John Maynard Keynes: An Interpretation Of His Theories, Legacy And Success

John Maynard Keynes revolutionised macro-economic theory, arguing that frictions prevented markets from being fully flexible, introducing the role of uncertainty and promoting controversial government spending in times of depression. He also mastered a life in academics, as an investor and as a diplomat. Keynes's economic theories didn't feature in government policy between the stagflation of the 1970s and 2008, but his legacy has been maintained through the promotion of economists such as Paul Krugman. His theories of the causes of and solutions to a world depression have been re-kindled since the beginning of the so-called 'Great Recession' in 2008. However there is a unique aspect of the state of the international economy today which was absent from the Great Depression: the sovereign debt crisis. In this essay, I will evaluate Keynesian economics by analysing some of his key theories about business cycles, and interpreting his counterparts in Classical economics. I will also evaluate the impact of Keynesian economics on the 'Great Recession' and whether Keynesian policies have been successful in key depressions.

Keynes's analysis of business cycles was in two stages: Treatise on Money in 1930 and more notably The General Theory of Employment, Interest and Money in 1936. The first tackled the central problem of what made the economic cycle alternate between prosperity and depression. It concluded that a fraction of income does not become someone else's income. In other words, we save some of our income, and so create a withdrawal of the circular flow of income. However, since we put our savings into bonds or banks, we allow them to be used again through loans to other businesses or to buy securities. Depressions can occur because this process is not automatic, but depends on businesses expanding their operations and being optimistic about future operations. There can be too little investment for all of savings, and businesses can be unwilling to expand. The General Theory sought to explain the next big question concerning the business cycle: why do economies remain in depression? Theoretically, when there are surplus savings, it becomes cheaper to borrow, and so businesses are encouraged to invest. However Keynes found the flaw in his own argument: when the economy goes into depression and contracts, income contracts as well and so savings are squeezed out - a depression dries up the savings. In 1929 Americans saved $3.7bn of their income. In 1932 and 1933 they were saving nothing (Heilbroner, 2000, p.270). The consequence of this lack of saving is devastating: the economy is paralysed. Since there is no surplus saving, there is no pressure on interest rates to encourage borrowing, and so there is no expansion, causing the economy to reach an "equilibrium". Keynes summarized this succinctly in The General Theory:

"An economy in depression could stay there. There was nothing inherent in the economic mechanism to pull it out. One could have "equilibrium" with unemployment, even massive unemployment." (Heilbroner, 2000, p.273)

Many aspects of Keynes's analysis in The General Theory are reflected in our economy today. Keynes saw capitalism, even in the 1930s, as a cash-generating machine rather than a goods-generating one, suggesting that people earned money in order to get more money. This is clearly reflected in the international economy today, with the prevalence of funds of all kinds, which aim to manage people's savings in order to earn more money.

This links with a more general evolution of economic thought, which was that money developed a purpose other than to simply to invest or spend: it is a method of storing wealth and protecting yourself against an uncertain future, by allowing you to delay decisions on what to buy. Keynes described money as "above all, a subtle device for linking the present to the future.a barometer of our distrust.concerning the future" (Skidelsky, 2009, p.96)

Paul Krugman, an ardent and well-known supporter of Keynes, has argued that Keynes's legacy in terms of economic theory is his compelling case against Say's law - that supply necessarily creates demand. Keynes showed that there was not always enough spending to fully employ the economy's resources. This is essentially due to people's freedom in a monetary economy: as investments become increasingly uncertain, demand for cash increases, which doesn't necessarily result in future consumption. Ricardo, a 19th century Classical economist, described that "demand is only limited by production" (Skidelsky, 2009, p.77), in a world of scarcity where the economic problem was more focused on producing enough goods, rather than the possibility of a lack of demand. Keynes, a century later, argued that saving could be a subtraction, not a part of, spending, and that demand could fall short of supply; there was no guarantee that income would equal spending. The Great Depression provides a strong example to support Keynes's claims, as it experienced the collapse of demand for goods that the industry was able to produce. Since then, however, mainstream economics has shifted back to the importance of supply of factor inputs and progress in technology, rather than demand-side policies, to promote economic growth. The issue of unemployment has been directed to supply-side reforms, such as de-regulation and education, and so macro-economic policies have been left to mainly maintain price stability. Which policies are most suitable to bring a country out of depression? The Classical response to an economic downturn, which has been observed in the past few years, is to cut interest rates. However this monetary response to try and stimulate borrowing and investment has certain key limitations. Firstly, as banks experience a serious downfall in the value of their investments, their interest-rate spread between the wholesale and retail cost of borrowing has increased substantially in order to cover for these losses. Secondly, investors not only consider the cost of borrowing but also the expectation of profit. If the expectation of profit falls below the cost of borrowing, then this dis-incentivises investors to borrow. Keynes summarised this clearly:

"Cheap money means that the riskless, or supposedly riskless, rate of interest will be low. But actual enterprise always involves some degree of risk" (Skidelsky, 2009, p.19)

However Keynesian policies have their flaws as well. New Classical economists believe in continuous market clearing, and that any stimulation should be done by the central bank printing more money. New Keynesians believe that markets fail due to imperfect information, among other frictions, and that a government should run a budget deficit financed by issuing bonds. Analysing the Keynesian approach further, there is a persistent criticism voiced by New Classical economists:

"The problem is simple: bailouts and stimulus plans are funded by issuing more government debt.The added debt absorbs savings that would otherwise go to private investments. In the end, despite the existence of idle resources, bailout and stimulus plans do not add to current resources in use. They just move resources from one use to another." (Skidelsky, 2009, p.49)

This is the most compelling case against government spending, whereby the government simply diverts resources from private spending. Supporters of free-market ideologies argue that private spending is more efficient and entrepreneurial than government spending. These are arguably key virtues which must be restored in an economy in order to gain momentum for growth. On the other hand, the government can invest in large infrastructure projects on a scale which could be more straining on the private sector. The argument then falls on the issue of time. In the short run, the government is able to invest more efficiently than private investors who are paralysed by an uncertain future.

In Keynes: the Return of the Master, Robert Skidelsky, the acclaimed biographer of Keynes, argues that the succession of financial crises stems from the failure of economics to take uncertainty seriously. Uncertainty was the centre-piece of Keynes's vision of why shocks to economies prevent rapid recoveries. It explains why people hold savings in liquid forms such as cash, why investments such as stocks are sometimes volatile, and why low expectations can dampen business activity for longer than anticipated. Keynes argued that when we are faced with levels of uncertainty, as rational agents, we fall back on conventions. This explains the development of 'safe-havens' in the recent crisis, namely the huge amount of investment in gold and stable countries, such as the USA and Germany. It also explains why households reduce consumption, and savings ratios increase. However, if we assume that economic agents learn from experience, they should not go on making the same mistakes if they are 'rational'. Although this can be applied theoretically in the long run, many of the mistakes in the Great Recession were unprecedented. Furthermore, the last Great Depression was over 80 years ago - long enough for personal experiences to disappear. Since consumption represents around 70% of the economy, uncertainty depresses aggregate demand. Krugman, supporting the Keynesian view, argues that the government must step in with stimulus spending and the Federal Reserve must promote inflationary monetary policy to kick start the economy. This reduces the output gap, but more importantly reduces the uncertainty of future returns for investors, and future income for households. This promotes optimism and confidence, key drivers of our economies.

Alan Greenspan, former Chairman of the Federal Reserve, stated that the cause of the crisis was the "under-pricing of risk worldwide" (Skidelsky, 2009, p.3). Efficient Financial Market Theory states that the prices of financial instruments - such as stocks and debt - reflect the best possible calculations of risk attached to ownership of this asset, considering all available information. This is the basis of all bank risk-management models. A more detailed model considers that an analysis of the spread of past returns will give us a range of 'uncertainty' for our future returns. Mathematically, EFMT assumes that the distribution of risk is represented by a Gaussian bell curve, whereby diversification reduces risk: any investor or fund manager will recognise this as a golden rule. However there is a fundamental flaw which was seriously exposed during the crisis. These risk-management models ignored the possibility of a correlation of risks. During 2008 "10% risks became 90% risks or higher, and all at the same time" (Skidelsky, 2009, p.41). Financial markets are naturally risky - it is this characteristic which produces returns on investment - and so new measures must be developed to measure risk more efficiently. However financial markets are also uncertain to a certain degree. It is this characteristic which Keynes argued the government should tackle, to protect the economy against the consequences of this uncertainty. It is also this distinction between risk and uncertainty which, Skidelsky argues, has been abolished. It is presumed that the probability distributions associated with the recent past can be applied to the future.

The real test of Keynes lies on whether his policy proposals resolved the Great Depression. In the USA, government spending increased from $10bn in 1929 to $15bn in 1936. National income and consumption rose by 50 percent. However unemployment continued at 9 million and it never dropped below 14% during the 1930s (Skidelsky, 2009, p.276 and Gold, 2012), suggesting that the cure did not work as well as it should have. There are several theories as to why this happened, but the main idea is that the government spending never reached amounts close to the program necessary to create full employment. Firstly, the Federal Reserve was more worried about inflation, and so established policies to discourage banks lending. Secondly, the businesses who received money pictured it as a threat rather than help; businesses had to co-operate with trade unions, accept new regulations and reform their practices. Thirdly, the spending necessary to provide full employment only occurred in World War 2 - $103bn (Skidelsky, 2009, p.276) - which was unimaginable in a peacetime economy.

The real test of Keynes can be re-applied to our economy today and has shown serious limitations. Firstly, mainstream theory, backed by the IMF and ECB, argues that countries' growth slows when their debt-to-GDP ratio reaches around 90% (Gold, 2012). This is significant because it could limit the amount of stimulus governments could apply before the returns decrease in value. This already takes away the Keynesian remedy for many of the countries most in need for a solution to their debt problems, notably Greece and Spain.

The clearest example to test Keynes's policies are Obama's stimulus plan in 2009. The output gap was estimated at around $2.9tn; Krugman called for around $1.2tn at the time; the stimulus itself was $800bn spread over 3 years (Gold, 2012). Krugman has argued that the package included too many tax cuts, was not large enough, and was not direct enough in its distribution. Stimulus added roughly 2.5m jobs by late 2010 (compared to the prediction of 3.7m), but as subsidies were ended and the government started to lay off workers, its impact faded (Gold, 2012). Once again the stimulus was not large and effective enough, mostly because of the politics limiting a sufficient spending programme.

Europe has essentially stalled economically with evident sovereign debt problems which must be fixed to allow the economies the freedom to grow. The collateral for the government's debt is tax receipts from its citizens. Recession and unemployment have undermined the capacity of governments to pay off interest of their current debt, as well as re-service debt. This has resulted in rising yields in debt markets, especially in southern European countries such as Spain, Portugal and Greece. Germany has applied the cure of austerity for any country with high sovereign debt, meaning an increase in tax and decrease in spending, ignoring the consequences in the real economy. This is summed up by Angela Merkel, in a statement curiously similar to a quote by Keynes: "In the long run you can't live beyond your means" (FT, 2012). Marcus Miller and Robert Skidelsky, in an article published in the FT, argued that dealing with sovereign debts must neither destroy the economy nor the political centre ground. This implies that Keynesian intervention is limited by political will-power, which itself is controlled by individuals through our democracy. Essentially this implies reduction of debt through measures other than austerity. Keynes went further by saying that both creditors and debtors should share the task of rescuing economies; this translates in debt cancellations, which prove to be extremely difficult politically. An example is Greece's recent debt haircut, where private investors were heavily pressured to suffer some of the losses.

Krugman argues that we are experiencing a balance of payments crisis where "no country has driven itself into a debt crisis with stimulus - nor has any country with significant debt regained investor confidence through austerity" (Krugman, 2012). This statement reflects the current economic climate, since countries have resulted in a debt crisis arguably mostly through significant bailouts and depressed consumption and investment. No country in significant debt situations, such as Greece and Spain, has regained confidence through austerity, as noted by the high bond yields. This opens the way for Keynesian stimulus as a solution, and notably not a cause of the debt crisis.

Keynes's theories explain many of the problems in the world economy since 2008, notably the uncertainty prevailing in investments and the failure to distinguish between risk and uncertainty, particularly in banks' risk-management models. Keynesian solutions, such as increased government spending to compensate for the lack of private sector investment, were only relatively successful during the Great Depression, and in the USA in 2009, considering the serious limitations set by political willpower. Although unsustainable debt now poses a further barrier to the effectiveness of Keynesian stimulus in Europe, Keynesian policies could aim to reduce uncertainty, and free up future investments which are currently stored in savings.