In times like these, when even the most sober analysts are wondering if were heading for another Great Depression, its wise to dust off John Maynard Keynes 1936 treatise, "The General Theory of Employment, Interest and Money."
Most of us remember Keynes from our college economics courses as the guy who advocated deficit spending to "prime the pump" during downturns. And that was certainly part of his argument. But revisiting "The General Theory," whats striking is that its a book about economic panics and the market psychology that produces them and the consequent need for government intervention. Parts of it could have been written this week to describe the cascading defaults of Bear Stearns, Lehman Brothers and AIG.
The problem with financial markets, Keynes argued, was that investors were periodically seized by what he called "liquidity preference," which made them wary of putting money into anything but the safest investments. "When disillusion falls upon an over-optimistic and overbought market, it should fall with sudden and even catastrophic force," he wrote. "Once doubt begins it spreads rapidly."
Thats a pretty good description of what has been happening on Wall Street. Weve gone from a bubble of over-enthusiasm to a state of panic with financial institutions so risk-averse they dont want to lend to anyone.
Keynes revolutionary idea was that financial markets were not inherently self-correcting, as classical economics had argued. Left to itself, Wall Street might remain in a liquidity trap in which the markets would stay frozen and productive investment would cease. So it fell to the government to take actions that would restore confidence and stimulate investment. "I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands," he …