What Is The Correct Keynes Solution?

(This article was originally published by TripleCrisis)

By Paul Davidson

The financial market crisis and the Great Recession of 2008-2010 provided the empirical nails for the coffin of the efficient market hypothesis.  Since the 1970s, efficient market theorists, government policy makers, and central bankers insisted that (1) government regulations of markets and large government spending policies are the cause of all our economic problems, and (2) ending big government and freeing markets, especially financial markets, from regulatory controls is the solution to our economic problems, domestically and internationally. Stickiness in wages and prices – including financial market prices – caused our economic problems.  Flexible market prices was the solution.

The fundamental principles underlying Keynes’s theory of liquidity can explain why free markets, free trade, freely flexible exchange rates and free international capital funds mobility are ultimately incompatible with the economic goal of global full employment and rapid economic growth. Moreover, Keynes’s liquidity analysis suggests policy prescriptions to completely prevent or at least quickly alleviate the distress caused by financial market problems.

In my 2009 book The Keynes Solution: The Path to Global Economic Prosperity, I explain why those who possess the Panglossian belief that free markets produce socially optimum solutions are wrong and why Keynes’s liquidity theory explains why laissez faire financial markets can never be efficient. The 2008-2010 Great Recession saw many nations use some small “Keynesian” stimulus policies to lift their economies out of recession. What was not appreciated in all the stimulus policy discussions is that Keynes’s fiscal stimulus proposal is based on Keynes’s revolutionary theory of the role of money to explain the operations of a capitalist system.

Keynes was primarily a monetary theorist and the words “money” or “monetary” appear in the title of most of his important books. Monetarists as well as Old and New Keynesian economists, however, believe that “money is neutral,” i.e., money does not affect production and exchange transaction decisions.  In contrast, Keynes’s liquidity theory insists that money is never neutral, i.e., that money affects real decision-making in both the short-run and the long run.

Many economists who call themselves “New Keynesians” or “Neoclassical Synthesis Keynesians” are trumpeting their victory over classical efficient market theorists, even though, as I document in  The Keynes Solution,  these “Keynesians” never understood Keynes’s revolutionary theory of money. 

In our capitalist system, Keynes insisted, entrepreneurs organize all production and exchange transactions over time in terms of money contracts. The essence of a capitalist system is the sanctity of the money contract. Orthodox economic theory, whether New Keynesian , Old Keynesian or mainstream classical theory, on the other hand, argue that decision-makers use “real” contracts to make production and exchange  decisions.

In the media, countries that pursued export led growth policies to obtain persistent favorable trade balances that are used to accumulate huge foreign reserves are considered to be economic miracles (e.g., Japan in the 1980s, China in the 1990s and 2000s, etc). In Keynes’s monetary analysis, however, the resulting international debt contracts held as reserves by these “miracle” economy nations threaten global prosperity. US financial markets supposedly efficiently allocate capital, yet in our entrepreneurial system, these markets continually suffer from “bubbles”, e.g., the dot.com bubble of the 1990s and the real estate bubble in the 2000s where  a small-sub prime mortgage set of defaults in the US spread to create a global banking,  financial market economic crisis. Outsourcing created unemployment (and limits if not actually lowers) real income for workers in developed nations in contrast to the gains that should accrue to labor under the conventional wisdom of the law of comparative advantage.

If entrepreneurs enter into nominal contracts in order to organize production and exchange activities, then liquidity, i.e., the ability to meet one’s money contractual commitment, outflows domestically and internationally becomes an essential foundation for understanding the operation of a capitalist economy. In Keynes’s solution to our global economic problems, the primary function of well organized and orderly financial markets is not to optimally allocate capital. Instead it is to provide liquidity so that holders of financial assets traded on such markets “know” he/she can make a fast exit and liquidate their portfolio position at a price close to the previous market price at any time he/she fears something bad is going to happen in the future. For business firms and households the maintenance of one’s liquid position is of prime importance if bankruptcy is to be avoided. In our world, bankruptcy is the economic equivalent to a walk to the gallows.

For more than 50 years my writings have often involved indicating the importance Keynes placed on the role of money in the economy. So-called “Keynesians,” whether they be Old Neoclassical Keynesians (e.g., Samuelson) or New Keynesians (e.g., Stiglitz or Krugman), have never paid adequate attention to the role of money in the economy. Given the current emphasis on leverage, “trouble asset” derivatives, credit-default swaps, etc., the opportunity has arisen to expose politicians and the public to the importance of Keynes’s revolutionary theory of money, money contracts, and liquidity vis-a-vis the “Keynesian” theories that have been propagated at most of our prestigious universities. Only if we get our Keynes theory right, will we get the Keynes solution for a globally economic prosperous system correct.


Paul Davidson is the Editor of the Journal of Post Keynesian Economics and a Scholar at the Bernard Schwartz Center forEconomic Policy and Analysis. He is the author of The Keynes Solution: The Path to Global Economic Prosperity.

[Photo courtesy of flickr user Public Domain Photos]


You can read more about "post-Keynesian" models of economic growth and stimulus in our conversation with Justin Yifu Lin, chief economist of the World Bank. The article was originally published in World Policy Journal, Spring 2011 issue.

Related posts

We’d like to get to know our readers a bit better as we work on some exciting new projects this year.

Please take a few minutes to complete World Policy’s 2018 survey!