Capitalism-and-Its-Critics-A-History-From-the

In making this proposal, Keynes was challenging two tenets of nineteenth-century liberalism: fiscal retrenchment and the freedom for capital to seek its highest return wherever that might be found. After some critics upbraided Keynes on the latter point, he wrote a second piece in which he said sticking by old principles was secondary to the imperative of reducing joblessness and employing idle resources. “In considering how to do this, we are brought to my heresy—if it is a heresy,” he wrote. “I bring in the State; I abandon laissez-faire—not enthusiastically, not from contempt of that good old doctrine, but because, whether we like it or not, the conditions for its success have disappeared.”19 In making this argument, Keynes was more prescient than many of his peers, who believed that the key to restoring prosperity was to re-create the pre-1914 environment. Keynes recognized that this was impractical, at least from Britain’s point of view. The war had shattered the country’s finances, undermined its international leadership, and upended its social system. In a changed world, new thinking and new measures were essential to ensure economic stability and buttress the essential elements of capitalist liberal democracy.

Keynes developed this argument in a public lecture that he subsequently turned into a pamphlet, The End of Laissez-Faire. In it, he said: “The important thing for Government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all.”20 Among the actions that Keynes included in this category were collecting and distributing economic data, controlling excessive population growth, and allocating savings “along the most nationally productive channels.” Still sensitive to classical liberal concerns about expanding the size of the state, he said that many of these activities could be carried out by semiautonomous bodies such as the Bank of England and the Port of London Authority. He also insisted that nothing he was promoting was “incompatible with what seems to me to be the essential characteristic of Capitalism, namely the dependence upon an intense appeal to the moneymaking and money-loving instincts of individuals as the main motive force of the economic machine.”21

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“By the late 1920s, Keynes had settled into respectable middle age. In 1925 he shocked his friends by marrying Lydia Lopokova, a Russian ballerina who had danced with Nijinsky, consorted with Stravinsky, and been directed by Diaghilev. Despite the skepticism of the Bloomsbury set, the match turned out to be a long and happy one. At an old farmhouse that Keynes leased in Tilton, East Sussex, Lydia did her dance exercises while he worked on a second book on monetary theory, which would be published in 1930 under the title A Treatise on Money. He also remained politically active. Ahead of the May 1929 general election, he helped Lloyd George with his book We Can Conquer Unemployment, in which the former prime minister expanded upon his demand for an extensive program of public works financed by public debt issuance. Together with Hubert Henderson, a former colleague from Cambridge, Keynes also published a pamphlet, Can Lloyd George Do It?,” which defended the Liberal leader’s proposals. On election day, however, the Liberal Party won only 59 of the 615 seats in the House of Commons. The Labour Party, under Ramsay MacDonald, formed a minority government, which depended on Liberal support.

Within months, this government, like many others around the world, was engulfed by the Great Crash of October 1929 and its calamitous aftermath. Keynes initially underestimated the significance of the Wall Street break. In an article for The New York Evening Post, he predicted that it would usher in lower interest rates around the world, which would soon revive business investment.22 This analysis proved far too optimistic. On both sides of the Atlantic, industrial production turned down sharply, and employers laid off workers in large numbers. Commodity prices, which had already been declining for some time, cratered, ushering in an agricultural depression. The price of wheat fell from \$1.50 a bushel in the summer of 1929 to \$0.49 a bushel in late 1932.23 By May 1930, Keynes had changed his economic prognosis. “We are now in the depths of a very severe international slump, a slump which will take its place in history amongst the most acute ever experienced,” he wrote in The Nation. “It will require not merely passive movements of bank rates to lift us out of a depression of this order, but a very active and determined policy.”24 Subsequent developments confirmed this diagnosis. By the end of 1930, the British unemployment rate had reached about 20 percent; the German rate was even higher. In the United States by the end of 1931, 16 percent of people were out of work, and the number was still rising.25

As prices, income, and employment all declined precipitously, many debtors—households, businesses, and farmers—defaulted on their bank loans. Pressures increased on banks, which, with no protections in place for depositors, were highly vulnerable to runs by nervous customers. In the final months of 1930, hundreds of American banks failed, including the Bank of United States, the fourth-biggest commercial bank in New York.26 In May 1931 the banking crisis shifted to Europe. Creditanstalt, the biggest bank in Austria, collapsed under the weight of bad debts. The shock waves quickly spread to Hungary, then Germany. Central banks tried and failed to stabilize the situation. In July the German government took drastic action and suspended the convertibility of its currency for gold. It seemed to some observers that global capitalism was imploding.

Keynes viewed these developments with growing alarm. In November 1929 the Labour government appointed an independent Committee on Finance and Industry under the chairmanship of Lord Macmillan, an eminent lawyer, to examine how to revive the economy. Keynes was one of the economists appointed to the Macmillan Committee. During the first half of 1930, it held a series of private hearings, at which Keynes and other members questioned expert witnesses, including Montagu Norman, the governor of the Bank of England, and Sir Richard Hopkins, a senior Treasury official. Hopkins told the committee that the fundamental economic problem was a crisis of confidence, which would relent only if the government cut spending and restored the budget to balance. As the public finances improved, optimism would return, and business activity would pick up.

Keynes regarded the notion that business investment and hiring would rebound of their own accord if austerity policies were imposed as wrongheaded. In his Treatise, he had identified the gap between saving and investment (by which he meant capital investment) as the key to economic downturns. If investment fell short of saving, a downturn was inevitable. The key to reviving the economy, therefore, was to encourage businesses to expand their capacity. But they would do this only if they could be assured of selling their products and making a profit, which was very difficult in an economic downturn. “For the engine which drives Enterprise is not Thrift, but Profit,” Keynes concluded.27 His argument wasn’t yet fully articulated, but the Treatise contained the germ of the Keynesian bargain between the state and the business sector, in which the government would employ its policy levers to maintain the conditions for profitable accumulation, and firms would go out and make capital investments and hire workers. After the Second World War, a version of this bargain would be struck in many advanced countries, including Britain and the United States. In the early 1930s, however, Western governments were still tied to old economic doctrines, and they were wary of expanding state intervention in the economy.

In Britain, it took a full-blown financial crisis to break the policy paralysis. In the summer of 1931, after Germany had left the gold standard, international investors started to sell sterling for gold, which depleted the Bank of England’s stock of the precious metal. The bank raised interest rates to make sterling assets more attractive, but the selling continued. In late July a committee of experts chaired by Sir George May of the Prudential insurance company advised the Labour government to introduce a range of austerity measures that included cutting roadbuilding programs and slashing unemployment benefits by a fifth. The prime minister himself wrote to Keynes and asked him for advice. In his reply, Keynes described the committee’s proposals as “a most gross perversion of social justice” and said they were pointless because “it is now nearly certain that we shall go off the existing gold parity at no distant date.”28 With the trade union movement and many Labour MPs strongly opposed to austerity measures, MacDonald and his cabinet couldn’t agree on what to do. On August 24, 1931, MacDonald offered his resignation to King George V, who urged him to stay on and form a National Government with the support of

Conservatives and Liberals. To the outrage of many Labour Party members, MacDonald agreed. In early September, the House of Commons approved a package of spending cuts, but investors and speculators continued to offload sterling regardless. Finally, over the weekend of September 19–20, after another week of heavy gold losses, the Bank of England and Downing Street gave up the fight. On Monday the 21st, the Chancellor of the Exchequer announced that Britain was suspending the convertibility of sterling to gold. Keynes, who had stayed in Tilton as the crisis unfolded, was vindicated. In a note to her mother-in-law, Lydia wrote: “M. is very pleased and says it is ‘new chapter.’”29

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Keynes was right: the demise of the gold standard was a historic moment. In the short run, however, the Great Depression only intensified on both sides of the Atlantic. Some of the images from its depths are still familiar: “Hoovervilles”—shantytowns of homeless people—springing up in many American cities; cloth-capped British workers walking hundreds of miles to London in the National Hunger March of September–October 1932; President Von Hindenburg, the World War I veteran, swearing in Adolf Hitler as chancellor of Germany on January 30, 1933. The nineteenth century had seen some major financial blowups, and the economic slump after World War I had been long and punishing, but industrial capitalism was now facing its greatest crisis. So were its defenders and would-be reformers.

Five weeks after Hitler’s swearing-in, Franklin Delano Roosevelt, the newly elected Democratic president of the United States, delivered his inaugural address, in which he proclaimed, “The only thing we have to fear is fear itself.” Roosevelt’s predecessor, the Republican Herbert Hoover, after initially dithering, had taken a number of steps to stabilize the stricken US economy, including setting up the Reconstruction Finance Corporation to lend to stricken banks and support public works projects. But these initiatives had come too late. Roosevelt and his kitchen cabinet, which included a number of progressive academics, knew that more drastic actions were necessary. The day after the inauguration, Roosevelt declared a national banking holiday. On March 9, 1933, Congress passed an

Emergency Banking Act that effectively introduced a system of federal deposit insurance, which ensured depositors couldn’t lose their money. This measure restored public confidence in the banking system and put an end to the runs that had plagued the Hoover administration. Later in March, Roosevelt announced the creation of a Civilian Conservation Corps, which would provide work relief programs for unemployed young men across the country. And in April, he issued an executive order suspending US participation in the gold standard—a decision that Keynes hailed as “Magnificently Right.”30

Although Keynes admired FDR’s activism, his links to and influence on the Roosevelt administration were somewhat tenuous. Although the president was determined to tackle mass joblessness, he was hardly a proto “Keynesian.” He had campaigned for office on a platform of reducing the federal deficit, and one of the first measures he introduced was a cut in federal salaries. Many of FDR’s advisers believed that the quickest way to revive the economy was to stabilize prices, which had fallen sharply, by preventing cutthroat competition among firms and raising wages. This was the thinking behind the National Industrial Recovery Act, which Congress passed in June 1933. In May 1934, during a trip to the United States, Keynes met with Roosevelt at the White House. The president told Felix Frankfurter, his friend and legal adviser, that he had “a grand talk with Keynes and liked him immensely,” but not much came of it.31 Keynes pressed Roosevelt’s advisers to raise the level of federal relief spending if they could. A year later the US administration did go down this route. In April 1935 Congress appropriated \$4.9 billion dollars for a nationwide program of emergency relief and public works projects—schools, hospitals, highways, and the like, about \$1.4 billion of which went to the new Works Progress Administration (WPA), which Roosevelt soon created by executive order.32 The level of spending was unprecedented, but the creators of the WPA viewed it primarily as a public relief program designed to employ jobless workers, rather than as a measure designed to prop up overall demand.

The first conscious application of what came to be known as Keynesian stimulus policies occurred in Sweden, which, like Britain, was forced off the gold standard in September 1931. Two years later, the Swedish Social Democratic Party, which occupied roughly the same political space as

Germany’s SPD and Britain’s Labour Party, formed a ruling coalition with the Agrarian Party. To tackle sky-high unemployment, the new government launched an ambitious program of public works, which it financed by issuing debt and running budget deficits. The political champion of this expansionist policy was the finance minister Ernst Wigforss, who had been influenced by Keynes’s 1929 pamphlet, Can Lloyd George Do It? Several young Swedish economists, particularly Gunnar Myrdal and Bertil Ohlin, also provided an intellectual justification for this policy. Indeed, they antedated Keynes in arguing that the government should balance the budget over the full economic cycle, with surpluses in the years of strong growth offsetting deficits built up during recessions.33 The Swedish medicine seemed to work. Between 1932 and 1937, the country’s unemployment rate, as was reported at the time, declined from 22.4 percent to 10.8 percent.34

Keynes, meanwhile, was working on providing a more comprehensive theoretical justification for countercyclical public spending. His previous book, A Treatise on Money, hadn’t explained what factors determined the overall level of output and employment. Since Keynes was calling on the government to use monetary and fiscal policy to achieve full employment, this was a big gap. The process of filling it began in 1932 and would take him nearly four years. It involved extensive discussions with his colleagues and students in Cambridge, and several iterations of writing and editing. By early 1935, he had completed a draft of a new book that was generally to his satisfaction. He had also settled on a title: The General Theory of Employment, Interest and Money. In a letter to George Bernard Shaw, the playwright and socialist, he wrote: “To understand my state of mind … you have to know that I believe myself to be writing a book on economic theory, which will largely revolutionise—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems.” Immodest as it was, this prediction proved accurate.35

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The General Theory, as it came to be known, was published in February 1936. Although it contained some vivid passages and brilliant insights, such as a comparison of stock market investing to picking the winner in newspaper beauty contests, it wasn’t an easy read, even for professional economists. In fact, parts of the book were so dense that even today there are vigorous debates about what they really mean. Keynes had one interpretation; some of his younger and more radical colleagues had another; the bulk of the economics profession had a third. As Keynes indicated to Shaw, he believed he had invented a new theoretical framework that subsumed “the classical theory” as a special case. This new framework consisted of four basic features: the principle of effective demand, the Keynesian multiplier, the theory of the liquidity preference, and the notion of the marginal efficiency of capital. The first two concepts were the most important, because they underpinned Keynes’s convictions that capitalism could be successfully managed and that the Great Depression had resulted from grave policy errors rather than an incurable flaw in the system.

The principle of effective demand states that the overall levels of output and employment are determined by “aggregate demand”—the sum of all individual demands for goods and services. Today this principle is widely regarded as a truism, but in 1936 it represented a departure from economic orthodoxy, which emphasized factors on the supply side of the economy, such as the level of wages, the state of technology, and rates of profitability. Contrary to some accounts, Keynes didn’t ignore the supply side. In chapter 2 of The General Theory, he stated explicitly that the economy would come to rest where “the aggregate demand function” was “intersected by the aggregate supply function.”36 Supply factors determined the economy’s potential output. However, Keynes rejected the classical claim that supply created its own demand, otherwise known as Say’s Law. In his new framework, the aggregate demand curve determined where the economy came to rest, and its position was determined by the levels of consumer spending, business investment, government spending, and net exports.

In casting his analysis in terms of supply and demand curves, Keynes employed a method that had been familiar to economists since 1890, when Alfred Marshall published the first edition of his Principles of Economics. Marshall’s supply-and-demand schedules represented the operation of a single product market—say, the market for concrete cinder blocks in Cleveland. Keynes’s curves represented the entire economy—hence the term macroeconomics. Depending on the relative positions of the aggregate demand and aggregate supply curves, the point where they intersected could occur at a high, low, or intermediate level of employment. “There is no reason in general for expecting it to be equal to full employment,” Keynes wrote. “The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another.”37 What was worse, if the economy came to rest at a position where employment was below its full-employment level, it could easily get stuck there. Even if wages fell— the traditional remedy for hard times—that wouldn’t restore full employment because firms, facing weak demand for their products, would still see no reason to hire more workers. In fact, falling wages could lead to a higher level of unemployment if they produced a further drop in aggregate demand.

In this setup, the level of aggregate demand is obviously vital, but what determines it? The multiplier provided the answer. Keynes picked up this concept from one of his brightest students, Richard Kahn, who in 1930 was elected to a fellowship at King’s. In 1931 Kahn published an article in The Economic Journal entitled “The Relation of Home Investment to Unemployment,” which explained how, in a country suffering from unemployment and excess capacity, a dollar’s worth of new investment spending (by the public or private sector) can circulate through the economy and produce more than a dollar’s worth of extra output and employment. Say a local government allocates \$10 million to rebuild an old bridge across a river. When work starts on the repair project, it creates income for individuals who get hired to do the job. They will then spend some of their wages on goods and services produced by other people, who in turn will do the same thing. And so on. In this manner, the initial boost to capital investment leads to successive rounds of spending: it has a “multiplier” effect.

Keynes said that the size of the multiplier depended on how much slack there was in the economy. If there was full employment and most industries were operating at full capacity, additional spending would lead to higher prices: the multiplier would fall toward zero. But in 1936, Britain and most other advanced countries were far from full employment. Relying on figures from the Russian American economist Simon Kuznets, Keynes estimated that the US multiplier had been about 2.5 during the late 1920s, and he said it was likely even higher now that the economy was in a slump, with lots of resources lying idle.38 Turning to Great Britain, Keynes argued that there was so much joblessness and spare capacity that it didn’t matter exactly how the government increased its spending: the important thing was to raise aggregate demand in one way or another. “If the Treasury were to fill old bottles with banknotes,” he wrote, “bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment … It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”39

Not surprisingly, Keynes is often referred to as a prophet of the economic middle way. At least in theory, his policy framework provided a center path between laissez-faire and the state diktat associated with communism and fascism. In the final chapter of The General Theory, he discussed some of its political implications. Given the imperative of encouraging capital investment, the government would need to keep interest rates at very low levels, he explained, much lower than previously. “Now, though this state of affairs would be quite compatible with some measure of individualism,” he went on, “it would mean the euthanasia of the rentier”— who lived on interest payments—“and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.”40 It was this scarcity that kept interest rates high, but there was no reason why it had to continue, Keynes argued. If private savings were too small to finance the level of investment needed to maintain full employment, “communal saving through the agency of the State” could make up the shortfall.41 The key point was that in order to keep up the level of aggregate demand, the government would need to use all the tools at its disposal, including low interest rates, tax and spending policies, and even a “somewhat comprehensive socialisation of investment.”42

This passage was to cause a good deal of confusion. Despite some of the language it contained, Keynes hadn’t changed his stripes and embraced wholesale state direction of the economy. The government’s expanded role in bolstering capital investment “need not exclude all manner of compromises and of devices by which public authority will cooperate with private initiative,” he hastened to add. “Moreover, the necessary measures of socialization can be introduced gradually and without a break in the general traditions of society.”43 Keynes also said that the policy approach he advocated was, in some respects, “moderately conservative in its applications.”44 Once the government had created a level of demand adequate to ensure full employment, it could largely rely on market forces to determine exactly what items were produced and consumed. The consequences for efficiency of decentralization were “even greater, perhaps, than the nineteenth century supposed,” Keynes continued. “But, above all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty in the sense that, compared with any other system, it greatly widens the field for the exercise of personal choice.”45