This year, Germany finally paid off its old bonds for World War 1 reparations, as Margaret MacMillan has noted in the New York Times.  MacMillan asserts that “John Maynard Keynes, a member of the British delegation in Paris, rightly argued that the Allies should have forgotten about reparations altogether.” Actually, the truth is more complicated.  A fuller understanding of Keynes’s role in the 1919 Paris peace conference after World War 1 may also offer a useful perspective on his contributions to economics.

Keynes became the most famous economist of his time, not for his 1936 General Theory, but for his Economic Consequences of the Peace (1920) and A Revision of the Treaty (1922). These were brilliant polemics against the 1919 peace conference, exposing the folly of imposing on Germany a reparation debt  worth more than 3 times its prewar annual GDP, which was to be repaid over a period of decades.

Germans saw the reparations as unjust extortion, and efforts to accommodate the Allies’ demands undermined the government’s legitimacy, leading to the rise of Nazism and the coming of a second world war. Keynes seemed to foresee the whole disaster. In his 1922 book, he posed the crucial question: “Who believes that the Allies will, over a period of one or two generations, exert adequate force over the German government to extract continuing fruits on a vast scale from forced labor?”

But what Keynes actually recommended in 1922 was that Germany should be asked to pay in reparations about 3% of its prewar GDP annually for 30 years. The 1929 Young Plan offered Germany similar terms and withdrew Allied occupation forces from the German Rhineland, but the Nazis’ rise to national power began after that.

In his 1938 memoirs, Lloyd George tells us that, during World War 1, Germany also had plans to seize valuable assets and property if they won WW1, “but they had not hit on the idea of levying a tribute for 30 to 40 years on the profits and earnings of the Allied peoples.  Mr. Keynes is the sole patentee and promoter of that method of extraction.”

How did Keynes get it so wrong on reparations? In 1871, after the Franco-Prussian War, Germany demanded payments from France, on a less vast scale (only a fraction of France’s annual GDP), while occupying northern France. To hasten the withdrawal of German troops, France made the payments well ahead of the required 3-year schedule, mainly by selling bonds to its own citizens. But the large capital inflow destabilized Germany’s financial system, which then led to a recession in Germany. Before 1914, some argued that such adverse consequences of indemnity payments for a victor’s economy would eliminate incentives for war and assure world peace. In response to such naive arguments, Keynes suggested in 1916 that postwar reparation payments could be extended over decades to avoid macroeconomic shock from large short-term capital flows and imports from Germany.

Nobody had ever tried to extract payments over decades from a defeated nation without occupying it, but that is what the Allies attempted after World War 1, following Keynes’s suggestion. Keynes argued about the payments’ size but not their duration.

Today economists regularly analyze the limits on a sovereign nation’s incentive to pay external debts. In our modern analytical framework, we can argue that the scenario of long-term reparation payments was not a sequential equilibrium. But such analysis uses game-theoretic models that were unknown to Keynes. As a brilliant observer, he certainly recognized the political problems of motivating long-term reparation payments over 30 years or more, but these incentive problems did not fit into the analytical framework that guided him in formulating his policy recommendations. So while condemning the Allies’ demands for Germany to make long-term reparation payments of over 7% of its GDP, Keynes considered long-term payments of 3% of GDP to be economically feasible for Germany, regardless of how politically poisonous such payments might be for its government. Considerations of macroeconomic stability could crowd out strategic incentive analysis for Keynes, given the limits of economic analysis in his time.

Reviewing this history today, we should be impressed both by Keynes’s skill as a critical observer of great policy decisions but also by the severe limits of Keynes’s analytical framework for suggesting better policies. Advances in economic theory have greatly expanded the scope of economic analysis since Keynes’s day and have given us a better framework for policy analysis than what Keynes ever had.

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