The Economic Consequences of the Peace: 1919

The true Keynesian "revolution" in theory and policy began not with The General Theory and other writings in the 1930s, but rather with the publi­cation of his book The Economic Consequences of the Peace (Keynes 1920).

In The Economic Consequences of the Peace, Keynes argued that the halcyon days of what he often referred to as "the glorious nineteenth century" had ended and that a healthy economy could not be recreated without funda­mental changes in the structure of Britain's economic system. He believed that Britain faced long-term decline, with chronically high unemployment that threatened the social and political order.

Though only 35 years old at the time, Keynes was the chief representa­tive of the British Treasury Department and an advisor to Prime Minister Lloyd George at the Paris Peace Conference of 1919. The purpose of the Conference was to decide on the conditions of the treaty that would end WWI. The Economic Consequences of the Peace was written to warn the North American, European, and British public that if the provisions of the Treaty of Versailles were enforced, the world would face the prospect of economic stagnation, financial crises, rising social and political unrest, and, in some countries, violent revolution. The transfer of real resources from vanquished to victor, the crippling system of financial reparations from losers to winners, and loan repayments among the Allies would make the restoration of peace and prosperity impossible, Keynes argued. Implementation of the provisions of the Treaty, in his view, could well lead to a future world war, which, of course, it did.

Keynes also used this occasion to make public for the first time his belief that Europe stood at the interstices between two epochs of economic history, one known and the other yet to be determined.

Keynes's main argument about the inevitable passing of the old order was that the conditions that made the high growth rate in Europe in the nineteenth century possible were inherently transitory. He listed four foundations for the prosperity of the era: a rapidly rising population; declining costs of imported food and raw materials to sustain a growing labor force; increasing global economic integration facilitated by unpre­cedented free trade, migration, and capital flows in the context of stable exchange rates and "security of property and person everywhere"¹; and a symbiotic economic relation between the old world and the new, in which Europe sent abroad the money capital, physical capital, and skilled labor that helped make possible the surplus food production in the new world that sustained a growing European population. The old order thus had much to recommend it, Keynes argued:

In this economic Eldorado, in this economic utopia, as the earlier economists would have deemed it, most of us were brought up... What an extraordinary episode in the economic progress of man that age was that came to an end in August 1914.

(Keynes 1920, pp. 10-11)^[2]

Most importantly, unique and inherently transitory conditions in the nineteenth century made it possible for Britain and other European coun­tries to achieve the exceptionally high rate of growth of the capital stock that was the driving force behind its prosperity. "Europe was so organized socially and economically as to secure the maximum accumulation of cap­ital" (Keynes 1920, p.

But Keynes believed the long-term foundation that sustained the high profit rate of the nineteenth century had now eroded. A good deal of space in this book is devoted to presenting Keynes's evolving theory of long- run or secular stagnation. The conventional wisdom among economists that The General Theory deals exclusively with short-run models is simply not true. For Keynes, as for Marx, slow long-term growth is a "tendency" of mature capitalist economies, though not a "law" that applies in all

The Economic Consequences of the Peace 27 times and all economies. There are various countertendencies - such as rapid population growth, system-transforming technical change, wars, the integration of new areas of the globe into the international capitalist system, and, in Britain, disproportionate control over international trade and finance - that can generate high rates of investment and employment for extended periods of time. But there is, in his view, no law that says that these countertendencies will always be strong enough to overcome the tendency of the rate of profit on capital investment to fall over time. When he was writing The General Theory in the early to mid-1980s, Keynes believed there were no endogenous economic forces strong enough to create sustained full employment in Britain or to end the global depres­sion.

According to the economic historian and macroeconomist Barry Eichengreen, the interwar British economy did in fact suffer from invest­ment stagnation as Keynes claimed. Levels of investment spending were much too low to generate anything near full employment. Britain "was hardly a high-investment economy in the 1920s and 1930s - to the con­trary, the failure to sustain a higher investment rate is frequently cited as one of its shortcomings... [and] there was no guarantee that Britain would again display respectable rates of capital investment in the future." (Eichengreen 2004, p. 316).

Since the savings rate was also high in the nineteenth century, finan­cial capital was affordable and available on a long-term basis to accu­mulating firms even when the pace of investment was rapid. Moderate interest rates in turn depended on a transitory combination of eco­nomic and social conditions. One was a very unequal distribution of income and wealth. The wealthy classes saved a high proportion of their income and were content to hold their financial wealth in the form of long-term gilt-edged bonds and, later, preferred stock at rea­sonable rates of interest. Moderate interest rates combined with high profit rates on capital investment facilitated the high economic growth rates that eventually, in the latter part of the nineteenth century, made life for the expanding working class at least tolerable.^{[3] * [4] "It was precisely the inequality of the distribution of wealth which made possible those vast accumulations of fixed wealth and of capital improvements which distinguished that age from all others" (Keynes 1920, p. 18). Keynes continued:}

28 The Economic Consequences... to The General Theory

All of this had now changed, and Keynes believed the changes were likely to be permanent.

The war, of course, disrupted many important aspects of the prewar economic order. It "has so shaken this system as to endanger the life of Europe altogether" (Keynes 1920, p. 25). Several of the major impediments to the reconstitution of the old order pointed to by Keynes turned out to be persistent. First, the era of cheap imported food was over. Therefore, further population growth would reduce living standards. Yet when population growth slows, the incentive to invest declines. Keynes con­stantly stressed that the sharp drop in the rate of population growth in Britain would weigh heavily on the rate of growth of the capital stock; see, for example, his 1937 Galton Lecture on secular stagnation reviewed in Chapter 15 of this book.

Second, the system was now heavily burdened with excessive debt of all kinds, public and private. Here is an early statement by Keynes of his belief in the crucial role played by the condition of the balance sheets of governments and real-sector and financial firms in the determination of economic conditions. It is an anticipation of what Hyman Minsky later called the "financial fragility" thesis. Keynes's concern about the dangers embedded in fragile balance sheets reappeared in his discussion of finan­cial instability in the USA in the late 1920s and early 1930s, as described in Chapter 10 of this book.

The war has ended with everyone owing everyone else immense sums of money. Germany owes a large sum to the Allies; the Allies owe a large sum to Great Britain; and Great Britain owes a large sum to the United States. The holders of war loans in every country are owed a large sum by the State; and the State in its turn is owed a large

The Economic Consequences of the Peace 29 sum by these and other taxpayers. The whole position is in the highest degree artificial, misleading and vexatious. We shall never be able to move again, unless we can free our limbs from these paper shackles. A general bonfire is so great a necessity that unless we can make of it an orderly and good-tempered affair in which no serious injustice is done to anyone, it will, when it comes at last, grow into a conflagra­tion that may destroy much else as well.

(Keynes 1920, p. 280)

Keynes pleaded with the ruling elites to eliminate the internal government debt of all the major countries in Europe by a very large one-time capital levy (or wealth tax) and greatly reduce the external debt through inter­national negotiations, a plea that ultimately went unheeded. "I am one of those who believe that a capital levy for the extinction of the [internal] debt is an absolute prerequisite of sound finance in every one of the European belligerent countries" (Keynes 1920, p. 280).

Third, the prewar system of international economic and financial exchange had broken down.

There are... three separate obstacles to the revival of trade: a mal­adjustment between internal prices and international prices, a lack of individual credit. to buy the raw materials needed to secure the working capital and to re-start the circle of exchange, and a disordered [international] currency system which renders credit operations haz­ardous or impossible quite apart from the ordinary risks of commerce. (Keynes 1920. pp. 243-244)

The first of these problems would continue to plague the system and occupy Keynes's attention for much of the interwar period. Britain would go back on the fixed exchange rate gold standard in 1925 at a highly overvalued pound.⁵ To prepare for the return of the gold standard, the Bank of England kept interest rates excessively high in the years leading up to 1925, a practice that continued right through 1931 when Britain left the gold standard. The fact that Britain had already lost much of its pre­vious dominance in important segments of trade reinforced the upward pressure on interest rates that lowered the pace of capital investment.

Finally, Keynes feared the consequences of war-generated inflation. Prices had remained reasonably stable for most of the period between the Napoleonic War and WWI, though in the period from 1896 to 1914 they had risen substantially. They then rose dramatically over the five years ending in 1920 at an average rate of about 20 percent per year. "The infla­tionism of the currency systems of Europe has proceeded to extraordinary lengths" (Keynes 1920, p. 238).

Keynes railed against the evils of inflation and the need to eliminate the policies that reproduced it. He incorrectly attributed to Lenin the idea

30 The Economic Consequences... to The General Theory

that "the best way to destroy the Capitalist System was to debauch the currency" (Keynes 1920, p. 235). Inflation arbitrarily redistributes wealth, he said, and thus violates canons of social justice that were very important to him, and it exacerbates uncertainty about the future to such a degree that business calculations become precarious if not futile. Uncertainty over future financial- and real-sector variables would become a center­piece of The General Theory. Unpredictable inflation turns the entrepreneur into a speculator, he argued, and destroys the foundation of the financial system.⁶

As inflation proceeds and the real value of the currency fluctuates wildly... all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth­getting degenerates into a gamble and a lottery.

(Keynes 1920, p. 235)

In his 1923 Tract on Monetary Reform (see Chapter 3), Keynes argued that a "regime of monetary contract" in which the total value of all legal commitments to make nominal payments is large relative to the size of the economy is inherently financially fragile. A serious deflation can trigger a cascade of defaults, leading to a financial crisis.⁷

For all of these reasons, Keynes concluded that the current severe problems in the economies of Europe were not just the result of a tem­porary adjustment in the transition from a war footing to a return to a peacetime economy. Rather, they were caused by deep-seated, long-term economic problems that were likely to result in sustained low growth and sustained high unemployment over the coming decades.

Thus, the conventional wisdom that Keynes first became concerned about serious structural flaws in capitalism when the Great Depression erupted in the early 1930s is not correct. He came to that conclusion more than a decade earlier. And, as we will demonstrate, he sustained his belief that capitalism was fundamentally or structurally flawed until he died in 1946.

The British economic historian Eric Hobsbawm opened his book Industry and Empire with yet another structural or long-run reason as to why the economic future of Britain looked especially gloomy after WWI. Britain had economically dominated the rest of Europe and, indeed, the rest of the world from the mid-eighteenth century through the nineteenth century. Much of its economic success in this era derived from this dom­inance. But its superiority was inherently transitory, based on conditions that could not possibly be sustained in the long run.

The Industrial Revolution marks the most fundamental transform­ation of human life in the history of the world recorded in written

The Economic Consequences of the Peace 31 documents. For a brief period it coincided with the history of a single country, Great Britain. An entire world economy was thus built on, or rather around, Britain, and this country temporarily rose to a position of global influence and power unparalleled by any state of its relative size before or since, and unlikely to be paralleled by any state in the foreseeable future. There was a moment in the world's history when Britain can be described, if we are not too pedantic, as its only work­shop, its only massive importer and exporter, its only carrier, its only imperialist, almost its only foreign investor; and for that reason its only naval power and the only one that had a genuine world policy. Much of this monopoly was simply due to the loneliness of the pioneer, monarch of all he surveys because of the absence of other surveyors. When other countries industrialized, it ended automatically, though the apparatus of world economic transfers constructed by, and in terms of, Britain remained indispensable to the rest of the world for a while longer. Nevertheless, for most of the world the "British" era of industrialization was merely a phase, - the initial, or an early phase - of contemporary history.

(Hobsbawm 1969, p. 13) Keynes drew the following conclusion from all this. "England is in a state of transition, and her economic problems are serious. We may be on the eve of great changes in her social and industrial structure" (1920, p. 253).

The most serious problems for England have been brought to a head by the war, but are in their origins more fundamental. The forces of the nineteenth century have run their course and are exhausted. The eco­nomic motives and ideals of that generation no longer satisfy us: we must find a new way and must suffer again the malaise, and finally the pangs, of a new industrial birth.

(Keynes 1920, p. 254, emphasis in original) Schumpeter (1946) wrote eloquently about the centrality and depth of Keynes's commitment to the "vision" of secular stagnation and emphasized that this "vision" from 1919 was the foundation of The General Theory. Before undertaking his analysis of The Economic Consequences of the Peace, Schumpeter said:

Keynes drew a sketch of the economic and social background of the political events he was about to survey. With but slight alterations of phrasing, this sketch may be summed up like this: Laissez-faire capit­alism, that "extraordinary episode," had come to an end in August, 1914. The conditions were passing in which entrepreneurial leader­ship was able to secure success after success, propelled as it had been by rapid growth of populations and by abundant opportunities to 32 The Economic Consequences... to The General Theory invest that were incessantly recreated by technological improvements and by a series of conquest of new sources of food and raw materials. Under these conditions, there had been no difficulty in absorbing the savings of a bourgeoisie that kept on baking cakes "in order not to eat them."⁸ But now (1920) those impulses were giving out, the spirit of enterprise was flagging, investment opportunities were vanishing, and bourgeois savings had, therefore, lost their social function; their persistence actually made things worse.

Here, then, we have the origin of the mainstream stagnation thesis - as distinguished from the one which we may, if we choose, find in Ricardo. And here we also have the embryo of the General Theory. Every comprehensive "theory" of an economic state of society consists of two complementary but essentially distinct elements. There is, first, the theorist's view about the basic features of that state of society, about what is and what is not important in order to understand its life at a given time. Let us call this his vision. And there is, second, the theorist's technique, and apparatus by which he conceptualizes his vision and which turns the vision into concrete propositions or "theories." In those pages of the Economic Consequences of the Peace we find nothing of the theoretical apparatus of the General Theory. But we find the whole of the vision of things social and economic of which that apparatus is the technical complement. The General Theory is the final result of a long struggle to make that vision of our age analytic­ally operative.

(Schumpeter 1946, pp. 500-501, emphasis in original)

Schumpeter argued that the secular stagnation thesis at the center of the Economic Consequences of the Peace was also the central pre-analytic "vision" that underpinned the economic theory and the suggested policies to fix the broken economic system presented in The General Theory 17 years later. The General Theory represents Keynes's ultimate theoretical foundation to support his "vision" of 1919.

The social vision first revealed in the Economic Consequences of the Peace, the vision of an economic process in which investment oppor­tunity flags and [high] savings habits nevertheless persist, is theor­etically implemented in the General Theory of Employment, Interest and Money, by means of the three schedule concepts: the consump­tion function, the [marginal] efficiency of [or expected rate of profit on] capital function, and the liquidity-preference [or demand to hold money as an asset] function.

(Schumpeter 1946, p. 510)

Schumpeter is arguing here that while the sole formal model in The General Theory is a short-run model such as the one formalized by Hicks as an IS/

The Economic Consequences of the Peace 33 LM model, the same formal model can be used to capture the outline of Keynes's "vision" of secular stagnation.

The old order had perished, but the appropriate structure of the new order was as yet unclear. Keynes's life work, as he saw it, was to help create a new economic order that would ensure full employment and social justice and would be brought about by evolutionary democratic processes rather than through violent revolutions such as those that shook Europe in the interwar years and would ultimately lead to WWII. He would call his proposed new economic order "Liberal Socialism." We will trace his efforts to create Liberal Socialism in Britain throughout the rest of the book.

Notes

1 "These factors of order, security and uniformity... prepared the way for the organization of that vast mechanism of transport, coal distribution, and foreign trade which made possible an industrial order of life in the dense urban centers of new population" (Keynes 1920, p. 16).

2 The British working class did not get to participate in this prosperity until the latter part of the century.

3 In the eighteenth century and much of the nineteenth century, the condition of the emerging working class both in the factories and at home was deplorable.

4 Moreover, Keynes knew that Britain's pre-WWI dominance in important areas of international trade had also evaporated.

5 Keynes famously attacked the decision to return to gold at its prewar par in his 1925 essay "The Economic Consequences of Mr. Churchill," which is discussed in Chapter 5.

6 Data on the decline of the wealth of ruling elites at this time through war and inflation can be found in Piketty (2014).

7 Inflation ended by 1921 to be followed by three years of sharp deflation, then 12 years of moderate deflation. Keynes would argue in the early 1930s that defla­tion in the context of fragile balance sheets everywhere is even more destruc­tive than inflation. Problems caused by inflation and deflation are discussed in Chapters 3 and 5.

8 This was an analogy Keynes used to express the idea that the wealthy consumed a relatively low percentage of their income.

3