Keynes and Money: A Man Obsessed?
By Benn Steil
John Maynard Keynes revolutionized economic theory to show that government intervention can stabilize economies. Photo courtesy of Tim Gidal/Picture Post/Getty Images.
Paul Solman: It is the anniversary of the fateful Bretton Woods monetary conference that took place in New Hampshire in July 1944. The Allies of World War II, all 44 of them, increasingly confident of victory, met to discuss and lay the plans for a post-war global economy, cognizant of how their predecessors had royally screwed up the economic aftermath of World War I.
The chief economic protagonists of the conference were the legendary artistocratic Englishman John Maynard Keynes and the feisty American Harry Dexter White, who was later drummed out of government for being overly sympathetic to, if not collaborative with, one of those Allies, the Soviet Union.
Benn Steil, senior fellow and director of international economics at the Council on Foreign Relations, has recently written a book about Keynes, White and the conference: "The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order."
He was gracious enough to post here recently on the subject: "Would a New 'Bretton Woods' Save the World Economy." I asked him to return for an anniversary post.
Benn Steil: The most renowned and revolutionary economist of his age, and the first-ever of the now-common celebrity variety, John Maynard Keynes spent a remarkable and colorful life as a scholar, journalist, polemicist, speculator and diplomat dedicated to one great intellectual challenge above all: unraveling the mysteries and combating the menaces (as he saw them) of the economic and social phenomenon of money.
Keynes' first academic article, "Recent Economic Events in India," published in 1909 when he was 26, marked the true beginning of his enduring intellectual love affair with matters of money. Generating "statistics of verification" linking Indian price movements with gold flows put him into a "tremendous state of excitement," he wrote to painter Duncan Grant. "Here are my theories -- will the statistics bear them out? Nothing except copulation is so enthralling."
His first experience in government, as an official in the U.K. India Office, led to the publication of his first book, "Indian Currency and Finance," in 1913. Two broad themes emerged that would become constants in Keynes' thinking.
The first was that progress in global monetary reform consisted in the progressive diminution of the role of gold. Those who insisted that a reserve currency need take the form of a physical commodity were misguidedly backing "a relic of a time when governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century."
Today, of course, popular debate is often heated over whether governments are insufficiently trustworthy in monetary matters or, alternatively, overly hidebound in their response to financial market breakdowns.
If "gold is at last deposed from its despotic control over us and reduced to the position of a constitutional monarch," Keynes pronounced with his trademark acerbic wit, "a new chapter of history will have opened. Man will have made another step forward in the attainment of self-government."
The second theme was that London was the natural hub upon which global monetary reform could and should be built. Half the world's trade at the time was financed by British credit, owing to the global reach of the empire and the reliably gold-backed pound sterling. London had thereby long thrived as the epicenter of world banking.
Unfortunately for Britain, however, World War I changed everything. Though America's entry into the war in April 1917 seemed to ensure an ultimate Allied victory, it would clearly be one in which the old financial and monetary order, with Britain at its head, would not survive. The United States, Keynes fumed, seemingly delighted "in reducing us to a position of complete financial helplessness and dependence . . . In another year's time, we shall have forfeited the claim we had staked out in the New World and in exchange this country will be mortgaged to America."
In the immediate aftermath of the war, Keynes turned his attention to combating what he saw as the wretchedly misguided financial terms imposed on defeated Germany, which he was convinced would lead to war again in due course. These ideas were developed in his trenchant 1919 international bestseller "The Economic Consequences of the Peace." Never one to be satisfied with mere commentary on financial affairs, however, Keynes dissipated much of the early profits from his book in his new hobby of currency speculation.
Setting out to synthesize his evolving post-war ideas on money, Keynes published "A Tract on Monetary Reform" in December 1923. The central argument of the book was that it was the demand for money, rather than its supply, that the monetary authorities should aim to stabilize. (When the proportion of their wealth people wish to hold in cash and bank accounts jumps around a lot, the economy itself becomes unstable.)
The most important implication of his argument, Keynes explained, was that the authorities should intervene actively and continuously to vary the supply of currency notes and the ratio of bank cash reserves to bank deposits. This was in marked contrast to the gold standard, the central villain of the peace in Keynes' telling, wherein the authorities behaved much more mechanically in response to movements in the monetary gold stock across borders: when gold flowed in, they loosened credit, and when it flowed out, they tightened credit.
Deflation was a natural periodic result of this mechanism and was more damaging to employment in an environment of growing union power and worker political participation. Central banking, Keynes believed, should now "be regarded as a kind of beneficent technique of scientific control such as electricity and other branches of science are."
Keynes acknowledged that the gold standard had performed admirably in the late 19th century, but insisted that conditions were decidedly different now. In particular, one of the many awful effects of the war was to transfer much of the world's monetary gold to the United States. There was more than a tinge of jealous nationalism in Keynes' assertion, however justified, that attempts to restore the gold standard, a "barbarous relic," would lead to a "surrender [of] the regulation of our price level and the handling of the credit cycle to the hands of the Federal Reserve Board," which had set up "a dollar standard ... on the pedestal of the Golden Calf."
The shift in financial power from London to New York and Washington, a threat to British financial independence and global influence, was to be a constant concern of Keynes, reflected even in his theoretical work, for the remainder of his career.
The question of money -- its function, its history, its management and its psychology -- became an ever-deeper fascination of Keynes. This was clearly as much visceral and emotional as it was intellectual.
In a 1928 essay titled "Economic Possibilities for Our Grandchildren," he famously condemned the "love of money [as] a somewhat disgusting morbidity, one of the semi-criminal, semi-pathological propensities which one hands over with a shudder to specialists in mental disease."
Reflecting views that were not uncommon among his class at the time, he also saw this love as a particular pathology of a particular group: Jews. "I still think the race has shown itself, not merely for accidental reasons," he wrote to a polite American critic of his views, "more than normally interested in the accumulation of usury."
Keynes himself was "more than normally" partial to speculation, which would cost him dearly that year. Long on commodities such as rubber, corn, cotton and tin, he was forced to sell securities to cover margin calls when the market turned against him. His net worth plummeted from £44,000 at the end of 1927 (about $3.5 million in current dollars) to £7815 at the end of 1929 following the Wall Street crash in October, in spite of his having no holdings of U.S. stocks at the time.
October of that year would see the publication of his first major tome: the two-volume "A Treatise on Money." A critical message of "Treatise," as Keynes saw it, was that a central bank (or, more specifically, the Bank of England, now that its dominant international role had been arrogated by the Fed) keeping monetary policy sufficiently tight so as to avoid the loss of gold reserves would wind up inflicting severe and lasting damage to domestic profits and employment owing to the endemic "stickiness" of certain prices.
That is, prices -- particularly wages -- failed to adjust downwards, as they should under classical economic theory. This Keynes believed, was largely the result of the resistance of organized labor to nominal wage cuts.
One of the critical differences between Keynes and the so-called classical economists is that whereas the latter believed that labor market blockages could be overcome politically, and psychological quirks through market forces, Keynes believed that it was monetary policy itself that needed to adapt to the "natural tendencies" of society and the "system as it actually is."
This debate renewed itself with great force in the 1970s, a period of so-called "stagflation": high unemployment and high inflation, a combination which puzzled many Keynesian-schooled economists at the time. (Orthodoxy held that rising unemployment should have put clear downward pressure on prices.)
"Treatise" ends with an important chapter on the management of international monetary affairs. Both wonky and visionary, it develops ideas that Keynes would later champion, unsuccessfully, at Bretton Woods in 1944. In particular, there was the concept of "Supernational Bank-money" (SBM): an international reserve asset to be issued by a new Supernational Bank, which Keynes hoped would, over time, come to supplant gold as the ultimate such reserve asset. Keynes would refashion SBM in the 1940s as "bancor," with the aim not just of supplanting gold but of preventing what seemed to be the inexorable march toward global dollar hegemony (a clear threat, in Keynes' eyes, to sovereign national economic decision-making).
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Critical reviews of "Treatise" from the likes of Friedrich Hayek, the young, rising Austrian economist at the London School of Economics, and former student Dennis Robertson convinced Keynes not that he was misdiagnosing the problem but that he needed a radically different theoretical approach to defend his diagnosis.
In spite of the pound's devaluation and a fall in interest rates, British unemployment reached 17 percent in 1932. Something, he was sure, was awry in the classical view of the self-correcting market, and that something, he was equally sure, had to do with the very nature of a money-based economy. But he had not yet put his finger on it. "We have been opposing the orthodox school more by our flair and instinct than because we have discovered in precisely what respects their theory is wrong," he confessed in November 1934.
Contravening his new and now oft-quoted principle that "finance [should] be primarily national," Keynes had begun enthusiastically buying shares on Wall Street in 1932, which would more than triple in value over the next four years. U.S. stocks made up 40 percent of his personal portfolio by 1936, the year he finally published his magnum opus: "The General Theory of Employment, Interest and Money."
"The General Theory" is one of the most influential works of economic thought -- and arguably the most intellectually audacious -- ever published. It is difficult to overestimate the book's impact on the economics profession, particularly in the United States. It virtually established macroeconomics as a discipline; the term, in fact, only started being used in the 1940s.
But the unusual style of "The General Theory" also made it difficult for even expert readers to separate out its "true" substance. It is only slightly outlandish to liken the book to the Bible: powerful in its message, full of memorable, mellifluous passages, at times obscure, tedious, tendentious and contradictory, a work of passion driven by intuition with tenuous logic and observation offered as placeholders until disciples could be summoned to supply the proofs.
As Keynes himself said of his masterwork, "I am more attached to the comparatively simple fundamental ideas which underlie my theory than to the particular forms in which I have embodied them ... if the simple basic ideas can become familiar and acceptable, time and experience and the collaboration of a number of minds will discover the best way of expressing them."
The central argument of the book was revolutionary (at least to economists): the economy had no natural tendency towards full employment. High unemployment could persist indefinitely if governments did not intervene forcefully to boost consumption demand. Cheap money provided by the central bank was not enough.
This was wholly contrary to classical economics, which held that protracted involuntary unemployment was a result of some interference in the workings of the price mechanism. Classical economics showed that full employment required flexible wages; Keynes showed why, with different assumptions, falling wages could actually worsen unemployment. These different assumptions were related to the nature of money, human psychology and conventions of contemporary society. Each of these on its own would do for his argument; he was not that particular.
Such a brazen treatise would have gotten a much colder reception during the American boom years of the 1920s, but in the midst of a Great Depression, with unheard-of levels of unemployment, it was compelling even to economists who disagreed with Keynes' logical apparatus. In the United States, the book held particular appeal as an intellectual justification for controversial New Deal policies. If today it seems natural to most policymakers that governments should run deficits in recessions to stabilize the economy, it was far from a natural notion in the 1930s; it was Keynes who made the prescription intellectually respectable.
Like another great mind of his time, Albert Einstein, Keynes had a preternatural ability to see relationships between complex phenomena entirely differently from the way generations of experts before him had. Though mathematics was the primary analytical tool for both physics and economics, neither Einstein nor Keynes was exceptionally gifted in, nor fascinated by, higher mathematics. They had an utterly rare gift of intellectual intuition. Both thought through problems which obsessed them through the vehicle of analogy, like riding on a light beam (which sparked Einstein's theory of special relativity) or living in an economy that produces and consumes only bananas (through which Keynes "proved" that thrift was deadly). A great admirer of Einstein, whom he had met in Berlin in 1926, Keynes, it would surely seem, quite consciously emulated Einstein's approach of turning on their heads eternal mechanisms the world thought it understood.
Isaac Newton had claimed that time was absolute and fixed, and who but a madman questioned this? Einstein did. Time was relative, he believed, and he subsequently proved it. Keynes' controversial claim of having erected a new "General Theory" was a transparent mimicking of Einstein's "general" (as contrasted to his merely "special") theory of relativity.
Classical economists -- that is, the only ones who were reputable in the 1920s -- believed in Say's Law, expressed by Keynes as "supply creates its own demand," and Keynes set out to prove that this was false. (See Paul Solman's explanation of Say's Law from 2012.) Keynes argued that Say's Law had everything the wrong way around; in fact, it was "expenditure [that] creates its own income." It was demand, not supply, that determined the level of economic activity. It was investment that called forth the requisite savings, through its boosting of income, not the other way around. The result, in Keynes' theoretical apparatus, was that demand, given the psychological factors which tended to depress it, could at any given time be insufficient to ensure full employment. Classical economics was wrong on this central issue, with terrible consequences when its prescriptions were followed.
The most fundamental analytical question that has divided economists since publication of "The General Theory" is whether a situation of persistent mass unemployment can be characterized as an "equilibrium," meaning that it can exist even if all prices are perfectly flexible.
This is where high theory and hard reality intersect because the answer has important implications for policy. If the answer is yes, this was indeed a revolutionary insight, as it meant that there was no self-correcting mechanism in the market -- a slump could go on forever unless government investment stepped in for what would otherwise be permanently deficient private investment. If the answer is no, however, then rather than initiate a self-sustaining recovery through the "multiplier effect," such intervention would mute the price signals calling for a shift in productive capacity toward more desired uses. The Keynesian solution addresses symptoms rather than causes, in the classical view, and thereby delays sustainable recovery.
This debate has never been resolved, as the same evidence is cited by each side to support its position. Thus the Japanese economic malaise of the 1990s was, in the Keynesian view, the result of premature termination of "fiscal stimulus," or, in the classical view, the result of an excessive reliance on it. The same debate repeated itself following the collapse of the U.S. housing market in 2007.
Keynes had struggled for years since his repudiation of the intellectual apparatus of "Treatise" to induce a compelling theoretical cause for his burning belief that investment could, even under flexible prices, fail to harmonize with savings in a way that would maximize aggregate income. In "The General Theory," he believed he had found it. It was the concept of "liquidity preference," or the idea that people might choose to hoard inert cash rather than consume or invest the fruits of their labor. The conviction that "money is the root of all evil," Keynes biographer Robert Skidelsky observed, "is almost a sub-text of the 'General Theory.'" Liquidity preference was the theoretical kernel that seeded Keynes' new thinking about global monetary reform. For Keynes' French nemesis during the debate on German war reparations, Jacques Rueff, who would go on in the 1960s to be a leading critic of Keynes' (and American Harry Dexter White's) World War II monetary reform blueprint, liquidity preference was not only the nub but the fatal flaw of "The General Theory" edifice.
Critiques of "The General Theory" are many and disparate, but Rueff was surely right to see Keynes' account of the workings of the monetary system as the crux of his case against classical economics. In a Quarterly Journal of Economics article published a year after Keynes' death in 1946, Rueff showed why, logically, "the demand for additional cash holdings," or what Keynes called derisively "the propensity to hoard," had to be "equivalent in its economic effects to demand for consumption goods or investment goods." If Rueff was right, Keynes had failed in his attempt to move beyond "Treatise" and to establish a theoretical foundation for his bold policy prescriptions.
Rueff's defense of classical economics was most readily grasped in a commodity-based monetary system, such as the pre-war gold standard, in that the demand for money was necessarily equivalent to the demand for mining, moving and monetizing gold. Yet it held just as well, Rueff argued, in a fiat money system in which central banks issued cash in return for securities -- securities representing "wealth which is either stored up or, more generally, on its way through the process of production."
To demand money is not to demand nothingness, as Keynes would have it, but rather to demand real wealth capable of being monetized within the framework of the existing monetary system. So just as an increased demand for gold does not itself diminish the purchasing power impinging on the market, an increased demand for money does not itself do so.
Rueff argued that Keynes' monetary and fiscal policy prescriptions had no sound basis. On the contrary, their inevitable result down the road would be inflation and a private productive apparatus less able to supply the goods and services people actually want. Hubert Henderson and others had shared this view, but it did not become widespread until the stagflation of the 1970s and the consequent anti-Keynesian blowback. At that point, the implication of "The General Theory" that government could always, and predictably, improve on the laissez-faire outcome no longer seemed tenable. The revival of the book following the 2008 economic crisis was largely based on the notion that it was a reliable tract on depression economics, if not in fact a "general theory" that could be applied in boom times as well, as Keynes had held.
Had it not been for the re-emergence of the dark clouds of war in the late 1930s, Keynes would almost certainly have lived longer and died less notable. Though a liberal cosmopolitan like Einstein, Keynes was not a nationally uprooted one, which disposed him differently towards politics. Keynes was thoroughly British, and it was the British problems of his day that drove his theorizing -- problems of deflation and depression, paying for war and surviving the perilous transitions to peace. And when war came to Britain once again, Keynes, in spite of his delicate and deteriorating health, was ready to man the frontlines of its critical financial engagement. Back again at the U.K. Treasury in 1940, he would emerge, through his role as Britain's head of delegation to the 1944 Bretton Woods international monetary conference, as the most celebrated economist-statesman in history.