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Financial reform: a Keynesian agenda

Duncan Weldon


The financial reform agenda remains open for Labour to seize. A solution to the dominance of finance capital would ensure it works as the ‘servant’ of industry and labour. 


As the various candidates for the Labour leadership begin to dissect the record of the previous government, the time is ripe for a reconsideration of economic policy. One area that is surely in need of reconsideration, after the crisis of 2008-09, is the relationship between government, the financial markets, and the real economy. In no other area of policy was the acceptance of the Thatcherite settlement more total – and the consequences, when they came, were especially serious.

The leadership contest is offering signs of progress and fresh thinking. Ed Balls has admitted that ‘light touch regulation’ was a mistake; Ed Miliband has spoken of the need for more mutually owned, and possibly state-owned, banking; and David Miliband has openly talked of New Labour not drawing enough of a distinction between industrial and financial capital. Whoever the next leader is, some form of financial reform will be central to their economic agenda.

Between 1997 and 2008 New Labour conceded much economic ground to the right. Guided by the perceived ghosts of Labour governments past, fiscal policy was constrained by ‘golden rules’ and monetary policy outsourced to technocrats with a remit of keeping inflation low. Whereas Labour made great strides in improving public services, and achieved more than is commonly recognised in terms of reducing inequality (or at least alleviating its increase), to all intents and purposes it ceased to have a distinct macro-economic policy. As Anthony Giddens, one of the prime intellectual influences behind New Labour, writes:

The era of Keynesian demand management, linked to state direction of economic enterprise, was over. A different relationship of government to business had to be established, recognising the key role of enterprise in wealth creation and the limits of state power. No country, however large and powerful, could control that marketplace: hence the ‘prawn cocktail offensive’ that Labour launched to woo the support of the City. (Giddens, 2010)

In the aftermath of the great crash, it should be painfully clear that the era of boundless belief in the abilities of unfettered free markets to deliver socially acceptable outcomes is over. Now is the time for Labour to challenge the post-Thatcherite economic settlement, in particular over the role and size of the financial sector. This article will argue that, in making its peace with financial capitalism, New Labour went too far; that the growth model it relied upon was always unsustainable; and that only through direct state action to reform the financial sector can a sustainable, socially democratic economy be created.

The Labour Party has been here before. In the aftermath of the defeat of 1931 the Party embarked on a process of analysis and review led by Hugh Dalton, and arrived in office in 1945 with a workable and radical programme of financial sector reform. The 1944 Labour Party paper Finance and Full Employment resonates today:

Blame for unemployment lies more with finance than with industry. Mass unemployment is never the fault of the worker; often it is not the fault of the employers. All widespread trade depressions in modern times have financial causes; successive inflation and deflation, obstinate adherence to the gold standard, reckless speculation, and over investment in particular industries…

Finance must be the servant, and the intelligent servant, of the community and productive industry; not their stupid master. (Labour Party, 1944)

This policy, I argue, was far more ‘Keynesian’ than later policies that have evoked his name. There are important lessons to be learned today both from the work conducted by party policy committees and others in the 1930s, and from the experience of Labour in government during the last great challenge to finance capital in 1945-47.


A Keynesian moment?

The great recession of 2008-2009 marked the return of macro-economic debate to British politics after an absence of nearly twenty years.

After the perceived debacle of the 1992 Shadow Budget, Labour fought the 1997 election on an explicit commitment to maintain the Conservatives’ spending plans for the first two years of the Parliament. In 2001 and 2005 the then government’s economic case rested on the endless repetition of statistics – the lowest inflation and interest rates since the 1960s, the longest period of unbroken economic growth since records began, and so on – and the Brownite ‘investment versus cuts’ dividing line, with every Conservative call for a cut in tax transformed into x number of teachers, police officers or nurses. In neat symmetry with Labour in the mid-1990s, one of David Cameron’s first acts on becoming Tory leader in the mid-2000s was a pledge to match Labour’s spending plans, a pledge seen at the time as vital to the ‘detoxification’ of the Conservative brand.

The most severe economic downturn since the war changed all of this. At the Pre-Budget Report (PBR) in late 2008 the government embarked on its fiscal stimulus, bringing forward investment spending and cutting VAT. Cameron and Osborne responded by renouncing Labour’s spending plans and openly advocating cuts. Despite a wobble in the polls in early 2010, attributed to Osborne’s talk of an ‘age of austerity’, the broad outlines of the 2010 campaigns were in place at the time of the 2008 PBR: Labour advocated government action to stimulate the economy, whilst Conservatives argued for immediate cuts in public spending and the prioritisation of deficit reduction.

Much popular commentary over the past two years has focussed on New Labour re-discovering Keynes in the face of global economic turmoil. This notion can be challenged on three separate grounds.

First, it is questionable quite how ‘Keynesian’ previous Labour governments have actually been. The 1929-1931, 1964-70 and 1974-79 Labour governments all responded to international financial problems by reigning in public spending and tightening fiscal policy. Despite the popular myth of spendthrift Labour administrations, the historical evidence for this charge is thin (1). Second, the extent of New Labour’s conversion to ‘Keynesianism’ can be questioned. The fiscal stimulus of 2008 was, by international standards, small. The total package equated to around 1.5 per cent of GDP compared to 5.9 per cent in the USA, or 3.4 per cent in supposedly austere Germany. And, although the issue of cutting public spending in 2010 was much debated during the general election campaign, New Labour fully intended to beginning cutting in 2011 (2).

More significantly, the term ‘Keynesian’ is open to interpretation. To most laypeople, and indeed many economists, Keynesianism is synonymous with managing demand by running budget deficits. It is presumably to this policy that Giddens was referring in the quote above. However, Keynes was primarily a monetary economist. As Peter Clarke says:

The eager student who supposes Keynes wrote of little else may resort to the short cut of using the cumulative index to the magnificent Royal Economic Society edition, in all twenty-nine volumes, of Keynes’ collected writings. Yes budget deficits are certainly there, taking up five lines of the index, or one-tenth of one column out of 746. The fact that, for the other 99.9 per cent of the time, Keynes was evidently not writing about deficits will seem surprising only to those – including many famous economists today – who have never actually read any of his books. (Clarke, 2009, 168-169, emphasis in original)


Keynes on investment

Keynes’s theory of investment and his emphasis on uncertainty were central to his economics, as was his analysis of the financial system. All have mainly been lost by latter day ‘Keynesians’ in both policy-making and academia. As his biographer Robert Skidelsky writes, only in the small ‘post-Keynesian’ school are these insights kept alive.

Within the academic community, the ‘post-Keynesian’ school of economists has remained closest to the spirit of Keynes’s General Theory. Their best-known member, Paul Davidson, has persistently maintained that old classical, New Classical and New Keynesian economists alike have betrayed Keynes’s legacy by accepting the ‘ergodic’ axiom – an axiom which holds the outcome at any future date is a statistical shadow of past and present market prices (3). The late Hyman Minsky also followed Keynes’s footsteps by depicting a financial system which transforms investment into speculation followed by collapse. (Skidelsky, 2009, 42)

Seventy-five years ago Keynes identified fluctuations in investment as the central driver of the macro-economy. Despite the tendency of the media, and even many economists, to concentrate on consumer spending, the situation today is no different.

Decline in fixed investment accounts for approximately 96 per cent of the fall in GDP in the OECD area as a whole and for 76 per cent of the decline of GDP in Europe. In three countries – the US, Spain, and Portugal – the decline in fixed investment was greater than the decline in GDP. In Japan, France and Greece the proportion of the fall in GDP due to the decline in fixed investment was over 70 per cent, 80 per cent and 90 per cent respectively. In every country except Germany the fall in fixed investment was the single biggest component of the decline in GDP. In short the decline in fixed investment entirely dominates the Great Recession. (Ross, Honge and Chi, 2010)

To Keynes, the central determinant of investment was what he termed ‘animal spirits’ – the confidence, or lack of confidence, that drives investment decisions. Investment decisions, dealing as they do with the future and the likely profitability (or not) of any given enterprise, are always by definition subject to uncertainty. In such circumstances rational calculation is almost impossible. Feelings and beliefs about the future rather than utility maximisation will drive decision-making. Loss of confidence can be become a self-fulfilling prophecy. If, for whatever reason, business people become pessimistic and cease investing, then demand in the economy will decrease and unemployment will rise. As unemployment rises, consumption starts to fall off and the economy’s prospects deteriorate further. This can in turn lead to an even greater loss of confidence – after all, who would choose to invest in the future in such circumstances?

It is a macro-economic accounting identity (rather than a theory) that, in a closed economy, investment must equal savings (S = I). One of the most fundamental distinctions between Keynes and earlier (and modern day) classical economists was the dispute as to which variable is dominant: 

Thus, post-Keynesians and neo-classicists can pretty much agree on definitions of saving and investment, for example. They can also agree that in a simple economy with no government and no foreign trade, savings must equal investment. This is, in fact, a basic national income accounting identity. Where these two schools differ is not here, but in how they see the causal nexus between the two. For neo-classicists, savings cause investment; it provides the funds needed to build new capital equipment. In contrast, post-Keynesians hold that investment determines savings. Investment can be financed by borrowing from banks, which does not require savings because banks create money by lending. Investment, in turn, generates jobs and incomes. Some of this income will be spent, and the rest saved; thus, at the end of the process, savings come to equal investment. (Holt and Pressman, 2007, 7, emphasis added)

Neo-classical models emphasise the ‘virtue’ of saving, or delaying consumption. The resulting savings will be transformed into investment by a seamless process resulting in a deepening capital stock and faster growth in the future. Keynes, by contrast, warned that increased saving would immediately reduce demand in the economy and lead to less investment and a smaller economy. Savings would still match investment, but only as a larger proportion of a smaller economy was being saved.

Significantly, Keynes’s analysis of investment was rooted in a model of the economy that recognised the importance of monetary and financial factors. The financial system is the nexus of the investment-savings relationship – the place where savings are transformed into investment. Far too much of conventional economic theory either ignores financial markets altogether or else assumes frictionless, perfectly functioning ‘efficient markets’. In Hyman Minsky’s account:

As the standard interpretation of Keynes was assimilated to traditional economics, the emphasis upon finance and debt structures that was evident in the 1920s and the early 1930s was lost. In today’s standard economic theory, an abstract nonfinancial economy is analysed. Theorems about this abstract economy are assumed to be valid for economies with complex financial and monetary institutions and usages. As pointed out earlier, this logical jump is an act of faith, and policy advice based upon the neoclassical synthesis rests upon this act of faith. Modern orthodox macro-economics is not and cannot be a basis for a serious approach to economic policy. (Minsky, 2008, 193)

The need for macro-economics to take account of the financial sector has only grown since Keynes wrote in the 1930s and Minsky in the 1970s. But any meaningful analysis of the financial sector requires the examiner to step outside the bounds of what is currently considered to be ‘economics’ and into the realms of ‘political economy’.


Financial capitalism

In a simple model of a capitalist economy with only three factors of production – land, labour and (physical) capital – the driver of growth is the process of accumulating more capital. Once the owner of capital has paid for the input of labour and land, they are left with a surplus, or profit. These profits are reinvested into the accumulation of more capital. This process leads to an increase in the capital stock and higher production, generating an ever higher surplus for reinvestment. This process of accumulation is the investment-savings function described above. Indeed, the left-wing Polish economist Michal Kalecki reformulated the standard S=I equations to show that S (savings) is equal to profit (Kalecki, 1971).

As the financial system evolved, it gradually became unnecessary for capitalists to invest their surplus in new physical capital. As Keynes noted, people generally prefer their assets to be as liquid as possible. Most people would rather own shares comprising a claim on a factory, which can be easily sold simply through ringing a stockbroker, than an actual factory, which may prove hard to sell in the short term.

But this financialisation of physical capital has the potential to cause problems: 

For Keynes, the structure of modern finance capitalism invited a periodic decoupling of the market for assets from production – and the possibility that speculative bubbles followed by inevitable bursting could destabilise the whole system. (Foster and Magdoff, 2009, 16)

Later Marxist thinkers have taken Keynes’ (and Kalecki’s) theories further, arguing that the process of financial capital accumulation has come to dominate the economy, especially since the perceived ‘drying up’ of opportunities to invest in the ‘real economy’. For the owners of capital the dilemma is what to do with the immense surpluses at their disposal in the face of a dearth of investment opportunities. Their main solution from the 1970s onwards was to expand their demand for financial products as a means of maintaining and expanding their money capital. On the supply side of this process, financial institutions stepped forward with a vast array of new financial instruments: futures, options, derivatives, hedge funds, and so on. The result was skyrocketing financial speculation that has persisted now for decades (Foster and Magdoff, 2009, 79-80).

The resulting process is what Andrew Gamble has termed the ‘financial-growth model’, which was adopted by Britain during the Thatcher era:

Within twenty years the financial sector in London had become one of the UK’s largest employers and export earners, and in comparative terms was large in relation to the rest of the economy … It accounted for 5 per cent of gross domestic product and over a million employees, and gave Britain the largest trade surplus in financial services in the world … The British government actively encouraged the growth of the financial sector and the service economy more generally to replace the gap left by the decline of manufacturing and the older industrial towns and cities. (Gamble, 2010, 16)

As Will Hutton has convincingly argued, Keynes – the monetary economist – would have foreseen the dangers of such an approach. ‘Keynes would be completely unsurprised by today’s events; he would have spent the previous decade warning of the existential danger posed by the mania for financial deregulation’ (Hutton, 2008).

This encouragement of the City was continued by Labour in government. It appeared to be the goose that continued to lay golden eggs. In 2006-07, the last year of the boom, financial services companies paid around £68bn of tax revenue to the exchequer, contributing a quarter of all corporation tax and nearly 14 per cent of the total tax take. Increasing revenues from the City allowed Labour to continue to increase spending on public services without the need to raise income tax or VAT. Attempts at greater regulation or even increased scrutiny, whether originating domestically or at the European level, were fought off with vigour by the Treasury. The contribution of financial services to tax revenues, the balance of payments and to keeping house prices on a rising trend (and hence ‘middle England’ content) placed its activities beyond question.

The nature of a system whereby money begat further money, with little real investment in the physical economy, was ignored; as was the increasing risk profile of its activities along with the extravagant payments made to staff. Finance capital came to dominate the British economy at the expense of both industrial capital and labour, despite much of what it did being derided as ‘socially useless’ by the head of the Financial Services Authority.


2009-2010: A tale of two economies

Perhaps the most vivid example of the decoupling of physical and financial capital identified by Keynes can be found in the period from March 2009 until March 2010, the year of ‘quantitative easing’. The Bank of England decided essentially to ‘print’ £200bn of electronic money and inject it directly into the financial system by buying government bonds from banks. During that year, lending by UK banks (themselves the recipients of much of the £200bn) to financial companies rose by £81bn, whilst lending to non-financial firms contracted by £21.4bn. As the financial sector found itself with ample liquidity, the real economy was starved of credit (4).

The results were striking. Unemployment, by the International Labour Organisation definition, rose from 7.3 per cent to 7.7 per cent – an extra 200,000 people out of work. Business investment, the primary driver of future prosperity, fell by 7.7 per cent. Industrial production recovered by a modest 0.6 per cent. The real economy struggled forward between March 2009 and March 2010 with sluggish growth, falling investment and rising unemployment (5).

In the financial sector, meanwhile, things were very different. The FTSE 100 index of leading shares rose by a staggering 44.7 per cent. House prices (as measured by Halifax) rose by 5.5 per cent. Bonuses returned, with an estimated pay-out of £6bn to staff, up from £4bn in 2008.

Although a temporary tax was charged on bank payrolls (raising £2.5bn) little attempt was made to ensure that the £200bn of ‘new money’ created by the state found its way into the real economy. Gordon Brown announced the creation of a new National Investment Corporation in his 2009 Labour Party conference speech but nothing of substance emerged from this. Even the nominally state-controlled Royal Bank of Scotland continued to make excessive pay-outs to staff in its ‘Global Markets’ division. In short, there was no challenge to the power of finance capital, despite the mess it had made of the economy and the near universal public distaste for bankers evident throughout the years from 2008 to 2010.


The Keynesian reform agenda

A solution to the dominance of finance capital does exist; a solution designed to make sure finance works as the ‘servant’ of industry and labour. In the 1930s Keynes forcibly argued that there was no logical basis for the ability of finance capital to charge an economic rent. 

Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. (Keynes, 2008, 235)

A deliberate policy of low interest rates, combined with controls on some forms of investment and a change in how the government manages its debt (which lies outside the scope of this article) could lead to the ‘euthanasia of the rentier’. 

I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change… 

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward. (Keynes, 2008, 235)

This Keynesian policy (6) was embraced by the Labour Party in the 1930s and best summarised in the Finance and Full Employment paper quoted above (7). The Attlee government, especially in the period of Dalton’s Chancellorship, pursued an aggressive programme of reform, beginning with the nationalisation of the Bank of England and extending to the introduction of the Industrial and Commercial Finance Corporation (ICFC, the UK’s first ‘venture capital’ form which eventually was privatised as 3i). In addition, wartime controls over certain financial activities were extended and a serious attempt was made to reform the operation of the government debt market. The Bank of England issued ‘guidance’ on the type of lending it wished to be advanced. One post-Keynesian economist notes: 

The policy eventually culminated in an attempt to hold long-term rates at 2.5 per cent from which the government eventually retreated. Yet this ‘failure’ should not detract from the more general preservation of cheap money under the Attlee government. Its economic and social achievements arguably stand apart from those of any other government in history.In the wake of post-war debt and currency instability, the economic growth and employment performance were outstanding.

But the Labour government lost office in the wake of infighting caused by the Korean War. The Conservative Party took office, and in November 1951 the re-activation of the discount rate as an instrument of economic policy was symbolic of the end of the monetary policies of the post-depression age.

The Labour Party Victory at the 1945 general election had made the financial reform agenda that had been debated for a half a century a brief reality. As with Keynes’s theory itself, this policy, its successes and failures are largely lost to history. (Tily, 2007, 34-35, emphasis added)

One major factor undermining the monetary and reform agenda was the political power of financial interests, supported in many cases by sympathetic officials in both the Treasury and the Bank of England. Perhaps the City’s fight-back in this period, culminating in the Conservative government of 1951 essentially reversing the policy, was to disprove Keynes’s claim that ‘it is ideas, not vested interests that are dangerous’ (Keynes, 2008, 239). Any programme of financial reform will soon run into the power of ‘vested interests’.


Contemporary lessons

Clearly the nature of financial capital has changed over the past seventy years, but the essential insights of Keynes, Kalecki and Minsky remain valid. A policy of low interest rates coupled with financial reform would allow credit to flow more easily but in a more productive manner than it did in the period of quantitative easing. The primary lesson of 2009-10 is clear: low interest rates and the expansion of the money supply are not enough to ensure sustainable growth. Without serious reform of the financial sector the money will simply flow into speculation, property and excessive remuneration.

Any programme of financial reform should be based around two interlocking aims: the avoidance of a repeat of the crisis, and ensuring that vital, long-term investments in the economy are funded. Both aims will require a reconsideration of the post-Thatcherite political economic settlement in terms of the role of government and the role of markets. The financial sector has evolved over the past thirty years and the solution is not simply a case of turning back the clock.

Concrete steps could include the establishment of a development bank, modelled on the German KfW or the Scandinavian Nordic Investment Bank, with state backing and a remit to increase investment; and the restructuring of the banking sector to break down both the size and complexity of the institutions involved. The revival of mutually-owned building societies and more regionally focussed institutions could also help both decentralise financial power and diminish the political clout of the sector. The nature of the Bank of England, its powers and its remit are long overdue a reconsideration; as is the openness of the UK economy to sometimes fleet-footed capital.

The Coalition’s plans as yet appear unclear and conflicted. The more radical proposals made by Vince Cable in opposition have been kicked into the long grass of a committee on the future of banking which will likely result in further watering down. As the profits of the sector have picked up, the old desire of governments to simply enjoy the tax revenues that result is reasserting itself. Osborne’s desire to return RBS and Lloyds to the private sector quickly for as high a price as possible further undermines the likelihood of serious reform.

Meanwhile, public anger at the banks remains, and the real economy continues to struggle. The financial reform agenda remains open for Labour to seize. As Elizabeth Durbin wrote twenty-five years ago: 

Leaders who care about reducing economic insecurity and injustice must devise effective programmes to address specific problems and feasible ways to establish public control of vital economic functions, which private market forces cannot perform unaided. Now, as in the 1930s, the central question is to find a strategy which can secure economic growth and egalitarian politics through the practice of the democratic method. To rediscover the way forward will require knowledge, discipline, foresight and imagination. British democratic socialist thought has a rich tradition of designing realistic programmes, which are in tune with their age and which can inspire the necessary vision of a ‘New Jerusalem’ for the next generation. (Durbin, 1985, 286)



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Clarke, P. (2009) Keynes: The Twentieth Century’s Most Influential Economist, London, Bloomsbury.

Durbin, E. (1985) New Jerusalems: The Labour Party and the Economics of Democratic Socialism, London, Routledge & Kegan Paul.

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Gamble, A. (2010) The Spectre at the Feast: Capitalist Crisis and the Politics of Recession, London, Palgrave Macmillan.

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Giddens, A. (2010) The Rise and Fall of New Labour, London, Policy Exchange.

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1. See Toye, 2009.

2. Figures taken from Prasad and Sorkin, 2009.

3. Simply put, the ‘ergodic axiom’ is the assumption that probabilities calculated from existing market data are equivalent to drawing a sample from market data which will exist in the future. In other words the future will always, to some degree, resemble the past.

4. Bank of England, Monetary and Financial Statistics.

5. Office for National Statistics, Labour Market Statistics, Business Investment and Index of Production.

6. For a detailed look at the economics of these proposals and in particular the importance of liquidity preference theory in understanding the determination of interest rates, see Tily, 2008.

7. There is some debate as to how ‘Keynesian’ the Labour Party was in this period. The works of Toye and Brooke in particular emphasise how much stress was placed on ‘planning’ in the period before 1947 and the lack of emphasis placed on budget deficits. However in the financial field, discussed in this article, it seems fair to describe the policy as ‘Keynesian’, in the post-Keynesian sense of the term.