The Iconoclastic Economist: John Maynard Keynes and the

Bloomsbury Group

Lynne Kiesling

Robert Gordon

Department of Economics, NU

Block Gallery discussion

February 2010

John Maynard Keynes (1883-1946)

• Biographical sketch• Early career• Civil service, WWI• His seminal economic

work• His involvement with the

Bloomsbury group• Moral, economic,

aesthetic

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Biographical sketch

• Born into an academic family in Cambridge, England

• Studied at Eton on scholarship

• Studied math at King’s College, Cambridge

• Studied philosophy and economics informally

• Took Civil Service exams

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Attitude and culture, backward and forward

• Keynes was of the last generation when the British empire was at its most powerful

• He was also of the last generation in which culture, not expertise, entitled leaders to govern

• He had a lifelong faith in the ability of government officials to do good

Civil Service, WWI

• 1906-1908: India Office• 1909: returned to Cambridge

– Studied probability theory– Studies and lectureship funded privately by 3

economists (one being his father!)– Wrote a book on Indian finance and currency

• 1915: Treasury post– Responsible primarily for credit

Treaty of Versailles, Consequences of the Peace

• Financial representative of Britain at treaty negotiations in 1919

• Worked to keep German reparations from being excessive

• Worried about pushing Germany into political extremism

• Possible German influence: Melchior

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The Economic Consequences of the Peace (1919)

• One of his most influential works -- some say his best

• Assessment of the possible outcomes of the Treaty of Versailles and its high war reparations

• Objected on moral and economic grounds• In hindsight, seen as prescient -- German

hyperinflation, rise of National Socialism• Led to Keynes being seen as anti-

establishment

“The policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness should be abhorrent and detestable,--abhorrent and detestable, even if it were possible, even if it enriched ourselves, even if it did not sow the decay of the whole civilized life of Europe.”

J.M. Keynes (1919)

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Money, unemployment, prices

• Keynes’ seminal work: The General Theory of Employment, Interest, and Money (1936)

• Started his research in the 1920s• Set out to provide a rigorous analysis of how

an economy can be in an equilibrium and have unemployment -- why don’t wages and prices adjust to employ all people who want jobs and all resources?

What I’ll CoverWhat I’ll Cover

Lynne and I agreed that she’d talk first for Lynne and I agreed that she’d talk first for about 30 minutes and I would follow up for about 30 minutes and I would follow up for about 15 minutesabout 15 minutes

I’m mainly going to talk about the contrast I’m mainly going to talk about the contrast between Keynes and two other schools of between Keynes and two other schools of thought in macroeconomicsthought in macroeconomics– Pre-Keynesian “Classical Macroeconomics” and Pre-Keynesian “Classical Macroeconomics” and

Post-Keynesian “New Classical Macroeconomics”Post-Keynesian “New Classical Macroeconomics” But First, Back to “Economic Consequences But First, Back to “Economic Consequences

of the Peace”of the Peace”

Keynes in 1919: The War Keynes in 1919: The War Damage Was Beyond Damage Was Beyond

Germany’s Ability to PayGermany’s Ability to Pay ““Even if every house and factory and Even if every house and factory and

cultivated field, every road and railway cultivated field, every road and railway and canal, every mine and forest in the and canal, every mine and forest in the German Empire could be carried away German Empire could be carried away and sold at a good price to a ready and sold at a good price to a ready buyer, it would not pay for half the cost buyer, it would not pay for half the cost of the war and of reparation added of the war and of reparation added together.”together.”

Keynes: “If we aim deliberately at the Keynes: “If we aim deliberately at the impoverishment of Central Europe, impoverishment of Central Europe, vengeance, I dare predict, will not limp.” vengeance, I dare predict, will not limp.”

But His Main Argument But His Main Argument Involved Involved

Not Bolshevism but Self-Not Bolshevism but Self-interestinterest For Keynes, the Victors (UK and France) were For Keynes, the Victors (UK and France) were

slitting their own throats with the Treaty of slitting their own throats with the Treaty of VersaillesVersailles

Germany could pay massive reparations only by Germany could pay massive reparations only by running a large export surplusrunning a large export surplus– Germany would have to devalue its currency to make its Germany would have to devalue its currency to make its

export goods cheap, thus destroying the competitiveness export goods cheap, thus destroying the competitiveness of UK and French exportersof UK and French exporters

““Germany would be forced to flood the world’s Germany would be forced to flood the world’s markets with goods at ridiculously low prices”markets with goods at ridiculously low prices”

““If Germany could compass the vast export trade If Germany could compass the vast export trade which the Paris proposals contemplate, it could only which the Paris proposals contemplate, it could only be by ousting some of the staple trades of Great be by ousting some of the staple trades of Great Britain from the markets of the world.” Britain from the markets of the world.”

In the End, Keynes Turned Out In the End, Keynes Turned Out to be Wrongto be Wrong

The Germans faced two burdens, the The Germans faced two burdens, the internalinternal debt that debt that the government owed to its own citizens as a result of the government owed to its own citizens as a result of wartime expenditures, and the wartime expenditures, and the externalexternal debt owed to debt owed to the Allied victors.the Allied victors.

The Germans never achieved the massive export The Germans never achieved the massive export surplus that Keynes feared would be a result of the surplus that Keynes feared would be a result of the externalexternal debt. Their domestic inflation wiped out any debt. Their domestic inflation wiped out any advantage of depreciationadvantage of depreciation

The German hyperinflation wiped out the The German hyperinflation wiped out the internalinternal public debt created by the expenses of the war.public debt created by the expenses of the war.

The obligation to pay reparations (the The obligation to pay reparations (the externalexternal debt) debt) was abrogated in 1931, after a decade of Germany was abrogated in 1931, after a decade of Germany dragging its heels and Allied failure to collectdragging its heels and Allied failure to collect

““What hyperinflation did for the internal German war What hyperinflation did for the internal German war debt, the Great Depression did for the external burden debt, the Great Depression did for the external burden imposed by reparations.”imposed by reparations.”

Without the Great Without the Great Depression . . . Depression . . .

There would have been no Hitler and There would have been no Hitler and no WW II (at least in Europe)no WW II (at least in Europe)

Keynes would not have climbed into Keynes would not have climbed into the ranks of the three greatest the ranks of the three greatest economists of the twentieth centuryeconomists of the twentieth century

For the Great Depression revealed For the Great Depression revealed the intellectual bankruptcy of the intellectual bankruptcy of classical economicsclassical economics

For the Classicals, the Full For the Classicals, the Full Economy Removes the Economy Removes the

MicroscopeMicroscope Classicals started with the microscope of Classicals started with the microscope of

standard price theory, still taught everywherestandard price theory, still taught everywhere If farmers produce too much wheat, the price will If farmers produce too much wheat, the price will

decline to lessen their incentive to produce and decline to lessen their incentive to produce and increase the customer’s desire to purchaseincrease the customer’s desire to purchase

Similarly, if an economy produces more than Similarly, if an economy produces more than consumers want to buy, the overall price level consumers want to buy, the overall price level will drop. Firms will want to produce less, with will drop. Firms will want to produce less, with lower wages workers will want to work less. lower wages workers will want to work less. All All will be well.will be well.

Classicals assumed: firms can sell all they want, Classicals assumed: firms can sell all they want, workers can work as many hours as they want. workers can work as many hours as they want. There is There is free choicefree choice in sales and employmentin sales and employment

Keynes Overturned Flexible Keynes Overturned Flexible Prices as a Cure-all for Prices as a Cure-all for

DepressionsDepressions Firms cannot afford to cut prices, because Firms cannot afford to cut prices, because

their costs are set by previous bargains with their costs are set by previous bargains with their workers and prices set by their supplierstheir workers and prices set by their suppliers

When consumers want to purchase less or When consumers want to purchase less or firms want to invest less or foreigners want to firms want to invest less or foreigners want to buy fewer exports, there is a decline in buy fewer exports, there is a decline in aggregate demandaggregate demand– This is the total amount that the economy wants This is the total amount that the economy wants

to purchase at today’s price levelto purchase at today’s price level In this world there is no longer In this world there is no longer free choicefree choice

Keynes’ 1935 Book is still Alive Keynes’ 1935 Book is still Alive in 2010in 2010

Can firms Can firms freely choosefreely choose how much to sell?how much to sell?– Not if customers stop coming into the restaurant or Not if customers stop coming into the restaurant or

the auto show room as they did in 2008-09the auto show room as they did in 2008-09– Sales are less than production so production must Sales are less than production so production must

be cutbe cut Can people Can people freely choosefreely choose how much to work?how much to work?

– Not if the restaurant or auto dealer tells them it no Not if the restaurant or auto dealer tells them it no longer needs them, they are laid off as in 2008-09longer needs them, they are laid off as in 2008-09

– Employment is less than the number of jobs people Employment is less than the number of jobs people are seeking, so many are unemployedare seeking, so many are unemployed

Unique Keynesian 1935 Unique Keynesian 1935 InsightsInsights

Consumer Demand depends not just on price Consumer Demand depends not just on price of goods, but on consumer incomeof goods, but on consumer income

Demand for workers depends not just on their Demand for workers depends not just on their wage but on the quantity of goods and services wage but on the quantity of goods and services produced – that tells firms how many workers produced – that tells firms how many workers are neededare needed

Interaction: People lose their jobs and buy Interaction: People lose their jobs and buy less. Firms sell less, cut production, and lay off less. Firms sell less, cut production, and lay off more workersmore workers

The Multiplier Effect. The Multiplier Effect. Each round of sales Each round of sales decline and job cuts creates another round.decline and job cuts creates another round.

This was the US economy in 2008-09This was the US economy in 2008-09

But Why Does Demand But Why Does Demand Decrease?Decrease?

Business Investment is Inherently UnstableBusiness Investment is Inherently Unstable Why?Why?

– Time to Build. Time to Build. It takes a long time to build a It takes a long time to build a condo or office buildingcondo or office building

– Planned in 2004, approved in 2005, construction Planned in 2004, approved in 2005, construction starts 2006 and ends 2007starts 2006 and ends 2007

– Coordination Failure. Coordination Failure. Only 2,000 condo units are Only 2,000 condo units are needed by 6,000 are builtneeded by 6,000 are built

Result: 2008 2009 2010 2011 market is Result: 2008 2009 2010 2011 market is flooded with unsold condo units, flooded with unsold condo units, construction falls from 6,000 to zero and the construction falls from 6,000 to zero and the multiplier effect kicks inmultiplier effect kicks in

Overbuilding Augmented by Overbuilding Augmented by Asset BubblesAsset Bubbles

Herd InstinctHerd Instinct creates asset bubbles. creates asset bubbles. – Investors believe prices will always go up, no Investors believe prices will always go up, no

danger of lossdanger of loss– Borrow as much as possible, multiplies profit Borrow as much as possible, multiplies profit IF IF

price continues to go up, but wipes out your price continues to go up, but wipes out your equity if price goes down even a small percentageequity if price goes down even a small percentage

– Investors do not learn from historyInvestors do not learn from history Examples. Stock market 1927-29, stock Examples. Stock market 1927-29, stock

market 1995-2000, housing market 2000-market 1995-2000, housing market 2000-20062006

When markets collapse and consumer wealth When markets collapse and consumer wealth declines, so do sales of consumer goodsdeclines, so do sales of consumer goods

What to Do? Keynesian What to Do? Keynesian Prescription of Fiscal PolicyPrescription of Fiscal Policy

The problemThe problem, consumers and business , consumers and business firms are not spending enough to create firms are not spending enough to create sufficient jobs for those who want to worksufficient jobs for those who want to work

The solutionThe solution, government must spend , government must spend more when the private sector spends lessmore when the private sector spends less

Keynes is the direct intellectual Keynes is the direct intellectual grandparent of the Obama stimulus grandparent of the Obama stimulus programprogram

What Would He Think?What Would He Think?Keynes Reincarnated from Keynes Reincarnated from

19451945 He’d Immediately Cite Yogi Berra:He’d Immediately Cite Yogi Berra: It’s déjà vu all over againIt’s déjà vu all over again He would immediately recognize the causes He would immediately recognize the causes

of the demand decline of 2008-09of the demand decline of 2008-09– The stock market decline would remind him of the The stock market decline would remind him of the

stock market bubble and collapse of 1927-29stock market bubble and collapse of 1927-29– The housing bubble would remind him of the The housing bubble would remind him of the

Florida land boom of the mid 1920sFlorida land boom of the mid 1920s– He would even recognize the role of the guilty He would even recognize the role of the guilty

mortgage brokers and Wall St. hustlers that mortgage brokers and Wall St. hustlers that brought the economy down in a binge of brought the economy down in a binge of overborrowing (“leverage and securitization”) with overborrowing (“leverage and securitization”) with their analogies in the late 1920s (“the investment their analogies in the late 1920s (“the investment trusts”)trusts”)

And If We Invited JMK Over And If We Invited JMK Over to a Northwestern Graduate to a Northwestern Graduate Macroeconomics Seminar?Macroeconomics Seminar?

He might briefly marvel at the projector and He might briefly marvel at the projector and Powerpoint slides, the cinema hall of the 1930s Powerpoint slides, the cinema hall of the 1930s brought into the classroombrought into the classroom

After recoiling from the layers of math and the After recoiling from the layers of math and the inarticulate mumblings of the modern generation, inarticulate mumblings of the modern generation, he would recognize immediately the failing of their he would recognize immediately the failing of their theories as a replay of the classical economists theories as a replay of the classical economists who came before himwho came before him

Their models assume that consumers Their models assume that consumers freely chose freely chose the amount they want to buy and people the amount they want to buy and people freely freely chose chose the amount they want to workthe amount they want to work

He would be startled to hear nothing of the He would be startled to hear nothing of the involuntary constraints faced by firms and workersinvoluntary constraints faced by firms and workers

Perhaps Keynes Would WalkPerhaps Keynes Would WalkOut of the Seminar in DisgustOut of the Seminar in Disgust

. . . When he heard a list of sources of . . . When he heard a list of sources of business cycles including “technology business cycles including “technology shocks”shocks”– Surely they’re not suggesting that the Great Surely they’re not suggesting that the Great

Depression was caused by forgetfulness?Depression was caused by forgetfulness? . . . When he heard a list of sources of . . . When he heard a list of sources of

business cycles including “preference business cycles including “preference shocks”shocks”– Surely they’re not suggesting that the Great Surely they’re not suggesting that the Great

Depression was caused by a sudden desire to Depression was caused by a sudden desire to eat fish instead of beef?eat fish instead of beef?

In 2009 the Media Speculated In 2009 the Media Speculated Whether We Would Need a Whether We Would Need a New Keynes to Explain the New Keynes to Explain the

CrisisCrisis While the details of the housing bubble While the details of the housing bubble

and Wall St amplification of that bubble and Wall St amplification of that bubble are new, the old idea of unbridled greed are new, the old idea of unbridled greed was familiar from the 1920swas familiar from the 1920s

Once housing prices began to decline, the Once housing prices began to decline, the Wall Street superstructure of exotic Wall Street superstructure of exotic securities collapsed like a house of cards, securities collapsed like a house of cards, as in the early 1930sas in the early 1930s

1930s Keynesian Theory fits the current 1930s Keynesian Theory fits the current crisis like a glovecrisis like a glove

Why Was 2008-09 a Big Why Was 2008-09 a Big Recession Instead of a 2Recession Instead of a 2ndnd

Great Depression?Great Depression? We Had Learned from Keynes:We Had Learned from Keynes: Monetary policy did not sit back Monetary policy did not sit back

passively as in 1930-32passively as in 1930-32 Fiscal policy went immediately into Fiscal policy went immediately into

action (think if March 1930 had been action (think if March 1930 had been like March 2009)like March 2009)

Our situation is bad, only slowly Our situation is bad, only slowly getting better, but without the ideas of getting better, but without the ideas of John Maynard Keynes it would be a lot John Maynard Keynes it would be a lot worseworse