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In Crisis, It’s good to re-read Keynes

A well-written essay on Keynes…can't be more relevant to today's crisis…"We are all Keynesians now", ONCE AGAIN.

Man in the News: John Maynard Keynes

By Ed Crooks

Man in the News: JM Keynes

“We have reached a critical point,” John Maynard Keynes wrote in March 1933. “We can … see clearly the gulf to which our present path is leading.” If governments did not take action, “we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict.”

As the world reels from a 1929-style stock market plunge and a 1931-style banking crisis, his words are a fair assessment of the dangers we face once again. Keynes, whose life’s mission was to save capitalism from itself, is more relevant than at any time since his death in 1946.

His renewed influence can be seen everywhere: in Barack Obama’s planned stimulus package, for example. When George W. Bush said his administration’s plan to take equity in banks was “not intended to take over the free market, but to preserve it”, he could have been quoting Keynes directly.

The key to Keynes was his commitment to preserving the market economy by making it work. He was dismissive of Marxism but believed the market economy could survive only if it earned the support of the public by raising living standards.

The role of the economist, he believed, was to be the guardian of “the possibility of civilisation”, and no economist has ever been more suited for that role.

Lionel Robbins, later head of the London School of Economics, described Keynes as “one of the most remarkable men that have ever lived,” surpassed in his time only by Winston Churchill. Even Friedrich Hayek, Keynes’ staunchest adversary, described him as “the one really great man I ever knew, and for whom I had unbounded admiration”.

His optimistic, positive thought reflected his comfortable and happy upbringing and career. An academic’s son, he won scholarships to Eton and Cambridge and fell in with the Bloomsbury Group, the circle of writers and artists such as Virginia Woolf and Lytton Strachey who embodied an ideal of cultured living.

He was an imposing figure, six feet, six inches tall and full of jokes, gossip and sharp observations. Alongside economics, he had an array of other interests as mathematician, administrator, academic, investor, journalist, art collector, politician, impresario and diplomat. He was even an exemplary husband, devoted to his wife, Lydia Lopokova, a ballerina. In his language he could be carelessly provocative. But, as he said: “Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”

When bad policies were making economic problems worse, he felt a moral obligation to change them. He worked with distinction at the Treasury during the first world war and at the war’s end argued presciently against the imposition of excessively harsh conditions on Germany. When his advice was ignored, he left and published his views in his first great polemic, The Economic Consequences of the Peace .

Returning to Cambridge, Keynes kept up a flow of books and articles, including The Economic Consequences of Mr Churchill, savaging Britain’s return to the gold standard in 1925. It was not until the Great Depression, however, that his ideas reached their full flowering, published as The General Theory of Employment, Interest and Money in 1936.

The heart of the book is the idea that economic downturns are not necessarily self-correcting. Classical economics held that business cycles were unavoidable and that peaks and troughs would pass. Keynes contended that in certain circumstances economies could get stuck. If individuals and businesses try to save more, they will cut the incomes of other individuals and businesses, which will in turn cut their spending. The result can be a downward spiral that will not turn up again without outside intervention.

That is where government comes in: to pump money back into the economy by some means, such as spending on public works, to persuade individuals and businesses to save less and spend more themselves.

Keynes wrote to George Bernard Shaw that he expected the General Theory to “largely revolutionise … the way the world thinks about economic problems”, and so it proved. Economists such as Paul Samuelson and James Tobin systematised Keynes’ ideas, using them as the foundations of what became orthodox thought and economic policy for more than two decades after the second world war.

The cover of Time magazine in December 1965 quoted Milton Friedman saying: “We are all Keynesians now.” Friedman later said he had been misrepresented by selective quotation, but the point held good. Charles L. Schultze, then US budget director, felt able to tell Time: “We can’t prevent every little wiggle in the economic cycle, but we now can prevent a major slide.”

By the time Richard Nixon borrowed Friedman’s line in 1971, however, the tide was already beginning to turn. Like a share tip from a lift boy, Nixon’s endorsement was a sign that Keynes’ intellectual stock was about to fall. Keynesian economics seemed as inadequate in the 1970s stagflation as classical economics had been for the 1930s depression, and Friedman’s monetarism eclipsed it among policy-makers in the US and Britain.

After crude applications of monetarism also foundered in the 1980s, modern macroeconomic orthodoxy blended ideas from both, reflecting a belief in the ability of monetary and fiscal policy to affect employment and growth, but also concern for inflation and budget deficits.

As the financial crisis has deepened, that orthodoxy has been shaken. The problems Keynes faced in the 1930s, such as the ineffectiveness of monetary policy and banking failures triggered by falling asset prices, again seem the most pressing. Keynes’ solutions, including greater public spending funded by borrowing, are becoming popular. The criticisms that this will fuel inflation and raise budget deficits are still heard but are increasingly seen as irrelevant.

Robert Skidelsky writes at the end of his definitive three-volume biography that Keynes’ ideas “will live so long as the world has need of them”. It certainly seems to need them now. Keynes was scathing about the view that the Great Depression was a return to normality, a necessary correction after the unsustainable excesses of the 1920s. On the contrary, he argued, the economic expansion should be seen as the normal state of affairs and the downturn was an “extraordinary imbecility”.

With the right policies, he said, the good times could be brought back. He was right then; we must hope he will be right again.

Panic, Fear and Financial Crisis

Edward Chancellor of GMO looks back in history of the similarities in financial crises.

"The passion of fear,” declared The Times on the day of Overend’s collapse, “is even more powerful than that of hope. There are men who can resist the seductions of promised profits and high premiums, but when depositors think a stoppage is imminent each rushes to secure his deposit in time, caring little for the consequences. Not long ago men trusted everybody; it would seem now that they trust nobody. A great machinery is thrown out of gear.”

full text is here:

The financial panic we have been living through has much in common with the great banking panics of the past: rumours of foundering financial giants, concerns about counterparties, the shepherding of cash and flight to the highest quality and most liquid credit instruments, the dumping of riskier assets regardless of price, international contagion and, above all, a heightened sense of the fragility of a weakened financial system. Yet this panic will pass, just like its predecessors.

Bank panics always have the same origin. “Every genuine business panic springs from the same root, which is rank speculation,” wrote one Victorian commentator. Thomas Tooke, the ­early 19th century merchant and author, ascribed the British crisis of 1793 to “a great and undue extension of the system of credit and paper circulation”. A year earlier, Thomas Jefferson, observing the first financial collapse in the independent United States, noted that “our paper bubble has burst”.

Bank panics invariably reveal the poor quality of lending that accompanied the preceding boom. Walter Bagehot, the greatest of 19th-century writers on finance, was aghast at the stupidity of the directors of the discount house Overend Gurney, whose failure in 1866 was the cause of the last run on a British bank before the ignominious demise of Northern Rock. “They ruined a firm almost inconceivably good by business so inexplicably bad that it could hardly be much worse if they had of set purpose tried to make it bad,” wrote Bagehot.

The behavioural characteristics of the panic are the obverse of those of the boom. Excessive confidence is replaced by extreme fearfulness and a nervous distrust takes the place of blind trust. During the panic, the buying frenzy of the boom gives way to panicky disposals.

Loss aversion becomes extreme during the panic. “The passion of fear,” declared The Times on the day of Overend’s collapse, “is even more powerful than that of hope. There are men who can resist the seductions of promised profits and high premiums, but when depositors think a stoppage is imminent each rushes to secure his deposit in time, caring little for the consequences. Not long ago men trusted everybody; it would seem now that they trust nobody. A great machinery is thrown out of gear.”

The machinery is thrown out of gear by the failure of what economists would call a systemically important financial institution, such as the Ayr Bank in June 1772, Pole Thornton & Co in December 1825, Overend Gurney in May 1866 (which The Times called “the greatest instrument of credit in the Kingdom”), Jay Cooke & Co in September 1873 and the downfall of the Bank of the United States in December 1930. Likewise, the bankruptcy filing of Lehman Brothers on September 15 triggered our current panic.

The main consequence of the panic is a wild scramble for liquidity. Money becomes scarce. This was even more pronounced when currencies were convertible into gold: in every panic, there was too little of the precious metal to go round. Interest rates rose and the securities prices collapsed. “The best mortgages cannot be converted into money without a sacrifice of 20 per cent, and undoubted business paper is selling in Wall Street at a discount of 3 per cent a month,” wrote the New Yorker Philip Hone during the panic of November 1837. Call money rates reached 100 per cent in October 1907.

Every panic is marked by a sense that the financial system is close to complete collapse. Never were such feelings more marked than during the panic that started in London in December 1825. “If the difficulties which existed in the money market had continued only eight-and-forty hours longer …” William Huskisson, the president of the Board of Trade, told the House of Commons, he sincerely believed “that the effect would have been to put a stop to all dealing between man and man, except by way of barter.” Or, as a director of the Bank of England put it during the midst of the crisis: “We must ask not who is gone, but who stands?”

Yet even in 1825 the authorities belatedly succeeded in quelling the panic in that incident by borrowing money from France and distributing a stash of old banknotes found in the vaults of the Old Lady. In the 20th century, the end of the panic tended to coincide with decisive government intervention: Roosevelt’s bank holiday of March 1933, the launching of the Bank of England’s “lifeboat” in December 1974 and the nationalisation of Japan’s Long-Term Credit Bank in October 1998, which was accompanied by a $500bn capital injection into the stricken banking system.

There is good cause for concern. Our modern credit system is more complex, more interconnected and more leveraged than in earlier times. On the other hand, the measures taken by the authorities to allay the crisis are far more extensive than on earlier occasions. Witness the wild scramble by governments around the world to guarantee bank debts, provide loans against dubious securities and inject capital into stricken financial firms.

It is important not to exaggerate the dangers. Dr Johnson dismissed the “general distrust and timidity” on display in 1772 as “little more than a panick terrour from which when they recover, many will wonder why they were frighted”. The current panic will pass as others have done beforehand. This does not mean the aftermath will be pleasant for the wider economy. Emergency measures may allay the panic but they cannot correct the credit excesses that are the root cause of the crisis.

The writer is a member of GMO’s Asset Allocation team

The Great Iceland Meltdown

Tom Friedman wrote on NY Times:

Who knew? Who knew that Iceland was just a hedge fund with glaciers? Who knew?

If you’re looking for a single example of how the globalization of finance helped get us into this mess and how it will help get us out, you need look no further than British newspapers last week and their front-page articles about the number of British citizens, municipalities and universities — including Cambridge — that are in a tizzy today because they had savings parked in Icelandic banks, through online banking services like Icesave.co.uk.

When I went to the Icesave Web site to see what it was all about, the headline read: “Simple, transparent and consistently high-rate online savings accounts from Icesave.” But then, underneath in blue letters, I found the following note appended: “We are not currently processing any deposits or any withdrawal requests through our Icesave Internet accounts. We apologize for any inconvenience this may cause our customers.”

Any “inconvenience?” When you can’t withdraw savings from an online bank in Iceland, that is more than an inconvenience! That’s a reason for total panic.


In a flat world, money can easily seek out the highest returns, and when word got around about Iceland, deposits poured in from Britain — some $1.8 billion. Unfortunately, though, when global credit markets closed up, and the krona fell, “the Icelandic banks were unable to finance their debts, many of which were denominated in foreign currencies,” The Times reported. When depositors rushed to get their money out, the Icelandic banking system had too little reserves to cover withdrawals, so all three banks melted down and were nationalized.

It turns out that more than 120 British municipal governments, as well as universities, hospitals and charities had deposits stranded in blocked Icelandic bank accounts. Cambridge alone had about $20 million, while 15 British police forces — from towns like Kent, Surrey, Sussex and Lancashire — had roughly $170 million frozen in Iceland, The Telegraph reported. Even the bobbies were banking in Iceland!

Globalization giveth — it was this democratization of finance that helped to power the global growth that lifted so many in India, China and Brazil out of poverty in recent decades. Globalization now taketh away — it was this democratization of finance that enabled the U.S. to infect the rest of the world with its toxic mortgages. And now, we have to hope, that globalization will saveth.