Keynes Figured it All Out a While Ago

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.


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  1. #1 by hazencage on November 16, 2011 - 6:16 pm

    Can you provide me with links that prove long term interest rates have been higher compared to previous eras? I was wondering because supposedly long term interest rates in America have remained at one percent for quite some time.

    • #2 by Unlearningecon on November 16, 2011 - 6:58 pm

      HI hazencage,

      I left out the evidence because I only have poorly taken photographs of books. It is incredibly hard to come by data on long term rates, and I plan to explore different cases on this blog as I find new data.

      I think you might be confusing the base rate – which Keynes regarded as largely irrelevant to his analysis – with the borrowing rates on long term corporate debt. I have a graph of U.S. corporate debt here:

      You can see that rates were low throughout the ‘golden era’ and have been higher since. Though they dip around 2001, they went straight back up again and expectations were never anchored downwards, which Keynes regarded as crucial. The repo market was also a significant source of funding in the recent crisis, something I plan to post about in the near future.

  2. #3 by solutions777 on November 16, 2011 - 6:39 pm

    Lets bottom line it: stupid people making bad economic decisions cause bad things to happen to their finances and to the economy, unless they work for the government, then nothing happens to them and very bad things happen to the economy. It is as simple as that.

    Want to cure the economy?

    Easy. Get the government out of the economy and make sure everybody is personally responsible for their own financial decisions. No bailouts, bankruptcies, etc. If a bank makes bad loans, their loss; if someone borrows more than they can repay, they are personally liable for all the debt. People need some fear of failure.

    Censorship is evil.

    • #4 by Unlearningecon on November 16, 2011 - 7:00 pm

      ‘Get government out of the economy’ is incredibly vague as they always have some role to play. Furthermore, the reality is that systemically important financial institutions cannot simply be allowed to go ‘poof’, even if that would be a nice idea. Whilst I agree that firms should have gone bankrupt, a completely passive approach would have left cash machines empty.

  3. #5 by charlesbarry on November 16, 2011 - 10:55 pm (run by Lawrence Officer of the University of Illinois) offers a good UK and US long-term interest rate time series. The methodology is fairly complicated, pulling in various federal, state and corporate bond yields over time to give a choice representative of the long term rates facing the economy.

    His data seem to match the source you cite above. Both nominal and real long term rates were lower from 1945 until 1970 than they are now.

    • #6 by Unlearningecon on November 17, 2011 - 3:40 pm

      Thanks a lot for that.

      EDIT: Long term rates on that site actually do not corroborate with the above graph. I’ll have to look into this.

  4. #7 by yorksranter on November 23, 2011 - 11:59 am

    Ha-Joon Chang makes a similar argument on the principle that if you let interest rates get too high, the only business propositions that can beat the spread are basically weird financial tricks and you’re very likely in Minsky stage 3.

  5. #8 by Blue Aurora on November 24, 2011 - 11:26 am

    Speaking of Keynes and Smith having figured it all out, I recommend reading this working paper by Michael Emmett Brady, which compares and contrasts Smith, Keynes, and Bentham on financial speculation.

    • #9 by Unlearningecon on November 24, 2011 - 12:52 pm

      Interesting, thanks.

      • #10 by Blue Aurora on November 24, 2011 - 2:32 pm

        You’re welcome. Have you heard of Michael Emmett Brady before this?

      • #11 by Unlearningecon on November 24, 2011 - 3:35 pm

        Yes I have seen his reviews one At first I concluded he was insane due to his writing style but he seems to know what he is talking about.

      • #12 by Blue Aurora on November 24, 2011 - 4:16 pm

        I’ve read his academic papers, and concluded that he is no fool either. I recommend reading this one, even if your mathematics is not at an advanced level. It’s well-written, well-presented, and makes a cogent argument that mathematicians and economists alike need to reconsider their views on Keynes’s approach to probability.

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