John Maynard Keynes and the dog that did not bark


From Franklin National Bank in 1974 to Citigroup, AIG, Morgan Stanley and others in 2008, the rescue of banks and financial institutions has played a key role in preventing recessions from developing into full-blown Great Depressions.

Curiously, however, nowhere in The General Theory does John Maynard Keynes, analyst par excellence of recessions, even mention the importance of bank rescues. It is not that the "father of macro-economics" was so busy expounding questions of theory that he did not have time for mere practical matters. He did attempt to analyse the cause of the Great Depression. And this is what he had to say:

"In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump. And, furthermore, since 'financial prudence' of this kind continued to be exercised through the slump by those great corporations which were still in a position to afford it, it offered a serious obstacle to early recovery." (Chapter 8)

Had any academic economist suggested three years ago that one of the causes of the Great Recession was too much saving in the form of depreciation provisions, his tenure would probably have been rescinded and his membership of the American Economic Association withdrawn. When Keynes says it, we genuflect.

But jokes apart, Keynes seriously does not seem to have had even the faintest glimmer of understanding of the vital part played by banks in the economy. His ignorance is a sharp regression compared with Walter Bagehot who, more than half a century earlier, had advised what would today be called central banks to "lend freely, at a high rate, on good collateral". Like the dog in Sherlock Holmes that did not bark, the absence of bank rescues in Keynes's principal work is a vital clue. It is an indirect indicator that the General Theory is, from beginning to end, one large error.

I have shown elsewhere, in Paul Krugman and the liquidity trap that Keynes's model is a currency-only model and that the moment banks are introduced into the system the thesis of liquidity preference and the liquidity trap collapses, and with it all of the General Theory.

The bulk of the General Theory is devoted to analysing aggregate demand. Aggregate supply is cursorily dismissed.

"The aggregate supply function, however, which depends in the main on the physical conditions of supply, involves few considerations which are not already familiar. The form may be unfamiliar but the underlying factors are not new. We shall return to the aggregate supply function in Chapter 20, where we discuss its inverse under the name of the employment function. But, in the main, it is the part played by the aggregate demand function which has been overlooked; and it is to the aggregate demand function that we shall devote Books III and IV." (Chapter 8)

The promise is of course not kept in Chapter 20, because there Keynes uses a circular argument to define aggregate supply in terms of aggregate demand. Along the way he devotes a lot of space to the factors controlling investment.

"For convenience of exposition we shall assume in the following discussion of the state of confidence that there are no changes in the rate of interest; and we shall write, throughout the following sections, as if changes in the values of investments were solely due to changes in the expectation of their prospective yields and not at all to changes in the rate of interest at which these prospective yields are capitalised. The effect of changes in the rate of interest is, however, easily superimposed on the effect of changes in the state of confidence." (Chapter 12)

"So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.(Chapter 12)

In waxing eloquent about uncertainty and the role played by long-term expectations Keynes seems to have lost sight of an unmistakably certain, present-day factor during slumps: the sharp fall in bank credit which, through the operation of a multiplier, results in a sharp contraction of production, and through the contraction of factor payments, to a sharp contraction in aggregate demand.

The last quote above is especially revealing. Keynes thinks of weakening of credit in terms of a fall in confidence on the part of the lender. It never seems to have occurred to him that banks were not lending, not because their confidence had fallen, but because their finances did not permit them to. This is especially shocking because bank failures were hardly a hidden part of the landscape during the Great Depression. According to Wikipedia: "After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s)."

Why was Bagehot so prescient about the importance of banks and Keynes so wrong-headed? It ultimately boils down to their respective views of money. Bagehot was a banker and Keynes was an asset manager. For Bagehot it must have been a matter of everyday observation that people borrowed money to buy bonds and stocks. In his view of things, money was what bought stocks and bonds. Keynes looked at money from the point of view of an asset manager. An asset manager received a certain amount of funds. He used some of these to buy stocks and bonds. What was left was for him, money. In other words, money was what did not buy stocks and bonds. This is, of course, the argument behind the speculative motive of liquidity preference.

To repeat:
For Bagehot, Money is what buys stocks and bonds.
For Keynes, Money is what does not buy stocks and bonds.

Both these views cannot be right. Unfortunately it is Keynes's completely erroneous view of money, the idea of money as cash balances, which has prevailed for the past 75 years (a view incidentally which has been shared by the monetarists and the Austrians). The only economist who got it right was Hyman Minsky, and no one really seems to have understood what he was saying. Nicholas Davenport wrote that speculation improved Keynes's economics and economics improved his speculation. The truth is that the speculator's view of money destroyed Keynes's economics and Keynesian economics damaged economics for the next 75 years.

The sorry chapter in modern economics called monetarism came to an end quite some time ago. If economics is to make any progress it is now time to put an end to the other sorry chapter called Keynesianism.

14 May 2011

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