It took me a while to get around to watching it, but the BBC’s Keynes documentary in their new ‘Masters of Money’ series was disappointing in all the predictable ways and in one surprising way. If it had been worse, it would have been less disappointing.
It was predictably disappointing in being sublimely uninformative. At one point the host, Stephanie Flanders, mentions that Keynes ‘didn’t seem to have an answer to the high inflation of the 1970s’. But she doesn’t say anything else about this, not even why. This is, of course, a reference to the most important thing to have happened to the legacy of ‘Keynesian’ theory (I’ll explain the scare quotes shortly); one would think a documentary about the legacy of Keynes and his relation to the present might have attempted to explain it.
‘Keynesian’ theorists (Flanders could have said) had arrived at the view that governments could trade off inflation against unemployment, maintaining high employment as long as they were willing to put up with high inflation (this was known as the Phillips curve, although it was not discovered by Phillips). Many big Western governments enthusiastically pursued this strategy and seemed to have some success with it. Then came Milton Friedman and the ‘rational expectations’ theories based on the work of Lucas, Barro, Muth, and others. Friedman argued, in effect, that inflation lowers unemployment only insofar as people are subject to money illusion – believing themselves to be richer when they have more money, even when prices have risen in proportion to their increase of money income. Ongoing inflation, however, will come to be factored into people’s estimations of their income. Thus allowing persistent inflation as a matter of policy is self-defeating. The stagflation of the 1970s –combining high unemployment with high inflation – seemed to vindicate his view. Keynesianism was abandoned. Monetarism – the policy of controlling inflation through monetary policy – was born, pursued by Thatcher and others until it was realized that controlling the money supply, or even saying what counts as the money supply, is more difficult than first believed. But one thing stuck: Friedman and his kind effectively returned macroeconomics to the pre-Keynesian view that government action to bring supply and demand into line is unnecessary and dangerous, since the market does this anyway. Hence all the deregulation leading up to the current crisis. That all seems rather important – but where was it?
The documentary was also predictably disappointing in perpetuating the Big Lie about Keynes: that the above-described policies really were based on his theories. They weren’t; they were based on a theory developed, not by Keynes, but by John Hicks and others – IS-LM, the Phillips curve. IS-LM was alleged to formalize Keynes’ theory into something like the terms of neoclassical economics; in reality it had very little to do with Keynes’ theory, as Hicks himself admitted in the 80s. Indeed, though it is rarely acknowledged these days, most of the ‘Keynesian’ models used to make forecasts for policy purposes were even simpler (and less Keynesian) than IS-LM; they gave almost the whole explanatory role to the consumption function, whereas Keynes believed that investment was the most important variable.
Why should that matter? This brings me to the surprisingly disappointing part. The documentary almost identifies the crucial insight of Keynes that was entirely lost in translation by Hicks and other epigones. This is the insight that investors make decisions under conditions of uncertainty rather than risk. Since I talked about him last post, I might as well use Steve Keen’s excellent explanation of the difference:
Risk applies to situations in which the regularity of past events is a reliable guide to the course of future events. Gambling gives us many such examples: if a tossed coin is seen to land showing heads roughly half the time, then you can reliably bet that there will be a 50:50 chance of heads in the future. If anyone bet you that heads would in future come up only 40 percent of the time, it would be sensible to take the bet. … Uncertainty applies when the past provides no reliable guide to future events. … A somewhat intimate example might illustrate the fallacy of identifying uncertainty with risk. Imagine that you are very attracted to a particular individual, and that you know this person has gone out with 20 percent of those who have asked him or her out in the past. Does this mean that you have a 20 percent chance of being lucky if you ‘pop the question’? Of course not. Each instance of attraction between two people is a unique event, and the past behavior of the object of your desires provides no guide as to how your advances will be received. How he or she will react cannot be reduced to some statistical prediction.
Economists before and after Keynes, having no idea how to mathematically formalize uncertainty, simply treat it as identical with risk. The IS-LM model includes neither uncertainty nor risk, while today’s hyper-complex macroeconomic models repeat the mistake of identifying the two. But the difference is important. Under conditions of uncertainty mass psychology rules rather than rationality, so that price movements come to be governed by exhuberance and panic rather than calculation. This is what Keynes seemed to have been talking about in chs.13 and 17 of the General Theory, sections which seem to receive no representation in IS-LM.
The documentary comes so close to revealing this that it’s tantalizing. Wandering through Keynes’ room in Charleston and lounging in his office at Cambridge, Flanders discusses his interest in probability theory and philosophy – just what you would need to identify the difference between uncertainty and risk. Leafing through pages of Keynes’ equations, she explains how he gambled on the stockmarket, trying to predict future asset prices using probability calculus, eventually finding that his formulae were unable to track real human behaviour. All she needed to add was that they were unable to do so because human behaviour creates uncertainty rather than risk and is therefore not amenable to probabilistic calculation. But of course this doesn’t fit with the Big Lie: Keynes was the father of the new ‘Keynesian’ ‘science’ of macroeconomics that dictated the policies of postwar Western governments and left out Keynes’ main insight altogether. My guess is that this is because it was a philosophical insight, and everyone knows that philosophy has nothing to do with economics.
If the documentary had avoided the Big Lie, it could have discussed how Keynes – the real Keynes – was able to explain something that modern macroeconomics is unable to explain and was accordingly unable to predict, namely the Shit Creek up which we currently find ourselves. We’d be less likely to have been here if modern economics hadn’t ‘proven’ that it was impossible for us to get here. Keynes revealed what was wrong with these ‘proofs’, but he was either ignored or misrepresented. That sounds like an interesting topic for a documentary.