Vienna, 18th March 2011
I am deeply honoured by the invitation of the Renner Institute to address you this evening at the conclusion of the conference on Austro-Keynesianism.
‘When the facts change, I change my mind. What do you do, sir?’ Keynes is supposed to have said, but almost certainly didn’t. This is a good text for my own sermon.
What changed my mind was the great recession of 2007-9, which stopped a few months short of becoming another Great Depression.
As Keynes’s biographer I never completely abandoned my faith in Keynes. But there was a clear hedging of bets in the last sentence of that biography, written in 2002: ’Keynes’s ideas will live so long as the world has need for them’. Well yes, but does it?
The extent to which I had swallowed the non-Keynesian message comes out in an article I wrote for the FT in 2001. Basically I endorsed the view that monetary policy could do all the fine tuning needed to ‘stabilise expectations’, though I covered myself by wondering whether it would be enough to deal with a serious drop in business confidence. I called this ‘minimum Keynesianism’. (FT, 16 August 2001).
This was the period of the ‘Great Moderation’. I now look back on it as reminiscent of the Roaring Twenties, which were supposed to go on forever. Then we had the collapse of 1929 followed by the collapse of the Credit Anstalt in 1931, Austria’s special contribution to the Great Depression. Then, as later, monetary policy was supposed to have cracked the problem of the business cycle. Keynes also believed this in the 1920s, but I, and others, had much less reason to do so after the Keynesian Revolution; yet we did.
The collapse of the banks in 2007-8 showed that the financial system – the system which drives investment – was just as naturally unstable as it always had been. We should have been warned by the East Asian crisis of 1997-8, but like many others I assumed this was a phenomenon of ‘immature financial markets’ and ‘crony capitalism’ which could not happen in the West.
But George Soros rightly pointed out in 2008 that ‘the salient feature of the current financial crisis is that it was not caused by some external shock….The crisis was generated by the system itself’.
This is what Keynes had always claimed: the market system lacked a thermostat and its temperature was likely to oscillate wildly unless controlled by the government.
There are two views about free markets, which I label for convenience the Ricardian and the Keynesian.
In the Ricardian view, markets have the property of always gravitating strongly to optimum equilibrium. Business cycles exist but will be short and shallow. Consequently unemployment, too, was a transient phenomenon. Governments have three economic functions only: to build and maintain some elements of infrastructure (particularly transport systems) which it would be too costly for private enterprise to finance; to maintain sound money; and to uphold the rules of competition. This view dominated economics before the Keynesian Revolution. Walras proved mathematically that a general market equilibrium was possible.
Economists developed quite a few ‘second best’ theories to explain why the real world didn’t actually behave like this. The flexible prices which secured GE could be interfered with by monopoly, trade unions, Protectionism, etc.
By contrast, Keynes denied that the market system had any internal mechanism for maintaining full employment. This meant that economies could drift on for years in a state of semi-slump. Governments should therefore assume responsibility for maintaining full employment. They could do this by securing enough spending power in the economy to employ all those who wanted to work. He invented macroeconomics. This was much more than just ‘sound money’: it involved fiscal and regulatory policy too.
Looking at what Keynes has to offer the 21st century I would now concentrate on the following key elements:
*market economies are inherently unstable.
*This is because of the existence of radical uncertainty, particularly as it affects investment markets. The chief expression of this is liquidity preference.
*Governments should reassert their macroeconomic functions, to which should be added sufficient equality of incomes to secure a broad basis of consumption demand.
To these I would add:
*rich countries should be making preparations for life beyond capitalism.
Let me deal with these points in turn.
1. The inherent instability of market economies. This needs less emphasis than the others. Economic life has always been marked by collapses and recoveries. These were caused by natural events beyond the wit of man to cope with. We have a pale echo of this in the effects of the Japanese tsunami on world stock markets: some economists predict that it will set back recovery by six months.
With the development of statistics in the 19th c, economists became increasingly interested in the supposedly rhythmic fluctuations of economies, that is, in business cycle theory. They discovered long cycles, medium cycles, short cycles. The most famous long cycle was the Malthusian population cycle. There was Jevons’ sunspot cycle theory of agricultural crises. There were cycles caused by the bunching of inventions, the gestation time of capital goods, and so on. And many more: you’ve all have heard of the Kondratieff cycle.
The common feature of these cycles was that they originated from events in nature which were at least partly unexpected and could not therefore be adequately guarded against. But the hope was that as statisticians discovered empirical regularities in these cycles, they could be forecast with a reasonable degree of accuracy, and if not wholly prevented, at least largely so. The elimination of the cycle in economics was part of the much grander project of eliminating the cycle in history to allow a linear progress towards a prosperous and pacified world.
Although Keynes is often considered a theorist of deep cycles, in fact he broke with this whole business cycle tradition. Because the very notion of a cycle assumed a predetermined future, subject to discoverable laws, and this was precisely the point Keynes wanted to deny. A large part of the future was radically uncertain, and therefore obeyed no laws.
Hence business cycle theory was a type of higher nonsense: more and more shorter and longer cycles were having to be invented in order to make sense of more and more data which never yielded, because it never could, any clear patterns. As Keynes said, the parameters are always shifting.
Therefore although economies were subject to frequent collapses, this was not in any rhythmic way, or according to discoverable laws. Keynes’s much more radical proposition was that there was nothing in a market system to maintain continuous full employment, and more often than not it was far from continuous or full. It could get there, but this was by happenstance, a lucky conjuncture. Normally it operated well below capacity, and from that already mediocre level there could be booms and busts, depending on the animal spirits of businessmen.
2. Keynes’s explanation of this was the existence of radical uncertainty. People were faced by the need to act but did not know what the future would bring. Thus there was a permanent fearfulness, punctuated by bursts of exuberant optimism and despair.
This nervousness affected particularly the investment system. For the essence of investment is the commitment of sums of money to obtain an income stream over a number of years into the future. We have worked out all kinds of devices for reducing the risk of losing our money. Still, there remains a risk, and we have to pay a premium for it, and that premium is the difference between full capacity utilisation and states short of that, depending on how high the premium is at different times. Keynes called this risk the liquidity premium, and I will come to it in a moment.
So when you want to understand Keynes’s explanation of why capitalist market economies lacked an internal mechanism for maintaining full employment (or optimum equilibrium if you prefer) you have to find it in his epistemology, his theory of knowledge.
What he said, and I quote, ‘Actually, however, we have as a rule, only the vaguest idea of any but the most direct consequences of our acts….The whole object of the accumulation of wealth is to produce results…at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague, and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical economic theory’. (CW, xiv, 113)
Because what the classic theory presupposed, Keynes argued, was that ‘at any given time facts and expectations…[were] given in a definite and calculable form; and risks…..[were]capable of an exact actuarial computation. The calculus of probability…was supposed to be capable of reducing uncertainty to the same calculable status as that of certainty itself….’ (CW,xiv, 112-3)
You can see that the classical theory which Keynes attacked already had an implicit theory of rational expectations. It was simply waiting to be properly mathematicised. Since the Chicago revolution of the 1980s all mainstream economists have been constrained to work within a rational expectations framework –that is, the proposition that everyone in principle has access to perfect information about future events. Those economists like Stiglitz and Krugman and others who wanted nevertheless to get Keynesian instability into their models from a framework that made it impossible, were forced to develop models in which there could, nevertheless, be actual information failures, due to contingent circumstances – ‘asymmetric information’ is a good example of this kind of theorising. But let me say, this has nothing to do with Keynes. Keynes believed in uncertain expectations, not rational expectations.
More importantly, models with asymmetric information don’t explain how the banking system collapsed in 2007-8. In this kind of breakdown symmetric ignorance is much more powerful than asymmetric information.
I mentioned the liquidity premium. This is the practical expression of uncertainty. People hoard money as a store of value. Keynes said that in terms of classical theory this was highly irrational, because liquidity yielded very low returns (with cash, zero returns). But in an uncertain world it makes a lot of sense to be able to get your hands on ready cash to meet unexpected obligations, above and beyond what you needed for regular transactions or foreseen contingencies. In short, the preference for liquidity was an artefact of uncertainty, and all rates of interest had a built-in uncertainty premium, which differed with the type of investment. These premiums in turn fluctuated with the state of ‘animal spirits.
So uncertainty attacked the investment engine from two sides. On the one hand it affected profit expectations –the return you expected to get from an investment. On the other side it affected the cost of capital. As Keynes put it the problem of maintaining stability arises because fluctuations in the expected profitability are likely to be greater than any practicable changes in the rate of interest. In fact, fluctuations in the former, leading to an increased desire for liquidity have exactly the wrong effect on the latter, by causing it to rise rather than fall.
It is for this reason that Keynes believed there was no automatic bounceback from deep recessions – because the adverse expectations which led to the collapse tended to persist for a long time.
3. Now I come to my third point, which is the Keynesian theory of macroeconomic policy. I already mentioned that the one counter-depression tool accepted by the new classical policy regime was monetary policy. Any precise inflation target leaves a little leeway for counter-cyclical monetary policy by mandating a reduction in interest rates if expected inflation falls below the target. If the economy is assumed to be normally cyclically stable then small variations in interest rates – a gentle hand on the tiller –should be enough to keep it on an even path. Using such small changes in interest rates to ‘manage’ market expectations became the mantra of central bankers during the ‘Great Moderation’.
This extraordinary power gifted to monetary policy was above all the work of Milton Friedman. All the important central bank governors, Bernanke, Mervyn King, Jean Claude Trichet, are Friedmanites, or monetarists.
These powerful monetary executives would accept that following a big financial collapse –which nevertheless, they would think of as a very rare event –there could be a temporary increase in what Keynes called ‘liquidity preference’ –if only because banking institutions would find themselves with a lot of non-performing loans. So for central bankers the correct response to such collapses is in two parts: to get bank rate down as near to zero as possible, and to increase the supply of money to the banking system to get it to start lending at low interest rates. All the major central banks have gone in for longer or shorter bouts of printing money, or quantitative easing, and no doubt further episodes are in store.
But there is a huge flaw in this theory which is implicit in my earlier discussion of liquidity preference. Keynes summed it up beautifully in a single sentence in the General Theory:
“If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip.”
The whole problem with printing money is contained in that short sentence. What Keynes is saying is that you can print as much money as you like, but if people don’t spend it, it will not stimulate the system to activity. What you’ve had in USA and Europe is a very big expansion in bank money, but a very mediocre growth in broad money, or bank deposits. In other words, the money being printed is going into the reserves of the banking system, and not being lent out to those who most need it –businesses and households. What we are seeing, in short, is Keynes’ ‘liquidity preference’ in action – a strong preference for keeping one’s money in cash or near cash, rather than committing it to illiquid investments which might yield a higher rate of return. This reflects the extreme uncertainty about the future course of recovery as well as real problems in the balance sheets of financial institutions.
What Keynes wrote in 1932 is still true, though in less extreme form:
“It may still be the case that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn…If this proves to be the case there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidise new investment.”
So what theory of economic policy follows from this? Evidently monetary policy alone was not enough to prevent the collapse. Macro policy needs to use fiscal policy as well as monetary policy (and if necessary exchange rate policy too) to balance the economy. I would also argue that incomes have to be more equally distributed to avoid the problem of the pile up of wealth draining consumption power from the population. Part at least of household overindebtedness springs from this cause.
But what needs to be done now?
The recovery is stalling as Keynes suggested that such a recovery resting on such policies would. The main need is to deploy idle cash to finance investment. European governments can’t do this directly because any further increase in borrowing is untenable. So we must find an alternative vehicle.
A National Investment Bank, initially seeded with capital by the government, could mobilise funds on the open market to support long term private investment. The essence of banking is the ability to make loans up to a multiple of several times the initial capital. Such a bank could attract money now languishing in idle balances by offering interest rates fractionally higher than the risk-free long-term bond rate and using these loans to finance long term investments in transport systems, green technology, and social housing on better conditions than such borrowers could obtain from commercial banks.
There are successful examples to draw on, from the German KfW to the Development Bank of Japan in Asia, Brazil’s National Bank, and many others. Take as an example the European Investment Bank. The EU governments which control it have contributed €50bn in initial capital, and the bank has raised a further €420bn on the capital market. It has used this to fund major infrastructure projects throughout Europe, from the port of Barcelona to the Warsaw beltway, and from France’s famous TGV network to Britain’s new, world-leading offshore wind industry. It has consistently turned a profit. I would double the capitalisation of the EIB over the next five years to enable it to expand its lending by a future €500bn. Here is a chance to do something practical about it.
The main aim of such an institution would be to steady the investment function. But it will kill three birds with one stone. Through its funding programme it would create a new class of long term bond reflecting the needs of the pension industry as the population ages. By lending for the long term, and in line with strategic economic and environmental priorities, it would help long term economic growth. And by ramping up its operations now –when corporate recovery is being hamstrung by shrinking bank lending and fiscal austerity it can offer a boost to aggregate demand when it is urgently needed.
I have omitted two topics of current concern: international money and finance and banking reform. On the first Keynes did have a lot to say, but it would take me too long to elaborate this evening. He took a leading part in setting up the Bretton Woods system which offered a payments system for a liberal economy less prone to violent disruptions than the old gold standard. He would I think be in the forefront of efforts to reform our present non-system. Here I will content myself with one quotation from the General Theory which touches on free trade and protection:
‘If nations can learn to provide themselves with full employment by their domestic policy…..there need be no important economic forces calculated to set the interest of one country against that of its neighbours. There would still be room for the international division of labour and for international lending….But there would no longer be a pressing motive why one country need force its wares or another or repulse the offerings of its neighbour, not because this was necessary to pay for what it wished to purchase, but with the express object of upsetting the equilibrium of payments so as to develop a balance of trade in its own favour…International trade would [become again] a willing and unimpeded exchange of goods and services in conditions of mutual advantage’. (GT, p.382-3)
I could also say something about reform of the banks to make them more socially responsible, but this is not a specifically Keynesian topic, so I omit it now. Glass-Steagall – the separation of the commercial and investment functions of banks – is the only way to prevent huge moral hazard problems stemming from the structures of banks “too big to fail”. Mervyn King, the governor of the Bank of England, has spoken out publicly in support of a modern version of the Glass-Steagall Act of 1933.
Instead I turn to my last point: Keynes’ vision of life beyond capitalism. In 1930 Keynes published a short essay called ‘Economic Possibilities for Our Grandchildren. Britain was entering the greatest depression of modern times; all minds were fixed on the crisis of capitalism. But Keynes was in a playful mood. He wanted to “disembarrass himself of short views and take wings into the future” The depression was an interruption, a tragic interruption to be sure, to the upward economic ascent of man.
The average income of the British worker was then £90 a year. Keynes argued that if the nation’s capital went on growing at 2 per cent a year, if output per person continued to grow at 1 per cent a year, and if there was no population growth, by the end of the century the average British worker would have an annual income of between £360 and £720, that is, between about four and eight times what he then earned. Translated into today’s prices, £360 would be £16,000 and £720 would be £32,000 Keynes drew ‘the startling conclusion that assuming no wars and no increase in population the economic problem may be solved in 100 years…Then we would be up against our real problem-how to…occupy leisure well and agreeably’. In 2008 income per head in the UK was $37,000, in the USA $42,000, and in the European Union $30,000. These figures give very rough orders of magnitude. What we can say is that we have arrived in Keynes’s ball park, that is, we are in sight of ‘having enough’.
As this point approached, Keynes predicted, mankind was likely to suffer ‘a general nervous breakdown’, because it would have been deprived of its traditional purpose. People would still have to do some work ‘for contentment’. Three hour shifts or a 15 hour week will ‘put off the problem for a little’. But in the end what would be needed was no less than a ‘new code of morals’. We shall have to breed out, or breed down, purposefulness and breed up carpe diem –‘the delightful people who are capable of taking direct enjoyment in things –the lilies of the valley who enjoy to breathe the air –the rare angelic beings who are perfectly good, which is almost the same thing as to say that they have no purpose whatever’.
All this, remember, was supposed to happen about now, or in the very near future, at least in rich countries. It hasn’t worked out like that, but it challenges to think why, and to rethink social arrangements forged in an era of scarcity for us in an age of abundance.
Although we should remember and honour Keynes as a great theorist of stabilization policy he has more to offer the 21st century than that. Because he asks the fundamental question that no economist now dares to ask: what is our economic civilization for? What is the purpose of money? What is the relation between money and the good life? Or more simply: ‘How much is enough?’ This is the title of the new book I am writing with my son, and it will be published in January next year. So if you want our answer you had better invite both of us to visit Vienna again.