Chapter 4:

John Maynard Keynes and the Great Depression

"Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."

- John Maynard Keynes


Historical Context within the profession

The Primacy of Demand

Economics occurs in historical context. The Great Depression was the context of British economist John Maynard Keynes' identification of the primacy of demand, the originating point of Demand Side.

Keynes influence preceded the Depression. As a young man he participated in the negotiations closing World War I. His acerbic Economic Consequences of the Peace, published in 1920, gained widespread attention immediately after the Treaty of Versailles. Over the next decade and a half Keynes analysis of the consequences of the terms imposed on Germany proved accurate. He predicted the desperate economic vise and the consequent social disruption which gave rise to Hitler and the Third Reich.

To the popular mind and to many of the intelligent and educated, the Great Depression seemed to be the end of the Capitalist experiment. The successful economies of the 1930s were those of Nazi Germany and Stalinist Russia. A choice seemed to be indicated between one of those two systems.

The standard economics of the time did not, as surprising as it may seem, include the possibility of, nor an explanation for, the massive unemployment and industrial stagnation the US entered in 1929. Previous crises were seen as minor corrections in a long-term stable state. When the Depression began, as it worsened, and as it lingered, the predominant advice of economists was, "Patience. Stay the course."

In economic circles, this condition of perpetual denial was founded on Say's law, the proposition that production itself, by its payments to labor and capital, created enough demand to purchase production. Adherence to Say's Law was virtually a litmus test for consideration as a serious economist.

Keynes saw the problem of the Depression as not enough demand. Farmers produced milk but dumped it in the street for want of buyers at a reasonable price. As prices crumbled, incomes crumbled, people hoarded against expected want, demand receded further, and the cycle went around again.

Keynes saw that adequate effective demand could return the economy to full employment of its labor and capital. Demand could create production, but production did not necessarily create demand.

The "liquidity trap" Keynes postulated arose when people preferred hoarding cash to investing or purchasing. When inflation turned to deflation, in fact, hoarding was a financially sound practice. Cash became an investment in itself, since it became more valuable over time. The cruel reality, however, was that savings in the absence of income sooner or later went for necessities.

The Multiplier

In concert with its originator R.F. Kahn, Keynes also developed and promoted the multiplier. Investment or government expenditure creates an economic surge as it echoes through the economy. The producer of one good is the consumer of another as his good is sold and he spends his income. Thus, money can be followed from hand to hand as it facilitates the exchange of goods and services. The same money buys shoes from the shoemaker as buys bread from the baker as buys meat from the butcher, but the consumer changes from shoemaker to baker to butcher. If the money stops - as above - in one or another's cookie jar, the sequence of purchases and sales is interrupted and the employment of people and facilities down the line never occurs. The economic activity is stopped by the act of hoarding.

The corollary to this sequence is Kahn's multiplier. Any particular amount of government spending or private investment will create multiples of that amount in economic activity, as the first new income is passed from consumer to producer, who then becomes the next consumer. The multiplier describes how much more activity will be created. It is the multiple of investment or government deficit spending in real increased economic activity.

Different economic actors will affect the multiplier differently. As the money passes through a poor person, for example, it will likely survive intact as a purchase of a good or service because a poor person tends to spend all of his or her income. Similarly, payments that go through government accounts tend to employ people and survive as demand for the subsequent services, because government is not in the business of saving. In contrast, payments to the wealthy are not so readily turned over. The tendency to save or spend in a manner which is tangential to the main economic life of the society is much greater among the wealthy. A full exploration of the multiplier and the factors that act to reduce it is presented in a later chapter.

Today the multiplier survives primarily to describe the stimulus value of government deficits and to offer an inappropriate justification for all tax cuts. Keynes himself preferred direct employment through public works. As all reliable economics texts will attest, direct government spending is undoubtedly greater stimulus than tax cuts, since the first round of leakage from private spending is absent in government spending. Tax cuts balanced by spending reductions are undoubtedly contractionary, for the same reason. Tax cuts funded by deficits is absurd economically, as it means revenue formerly generated in taxes is now being borrowed. Yet this is precisely the policy of the current Bush administration. The same revenue thus comes with the cost of interest attached.

Tax cuts also produce on the margin of personal demand. The "margin" refers to the last increment. Marginal income tax rates, for example, refer to income above a certain level. Income below that level is taxed at a lower rate. In the case of tax cuts, the money freed up to individuals and households would be spent on items less essential than the first dollars of income. Thus tax cuts produce more discretionary goods and services than direct employment from public works - more deodorant and cell phones and fewer houses. Public works employ people directly and distribute demand across the full spectrum of household needs.

Casino Markets
Dead Ideas from Live Economists: The Efficient Markets Hypothesis

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done, JM Keynes, General Theory of Employment, Interest and Money Ch 12, p142 in Google Book edition, Atlantic Publishers

If there is one economic doctrine that has been central to thinking about economic and social policy over the last three decades, it is the Efficient Markets Hypothesis, or more properly, the efficient financial markets hypothesis. The EMH says that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production.
Although economists since Adam Smith have pointed out the virtues of markets in general, the EMH with its focus on financial markets is specific to the era of finance-driven capitalism that emerged from the breakdown of the Keynesian Bretton Woods system in the 1970s. The EMH justified, and indeed demanded, financial deregulation, the removal of controls on international capital flows and the massive expansion of the financial sector that ultimately produced the greatest financial crisis in history.

Some more linking material to come here
Keynes and the casino

Few economists have been successful investors, and quite a few have been disastrous failures. But after a narrow escape from disaster early in his investing career John Maynard Keynes made a fortune for his Cambridge college by speculating in futures markets It is a striking paradox that Keynes was among the most scathing of all economists in his assessment of the role of financial markets.

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” (General Theory Ch 12, p142 in Google Book edition, Atlantic Publishers

During the decades of the long Keynesian boom, financial markets were tightly regulated, and, as a result, financial crises disappeared almost entirely from the experience and memory of the developed world. At the margin, substantial profits could be made by finding ways to work around the regulations, while relying on governments to maintain the stability of the system as a whole. Not surprisingly, there was a warm reception for theoretical arguments that presented a more favorable view of financial markets.

Keynes’ views were reflected in the systems of financial regulation adopted as governments sought to rebuild national economies and the global economic system in the wake of World War II. The international negotiations undertaken at a meeting in Bretton Woods, New Hampshire, in 1944, where Keynes represented the British government, established an international framework in which exchange rates were fixed and movements of capital tightly controlled.

National governments similarly adopted policies of stringent financial regulation, and established a range of publicly-owned financial institutions in response to the failures of the private market. In the United States, a host of regulatory bodies were established to control financial institutions. The Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC) and prohibited bank holding company from owning other financial companies. The Federal National Mortgage Association (later quasi-privatised as Fannie Mae, and then renationalised during the early stages of the 2008 meltdown) was established to support the mortgage market.

Although the details of intervention varied from country to country, the effect was the same everywhere. Banking in the 1950s and 1960s was a dull but secure business, resembling a public utility in many respects. Parents scarred by the Depression urged their children to look for ‘a nice safe job in a bank’.

The Efficient Markets Hypothesis changed all that.

It was not Keynesian economics and employment policies that ended the Great Depression, but rather the advent of World War II. The War validated the Keynesian prescription as massive government expenditures and the employment of millions in the military and millions more in munitions and support supercharged the economy. The unprecedented output may have been dedicated to the nonproductive activity of war, but standards of living actually increased domestically across the board during the War. People ate better, dressed better and lived better in the United States during the War than they had in the years prior. At the same time they generated the tremendous product the War consumed.

In the next chapter we explore what happened when peace resumed. It is worth noting that the transition from a war economy to a peace economy began with a Keynesian commitment to full employment, the Full Employment Act of 1946. This recognized the power of government to produce economic outcomes - unthinkable a few years earlier. The economics propounded by Keynes worked. It was not a challenge to market capitalism, but a necessary adjustment. It is a lesson we need to learn again. Absent another adjustment to market capitalism, the society will fail.

No comments:

Post a Comment