Before Keynes wrote his seminal book titled "The General Theory of Employment, Interest and Money" in 1936, we used to live in a world dominated by Adam Smith. This was the world of the "invisible hand." The government needed to stay out of the economy, we believed, because markets would self-correct and find a new equilibrium thanks to the magic of supply and demand. All the government needed to do was adopt a sound budget and avoid budgetary excess. The invisible hand of the markets would take care of the rest.Today, we remember Keynes as the economist who challenged this classic economic theory by advocating deficit spending during downturns. But what revolutionized the field of economics with Keynes' work was more than that. Keynes argued that in times of financial panic and recession, the government had a legitimate role to play and a legitimate right to intervene to save capitalism. He basically argued that markets take too long to self-correct. And in the long run, as he once argued in a conference "We are all dead." Therefore, the invisible hand of the markets needs to be tempered with the very visible hand of the government. Parts of what Keynes wrote in 1936 could have been written today to describe the panic in the markets and the government intervention.
Part of the problem with financial markets, Keynes argued, is the investor preference for liquidity. In times of crisis, people want their money in the safest investments. It is the nature of organized investment markets that when there is a major downturn, people panic and get out of riskier areas that created strong profits in the past. In other words, all bubbles eventually burst and people run for safety. In Keynes's own words, "Once doubt begins it spreads rapidly."
This is exactly what has been happening on Wall Street over the past few months. We've gone from a bubble of over-enthusiasm -- irrational exuberance, as Alan Greenspan, the former head of the Federal Reserve, once called it -- to a state of panic in which financial institutions are so risk-averse that they don't want to lend to anyone.
Keynes's revolutionary idea was that in such a major crisis, financial markets would not be inherently self-correcting, as classic economists such as Adam Smith argued. Left to itself, the markets might remain in a liquidity trap and stay frozen. This would lead to recession and in the worst cases to a Great Depression-like scenario. So it fell to the government to take actions that would restore confidence and stimulate investment.
This is what Treasury Secretary Henry Paulson is trying to do to overcome the present financial crisis. Since he intervened to rescue Bear Stearns in March, Paulson has been trying to pump cash into the markets. These markets are currently locked up because of the extreme liquidity preference of investors. Yet there is a major problem: Each rescue measure only sets up the next disaster, and there is much reluctance in the US Congress to approve a government pledge to buy up $700 billion or more of mortgage-backed securities.
American legislators also want to avoid bailing out foolish investors. After all, they are playing with taxpayers' money, and there is a growing sense among middle-class Americans that the rich can get away with anything. I just heard this view expressed in the most amusing way when someone on the radio referred to the American economic system as "socialism for the wealthy and capitalism for the poor." This is why if the taxpayers are going to acquire $700 billion in real estate assets, perhaps the eventual profits can fund new investments in infrastructure or energy technology. Reading Keynes these days reminds me that public purposes are best served by public institutions. We are Keynesians today…
