that market economies so often fall short of potential output and “overshoot” on both the up and down sides, is that investors and businesses must make calculations about spending and hiring in the face of a fundamentally uncertain future. Investors are the “prime movers” of the economy, and also the source of market volatility. Consumers, by contrast, behave fairly predictably, spending a stable percentage of their incomes on goods and services of various kinds, except on occasions when fear and panic lead them to reduce expenditures and increase savings. Investors, on the other hand, must allocate funds based upon uncertain assessments of conditions many years into the future. “Our knowledge of the factors that will govern the yield of an investment some years hence is usually very slight and often negligible,” Keynes wrote in The General Theory. To complicate matters further, the evolution of stock markets requires investors to make judgments about how other investors assess the future—since those assessments, when added up, determine the value of stocks.
Keynes pointed to the distinction between risk and uncertainty. Risks are subject to calculation but uncertainties are not. Investors, Keynes argued, confront an unknowable future—that is, an uncertain future—when they commit funds for five, ten, or thirty years. They cannot know if a war, inflation, a natural disaster or some other unpredictable event will intervene to undermine their investments. In a rational universe, investors might keep their funds on the sidelines permanently due to the impossibility of knowing what the future holds. In the world as it is, Keynes suggested, investors are moved not by calculations of risk but by alternating moods of confidence and pessimism that are socially contagious but loosely grounded in real conditions. These are the “animal spirits” that at bottom drive the market economy. Keynes thought that investor uncertainty was a factor that kept interest rates too high because it required lenders to demand a premium on loans. Uncertainty also cut in the other direction: from the standpoint of businessmen, future profits may appear too uncertain to justify the loans required to expand or start their enterprises. In times of pessimism, uncertainty was one of the factors that drove the economy along in a downward spiral. This element of Keynes’s theory pointed in the direction of central bank policy to maintain interest rates at low levels to eliminate the “uncertainty premium,” even if such a policy risked inflation or weakening of the currency.
Keynes thus drew a portrait of the market economy that was very close to the opposite of that drawn by his eighteenth- and nineteenth-century predecessors. They saw a system that operated like a machine with its various parts working together to keep it moving forward even in the face of external shocks, which might slow it down but could not knock it off course for very long. In their view, entrepreneurs and investors were the rational and calculating participants that kept the economic machine moving. Keynes described a system that was inherently prone to booms and busts because its various parts did not work in harmony and because it was greatly influenced by shifting investor moods. In his theory, investors and entrepreneurs were the dynamic but capricious elements, putting their funds into play and withdrawing them according to those shifting moods about future prospects and in response to the spending and saving decisions of consumers.
Thus, consumers and investors increased or reduced their spending in a reciprocal dynamic, creating a “pro-cyclical” bias in the system and giving the market its boom-and-bust character. Keynes looked to government spending and borrowing as a countercyclical factor that might stabilize the system, particularly during slumps when consumer hoarding and investor pessimism sent the economy into a downward spiral. This new role for government may have represented his most radical departure from his nineteenth-century predecessors.
Keynes was by no means the first economist or public figure to call for public spending or public works projects to reduce unemployment during slumps. Spending on public works was a common theme in political platforms in the United States and Great Britain during the 1920s and 1930s, though the proposals were generally set forth as emergency measures, not as a systemic means of stabilizing the economy over the long term. Keynes recommended public works projects to President Roosevelt when the two met in Washington in 1933, before Keynes worked out the details of his general theory. Keynes had also called for a larger role for the state in the management of the economy during the 1920s when there was no immediate crisis of unemployment. In 1925, for example, he urged the Liberal Party to adopt a platform in which the state would take a large role in “directing economic forces in the interests of justice and social stability.”8 Like many other liberals of the time, Keynes wanted the state to take on greater powers over the economy, with or without a broad theoretical rationale.
What was novel about his call for public spending in The General Theory was the broad theoretical case that he advanced for it, with public spending used as an antidote to the failure of the marketplace and as a means to restimulate private economic activity. In effect, Keynes developed a technical or instrumental case for the expansion of state powers, rather than a political or ideological one. This was another way in which he saw the state as a potential partner with the business sector instead of a rival or competitor. Keynes envisioned a new order of capitalism in which the state would act to reduce the uncertainty that he felt was a source of instability in the marketplace.
The state could manage its spending and borrowing policies toward the goal of stabilizing consumer demand, which would reduce the uncertainty faced by investors and thereby smooth out the boom-and-bust cycle of the capitalist order. Keynes pointed out that when individuals hold back on consumption or cannot spend because they lose income during slumps, and when investors defer spending because they lose confidence, government can step in to borrow and spend as a means of maintaining demand and generating investment, instead of waiting for the market to make adjustments that may take a long time to occur. Every dollar or pound spent by governments in times of slack demand would be multiplied by some fraction as it is spent and passed through the economy by consumers. In Keynes’s simplified model, domestic output is determined by these three factors: consumption plus investment plus government spending (plus net exports).
While in recessions or depressions it would be preferable for governments to spend on useful and needed projects, Keynes said that any form of spending would be preferable to a policy of inaction. As recovery takes place, government budgets might be brought back into balance and debts incurred during slumps can be paid down. Keynes argued that his approach represented a middle path, or a third way, between the failures of laissez-faire and the excesses of socialism because it was a policy of gradualism that left intact the institutions of private property and representative government.
In terms of short-term policy, there were several attractive features to the approach he outlined. First, there was the proposal to balance public spending over the business cycle in order to bring public budgets into phase with the natural ups and downs of the market economy, which meant that Keynes was not departing all that far from the principles of fiscal rectitude. In addition, he called for public borrowing mainly when interest rates were at their lowest point during the business cycle. Second, he provided policymakers with new tools to deal with slumps as alternatives to beggar-thy-neighbor trade policies like tariffs and currency devaluations, and also as alternatives to central bank credit policies that he judged to be ineffective during slumps. Third, his recommendations involved (at least from his point of view) only limited interventions into the market system. He wrote, “Apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialize economic life than there was before. . . . It is in determining the volume, not the direction, of actual employment that the existing system has broken down.”9 Policymakers need not direct spending into this or that area of the marketplace, but simply control the general volume of spending to support consumer demand and maintain full employment. (What Keynes overlooked is that officials cannot help but direct money to particular areas of the economy when they allocate funds.)
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So far, this is the “conservative” Keynes who called for modest government interventions into the economy in order to reverse slumps and to maintain full employment. He did not mount a moral attack on the market system but
