Re-reading Keynes

Editor's Note: Nadia Piffaretti is assistant and advisor to the Senior Vice President and Chief Economist, Development Economics.

“The world has been slow to realize that we are living in the shadow of one of the greatest economic catastrophes of modern history”. This could be the opening to any one of the dozens of Op-Eds appearing since the start of the crisis, but they are the words of J. M. Keynes from his 1930 piece The Great Slump of 1930.

I distractedly read this piece at university, not finding it particularly interesting or memorable. But here I am re-reading the original thoughts of this towering economist in hopes of finding some wisdom that will be germane to the current economic crisis. What I found instead is a striking 80-year-old summary of some of the same debates we are engaging in today.

Yet, if the world has changed, if we have learned vital lessons, how is this possible?

Keynes’ recounting of the crisis sounds all too familiar. From the start, his narrative assumes a terrible accident, an episode not grounded in the fundamentals underlying dynamic growth: “Today we have involved ourselves in a colossal muddle” - it was never meant to be, but it happened - “having blundered in the control of a delicate machine, the working of which we do not understand".

“The machine would merely have been jammed as the result of the muddle. But because we have magneto trouble, we need not assume that we shall soon be back in a rumbling wagon and that motoring is over…How, then, can we start up again?”

Keynes focuses on the dynamic of unemployment, linked to firms’ expectations of low realization of profits. He notes the lack of effective demand due to decreased household  consumption. Put simply and without the intricacies of his Treatise on Money, Keynes outlines the centrality of the relation between profits and effective demand:

Profits of the producers of consumption-goods can only be restored, either by the public spending a larger proportion of their incomes on such goods (which means saving less), or by a larger proportion of production taking the form of capital goods. But capital-goods will not be produced on a larger scale unless the producers of such goods are making profits.

Why then is the production of capital goods less profitable? These profits “depend on whether the public prefer to keep their savings liquid in the shape of money or its equivalent or to use them to buy capital-goods or equivalent…with the result that less capital-goods will be produced; with the result that, for the reasons given above, producers of consumption-goods will also make a loss. In other words, all classes of producers will tend to make a loss; and general unemployment will ensue. By this time a vicious circle will be set up. The “unsatisfactory market for capital investment” is the root-cause for the “lack of enterprise".

While Keynes blames the start of the crisis on the changed sentiment of lenders, he stresses that it was the attitude of borrowers which allowed it to persist:

The existence of political borrowers to meet Treaty obligations, of banking borrowers to support newly restored gold standards, of speculative borrowers to take part in Stock Exchange booms, and of distressed borrowers to meet the losses which they have incurred through the fall in prices, all of whom were ready if necessary to pay almost any terms, have hitherto enabled lenders to secure from these various classes of borrowers higher rates than it is possible for genuine new enterprise to support.

Keynes, by focusing on profit, is reminding us that extending lending to big troubled enterprises to cover losses can actually crowd out life support to new enterprises. Shouldn’t this be a major concern amidst a “protracted flagging recovery”? Answering this question might reveal fundamental mistakes in the current attempts at crisis containment: Is it about managing de-leveraging, or is it about restoring profitability?

With a haunting foreshadowing, Keynes observed: “A wide gulf, therefore, is set between the ideas of lenders and the ideas of borrowers for the purpose of genuine investment; with the result that the savings of the lenders are being used up in financing business losses and distress borrowers, instead of financing new capital work”. This account bears a striking resemblance to the 2008-2009 conundrum. Are we then repeating mistakes made 80 years ago?

Keynes concludes by defining the fundamental economic trap laid in 1930: “At this moment the slump is probably a little overdone for psychological reasons. A modest upward reaction, therefore, may be due at any time. But there cannot be a real recovery, in my judgment, until the ideas of lenders and the ideas of productive borrowers are brought together again; partly by lenders becoming ready to lend on easier terms and over a wider geographical field, partly by borrowers recovering their good spirits and so becoming readier to borrow”. Keynes warns darkly, “if the diagnosis is right, the slump may pass over into a depression, which might last for years".

The piece does not offer ready-to-adopt policies, but my re-reading of it left me with a sense of restored clarity on the central question: How to restore firms’ profitability, the key driver of growth and employment?