Keynes, Schumpeter and the Great Post-War Mistake: Sylvia Nasar

In January 1919, as the Allied leaders met in Paris to hammer out a treaty ending World War I, famine and pestilence raged from St. Petersburg to Istanbul. To the Britons and Americans who came to survey the damage, the whole continent seemed to be in extremis.

Eight weeks after the signing of the armistice, peace had not been restored. The Allied blockade was still in effect. Dozens of small wars erupted, involving hundreds of thousands of troops. Entire populations were being terrorized by pogroms and expulsions. Eight and a half million men had died. Nearly as many were left physically disabled or psychologically maimed. A generation in Central Europe was growing up underfed and undersized -- the Kriegskinder, or children of war.

Victors and losers alike were saddled with massive debts and faced pressure to compensate those who had sacrificed so much. Yet every avenue back to normalcy was blocked. Trade was at a standstill, credit frozen, production stymied by lack of raw materials, the workforce idle. The economic mechanism of Europe had to be unjammed, yet the men in Paris persisted in believing that their nations’ losses could be recouped by extracting reparations and redrawing borders.

The Wunderkind

“Starvation means Bolshevism,” a British general warned. The word in Paris was that Vienna, flanked by two Red capitals, would be the next to succumb. In April, thousands of gaunt and ragged men -- unemployed factory workers, paid agitators, demobbed soldiers, many with missing limbs -- descended on Vienna’s Ringstrasse, setting the Parliament building ablaze and attacking the police. The militia finally restored order, but not before a horse was shot out from under a policeman. As the animal lay dead in the street, a hungry mob tore it to pieces and carried off hunks of bloody meat. For ordinary Viennese, who adored the emperor’s white show horses the way Americans loved boxing champions, the incident was a sign that civilization was reverting inexorably to barbarism.

While the street battle raged a mile away, the bankrupt government of a dismembered Austrian Republic -- surrounded by hostile states, threatened by revolution, awaiting the Allied peace terms being decided in Paris -- met in the freezing chancellery. Its youngest member was the new finance minister, Joseph Schumpeter. The urbane, clever, ambitious Wunderkind of the defunct Austro-Hungarian Empire had opposed the war, avoided the draft and advised the now-exiled emperor to make a separate peace with the Allies. A member of the conservative opposition party, Schumpeter had nonetheless leapt at the chance to join a government run by his Marxist university pals, gloomy men who saw no future for Austria other than communism or “Anschluss” -- economic and political union with Germany.

If a nation decides to commit suicide, Schumpeter quipped, a doctor had better be present. But he radiated optimism. Six months after the armistice he had already unveiled a plan for postwar economic recovery. The capitalist welfare state, which he called the “Steuerstaat,” or “tax state,” would survive, he predicted. Any crises would result not from the triumph of socialism, but rather from the tendency of voters’ expectations to race ahead of their willingness to pay taxes. The republic would face constant pressure to run budget deficits and to ease debt burdens by resorting to inflation.

Schumpeter’s ‘Intrigues’

He believed that a shrunken Austria had the means to recover. As long as entrepreneurs were allowed to create new enterprises, the financial system was functioning efficiently and there were not too many barriers to trade, society could regenerate itself. He rejected the popular assumption that economic viability depended on vast territories, huge populations and natural resources. Switzerland, whose per-capita income rivaled that of Britain, was no bigger than Scotland. And before the war, Vienna had been the most important center of finance, transportation and trade in Central Europe.

As long as the Allies or neighboring countries did nothing to prevent Austria from trading freely or its government from restoring its creditworthiness, Schumpeter saw no reason Vienna couldn’t resume its prewar economic role.

Frustrated by his own government’s paralysis and pessimism, Schumpeter forwarded his plan for postwar recovery to a British treasury official in Paris, whom he had met before the war. As the treasury’s envoy in Vienna cabled, “The Austrian finance minister does not share the general opinion that Anschluss to Germany was Austria’s only salvation.” He added, “Suffice it to say that it was a rare and fortunate privilege to have had to deal with such a genial, open-minded expert.”

The Austrian foreign minister had another view. “Schumpeter carries on with his intrigues,” he wrote to the prime minister, “I shall do nothing for the time being, but after the conclusion of the peace treaty it will be inevitable to force his resignation.”

The Incorrigible Optimist

John Maynard Keynes, the recipient of the cable containing Schumpeter’s recovery plan, was also a man at odds with his government. Although relatively junior, he was an expert on inter-allied finance and reparations and was “one of the most influential men behind the scenes” at the peace negotiations. And he was by nature, according to his biographer Robert Skidelsky, “an incorrigible optimist.”

Precocious, supremely self-confident and abominably rude, Keynes was certain that he knew what must be done. The prosperous prewar economy, highly specialized and interdependent, was at a standstill. To get it moving again, as opposed to merely preventing mass starvation, required that the Allies focus on removing barriers to trade, dealing with war debts and stabilizing currencies.

Keynes tried vainly to get the ears of the Big Four -- the leaders of Britain, France, Italy and the U.S. then negotiating at the Paris Peace Conference. The French accused him of having greater sympathy for German suffering than French, while Bernard Baruch and other American officials were convinced that he wanted the U.S. -- not the Germans or the British -- to foot the bill for the war.

In the early morning hours of May 4, Keynes was pacing through Paris’s deserted streets, pondering an early draft of the Versailles treaty, when he ran into two friends, one of them Herbert Hoover, head of the Allied food relief program. “We all agreed it was terrible,” Hoover wrote in his memoir.

The incorrigible optimist retreated to bed, ill with the flu and depressed by his failure to persuade the Big Four to focus on economic recovery. Feeling like “an accomplice in all this wickedness and folly,” Keynes made up his mind to resign, he confided in a letter. “The Peace is outrageous and impossible and can bring nothing but misfortune.”

Consequences of Peace

By Christmas, Keynes had exacted some measure of revenge on the Big Four -- including his boss, British Prime Minister Lloyd George -- by publishing a brilliant peroration, “The Economic Consequences of the Peace.” It savaged the treaty, and was as memorable for its acid portraits of the men in charge as for its gloomy conclusions. Keynes argued that the treaty had sown the seeds of another war by adding to the loser’s debts while wresting away their means of paying them. Vengeance will not limp, he warned, “and nothing can then delay for very long that final civil war between the forces of reaction and the despairing convulsions of revolution.”

In the terrible years immediately after the war, Germany and Austria succumbed to economic chaos, hyperinflation and a catastrophic loss of faith in democracy by their middle classes. The victorious Allies too suffered disillusioning economic setbacks -- not exactly the heroes’ welcome that returning troops were promised. Bruised from their losing battles, eager for success on new fronts, Schumpeter became a banker and Keynes went to work in the City, London’s Wall Street. For Schumpeter, the most creative part of his career was over. For Keynes, the rush of inspiration that led to his “economics of the whole” -- rooted in his experiences in the aftermath of the Great War -- still lay ahead.

(Sylvia Nasar, a former New York Times economics reporter and the author of “A Beautiful Mind,” teaches journalism at Columbia University. This is the third in a five-part excerpt of her new book, “Grand Pursuit: The Story of Economic Genius,” to be published by Simon & Schuster on Sept. 13.)

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