Keynes and After: What Perceptions Now?

The hypnotic attraction of the mathematical modelling of rational expectations and efficient market theories seduced many self-assumed Keynesians into unconsciously denying him. But just ‘going back’ to reading The General Theory is not enough.

The postwar period in the UK, as in much of Europe, was known as a ‘Keynesian era’. Keynes had reversed ‘the Treasury view’ that market confidence in a recession or slump needed to be gained by spending cuts – the same view now echoed by Jean-Claude Trichet at the ECB. The commitment of European governments to halve fiscal deficits to placate rating agencies which had ranked banks AAA until they collapsed in the subrprime crisis also now is monetarist rather than Keynesian and, if not reversed, will cause a beggar-my-neighbour deflation at horrendous social cost.

In the UK general election of May this year, the Liberal Democrats campaigned actively against a cuts agenda and posed themselves as the party to keep the Tories out. Yet now are advocating major cuts in what has become known as a Con-Dem coalition.  So where is the surprise?  Surely not in that the Conservatives should echo Margaret Thatcher’s ‘there is no alternative’? Nor that the public has found a Tory mailed fist in what during the election was a velvet glove. The real surprise has been for Liberal Democrat voters, with mass resignations already by Lib-Dem party members, the possibility of a split in the parliamentary party and the prospect of a collapse of support in the next general election

What are the implications for the Labour Party, its current leadership election and the prospect that it might win such an election?  Labour MP and former minister Ed Balls, is making the most ‘Keynesian’ case among the candidates for the leadership that cuts should be stalled until there are clear signs that a recovery is under way.  Yet Gordon Brown during most of his ten year tenure at the UK Treasury, and for most of which Ed Balls was his economic adviser, argued until the financial collapse of 2008 that the era of ‘tax and spend’ and ‘boom and bust’ was over. This had been rejection by ‘New Labour’ of former Labour governments until the mid 1970s presuming that Keynesian fiscal and monetary policies could assure full employment. 

What this paper submits is that were underlying reasons for the end of the Keynesian era by the mid 70s both in Europe and the UK which many Keynesians themselves did not recognise. In doing so, it relates its case to psychology, as Keynes had done, but in particular the psychology of Gestalt, or perceiving either concepts or economic outcomes in different ways, and thus different ‘Keynesianisms’.  Also that where Keynes was right this needs to be recovered from the library of the great unread – including The General Theory – yet needs to be qualified also on where he was wrong.

Gestalt, Keynes and Psychology

The first generation of Keynesians in the decade from the publication of The General Theory in 1936 read it rather than ‘Keynesian’ textbooks since at the time there were none. This included both Harold Macmillan, later to be a Conservative prime minister, and whose company published it, and Harold Wilson, who headed the 1964-70 and 1974-76 Labour governments. It also included three Rockefeller fellows at Harvard just before the war who were part of a reading group aiming to understand The General Theory, two of whom read it with a similar perceptions or Gestalt, while the third did not..
One of the Harvard trio was John Kenneth Galbraith, who saw the need to match Keynesian demand management by a supply-side economics which recognised market dominance by big business and the need for both governments and trades unions to countervail this.

Another was the less known Robert Marjolin, who drew on Keynes’ concept of effective demand, but saw the need for long-term investment to match it, and shortly was to achieve this as head of the OEEC Marshall Aid European Recovery Programme. But Marjolin, in this, also was committed to planning. He sent back the initial Italian proposals for Marshall Aid on the basis that he wanted a plan for for recovery rather than a shopping list for reconstruction.

The third in the trio was Paul Samuelson who, following a similar earlier Gestalt by John Hicks, presumed that Keynes’ key concepts could be wedded with the neoclassical theory of the firm and equilibrium analysis. Then, in his best selling postwar Economics, stripped the psychology from all of Keynes’ key concepts and reduced them to mathematical axioms.

This included ignoring the dependence on individual and mass psychology of Keynes’ ‘propensity to consume’, or whether people feel secure enough to spend rather than save; ‘liquidity preference’, or whether they reckon they should hold onto their money rather than invest; also, the ‘marginal efficiency of capital’, which depends on whether or not investors sense that they will make profits in future if they choose to invest now. Keynes’ ‘long-term state of expectations’ about the future also was what investors expected future profits would be which he stressed in chapter 12 of his General Theory, would depend on both individual and mass psychology rather than calculus.

Thus if long-term expectations were low or negative, managers would not expect to be able to make future profits from current investment (low marginal efficiency of capital) and would ‘wait and see’ rather than invest, therefore hanging onto their money (high liquidity preference). In turn, as in Europe and the US now, if people were unsure that they or members of their families would keep or gain jobs, they would prefer to hold onto what money they have rather than spend (low propensity to consume and high liquidity preference). As an outcome, economies could remain indefinitely recession, as in the slump such as that which followed the Crash of 1929 and as is proving to be the case in the UK and much of Europe now.

Most of the next generation of econmists trained during the Keynesian era did not read Keynes himself but Samuelson’s Economics or similar texts posthumously wedding him to the ‘optimisation’ of neoclassical general equilibrium theory, such as, in the UK, Richard Lipsey’s Positive Economics. This hybrid or sometimes deemed ‘bastard ‘Keynesianism’ was so shallow and so lacked deeper legitimation that within months of the 1973 oil shock it was hard to find an avowed Keynesian either in the UK Treasury or any European finance ministry.

Then, even before second OPEC oil price hike of 1979 there was another Gestalt switch from Keynes’ perception of the key relation in the Fisher definition of money supply of m v = p t as between ‘v’ for the velocity of circulation and ‘t’ for the level of the level of demand to Friedman’s claim that it was between ‘m’ for the rate of growth of money supply and ‘p’ for price levels. With the oil shocks Friedman, hitherto offstage rather than even backstage, suddenly found he was in the footlights, and played it to the full.

This then was compounded by the hypnotic attraction of the mathematical modelling of rational expectations and efficient market theories of Black and Scholes, Fama, French and others which, as Paul Krugman claimed with good reason a New York Times article of September last year, seduced many self-assumed Keynesians into a sometimes unconscious denial of his central claim that there was no mathematical basis for assessing future market outcomes. 

Such as wih a sometime member of the monetary policy committee of the Bank of England who was convinced from the 1960s that he was a Keynesian yet from the 1970s began to make arguments which clearly assumed rational expectations. When challenged on this he claimed that rational expectations theory was compatible with Keynes. When asked what about Keynes chapter 12 of the General Theory in which he stressed their dependence on both individual and mass psychology he frankly enough replied ‘I’ve never read The General Theory’.

Or, a similar displacement of this in Keynes by a director in the economics and finance directorate general of the European Commission responsible in the 1990’s for what was emerging as the Stability and growth Pact for a single curency.  A committed social democrat who claimed also that he was a convinced Keynesian, he nonetheless based his whole case for governments reducing deficits to 3% and borrowing to 60% on the ‘crowding out’ hypothesis without recognising either that this was Friedman against Keynes, or even knowing that Friedman himself assumed that this depended on full employment which Europe neither then nor now has.

Not Just Back to Keynes

So what of Keynes now?  Just ‘going back’ to him or recommending reading The General Theory is not enough, even if it could help if showing knowledge at least of its Chapter 12 on The State of Long Term Expectation should be obligatory for the appointment of any central banker.

 What needs to be recognised is where Keynes was both right and wrong. Entirely right in his case on effective demand and that governments need to sustain and stimulate it in a recession. Thoroughly right on his case that - unlike the rational expectations and efficient market theories which helped spawn the subprime crisis – there is no mathematical basis for predicting future market outcomes. Yet also wrong in that he relied assumptions both on the supply of goods and services and in international trade and payments which already were outdated when he wrote the General Theory.

The first, which he claimed in his Concluding Notes on the Social Philosophy to the General Theory Might Lead, was that provided the State intervened to manage the level  of demand, the processes of ‘perfect and imperfect competition’ could assure supply. Yet this already was wrong for multiple reasons, including that the time horizon for investments already was longer than the budgets of governments, as well as that capital already was going multinational, investing globally and influenced in this by more than fiscal and monetary policies in one country.

A second was that although Keynes had criticised Ricardo for ‘axiomatic’ thinking, he also relied on Ricardo’s principle of comparative advantage which assumed not only that trade was between different firms in different countries but that also there would be no capital mobility between them.  This was wrong even for one of the two products which Ricardo took as paradigmatic examples, English corn and Portuguese wine, and where the wine trade between them was developed by British capital in Portugal through companies whose brand names are not Portuguese but Churchill, Gilbey, Offley, Warr and others.

Thirdly, that this had effects which were to profoundly comrpomise the Bretton Woods framework and postwar trade liberalisation through GATT, and later through the WTO. With the attraction especially of US and UK direct investment to Asia - initially to UK protectorates such as Singapore and Hong Kong, and US protecorates such as Taiwan and South Korea – the outcome was what Adam Smith had recognised as absolute advantage. As now in China which can combine much of the world’s most advanced technology with much or literally most of its lower and least cost manufacturing labour.

Fourth, that major foreign production by US and UK companies - eight times that of Germany or Japan in the case of the US, and four times as much for the UK, even in the 1970s - was to profoundly compromise Keynes’ principle of managed exchange rates for the two currencies which then were its lynchpins – sterling and the dollar. For with global production on such a scale, neither American nor British multinational companies had an interest in lowering prices to follow through a depreciation of the dollar or devaluation of the pound since to do so would have been to compete against themselves abroad or an ‘own competitor’ effect.

Little of this was recognised during the ‘high period’ of Keynesianism in the UK when the economic adviser to the then Prime Minister Harold Wilson, Thomas Balogh, and to the then chancellor of the exchequer Jim Callaghan, Nicholas Kaldor, both argued devaluation as the response to Britain’s deteriorating trade balance and speculation against the pound from foreign exchange markets.

Wilson initially resisted devaluation, which resulted in the July 1966 deflationary package which cut the floor from beneath its 1965 National Plan, but then was forced into it by speculation against sterling in November 1967. This stabilised the pound, but had no proportional effect on export performance because of the ‘own competitor’ effect.

This was later evidenced by two independent studies. The first by Hague, Oakeshott and Strain found no significant export-effect from the 1967 devaluation. The second, by Peter Holmes delved deeper and found that not one of the 220 firms responsible for two thirds of British visible export trade had followed through the 1967 devaluation by lowering prices in other markets. Some had lowered prices abroad during this period, but for other for other reasons which concerned oligopoly rather than perfect or imperfect competition, such as ‘entry pricing’ to gain market access ‘no-entry’ pricing by dropping price to deter a competitor from doing so.
The authors of both studies declared themselves perplexed, in that ‘UK’ firms did not appear to be profit maximisers. Yet this again was a Gestalt misperception based on the Keynesian presumption that trade was between different firms in different countries rather than multinational companies, and thus missed the ‘own competitor’ effect. This also is where Dunning has acidly remarked that there is no point in looking for a theory of the firm in theories of comparative advantage, since there is none.

Vitally, in political terms, and the beginning of the discrediting of Keynesianism in the UK, while 1967 devaluation stabilised sterling it was accompanied by deflationary fiscal measures in successive budgets to avoid inflationary effects from the higher cost of imports. It had not offset this by the ‘export-led growth’ and export and employment multipliers which Keynesians such as Kaldor and Balogh has assumed. There was no net gain, as there will not be now for Europe as negative multpliers kick in and may even double the direct cuts at which governments are aiming.

Nor had the 1967 devaluation proved that there was nothing wrong with the merely indicative National Plan of 1965 other than not devaluing earlier, as Anthony Crosland claimed in opposition to a different planning through leading firms proposed in the early 70’s on the model of French, Belgian and Italian inspired ‘planning agreements’ and which then gained strong support on the National Executive of the Labour Party and became the basis of Labour’s trade and industry policy from 1973.

Thus the UK at the height of the Keynesian era suffered pain in the 1966 deflation, followed by more with the restraint on public spending after the 1967 devaluation, for reasons which Keynesians did understand – the exposure of sterling – but for others which were highly resisted by many of them when the outcome that the 1967 devaluation ‘had not worked’ – and the risk of de-industrialisation with globalisation of British capital – became evident in the 1970s.

Can One Learn Up?

So what of an alternative analytic framework?  This arguably should be not only post Keynesian and post Ricardian but also post Marxian in that, unlike Keynes, Marx clearly recognised that the accumulation of capital depended not only an extraction of surplus, which both Smith and Ricardo had, but aso related this to accumulation on a global scale and the role of a reserve army in servicing it.  And where he and Smith both were reasoning in terms of absolute advantage, and were right, whereas both Ricardo and Keynes were wrong.

A first learning up’ in post Keynesian terms is from where Keynes was entirely right - the need for governments to assure effective demand when both growth and confidence is low to prevent a collapse of confidence and the risk of further recession, or slump. But if European governments could do so this again would need a Gestalt shift in realising that while EU member states are deep in debt the EU itself has next to none. It had none at all until May this year when the European Central Bank began to buy up some member states’ national debt. 

Thus the eurozone is weak but the European Union is not. It is better placed to finance an economic recovery programme on the style of the US New Deal by issuing its own bonds than the US. With EU borrowing near to zero, this is as Timothy Geithner could tell President Obama tomorrow that he had reduced US federal debt to a fraction of 1% of GDP.  By borrowing to invest on its own account, the EU also would be starting from a much lower base than the Roosevelt administration in the New Deal.

What I have suggested in an earlier paper for Insight is that there is an Alexandrine solution to this which could cut the Gordian knot on national debt by transferring a tranche of it to the European Union as EU bonds, attracting investment in them from surplus economies and sovereign wealth funds. Issuing such bonds was part of my 1993 report on economic and social cohesion in the 1990s to Jacques Delors, following which he recommended them in his White Paper of December 1993. At the time the Netherlands and Luxembourg supported but France and Germany were opposed. Now only Germany is opposed. Whether the European Council might resort to qualified majority voting to adopt them is an open question. Had the Giscard d’Estaing Convention on a Constitution for Europe adopted the recommendation of enabling majority voting by a majority of countries in favour of a new policy or a new policy initiative, as recommended on it by its then vice president Giuliano Amato, and similar in principle to ‘enhanced cooperation’, issuing the bonds now would not be blocked.

Second, any post Keynesian analytic framework needs to recognise that multinational companies need a conceptual and analytic framework which can explain their behaviour.  They are in between but dominate both micro national firms and macroeconomic outcomes. Micro or micros - in Greek - means small. Macro or macros in Greek means big but also, in economics, total or aggregate. Mesos in Greek means in between. It was on coming to this – and drawing on experience of having been first an economic assistant to Wilson in the Cabinet Office and then a political assistant in no. 10 - that in the 1970’s and 1980s I developed the concept of mesoeconomics and showed that a meso sector of large and multinational firms could divorce both monetarist and Keynesian micro-macro syntheses.

There are various implications within such an alternative meso analytic approach which range beyond this paper. They include going back to the first generation Keynesians such as the case of Robert Marjolin on the need for public investments which was such a success in the postwar European recovery programme, and that of Galbraith on the need for countervailing oligopolistic big business. But this would imply more than a new Keynesianism which would redress only imperfections in markets which is the main thrust of Paul Krugman’s otherwise well intentioned recommendations in his New York Times article last year.

Such a meso and especially meso-macro approach may be able to gain wider resonance in an era of ‘too big to fail’ than it did when first broached in the 1970s and 1980s. Not least it would recover economics from the tKeynesian-neoclassical cul-de-sac of Samuelson and could open a new post research and policy agenda on which readers of Insight might wish both to comment and contribute.


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Stuart Holland

Formerly adviser on European affairs to Harold Wilson, Jacques Delors and Antonio Guterres. Currently Visiting Professor in the Faculty of Economics of the University of Coimbra. His new book "Europe in Question – and what to do about it" is published as an eBook by Spokesman Press and available on Amazon.