Keynes Torpedoed by PBS

Gary North - July 22, 2013

Reality Check

Occasionally something happens that cheers me up enormously, but I find it utterly hard to believe that it happened. Such is the case with Benn Steil, who is a senior fellow and director of international economics at the Council on Foreign Relations

He has written a book about John Maynard Keynes and Harry Dexter White, two men with three names each: The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order. It is a great title and a great book. Why? Because it admits publicly what hard-core conservatives have said for over 60 years, and what Soviet-era documents revealed in 1997, namely, that White was a pro-Soviet ideologue, and maybe a spy. He was the U.S. Treasury's senior man at the Bretton Woods meeting in 1944. He and Keynes really did give the world the post-War monetary system: the IMF, the World Bank, and the dollar-based, post-War, gold-exchange standard, which Nixon killed on August 15, 1971.

When this comes from the senior economist at the Council of Foreign Relations, it's gospel truth in the American Establishment. That is why the book is so important.

Steil is a good writer. He understands the issues that Keynes dealt with. He understands the centrality of one idea throughout Keynes' career: his hatred of the international gold standard. In a recent article on PBS -- PBS!!! -- he explained this.

Keynes' first academic article, "Recent Economic Events in India," published in 1909 when he was 26, marked the true beginning of his enduring intellectual love affair with matters of money. Generating "statistics of verification" linking Indian price movements with gold flows put him into a "tremendous state of excitement," he wrote to painter Duncan Grant. "Here are my theories -- will the statistics bear them out? Nothing except copulation is so enthralling."

All that is missing here is the information that it was Duncan Grant with whom Keynes was copulating.

His first experience in government, as an official in the U.K. India Office, led to the publication of his first book, "Indian Currency and Finance," in 1913. Two broad themes emerged that would become constants in Keynes' thinking.

The first was that progress in global monetary reform consisted in the progressive diminution of the role of gold. Those who insisted that a reserve currency need take the form of a physical commodity were misguidedly backing "a relic of a time when governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century." . . . .

If "gold is at last deposed from its despotic control over us and reduced to the position of a constitutional monarch," Keynes pronounced with his trademark acerbic wit, "a new chapter of history will have opened. Man will have made another step forward in the attainment of self-government."

The second theme was that London was the natural hub upon which global monetary reform could and should be built.

Steil goes on to explain why Keynes's hatred of the gold standard was the central theme in his subsequent books, including The General Theory.

Setting out to synthesize his evolving post-war ideas on money, Keynes published "A Tract on Monetary Reform" in December 1923. The central argument of the book was that it was the demand for money, rather than its supply, that the monetary authorities should aim to stabilize. (When the proportion of their wealth people wish to hold in cash and bank accounts jumps around a lot, the economy itself becomes unstable.)

The most important implication of his argument, Keynes explained, was that the authorities should intervene actively and continuously to vary the supply of currency notes and the ratio of bank cash reserves to bank deposits. This was in marked contrast to the gold standard, the central villain of the peace in Keynes' telling, wherein the authorities behaved much more mechanically in response to movements in the monetary gold stock across borders: when gold flowed in, they loosened credit, and when it flowed out, they tightened credit.

Deflation was a natural periodic result of this mechanism and was more damaging to employment in an environment of growing union power and worker political participation. Central banking, Keynes believed, should now "be regarded as a kind of beneficent technique of scientific control such as electricity and other branches of science are."

Keynes wanted fiat money created by the central bank. This was the heart of Keynesian economics in 1923. The question is this: Was it the heart of The General Theory. Steil says it was. This is why his book is so important from the point of view of the history of economic thought.

Keynes acknowledged that the gold standard had performed admirably in the late 19th century, but insisted that conditions were decidedly different now. In particular, one of the many awful effects of the war was to transfer much of the world's monetary gold to the United States. There was more than a tinge of jealous nationalism in Keynes' assertion, however justified, that attempts to restore the gold standard, a "barbarous relic," would lead to a "surrender [of] the regulation of our price level and the handling of the credit cycle to the hands of the Federal Reserve Board," which had set up "a dollar standard ... on the pedestal of the Golden Calf."

The shift in financial power from London to New York and Washington, a threat to British financial independence and global influence, was to be a constant concern of Keynes, reflected even in his theoretical work, for the remainder of his career.

He hated the gold standard, and he also hated the idea that the United States was the new center of finance. I need to add this. The United States had a gold-backed currency. England did not in 1923. Churchill restored the gold standard in 1925, as Chancellor of the Exchequer, but he did so at the pre-1914 rate of exchange -- pre-World War I inflation. Gold then flowed out: it was a bargain (a fake low price in pounds). This was unsustainable. In 1931, England abandoned the gold standard.

The question of money -- its function, its history, its management and its psychology -- became an ever-deeper fascination of Keynes. This was clearly as much visceral and emotional as it was intellectual.

In a 1928 essay titled "Economic Possibilities for Our Grandchildren," he famously condemned the "love of money [as] a somewhat disgusting morbidity, one of the semi-criminal, semi-pathological propensities which one hands over with a shudder to specialists in mental disease."

Reflecting views that were not uncommon among his class at the time, he also saw this love as a particular pathology of a particular group: Jews. "I still think the race has shown itself, not merely for accidental reasons," he wrote to a polite American critic of his views, "more than normally interested in the accumulation of usury."

What's this? The beloved Keynes, a Jew-baiter? Will wonders never cease?

In 1927, his Treatise on Money appeared.

October of that year would see the publication of his first major tome: the two-volume "A Treatise on Money." A critical message of "Treatise," as Keynes saw it, was that a central bank (or, more specifically, the Bank of England, now that its dominant international role had been arrogated by the Fed) keeping monetary policy sufficiently tight so as to avoid the loss of gold reserves would wind up inflicting severe and lasting damage to domestic profits and employment owing to the endemic "stickiness" of certain prices.

That is, prices -- particularly wages -- failed to adjust downwards, as they should under classical economic theory. This Keynes believed, was largely the result of the resistance of organized labor to nominal wage cuts.

Why were trade unions able to resist natural wage cuts? Steil does not discuss this, yet it was the central economic fact of the Great Depression. The British government had granted monopoly protection to labor unions, so businesses could not legally fire union members who resisted wage cuts. Result: bankruptcies and unemployment. This was standard economic analysis in 1927. Nothing new here. But Keynes refused to blame government intervention for this situation. He wanted government intervention -- fiscal deficits and central bank inflation -- to offset its effects. What was true of Great Britain was true of Germany and the United States after 1933. Government-mandated price and wage floors made downward price flexibility illegal. Murray Rothbard offered the evidence of this half a century ago in America's Great Depression. The academic world ignored it.

One of the critical differences between Keynes and the so-called classical economists is that whereas the latter believed that labor market blockages could be overcome politically, and psychological quirks through market forces, Keynes believed that it was monetary policy itself that needed to adapt to the "natural tendencies" of society and the "system as it actually is."

Critical reviews of "Treatise" from the likes of Friedrich Hayek, the young, rising Austrian economist at the London School of Economics, and former student Dennis Robertson convinced Keynes not that he was misdiagnosing the problem but that he needed a radically different theoretical approach to defend his diagnosis.

He then wrote The General Theory (1936). The book is incoherent. Steil calls it "the unusual style." It was unusual for Keynes, surely. He was a master stylist. Read Essays on Biography. The unreadable style of the book is a tip-off that Keynes was utterly confused. The book's style reflects this confusion.

But the unusual style of "The General Theory" also made it difficult for even expert readers to separate out its "true" substance. It is only slightly outlandish to liken the book to the Bible: powerful in its message, full of memorable, mellifluous passages, at times obscure, tedious, tendentious and contradictory, a work of passion driven by intuition with tenuous logic and observation offered as placeholders until disciples could be summoned to supply the proofs.

Sadly, Hayek refused to write a reply. As he said decades later, he had spent a lot of time critiquing Keynes' book on money, only to have Keynes dismiss the book, saying that he no longer believed it, and he was writing another. (Anyway, this was one explanation that Hayek offered decades later. There were others.) This was a catastrophic misjudgment on Hayek's part. The academic world figured he could not refute it. Steil does not mention this.

The central argument of the book was revolutionary (at least to economists): the economy had no natural tendency towards full employment. High unemployment could persist indefinitely if governments did not intervene forcefully to boost consumption demand. Cheap money provided by the central bank was not enough.

This was wholly contrary to classical economics, which held that protracted involuntary unemployment was a result of some interference in the workings of the price mechanism. Classical economics showed that full employment required flexible wages; Keynes showed why, with different assumptions, falling wages could actually worsen unemployment. These different assumptions were related to the nature of money, human psychology and conventions of contemporary society. Each of these on its own would do for his argument; he was not that particular.

"Keynes showed why, with different assumptions, falling wages could actually worsen unemployment." Keynes showed no such thing. Governments used the threat of violence to create price floors. The market responded to price floors as it always does: with unemployment. There was nothing new here, but the "new economics" taught otherwise, beginning in 1936. This led to what Steil calls the New World Order at Bretton Woods. It did, indeed. Steil is saying what Austrian school economists have said for 60 years.

Such a brazen treatise would have gotten a much colder reception during the American boom years of the 1920s, but in the midst of a Great Depression, with unheard-of levels of unemployment, it was compelling even to economists who disagreed with Keynes' logical apparatus. In the United States, the book held particular appeal as an intellectual justification for controversial New Deal policies. If today it seems natural to most policymakers that governments should run deficits in recessions to stabilize the economy, it was far from a natural notion in the 1930s; it was Keynes who made the prescription intellectually respectable.

Steil then offers an insight that is crucial to understanding the failure of The General Theory. Keynes focused on fiscal policy: national government deficits. But, in fact, he was still stuck with his monetary theory in A Treatise on Money. This is what Hayek did not see, and why his silence was so costly to liberty.

Here is the historical crucial fact, long ignored. It was not Hayek, but Jacques Rueff who spotted the flaw.

Keynes had struggled for years since his repudiation of the intellectual apparatus of "Treatise" to induce a compelling theoretical cause for his burning belief that investment could, even under flexible prices, fail to harmonize with savings in a way that would maximize aggregate income. In "The General Theory," he believed he had found it. It was the concept of "liquidity preference," or the idea that people might choose to hoard inert cash rather than consume or invest the fruits of their labor. The conviction that "money is the root of all evil," Keynes biographer Robert Skidelsky observed, "is almost a sub-text of the 'General Theory.'" Liquidity preference was the theoretical kernel that seeded Keynes' new thinking about global monetary reform. For Keynes' French nemesis during the debate on German war reparations, Jacques Rueff, who would go on in the 1960s to be a leading critic of Keynes' (and American Harry Dexter White's) World War II monetary reform blueprint, liquidity preference was not only the nub but the fatal flaw of "The General Theory" edifice.

Critiques of "The General Theory" are many and disparate, but Rueff was surely right to see Keynes' account of the workings of the monetary system as the crux of his case against classical economics. In a Quarterly Journal of Economics article published a year after Keynes' death in 1946, Rueff showed why, logically, "the demand for additional cash holdings," or what Keynes called derisively "the propensity to hoard," had to be "equivalent in its economic effects to demand for consumption goods or investment goods." If Rueff was right, Keynes had failed in his attempt to move beyond "Treatise" and to establish a theoretical foundation for his bold policy prescriptions.

Stell nails it: "Rueff argued that Keynes' monetary and fiscal policy prescriptions had no sound basis. On the contrary, their inevitable result down the road would be inflation and a private productive apparatus less able to supply the goods and services people actually want."

He does not mention that Rueff was Charles de Gaulle's economic advisor. It was Rueff who persuaded de Gaulle to start pulling France's gold from the U.S. Treasury (by way of the gold vault at the New York Federal Reserve Bank) in 1965.

In April 1969, my article appeared in The Freeman: "Repressed Depression." It was a critique of central bank inflation as a cure for recession. I said this would lead to price inflation. A few weeks after it appeared, the editor of The Freeman, Paul Poirot, received a letter from Rueff. He told Poirot that he thought my article was first-rate. That was the only time a major economist ever sent a fan letter for something I wrote. (I'm still hoping for another.) It was not until I read Steil's article that I realized why Rueff liked it. It had been Rueff's position 22 years earlier.

When the senior economist at the Council on Foreign Relations writes a book like Steil's and articles on PBS to summarize its findings, we can be sure that something new is blowing in the wind.

Let us hope that, before too long, Keynesianism is gone with the wind.