How would Keynes have analysed the Great Recession of 2008 and 2009?

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Robert Skidelsky
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 In recent years some monetary economists have voiced scepticism about aspects of the Keynesian revolution, particularly the importance of the 1936 General Theory relative to Keynes’s entire corpus.¹ These sceptics have performed a valuable service by encouraging more whole-hearted Keynesians (including the author of this chapter) to look carefully at Keynes’s earlier work, notably the 1930 Treatise on Money. Arguably, the Treatise is in many ways a better guide than the General Theory to how Keynes would have thought about the Great Recession. The sceptics, notably David Laidler, have tried to position Keynes in the larger debates about monetary theory and policy in the inter-war period, so that the undoubted originality of some of Keynes’s thinking can be set in the proper context. In particular, when writing the Treatise in the late 1920s Keynes was aware of Knut Wicksell’s ideas about the “natural rate of interest”, and the possible macroeconomic significance of dif-ferences between it and the “market rate of interest”. But this strand of thought was sidetracked in the General Theory, where Keynes developed more rigorously his own liquidity-preference theory of the rate of interest.²

Britain’s economic performance in the first five years from the collapse of late 2008 and early 2009 had similarities to that in the early 1930s, which saw an initially rather cautious recovery from the global downturn in the three years from 1929. In both the early 1930s and the early 2010s, parts of the UK economy were booming, but much of it was struggling. If he had been born in, say, 1963 instead of 1883, what would Keynes have made of the recent Great Recession and its sequel? A reasonable approach to the counterfactual is to recall what Keynes said about the Great Depression and its aftermath.

paraphrase Reinhart and Rogoff, “This time is not different.” Distinctions need to be drawn between:

â—� the conceptual apparatus Keynes brought to the analysis of business cycles in the Treatise on Money (TM), including his discussion of policy responses;

â—� Keynes’s “real time”explanations of, and remedies for, the slump of the early 1930s as it developed, based on the analysis in the TM; and

â—� the conceptual apparatus of the General Theory (GT), which was developed to explain a situation of persisting unemployment (“unemployment equilibrium”), and to suggest policies to restore and maintain full employment.

These discussions take up three of the following sections. They are essential background to Keynes’s likely procedure in analysing the Great Recession and prescribing policies to deal with it, which are covered in the fourth section. Only the third section represents the “Keynesian model”, as most economists understand the matter. But the ideas and proposals in the first and second sections need to be incorporated in our account if we are to develop a full counterfactual story.

The main topic of TM was the genesis and life history of the “credit cycle”. This phrase, which is now almost an archaism, can be seen as synonymous with the “trade cycle” or “business cycle”. Keynes used it repeatedly in the TM, in a policy environment still innocent of the notion of “macro-economic policy” and even the word “macroeconomics”.³ The TM’s Fundamental Equations of Value were versions of the quantity theory of money. In the hands of Wicksell and others, the quantity theory of money was evolving towards a theory of the workings of an economy where money is created entirely by bank credit and which is, in that sense, a “pure credit”economy. (For most of its history since the development of coinage by the Ionian Greeks in the sixth century bc, money has been either a com-modity or linked to a commodity base.) In a pure credit economy banks create new money in response to the demand for loans, subject to such constraints as may be imposed by the central bank. Keynes’s account in the TM set out from what he termed “identities or statical [sic] equations relating the turnover of monetary instruments to the turnover of things traded for money”.⁴ In the TM (unlike the GT), “investment” could differ from “savings”, and much ink was spilt both on pinning down the meaning of the terms, and discussing the complications of the economy’s response to differences between the two notions as thus defined. In equilibrium, the TM’s concept of “savings” was equal to its concept of “investment”. But there was nothing to guarantee equilibrium. Ahead of the event (or ex ante), the plans of savers and investors – who were distinct and separate agents – would not necessarily mesh.

In the TM Keynes’s cycle was characterized by fluctuations in investment – driven by uncertain expectations of profit – around a stable rate of saving. In the upswing investment “runs ahead” of saving, while in the downswing it “runs behind”. Another way of putting the matter was to appeal to Wicksell’s language. The cycle could be characterized by move-ments in the “market” rate of interest around its “natural rate” (which in the GT was to become the marginal efficiency of capital) or fluctuations in the “natural”rate when these were not offset by appropriate changes in the “market” rate. (Changes in the market rate of interest reflected develop-ments in the banking system, whereas changes in the natural rate might be due to new technologies.) In an economy insulated against external shocks, booms and slumps were viewed in the TM as “simply the expression of the results of an oscillation of the terms of credit about their equilibrium position”.⁵ We shall see later that Keynes used these ideas to explain the global depression of 1929–32, and the recovery from it.

In the TM Keynes was concerned to link his analysis of what he termed “changes in the investment factors” and “due to industrial factors” to the banking system and the quantity of money. Bank deposits were under-stood to be the dominant form of money in a modern economy, and they were divided into income, business, and savings deposits. Cutting across this, some deposits supported transactions in the “industrial circulation”, whereas others were committed to the “financial circulation”. By the industrial circulation Keynes meant “the business of maintaining the normal process of current output, distribution, and exchange and paying the factors of production their incomes”; by the financial circulation he understood “the business of holding and exchanging existing titles to wealth. . ., [including] speculation and the process of conveying current savings and profits into the hands of entrepreneurs”^.6

The industrial circulation absorbed the income deposits and parts of the business deposits (labelled “Business Deposits A”), and money in the financial circulation comprised the savings deposits and the remainder of business deposits (“Business Deposits B”). It was the variability of the two “circulations”, and particularly the shifts between Business Deposits A and B, which intruded on the business cycle. Money flowed from the financial circulation to the industrial circulation in a boom, and the other way round in a downturn. The central bank had to be concerned to keep the proportions of the two circulations constant. Keynes was under no illusions. Credit cycles might take many forms, but “the behaviour of the banking system can always intervene to mitigate or aggravate their severity”.⁷ Perhaps the “effective”bank rate might be manipulated to keep savings and investment “at an approximate equality”, but only with suc-cessful currency management might the credit cycle “not occur at all”.⁸

Books III and IV took up 13 chapters and covered over 200 pages of the first volume (on The Pure Theory of Money) of the TM. They were Keynes’s most detailed and consecutive exposition of the credit cycle, with the economy clearly being out of equilibrium most of the time. The differ-ent causal ingredients (from “the monetary side”as opposed to “the invest-ment side”, as he put it) were brought together in often complex statements about hypothetical sequences of events. The discussion could not have been easy for contemporaries to follow and it remains difficult for twenty-first-century readers. At any rate, towards the end of Chapter 19 Keynes offered a synoptic account of the “normal course of a credit cycle”. It does not start in the banking system. To quote,

"Something happens – of a non-monetary character – to increase the attractions of investment. It may be a new invention, or the development of a new country, or a war, or a return of ‘business confidence’ as the result of many small influ-ences tending the same way. Or the thing may start – which is more likely if it is a monetary cause which is playing the chief part – with a stock exchange boom, beginning with speculation in natural resources or de facto monopolies, but eventually affecting by sympathy the price of new capital goods.

The rise in the natural rate of interest is not held back by increased saving; and the expanding volume of investment is not restrained by an adequate rise in the market rate of interest.

Now banking and money come very much into the story.

This acquiescence of the banking system in the increased volume of invest-ment may involve it in allowing some increase in the total quantity of money; but at first the necessary increase is not likely to be great and may be taken up, almost unnoticed, out of the general slack of the system, or may be supplied by a falling off in the requirements of the financial circulation without any change in the total volume of money.

At this stage the output and price of capital goods begin to rise.Employment improves and the wholesale index rises. The increased expenditure of the newly employed then raises the price of consumption goods and allows the producers of such goods to reap a windfall profit. By this time practically all categories of goods will have risen in price and all classes of entrepreneurs will be enjoying a profit.

At first the volume of employment of the factors of production will increase without much change in their rate of remuneration. But after a large propor-tion of the unemployed factors have been absorbed into employment, the entrepreneurs bidding against one another under the stimulus of high profits will begin to offer higher rates of remuneration.

It is striking how – unlike many modern economists – Keynes freely blends discussion of factor and product markets with the monetary analysis. To continue,

All the while, therefore, the requirements of the industrial circulation will be increasing . . ..A point will come, therefore, when the banking system is no longer able to supply the necessary volume of money consistently with its prin-ciples and traditions [e.g. reserve ratios] . . .

It is astonishing, however – what with changes in the financial circulation, in the velocities of circulation, and in the reserve proportions of the central bank – how large a change in the earnings bill can be looked after by the banking system without an apparent breach in its principles and traditions.

It may be, therefore, that the turning-point will come, not from the reluctance or the inability of the banking system to finance the increased earnings bill, but from a faltering of financial sentiment, due to some financiers, from prescience or from their experience of previous crises, seeing a little further ahead than the business world or the banking world. If so, the growth of “bear” sentiment [liquidity preference in the GT] will . . . increase the requirements of the finan-cial circulation. It may be, therefore, the tendency of the financial circulation to increase [for speculative purposes], on the top of the increase in the industrial circulation, which will break the back of the banking system and cause it at long last to impose a rate of interest, which is not only fully equal to the natural rate but, very likely in the changed circumstances, well above it.

Keynes realized that, in practice, cyclical fluctuations might have more than one cause and warned that the collapse might come

"in the end as the result of the piling up of several weighty causes – the evapora-tion of the attractions of new investment, the faltering of financial sentiment, the reaction in the price level of consumption goods, and the growing inability of the banking system to keep pace with the increasing requirements, first of the industrial circulation and later of the financial circulation also’."⁹

For Keynes, analysis was always the prelude to prescription. His aim was to prevent, or at least mitigate, the “credit” cycle. The duty of the central bank was to supply the appropriate quantity of money for each phase of the cycle, meaning to offset both boom and slump tendencies. In his words, now from the second volume (The Applied Theory of Money) of TM, “To maintain that the supplies in a reservoir can be maintained at any required level by pouring enough water into it is not inconsistent with admitting that the level of the reservoir depends on many other factors besides how much water is poured in.”¹⁰ The claim in TM was that by its influence on the price and volume of credit the central bank could control the rate of investment, and hence influence demand, output and employment.¹¹ Three instruments were available to the central bank for this purpose. It could vary the terms of its “advances” (loans) to its member banks; it could alter the amount of its own investments; and it could adjust member banks’ reserve require-ments. Keynes concentrated on the first two. (He did not consider at all changes to banks’ capital requirements, which [as discussed in the chapters to the second part of this book] was the principal initial policy response to theGreatRecessioninlate2008. When Keynes was writing, the size of their capital buffers was regarded as a matter to be determined mainly by banks’ own boards of directors. The ownership and control rights of the share-holders were respected.) Keynes was confident that, by varying its “bank rate”, the central bank could control the short-term rate of interest. But the effect of the short rate on the long rate was uncertain.

In Keynes’s judgement, the long-term rate – the yield on long-dated bonds rather than the rate in the money markets – was the important one in determining fixed investment. If movements in bank rate failed to shift bond yields, the central bank could still bring those yields to any figure it wanted by buying or selling the right kind and amount of securities. This second method was a further development of what Keynes called “the British system”.¹² The second volume of TM proposed that,

The new post-war element of “management” consists in the habitual employ-ment of an “open-market”policy by which the Bank of England buys and sells investments with a view to keeping the reserve resources of the member banks at the level which it desires. This method . . . seems to me to be the ideal one. . . . [I]t enables the Bank of England to maintain an absolute control over the creation of credit by the member banks . . . It is no exaggeration to say that the individual member banks have no power to influence the aggregate volume of bank money . . .¹³

Plainly, Keynes attached great significance to “the aggregate volume of bank money” or, in modern parlance, the quantity of money broadly defined. If somehow errors in monetary management had led to highly depressed economic conditions, the central bank should be prepared to embark on open-market operations à outrance. The “extraordinary methods” he contemplated were

in fact, no more than an intensification of the normal procedure of open-market operations. I do not know of any case in which the method of open-market operations has been carried out à outrance. Central banks have always been too nervous hitherto – partly, perhaps, under the influence of crude versions of the quantity theory – of taking measures which would have the effect of causing the total volume of bank money to depart widely from its normal volume, whether in excess or in defect. But this attitude of mind neglects, I think, the part which the “bullishness” or “bearishness” of the public plays in the demand for bank money; it forgets the financial circulation in its concern for the industrial circu-lation, and overlooks the statistical fact that the former may be quite as large as the latter and much more capable of sharp variation.

I suggest, therefore, that bolder measures are sometimes advisable, and that they are quite free from serious danger whenever there has developed on the part of the capitalist public an obstinate “bullishness”or “bearishness”towards securities. On such occasions the central bank should carry its open-market operations to the point of satisfying to saturation the desire of the public to hold savings deposits, or of exhausting the supply of such deposits in the con-trary case.

The industrial and financial circulations, which are barely mentioned in modern macroeconomics, remained at the centre of the stage in the cyclical drama envisaged by Keynes in 1930.

The risk of bringing to bear too rapidly and severely on the industrial circula-tion, when it is the financial circulation which is being aimed at, is greater I think in the case of a contraction of credit than in the case of an expansion. But, on the other hand, it is less likely to be necessary to resort to extreme measures to check a boom than to check a slump. Booms, I suspect, are almost always due to tardy or inadequate action by the banking system such as should be avoidable; there is much more foundation for the view that it is slumps which may sometimes get out of hand and defy all normal methods of control. It will be, therefore, on the problem of checking a slump that we shall now concentrate our attention.

Keynes now offered his thoughts on the specifics of anti-deflationary monetary action.

My remedy in the event of the obstinate persistence of a slump would consist, therefore, in the purchase of securities by the central bank until the long-term market rate of interest has been brought down to the limiting point . . ..It should not be beyond the power of a central bank (international complications apart) to bring down the long-term market rate of interest to any figure at which it is itself prepared to buy long-term securities. For the bearishness of the capitalist public is never very obstinate, and when the rate of interest on savings deposits is next door to nothing the saturation point can fairly soon be reached. If the central bank supplies the member banks with more funds than they can lend at short term, in the first place the short-term rate of interest will decline towards zero, and in the second place the member banks will soon begin, if only to main-tain their profits, to second the efforts of the central bank by themselves buying securities. This means that the price of bonds will rise . . ..If the effect of such measures is to raise the price of “equities” (e.g. ordinary shares) more than the price of bonds, no harm in a time of slump will result from this; for investment can be stimulated by its being unusually easy to raise resources by the sale of ordinary shares as well as by high bond prices. Moreover, a very excessive price for equities is not likely to occur at a time of depression and business losses.¹⁴

Keynes thus envisaged two transmission channels from money to activ-ity, the bank lending channel via the fall in short-term rates, and what would now be called the “portfolio rebalancing channel”, reflecting the direct effect of the Bank’s bond purchase programme on the prices of “securities”.

Keynes used the apparatus in TM both to analyse the causes of the slide in asset prices and economic activity that began in 1929 and 1930, and to suggest policies to counter the worst of the effects. But it is important as a preliminary, before seeing how Keynes applied his theories, to dismiss a tiresome argument about whether Hayek or Keynes was more success-ful at foreseeing the collapse of 1929. The truth is that both Hayek and Keynes foresaw a collapse of the boom, but from different analytic posi-tions. Hayek thought that the slump originated in the credit expansion started by the Fed in 1927. This unleashed an orgy of over-investment – “mal-investment”, in his terminology – which could not be checked by the dear money subsequently imposed in 1928. The Fed’s discount rate went up from 3.5 per cent in January 1928 to 5 per cent in July. On 15 August 1928 Keynes wrote to an American correspondent, “I cannot help feeling that the risk just now is all on the side of a business depression . . . If too long an attempt is made to check the speculative position by dear money, it may well be that the dear money, by checking new investments, will bring about a general business depression”.¹⁵ Keynes was to insist repeatedly that no Hayekian “over-investment” had taken place in the 1920s. Rather that decade had featured “under-investment” in new capital equipment relative to corporate savings.

Keynes’s “real time” analysis of the causes of the slump started in the TM itself, in early 1930.¹⁶ It was repeated in more or less identical form in lectures, speeches and letters over the coming three years, and in the GT in 1936. It is important in understanding the contemporary discussion to realize that the global downturn emanated from the USA, and was much worse in the USA than in the UK. According to recognized authorities, the USA’s real gross national product fell by 28 per cent between 1929 and 1932, whereas the UK’s went down by less than 6 per cent.17 (The UK’s problems were almost entirely caused by the external environment. Domestic demand dropped only 1.5 per cent between 1929 and 1932 and consumption actually rose in the three years, despite a significant fall in net foreign income. As noted elsewhere in this volume the USA’s quantity of money, broadly-defined and according to the Friedman and Schwartz data, collapsed by over 38 per cent between October 1929 and April 1933.18 In the same period the UK’s M3 money measure – as estimated by Capie and Webber – increased, from £2549.0 billion to £2740.3 billion, or by 7.5 per cent.19 Thousands of banks in the USA could not repay deposi-tors with cash and “closed their doors”. Not a single bank in the UK – or indeed the British Empire – went under in the 1929–32 period.)

The most succinct explanation of the US collapse comes from a lecture in Chicago which Keynes delivered in June 1931. The leading character-istic of the 1920s boom, he said, was “an extraordinary willingness to borrow for purposes of real new investment at very high rates of interest”. The resulting prosperity, based on “building, the electrification of the world, and the associated enterprises of roads and motor cars”, diffused prosperity globally. The part played by inflation in maintaining expendi-ture was “surprisingly small”. The slump since mid-1929 was due to “extraordinary imbecility”, not over-investment producing an inevitable reaction. Business conditions required interest rates to fall, but instead the Federal Reserve Board had pushed up interest rates to check speculation on Wall Street. Very dear money in the USA had global contractionary effects by pushing up interest rates in other gold standard countries. Also capital flows were attracted to the USA, to the detriment of foreign bond issuance in other countries. Once the decline started it gained cumulative force. This was “the whole of the explanation of the slump”.²⁰ In the GT Keynes again rebutted Hayek’s emphases on mal-investment that had recurred in the polemical exchanges they had had since Hayek had taken up a position at the London School of Economics in January 1931. To quote,

"It would be absurd to assert of the United States in 1929 the existence of over-investment in the strict sense. The true state of affairs was of a different character. New investment during the previous five years had been, indeed, on so enormous a scale in the aggregate that the prospective yield of further addi-tions was, coolly considered, falling rapidly . . . In fact, the rate of interest was high enough to deter new investment except in those particular directions which were under the influence of speculative excitement and, therefore, in special danger of being overexploited; and a rate of interest, high enough to overcome the speculative excitement, would have checked, at the same time, every kind of reasonable new investment. Thus an increase in the rate of interest, as a remedy for the state of affairs arising out of a prolonged period of abnormally heavy new investment, belongs to the species of remedy which cures the disease by killing the patient."²¹

Pride of place in Keynes’s explanation of Britain’s milder problems went back to the egregious policy mistake of the Bank of England in overvalu-ing the pound by returning to the gold standard in 1925. This had created an adjustment problem which was too difficult to overcome. In Keynes’s words, contributing in 1932 to the Lloyd’s Bank Monthly Review,

"On the one hand, it was obviously impracticable to enforce by high Bank Rate or contraction of credit a deflation sufficiently drastic to bring about a reduc-tion in internal costs appropriate to the parity adopted. On the other hand, the maintenance of a low Bank rate would have . . . led to a rapid loss of gold and a much earlier collapse of the gold standard . . . the policy actually adopted was to preserve a middle-course – with money dear enough to make London an attractive centre for foreign short-term funds but not dear enough to force an adjustment of internal costs."²²

Keynes had already developed these ideas to some extent in testimony to the Macmillan Committee in March 1930, remarking that,

"The way prices are forced down is this. You put the bank rate at a level at which savings are in excess of investments. Business men make losses, prices fall, and then at long last the business man forces down the remuneration of the factors of production. But if you jam the machine halfway through so you have a chronic condition in which business men make losses, you also have a chronic condition of unemployment, a chronic condition of waste."²³

Keynes’s analysis of the slump pivoted on the growing divergence between the opinions of lenders and borrowers, that is, between the market and natural rates of interest. In his earliest account, in the TM, written early in 1930 when the downturn was gaining force, Keynes emphasized the role of what he called “artificial” borrowers in preventing the market rate of interest from falling in line with a presumed decline in the natural rate. Among such borrowers he included “distressed” borrowers, chiefly governments, which borrowed not for investment in productive enterprise but to repay their debts, “banking” borrowers (sometimes governments and sometimes banks) which borrowed to build up liquid reserves follow-ing the general return to the gold standard, and “speculative” borrowers, such as the rich individuals who emerged in 1928 and 1929 to participate in the feverish, final “bull”phase in US equities.²⁴ In all these cases, the lender called the shots and could prevent a drop in the rate of interest.

At this stage Keynes referred mostly to the collapsing confidence of borrowers. In other words, it was the collapse in non-banks’ marginal efficiency of capital rather than a general reluctance to lend (on the part of both banks and non-banks) which was undermining demand. Thus in December 1930 he opined that, “the fall of prices has been disastrous to those who have borrowed, and anyone who has postponed new enterprise has gained by his delay”.²⁵ This was consistent with the typical causal sequence as he saw it. First, a collapse in the expected rate of profit led to a fall in investment. Then demand weakness would cause a reduction in prices and the actual rate of profit, leading to another fall in investment. Like Irving Fisher, Keynes realized that, once expectations of deflation had become widespread, they became self-feeding and might initiate a vicious downward spiral.

The banking system – a feature of the capitalist economy which is both fractionally reserved and highly leveraged, and in these respects is inherently fragile – might aggravate the downward instability. Once profit expectations had been hit, and once the natural rate of interest (in this sense) had declined, the banks were in trouble. In December 1930 Keynes warned that, “It is obvious that the present trend of events cannot go much further without something breaking. If nothing is done, it will be amongst the world’s banks that the really critical breakages will occur.”²⁶ On cue came the global banking crisis of summer 1931. Keynes wrote from the USA in June 1931 that the American banks “have purchased great quanti-ties of second-grade bonds which have depreciated in value”, while “their advances to farmers and against real estate are inadequately secured”. So nervous were depositors that safe boxes (to look after the cash with-drawn from banks) were no longer obtainable. Again in his words, “At any moment bank runs are liable to break out almost anywhere in the country. All this tends towards a mania for liquidity.” “Barmy” opposition from New York banks was inhibiting the Fed from expansionary open-market operations on a sufficient scale.²⁷ Keynes’s analysis here was identical to – and indeed anticipated by over 30 years – Milton Friedman’s and Anna Schwartz’s retrospective analysis of the Fed’s failure in the 1963 A Monetary History of the United States.

In one of his magazine articles on ‘The consequences to the banks of the collapse of money values’, Keynes – unusually – discussed banks’ capital position as distinct from their cash reserves.²⁸ Given the importance of the regulatory upheaval in late 2008 and its role in the Great Recession, the article might have received more comment in the Keynes renaissance of recent years. Written in August 1931, but published in Vanity Fair in January 1932, the article illustrated Keynes’s deep understanding of banking practices. After discussing banks’ tendency to lend amounts less than the collateral by a “margin” for safety, it observed,

A year ago it was the failure of agriculture, mining, manufactures, and trans-port to make normal profits, and the unemployment and waste of productive resources ensuing on this, which was the leading feature of the economic situa-tion. Today, in many parts of the world, it is the serious embarrassment of the banks which is the cause of our gravest concern. Never before has there been such a world-wide collapse over almost the whole field of the money values of real assets as we have experienced in the last two years. And, finally, during the last few months – so recently that the bankers themselves have, as yet, scarcely appreciated it – it has come to exceed in very many cases the amount of the conventional “margins”. In the language of the market the “margins”have “run off”, much of the world banking system technically insolvent, and much less willing than they would normally be to finance any project which might involve a lock up of their resources.

In a typical sally Keynes continued, “Banks and bankers are by nature blind”. Quite simply, and again as in 2008 and 2009, they had not seen what was coming. Keynes’s derision was nicely put.

Some of them have even welcomed the fall of prices towards what, in their inno-cence, they have deemed the just and “natural” and inevitable level of pre-war, that is to say, to the level of prices to which their minds became accustomed in their formative years. In the United States some of them employ so-called “economists” who tell us even today that our troubles are due to the fact that the prices of some commodities and some services have not yet fallen enough, regardless of what should be the obvious fact that their cure, if it could be real-ised, would be a menace to the solvency of their institution. A “sound” banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.²⁹

Early in the Great Depression Keynes did not doubt that “natural forces” would bring about some recovery. In 1930 he could write, “A partial recovery, therefore, is to be anticipated merely through the elapse of time and without the application of purposeful remedies.”In principle, a new point of equilibrium could be reached by an all-round reduction in money-wages accompanied by a fall in the market rate of interest. But the first was politically impossible, while the fall in the long-term rate of inter-est was likely to be “a long and a tedious process”. The drive for cheaper money needed to be “accelerated by deliberate policy. For the slump itself produces a new queue of “distress”borrowers who have to raise money on the best terms available to meet their losses, particularly governments of countries whose international equilibrium has been upset by the fall in the price of their exports.”³⁰

In these circumstances, “purposeful” action was needed to raise the price level. To be precise, quoting now from TM,

"The Bank of England and the Federal Reserve Board might put pressure on their member banks to do what would be to the private advantage of these banks if they were all to act together, namely, to reduce the rate of interest which they allow to depositors to a very low figure, say ½ per cent. At the same time these two central institutions should pursue bank-rate policy and open-market operations à outrance, having first agreed amongst  themselves that they will take steps to prevent difficulties due to international gold movements from interfer-ing with this. That is to say, they should combine to maintain a very low level of the short-term rate of interest, and buy long-dated securities either against an expansion of central bank money or against the sale of short-dated securi-ties until the short-term market is saturated. It happens that this is an occasion when, if I am right, one of the conditions limiting open-market operations à outrance does not exist; for it is not an occasion – at least not yet – when bonds are standing at a price above reasonable expectations as to their long-term normal, so that they can still be purchased without the prospect of a loss . . . Not until deliberate and vigorous action has been taken along such lines as these and has failed, need we, in the light of the argument of this treatise [TM], admit that the banking system can not, on this occasion, control the rate of investment and, therefore, the level of prices." ³¹

In Chicago in June 1931, Keynes insisted that the main task facing public policy was to lift the level of investment. He offered two main policy sug-gestions for doing this. First was a set of “new construction programmes under the direct auspices of government”; second was a concerted attempt, by means of “banking policy”, to bring down the long-term rate of inter-est. But by the start of 1932 the banking system in the USA and many other countries (although not the UK) appeared to be frozen, as losses on old loans damaged solvency and the ability to extend new credits. Keynes was losing his faith in the ability of “banking policy”, and monetary policy in the round, to lift the world economy out of slump. “It may still be the case”, he said in February 1932,

"that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot be expected to earn . . . If this proves to be the case there will be no means of escape from prolonged and perhaps interminable depression except by direct state interven-tion to promote and subsidise new investment."³²

In spring 1933 Keynes wrote a pamphlet, The Means to Prosperity, based on four articles in The Times. By now he had almost given up on monetary policy. In his words, there was “no means of raising world prices except by an increase of loan-expenditure throughout the world”.³³ In the US edition of The Means to Prosperity he introduced material on the multiplier which he had developed in The New Statesman and Nation of 1 April. This was the first time that Keynes used multiplier analysis to support the case for public works. His words may have been for an American readership, but he referred to the British situation. To quote,

"it is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the budget – that we must go slowly and cautiously with the former for fear of injuring the latter. Quite the contrary. There is no possibility of balancing the budget except by increasing the national income, which is much the same thing as increasing employment."

Half a page later he resumed,

"Substantially the same argument also applies to a relief of taxation by sus-pending the Sinking Fund and by returning to the practice of financing by loans those services which can properly be so financed, such as the cost of new roads charged on the Road Fund and that part of the cost of the dole which can be averaged out against the better days for which we must hope. For the increased spending power of the taxpayer will have precisely the same favour-able repercussions as increased spending power due to loan-expenditure; and in some ways this method of increasing expenditure is healthier and better spread throughout the community. If the Chancellor of the Exchequer will reduce taxation by £50 million through suspending the Sinking Fund and borrowing in those cases where formerly we thought it reasonable to borrow, the half of what he remits will in fact return to him from the saving on the dole and the higher yield of a given level of taxation – though . . . it will not necessarily return to him in the same budget." ³⁴

He mocked the critics of expansionary fiscal policy, as it would nowa-days be called. The trouble was that many participants in the policy debate tacitly assumed a fully employed economy. Keynes asked, “Why should [his] method of approach appear to so many people to be novel and odd and paradoxical?” He conjectured,

"I can only find the answer in the fact that all our ideas about economics, instilled into us by education and atmosphere and tradition are, whether we are conscious of it or not, soaked with theoretical pre-suppositions which are only properly applicable to a society which is in equilibrium, with all its pro-ductive resources already employed . . . Obviously if the productive resources of the nation were already fully occupied, none of the advantages could be expected which, in present circumstances, I predict from an increase of loan-expenditure. For in that case increased loan-expenditure would merely exhaust itself in raising prices and wages and diverting resources from other jobs."³⁵

The discussion in this section can now be summarized. Keynes’s “real time” analyses in the Great Depression had the following four noteworthy features. First, at all times he rejected the “liquidationist” policy being urged by conservative bankers and far too many economists. While he accepted that, theoretically, a new equilibrium could be attained by reduc-ing costs in line with prices, he thought the attempt to do this would destroy the capitalist system. Capitalism could be crippled by the downward spiral of “debt deflation” highlighted by Irving Fisher. In Keynes’s words, If we reach a new equilibrium by lowering the level of salaries and wages, we increase proportionately the burden of monetary indebtedness. National debts, war debts, obligations between the creditor and debtor nations, farm debts, real estate mortgages – all this financial structure would be deranged . . . A wide-spread bankruptcy, default, and repudiation of bonds would necessarily ensue. Banks would be in jeopardy . . . And what would be the advantage of having caused so much ruin?³⁶

Second, although Keynes, like Fisher, deployed powerful arguments against deflation, he could not explain why, left to itself, the economy should not run down almost indefinitely. This was because, according to the TM theory, during the downward spiral saving would always be running ahead of investment. A new equilibrium had to wait till the community was too poor to save. The lacuna in his understanding stemmed partly from the incompleteness of his theoretical rethinking. At this stage he lacked vital bits of what was to become Keynesian theory, such as the consumption function, the multiplier, and the theory of effective demand.

Third, his progress towards the revolutionary concepts and ideas in the GT was hampered by the dysfunctional definitions of saving, income and profits in the TM. In the GT the S 5 I equality holds for all states of equilibrium; in TM it prevailed only for full employment equilibrium. Keynes realized that savings decline during the downturn. He talked of them being “spilt on the ground” in financing “business losses”. He also talked of government “dissaving”, as deficits automatically expanded. In short, he understood perfectly well that savings declined with income, and that “excess saving” was an artefact of his definitions and, specifically, of excluding profit and loss from income. (As Dennis Robertson noticed, “the savings which are so deplorably abundant in a slump consist largely of entrepreneurs’incomes which are not being spent, for the simple reason that they have not been earned.”³⁷) But Keynes wanted to explain what happens in the passage from one state of equilibrium to another. He would have spared himself much misunderstanding had he distinguished between what people want to save ex ante and what they succeed in saving ex post. But this would have led him to focus on what happened to income and output, rather than on what happened to prices, and that shift in focus came only with the GT.

Fourth, and crucially, as the Great Depression deepened in 1932 and 1933, his policy emphasis switched from monetary policy, even monetary policy à outrance, to reflationary fiscal action.

For all his insight, brilliance and influence, Keynes was not a rigorous tech-nical economist. Much of his work was loosely stated and open to more than one interpretation, and its ambiguity has led to disagreement and trouble. Members of his profession squabble not just about the meaning of his theories, but even about the type of method he employed. Some say that the GT is largely about disequilibria, with Keynes concerned to explore the processes by which equilibrium is restored.³⁸ Others claim that the GT’s theory of national income determination is an equilibrium state-ment. At any rate, a contrast in approach between the TM and the GT is undeniable. The GT is much more structured and consecutive than the TM. The argument arrives at theoretical propositions, which can be con-verted into equations, even if Keynes himself did not do that. Unlike the TM, the GT offered no extended treatment of the phases of the business cycle, and it says little about banking institutions and avoids the phrase “the natural rate of interest”.

By 1936, when the GT was published, all the upheaval which produced the Great Depression had already happened. There were no disequilibrium phenomena – disequilibrium prices, windfall profits and losses, excess savings, and the like – which time could be expected to rectify. All the adjustments had been made through changes in income and output, and the US and UK economies had settled down to a condition of chroni-cally low employment or – in Keynes’s language – to an “unemployment equilibrium”. The risk that this condition might be semi-permanent – and that the semi-permanence of high involuntary unemployment invalidated the notion that capitalist economies had innate stabilizing properties that would ensure cyclical recovery – was implicit in his “real time” analyses of the Great Depression. Crucially for the wider public debate, the semi-permanence of high involuntary unemployment invalidated the notion that capitalist economies had innate stabilizing properties that would ensure cyclical recovery.

In the GT Keynes cut through the maze to focus on a single question: what determines the level of output at any time? The answer he gave was “effective demand”, understood as the point (implicitly in a diagram, which did not in fact appear in the GT) where the aggregate demand func-tion intersects with the aggregate supply function, and spending does give rise to decisions to produce and employ.39 In the GT Keynes showed that effective demand could be – and long remain – at a level too low for full use of the community’s resources. Demonstration of the result hinged on blockages to the “natural” recovery of investment. The description of this parlous condition started from an assumption of an earlier shrinkage in investment, and with that the community’s income, output and employ-ment had also fallen. There were no “surplus” savings, because saving had fallen in line with income. Real wages remained above the level necessary for full employment, because they depended on the state of aggregate demand, not on labour market money-wage bargains. The rate of inter-est was fixed above the natural rate (or the marginal efficiency of capital) by liquidity preference. There was no escape from low employment via the export channel, because the analysis applied to an economy that was “closed”to trade and capital flows. (This made sense if Keynes was writing about an economy, such as the USA’s, that was big relative to the world economy as a whole. Alternatively, he could be viewed as theorizing about the world as a whole suffering from a deficiency of aggregate demand.)

How could the economy escape from this unsatisfactory state of chronic underemployment? The move to a higher equilibrium depended on an increase in the marginal efficiency of capital, but there was nothing in the existing situation to warrant it. In both the TM and the GT Keynes emphasized the dependence of long-term expectations on short-term expectations.⁴⁰ The depression could cast a long shadow, persisting several years from the initial adverse shock. The lifting of the clouds had to be engineered by the government.

The tendency of the TM was to use disequilibrium analysis, whereas the GT makes statements about equilibrium. Nevertheless, the substantive differences between the two can be exaggerated. First, no more than in the TM, did Keynes in the GT envisage his “unemployment equilibrium” as static and rigid. Chapter 22 of the GT is about the trade cycle. There would always be a bounce – perhaps only a dead cat bounce – from the lowest point in the cycle. Capital equipment would have to be replaced, while working capital would need replenishment. There might even be bursts of speculative excitement. The theme he wanted to argue was that no sustain-able recovery was possible unless the “inducement to invest” reached its pre-recession level. This would not happen spontaneously. A push from the government, in the form of extra spending or lower taxation, was needed.

Secondly, the “unemployment equilibrium”of the GT is much closer to the low-wage equilibrium of the TM than the term suggests. The phrase “unemployment equilibrium” implies no wage adjustment has occurred, whereas the TM account envisaged a return to equilibrium via wage adjust-ment. But Keynes also said that in the low-wage equilibrium of TM, many workers would be employed outside the industrial system as “gardeners and chauffeurs”.⁴¹ His thinking was that, as industries with high value added per person retrench because of weak demand, the economy would decant workers into the bottom end of the service sector. “Unemployment equilibrium” could be viewed as an institutional artefact created by the availability of unemployment benefits. The notion of “underemployment equilibrium” sums up better Keynes’s idea of what an inferior equilibrium would look like, combining insights from both the TM and GT.

But in one vital respect the GT goes beyond the TM. The TM’s agenda is still very much monetary. In the GT, by contrast, monetary expansion yields to public investment as the route to recovery. Monetary policy must help and accommodate public investment policy. It must do that, because on its own, it cannot push the economy all the way back to full employment.

The GT envisaged a situation in which confidence was so low that repeated injections of money into the banking system failed to bring down the long-term rate of interest to the required level. He conjectured a possible deep depression, in which bond yields were so low that investors feared eventual yield rises and capital losses. If the authorities engineered increases in their money balances, the non-bank public would let the ratio of money to non-money assets (and to national income and expenditure) rise without limit. This was Keynes’s famous “liquidity trap”. A long-term interest rate of 2 per cent “leaves more to fear than to hope, and offers at the same time, a running yield which is only sufficient to offset a very small measure of fear [of illiquidity]”. In this case, liquidity preference may become “virtually absolute”, in the sense that almost everybody would commit any extra wealth to cash rather than to bonds (or indeed to equities and real estate). In the mid-1930s there had been no examples of the pure liquidity trap, as Keynes understood that notion, although he thought that the USA had come close to it in 1932.⁴²

Ultimately, the rate of interest, like the marginal efficiency of capital, was “a psychological phenomenon”. An expansionary monetary policy (of big asset purchases) which appeared to the investing public as being “experimen-tal in character or easily liable to change” might cause liquidity preference to strengthen, which would counteract the stimulatory effect. On the other hand, the same policy might succeed if it “appealed to public opinion as beingreasonableandpracticableandinthepublicinterest,andpromotedby an authority unlikely to be superseded”.⁴³ However, the uncertainty attach-ing to the outcome of monetary operations led Keynes in the GT to be:

"sceptical of the success of a merely monetary policy directed towards influenc-ing the rate of interest. I expect to see the State, which is in a position to calcu-late the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest." ⁴⁴

In the GT portfolio choice was confined to two assets only, money and bonds, unlike the TM which offered a choice between money, bonds and “securities”, where securities of course included equities. The basic reason for the omission of securities was that Keynes wanted to direct attention to the difficulty facing the monetary authority in forcing down the long-term rate of interest when risk aversion in the investment com-munity was particularly strong. However, his scepticism about monetary policy in a depression had a long-term effect on thinking about economic policy-making, particularly in Britain. It affected both academic tuition and actual policy decisions for at least a generation after his death. The Keynesians were known to be supporters of “cheap money” (that is, very low interest rates) well into the inflationary 1960s and 1970s, even if by then exchange controls and lending restrictions were required to make very low interest rates possible.

In the light of what Keynes wrote about the Great Depression, how would he have analysed the contraction which started in 2008? And what pre-scriptions would he have made? Five points are now developed. They are surmises, but they seem justified by consistent themes in all of his work in the late 1920s and 1930s.

First, as in 1930 and later, he would not have attributed the 2008 downturn to cheap money and over-investment. He would have had no truck with the Austrian School’s diagnosis and recommendations. Keynes regarded the speculative aspects of the pre-recession situation as a second-ary phenomenon, masking a basic situation of under-investment in fixed capital relative to corporate saving. (This turned out to be Greenspan’s retrospective view as well.⁴⁵) He would have regarded the triggering cause of the crisis as the stiffening of the Federal Reserve’s monetary stance from 2005 onwards, as it tried to control the housing boom. He would have con-sidered that the Fed made exactly the same mistake in the 2000s as it had in the 1920s. To recall his words, “If too long an attempt is made to check the speculative position by dear money, it may well be that the dear money, by checking new investments, will bring about a general business depression”. The Fed should have sought to limit credit to the housing sector, without choking off credit to the rest of the economy.

Second, Keynes would have approved of the concerted central bank rescue operations of 2009, which followed closely his prescription of “open market operations à outrance”, and would have attributed to them a decisive role in stopping the slide down into another Great Depression. He might well have considered the bank bail-outs excessive. In the British bank run which immediately preceded the outbreak of war in 1914, he advised a Treasury guarantee for commercial banks’ illiquid assets only. (This paralleled a similar proposal for the establishment of a “bad bank” [to absorb banks’ bad assets, which could not be sold and so were illiquid] in 2009 and 2010. The bad bank idea was implemented only in Ireland.)

Third, Keynes would have deplored the UK’s premature suspension of QE in 2010 before the recovery was secure. (Admittedly, inflation was at the time running well above target and the UK did return to QE at a later date.) Keynes would probably have attributed the Eurozone relapse of 2012 and 2013 to the ECB’s withdrawal of the so-called “non-standard measures” and been critical of the Bundesbank thinking from which the decision to withdraw them was derived. (Eurozone output fell by 4.5 per cent in 2009, in the Great Recession as such. But it slipped again by 0.9 per cent in 2012 and 0.3 per cent in 2013, after only a weak recovery in 2010 and 2011. For more on the debate on the non-standard measures, see Chapter 4 above, pp.XXX.) He would have attributed the greater success of the Fed’s QE policy at least partly to its purchase of a wider range of assets, especially mortgage-backed securities. (The USA – unlike the Eurozone – suffered no output declines, on an annual basis, after 2009. Output rose by 2.2 per cent in 2012 and 1.5 per cent in 2013.)

Fourth, Keynes would have rejected policies of fiscal austerity which were widely enacted after the 2009 fiscal stimulus agreed at the G20 meet-ings in late 2008. (See Table 9.1.) He would have done so for exactly the same reason he gave in 1933. In his words,

"it is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the budget – that we must go slowly and cautiously with the former for fear of injuring the latter. Quite the contrary. There is no possibility of balancing the budget except by increasing the national income, which is much the same thing as increasing employment."

He would have approved the pursuit of a balanced budget on current account, if accompanied by an enlarged programme of capital spending. He would have been prepared, if necessary, to finance the government deficit from the central bank. In his view, a combination of better-targeted QE and loan-financed public investment would have made the slump shorter and shallower.

Fifth, Keynes would not have believed the present recovery securely based, despite the improvement in asset prices. He would have pointed to the lack of recovery of investment, the speculative basis of the revival, and the continued deficiency of aggregate demand. In other words, he would expect another downturn.

Is there room for final, more wide-ranging reflections? The first decade of the new millennium resembled the 1920s in that, about the middle of both decades, supply-side performance was challenged by a fall in the TM’s “natural rate of interest”. In other words, the marginal returns on new capital equipment seemed to deteriorate, after bursts of heavy invest-ment in new technology. Western economies now await the next burst of innovation to revive the “animal spirits” of entrepreneurs after the latest bout of “creative destruction”. But can we rely on investment to restore full employment?

In his essay, ‘Economic possibilities for our grandchildren’ (1930), Keynes predicted a secular decline in the rate of capital accumulation, leading to growing “technological unemployment”.⁴⁶ He was more explicit in the GT, where the ‘Concluding notes’ proposed such a looming abun-dance of capital that its “marginal efficiency” would fall to “a very low figure”. The result would be the “euthanasia of the rentier”, where the rentier could be regarded as “the functionless investor”.⁴⁷ In the 1940s, hypotheses about “secular stagnation”became common in the USA, based on the decline in population growth and the “closing of the frontier”.⁴⁸ These were dispelled by the strong investment performance and economic growth of developed countries in the 1950s and 1960s. But this occurred after the Second World War, which had created a huge pent-up demand for new equipment, transport infrastructure, and household appliances, as well as the requirements of a “military-industrial complex” which fed the needs of the Cold War.

It may be that some tendency for the natural rate of interest to decline had started in the developed countries by the late 1960s. Productivity growth has undoubtedly slowed down since then. Some crucial changes in the political economy of capitalism after about 1980 can be viewed as a response to this, specifically the upsurge of neo-liberal ideology, the growing inequality of wealth and incomes, and the increased importance of financial services, and an apparent rise in structural unemployment. The Old Normal of the early post-war decades now seems confined to “moments of excitement”, as in the dot.com revolution of the 1990s. Invention may continue, but it will require smaller inputs of capital and labour than in the past. The New Normal will be of slower growth, as too many companies and households struggle to escape the burden of debts incurred in a past era of more buoyant expectations.

Keynes’s policy response to the Depression of the 1930s was to restore investment activity to “normal”. But what if, for us today, the New Normal is marked by a permanent decline in the demand for new capital? It is entirely possible that, in the aftermath of the collapse of 2008, Keynes would have had a different set of recovery priorities. This is suggested by two quotations which show the way his mind was working at the end of his life. The first is from a memorandum, ‘The long-term problem of full employment’, dated 25 May 1943:

"We are more likely to succeed in maintaining employment if we do not make this our sole, or even our first, aim. Perhaps employment, like happiness, will come most readily when

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