NINE

Toward The General Theory

The Cost-Free Cure for Unemployment, 1932–33

The next few years saw a distinct shift in strategy from Keynes. He was a brilliant popular polemicist, but for all his phrase making and eloquence urging governments to instigate public works to cure unemployment, he felt that he was making little progress. In the aftermath of A Treatise on Money, Keynes was suffering from a distinct lack of influence in high places. Ramsay MacDonald’s “National” administration was a Conservative government by any other name. The Conservatives thought Keynes antibusiness, and he was declared persona non grata in Whitehall. The Labour Party, in defeat, had swung leftward, and members had little time for Keynes’s prescriptions for what they were sure was a doomed capitalist system. For their part the Liberals, the party Keynes felt was his spiritual home, were beaten, down and out.

Keynes was now barely tolerated in the corridors of power. It is true he could still be found having lunch from time to time with MacDonald at the establishment watering hole, the Athenaeum Club in Pall Mall, but this was but a lingering ghost of the sway he once enjoyed with those who operated the levers of power. He retained a position on the Committee on Economic Information, a subset of the prime minister’s Economic Advisory Council, but when yet another new committee of top economists was set up in February 1932 to advise on policy, Keynes was left out, while his orthodox rival Lionel Robbins was awarded a place.

Keynes determined that the new book he was setting out on would be aimed not at the general public, nor at politicians, nor civil servants in the Treasury, nor the masters of finance in the banks, but at his fellow economists. Having failed to instigate change via a more direct route, he now embarked on a long march to finesse his theories so that economists would take up the campaign on his behalf. To that end he decided that the arguments in The General Theory, as the name immodestly suggested,1 should be soberly presented, comprehensive in their range, and logically tight. He began sifting his thoughts, sharing the burden by accepting criticism from members of the Circus, and consulting close colleagues whose keen intellects he believed would help The General Theory be wholly convincing to those prepared to be persuaded. It would take more than five years to complete the work.

Keynes’s combative encounters with Hayek had proved so irritating, and so fruitless, that he deemed further debate with the classical economists to be futile. He was attempting to reach beyond the constraints of orthodox market economics and believed Hayek to be so trapped in the old thinking as to be incapable of grasping the brave new concepts he was now configuring. He scrawled over a copy of Hayek’s essay “Capital Consumption,” published in English in 1932, “The wildest farrago of nonsense yet.”2 They crossed each other’s paths now and then and had glancing conversations about their differences, but Keynes felt no urge to try to persuade Hayek of the errors in his thinking. “Hayek has been here for the weekend,” Keynes wrote to Lydia from King’s College in early 1933. “I sat by him in hall last night and lunched with him at Piero’s [Sraffa] today. We get on very well in private life. But what rubbish his theory is—I felt today that even he was beginning to disbelieve it himself.”3 Keynes was an eager progressive, keen to help advance the world toward a more humane future; Hayek, though he claimed throughout his life that he was not a conservative, was deeply skeptical of the new. Hayek was aware that his contribution to the debate with Keynes was little more than repeating the pessimistic logic inherent in Austrian School thinking. As he was later to confess, “What I had done had often seemed to me more to point out barriers to further advance on the path chosen by others than to supply new ideas which opened the path to further development.”4

A person with whom Keynes kept in regular contact during this important period of brainstorming was the Oxford economist Roy Harrod, who had studied economics under Keynes in the fall of 1922 and whose official biography of Keynes, published six years after Keynes’s death, “must be credited as a major element in the rapid dissemination of Keynes’ ideas in the 1950s.”5 Harrod was periodically sent sets of galley proofs of The General Theory to solicit his observations and criticisms. He recalled that his comments on each successive draft “were composed with fervour, in a strain of ardent admiration and with a sense of his mighty achievement, but also with a persistent and implacable zeal to convert him on certain points.”6

As the features of The General Theory slowly began to emerge, it became plain that Keynes, in his usual controversial style, felt he needed to fully refute the thoughts of Hayek and his kind if he was to overcome the unthinking adherence to classical economics that stalked the corridors of the Treasury. While members of the Circus were in the trenches in the battle against orthodoxy and were eager to egg him on, Harrod remained a rare voice of moderation. “My main endeavour was to mitigate his attack on the ‘classical school,’” recalled Harrod. “I agreed with him that there was a woeful gap in the traditional theory of unemployment and that the root of the matter was an incorrect theory of interest; where I disagreed was in regard to his allegation that the traditional theory of interest did not make sense. It seemed to me that this was pushing his criticism too far, would make too much dust, and would give rise to irrelevant controversies.”7 Keynes was not worried about making dust and declined to remove a barely veiled ad hominem attack on Hayek in the final draft of The General Theory. If the old ways of thinking were obstructing a wider appreciation of his radical new approach to understanding economics, and thereby increased unnecessary misery in the world, Keynes felt Hayek’s ideas must be addressed, dissected, and convincingly dispatched.

The most important influence on Keynes’s thinking in the early 1930s, however, remained the Circus. And none was more significant than Richard Kahn in allowing Keynes to square the circle and show that increased investment would raise demand without causing a catastrophic increase in prices. The Circus proper met in earnest during the academic year 1930–31, disbanding its formal meetings before the Cambridge examinations of May 1931, many months before Keynes began to gather his thoughts to write The General Theory. Richard Kahn, Joan and Austin Robinson, Piero Saffra, James Meade, and others, however, continued to tease and dissect every twist and turn in Keynes’s thinking and made a substantial contribution to his internal debate. Keynes wrote in his preface to The General Theory, “The writer of a book such as this, treading along unfamiliar paths, is extremely dependent on criticism and conversation if he is to avoid an undue proportion of mistakes. It is astonishing what foolish things one can temporarily believe if one thinks too long alone.”8

Some doubt has been cast on the contribution the Circus made to The General Theory,9 but Circus members themselves were certain that their often tart criticisms, funneled through Kahn to Keynes, made a considerable difference to Keynes’s thinking and the final work. “To anybody who did not know Keynes, it is astonishing that he was willing, week after week, to discuss with me, acting as the group’s spokesman, the problems which had arisen and their implications,”10 recalled Kahn. It was a sentiment endorsed by Austin Robinson, who offered an important insight into why Keynes felt he needed to vanquish the ideas of orthodox economists such as Hayek. “At no moment in his life, I think, did Keynes’s greatness of character appear more strongly than at this time,” he recalled. “Keynes never even appeared to hesitate. He was off with the rest of us in pursuit of truth with as enthusiastic a zest as if he were demolishing the work of his worst enemy.”11 Which, when it came to the work of Hayek and Robbins, he was.

The Circus certainly left its mark. Members were instrumental in persuading Keynes that he was in error in A Treatise when he invoked “the widow’s cruse,” a typically colorful Keynesian analogy that suggested that when entrepreneurs spent part of their profit on buying goods, they raised prices to a similar degree, thereby restoring their profits to their former level and leaving them as rich as before, much like the pitcher of oil in the biblical story of the “widow’s cruse” (1 Kings 17:8-16) that remained full however much the widow poured from it. By the same token, they disabused him of his fondness for the obverse notion to the widow’s cruse, which he termed “the Danaid jar,” after the Greek myth that told of the daughters of Danaus in the Underworld who were sentenced to perpetually replenish a leaky jar. Keynes’s Danaid jar theory suggested that when entrepreneurs sought to curtail their losses by cutting their consumption and increasing savings, the law of diminishing returns meant they could never recover their former wealth.12 Both Kahn and Joan Robinson drew Keynes’s attention to his error in thinking that, in describing the closed economy necessary to establish his conclusions, he deemed the output of consumption goods to be fixed and finite. Kahn exposed the fallacy thus: “If entrepreneurs responded to the abnormal profits by increasing the output of consumption goods, the price level of consumption goods would progressively fall, and abnormal profits would fall, until either entrepreneurs earned no more than normal remuneration or some barrier was encountered—full capacity utilisation or full employment of labour.”13

In his defense, in an anguished letter to Joan Robinson, Keynes pointed out that in parts of A Treatise, “I have long discussions [on] the effects of changes in output; it is only at a particular point in the preliminary theoretical argument that I have assumed constant output.”14 But the objection of Circus members to both fallacies suggested to Keynes what was to become a pivotal element of The General Theory, that overall output was not fixed and could be raised through increased investment to a point where everyone in an economy was employed.15 It was this first slender thread of thought that led to Keynes’s wholesale contradiction of the claim of classical economists like Hayek that an economy, left to its own devices, in the long run inevitably came to rest at a state of equilibrium where there was full employment. Keynes was to argue in The General Theory that in the short and medium terms an economy could reach equilibrium with considerable unemployment and that the full employment equilibrium predicted by classical economists too often proved to be elusive. Keynes believed that the chronic unemployment endured in Britain and America in the 1920s and 1930s was evidence that the full employment equilibrium was a fallacy.

During the writing of The General Theory, Kahn proved to be far more than Keynes’s favorite and most devoted pupil; he acquired something of the status of a missing son. He alone was invited to take part in the intense long hours of conversation Keynes needed to define and refine his thoughts. From an early date Kahn was admitted into Keynes’s lonely ivory tower and allowed to act as a patient and clearheaded creative partner. Kahn explained how he was used as a sounding board to monitor Keynes’s far-flung ruminations. “It was in the course of the year 1930 that I began to spend part of most vacations staying with Keynes and Lydia at [Keynes’s Sussex farmhouse] Tilton,”16 Kahn recalled. “I relieved the solitude and provided, by being on the spot, a more rapid method of discussion than correspondence by post.”17 Kahn also amended Keynes’s text. “My written—as opposed to oral—contributions were made in the margins of galley proofs,” he wrote. “Such a note would take the form either of minor redrafting; or of an indication that Keynes and I should discuss the passage indicated, or of the correction of a misprint.”18

It was Kahn, too, who provided perhaps the most important single new element to Keynes’s thinking by providing a cogent explanation for why public investment, even on borrowed money, could soon recoup its cost while drastically reducing unemployment: what Kahn at first termed “the ratio” and Keynes famously renamed “the multiplier.” Keynes had intuitively concluded that public investment would soon pay for itself while putting the jobless to work in his 1929 Liberal Party general-election pamphlet, “Can Lloyd George Do It?” coauthored with Hubert Henderson. The Liberals promised to invest £100 million a year in public works for three years to create jobs, a policy the Treasury dismissed as a waste of money.

Keynes argued that, on the contrary, the new jobs would cost little, that they would if anything boost business confidence because entrepreneurs would invest to take advantage of the new demand from those newly employed, and that the jobs directly created by the government would be accompanied by new private sector jobs for those who provided goods and services to the newly employed. “The fact that many workpeople who are now unemployed would be receiving wages instead of unemployment pay would mean an increase in effective purchasing power which would give a general stimulus to trade,” Keynes and Henderson argued. “Moreover, the greater trade activity would make for further trade activity; for the forces of prosperity, like those of a trade depression, work with a cumulative effect.”19 It was common sense that this was so, Keynes argued, while conceding that “it is not possible to measure effects of this character with any sort of precision.”20 In his article “The Relation of Home Investment to Unemployment,” published in the June 1931 issue of Economic Journal, Richard Kahn set himself the task of statistically proving that what Keynes surmised about the multiplier was true.

Kahn recalled how his work toward solving the riddle of the multiplier came about. “I began work on my so-called ‘multiplier’ article in the Austrian Tyrol in August 1930,” he wrote. “I was inspired by ‘Can Lloyd George Do It?’ partly because this marked a milestone in the development of thought, but also because of certain arithmetical and logical problems which it raised.”21 The more Kahn explored the problem of how to assess how many would be indirectly employed as a result of the government employing workers, the more he was amazed by how accurate Keynes and Henderson’s guesswork had been. Kahn set aside the problem of attempting to quantify the additional jobs deriving from the added investment stemming from the growth in business confidence that an injection of a substantial sum of public funds into the marketplace would provoke because “the state of confidence about the near future . . . is a difficult subject to assess, still more to quantify.”22 He was certain there would be additional employment from improved business confidence, but left such tricky calculations about exactly how many new jobs it would create for later.

Kahn concentrated instead on the central contention in Keynes and Henderson’s claim, that for every million pounds spent on the construction of new roads, five thousand new jobs would be created, about half directly and half indirectly. Keynes and Henderson had estimated that “nearly half of the capital cost would be recovered at the time,” with a full one-fourth saved by not having to pay out money in unemployment relief. Kahn, too, concluded that government savings from not having to pay unemployment insurance, plus savings from spending on poor relief, amounted to half the cost. He also agreed with the pair’s estimate that the new employment would generate taxation revenue amounting to a further eighth of the cost. Kahn was astounded that Keynes and Henderson’s estimates should be so similar to the results of his own more demanding mathematical analysis. He wrote, “It is remarkable that the inspired guesses of Keynes and Henderson turned out to be so accurate, although, so far as is known, they made no estimate of the ‘multiplier’—the ratio of the total additional employment (primary and secondary) to the primary employment.”23 Kahn concluded that the multiplier might vary from country to country, depending on how much benefit from the public investment leaked abroad, as it would with major trading nations like Britain. He estimated that in Britain the figure lay between 0.56 and 0.94 “and I suggested that the adoption of 3/4 would be ‘erring in the direction of under-statement.’”24

“My main concern—from the start,” recalled Kahn, “was to prove that the various offsets—the increase in the yield of taxation, savings of various kinds to the Exchequer . . . the increase in the excess of imports over exports”—as the newly employed would likely spend on imported goods but would not contribute to exports—“the increase in private savings (mainly out of profits), and the change in the rate of saving due to the rise in prices—added up to the cost of the investment.”25 Kahn anticipated two objections to public works funded by government that would soon be raised by the classical school, that such measures would increase inflation and, from Dennis Robertson,26 that they would achieve little more than add to the quantity of money in circulation. Kahn dismissed the predicted rise in the cost of living as an “extraordinary fatuity,” because “the rise in prices, if it occurs at all, is a natural concomitant of increased output, to a degree indicated by the slope of the supply curve.”27 That is, whenever demand was increased, by whatever means, it tended to raise prices. There was nothing special about inflation caused by artificially raising demand. He concluded that the objection against increasing output, or supply, because it was prompted by the use of public funds, or borrowing, rather than private funding of employment, was therefore a red herring. As for the objection to the government printing money rather than raising it from lenders, Kahn argued that “there was no reason why additional expenditure on public works needed to be financed by the creation of additional money as against borrowing from the public (though if a heavy programme was started off suddenly, some temporary help from the banking system would be useful for pump-priming purposes).”28

While Keynes’s thinking toward The General Theory was not known outside of his small band of intimates, those who were opposed to his developing ideas, such as Hayek and Robbins at the LSE, could hardly avoid hearing that Keynes was making considerable headway toward his magnum opus. Then, in the summer of 1932, all started to come clear. Keynes began expounding on his post-Treatise thoughts in a series of Monday-morning lectures to his Cambridge students, titled “The Pure Theory of Money,” which were widely attended by members of the faculty, by undergraduates from other disciplines, and even by a number of interested invited visitors. In the autumn term, after a long summer of heavy rumination at Tilton, Keynes resumed his lecture series with a significant announcement to his assembled pupils, that the new title of his subsequent lectures would be “The Monetary Theory of Production.” “With these words in October 1932,” recalled Lorie Tarshis, a visiting postgraduate student from Toronto University who attended all four of the series, “Keynes . . . in effect announced the beginning of the Keynesian Revolution.”29

Lecture by lecture, reading from successive sets of galley proofs amended in his own hand, Keynes presented the latest iterations of his thinking. It was clear to those who attended that they were witnessing something out of the ordinary. As Tarshis recalled, “As the weeks passed, only a stone would not have responded to the growing excitement [the lectures] generated.”30 Michael Straight, an American undergraduate, recalled, “It was as if we were listening to Charles Darwin or Isaac Newton. The audience was hushed as Keynes spoke.”31 By the end of the series, Keynes had worked through his ideas to his own satisfaction and was ready to consign to his publisher, Macmillan, the final set of corrected proofs of a work that many would view as the most influential body of economic theory written in the twentieth century.

Although Keynes largely confined himself to academic life during the gestation of The General Theory, he did allow himself one significant sally into the public realm. When it was announced that an international summit, the World Economic Conference, was to be held in London in June 1933, Keynes could not resist a chance to contribute. He wanted to ensure that his most recent thinking would be available to policy makers. He proposed to the editor of The Times, Geoffrey Dawson, a series of articles suggesting a way to solve the worldwide economic trough through international cooperation. The articles offered a sneak preview of a revolutionary theory that would soon alter the world.

After appearing in The Times, the articles were collected as a pamphlet, The Means to Prosperity, a document that proved to be the base camp to The General Theory’s peak. For once, Keynes, now aged fifty, abandoned the easy phrase making and colorful sarcasm that had become his stock-in-trade and instead set out clearly and without sensation an argument he felt would attract the attention of the economists and finance ministers heading to London. He challenged them to either agree with his prescription for creating millions of new jobs at a minimum of cost to the taxpayer or point out where he was mistaken. It was the most cogent, disciplined, persuasive account of his imaginative ideas yet expressed, and contained all the elements that would come to be known as “Keynesianism.” Far more than The General Theory, which was intended to influence academic economists, The Means to Prosperity was made deliberately accessible for those, like many of the world’s finance ministers, who had little knowledge of economics. For the Hayekians, The Means to Prosperity was the clearest signal yet of the scale of the impending Keynesian challenge to their philosophy. It gave them fair warning of what was to come in The General Theory and suggested to them that it was time to prepare counterarguments.

In The Means to Prosperity, Keynes was blunt about those who suggested that the world economy would recover if traditional remedies were employed. “There are still people who believe that the way out can only be found by hard work, endurance, frugality, improved business methods, more cautious banking, and, above all, the avoidance of devices,”32 he wrote. Armed with Kahn’s paper, Keynes for the first time publicly integrated the multiplier into his proposal that governments should spend to raise overall demand in the economy. And he confronted head-on the assertion by Hayekians that government spending would only spur inflation.

“If the new expenditure is additional and not merely in substitution for other expenditure, the increase of employment does not stop there,” he wrote. “The additional wages and other incomes paid out are spent on additional purchases, which in turn lead to further employment. If the resources of the country were already fully employed, these additional purchases would be mainly reflected in higher prices and increased imports. But in present circumstances this would be true of only a small proportion of the additional consumption, since the greater part of it could be provided without much change of price by home resources which are at present unemployed.”33

For those who were coming to terms for the first time with how the multiplier worked, Keynes spelled it out. “The newly employed who supply the increased purchases of those employed on the new capital works will, in their turn, spend more, thus adding to the employment of others; and so on.” He suggested that the multiplier figure in Britain was 2, but he did not want to overpromise lest his arguments appear fantastic, so he suggested that every pound the government spent on creating new jobs was worth one and a half pounds to the total economy. “Additional loan-expenditure of £200 on materials, transport, and direct employment puts, not one man to work for a year, but—taking account of the whole series of repercussions—one and a half men,”34 he wrote. He stressed that employment was not the only benefit of the multiplier. “Half of what [the chancellor of the exchequer] remits will in fact return to him from the saving on the dole and the higher yield of a given level of taxation.”35 This was to become a key element of The General Theory, that economists and financial ministers should scrutinize not whether the income and outflow of national expenditures were in balance but the scale of the overall income of the nation, what Keynes would call a nation’s “aggregate demand.”

In an argument familiar to the one that would reemerge after the banking crisis of 2008, when plans for a stimulus from government borrowing were immediately countered by anxiety about the budget deficit, Keynes asserted that “it is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the Budget—that we must go slowly and cautiously with the former for fear of injuring the latter. Quite the contrary. There is no possibility of balancing the Budget except by increasing the national income, which is much the same thing as increasing employment.”36 Again, a pivotal element of The General Theory was on display: that national income was equal to the sum of the incomes of those employed.

Keynes estimated it would cost £100 million a year to put 1 million people to work, of which £50 million might come from a reduction in taxation. This was Keynes’s first suggestion that tax breaks could be used to stimulate the economy, a policy that became a hallmark first of Keynesians and Keynesian finance ministers but then a talisman of their conservative opponents. He cautioned that for such a reduction in taxes to have the desired effect on the job market, it “does not apply to a relief of taxation balanced by an equal reduction of Government expenditure (by reducing school teachers’ salaries, for example); for this represents a redistribution, not a net increase, of national spending power.”37 As Harrod observed, “We begin here to get the first inkling of an idea, more radical than any recommended so far, that the Chancellor of the Exchequer should pump in additional purchasing power, not only by financing public works through loans, but also by remitting taxation without reducing current expenditure. This is almost ‘deficit finance’ in the full sense.”38

On top of this, Keynes made a broader appeal for concerted action to increase demand worldwide and, in the face of widespread deflation (falling prices) that deterred business activity, to deliberately raise prices as an incentive to entrepreneurs and private industry. “There is no effective means of raising world prices except by increasing loan-expenditure throughout the world,” he asserted. “It was, indeed, the collapse of expenditure financed out of loans advanced by the United States, for use both at home and abroad, which was the chief agency in starting the slump.”39

Keynes then ventured into territory that would guide the thinking of the victorious Allies attempting to restore the worldwide economy after the devastation inflicted by World War II. He had often expressed his contempt for gold as an arbitrary measure of wealth. What he now proposed was that the world’s finance ministers should print money in concert, as if it were backed by gold. For Keynes, “notional gold” was every bit as useful as real gold ingots. Individual nations had long abandoned tying their supply of banknotes to the actual amount of gold stored in their treasuries; why not apply the same financial logic to a worldwide system of credit, where each nation would be provided with “gold notes” that had all the benefits of a cache of gold but without that cache actually existing. It was, Keynes urged, a means of restoring confidence in a world market that had frozen in the face of economic failure. But if it was an instrument to reinstate confidence, it was more than a mere confidence trick. As Roy Harrod would explain, “No one would think it a confidence trick if all these nations discovered an equivalent amount of gold in local mines and were encouraged to go forward by the reserves thereby acquired. Why should not gold certificates play a similar role?”40

Keynes then ventured an idea that would come into its own when the Allies contemplated how to ensure that the postwar world would avoid repeating the errors of the Versailles Treaty: the establishment of a world banking body, an idea that would become manifest in the World Bank. He proposed $5 billion in “gold-notes” distributed to each country according to “some such formula as the amount of gold which it held in reserve at some recent normal date, e.g., at the end of 1928.”41 To ensure currency stability, Keynes, who had long dismissed gold as a useful standard against which to peg currencies, was, perhaps reluctantly, convinced that the notional-gold standard should continue to rule his new world financial regime. “The notes would be gold-notes,” he wrote, “and the participants would agree to accept them as the equivalent of gold. This implies that the national currencies of each participant would stand in some defined relationship to gold.”42

There was a deeply ominous note in one of Keynes’s parting observations. In The Economic Consequences of the Peace he had predicted that reparations imposed on the defeated nations would foster ideal conditions for the flowering of extreme political movements, whether of the Right or the Left. While he did not in The Means to Prosperity allude to events that had taken place in Germany, just two months before his pieces appeared—namely, the rise of the Nazis headed by Adolf Hitler, appointed chancellor in January 1933—he did hint at another set of circumstances that would also display his prescient understanding of how the world span.

“Some cynics, who have followed the argument thus far, conclude that nothing except a war can bring a major slump to its conclusion,” he wrote. “For hitherto war has been the only object of governmental loan-expenditure on a large scale which governments have considered respectable. In all the issues of peace they are timid, over-cautious, half-hearted, without perseverance or determination, thinking of a loan as a liability and not as a link in the transformation of the community’s surplus resources, which will otherwise be wasted, into useful capital assets. I hope that our Government will show that this country can be energetic even in the tasks of peace.”43