‘we were … monetarists … pre-Friedman’.27
During the golden age, mainstream Keynesian economics became ‘normal’ science, with a ‘research programme’ based on the core Keynesian assumption that the unmanaged working of capitalist economies generated insufficient levels of demand to maintain full employment. It failed to develop the key concepts necessary to cope with, much less avert, inflation.
Keynes had seemingly left an upside-down universe – a ‘general theory’ of employment, without money and prices. This was not, in fact, true of the General Theory of Employment, Interest, and Money. But it was the emphasis Keynes gave to his theory in the circumstances of the 1930s, which was inherited, with far less justification, by his disciples in the 1950s and 1960s. To compress a complicated story: what Joan Robinson called ‘bastard Keynesianism’ resulted from a peace treaty between Keynesian and anti-Keynesian economists – called the neo-classical synthesis – by which the anti-Keynesians (mainly Americans) accepted the possibility of short-period ‘underemployment equilibrium’ in return for Keynesian acceptance that downwardly rigid money wages were the necessary and sufficient condition of it. Thus the General Theory turned out to be a ‘special case’ of the classical theory after all, but with important implications for policy. A world in which money wages are rigid and business confidence is variable is still a world which requires Keynesian therapy. However, this ‘treaty’, which confirmed the relevance of Keynesianism as policy while leaving it bereft of any micro-theoretical underpinnings, depended to a large extent on fears of a renewed depression.28
The income-expenditure model was the main Keynesian policy construction. With wages and prices fixed, together with the capital stock, wealth and the state of expectations, the model exhibited a simple dependence of output and employment on expenditure. Further, the analysis readily lent itself to quantification and thus macroeconomic modelling, so that the task of securing the desired level of output and employment was made to seem deceptively easy. ‘Quantities adjust, not prices’ was the flag under which the early Keynesians sailed. This left them without an economic theory of inflation or, indeed, a tenable definition of full employment. There were, in the argot, no ‘supply constraints’.
In place of an inflation theory there was an empirical observation dating from 1958, the Phillips curve, which showed a stable inverse relationship between the level of unemployment and the rate of change of money wages: a lower level of unemployment brings about a higher rate of increase of money wages, and vice versa. Policy-makers thus supposedly had a ‘menu of choice’ between degrees of inflation and of unemployment. The message of the Phillips curve for most British Keynesians was clear. Since it was considered immoral to run the country with a ‘higher margin of unused capacity’, the government should maintain unemployment as close as possible to zero, and use an incomes policy to control wage costs, either in agreement with the trade unions or by legislation. Wage-push at full exployment rather than excess demand was identified as the cause of inflation. The refusal of Keynesians to take supply constraints seriously left them with cost control as their only weapon against inflation. But this begged the question of how much power a government had, or should have, in a free society.29
It was left to Milton Friedman of Chicago University to restate the ‘classical’ theory of inflation – the quantity theory of money. As we have seen, Friedman’s work on the consumption function (one of Keynes’s own building blocks) had led him to believe that the ‘demand for money’, and therefore economic activity, was much more stable than Keynes had assumed. This meant that for most circumstances the quantity theory of money was a good predictor of inflation. Friedman’s policy rule was to ensure just enough money in the economy to finance what the economy was capable of producing: the unfettered forces of productivity and thrift would maintain a high level of activity. It could be argued that this was the ‘right kind of theory’ for the world of the 1950s and 1960s, just as Keynes’s had been for the world of the 1920s and 1930s.
Friedman’s decisive amendment to the dominant Keynesian orthodoxy came in 1967, with his concept of the ‘natural’ rate of unemployment. His central idea was that in the long-run, labour markets clear at an institutionally-determined unemployment rate, and that any attempt, by expanding money demand, to maintain the actual unemployment rate below this ‘natural’ rate will lead only to accelerating inflation.30 The seeds of this are to be found in Keynes’s own distinction in chapter two of the General Theory between ‘voluntary’ and ‘involuntary’ unemployment and his chapter nineteen on prices. Broadly speaking, Keynes defined full employment as the maximum that could be reached by expansionary measures. If one tried to lower unemployment beyond this, one would run into inflationary problems.
Friedman’s much sharper concept of the ‘natural’ rate of unemployment provided a theoretical explanation of the tendency for inflation to increase: governments had been trying to hold actual unemployment below its ‘natural’ rate by expanding the money supply too much. He added one argument, known in the literature as the theory of adaptive expectations. The employment-creating effects of expansionary policy depend on ‘money illusion’ – on employed workers not pressing for money wage increases to compensate them for higher prices. But once inflation is expected, money illusion disappears. The employment effects of expansionary policy become increasingly temporary, the price effects increasingly permanent.
It has to be said that there was nothing in this which could not have been developed from the General Theory, had Keynesian economists been minded to do so. In fact, it was a fervent Keynesian, Abba Lerner, who developed a distinction between ‘high’ and ‘low’ full employment in 1951, high full employment leading to demand-pull inflation, low full employment keeping prices stable, and intermediate levels creating cost-push inflation.31 However, even though British unemployment for most of the golden age was less than 2 per cent, mainstream Keynesians denied the existence of demand-pull inflation, rejected the distinction between ‘high’ and ‘low’ full employment, and simply said that cost-push inflation should be prevented by controlling incomes. The point is that Keynesian theory might have been refashioned and extended to suit post-war problems, but Keynesian orthodoxy stood in the way. Keynesian economists, therefore, cannot simply blame their defeats on policy mistakes or unexpected events. Politicians no doubt wished to maintain the high levels of full employment achieved in the 1950s and 1960s. There was little in the theory they were being supplied with to tell them that this might be impossible in a free society. By the 1960s, Keynesian beliefs were held religiously, and Friedman was branded as the Antichrist.
In the 1960s, British economic policy was set to target not inflation but growth, a growth target of 4 per cent a year for five years being announced in 1961. The object of policy became to make the economy grow faster than it had in the 1950s. David Marquand has called this a shift from arms’ length to hands-on Keynesianism.32 But to what extent did it reflect Keynesian analysis or prescription? The answer is far from clear. On the one hand, ‘growthmanship’ was a political decision reflecting the view of virtually the whole of the British ruling class that Britain was ‘falling behind’ the more successful capitalist economies like Germany and France. For the Labour Party, which took power in 1964, the fear was that slow growth would endanger the achievement of its welfare objectives within the framework of consensual politics; that is, one that vetoed higher taxes to finance higher welfare spending. ‘Economic growth sets the pace at which Labour can build the fair and just society we want to see …’33 An important background factor was the