John Maynard Keynes Great Thinkers in Economics Series Series Editor: Professor A

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John Maynard Keynes Great Thinkers in Economics Series Series Editor: Professor A. P. Thirlwall, is Professor of Applied Economics, University of Kent, UK. Great Thinkers in Economics is designed to illuminate the economics of some of the great historical and contemporary economists by exploring the interactions between their lives and work, and the events surrounding them. The books will be brief and written in a style that makes them not only of interest to professional economists, but also intelligible for students of economics and the interested lay person.

Titles include: William J. Barber GUNNAR MYRDAL Paul Davidson JOHN MAYNARD KEYNES Gordon Fletcher DENNIS ROBERTSON Peter D. Groenewegen ALFRED MARSHALL Gavin Kennedy ADAM SMITH John E. King NICOLAS KALDOR Alessandro Roncaglia PIERO SRAFFA Michael Szenberg and Lall Ramrattan FRANCO MODIGLIANI

Forthcoming titles include: Gerhard Michael Ambrosi ARTHUR C. PIGOU Esben Sloth Anderson JOSEPH A. SCHUMPETER Robert Dimand JAMES TOBIN G. C. Harcourt and Prue Kerr JOAN ROBINSON AND HER CIRCLE Michael A. Lebowitz KARL MARX Julio Lopez and Michaël Samuel Assous KALECKI’S THEORY OF CAPITALIST ECONOMIES Roger Middleton ROBERT SOLOW Paul Mosley and Barbara Ingham SIR ARTHUR LEWIS Charles Rowley JAMES MCGILL BUCHANAN J. R. Stanfield JOHN KENNETH GALBRAITH Warren Young and Esteban Perez ROY HARROD

Great Thinkers in Economics Series Standing Order ISBN 978–1–4039–8555–2 (Hardback) 978–1–4039–8556–9 (Paperback) (outside North America only) You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England John Maynard Keynes

Paul Davidson © Paul Davidson 2007, 2009 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2007 Published in paperback 2009 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin's Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-0-230-22920-4 ISBN 978-0-230-23547-2 (eBook) DOI 10.1007/978-0-230-23547-2 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress.

10 9 8 7 6 5 4 3 2 1 18 17 16 15 14 13 12 11 10 09 To Louise, Robert, Diane, Greg, Chris, Emily, Arik, Gavi, and Zakkai This page intentionally left blank Contents

List of Figures x List of Tables xi Preface xiii Chapter 1 An Introduction to Keynes and His Revolutionary Views 1 I. Keynes’s early intellectual surroundings 3 II. Keynes’s intellectual development 5 Chapter 2 How the Great War and Its Aftermath Affected Keynes’s Thinking 7 Chapter 3 Keynes’s Middle Way: Liberalism is Truly a New Way 13 Chapter 4 The Before and After of Keynes’s General Theory 18 I. Keynes’s revolutionary theory versus mainstream classical theory 18 II. Axioms and theory building 26 III. The neutral money axiom 27 IV. The gross substitution axiom 30 V. Uncertainty and the ergodic axiom 31 VI. Aborting Keynes’s revolutionary analysis 35 Chapter 5 The Conceptual Difference between Keynes’s General Theory and Classical Theory – Savings and Liquidity 38 I. What is a classic book? 38 II. Say’s Law 40 III. The aggregate supply function 44 IV. The aggregate demand function 44 V. A note on Friedman’s alternative definition of saving 55 Chapter 6 Further Differentiating Keynes’s Aggregate Demand Function 58 I. Two aggregate demand components 58 II. Investment spending 60

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III. What about other components of D2?64 IV. Government taxes and spending 65 Appendix to chapter 6: deriving the aggregate supply and aggregate demand functions 68 Chapter 7 The Importance of Money, Contracts, and Liquid Financial Markets 75 I. The reality of money contracts 75 II. Contracts, markets, and the security blanket of liquidity 78 III. Liquidity and contracts 87 IV. The role of financial markets 90 V. Financial markets and Keynes’s liquidity theory 96 VI. The need for market orderliness 97 VII. Booms and busts 98 VIII. Is reality predetermined, immutable, and ergodically knowable or nonergodic, unknowable, and transmutable? 100 IX. Crucial decisions and Schumpeterian entrepreneurship 112 X. Designing policy 114 Chapter 8 World War II and the Postwar Open Economies System 116 I. Planning for the postwar open economy system 117 Chapter 9 Classical Trade Theory versus Keynes’s General Theory of International Trade and International Payments 126 I. The benefits associated with the classical theory of international trade 126 II. International trade and liberalized markets: the facts 127 III. Trade, the wealth of nations, and the law of comparative advantage 128 IV. Can a reduction (devaluation) in the exchange rate always cure an unfavorable trade balance? 138 Chapter 10 Reforming the World’s Money 145 I. A lesson from the early post–World War II history 145 II. The Bretton Woods experience and the Marshall Plan 146 Contents ix

III. Keynes, free trade, and an international payments system that promotes full employment 148 IV. Changing the international payments system 152 Chapter 11 Inflation 160 I. Contracts, prices, and inflation 161 II. The inflation process in a Keynes world 162 III. Incomes inflation 163 IV. Incomes policy 164 Chapter 12 Keynes’s Revolution: The Evidence Showing Who Killed Cock Robin 169 I. Fixed wages and the problem of unemployment 174 II. Who actually aborted Keynes’s revolution? 176 III. Samuelson’s Neoclassical Synthesis Keynesianism 176 IV. The coming of Keynesianism to America 179 V. How did Samuelson learn Keynes’s theory? 180 VI. The axiomatic differences between Samuelson’s Neoclassical Keynesianism and Keynes/post-Keynesian theory 183 VII. What about Hicks’s IS-LM model? 185 VIII. Conclusion 187 Postscript: The Great Financial Crisis of 2008–2009 190 I. What caused the economic and financial crisis of 2008? 190 II. Financial market policy 198 III. Policy to create a recovery in the real economy in 2009 201 Notes 203 Bibliography 214 Index 220 List of Figures

5.1 Two-stage spending decision-making process for saving out of current income 49 6.1 Aggregate demand and supply 70 6.2 Deriving the demand-outlay curve 73

x List of Tables

7.1 Real GDP (annualized growth rate) 96 9.1 United States international payments balances (in billions of dollars) 142

xi This page intentionally left blank Preface

In economics you cannot convict your opponent of error, you can only convince him of it. And even if you are right you cannot convince him … if his head is already filled with contrary notions. — Attributed to John Maynard Keynes

The purpose of this book is to convince the reader, whether an intelligent layperson, a student of economics, or even a professional economist, that what passes as the conventional economic wisdom espoused by the talking heads on television or written about in the mass media and mainstream professional economics journals is not applicable to the world in which we live. I hope to demonstrate that the revolutionary economic analysis of John Maynard Keynes, the greatest thinker in economics in the 20th century, is the most apt description of our market- oriented, money-using entrepreneurial economy. The less the reader has been exposed to traditional economic analysis, the less his/her head is filled with what Harvard Professor John Kenneth Galbraith described as the “conventional wisdom” and “innocent frauds” of orthodox economists. Consequently, convincing the lay reader of how a monetary economy really operates will be an easier task for me than convincing an economics student, while the hardest task will be convincing the professional economist who professes the conventional wisdom by rote. Accordingly, although I have tried to provide a clear exposition, I have found it necessary occasionally to introduce technical jargon and tools into the discussion in order to jog the minds of students and their professors. The most difficult of these technical discourses I have relegated to the appendix to chapter 6. I suggest that the lay reader can readily skip this appendix without loss. The first three chapters of this book briefly describe Keynes’s early development into a traditional orthodox economist, and how the economic realities of World War I and its aftermath convinced Keynes that the economics that he taught and practiced was deficient. Chapters 4 through 6 describe how, after more than a decade of thought, Keynes was able to differentiate his analysis from classical economic theory. Chapter 7 summarizes Keynes’s view of the economic system in which we live. The lay reader will find the discussion in chapter 7 so obviously

xiii xiv Preface correct that he/she will be amazed to learn that mainstream professional economists do not accept this description and analysis. Chapters 8–10 develop Keynes’s analysis to solve the economic problems of the 21st- century global economy. Chapter 11 deals with the problem of inflation and explains how Keynes’s analysis leads to recommendations for fight- ing inflation that differ dramatically from the innocent fraud perpe- trated by central bankers who claim to be able to inflation-target. Finally, chapter 12 explains how the anti-communist (McCarthyism) witch hunt immediately after World War II, plus the mathematization of the discipline of economics, led to obfuscation as to what was Keynes’s revolutionary theory, and why it has not become the handmaiden of all professional economists. Hopefully, when enough people have read this book, Keynes’s analysis will again affect economists and government policymakers’ thoughts, and we will make strides toward eliminating the major faults of the economic system in which we live, namely, the inability to provide jobs for all who are willing, able, and capable of working and the growing inequalities of incomes and wealth that have affected both the developed and less developed nations of our globalized economy.