I regard it as a tragedy that even prominent Keynesians think Keynes had little to say about the cause of busts other than ‘Animal Spirits’. Keynes was incredibly clear on why downturns – particularly severe ones – took place:
I see no reason to be in the slightest degree doubtful about the initiating causes of the slump….The leading characteristic was an extraordinary willingness to borrow money for the purposes of new real investment at very high rates of interest – rates of interest which were extravagantly high on pre-war standards, rates of interest which have never in the history of the world been earned.
Adam Smith shared this view, and offers a typically readable, if lengthy, explanation of why it leads to problems:
The legal rate, it is to be observed, though it ought to be somewhat above, ought not to be too much above the lowest market rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into the those which were most likely to waste and destroy it. Where the legal rate of interest, on the contrary, is fixed but a very little above the lowest market rate, sober people are universally preferred as borrowers to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people, then in those of the other. A great part of the capital of the country is thus thrown into the hands in which it is most likely to be employed with advantage.
Keynes formulated a rigorous theoretical explanation for this, applying the concept of irreducible uncertainty – risks to which we are unable to assign a probability – to economics. According to Keynes, investors were inclined to hold cash rather than invest it in bonds, as the former was more liquid and hence responsive to unforeseeable events. The interest rate was thus the premium offered for parting with this liquidity, and in a world of uncertainty would probably be too high to approximate full employment, which he considered the ‘special case’ of neoclassical economics, as opposed to his ‘General Theory’.
Consequently, the monetary authorities were required to intervene to keep it permanently low to encourage sustainable investment. High rates both discouraged investment and forced those who borrowed into more speculative and risky endeavours. Keynes considered speculation a significant source of inflation, and thus low rates killed two birds with one stone. International stabilisation, particularly capital controls, was required for governments to maintain low rates in their own currency.
Keynes was, unfortunately, incredibly naive in that he was primarily concerned with communicating his ideas to policymakers rather than students, fellow academics or the general public. He managed to establish the BW system and encouraged governments around the world to adopt a policy of low long term rates. Rates in the UK fell to a steady 2-3% at the end of WW2, which is why unemployment was incredibly low, despite an austerity program even more vicious than today’s. This stability – including low inflation – continued until BW was dismantled in the 1970s, and as stagflation set in ‘Keynesian’ economics was abandoned. Since then, long term rates have been far higher and, unsurprisingly, growth and employment have been lower and more unstable.