We’re all Keynesians now? I’m not!

John Maynard Keynes is back. According to the Wall Street Journal, ‘We’re all Keynesians again’ (1).

Keynes is the economist most associated with government intervention in the market. His most important work was the General Theory of Employment, Interest and Money, published in 1936, and he was the most influential economist of the post-Second World War period. In the 1970s his school of thought fell from favour, knocked out by the one-two punch of theory (criticisms from monetarists led by Milton Friedman) and practice (the economic crisis).

Recent government actions in response to the financial crisis – in particular the Bush and Obama stimulus packages in the US – have been widely viewed as a sign that Keynes’ brand of economics is back in fashion. Whatever their theoretical inclinations prior to the crash, a majority of economists – and especially those in the Obama administration – dropped any inhibitions they may have had about increasing state spending and debt substantially when confronted with what they thought was the prospect of another Great Depression. As Robert Lucas, a leading economist and critic of Keynes, puts it, ‘I guess everyone is a Keynesian in a foxhole’ (2).

But Keynes’ comeback is partial. It is noticeable that Washington policymakers have not provided a rationale for their actions by reference to Keynes’ theories. And Keynesian-influenced economists remain on the defensive today, and feel they still need to argue their corner. A recent New York Times feature article by Princeton economist Paul Krugman, a leading Keynesian, asked ‘How did economists get it so wrong?’. Krugman mainly blames neo-classical ‘freshwater’ economists (that is, inland-based economists, such as those at the University of Chicago), but also says the New Keynesian ‘saltwater’ economists (those based on the coasts) were also too uncritical, and he calls for rethinking economics (3).

So, rather than a strong, clear-cut reassertion of Keynesianism, there is much soul-searching and debate among economists. Stepping into this discussion, Robert Skidelsky argues for embracing the English economist’s views in Keynes: The Return of the Master. Skidelsky is best known for his highly regarded three-volume biography of Keynes. Although a historian by profession, Skidelsky has a firm grasp of Keynes’s ideas and the broader economic issues at stake, and his lucid writing style makes his book valuable for specialists and non-specialists alike.

Skidelsky aims to provide an account of how Keynes’ theoretical insights remain relevant in the context of today’s financial crisis. He recognises that, despite the talk of a comeback, the case for Keynes still needs to be made. Few, for instance, are arguing for a return to Keynesian policy as practised in its postwar heyday. ‘No one has yet suggested reviving Keynesian fiscal policy to stabilise economic activity at a high level’, he writes.

Misconceptions about Keynes persist, Skidelsky argues, such as the view that Keynes was ‘a tax-and-spend fanatic’. Moreover, not having a proper appreciation of Keynes’ views means that the appropriate corrective action will not be taken. For example, he believes both regulators and bankers continue to rely on flawed financial models, which they would question, if not abandon entirely, if they grasped what Keynes had to say about risk and uncertainty.

Skidelsky begins with a clear and concise account of how the financial crisis unfolded and how governments responded. He skillfully knocks down the pedestrian arguments that try to pin the blame for the crisis on particular players. Quite rightly, he notes, ‘there is something disagreeable about the mass hysteria directed against the bankers, reminiscent of ancient witch-hunts, pogroms and human sacrifices at times of poor harvests’. Bankers, credit-rating agencies, hedge funds, central bankers, regulators, governments – blaming some or all of these is a form of scapegoating that does not address the root causes of the crisis.

Instead, Skidelsky argues, the real problem was one of theory: ‘At the root of the crisis was not failures of character or competence, but a failure of ideas.’ Here Skidelsky refers to neo-classical economics, which has held sway since the 1980s and, in its purist version, postulates that markets are automatically self-correcting (4). In particular, Skidelsky takes aim at more recent neo-classical ideas, such as ‘rational expectations’ and ‘efficient financial market theory’, which emphasise the self-regulating nature of markets. ‘It was the wrong ideas of economists which legitimised the deregulation of finance, and it was the deregulation of finance which led to the credit explosion which collapsed into the credit crunch.’

It is true, as Skidelsky contends, that the fact of the recent severe downturn is a direct blow to these neo-classical nostrums. Until the crisis hit, most economists had believed that we were living in a ‘Great Moderation’ in which the ups and downs of the business cycle could be smoothed out. But as Alan Greenspan, the former head of America’s central bank, the Federal Reserve, admitted, the crash has meant that ‘the whole intellectual edifice’ had ‘collapsed’ (5).

However, the situation is not as black-and-white as Skidelsky portrays. For a start, we have not been living in a free-market world for the past 20 years. Despite the dominant laissez-faire ideology proclaimed since the Reagan-Thatcher era, the role of the state in the economy has in fact grown in importance. US politicians – both Republicans and Democrats alike – did not just deregulate the financial sphere; they actively promoted the growth of finance by means of incentives and other favourable treatment.

Furthermore, while Skidelsky rightly dismisses the ‘blame game’, his own explanation - financial deregulation – is not a sufficient one either. In this, he is not alone: most economists today seek to locate the cause of the crisis in the financial arena itself. However, it is not just the case that the financial crisis set off tremors that damaged the rest of the economy; the expansion of credit in the first place was due to the stagnation in the real economy, and that underlying weakness meant that it was more vulnerable to financial collapse.

But does it automatically follow that Keynes is the answer? No. Even if the current crisis discredits neoclassical ideas, Keynesianism, too, was discredited in the 1970s and that remains a major hurdle to overcome. Skidelsky evaluates the record of Keynesianism by comparing economic performance in the ‘Keynesian era’ of 1950-1973 versus the ‘post-Keynesian era’ of 1980-2008, and, not surprisingly, finds that the postwar boom period had a better record. But the success during that period cannot be attributed to Keynesian policies, such as deficit financing, which did not really come into play until the 1960s. In fact, the boom was the result of a new foundation for accumulation following the destruction of capital during the Second World War (6).

Skidelsky’s comparison ignores the 1974-1979 years, which shed a more negative light on Keynesianism. Skidelsky argues that only to a ‘limited extent’ was Keynesian policy of the 1960s responsible for the ‘stagflation’ (stagnation and inflation) crisis of the following decade. ‘But there were more profound reasons relating to the drift of social policy (sometimes called the “revolution in entitlements”), the role of the United States in the world, and the weakness of the Bretton Woods system of international institutions.’ It’s true that Keynesianism in practice did not cause the 1970s crisis, but equally it could not prevent it, and instead shaped the form it took, namely an inflationary and state-fiscal crisis.

Nevertheless, no matter what its debatable merits in the past, Skidelsky argues that Keynes can be updated and made relevant for today. But to do so, he refashions Keynes to force-fit him into today’s commonplace prejudices – namely, that the economy is finance-driven, and human behaviour and psychology are at its roots.

The core of Keynes’ thought, according to Skidelsky, is how to deal with systemic uncertainty, which he believes is at the root of the current financial crisis. Skidelsky says Keynes made an important distinction between risk and uncertainty. Risk is measurable and a normal part of the workings of capitalism, but uncertainty (which is unmeasurable risk) is a major problem because it damages, if not shuts down completely, investors’ confidence to invest.

This emphasis on uncertainty is in fact something of a re-interpretation of Keynes, although Skidelsky is not the only economist to make this point. The consensus understanding of Keynes is based on the ideas of his major 1936 work, the General Theory, and it is centred on the idea of ‘effective demand’ – how capitalist economies can suffer from a lack of purchasing power and how governments could step in and fill that shortfall. Skidelsky, however, focuses on a 1937 paper written by Keynes, which stresses the uncertainty concept.

Keynes was mistaken to believe that government spending could be a solution to the problems of a breakdown in the investment cycle. Fiscal deficits created their own problems. But at least the ‘effective demand Keynes’ in the General Theory addressed aggregate economic categories, and were certainly an advance over the prevalent neo-classical ideas of his time that extrapolated from the motives of individuals and single firms. In that respect, the ‘uncertainty Keynes’ Skidelsky puts to the fore is a step backwards, a move away from structural relationships towards the psychological motivations of investors, their so-called ‘animal spirits’. This emphasis also positions the financial sector as much more the driving engine of the economy – a view that it is common today, but mistaken.

Skidelsky believes Keynes is relevant for another reason as well – because he was a moralist. ‘The crisis has brought to a head wider issues concerning the explanation of human behaviour and the role of moral judgments in economics.’ This discussion of ‘human behaviour’ is a way to suggest that Keynes was a precursor for a newer trend today: behavioural economics. Economists of this persuasion question the idea that humans are rational, and believe irrationality can explain economic movements, especially in finance. For example, financial gains can lead to over-confidence and bubbles; or, losses lead to panics and excessive risk-aversion.

The economy should not be viewed as a purely technical or mathematical issue, one that is cut off from human questions. But it is not a positive development if the human subject that is brought back into the picture is a degraded one. Neoclassical ‘rational expectations’ theory can certainly be criticised for creating an artificial world that builds off its own assumptions. But when Skidelsky and behavioural economists attack the ‘rational expectations’ assumption that people are rational beings who are likely to make logical decisions, they are taking a big step backwards in their concept of humanity. And a subjective psychological theory based on the ‘irrational exuberance’ of investors is hardly a convincing explanation for a complex, system-wide crisis of the economy.

The current disarray in economic thinking provides an opening to debate new ideas about how the economy works and how it can be improved. Recasting Keynes to fit today’s prejudices about irrational humans and finance-led economy is not the answer – we need to challenge those prejudices rather than adapt to them. Truly fresh thinking would include issues that are not being discussed much today: the real economy and how it interacts with finance; production as opposed to today’s narrow fixation on consumption; growth and technological innovation rather than avoiding imbalances of supply and demand. By all means, let’s bring the human subject back in, but one that can develop the economy, not be at the mercy of it.

Sean Collins is a writer based in New York.

Keynes: The Return of the Master, by Robert Skidelsky, is published by Allen Lane. (Buy this book from Amazon(UK).).)

This article is republished from the September 2009 issue of the spiked review of books. View the whole issue here.

(1) George Melloan, ‘We’re all Keynesians again’, Wall Street Journal, 13 January 2009

(2) Cited in Justin Fox, ‘The Comeback Keynes’, Time, 27 January 2009

(3) Paul Krugman, ‘How did economists get it so wrong?’, New York Times Magazine, 6 September 2009

(4) Confusingly, Skidelsky refers to the neo-classical economists as ‘classical’. Keynes also used this designation, as he believed that the neo-classical economists were continuing in the classical tradition of Adam Smith and David Ricardo.

(5) Cited in Paul Krugman, ‘How did economists get it so wrong?’, New York Times Magazine, 6 September 2009

(6) See Do we need a new ‘New Deal’?, by Sean Collins