Question: What facts have changed in the recent economy that might cause Keynes to change his mind?
Robert Skidelsky: Of course you can't have the same, you can't have exactly the same remedies for a completely different kind of economy and things have changed since his day. And therefore, it's always a slightly artificial discussion to say, "Well, what would Keynes have done under the present circumstances?"
Still, to try and carry the point a bit further, I don't think there's been as much change in the financial system as one might think. Sure enough, Keynes' focus was on the stock market rather than on the banking system because at that time, firms, you know, raise money on the whole, they raise capital through the stock market and the role of bonds and bank borrowing in the financing of business was less than it is now. But, if you read chapter 12 of the General Theory, you get an analysis of herd behavior and the volatility of psychology of financial markets, which I think can be applied without very much amendment to what happened in 2007 and 2008. I think he's got the psychology of these markets right.
There's much less manufacturing done than there was on his day and that may mean that when an economy starts running down, there are different factors involved. It may be that, in fact wages are more flexible now because when you have very heavy manufacturer, this was also the scene of very powerful unions. But on the other hand, you have a larger public sector than you did in Keynes' day so I'm not sure that wages would be any less sticky today than they were in his day.
Question: What has distinguished the psychology of the hoarding saver from that of the rabid investor in the last few years?
Robert Skidelsky: That distinction between the psychology of the saver and the psychology of the investor is very closely connected with Keynes' distinction between risk and uncertainty. He did not think that the future was always merely risky in the sense that you, it was like betting on things happening and giving, being able to put numbers. In other words, having a set of probabilities about what would happen. He thought that a lot of it, and particularly when you were doing long-term investment, was unknown. You just didn't know what was going to happen. Of course, you invented various ways of dealing with that, but you didn't know and therefore, he thought of uncertainty as being a very, very dominant impulse in human behavior, dominant motive for human behavior. And when the future is uncertain, in that sense, he thought that a lot of saving would be directed towards securing, securing more, getting more security in the present, rather than building wealth in the future, which was the classical view, you save in order to invest, in order to consume more later on. Keynes thought of saving much more as a kind of hoarding, or rather, what he had called the propensity to hoard or liquidity preference, would normally be stronger than the inducement to invest.
And so that's the way he separated them out via this crucial category of uncertainty. If you have no uncertainty, then of course the classical economics is true, and also a lot of modern financial economics. You have no uncertainty, you don't need, you have no problem of liquidity, you don't need to keep cash, there's, money has no utility in a certain world, whereas an uncertain world it has a great deal of utility.
As we, you know, we have to act, we have to take views and to say I don't know isn't really the basis for a decision unless we just act on caprice, you know? But, I mean, investors expect more than that. And so what were people selling, selling securities and anything else, is they do insurance policies, whatever, they invent numbers. Now, they're not inventing them in some sense of trying to cheat, but they are saying, "Well, let's start with some estimates," in other words, through something like using Bayes Theorem, we'll bet that it'll be like this. And then we look for evidence that confirms that. And so in a way, they're trying to work out some risk premiere that have some correspondence with actual risks. But they don't, they're not, they can't go very far that way, along those lines, because the actual correspondence isn't really there in a lot of cases. So once people stop believing in these stories, and then the crash can come very, very quickly. They believe that house prices are correctly priced for some time and then suddenly they realized there's no real basis for that. But what is the correct price? We don't know that either. It's just that everything swings. People suddenly cancel their existing bets and want to get out.
Now, none of that behavior seems to me to be explicable unless you have uncertainty there. And economics should start, I think, with the assumption that a lot of economic life is going to be uncertain. Now, what kind of economics and economic modeling and economic theory follows from that?
Question: Can there be an imbalance between saving and investment?
Robert Skidelsky: Well, I think we can certainly have an imbalance X and T before the event, because in his equilibrium model, saving and investment are always equal, by definition. But that's realized saving and investment. But before, as you're coming into your crises, then there is an imbalance. People want to save more than others want to invest. And unless, and then he says, well, look, in classical theory, the theory he was combating, the theory of his day, what happens in that situation is the rate of interest moves immediately to adjust these two, this discrepancy, this X and T discrepancy, so that in fact, everything proceeds smoothly and savings flow into investments smoothly. Whereas Keynes says, "No, the rate of interest doesn't do this because the rate of interest, what it equalizes is the desire to hoard money with the supply of money so that it can remain above what's necessary. It doesn't fall by as much as is necessary to equalize saving and investment." And so in a way, that self-adjusting mechanism, which classical economics assumed to exist, wasn't there. I know that's a bit technical, but all it means is that you, the government has to intervene at that point. That there's no automatic mechanism in a market system that reconciles the desire to save and the desire to invest. And therefore, the government has to sort of do something or the Federal Reserve, the Fed, or the Central Bank, or whatever, it has to intervene.
It has to create enough investment, I would put it this way, for the economy not to suffer from a fall in aggregate demand because if you have a fall in the savings function relative to what people want to say, you then start having spending falling off because that sort of portion of spending, that is going to investment, has decreased and all that's happened is that the extra saving, if you like, saving relative to investment is just left to fall in aggregate spending, that leads to a fall in output, and that leads to a rise in unemployment.
So, if you don't have a balance within the market system itself, then you need an external balance and that's what I think Keynes believed and I think that's what happened last time. What would've happened, do you think, had the government not intervened in October 2008? Suppose it had let the whole of, a lot of the banking system collapse? And what would've happened, do you think, to the economy? I mean, people would have then lost a lot of their money, or some of it might have been secured because there was deposit insurance up to a certain point, but a lot of people would have just lost their money. That means that they wouldn't have had any spending power left. How could they have bought anything without any money if it had all disappeared? The catastrophe to the economy would've been absolutely unbelievable. And yet classical economists say, "Oh, well, no, it would've adjusted perfectly happily, a few weeks of pain and then everything would've gone on as before, without a banking system left." I think you only have to sort of think about that and realize that the government had to intervene to save the economy. And that's what makes it so maddening, that these bankers are back saying it was all the government's fault. I mean, the government saved their skins. It didn't want to, but it needed to save their skins in order to save the rest of us. And now they say--I mean, it makes me very annoyed actually.
Question: Is there anything the government can do to speed up the adjustment process in the financial sector?
Robert Skidelsky: Well, there's a lot to unpick in that. I don't, first of all, I don't know what building too many houses and that really means. I mean, one of the, what I do know is that the housing bubble was not based largely on house building. It was actually based on swapping titles to houses because new starts as a proportion of house sales had plummeted. And so in a way it was a speculative bubble.
Now, I think, and that had to be, that had to collapse. And so I agree with you, prices got out of line and the crises was in a way a return to something that was more sustainable. But the deeper question is how had this got to happen? Was it really because monetary policy had been kept too loose for too long as was later alleged. Because if it's true that as financial economics claims, that securities are always correctly priced and the risks are correctly priced, how did this huge under-pricing of risk actually happen? And I don't think the classical people have a good answer to that. I think Keynes has an answer because he says that such mis-pricing of risks is inevitable because we don't actually know what the risks are. And therefore, they may be correctly priced by accident and also if they, and there may be a lot of conventional belief that they are correctly priced, but the chances are very, very high that they won't be and therefore, they'll come crashing down. So I'd like to know what the classical story is about this under pricing of risk worldwide. How was it possible for this systemic mis-pricing of risk, which was later acknowledged to be at the root of the banking crises to develop? I don't know the answer to that.
Recorded on December 16, 2009