Keynes: The Return of the Master

Less on Keynes himself than I thought.

Don't bother reading this. Overly academic and pretentious - hard to read, poor description of ideas, almost nothing about the man himself. Worst book I've read for ages. ( )

Remedial reading is seldom entertaining. Lord Skidelsky has written an outstanding multi-volume biography of the 20th century's greatest economist, John Maynard Keynes. This book serves as an introduction to those who are too lazy to read the biography (or its abridgment - to which I plead guilty, my reading progress being stuck after a few hundred pages) or an economics textbook about proper Keynesianism (if they still print those in the US).

The book is divided into three parts. The first part is a (flawed) account of the current economic crisis. The book was written too early for a balanced account. Skidelsky, whose political views journeyed all over the place, places too much blame on the greedy poor taking out undeserving mortgages and not enough on corrupt bankers. He is also hampered by the fact that he continued to author Greenspanish paeans to the self-correcting market and the need for ultra-low inflation. He only manages partly to walk back on his former ideas.

The second part is a short recapitulation of Keynes' life as a successful hedge fund manager, who nevertheless was nearly wiped out multiple times during the Great Depression, advisor to the British government and shaper of Bretton Woods. Part two also includes a quick overview of the main Keynesian ideas. Skidelsky points to Keynes' important notions of uncertainty and animal spirits that reign beyond the possibilities of economic calculus.

Part three pleads for the return of intelligent Keynesianism in fiscal policy, a plea that only the pernicious influence of the Chicago economists prevents from being a mainstream idea. It as a sad fact that most US-trained economists are ignorant about Depression economics. If only the "practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist,” would let John Maynard Keynes be that defunct economist. ( )

Ideas of a master written by one. ( )

What would Keynes have done? That, superficially, is the main thrust of historian Robert Skidelsky's analysis of today's Great Recession. Skidelsky is the foremost biographer of John Maynard Keynes (1883-1946), the English economist who effectively created the field of macroeconomics and whose theories were mainstream economic orthodoxy from the 1950s to the 1980s. Keynes's Depression-era economic analysis and proposals provided a game plan for policy-makers confronted with economic stagnation and massive unemployment in the 1930s. In other words, a situation similar (if much more dire) to the one we face today.

Skidelsky's argument is that Keynes's ideas remain relevant, despite falling out of fashion in the tumultuous, inflationary 1970s, and that policy-makers should heed what Keynes had to say as they correct the massive mistakes that led to the 2008-2009 economic crisis. More importantly, he makes the case that the macroeconomic orthodoxy that supplanted Keynesianism, based on New Classical theories formulated by Milton Friedman and others, is the source of the current crisis. Writing in a clear, non-technical style, with surprising fluency, Skidelsky shows how New Classical ideas, and the anti-government “free market” ideology they inspire and support, have created a recipe for disaster.

Keynes famously remarked that “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly supposed. Indeed the world is ruled by little else.” Skidelsky's critique of the New Classical theories shows just how right the Master was. The Reagan-Thatcher Revolution of the 1980s ushered in the golden age of the New Classicals, whose elegant mathematical models demonstrated that “rational” markets (especially for wages and prices) adjust instantaneously to new information or conditions; that “rational” workers will respond to business-cycle “shocks” by deciding to work for lower pay, work fewer hours, or spend more time with their families; and that “efficient” financial markets are capable of precisely quantifying risk.

But these outcomes, Skidelsky demonstrates, are based on some heroically unrealistic assumptions about human behavior. By assuming away much of the messiness of real economic life, the New Classical models “prove” that market outcomes are everywhere and always the most efficient outcomes; that government intervention (including regulation) can never improve market outcomes (market failures simply don't exist) and will usually make those outcomes worse; and that with perfect information, markets will always assess and price risk correctly. Other recent writers, most notably economist Joseph Stiglitz ("Freefall: America, Free Markets, and the Sinking of the World Economy "), have similarly criticized New Classical theory.

The "free market" ideology these ideas inspired still pervades American politics – government regulation is unjustified, market solutions are always the best solutions, rules put in place to protect workers and consumers or moderate income inequalities are the slippery slope to socialism. This ideology has particularly benefitted firms looking to escape constraints on their actions (such as the Glass-Steagall separation of retail and investment banks, abolished in 1999) or pursue risky financial “innovations” (such as securitized mortgages and credit default swaps). Regulators and firms alike came to assume that markets had all the data needed to assess, price and insure against the failure of financial instruments (credit default swaps are, in effect, insurance policies).

Keynes faced a similar kind of economic orthodoxy in the 1930s, based on old classical economics. Like the newer, fancier versions, classical economic models did not include the possibility of involuntary unemployment. It was assumed that after an economic shock, markets would adjust. Period. But the models said nothing about how long it might take markets to “adjust” (Keynes highlighted this glaring failure of classical theory by wryly noting that "In the long run we are all dead") and offered no guidance to governments looking to alleviate massive unemployment (over 25% in the United States in 1933, nearly three times the 2010 rate).

In fact, classical economic orthodoxy called for reduced spending and budget surpluses (sound familiar?), even in the face of financial collapse and escalating unemployment, and the Treasury and the Federal Reserve obliged, plunging the US economy into deep depression in 1932. Keynes challenged orthodoxy by arguing that more government spending, not less, was needed prop up aggregate demand (investment and consumption), keep the financial system afloat, and prevent widespread business failures and worker layoffs. Ultimately, it was just such spending – first for limited New Deal public works and other programs, then for the massive military needs of World War II – that pulled the US out of the Depression. It was also Keynesian spending of this type that prevented the current crisis from becoming worse in 2008-2009. (For a Keynesian approach to the situation that prevailed in August 2010, see economist Laura Tyson's op-ed piece, "Why We Need a Second Stimulus," in the August 29 New York Times.)

Skidelsky argues that from 1951 to 1973, when Keynesian orthodoxy ruled, the United States enjoyed one of the longest periods of low unemployment and high growth in its history, a substantially better record than the 1980-2008 New Classical era, which saw higher unemployment, slower growth, and five global recessions. He acknowledges that the Keynesian-influenced economists and policy-makers of the 1950s and 1960s were overconfident in their ability to keep the economy at full employment without incurring inflationary costs, but it's hard to argue with his point that since the Fed substituted inflation targeting for full employment goals in the 1980s, lower- and middle-class income growth has stagnated and the gap between the rich and the rest of us has turned into a yawning chasm.

Skidelsky is also highly critical of the financial industry's reliance on risk models that share the same New Classical flaws. Bankers use these mathematical models to make precise, quantitative judgments about the probability that financial instruments (like mortgage-backed securities) will fail and what measures (like credit default swaps) are needed to offset that risk. But Skidelsky argues that because these risk models are based on the same unrealistic assumptions found in New Classical theories, they are not as reliable as their users believe.

Keynes demonstrated long ago that uncertainty dominates financial markets and that there simply is not enough data in most cases to calculate reliable risk probabilities. Financial markets are not like insurance markets – reliable demographic and actuarial data provide a firm basis for calculating insurance risk and pricing policies, and the fact that, say, one house unexpectedly burns down has no effect on the risk of others sharing the same fate. But such reliable risk data does not exist for most financial securities (especially highly-complex “innovative" instruments)and the failure of some can indeed lead to the default of others.

Skidelsky, in contrast to other analysts of the current crisis, is rather charitable toward Wall Street bankers. Rather than simply condemning their unregulated greed, he suggests that otherwise well-meaning people were mesmerized (willingly or not) by their risk models into thinking they had it under control. He notes in passing that the economists whose Nobel Prize-winning derivative pricing model was utilized by the Long Term Capital Management hedge fund believed firmly in their risk program until the day the fund collapsed in 1998 and nearly brought on a national financial crisis.

In the end, Skidelsky's recommendations are simple and straight-forward: Restore the division between retail (where deposits are government-insured) and investment banking (which gambles private money), and take steps to prevent investment banks from becoming “too large to fail.” Use discretionary fiscal policy to maintain stability and keep the economy on a path to full employment, “minus the 'fine-tuning' obsession” of the earlier Keynesian period. And more idealistically, try to reach a societal consensus about the goal of economic activity.

Keynes was a philosopher as much as an economist, and he argued that economic activity is not an end in itself (as sterile, abstract New Classical theories imply) but a tool to achieve a better life for society. “We do not wish,” he said, “to be at the mercy of world forces working out...some uniform equilibrium according to the ideal principles of laissez-faire.” Rather he argued for policies (such as measures that help put people to work) that would give individuals opportunities to maximize their own prosperity – “We each have our own fancy. Not believing that we are saved already, we each would like to have a try at working out own salvation.” Keynes, to use current lingo, was about societies empowering their members to enjoy a prosperous life. I agree with Skidelsky that that is the ideology we should embrace. ( )