Being keen on Keynes stops markets behaving badly

It is more than 70 years since the General Theory changed the way economists thought. Its insistence that the state protect the public good is back in vogue.

Harry Dexter White, the US Treasury secretary, left, and John Maynard Keynes at the inaugural meeting of the IMF's board of governers in March 1946.

For decades, Keynesianism was associated with social democratic big-government policies. But John Maynard Keynes's relationship with social democracy is complex. Although he was an architect of core components of social democratic policy - particularly its emphasis on maintaining full employment - he did not subscribe to public ownership or massive expansion of the welfare state.

In The General Theory of Employment, Interest and Money, Keynes ends by summarising the strengths and weaknesses of the capitalist system. On one hand, capitalism offers the best safeguard of individual freedom, choice and entrepreneurial initiative. On the other hand, unregulated markets fail to achieve two central goals of any civilised society: "The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes."

This suggested an active role for government, which dovetailed with important strands of left-wing thought. Until The General Theory was published in 1936, social democrats did not know how to go about achieving full employment. There was an idea, originally derived from Ricardo and Marx, that the capitalist class needed a "reserve army of the unemployed" to maintain its profit share. If profits were eliminated, the need for that reserve army would disappear. Labour would be paid what it was worth and everyone willing to work would be able to find a job.

But, apart from the political impossibility of nationalising the whole economy peacefully, this approach suffered from the fatal flaw of ignoring the role of aggregate demand. Keynes demonstrated that the main cause of bouts of heavy and prolonged unemployment was not worker encroachment on profits, but the fluctuating prospects of private investment in an uncertain world. Nearly all unemployment in a cyclical downturn was the result of the failure of investment demand.

Thus, the important thing was not to nationalise the capital stock, but to socialise investment. Industry could be safely left in private hands, provided the state guaranteed enough spending power in the economy to maintain a full-employment level of investment. Moderate re-distribution was the more politically radical implication of Keynes's economic theory, but the measures outlined above were also the limits of state intervention for him.

Today, ideas about full employment and equality remain at the heart of social democracy. But the political struggle needs to be conducted along new battle lines. Whereas the front used to run between government and the owners of the means of production - the industrialists - now, it runs between governments and finance. Such measures as the efforts by the European Parliament to regulate the derivatives market are contemporary expressions of the wish to reduce the power of financial speculation to damage the economy.

The new focus on the need to tame the power of finance is largely a consequence of globalisation. Yet, while large global companies use their high concentration of financial resources to press for further deregulation, the crisis has turned their size into a liability. Being too big to fail simply means being too big. Keynes saw that "it is the financial markets' precariousness which creates no small part of our contemporary problem of securing sufficient investment". That rings truer today than in his own day. Rather than securing investment for productive sectors of the economy, the financial industry has become adept at securing investment in itself.

Keynes's main contribution to social democracy lies in his insistence that the state as ultimate protector of the public good has a duty to supplement and regulate market forces. If we need markets to stop the state from behaving badly, we need the state to stop markets from behaving badly. Nowadays, that means stopping financial markets from behaving badly. That means limiting their power, and their profits.

Robert Skidelsky, a member of the British House of Lords, is professor emeritus of political economy at Warwick University, author of a prize-winning biography of John Maynard Keynes, and a board member of the Moscow School of Political Studies