John Maynard Keynes

Presentation by Russell Baker, Caitlin Buckvold, Zachary Hanson, and Max Shaugnessy April 10, 2012

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Presentation Outline

Section I o Historical context, Keynes’ early life, career path • Section II o o o Major Works – Economic Consequences of the Peace, Treatise on Money

General Theory of Employment, Interest and Money Academic Influences

• Section III o Critiques of Keynesianism and modern applications

Section I

What factors influenced Keynes’ General Theory?

John Maynard Keynes “Ideas shape the course of history.”

• Life: June 5, 1883 – April 21, 1946 Born and raised in England • • • • Family: Father – Robert Neville Keynes Mother – Florence Ada Keynes Brother – Geoffrey Keynes. Knighted for work on blood transfusion, married granddaughter of Charles Darwin Sister – Margaret Keynes. Married Noble Prize winning Physiologist Early Life

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Florence Ada Keynes

Social Reformer and Mayor of Cambridge • Ran numerous charities: o o o Provided pensions for elderly living in poverty Provided services for “deserving” poor Reintegrated inmates back into society • Loving mother, devoted to Keynes

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John Neville Keynes

Economist and Lecturer in Moral Sciences at Cambridge University • • • “Positive Economy” “Normative Economy” “Art of Economics” • Loving father, devoted to Keynes

• Studied at Eton and King’s College, Cambridge o In 1904, earned B.A. in Mathematics • President of the Cambridge Liberal Club o Promoted redistribution of wealth o Favored government involvement in the economy • Member of Cambridge Apostles o Creepy, secret-society o Debating forum for members that included many prominent mathematicians and philosophers Keynes’ Life Education

• Clerk for India Office, 1906-1908 • Lecturer and Researcher on probability theory at Cambridge, 1909-1913 o o Published a series of articles on the Indian economy First book: Indian Currency and Finance, 1913 • Treasury, 1915 o One of the negotiators for terms of Versailles Peace Treaty Keynes’ Life 1906-1915

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World War I

Treaty of Versailles o o Britain, France, and USA responsible for negotiating terms of treaty with Germany Keynes working behind the scenes • Terms of Treaty o Astronomical reparations o Crippled German economy • Keynes’ Beliefs o o Reparations should be minimal Need to protect German citizens from starvation

5 0 15 10 20 25 Unemployment in Great Britain (1900-1950) Unemployment rates had an enormous amount of influence on Keynes’ arguments

• Treatise on Probability, 1921 o

First, large mathematical work by Keynes

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Becomes an investor and currency speculator

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Very wealthy by the end of the 1920s

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Advocates against the Gold Standard

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Believes that, to decrease unemployment, Churchill should devalue the British Sterling

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Continues to work as a lecturer at Cambridge University

Keynes’ Life 1920-1930

• Keynes loses most of his fortune after the Great Depression • A Treatise on Money, 1930 o Describes why unemployment persists at such high levels • Critical of British austerity measures during Depression, advocates for increased government spending Great Depression

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Britain abandons Gold Standard, 1931

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Keynes re-earns fortune through sales of the

General Theory and

currency speculation • Keynes’ health begins to fail • Economic Adviser to the British Government Keynes’ Life 1930s

• The General Theory of Employment, Interest and Money Keynes’ Masterpiece • Hugely influential across the world • Foundation of Keynesianism

• Keynes negotiates with USA to secure loans to Britain during wartime • Argues that the taxes should be increased and a mandatory savings rate established to pay for the War o Avoid inflation after War’s end • Keynes, now a Baron, takes a seat in the House of Lords among the Liberal Party • Advocates new monetary system after the War Keynes’ Life 1940s, World War II

• Established IMF and pre-cursor to the World Bank (International Bank for Reconstruction and Development) Bretton Woods • Establishes a world monetary system of fixed exchange rates tied to the US dollar

What factors influenced Keynes’ General Theory?

1. Family 2. Education at Cambridge 3. Government Service 4. World War I 5. Great Depression

“[With Bretton Woods]… we have shown that a concourse of forty-four nations are actually able to work together at a constructive task in amity and unbroken concord. Few believed it possible. If we can continue in a larger task as we have begun in this limited task, there is hope for the world.”

- John Maynard Keynes

Section II

Keynes’ Major Works

The Economic Consequences of the Peace

“If we aim deliberately at the impoverishment… nothing can then delay for very long that final war between the forces of Reaction and the despairing convulsions of Revolution, before which the horrors of the late German war will fade into nothing.” - John Maynard Keynes

• France o Wanted to set back German progress 50 years • United States o o Woodrow Wilson left Washington “enjoying a prestige and moral influence unequalled in history” In fact, weak-minded and not knowledgeable of European conditions • The French succeeded in achieving many of their demands

The Economic Consequences of the Peace

Versailles Conference Overview

• Treaty of Versailles, 1919, crippled German economy • Keynes’ proposals overlooked, considered controversial • Wrote The Economic Consequences of Peace in two months the following Summer of 1919 •

The Economic Consequences of

Peace was largely a critique of the Treaty of Versailles

The Economic Consequences of the Peace

The Treaty of Versailles Overview

• Europe cannot prosper without an equitable, integrated economic system • The Allies violated the Fourteen Points: a commitment fairness regarding reparations, territorial adjustments, and economic matters

The Economic Consequences of the Peace

The Treaty of Versailles Criticism

• Reparations were severe, exaggerated, and questionable • Inflation hit Europe hard, with Germany experiencing hyperinflation • Keynes attributed the hyperinflation to governments being too short-sighted to secure loans or taxes from resources they acquired, (and instead) have printed notes for the balance”

The Economic Consequences of the Peace

The Treaty of Versailles Aftermath

• Keynes claimed the Treaty did not include a rehabilitation plan to the European economy • Three key problems 1. Decline in Europe’s internal productivity 2. Breakdown of transportation and infrastructure 3. Inability to import goods and supplies from overseas

The Economic Consequences of the Peace

Europe after the War

• Keynes suggested a plan to help remedy the situation: 1. Revising the treaty and reparations 2. Abandonment of inter-ally Indebtedness 3. An international loan 4. European relations with Russia

The Economic Consequences of the Peace

Solving Europe’s Problems

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The Economic Consequences of Peace

became an immediate bestseller on both sides of the Atlantic • Solidified Keynes’ reputation as a leading economist • Public perceived Germany was being treated unfairly, resulting in public support for appeasement • Keynes predicted the next war would begin twenty years from 1919

The Economic Consequences of the Peace

Success and Influence

A Treatise on Money

• Published in 1930, written during the beginning stages of the Great Depression • A Treatise on Money professed his views on money, interest, and monetary policy • Many of his views were borrowed from his mentors, Alfred Marshall and Arthur Pigou

A Treatise on Money

Background

• Keynes’ introduced his theory that where saving exceeds investment, recession will occur • Keynes suggested that in order to stabilize the economy, the price level must first be stabilized • Government Central Bank  lower interest rates when prices rise, raise interest rates when prices fall • Many of his ideas are further developed in his future work,

General Theory A Treatise on Money

Monetary Policy

Classical Theory Keynes

• Critically acclaimed as a hard to read, and many of the concepts were a work-in-progress • Hayek wrote three reviews and critiques on A Treatise on Money • Their debates / critiques largely revolved around discrepancies in terminology, especially as it pertained to saving and investment models • Both were promising economists aspiring to develop economic models / theory

A Treatise on Money

Reception

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A Treatise on Money

served as a prequel to his greatest masterpiece – The

General Theory of Employment, Interest, and Money.

• Many fundamental concepts within

General Theory were

more polished ideas from A Treatise on

Money

A Treatise on Money

Legacy

The General Theory of Employment, Interest and Money

“It is astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics”

- John Maynard Keynes

• The General Theory was written during the Great Depression, published in 1936 • Keynes introduces the book with the radical claim that The General Theory is meant to contrast his arguments with those of classical theory of economics • Keynes claims that classical economics are applicable to only special cases, which “happen not to be those of the economic society in which we actually live”

The General Theory on Employment, Money and Interest

Book I

Introduction

• Classical theory of employment says the labor market is determined by supply & demand, where unemployment strictly caused by either frictional unemployment or voluntary unemployment

The General Theory on Employment, Money and Interest

Book I

Introduction • Doesn’t explain Great Depression o People must simply work for less?

• Classical Theory – supply creates its own demand. If there are people willing to work, jobs will be created to use them o Unemployed is a result of refusal to work

1. The real wage is equal to the marginal disutility of the existing employment;

The General Theory on Employment, Money and Interest

Book I

The Classical Assumptions 1. There is no such thing as involuntary unemployment in the strict sense; and 1. Supply creates its own demand (Say’s Law)

1. Workers and unions will protest nominal wage reductions, but not real wage reductions under the classical school o Inflation a better solution than wage cuts?

2. If wages decrease, cost of production decreases, then prices decrease  real wages stay the same • Keynes uses this example to criticize fundamental assumptions of classical economics

The General Theory on Employment, Money and Interest

Book I

A Critique of Classical Labor Model

• People earn money, then spend some of it – not all of it, resulting in “insufficient effective demand” • • Businesses hire based off how much they expect to sell o Spending determines employment, supporting the idea of unemployment The existence of “insufficient effective demand” will often result in less-than optimal unemployment levels, despite that marginal product of labor > marginal disutility of employment

The General Theory on Employment, Money and Interest

Book I

Effective Demand

• These two fundamental concepts left Keynes baffled as to how classical Ricardian economics is considered “complete” and “victorious”

The General Theory on Employment, Money and Interest

Book I

Criticism of Classical Economics • “It may well be that the classical theory represents the way in which we should like our economy to behave. But to assume that it actually does so is to assume our difficulties away.”

• Prospective yield: value of expected returns – cost of inputs and maintenance • Supply price: cost of manufacturer making new machine (replacement cost)

The General Theory on Employment, Money and Interest

Book IV

Marginal Efficiency of Capital Marginal Efficiency of Capital = prospective yield – supply price

• Increasing investment in capital has two effects: o Decreases prospective yield in the long run o Increases supply price in short run  Overall diminishing the marginal efficiency • •

Investment-demand schedule:

how much investment must increase to lower ME to a given level Investment will be pushed until ME (general) = market interest rate

The General Theory on Employment, Money and Interest

Book IV

Marginal Efficiency of Capital

• Changes in value of money affect expected yield Expect inflation increases attracting more investment  yield And vice versa • • • No way to predict long-term expected yields “Beat the gun” in stock markets Instability due to “animal spirits”

The General Theory on Employment, Money and Interest

Book IV

Marginal Efficiency of Capital

• Interest rates are the price people demand for parting with their money • Depends on: o liquidity preference (desire to hold cash) o money supply • Driven by bond market speculation o expected increase in r  hold cash now, buy bonds later • People believe saving lowers interest rates when really it lowers demand and increases unemployment

The General Theory on Employment, Money and Interest

Book VI

Interest Rates

Increases prices Increases liquidity preference

Increase MS

Decreases r Increases employment Increases investment

• Central bank can lower short term rates by printing money buying short-term government debt o US did this in Great Depression • To extend this to long-term rates, government should buy long term bonds • Larger amount of cash they seek to create by purchasing bonds/debt, greater the fall of r

The General Theory on Employment, Money and Interest

Book IV

Controlling the Interest Rate • Monetary policy seen as experimental will not delivery long-term reduction of r o it will only increase “precautionary motive” of holding cash

• Liquidity traps • Rates fall so low that everyone prefers holding cash and authority loses control over the rates • Hyperinflation – no one wants to hold cash • Crises – can’t get people to want to reasonably part with their cash

The General Theory on Employment, Money and Interest

Book IV

Problems with Controlling the Interest Rate

• For full employment, government keeps r down by printing money • More profitable to invest in things with lower yields • ME  zero (remember: ME = yield – supply cost) • No one would invest in anything anymore • Accumulation but no growth • The rentier disappears

The General Theory on Employment, Money and Interest

Book IV

Problems with Controlling the Interest Rate

The General Theory on Employment, Money and Interest

Book V

Changes in money-wages The employment function The theory of prices

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Classical argument: A

reduction in wages stimulates demand (due to reduced production costs)

The General Theory on Employment, Money and Interest

Book V

Money-wages, Chapter 19 •

Keynes’ rebuttal:

fixed This could only be true if aggregate demand is

• The profits realized by entrepreneurs as a result of lower production costs will be disappointing, and employment will fall back to its previous figure

The General Theory on Employment, Money and Interest

Book V

Keynes’ Analysis

Why the classical money wage theory doesn’t work

• The reduction of money-wages will have no lasting tendency to increase employment!

The General Theory on Employment, Money and Interest

Book V

Therefore…

• Propensity to consume • Schedule of marginal efficiencies of capital; (Expected income = Price of capital asset) • Rate of interest

Why?

• Demand • Investment

The General Theory on Employment, Money and Interest

Book V

Then which factors are related to increasing employment?

• • A flexible money policy is preferred because it is easier to implement Flexible wage policies would be unjust, wasteful, and disastrous

The General Theory on Employment, Money and Interest

Book V

Flexible Wage Policy v. Flexible Money Policy Which is preferred?

• If labor was in a position to affect change, then Trade Unions would rule monetary policy

• Short run: o Stable prices o Stable employment • Long run: o Prices fall slowly as a result of better technology, while wages remain stable o OR, wages rise slowly as prices stay stable

The General Theory on Employment, Money and Interest

Book V

Rigid Wage Policies Why does Keynes believe wages should be somewhat rigid?

• Quantity Theory of Money is not 100% right o Emphasis on money

demand

• Recent mathematical models are “mere concoctions”

The General Theory on Employment, Money and Interest

Book V

The Theory of Prices Chapter 21 • Deceptive simplicity to assume A  B.

• The long-run relationship between the national income and the quantity of money will depend on

liquidity preferences

o Psychology of the public

The General Theory on Employment, Money and Interest

Book V

Theory of Prices: A Generalization • The very long-run course of prices has always been upward

Section III

Modern application of Keynes & its critics

• First coined by Milton Friedman in 1965 • Later repeated by Richard Nixon in 1971 •

“I guess everyone is a Keynesian in a foxhole”

– Robert Lucas • Popular phrase following the financial crisis and subsequent bailouts “

We’re all Keynesians now

” “We’re All Keynesians Now”

What do modern economists think of Keynes?

• “How Did Economists Get It So Wrong?” by Paul Krugman • “How Did Paul Krugman Get It So Wrong?” by John Cochrane

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Saltwater v. Freshwater

Irrational market behavior, animal spirits Boost consumption & effective demand Return to Keynes. Fiscal stimulus, re-regulate finance • • • Efficient markets hypothesis Robert Barro’s Ricardian Equivalence The solution is not to “rehabilitate an eighty year old book”

Conclusion