What drives economic growth and stagnation? What types of methodologies and tools do we need to accurately explain economic epochs in the past and present? What models and policy approaches can lead to prosperity for all? These questions occupied the mind of John Maynard Keynes from World War One until his death in 1946. Keynes, one of the most influential economists of all time, is often claimed to have “saved capitalism.” His legacy, as understood by most of the economics profession, was to cure laissez-faire capitalism with countercyclical fiscal policy—using expansionary government spending during recessions to increase output and employment.
In his new book, Keynes Against Capitalism, economist James Crotty argues that this interpretation of Keynes is profoundly mistaken. Keynes, Crotty argues, wanted to replace capitalism with his own program of “liberal socialism.” Through the book, he demonstrates that 1) Keynes fundamentally rejected the theoretical model that undergirds laissez-faire capitalism; and 2) the cornerstone of Keynes’ liberal socialism program was permanent, large-scale public and semi-public investment guided by the state, accompanied by low interest rates and capital controls.
This review will summarize these two central arguments and then go on to discuss the book’s relevance to the current macroeconomic environment—in particular, contemporary debates on secular stagnation, short-termism, and the role of public investment in the economy.
Crotty argues that Keynes could not have wanted to “save capitalism” given that he dedicated his entire career to critiquing the classical economic model. He shows that Keynes rejected three central conclusions of classical theory: 1) when the economy is operating normally, the productive capacity of both labor and capital is maximized; 2) if something moves the economy away from this point, “market forces” will move the economy back towards the full employment of all productive resources; and 3) once the economy is at full employment only an external “shock” can move it away from full employment. In addition to the less-central critiques Keynes made of perfect competition and reversible investment, Crotty traces these three main critiques from their conception as Keynes’s “pre-analytic” vision to their full theoretical development in The General Theory of Employment, Interest and Money.
First, Crotty argues that, after WWI, Keynes began to believe that powerful engines of capital accumulation were necessary for long-term eras of prosperity. Specifically, Keynes became convinced that the unique characteristics of the 19th century—such as rapid population growth, major technological innovation, and war—were responsible for Britain’s extraordinary economic growth. Long-term, sustainable growth engines such as these would provide consistent capital investment, regardless of short-run profit expectations. Without these factors, there was no reason to expect the economy would remain stable at full employment since capital investment on a consistent basis would not be guaranteed. In fact, it was much more likely the economy would “stagnate” at high levels of unemployment. This directly contradicts the first central conclusion of classical theory.
Second, Crotty shows that Keynes began to reject the idea that the economy would automatically stabilize itself if it deviated from full employment. This was obvious to Keynes after he witnessed the destruction that deflation had wreaked on the interwar British economy. According to classical theory, two mechanisms would stabilize any deviation from equilibrium: wage-price deflation and declining interest rates. When there is an excess supply of labor, nominal wages and prices should fall because workers are competing for scarce jobs and firms are competing for scarce customers. Once real wages fall, firms will hire more workers. This will increase employment and output thus returning the economy to full productive capacity. Keynes argued that deflation is more likely to destabilize the economy because deflation can cause defaults in the financial sector which can lead to a financial panic. More specifically, deflation can cause asset prices to fall. If the value of assets a person or business owns decreases below the value of debts owed, the person or business becomes insolvent. Widespread insolvency makes lenders fearful of lending and can cause liquidity to dry up. This creates more defaults, more insolvency, and less liquidity. In this way, Keynes argued deflation was much more likely to wreak havoc on an economy than stabilize it.
Crotty draws on Keynes’s analysis of U.S. financial markets to discuss Keynes’s third major critique of classical theory—the rejection of the idea that once the economy is at full employment only an external shock (for example, an increase in the price of imported oil) can destabilize it. After observing U.S. financial markets in the early 1930s, Keynes began to see how instability emerges out of seemingly stable economic moments. He argued that financial markets are anything but efficient and well-behaved; they are prone to bouts of mania and panics which can disrupt the economy from within. For example, periods of prolonged economic growth and prosperity can increase confidence and the willingness to take risks. These “animal spirits,” as he famously put it, can lead to deviations of stock prices from their underlying fundamental value, generating a bubble. Once it becomes clear stock prices have become substantially overvalued and investors begin frantically selling the stock, a panic can set in.
The methodological theme that underlies Keynes’s three central rejections of classical theory's conclusions is the realism of assumptions. Keynes argued that because classical theory’s assumptions do not reflect the real economy, the classical model is not useful for solving problems “of the actual world.” The first classical theory conclusion requires that the unique conditions of the 19th century continue indefinitely. The second requires that wage and price deflation occur seamlessly, prices fall less than wages, and the deflation of the real wage encourages firms to hire more workers. The third assumes that the future is inherently knowable and the probability of all possible events can be calculated indefinitely through time. The reason why classical theory drew conclusions that did not reflect the actual economic experience of Britain in the early twentieth century is because the theory’s assumptions are unrealistic.
Crotty argues that this is why Keynes used the assumption of fundamental uncertainty to underlie all his models and theories. Keynes believed that the future was inherently unknowable. We may be able to calculate the probabilities of death, but how can we possibly know when we will die? Because humans are faced with an unknowable future, Keynes argued that they develop decision-making processes based on heuristics or rules-of-thumb. If this type of human behavior is assumed, the entire macroeconomic model changes. Bubbles, manias, and panics in financial markets can lead to erroneous expectations and decreased confidence, causing declines in investment that lead to decreased output and employment.
Crotty makes it clear that the cornerstone of Keynes’s macroeconomic theory was a large-scale, permanent public investment program that would manage and administer about two-thirds of national investment. A public investment program of this scope, along with all of the other supporting policies Keynes advocated for, Crotty argues, is not any form of capitalism as we know it. In other words, Keynes’s version of public investment was, “definitely not a short-term government stimulus program designed to ‘kickstart’ a temporarily sluggish economy and then let free enterprise take over.”
According to him, Keynes had two key motivations for his large-scale public investment program. First, the “secular stagnation” that plagued Britain during the interwar years was something Keynes saw as a problem confronting all mature capitalist economies. As a nation’s capital stock grows, it becomes less profitable to make new investments, meaning that, at some point, investment will stagnate. Second, financial markets, under the assumption of fundamental uncertainty, can cause crashes that shatter people’s expectations and make them afraid to take risks in the near future, “Business is weighted down by timidity… No one is ready to plant seeds which only a long summer can bring to fruit.” This behavior can cause volatile or weak investment. For these two reasons, Keynes argued that it was essential for the government to plan and execute the lion’s share of investment. In his model, this investment would be accompanied by low interest rates and capital controls to prevent savings from leaving the country in search of higher returns.
The book provides a set of policy proposals for economies struggling with secular stagnation and volatile or weak investment caused by unstable financial markets. This could arguably describe the U.S. economy in recent years. Economists Larry Summers and Paul Krugman have both revived the “secular stagnation” hypothesis as a possible explanation for slow economic growth following the Great Recession. As late as 2018, Larry Summers warned that the threat of secular stagnation was not over.
Weak business investment has been linked to “short-termism”—the focus on short-term gains by corporate managers and financial markets in general. One of the major causes of short-termism is the increasing power of shareholders relative to other stakeholders in the firm. Keynes argued that managers and shareholders make business investment decisions very differently. When companies were primarily family-owned, managers had “skin in the game” and would not invest purely in pursuit of profit, they “embarked on business as a way of life, not relying on a precise calculation of prospective profit.” One of Keynes’s solutions to the “insane” financial market casinos of the early 1930’s was to lengthen the amount of time shareholders were required to hold their shares. In a 2015 paper, Mike Konczal, J.W. Mason, and I discuss this solution as a potential way to address short-termism. Other solutions we propose are directly related to Keynes’s insights on manager and shareholder investment behavior. For example, removing stock options from CEO pay would eliminate the incentive for managers to behave like shareholders. Establishing worker representation on corporate boards would provide countervailing power to shareholders’ influence on business investment decisions.
The book also offers an institutional framework for a large-scale public and semi-public investment program. The cornerstone of this program would be a Board of National Investment. The responsibilities of the Board would be to:
… gather the necessary sources of finance and allocate them to pay for economically and socially efficient investment projects in a manner calculated to ensure the full employment over the long run.
Beyond the theoretical debates, Crotty also identifies the types of institutions and capital projects Keynes had in mind. By “semi-public institutions” Keynes meant organizations like universities, utility providers, and transportation centers. Capital projects would include but not be limited to: building houses and roads, expanding electric power generation, afforestation, slum clearance, and the development of canals, docks, and harbors.
However, none of Crotty’s descriptions of these projects include an explicit discussion of the practical barriers that might mar a large-scale public investment program. Despite Keynes’s attention to the realism of assumptions and applicability to the real-world, he never addressed, for example, how the pace of capital investment could be sped up or slowed down in practice. My forthcoming dissertation research explores this very question. Using interviews with state and local government budget officials, my research addresses both the realism of assumptions and applicability of a Keynesian program to the real-world. The initial results show that attempting to adjust the pace of capital spending can be fraught with institutional and practical barriers.
A huge value of the book is that it differentiates the messages of Keynes’s original work from modern-day “Keynesians.” Crotty shows that the IS-LM incarnation of Keynes captured very little of Keynes’s beliefs and left out the most important parts of his thought. What these “Keynesians” leave out includes: the realism of assumptions and fundamental uncertainty; the attack on classical theory’s stabilizing market forces of wage-price deflation and decreasing interest rates; secular stagnation; the importance of balance sheets; the ability of an economy to endogenously create instability through financial markets; and virtually all of the policy prescriptions that Keynes proposed throughout his career. According to Crotty, you “cannot generate Keynes’s favored Liberal Socialist policy regime from an IS-LM economic model.”
There is hope that the macroeconomics discipline might finally be catching on to Keynes’s relentless insistence that the assumptions of any model must be applicable to the real-world. In a recent article reflecting this turn, Heather Boushey quotes Emmanuel Saez: “If the data don’t fit the theory, change the theory.”