Commentary Magazine

The Keynes Bubble

As a former academic economist who at mid-career migrated into the worlds of policy and financial markets, I am sometimes asked how the latter experiences differ from the academic one. I reply—especially with regard to involvement in financial markets—that I get humiliated a lot more. The financial crisis, which reached its most acute phase just a year ago with the failure of Lehman Brothers, has resulted in some humiliation, or at the very least severe criticism, for academic economists who are said to have missed the whole problem and thereby contributed to its severity. The criticism comes from those who ask, in essence, “How could it have happened if you’re so smart?”

Indeed, economists and economic doctrine have been facing some serious censure—some of it well deserved, some not—for having largely “missed” the causes of the financial crisis. Take the “efficient-market hypothesis,” according to which the actions of millions of people conducting billions of transactions will, in the aggregate, prove to be the most rational and reliable determinant of value. Many have claimed that the efficient-market hypothesis helped cause the financial bubble and its subsequent explosion by building a blind faith in the accuracy of market prices.

Robert Skidelsky, the eminent British academic economist, suggests in his latest book, Keynes: Return of the Master, that the crisis would not have happened if present-day economists had been more like John Maynard Keynes (1883-1946), the seminal advocate for government’s taking a leading role in financial decision-making. The movement by modern economic theorists away from Keynes’s insights, Skidelsky argues, was a major cause of economic hubris that led to the -financial bubble, its collapse, and the painful aftermath.

For critics like Skidelsky, the two major culprits of modern economic doctrine responsible for the unrecognized buildup of the financial crisis were the efficient-market hypothesis, pioneered by Eugene Fama, and the new classical school of macroeconomics, pioneered by Robert Lucas. A brief description of each of these doctrines is useful in the context of current discussions of the financial crisis.

Lucas’s way of thinking constituted a powerful attack on large-scale measures to reverse the effects of economic downturns undertaken by the government (fiscal policy) or the central bank (monetary policy). Such measures as increases in spending or increases in the money supply would, Lucas’s school argued, be fully anticipated by rational economic agents, be taken into account in market behavior before they could be fully implemented, and therefore prove largely ineffective.

The efficient-market hypothesis suggested, essentially, the same thing with respect to prices of financial assets. In its strongest form, the suggestion was that all available information regarding the market price of financial assets would be instantly incorporated into the price of such assets, and so market speculation would not, in the end, prove to be profitable.

Neither the new classical economics nor the efficient-market hypothesis survived in its purest form. After all, even after they achieved widespread support, the government and the Fed still continued to employ fiscal and monetary measures in an attempt to stabilize the economy—and private investors continued to devote massive resources to attempt to surpass average performance.

How, after all, can neoclassical economics be said to describe the workings of the world when business cycles—upturns and downturns, growth spurts and recessions—persist in defiance of the notion that markets will always find their proper level? Lucas’s followers have a rational explanation for it—“sticky -prices,” or the fact that people will hold on to false ideas of intrinsic worth owing to binding contracts that do not allow prices to fall or information asymmetries between buyers and sellers.

As for the continued existence of profitable speculators in the world of neoclassical economics, in which all market values factor in future changes, the fact is that someone has to make markets efficient by bringing to bear new information on market pricing. Those who move quickly to reflect new information in market prices may well be rewarded at the expense of those who move more slowly.

Does the work of Keynes offer a better description of the true workings of the market? So Skidelsky claims. Keynes’s masterwork was his General Theory of Employment, Interest, and Money, published in 1936. It was directly concerned with the economic crisis of his time and was an attempt to find a way out. Keynes’s great concern was the possibility that aggregate demand in an economy could settle at a level far too low to create anything like full employment.

The problem was the threat of a “liquidity trap.” In a time of crisis, households and firms become so uncertain about the future that they wish to store all purchasing power in the form of riskless cash. That phenomenon renders monetary policy ineffective because it means that any effort by a central bank to increase the money supply will simply be held by highly uncertain households and businesses rather than spent. The process of pushing the money supply higher and higher with no corresponding acceleration in economic activity forces interest rates to fall to zero. This, in turn, causes deflation to intensify as monetary velocity—the ratio of nominal GDP to the nominal money supply—falls. Deflation itself becomes self-reinforcing; deflation causes more deflation in a spiral from which it is nearly impossible to extricate an economy.


Keynes’s solution was to bypass the conventional economy through the direct intervention of government. He argued that government should borrow and spend. The activity that would result from this would be enhanced through a “multiplier effect,” which would boost GDP by some multiple of the increase in government spending. That all sounded like a godsend, and it was treated as such.

After the appearance of The General Theory, classical (pre-Keynesian) economists argued, a little wistfully, that the economic system would always find its own way to full employment if only prices and wages were allowed to fall far enough. Even if wages proved to be sticky on the way down—that is, if workers resisted pay cuts and thereby allowed unemployment to rise—price levels could still fall. The resulting deflation would, eventually, cause the purchasing power of cash to rise. Consumers would feel sufficiently well off to spend in ways that would bring the economy back to full employment.

This might have been sensible in theory, but such a deflationary bungee jump would be too slow to be a viable way of boosting demand. What if it took years for prices to fall to the proper level? Or, more ominously, what if deflation got out of hand, spiraling down so fast that the real burden of debts would soar and thereby crush the indebted sector of the economy—both corporations and households, not to mention governments, whose revenues would be collapsing while the real burden of their debts would be rising?


Keynes’s real message was that a declining overall price level—too many falling prices of goods, services, and labor—was too dangerous to risk. Instead, expedient methods to boost demand, stabilize prices, and help increase the overall level of employment would be necessary to preempt a prolonged depression. Countercyclical government spending at a time of private-sector slowdown or reversal was the antidote, financed by government borrowing if that would be sufficient to do the trick, or by central banks printing money if stronger medicine was needed to preempt deflation.

His ideas carried the day. Keynes was the most influential economic thinker in the West from the time of the publication of the General Theory until the 1970s. His star began to wane after politicians (in the United States especially) tried to use Keynesian ideas in circumstances they were not originally meant to address—simple cyclical downturns rather than Great Depressions. After Lyndon Johnson sought to fight the war in Vietnam and pay for the Great Society all at once through government borrowing, the stage was set for a decade of inflation that culminated in double-digit price increases, 14 percent government-bond yields, and a collapsing dollar.

Milton Friedman adduced convincing empirical evidence showing that printing money to counter cyclical downturns (as opposed to Depression-style collapses of demand) boosted inflation without affecting growth. The explanation for all this was contained in Lucas’s new classical theory of macroeconomics. And economic thinking, like business, has its cycles.

Skidelsky has written an enjoyable and stimulating biography of Keynes. However, the practical suggestions Skidelsky makes are actually quite silly and do not obviously follow from his lively discussion of Keynes and Keynesian economics.

He calls for a “reconstruction of economics” based on Keynes’s somewhat opaque observation that “economics is a moral, not a natural science.” In this vein, Skidelsky proposes separating the postgraduate study of macroeconomics (which is about the behavior of the economy as a whole) from that of microeconomics (which analyzes individual behavior) in order to “protect macroeconomics from the encroachment of the methods and habits of mathematicians.” This will, he says, humanize economics and lead to a rebirth of thinkers who might follow in Keynes’s footsteps.

Having more economists who are as urbane and worldly as Keynes would no doubt make life in a modern academic setting considerably more pleasant. But it is not clear how a humanization of economics departments would have helped prevent the financial crisis that followed the collapse of the post-2002 real-estate bubble or how it would have prevented a fully rational market response to former Fed Chairman Alan Greenspan’s disastrous notion that asset bubbles cannot be identified before the fact and that the fallout from their bursting can be managed afterward.

As Charles Prince, the former CEO of Citigroup, stated so succinctly in July 2007, just before the bubble burst: “When the music is playing, you have to get up and dance.” By this he meant that the Fed’s willingness to ignore bubbles and clean up the consequences of the collapse afterward guaranteed that financial institutions that weren’t “dancing”— taking on gobs of financial risk—would be underperforming their competitors. You did indeed have to “get up and dance.” This worked for individual institutions for a time, but it resulted in a systemic disaster that began to unravel in the middle of 2007.


Skidelsky’s review of Keynesian doctrine does suggest some promising avenues for future exploration. Keynes’s major contribution to macroeconomics was to lift the classical veil that had previously been draped over the subject of money. For Keynes, as Skidelsky notes, the role of money as a store of value makes it into “a subtle device for linking the present to the future.” And Keynes’s description of the “liquidity trap” was indeed extraordinarily helpful in analyzing the condition of the financial crisis that emerged last year. The Fed’s first response was to expand its balance sheet in order to expedite bank lending and help support bank balance sheets and avoid a run on the banking system. All these initiatives succeeded, and Keynes would have welcomed them.

Subsequently, the Keynesian notion—described with considerable approval by Skidelsky—of a fiscal-stimulus package equal to about 5 percent of GDP was undertaken in February 2009. In a liquidity trap, the ideal conditions for an effective fiscal-stimulus measure do exist. Unfortunately, the Obama stimulus measure was poorly designed and has, so far, resulted in relatively little stimulus. The tax-cut portion of it was largely saved by consumers rather than spent in a way that would create economic growth, while the spending portion is dedicated to subsidies for state and local governments, along with special provisions for less-than-productive pork-barrel projects favored by politicians.

Based on the analysis of the latest and other U.S. fiscal-stimulus packages conducted by Alan Auerbach and William Gale, two prominent public-finance theorists who have been advising the Obama administration (presented at the Kansas City Fed’s annual Jackson Hole Symposium in August), the current stimulus package has been less than effective. Neither of the authors was willing to recommend another stimulus package given the disappointing results from the measures undertaken so far.


So what now? One possible conclusion to draw from all this is that nothing works, that every theory has a terrible deficiency built into it, and that the real world will eventually test it, find the weakness, and expose its hollowness. But rather than abandon the brilliant thinking that has gone before—either in the form of Keynes’s path-breaking analysis of the role of money or the insights of the new classical economics and the efficient-market hypothesis in demonstrating that government intervention can be counterproductive—it is probably best for all camps to undergo a period of reflection. This has been a sobering time for economists of all stripes. Indeed, one can say that the Keynesian moment that gave rise to Skidelsky’s book may already have passed, since the stimulus simply hasn’t worked as promised. And, of course, conservative economists have been eating crow for a year or more. Perhaps, out of all this humiliation, a new humility may emerge, from which a new consensus can form.

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