Book review - Keynes: The Return of the Master, by Robert Skidelsky

Skidelsky argues that it's time for a paradigm shift in macroeconomics - inspired by Keynes.

by Shamik Dhar
Last Updated: 25 Oct 2010

John Maynard Keynes was not only the greatest 20th-century economist, he was also the most quotable. His second most famous aphorism was that 'practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist'. And this book's central argument is that, more than greedy bankers, incompetent policy makers or naive investors, it's the ideas of defunct economists that are to blame for causing the worst global recession since the great depression. Along the way, according to the author, we have been forced to rehabilitate Keynes, the man who first saw that capitalism is prone to periodic collapses and then set about saving it from itself.

The book is at once an introduction to Keynes' ideas and an attack on the prevailing intellectual consensus. Chief villain and defunct economist emeritus is Robert Lucas, high priest of the Chicago School, which undermined Keynesian theory in the 1970s. According to Skidelsky, three ideas associated with Lucas and the Chicago revolution lie at the heart of economic orthodoxy and are not only wrong but highly dangerous. 'By their influence on the way policy makers think about the world, they have helped create a system which is inefficient, unjust and prone to frequent collapses.'

The three premises are the rational expectations hypothesis, real business cycle theory and the efficient markets theory. Skidelsky sketches each of them nicely, and describes the intellectual and political climate under which they flourished. There isn't space to describe them fully here; suffice to say they promoted the efficiency of markets over government intervention and ruled out the possibility of financial collapse and economic slumps.

Skidelsky overestimates their influence: few economists believed in the literal truth of any of these propositions, and the absurdity of their implications was obvious to most. The distinguished economist Robert Solow once described real business cycle theory as trying to explain the great depression in terms of 'a mass outbreak of laziness'. Rather, it was the mindset associated with these propositions that led many policy-makers into complacency. The attitude is possibly best summed up in the Greenspan doctrine - the view that modern financial markets are best left to police themselves and that central banks cannot identify asset price bubbles in advance, so should not try to prick them.

By contrast, Keynes believed that 'animal spirits' determine macroeconomic outcomes. He believed that capitalism is inherently unstable, that slumps and high unemployment can persist and that governments can and must try to do something about them. In the language of modern economics, there is not one but a multiplicity of equilibria that the economy can reach and the authorities play a crucial role in deciding which of them will prevail.

But, according to Skidelsky, the malaise went much deeper than the specifics of the Chicago school assumptions. It is the methodology of modern macroeconomics that must be overthrown. In the past 30 years, it has evolved into an over-mathematical, narrow-minded, exclusive discipline, the kind Keynes would have no truck with. Even so-called 'new Keynesians' share this addiction to formalism, but the axiomatic approach has been undermined by the weakness of the axioms, which are not realistic.

Take the treatment of expectations, for instance. Skidelsky credits Keynes with being the first to assert the centrality of expectations to economics; indeed, one could argue that Keynes' most important insight was that expectations determine economic equilibria, not the other way round. However, Keynes did not believe that expectations were amenable to mathematical analysis. His theory of probability told him that there is a difference between risk and uncertainty: the former could be described by frequencies and probability distributions, the latter could not.

The mortgage securitisation boom was underpinned by the assumption that all risks could be priced and controlled using apparently sophisticated mathematical models. Keynes would not have been surprised when they failed.He believed instead that big economic decisions are characterised by uncertainty, not risk. The future is unknowable, and is determined as much by what people think might happen as by what is objectively out there.

Keynes was a more than competent mathematician but was deeply suspicious of its usefulness to economics. It is a sentiment Skidelsky shares, and he argues that economics is, or should be, a 'moral science' first (I think they both go too far - but that's another story). Keynes would not have predicted when the crisis would occur, but he would have assumed that a crisis would happen at some point.

In summary, this is a very good book. Its central premise that bad economic ideas lie behind the present crisis is probably true, and it reminds us how great and insightful an economist Keynes was. Its analysis of the methodological failures of macroeconomics is spot-on, and its plea for a more inclusive, historically literate macroeconomics is well timed.

The book is stronger on description than prescription, and its intellectual heroes and villains are crudely painted at times. But it sets out a manifesto for fundamental change in the subject that ought to reduce the impact of bad ideas in the future. Macroeconomics is ripe for a 'paradigm shift' and we don't have to look far to see where those 'new' ideas might come from. The master has returned.

Keynes: The Return of the Master

Robert Skidelsky
Allen Lane

Shamik Dhar is director of Fathom Financial Consulting

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