John Maynard Keynes, the economist who arguably did more economic damage than any before or since, died 80 years ago tomorrow, on 21 April 1946.
His major work, The General Theory of Employment, Interest and Money, had been published just ten years earlier, in February 1936. The book revolutionised economics by focusing on macroeconomic “aggregates” such as total output, employment, income and government spending, where previously the focus had been on microeconomic issues of how markets clear in an efficient way.
The General Theory argued that market wages and prices were not perfectly flexible (as economic models of the time tended merely to assume), and that this “stickiness” meant that market economies would not always adjust quickly and efficiently to events, potentially giving rise to long periods of low output and persistent unemployment. To correct that situation, and maintain employment and growth, Keynes suggested that government intervention was needed, with spending and taxation policy being adjusted to manage demand. Thus, governments could ease recessions by increasing their spending or cutting taxes, and by running deficits, so putting more money in people’s pockets and stimulating economic activity.
What Keynes overlooked was that government spending and taxation are themselves sticky; and because players in the market face competition and so have to adjust their prices and wages at some point, the government as a monopoly employer and service provider faces no such competitive pressure. In the event, governments proved far happier raising their spending than they ever did at cutting it. And they also proved far happier to run deficits than to reduce them.
We must remember that Keynes wrote The General Theory in 1935, when the Great Depression of 1929-1939 was still in progress. So his focus was on government spending, and deficit spending, to boost economic activity during recessions — rather than on cutting spending and deficits during upturns. And this expansionary message was the one that was taken by the economists and policymakers of the time.
Keynes was the best-known economist of his time, but almost equally well known in the 1930s was Friedrich Hayek, who in 1974 would go on to win the Nobel Prize in Economic Science. The Austrian-born Hayek was, unsurprisingly, a member of the Austrian School of Economics, which focused on how individual economic decisions are made. Economists like Hayek therefore had little time for Keynes’s obsession with “aggregates” that were, to them, mere statistics that concealed more than they explained about the underlying motives and forces that make economic events happen.
Hayek had written a long, critical academic review of Keynes’s 1930 A Treatise on Money, in which Keynes argued that recessions were caused by a lack of demand. The Treatise therefore argued that during recessions, spending should be encouraged and saving discouraged. Hayek, however, having spent much of the 1920s examining boom and bust cycles, believed that the busts were the inevitable consequence of an earlier boom caused by easy money and low interest rates. Rather than being the solution, therefore, government policy was actually the cause of the problem.
According to Hayek, when he tackled Keynes in person on the Treatise, Keynes told him that he had completely changed his mind on the subject. Hayek concluded that all his work in critically reviewing and lecturing about the Treatise had been wasted. So when the General Theory was published, which Hayek regarded as even more deeply mistaken, he did not review it, thinking Keynes would change his mind yet again. And changing his mind was something Keynes was well known for: hence the famous quote attributed to him: “When the facts change, I change my mind.”
But it was not just changing facts that influenced Keynes; it was changing political needs and circumstances too. Hayek came to know Keynes more personally when the London School of Economics was evacuated to Cambridge during the Second World War. Keynes found Hayek accommodation near his own college, King’s. And on occasional nights, they could both be found on the roof of King’s College, spotting for enemy aircraft. Hayek later described Keynes as always busy — “He was the busiest man I ever knew” — always obsessing over managerial policy questions and tailoring his output to suit them, rather than focusing on getting the economic principles right.
Keynes was therefore wrong, thought Hayek, to call his book the General Theory because it was not something of general application, but a theory of recessions and depressions. In late 1945, with things at last looking brighter after five years of war, Hayek again tackled Keynes, warning him that in an improving economy, the deficit spending policies that he had advocated in 1936 would cause inflation. Keynes, said Hayek, agreed and said he must “do something about that.” But six months later, soon after the Bretton Woods conference that expanded government control to exchange rates, Keynes died of a heart attack at age 62 and could not do it.
Hayek therefore came deeply to regret not critiquing the General Theory when it had been published. Keynes’s followers, thinking he had indeed bequeathed the world a general theory of demand management, did indeed press on with his expansionary economic policies, even when the threat of recession was long gone. Focusing on a “full employment” policy that required increasing volumes of government spending and deficit spending. Politicians, revelling in their rising budgets, were pleased to oblige. But it was a fantasy lifestyle that could be financed only by debt or inflation; and governments chose the latter as it was far less visible than the national debt figure.
Keynes’s legacy, therefore, is a sad one
Yet as Hayek had predicted, it took increasing doses of inflation to keep the boom going. By 1975, inflation in the UK had reached 24-26 per cent, distorting every price in the economy and making business planning and investment impossible. The result was long periods of “stagflation” — inflation without economic growth, something Keynes’s followers could not satisfactorily explain. It took the economist Milton Friedman to explain the simple fact that, the more money governments print, the more worthless it becomes.
Keynes’s legacy, therefore, is a sad one. Not just decades of postwar economic distortion and inflation, but an unjustified faith in governments as the drivers of economic growth. And of course overlarge, bloated governments that believe they have the power to improve every other part of our lives too — a belief they too often test to destruction.