General theory after 75 years: Keynes still pretty much alive and influential

Seventy five years have now passed since the publication of ‘The General Theory of Employment, Interest and Money’ by the 20th century’s most influential economist, John Maynard Keynes, in 1936.

This was therefore considered as a fitting occasion for commemorating Keynes’ masterpiece by his alma mater and one-time employer, University of Cambridge in the UK, by inviting renowned academics from both sides of the Atlantic to a conference held in Cambridge from 19-21 June 2011.

The honour of delivering the plenary lecture at the conference was done by the Nobel Laureate and Princeton Professor, Paul Krugman, who talked on ‘Mr Keynes and the Moderns’ (available at http://www.princeton.edu/~pkrugman/keynes_and_the_moderns.pdf).

Krugman in a tone of modesty and humbleness admitted that he was not the best qualified to speak at the conference due to three disqualifications. First, he was not a Keynes scholar (but others believe that he has been very much influenced by Keynes). Second, he had not done much work in macroeconomics area (but his specialty, international trade, is a sub part of macroeconomics). Third, he was not a serious intellectual historian (again, an economic policy advisor of Krugman’s calibre cannot do his job unless he has a good knowledge of history).

In my view, Krugman had a unique qualification to be there. Both Krugman and Keynes are of the same breed and Krugman, like Keynes, is a ‘critic of critics’ and does not dare to express his true views on issues of importance.

His regular economic columns in The New York Times, Slate and USA Today bear ample evidence to this side of his personality. Hence, as expected, once his speech was out, it was like stirring up a hornets’ nest and his critics started to fill web page after web page with scathing criticisms. Some even had found fault with the organisers for not including genuine Keynesians in the conference (see the web column of Ann Pettifor in www.debtonation.org).

Keynes, the rebel in the family

Keynes was indeed a rebel in the family of economists. He questioned his seniors who were known as classics and his peers equally. This quality earned him both reputation and wrath. While at Cambridge, he was a member of a secret society known as Apostles that examined contemporary ethical and political issues by deviating from the established norms.

He was a member of the British delegation to Versailles Summit that had been summoned to impose war reparation measures on the defeated Germany after the World War I. While others in the summit were after Germany’s pound of flesh, Keynes held a different opinion. He felt that the proposed measures were too harsh.

Having resigned from the membership of the delegation over this disagreement, he returned to England and wrote ‘The Economic Consequences of the Peace’ in 1919. His argument was that the harsh penalties imposed on Germany would not augur well for the peace in Europe and the conquerors had thereby left a boiling cauldron in Europe. The subsequent events in Europe leading to the World War II within the next two decades proved Keynes correct.

Keynes’ more open battle took place in 1925 with Winston Churchill, Chancellor of Exchequer, over the latter’s attempt at returning Britain to the gold standard, a system of fixing the value of the sterling pound in terms of gold and making it necessary to maintain a balance of gold to back every pound note issued by Britain. Churchill could not be faulted for this, because the overwhelming advice he got was supportive of that move. Keynes, along with a minority of others, disagreed with him.

His argument, which Churchill downplayed as a naivety of a Cambridge economist, was that if Britain returned to the gold standard, it would create a ‘paradox of unemployment amidst dearth,’ implying that when there is an excess demand for goods, there cannot be an excess supply of labour. This is because the suppliers who step up production to take advantage of the demand in the market should hire those unemployed people.

But, if money supply growths are constrained by the straight-jacketed gold standard, there will not be enough money income with people to buy those goods, thereby making unemployment a permanent feature. Perhaps, this was an early hint of what Keynes was going to present in a more formal way in 1936 in The General Theory.

Keynes and others lost their battle and Britain returned to the gold standard in 1925. Angry Keynes wrote a pamphlet titled ‘The Economic Consequences of Mr. Churchill’ criticising Churchill, a satirical twist of the title of his earlier successful book. But many felt, according to Churchill’s biographer, Roy Jenkins, that singling out Churchill for the full blame by Keynes was unfair, because it was a collective decision made by many attached to the British Treasury.

However, six years later, Keynes proved correct again. In 1931, the very same Churchill, as Chancellor of Exchequer, had to oversee Britain’s exit from the gold standard, but by that time, it was too late, because Britain had already got into the worst kind of economic depression marked by massive unemployment.

Strangely, that appeared to be a natural evolution of the process set forth in 1925, the ‘paradox of unemployment amidst the plenty’. Goods were produced, but could not be sold because people did not have enough money incomes. Hence, they could not be continuously employed.

Keynesian prescription: Spend out of recession

The emerging situation then spawned an open debate as to what should be done to correct the malady. The growing economic depression in Britain put the sterling pound under pressure in international markets and that was not good news for the world’s number one reserve currency at that time.

The Government appointed a committee under the chairmanship of Sir George May, a private sector financial expert, to come up with appropriate policy prescriptions. The May Committee, taking both the domestic and international conditions into account, suggested that Britain should cut its expenditure, especially unemployment benefits, and balance the budget so as to instil confidence among the international community about the British economy and its currency.

Again, the Committee could not be faulted for taking this broader view because there were other contenders like France, Germany and USA to become the global economic leader. Hence, in the long run, though the adjustment is slow and painful, Britain would gain its old glory once again.

Keynes disagreed. He angrily wrote to the then Prime Minister that in his opinion, the May Committee Report was the most foolish document he had set his eyes on. His suggestion was that Britain should increase its public spending, devalue the sterling pound and curtail its foreign investments. It appears that this was a battle between the short-run survival and long-run stability.

As Keynes very boldly pronounced in The General Theory, people should be concerned only about the short run because in the long run, according to him, ‘we all are dead’. His desire was to come out of the depression as quickly as possible because it was permanently hurting the British economy by making unemployment a permanent feature.

By implication, it meant that the goals of regaining the old glory and attaining long-term stability should be attempted only after arresting the immediate problem. This in fact made sense because in early 1930s, the British economy was very sick and the sick man was going to die taking everything with him. This had to be avoided.

But as expected, this critic of the critics and rebel in the family did not have many supporters in the Government or among academics. For most of the part, he was a loner and stood separate from the rest of the herd. But it trained him to come out with his masterpiece, The General Theory, which revolutionised the science of economics in the coming decades.

‘The General Theory’: The misunderstood policy prescription

‘The General Theory’ is considered by many as one of the most tedious readings. This is despite the fact that it does not contain frightening mathematical equations like many standard books on economics. Yet, it cannot be understood properly just by reading once.

According to Goh Keng Swee, Singapore’s first Finance Minister and architect of that country’s economic miracle, as an undergraduate in early 1940s, he read the book from cover to cover no fewer than three times, some chapters even more, but still could not understand the basic message delivered in the book.

Because of this fact, according to some, what came to be practised as Keynesian economics and what Keynes actually said were two different concepts. Decades later in early 1970s, Axel Leijonhufvud of the University of California at Los Angeles had to write a new book on ‘Keynesian Economics and the Economics of Keynes’ to separate the two.

Krugman: See how Keynes is relevant today

Today, we are in a bigger predicament. We cannot go back to 1930s to get a firsthand feeling of the situation that prevailed in the world at that time to understand what Keynes actually said. We have to depend on secondary sources and get the help of numerous simplified versions of ‘The General Theory’ written by Keynes’ disciples like Alvin Hanson and Dudley Dillard.

This practical difficulty would have worried Krugman when he had to deliver a lecture on ‘The General Theory’ 75 years later. That would have been the reason for him to start his speech by disclaiming that he was not a historian. He therefore proposes a pragmatic approach. One should not get into an irrelevant debate today to resolve what Keynes actually said. “What matters is what we make of Keynes, not what he really meant” he pronounces boldly in his plenary lecture.

In other words, the questions which one should ask today are whether Keynes is useful and relevant. He further says that “Keynes was a great man, but only a man, and our goal now is not to be faithful to his original intentions, but rather to enlist his help in dealing with the world as best we can”.

Keynes: If people don’t buy, let the government

But what did Keynes say? To a layman, it goes like the following. An economy is a huge enterprise where thousands of people producing and consuming. To produce, they use various inputs and by selling those inputs, they earn incomes. Then, the very same producers are converted to consumers and use those incomes to buy those goods available in the market. This enables producers to continue with production without having unsold stocks. If this process goes on well, then there are no so-called economic recessions.

But how does an economy get into a recession? That is because, according to Keynes’ diagnosis, people do not use all their incomes to buy what they have produced. This deficiency in buying leads to the accumulation of unsold goods with producers who then produce less in the next cycle hiring less people. So, it gives rise to recession and unemployment. This is what Britain and other countries experienced in 1930s and, according to Krugman, what the world is experiencing today.

Keynes came up with a unique solution to this problem which others had thought of risky and dangerous. That is, if people do not buy enough, get another to buy enough and take the economy out of recessions. This other person is the government which can place a huge purchase order to complement what people are already buying inadequately.

The best thing about the government is that it can finance the huge purchase order by borrowing or printing money or both. So, the unsold stocks getting accumulated with producers get sold out, unemployed people get hired back and more and more new wealth is created. Thus, it is spending more by governments in the face of recessions and not less that would take economies out of recessions. That is why Keynes found the May Committee Report suggesting a cut in the government spending the most foolish document which he had ever set his eyes on.

Magic multiplication of wealth

Keynes’ policy prescription was augmented by another unique discovery made by him. That was the dynamism of the government’s new expenditure or how a single expenditure made today would affect an economy over a period. He found that when one man spent, another man earned and when that second man spent, a third man earned.

This goes on infinitely but at a lesser rate because each person saves some of his income and does not spend in full. But, the new series of income created over a period of time raises the wealth of people to still higher levels. Keynes called this the multiplier process because it multiplied the initial government expenditure into a bigger income later.

So, who would reject such a beautiful way of creating new incomes and making people richer just by spending a smaller amount of money? No one, and when this was revealed, politicians in both developed and developing countries, with the exception of a few, embraced it ardently.

JR: An early convert to Keynesianism

According to the biographers of J.R Jayewardene of Sri Lanka, K.M. de Silva and Howard Wriggins, JR is said to have read ‘The General Theory’ and become an instant convert. His subsequent work, the first budget speech, a creation of the Central Bank, his speech at the opening of the Central Bank and many more things he did in the first few years of independent Ceylon testify to his Keynesian leanings.

In the first budget speech for 1947, he found fault with the colonial administration for balancing the budget, thereby subordinating all other goals, namely, development and employment, to that obsession. He even warned the Central Bank in the opening ceremony that money should be produced not for the sake of money, but to serve the people. This was in sharp contrast to what his Prime Minister, D.S. Senanayake, said at the same ceremony that the new Central Bank should be mindful of the harmful consequences of following a loose money printing policy.

JR was not alone in having faith in this type of magic to quick prosperity. All his successors and many mainstream academics were Keynesian faithfuls. In the developed world, almost all academics and politicians were Keynesians. But there were a few exceptions.

John Exter, architect of the Central Bank of Ceylon and its founding Governor, warned in his report known as the Exter Report that Ceylon, which spent about a half of its income on imports, would find that the money pumped by the government through deficit financing would leak out of the country through increased imports and create enormous balance of payments problems. Ceylon’s experience throughout its post-independence history has vindicated Exter.

The sceptics of Keynes

To the east of Ceylon in Singapore, Goh Keng Swee says that his colleagues did not believe that the Central Bank credit could create wealth. Instead, it was diligence, education and skills that were to create wealth in a country. Hence, Singapore, right from the beginning, avoided Keynesian policies because they would, as was also pointed out by Exter, invariably lead to balance of payments problems forcing a country to resort to foreign exchange controls or devaluation of its currency. Ceylon did both to the detriment of its future wealth creation.

In the US, Ayn Rand, the philosopher cum novelist, launched a lone battle against Keynesian invasion of the US, because she had first-hand experience of what would happen to an economy when there is State control over all economic activities in her former country of living, the Soviet Union.

Friedrich von Hayek took issue with Keynesianistic state expansion in a book titled ‘The Road to Serfdom,’ which Keynes himself categorised as unworthy of reading. Margaret Thatcher is also reported to have read both ‘The General Theory’ and ‘The Road to Serfdom’ in late 1940s whilst at Oxford and become an instant fan of the latter.

Today, Keynesians are everywhere, including in central banks

Today, there are Keynesians in governments, in politics and also in central banks. In developed countries whenever there are economic recessions, all these parties resort to Keynesian deficit financing, now renamed ‘stimulus packages’.

In developing countries, that has been the magic wand to quick prosperity. The risk factors associated with this policy, namely, displacement of the private sector, over expansion of the government sector, long-term debt and budgetary issues, balance of payments problems and consequential inflation have not deterred those who prescribe it.

Many hold the opinion that had Keynes known that his policies would be misused by corrupt politicians and ineffective bureaucrats, he would not have prescribed them. The history of the world since Keynes abounds examples of countries falling into severe difficulties simply because once they started deficit financing or stimulus packages, they did not know how and when they should exit them when the risk factors are present.

One good example is Sri Lanka’s fertiliser subsidy which started with Rs. 4 billion in 2006 and has ballooned to Rs/ 50 billion in 2011. As the heavily-indebted Greece is experiencing today, the recovery path punctures the nation’s sovereignty, imposes enormous social and economic burdens on people and brings in political instability.

The tiger’s enmity with its guru, the cat

This is because Keynes prescribed deficit financing, but did not live long enough to see how his policy would be misused. He therefore could not teach errant nations when and how they should apply breaks. Even his disciples, including Krugman, do not have an antidote when the patient starts to die due to heavy doses of stimulus packages. Keynes did not bother about it, because he was so faithful to his prescription that he did not anticipate failures.

An Indian folktale says that the cat, the small member of the feline family, taught its big brother, the tiger, how to climb trees, but did not teach it how it should climb down. So, the tiger after climbing freely to the top of the tree with its new skills has to jump to the ground risking its paws or life. For this omission in the teaching content, the folktale says that whenever a tiger meets a cat, it would kill the cat, but because it is the tiger’s guru, it places the dead body on a branch of a tree out of veneration.

In my view, today, the relationship between Keynes and his errant followers is exactly equal to the enmity between the tiger and its guru, the cat.

(W.A Wijewardena can be reached at [email protected].)