In macroeconomics, a general glut
is an excess of supply in relation to demand, specifically, when there
is more production in all fields of production in comparison with what
resources are available to consume (purchase) said production.
This exhibits itself in a general recession or depression, with high and persistent underutilization of resources, notably unemployment and idle factories.
The Great Depression is often cited as an archetypal example of a general glut.
The term dates to the beginnings of classical economics
in the late 18th century, and there is a long-running debate on the
existence, causes, and solutions of a general glut. Some classical and neoclassical economists argue that there are no general gluts, advocating a form of Say's law (conventionally but controversially phrased as "supply creates its own demand"), and that any idling is due to misallocation of resources between
sectors, not overall, because overproduction in one sector necessitates
underproduction in others, as is demonstrable in severe price falls
when such alleged 'malinvestment'
in gluts clear; unemployment is seen as voluntary, or a transient
phenomenon as the economy adjusts. Others cite the frequent and
recurrent economic crises of the economic cycle as examples of a general glut, propose various causes and advocate various solutions, most commonly fiscal stimulus (government deficit spending), a view advocated in the 19th and early 20th century by underconsumptionist economists, and in the mid to late 20th and 21st century by Keynesian economics and related schools of economic thought.
One can distinguish between those who see a general glut (greater supply than demand) as a supply-side issue, calling it overproduction (excess production), and those who see it as a demand-side issue, calling it underconsumption (deficient consumption). Some believe that both of these occur, such as Jean Charles Léonard de Sismondi, one of the earliest modern theorists of the economic cycle.
Classical economic theory
Introduction
The general glut problem is identified within the classical political economy of the era of Adam Smith and David Ricardo.
The problem is that, as labor becomes specialized, if people want a
higher standard of living, they must produce more. However, producing
more lowers prices and leads to the need to produce yet more in
response. If those who have money choose not to spend it, then it is
possible for a national economy to become glutted with all of the goods
it produces, and still be producing more in hopes of overcoming the
deficit. While Say's Law supposedly dealt with this problem, successive economists came up with new scenarios which could throw an economy out of general equilibrium, or require expansion through conquest, which became termed imperialism.
The nature of the general glut
In
Classical Economics, the chief economic concern of all economists
according to Thomas Sowell (On Classical Economics, 2006, pp. 22) was
how to generate and sustain stable economic growth on a national level.
Each factory-producer's basic concern is of maximizing return on
investment through sales. Yet, concern was also expressed that savings
(and not spending money by the wealthy classes) or production of the
wrong items contrary to market demand would produce a nationwide
economic glut (a.k.a. recession/depression) because of the un-purchased
(unconsumed) products which result in unemployment, idle factories, low
national output, and wealth fleeting from the nation. Some theorized
that a general glut is then (in the basic case over time) avoidable and
not inevitable. Say's Law says, Since "savings equals investment" in a
bank or other wise, money is always spent and ultimately reinvested into
more or newer production activities which generates demand (both for
the production resources and the items produced). Say's Law: Since
"demand is always present," then, "production generates its own demand."
Then if a glut exists, producers must react to market demand
liquidating glut items and produce the items the market desires. Demand
will return and any remaining glut will then be distributed by the
market. A company/country only needs to keep producing, or produce more
wisely, or respond to market conditions with products that meet
consumer's demands to avoid a (national recession/depression) glut.
Say's law
According to French economist Jean-Baptiste Say,
the concentration of wealth into resources dedicated to savings and
re-investment simply adds to the ability of consumption to consume more.
And so, he states, there can be no general glut because investment in
"production creates its own demand." A producer/country only need
liquidate the glut items and redirect its production activities to items
the market demands to eliminate the glut and prosperity will return.
Malthus's solution
Thomas Malthus
proposed that a glut of production localised in time rather than by
industry or field of production would meet the requirement of Say's Law
that general gluts cannot exist and yet would constitute just such a
general glut. The consequences then are worked out by Malthus, although Simond de Sismondi
first proposed this problem before him. Malthus is more famous for his
earlier writings which tried to prove the opposite problem, a general
over-consumption, as an inevitability to be lived with rather than
solved.
This is a demand side theory, rather than the supply-side
theory of classical economics; the fundamental ideas are that savings in
a recession or depression causes the paradox of thrift (excess saving, or more pejoratively, "hoarding"), causing a deficit of effective demand, yielding a general glut. Keynes locates the cause in sticky wages and liquidity preference.
Marxian
Karl Marx's critique of Malthus started from a position of agreement.
Marx's idea of capitalist production, however, is characterized by his
concentration on the division of labor and his notion that goods are
produced for sale and not for consumption or exchange. In other words,
goods are produced simply for the intention of transforming output into
money. The possibility of a lack of effective demand, therefore, is held
only in the possibility that there might be a time lag between the sale
of a commodity (the acquisition of money) and the purchase of another
(its disbursement). This possibility, also originally crafted by
Sismondi (1819), endorsed the idea that the circularity of transactions
was not always complete and immediate. If money is held, Marx contended,
even if for a little while, there is a breakdown in the exchange
process and a general glut can occur.
For Marx, since investment is part of aggregate demand, and the
stimulus for investment is profitability, accumulation will continue
unhindered as far as profitability is high. However, Marx saw that
profitability had a tendency to fall, which would lead to a crisis in
which insufficient investment generates an insufficiency of demand and a
glut of markets. The crisis itself would operate to raise
profitability, which would start a new period of accumulation. This
would be the mechanism for crisis occurring repeatedly.
Post-Keynesian
Some Post-Keynesian economists see the cause of general gluts in the bursting of credit bubbles, particularly speculative bubbles.
In this view, the cause of a general glut is the shift from private
sector deficit spending to private sector savings, as in the debt-deflation hypothesis of Irving Fisher and the Financial Instability Hypothesis of Hyman Minsky,
and locate the paradox of thrift in paying down debt. The shift from
spending more than one earns to spending less than one earns (in the
aggregate) causes a sustained drop in effective demand, and hence a
general glut.
Austrian
Austrian economics
do not see "general glut" as a meaningful way of describing an economy,
indeed Austrian Economists do not believe it is possible to have too
much of everything. In the Austrian analysis, it is the misallocation of
resources that should be avoided. Producing too much of the wrong
things, and not enough of the right things, is what Austrians believe to
be truly wrong with an economy
The General Theory of Employment, Interest and Money of 1936 is a book by English economist John Maynard Keynes. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution".
It had equally powerful consequences in economic policy, being
interpreted as providing theoretical support for government spending in
general, and for budgetary deficits, monetary intervention and
counter-cyclical policies in particular. It is pervaded with an air of
mistrust for the rationality of free-market decision making.
The central argument of The General Theory is that the level of employment is determined not by the price of labour, as in classical economics, but by the level of aggregate demand.
If the total demand for goods at full employment is less than the total
output, then the economy has to contract until equality is achieved.
Keynes thus denied that full employment was the natural result of competitive markets in equilibrium.
In this he challenged the conventional ('classical') economic wisdom of his day. In a letter to his friend George Bernard Shaw on New Year's Day, 1935, he wrote:
I believe myself to be writing a book on economic theory
which will largely revolutionize — not I suppose, at once but in the
course of the next ten years — the way the world thinks about its
economic problems. I can't expect you, or anyone else, to believe this
at the present stage. But for myself I don't merely hope what I say,— in
my own mind, I'm quite sure.
The first chapter of the General theory (only half a page long) has a similarly radical tone:
I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general.
The object of such a title is to contrast the character of my arguments
and conclusions with those of the classical theory of the subject, upon
which I was brought up and which dominates the economic thought, both
practical and theoretical, of the governing and academic classes of this
generation, as it has for a hundred years past. I shall argue that the
postulates of the classical theory are applicable to a special case only
and not to the general case, the situation which it assumes being a
limiting point of the possible positions of equilibrium. Moreover, the
characteristics of the special case assumed by the classical theory
happen not to be those of the economic society in which we actually
live, with the result that its teaching is misleading and disastrous if
we attempt to apply it to the facts of experience.
Summary of the General Theory
Keynes's
main theory (including its dynamic elements) is presented in Chapters
2-15, 18, and 22, which are summarised here. A shorter account will be
found in the article on Keynesian economics. The remaining chapters of Keynes's book contain amplifications of various sorts and are described later in this article.
Book I: Introduction
The first book of the The General Theory of Employment, Interest and Money is a repudiation of Say's Law.
The classical view for which Keynes made Say a mouthpiece held that the
value of wages was equal to the value of the goods produced, and that
the wages were inevitably put back into the economy sustaining demand at
the level of current production. Hence, starting from full employment,
there cannot be a glut of industrial output leading to a loss of jobs.
As Keynes put it on p. 18, "supply creates its own demand".
Stickiness of wages in money terms
Say's
Law depends on the operation of a market economy. If there is
unemployment (and if there are no distortions preventing the employment
market from adjusting to it) then there will be workers willing to offer
their labour at less than the current wage levels, leading to downward
pressure on wages and increased offers of jobs.
The classics held that full employment was the equilibrium
condition of an undistorted labour market, but they and Keynes agreed in
the existence of distortions impeding transition to equilibrium. The
classical position had generally been to view the distortions as the
culprit
and to argue that their removal was the main tool for eliminating
unemployment. Keynes on the other hand viewed the market distortions as
part of the economic fabric and advocated different policy measures
which (as a separate consideration) had social consequences which he
personally found congenial and which he expected his readers to see in
the same light.
The distortions which have prevented wage levels from adapting
downwards have lain in employment contracts being expressed in monetary
terms; in various forms of legislation such as the minimum wage and in
state-supplied benefits; in the unwillingness of workers to accept
reductions in their income; and in their ability through unionisation to
resist the market forces exerting downward pressure on them.
Keynes accepted the classical relation between wages and the marginal productivity of labour, referring to it on page 5 as the "first postulate of classical economics" and summarising it as saying that "The wage is equal to the marginal product of labour".
The first postulate can be expressed in the equation y'(N) = W/p,
where y(N) is the real output when employment is N, and W and p are the
wage rate and price rate in money terms (and hence W/p is the wage rate
in real terms). A system can be analysed on the assumption that W is
fixed (i.e. that wages are fixed in money terms) or that W/p is fixed
(i.e. that they are fixed in real terms) or that N is fixed (e.g. if
wages adapt to ensure full employment). All three assumptions had at
times been made by classical economists, but under the assumption of
wages fixed in money terms the 'first postulate' becomes an equation in
two variables (N and p), and the consequences of this had not been taken
into account by the classical school.
Keynes proposed a 'second postulate of classical economics'
asserting that the wage is equal to the marginal disutility of labour.
This is an instance of wages being fixed in real terms. He attributes
the second postulate to the classics subject to the qualification that
unemployment may result from wages being fixed by legislation,
collective bargaining, or 'mere human obstinacy' (p6), all of which are
likely to fix wages in money terms.
Outline of Keynes's theory
Keynes's
economic theory is based on the interaction between demands for saving,
investment, and liquidity (i.e. money). Saving and investment are
necessarily equal, but different factors influence decisions concerning
them. The desire to save, in Keynes's analysis, is mostly a function of
income: the wealthier people are, the more wealth they will seek to put
aside. The profitability of investment, on the other hand, is
determined by the relation between the return available to capital and
the interest rate. The economy needs to find its way to an equilibrium
in which no more money is being saved than will be invested, and this
can be accomplished by contraction of income and a consequent reduction
in the level of employment.
In the classical scheme it is the interest rate rather than
income which adjusts to maintain equilibrium between saving and
investment; but Keynes asserts that the rate of interest already
performs another function in the economy, that of equating demand and
supply of money, and that it cannot adjust to maintain two separate
equilibria. In his view it is the monetary role which wins out. This is
why Keynes's theory is a theory of money as much as of employment: the
monetary economy of interest and liquidity interacts with the real
economy of production, investment and consumption.
Book II: Definitions and ideas
The choice of units
Keynes sought to allow for the lack of downwards flexibility of wages
by constructing an economic model in which the money supply and wage
rates were externally determined (the latter in money terms), and in
which the main variables were fixed by the equilibrium conditions of
various markets in the presence of these facts.
Many of the quantities of interest, such as income and consumption, are monetary. Keynes often expresses such quantities in wage units
(Chapter 4): to be precise, a value in wage units is equal to its price
in money terms divided by W, the wage (in money units) per man-hour of
labour. Keynes generally writes a subscript w on quantities expressed in
wage units, but in this account we omit the w. When, occasionally, we
use real terms for a value which Keynes expresses in wage units we write
it in lower case (e.g. y rather than Y).
As a result of Keynes's choice of units, the assumption of sticky
wages, though important to the argument, is largely invisible in the
reasoning. If we want to know how a change in the wage rate would
influence the economy, Keynes tells us on p. 266 that the effect is the
same as that of an opposite change in the money supply.
The identity of saving and investment
The
relationship between saving and investment, and the factors influencing
their demands, play an important role in Keynes's model. Saving and
investment are considered to be necessarily equal for reasons set out in
Chapter 6 which looks at economic aggregates from the viewpoint of
manufacturers. The discussion is intricate, considering matters such as
the depreciation of machinery, but is summarised on p. 63:
Provided it is agreed that income is equal to the value
of current output, that current investment is equal to the value of that
part of current output which is not consumed, and that saving is equal
to the excess of income over consumption... the equality of saving and
investment necessarily follows.
This statement incorporates Keynes's definition of saving, which is the normal one.
Book III: The propensity to consume
Keynes's propensities to consume and to save as functions of income Y.
Book III of the General Theory is given over to the propensity
to consume, which is introduced in Chapter 8 as the desired level of
expenditure on consumption (for an individual or aggregated over an
economy). The demand for consumer goods depends chiefly on the income Y
and may be written functionally as C(Y). Saving is that part of income
which is not consumed, so the propensity to save S(Y) is equal to
Y–C(Y). Keynes discusses the possible influence of the interest rate r
on the relative attractiveness of saving and consumption, but regards it
as 'complex and uncertain' and leaves it out as a parameter.
His seemingly innocent definitions embody an assumption whose consequences will be considered later.
Since Y is measured in wage units, the proportion of income saved is
considered to be unaffected by the change in real income resulting from a
change in the price level while wages stay fixed. Keynes acknowledges
that this is undesirable in Point (1) of Section II.
In Chapter 9 he provides a homiletic enumeration of the motives
to consume or not to do so, finding them to lie in social and
psychological considerations which can be expected to be relatively
stable, but which may be influenced by objective factors such as
'changes in expectations of the relation between the present and the
future level of income' (p95).
The marginal propensity to consume and the multiplier
The marginal propensity to consume,
C'(Y), is the gradient of the purple curve, and the marginal propensity
to save S'(Y) is equal to 1–C'(Y). Keynes states as a 'fundamental
psychological law' (p96) that the marginal propensity to consume will be
positive and less than unity.
Chapter 10 introduces the famous 'multiplier' through an example:
if the marginal propensity to consume is 90%, then 'the multiplier k is
10; and the total employment caused by (e.g.) increased public works
will be ten times the employment caused by the public works themselves'
(pp116f). Formally Keynes writes the multiplier as k=1/S'(Y). It follows
from his 'fundamental psychological law' that k will be greater than 1.
Keynes's account is not clear until his economic system has been fully set out (see below). In Chapter 10 he describes his multiplier as being related to the one introduced by R. F. Kahn in 1931. The mechanism of Kahn's multiplier
lies in an infinite series of transactions, each conceived of as
creating employment: if you spend a certain amount of money, then the
recipient will spend a proportion of what he or she receives, the second
recipient will spend a further proportion again, and so forth. Keynes's
account of his own mechanism (in the second para of p. 117) makes no
reference to infinite series. By the end of the chapter on the
multiplier, he uses his much quoted "digging holes" metaphor, against laissez-faire.
In his provocation Keynes argues that "If the Treasury were to fill old
bottles with banknotes, bury them at suitable depths in disused
coalmines which are then filled up to the surface with town rubbish, and
leave it to private enterprise on well-tried principles of
laissez-faire to dig the banknotes up again" (...), there need be no
more unemployment and, with the help of the repercussions, the real
income of the community, and its capital wealth also, would probably
become a good deal greater than it actually is. It would, indeed, be
more sensible to build houses and the like; but if there are political
and practical difficulties in the way of this, the above would be better
than nothing".
Book IV: The inducement to invest
The rate of investment
Keynes's schedule of the marginal efficiency of capital
Book
IV discusses the inducement to invest, with the key ideas being
presented in Chapter 11. The 'marginal efficiency of capital' is defined
as the annual revenue which will be yielded by an extra increment of
capital as a proportion of its cost. The 'schedule of the marginal
efficiency of capital' is the function which, for any rate of interest
r, gives us the level of investment which will take place if all
opportunities are accepted whose return is at least r. By construction
this depends on r alone and is a decreasing function of its argument; it
is illustrated in the diagram, and we shall write it as I (r).
This schedule is a characteristic of the current industrial
process which Irving Fisher described as representing the 'investment
opportunity side of interest theory'; and in fact the condition that it should equal S(Y,r) is the equation which determines the interest rate from income in classical theory. Keynes is seeking to reverse the direction of causality (and omitting r as an argument to S()).
He interprets the schedule as expressing the demand for
investment at any given value of r, giving it an alternative name: "We
shall call this the investment demand-schedule..." (p136). He also
refers to it as the 'demand curve for capital' (p178).
For fixed industrial conditions, we conclude that 'the amount of
investment... depends on the rate of interest' as John Hicks put it in 'Mr. Keynes and the "Classics"'.
Interest and liquidity preference
Keynes
proposes two theories of liquidity preference (i.e. the demand for
money): the first as a theory of interest in Chapter 13 and the second
as a correction in Chapter 15. His arguments offer ample scope for
criticism, but his final conclusion is that liquidity preference is a
function mainly of income and the interest rate. The influence of income
(which really represents a composite of income and wealth) is common
ground with the classical tradition and is embodied in the Quantity Theory; the influence of interest had also been noted earlier, in particular by Frederick Lavington (see Hicks's Mr Keynes and the "Classics").
Thus Keynes's final conclusion may be acceptable to readers who
question the arguments along the way. However he shows a persistent
tendency to think in terms of the Chapter 13 theory while nominally
accepting the Chapter 15 correction.
Chapter 13 presents the first theory in rather metaphysical terms. Keynes argues that:
It should be obvious that the rate of interest cannot be a
return to saving or waiting as such. For if a man hoards his savings in
cash, he earns no interest, though he saves just as much as before. On
the contrary, the mere definition of the rate of interest tells us in so
many words that the rate of interest is the reward for parting with
liquidity for a specified period.
To which Jacob Viner retorted that:
By analogous reasoning he could deny that wages are the
reward for labor, or that profit is the reward for risk-taking, because
labor is sometimes done without anticipation or realization of a return,
and men who assume financial risks have been known to incur losses as a
result instead of profits.
Keynes goes on to claim that the demand for money is a function of the interest rate alone on the grounds that:
The rate of interest is... the "price" which equilibrates
the desire to hold wealth in the form of cash with the available
quantity of cash.
Frank Knight commented that this seems to assume that demand is simply an inverse function of price. The upshot from these reasonings is that:
Liquidity-preference is a potentiality or functional
tendency, which fixes the quantity of money which the public will hold
when the rate of interest is given; so that if r is the rate of
interest, M the quantity of money and L the function of
liquidity-preference, we have M = L(r). This is where, and how, the
quantity of money enters into the economic scheme.
And specifically it determines the rate of interest, which therefore
cannot be determined by the traditional factors of 'productivity and
thrift'.
Chapter 15 looks in more detail at the three motives Keynes
ascribes for the holding of money: the 'transactions motive', the
'precautionary motive', and the 'speculative motive'. He considers that
demand arising from the first two motives 'mainly depends on the level
of income' (p199), while the interest rate is 'likely to be a minor
factor' (p196).
Keynes treats the speculative demand for money as a function of r
alone without justifying its independence of income. He says that...
what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level...
but gives reasons to suppose that demand will nonetheless tend to
decrease as r increases. He thus writes liquidity preference in the form
L1(Y)+L2(r) where L1 is the sum of transaction and precautionary demands and L2
measures speculative demand. The structure of Keynes's expression plays
no part in his subsequent theory, so it does no harm to follow Hicks by
writing liquidity preference simply as L(Y,r).
'The quantity of money as determined by the action of the central
bank' is taken as given (i.e. exogenous - p. 247) and constant (because
hoarding is ruled out on page 174 by the fact that the necessary
expansion of the money supply cannot be 'determined by the public').
Keynes does not put a subscript 'w' on L or M, implying that we
should think of them in money terms. This suggestion is reinforced by
his wording on page 172 where he says "Unless we measure
liquidity-preference in terms of wage-units (which is convenient in some
contexts)... ". But seventy pages later there is a fairly clear
statement that liquidity preference and the quantity of money are indeed
"measured in terms of wage-units" (p246).
The Keynesian economic system
Keynes's economic model
In
Chapter 14 Keynes contrasts the classical theory of interest with his
own, and in making the comparison he shows how his system can be applied
to explain all the principal economic unknowns from the facts he takes
as given. The two topics can be treated together because they are
different ways of analysing the same equation.
Keynes's presentation is informal. To make it more precise we
will identify a set of 4 variables – saving, investment, the rate of
interest, and the national income – and a parallel set of 4 equations
which jointly determine them. The graph illustrates the reasoning. The
red S lines are shown as increasing functions of r in obedience to
classical theory; for Keynes they should be horizontal.
Graphical representation of Keynes's economic model, based on his own diagram at page 180 of the General Theory.
The
first equation asserts that the reigning rate of interest r̂ is
determined from the amount of money in circulation M̂ through the
liquidity preference function and the assumption that L(r̂)=M̂.
The second equation fixes the level of investment Î given the
rate of interest through the schedule of the marginal efficiency of
capital as I(r̂).
The third equation tells us that saving is equal to investment:
S(Y)=Î. The final equation tells us that the income Ŷ is the value of Y
corresponding to the implied level of saving.
All this makes a satisfying theoretical system.
Three comments can be made concerning the argument. Firstly, no
use is made of the 'first postulate of classical economics', which can
be called on later to set the price level. Secondly, Hicks (in 'Mr
Keynes and the "Classics"') presents his version of Keynes's system with
a single variable representing both saving and investment; so his
exposition has three equations in three unknowns.
And finally, since Keynes's discussion takes place in Chapter 14,
it precedes the modification which makes liquidity preference depend on
income as well as on the rate of interest. Once this modification has
been made the unknowns can no longer be recovered sequentially.
Keynesian economic intervention
The
state of the economy, according to Keynes, is determined by four
parameters: the money supply, the demand functions for consumption (or
equivalently for saving) and for liquidity, and the schedule of the
marginal efficiency of capital determined by 'the existing quantity of
equipment' and 'the state of long-term expectation' (p246).Adjusting the
money supply is the domain of monetary policy.
The effect of a change in the quantity of money is considered at
p. 298. The change is effected in the first place in money units.
According to Keynes's account on p. 295, wages will not change if there
is any unemployment, with the result that the money supply will change
to the same extent in wage units.
We can then analyse its effect from the diagram, in which we see
that an increase in M̂ shifts r̂ to the left, pushing Î upwards and
leading to an increase in total income (and employment) whose size
depends on the gradients of all 3 demand functions. If we look at the
change in income as a function of the upwards shift of the schedule of
the marginal efficiency of capital (blue curve), we see that as the
level of investment is increased by one unit, the income must adjust so
that the level of saving (red curve) is one unit greater, and hence the
increase in income must be
1/S'(Y) units, i.e. k units. This is the explanation of Keynes's
multiplier.
It does not necessarily follow that individual decisions to
invest will have a similar effect, since decisions to invest above the
level suggested by the schedule of the marginal efficiency of capital
are not the same thing as an increase in the schedule.
The equations of Keynesian and classical economics
Keynes's
initial statement of his economic model (in Chapter 14) is based on his
Chapter 13 theory of liquidity preference. His restatement in Chapter
18 doesn't take full account of his Chapter 15 revision, treating it as a
source of 'repercussions' rather than as an integral component. It was
left to John Hicks to give a satisfactory presentation.
Equilibrium between supply and demand of money depends on two variables
– interest rate and income – and these are the same two variables as
are related by the equation between the propensity to save and the
schedule of the marginal efficiency of capital. It follows that neither
equation can be solved in isolation and that they need to be considered
simultaneously.
The 'first postulate' of classical economics was also accepted as
valid by Keynes, though not used in the first four books of the General Theory.
The Keynesian system can thus be represented by three equations in
three variables as shown below, roughly following Hicks. Three analogous
equations can be given for classical economics. As presented below they
are in forms given by Keynes himself (the practice of writing r as an
argument to V derives from his Treatise on money).
Here y is written as a function of N, the number of workers employed;
p is the price (in money terms) of a unit of real output; V(r) is the
velocity of money; and W is the wage rate in money terms. N, p and r are
the 3 variables we need to recover. In the Keynesian system income is
measured in wage units and is therefore not a function of the level of
employment alone since it will also vary with prices. The first
postulate assumes that prices can be represented by a single variable.
Strictly it should be modified to take account of the distinction
between marginal wage cost and marginal prime cost.
The classics took the second equation as determining the rate of
interest, the third as determining the price level, and the first as
determining employment. Keynes believed that the last two equations
could be solved together for Y and r, which is not possible in the
classical system.
He accordingly concentrated on these two equations, treating income as
'almost the same thing' as employment on p. 247. Here we see the benefit
he has gained by simplifying the form of the consumption function. If
he had written it (slightly more accurately) as C(Y,p/W), then he would
have needed to bring in the first equation to get a solution.
The classical theory of employment for wages fixed in money terms. (The three curves have different vertical scales.)
If
we wish to examine the classical system our task is made easier if we
assume that the effect of the interest rate on the velocity of
circulation is small enough to be ignored. This allows us to treat V as
constant and solve the first and third equations (the 'first postulate'
and the quantity theory) together, leaving the second equation to
determine the interest rate from the result. We then find that the level of employment is given by the formula
.
The graph shows the numerator and denominator of the left-hand
side as blue and green curves; their ratio – the pink curve – will be a
decreasing function of N even if we don't assume diminishing marginal
returns. The level of employment N̂ is given by the horizontal position
at which the pink curve has a value of , and this is evidently a decreasing function of W.
Chapter 3: The principle of effective demand
The
theoretical system we have described is developed over chapters 4–18,
and is anticipated by a chapter which interprets Keynesian unemployment
in terms of 'aggregate demand'.
The aggregate supply Z is the total value of output when N
workers are employed, written functionally as φ(N). The aggregate
demand D is manufacturers' expected proceeds, written as f(N). In
equilibrium Z=D. D can be decomposed as D1+D2 where D1 is the propensity to consume, which may be written C(Y) or χ(N). D2 is explained as 'the volume of investment', and the equilibrium condition determining the level of employment is that D1+D2 should equal Z as functions of N. D2 can be identified with I (r).
The meaning of this is that in equilibrium the total demand for
goods must equal total income. Total demand for goods is the sum of
demand for consumption goods and demand for investment goods. Hence
Y = C(Y) + S(Y) = C(Y) + I (r); and this equation determines a unique
value of Y given r.
Chapter 5: Expectation as determining output and employment
Chapter
5 makes some common-sense observations on the role of expectation in
economics. Short-term expectations govern the level of production chosen
by an entrepreneur while long-term expectations govern decisions to
adjust the level of capitalisation. Keynes describes the process by
which the level of employment adapts to a change in long-term
expectations and remarks that:
The level of employment at any time depends... not merely
on the existing state of expectation but on the states of expectation
which have existed over a certain past period. Nevertheless past
expectations, which have not yet worked themselves out, are embodied in
to-day's capital equipment... and only influence [the entrepreneur's]
decisions in so far as they are so embodied.
Chapter 11: Expectation as influencing the schedule of the marginal efficiency of capital
The
main role of expectation in Keynes's theory lies in the schedule of the
marginal efficiency of capital which, as we have seen, is defined in
Chapter 11 in terms of expected returns. Keynes differs here from Fisher
whom he largely follows, but who defined the 'rate of return over cost'
in terms of an actual revenue stream rather than its expectation. The
step Keynes took here has a particular significance in his theory.
Chapters 14, 18: The schedule of the marginal efficiency of capital as influencing employment
Keynes
differed from his classical predecessors in assigning a role to the
schedule of the marginal efficiency of capital in determining the level
of employment. Its effect is mentioned in his presentations of his
theory in Chapters 14 and 18 (see above).
Chapter 12: Animal spirits
Chapter 12 discusses the psychology of speculation and enterprise.
Most, probably, of our decisions to do something
positive, the full consequences of which will be drawn out over days to
come, can only be taken as a result of animal spirits – of a spontaneous
urge to action rather than inaction, and not as the outcome of a
weighted average of quantified benefits... Thus if the animal spirits
are dimmed and spontaneous optimism falters, leaving us to depend on
nothing but a mathematical expectation, enterprise will fade and die.
Keynes's picture of the psychology of speculators is less indulgent.
In point of fact, all sorts of considerations enter into
the market valuation which are in no way relevant to the prospective
yield... The recurrence of a bank-holiday may raise the market valuation
of the British railway system by several million pounds.
(Henry Hazlitt examined some railway share prices and found that they did not bear out Keynes's assertion.)
Keynes considers speculators to be concerned...
...not with what an investment is really worth to a man
who buys it 'for keeps', but with what the market will value it at,
under the influence of mass psychology, three months or a year hence...
This battle of wits to anticipate the basis of conventional
valuation a few months hence, rather than the prospective yield of an
investment over a long term of years, does not even require gulls
amongst the public to feed the maws of the professional;– it can be
played by professionals amongst themselves. Nor is it necessary that
anyone should keep his simple faith in the conventional basis of
valuation having any genuine long-term validity. For it is, so to speak,
a game of Snap, of Old Maid, of Musical Chairs – a pastime in which he
is victor who says Snap neither too soon nor too late, who passed the
Old Maid to his neighbour before the game is over, who secures a chair
for himself when the music stops. These games can be played with zest
and enjoyment, though all the players know that it is the Old Maid which
is circulating, or that when the music stops some of the players will
find themselves unseated.
Or, to change the metaphor slightly, professional investment may
be likened to those newspaper competitions in which the competitors have
to pick out the six prettiest faces from a hundred photographs, the
prize being awarded to the competitor whose choice most nearly
corresponds to the average preferences of the competitors as a whole; so
that each competitor has to pick, not those faces which he himself
finds prettiest, but those which he thinks likeliest to catch the fancy
of the other competitors, all of whom are looking at the problem from
the same point of view. It is not a case of choosing those which, to the
best of one's judgment, are really the prettiest, nor even those which
average opinion genuinely thinks the prettiest. We have reached the
third degree where we devote our intelligences to anticipating what
average opinion expects the average opinion to be. And there are some, I
believe, who practise the fourth, fifth and higher degrees.
Chapter 21: Wage behaviour
Keynes's
theory of the trade cycle is a theory of the slow oscillation of money
income which requires it to be possible for income to move upwards or
downwards. If he had assumed that wages were constant, then upward
motion of income would have been impossible at full employment, and he
would have needed some mechanism to frustrate upward pressure if it
arose in such circumstances.
His task is made easier by a less restrictive (but nonetheless crude) assumption concerning wage behaviour:
let us simplify our assumptions still further, and
assume... that the factors of production... are content with the same
money-wage so long as there is a surplus of them unemployed... ; whilst
as soon as full employment is reached, it will thenceforward be the
wage-unit and prices which will increase in exact proportion to the
increase in effective demand.
Chapter 22: The trade cycle
Keynes's theory of the trade cycle
is based on 'a cyclical change in the marginal efficiency of capital'
induced by 'the uncontrollable and disobedient psychology of the
business world' (pp313, 317).
The marginal efficiency of capital depends... on current
expectations... But, as we have seen, the basis for such expectations is
very precarious. Being based on shifting and unreliable evidence, they
are subject to sudden and violent changes.
Optimism leads to a rise in the marginal efficiency of capital and
increased investment, reflected – through the multiplier – in an even
greater increase in income until 'disillusion falls upon an
over-optimistic and over-bought market' which consequently falls with
'sudden and even catastrophic force' (p316).
There are reasons, given firstly by the length of life of
durable assets... and secondly by the carrying-costs of surplus stocks,
why the duration of the downward movement should have an order of
magnitude... between, let us say, three and five years.
And a half cycle of 5 years tallies with Jevons's sunspot cycle length of 11 years.
Income fluctuates cyclically in Keynes's theory, with the effect
being borne by prices if income increases during a period of full
employment, and by employment in other circumstances.
Wage behaviour and the Phillips curve
Keynes's
assumption about wage behaviour has been the subject of much criticism.
It is likely that wage rates adapt partially to depression conditions,
with the consequence that effects on employment are weaker than his
model implies, but not that they disappear.
Lerner pointed out in the 40s that it was optimistic to hope that
the workforce would be content with fixed wages in the presence of
rising prices, and proposed a modification to Keynes's model. After this
a succession of more elaborate models were constructed, many associated
with the Phillips curve.
Keynes's optimistic prediction that an increase in money supply would be taken up by an increase in employment led to Jacob Viner's
pessimistic prediction that "in a world organized in accordance with
Keynes' specifications there would be a constant race between the
printing press and the business agents of the trade unions".
Models of wage pressure on the economy needed frequent correction
and the standing of Keynesian theory suffered. Geoff Tily wrote
ruefully:
Finally, the most destructive step of all was Samuelson's and [Robert] Solow's
incorporation of the Phillips curve into 'Keynesian' theory in a manner
which traduced not only Phillips but also Keynes's careful work in the General Theory,
Chapter 21, substituting for its subtlety an immutable relationship
between inflation and employment. The 1970s combination of inflation and
stagnating economic activity was at odds with this relationship, and
therefore 'Keynesianism', and by association Keynes were rejected.
Monetarism was merely waiting in the wings for this to happen.
Keynes's assumption of wage behaviour was not an integral part of his
theory – very little in his book depends on it – and was avowedly a
simplification: in fact it was the simplest assumption he could make
without imposing an unnatural cap on money income.
The writing of the General Theory
Keynes drew a lot of help from his students in his progress from the Treatise on Money (1930) to the General Theory (1936). The Cambridge Circus, a discussion group founded immediately after the publication of the earlier work, reported to Keynes through Richard Kahn, and drew his attention to a supposed fallacy in the Treatise where Keynes had written:
Thus profits, as a source of capital increment for
entrepreneurs, are a widow's cruse which remains undepleted however much
of them may be devoted to riotous living.
The Circus disbanded in May 1931, but three of its member - Kahn, Austin and Joan Robinson
– continued to meet in the Robinsons' house in Trumpington St.
(Cambridge), forwarding comments to Keynes. This led to a 'Manifesto' of
1932 whose ideas were taken up by Keynes in his lectures.
Kahn and Joan Robinson were well versed in marginalist theory which
Keynes did not fully understand at the time (or possibly ever), pushing him towards adopting elements of it in the General Theory. During 1934 and 1935 Keynes submitted drafts to Kahn, Robinson and Roy Harrod for comment.
There has been uncertainty ever since over the extent of the collaboration, Schumpeter describing Kahn's "share in the historic achievement" as not having "fallen very far short of co-authorship" while Kahn denied the attribution.
Keynes's method of writing was unusual:
Keynes drafted rapidly in pencil, reclining in an
armchair. The pencil draft he sent straight to the printers. They
supplied him with a considerable number of galley proofs, which he would
then distribute to his advisers and critics for comment and amendment.
As he published on his own account, Macmillan & Co., the
'publishers' (in reality they were distributors), could not object to
the expense of Keynes' method of operating. They came out of Keynes'
profit (Macmillan & Co. merely received a commission). Keynes'
object was to simplify the process of circulating drafts; and eventually
to secure good sales by fixing the retail price lower than would
Macmillan & Co.
The advantages of self-publication can be seen from Étienne Mantoux's review:
When he published The General Theory of Employment, Interest and Money
last year at the sensational price of 5 shillings, J. M. Keynes perhaps
meant to express a wish for the broadest and earliest possible
dissemination of his new ideas.
Chronology
Keynes's work on the General Theory began as soon as his Treatise on Money had been published in 1930. He was already dissatisfied with what he had written and wanted to extend the scope of his theory to output and employment. By September 1932 he was able to write to his mother: 'I have written nearly a third of my new book on monetary theory'.
In autumn 1932 he delivered lectures at Cambridge under the title
'the monetary theory of production' whose content was close to the Treatise
except in giving prominence to a liquidity preference theory of
interest. There was no consumption function and no theory of effective
demand. Wage rates were discussed in a criticism of Pigou.
In autumn 1933 Keynes's lectures were much closer to the General Theory,
including the consumption function, effective demand, and a statement
of 'the inability of workers to bargain for a market-clearing real wage
in a monetary economy'. All that was missing was a theory of investment.
By spring 1934 Chapter 12 was in its final form.
His lectures in autumn of that year bore the title 'the general theory of employment'.
In these lectures Keynes presented the marginal efficiency of capital
in much the same form as it took in Chapter 11, his 'basic chapter' as
Kahn called it. He gave a talk on the same subject to economists at Oxford in February 1935.
This was the final building block of the General Theory. The book was finished in December 1935 and published in February 1936.
Observations on its readability
Keynes was an associate of Lytton Strachey and shared much of his outlook. Many economists found General Theory difficult to read, with Étienne Mantoux calling it obscure, Frank Knight calling it difficult to follow, Michel DeVroey commenting that "many passages of his book were almost indecipherable", and Paul Samuelson calling the analysis "unpalatable" and incomprehensible.
Raúl Rojas dissents, saying that "obscure neo-classical
reinterpretations" are "completely pointless since Keynes' book is so
readable".
Inessential chapters
Chapter 16: Sundry observations on the nature of capital
§I: Say's Law
Keynes
reiterates his denial that an act of saving constitutes an act of
investment. A formulation of classical macroeconomics in three equations was given above as follows:
y'(N) = W/p i (r) = s(y(N),r) M̂ = p·y(N) / V(r)
The role of Say's Law in Keynes's interpretation of them can be seen if we split the second equation into two components:
i (r) = id(y(N),r) id(y(N),r) = s(y(N),r)
the first of which asserts the equilibrium between investment and its
corresponding demand, and the second of which identifies the demand for
investment with the desired level of saving. In rejecting the second
component Keynes denies that the total demand for goods in an economy is
identical with its total income – i.e. that supply creates its own
demand – and is therefore able to make their equality an equilibrium
condition.
Chapter 16 contains a few statements in support of the view that
saving does not necessarily add to the demand for capital goods.
An act of individual saving means – so to speak – a decision not to have dinner to-day. But it does not
necessitate a decision to have dinner or to buy a pair of boots a week
hence or a year hence or to consume any specified thing at any specified
date.
... an individual decision to save does not, in actual
fact, involve the placing of any specific forward order for consumption,
but merely the cancellation of a present order.
He adds that:
The absurd, though almost universal, idea that an act of
individual saving is just as good for effective demand as an act of
individual consumption, has been fostered by the fallacy... that an
increased desire to hold wealth, being much the same thing as an
increased desire to hold investments, must, by increasing the demand for
investments, provide a stimulus to their production; so that current
investment is promoted by individual saving to the same extent as
present consumption is diminished.
It is in this chapter that Keynes mentions "the ownership of money
and debts" as "an alternative to the ownership of real capital-assets"
(p212). On the same page he draws attention to what he considers to be
the error of...
... believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield.
§II–IV: The declining yield of capital
Keynes
argues that the value of capital derives from its scarcity and
sympathises with 'the pre-classical doctrine that everything is produced by labour' (p213). The preference for direct over roundabout processes will depend on the rate of interest.
He wonders what would happen to 'a society which finds itself so
well equipped with capital that its marginal efficiency is zero' while
money provides a safe outlet for savings. He does not consider this
hypothesis far-fetched: on the contrary...
... a properly run community... ought to be able to bring
down the marginal efficiency of capital in equilibrium approximately to
zero within a single generation...
He asserts that...
... the position of equilibrium, under conditions of laissez-faire, will be one in which employment is low enough and the standard of life sufficiently miserable to bring savings to zero'.
The misery does not depend on any assumption of static wages. If the
return to capital falls to zero then according to Keynes's theory there
will be no investment, and income must collapse to the point at which
the propensity to save disappears. However his conclusions are not
pessimistic because he postulates that steps may be taken to adjust the
interest rate to ensure full employment (p220), that 'enormous social
changes would result' and that 'this may be the most sensible way of
getting rid of many of the objectionable features of capitalism' (p221).
Chapter 17: The essential properties of interest and money
Keynes
begins by defining 'own rates of interest'. If the market price for
purchasing the commitment to supply a bushel of wheat every year in
perpetuity was the price of 50 bushels, then the 'wheat rate of
interest' would be 2%. He then tries to find the property which
justifies us in regarding the money rate as the true rate. His arguments
didn't satisfy his supporters who accepted Pigou's contention that it makes no difference which rate is used.
Hazlitt went further, considering the very concept of an own rate
of interest to be 'one of the most incredible' of the 'confusions in
the General Theory.
Book V: Money-wages and prices
Chapter 23: Notes on mercantilism
In
§I–IV Keynes gives a sympathetic notice to the 17th century
mercantilists who, like himself, believed interest to be a monetary
phenomenon and saw high interest rates as harmful. He accepts their
conclusion that in principle export restrictions may prevent the flow of
money abroad and lead to economic advantages at home.
For similar reasons Keynes sees justice in scholastic prohibitions of usury. He remarks in §V that Adam Smith had supported a maximum legal rate of interest. Smith's reasoning – certainly surprising from the proponent of the 'invisible hand'
of markets – was based on a fear that a high rate of interest would
lead to loans being cornered by spendthrifts and get-rich-quick
'projectors'.
§VI is devoted to the theories of 'the strange, unduly neglected prophet Silvio Gesell'
who had proposed a system of 'stamped money' to artificially increase
the carrying costs of money. 'The idea behind stamped money is sound',
says Keynes, but subject to technical difficulties, one of which is the
existence of other outlets for liquidity preference such as jewellery
and formerly land. It is interesting that Keynes considered durable
assets to be as much a problem as banknotes: even when they satisfy the
same motives for ownership, they lack the property that wages are fixed
in terms of them.
Keynes's final brief survey in §VII is of theories of underconsumption. Bernard Mandeville in the early 18th century and Hobson and Mummery in the late 19th were amongst those who believed that private thrift was the source of public poverty rather than riches.
Chapter 24: Concluding notes on social philosophy
Saving
does not, in Keynes's view, engender investment, but rather impedes it
by reducing the likely return to capital: "One of the chief social
justifications of great inequality of wealth is, therefore, removed"
(p373).
It would not be difficult to increase the stock of
capital up to a point where its marginal efficiency had fallen to a very
low figure... [This] would mean the euthanasia of the rentier, and,
consequently, the euthanasia of the cumulative oppressive power of the
capitalist to exploit the scarcity-value of capital... it will still be
possible for communal saving through the agency of the State to be
maintained at a level which will allow the growth of capital up to the
point where it ceases to be scarce... And it would remain for separate
decision on what scale and by what means it is right and reasonable to
call on the living generation to restrict their consumption, so as to
establish in course of time, a state of full investment for their
successors.
In some other respects the foregoing theory is moderately
conservative in its implications... Thus, apart from the necessity of
central controls to bring about an adjustment between the propensity to
consume and the inducement to invest, there is no more reason to
socialise economic life than there was before.
... the ideas of economists and political philosophers,
both when they are right and when they are wrong, are more powerful than
is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct
economist. Madmen in authority, who hear voices in the air, are
distilling their frenzy from some academic scribbler of a few years
back... But, soon or late, it is ideas, not vested interests, which are
dangerous for good or evil.
Reception
Keynes did not set out a detailed policy program in The General Theory, but he went on in practice to place great emphasis on the reduction of long-term interest rates and the reform of the international monetary system as structural measures needed to encourage both investment and consumption by the private sector. Paul Samuelson
said that the General Theory "caught most economists under the age of
35 with the unexpected virulence of a disease first attacking and
decimating an isolated tribe of South Sea islanders."
Praise
Many of the innovations introduced by The General Theory continue to be central to modern macroeconomics. For instance, the idea that recessions reflect inadequate aggregate demand and that Say's Law (in Keynes's formulation, that "supply creates its own demand")
does not hold in a monetary economy. President Richard Nixon famously
said in 1971 (ironically, shortly before Keynesian economics fell out of
fashion) that "We are all Keynesians now", a phrase often repeated by Nobel laureate Paul Krugman (but originating with anti-Keynesian economist Milton Friedman, said in a way different from Krugman's interpretation). Nevertheless, starting with Axel Leijonhufvud, this view of Keynesian economics came under increasing challenge and scrutiny and has now divided into two main camps.
The majority new consensus view, found in most current text-books and taught in all universities, is New Keynesian economics, which accepts the neoclassical concept of long-run equilibrium but allows a role for aggregate demand
in the short run. New Keynesian economists pride themselves on
providing microeconomic foundations for the sticky prices and wages
assumed by Old Keynesian economics. They do not regard The General Theory itself as helpful to further research. The minority view is represented by post-Keynesian economists, all of whom accept Keynes's fundamental critique of the neoclassical concept of long-run equilibrium, and some of whom think The General Theory has yet to be properly understood and repays further study.
In 2011, the book was placed on Time's top 100 non-fiction books written in English since 1923.
Criticisms
From the outset there has been controversy over what Keynes really
meant. Many early reviews were highly critical. The success of what came
to be known as "neoclassical synthesis" Keynesian economics owed a great deal to the Harvard economist Alvin Hansen and MIT economist Paul Samuelson as well as to the Oxford economist John Hicks. Hansen and Samuelson offered a lucid explanation of Keynes's theory of aggregate demand with their elegant 45° Keynesian cross diagram while Hicks created the IS-LM diagram. Both of these diagrams can still be found in textbooks. Post-Keynesians argue that the neoclassical Keynesian model is completely distorting and misinterpreting Keynes' original meaning.
Just as the reception of The General Theory was encouraged by the 1930s experience of mass unemployment, its fall from favour was associated with the 'stagflation' of the 1970s. Although few modern economists would disagree with the need for at least some intervention, policies such as labour market flexibility are underpinned by the neoclassical notion of equilibrium in the long run. Although Keynes explicitly addresses inflation, The General Theory
does not treat it as an essentially monetary phenomenon or suggest that
control of the money supply or interest rates is the key remedy for
inflation, unlike neoclassical theory.
Lastly, Keynes' economic theory was criticized by Marxian economists,
who said that Keynes ideas, while good intentioned, cannot work in the
long run due to the contradictions in capitalism. A couple of these,
that Marxians point to are the idea of full employment, which is seen as
impossible under private capitalism; and the idea that government can
encourage capital investment through government spending, when in
reality government spending could be a net loss on profits.
Keynesian economists generally argue that aggregate demand is volatile and unstable and that, consequently, a market economy often experiences inefficient macroeconomic outcomes – a recession,
when demand is low, and inflation, when demand is high. Further, they
argue that these economic fluctuations can be mitigated by economic
policy responses coordinated between government and central bank. In particular, fiscal policy actions (taken by the government) and monetary policy actions (taken by the central bank), can help stabilize economic output, inflation, and unemployment over the business cycle.
Keynesian economists generally advocate a market economy –
predominantly private sector, but with an active role for government
intervention during recessions and depressions.
Macroeconomics
is the study of the factors applying to an economy as a whole.
Important macroeconomic variables include the overall price level, the
interest rate, the level of employment, and income (or equivalently
output) measured in real terms.
The classical tradition of partial equilibrium theory
had been to split the economy into separate markets, each of whose
equilibrium conditions could be stated as a single equation determining a
single variable. The theoretical apparatus of supply and demand curves developed by Fleeming Jenkin and Alfred Marshall provided a unified mathematical basis for this approach, which the Lausanne School generalized to general equilibrium theory.
For macroeconomics, relevant partial theories included the Quantity theory of money determining the price level and the classical theory of the interest rate.
In regards to employment, the condition referred to by Keynes as the
"first postulate of classical economics" stated that the wage is equal
to the marginal product, which is a direct application of the marginalist principles developed during the nineteenth century (see The General Theory). Keynes sought to supplant all three aspects of the classical theory.
Precursors of Keynesianism
Although Keynes's work was crystallized and given impetus by the advent of the Great Depression, it was part of a long-running debate within economics over the existence and nature of general gluts.
A number of the policies Keynes advocated to address the Great
Depression (notably government deficit spending at times of low private
investment or consumption), and many of the theoretical ideas he
proposed (effective demand, the multiplier, the paradox of thrift), had
been advanced by various authors in the 19th and early 20th centuries.
Keynes's unique contribution was to provide a general theory of these, which proved acceptable to the economic establishment.
Numerous concepts were developed earlier and independently of Keynes by the Stockholm school during the 1930s; these accomplishments were described in a 1937 article, published in response to the 1936 General Theory, sharing the Swedish discoveries.
The paradox of thrift was stated in 1892 by John M. Robertson in his The Fallacy of Saving, in earlier forms by mercantilist economists since the 16th century, and similar sentiments date to antiquity.
Keynes's early writings
In 1923 Keynes published his first contribution to economic theory, A Tract on Monetary Reform, whose point of view is classical but incorporates ideas that later played a part in the General Theory. In particular, looking at the hyperinflation in European economies, he drew attention to the opportunity cost of holding money (identified with inflation rather than interest) and its influence on the velocity of circulation.
In 1930 he published A Treatise on Money,
intended as a comprehensive treatment of its subject "which would
confirm his stature as a serious academic scholar, rather than just as
the author of stinging polemics", and marks a large step in the direction of his later views. In it, he attributes unemployment to wage stickiness and treats saving and investment as governed by independent decisions: the former varying positively with the interest rate, the latter negatively. The velocity of circulation is expressed as a function of the rate of interest. He interpreted his treatment of liquidity as implying a purely monetary theory of interest.
Keynes's younger colleagues of the Cambridge Circus and Ralph Hawtrey believed that his arguments implicitly assumed full employment, and this influenced the direction of his subsequent work. During 1933, he wrote essays on various economic topics "all of which are cast in terms of movement of output as a whole".
Development of The General Theory
At the time that Keynes's wrote the General Theory,
it had been a tenet of mainstream economic thought that the economy
would automatically revert to a state of general equilibrium: it had
been assumed that, because the needs of consumers are always greater
than the capacity of the producers to satisfy those needs, everything
that is produced would eventually be consumed once the appropriate price
was found for it. This perception is reflected in Say's law and in the writing of David Ricardo,
which states that individuals produce so that they can either consume
what they have manufactured or sell their output so that they can buy
someone else's output. This argument rests upon the assumption that if a
surplus of goods or services exists, they would naturally drop in price
to the point where they would be consumed.
Given the backdrop of high and persistent unemployment during the
Great Depression, Keynes argued that there was no guarantee that the
goods that individuals produce would be met with adequate effective
demand, and periods of high unemployment could be expected, especially
when the economy was contracting in size. He saw the economy as unable
to maintain itself at full employment automatically, and believed that
it was necessary for the government to step in and put purchasing power
into the hands of the working population through government spending.
Thus, according to Keynesian theory, some individually rational microeconomic-level
actions such as not investing savings in the goods and services
produced by the economy, if taken collectively by a large proportion of
individuals and firms, can lead to outcomes wherein the economy operates
below its potential output and growth rate.
Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut,
although there was disagreement among them as to whether a general glut
was possible. Keynes argued that when a glut occurred, it was the
over-reaction of producers and the laying off of workers that led to a
fall in demand and perpetuated the problem. Keynesians therefore
advocate an active stabilization policy to reduce the amplitude of the
business cycle, which they rank among the most serious of economic
problems. According to the theory, government spending can be used to
increase aggregate demand, thus increasing economic activity, reducing
unemployment and deflation.
Origins of the multiplier
The Liberal Party
fought the 1929 General Election on a promise to "reduce levels of
unemployment to normal within one year by utilising the stagnant labour
force in vast schemes of national development". David Lloyd George launched his campaign in March with a policy document, We can cure unemployment, which tentatively claimed that, "Public works would lead to a second round of spending as the workers spent their wages." Two months later Keynes, then nearing completion of his Treatise on money, and Hubert Henderson
collaborated on a political pamphlet seeking to "provide academically
respectable economic arguments" for Lloyd George's policies. It was titled Can Lloyd George do it? and endorsed the claim that "greater trade activity would make for greater trade activity ... with a cumulative effect". This became the mechanism of the "ratio" published by Richard Kahn in his 1931 paper "The relation of home investment to unemployment", described by Alvin Hansen as "one of the great landmarks of economic analysis". The "ratio" was soon rechristened the "multiplier" at Keynes's suggestion.
The multiplier of Kahn's paper is based on a respending mechanism familiar nowadays from textbooks. Samuelson puts it as follows:
Let’s suppose that I hire unemployed resources to build a
$1000 woodshed. My carpenters and lumber producers will get an extra
$1000 of income... If they all have a marginal propensity to consume of
2/3, they will now spend $666.67 on new consumption goods. The producers
of these goods will now have extra incomes... they in turn will spend
$444.44 ... Thus an endless chain of secondary consumption respending is set in motion by my primary investment of $1000.
Samuelson's treatment closely follows Joan Robinson's account of 1937
and is the main channel by which the multiplier has influenced
Keynesian theory. It differs significantly from Kahn's paper and even
more from Keynes's book.
The designation of the initial spending as "investment" and the
employment-creating respending as "consumption" echoes Kahn faithfully,
though he gives no reason why initial consumption or subsequent
investment respending shouldn't have exactly the same effects. Henry Hazlitt, who considered Keynes as much a culprit as Kahn and Samuelson, wrote that ...
... in connection with the multiplier (and indeed most of the time) what Keynes is referring to as "investment" really means any addition to spending for any purpose... The word "investment" is being used in a Pickwickian, or Keynesian, sense.
Kahn envisaged money as being passed from hand to hand, creating employment at each step, until it came to rest in a cul-de-sac (Hansen's term was "leakage"); the only culs-de-sac
he acknowledged were imports and hoarding, although he also said that a
rise in prices might dilute the multiplier effect. Jens Warming
recognised that personal saving had to be considered, treating it as a "leakage" (p. 214) while recognising on p. 217 that it might in fact be invested.
The textbook multiplier gives the impression that making society
richer is the easiest thing in the world: the government just needs to
spend more. In Kahn's paper, it is harder. For him, the initial
expenditure must not be a diversion of funds from other uses, but an
increase in the total expenditure: something impossible – if understood
in real terms – under the classical theory that the level of expenditure
is limited by the economy's income/output. On page 174, Kahn rejects
the claim that the effect of public works is at the expense of
expenditure elsewhere, admitting that this might arise if the revenue is
raised by taxation, but says that other available means have no such
consequences. As an example, he suggests that the money may be raised by
borrowing from banks, since ...
... it is always within the power of the banking system
to advance to the Government the cost of the roads without in any way
affecting the flow of investment along the normal channels.
This assumes that banks are free to create resources to answer any demand. But Kahn adds that ...
... no such hypothesis is really necessary. For it will be demonstrated later on that, pari passu
with the building of roads, funds are released from various sources at
precisely the rate that is required to pay the cost of the roads.
The demonstration relies on "Mr Meade's relation" (due to James Meade) asserting that the total amount of money that disappears into culs-de-sac is equal to the original outlay, which in Kahn's words "should bring relief and consolation to those who are worried about the monetary sources" (p. 189).
A respending multiplier had been proposed earlier by Hawtrey in a
1928 Treasury memorandum ("with imports as the only leakage"), but the
idea was discarded in his own subsequent writings. Soon afterwards the Australian economist Lyndhurst Giblin published a multiplier analysis in a 1930 lecture (again with imports as the only leakage). The idea itself was much older. Some Dutch mercantilists had believed in an infinite multiplier for military expenditure (assuming no import "leakage"), since ...
... a war could support itself for an unlimited period if
only money remained in the country ... For if money itself is
"consumed", this simply means that it passes into someone else's
possession, and this process may continue indefinitely.
Multiplier doctrines had subsequently been expressed in more theoretical terms by the Dane Julius Wulff (1896), the Australian Alfred de Lissa (late 1890s), the German/American Nicholas Johannsen (same period), and the Dane Fr. Johannsen (1925/1927). Kahn himself said that the idea was given to him as a child by his father.
Public policy debates
As
the 1929 election approached "Keynes was becoming a strong public
advocate of capital development" as a public measure to alleviate
unemployment. Winston Churchill, the Conservative Chancellor, took the opposite view:
It is the orthodox Treasury dogma, steadfastly held ...
[that] very little additional employment and no permanent additional
employment can, in fact, be created by State borrowing and State
expenditure.
Keynes pounced on a chink in the Treasury view. Cross-examining Sir Richard Hopkins, a Second Secretary in the Treasury, before the Macmillan Committee
on Finance and Industry in 1930 he referred to the "first proposition"
that "schemes of capital development are of no use for reducing
unemployment" and asked whether "it would be a misunderstanding of the
Treasury view to say that they hold to the first proposition". Hopkins
responded that "The first proposition goes much too far. The first
proposition would ascribe to us an absolute and rigid dogma, would it
not?"
Later the same year, speaking in a newly created Committee of
Economists, Keynes tried to use Kahn's emerging multiplier theory to
argue for public works, "but Pigou's and Henderson's objections ensured
that there was no sign of this in the final product".
In 1933 he gave wider publicity to his support for Kahn's multiplier in
a series of articles titled "The road to prosperity" in The Times newspaper.
A. C. Pigou
was at the time the sole economics professor at Cambridge. He had a
continuing interest in the subject of unemployment, having expressed the
view in his popular Unemployment (1913) that it was caused by "maladjustment between wage-rates and demand" – a view Keynes may have shared prior to the years of the General Theory.
Nor were his practical recommendations very different: "on many
occasions in the thirties" Pigou "gave public support ... to State
action designed to stimulate employment".
Where the two men differed is in the link between theory and practice.
Keynes was seeking to build theoretical foundations to support his
recommendations for public works while Pigou showed no disposition to
move away from classical doctrine. Referring to him and Dennis Robertson,
Keynes asked rhetorically: "Why do they insist on maintaining theories
from which their own practical conclusions cannot possibly follow?"
The General Theory
Keynes set forward the ideas that became the basis for Keynesian economics in his main work, The General Theory of Employment, Interest and Money (1936). It was written during the Great Depression,
when unemployment rose to 25% in the United States and as high as 33%
in some countries. It is almost wholly theoretical, enlivened by
occasional passages of satire and social commentary. The book had a
profound impact on economic thought, and ever since it was published
there has been debate over its meaning.
Keynes and classical economics
Keynes begins the General Theory with a summary of the classical theory of employment, which he encapsulates in his formulation of Say's Law as the dictum "Supply creates its own demand".
Under the classical theory, the wage rate is determined by the marginal productivity of labour, and as many people are employed as are willing to work at that rate. Unemployment may arise through friction
or may be "voluntary," in the sense that it arises from a refusal to
accept employment owing to "legislation or social practices ... or mere
human obstinacy", but "...the classical postulates do not admit of the
possibility of the third category," which Keynes defines as involuntary unemployment.
Keynes raises two objections to the classical theory's assumption
that "wage bargains ... determine the real wage". The first lies in the
fact that "labour stipulates (within limits) for a money-wage rather
than a real wage". The second is that classical theory assumes that,
"The real wages of labour depend on the wage bargains which labour makes
with the entrepreneurs," whereas, "If money wages change, one would
have expected the classical school to argue that prices would change in
almost the same proportion, leaving the real wage and the level of
unemployment practically the same as before."
Keynes considers his second objection the more fundamental, but most
commentators concentrate on his first one: it has been argued that the quantity theory of money protects the classical school from the conclusion Keynes expected from it.
Keynesian unemployment
Saving and investment
Saving is that part of income not devoted to consumption, and consumption is that part of expenditure not allocated to investment, i.e., to durable goods.
Hence saving encompasses hoarding (the accumulation of income as cash)
and the purchase of durable goods. The existence of net hoarding, or of a
demand to hoard, is not admitted by the simplified liquidity preference
model of the General Theory.
Once he rejects the classical theory that unemployment is due to
excessive wages, Keynes proposes an alternative based on the
relationship between saving and investment. In his view, unemployment
arises whenever entrepreneurs' incentive to invest fails to keep pace
with society's propensity to save (propensity is one of Keynes's
synonyms for "demand"). The levels of saving and investment are
necessarily equal, and income is therefore held down to a level where
the desire to save is no greater than the incentive to invest.
The incentive to invest arises from the interplay between the
physical circumstances of production and psychological anticipations of
future profitability; but once these things are given the incentive is
independent of income and depends solely on the rate of interest r. Keynes designates its value as a function of r as the "schedule of the marginal efficiency of capital".
The propensity to save behaves quite differently. Saving is simply that part of income not devoted to consumption, and:
... the prevailing psychological law seems to be that
when aggregate income increases, consumption expenditure will also
increase but to a somewhat lesser extent.
Keynes adds that "this psychological law was of the utmost importance in the development of my own thought".
Liquidity preference
Determination of income according to the General Theory
Keynes viewed the money supply
as one of the main determinants of the state of the real economy. The
significance he attributed to it is one of the innovative features of
his work, and was influential on the politically hostile monetarist school.
Money supply comes into play through the liquidity preference
function, which is the demand function that corresponds to money
supply. It specifies the amount of money people will seek to hold
according to the state of the economy. In Keynes's first (and simplest)
account – that of Chapter 13 – liquidity preference is determined solely
by the interest rater—which is seen as the earnings forgone by holding wealth in liquid form: hence liquidity preference can be written L(r ) and in equilibrium must equal the externally fixed money supply M̂.
Keynes’s economic model
Money supply, saving and investment combine to determine the level of income as illustrated in the diagram, where the top graph shows money supply (on the vertical axis) against interest rate. M̂ determines the ruling interest rate r̂ through the liquidity preference function. The rate of interest determines the level of investment Î
through the schedule of the marginal efficiency of capital, shown as a
blue curve in the lower graph. The red curves in the same diagram show
what the propensities to save are for different incomes Y ; and the income Ŷ
corresponding to the equilibrium state of the economy must be the one
for which the implied level of saving at the established interest rate
is equal to Î.
In Keynes's more complicated liquidity preference theory
(presented in Chapter 15) the demand for money depends on income as well
as on the interest rate and the analysis becomes more complicated.
Keynes never fully integrated his second liquidity preference doctrine
with the rest of his theory, leaving that to John Hicks: see the IS-LM model below.
Wage rigidity
Keynes
rejects the classical explanation of unemployment based on wage
rigidity, but it is not clear what effect the wage rate has on
unemployment in his system. He treats wages of all workers as
proportional to a single rate set by collective bargaining, and chooses
his units so that this rate never appears separately in his discussion.
It is present implicitly in those quantities he expresses in wage units,
while being absent from those he expresses in money terms. It is
therefore difficult to see whether, and in what way, his results differ
for a different wage rate, nor is it clear what he thought about the
matter.
Remedies for unemployment
Monetary remedies
An
increase in the money supply, according to Keynes's theory, leads to a
drop in the interest rate and an increase in the amount of investment
that can be undertaken profitably, bringing with it an increase in total
income.
Fiscal remedies
Keynes'
name is associated with fiscal, rather than monetary, measures but they
receive only passing (and often satirical) reference in the General Theory. He mentions "increased public works" as an example of something that brings employment through the multiplier, but this is before he develops the relevant theory, and he does not follow up when he gets to the theory.
Later in the same chapter he tells us that:
Ancient Egypt was doubly fortunate, and doubtless owed to
this its fabled wealth, in that it possessed two activities, namely,
pyramid-building as well as the search for the precious metals, the
fruits of which, since they could not serve the needs of man by being
consumed, did not stale with abundance. The Middle Ages built cathedrals
and sang dirges. Two pyramids, two masses for the dead, are twice as
good as one; but not so two railways from London to York.
But again, he doesn't get back to his implied recommendation to
engage in public works, even if not fully justified from their direct
benefits, when he constructs the theory. On the contrary he later
advises us that ...
... our final task might be to select those variables
which can be deliberately controlled or managed by central authority in
the kind of system in which we actually live ...
and this appears to look forward to a future publication rather than to a subsequent chapter of the General Theory.
Keynesian models and concepts
Aggregate demand
Keynes–Samuelson cross
Keynes' view of saving and investment was his most important
departure from the classical outlook. It can be illustrated using the "Keynesian cross" devised by Paul Samuelson. The horizontal axis denotes total income and the purple curve shows C (Y ), the propensity to consume, whose complement S (Y ) is the propensity to save: the sum of these two functions is equal to total income, which is shown by the broken line at 45°.
The horizontal blue line I (r ) is the schedule of the marginal efficiency of capital whose value is independent of Y.
The schedule of the marginal efficiency of capital is dependent on the
interest rate, specifically the interest rate cost of a new investment.
If the interest rate charged by the financial sector to the productive
sector is below the marginal efficiency of capital at that level of
technology and capital intensity then investment is positive and grows
the lower the interest rate is, given the diminishing return of capital.
If the interest rate is above the marginal efficiency of capital then
investment is equal to zero. Keynes interprets this as the demand for
investment and denotes the sum of demands for consumption and investment
as "aggregate demand",
plotted as a separate curve. Aggregate demand must equal total income,
so equilibrium income must be determined by the point where the
aggregate demand curve crosses the 45° line. This is the same horizontal position as the intersection of I (r ) with S (Y ).
The equation I (r ) = S (Y ) had been
accepted by the classics, who had viewed it as the condition of
equilibrium between supply and demand for investment funds and as
determining the interest rate (see the classical theory of interest). But insofar as they had had a concept of aggregate demand, they had seen the demand for investment as being given by S (Y ),
since for them saving was simply the indirect purchase of capital
goods, with the result that aggregate demand was equal to total income
as an identity rather than as an equilibrium condition. Keynes takes
note of this view in Chapter 2, where he finds it present in the early
writings of Alfred Marshall but adds that "the doctrine is never stated to-day in this crude form".
The equation I (r ) = S (Y ) is accepted by Keynes for some or all of the following reasons:
As a consequence of the principle of effective demand, which asserts that aggregate demand must equal total income (Chapter 3).
As a consequence of the identity of saving with investment (Chapter
6) together with the equilibrium assumption that these quantities are
equal to their demands.
In agreement with the substance of the classical theory of the
investment funds market, whose conclusion he considers the classics to
have misinterpreted through circular reasoning (Chapter 14).
The Keynesian multiplier
Keynes introduces his discussion of the multiplier in Chapter 10 with a reference to Kahn's earlier paper (see below).
He designates Kahn's multiplier the "employment multiplier" in
distinction to his own "investment multiplier" and says that the two are
only "a little different".
Kahn's multiplier has consequently been understood by much of the
Keynesian literature as playing a major role in Keynes's own theory, an
interpretation encouraged by the difficulty of understanding Keynes's
presentation. Kahn's multiplier gives the title ("The multiplier model")
to the account of Keynesian theory in Samuelson's Economics and is almost as prominent in Alvin Hansen's Guide to Keynes and in Joan Robinson's Introduction to the Theory of Employment.
Keynes states that there is ...
... a confusion between the logical theory of the
multiplier, which holds good continuously, without time-lag ... and the
consequence of an expansion in the capital goods industries which take
gradual effect, subject to a time-lag, and only after an interval ...
and implies that he is adopting the former theory.
And when the multiplier eventually emerges as a component of Keynes's
theory (in Chapter 18) it turns out to be simply a measure of the change
of one variable in response to a change in another. The schedule of the
marginal efficiency of capital is identified as one of the independent
variables of the economic system: "What [it] tells us, is ... the point to which the output of new investment will be pushed ..."
The multiplier then gives "the ratio ... between an increment of
investment and the corresponding increment of aggregate income".
G. L. S. Shackle regarded Keynes' move away from Kahn's multiplier as ...
... a retrograde step ... For when we look upon the
Multiplier as an instantaneous functional relation ... we are merely
using the word Multiplier to stand for an alternative way of looking at
the marginal propensity to consume ...
which G. M. Ambrosi cites as an instance of "a Keynesian commentator
who would have liked Keynes to have written something less 'retrograde'".
The value Keynes assigns to his multiplier is the reciprocal of the marginal propensity to save: k = 1 / S '(Y ).
This is the same as the formula for Kahn's mutliplier in a closed
economy assuming that all saving (including the purchase of durable
goods), and not just hoarding, constitutes leakage. Keynes gave his
formula almost the status of a definition (it is put forward in advance
of any explanation).
His multiplier is indeed the value of "the ratio ... between an
increment of investment and the corresponding increment of aggregate
income" as Keynes derived it from his Chapter 13 model of liquidity
preference, which implies that income must bear the entire effect of a
change in investment. But under his Chapter 15 model a change in the
schedule of the marginal efficiency of capital has an effect shared
between the interest rate and income in proportions depending on the
partial derivatives of the liquidity preference function. Keynes did not
investigate the question of whether his formula for multiplier needed
revision.
The liquidity trap
The liquidity trap.
The liquidity trap is a phenomenon that may impede the effectiveness of monetary policies in reducing unemployment.
Economists generally think the rate of interest will not fall
below a certain limit, often seen as zero or a slightly negative number.
Keynes suggested that the limit might be appreciably greater than zero
but did not attach much practical significance to it. The term
"liquidity trap" was coined by Dennis Robertson in his comments on the General Theory, but it was John Hicks in "Mr. Keynes and the Classics" who recognised the significance of a slightly different concept.
If the economy is in a position such that the liquidity
preference curve is almost vertical, as must happen as the lower limit
on r is approached, then a change in the money supply M̂ makes almost no difference to the equilibrium rate of interest r̂ or, unless there is compensating steepness in the other curves, to the resulting income Ŷ. As Hicks put it, "Monetary means will not force down the rate of interest any further."
Paul Krugman has worked extensively on the liquidity trap,
claiming that it was the problem confronting the Japanese economy around
the turn of the millennium. In his later words:
Short-term interest rates were close to zero, long-term
rates were at historical lows, yet private investment spending remained
insufficient to bring the economy out of deflation. In that environment,
monetary policy was just as ineffective as Keynes described. Attempts
by the Bank of Japan to increase the money supply simply added to
already ample bank reserves and public holdings of cash...
The IS–LM model
IS–LM plot
Hicks showed how to analyze Keynes' system when liquidity preference
is a function of income as well as of the rate of interest. Keynes's
admission of income as an influence on the demand for money is a step
back in the direction of classical theory, and Hicks takes a further
step in the same direction by generalizing the propensity to save to
take both Y and r as arguments. Less classically he extends this generalization to the schedule of the marginal efficiency of capital.
The IS-LM model uses two equations to express Keynes' model. The first, now written I (Y, r ) = S (Y,r ), expresses the principle of effective demand. We may construct a graph on (Y, r ) coordinates and draw a line connecting those points satisfying the equation: this is the IS curve. In the same way we can write the equation of equilibrium between liquidity preference and the money supply as L(Y ,r ) = M̂ and draw a second curve – the LM curve – connecting points that satisfy it. The equilibrium values Ŷ of total income and r̂ of interest rate are then given by the point of intersection of the two curves.
If we follow Keynes's initial account under which liquidity preference depends only on the interest rate r, then the LM curve is horizontal.
... modern teaching has been confused by J. R. Hicks' attempt to reduce the General Theory
to a version of static equilibrium with the formula IS–LM. Hicks has
now repented and changed his name from J. R. to John, but it will take a
long time for the effects of his teaching to wear off.
Hicks subsequently relapsed.
Keynesian economic policies
Active fiscal policy
Typical intervention strategies under different conditions
Keynes argued that the solution to the Great Depression was to stimulate the country ("incentive to invest") through some combination of two approaches:
A reduction in interest rates (monetary policy), and
Government investment in infrastructure (fiscal policy).
If the interest rate at which businesses and consumers can borrow
decreases, investments that were previously uneconomic become
profitable, and large consumer sales normally financed through debt
(such as houses, automobiles, and, historically, even appliances like
refrigerators) become more affordable. A principal function of central banks in countries that have them is to influence this interest rate through a variety of mechanisms collectively called monetary policy.
This is how monetary policy that reduces interest rates is thought to
stimulate economic activity, i.e., "grow the economy"—and why it is
called expansionary monetary policy.
Expansionary fiscal policy consists of increasing net public
spending, which the government can effect by a) taxing less, b) spending
more, or c) both. Investment and consumption by government raises
demand for businesses' products and for employment, reversing the
effects of the aforementioned imbalance. If desired spending exceeds
revenue, the government finances the difference by borrowing from capital markets
by issuing government bonds. This is called deficit spending. Two
points are important to note at this point. First, deficits are not
required for expansionary fiscal policy, and second, it is only change
in net spending that can stimulate or depress the economy. For example,
if a government ran a deficit of 10% both last year and this year, this
would represent neutral fiscal policy. In fact, if it ran a deficit of
10% last year and 5% this year, this would actually be contractionary.
On the other hand, if the government ran a surplus of 10% of GDP last
year and 5% this year, that would be expansionary fiscal policy, despite
never running a deficit at all.
But – contrary to some critical characterizations of it – Keynesianism does not consist solely of deficit spending, since it recommends adjusting fiscal policies according to cyclical circumstances.
An example of a counter-cyclical policy is raising taxes to cool the
economy and to prevent inflation when there is abundant demand-side
growth, and engaging in deficit spending on labour-intensive
infrastructure projects to stimulate employment and stabilize wages
during economic downturns.
Keynes's ideas influenced Franklin D. Roosevelt's
view that insufficient buying-power caused the Depression. During his
presidency, Roosevelt adopted some aspects of Keynesian economics,
especially after 1937, when, in the depths of the Depression, the United
States suffered from recession yet again following fiscal contraction.
But to many the true success of Keynesian policy can be seen at the
onset of World War II,
which provided a kick to the world economy, removed uncertainty, and
forced the rebuilding of destroyed capital. Keynesian ideas became
almost official in social-democratic Europe after the war and in the U.S. in the 1960s.
The Keynesian advocacy of deficit spending contrasted with the classical and neoclassical
economic analysis of fiscal policy. They admitted that fiscal stimulus
could actuate production. But, to these schools, there was no reason to
believe that this stimulation would outrun the side-effects that "crowd out" private investment: first, it would increase the demand for labour and raise wages, hurting profitability; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating.
The Keynesian response is that such fiscal policy is appropriate only when unemployment is persistently high, above the non-accelerating inflation rate of unemployment
(NAIRU). In that case, crowding out is minimal. Further, private
investment can be "crowded in": Fiscal stimulus raises the market for
business output, raising cash flow and profitability, spurring business
optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation.
Second, as the stimulus occurs, gross domestic product rises—raising the amount of saving,
helping to finance the increase in fixed investment. Finally,
government outlays need not always be wasteful: government investment in
public goods
that is not provided by profit-seekers encourages the private sector's
growth. That is, government spending on such things as basic research,
public health, education, and infrastructure could help the long-term
growth of potential output.
Keynesian economists believe that adding to profits and incomes
during boom cycles through tax cuts, and removing income and profits
from the economy through cuts in spending during downturns, tends to
exacerbate the negative effects of the business cycle. This effect is
especially pronounced when the government controls a large fraction of
the economy, as increased tax revenue may aid investment in state
enterprises in downturns, and decreased state revenue and investment
harm those enterprises.
Views on trade imbalance
In the last few years of his life, John Maynard Keynes was much preoccupied with the question of balance in international trade. He was the leader of the British delegation to the United Nations Monetary and Financial Conference in 1944 that established the Bretton Woods system of international currency management.
He was the principal author of a proposal – the so-called Keynes Plan – for an International Clearing Union.
The two governing principles of the plan were that the problem of
settling outstanding balances should be solved by 'creating' additional
'international money', and that debtor and creditor should be treated
almost alike as disturbers of equilibrium. In the event, though, the
plans were rejected, in part because "American opinion was naturally
reluctant to accept the principle of equality of treatment so novel in
debtor-creditor relationships".
The new system is not founded on free trade (liberalisation of foreign trade)
but rather on regulating international trade to eliminate trade
imbalances. Nations with a surplus would have a powerful incentive to
get rid of it, which would automatically clear other nations' deficits. Keynes proposed a global bank that would issue its own currency—the bancor—which
was exchangeable with national currencies at fixed rates of exchange
and would become the unit of account between nations, which means it
would be used to measure a country's trade deficit or trade surplus.
Every country would have an overdraft facility in its bancor account at
the International Clearing Union. He pointed out that surpluses lead to
weak global aggregate demand – countries running surpluses exert a
"negative externality" on trading partners, and posed far more than
those in deficit, a threat to global prosperity. Keynes thought that
surplus countries should be taxed to avoid trade imbalances.
In "National Self-Sufficiency" The Yale Review, Vol. 22, no. 4 (June 1933), he already highlighted the problems created by free trade.
His view, supported by many economists and commentators at the
time, was that creditor nations may be just as responsible as debtor
nations for disequilibrium in exchanges and that both should be under an
obligation to bring trade back into a state of balance. Failure for
them to do so could have serious consequences. In the words of Geoffrey Crowther, then editor of The Economist,
"If the economic relationships between nations are not, by one means or
another, brought fairly close to balance, then there is no set of
financial arrangements that can rescue the world from the impoverishing
results of chaos."
These ideas were informed by events prior to the Great Depression
when – in the opinion of Keynes and others – international lending,
primarily by the U.S., exceeded the capacity of sound investment and so
got diverted into non-productive and speculative uses, which in turn
invited default and a sudden stop to the process of lending.
Influenced by Keynes, economic texts in the immediate post-war
period put a significant emphasis on balance in trade. For example, the
second edition of the popular introductory textbook, An Outline of Money,
devoted the last three of its ten chapters to questions of foreign
exchange management and in particular the 'problem of balance'. However,
in more recent years, since the end of the Bretton Woods system in 1971, with the increasing influence of Monetarist
schools of thought in the 1980s, and particularly in the face of large
sustained trade imbalances, these concerns – and particularly concerns
about the destabilising effects of large trade surpluses – have largely
disappeared from mainstream economics discourse and Keynes' insights have slipped from view. They are receiving some attention again in the wake of the financial crisis of 2007–08.
Postwar Keynesianism
Keynes's ideas became widely accepted after World War II,
and until the early 1970s, Keynesian economics provided the main
inspiration for economic policy makers in Western industrialized
countries.
Governments prepared high quality economic statistics on an ongoing
basis and tried to base their policies on the Keynesian theory that had
become the norm. In the early era of social liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation, an era called the Golden Age of Capitalism.
In terms of policy, the twin tools of post-war Keynesian
economics were fiscal policy and monetary policy. While these are
credited to Keynes, others, such as economic historian David Colander, argue that they are, rather, due to the interpretation of Keynes by Abba Lerner in his theory of functional finance, and should instead be called "Lernerian" rather than "Keynesian".
Through the 1950s, moderate degrees of government demand leading
industrial development, and use of fiscal and monetary counter-cyclical
policies continued, and reached a peak in the "go go" 1960s, where it
seemed to many Keynesians that prosperity was now permanent. In 1971,
Republican US President Richard Nixon even proclaimed "I am now a Keynesian in economics."
Beginning in the late 1960s, a new classical macroeconomics movement arose, critical of Keynesian assumptions,
and seemed, especially in the 1970s, to explain certain phenomena
better. It was characterized by explicit and rigorous adherence to microfoundations, as well as use of increasingly sophisticated mathematical modelling.
With the oil shock of 1973,
and the economic problems of the 1970s, Keynesian economics began to
fall out of favour. During this time, many economies experienced high
and rising unemployment, coupled with high and rising inflation,
contradicting the Phillips curve's prediction. This stagflation
meant that the simultaneous application of expansionary
(anti-recession) and contractionary (anti-inflation) policies appeared
necessary. This dilemma led to the end of the Keynesian near-consensus
of the 1960s, and the rise throughout the 1970s of ideas based upon more
classical analysis, including monetarism, supply-side economics, and new classical economics.
However, by the late 1980s, certain failures of the new classical models, both theoretical (see Real business cycle theory) and empirical (see the "Volcker recession") hastened the emergence of New Keynesian economics,
a school that sought to unite the most realistic aspects of Keynesian
and neo-classical assumptions and place them on more rigorous
theoretical foundation than ever before.
One line of thinking, utilized also as a critique of the notably
high unemployment and potentially disappointing GNP growth rates
associated with the new classical models by the mid-1980s, was to
emphasize low unemployment and maximal economic growth at the cost of
somewhat higher inflation (its consequences kept in check by indexing
and other methods, and its overall rate kept lower and steadier by such
potential policies as Martin Weitzman's share economy).
In the postwar era, Keynesian analysis was combined with neoclassical economics to produce what is generally termed the "neoclassical synthesis", yielding neo-Keynesian economics, which dominated mainstream macroeconomic thought.
Though it was widely held that there was no strong automatic tendency
to full employment, many believed that if government policy were used to
ensure it, the economy would behave as neoclassical theory predicted.
This post-war domination by neo-Keynesian economics was broken during
the stagflation of the 1970s. There was a lack of consensus among macroeconomists in the 1980s, and during this period New Keynesian economics was developed, ultimately becoming- along with new classical macroeconomics- a part of the current consensus, known as the new neoclassical synthesis.
Post-Keynesian economists, on the other hand, reject the
neoclassical synthesis and, in general, neoclassical economics applied
to the macroeconomy. Post-Keynesian economics is a heterodox school
that holds that both neo-Keynesian economics and New Keynesian
economics are incorrect, and a misinterpretation of Keynes's ideas. The
post-Keynesian school encompasses a variety of perspectives, but has
been far less influential than the other more mainstream Keynesian
schools.
Interpretations of Keynes have emphasized his stress on the
international coordination of Keynesian policies, the need for
international economic institutions, and the ways in which economic
forces could lead to war or could promote peace.
Keynesianism and liberalism
In a 2014 paper, economist Alan Blinder
argues that, "for not very good reasons," public opinion in the United
States has associated Keynesianism with liberalism, and he states that
such is incorrect. For example, both Presidents Ronald Reagan (1981-89) and George W. Bush (2001-09)
supported policies that were, in fact, Keynesian, even though both men
were conservative leaders. And tax cuts can provide highly helpful
fiscal stimulus during a recession, just as much as infrastructure
spending can. Blinder concludes, "If you are not teaching your students
that 'Keynesianism' is neither conservative nor liberal, you should be."
Other schools of macroeconomic thought
The
Keynesian schools of economics are situated alongside a number of other
schools that have the same perspectives on what the economic issues
are, but differ on what causes them and how best to resolve them. Today,
most of these schools of thought have been subsumed into modern
macroeconomic theory.
Stockholm School
The Stockholm school
rose to prominence at about the same time that Keynes published his
General Theory and shared a common concern in business cycles and
unemployment. The second generation of Swedish economists also advocated
government intervention through spending during economic downturns although opinions are divided over whether they conceived the essence of Keynes's theory before he did.
Monetarism
There was debate between monetarists and Keynesians in the 1960s over the role of government in stabilizing the economy. Both monetarists
and Keynesians agree that issues such as business cycles, unemployment,
and deflation are caused by inadequate demand. However, they had
fundamentally different perspectives on the capacity of the economy to
find its own equilibrium, and the degree of government intervention that
would be appropriate. Keynesians emphasized the use of discretionary fiscal policy and monetary policy, while monetarists argued the primacy of monetary policy, and that it should be rules-based.
The debate was largely resolved in the 1980s. Since then,
economists have largely agreed that central banks should bear the
primary responsibility for stabilizing the economy, and that monetary
policy should largely follow the Taylor rule – which many economists credit with the Great Moderation. The financial crisis of 2007–08,
however, has convinced many economists and governments of the need for
fiscal interventions and highlighted the difficulty in stimulating
economies through monetary policy alone during a liquidity trap.
Marxian economics
Some Marxist economists criticized Keynesian economics. For example, in his 1946 appraisal Paul Sweezy—while admitting that there was much in the General Theory's
analysis of effective demand that Marxists could draw on—described
Keynes as a prisoner of his neoclassical upbringing. Sweezy argued that
Keynes had never been able to view the capitalist system as a totality.
He argued that Keynes regarded the class struggle carelessly, and
overlooked the class role of the capitalist state, which he treated as a
deus ex machina, and some other points.
While Michał Kalecki was generally enthusiastic about the Keynesian revolution,
he predicted that it would not endure, in his article "Political
Aspects of Full Employment". In the article Kalecki predicted that the
full employment delivered by Keynesian policy would eventually lead to a
more assertive working class and weakening of the social position of
business leaders, causing the elite to use their political power to
force the displacement of the Keynesian policy even though profits would
be higher than under a laissez faire system: The erosion of social
prestige and political power would be unacceptable to the elites despite
higher profits.
Public choice
James M. Buchanan
criticized Keynesian economics on the grounds that governments would in
practice be unlikely to implement theoretically optimal policies. The implicit assumption
underlying the Keynesian fiscal revolution, according to Buchanan, was
that economic policy would be made by wise men, acting without regard to
political pressures or opportunities, and guided by disinterested
economic technocrats. He argued that this was an unrealistic assumption
about political, bureaucratic and electoral behaviour. Buchanan blamed
Keynesian economics for what he considered a decline in America's fiscal
discipline.
Buchanan argued that deficit spending would evolve into a permanent
disconnect between spending and revenue, precisely because it brings
short-term gains, so, ending up institutionalizing irresponsibility in
the federal government, the largest and most central institution in our
society.
Martin Feldstein
argues that the legacy of Keynesian economics–the misdiagnosis of
unemployment, the fear of saving, and the unjustified government
intervention–affected the fundamental ideas of policy makers.
Milton Friedman
thought that Keynes's political bequest was harmful for two reasons.
First, he thought whatever the economic analysis, benevolent
dictatorship is likely sooner or later to lead to a totalitarian
society. Second, he thought Keynes's economic theories appealed to a
group far broader than economists primarily because of their link to his
political approach.
Alex Tabarrok
argues that Keynesian politics–as distinct from Keynesian policies–has
failed pretty much whenever it's been tried, at least in liberal
democracies.
In response to this argument, John Quiggin,
wrote about these theories' implication for a liberal democratic order.
He thought that if it is generally accepted that democratic politics is
nothing more than a battleground for competing interest groups, then
reality will come to resemble the model.
Paul Krugman wrote "I don’t think we need to take that as an immutable fact of life; but still, what are the alternatives?"
Daniel Kuehn, criticized James M. Buchanan. He argued, "if you have a
problem with politicians - criticize politicians," not Keynes. He also argued that empirical evidence makes it pretty clear that Buchanan was wrong.
James Tobin argued, if advising government officials, politicians, voters, it's not for economists to play games with them.
Keynes implicitly rejected this argument, in "soon or late it is ideas
not vested interests which are dangerous for good or evil."
Brad DeLong
has argued that politics is the main motivator behind objections to the
view that government should try to serve a stabilizing macroeconomic
role. Paul Krugman
argued that a regime that by and large lets markets work, but in which
the government is ready both to rein in excesses and fight slumps is
inherently unstable, due to intellectual instability, political
instability, and financial instability.
New classical
Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and in particular emphasized the idea of rational expectations.
Lucas and others argued that Keynesian economics required remarkably
foolish and short-sighted behaviour from people, which totally
contradicted the economic understanding of their behaviour at a micro
level. New classical economics introduced a set of macroeconomic theories that were based on optimizing microeconomic behaviour. These models have been developed into the real business-cycle theory, which argues that business cycle fluctuations can to a large extent be accounted for by real (in contrast to nominal) shocks.
Beginning in the late 1950s new classical macroeconomists began
to disagree with the methodology employed by Keynes and his successors.
Keynesians emphasized the dependence of consumption on disposable
income and, also, of investment on current profits and current cash
flow. In addition, Keynesians posited a Phillips curve
that tied nominal wage inflation to unemployment rate. To support
these theories, Keynesians typically traced the logical foundations of
their model (using introspection) and supported their assumptions with
statistical evidence.
New classical theorists demanded that macroeconomics be grounded on the
same foundations as microeconomic theory, profit-maximizing firms and
rational, utility-maximizing consumers.
The result of this shift in methodology produced several important divergences from Keynesian macroeconomics: