Fanning the flames of the current resurgence in Keynesian economic thought is the second and most relevant book in Lord Skidelsky’s three-part biography of John Maynard Keynes. John Maynard Keynes—The Economist As Saviour 1920-37 (MacMillan. 1992, £20) covers the period when Keynes's most influential and original work was undertaken.
Its subtitle is appropriate enough, for it was in this period that Keynes effectively manoeuvred himself into the dubious position of being seen as the saviour of capitalism. It was certainly a time in which capitalism seemed to need a new saviour, for as the economy dipped in the early 1930s, so did the reputations of the orthodox and dominant capitalist economists like Marshall and Pigou, who had thought a major world slump unlikely.
Law of markets
To these economists—dubbed the "classical school" by Keynes—"Say’s Law" that every seller brings a buyer to market largely held true. Unemployment in the capitalist economy was considered by them to be a essentially transient phenomenon caused principally by temporary and isolated overproduction in certain spheres of industry that did not become generalized, or by wage inflexibility promoted by trade union power. Any long-term unemployment. they thought, could be eradicated through adjustments to real wages.
Keynes, in his General Theory of Employment, Interest and Money (1936), was the first capitalist economist to mount a serious challenge to these views and in so doing developed a theory which he claimed could save capitalism from itself and from the economists who had failed to understand it. As Skidelsky puts it:
All these (economists], Keynes said, lacked a theory of effective demand, the fatal flaw in the system, he pointed out. lay in the variability of spending relative to earnings; and this was rooted in the use, and purposes, of money. The result was that the market system was liable to collapse into prolonged depression. If the logical flaw in classical reasoning which "proved” this was impossible could be corrected. and communities induced by policy to consume what they can produce, the existing system could be saved, (p. 484)
Keynes’s discovery of the "logical flaw" in the classical economists’ arguments—Say’s Law of markets—was not, however, as revolutionary as Keynes and many of his followers contended. Seventy years earlier Marx had commented that:
Nothing could be more foolish than the dogma that because every sale is a purchase, and every purchase a sale, the circulation of commodities necessarily implies an equilibrium between sales and purchases . . . its real intention is to show that every seller brings its own buyer to market with him . . . But no-one directly needs to purchase because they have just sold. (Capital, Vol. 1, chapter 3, section 2a).
Moreover, the theory of effective aggregate demand developed by Keynes was itself deficient and led his own key arguments against Say's Law being rooted in under-consumptionist economic thought. Keynes argued that saving constitutes a subtraction from aggregate demand, and that as capitalism proceeds to concentrate more and more wealth into fewer hands, it would be imperiled by the increasing inability of the rich to consume or directly invest all of their wealth.
A good deal of the policy carried out in Keynes’s name by governments wishing to avert slumps has centered on attempts to revive aggregate demand by reducing the incentive to hoard and save wealth and by redistributing income to those sectors of society most likely to spend it. It has never worked, precisely because serious attempts at doing this imperil the very profit-accruing sectors which the capitalist economy finds necessary for its further expansion. This was classically the case with the last British Labour government from 1974-6 when unemployment more than doubled despite concerted intervention on Keynesian lines.
If Keynes’s legacy on the trade cycle and the nature of effective demand in the capitalist economy has been, at best, mixed, much of Skidelsky’s book is spent outlining the genesis of his thought on the one area where he was more muddled still—monetary matters. In his Tract On Monetary Reform (1923) and in the Report of the MacMillan Committee on Finance and Industry (1931) which he helped draft, Keynes outlined the spurious "credit creation" theory which can even now be found in most modern economics textbooks. Keynes's argument was that banks could create multiples of credit, and hence new deposits, from a given initial deposit base, and by so doing, add to purchasing power.
The justifications advanced by Keynes and the MacMillan Committee for the credit creationist view were entirely bogus and rested on an ideal model of a banking system that was very far removed from actual banking practice. In their simple model of a banking system only one bank existed. Into this bank a depositor came along and deposited £1,000 in cash. Operating with a ten percent cash reserve ratio, the bank then lent out £900 which was withdrawn by cheque, only to come back to the same bank as a new deposit. After this transaction. the deposits in the bank totalled £1,900 made up of the initial £1,000 plus the later cheque deposit of £900. Against this liability, the bank had assets of £1,000 cash and £900 owed to it by customers.
Keynes and the MacMillan Committee alleged that this process could be repeated nine more times with a ten percent cash reserve, so that the bank’s books would eventually show £10.000 in deposits balanced by the £1,000 cash together with £9.000 in loans owed by borrowers. Therefore, from an initial £1,000 cash deposit base, the bank had "created" £9,000 of credit. granted as new deposits.
Keynes's theory was entirely spurious because in the real world of capitalism this cannot happen. The assumption of a one-bank financial system is totally unrealistic, as is the assumption that the only money to be withdrawn from the bank’s accounts would be by cheque. Although Keynes and the MacMillan Committee assumed a ten percent cash reserve, they also assumed that in practice this cash reserve would never be called upon by depositors. They took it for granted that the initial £1,000 cash deposit remained entirely unchanged throughout the whole series of transactions. a totally unrealistic proposition by anybody’s standards.
Keynes’s incorrect views on credit creationism led him to make a number of equally absurd contentions about other monetary matters. Foremost among these was the idea that the banks, because of their ability to create purchasing power, effectively determine the price level. This is what Keynes argued in his Tract On Monetary Reform:
The initial price level is mainly determined by the amount of credit created by the banks . . . the amount of credit, so created, is in turn roughly measured by the volume of the banks' deposits, (p. 178).
In recent years this view has largely been taken up by the so-called “monetarists" and has periodically been the view held by Conservative governments since 1979. To them, as for Keynes, notes and coins are only the insignificant “small change of the monetary system", with the money supply consisting predominantly of bank deposits supposedly “created" by the actions of the banks themselves. Because of this view a smokescreen has arisen whereby the real cause of the persistent rise in prices since the beginning of the Second World War has been obscured—that is, the policy of successive governments of issuing an excess of inconvertible paper currency in the vain hope that its effects would be only beneficial to the economy as a whole.
In his book Skidelsky makes it clear that the principal opponent of credit creationism and its related fallacies within the realms of capitalist economics was Professor Edwin Cannan of the London School of Economics (who Skidelsky erroneously says regarded himself as a socialist). Cannan correctly contended that banks can “create" nothing and do not determine the price level, being only intermediaries in the financial process who lend out sums of money that have been deposited with them at higher rates of interest than they pay to depositors to attract money in.
Unfortunately, Skidelsky does not acknowledge the sustained opposition mounted by the Socialist Party to the credit creationist viewpoint—virtually alone among all the political parties in Britain and an opposition underpinned by the Marxian proposition that wealth can only arise through production and not via the process of circulation. Nor, in accepting the general Keynesian outlook on effective demand, unemployment, inflation and credit, does he show any awareness of why the “second coming" of Keynes is unlikely to be any more successful than the first. Skidelsky and others should note that the working class has experienced Keynesian failure before, and we don't want or need a repeat performance.