Keynes and the Market Part 2

By the late 1920s, Irving Fisher was America ' s most famous economist and . nancial pundit - a man who, like Keynes, achieved distinction in both academia and business.A professor of economics at Yale University, Fisher became a multimillionaire after his Index Visible Company, producer of an early version of the Rolodex, merged with Rand in 1925, with Fisher becoming a major shareholder in the new ent.i.ty. In his unique position as theoretician, entrepreneur, and market player, Fisher was a shaman of the stock market, called upon at regular intervals to read the auguries of Wall Street - especially when the great G.o.d Market seemed restive and disobliging.

Fisher was Wall Street ' s Pollyanna, always ready to offer a rea.s.suring comment or upbeat prognostication to the investing congregation. His great friend, but professional nemesis, was the securities a.n.a.lyst

Roger Babson, dubbed " the Prophet of Loss " by New York newspapers. Babson had presaged a stock market correction since 1926, but, like his fellow unbelievers, had been dismissed as little more than a " sandbagger of American prosperity " by most market watchers. However, on September 5, 1929 - just two days after the Dow Jones Industrial Average had recorded an all - time high of 381.2 points - Babson ' s apprehensions . nally found an audience. In a speech to group of businessmen, he warned: Sooner or later a crash is coming, and it may be terri. c . . . factories will shut down . . . men will be thrown out of work . . . the vicious circle will get in full swing and the result will be a serious business depression.

Wall Street fell around 3 percent that day, and the " Babson break " marked the beginning of six weeks of erratic trading.

Fisher, unsurprisingly, disputed Babson ' s dark and destabilizing predictions. In mid - October 1929, less than a fortnight before the Great Crash, the Professor stated, " Stock prices have reached what looks like a permanently high plateau . . . I expect to see the stock market a good deal higher . . . within a few months." His effort to quell the bears was, however, unsuccessful. On the morning of October 24, 1929 - " Black Thursday," as it later became known - the Wall Street bubble was p.r.i.c.ked. Panic selling gripped the exchange in the morning, the . nancial hemorrhaging staunched only when a cabal of in. uential bankers ostentatiously stepped on to the trading .oor, brandishing a pocketful of buy orders.

The intervention a.s.suaged skittish investors, but only temporarily. Although the weekend break provided a respite from the gyrations of Wall Street, distance from the market also afforded a disturbingly grim vista to spooked shareholders. " Black Monday," October 28, was a .nancial bloodbath. The Dow Jones index fell by almost a quarter in a single day - the largest one - day decline in Wall Street ' s history - and in some cases only a lack of buyers arrested the precipitate fall in stock prices. The following day - maintaining the swarthy theme, " Black Tuesday " - witnessed another calamitous decline, this time by a further 13 percent. In that last week of October, stock ticker machines - overwhelmed by the unprecedented trading volume and disgorging tape long after the market had closed - tapped out a staccato requiem for the Great Bull Market of the 1920s.

Nightmare on Wall Street Some of the people I knew lost millions. I was luckier.All I lost was two hundred and forty thousand dollars . . . I would have lost more but that was all the money I had.

-Groucho Marx, GROUCHO AND ME Irving Fisher, that unconquerable optimist, naturally imparted a sanguine spin to the October meltdown. He attributed the severe decline in the Dow Jones index to a " shaking out of the lunatic fringe " and in November 1929 volunteered the opinion that " the end of the decline of the Stock Market will probably not be long, only a few more days at most." In early 1930 he again tried to convince the market - and, in light of his ma.s.sive exposure, perhaps himself - that " for the immediate future, at least, the outlook [for stocks] is bright." Many others shared Fisher ' s dogged optimism - even Wall Street ' s archrealist, the . nancier Bernard Baruch, felt con.dent enough by mid - November to cable Winston Churchill with the unequivocal message that the " . nancial storm [has] de. nitely pa.s.sed."

For a while, it looked as if the black days of late 1929 had indeed been nothing more than a pit stop on the road to prosperity. Wall Street was unusually volatile in the wake of the October tempest, but the overall trend was positive - by April 1930 the Dow Jones index was almost 30 percent above the depths plumbed six months earlier. But these brief .ares of con.dence turned out to be no more than " suckers ' rallies," the last instinctive convulsions of a dying market.Wall Street resumed its descent in mid - 1930, and by 1932 the Dow Jones Industrial Average stood at a miserable 41.2 points, a drop of almost 90 percent from its September 1929 peak. It would be a quarter of a century before the Dow Jones again reached the heights scaled during the Roaring Twenties.

Irving Fisher, like myriad other speculators and investors, was wiped out. He and his immediate family had borrowed money to buy additional Rand shares at the bull market ' s pinnacle, and his son later estimated Fisher ' s loss at around $10 million, well over $100 million in present - day terms. Fisher ' s insolvency obliged Yale University to buy his house and rent it back to him, with Fisher often unable to pay his new landlord. He came to the attention of the IRS for nonpayment of tax, and was forced to borrow money from his wealthy sister - in - law. As a neocla.s.sical economist whose professional interest was the study of rational markets, he was, for the remainder of his life, the b.u.t.t of never ending jokes for his na ve faith in ever - ascending stock prices.

Prophet Warning Wall Street did have a go yesterday. Did you read about it? The big- gest crash ever recorded . . . I have been in a thoroughly .nancial and disgusting state of mind all day.

-Keynes to Lydia, October 25, 1929 In contrast to his American confrere, Keynes had substantially reduced his exposure to the stock market prior to the Great Crash of 1929. This move was not, however, attributable to any superior foresight on Keynes ' account. Rather, his " terrifying adventures " on the speculative markets - this time, the commodities market - had once again brought him undone. In 1928, after several years of pro.table trading, Keynes ' positions in the rubber, corn, cotton, and tin markets turned against him, and he was obliged to liquidate the bulk of his equities to cover these losses.The stock exchange upheavals of late 1929 then exacted a heavy toll on what little remained of Keynes ' stock portfolio: his main holding - the Austin Motor Car Company - lost over three - quarters of its value in the .nal two years of the 1920s. In aggregate, Keynes ' net worth declined by more than 80 percent over this period - from 44,000 at the start of 1928 to less than 8,000 two years later - and, for the second time in his life, he found himself poised on the precipice of . nancial ruin.

Despite the a.s.sault on his wealth, Keynes initially shared Fisher ' s con.dence that the events of late 1929 were mere " corrections." He a.s.sured readers of the New York Evening Post the day after Black Thursday that " commodity prices will recover and farmers will . nd themselves in better shape." However, by as early as November 1929 his view on the situation had darkened considerably. Keynes thought that a major economic downturn was imminent and recommended to his fellow directors that the Independent Investment Company, which was heavily invested in Wall Street, sell its securities and repay outstanding debts. By May 1930, Keynes was broadcasting his bleak message to a much wider audience: The fact is - a fact not yet recognized by the great public - that we are now in the depths of a very severe international slump, a slump which will take its place in history amongst the most acute ever experienced. It will require not merely pa.s.sive movements of bank rates to lift us out of a depression of this order, but a very active and determined policy.

The Canary in the Coal Mine It was borrowed time anyhow - the whole upper tenth of a nation living with the insouciance of grand dukes and the casualness of chorus girls.

-F. Scott Fitzgerald, ECHOES OF THE JAZZ AGE The events of October 1929 were in fact an early symptom - rather than the cause - of a far more malignant malady.The Wall Street sideshow had diverted attention away from unsustainable imbalances within the wider community - as the economic historian Robert Heilbroner noted, just prior to the Crash, " some twenty - four thousand families at the apex of the social pyramid received a stream of income three times as large as six million families squashed at the bottom." Credit had largely been channeled away from the real economy and into . nancial speculation and conspicuous consumption, and while easy money stoked the speculative inferno of the late 1920s, farmers and other primary producers struggled with poor prices and mounting debts.

The gilded mansion of American prosperity proved to be top heavy and teetering, perched precariously on the sandy foundations of installment credit and margin loans.The tremors on Wall Street had .nally brought down this house of cards.There were foreclosures, runs on banks, and, ultimately, ma.s.ses of men laid off. By 1933, a quarter of the United States work force was unemployed, industrial production was only half that of 1929, and real income per capita had fallen to levels not seen since the start of the century. Over 5,000 banks had gone to the wall and " Hoovervilles " - shanty towns of the dispossessed - scarred the country, like open sores on the body politic.

The Wall Street contagion quickly spread beyond American frontiers, the web of obligations arising from the Versailles settlement entangling nations and frustrating their best efforts to quarantine the growing .nancial pandemic.Worse still, in a Canute - like effort to hold back the deadening tide, Western governments sought refuge behind ever - higher trade barriers. In dismantling the structure of free trade, the developed world was slowly dismembering its golden goose - this protectionist race to the bottom halved the volume of international trade in the four years following the Crash. Deprived of the oxygen of commerce, the world swooned into a state of near - paralysis.

Carpe Diem But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is .at again.

-Keynes, A TRACT ON MONETARY REFORM With increasing urgency, Keynes exhorted governments to act decisively to wrest the Western world from " the bog " into which it had sunk - " Activity and boldness and enterprise," he told a radio audience in early 1931," must be the cure." His pleas were, however, largely ignored by the pract.i.tioners of sound .nance. Conventional wisdom counseled a policy of " liquidationism " - letting the hard times " purge the rottenness out of the system," in the words of Andrew Mellon, then the United States Secretary of the Treasury. These high priests of orthodox .nance argued that the slump was no more than a rather spectacular manifestation of the " business cycle " which coursed through all developed economies, and that, ultimately, the Western world would right itself and full employment be restored.

Business cycles had long been viewed as an inevitable feature of advanced societies. The .rst recorded economic forecast had, after all, been Joseph ' s prediction of seven years of plenty followed by seven years of famine in Pharaonic Egypt, and Keynes himself had been born in the middle of what had been termed " the Great Depression " until it was trumped by the far more serious calamity of the 1930s. Indeed, downturns were welcomed by many as a type of Darwinian spring cleaning, in which underperforming enterprises are winnowed from the commercial weal. Certain " austere and puritanical souls," Keynes would later remark, even viewed slumps as a kind of divine retribution by the market, as: . . . an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man ' s speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy.

Implicit in the idea of business cycles, however, is the notion that - as surely as spring follows winter - the economy will at some stage revert to its previous prosperity. Cla.s.sical economics, as Keynes summarized, presumed that: . . . the existing economic system is, in the long run, a self - adjusting system, though with creaks and groans and jerks, and interrupted by time lags, outside interference and mistakes.

Despite the ferocity of the Great Depression, orthodoxy ' s faith in the ef.cacy of markets remained largely intact, seemingly unperturbed by the millions of unemployed, the dest.i.tution of families, and the unraveling of nations. Keynes abhorred the easy complacency of cla.s.sical hardliners, and their serene a.s.surances to the ma.s.ses that society would eventually emerge from the Great Slump. In a stark rejoinder to the liquidationists selling their scorched earth policies, he reminded them that " in the long run we are all dead." In the time of its greatest crisis, capitalism simply did not have the luxury of waiting for the economy to heal itself.

The Croakings of a Ca.s.sandra During the past 12 years I have had very little in.uence, if any, on policy. But in the role of Ca.s.sandra, I have had considerable success as a prophet.

-Keynes, speech to Members of Parliament, September 16, 1931 As the 1930s stuttered on, there was scant evidence that the developed world was returning to health. Economies wallowed, unemployment levels remained stubbornly persistent, rumblings of discontent grew bolder, and men became restive. In 1932 U.S.Army units - commanded by Douglas MacArthur and George Patton, and a.s.sisted by Dwight Eisenhower in his .rst taste of armed con. ict - brutally cleared with bayonets and tanks and teargas the makeshift camps of thousands of war veterans who had marched on the Capitol demanding government aid. That same year in Britain - where of.cial unemployment levels averaged 20 percent nationally, and up to 70 percent in some regions - Sir Oswald Mosley, a former Government minister, seeded the British Union of Fascists in the fertile soil of discontent and despair. And on Continental Europe, the Great Depression acted as a kind of giant centrifuge - hurling men and women away from the political center, toward the extremes of socialism and fascism.

Keynes ' gravest forebodings had come to pa.s.s. He had warned that the harsh tribute extracted from the Central Powers under that " d.a.m.nable and disastrous doc.u.ment," the Versailles Treaty, would create insoluble international tensions. Later, he predicted that a return to the gold standard at prewar exchange rates would severely distort trade and capital .ows. And, now, as the world lurched even further into the mora.s.s, he despaired at the " beggar - thy - neighbor " policies of increasingly protectionist governments, remarking that: The modern capitalist is a fair - weather sailor.As soon as a storm rises, he abandons the duties of navigation and even sinks the boats which might carry him to safety by his haste to push his neighbor off and himself in.

Civilization, Keynes realized, rested on " a thin and precarious crust." He believed that the standard nostrum of cla.s.sical theory - letting " matters take their natural course " - was inadequate and, moreover, misguided. Keynes, with the dubious advantage of already having lived through a decade - long recession in Britain, realized that the Great Depression was more than a merely cyclical phenomenon, and that there were fundamental structural factors which prevented the world from hauling itself out of the quagmire. He had previously used newspaper articles, pamphlets, open letters to heads of state, and what he coyly described as " suggestions to the Treasury " as his soapbox. But despite the energy with which Keynes prosecuted his case, he realized something more was needed - nothing less than a new economic theory which would explain, and solve," the enormous anomaly of unemployment in a world full of wants."

Keynes would utilize the insights gained from his roller - coaster ride on the .nancial markets to develop a revolutionary theory that accounted for the booms and busts of modern economies. A central contention of Keynes ' radical thesis would be that . nancial markets were not always ef.cient, and that upheavals in the world of money could lead to disturbances in the real economy. As a not unwelcome incidental, Keynes would also alight on a set of investment principles - one of the earliest formulations of the value investing philosophy subsequently adopted by the likes of Warren Buffett - which would propel him to immense wealth. Like his contemporary Irving Fisher, Keynes had been .nancially mauled by the volatile markets of the late 1920s. Unlike the unfortunate Fisher, however, Keynes would emerge from the slump with his professional reputation burnished and his riches even greater.

Chapter 5

Raising a Dust

Into the Daylight . . . the problem of want and poverty and the economic struggle between cla.s.ses and nations is nothing but a frightful muddle, a tran sitory and an unnecessary muddle.

-Keynes, ESSAYS IN PERSUASION In 1930 - as stock markets faltered, dole queues lengthened, and dark clouds of despair shadowed the Western world - John Maynard Keynes, in a characteristically contrarian mood, proffered a vision of civiliza-tion one hundred years hence. He invoked a world where, due to the supreme ef.ciency of the capitalist system, the " struggle for subsistence " has been overcome and man has at last been led " out of the tunnel of economic necessity into daylight." In this utopia, economists are at last relegated to their proper place in society - " as humble, competent peo-ple, on a level with dentists," mere technocrats piloting with a delicate touch the ship of state.

Keynes predicted that when this economic Eden has . nally been reached: We shall be able to rid ourselves of many of the pseudo - moral prin-ciples which have hag - ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues.

For Keynes, the cult of capitalism fostered a bizarre parallel universe of inverted values, sanctifying some of man ' s least attractive tendencies - " avarice and usury and precaution " - into a credo for society. He accepted, however, that the means justi.ed the ends - " wisely man-aged, [capitalism] can probably be made more ef.cient for attaining economic ends than any alternative system yet in sight." Keynes ' atti-tude to capitalism was rather like that of Churchill ' s to democracy - the worst system ever invented, except for all the others. It was a neces-sary crutch until man .nally reached the sunlit uplands of abundance, upon which time a more n.o.ble means of administering society could be implemented.

Capitalism ' s chief virtue, and saving grace, had been its ef. cacy. If the free market system relinquished its claim to matchless productivity there was a danger that other, ostensibly less morally repugnant, social models would be preferred.As Keynes observed: Modern capitalism is absolutely irreligious, without internal union, without much public spirit, often, though not always, a mere conge-ries of possessors and pursuers. Such a system has to be immensely, not merely moderately, successful to survive.

The apparent failure of the free market system to " deliver the goods," Keynes noted in 1933, meant that Western nations were increasingly willing to abandon their Faustian pact with capitalism and instead embark " on a variety of politico - economic experiments."

Despite his own antipathy to many aspects of the system, Keynes believed that capitalism was not fatally .awed. The profound prob-lems of chronic unemployment and economic stagnation had a simple cause, he a.s.serted, and were amenable to a simple remedy. All that was required was to dethrone the existing orthodoxy, and to ground a new theory more .rmly in the realities of everyday economic life - an environment in which individuals grappled with an uncertain future and were prey to greed, fear, and irrationality.

Casting Out the Money Changers There is always an easy solution to every human problem - neat, plausible, and wrong.

-H. L. Mencken, PREJUDICES In March 1933, the recently installed leader of a great but humbled nation addressed his countrymen for the .rst time in his new capacity. Like an Old Testament .rebrand, the leader fulminated against the men of . nance who had imperiled his beloved country: The money changers have .ed from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths.The measure of the restoration lies in the extent to which we apply social values more n.o.ble than mere monetary pro. t.

Noting that " this Nation asks for action, and action now," he urged his compatriots to " move as a trained and loyal army willing to sacri-.ce for the good of a common discipline . . . because it makes possible a leadership which aims at a larger good." If the national emergency remained critical, the leader cautioned, he would seek " broad Executive power . . . as great as the power that would be given to me if we were in fact invaded by a foreign foe."

Franklin Delano Roosevelt ' s Inaugural Address as President of the United States was delivered in the depths of the Depression - when, as FDR observed apocalyptically," the withered leaves of industrial enter-prise lie on every side . . . [and] the savings of many years in thousands of families are gone." It disturbingly echoed the messianic platform of the German n.a.z.i Party, which, just two days after Roosevelt ' s inauguration, garnered the largest number of votes in the country ' s last free election before the Second World War.The Western world was becoming increasingly desperate - the capitalist system that had served it so well now seemed irremediably broken, and only extreme measures appeared capable of tearing it from its torpor.

This sense of despondency was deepened by the apparent triumphs of Soviet Russia, the country that had most emphatically broken with the free market. Under the uncompromising Five Year Plans issued from the Kremlin, the Soviet Union ma.s.sively increased its industrial output in the 1930s, almost quadrupling its share of global manu-factured products. Seduced by communism ' s fraternal ideals and its material successes, and perhaps unaware of the human suffering that underwrote these achievements, many of Keynes ' friends and students turned " Bolshie " in the Depression decade. Others - generally those in the City or Whitehall - instead sought refuge in the stern, rea.s.suring order of corporatism or fascism. Although the Bolsheviks, the Colonel Blimps, and the Blackshirts squared - off from different ends of the political spectrum, they did have one thing in common - a conviction that the free enterprise system no longer did the job, and needed to be replaced. It seemed, in the mid - 1930s, that Marx ' s grim prognosis of the inbuilt obsolescence of capitalism may have been correct after all.

A New Wisdom Half of the copybook wisdom of our statesmen is based upon a.s.sump tions that were at one time true, or partly true, but are now less and less true by the day.We have to invent new wisdom for a new age.

-Keynes, ESSAYS IN PERSUASION Keynes was not impressed by the arguments of those wishing to depose capitalism. He seemed to regard communism as more Groucho Marx than Karl Marx, dismissing it as " complicated hocus - pocus " and remarking to his students that he had read Das Kapital " as if it were a detective story, trying to .nd some clue to an idea in it and never succeeding." Similarly, he had no time for fascism as a political solution - Keynes ' call to action, he informed the British Fascist leader Oswald Mosley, " was to save the country from [you], not to embrace [you]." In Keynes ' opinion, the most serious threat to capitalism came not from the aspiring revolutionaries peddling their " quack remedies," but rather from those who most strenuously proclaimed their fealty to the existing order.

Orthodox .nance argued that just as in hard times a household should exercise strict .nancial discipline, so, too, should slump - af. icted governments practice .nancial sobriety.As Adam Smith reasoned, " What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom," and conventional wisdom merely extrapolated good housekeeping to the national arena. Backing up orthodoxy ' s intuitions were the maxims of cla.s.sical economics, which posited that the free market system bene.ted from a system of checks and balances that ensured that the economy always tended toward full employment.

In the Panglossian world of cla.s.sical theory, all savings would be invested, all workers employed, and all products consumed. Consequently, as Keynes remarked, any interference with this self -adjusting system was viewed as: . . . not merely inexpedient, but impious, as calculated to r.e.t.a.r.d the onward movement of the mighty process by which we ourselves had risen like Aphrodite out of the primeval slime of ocean.

However, like the Greek philosopher Thales, who stumbled into a well while gazing at the stars, cla.s.sical fundamentalists were so dazzled by the beauty of their theoretical superstructure that they disregarded the inadequacies of its foundations. Keynes argued that cla.s.sical theory ' s " tacit a.s.sumptions are seldom or never satis.ed, with the result that it cannot solve the economic problems of the actual world." Rather than reprimand reality for failing to live up to the exacting standards of theory, Keynes would develop a model that embraced and explained real-world imperfections.

Bowling Over the Frock Coats All successful revolutions are the kicking in of a rotten door.

-John Kenneth Galbraith, THE AGE OF UNCERTAINTY Keynes, the proud iconoclast, was never one to be fettered by the accepted economic verities. He exhibited the underrated English vir-tue of pragmatism, of not being too tightly wed to any particular world view - as he airily informed a Parliamentary Committee in 1930," I am afraid of ' principle.' " Keynes maintained that economics " is a technique of thinking . . . not a body of settled conclusions." Although originally a zealous defender of the cla.s.sical tradition, by the mid - 1920s he increas-ingly ranged himself with the " cranks," a.s.serting that a free market economy could stall at " underemployment equilibrium " for lengthy periods.

Keynes observed that cla.s.sical economics - built on an a.s.sumption of scarcity of resources - was poorly equipped to deal with the situation of excess, squandered resources. The orthodoxy, he stated, " has ruled over us rather by hereditary right than by personal merit," and its policy prescriptions often confounded common sense. Keynes merci-lessly attacked the " timidities and mental confusions of the so - called ' sound ' . nance " - those who recited, as if by rote, the tired tenets of cla.s.sical theory in support of a policy of .nancial rect.i.tude and caution: When we have unemployed men and unemployed plant . . . it is utterly imbecile to say that we cannot afford these things. For it is with the unemployed men and the unemployed plant, and with nothing else, that these things are done.

a.s.sailing the " deadhead " liquidationists, Keynes argued that the cla.s.sical paradigm was not inviolate, was not Holy Writ, and by exten-sion the slump was not akin to an Act of G.o.d - it was a human prob-lem, and could be solved by the application of sound thinking and courageous initiatives. As Keynes declared in late 1934, " We are . . . at one of those uncommon junctures of human affairs where we can be saved by the solution of an intellectual problem, and in no other way." In arriving at a solution to the overwhelming social problem of his time, Keynes would jettison many of the a.s.sumptions and conclusions underwriting cla.s.sical theory.As he declared to a radio audience: There is no reason why we should not feel ourselves free to be bold, to be open, to experiment, to take action, to try the possibilities of things. And over against us, standing in the path, there is nothing but a few old gentlemen tightly b.u.t.toned - up in their frock coats, who only need to be treated with a little friendly disrespect and bowled over like ninepins.

The General Theory I want , so to speak, to raise a dust; because it is only out of the con- troversy that will arise that what I am saying will get understood.

-Keynes to a fellow economist,August 27, 1935 The General Theory of Employment, Interest and Money, published in February 1936, disputed the orthodox doctrine that free mar-kets always produce optimal results. Like its namesake, Einstein ' s General Theory of Relativity, Keynes ' magnum opus overthrew the accepted theoretical structure, showing that markets were not necessarily a.n.a.logous to the clockwork precision of Newtonian physics. Keynes likened cla.s.sical economists to " Euclidean geom-eters in a non - Euclidean world who, discovering that in experi-ence straight lines apparently parallel often meet, rebuke the lines for not keeping straight." In his opinion, parts of the cla.s.sical doc-trine, although theoretically elegant, were based on . awed a.s.sump-tions and deduced outcomes clearly diverging from those in the real world. Keynes set himself the task of overturning the redundant truths of his predecessors. As he prophesied to his friend George Bernard Shaw in 1935, The General Theory would " largely revolutionize . . . the way the world thinks about economic problems."

The General Theory was written at a time when most of the developed world had already endured years of chronic unemploy-ment and stagnation - a situation that orthodox economic doctrine deigned impossible, as theory dictated that markets were self - correcting and naturally worked toward full employment. Cla.s.sical economists argued that the economy was languishing partly because workers were not suf. ciently . exible - if only they would behave more like the rational automatons of cla.s.sical economic theory, willing to take a cut in wages suf.cient to justify their employment, then the labor market would self - correct and full employment return.

Keynes believed the orthodox theory - which essentially blamed the unemployed for their plight - to be " wicked " and, moreover, wrong -headed. A central conclusion in The General Theory- informed by Keynes ' own experience as a speculator - was that the psychology of uncertainty impaired the ef.cient operation of the market. The existence of uncertainty would periodically result in bouts of underinvestment and oversaving, leading in turn to underutilization of an economy ' s resources. The Keynesian solution to this state of affairs was, in essence, to boost an economy ' s aggregate expenditure by increasing government spending to offset lower business and consumer activity.

Money Matters Speculation improved his economics and economics improved his speculation.

-Nicholas Davenport on Keynes, MEMOIRS OF A CITY RADICAL The Keynesian prescription was not unlike one of those Eastern sects which hold that worldly temptations and vices can only be defeated through overindulgence. In the same way that Adam Smith thought that the " vain and insatiable desires " of consumers led by the operation of an invisible hand to the advancement of society as a whole, so, too, did Keynes propose a type of hidden hand which transformed the perceived vices of de. cit . nancing into the virtues of full employment and economic stabil-ity. In challenging the paradoxical doctrine of the invisible hand, Keynes, the great perverter, proposed an equally counterintuitive proposal - that at certain times, state pro.igacy could be the most responsible policy.

This idea was deeply offensive to the laissez - faire orthodoxy and to the precepts of sound .nance, which clung rigidly to balanced budgets and the principle that expenses should not outrun revenue. Russell Lef.ngwell, an American banker who had known Keynes since the days of the Paris Peace Conference, typi.ed the City ' s condescend-ing response to his ideas: . . . Keynes and all his school . . . have not the judgment of practical men . . . They are civil servants.They are professors of political econ omy. They are not bankers and they are not business men.

In fact, it was precisely because Keynes was more than just a civil servant or economist that he could break free from the orthodox mind-set and develop a theory to explain persistent underemployment, for it was Keynes ' experiences on the .nancial markets that gave him an insight into the true workings of modern economies.Traditional theory had largely overlooked the importance of money and . nancial exchanges - in the cla.s.sical realm they were little more than conduits, a veil over " real economy " processes.As the Scottish philosopher David Hume had summarized two centuries before, money in orthodox theory is " none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy."

Rather than abstracting money and .nancial markets from eco-nomic theory, Keynes saw them as a driving force. He realized that money was far more than a medium of exchange or the insubstantial shadow of real economy activities - it was " above all, a subtle device for linking the present to the future." Keynes noted that: . . . our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conven-tions concerning the future . . . The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

" Liquidity preference " - the desire to hold cash or near - cash - is a gauge of individuals ' wariness about the future. When money moves from " industrial circulation " to " . nancial circulation " - when, rather than being invested in enterprise, savings instead lie fallow - slumps can occur. The .ow of money can be thought of as an economy ' s metabo-lism, and when individuals h.o.a.rd their savings because of fears for the future, or when investors lack con.dence to embark on new projects, the daisy chain of prosperity breaks and " enterprise will fade and die."

Spender of Last Resort . . . this is not a crisis of poverty, but a crisis of abundance . . . The voices which - in such a conjuncture - tell us that the path of escape is to be found in strict economy and in refraining, wherever possible, from utiliz-ing the world ' s potential production are the voices of fools and madmen.

-Keynes, THE WORLD'S ECONOMIC OUTLOOK Rather than having complex and profound causes requiring a radical remedy, Keynes argued that the protracted slump had a simple cause and was capable of a simple solution.The economic engine, he a.s.serted, was suffering from nothing more than " magneto trouble." The motor was largely sound and there was plenty of fuel in reserve - all that was required was a transforming spark to kick - start the machine and return it to the road to prosperity. In the depths of the Great Slump, Keynes buoyantly informed radio listeners that " we are suffering from the growing pains of youth, not from the rheumatics of old age." The celebrated invisible hand, Keynes implied to his audience, merely needed a helping hand.

Like the humanists of an earlier age who rejected the notion of man as a pa.s.sive plaything of G.o.d ' s will, the Keynesian prescription did not abdicate responsibility for economic welfare to an omniscient, all -powerful market. Rather, man ' s economic destiny was .rmly within his own hands - governments could actively intervene to smooth the busi-ness cycle by " spending against the wind," as Keynes termed . scal . ne -tuning.As he declared: The important thing for government is not to do things which indi viduals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all.

The General Theory polarized opinion. Some commentators, although admiring the book ' s cleverness, believed it to be intellectually . awed," a farrago of confused sophistication." Arthur Pigou, a Cambridge econom-ics professor, was complimentary in a rather backhanded way. " We have watched an artist .ring arrows at the moon," he commented." Whatever be thought of his marksmanship, we can all admire his virtuosity." Others, such as the Austrian economist Friedrich von Hayek, thought it a . rst step to the totalitarian states that had developed in Germany and Russia. Keynes robustly rejected " the pessimism of the reactionaries who con-sider the balance of our economic and social life so precarious that we must risk no experiments." In moderating the excesses of capitalism - by introducing an element of " socialization of investment " - Keynes believed that society would, in effect, be inoculated against the far more serious threats of collectivism and authoritarianism.

Keynes thought his " monetary theory of production " to be " moderately conservative in its implications ." The Keynesian blue-print merely advocated an external stimulus - " an impulse, a jolt, an acceleration," as Keynes put it - when Adam Smith ' s invisible hand becomes atrophied through inaction. Once the economic engine had been reignited and " our central controls succeed in establish-ing an aggregate volume of output corresponding to full employment as nearly as is practicable," then, he commented, " the cla.s.sical theory comes into its own again from this point onwards." In the previous century Lord Salisbury had stated that British foreign policy was " to .oat lazily downstream, occasionally putting out a diplomatic boathook to avoid collisions." Keynes ' s proposed economic policy was similar in conception but somewhat more vigorous in execution - the govern-ment would act as a rudder on the ship of state, guiding the economy out of danger when unemployment and stagnation loomed.

The Mark of Keynes All truth pa.s.ses through three stages. First, it is ridiculed. Second, it is violently opposed.Third, it is accepted as being self - evident.

-Arthur Schopenhauer, ON THE WISDOM OF LIFE Considering that Keynes ' theory told many politicians exactly what they wanted to hear - that the path to recovery lay not in austerity but in higher spending and lower taxes - it is somewhat surprising that his ideas took so long to be accepted by policymakers. It would not be until that period of sustained global public expenditure otherwise known as the Second World War that " Keynesianism " became the dominant creed of Western nations. Keynes had written in The General Theory that: Practical men, who believe themselves to be quite exempt from any intellectual in.uences, are usually the slaves of some defunct econo-mist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

Keynes ' academic scribblings - the belief that .scal policy should be used to . ne - tune an economy ' s " aggregate demand " - usurped the laissez - faire theories of the cla.s.sical school almost as comprehensively as Darwin ' s narrative had displaced that of Genesis.

For three decades after the war, as the Western world luxuriated in conditions of " permanent boom," even Keynes ' most vehement ideo-logical adversaries reluctantly conceded that " we are all Keynesians now." Keynes had dragged economics, kicking and screaming, into the twentieth century - from a study of choice under conditions of scar-city to a study of choice under conditions of uncertainty, and from an emphasis on microeconomic factors to an emphasis on aggregates. In his own way, he contributed to the Bloomsbury mission to introduce modernism into Western society, for his economics owed perhaps more to Sigmund Freud ' s conception of the primal mind than to earlier notions of economic rationality and mechanistic order.

The Keynesian hegemony would .nally yield to a counterrevolution of sorts in the 1970s, when conditions of " stag. ation " - consistently rising prices in an environment of high unemployment - fostered the revival of neocla.s.sical economics in general, and monetarism in partic-ular. But just as the embers of the .rst Keynesian coup were . ickering out, a second Keynesian revolution was being kindled. In the late 1970s, the emerging discipline of behavioral . nance - a melding of econom-ics and psychology - rediscovered Keynes ' views on investor psychol-ogy and stock market behavior. Having comprehensively overthrown many of the con.dent conclusions of cla.s.sical economics over half a century ago, The General Theory - perhaps the world ' s .rst major work on behavioral economics - would once again prove a foundation text for new ways of thinking.

Chapter 6

Animal Spirits

What Goes Up . . .

To every action there is always opposed an equal reaction.