The Triumph of Keynesian Economics

Following is chapter two of my 2009 book, The New American Economy (New York: Palgrave Macmillan). It was completed in early May of that year. The research, which was mostly done in 2008, was vital to my understanding of the 2008/2009 recession, which I believe had precisely the same cause as the Great Depression, but was about one third as deep, owing primarily to swift action by the Federal Reserve and enactment of an inadequate but nevertheless positive fiscal stimulus in early 2009. I have not updated it, but only reformatted it and included hyperlinks.

When I first began studying economics in 1969 I was quickly attracted to those economists with a free-market perspective. In those days, almost all of them were affiliated with either the Austrian school of Ludwig von Mises and F.A. Hayek or the Chicago school of Frank Knight and Milton Friedman. While superficially similar, these two schools of economic thought had too many methodological disagreements to ever really be allies.1 But they did share a common view of John Maynard Keynes as a man of the far left whose theories were primarily responsible for inflation and most of the other economic ills of society at that time.

I got to know many of the most prominent anti-Keynesian economists of the 1970s, including Mises, Hayek, Friedman, Murray Rothbard, Henry Hazlitt, Gottfried Haberler, W.H. Hutt, James Buchanan, and Allan Meltzer, and felt comfortable among those of any school that was opposed to Keynesian economics. One of the first articles I ever published was an attack on Keynes that appeared in the Rutgers College newspaper. Some of my earliest academic works were attacks on Keynesian economics.2

Eventually I fell in with some economists trying to develop an explicit alternative to Keynesian economics that came to be called supply-side economics, which I will discuss in chapter 4. Ironically, even as supply-side economics achieved ascendancy in the 1980s and Keynesian economics seemed thoroughly discredited, I found myself mourning its passing. It had been the glue that united the left on economic policy for a long time. But once Keynesian economics fell from grace, I saw it being replaced by industrial policy, the idea that government needed to directly guide the economy with subsidies, regulations, and trade protection. In the 1980s many on the left viewed these sorts of policies as the keys to Japan’s incredible economic success.3

I suddenly realized that Keynesian economics was far preferable to the quasi-socialist policies that seemed to be replacing it on the left. It was then that I understood that Keynes had developed his theories in large part to save the free market from Marxism and various socialisms of the left and right that were highly popular in the depths of the Great Depression, which was widely viewed as representing the ultimate failure of capitalism. I saw that complete rejection of Keynes had created a vacuum that was being filled by something far worse. I began an effort to rehabilitate Keynes and eventually came to have a great deal of respect for his ideas.4

This respect grew as I read Keynes himself rather than relying on the interpretations of his followers or his critics. Especially valuable in understanding him and what he was trying to accomplish in the 1930s are his early works. Everything he wrote before The General Theory of Employment, Interest and Money in 1936 tends to be ignored by economists and historians alike. But it is critical to see how Keynes thought his way through economic problems very similar to those we are suffering today. He was such a prolific writer and commentator, and his collected works are so well organized and indexed, that it is possible to see the evolution of his thinking in real time.

I believe it’s time to rehabilitate Keynes. His theories provide the best guide to the problems we

face today that economics has to offer. As the previous chapter shows, many economists had concluded well before 1936 that the fundamental economic problem was deflation and that an expansive fiscal policy was necessary to mobilize monetary policy to stop prices from falling. But they were unsuccessful in getting policymakers adopt the right policies or be bold enough to offset the economy’s downward momentum. Keynes succeeded where they failed. This chapter explains how.

Keynes: Enemy of Inflation and Deflation

Since Keynes is still often condemned as a crude inflationist, it’s important to understand that he

always held price stability to be among the most important prerequisites for economic progress. As he wrote in 1919:

[Russian Revolution leader Vladimir] Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.5

For many years, it was thought that Keynes was mistaken because there was no record of Lenin having said what Keynes quoted.6 But in a quote recently unearthed by economist Kurt Schuler, Lenin indeed said exactly what Keynes said he said and did believe that inflation would destroy capitalism. As Lenin said in 1919:

Hundreds of thousands of ruble notes are being issued daily by our Treasury. This is done not in order to fill the coffers of the state with practically worthless paper, but with the deliberate intention of destroying the value of money as a means of payment. There is no justification for the existence of money in a Bolshevist State, where the necessities of life shall be paid by work alone….

Already even the hundred ruble note is almost valueless in Russia. Soon even the simplest peasant will realize that it is only a scrap of paper not worth more than the rags from which it is manufactured. Men will cease to covet and hoard it so soon as they discover it will not buy anything, and the great illusion of the value and power of money on which the capitalist state is based will have been definitely destroyed.

This is the real reason why our presses are printing ruble bills day and night without rest. But this simple process must, like all the measures of Bolshevism, be applied all over the world in order to render it effective. Fortunately, the frantic financial debauch in which all the governments have indulged during the war has paved the way everywhere for its application.7

Keynes thought it was a terrible mistake for the Versailles Treaty, which ended World War I, to force Germany to pay huge reparations to the war’s victors. They would cripple Germany’s economy and make it fertile ground for revolution. Keynes’s fears were soon realized when Germany tried to inflate its way out of its debts by just printing money. At the peak of the resulting hyperinflation in 1923 even the largest bank notes were barely worth the paper they were printed on; a wheelbarrow full of money was needed just to buy a loaf of bread. And, as Keynes predicted, the result was to impoverish the middle class while enriching the wealthy, who borrowed heavily, bought gold and foreign currencies, and repaid their debts in money that was virtually worthless.

It is generally agreed that the social unrest created by the German hyperinflation was central to the rise of Adolf Hitler and the Nazi Party. As economist Lionel Robbins put it in 1937, “Hitler is the foster-child of the inflation.” In a 1942 lecture, the great German novelist Thomas Mann agreed: “A straight line runs from the madness of the German inflation to the madness of the Third Reich.” Historians Niall Ferguson and Brigitte Granville concur: “By discrediting free markets, the rule of law, parliamentary institutions, and international economic openness, the Weimar inflation proved the perfect seedbed for national(ist) socialism.”8

Keynes was keenly aware of events in Germany. His 1919 book, The Economic Consequences of the Peace, had made him well known as an expert on the subject and he was in regular contact with German economists and businessmen during the early 1920s. In his Tract on Monetary Reform, published in 1923, Keynes often referred to the disastrous effects of inflation in Germany. Indeed, the Tract is one of the strongest anti-inflation polemics ever written. Its basic theme is that price stability is essential to the operation of capitalism. Keynes even suggested that capitalism could not survive in its absence. And opposition to inflation wasn’t just a public posture for Keynes. In private communications with British Treasury officials he was quite adamant about the need to fight inflation with the strongest possible measures.9

Keynes’s opposition to inflation flowed from his belief in the importance of stable money—he was equally opposed to inflation and deflation. Many so-called hard-money people today adamantly oppose inflation but don’t complain about the problems of deflation and often view it positively.10 Keynes was not one of these. In his view, the main effect of inflation was to impose a de facto tax on capital—which in practical terms meant on the wealthy, whom he called the rentier class, those who didn’t work for a living and lived off income from capital. But at the same time, inflation benefited the business class, which was able to increase prices faster than costs rose, leading to higher profits.11

Deflation, on the other hand, mainly hurt workers because it led to unemployment as real wages increased, forcing employers to lay off employees in order to reduce labor costs. Eventually, the unemployment would force employers to cut nominal wages by the amount of the deflation, but this was a very painful and prolonged process. Thus, although inflation and deflation were both bad, deflation was the bigger problem distributionally in Keynes’s view, because it was worse to raise unemployment than to harm the rentiers.12 That is why he was so opposed to the British government’s policy of intentionally deflating the pound after World War I to restore the prewar exchange rate.

The deflation in Britain began in 1920 when the government committed itself to raising the value of the pound back up to $4.86 from $3.66. This required a shrinkage of the money supply in order to make the pound scarcer vis-à-vis the dollar. The British government considered it important both economically and morally to restore the prewar parity lest all of those who had bought British bonds suffer a de facto 30 percent loss. It was also thought that failure to repay its debts at the prewar parity would raise interest rates by adding a risk premium to British bonds, making them less attractive to foreign investors.13

Shrinking the money supply causes prices to fall, which puts downward pressure on wages. But producers can’t very well cut prices unless their costs also fall and labor is the largest expense for any business. As Keynes explained in 1925:

Our problem is to reduce money wages and, through them, the cost of living, with the idea that, when the circle is complete, real wages will be as high, or nearly as high, as before….The object of credit restriction, in such a case, is to withdraw from employers the financial means to employ labor at the existing level of prices and wages. The policy can only attain its end by intensifying unemployment without limit, until the workers are ready to accept the necessary reduction of money wages under the pressure of hard facts.14

In the past, workers had been disorganized and less able to resist demands by employers for lower wages when the Bank of England tightened money to protect the pound. But by the 1920s unionization had become widespread and workers were in a better position to resist wage cuts. The institution of welfare programs also made it easier for workers to survive without working, thus prolonging strikes and raising unemployment.15 In 1926 a massive general strike against wage cuts convinced Keynes that offsetting an inflation with a deflation as a means to maintain average price stability was no longer a viable option. Since workers would strenuously resist the wage cuts that were a necessary consequence of a deflation, British businesses would be compelled by market forces to cut prices yet be stuck with high labor costs that would cripple them.

The first effect of deflation, Keynes believed, was felt by entrepreneurs because they were forced to reduce market prices for their output while their costs were largely unchanged. In the initial phase of this development they simply absorbed the losses and reduced their profits. In the second phase they cut back on their least profitable lines of business. Only after this process had continued for some time did employers finally feel compelled to force wage cuts. Thus the full implementation of a deflationary program was very protracted and therefore inefficient.16

By contrast, the process of inflation was relatively smooth. Entrepreneurs could raise their prices as soon as they sensed increased demand. Since their costs were largely fixed in the short-run, the price increases raised profits and encouraged capital investment. Although workers suffered from a fall in real wages as prices rose while their wages were unchanged, they also benefited from a rise in employment as businesses expanded production in response to higher profits. Thus while inflation and deflation each had their negative consequences, Keynes saw some benefits to inflation while deflation essentially had none. Given a choice, therefore, a modest inflation was much to be preferred over the equivalent deflation.17

In the post–World War II era, most U.S. recessions took place under inflationary conditions. This greatly aided economic readjustment by, for example, reducing real wages when nominal wage rates were unchanged. But the recession of 2008-2009 created deflationary conditions like those of the 1930s. Unless workers were willing to accept actual pay cuts there was no way businesses could avoid massive layoffs and bankruptcies—a situation most evident in the problems of the auto industry, which had the highest wages and benefits in the manufacturing sector and suffered the brunt of the deflationary pressure, hastening a collapse in sales and profits.

The Great Depression

When the Great Depression began, Keynes opposed the traditional cure for economic downturns—price and wage cuts that would restore equilibrium. It wasn’t that this cure wouldn’t work, he thought, it’s that the social cost of this policy was so great that it would threaten the maintenance of liberal democracy, leading to an authoritarian state such as that in the Soviet Union. As Keynes explained to an American audience in a 1931 lecture:

Will not the social resistance to a drastic downward readjustment of salaries and wages be an ugly and dangerous thing? I am told sometimes that these changes present comparatively little difficulty in a country such as the United States where economic rigidity has not yet set in. I find it difficult to believe this. But it is for you, not me, to say. I know that in my own country a really large cut of many wages, a cut at all of the same magnitude as the fall in wholesale prices, is simply an impossibility. To attempt it would be to shake the social order to its foundation. There is scarcely one responsible person in Great Britain prepared to recommend it openly.18

Instead of forcing wages and prices to adjust to a monetary deflation, Keynes thought it made much more sense to readjust the currency. Better to raise prices back up to where they were previously than endure the pain of vast unemployment and huge wage cuts, he argued. This would restore equilibrium without the necessity of reducing wages by the same percentage that the price level had fallen. As Keynes put it, “The cumulative argument for wishing prices to rise appears to me…to be overwhelming.”19

Shortly after giving this lecture, Keynes wrote an article for the American magazine Vanity Fair in which he explained his point further. The decline in prices, he said, was so severe that it threatened the whole financial structure. Eventually the economy would recover on its own, but without governmental action the result would be “a period of waste and disturbance and social injustice.” Keynes viewed this forced rearrangement of wealth as utterly unnecessary and feared that its capriciousness would reinforce the idea that capitalism had no redeeming moral foundation.20

In early 1933 Keynes published a short pamphlet, The Means to Prosperity. In it he expressed growing frustration with the inability of policymakers to understand the nature of the economic problem and to take sufficiently bold actions to deal with it. He was especially critical of the large tax increase enacted by the United States in 1932, which Keynes felt was totally counterproductive. In the process, he even developed a version of what later became known as the Laffer curve—the idea that tax rates may be so high as to reduce revenue. As Keynes explained:

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more—and who, when at last his account is balanced with naught on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.21

Keynes tried as hard as he could to get Franklin D. Roosevelt and other American policymakers to understand that the issue was one of deflation. But as the previous chapter recounts, his efforts were largely futile. By the end of 1934, meaningful understanding of the fundamental economic problem was still limited to a few isolated individuals like Irving Fisher who seemed to have little influence with those in power at the White House, Treasury, or Federal Reserve. This led Keynes to conceive of a new approach to the problem designed to get around the institutional resistance to a monetary and fiscal policy sufficiently expansive to get the job done.

The General Theory

By 1935, Roosevelt was still pursuing ad hoc stimulus policies. Although the overall size of the U.S. economy had grown 10.8 percent in 1934, it was still a third below its potential based on pre-depression growth rates.22 The administration and Congress seemed unwilling to pursue aggressive stimulus policies and instead reacted half-heartedly to minicrises as they occurred. Many economists were equally frustrated in 2009 as the very justification for any stimulus was hotly debated even as the economy continued to deteriorate.

Keynes decided that he needed to make the argument for stimulus much more systematically and in much more detail than he had done previously. During 1935 he worked on a new book, The General Theory of Employment, Interest and Money. Published the following year, its basic argument was that it was impractical to reduce unemployment by forcing down money wages to adjust for a monetary deflation.23 It was vastly preferable, Keynes explained, to simply reduce real (inflation-adjusted) wages by offsetting the deflation with a compensating inflation. As he put it early in the book:

Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labor whenever there is a rise in the price of wage- goods. It is sometimes said that it would be illogical for labor to resist a reduction of money-wages but not to resist a reduction of real wages…. But, whether logical or illogical, experience shows that this is how labor in fact behaves.24

Further on Keynes was even more explicit about using inflation to reduce real wages in order to raise employment. “A movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices,” he wrote.25

Keynes’s argument basically boiled down to practicality. “A flexible wage policy and a flexible money policy come, analytically, to the same thing,” he explained, “inasmuch as they are alternative means of changing the quantity of money in terms of wage-units.” Keynes conceded that governments could theoretically force down wage rates by decree but that only authoritarian states had such power. Every nation, however, had the power to alter the value of its currency and thus the price level through monetary policy. As he put it:

A change in the quantity of money…is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable….It can only be an unjust person who would prefer a flexible wage policy to a flexible money policy.26

Part of the problem, however, was getting money out into the economy where it could do some good. Lower interest rates by themselves would not bring forth additional investment because of a liquidity trap that results when market rates are so low that money and bonds become virtually interchangeable. When this happens, open market operations by the central bank, which involves buying bonds and paying for them with newly created money, become impotent. It would simply be exchanging one asset for another that is virtually identical because money is really just a perpetual bond that pays no interest.27

Getting the money moving, so to speak, requires the government to engage in deficit financing precisely for the purpose of increasing market interest rates, which would get the economy out of the liquidity trap and make an expansive monetary policy effective once again. It didn’t really matter what the money raised by borrowing was spent on as long as it involved the purchase of goods and services. Income transfers and tax cuts were less effective because much of the money would be saved, thus frustrating the need to raise interest rates. It would be best for governments to finance the construction of socially beneficial public works, such as roads and buildings.28 But for macroeconomic purposes it was not necessary that the construction be inherently productive, because the primary purpose of the effort was to create a mechanism for making monetary policy effective.

Toward this end, Keynes suggested that pyramid-building, earthquakes, and even wars might serve an economically useful purpose when the economy was stuck in a liquidity trap, because they forced governments to spend funds rapidly and run deficits. He jokingly proposed that governments might even bury cash in old mine shafts that had been filled with rubbish. The resources expended by entrepreneurs to dig up the money would make the scheme economically productive to society by employing workers, creating incomes, and mobilizing capital.29

It must be emphasized that Keynes was being facetious. He understood that societies could not enrich themselves in the long run through such wasteful projects. They were applicable only during times when deflation had brought on an economic slowdown that reduced interest rates to the point where a liquidity trap existed. These were extremely special circumstances that occurred only very, very rarely; in normal times, Keynes knew perfectly well, such schemes would be economically counterproductive.

The Obama administration tried to make this point as well in early 2009 in trying to get a massive stimulus bill enacted. It was more important to do something quickly, it explained, even if it meant wasting a lot of money on programs of dubious value. Growth would not come from the programs themselves but from the overall impact of the deficit on the economy. But because it did not explain the Keynesian argument very well, the Obama administration left itself open to easy attack by Republicans who ridiculed the stimulus as a grab bag of spending with no inherent logic.

Reaction to the General Theory

The initial reaction to The General Theory among professional economists was quite modest. They recognized very quickly that Keynes wasn’t really saying anything much different than he had been saying all along. Among those who were initially less than enthusiastic were many who would later be among the strongest supporters of Keynesian economics. For example, one of the first reviews of The General Theory was by economist Alvin H. Hansen, who became Keynes’s number one advocate in the United States during the early postwar era. Writing in the Yale Review, Hansen saw little, if anything, in The General Theory that was inconsistent with mainstream economics, given Keynes’s assumption of relatively inflexible wages and prices. A few months later, writing in the Journal of Political Economy, Hansen reiterated his view that there was nothing new in The General Theory:

The book under review is not a landmark in the sense that it lays a foundation for a “new economics.” It warns once again, in a provocative manner, of the danger of reasoning based on assumptions which no longer fit the facts of economic life…. The book is more a symptom of economic trends than a foundation stone upon which a science can be built.30

Shortly thereafter, Wassily Leontief, winner of the Nobel Prize in economics in 1973, was equally dismissive. “The difference between Mr. Keynes’ new theory of economic equilibrium and the ‘orthodox’ classical scheme is fundamentally a difference in assumption,” he wrote in the Quarterly Journal of Economics.31 In that same issue, economist Jacob Viner, one of the greatest of the twentieth-century economists, also saw no meaningful difference between Keynes’s theory and the traditional view except in terms of his preference for inflation over wage cuts as a cure for unemployment: “Keynes’ reasoning points obviously to the superiority of inflationary remedies for underemployment over money-wage reductions….The only clash here between Keynes’ position and the orthodox one is in his denial that reduction of money wage rates is a remedy for underemployment.”32

Later economists came to the same conclusion—Keynes had simply assumed “sticky” wages and adapted a theory around that assumption.33 This was not nothing in the days of the Great Depression, but hardly earth shattering. Indeed, it didn’t have any effect whatsoever on economic policy in the near term.

Consequently, the Roosevelt administration was unmoved by Keynes’s new argument for

stimulus. Indeed, it went in the opposite direction, raising taxes and tightening fiscal policy rather than expanding it. In 1937 Treasury Secretary Henry Morgenthau even convinced Roosevelt that balancing the budget was what was needed to restore growth. At the same time, passage of the Social Security Act increased taxes by imposing a payroll tax for the first time. Since benefits weren’t paid out until 1940, for the first three years of the program Social Security took more out of the economy than it put in.34

At the same time, the Federal Reserve unwisely tightened monetary policy because it was becoming concerned about inflation, which rose from 1.4 percent in 1936 to 2.9 percent in 1937. The result was a severe recession in 1937 following three years of fairly robust growth. After growing at an average rate of almost 10 percent per year between 1934 and 1937, real GDP fell 3.4 percent in 1938.35

The economic downturn was deeply frustrating to Roosevelt. It called into question the whole rationale for the New Deal to date, but finally made him and his advisers sympathetic to the Keynesian idea of pumping up spending despite the political risks. As historian Charles A. Beard explains:

In its range the shock of the economic collapse was startling to President Roosevelt and his advisers. Unemployment continued to be alarming in amount and effects. Labor agitation grew more turbulent. The hostility of the financial community was aggravated. To the administration, an enlargement of federal spending seemed again necessary as a stimulus to business recovery, and that meant an extension of the “deficit financing” which had for a time been regarded, even by many New Dealers, as a temporary and deplorable expedient. Doubts came to the President and his counselors: perhaps they had been wrong in seeking recovery through specific measures they had espoused and were at the end of their improvisation.36

There was still strong resistance to the idea of intentionally running deficits because balancing the budget annually had been considered the norm since the time of the Founding Fathers. The deficits to date had only reluctantly been tolerated. Therefore, to get Congress and the American people to support a sufficiently large-scale spending program, it had to be for something everyone viewed as absolutely necessary and legitimate. A military buildup fit the bill nicely. But first the American people had to be convinced that it was justified by national security. Here, Roosevelt’s growing concerns about impending war dovetailed with the Keynesian approach to economic stimulus.37

A shift in focus also helped Roosevelt with some of his political problems following the Democrats’ big loss in the 1938 elections. As historian Basil Rauch explains, “The president effectively checked the growth of opposition by reducing domestic affairs to secondary position and working for party and national unity on a program of foreign policy.”38 Those on the left immediately recognized the political and economic shift. Writing in the liberal New Republic magazine in November 1938, columnist John T. Flynn made this observation:

Well, it looks as if the United States was going to have its war scare and of course its battle implements to match the degree of our fright. The President of the United States has set out as the drummer of fear and is deliberately selling to our people the baleful notion that some enemy is about to assail us and that we are defenseless against the coming attack…. The next phase, of course, is the President’s current, still undisclosed, plans for the greatest peacetime rearmament of both the army and the navy in our history…. We are now to attempt to make a great arms program the basis of our recovery effort instead of depending on consumer-goods production.39

The clouds of war were gathering in Europe and Roosevelt was increasingly convinced that American intervention was inevitable. But neutrality laws enacted to keep America out of another European war blocked direct action by the United States. They grew from a widespread belief that British pressure and lobbying by arms manufacturers had maneuvered the United States into a war in 1917 in which it had no vital interests. In a January 1937 poll 64 percent of Americans agreed that it was a mistake for America to have entered the First World War.40 An intense desire for isolation from the problems of Europe, therefore, prevented Roosevelt from taking preparatory measures for another war, which simultaneously inhibited defense spending on the scale Keynes thought was necessary for his theory to work.

The outbreak of World War II in Europe in September 1939 increased Roosevelt’s conviction

that America would eventually have to join the fighting. At the same time, it was increasingly evident that national defense was the only purpose for which he might be able to get sufficient support to raise spending and deficits enough to make a real impact on the economy. The conservative congressional coalition of Republicans and southern Democrats, which had gained great strength after the 1938 elections, vigorously advocated economy in government expenditures, but was willing to make an exception for military spending. In a 1939 column Flynn identified this tendency: “I find among conservative groups a phenomenon which is worth noting. It is that while there is a growing feeling against the use of deficit financing for recovery or relief purposes, there is a very strong feeling in favor of spending money for national defense, despite the fact that it must be done with borrowed funds.”41

By mid-1940, Keynes was lamenting that the federal government had still not done nearly enough to raise spending by an amount sufficient to really make a difference, economically. In a New Republic article, he complained that spending was “hopelessly inadequate.” Keynes speculated that only “war conditions” would bring forth expenditures “on the scale necessary to make the grand experiment which would prove my case.”42

Depression’s End

World War II finally did what the New Deal couldn’t do and ended the Great Depression. It

forced the federal government to run deficits on an unprecedented scale, while the Federal Reserve fixed interest rates and provided as much liquidity to the banking system as necessary to keep them from rising.43 Economists concluded that the war brought about the ultimate success of Keynesian economic theory and they all adopted the new approach en masse. Within a few years, it was hard to find any economist who was not essentially a Keynesian.

Ironically, at the very moment of his greatest triumph, Keynes himself was backing away from his own program. In 1944 economist F. A. Hayek published The Road to Serfdom, a book that was highly critical of the growth of government, partly as the result of the widespread adoption of Keynesian economic theories. Nevertheless, in a June 1944 letter to Hayek, Keynes proclaimed himself to be largely in agreement with his argument. Indeed, not only in agreement with it, “but in a deeply moved agreement.”44

In the last article he ever wrote, Keynes tried to turn the clock back toward the classical economics that had been thoroughly discredited by the length and depth of the Great Depression and ultimately superseded by Keynesian economics. Keynes warned that the baby had been thrown out with the bathwater and economists needed to appreciate the enduring truths of classical economics. As he put it:

I find myself moved, not for the first time, to remind contemporary economists that the classical teaching embodied some permanent truths of great significance, which we are liable today to overlook because we associate them with other doctrines which we cannot now accept without much qualification. There are in these matters deep undercurrents at work, natural forces, one can call them, or even the invisible hand, which are operating toward equilibrium. If it were not, we could not have got on even so well as we have for many decades past.45

Through the years, many economists have puzzled over the contradictions in Keynes’s work. But there is one thing that ties it all together: his intense desire to influence public policy. As Keynes biographer Robert Skidelsky put it, “He invented theory to justify what he wanted to do.” If one goes through the 30 volumes of his collected works, the vast bulk of the material is not technical economics, but articles for newspapers and popular magazines, as well as memoranda and policy papers for government officials. “He was an opportunist who reacted to events immediately and directly, and his reaction was to produce an answer, to write a memorandum, and to publish at once,” economist Elizabeth Johnson explains.46 In this respect, economist Don Patinkin believes that Keynes and his ideological opposite, Milton Friedman, were really two of a kind:

For both of these men the purpose of economic analysis is not only to construct theoretical models, but to lead to policy recommendations—and accordingly both had a continuous and detailed concern with the current empirical data on the workings of the economy. Furthermore, both regarded as an essential part of their task as economists not only to formulate policy positions, but to generate public opinion in support of them. And both sedulously exploited all means of communication for this purpose: articles in leading newspapers and magazines; books and pamphlets; participation in radio and television programs (of course, there was no television in Keynes’ day; but can anyone doubt he would have been a television personality if there had been?); appearances and testimony before government committees and bodies; and personal contacts with leading government officials responsible for formulating and carrying out policy, while at the same time eschewing (except in wartime) official government positions.47

It is clear that Keynes would often put forward proposals because he thought they would be helpful at a particular moment in time, knowing full well that it would be highly undesirable for them to be maintained for the long term. Perhaps the best example of this expediency was Keynes’s proposal for national self-sufficiency. Before the Great Depression, he was a conventional free trader. But then he got the idea that it might be economically beneficial if nations could avoid international trade as much as possible. This would insulate them from economic and financial problems imported from abroad. When Keynes first put forward this idea in 1930, his friend Roy Harrod expressed concern. Keynes told him not to worry: “When this phase is past, we can reverse the process.” Unfortunately, when Keynes actually tried to do this at the end of World War II, he found it harder to undo what he had done than he thought it would be. The problem was, as Harrod explained, “the autarkists and trade controllers were now in the saddle.”48

Keynes had enormous confidence in his ability to manipulate public opinion and this had a great deal of impact on the nature of his work. For one thing, it obviated any necessity for consistency; he would say what needed to be said one day and if it needed to be changed the next day, then he would simply make it happen. Hayek thought this was the key to understanding Keynes, as he explained in a review of Harrod’s biography of Keynes in 1952:

Perhaps the explanation of much that is puzzling about Keynes’s mind lies in the

supreme confidence he had acquired in his power to play on public opinion as a supreme master plays on his instrument. He loved to pose in the role of a Cassandra whose warnings were not listened to. But, in fact, his early success in swinging around public opinion about the peace treaties had given him probably even an exaggerated estimate of his powers. I shall never forget one occasion—I believe the last time that I met him—when he startled me by an uncommonly frank expression of this. It was early in 1946, shortly after he had returned from the strenuous and exhausting negotiations in Washington on the British loan…. A turn in the conversation made me ask him whether he was not concerned about what some of his disciples were making of his theories. After a not very complimentary remark about the persons concerned, he proceeded to reassure me by explaining that those ideas had been badly needed at the time he had launched them. He continued by indicating that I need not be alarmed; if they should ever become dangerous I could rely upon him again quickly to swing round public opinion—and he indicated by a quick movement of his hand how rapidly that would be done. But three months later he was dead.49

Other economists have expressed similar views of Keynes. For example, in his presidential address to the American Economic Association in 1951, Harvard economist John H. Williams said that Keynes “started with what he regarded as the policy requirements of the time and built his theory around them.” Keynes himself probably would have agreed with this assessment. He once explained that his policy prescriptions were often unrelated to their apparent theoretical underpinnings. In discussing The General Theory, Keynes said: “I consider that my suggestions for a cure, which, avowedly, are not worked out completely, are on a different plane from the diagnosis. They are not meant to be definitive; they are subject to all sorts of special assumptions and are necessarily related to the particular conditions of the time.”50

Keynes fully understood that his theory would have different applications at different times. As

he told economist Gardner Means in 1939, “I would emphasize again the distinction between my

General Theory, regarded as a more or less all-embracing theory, and the applications of it which can be made in different circumstances according to the different sets of realistic assumptions.” This, Skidelsky believes, was the real beauty of the Keynesian system: it could easily be used to support a variety of actions that governments wanted to take for other reasons.51

Of course, Keynesian economics fit in nicely with liberal political views about the need for government to be more deeply involved in the economy, which were dominant among the intelligentsia of the 1930s and 1940s. As economist Joseph Schumpeter explained, “Whatever its merit as a piece of analysis may be, there cannot be any doubt that it [The General Theory] owed its victorious career primarily to the fact that its argument implemented some of the strongest political preferences of a large number of modern economists.”52

In short, Keynesian economics was a brilliant synthesis of both the theoretical and the practical. It was primarily a theory for the times that also made some important contributions to economic science. But it was mainly a rationale for things governments everywhere wanted to do anyway—such as break free of the balanced-budget constraint—that they would have done with or without Keynes. His theories, however, made them seem scientific rather than merely opportunistic.

Keynes as a Conservative

One thing that is a constant in Keynes’s efforts is that they were consistently motivated by a desire to maintain the liberal capitalist order. Honest conservatives have always understood this. In 1945 economist David McCord Wright noted that a conservative political candidate could easily run a campaign “largely on quotations from The General Theory.” The following year, economist Gottfried Haberler of the conservative Austrian school conceded that the specific policy recommendations of Keynesian economics were not at all revolutionary. “They are in fact very conservative,” he admitted.53

In 1981 Wealth and Poverty author George Gilder said that Keynes’s works “are far more favorable to supply-side economic policy than current Keynesians comprehend.” He thought that Keynes deserved special credit for restoring “to a position of appropriate centrality in economic thought the vital role and activity of the individual capitalist.” Peter Drucker, another conservative admirer of Keynes, viewed him as not merely conservative but ultraconservative:

He had two basic motivations. One was to destroy the labor unions and the other was to maintain the free market. Keynes despised the American Keynesians. His whole idea was to have an impotent government that would do nothing but, through tax and spending policies, maintain the equilibrium of the free market. Keynes was the real father of neoconservatism, far more than Hayek!54

John Kenneth Galbraith, whose politics were well to the left of Keynes, not to mention Drucker, agreed with this assessment. “The broad thrust of his efforts, like that of Roosevelt, was conservative; it was to endure that the system would survive,” he wrote. But, Galbraith added, “such conservatism in the English-speaking countries does not appeal to the truly committed conservative.”55

Keynes’s friend and biographer Harrod tells us that underneath his veneer of trendy liberalism, Keynes was always deeply conservative.56

He valued institutions which had historic roots in the country; he was a great upholder of the virtues of the middle-class which, in his view, had been responsible for all the good things that we now enjoy; he believed in the supreme value of intellectual leadership, in the wisdom of the chosen few; he was interested in showing how narrow was the circle of kinship from which the great British leaders in statesmanship and thinking had been drawn; and he was an intense lover of his country…. He was not a Socialist. His regard for the middle- class, for artists, scientists and brain workers of all kinds made him dislike the class-conscious elements of Socialism. He had no egalitarian sentiment; if he wanted to improve the lot of the poor…that was not for the sake of equality, but in order to make their lives happier and better…. He did not think it would be beneficial for the State to run industry and trade. He considered the doctrine of State Socialism to be quite obsolete.57

As Keynes himself explained, “the class war will find me on the side of the educated bourgeoisie.” Conservative icon Edmund Burke was one of his political heroes. Keynes expressed contempt for the British Labor Party, calling its members “sectaries of an outworn creed mumbling moss-grown demi-semi Fabian Marxism.” He also termed the British Labor Party an “immense destructive force” that responded to “anti-communist rubbish with anti- capitalist rubbish.”58

It was obvious to those on the political left and in the Soviet Union that Keynes was one of socialism’s greatest enemies, even if some on the right still view Keynes as a crypto- communist.59 State socialism, he said, “is, in fact, little better than a dusty survival of a plan to meet the problems of fifty years ago, based on a misunderstanding of what someone said a hundred years ago.” Indeed, Keynes told George Bernard Shaw that the whole point of The General Theory was to knock away the Ricardian foundations of Marxism.60

Keynes often expressed disdain for Soviet Communism. “Red Russia holds too much which is detestable,” he wrote, terming Communism “an insult to our intelligence.” Communists, Keynes believed, were people who produced evil in the hope that good may come of it. And he had little respect for Karl Marx, calling him “a poor thinker,” and Das Kapital “an obsolete economic textbook which I know to be not only scientifically erroneous but without interest or application for the modern world.” Keynes went on to say:

On the economic side I cannot perceive that Russian Communism has made any contribution to our economic problems of intellectual interest or scientific value. I do not think that it contains, or is likely to contain, any piece of useful economic technique which we could not apply, if we chose, with equal or greater success in a society which retained all the marks, I will not say of nineteenth-century individualistic capitalism, but of British bourgeois ideals. Theoretically at least, I do not believe that there is any economic improvement for which revolution is a necessary instrument. On the other hand, we have everything to lose by the methods of violent change. In Western industrial conditions the tactics of Red revolution would throw the whole population into a pit of poverty and death.61

Keynes understood completely the central role of profit in the capitalist system. This is one reason why he was so strongly opposed to deflation and why, at the end of the day, his cure for unemployment was to restore profits to employers. He also appreciated the importance of entrepreneurship, which he called “animal spirits”: “If the animal spirits are dimmed and the spontaneous optimism falters…enterprise will fade and die.” And he knew that the general business environment was critical for growth; hence business confidence was an important economic factor. As Keynes acknowledged, “Economic prosperity is…dependent on a political and social atmosphere which is congenial to the average businessman.”62

Opposition to Planning

A major theme of Keynes’s General Theory is the importance of maintaining the freedom for prices to adjust, which is essential for the proper functioning of the economy. This made Keynes a strong opponent of national economic planning, which was much in vogue after the Second World War. “The advantage to efficiency of the decentralization of decisions and of individual responsibility is even greater, perhaps, than the nineteenth century supposed; and the reaction against the appeal to self-interest may have gone too far,” he wrote.63

Indeed, the whole point of his General Theory, Keynes felt, was about preserving what was good and necessary in capitalism as well as protecting it against authoritarian attacks by separating microeconomics, the economics of prices and the firm, from macroeconomics, the economics of the economy as a whole. In order to preserve economic freedom in the former, which Keynes thought was essential for efficiency, increased government intervention in the latter was unavoidable. While pure free marketers might lament this development, the alternative, as Keynes saw it, was the complete destruction of capitalism and its replacement by some form of socialism. As he explained:

Whilst…the enlargement of the functions of government…would seem to a nineteenth century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it…both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative….The

authoritarian state systems of today seem to solve the problem of unemployment at the expense of efficiency and of freedom. It is certain that the world will not much longer tolerate the unemployment which…is associated—and, in my opinion, inevitably associated—with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.64

In Keynes’s view, it was sufficient for government intervention to be limited to the macroeconomy—that is, to use monetary and fiscal policy to maintain total spending (effective demand), which would both sustain growth and eliminate political pressure for radical actions to reduce unemployment. “It is not the ownership of the instruments of production which is important for the State to assume,” Keynes wrote in The General Theory. “If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary.” As he explained more clearly in a letter to The Times of London in 1940:

If the community’s aggregate rate of spending can be regulated, the way in which

personal incomes are spent and the means by which demand is satisfied can be safely left free and individual. Just as in the war the regulation of aggregate spending is the only way to avoid the destruction of choice and initiative…through the complex tyranny of all-round rationing, so in peace it is only the application of this principle which will provide the environment in which the choice and initiative of the individual can be safely left free. This is the one kind of compulsion of which the effect is to enlarge liberty. Those who, entangled in old unserviceable maxims, fail to see this further-reaching objective have not grasped, to speak American, the big idea.65

One of Keynes’s students, Arthur Plumptre, explained his philosophy this way. In Keynes’ view, Hayek’s “road to serfdom” could as easily come from a lack of government as from too much. If high unemployment was allowed to continue for too long, Keynes thought the inevitable result would be socialism—total government control—and the destruction of political freedom. This highly undesirable result had to be resisted and could only be held at bay if rigid adherence to laissez-faire gave way, but not too much. As Plumptre put it, Keynes “tried to devise the minimum government controls that would allow free enterprise to work.”66

Keynes died at the age of 63 on April 21, 1946, shortly after returning from an arduous visit to the United States where he had participated in negotiations relating to postwar economic institutions such as the International Monetary Fund. He did not live to see the final triumph of his ideas, which really reached their pinnacle in the 1960s. But just over a decade later the word “Keynesian” would become a hostile epithet, as Keynes’s theories were widely blamed both for causing the inflation of the 1970s and for lacking any means to deal with it.

Contemporary Relevance

I was completing this book just as the economic crisis hit with severity in the fall of 2008 and was very grateful for having finished the research because it greatly clarified in my mind what needed to be done for the economy.

The parallel to the Great Depression seemed clear to me. The key difference was that the

Federal Reserve didn’t allow the money supply to shrink as it did in the 1930s. However, velocity—the speed at which money turns over as people spend it—fell so much in 2008 and 2009 that it had economic effects identical to a sharp decline in the money supply. The decline in spending—and hence velocity—resulted from the collapse in wealth that in turn resulted from a sharp fall in housing and stock prices. According to the Fed’s flow of funds statistics, net household wealth fell to $51.5 trillion in the fourth quarter of 2008 from $64.3 trillion in the third quarter of 2007, which reduced aggregate spending by at least $600 billion per year and perhaps twice that—more than enough to create a severe recession.67

The Fed tried to compensate for the fall in velocity by virtually doubling the monetary base from $90 billion in September 2008 to $170 billion in January 2009. But rather than lead to a doubling of the money supply, banks simply sat on the money because there was no demand for loans. Excess reserves—deposits private banks hold at the Federal Reserve as backing for their deposits over and above what the Fed requires—rose from less than $2 billion in August 2008 to $80 billion in January 2009. It was as if an individual took savings out of an interest-earning account and deposited them all in a checking account earning no interest.

In short, money was immobilized and simply piled up in ultrasafe Treasury bills instead of financing consumption and investment. Indeed, at one point yields on T-bills actually fell to zero.68 This was classic evidence of a liquidity trap just like the one in the 1930s. Under such circumstances, it seemed to me that the federal government had no choice but to try and compensate for the fall in private spending by increased government spending.69 Only when aggregate spending increased would money begin to circulate, making Federal Reserve policy effective again, thereby relieving the deflation at the heart of the nation’s economic problem.

This view put me very much in the minority among conservatives, virtually all of whom felt that fiscal stimulus was useless and that the Fed had gone overboard in trying to stimulate money growth. But they had made the same arguments in the early 1930s. Now, as then, I think Keynes was right and the conservatives were wrong.

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