The Keynes Solution: The Path to Global Economic Prosperity

The Keynes Solution: The Path to Global Economic Prosperity

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by Paul Davidson

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Today's financial crisis has led to a widespread lack of confidence in the laissez faire style of economic policy. In The Keynes Solution author Paul Davidson provides insights into how we got into the crisis—but more importantly how to use Keynes economic philosophy to get out of this mess. John Maynard Keynes was committed to making the market


Today's financial crisis has led to a widespread lack of confidence in the laissez faire style of economic policy. In The Keynes Solution author Paul Davidson provides insights into how we got into the crisis—but more importantly how to use Keynes economic philosophy to get out of this mess. John Maynard Keynes was committed to making the market economy work—but our current system has been a dismal failure. Keynes advocated for an interventionalist government role, in cooperation with private initiative, to mitigate the adverse effects of recessions, depressions and booms. His economic policy helped the world out of the great depression and was an important influencer in the thinking behind FDR's new deal policies. In this book Keynesian expert Davidson makes recommendations and details plans for spending, monetary policy, financial market rules and regulation, and wages—all to reverse the effects of our past policies. Keynes renewed influence can be seen everywhere: in Barack Obama's planned stimulus package, for example—and this book explains the basic tenet of Keynesian economics as well as applied solutions to today's critical situation.

Editorial Reviews

From the Publisher

“A true believer, Mr. Davidson lays out Keynesianism in easy-to-understand language and makes a strong case that it is just as relevant today. There are some doubters who fear that Keynesian spending is dangerous because it produces unbalanced budgets. Mr. Davidson responds that deficits in times of crisis lead to prosperity when the economy recovers. The most tantalizing part, however, is the appendix, entitled "Why Keynes's Ideas Were Never Taught in American Universities." Mr. Davidson writes about how the work of one of his fellow Keynesians was attacked by William F. Buckley Jr. in the 1950s and how other peers watered down Keynes's teachings to avoid similar controversy.” —Devin Leonard, The New York Times

“A constructive look at how to redesign the global financial system in the aftermath of the credit meltdown.” —

“Paul Davidson is the keeper of the Keynesian flame. Keynes lives (intellectually), and Davidson is one of the reasons.” —Alan S. Blinder, Gordon S. Rentschler Memorial Professor of Economic and Public Affairs, Princeton University

“Paul Davidson has persistently attacked conventional economics for having ignored Keynes's emphasis on uncertainty, and the use of money as a store of value, in causing economic crises. In this lucid new book, he exposes the intellectual mistakes which led to the present world economic downturn, and shows how Keynes's ideas can help bring about a ‘civilized economic society'.” —Robert Skidelsky, author of John Maynard Keynes 1883-1946: Economist, Philosopher, Statesman

“Paul Davidson has given us a timely and lucid answer to the important question: What would Keynes have said? He is particularly good on the disastrous condition of the mainstream economics, which ignored Keynes for decades, and is now exposed as having left us wholly unprepared for the crisis at hand.” —James K. Galbraith, The University of Texas at Austin, author of The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too

“America's seminal economist, Dr. Paul Davidson, has written the clearest vision of money and math mechanics, to date. Not since the 18th century's true mathematical logicians, De Morgan, Jevons, Clifford, Peirce and Veblen, have scientific ideas of logic, money and math mechanics been laid so clearly before our eyes. Never before, in the history of economics, has so much been revealed by such a simple, yet scientific, method. . . . I see it having the potential of reaching not only the academic economists, but most all political, academic and intellectual elites, along with many private citizens. This is what the nation and world really and truly needs--a clear and concise manual to explain and solve the world's massive problems. Davidson has succeeded as no other in accomplishing this job.” —Economist L.A. Gillespie

“One of the best books I have ever read. What I found amazing was that [Davidson] was able to address and articulate the gaps among the common sense explanations that I have for what is going on today. In fact, his chapters on trade and the trade deficit are the best I have ever read. He is also the first economist that I have read who tackles the issue head on, and he ends up in an interesting place. He proposes a solution that closely mirrors what Buffett proposed in his essay on the dollar, although Davidson takes it a step further and gives an international credit solution. [T]his is a great, great book. I have made it my quest since March, 2001 to resolve these macroeconomic questions. For the last eleven months it has dominated my thinking, as the financial panic forced it to the forefront of my risk assessment. At last, I can move on. I no longer feel behind on my awareness. I recommend it heartily.” —Roger Farley, Ronin Capital

“I've just finished reading [The Keynes Solution] and am now in the process of adding it to my student reading lists as it is indeed a wonderful book. Cant make up my mind which is my favourite chapter. So much to choose from. If only our likely future (unfortunately) PM and Chancellor would read chapter 5.” —Robert Jones, Professor of Economics, Nottingham Business School

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The Keynes Solution

The Path to Global Economic Prosperity

By Paul Davidson

Palgrave Macmillan

Copyright © 2009 Paul Davidson
All rights reserved.
ISBN: 978-0-230-61920-3



[T]he ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.

—John Maynard Keynes

Politicians and talking heads on television are continuously warning the public that the current economic crisis that began in 2007 as a small subprime mortgage default problem in the United States has created the greatest economic catastrophe since the Great Depression of the 1930s. What is rarely noted, however, is that what is significant about this current global economic and financial crisis is that its origin lies in the operations of free (unregulated) financial markets. Yet for more than three decades, mainstream academic economists, policymakers in government, and central bankers and their economic advisors have insisted that: (1) both government regulations of markets and large government spending policies are the cause of our economic problems, and (2) ending big government and freeing markets from government regulatory controls is the solution to our economic problems.

By the autumn of 2008, it became clear that the liberalized financial markets of the twenty-first century could not heal the bloodletting catastrophe that they had caused. In October 2008, the United States Secretary of the Treasury and former head of a major investment bank, Henry Paulson, went to Congress to request an unprecedented $700 billion in funds to bail out private financial institutions that, in earlier years, had made spectacular profits from their operations in these liberalized financial markets. The chief officers of these financial service institutions had been rewarded in salaries and bonus sums that only a decade earlier would have seemed equivalent to the income of a king in a fairy tale.

As the situation worsened every day during that autumn, it soon became clear that this financial bailout would not be sufficient to restore a prosperous economy. Governments around the world began to recognize the need for a big fiscal spending operation to help their economies to recover or, at least, to prevent rising unemployment and failing businesses from getting worse. Such spending recovery plans often are referred to as Keynesian economic stimulus plans—named for a twentieth-century English economist, John Maynard Keynes. In an article entitled "The Comeback Keynes," appearing in the October 23, 2008, issue of TIME magazine, Robert Lucas, who won a Nobel Prize for developing the theory of rational expectations that became a foundation for the belief that free markets provide the solution to any of our economic problems, is quoted as saying, "I guess everyone is a Keynesian in a foxhole."

In the early 1970s, however, the oil price spike by the Organization of Petroleum Exporting Countries (OPEC) led to extraordinarily high rates of inflation. What then was interpreted incorrectly as the "Keynesian" solution to this inflation problem did not appear to work. Instead, it seemed to induce a period of "stagflation"—a period in which both unemployment and prices were rising simultaneously. The failure of what was then called Keynesian anti-inflation policy, plus the public dissatisfaction with the Vietnam War, added to the general public's distrust of U.S. government policies. This revolt against big-government policies captured the public's imagination and opened up space for those who advocated a philosophy to get big government out of the way.

Accordingly, since the 1970s, economists and government policymakers have buried and almost forgotten Keynes's economic ideas and philosophy. Led by Milton Friedman and his colleagues at the University of Chicago, the ideas of the economics profession were recaptured by a free market, laissez-faire ideology. The public and government policymakers were educated in the classical economic ideas that only two things had to be done to promote economic progress and prosperity: (1) end the era of big government by reducing taxation to a bare minimum so that government had no money to spend on "lavish" programs, and (2) liberalize markets from all the government rules and regulations that had been installed by Franklin Roosevelt's New Deal administration. This alleged desirability of small government and unfettered markets was embraced by politicians, such as President Ronald Reagan in the United States and Prime Minister Margaret Thatcher in the United Kingdom.

No one was a greater advocate for freeing financial markets from all forms of government regulation than Alan Greenspan, the chairman of the Federal Reserve System (the Fed) from 1987 to 2006. During his reign at the Fed, the public and politicians treated Greenspan as if he could do no wrong. In testimony before congressional committees over the years, in language so oblique that it was hard to comprehend, Greenspan appeared to explain the inevitability of prosperity that would result from an unregulated, sophisticated financial system. And during his tenure as the chairman of the Federal Reserve Board of Governors, the U.S. economy did seem to be in a perpetual mode of low rates of inflation and significant economic growth—although, in hindsight, we recognize that much of the economic growth and prosperity was due mainly to the dotcom bubble of the 1990s, followed by a housing bubble in the first years of the twenty-first century. Currently, many "experts" now blame Greenspan for our problems, arguing that the cause of these "bubbles" was the easy-money and low-interest policy pursued by the Fed during Greenspan's tenure.

Nevertheless, while Greenspan was chairman, he was so persuasive that whether a Republican or a Democrat occupied the White House, the presidential administration endorsed Greenspan's idea of the efficiency of free markets. In fact, in his 1996 State of the Union address, President Bill Clinton announced that "the era of big government has ended."

Despite this optimism about a strong economy and small government, it should now be obvious that as a result of several decades of deregulation of markets, which Greenspan championed, and smaller government spending programs (except for military expenditures), both the United States and the global economy are enmeshed in the greatest economic crisis since the Great Depression.

In an amazing mea culpa testimony before the House Committee on Oversight and Government Reform on October 23, 2008, Alan Greenspan admitted that he had overestimated the ability of free financial markets to self-correct and had entirely missed the possibility that deregulation could unleash such a destructive force on the economy. In his prepared testimony discussing the financial crisis, Greenspan stated:

This crisis, however, has turned out to be much broader than anything I could have imagined.... [T]hose of us who had looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.... In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize [in economics] was awarded for the discovery of the [free market] pricing model that underpins much of the advance in [financial] derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, [has] collapsed.

Under questioning by members of the congressional committee, Greenspan admitted that the events in financial markets forced him to reappraise his view that financial regulation is not required. He then stated: "I found a flaw in the model that I perceive is the critical functioning structure that defines how the world works. That's precisely the reason I was shocked.... I still do not fully understand why it happened, and obviously to the extent that I figure it happened and why, I shall change my views."

A major purpose of this book is to explain in simple language the two major different economic ideas and philosophies regarding how a capitalist system operates and how these ideas suggest different explanations of the economic problems that arise over time. Moreover, I will explain how these alternative economic philosophies provide different rationales for solving the economic difficulties of the capitalist system in which we live. The first set of ideas goes by various names: classical or neoclassical economics, efficient market theory, and mainstream economic theory. The second analytical set of ideas is the liquidity and monetary analysis developed by John Maynard Keynes.

Winston Churchill once said, "No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time." In a similar vein, during the Great Depression of the 1930s, Keynes developed an analytical framework designed to save what he clearly saw was the very imperfect entrepreneurial economic system that we call capitalism. Despite its imperfections, Keynes believed that capitalism was the best system humans have devised to achieve a civilized economic society. He recognized, however, that capitalism had two major faults: (1) its failure to provide persistent full employment for all those who want to work, and (2) its arbitrary and inequitable distribution of income and wealth. Until these faults were corrected, Keynes argued, the capitalist system could be extremely unstable and therefore subject to periods of economic booms that could often lead to catastrophic economic collapses.

Keynes's analysis explained why these two capitalist faults occur and how they can destabilize the economy. He argued that the government had a vital role to play to at least mitigate, if not completely remove, these flaws from the capitalist economic system in which we live. Keynes argued that, with properly designed government policies that cooperate and augment private initiatives, we could develop a stable, fully employed capitalist economy that would still enjoy the advantages of a market-oriented entrepreneurial system. These advantages, Keynes noted, are:

of decentralization and of the play of self-interest.... But, above all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty in the sense that, compared with any other system, it greatly widens the field for the exercise of personal choice. It is also the best safeguard of the variety of life, which emerges precisely from this extended field of personal choice, and the loss of which is the greatest of all losses of the homogeneous or totalitarian state. For this variety preserves the traditions which embody the most secure and successful choices of former generations; it colours the present with the diversification of its fancy; and, being the handmaiden of experience as well as of tradition and of fancy, it is the most powerful instrument to better the future.

If the government pursued Keynes's policy recommendations, and if we avoided major wars and civil dissent while we controlled population growth, then, Keynes believed, our grandchildren could inherit a world where starvation and poverty would be banished.

During the first quarter century after World War II, most governments in capitalist nations actively pursued the economic policies derived from Keynes's economic ideas. Stimulated by policies suggested by Keynes's ideas, per capita economic growth in the capitalist world occurred at a rate that had never been reached in the past nor matched since. The free world economy was starting to reach the civilized goal that Keynes envisioned. This postwar quarter century was an era of unsurpassed economic global prosperity, characterized by economist Irma Adelman as the "Golden Age of Economic Development ... an era of unprecedented sustained economic growth in both developed and developing countries."

This golden age of capitalist economic development raised the standard of living in noncommunist nations at such an unparalleled pace that by 1971 it has been recorded that even the Republican president Richard Nixon announced, "We are all Keynesians now."

In the chapters that follow, I develop the foundation of the "intellectual edifice" underlying classical economic ideas of the model that Greenspan believes in and that was propagated by classical economists and Nobel Prize winners such as Milton Friedman, Robert Lucas, Myron Scholes, and Robert Merton. I explain how these classical economic ideas led nations to repeat the errors that had led to the Great Depression. I also explain the differences between Keynes's analytical framework and the free "efficient market" analysis of the Chicago school that captured the mind of politicians and policymakers. I explain why Keynes's analysis leads to a different view regarding the role of government in stabilizing a market-oriented capitalist system and thereby avoiding the shipwrecks of financial crises.

I hope that, in my discussion of these ideas of classical economists versus Keynes, the reader is able to decide which is a more reasonable and applicable approach for understanding the cause of our current economic malady and the medicine necessary to cure the problem. I hope to convince the reader that incorporating the ideas of John Maynard Keynes into our entrepreneurial (capitalist) system will help rescue us from the economic havoc this economic and financial crisis that started in 2007 has caused. Perhaps if Greenspan reads this book and comprehends its message, then he will finally figure out what happened to cause the collapse of the classical intellectual edifice in which his mind resided and will change his views.



Those who cannot remember the past are condemned to repeat it.

—George Santayana

Although there were economic crises and unemployment problems in the nineteenth and early twentieth centuries, until the Great Depression that began in 1929, economists and politicians believed that booms and busts were nothing more than a natural business cycle. These economists believed that such natural phenomena were self-healing. Accordingly, until the Great Depression, most of these economists presumed that any economic downturn would be readily cured naturally by flexible prices operating in a free competitive market.

To the extent that downturns tended to persist, almost all economists of the time argued that this persistence was due to rigidities in wages and prices that are the result of monopolistic firms fixing prices, labor unions fixing wages, and/or government policies that intervened and limited the wage and price flexibility that would occur in competitive markets free of government interference.

In the United States, after a brief recession following World War I, the Roaring Twenties was a period of unbridled prosperity. In 1929, only 3.2 percent of American workers were unemployed. In 1920, the Dow Jones Stock Index stood at 63.9. During the years that followed, the New York Stock Exchange climbed to unprecedented highs. In 1929, the Dow Jones average peaked at 381.2, an increase of more than 500 percent in a little over eight years.

During the decade's stock market boom, people were able to buy stocks on "margin"—that is, for as little as 5 percent down and borrowing the rest—thereby leveraging their stock position by a ratio of 19 to 1. In other words, they could borrow $19 for every $20 they invested in the stock market.

By 1929, small individual investors, including blue-collar workers who had never invested in anything and knew little or nothing about the firms they invested in, were buying into the stock market on margin. Often these margin buyers relied on brokers or bankers to tell them where the profitable action was. Nevertheless, everyone in America seemed to be getting rich.

Just a few days before the stock market crash of October 24, 1929, one of the most eminent classical economists of the time, Professor Irving Fisher of Yale University, told an audience that the market had reached a high plateau from which it could only go up. Then, suddenly, the bottom fell out. By June 1932, the Dow Jones had dropped by 89 percent from its 1929 high. It is said that Professor Fisher, who had put his money in what he believed in, lost between $8 million and $10 million—a vast sum in 1929—in this crash. The Great Depression had hit America.

From 1929 through 1933, the American economy went down-hill. It seemed as if the economic system was enmeshed in a catastrophe from which it could not escape. Unemployment went from 3.2 percent in 1929 to almost 25 percent by 1933. One out of every four workers in the United States was unemployed by the time Franklin D. Roosevelt was inaugurated as president in March 1933. A measure of the standard of living of Americans, the real gross domestic product (GDP) per capita, fell by 52 percent between 1929 and 1933. This meant that, by 1933, the average American family was living on less than half of what it had earned in 1929. The American capitalist dream appeared to be shattered.

Many economic experts of those times still invoked classical economic theory to argue that the high level of unemployment in the United States was due to some fixity of wages and/or prices; and the depression would force workers and firms to accept lower prices. Consequently, the depression could not persist. The economy would soon right itself as long as the government did not interfere with the workings of a free competitive market system and workers and business firms accepted lower wages and prices for their productive efforts.


Excerpted from The Keynes Solution by Paul Davidson. Copyright © 2009 Paul Davidson. Excerpted by permission of Palgrave Macmillan.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Meet the Author

Paul Davidson is Holly Chair of Excellence in Political Economy at the University of Tennessee, Knoxville. He has previously held Professorships at the University of Pennsylvania and Rutgers University. He is Editor of the Journal of Post Keynesian Economics, a former member of Brookings Economics Panel, and is the author, co-author or editor of twenty-two books and more than 200 articles. His books include Money and the Real World, Post Keynesian Macroeconomic Theory, International Money and the Real World: Economics for a Civilized Society, and Financial Markets, Money and the Real World.

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The Keynes Solution: The Path to Global Economic Prosperity 5 out of 5 based on 0 ratings. 2 reviews.
Anonymous More than 1 year ago
Anonymous More than 1 year ago
Here is what one blogger has written about Paul Davidson's. book THE KEYNES SOLUTION: THE PATH TO GLOBAL ECONOMIC PROSPERITY. (Palgrave, New York, 2009). The blog is One Lucid Diamond. America's seminal economist, Dr. Paul Davidson, has written the clearest vision of money and math mechanics, to date. Not since the 18th century's true mathematical logicians, De Morgan, Jevons, Clifford, Peirce and Veblen, have scientific ideas of logic, money and math mechanics been laid so clearly before our eyes. Mr. Davidson begins with a simple explanation of a true scientific method, any high school student can easily understand, then exposes the fallacies in relation to and of the classical economists' and mathematicians' mistakes, of economic model mis-applications and mis-interpretations of. He reveals his entire thesis in a simple dialectic method any gifted 5th grade student could understand, by keeping the technicalities to his other 22 published books, and some 200 articles. Never before, in the history of economics, has so much been revealed by such a simple, yet scientific, method. As an example, Mr. Davidson, shows how the 'universal' facts, habits and ambitions of money, control the 'particular' events of all economic history. He does this by revealing Keynes' true vision of how all nations' balance of payments' imbalances and hoarding, actually starves the world of its productive employment potential. This is truly where all macro-economic theses should start, yet sadly almost all other classical macro-economists see not the forest for the trees. It's taken America's yet unrecognized genius, Paul Davidson, to point this very fact out. He further exposes this first and foremost generating problem, creating the other unrecognized problems' mechanics with and in 'the ergodic theory', 'the neutrality of money theory', 'comparative advantage theory', 'free-trade theory', 'efficient market theory', 'the incompatibility theory of mobile money and full employment', and all really generated from the fundamental 'balance of payments' imbalances and hoarding theory and facts', just as Keynes originally stated and implied them, in his total works, published and unpublished, private and governmental letters, etc. After clearly and succinctly showing the relationships between true Keynesian theories and facts, against classical mis-interpretations of the same theories and facts, Davidson easily explains his extended Keynesian solution, to the world's present problems. This is done through his recognition of the world's need for not only a new 're-regulation of financial markets and trade', but also his, as it was Keynes', call for a new 'international financial architecture', to re-balance the world's prices, money and currency contracts. Davidson has updated Keynes' ideas to a 21st century feasible plan of fundamental economic and highly possible political actions, the world sorely needs. Never before has an economic book impressed me as much as this little treatise, as I see it having the potential of reaching not only the academic economists, but most all political, academic and intellectual elites, along with many private citizens. This is what the nation and world really and truly needs__a clear and concise manual to explain and solve the world's massive problems. Davidson has succeeded as no other in accomplishing this job. . ----------------------------------------------------------