Excerpt from Keynes: The Return of the Master, by Lord Robert Skidelsky (Penguin Books, 2010). Reprinted with permission from the author.
Chapter 8: Keynes for Today
The Need to Rethink
Any great failure should force us to rethink fundamental ideas. The present economic crisis is a great failure of the market system. As George Soros has rightly pointed out, ‘the salient feature of the current financial crisis is that it was not caused by some external shock like OPEC . . . The crisis was generated by the system itself.’ It originated in the US, the heart of the world’s financial system and the source of much of its financial innovation. That is why the crisis is global, and is indeed a crisis of globalization. But the crisis also reveals an ideological and theoretical vacuum where the challenge from the left used to be. Capitalism no longer has a global antagonist.
One can see that there were three kinds of failure. The first was institutional: banks mutated from utilities into casinos. However, they did so because they, their regulators and the policymakers sitting on top of the regulators all succumbed to something called the efficient market theory: the view that financial markets could not consistently misprice assets and therefore needed little regulation. So the second failure was intellectual. The most astonishing admission was that of former Federal Reserve chairman Alan Greenspan in autumn 2008 that the Fed’s regime of monetary management had been based on a ‘flaw’. The ‘whole intellectual edifice’, he said, ‘collapsed in the summer of last year’. Behind the efficient market idea lay the intellectual failure of mainstream economics. It could not anticipate or explain the meltdown because the majority of economists are committed to the view that markets are self-correcting, sooner or later. The economics profession both sanctioned and rationalized a model of society which supported a minimally supervised rule of markets. As a consequence, the failure of markets has marginalized economics itself. It is left on the sidelines as politicians try to salvage something from the breakdown of the market order.
But the crisis also represents a moral failure: that of a system built on money values. At the heart of the moral failure is the worship of economic growth for its own sake, rather than as a way to achieve the ‘good life’. As a result, economic efficiency – the means to economic growth – has been given absolute priority in our thinking and policy. The main moral compass we now have is a thin and degraded notion of economic welfare, measured in terms of quantity of goods. This moral lacuna explains uncritical acceptance of globalization and financial innovation, and the sanctification of those practices which give the pursuit of wealth priority over other human concerns.
Keynes distinguished between recovery and reform. Recovery is essentially a matter of treating symptoms. Global aggregate demand is collapsing; extra spending is needed to revive it. But, beyond this, what kind of permanent system should be created to minimize the impact of Black Swans? Recovery and reform sometimes point in different directions.
If one wants to keep the capitalist system going – and there is no alternative – confidence, especially the confidence of the business community in the policies of the government, is essential. Reforms should not be pressed prematurely, because they may cut off recovery by denting business confidence; and they should follow a deep, not superficial, attempt at understanding what went wrong. Keynes was very clear about this in the early 1930s. It might even be necessary to have a ‘conservative’ budget, he told a Swedish correspondent, if that would help to get lower long-term interest rates. The problem is the same today: how to carry out a Keynesian policy when most of the key actors have a non-Keynesian model of the economy.
Just as there is no single Keynesian way out of depression, so there is no single Keynesian system of political economy. Keynesianism can at best be a common element in very different systems of mixed economic life. In terms of economic policy it has only one proposition: that governments should make sure that aggregate demand is sufficient to maintain a full-employment level of activity. By what mix of politics, policy and institutional innovation this is to be done is a political-economy question. One thing of which we can be tolerably sure is that the next phase of political economy will see less reliance on export-led growth, a more restricted financial system, an expanded public sector, and a more modest role for economics as tutor of governments.
Political Business Cycles
Historians have always been fascinated by cyclical theories of history. Societies are said to swing like pendulums between alternating phases of vigour and decay, progress and reaction, licentiousness and puritanism. Each outward movement produces a crisis of excess which leads to a reaction. The equilibrium position is hard to achieve and always unstable.
In his Cycles of American History (1986), Arthur Schlesinger Jr defined a political-economy cycle as ‘a continuing shift in national involvement between public purpose and private interest’. The swing he identified was between ‘liberal’ (what Europeans would call social-democratic) and ‘conservative’ epochs. The idea of the ‘crisis’ is central. Liberal periods succumb to the corruption of power, as idealists yield to time-servers, and conservative arguments against rent-seeking politicians win the day. But the conservative era then succumbs to a corruption of money, as financiers and businessmen use the freedom of deregulation to rip off the public. A crisis of under-regulated markets presages the return to a liberal era.
This idea fits the American historical narrative tolerably well. It also makes sense globally. The era of what Americans would call ‘conservative’ economics opened with the publication of Adam Smith’s The Wealth of Nations in 1776. Yet, despite the early intellectual ascendancy of free trade, it took a major crisis – the potato famine of the early 1840s – to produce an actual shift in policy: the 1846 repeal of the Corn Laws, which ushered in the free-trade era.
In the 1870s, the pendulum started to swing back to what the historian A. V. Dicey called the ‘age of collectivism’. The major crisis that triggered this was the first great global depression, produced by a collapse in food prices. It was a severe enough shock to produce a major shift in political economy. This came in two waves. In the first wave, all industrial countries except Britain put up tariffs to protect employment in agriculture and industry. (Britain relied on mass emigration to eliminate rural unemployment); all industrial countries except the US started schemes of social insurance to protect their citizens against life’s hazards. The Great Depression of 1929-32 produced a second wave of collectivism, now associated with the ‘Keynesian’ use of fiscal and monetary policy to maintain full employment. Most capitalist countries also nationalized key industries. Roosevelt’s New Deal regulated banking and the power utilities, and belatedly embarked on the road of social security. International capital movements were severely controlled everywhere.
This movement was not all one way, or else the West would have ended up with Communism, which was the fate of large parts of the globe. Even before the crisis of collectivism in the 1970s, a swing-back had started, as trade, after 1945, was progressively freed and capital movements were liberalized. The rule was free trade abroad and social democracy at home.
The Bretton Woods system, set up with Keynes’s help in 1944, was the international expression of liberal/social-democratic political economy. By providing an environment that reduced incentives for economic nationalism, it aimed to free foreign trade after the freeze of the 1930s. At its heart was a system of fixed exchange rates, subject to agreed adjustment, to avoid competitive currency depreciation, and controls on the international movement of capital and short-term financial help for countries in balance-of-payments difficulties.
The crisis of liberalism, or social democracy, which unfolded with stagflation and ungovernability in the 1970s, broadly fits Schlesinger’s notion of the ‘corruption of power’. The Keynesian/social-democratic policymakers succumbed to hubris, an intellectual corruption which convinced them that they possessed the knowledge and the tools to manage and control the economy and society from the top. This was the malady against which Hayek had inveighed in his classic The Road to Serfdom. The attempt in the 1970s to control inflation by wage and price controls led directly to a ‘crisis of governability’, as trade unions, particularly in Britain, refused to accept them. Large state subsidies to producer groups, both public and private, fed the typical corruptions of behaviour identified by the new right: rent-seeking, moral hazard, free-riding. Palpable evidence of government failure obliterated earlier memories of market failure. The new generation of economists abandoned Keynes and, with the help of sophisticated mathematics, reinvented the classical economics of the optimally self-correcting market. Battered by the crises of the 1970s, governments caved in to the ‘inevitability’ of free-market forces. The swing-back became worldwide with the collapse of Communism.
A conspicuous casualty of the swing-back was the Bretton Woods system, which succumbed in the 1970s to the refusal of the US to curb its domestic spending. Currencies were set free to float, and controls on international capital flows were progressively lifted. This heralded a wholesale change of direction towards free markets and the idea of globalization. This was, in concept, not unattractive. The idea was that the traditional nation state – which had been responsible for so much organized violence and wasteful spending – was yielding to a ‘market state’ whose main job was to integrate its population into the global market, to the great advantage of prosperity, democracy and peace. All this Panglossian rhetoric is now in abeyance.
Today a large part of the world are living through a crisis of conservatism. The financial crisis has brought to a head a growing dissatisfaction with the corruption of money. Neoconservatism has sought to justify fabulous rewards to a financial plutocracy while median incomes stagnate or even fall; in the name of efficiency, it has promoted the offshoring of millions of jobs, the undermining of national communities, and the rape of nature. Such a system needs to be fabulously successful to command allegiance. Spectacular failure is bound to discredit it.
The crisis of conservation is not universal. It is much less acutely felt in the post-Soviet world which is still mentally in the throes of escaping from the tentacles of state socialism. It makes little sense of what is happening in the recently emerged market economics of East Asia, notably China, which exhibit hybrid systems of state and market. And the dichotomy of state and market has been less apparant in Europe’s ‘social market economy’. Different groups of countries are on different paths to different futures which cannot be understood by sole reference to contemporary Anglo-American experience.
In any case, even though cyclical theory is highly suggestive, political economy does not swing back and forward round a static Newtonian equilibrium. History is more like a spiral staircase than a swingometer. Some learning does take place, and one of the things we surely have learned – or relearned – since Keynes is that governments can fail as well as markets. We need a new synthesis, in which government is accepted as non-benevolent, but the market is not thereby totally rehabilitated.
So what system would Keynes be trying to set up today? I will try to use my knowledge of what he said and thought to speak as far as I can in his own accent. But he did not cover the whole ground, and, though I believe he was the wisest and most intelligent economist of the last century, much of what I say is an extrapolation of what he might have thought had he lived through the last sixty years.
Uncertainty tends to turn long-term investment into short-term speculation. Denial of the need to guard against uncertainty allows what Keynes called the ‘financial circulation’ to expand exponentially at the expense of the ‘industrial circulation’. This has been happening everywhere – but notably in the UK, where the financial system has become master, not servant, of production, the royal road to paper wealth. Any reform of our present system will require restricting the role of finance, and adopting a highly sceptical attitude to the claims made on behalf of financial engineering. Broadly speaking, Keynese saw the US banking crisis of 1930-31 as an induced effect of the decline in aggregate spending. His view was: look after demand and the banks will look after themselves. Given today’s dominance of finance, this cavalier attitude cannot be sustained. However, Keynes’s distinction between risk and uncertainty gives us the intellectual tools to think about banking reform.
If financial markets are merely risky, the important reform is to develop better measures of risk, and enforce them, where necessary by regulation. If on the other hand there is bound to be irreducible uncertainty in financial operations, the state has an additional duty, which is to protect society as a whole against the consequences of bets which go wrong. This might involve breaking up the banking system to prevent contagion from one banking sector to another. Current discussion of banking reform is poised between these two alternatives.
The debate between regulation and break-up goes all the way back to the early days of Roosevelt’s New Deal, which pitted the trust-busters against the controllers. In banking, the trust-busters won the day with the Glass-Steagall Banking Act of 1933, which divorced commercial from investment banking and, in addition, guaranteed bank deposits. With the dismantling of Glass-Steagall, completed in 1999, the banks were set free to merge without regulation. The bankers, that is, finally won against both busters and regulators, while maintaining deposit insurance for the commercial banks. It was this largely unregulated system which came crashing down in 2008, with worldwide repercussions.
One widely discussed problem with this system is that of moral hazard. The idea is that if a risk-taker is insured against loss he is likely to take more risks. This situation arises when, if the bank in which I have placed my account goes bust, it is the taxpayer, not the bank, which owes me the money. This is the effect of deposit insurance. Additionally, the country’s central bank acts as ‘lender of last resort’ to banks considered ‘too big to fail’. The result is that banks enjoying deposit insurance and access to central bank funds are free to gamble with their depositors’ money; as columnist John Kay has put it, they are ‘banks with casinos attached to them’.
Further, after the disastrous experiment of allowing Lehman Bros to fail in September 2008, bail-out facilities in the USA were extended ad hoc to investment banks, mortgage providers, and big insurers like AIG, protecting managers, creditors, and stockholders against loss. (Goldman Sachs became eligible for subsidised Fed loans by turning itself into a holding company). In other words, what started as a policy to reduce risk in the banking system had led to a situation in which most institutions had been set free to take risks without having to foot the bill for failure. Public anger apart, this is an untenable position.
Premature rejection of bank nationalization has left us with the same two alternatives as in 1933: break-up or regulation. Taking his cue from Paul Volcker, former chairman of the Fed, President Obama, on 21 January 2010, proposed a modern form of Glass-Steagall. Under the Obama-Volcker proposals, commercial banks would be forbidden to engage in proprietary trading – trading on their owners’ account – and from owning hedge funds and private equity firms. In addition, they would be limited in their holding of derivative instruments, and Obama has suggested that no commercial bank should have more than 10% of national deposits. The purpose of the reform is to reduce the risks that can be taken by any financial institution which is backed by the federal government, and so prevent the spread of contagion and tax-payer liability. Behind it, though, lies the more radical ‘trust-busting’ notion of reducing the monopoly power of the financial sector.
The regulatory approach, promoted by Britain’s Financial Service Authority chairman Adair Turner, believes that financial stability can be achieved without changing the structure of the banking system. A new portfolio of regulations would increase banks’ capital requirements, limit the debt they could take on, substitute ‘dynamic’ for ‘static’ accounting rules, provide regular ‘stress’ tests, and establish a Consumer Financial Protection Agency to protect naïve borrowers against predatory lenders.
The philosophy behind this approach was set out in the FSA’s Turner review of March 2009. It identifies ‘a failure to design regulatory tools to respond to emerging systemic risks’. The nub of the argument is that risk management methods did not adequately reflect the new risks created by the spread of derivatives. There are fleeting moments of doubt as to whether even improved risk-management techniques can make financial markets more ‘efficient’ in the sense of being able to price risks correctly; nevertheless, the Review concludes that the challenge to efficient market theory doesn’t require a ‘fundamental shift from FSA’s current policy stance’. What it does require is ‘systemic risk regulation’. Its intellectual position is similar to that of those New Keynesians who buy the rational expectations model, but qualify its applicability to real world situations by pointing to information failures.
This is not an ‘either-or’ matter. In his written testimony to the Senate Banking Committee on 4 February 2010, Professor Simon Johnson endorsed the Volcker approach, but also favoured strengthening commercial banks’ capital ratios ‘dramatically’ – from about 7% to 25% – and improving bankruptcy procedures through a ‘living will’, which would freeze some assets, but not others.
There are a couple of powerful arguments against the principles of the Obama reform. Critics point out that ‘plain old bad lending’ by the commercial banks accounted for 90% of bank losses. The classic case is Britain’s Royal Bank of Scotland, a commercial, not an investment, bank. The commercial banks’ main losses were incurred in the residential and commercial housing markets. The remedy here is not to break up the banks, but to limit bank loans to this sector – say, by forcing them to hold a certain proportion of mortgages on their books or by increasing the capital which needs to be held against loans.
Again, it has been pointed out that countries with integrated banking systems like Canada did not have to bail out any of their financial institutions. Canada’s banks were not too big to fail, but too boring to fail. Trying to puzzle out why this might be so, the Financial Times’s Chrystia Freeland finds the key reason in the financial sector’s lack of political clout. There is nothing in Canada to rival the power of Wall Street or the City of London. This enabled the government to swim against the tide of financial innovation and de-regulation. It is countries like the USA and UK with politically dominant financial sectors competing to take over the leadership of the world which suffered the heaviest losses.
This is the point that the well-intentioned regulators miss. At root, the battle between the two approaches is a question of power, not of technical financial economics. As Professor Simon Johnson pointed out in his Congressional testimony, ‘solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraint on regulation and the political power of big banks’. They assume that regulators will be able to identify excess risks, prevent banks from manipulating the regulations, resist political pressure to leave the banks alone, and impose controversial corrective measures ‘that will be too complicated to defend in public’. They also assume that governments will have to the guts to back them, while their political opponents accuse them of socialism and crimes against freedom, innovation, dynamism, and so on.
The intellectual choice between the two alternatives depends on whether one thinks risk or uncertainty is the main problem. Keynes’s view was that risk could be left to look after itself; the government’s job was to reduce uncertainty. Genuinely risky activities, Keynes implies, should be left to the market, with entrepreneurs being allowed to profit from risks well-taken, and suffer the losses of bad bets. On the other hand, uncertain activities with large impacts should be controlled by the state in the public interest. How to make this distinction operationally significant should be the major object of the reform of financial services in the aftermath of the crisis.
 George Soros, ‘The crisis & what to do about it’, New York Review of Books, 4 December 2008.
 Skidelsky, Keynes, vol 2, p. 487.
 Paul Volcker, ‘How to Reform Our Financial System’, New York Times, 31 January 2010.
 Chrystia Freeland, ‘What Toronto can teach New York and London’, Financial Times 29 January 2010.
Excerpted from Keynes by Robert Skidelsky. Copyright © Robert Skidelsky, 2010. All rights reserved.
Robert Skidelsky is Emeritus Professor of Political Economy at the University of Warwick, and a member of the British House of Lords. His three volume biography of the economist John Maynard Keynes (1983, 1992, 2000) received numerous prizes, including the Lionel Gelber Prize for International Relations and the Council on Foreign Relations Prize for International Relations. He is the author of the The World After Communism (1995) (American edition called The Road from Serfdom). He was made a life peer in 1991, and was elected Fellow of the British Academy in 1994. He is chairman of the Governors of Brighton College. Since 2002, he has been chairman of the Centre for Global Studies. In 2010, he joined the Advisory Board of the Institute of New Economic Thinking. He writes a monthly column for Project Syndicate, Against the Current, which is syndicated in newspapers all over the world.
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