by Sylvia Nasar
Von Mises had been trying to obtain a position for Hayek at the Chamber of Commerce. When he failed, he raised enough money to create an independent forecasting institute and put Hayek in charge of it. The Austrian Institute for Business Cycle Research was modeled on the academic and private American organizations that Hayek had visited in the United States, and Hayek became its first director. Thus, at thirty, he found himself running a research institute with ties to similar organizations abroad and publishing a monthly forecast for an international audience—though his entire staff consisted of two typists and one clerk.
In 1928, Hayek submitted the book he had started to write in New York, Monetary Theory and the Business Cycle, as his “habilitation” to the University of Vienna. Lionel Robbins, a young working-class Liberal at the London School of Economics who was looking for intellectual allies, happened to attend Hayek’s trial lecture on “The ‘Paradox’ of Saving” and was so impressed that he asked whether he had any interest in coming to London. Robbins also expressed interest in the institute’s latest forecast. In his April 1929 newsletter, Hayek noted corporate borrowing was growing faster than production in the United States and warned of “unpleasant consequences.” That observation led Robbins subsequently to credit his protégé with prophesying the 1929 stock market crash. In fact, Hayek’s alarm was transitory. In his October 1929 newsletter, he reassured readers that neither “a sudden breakdown of the New York Stock Exchange” nor a “pronounced” economic crisis were imminent.34
Chapter IX
Immaterial Devices of the Mind: Keynes and Fisher in the 1920s
The world is gradually awakening to the fact of its own improvability. Political economy is no longer the dismal science.
—Irving Fisher, 19081
We should be led to control and reduce the so-called “business cycle.”
—Irving Fisher, 19252
The Great War had postponed the need for Keynes to settle on a career. At one time, he had thought he wanted to run a railroad, but railroads were no longer as glamorous as before the war. That high ground was now occupied by finance. The business of borrowing, lending, and insuring had been transformed by floating currencies, huge war debts, the urgent need for credit, and the vexing issue of reparations. Once a staid if mysterious backwater, finance had become the fastest-growing industry—or, in the eyes of skeptics, a giant casino.
Oswald “Foxy” Falk, a stockbroker friend whom Keynes had brought to the Treasury during the war, introduced him to the City, London’s Wall Street. Within a year Keynes found himself chairman of an insurance company. He knew nothing about insurance or the desirability of diversifying an investment portfolio. A life insurance company “ought to have only one investment and it should be changed every day,”3 he opined at his first board meeting. That Fisher’s notion of a trade-off between an investment’s risk and its rate of return had not occurred to Keynes is a sign of how novel it was. Like so many ideas that seem too obvious to require discovery, the idea that putting all one’s eggs into a single basket was risky was generally as little understood as Einstein’s theory of relativity.
Keynes by no means limited himself to running the insurance company. The collapse of the global gold standard, with its fixed exchange rates—something like a single world currency—during the war and its replacement by floating exchange rates had created a foreign exchange speculator’s paradise. When his speculation in francs, dollars, and pounds prospered, as in the fall of 1919 and the spring of 1920, Keynes was able to buy paintings by Seurat, Picasso, Matisse, Renoir, and Cézanne. “The affair is of course risky but Falk and I, seeing that our reputations depend on it, intend to exercise a good deal of caution,” Keynes assured his father, who, like several of his son’s Bloomsbury trust-fund friends, had blithely handed over several thousand pounds for him to manage. Perhaps the son’s next thought—“Win or lose this high stakes gambling amuses me”—should have set off warning bells.4
In this expansive frame of mind, Keynes took Vanessa Bell and Duncan Grant on a whirlwind tour of the Continent in the spring of 1920. They paid a visit to the American art historian and promoter of Renaissance painters Bernard Berenson. At Berenson’s Florentine villa, I Tatti, Keynes and Grant each pretended, to their own but not their host’s great amusement, to be the other. But mostly they went shopping. Even Keynes, who tended to be a tightwad where trivial sums were concerned, bought seventeen pairs of leather gloves. In March, around the time Joseph Schumpeter was poised to embark on his own high-stakes gambling spree in Vienna, Keynes had decided to go long in dollars on behalf of his syndicate. Prices were rising faster in Britain—and even more so in Europe—than in the United States, he reasoned, so the pound would be sure to weaken against the dollar. His logic was perfectly sound, his timing, not so much. No sooner had he returned to London than the franc, mark, and lire began, perversely, appreciating against the dollar. By the time fundamentals once again prevailed, Keynes was wiped out. Through some reverse alchemy his £14,000 of profits had turned into a loss of more than £13,000. Astonishingly, his investors’ confidence in his genius did not falter. His father and friends were convinced that Keynes would soon recoup his and their losses, and his broker agreed to reopen his account if he could put up £7,000. Even more amazingly, these remarkable acts of faith proved to be justified. By the end of 1924, Keynes was a wealthy man.
After his success as a best-selling author, Keynes had turned to journalism to help finance the lifestyle to which he was becoming accustomed. He wrote for the Manchester Guardian and Lord Beaverbrook’s’ London Evening Standard, and the American New Republic. According to his biographer Robert Skidelsky, Keynes’s career in print supplied one-third of his income during the 1920s and culminated in his becoming publisher of the left-wing political weekly founded by the Webbs and G. B. Shaw, the New Statesman. Peter Clarke, another of Keynes’s biographers, observed that launching “assaults of thoughts upon the unthinking” seemed to bring out the remarkable range of Keynes’s talents.5
In 1922, his topic of choice was money and banking. Before World War I, monetary economics had been more or less an American obsession. But Irving Fisher, virtually the only American economic theorist taken seriously in Cambridge, had convinced Keynes that money had a far more powerful effect on the “real” economy than accepted theory allowed.6 As early as 1913, a couple of years after he and Fisher met at George V’s coronation, in a speech to a group of businessmen in London, Keynes was echoing Fisher’s view that the key to booms and depressions was “the creation and destruction of credit.”7 The economic disorders that followed the war seemed to bear out Fisher’s argument.
In 1923, Keynes was so excited by the new ideas that he distilled what he had been thinking and writing about in A Tract on Monetary Reform:
The fluctuations in the value of money since 1914 have been on a scale so great as to constitute, with all that they involve, one of the most significant events in the economic history of the modern world. The fluctuation of the standard, whether gold, silver or paper, has not only been of unprecedented violence, but has been visited on a society of which the economic organization is more dependent than that of any earlier epoch on the assumption that the standard of value would be moderately stable.
He tried to show that inflations and deflations made it difficult for investors and businessmen to calculate the effects of decisions and, to a much greater degree than the public appreciated, distorted decisions to save or invest. But he also took pains to convey a more general point on which he and Fisher were of one mind: “We must free ourselves from the deep distrust which exists against allowing the regulation of the standard of value to be the subject of deliberate decision. We can no longer afford to leave [things to nature].” The evil of inflation was that it redistributed existing wealth arbitrarily, pitting one group of citizens against another and, ultimately, undermining democracy. The evil of deflation was that it retarded the creation of new wealth by destroying jobs and incomes.
It is not necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned. The individualistic capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring rod of value and cannot be efficient—perhaps cannot survive—without one.
Again and again, Keynes stressed his main message, namely, that there was a remedy: “The remedy would lie . . . in so controlling the standard of value that, whenever something occurred which, left to itself, would create an expectation of a change in the general level of prices, the controlling authority should take steps to counteract this expectation.” And failure to make money the “subject of deliberate decision” would leave a dangerous vacuum in which “a host of popular remedies . . . which remedies themselves—subsidies, price and rent fixing, profiteer hunting, and excess profits duties—eventually became not the least part of the evils.”
The most famous of Keynes’s phrases—“In the long run we are all dead”—appears in the Tract in the following context: “This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”8 Later, Schumpeter and other critics interpreted Keynes’s flippant phrase to mean that he was indifferent to the inflationary consequences of short-term monetary or fiscal stimulus. But it is clear from the passage that he was attacking the belief that inflation and deflation would cure themselves without active management. His point was, nations had to make deliberate choices between two desirable but incompatible goals. He borrowed the idea from Fisher, whom he called “the pioneer of price stability as against exchange stability.”9 In a world in which capital flowed freely across borders, countries had to choose between stable prices for their imports and exports, on the one hand, and stable prices for their domestically produced goods and services, on the other. They couldn’t have both. They had to choose. Keynes left no doubt as to which choice he favored. Domestic price stability was of paramount importance in avoiding socially disruptive transfers of wealth and high unemployment.
• • •
World War I had wrecked the gold standard. Since 1875 the British government had guaranteed that £6 could be exchanged at the Bank of England for one troy ounce of gold, and it was the bank’s job to see to it that the supply of pounds grew no faster or slower than the rate required to maintain that parity. When other countries pegged their currencies to gold, the effect was, of course, to fix the rate of exchange between all “hard” or gold-standard currencies. For example, since the US government determined that $30 could be exchanged for one troy ounce of gold, £1 equaled $5. In other words, as the economist Paul Krugman has observed, the nineteenth-century gold standard operated almost like a single world currency regulated by the Bank of England.
When the war broke out, one combatant after the other went off gold in order to buy arms and feed their armies. After the war, the holy grail of British politicians and their Chancellors of the Exchequer was the earliest possible return to the gold standard. No politician was a stronger supporter of reinstating the prewar gold standard than Winston Churchill, who had rejoined the Conservative Party and had been appointed Chancellor of the Exchequer by Stanley Baldwin, the leader of the new Tory government.
On March 17, 1925, Keynes attended a fateful dinner with Churchill at which he tried to convince the chancellor that the pound would be grossly overvalued at the prewar parity. While a strong pound would be a boon to Britain’s financial industry, it would cripple the old export industries—textiles and coal especially—and result in mass unemployment. This was an argument that he and Irving Fisher had long been making in the press. Keynes did not succeed. As Churchill said afterward, referring to a 1918 campaign promise: “This isn’t an economic matter; it is a political decision.”10
“The Economic Consequences of Mr. Churchill”—as Keynes called a pamphlet he wrote a few months later—were more or less precisely what he, Fisher, and other opponents had predicted. In anticipation of the new policy to raise the foreign exchange value of the pound by 10 percent, the Bank of England had raised its discount rate from 4 percent to 5 percent, a full point above the New York rate, in December 1924. The purpose was to stimulate demand for the pound by attracting short-term American funds to London. As higher interest rates choked off the flow of new credit and the strong pound dampened demand for exports, Britain’s heavy industry cratered while unemployment in England’s north soared. Keynes blamed the slump on Churchill’s failure to take his advice.
• • •
Here it is necessary to backtrack slightly. As Keynes succeeded in working out how he was going to make a living and where he would spend his energies, he began to think more about how he wanted to live. He was in his late thirties. Something was missing. For much of 1921 and 1922, he had considered himself “married” to Sebastian Sprott, one of the beautiful undergraduates he met while lecturing at Cambridge. He had also had other affairs. Not only did none of these attachments match the intensity of his relationship with Duncan Grant a decade earlier, but they also intensified his dissatisfaction. They were a reminder that for a variety of reasons, including that homosexuality was both illegal and socially unacceptable, such relationships could never provide him with a partner with whom he could share his rich, varied, and increasingly public life.
Keynes had always been happy in the bosom of his own family. His old Bloomsbury friends were mostly married, living with someone, setting up households, having children. They more or less expected him to do the same, but his choice—a Russian ballerina with a voluptuous body and a droll sense of humor but no obvious intellectual interests—first amazed, then horrified them. Keynes met Lydia Lopokova, who danced comic roles, on an opening night of the Ballets Russes. Their passionate affair commenced in May 1921 when he found an excuse to put her up in the Bloomsbury apartment above his own, belonging to the as yet unsuspecting Vanessa Bell. Four years later, on August 3, 1925, they married in London amid great fanfare and with huge crowds gathered outside. Before the wedding, Keynes purchased a country estate, Tilton, in Surrey, where he strode around in tweeds, inspecting hogs and wheat and behaving like a country squire.
• • •
He spent his honeymoon in Russia as a guest at his in-laws’ in Saint Petersburg—now named Leningrad—and subsequently as a guest of the Soviet government in Moscow. Along with several other Cambridge dons, he represented the university at the bicentennial of the Russian Academy of Sciences. Keynes’s VIP schedule included visits to the economic planning ministry and the state bank, Hamlet in Russian, the ballet, and endless banquets. As he wrote to Virginia Woolf, his hosts “embarrassed him with a medal set in diamonds.” When he and Lydia turned up at Woolf’s house in Surrey after the trip, she found that Keynes had traded his country squire tweeds for an embroidered Tolstoy shirt and Astrakhan fur cap. Afterward she summarized Keynes’s impressions of Russia for the benefit of their mutual friends:
Spies everywhere, no liberty of speech, greed for money eradicated, people living in common . . . ballet respected, best show of Cézanne and Matisse in existence. Endless processions of communists in top hats, prices exorbitant yet champagne produced, & the finest cooking in Europe, banquets beginning at 8:30 and going on until 2:30 . . . then the immense luxury of the old Imperial trains; feeding off the Tsar’s plate.
As usual, he displayed his journalist’s verve for telling detail, false notes, and delicious contradictions, but he also used his analytical prowess to distinguish appearance from reality. The other VIPs left Moscow incredibly impressed by the relatively well-fed, clothed, and housed Soviet worker, who, apparently, never had to fear unemployment as his Western counterparts did. But Keynes could explain to New Republic readers that the Soviet economic “miracle” was a Potemkin village. The typical urban worker
did indeed live better than before the war. Indeed, he lived “at a standard of life that is higher than its output justifies,” Keynes reported. But the other six in seven Soviet citizens were small farmers who were being exploited even more ruthlessly than under the tsar:
The Communist Government is able to pamper (comparatively speaking) the proletarian worker who is of course its especial care, by exploiting the peasant . . . The official method of exploiting the peasant is not so much by taxation—though the land tax is an important item in the budget—as by price policy.
Moscow could pay urban workers two or three times what a peasant earned by the simple expedient of forcing peasants to sell their crops to the government at prices far below those of the world market. The result was not just to lower the living standards of the majority of Russians but also to wreck the economy. Farm output, “the real wealth of the country,” was falling, farm income was drying up, and an uncontrolled rural exodus was under way. Moscow and Saint Petersburg were full of homeless illegals and had unemployment rates closer to 20 or 25 percent than the official zero. “The real income of the Russian peasant is not much more than half of what it used to be, whilst the Russian industrial worker suffers overcrowding and unemployment as never before,” Keynes concluded.11
Though he advised his Soviet hosts to reverse their ruinous policies, he conceded that the Soviet economy was not “so inefficient as to be unable to survive,” albeit “at a low level of efficiency” and low living standards. And he did not contradict the prediction of Grigory Zinoviev, Stalin’s second in command, that ten years hence “the standard of living will be higher in Russia than it was before the war, but in all other countries lower,”12 although only because he had qualms about the West. Perhaps because his in-laws in Saint Petersburg were being persecuted or, more likely, because he was appalled to a greater degree by inefficiency, ugliness, and stupidity than by cruelty, he dismissed the notion that Soviet Russia held the key to the West’s salvation:
