John Maynard Keynes

John Maynard Keynes 1st Baron of Tilton (1883-1946), was an English economist who revolutionized economic theory and policy by linking employment and income to public and private expenditure. He is also known for his role in the creation of new international monetary institutions in World War II.

John Maynard Keynes was born on June 5, 1883, the son of John Neville Keynes, registrar of the University of Cambridge and eminent logician and economist. John Maynard's mother, a charming and talented woman, was onetime mayor of Cambridge. He was educated at Eton and King's College, Cambridge, and began a career in the civil service, where he was assigned to the India Office from 1906 to 1909. There he acquired an intimate knowledge of the government service and an interest in Indian currency and finance that was to bear fruit a few years later.

His Writings

In 1909 Keynes was elected fellow of King's College and returned to Cambridge. In 1911 he was chosen, in spite of his youth and inexperience, as editor of the Economic Journal, the publication of the Royal Economic Society and one of the leading professional journals. From that time until 1945 his duties were carried out with outstanding promptness and efficiency. In 1913 his first book, Indian Currency and Finance, was published shortly after he was appointed to the Royal Commission on Indian Currency and Finance. His book has been referred to as the best in the English language on the gold exchange standard.

With the outbreak of World War I Keynes entered the Treasury, first as an unofficial and unpaid assistant. Before the end of the war he held a position equivalent to an assistant secretary and was largely responsible for handling Interallied finances.

At the conclusion of the war Keynes went to the Paris Conference as principal representative of the Treasury and deputy for the chancellor of the Exchequer on the Supreme Economic Council. It soon became apparent to him that the economic terms of the treaty and particularly the reparations settlement were impossible of fulfillment. He resigned in June 1919 and set forth his case in The Economic Consequences of the Peace (1919). Although the book aroused tremendous controversy, subsequent events have demonstrated the substantial correctness of his position.

Having left the public service, Keynes returned to Cambridge as second bursar of King's College. In 1921 he assumed the first of a number of important company directorships. Also that year, he published A Treatise on Probability and, a year later, A Revision of the Treaty, a sequel to The Economic Consequences. In 1923 his Tract on Monetary Reform appeared. From 1924 until his death he was first bursar of King's College and through his expert management made King's what a contemporary has described as "indecently rich."

In 1925 Keynes married Lydia Lopokova, a Russian ballerina, who was as outstanding a person in her own way as he was in his. Although he had for many years been a collector of rare books and fine art, he now became an active patron of the theater, helping in later years (1932) as treasurer of the Camargo Society to bring about a union of the resources of the Camargo, the Vic-Wells, the Rambert Ballet, and others. In 1936 he founded and generously financed the Cambridge Arts Theatre.

Keynes's Treatise on Money, a two-volume work that generations of students have found full of brilliant insights but incomprehensible as a whole, was published in 1930. In it Keynes attempted with little success to break free of the shortcomings and limitations of the Cambridge version of the quantity theory of money. In retrospect, one can see the germ of many of the ideas that distinguish his later work— but as isolated flashes of insight lacking the proper framework and, as a result, not leading to any very useful or interesting conclusions.

Finally, in 1936, came Keynes's General Theory of Employment, Interest and Money, a book that not only revolutionized economic theory but also had a direct impact on the lives of a large proportion of the world's population. Here Keynes took issue with the classical theory which found in a competitive capitalist economy a set of mechanisms that automatically move the economy toward a state of full employment. (The term "classical" is used here to mean the mainstream of orthodox economic theory beginning with Adam Smith and running through the work of Ricardo, Mill, Marshall, and others.) These mechanisms functioned in the labor market and in the market for goods and services.

Classical Position

In the labor market, competition among workers assures full employment on the condition that the real rate of wages responds to the forces of supply and demand. In the market for goods and services, however, the question arises if there is any assurance that all of the output produced at full employment will find buyers. The classical economists found the answer to this question to be in the affirmative. To understand the rationale of their position, it is necessary to keep firmly in mind the truism that, in the aggregate, the value of output and income are identical. It follows from that truism that if all output is to be purchased, expenditures must be exactly equal to income.

Given this truism, how did the classical economists see this mechanism working? There are two types of expenditures made, those on goods and services for consumption purposes and those for goods and services purchased with an eye for resale or to be used to produce more goods and services. The first type of expenditure is called consumption, and the second, investment. If that part of income that is not spent on consumers goods is called "saving," then income and expenditures will be equal if saving is equal to investment. Hence, expenditures are equal to the value of output.

The classical economists believed that saving and investment were both functions of the rate of interest, with savers saving more and investors investing less as the rate of interest rises, and the reverse happening when the rate of interest falls. The interest rate would always adjust in such a way as to assure that all of current output would be purchased.

Keynes's Theory

Keynes disagreed with both the labor market analysis and the goods market analysis of the classicists. He argued that changes in money wage rates do not result in corresponding changes in real wages because of their impact on the incomes and, therefore, on the expenditures of wage earners. Lower money wages, he argued, would force lower demand for goods and services and therefore lower their prices. Real wages would be unchanged.

With respect to the product market, Keynes held that saving is a function of the level of income rather than of the rate of interest. There is no reason to believe that the amount that investors will be willing to invest (determined, according to Keynes, by the rate of interest and by the expectations about the future held by potential investors) will turn out to be equal to the amounts that savers wish to save out of a full employment level of income. Where savers wish to save more than investors wish to invest, part of current output will go unsold. This will lead producers to cut back on current output and therefore on employment and income. As income falls, saving will fall. Income will keep on falling until savers are willing to save no more than investors wish to invest.

Liquidity Trap

Since the system, as Keynes saw it, does not tend to seek full employment when left to itself, it is necessary for policy makers to do so. Basically, two possibilities exist: monetary authorities may induce investors to invest the desired amounts through their control over the rate of interest, or fiscal authorities may close the gap between investment and full employment levels of saving with government expenditures.

Keynes was somewhat pessimistic about the ability of monetary authorities to bring about the necessary changes in private investment expenditures. Under some circumstances the central bank can drive interest rates down by increasing the money supply. The public, finding itself with more money than it wishes to hold, will attempt to convert it into interest-earning assets. This will drive the prices of securities up and, consequently, interest rates down.

Once the interest rate is driven down to a level at which the public believes that it must rise again, holding securities entails the risk of taking a capital loss. Under these circumstances the public will not convert additional money balances into securities, and the interest rate will not be driven down any further. This floor on interest rates is known as the liquidity trap and represents a severe limitation on the central bank's ability to stimulate private investment.

Keynes also saw another and perhaps more serious limitation to monetary policy. Private investors, he maintained, make their decisions not only on the basis of the interest rate but also on the basis of their expectations about costs and demand for their product in the future. All of these expectations are lumped together for convenience's sake into what he called the marginal efficiency of capital. The important thing about the marginal efficiency of capital is that it is based, not upon known facts, but upon expectations about the future which must, of necessity, be very uncertain. The uncertainty means that the marginal efficiency is likely to be very unstable. Keynes regarded it as entirely possible that the marginal efficiency of capital could be so low that even a rate of interest of zero would not be sufficient to stimulate a full employment level of investment.

Thus, although in later years he was less pessimistic about the usefulness of monetary policy, Keynes was inclined to believe that fiscal policy would have to bear the main part of the burden of assuring full employment. Further, he was inclined to believe that in mature economies, such as those of the United States and western Europe, high levels of income had led the public to save large proportions of their income, while the factors that had historically provided expanding investment opportunities were disappearing. This idea is known as the stagnation hypothesis and enjoyed a wide acceptance during the 1930s and 1940s.

Return to Public Service

With the beginning of World War II, Keynes again entered the public service. In July 1940 he was asked to serve as adviser to the chancellor of the Exchequer, and he was soon after elected to the Court of the Bank of England and was raised to the peerage as Lord Tilton in 1942. Through his work, national income and expenditure accounts were developed and utilized in the preparation of wartime budgets. In addition to internal finance, he had special responsibility for intergovernmental finance, lend-lease, and mutual aid. This work required that he become a sort of special envoy to Washington and Ottawa in particular.

In the closing days of the war, Keynes played a major role in negotiating the United States loan to Great Britain and in the establishment of the International Monetary Fund and the Bank for Reconstruction and Development. Keynes died of a heart attack on Easter Sunday, April 21, 1946, shortly after having returned from the inaugural meetings of the International Monetary Fund and the World Bank in Savannah, Ga.

Further Reading on John Maynard Keynes

The most definitive study of Keynes's life and work is The Life of John Maynard Keynes (1951), written by R. F. Harrod, who was a friend and an eminent economist in his own right. A shorter but highly readable biography is Seymour E. Harris, John Maynard Keynes, Economist and Policy Maker (1955). Robert Lekachman, The Age of Keynes (1966), contains some material not found in the earlier volumes, including an up-to-date appraisal of Keynes's influence. See also Lawrence R. Klein, The Keynesian Revolution (2d ed. 1966).