Ha-Joon Chang - Economics - The User's Guide

Unfortunately, there is no guarantee that savings will equal investment, especially when those who invest and those who save are not one and the same, unlike in the early days of capitalism, when capitalists mostly invested out of their own savings and workers could not save, given their low wages. This is because investment, whose returns are not immediate, is dependent on investors’ expectations about the future. In turn, these expectations are driven by psychological factors rather than rational calculation because the future is full of uncertainty.

Uncertainty is not simply about not knowing exactly what is going to happen in the future. For some things, we can rather accurately calculate the probability of each possible contingency – economists call this risk. Indeed, our ability to calculate the risk involved in many aspects of human life – death, fire, car accident and so on – is the very foundation of the insurance industry. However, for many other things, we do not even know all the possible contingencies, not to speak of their respective likelihoods. The best explanation of the concept of uncertainty was given by, perhaps surprisingly, Donald Rumsfeld, the defence secretary in the first government of George W. Bush. In a press briefing regarding the situation in Afghanistan in 2002, Rumsfeld opined: ‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’ The idea of ‘unknown unknowns’ nicely sums up Keynes’ concept of uncertainty.

Active fiscal policy for full employment: the Keynesian solution

In an uncertain world, investors may suddenly become pessimistic about the future and reduce their investments. In such a situation, there will be more savings than are needed – there will be, in technical terms, a ‘savings glut’. The Classical economists thought this glut would be sooner or later eliminated, as the lower demand for savings would drive the interest rate (that is, the price of borrowing, if you like) down, making investments more attractive.

Keynes argued that this does not happen. As investment falls, overall spending falls, which then reduces income, as one person’s spending is another’s income. A reduction in income in turn reduces savings, as savings are essentially what are left after consumption (which tends not to change much in response to a fall in income, being determined by our survival necessities and habit). In the end, savings will contract to match the now lower investment demand. If excess savings are reduced in this way, there will be no downward pressure on interest rates and thus no extra stimulus for investment.

Keynes thought that investment will be high enough for full employment only when animal spirits– ‘a spontaneous urge to action rather than inaction’, as he defines it – of the potential investors are stimulated by new technologies, financial euphoria and other unusual events. The normal state of affairs, in his view, would be that investment is equated to savings at a level of effective demand(the demand that is actually backed up by purchasing power) that is insufficient to support full employment. In order to achieve full employment, Keynes argued, the government therefore has to use its spending actively to prop up the level of demand. [95] Over time – in his grandchildren’s generation, as Keynes put in a famous article titled ‘Economic Possibilities for Our Grandchildren’ (though he himself had no children) – living standards in countries like Britain will have risen sufficiently that not much new investment would be needed. At such a point, he envisaged, the focus of policy should be switched to reducing working hours and increasing consumption, mainly by redistributing income to poorer groups, which spend larger proportions of their incomes than the richer ones.

Money gets a real job in economics: the Keynesian theory of finance

The prevalence of uncertainty in Keynesian economics means that money is not simply an accounting unit or merely a convenient medium of exchange, as the Classical (and the Neoclassical) school thought. It is a means to provide liquidity(or the means to quickly change one’s financial position) in an uncertain world.

Given this, the financial market is not just a means to provide money to invest but also a place to make money by taking advantage of the differences among people’s views about returns on the same investment projects – in other words, a place for speculation. In this market, the buying and selling of an asset is driven not mainly by the ultimate return that it will deliver but by expectations about the future – and, more importantly, the expectations about what other people expect, or, as Keynes put it, the ‘average opinion about the average opinion’. This, according to Keynes, provides the basis for the herd behaviour that is often witnessed in financial markets, making it inherently prone to bouts of financial speculation, boom and ultimately bust. [96] The history of financial speculation is beautifully documented in C. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crisis (London: Macmillan, 1978).

It is upon this analysis that Keynes famously warned against the danger that the speculation-driven financial system can pose: ‘Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.’ He should know – he was a very successful financial speculator himself, amassing a fortune of over £10 million (or $15 million) in today’s money, even after very generous donations to charitable causes. [97] He also earned large sums for King’s College, Cambridge, whose investment portfolio he was in charge of as the bursar (financial manager) between 1924 and 1944.

An economic theory fit for the twentieth century – and beyond?

The Keynesian school built an economic theory that was more fit for the advanced capitalist economy in the twentieth century than that of the Classical or Neoclassical schools.

Keynesian macroeconomic theory is built on the recognition that the structural separation of savers and investors that emerged from the late nineteenth century has made the equalization of savings and investment, and thus the achievement of full employment, more difficult.

Moreover, the Keynesian school rightly highlights the key role that finance plays in modern capitalism. The Classical school did not pay too much attention to finance, as it was developed at a time when the financial market was primitive. The Neoclassical theory was developed in a world which was already quite similar to the one Keynes was living in, but, given its failure to acknowledge uncertainty, money is not essential in it. In contrast, finance plays a key role in Keynesian theories, which is why it has been so useful in helping us understand episodes like the Great Depression of 1929 and the 2008 global financial crisis.

‘In the long run we are all dead’: shortcomings of the Keynesian school

The Keynesian school can be criticized for paying too much attention to short-term issues – as summarized in the famous quip by Keynes that ‘in the long run we are all dead’.

Keynes was absolutely right in emphasizing that we cannot run economic policies on the hope that in the long run the ‘fundamental’ forces, such as technology and demography, will somehow sort everything out, as the Classical economists used to argue. Nevertheless, its focus on short-run macroeconomic variables has made the Keynesian school rather weak on longterm issues, such as technological progress and institutional changes. [98] Michal Kalecki (1899–1970), with his Marxist influence and interest in developing economies, and Nicholas Kaldor (1908–86), who had one foot in the Developmentalist tradition and who was, having been brought up in the Austro-Hungarian Empire, no stranger to the ideas of the Austrians and Schumpeter, were exceptions in this regard.