Bill Totten's Weblog

Friday, November 07, 2008

Will the real Keynes stand up ...

... not this sad caricature?

The great economist is back in fashion, but it will be a disaster if his brilliant theories are now misapplied

by Will Hutton

The Observer (November 02 2008)

With the Bank of England declaring that the Western banking system is in its most acute crisis since 1914, John Maynard Keynes is back. Alistair Darling is the first Chancellor since Roy Jenkins to speak warmly of the 20th-century's greatest economist. Newspaper and television profiles mushroom. This is the man who said that countries must spend their way out of recessions, you will read, by allowing public borrowing to rocket. Keynes is allegedly the original big-spending, big government liberal. And along the way, you will have learnt that his ballerina wife, Lydia Lopokova, had to cross-dress because he never relinquished his taste for beautiful young men. That we need a little Keynesianism - a dodgy doctrine from a gay libertine - is a sign of how desperate the economic situation has become.

For a convinced Keynesian such as myself, it is a depressing caricature of what remains the most subtle and best explanation of why market economies work as inefficiently as they do. Worse, it may lead not only to some costly policy mistakes, but it will mean that a once in a generation chance to reform the British and world financial system will be missed. The time has come to assert the real Keynes.

This is a Keynesian moment because an out-of-control financial system has created a potential slump that can only be solved by the close but generous reform of finance. For Keynes, the interaction of the financial system with the real economy is capitalism's existential problem. Banks are where our savings reside without any promissory note about when we intend to spend them, so that the spectre permanently hovers over the economy of there either being too little spending or too much. The job of finance is to recycle those savings back into investment and so sustain overall levels of demand, production and employment at a balanced rate.

Free-market economists maintain that free decisions in free financial markets will propel the rate of interest to take the entire weight of this existential task. Keynes disputed this to the depths of his being. Financial markets were different from the real economy, he proved, and operated on very different, short-term time horizons and impulsive passions. If farming were to be organised like the stock market, he once wrote, a farmer would sell his farm in the morning when it was raining, only to buy it back in the afternoon when the sun came out.

This is a ludicrous way to approach any economic activity, but it is how the stock market values companies. Financial markets are always more transactional, more short term and move faster than anyone in the real economy could ever contemplate.

Moreover, they are prone to wild enthusiasm and pessimism. Human beings do not know the future. We may try to attach rational probabilities to certain outcomes, but that is not the point; there are, Keynes said, prefiguring Donald Rumsfeld, unknown unknowns. An unknowable future creates herd effects, waves of irrational exuberance or gloom. We doubt our individual capacity to figure out what lies ahead, so we surrender to the greater wisdom of crowds.

Because financial markets permit many more fast, transactional, short-term decisions than any other, they swing faster with the crowd than any other part of the economy. Alternating between asset price bubbles and hoarding of cash is in their DNA. And free-market economists' attempts to prove otherwise, along the way serving the interests of a financial plutocracy, are just wrong.

Thus, credit flows and the prices of financial assets must be constantly monitored to see if they are behaving rationally. Intervention in the financial markets - regulatory, institutional, via monetary policy and in collaboration with other governments - is vital. The socialisation of the financial system may, paradoxically, be an imperative to save capitalism. Contra-cyclical government borrowing in recessions may be helpful. But the big game is to do everything you can to stimulate private sector credit flows.

Keynes would be completely unsurprised by today's events; he would have spent the previous decade warning of the existential danger posed by the mania for financial deregulation. The Bank of England revealed in its financial stability review last week that in the seven years up to 2008 British banks had lent GBP 700 billion more to their customers than they had saved, making up the difference from taking deposits from abroad via the now dead markets in securitised assets insured by credit default swaps. If the banks try to restore just half of the gap over twelve months by returning to the ratios in 2003, the Bank of England shows that they would have to cut lending by a depression-inducing five per cent. Even doing it over three years implies that lending growth will fall by two-thirds - a prolonged recession.

How much feasibly can Chancellor Darling offset this by increasing government borrowing over and above the operation of the automatic stabilisers during a recession - tax revenues falling and social security spending rising? To increase government borrowing by an additional two per cent of GDP - some GBP 30 billion - is the most which is practically possible. It would be helpful, but unless we stop the banks closing the funding gap we are sunk. Which is why Keynesians focus on monetary policy and the financial system as the principal swing factors at moments such as this. The Bank of England must cut interest rates from 4.5 per cent to 3.0 per cent next week as a minimum. Moreover, the government has to devise mechanisms to persuade the banks they can safely lend and reduce that funding gap slowly.

Most important is the introduction of schemes that insure the nominal value of loans, such as James Crosby's proposal to create a government insurance scheme for raising funds for mortgages. We need similar schemes for small firms' working capital requirements and larger firms' investment needs. I would create lending organisations as Roosevelt did in the 1930s. In the longer term, we need to develop a new insurance infrastructure to help banks - and borrowers - better manage risk. None of this will be delivered by market forces. Everything will have to be created by government.

For everybody, there is an event or book that changed their life. Mine was reading Axel Leijonhufvud's great exposition - On Keynesian Economics and the Economics of Keynes (1968) - twenty years ago. I had worked in the City and had experienced its dysfunctional short termism and wild fevers at first hand. Keynes was the economist who put it all together, the liberal who understood why free finance is capitalism's greatest enemy.

The State We're In (1995) was my attempt to devise a Keynesianism for our own times. I will stand by the heart of the book - deregulate financial markets and create a financial system that dominates business at your peril - to my last. But there was no constituency for reform ten years ago. Keynesians of my ilk were seen as irrelevant and wrong.

But now, with Keynes back in fashion, if we don't do Keynesianism right, we risk a very nasty recession indeed. The Chancellor used his Mais lecture last week to argue for a welcome pragmatism on fiscal policy and urged the Bank of England to do the same on monetary policy. He won't get far, though, unless he can directly change the banks' lending policies. We need him to become the complete Keynesian. There are only weeks left before the downward vortex becomes irretrievably deep. Read Leijonhufvud. And act.

Bill Totten


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