New Perspectives

In Economics and Finance

Keynes’s General Theory at 80, by Robert Skidelsky

Keynes famously wrote ‘In the long run we are all dead’. How alive is he, 80 years after the publication of the General Theory of Employment, Interest and Money?

Two aspects of his’ legacy seem secure. First, he invented macroeconomics – the theory of output as a whole. He called his theory “general” to distinguish it from the pre-Keynesian theory which assumed a unique level of output – full employment. In showing how economies could remain stuck in a position of 'under-employment equilibrium’ Keynes challenged the central paradigm of the orthodox economics of his day, that markets for all commodities, including labour, are simultaneously cleared by prices.In doing so, he added a new dimension to policymaking: governments may need to run deficits to maintain full employment.

The aggregate equations that underpin Keynes’ 'general theory’ still populate economics textbooks and shape macroeconomic policy. Even those who insist that market economies gravitate toward full employment are forced to argue their case within the framework that Keynes created. Central bankers adjust interest rates to secure a full employment balance between total demand and supply, because, thanks to Keynes, it is known that this balance might not occur automatically.

Keynes’s second major legacy is the idea that governments can and should prevent depressions. This can be seen in the difference between the strong policy response to the collapse of 2008-2009 and the passive reaction to the Great Depression of 1929-1932. As the Nobel laureate Robert Lucas, an opponent of Keynes, admitted in 2008: “I guess everyone is a Keynesian in a foxhole.”

However, Keynes's theory of 'under-employment equilibrium’ is no longer accepted by most economists and policymakers. The global financial crisis of 2008 bears this out. The collapse discredited the more extreme versions of the optimally self-adjusting economy. But most governments started cutting their deficits long before recovery was secure. Implicitly, that is, they accepted the pre-Keynesian doctrine that, following a shock, economies quickly bounce back to full employment.

There are three main reasons for what I would call a theoretical regression. First, the belief in the labour-market-clearing power of prices was never wholly overturned. So most economists came to view unemployment as a sticky-wage problem of temporary duration, not a normal state of affairs. The rejection of Keynes's notion of radical uncertainty and the role of money as a store of value lay at the heart of this reversion to pre-Keynesian thinking.

Second, post-war Keynesian policies of 'demand-management' ran into inflationary trouble at the end of the 1960s.This lent credence to Friedman’s contention that inflation was caused by governments printing too much money. The collapse of incomes policies designed to restrain wage costs reinforced Friedman’s message.

So the Keynesian full employment target was replaced by the inflation target, and unemployment was left to find it its ‘natural’ rate, whatever that was. It was with this defective navigational equipment that politicians sailed full steam ahead into the icebergs of 2008.

However, the most important reason for Keynes’s fall from grace was the rightward ideological shift that began with British Prime Minister Margaret Thatcher and US President Ronald Reagan. At the heart of this was the desire to shrink the postwar welfare state. Keynesian fiscal policy fell victim to the anti-statist current, showing, if it needed demonstration, that it is almost impossible to separate positive from normative economics.

Yet a reaction against current orthodoxy is clearly apparent. Faced with the anaemic recovery from the crash of 2007-8, the IMF has started to argue that monetary stimulus needs to be backed by fiscal expansion.

An even bigger shock to the pre-crash orthodoxy than the crash itself was the revelation of the corrupt power of the financial system and the extent to which governments had allowed their policies to be scripted by the bankers. To control financial markets in the interests of full employment and social justice lies squarely in the Keynesian tradition.

For the new generation of students, Keynes’s relevance may lie less in his specific policies than in his view of how to do economics. He criticised his profession for modelling on the basis of unreal assumptions. Students of economics eager to escape from the skeletal world of optimizing agents will find Keynes’s economics inherently sympathetic. That is why I expect Keynes to be a still living presence twenty years hence, on the centenary of the General Theory. 

Lord Skidelsky is Emeritus Professor of Political Economy at the University of Warwick. He is the author/ co-author of a number of publications, including Austerity vs StimulusWho Runs the Economy?, and Are Markets Moral?

John Maynard Keynes