ohn Maynard Keynes, the most in uential economist of the twentieth century, was a connoisseur of paintings and had a large collection that he nearly sold when he went almost bankrupt for the second time after the crash of 1929. He was a hedge fund manager (before the term existed) and invested in a wide array of assets. In the process, he went nearly bankrupt thrice.
Having learnt from his investment mistakes, Keynes turned into what today is known as a ‘value’ investor. In his personal life, he was bisexual. In 1925, at the age of forty-two, he married Lydia Lopokova, a Russian ballerina. In the years to come, Lopokova became a great friend of Pablo Picasso, who sketched her many times. The two had a happy marriage, till Keynes, who had a weak heart, died in 1946 when he was just sixty-two.
Both his parents outlived him. His wife died in 1988.
Very few economists of repute have speculated in the stock and commodity markets.
Keynes was one of them. With this he had a very good idea of how the markets worked, and this insight showed up in his economics as well. As Nicholas Davenport wrote in Memoirs of a City Radical, ‘Speculation improved his economics and economics improved his speculation.’1
Keynes really came into his own in 1936 when his magnum opus The General Theory of Employment, Interest and Money was published. After this book came out, there was no stopping him. The ‘paradox of thrift’, which he discussed in the book, was one of the earliest explanations of the Great Depression. As Paul Samuelson, the rst American to win a Nobel Prize in economics, wrote in Economics:
It is a paradox, because in kindergarten we are all taught that thrift is always a good thing. Benjamin Franklin’s ‘Poor Richard’s Almanac’ never tired of preaching the doctrine of saving. And now comes a new generation of alleged nancial experts who seem to be telling us that black is white and white is black, and that the old virtues may be modern sins.2
Keynes said that when it came to thrift or saving, the economics of the individual differed from the economics of the system. For an individual to save by cutting down on expenditure made tremendous sense. But when a society, as a whole, began to save more, there was a problem. This was because the expenditure of one person was the income for
another. When expenditure reduced, incomes would fall too, leading to a further reduction in expenditure. And so the cycle would continue. The aggregate demand of a society as a whole would fall in the end, leading to either lower prices, lower production or both, thus impeding economic growth and causing economic contraction. Raj Patel explains this phenomenon in The Value of Nothing:
In a recession, a reasonable thing for me to do is start saving more than I did before, but if everyone does it, the aggregate level of demand in the economy falls because no one is buying things, meaning the recession gets even worse, which means we save even more, and so on.3
After the stock market crash in late October 1929, people’s perceptions of the future changed, leading them to cut down on their expenditure. In 1930, consumer durables expenditure in the US fell by over 20 per cent and residential housing expenditure fell by 40 per cent. This continued for the next two years, and as a result, the overall economy contracted by 20.1 per cent, 14.2 per cent, and 25.1 per cent in the years 1930, 1931 and 1932, respectively.4 This came after the ready availability of money had fuelled a spending spree on consumer durables during the second half of the 1920s.5 As per Keynes’ ideas, the way out of this situation was for someone to spend more. Citizens and businesses were not willing to spend more, given the state of the economy. The only way out of this situation was for the government to spend more on public works and other programmes. This would act as a stimulus and thus cure the recession.
In The General Theory, Keynes went to the extent of saying:
If the Treasury were to ll old bottles with banknotes, bury them at suitable depths in disused coalmines which are then lled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.’6
How would this help in reviving the economy during recessionary times? Raj Patel explains this in The Value of Nothing as follows:
Keynes suggested, rhetorically, that if they lacked the imagination for anything more creative, governments could simply bury bottles of money under tons of trash, and that this would help get the economy going. It may sound bizarre, but it would certainly be worth someone’s while to dig up free money. To nd these banknotes would require workers. Those workers would need to pay for food and
shelter and everything else they needed to survive while they dug. The grocers who fed them and the landlords who rented to the workers would then have cash to spend, which they would use to buy other goods, and so on. This is called the
‘multiplier effect’, and it’s the added return that a government gets from spending its money in the economy.7
Keynes was basically saying that during times such as the Great Depression, cutting interest rates to low levels would not tempt either people or businesses to borrow because of the tight economic situation. Cutting taxes so that people would have more to spend was one way out. But the best way was for the government to spend more money, and become the ‘spender of the last resort.’8 Also, it did not matter if the government ended up running a budget de cit in doing so. Budget de cit is the difference between what a government earns and what it spends.
Keynes’ General Theory was initially ignored. It was not fashionable in those days for governments to spend more than they were earning, as it is now. As Roosevelt put it, ‘Any government, like any family, can, for a year, spend a little more than it earns. But you know and I know that a continuation of that habit means the poorhouse.’9 And if the government had to be the spender of the last resort, it had to spend much more than it earned.
But while Keynes was expounding on his theory, it was already put into practice by Adolf Hitler, who had deployed 100,000 workers for the construction of the Autobahn, a nationally coordinated motorway system in Germany which was supposed to have no speed limits. Hitler rst came to power in 1934. By 1936, the German economy was chugging along nicely, having recovered from a devastating slump and unemployment.10 Italy and Japan had also followed a similar strategy. These countries had not bothered about their budget deficits, because they had hoped to pay them off by waging war.
Very soon, Great Britain would end up doing what Keynes had been recommending.
Great Britain had more or less done away with both its army and air force after the First World War. But the rise of Hitler led to a situation where massive defence capabilities had to be built within a very short period of time. The prime minister of the time, Neville Chamberlain, was in no position to raise taxes to nance defence expenditure. What he did instead was borrow money from the public. By the time the Second World War started in 1939, the British budget de cit was already projected to be around £1 billion, or around 25 per cent of the national income. The de cit spending, which started to happen even before the Second World War, led to a boom in the British economy, especially in the south of England, where ports and bases were being expanded and ammunition factories were being built.11
This left very little doubt in the minds of politicians, economists and people around the world that the economy worked the way Keynes said it did. Keynesianism was to become the economic philosophy of the world for the next few decades.
Lest we come to the conclusion that Keynes was an advocate of a government running high budget de cits all the time, it needs to be clari ed that his stated position was far from this. Keynes essentially believed that during recessions, trying to balance the budget, or ensuring that income matches expenditure, was not the best thing for a government to do. In a recessionary environment, the chances were that the government’s income would fall because of lower tax collection. The only way to balance a budget would be to raise existing taxes, introduce new ones or cut expenditure. Any of these measures would squeeze the economy further.12
Keynes believed that on an average, the government budget should be balanced. This meant that during years of prosperity, governments should run budget surpluses. But when the environment is recessionary, governments should spend more than what they earn, even running budget deficits.13
But over the decades, politicians have only taken one part of Keynes’ argument and run with it. The idea of running de cits during bad times became permanently etched in their minds. However, they forgot that Keynes had also wanted them to run surpluses during good times.
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The Great Depression inspired many Americans to study economics. Milton Friedman was one such individual. Friedman had scholarships to study mathematics at Brown University and economics at the University of Chicago. ‘Put yourself in 1932 with a quarter of the population unemployed. What was the urgent problem? It was obviously economics, and so, there was never any hesitation on my part to study economics,’ Friedman told a biographer years later.14
In 1963, Milton Friedman would write A Monetary History of the United States, 1867–
1960 with Anna J. Schwartz, which also featured a revisionist history of the Great Depression. Friedman and Schwartz argued that the Federal Reserve System ensured that a mere stock market crash became the Great Depression.
As we saw earlier, between 1929 and 1933, more than 7,500 banks with deposits amounting to nearly $5.7 billion, had crashed.15 This, according to Friedman and Schwartz, led to the total amount of currency in circulation and demand deposits at banks plunging by one-third. If the Federal Reserve had only pumped more money into the banking system, enough con dence would have been created among the depositors who had lost their money and the Great Depression could have been avoided. With banks going bankrupt, depositors’ money was either stuck or permanently lost to them. Under this situation, they cut down further on expenditure to try and build their savings.
As Milton Friedman had already written in Capitalism and Freedom, in 1962:
The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement, rather than by an inherent instability of
the private economy. A governmentally established agency – the Federal Reserve System – had been assigned responsibility for monetary policy. In 1930 and 1931, it exercised this responsibility so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe.16
This paragraph, as we shall see, would have a huge impact on the actions of central bank governors in the days to come.
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In 1937, a massive heart attack forced Keynes into premature retirement. But when the Second World War began, Keynes was back at work, acting as the de facto Chancellor of the Exchequer for Winston Churchill, who was then prime minister of Great Britain.
Keynes died of a massive heart attack on 21 April 1946 at the age of sixty-two. He never got around to investigating what really ended the Great Depression. The conventional explanation is that as countries entered the Second World War, the government expenditure that came with it provided the required stimulus to various economies, thus ending the Great Depression.
The recovery of the US from the Great Depression was an unintended consequence. This term essentially means an unexpected outcome of a purposeful action. When Roosevelt set the price of gold at $35 per ounce, he was merely acting according to his belief that by increasing the price of gold, he could create some inflation.
This did happen, and Roosevelt did manage to create some in ation. But the higher price of gold also led to something unexpected that Roosevelt had not foreseen. The devaluation of the dollar against gold increased monetary gold stock. Between December 1933 and July 1934, the monetary gold stock nearly doubled and increased at an average annual rate of 15 per cent between December 1934 and December 1941.17
There were several reasons for the huge in ow of gold into the US. First and foremost was the fact that gold was now worth $35 per ounce against the earlier $20.67. Hence, anyone bringing gold into the US and exchanging it for dollars would receive more dollars for it. To a large extent, this explained the initial gold import worth $758 million between February and March 1934, immediately after the devaluation of the dollar by Roosevelt.18
The second reason was that the higher price motivated gold mining companies worldwide to produce more gold. This added almost $1 billion worth of gold every year to the existing gold reserves. The third reason was the rise of Hitler, the German mobilization for war, and the annexation of Czechoslovakia, Austria, and Rhineland. Due to this, a huge amount of gold was channelled across from Europe to the US. As a later-day economist put it, ‘Without … Hitler to spawn a capital ight to the US, virtually no US recovery would have occurred before 1941.’19
These three reasons ensured that the value of the gold held by the Federal Reserve
System in the US tripled to $12 billion between 1933 and 1937.20 But how did all this gold translate into a recovery?
The Gold Standard Act of 1934, which had devalued the dollar to $35 per ounce from
$20.67, also set up a stabilization fund, which was to be used by the American treasury for intervening in the foreign exchange market. But this fund was endowed in only gold. This meant that the gold coming into the country could not be bought by the treasury, because the fund did not have the dollars required to buy it as it was endowed only in gold. There was no sterilization of the gold that was coming in, and all of it quickly seeped into the system.21
With all the extra gold entering the system, the supply of paper money issued against gold also grew. America was still on the gold standard, and an increase in the amount of monetary gold meant an increase in the paper money in the economy. Between December 1933 and December 1936, the M1, a measure of money supply (which includes physical currency and the money kept in demand accounts), rose by 27 per cent. It rose by 56 per cent between December 1937 and December 1942.22
There was a lot of money owing through the system, and it percolated through the rest of the economy. Interest rates were also pushed down. The interest rate on commercial paper, a kind of nancial security through which businesses borrow money for less than a year, fell from an average of 2.73 per cent in 1932 to 0.75 per cent in 1936.23
With loans easily available at extremely low interest rates, the industrial production expanded by more than 40 per cent between 1932 and 1937.24 This also led to the GNP of the US rising by 33 per cent between 1933 and 1937, and by 49 per cent between 1938 and 1942. The rate of unemployment fell from its peak of 25 per cent to 10 per cent in 1941.25
Prices had fallen 37 per cent between 1929 and 1933.26 They subsequently rose by 27 per cent between December 1933 and December 1936, and by 56 per cent between December 1937 and December 1942,27 as the money supply expanded rapidly. This created an expectation of in ation among people, who then began spending their hard-earned money, thus effecting a revival of the American economy.
Despite this recovery, the index of industrial production, a measure of industrial activity in the country, crossed its 1926 level only in the Second half of 1942.28 This was after the US entered the second World War in late 1941, in response to the Japanese attack on Pearl Harbour in Hawaii. After that, the US government spending shot up, as it had in Great Britain in late 1930s, and the US truly and surely came out of the Great Depression.
The role of money supply in the recovery that slowly followed the Great Depression was rst highlighted by Friedman and Schwartz in their study A Monetary History of the United States, 1867–1960. They wrote:
The rapid rate of rise in the money stock certainly promoted and facilitated the concurrent economic expansion … the rapid rate [of growth of money stock] in the three successive years from June 1933 to June 1936 … was a consequence of the
gold in ow produced by the revaluation of gold, plus the ight of capital to the United States.29
Just as the ideas of Keynes had, the ideas of Friedman and Schwartz would have a huge impact on economists, politicians and central bankers in the years to come.
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