John Maynard Keynes
and Keynesian Economics
[Originally published in German in 1980; reprinted
The Laissez-Faire City Times, Vol. 3, No. 10, 8 March
John Maynard Keynes (1883-1946) is the latest in a line of great
British economists who had a profound influence on the discipline of
economics. By common consent, the line starts with Adam Smith
(1723-1790), whose Wealth of Nations (1776) is generally regarded as
the founding document of modern economics. It continues with David
Ricardo (1772-1823), whose Principles of Political Economy (1817)
dominated classical economics for much of the nineteenth century, and,
incidentally, provided Karl Marx with one of his central concepts: the
labor theory of value. John Stuart Mill's (1806-1873) Principles of
Political Economy, published in the same year, 1848, as the Communist
Manifesto by Marx and Engels, became the standard textbook in the
English-speaking world-and beyond-for decades. William Stanley
Jevons's (1835-1882) Theory of Political Economy (1871) inaugurated
the "marginal revolution," which replaced, or supplemented,
emphasis on cost of production (supply) as determining value with
emphasis on utility (demand). He resolved the classic diamond-water
paradox-diamonds are a luxury, water a necessity, yet diamonds command
a higher price than water-by showing that "marginal utility"-the
utility gained from having one more unit of something-not "total
utility" plays the key role in determining price. Alfred Marshall
(1842-1924), Keynes's own teacher, guide, and patron, dominated
economics in the English-speaking world from the publication of the
first edition of his classic, Principles of Economics (1890), to the
Keynes clearly belongs in this line. In listing "the"
classic of each of these great economists, historians will cite the
General Theory as Keynes's path-breaking contribution. Yet, in my
opinion, Keynes would belong in this line even if the General Theory
had never been published. Indeed, I am one of a small minority of
professional economists who regard his Tract on Monetary Reform
(1923), not the General Theory, as his best book in economics. Even
after sixty-five years, it is not only well worth reading but
continues to have a major influence on economic policy.
1. KEYNES'S LIFE
From 1908 to his death in 1946, Keynes was an active Fellow of King's
College, Cambridge, influencing successive generations of students.
For many years, he was also Bursar of King's College, and is credited
with making it one of the wealthiest of the Cambridge colleges. From
1911 to 1944, he was the editor or joint-editor of the Economic
Journal, at the time the leading professional economic periodical in
the English-speaking world. Simultaneously, he was also Secretary of
the Royal Economic Society.
Despite his lifelong commitment to economics, the earliest work he
completed-though not the earliest to be published -- was in
mathematics not economics --
A Treatise on Probability -- essentially completed by 1911,
but first published in 1921. It is a mark of Keynes's range, creative
originality, and insight that much recent work in statistics has
returned to the themes of the Treatise on Probability. In
economics, his first major publication was Indian Currency and
Finance (1913), a product of his service in the India Office of
the British government from 1906 to 1908.
Monetary Reform (1923) was followed in 1930 by the two-volume
Treatise on Money, much of which remains of value, though Keynes
himself came to regard its theoretical analysis as simply a step on
the road to the General Theory, the last of his major works. These
major works were supplemented by numerous articles, reviews, and
biographical essays on some of his predecessors.
Keynes's interest and influence were by no means limited to the
confines of the academy. For decades he exerted a major influence on
public affairs and played an active role in the world of business. His
Economic Consequences of the Peace (1919), based on his activities as
an adviser to the British Treasury during the negotiation of the
Versailles Peace Treaty, had a major impact on public opinion and
public policy, not only in Britain but throughout the world, and not
only immediately. It was translated into many languages, became a
worldwide best-seller, and first established Keynes as a major public
figure. It influenced the reaction of both victors and vanquished to
the Versailles Peace Treaty. Indeed, in a book, The Carthaginian
Peace; or, the Economic Consequences of Mr. Keynes, published more
than two decades later (1946), Etienne Mantoux pays the Economic
Consequences a backhanded compliment by arguing that Keynes's
debunking of the peacemakers was the source of all subsequent evil,
including World War II.
From 1919 on, Keynes remained active in public matters, publishing a
steady stream of articles on current affairs in nonprofessional
journals and newspapers, advising and participating in the
deliberations of the Liberal party, serving as chairman of the Nation
and Athenaeum when it was acquired by a group of Liberals in 1922, and
later as director of the combined New Statesman and Nation, leading
journals of opinion for which he wrote frequently. He brought together
many of his most significant pieces on public affairs in Essays in
Persuasion (1931). He served on government commissions, notably the
Macmillan Commission, and advised and consulted with successive
governmental ministers. He was chairman of the National Mutual
Insurance Company and director of several other insurance companies.
His interests were truly catholic: E. A. G. Robinson, who was
co-editor of the Economic Journal with Keynes for some years and
succeeded him as editor, begins an Encyclopaedia Britannica
article on Keynes by describing him as "1st Baron . . . , British
economist who revolutionized economic theories, critic and architect
of national economic policies, political essayist, successful
financier, bibliophile and patron of the arts." His interest in
one particular art, ballet, was both cause and effect of his marriage
in 1925 to Lydia Lopokova, a famous Russian ballerina. He established
and largely financed the Cambridge Arts Theater and was a trustee of
the National Gallery.
From 1919 to World War II, Keynes's connection with government was
primarily as an influential outsider. From 1940 on, he served in
government in a variety of capacities concerned with the economic
conduct of the war and postwar reconstruction. He was the chief
British representative at Bretton Woods in 1944, where he was a major
architect of the plans for the International Monetary Fund and the
World Bank for Reconstruction and Development. He was the chief
negotiator of the large U.S. loan to Britain in 1945. On his return to
Britain, he played an important role in persuading the British
Parliament to adopt the Bretton Woods agreement. He died shortly
thereafter, on April 21, 1946.
2. THE INFLUENCE OF THE GENERAL THEORY
To return to the General Theory: its influence on both economic
thinking and economic practice was profound. The "Keynesian
revolution" was far more than a figure of speech. From shortly
after the publication of the book in 1936 to at least the 1960s, the
majority of professional economists, and certainly the most prominent,
termed themselves "Keynesians." Those who called themselves
non- or anti-Keynesians were a beleaguered minority, supplemented, it
must be said, by some important writers on economics who were not
members of the professional guild. Governments around the world
hastened to adopt "Keynesian policies," though many an
economist-both Keynesians and anti-Keynesians-regarded some of the
policies, particularly when they led to inflation, as at best "bastard
As of this writing (1988), the status and influence of the book has
changed. It continues to have a major influence on economic thinking
and economic policy, and will long continue to do so, but for very
different reasons and in a very different way than it did initially.
The catalyst for the change was the inflation and stagflation of the
1970s. As Robert Lucas wrote in 1981, "Proponents of a class of
models which promised 3 1/2 to 4 1/2 percent unemployment to a society
willing to tolerate annual inflation rates of 4 to 5 percent have some
explaining to do after a decade such as we have gone through [i.e.,
the 1970s, when inflation rose to 16 percent and unemployment to 8
percent in the United States, and to 30 percent and 6 percent in the
U.K. Inflation rose as high as 25 percent in Japan and 7 percent in
Germany, though unemployment remained relatively low]. A forecast
error of this magnitude and central importance to policy has
consequences, as well it should."
The predictions to which Lucas refers were based on the so-called
Phillips curve which linked inflation inversely to
unemployment-allegedly, the higher the rate of inflation, the lower
the level of unemployment. The curve was asserted by many Keynesians
to be stable over time and to specify a menu of combinations of
inflation and unemployment, any of which was attainable by the
appropriate monetary and fiscal policy. Lucas went on to note that "in
the late 1960s Milton Friedman (1968) and Edmund Phelps (1968) had
argued . . . that these predicted Phillips curve trade-offs were
spurious." They emphasized the importance of distinguishing
between anticipated and unanticipated inflation in interpreting the
Phillips curve, and Friedman introduced the concept of a "natural
rate of employment" to which the economy would tend as economic
actors adjusted their anticipations.
"The central forecast to which [Friedman's and Phelps's]
reasoning led," Lucas continued, "was a conditional one, to
the effect that a high-inflation decade should not have less
unemployment on average than a low-inflation decade. We got the
high-inflation decade, and with it as clear-cut an experimental
discrimination as macro-economics is ever likely to see, and Friedman
and Phelps were right."
The 1980s have been no kinder to the earlier Keynesian models. In the
U.S., inflation was brought down drastically, accompanied by a
temporary increase in unemployment to a peak of nearly 11 percent-a
short-term reaction to unanticipated disinflation along Phillips curve
lines. But then, from 1983 on, unemployment fell concurrently with
further declines in inflation, reaching 6 percent by the end of 1987
when inflation was about 4 percent-a flat contradiction of the
asserted negative relation between unemployment and inflation embodied
in the Phillips curve. In the U.K., too, an initial decline in
inflation was accompanied by a sharp rise in unemployment, which was
very much slower to decline but has more recently begun to do so. In
Germany, inflation has come down since the early 1980s; unemployment
rose initially, as in the U.S. and the U.K., but, in contrast to them,
continued to rise after inflation had settled down, and has remained
high. Japan, which was the first of the major countries to cut sharply
the rate of inflation, has succeeded in keeping inflation low with
little change in its recorded unemployment rate. All in all, this
experience is hardly consistent with a stable trade-off between
inflation and unemployment.
Experience led to disillusionment with initial Keynesianism on the
part not only of professional economists but also of policymakers. The
most dramatic evidence came from James Callaghan, when he was the
Labour prime minister of the U.K.-the party and the country that had
gone farthest in embracing and adopting Keynesian policies. Said
Callaghan in 1976, "We used to think that you could just spend
your way out of a recession and increase employment by cutting taxes
and boosting government spending. I tell you, in all candor, that that
option no longer exists; and that insofar as it ever did exist, it
only worked by injecting bigger doses of inflation into the economy
followed by higher levels of unemployment as the next step. That is
the history of the past twenty years."
Despite the widespread rejection of some of the key propositions that
constituted the "Keynesian revolution," the book continues
to have a major impact on economic thinking. Some indication of its
influence is given by the continuing citations to the book in the
professional literature. Data from one citation index, which covers a
wide range of economic journals, are available for sixteen years, 1972
to 1987. In all, there were 1,558 citations to the General Theory, or
an average of nearly 100 a year. Of the total, 729 occurred in the
first eight years, 829 in the second eight, so there is no sign that
interest in the book is declining. However, the character of the
book's influence has changed. Some years ago, I remarked to a
journalist from Time magazine, "We are all Keynesians now; no one
is any longer a Keynesian." In regrettable journalist fashion,
Time quoted the first half of what I still believe to be the truth,
omitting the second half. We all use Keynesian terminology; we all use
many of the analytical details of the General Theory; we all accept at
least a large part of the changed agenda for analysis and research
that the General Theory introduced. However, no one accepts the basic
substantive conclusions of the book, no one regards its implicit
separation of nominal from real magnitudes as possible or desirable,
even as an analytical first approximation, or its analytical core as
providing a true "general theory."
As one, no doubt somewhat idiosyncratic, view of the book, I quote
from a reply that I wrote some years ago to criticisms of my work
mostly from a "Keynesian" point of view:
"One reward from writing this reply has been the
necessity of rereading earlier work, in particular [Keynes's] . . .
General Theory. The General Theory is a great book, at once more
naive and more profound than the 'Keynesian economics' that [unreadable]
contrasts with the 'economics of Keynes.'
"I believe that Keynes's theory is the right kind of theory in
its simplicity, its concentration on a few key magnitudes, its
potential fruitfulness. I have been led to reject it, not on these
grounds, but because I believe that it has been contradicted by
evidence: its predictions have not been confirmed by experience.
This failure suggests that it has not isolated what are 'really' the
key factors in short-run economic change.
"The General Theory is profound in the wide range of problems
to which Keynes applies his hypothesis, in the interpretations of
the operation of modern economies and, particularly, of capital
markets that are strewn throughout the book, and in the shrewd and
incisive comments on the theories of his predecessors. These clothe
the bare bones of his theory with an economic understanding that is
the true mark of his greatness.
"Rereading the General Theory has . . . reminded me what a
great economist Keynes was and how much more I sympathize with his
approach and aims than with those of many of his followers."
3. THE MESSAGE OF THE GENERAL THEORY
As its title indicates, the General Theory is almost pure abstract
theory. There is only passing reference to applied economics,
statistical magnitudes, or economic policy. Yet, like all of Keynes's
writings on economics, it was inspired by a major contemporary problem
and written in the hope and expectation of providing a solution. The
book was written during the worldwide Great Depression following 1929,
when idle men, idle machines, and unmet demand coexisted on a large
scale for years on end and produced widespread poverty, misery, and
deprivation. For Britain, it followed a near-decade of economic
stagnation, high unemployment, and long-term dependence of many
families on a government dole. The key problem of the time was how to
explain the apparent paradox, and, more urgently, how to resolve it.
Ups and downs in economic activity involving occasional periods of
wide-spread unemployment had long occurred and had engaged the
attention of numerous economists under the rubric of "business
fluctuations," or "business cycles." Various theories
had been offered to explain them. Most earlier theories implicitly
accepted the proposition that a private-enterprise capitalist system
contained self-correcting forces that would keep disturbances
temporary. By corrective adjustments to changes in circumstances, the
system, it was believed, would tend toward full employment of both men
and machines-save only for fractional and transitory unemployment
implicit in a dynamic economy. However, the long duration and
magnitude of the unemployment during the Great Depression and the
prior years in Britain did not seem to fit this pattern. Could these
be interpreted as simply a temporary, if long-lasting, disturbance? Or
did they indicate a defect in the supposed self-adjusting forces at
work, so that the economy could get stuck for long periods of time at
a position of high unemployment-a position that might have just as
much reason to be regarded as an "equilibrium" as a position
of full employment?
Such a possibility had frequently been asserted by socialist and
other critics of a capitalist system, whom the mainline professional
economists had regarded as "crackpots." Keynes took the
possibility seriously and proceeded to construct an hypothesis that he
believed demonstrated the possibility-indeed the frequent
reality-that, without government intervention, a private-enterprise
capitalist system using a non-commodity money would tend toward a
position characterized by a high level of involuntary unemployment of
persons who would willingly be employed at the current wage rate but
could not find jobs.
The classical remedy for idle men, according to Keynes, was a decline
in the real wage rate, which would reduce the number of persons
seeking jobs and increase the number of persons employers wanted to
hire. The classical remedy for idle machines was a reduction in the
cost to enterprises of using and producing such machines, and that was
expected to occur via a reduction in the real interest rate.
In the 1920s and 1930s in Britain, these classical remedies seemed
either inoperative or ineffective. Keynes set himself the task of
explaining why, of constructing an alternative theory that would both
explain what was happening and justify alternative policies-such as
the large public works programs he had been recommending since the
In one sense, his approach was strictly Marshallian: in terms of
demand and supply. However, whereas Marshall dealt with specific
commodities and "partial equilibrium," Keynes proposed to
deal with what he called "aggregate demand" and the "aggregate
supply function," and with general not partial equilibrium.
Where he deviated from Marshall was in the key variables that he
regarded as producing equilibrium between demand and supply and in the
process of adjustment to a change in demand or supply. In Marshallian
analysis, the key role was played by prices, which reacted quickly to
any change in circumstances. Let there be a sudden increase in demand,
in the sense of a demand function relating the quantity demanded to
price. In Marshall's view, the immediate reaction would be on prices,
which would rise to choke off the quantity demanded to the prior level
plus whatever additional quantities might be made available from
inventories. The rise in prices during the "market period"
would give producers an incentive to increase output in the "short
run" by using existing plant and equipment more intensively, and,
if the increased demand persisted, in the longer run by adding to
plant and equipment. In short, prices adjusted rapidly, quantities
slowly, and changes in prices played the major role in producing
To Keynes, it seemed clear that this process had been inoperative or
ineffective with respect to the economy as a whole. Nominal wage rates
had indeed declined, but so had nominal prices, so that real wages had
hardly moved, and may indeed have increased. He concluded that
movements in prices and interest rates could not be counted on.
Accordingly, he reversed Marshall's presumptions: prices of labor and
capital, at least "real wages" and "real interest
rates," are very slow to adjust; quantities, which is to say
consumption, investment, and their sum, total output, are highly
flexible and adjust rapidly. Changes in output (aggregate supply), not
in prices, play the major role in producing equilibrium. Accordingly,
as a first approximation-though one he never really relaxed-he took
prices as given by forces outside his analysis. As a first
approximation, also, he abstracted from both government spending and
international trade, but these could readily be integrated into the
analysis without affecting its substance.
Keynes defined aggregate demand and aggregate supply in terms of
employment, in line with his view that he was developing a "theory
However, both Keynes and his followers tended to replace employment
by output and to express aggregate demand and aggregate supply in
terms of the value of output demanded by the public and supplied by
Aggregate demand, in these terms, is the sum of expenditures on
consumption goods and expenditures on investment goods. Keynes
regarded expenditures on consumption as depending on income,
introducing one of his key concepts: the propensity to consume, or, in
his words, "the functional relationship
given level of income in terms of wage-units, and
expenditure on consumption out of that level of income."
A "fundamental psychological law," which plays a key role
in the Keynesian system, is that "men are disposed
increase their consumption as their income increases, but not by as
much as the increase in their income" -- i.e., the "marginal
propensity to consume" is less than unity.
Keynes defined investment as "the current addition to the value
of the capital equipment which has resulted from the productive
activity of the period." He regarded investment as depending on
the "marginal efficiency of capital," the second of his key
concepts, which he defined as "that rate of discount which would
make the present value of the series of annuities given by the returns
expected from the capital-asset during its life just equal to its
supply price," i.e., "the cost of producing" one more
unit of the asset. Like the propensity to consume, the marginal
efficiency of capital is a function or schedule relating the amount of
investment to the interest rate, since entrepreneurs would have an
incentive to add to investment so long as the yield exceeded the
interest rate at which they could borrow the funds to finance the
The interest rate, in turn, he regarded as determined by "liquidity
preference," the third of his key concepts. "An individual's
liquidity-preference is given by a schedule of the amounts of his
resources, valued in terms of money or of wage-units, which he will
wish to retain in the form of money in different sets of
circumstances." He regarded the amount of their assets that
individuals would want to hold in the form of money as depending on
both income and the interest rate-income because that would affect the
amount held for "transactions- and precautionary-motives,"
the interest rate, because that would affect the amount held "to
satisfy the speculative-motive." 
If, as Keynes did, we let Y be income, identical with the value of
output, C be consumption, I be investment, L liquidity preference, M
the quantity of money, and r the interest rate, then aggregate demand
is given by
Y = C(Y) + I(r) (1)
and the demand for money by
M = L(Y,r) (2)
In line with his implicit assumption about the relative speed of
adjustment of prices and output, Keynes regarded supply as essentially
passive, expanding or contracting as demand expanded or contracted,
subject only to the proviso that employment is less than "full,"
which he defined as the point at which an increase in aggregate demand
would call forth no additional workers willing to work at the wage
offered. This leads him to regard aggregate supply as given simply by
aggregate demand, or
YS = YD (3)
and the level of aggregate supply and demand as affecting not a price
but solely employment.
If we regard the interest rate as fixed, along with other prices,
then equations (1) and (3) define the famous Keynesian "multiplier"
(attributed by Keynes to Richard Kahn). For a simple version, assume
that the consumption function is linear:
C = a + bY (4)
with b, of course, less than one. Substituting (4) in (1) and
solving for Y, we have
Y = [a + I(r)]/(1-b) (5)
The multiplier is 1/(1-b), which, given that b is between zero and
unity, is necessarily greater than unity. The multiplicand, (a + I),
came to be termed "autonomous" spending, i.e., spending not
dependent on the level of income. In addition, once government was
introduced into the analysis, autonomous spending was regarded as
including not only autonomous consumption spending (a) and investment
(I ) but also government spending.
Equations (1) and (3) define also the equally famous "Keynesian
cross," which has been reproduced in literally hundreds of
textbooks in the past half century and is reproduced here in Figure 1.
The graph makes clear the key importance of the "fundamental
psychological law" that the marginal propensity to consume is
less than unity. If it were unity, the YD line would parallel the YS
line and there would be either no or an infinite number of equilibrium
positions, according as the two parallel lines were distinct or
identical. If it exceeded unity, the YD line would slope more steeply
than the YS line, and any point of intersection would be an unstable
equilibrium position. Because it slopes less steeply, the intersection
at YO is a stable equilibrium. If output were temporarily higher than
YO, employers would be making losses, since the aggregate supply price
would exceed aggregate demand, and would seek to contract output.
Conversely, if output were temporarily lower than YO, employers would
be making profits and would seek to expand.
If, for whatever reason, investment were to increase from IO to I'O,
the YD line would shift to Y'D and the new equilibrium would shift to
Y'O . At YF, the point of full employment, the process would end, and
"the crude quantity theory of money," which is the
particular object of Keynes's scorn and derision-no doubt because of
his long earlier adherence to it-"is fully satisfied."
Marvelously simple. A key that apparently unlocks the mystery of
long-continued unemployment: inadequate autonomous spending or too low
a propensity to consume. Increase either, or both, being careful
simply not to go too far, and full employment could be attained. What
a wonderful prescription: for consumers, spend more out of your
income, and your income will rise; for governments, spend more, and
aggregate income will rise by a multiple of your additional spending;
tax less, and consumers will spend more with the same result. Though
Keynes himself, and even more, his disciples, produced much more
sophisticated and subtle versions of the theory, this simple version
contains the essence of its great appeal to non-economists and
Here was one of the most famous and respected economists in the world
informing governments that the way to full employment was paved with
higher spending and lower taxes. What more attractive advice could
politicians wish for? Long regarded public vices turned into public
virtues! Marvelously simple, yes. But also simply marvelous. How could
a position such as YO in Figure 1 be regarded as a long-term
equilibrium-as was implied in the claim that the theory was "general"?
At that point, men and machines are idle. Would not the excess supply
of men and machines exert downward pressures on the prices of both?
Yes, said Keynes, but, if effective, that would be accompanied by
lower money prices of output that would cancel the lower money wages
and money cost of capital, so that real wages and the real cost of
capital would be unaffected-which is why Keynes expressed all
aggregate magnitudes in "wage-units." Hence, said Keynes,
flexible wages and prices would do no good. Far better to operate
directly on spending.
Of course, Keynes recognized that changes in prices, interest rates,
and quantity of money did have effects that provided alternative
avenues of escape from the so-called "underemployment
equilibrium." At best, it was a transitory equilibrium position,
the existence of which would set in motion self-corrective forces. But
Keynes tended to rule out these alternative avenues of escape as of no
practical significance because of his empirical judgment that prices,
wages, and interest rates were highly sluggish. Indeed, some
commentators on Keynes maintain that he deliberately overstated his
case in order to shock the economics profession into paying attention
-- a tactic that is common to every innovator, whether it be of an
idea or a product.
Only one alternative avenue of adjustment is explicitly present in
equations (1) and (2)-via the interest rate and the quantity of money.
This avenue, analyzed at some length in the General Theory, and found
wanting to produce, by itself, a full employment equilibrium, also was
rapidly incorporated in an alternative, more sophisticated graphical
representation of the Keynesian system developed almost simultaneously
by John Hicks and Roy Harrod. Figure 2 presents Hicks's IS-LM
version, which very quickly became the orthodox version.
In this diagram, the vertical axis is the interest rate. The
horizontal axis is income expressed in wage-units, so that it is also
output and employment. The IS curve traces equation (5), i.e., it
shows the combinations of interest rate and output that would satisfy
equation (1): the higher the interest rate, the lower investment and
hence income, and conversely, which is why the IS curve has a negative
slope. Put differently, it shows the combinations of interest rate and
output at which the amount some people wish to invest is equal to the
amount other people wish to save, which is what explains the S in IS.
But note that the accommodation of saving to investment is produced
not by the direct effect of the interest rate on saving, but by the
effect of the level of income on saving, via the propensity to
The LM curve traces equation (2) for a fixed quantity of money. Here,
the higher the interest rate, the lower the quantity of money that the
public would want to hold for a given income, and hence the higher
income must be in order for the actual quantity of money to be
willingly held. Hence the positive slope of the LM curve.
The intersection of the IS and LM curve at YO is the counterpart of
the intersection of the aggregate demand and supply curves in Figure 1
at YO. Similarly, the IS' curve is the counterpart of the Y'O curve in
Figure 1, reflecting a higher level of investment. It is the IS curve
moved to the right by the change in income assumed to be produced by
the increase in investment-the change in investment times the
What is new in Figure 2 are the LM curves. Each LM curve is for a
specific quantity of money: the LM curve for M = MO, the (LM)' curve
for M = M'O , which is larger than MO. For the community to hold the
larger quantity of money willingly, either the interest rate must be
lower for a given income or income higher for a given interest rate,
which is why the (LM)' curve is to the right of the LM curve.
The IS curve in the diagram embodies a possible Keynesian escape from
underemployment via increases in investment (or, more generally,
autonomous spending including government spending). Let autonomous
spending be high enough so that the IS curve intersects the LM curve
at point F, and full employment would be attained with the initial
quantity of money. The LM curve offers an alternative escape via the
quantity of money. Let the quantity of money be large enough so that
the LM curve intersects the IS curve at point F', and full employment
would be attained with the initial marginal efficiency of capital
schedule. Keynes and his followers rejected this possibility as highly
unrealistic, largely on the alleged empirical grounds that (1) private
autonomous expenditures were little affected by changes in the
interest rate while (2) there was a floor to the interest rate at
which the community would be willing to hold assets other than money,
so that, in the neighborhood of this floor, the quantity of money the
community would be willing to hold would be highly sensitive to the
interest rate: in short, a low elasticity of investment, but a high
elasticity of liquidity preference, with respect to the interest rate.
Figure 3 shows an extreme version of these assumptions: perfectly
inelastic investment and perfectly elastic liquidity preference. We
are back to the Keynesian cross of Figure 1. No changes in the
quantity of money can produce a full employment equilibrium. This LM
curve depicts a "liquidity trap," of which Keynes wrote, "whilst
the limiting case might become practically important in future, I know
of no example of it hitherto. Indeed, owing to the unwillingness of
most monetary authorities to deal boldly in debts of long term, there
has not been much opportunity for a test." Of course, it is
not necessary to go to this extreme to generate Keynesian unemployment
equilibria, and Keynes and his followers did not, though some of the
more enthusiastic of his disciples came very close during the high
tide of the Keynesian revolution. It is only necessary to suppose a
highly inelastic IS curve, and a highly elastic LM curve, as in Figure
4. In this version, a negative interest rate would be required for a
full employment equilibrium. The Keynesians ruled out this possibility
by the assumption of given prices.
The avenue of adjustment that is not explicitly allowed for in either
equations (1) and (2) or in the more sophisticated IS-LM diagram is
the level of prices and wages. As already noted, a Keynesian position
of underemployment equilibrium means downward pressure on wages and
prices. Keynes explicitly recognized that a change in real wages would
affect employment by altering both the supply and the demand for
labor. However, he ruled out that avenue of escape on the grounds
that prices and wages would tend to change pari passu leaving
real wages largely unchanged-not a bad empirical approximation for the
kind of major disturbances, such as the Great Depression, whose origin
and cure Keynes was seeking. Keynes discussed two other effects of
changes in the level of prices and wages. The first is on the real
quantity of money, and thence the rate of interest. A lower level of
prices is equivalent to a higher quantity of money, and like an
increase in the quantity of money would shift the LM curve to the
right. The second is the effect of a lower rate of interest on the
consumption function, an effect that has come to be called the Keynes
effect. The lower the interest rate, the higher the capital value of a
given stream of income-such as rent on a piece of land, or coupons on
a bond. Hence, a lower interest rate increases the wealth of the
community. The higher the wealth, the less pressure to add to wealth
via savings, and hence the higher is likely to be the average and
marginal propensity to consume at any income.
Though Keynes recognized the existence of these avenues of
adjustment, he largely dismissed them on empirical grounds.
Sluggishness of price movements had pride of place, but inelasticity
of investment and elasticity of liquidity preference with respect to
the interest rate and inelasticity of consumption with respect to
wealth were also important.
A third effect of a pari passu change in prices and wages,
which came to be known as the "Pigou" effect, was not
discussed explicitly by Keynes. The lower the price level, the higher
the real value of the fixed quantity of money. In principle, there is
no limit to the real value of a fixed nominal quantity of money, and
hence no limit to the wealth of a community, and accordingly, no limit
to the extent to which the IS curve could be shifted to the right by
the reduction in the incentive to save. There is much dispute
about the empirical importance of this effect. I personally regard it
as minor. However, on the purely abstract theoretical level of the
General Theory, it conclusively demonstrates that there is no such
flaw in the price system as Keynes professed to demonstrate. His
position of underemployment equilibrium, whatever else it might be,
was not a long-run equilibrium position that set in motion no
effective forces tending toward full employment.
What difference does this abstract analysis make? Is it not simply
arguing about how many angels can dance on the point of a pin? The
answer is that it destroys Keynes's most striking and radical claim
made in the first paragraph of the General Theory: that what he called
the "classical economics," and, in particular, the quantity
theory of money, were fundamentally fallacious, "that the
postulates of the classical theory are applicable to a special case
only and not to the general case, the situation which it assumes being
a limiting part of the possible positions of equilibrium. Moreover,
the characteristics of the special case assumed by the classical
theory happen not to be those of the economic society in which we
actually live, with the result that its teaching is misleading and
disastrous if we attempt to apply it to the facts of experience."
If this extreme claim is wrong, Keynes's theory becomes not a theory
of "equilibrium" but at best a theory of disequilibrium,
readily encompassed in the earlier orthodoxy. Conventional wisdom
prior to the General Theory had always recognized that fluctuations
existed, and that periods of widespread unemployment did occur from
time to time. But it regarded these as responses to changes in
circumstances, plus rigidities in prices, wages, and other variables
that impeded rapid adjustment to the new circumstances. And, indeed,
conventional economic wisdom has by now come to regard the Keynesian
theory as a theory of disequilibrium, which provides a useful way to
analyze the process of adjustment to changes in circumstances in a
world of relatively rigid prices and wages. It should be added that
there does remain a significant number of respected economists who
continue to regard Keynes's contribution as providing a truly general
theory fully justifying his initial claims, and continue to regard him
as having demolished the so-called classical theory.
There remains the twin questions of why Keynes, who described himself
in the preface to the German edition as having been "a priest of"
the English classical quantity theory tradition, regarded it as
incompetent to explain the persistence of high unemployment in the
1920s and 1930s, and of how those of us who disagree with him
reconcile that remarkable phenomenon with the earlier theory. The key
to the answer to both questions is the interpretation of monetary
developments, and particularly monetary policy in the 1930s. Consider
first the situation in the U.S. By contrast with Britain, the 1920s
were a period of general prosperity, high employment, and relatively
There was no reason to question the importance of monetary policy.
Indeed, the Federal Reserve System in the United States took for
itself much of the credit for the good performance of the economy. But
then came the Great Depression. Its initial phase, from 1929 to late
1930, had all the characteristics of a garden-variety recession,
though somewhat more severe than most, and, indeed, had it ended in
early 1930, or even early 1931, as it showed some signs of doing, it
would have gone down in history in that way, not as a major
contraction, let alone Great Depression. But the second phase, from
the end of 1930 to 1933, was very different. It was marked by a
succession of banking crises, and the veritable collapse of the
banking system leading to an unprecedented "bank holiday" in
March 1933, during which all the banks of the country-including the
Federal Reserve Banks themselves-were closed for business. When the
holiday ended and "sound banks" reopened, they numbered only
two-thirds as many as were in existence in 1929. This sequence of
events was accompanied by a disastrous increase in unemployment, and
major declines in prices, wages, and national income both in current
and constant prices. From 1929 to 1933, "money income fell 53
percent and real income 36 percent.
Per capita real income in
1933 was almost the same as in the depression year of 1908, a quarter
of a century earlier
the trough of the depression one person
was unemployed for every three employed." And what happened
in the United States was duplicated-the banking disaster partly
excepted-around the world.
To Keynes and many of his contemporaries, this sequence of events
seemed a clear contradiction of the earlier theory and of the efficacy
of monetary policy. They tended then, as many still do, to regard
monetary policy as operating via interest rates. Short-term interest
rates in the United States had fallen drastically during the
contraction. In particular, the discount rate charged by the Federal
Reserve Banks on loans to banks that were members of the Federal
Reserve System was steadily reduced from 6 percent in 1929 to 1.5
percent by the fall of 1931, though it was then abruptly increased to
3.5 percent in response to Britain's departure from gold in September
1931, and was still 2.5 percent in early 1933. Judged in these terms,
monetary policy was "easy," yet it apparently had been
powerless to stem the contraction, giving rise to widespread
apprehension that monetary policy was like a string: you could pull on
it, but not push on it, i.e., monetary policy could check inflation
but could not offset contraction.
From another, and I would argue far more significant, point of view,
monetary policy was anything but "easy." That point of view
regards monetary policy as operating via the quantity of money. In
terms of annual averages, the quantity of money in the United States
fell by one-third from 1929 to 1933-by 2 percent from 1929 to 1930,
just before the onset of the first banking crisis, and by a further 32
percent from 1930 to 1933. Data on the quantity of money were not
published regularly at that time and were not readily available even
with some lag, whereas interest rates were readily and contemporarily
available-both effect and reinforcement of the tendency to interpret
monetary policy in terms of the interest rate rather than the quantity
Keynes may well not have known what was happening to the quantity of
money, though if he had, he would also have known that "[a]t all
times throughout the 1929-33 contraction, alternative policies were
available to the [Federal Reserve] System by which it could have kept
the stock of money from falling, and indeed could have increased it at
almost any desired rate." Far from demonstrating, as Keynes
concluded, that monetary policy is impotent, "[t]he contraction
is in fact a tragic testimonial to the importance of monetary forces."
The contraction continued and deepened not because there were no
equilibrating forces within the economy but because the economy was
subjected to a series of shocks succeeding one another: a first
banking crisis beginning in the fall of 1930, a second beginning in
the spring of 1931, Britain's departure from gold in September 1931,
and the final banking crisis beginning in January 1933-all accompanied
by a decline in the quantity of money of 7 percent from 1930 to 1931,
17 percent from 1931 to 1932, and 12 percent from 1932 to 1933.
Even after the end of the contraction and the start of revival in
1933, the shocks continued and impeded recovery: major legislative
measures during Franklin Delano Roosevelt's New Deal that interfered
with market adjustments and generated uncertainty within the business
community, although some of them, particularly the enactment of
federal insurance of bank deposits, reassured the community about the
safety and stability of the financial institutions; then ill-advised
monetary measures in 1936 that halted the rapid rise that had been
occurring in the quantity of money and produced an absolute decline
from early 1937 to early 1938 that exacerbated if it did not produce
the accompanying severe cyclical decline.
Keynes's readiness to interpret the U.S. experience as evidence of
the impotence of monetary policy was greatly strengthened by the
British experience. By contrast with the U.S., the 1920s was a period
of stagnation and high unemployment that the severe worldwide
contraction beginning in 1929 intensified. However, the contraction
ended earlier in Britain than in the U.S., shortly after Britain left
the gold standard and thereby cut its monetary link with the U.S.
Here, too, a succession of shocks played an important role: the end of
World War I and demobilization; the pressure to return to gold at the
prewar parity, which required internal deflation; the return in 1925
to gold at a parity that overvalued the pound sterling, particularly
after France returned to gold at a parity that undervalued the franc;
and, finally, the shock waves that spread from the U.S. after 1929.
The effect of steady deflationary pressure was reinforced by "an
unemployment insurance scheme that paid benefits that were high
relative to wages available subject to few restrictions.
a few interwar observers saw clearly the effects of unemployment
insurance, Keynes and his followers did not."
4. KEYNES'S POLITICAL INFLUENCE
In judging Keynes's overall influence on public policy, it is
necessary to distinguish his bequest to technical economics from his
bequest to politics. Keynes's bequest to technical economics was
strongly positive. His bequest to politics, in my opinion, was not.
Yet I conjecture that his bequest to politics has had far more
influence on the shape of today's world than his bequest to technical
economics. In particular, it has contributed greatly to the
proliferation of over-grown governments increasingly concerned with
every phase of their citizens' daily lives.
I can best indicate what I regard to be Keynes's bequest to politics
by quoting from his famous letter to Professor Friedrich von Hayek
praising Hayek's Road to Serfdom. The part generally quoted is from
the opening paragraph of the letter: "In my opinion it is a grand
[M]orally and philosophically I find myself in agreement
with virtually the whole of it; and not only in agreement with it, but
in a deeply moved agreement."
The part I want to direct attention to comes later:
"I should therefore conclude your theme rather
differently. I should say that what we want is not no planning, or
even less planning, indeed I should say that we almost certainly
want more. But the planning should take place in a community in
which as many people as possible, both leaders and followers wholly
share your own moral position. Moderate planning will be safe if
those carrying it out are rightly orientated in their own minds and
hearts to the moral issue.
"What we need therefore, in my opinion, is not a change in our
economic programmes, which would only lead in practice to
disillusion with the results of your philosophy; but perhaps even
the contrary, namely, an enlargement of them . . . . No, what we
need is the restoration of right moral thinking-a return to proper
moral values in our social philosophy.
Dangerous acts can be
done safely in a community which thinks and feels rightly, which
would be the way to hell if they were executed by those who think
and feel wrongly."
Keynes was exceedingly effective in persuading a broad
group-economists, policymakers, government officials, and interested
citizens-of the two concepts implicit in his letter to Hayek: first,
the public interest concept of government; second, the benevolent
dictatorship concept that all will be well if only good men are in
power. Clearly, Keynes's agreement with "virtually the whole"
of the Road to Serfdom did not extend to the chapter titled "Why
the Worst Get on Top."
Keynes believed that economists (and others) could best contribute to
the improvement of society by investigating how to manipulate the
levers actually or potentially under control of the political
authorities so as to achieve desirable ends, and then persuading
benevolent civil servants and elected officials to follow their
advice. The role of voters is to elect persons with the right moral
values to office and then let them run the country.
From an alternative point of view, economists (and others) can best
contribute to the improvement of society by investigating the
framework of political institutions that will best assure that an
individual government employee or elected official who, in Adam
Smith's words, "intends only his own gain
an invisible hand to promote an end that was no part of his intention,"
and then persuading the voters that it is in their self-interest to
adopt such a framework. The task, that is, is to do for the political
market what Adam Smith so largely did for the economic market.
Keynes's view has been enormously influential-if only by strongly
reinforcing a pre-existing attitude. Many economists have devoted
their efforts to social engineering of precisely the kind that Keynes
engaged in and advised others to engage in. And it is far from clear
that they have been wrong to do so. We must act within the system as
it is. We may regret that government has the powers it does; we may
try our best as citizens to persuade our fellow citizens to eliminate
many of those powers; but so long as they exist, it is often, though
by no means always, better that they be exercised efficiently than
inefficiently. Moreover, given that the system is what it is, it is
entirely proper for individuals to conform and promote their interests
within it. An approach that takes for granted that government
employees and officials are acting as benevolent dictators to promote
in a disinterested way what they regard as the public's conception of
the "general interest" is bound to contribute to an
expansion in governmental intervention in the economy -- regardless of
the economic theory employed. A monetarist no less than a Keynesian
interpretation of economic fluctuations can lead to a fine-tuning
approach to economic policy.
The persuasiveness of Keynes's view was greatly enhanced in Britain
by historical experience, as well as by the example Keynes himself
set. Britain retains an aristocratic structure-one in which noblesse
oblige was more than a meaningless catchword. What has changed are the
criteria for admission to the aristocracy-if not to a complete
meritocracy, at least some way in that direction. Moreover, Britain's
nineteenth-century laissez-faire policy produced a largely
incorruptible civil service, with limited scope for action, but with
great powers of decision within those limits. It also produced a
law-obedient citizenry that was responsive to the actions of the
elected officials operating in turn under the influence of the civil
service. The welfare state of the twentieth century has almost
completely eroded both elements of this heritage. But that was not
true when Keynes was forming his views, and during most of his public
Keynes's own experience was also influential, particularly to
economists. He set an example of a brilliant scholar who participated
actively and effectively in the formulation of public policy-both
through influencing public opinion and as a technical expert called on
by the government for advice. He set an example also of a
public-spirited and largely disinterested participant in the political
process. And it is not irrelevant that he gained worldwide fame, and a
private fortune, in the process.
The situation was very different in the United States. The United
States is a democratic not an aristocratic society, as Tocqueville
pointed out long ago. It has no tradition of an incorruptible or able
civil service. Quite the contrary. The spoils system formed public
attitudes far more than a supposedly non-political civil service. And
it did so even after it had become very much emasculated in practice.
As a result, Keynes's political bequest has been less effective in the
United States than in Britain, which partly explains, I believe, why
the "public choice" revolution in the analysis of politics
occurred in the United States. Yet even in the United States, Keynes's
political bequest has been tremendously effective. Certainly most
writing by economists on public policy -- as opposed to scientific and
technical economics-has been consistent with it. Economists, myself
included, have sought to discover how to manipulate the levers of
power more effectively, and to persuade -- or educate -- governmental
officials regarded as seeking to serve the public interest.
I conclude that Keynes's political bequest has done far more harm
than his economic bequest and this for two reasons. First, whatever
the economic analysis, benevolent dictatorship is likely sooner or
later to lead to a totalitarian society. Second, Keynes's economic
theories appealed to a group far broader than economists primarily
because of their link to his political approach. Here again, Keynes,
in his letter to Hayek, said it better than I can: "Moderate
planning will be safe if those carrying it out are rightly orientated
in their own minds and hearts to the moral issue. This is in fact
already true of some of them. But the curse is that there is also an
important section who could almost be said to want planning not in
order to enjoy its fruits but because morally they hold ideas exactly
the opposite of yours [i.e., Hayek's], and wish to serve not God but
the devil. Reading the New Statesman and Nation one sometimes feels
that those who write there, while they cannot safely oppose moderate
planning, are really hoping in their hearts that it will not succeed;
and so prejudice more violent action. They fear that if moderate
measures are sufficiently successful, this will allow a reaction in
what you think the right and they think the wrong moral direction.
Perhaps I do them an injustice; but perhaps I do not."
Keynes did not let this analysis prevent him from serving until his
death as chairman of the New Statesman and Nation-presumably in the
hope of influencing the moral views of its editors and writers. I
regard Keynes's analysis as indicating that the key problem is not how
to achieve a moral regeneration but rather how either to frustrate
what Keynes regards as "bad morals," or to construct a
political framework in which those "bad morals" serve not
only the private but also the public interest, just as, in the
economic market, private greed is converted to public service.
The literature on Keynes and on the General Theory is by now immense.
Of the books specifically devoted to Keynes's life, two stand out: the
initial authorized biography by his student and disciple, Roy F.
Harrod, The Life of John Maynard Keynes (1951); and the more recent
multi-volume biography by Robert J. A. Skidelsky, John Maynard Keynes,
Vol. 1: Hopes Betrayed, 1883-1920 (London: Macmillan, 1983), and Vol.
2: The Economist as Prince, 1920-1937 (London: Macmillan, 1988). The
Collected Writings of John Maynard Keynes have been published under
the auspices of the Royal Economic Society in 29 volumes (Macmillan,
1971 to 1982), with a final Bibliography and Index yet to come. This
splendid collection includes not only his major work but also his
published articles on economics and politics, many previously
unpublished items, including letters, official memoranda and notes,
and the like.
- The biographical essays on
economists are gathered together in his Essays in Biography
(1933), along with similar essays on politicians and others.
- In the U.S., the most
important was doubtless Henry Hazlitt, The Failure of the New
Economics: An Analysis of the Keynesian Fallacies (Princeton,
N.J.: Van Nostrand, 1959).
- The phrase was coined by Joan
Robinson, one of the earliest and most dedicated members of
Keynes's inner circle, in her review of Harry Johnson's Money,
Trade and Economic Growth (1962), Economic Journal, vol. 72
(September 1962), p. 690. However, she used it to refer to the
theories of some of Keynes's followers, rather than to policies.
- Robert E. Lucas, Jr., "Tobin
and Monetarism: A Review Article," Journal of Economic
Literature, vol. 19 (June 1981), p. 560.
- Axel Leijonhufvud, On
Keynesian Economics and the Economics of Keynes (London: Oxford
University Press, 1968).
- Milton Friedman's Monetary
Framework: A Debate with His Critics, ed. by Robert J. Gordon
(Chicago: University of Chicago Press, 1974), pp. 133-34.
- The General Theory of
Employment Interest and Money (London: Macmillan, 1936), pp. 90,
96, and 114.
- Ibid., pp. 62 and 135.
- Ibid., pp. 166 and 199.
- Ibid., p. 289.
- John R. Hicks, "Mr.
Keynes and the 'Classics': A Suggested Interpretation,"
Econometrica, vol. 5 (April 1937), pp. 147-59; Roy F. Harrod, "Mr.
Keynes and Traditional Theory," Econometrica, vol. 5 (January
1937), pp. 74-86.
- The General Theory, p. 207.
- The interest rate that is
relevant to investment is the "real" interest rate,
i.e., the nominal rate of interest less the rate of inflation, and
the "real" interest rate has often been negative.
- See, for example, ibid., p.
- For a fuller theoretical
analysis of (a) the possibility of a negative equilibrium interest
rate, and (b) the Keynes and Pigou effects, see Milton Friedman,
Price Theory (Chicago: Aldine Publishing Co., 1976), pp. 313-21.
- Ibid., p. 1.
- The most prominent of this
group are the late Joan Robinson, the late Nicholas Kaldor, in
Britain, and Professor Robert Eisner, in the United States.
- Milton Friedman and Anna J.
Schwartz, A Monetary History of the United States, 1867-1960
(Princeton: Princeton University Press for the National Bureau of
Economic Research, 1963), p. 301.
- Ibid., pp. 693 and 300.
- Daniel K. Benjamin and Levis
A. Kochin, "Searching for an Explanation of Unemployment in
Interwar Britain," Journal of Political Economy, vol. 87
(June 1979), p. 441.
- The rest of this preface up to
the final paragraph is drawn largely from my "Comment on
Leland Yeager's Paper on the Keynesian Heritage," in The
Keynesian Heritage, a symposium by Leland Yeager, Milton Friedman,
and Karl Brunner, Center Symposia Series CS-16 (Rochester, N.Y.:
Center for Research in Government Policy and Business, Graduate
School of Management, University of Rochester, 1985), pp. 12-18.
- Donald Moggridge, ed., John
Maynard Keynes, The Collected Writings, Vol. XXVII: Activities,
1940-1946, pp. 385, 387, 388.