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The world still can learn from Keynesian economics

Reagan-like faith in efficient markets set the stage for the financial meltdown

November 23, 2009|Michael Hiltzik
  • John Maynard Keynes recognized the notion that the market could be left to regulate itself was flawed.
John Maynard Keynes recognized the notion that the market could be left… (Associated Press )

Great crises have a way of reminding us that acting as though we know perfectly well what the future holds almost always leads to disaster.

That's especially true in economics, which tends to underscore the murkiness of the real world by dealing out surprises one after another -- booms, crashes, bubbles, you name it.

It's fitting, therefore, that the recent economic meltdown has begun to restore that great apostle of uncertainty, John Maynard Keynes, to his rightful position of influence in economic thought.

"Keynes asked why financial markets are inherently unstable," Robert Skidelsky told me the other day. "His answer was that we don't know what the future will bring. He talked about the inherent precariousness of knowledge, that when we estimate the future we're only disguising our ignorance."

If that sounds obvious, keep in mind that the financial disaster of recent times was born in the hubris that the financial markets are nearly flawless machines for assessing risk and that government regulation would make them inefficient.

Skidelsky is a British economic historian whose three-volume biography of Keynes came out on these shores from 1986 to 2001. We had a chance to talk last week while he was visiting the U.S. to promote his latest work, "Keynes: The Return of the Master," published in September, which aims to spotlight the relevance of Keynesian economics for modern times.

He argues that it's impossible to miss the connections: For one thing, the banking and credit collapse of recent years stems from precisely the same economic mistakes Keynes saw in the 1920s.

For another, the government stimulus programs that have stemmed the worldwide decline and begun the process of recovery are based on his precept that when confidence is shattered in the private investment market, the only remedy is "state intervention to promote and subsidize new investment" -- presumably by deficit spending.

"The most positive difference between now and the Depression," Skidelsky says, "is that we have Keynes' writing, so that governments didn't repeat the mistake of the early '30s of cutting their own spending when private spending was falling."

Keynes (1883-1946) is sometimes described as not an economist so much as a moral philosopher. His intellectual affinity was less toward bankers than artists -- he was part of the literary Bloomsbury Group, among whose most famous members were Virginia Woolf and E.M. Forster.

Yet he was the antithesis of the ivory tower intellectual. His ideas emerged directly from his experience running a sort of proto-hedge fund speculating in currencies and commodities between the world wars. In the process he experienced his share of personal ups and downs. He made healthy profits in 1920 by shorting the mark, franc and lira, but lost heavily in a highly leveraged bet against the pound when the Bank of England raised interest rates.

Keynes' Bloomsbury friends were among those he wiped out. But he recovered and made good some of their losses. He lost a second fortune in the Depression, but made it all back, and more, buying at the lows during the '30s. At his death in 1946, Skidelsky writes, he was worth about $20 million in today's terms.

"The instability of the financial markets was a crucial experience for him as a thinker and as a player," Skidelsky says.

The hallmark of Keynes' thought was the recognition that the efficient-market theory -- the notion that the market synthesizes all that is known and that needs to be known about current conditions and that it therefore can be left to regulate itself -- is flawed.

"If you have a self-regulating market," Skidelsky explains, "you don't have crashes like this. You don't have great contractions."

Keynesian economics and its implicit warning that the free market has inherent limitations and therefore demands regulation remained in vogue from World War II until the mid-1970s, followed by its nearly complete abandonment by British Prime Minister Margaret Thatcher and President Ronald Reagan in the 1980s.

Many of the problems that developed since then derived from the assumption that risk can be predicted, measured and accurately priced.

Banks were allowed to enter the securities businesses because surely they know how to manage risk. Subprime mortgages were packaged into securities, so investors could buy just as much risk as they thought they could handle. The outsized bonuses pocketed by derivatives traders were based on the idea that the profits for which they were rewarded were riskless -- that is, they wouldn't backfire down the line.

The uncertainty of real life eventually, and inevitably, came back to bite them where it hurts. (It's the rest of us who bear the tooth marks.)

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