John Maynard Keynes with fellow member of the Bloomsbury Group Duncan Grant. Photo: Wikipedia John Maynard Keynes with fellow member of the Bloomsbury Group Duncan Grant. Photo: Wikipedia

In the first part of our series considering the merits and pitfalls of Keynesian economics, Dominic Alexander looks at the history of Keynes’ contribution

The Limits of Keynesianism series:
Part One: John Maynard Keynes and Orthodox Economics
Part Two: The Assumptions Keynes Makes
Part Three: Marx, Keynes and the Analysis of the Trade Cycle
Part Four: The Keynesian Attack on the Labour Theory of Value
Part Five: can the working class advance within capitalism?

Economics as a profession was profoundly embarrassed by the financial crisis of 2008, and its standing has been further diminished by the ongoing new ‘Long Depression’, which was unforeseen by its orthodox practitioners. Demands for a widening of perspectives and approaches in the profession have not, as yet, made for noticeable breakthroughs in elite thinking about alternatives to the neoliberal model of capitalism.As Larry Elliott in The Guardian argued:

Since the financial crisis broke 10 years ago, policymakers have viewed the disruption as a temporary phenomenon. Growth would pick up. Productivity would rise. Inflationary pressure would increase. Interest rates would return to more normal levels. It hasn’t happened.

The impasse in economic theory and practice today is not unlike that over eighty years ago when capitalism went into its last great crisis, during what came to be called the Great Depression, taking over the moniker for the earlier depression of the late nineteenth century, which then became known instead as the Long Depression.

These periodic great crises, and other problematic periods, such as the ‘stagflation’ of the 1970s, go against one of economics’ most cherished orthodoxies, that capitalism in its purity is a stable system. As long as there are not any outside de-stabilising influences, such as government intervention, then capitalist markets will ‘return to equilibrium’. It was this assumption that informed the American President Hoover in the early 1930s, famous for the emergence of ‘Hoovervilles’, mass encampments of the unemployed, under his watch. It is perhaps the memory of the disaster of the 1930s which led to US governments after 2008 pursuing mildly reflationary policies (at least in comparison to the British Tories’ insistence on uncompromising austerity). The very vocabulary which is now used to describe a government which intervenes to boost the economy during a downturn, goes back to the new economic theory which emerged from the Great Depression, that of John Maynard Keynes.

J.M. Keynes himself came of age as an economist in the period after ‘neoclassical economics’ was born at the end of the nineteenth century. Although Keynes and Keynesianism are often seen as the opposite of the neoclassical school of economics, his thinking grew out of precisely that context. In the period after World War Two, forms of Keynesian policy became the standard repertoire of governments to manage their economies up to at least the late 1970s. A variant of Keynesianism returned after 2008 with such policies as ‘quantitative easing’. In the 1960s, it was reported that even Milton Friedmann had said that ‘we are all Keynesians now’, although he himself claimed to have been somewhat misquoted. Nonetheless, the sheer currency of the phrase is a good indication of the status Keynes had at the time.

Marginalism: aquatic economists

Despite this history, Keynesianism has never dominated the profession of economics, which has remained focused on marginalist theory. The concept of ‘marginal utility’ emerged in the second half of the nineteenth century, developed by William Jevons among others. While its elaboration is often described as the ‘marginalist revolution’, it has not generally impressed Marxists with the profundity of its insights into the nature of the capitalist economy. Very simply, it posits that the value of a commodity to the consumer depends upon the quantity already possessed, so that the additional (‘marginal’) value of the acquisition of each additional unit will decline in a quantifiable manner. This reflects back on the producer who has to consider the marginal efficiency of capital in investing in each additional unit of production.

This conceptual move was important because it allowed economics to become a highly technical endeavour, where sophisticated statistical applications could dominate the research agenda. Simply applying precise numbers to the abstract marginal values allows all sorts of hypothetical as well as empirical calculations to replace the more problematic analysis of value carried out by the classical economists. If this seems like an unwarranted assault on the integrity of a profession, then consider what an eminent economist himself has to say about the state of his profession in the years before the great crash of 2008.

James K. Galbraith (son of the famous American liberal economist John Kenneth Galbraith), sees academic economics as so dominated by mathematical modelling, proceeding from the concept of marginal utility, that all practitioners of discipline can be divided into ‘freshwater economists’ and ‘saltwater economists’. Both of these groups of economists use mathematical models to prove their propositions, but the later sort allow a modicum of ‘salt’, that is to say, messy reality, into their equations, while the former prefers to keep their calculations pure:

Economists using mathematical expressions to decorate arguments about the perfection of market systems may believe that their work is beautiful … The main purpose of the math is not to clarify, or to charm, but to intimidate. And the tactic is effective. An idea that would come across as simpleminded in English can be made “impressive looking” with a sufficient string of Greek symbols. A complaint about the argument can be deflected, most easily, on the ground that the complainer must not understand the math.[1]

Here, James Galbraith is also unpicking a fundamental tenet of the profession, which is the commitment to the ‘dynamic stochastic general equilibrium approach’. This mouthful concerns the assumptions economists make in order to predict economic developments through manageable sets of calculations. Boiled down, it requires that in their models, all actors are identical, and all behave ‘rationally’ with perfect access to information about the market. Thus:

the economy can be modelled as though there were just one person in it, predicting the future with foresight based on an accurate model, as much calculating power as required, and subject only to random (hence unpredictable) shocks and errors.[2]

A consequence of this approach is that any crisis in the system cannot be due to anything inherent in the nature of capitalism, or ‘the market’, but must be a meaningless accident, and so, if left alone, the market will restore itself to equilibrium. A major follower of Keynes, Hyman Minsky, is said to have rejected neoclassical economics because ‘in its core models, a depression is an impossibility.’[3] The intellectual desert of this kind of thinking does mean that it is difficult for its inhabitants to conceive of alternative ways of thinking, even when confronted with the reality of an ongoing worldwide economic crisis. It seems that little has been learned since Hoover’s time after all.

Nonetheless, marginalism has continued to perform another valuable service to bourgeois economics ever since the nineteenth century, and this was to enable it to escape the increasingly intractable problems of classical political economics. Marx was the culmination of that tradition, and working on the basis of bourgeois political economists, most notably David Ricardo, he showed that capitalism was inherently prone to crisis, and riven with dangerous contradictions. The ‘marginalist revolution’ was the basis for neoclassical economists to be able to declare that Marx was old-fashioned, outdated, and dismissible. Marginal utility theory was, however, just an evasion of the issues. It did nothing to answer any of the problems raised by Marx’s analysis. Even so, there was now a new way to approach economics, so old concerns could be dismissed out of hand.

The failure of equilibrium

Events were soon to disturb the complacency of economists, with the disruption of the First World War, and, for Europe in the 1920s, the uncertain recovery from that cataclysm, soon overtaken by the crash of 1929 and the Great Depression. Keynes’ economic thinking took place in this context, with the added concern of Britain’s evident decline from world power status, giving way to the new strength and dynamism of the United States.

His first notable contribution was ‘The Economic Consequences of the Peace’, in which he attempted to warn against the harsh peace imposed on Germany by the Versailles Treaty. He pointed out that attempting to extract huge money payments from Germany, reparations, would not be possible unless Germany’s exports increased commensurately to provide the requisite foreign currency. This could only occur at the expense of the other power’s exports, so they would not be gaining anything.[4] Later, he would criticise Britain’s decision to attempt to retain the gold standard for sterling, showing again a willingness to criticise standard thinking, with a particular focus on monetary issues.

It was not, however, until the impact of the Great Depression had worked itself through his thinking that Keynes made really major contributions to economics. His new thinking culminated in the work the General Theory of Employment, Interest and Money. It is still debated how far this new theory challenged existing economics, with some Keynesians wanting to claim that his theory was compatible with orthodox assumptions. However that may be, the key advance in Keynes’ new theory was to disprove the old assumption that the market would always return to an equilibrium of full employment. Keynes argued that, in fact, capitalism could come to an equilibrium with high unemployment, and relatively low investment and usage of existing productive forces. Capitalism under laissez-faire conditions could no longer be assumed to deliver the best results for society.

In addition to that argument, Keynes did also break to some extent with the methodological individualism of orthodox economics. With the thrift paradox, for example, he showed how a virtue at the individual level could become a social ill. For an individual to save is an act of prudent restraint, but too much saving in the economy overall will lead to a decline in consumption, or effective demand, and this will lead to a decline in production, and then higher unemployment. Aggregated thrift becomes harmful to the economy.

One of the central experiences of the Depression was explained by this insight.The classical argument, that a fall in wages increases employment since the marginal cost of labour becomes cheaper, turned out not to hold true. In fact, the imposition of austerity during a downturn only accentuates economic decline. Keynes pointed out that the argument from a part to the whole, or from the individual perspective to the totality, is absolutely flawed. Thus, in this case, the classical argument ran that if a factory cuts the wages of its workers, it will be able to sell its product more cheaply. Thus, larger quantities will be sold, and the factory will be able to employ more workers.[5]

This will hold true of an individual producer assuming that the wages of other workers in the economy are not also reduced. However, the flaw in the classical argument was, and is, precisely to scale up from the individual to the general, without considering that different dynamics govern the different levels of analysis. Thus, at a general level, if firms reduce the wages of their workers, then the total aggregate demand in society will fall, reducing demand for everyone’s products.

This is a lesson that needs to be applied generally in the analysis of capitalism, and even of societies across the board. Actions that may have a certain logic at the level of individual behaviour, have very different effects at the level of the totality. It is an important aspect of Keynes’ economic thinking that he was able to perceive this problem, which is referred to as the ‘fallacy of composition’.[6] Indeed, it leads to important policy prescriptions at the heart of the Keynesian response to the Great Depression: do not react to a downturn with cuts in government spending.

In response to collapsing aggregate demand in the economy, the state must absolutely not respond to the fall in its own income (through the fall in tax receipts, as economic activity collapses) with austerity. The effect of fiscal austerity will be a severe deepening of recession, as Germany found to disastrous cost in the early 1930s. Rather, the state must spend money to stimulate demand; only state spending can lift the economy out of the downward spiral. Declining demand leads to collapsing production, which raises unemployment, leading to even less demand, and so on. Prudent economic behaviour at the level of the household precisely does not scale up to the level of the state.

If the ‘fallacy of composition’ is a key insight of Keynes, it remains only a partial one. Keynes did not go on to examine capitalism in a fully dialectical way, grasping the contradictory dynamics of the parts and the whole, as Marx had done before him. Rather, Keynes remained wedded to an essentially empirical ‘common sense’ approach, in which the simple relations of ‘supply and demand’ remained his essential analytical tool. The result is an impressive, indeed crucial system of economic analysis and policy, but a contradictory one also.

Keynesianism can be both highly critical of capitalism, and yet committed to maintaining it. It contains essential insights which can lead to important reforms within the system to the benefit of working people, and yet elements which encode a surrender to the interests of capital at crucial moments. Picking apart these elements of Keynesianism requires an extended discussion of its theory and application since the 1930s, before a balanced assessment can be made of its use to the greater project of the emancipation of labour.

This is the first in a five-part series, which will be published weekly. Part two is available here

[1] James K. Galbraith, The End of Normal: The Great Crisis and the Future of Growth (London 2014), p.67.

[2] Ibid. p.68.

[3] Steve Keen, Debunking Economics: The Naked Emperor Dethroned? (London 2011), p.17.

[4] The French actually got around this problem in 1923, during the occupation of the Ruhr, by simply appropriating commodities like coal, and giving them over to French industry, thereby forcing Germany to pay reparations, ‘in kind’.

[5] John Maynard Keynes, The General Theory of Employment, Interest and Money in The Essential Keynes, ed. Robert Skidelsky (London 2015), pp.241-2.

[6] Skidelsky, The Essential Keynes, p.xxix, p.240

Dominic Alexander

Dominic Alexander is a member of Counterfire, for which he is the book review editor. He is a longstanding activist in north London. He is a historian whose work includes the book Saints and Animals in the Middle Ages (2008), a social history of medieval wonder tales, and articles on London’s first revolutionary, William Longbeard, and the revolt of 1196, in Viator 48:3 (2017), and Science and Society 84:3 (July 2020). He is also the author of the Counterfire books, The Limits of Keynesianism (2018) and Trotsky in the Bronze Age (2020).

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