Reason and Reasonableness in Keynes: Lessons from The Economic Consequences of the Peace 90 Years Later

Abstract

The crisis that has hit the world economy has made once again topical the principles that Keynes advocated to address the loss of market confidence and the decline in production and employment. A re-reading of the Economic Consequences of the Peace points along a path parallel to the one usually associated with Keynesian policies – deficit spending and public investments – which relies on the concept of reasonableness. This paper outlines the context in which the Consequences was written and then traces Keynes’s approach back to the Bloomsbury background. It is argued that the distinction between reason (or rationality) and reasonableness, to be seen also in Rawls, is one of the characteristic features of Keynes’s economic thought which can be used to trace out a parallel between the humiliation of the conquered at Versailles and the debtor mortification inflicted on Lehman Brothers. The conclusion is that the return to Keynes we should wish for is not only a matter of supporting demand in order to avoid general deflation, or reform of the international monetary system to avert the effects of the present world imbalances, but more extensive application of the Keynesian concept of reasonableness against the so-called rationality of individuals and markets.

Comments on Professor Marcuzzo’s Paper

Moshe Justman

The theme that Professor Marcuzzo has placed at the center of her fascinating paper, the distinction between rationality and reasonableness, recalled discussions I had some years ago with our departed colleague and my good friend Ehud Zuscovitch, who regularly taught a course on the History of Economic Thought (from Aristotle to Adam Smith) in our department. Ehud received his economic education in France and became a Directeur de Recherche in the CNRS as well as Professor of Economics at Ben Gurion University, which like all university economics departments in Israel is dominated by the Anglo-American tradition. He first introduced me to the distinction between the rational French and the reasonable British, and Professor Marcuzzo’s threefold application of this distinction, between rationality and reasonableness, in this power illustrates its potential scope.

Professor Marcuzzo first, and most persuasively, applies it to the events John Maynard Keynes describes in The Economic Consequences of the Peace, the peace negotiated at Versailles after the First World War. There were certainly other forces at work, too, which shaped the negotiations at Versailles – the French having repeatedly suffered at the hands of the Germans were more apprehensive of German reconstruction. And, of course, there was some popular thirst for revenge after a long and bitter war, which the elected officials who led the national delegations could not ignore. (Civil servants, like Keynes, have the privilege of greater dispassion.) But looking back on these events it seems clear that the neither the French nor the British delegation, led by the Welsh Prime Minister Lloyd-George, were acting reasonably: they failed to see what they should have been able to see even at the time, what seemed evident to Keynes, that the peace negotiated at Versailles was unreasonable for Britain and France because it was inconsistent with their economic interests, as only an economically viable Germany could realistically be expected to make substantial reparations.

Applying this distinction to the disagreement between the United Kingdom and the United States regarding the economic consequences of the Second World War seems less straightforward. In this case, the essential underlying difference between the parties was not between reasonableness and rationality but between two different implicit perspectives on the war. In the British view, which Keynes argued, the war was a partnership between Britain and America to defend the cause of freedom against the totalitarian threat of the Axis powers – a partnership in which Britain had borne a disproportionate share of the costs. It was therefore only fair, or “reasonable” (perhaps in a slightly different sense of the word) that the United States forgive British debts. “If the tables were turned”, the unspoken argument runs, “and it were the United Kingdom rushing to the rescue of the United States, we would forgive your debts. It is only reasonable that friends thus share risks and not exploit a temporary advantage to the full”.

Of course, the United States saw the war in a different light altogether. The war in Europe was precisely that, a war in Europe, in which the United States was helping its friends (and pursuing its interests), but a war which certainly posed no threat to its own territorial integrity. As America saw it, Britain was waging a war it risked losing badly and the United States stepped in, as a friend, sacrificing its material resources and the lives of its soldiers in Britain’s aid; and lending Britain the resources it needed to continue the war – without immediate consideration of payment. The implicit notion of reciprocity that underlies Keynes’ call for reasonableness, were it stated explicitly, would have been laughed out of the room. This was clearly a one-way street and would continue to be so in the foreseeable future.

Indeed, the Americans might have argued with equal if not greater force that Britain was not being reasonable. Rather than offer compensation to the United States for the losses it incurred to save Britain from the Nazi threat, it was asking the United States to foot the bill for Britain’s part in the war, as well. What the Americans offered instead was to roll over the debt, extending much needed credit for the rebuilding of Europe through the Marshall plan. While this was certainly less favorable for Britain it was not detrimental to American interests, and hence not an unreasonable position for the United States to take.

Versailles was unreasonable for the Allies because it was ultimately bad for them, in a way that could be foreseen at the time. The same cannot be said of the economic consequences of the Second World War for the United States. The Marshall plan was a great success – the years after the war were economically prosperous for the United States and the Marshall plan also laid the foundation for the political alliance that the United States formed to counter the threat of Soviet expansion. The United States’ refusal to forgive British debt after the war was not “unreasonable” in the sense that Versailles was unreasonable. There was no reason at the time to expect it to have an unfavorable impact on American interests, and indeed it had no such effect.

The third case Professor Marcuzzo turns her attention to is the United States government’s decision not to bail out Lehman Brothers. This is much nearer actual events and so more difficult to analyze, as it is not yet clear what exactly transpired. There is a clear principle involved, that markets cannot function efficiently unless they are subject to the discipline of the marketplace – unless the rules of the game are kept and those who fail are required to bear the cost of their failure. Rationality requires that rules be kept; reasonableness, in this context, may be likened to an inner voice telling us that every rule has exceptions. And there were good reasons, too, for seeing this as an exception, primarily the fear of grave external repercussions that widespread financial failure would have on the American economy at large and on the world economy. Indeed, there were precedents of such bailouts on the part of the United States government in the past. Was this the time to apply the rule or was this the exception? Would a more flexible approach to Lehman Brothers have averted the crisis or lessened its consequences?

There are two reasons why I would hesitate to label the actions of the United States government in this matter as unreasonable. The first is that we do not know now and certainly could not have known at the time what might have happened if Lehman Brothers had been bailed out. There were too many things going on at once, too much uncertainty and too little information. The second is that Treasury officials were making earnest efforts to avert the fall of Lehman Brothers by brokering a bailout through the market, as had been done in the case of Bear Sterns. They were not able to do so in the very short time frame they had to work in, but they were not indifferent to Lehman Brothers’ plight or oblivious to the serious consequences that its failure might have, though with hindsight it might be argued that they underestimated their gravity. Unfortunately, as Henry Paulson argues in his recently published version of these events, the government did not have the authority to intervene directly, e.g., by infusing government funds to purchase Lehman Brothers’ illiquid assets, and Congress was not prepared to issue such authority until there was an actual, palpable crisis for all to see. Such direct involvement was not politically feasible when it might have made a difference. And for good reason. There are moral hazard issues in allowing politicians to bail out investment bankers other than in obviously exceptional circumstances. The voting public is right to view such interventions with suspicion. In sum, the decision not to bail out Lehman Brothers may well have been wrong but given what was known at the time and the political realities of representative government it seems harsh to attribute the failure of Lehman Brothers to an unreasonably inflexible laissez-faire position on the part of the United States government.

There is another, secondary line of argument running through Professor Marcuzzo’s description of the events leading up to Lehman Brothers’ failure, which merits at least a brief comment: the “tribal” allegiances that pitted Ivy League graduates against those who attended less exclusive schools. I am not in a position to judge the practical import of this dimension, but there is an element of irony that arises from her description. It was not that long ago – a few decades back, when investment banks were privately held companies – that the divisions in Wall Street ran along religious lines, between Christian firms, such as JP Morgan or Merril Lynch, and Jewish firms, such as Goldman Sachs or Lehman Brothers. That Professor Marcuzzo can describe the Christian Scientist Paulson as belonging to the Goldman Sachs “tribe” shows how far the United States has progressed in removing old prejudices.

Professor Marcuzzo has written a fascinating, thought-provoking paper. The distinction she chose as the theme of her analysis opens up many new directions for thought, allowing us to draw illuminating parallels among these three very different events and see each in a new light.