Friday, December 7, 2012

Actually, Generally

John Maynard Keynes was born in Cambridge in 1883 to a professor and a social reformer. His adolescence and young adulthood were charmed by an almost unbroken string of successes; he won a scholarship to Eton, a scholarship to Cambridge, and a position of esteem in the Indian Ministry of Finance; he was universally praised for his service to the British Treasury during World War I, and his second book, a critique of the economic penalties imposed on Germany by the Treaty of Versailles entitled The Economic Consequences of the Peace, catapulted him onto the intellectual world stage before his thirtieth birthday. 

Keynes’ more benevolent biographers say that his early achievements buoyed him with a sense of “incorrigible optimism” and gave him confidence in his ability to solve almost any problem.[1]  In other words, the fame went to his head.  Sometime after the war Keynes decided that it was his destiny, or rather, his duty, to fix what was wrong with economics, and he published his first attempt at a magnum opus, A Treatise on Money, in 1930. Another young economist at the time, Frederick Hayek, wrote a highly critical review of A Treatise on Money that included the line, "It is only with extreme caution and the greatest reserve that one can attempt to criticize, because one can never be sure whether one has understood Mr. Keynes aright."  The quiet reception the book received from others implies that Hayek more or less hit the nail on the head.[2]In 1936, Keynes gave the opus another go with The General Theory of Interest, Employment and Money.  The breathtakingly ambitious opening paragraph reads:

“I have called this book The General Theory of Interest, Employment and Money, placing the emphasis on the prefix General. The object of such a title is to contrast the character and conclusions of my arguments with those of the classical theory of the subject, upon which I was brought up and which dominates economic thought, both theoretical and practical, of the governing classes of this generation, as it has for hundreds of years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be the characteristics of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we apply it to facts of experience.”

To be fair, Keynes wrote in a time of great economic upheaval.  Keynes' Cambridge was influenced greatly by Alfred Marshall, who with a talented cohort of English, French and Austrian economists brought about the “marginal revolution,” the first great challenge to classical thought as defined by David Ricardo and Adam Smith.[3]  This “new” economics was still full of holes, and fiercely contested by a growing contingent of continental economists arguing from a very different set of first principles.  Further, the extra-ordinary political circumstances of the inter-war period generated an extra-ordinary demand for creative economic policy; times where hard, and politicians were desperate. Still, to dismiss nearly all of established economic thought with the words, “actually, generally” required a bravado unlikely to be matched ever again in economics.

Keynes was a brilliant writer as well as a great economist, and The General Theory is worthwhile for its clever commentary on economic history and human psychology alone.  But what, when you boil off the trimmings, is so “actually, generally” different about his bookBy 1936, Keynes had been grasping at a thread for two decades. During his early years he had discovered a principle that he knew, but could not prove, played a central role in economies of exchange.  He captured the spirit, but not the logic of that principle in The Economic Consequences of the Peace, and recognized a compatriot in Bernard Mandeville, the sometimes-ridiculed author of 17th century poem called The Fable of the Bees.  He embarked on the six-year journey that would produce A Treatise on Money to attempt to translate that idea into modern economic language; readers today can still catch glimpses of the principle in the thick double volume, only to be dragged back into the dark labyrinth of Keynes’ botched attempt to integrate intuition with established thought.  The General Theory still fell far short of perfect clarity, but in it Keynes was finally able to convey in the formal language of academia what he had known for two decades in his heart.

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The principle surfaces clearest in Chapter 12, The State of Long Term Expectation. It comes in two parts. First is the realization that we actually know little, if anything at all, about the future.  Keynes put this way:

“If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.”

(Perhaps Keynes’ belief in the ignorance of man was what empowered him to make such sweeping statements about the error of the economists who came before him).

Second is the revelation that when information is scarce, our decisions depend on our expectations, and our expectations depend on our confidence.

The considerations upon which expectations of prospective yields are based are partly existing facts which we can assume to be known more or less for certain, and partly future events which can only be forecasted with more or less confidence…The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to discuss it in general terms.”
Keynes specified that the state of confidence can be modeled through a single number, which he called the prospective yield or marginal return on capital, which determines investment, which influences demand. This was a new thought in a new direction; the classical economists had largely ignored demand, focusing on supply or production, and while the marginal economists established that demand was important, they had little to offer to explain its shifts. Finally, with Keynes, there was an answer, and a gloriously simple one: it was confidence. When confidence is strong, people spend more, invest more, and produce more, and the economy grows; when confidence is weak, people spend less, invest less, and produce less, and the economy sinks into recession. Keynesian confidence explains why "dream big" and "keep calm and carry on" apply to macroeconomies, and why, all things considered, "it's better to have tried and failed than to have never tried at all."

But Keynes, like Smith, didn’t take his theory all the way. The prophet of “actually, generally” failed to be completely general, and therefore failed to be completely actual. First, he underestimated the influence of confidence when he limited its effect to the prospective yield on investment. 40 years later Milton Friedman pointed out that confidence also plays a role in expectations of future prices.  Second, he leaned on a complicated crutch of his own creation to explain exactly how confidence related to money, built from an insubstantial theory of liquidity preference and held straight with a heavy pile of sticky prices. Together, the two failures tore down his General Theory of Interest Employment and Money and reduced it to what most economists today categorize as a special theory of liquidity crises.

Keynes did, however, prove his principle, both with his theory and with his life. Confidence today is key to our understanding of how economies boom, bust, and grow, and had it not been for one cocksure economist, we may have never even tried to understand.

[1] David Gowland. "Biography of Baron John Maynard Keynes". Retrieved 29 May 2009.
[2] Keynes never humbled himself enough to admit he had been wrong, but upon meeting Hayek several years later he did purportedly say, “Oh, never mind, I no longer believe all that.” He was already working on the next big thing.
[3] Not including Marx, who has never been popular with academic economists and who was not respected as an economic thinker until the 1950s**


  1. His first book actually was actually 'Indian Currency and Finance' published in 1913, and his Fellowship thesis, which was only published in 1921, was written before 'The Economic Consequences of the Peace.' Also, although Marshall was around, and Keynes had plenty of access to him, his actual teacher was Pigou. The General Theory is worthwhile because of the Principle of Effective Demand and the refutation of Say's Law. On human (what else?) psychology is probably not worth reading (but not my area, and mind you it’s irrelevant for good, objective economics; let the confidence fairies vanish from the profession), and on economic history is exceedingly thin at best. The main argument of the book is that the system can fluctuate around a level of high unemployment (by the way in the US the economy was below 4% unemployment for only a few years in 4 occasions since the early 1940s, meaning after the Depression, so full employment almost never happens; i.e. the evidence is on Keynes' side). It does not depend on confidence at all. Not enough demand is what causes persistent unemployment, and lower wages and interest rates cannot adjust the system to full employment. You must read chapter 19 of the GT to get the point where he explains that price flexibility does not lead to adjustment.

  2. Thanks for you comment. You're right, I was careless to say Consequences of the Peace was his first book (although it was his first book of consequence) and that he studied under Marshall (although I'd argue his economic education was more formed by Marshall than Pigou), and I certainly aggree with you when you say that not enough demand causes persistent unemployment.
    I'm quite surprised however that you dismiss confidence so resolutely; I knew I was being slightly controversial, but I thought it was by putting it above sticky prices, not by mentioning it at all. I do define confidence a bit particularly, as tied to expectation, and if you don't accept that I may understand you, but in Chapter 19 Keynes says "For we have shown that the volume of employment is uniquely correlated with the volume of effective demand measured in wage-units, and that the effective demand, being the sum of the expected consumption and the expected investment, cannot change, if the propensity to consume, the schedule of marginal efficiency of capital and the rate of interest are all unchanged." And of course spends several chapters earlier talking about the psychology behind the propensity to consume & the marginal rate of capital. It seems very clear to me in this sentence that confidence influences effective demand; if it is not confidence, what is it?

    1. Confidence tends to be the result not the cause. Marriner S. Eccles, the chairman of the Fed during the depression, wrote in his autobiographic book, 'Beckoning Frontiers,' that "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Put clearly, lack of trust is the result of lack of demand. So what would allow a firm to invest, if workers had higher salaries and could buy more things, or if they could borrow and buy more things. The 1940s to 70s period was a wage-led boom, while the last 30 have been debt-led booms, which are also more prone to financial instability and crises.

    2. I think you've got your causality reversed. Isn't the debt level determined by the lender's confidence in the borrower's ability to pay back the debt? That's what an interest rate is, after all, a risk premium. (if you look back into the theory and origin of the concept of time preference you'll see that too is essentially a risk premium). And what induces entrepreneurs to raise wages? Confidence in their ability to sell enough at high enough a price to make the wages worth it-- labor is paid before the product is sold. That quote from Eccles sounds very ABCT. (Maybe you're an ABCT kinda guy and I haven't read your blog very closely). Quote Skidelesky: "In economics, his more persistent ideas concern the pervasiveness of uncertainty and the part it plays in preventing economies performing at anywhere near their potential, except at moments of "excitement'"' his conception of economies as 'sticky masses' rather than fluids... and his stress on the duty of government to keep economic life up to the mark."