It has been suggested that Keynesian economics remains the best framework that we have for making sense of recessions, but that macroeconomic theory also needs to do a better job of incorporating the realities of finance. There may be a fundamental contradiction between these two suggestions.

In their book Microeconomics of Banking, Xavier Freixas and Jean-Charles Rochet noted that there was no microeconomic theory of banking before the 1970s.  Banks and other financial intermediaries earn their profits by knowing more than depositors about the quality of borrowers’ investments.  So an economic theory of banking requires an ability to analyze transactions among agents who have different information.  Economists first developed such agency theories only around 1970, building on previous advances in game theory.

So John Maynard Keynes’s 1936 General Theory and other classic theories of macroeconomics were developed when there was no real economic theory of banking.  Inevitably this limited the scope of their analysis.  For example, if the 1933 Glass–Steagall Act of banking regulatory reform was essential for halting America’s catastrophic slide into the Great Depression, there would be no way to incorporate that fact into the analysis without an economic theory of banking.

An economic theorist who rereads the General Theory today may be struck by the absence of any serious analysis of how massive bank failures could have been involved in causing the Great Depression.  In chapter 11, Keynes briefly discussed moral hazard in lending, but he had no analytical framework to use these insights, and they tended to get lost in the discussion.

But Keynes was a brilliant observer, even when he could not fit his observations into his theories.  For a contrasting view on the role of banks, look at Keynes’s previous book, his 1930 Treatise on Money.  Near the end of that book, in chapter 37, Keynes made the following observation:

“The relaxation or contraction of credit by the Banking System does not operate merely through a change in the rate charged to borrowers; it also functions through a change in the abundance of credit.  If the supply of credit were distributed in an absolutely free competitive market, these two conditions, quantity and price, would be uniquely correlated with one another and we should not need to consider them separately.  But in practice, the conditions of a free competitive market for bank-loans are imperfectly fulfilled.  There is an habitual system of rationing in the attitude of banks to borrowers — the amount lent to any individual being governed not solely by the security and rate of interest offered, but also by reference to the borrower’s purposes and his standing with the bank as a valuable or influential client.  Thus, there is normally a fringe of unsatisfied borrowers who are not considered to have the first claims on a bank’s favours, but to whom the bank would be quite ready to lend if it were to find itself in a position to lend more.  The existence of this unsatisfied fringe allows the Banking System a means of influencing the rate of investment supplementary to the mere changes in the short-term rate of interest.”

There is an interesting suggestion here that even short-term loans might implicitly depend on long-term relationships between investors and financial intermediaries. Such an idea could be the basis for a theory of macroeconomic fluctuations in which bank failures could affect investment.

In 1936, however, Keynes could not build a theory in which monetary policy could affect aggregate investment other than through its effect on the interest rate.  His 1930 observation got lost in his subsequent analysis because it did not fit into his analytical framework.  He had no way to answer the obvious question: If so many eager qualified borrowers are unable to get loans at the current interest rate, why don’t banks offer to lend to them at a higher interest rate?  Today economists understand how such credit rationing can be derived from considerations of adverse selection or moral hazard in borrowing.  The classic introduction to the subject is by Joseph Stiglitz and Andrew Weiss in 1981.