Keynes, John Maynard

Keynes, John Maynard 1883-1946

BIOGRAPHY

ECONOMIC THEORY

THE CONSEQUENCES OF KEYNES

BIBLIOGRAPHY

The doyen of Cambridge economists, bursar of King’s College, and eventual Baron Keynes of Tilton, John Maynard Keynes was a leading member of the Bloomsbury Group, an astute collector of the writings of Isaac Newton (1642–1727), a long-time editor of the Economic Journal, a U.K. government policy advisor of significant magnitude, and the main instigator of a revolution in economic theory that created an approach (Keynesianism) that came to dominate Western economic discourse from the end of World War II (1939–1945) until the mid-1970s.

Keynes was undoubtedly the most famous and influential economist of the mid-twentieth century. His 1936 book The General Theory of Employment, Interest, and Money is often cited as the single most important book in economic theory published in the interwar period, and it could reasonably be said to have created modern macroeconomics. One graphical representation of the economy that came out of this book—IS-LM analysis—became a staple of textbook economics for many years to come, even though it was later shown not to originate from Keynes’s work alone, but from one individual’s particular interpretation of it. Keynes’s interventionist proposals for helping to regulate the aggregate level of employment through demand management remained in use in various forms for decades after World War II, and his policy advice on financing both World War I (1914–1918) and World War II was crucial to enabling Allied victories on both occasions. Some of his pithy aphorisms, such as “in the long run we are all dead,” have become legendary.

Despite his undoubted great influence on economics, his legacy is highly controversial. Criticized from the right for advocating inflationary financing, and from the left for attempting to rescue capitalism rather than replace it, the demise of Keynesianism as the dominant force in mainstream economics is usually dated to the mid-1970s, when inflation combined with high unemployment to produce stagflation, something that Keynes had not predicted. Despite such unforeseen developments, his influence still remained active through a number of heterodox approaches to the subject, such as post-Keynesian economics and even new Keynesianism. Like all truly great intellectuals, fresh interpretations of his work are periodically presented, and neglected aspects of it are continually rediscovered.

BIOGRAPHY

Maynard Keynes (as he was known to his friends) was the son of John Neville Keynes (1852–1949), also a well-known economist and the author of The Scope and Method of Political Economy (1891). Maynard Keynes experienced an elite education at Eton and then studied at King’s College Cambridge, where he was appointed to a lectureship in economics after a period working in the British Civil Service. He was soon involved in providing policy advice on financial affairs in India, which then developed into governmental service in the U.K. Treasury regarding the financing of World War I. He was the main Treasury representative at the signing of the Peace Treaty at Versailles, and after the war he strongly criticized the level of the reparations demands made on Germany. In the early 1920s, he argued that Britain should not return to the prewar gold standard system, and if it did, it should not be at prewar parity. In both these instances, his advice was ignored, but in retrospect his judgment has appeared correct to many commentators. By the end of the 1920s, Keynes was supporting David Lloyd George’s (1863–1945) call for a program of government-funded economic expansion of around 2.5 percent of national income per year, in order to cure persistent unemployment.

In addition to his economic works, Keynes published A Treatise on Probability (1921), which provided a critique of the frequency conception of probability then in vogue. Instead of this approach, Keynes favored a logical conception in which probability was seen as being relative to human knowledge, rather than being taken as a given fact of nature. He also published various essays on political matters and even some biographical sketches. In an essay on his early beliefs, he stressed the significance of the British philosopher G. E. Moore’s (1873–1958) Principia Ethica (1903) to the formation of his general attitudes. Keynes had interpreted Moore as applying logical analysis to such areas as feelings, sense-data, and morality, and he later described such an approach as “sweeter air by far” than Sigmund Freud (1856–1939) or Karl Marx (1818–1883). During World War II, Keynes again successfully served in the U.K. Treasury, where he coordinated his activities closely with the U.S. government. He died in 1946, a year after the war ended.

ECONOMIC THEORY

Keynes is best known for introducing into the vocabulary of economists concepts such as the marginal efficiency of capital, liquidity preference, effective demand, the multiplier, and the propensity to consume. He also developed more rigorous definitions of the basic elements of economic analysis, such as income, savings, and investment. However, it is important to realize that Keynes was not working in isolation; instead he actively participated in debates that occurred throughout the 1920s and 1930s among British economists such as D. H. Robertson (1890–1963), Richard F. Kahn (1905–1989), R. G. Hawtrey (1879–1975), and Joan Robinson (1903–1983). Consequently, what precisely is taken to constitute the “Keynesian revolution” in economics is an essentially disputed topic. Keynes himself emphasized that the revolution was directed against the classical theory of employment, but his account of this theory through the work of the economist A. C. Pigou (1877–1959) was itself controversial. Keynes argued that the classical approach only allowed for the existence of frictional and voluntary unemployment, and denied the possibility of involuntary unemployment. Given the context of the Great Depression of the 1930s, Keynes implied that this approach was unrealistic, and set about showing how capitalism could generate significant levels of involuntary unemployment when certain conditions were met.

Keynes presented effective demand (aggregate demand backed by money) as the key concept of his general theory. He asserted that the volume of total employment was determined by the interrelation of aggregate supply and aggregate demand. As opposed to the classical doctrine, in which supply was said to create its own demand (Say’s Law), Keynes suggested that in reality an increase in supply did not necessarily lead to a corresponding increase in demand. This was because when employment increased, aggregate real income also increased. However, due to the psychological factors involved (the propensity to consume), when income increased so also did consumption, but (crucially) by not as much as income. In order to cover this deficit, an increase in investment sufficient to absorb the excess was required, but there was no guarantee that the necessary level of increased investment would naturally follow. Keynes outlined that the amount of investment was actually dependent on the inducement to invest, which in turn was determined by the relation between the marginal efficiency of capital and interest rates.

Keynes defined the marginal efficiency of capital as being equal to the interest rate that would make the present value of the future returns from a capital good equal to its supply price, and hence it depended on expected returns. Keynes further outlined how the marginal efficiency of capital declined as investment in any particular capital good increased. Given this declining schedule and with any given rate of interest, there was no reason to assume that actual investment would correspond to the amount required to cover the deficit between increased income and consumption. Thus the level of effective demand required to ensure full employment was not necessarily created by the self-adjusting mechanisms of a market economy. Put another way, the economic system did not automatically generate full employment.

To explain the unusual duration of the Great Depression, Keynes suggested that in the 1930s the marginal efficiency of capital was actually much lower than it had been in the nineteenth century, and hence the rate of interest that would generate higher employment levels was unacceptable to many owners of accumulated wealth. To explain the heightened amplitude of depressions, Keynes christened the ratio between an increment of investment and increased income the investment multiplier, and suggested that a multiplier greater than unity accounted for how relatively small fluctuations in investment could generate much larger fluctuations in employment. Keynes concluded from this analysis that investment was promoted by low rates of interest and that this would be facilitated by the disappearance of the rentier class within capitalism.

The “Keynesian revolution” was not only directed against classical economists, but also against Keynes’s earlier approach, which had preached adherence to the framework provided by the Cambridge version of the quantity theory of money. In this respect it is necessary to consider Keynes’s major works in economics published prior to The General Theory. His first book was Indian Currency and Finance (1913), which provided an analysis of the operation of the gold-exchange standard. This was followed by The Economic Consequences of the Peace (1919), an attack on the terms of the Versailles Peace Treaty, and a Tract on Monetary Reform (1923), dealing with the problems of postwar inflation. These books, although undoubtedly important in practical terms, were less significant in terms of providing innovations in pure theory. The Treatise on Money (1930) was Keynes’s most significant work in economic theory prior to The General Theory. Here Keynes emphasized the importance of the behavior of the banking system to understanding fluctuations; by controlling credit, banks necessarily controlled aggregate expenditure. Booms and slumps were thus the result of the oscillation of the terms of credit about their equilibrium position, defined as occurring when savings equaled investment. Disequilibrium was possible in this model as international influences adversely affected the domestic banking system, causing the terms of credit to move above or below their equilibrium level at any given time. The difference between this type of analysis of trade cycles and that given in The General Theory was significant; in the latter, emphasis was transferred away from monetary factors to psychological propensities and expectations of future yields on investment goods.

THE CONSEQUENCES OF KEYNES

Keynes’s new economics, brilliant though it undoubtedly was, was not without flaws. The abstract concepts that Keynes deployed with such aplomb were sometimes ambiguous, and his use of them produced much ongoing debate. Milton Friedman’s A Theory of the Consumption Function (1957) was devoted to empirically investigating Keynes’s psychological rule of increased savings (in percentage terms) as income rose. Friedman concluded that Keynes was mistaken in his presentation of the nature of the propensity to consume, as the ratio between income and savings was the same for all levels of income, but depended on other factors, such as interest rates and the ratio of wealth to income. Friedman later led the monetarist counterrevolution against the Keynesian approach. There was also a question over how “general” Keynes’s General Theory actually was. Since it was designed in part to explain the historical circumstances of the 1930s, was its relevance limited only to the interwar period?

Despite such ambiguities, the impact of The General Theory on Western economics immediately after 1936 was so great that it swept aside the valuable contributions of contemporary economists like Joseph Schumpeter (1883–1950), whose monumental work Business Cycles (1939) found little direct resonance in the West due, at least in part, to the phenomenal success of Keynes’s book. Keynes also became involved in a debate over the importance of the new econometric methodology (as developed by the Dutch economist Jan Tinbergen [1903–1994]) to economic analysis. Keynes was highly critical of the extensive use of mathematical models in economics being promoted by the econometricians, but his reservations were quickly swept aside. Ironically, it was the success of the Keynesian IS-LM model that added some impetus to the drive for econometric modeling.

The Keynesian system was for many years after World War II hailed by the Left as proof of the inadequacies of capitalism as an economic system and the necessity of increased state control of the commanding heights of the economy. Keynes himself saw his work as a means of improving the internal mechanics of the free-market system, and he criticized state socialism as inefficient and as too restrictive of individual freedoms. Keynes traveled to the USSR on a number of occasions, but he found the fanatical zeal of the Bolsheviks toward Marx’s Capital to be incomprehensible. He declared support for significant inequalities of wealth and income, but not to such a degree that it would impede the entrepreneurial function. Yet he disputed the argument that enlightened self-interest always operated in the public interest, and he saw an important role for the directive intelligence of society organized as a whole exercising some control over private business.

Given the level of his fame and the degree of his policy influence, Keynes’s private life and general views have come under some scrutiny. Early in his life he had intimate relationships with male suitors (such as Duncan Grant [1885–1978], the Bloomsbury painter), but he went on to marry a Russian ballerina in 1925, his “conversion” to heterosexuality being the cause of some friction between members of the Bloomsbury set. He has been accused of “soft” anti-Semitism and also of not realizing the full consequences of his policies of war finance for less developed countries like Russia. Despite such criticism, Keynes’s status as one of the most important economists since Adam Smith (1723–1790) remains unshaken, and his legacy of bringing greater sophistication to economic theory is an enduring one. It seems unlikely that any individual economist could replicate Keynes’s pervasive influence over the subject in the future.

SEE ALSO Absolute Income Hypothesis; Consumption Function; Economics, Keynesian; Economics, New Keynesian; Economics, Post Keynesian; Interest, Neutral Rate of; Macroeconomics; Policy, Fiscal; Policy, Monetary; Unemployment; Voluntary Unemployment

BIBLIOGRAPHY

Barnett, Vincent. 2001. Calling Up the Reserves: Keynes, Tugan-Baranovsky, and Russian War Finance. Europe-Asia Studies 53 (1): 151–169.

Clarke, Peter. 1988. The Keynesian Revolution in the Making, 1924–1936. Oxford: Clarendon Press.

Friedman, Milton. 1957. A Theory of the Consumption Function. Princeton, NJ: Princeton University Press.

Hicks, J. R. 1937. Mr. Keynes and the “Classics”: A Suggested Interpretation. Econometrica 5 (2): 147–159.

Keynes, John Maynard. 1921. A Treatise on Probability. London: Macmillan.

Keynes, John Maynard. 1930. Treatise on Money. London: Macmillan.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan.

Laidler, David. 1999. Fabricating the Keynesian Revolution: Studies of the Inter-War Literature on Money, the Cycle, and Unemployment. Cambridge, U.K.: Cambridge University Press.

Skidelsky, Robert. 1992. John Maynard Keynes: The Economist as Saviour, 1920–1937. London: Macmillan.

Vincent Barnett