But I do now regard that as the worm which has been gnawing at the insides of modern civilisation and is responsible for its present moral decay. We used to regard the Christians as the enemy, because they appeared as the representatives of tradition, convention and hocus-pocus. In truth it was the Benthamlte calculus, based on an over-valuation of the economic criterion, which was destroying the quality of the popular Ideal.
Moreover, it was this escape from Bentham, joined with the unsurpassable individualism of our philosophy, which has served to protect the whole lot of us from the final reductio ad absurdum of Benthamism known as Marxism. We have completely failed, indeed, to provide a substitute for these economic bogus-faiths capable of protecting or satisfying our successors. But we ourselves have remained – am I not right in saying all of us? – altogether immune from the virus, as safe in the citadel of our ultimate faith as the Pope of Rome in his.
This is what we gained. But we set on one side, not only that part of Moore's fifth chapter on 'Ethics in relation to Conduct' which dealt with the obligation so to act as to produce by causal connection the most probable maximum of eventual good through the whole procession of future ages (a discussion which was indeed riddled with fallacies), but also the part which discussed the duty of the individual to obey general rules. We entirely repudiated a personal liabiljty on us to obey general rules. We claimed the right to judge every individual case on its merits, and the wIsdom, experience and self-control to do so successfully. This was a very important part of our faith, violently and aggressively held, and for the outer world it was our most obvious and dangerous characteristic. We repudiated entirely customary morals, conventions and traditionaI wisdom. We were, that is to say, in the strict sense of the term, immoralists. The consequences of being found out had, of course, to be considered for what they were worth. But we recognised no moral obligation on us, no inner sanction, to conform or to obey. Before heaven we claimed to be our own judge in our own case…
I am not now concerned, however, with the fact that this aspect of our code was shocking. It would have been not less so, even if we had been perfectly right. What matters a great deal more is the fact that it was flimsily based, as I now think, on an a priori view of what human nature is like, both other people's and our own, which was disastrously mistaken.
I have said that we were amongst the first to escape from Benthamism. But of another eighteenth-century heresy we were the unrepentant heirs and last upholders. We were among the last of the Utopians, or meliorists as they are sometimes called, who belIeve in a continuing moral progress by virtue of which the human race already consists of reliable, rational, decent people, influenced by truth and objective standards, who can be safely released from the outward restraints of convention and traditional standards and inflexible rules of conduct, and left, from now onwards, to their own sensible devices, pure motives and reliable intuitions of the good. The view that human nature is reasonable had in 1903 quite a long history behind it. It underlay the ethics of self-interest – rational self-interest as it was called – just as much as the universal ethics of Kant or Bentham which aimed at the general good; and it was because self-interest was rational that the egoistic and altruistic systems were supposed to work out in practice to the same conclusions.
In short, we repudiated all versions of the doctrine of original sin, of there being insane and irrational springs of wickedness in most men. We were not aware that civilisation was a thin and precarious crust erected by the personaly and the will of a very few, and only maintained by rules and conventions skilfully put across and guilefully preserved. We had no respect for traditional wisdom or the restraints of custom. We lacked reverence, as Lawrence observed and as Ludwig with justice also used to say – for everything and everyone. It did not occur to us to respect the extraordinary accomplishment of our predecessors in the ordering of life (as it now seems to me to have been) or the elaborate framework which they had devised to protect this order… As cause and consequence of our general state of mind we completely misunderstood human nature, including our own…
It seems to me that Moore’s chapter on ‘The Ideal’ left out altogether some whole categories of valuable emotion. The attribution of rationality to human nature, instead of enriching it, now seems to me to have impoverished it. It ignored certain powerful and valuable springs of feeling. Some of the spontaneous, irrational outbursts of human nature can have a sort of value from which our schematism was cut off. Even some of the feelings associated with wickedness can have value. And in addition to the values arising out of spontaneous, volcanic and even wicked impulses, there are many objects of valuable contemplation and communion beyond those we knew of – those concerned with the order and pattern of life amongst communities and the emotions which they can inspire…
And as the years wore on towards 1914the thinness and superficiality, as we as the falsity, of our view of man's heart became, as it now seems to me, more obvious; and there was, too, some falling away from the purity of the original doctrine… I fancy we used in old days to get round the rich variety of experience by expanding illegitimately the field of aesthetic appreciation… classifying as aesthetic experience what is really human experience and somehow sterilising it by this mis-classification.
If, therefore, I altogether ignore our merits – our charm, our intelligence, our unworldliness, our affection I can see us as water-spiders gracefully skimming, as light and reasonable as air, the surface of the stream without any contact at all with the eddies and currents underneath. And if Iimagine us as coming under the observation of Lawrence's ignorant, jealous, irritable, hostile eyes, what a combination of qualities we offered to arouse his passionate distaste; this thin rationalism skipping on the crust of the lava, ignoring both the reality and the value of the vulgar passions, joined to libertinism and comprehensive irreverence, too clever by half for such an earthy character as Bunny, seducing with its intellectual chic such a portent as Ottoline, a regular skin-poison. All this was very unfair to poor, silly, well-meaning us. But that is why I say that there may have been just a grain of truth when Lawrence said in 1914 that we were 'done for'.
The SEC charges that Goldman Sachs defrauded customers when it sold them synthetic CDOs without telling them that the securities that comprised them had been selected by a hedge fund precisely on the basis of their having a high probability of default. What, I hear you asking, is a synthetic CDO? Well, see if you can follow the bouncing ball:
- A mortgage, from the perspective of the lender, is a security that pays a fixed amount each month for 15, 20, or 30 years (I'm referring to conventional mortgages here).
- A mortgage-backed security (MBS) is a pool of mortgages. Like a mutual fund, it is a security whose payments are generated by the mortgages it contains.
- A collateralized debt obligation (CDO) is a pool of MBS. Its payments are generated by the payments on the MBS it contains, with the complication that the CDO divides payments into risk classes or "tranches." Any defaults on the underlying MBS are assigned to the lowest rated tranche first, then to higher level tranches as needed, so that if you buy the highest tranche you are insulated from most of the defaults on the underlying MBS.
- A credit default swap is a transaction in which one party makes small periodic payments to another party as long as an underlying asset such as a CDO continues to generate payments, and makes a large payment in the reverse direction if the underlying asset defaults. It is essentially an insurance policy on the underlying asset.
- A synthetic CDO is a collection of credit default swaps whose payment structure is designed to mimic the payment stream that would be generated from a CDO.
That's simple enough. But the question that naturally arises is the one posed by Andrew Ross Sorkin: "What purpose does a synthetic C.D.O., which contains no actual mortgage bonds, serve for capital markets, and for society? To answer this question, we turn to the Book of Keynes, Chapter 12. Read the whole chapter, it is chock full of insights. But the relevant passage for the present question is this:
In former times, when enterprises were mainly owned by those who undertook them or by their friends and associates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not really relying on a precise calculation of prospective profit... Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and II in the morning and reconsider whether he should return to it later in the week...
Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called 'liquidity'. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is 'to beat the gun', as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow...
The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.
The answer is liquidity. Mortgage-backed securities make mortgages more liquid, hence more valuable to the lender, hence available at a lower price (interest rate) to the borrower. CDOs make MBS more liquid, hence more valuable, which further lowers the rate at which lenders are willing to extend mortgages. Credit default swaps make CDOs more liquid, and synthetic CDOs do the same. The social benefit from all these derivatives is greater liquidity for assets that by their nature are illiquid, hence lower mortgage rates for prospective homebuyers. The tradeoff is, in a financial panic investors try to exercise the liquidity value of these investments. But the house itself that is the asset underlying the pyramid of finance is not liquid, and therefore the rush for liquidity creates a collapse in the real economy.
But the argument for MBS, CDO, CDS, synthetic CDO and the like presumes that the liquidity value priced into these instruments reflects the true risks associated with each of these assets. The current situation has arisen in part because these assets were mispriced, which resulted in overinvestment in the underlying asset (housing). They were mispriced for a number of reasons, including stupidity on the part of market participants, corruption of the rating agencies, and (alleged) fraud on the part of institutions like Goldman Sachs. One way to increase the probability that these types of securities are correctly priced is to force them to be traded over organized exchanges rather than "over-the-counter" as in the Goldman Sachs deals. This is one of the most important elements of the financial reform bill that the Democrats are trying to pass. But Keynes tells us that even if assets are correctly priced in ordinary times, the function of financial markets of making fundamentally illiquid assets like houses appear to investors as liquid assets presents a dilemma: though it fosters investment, it also makes the economy susceptible to periodic panics that result in economic crisis.
The debates between John Maynard Keynes and those who do not accept his views are just as fresh today as they were in the 1920s and 30s. That is both a testament to the power of Keynes' ideas and a damning indictment of Economics' claim to be a science. Two cases in point:
(1) Recent fears that inflation is just around the corner, coupled with skepticism about the effectiveness of last year's fiscal stimulus. From Keynes' "A Programme of Expansion," May 1929:
"The suggestion that a policy of capital expenditure, if it does not take capital away from ordinary industry, will spell Inflation, would be true enough if we were dealing with boom conditions... But we are far, indeed, from such a position at the present time. A large amount of deflationary slack has first to be taken up before there can be the smallest danger of a development policy leading to Inflation. To bring up the bogy of Inflation as an objection to capital expenditure at the present time is like warning a patient who is wasting away from emaciation of the dangers of excessive corpulence."
"The whole of the labour of the unemployed is available to increase the national wealth. It is crazy to believe that we shall ruin ourselves financially by trying to find means for using it and that "Safety First" lies in continuing to maintain men in idleness. It is precisely with our unemployed productive resources that we shall make the new investments."
"Negation, Restriction, Inactivity - these are the Government's watchwords. Under their leadership we hav been forced to button up our waistcoats and compress our lungs. Fears and doubts and hypochondriac precautions are keeping us muffled up indoors. But we are not tottering to our graves. We are healthy children. We need the breath of life. There is nothing to be afraid of. On the contrary, the future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered."
Defenders of Keynes, such as the recent convert Bruce Bartlett, often claim that he supported capitalism... His interventionist measures had as their aim not the replacement of capitalism by socialism or fascism. Rather, it is alleged, Keynes aimed to save the existing order. The unhampered market cannot by itself recover from a severe depression or at best can do so after long years of privation and unemployment. Keynes discovered a way by which the government, through an increase in spending, can restore the economy to prosperity... Hunter Lewis convincingly shows the error of this often heard line of thought. Keynes, far from being the savior of capitalism, aimed to replace free enterprise with a state-controlled economy run by "experts" like him. His prescriptions for recovery from depression do not save capitalism: they derail the price system by which it functions...
Further, Keynes ignored the significance of a fundamental fact. The rate of interest is also a price. It reflects the preferences of consumers for present over future goods: the greater the time preference, the higher the rate of interest. Keynes principal aim in economic policy, not only to combat depressions but more generally, was to keep the rate of interest low: ideally, it should be done away with entirely. To do so flies in the face of consumer preferences. If the rate of interest is forced below what it would have been on the unhampered market, then people are being compelled to invest more than they wish. The point holds altogether apart from the Austrian theory of the business cycle, which Lewis fully accepts. That theory tells us that forcing the rate of interest below the natural rate may lead to an unsustainable boom. But even if this theory were mistaken, interference with interest rates would still distort the economic system. "Businesses depend on prices to give then the information with which to run the economy. If the price system for interest rates is broken, no part of the price system is unaffected. "
Of course a careful reading of the General Theory and Keynes' other works makes it clear that he was not in favor of government control of the economy. Government should manage the aggregate amount of spending through fiscal and monetary policy, but leave the allocation of investment spending to the private sector. When Keynes argues for the "socialization of investment" in the General Theory he is talking about the creation or expansion of semi-public institutions like "Universities, the Bank of England, the Port of London Authority, even perhaps the Railway Companies" and even throws in corporations whose management is insulated from the short-sighted demands of shareholders and are therefore free to take up social responsibilities (see "The End of Laissez-Faire," 1926). He approved not the free-wheeling capitalism we now have, nor something like the "commanding heights" program of the post-war Labor governments in the UK, but a system in which a critical mass of private enterprises were structurally insulated from the vagaries of the market.
It's entertaining to imagine how Keynes would have responded to each of Gordon's (and by implication Lewis') critiques of Keynes' theory. I'll take just one, the meaning of the interest rate. Keynes argued that
"It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period." (GT, chapter 13)
Capital, Keynes argued, earns a rate of return (equal to the rate of interest) not because it is productive, but because it is scarce. Thus the solution to our problems in the long-term is to lower the rate of interest and flood the world with capital. It's an interesting, provocative argument that I'm not sure I agree with, but it's ludicrous to claim that Keynes policy prescriptions are based on his having "ignored" the "fact" of the true determinants of the rate of interest.
Samuelson and Solow's (1960) paper on the Phillips curve in the U.S. has been widely derided. The paper noted that wage inflation and the unemployment rate tended to be negatively correlated in the US during the 1940s and 1950s. This meant there was a "tradeoff" between inflation and unemployment: low rates of inflation could be "bought" with high rates of unemployment, low rates of unemployment could be "bought" with high rates of inflation. As the story goes, this argument convinced policymakers that they could achieve permanently lower inflation with a modestly high but stable rate of inflation, which led to the policy mistakes giving us high inflation and high unemployment in the 1970s.
A fascinating paper by James Forder at Oxford U. puts the lie to the argument. Forder notes that it was only in the 1970s that economists began to claim that Samuelson and Solow interpreted their Phillips curve to mean that the tradeoff between inflation and unemployment was a stable one, i.e. one that could be exploited by policymakers to reduce the unemployment rate to 3 or 4 percent. Forder argues that throughout the 1960s the paper was taken to have a different message entirely: that the existence of the tradeoff meant that we could not easily achieve the twin objectives of full employment and price stability, and that the tradeoff was not stable and therefore not exploitable. So why the change in interpretation?
Forder dates the transition in interpretation to Milton Friedman's introduction of the expectations augmented Phillips curve in 1968. This is certainly right. Friedman and his followers needed a strawman against which to build their argument for the existence of a natural rate of unemployment. It was convenient to claim that Keynesians had argued for a stable tradeoff between inflation and unemployment, since then they could demonstrate that that claim was logically false because as we all know there is a unique equilibrium level of employment and unemployment, then show how belief in the permanent tradeoff contributed to the Great Inflation of the 1970s, then advocate for reform of monetary policy institutions to make sure this doesn't happen again.
But Keynesians shouldn't get too touchy about the monetarists' mischaracterization of Samuelson and Solow's views. This is, after all, exactly what Keynes himself did to the so-called "Classical" economists in The General Theory. He begins his book by defining Classical economics (which was not generally recognized at the time as a distinct school of thought, at least not in the way Keynes used the term) in fairly cartoonish terms, and then proceeds to demolish this theory. Keynes did the world a service - thanks to his work we gained an understanding of both Keynesian and non-Keynesian (Classical) macroeconomic theory, which had been a complete muddle before. And I suppose the monetarists did us the same favor with Samuelson and Solow.
You know, if you read John Maynard Keynes railing against the fiscal austerions and gold bugs in the British Treasury during the 1920s-30s, you don't need to read anything else about what's going on in Europe today.
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