THE GENERAL THEORY OF EMPLOYMENT,
INTEREST, & MONEY

by

John Maynard Keynes

Part I: Elements of the General Theory

Page Contents

Keynesian theory

Labor market theory

The General Theory

FUTURECASTS online magazine
www.futurecasts.com
Vol. 6, No. 5, 5/1/04.

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Introduction to Parts I & II

Keynesian theory:

 

&

  In the source of Keynesian theory, "The General Theory of Employment, Interest, and Money," John Maynard Keynes purports to provide a "general theory" for self-regulating capitalist market systems. He asserts that it is applicable generally in all economic circumstances. Classical concepts, on the other hand, operate only in those rare "special" circumstances where full employment is possible.
 &

With disconcerting frequency, Marxian stupidities were invoked with approval, although in only one instance explicitly crediting Marx.

  However, it is Keynesian theory that - if applicable at all - is applicable only in very narrow circumstances - like the "special" circumstances of the depths of the Great Depression where political leaders proved incapable of reforming the fundamental policy stupidities that prevented recovery.
 &
  Keynes nevertheless successfully convinced multitudes of supposedly knowledgeable economists to accept a series of black-is-white arguments. Savings became bad and deficits became good, and the prudent accumulation of reserves for foreseeable and unforeseeable contingencies was imprudently responsible for disastrous consequences. The accumulation of capital assets becomes an economic obstacle rather than an economic advantage. Investment and employment is stimulated by inflation and hindered by price declines. Market liquidity becomes more of a problem than an advantage.
 &
  Free trade has disadvantages and closed economic systems have advantages because of the greater ease of manipulating the latter. With disconcerting frequency, Marxian stupidities were invoked with approval, although in only one instance explicitly crediting Marx.
 &  Although controversy over war debts and other international debts and trade war protectionism was raging around him, Keynes has not a word to offer about the obvious roles of such government policies in the business cycle in general and the Great Depression in particular. See Great Depression Chronology Series, beginning with "The Great Depression: The Crash of '29."
 &

Keynes provides a rationale for pursuing short term relief from economic problems by means of budgetary deficits and monetary inflation - palliatives that must  ultimately just make matters considerably worse.

  Over a century of capitalist economic history was thus ignored, as were all arguments to the contrary, until Keynesian theories were put to the test in the 1970s - and predictably failed miserably wherever pursued.
 &
  Nevertheless, Keynesian concepts are once again popular and in use today - especially in the United States under the Bush (II) administration. They remain very popular with political leaders, since they provide intellectual cover for doing what political leaders have always done when seeking to put off confronting the real problems that afflict an economy. Keynes provides a rationale for pursuing short term relief from those problems by means of budgetary deficits and monetary inflation - palliatives that must  ultimately just make matters considerably worse.
 &

The influence of Marx:

 

&

 It is evident that Keynes rejected much of the worst of Marxian doctrine. Keynes relies on competitive markets to allocate resources where Marx naÔvely relies on socialist directives. Keynes uses market exchange values instead of Marx's impractical concept of industrial labor use-values. Keynes had infinite faith in paper money managed by governments - Marx had none. (Both are wrong on this last one.)
 &

  Keynes can thus omit all of the twisted indeterminate and nonfunctional definitions and redefinitions of economic terms that Marx relied upon for the defense of his narrow industrial labor use-value concept and for support of his propaganda myth. Profits - frequently referred to as "income" or "yields" - takes its obvious place for Keynes as a determining factor for capitalist economic activity. Although he views capitalism as unable to operate at optimal levels for any length of time, Keynes recognizes - unlike Marx - that capitalism is inherently stable within the parameters of the business cycle.
 &
  Moreover, Keynes avoids many of the weaknesses of logic that permeate Marx's work. See the series of articles beginning with Karl Marx, "Capital (Das Kapital)" vol. 1 (I), "Value Determined by an Abstract Labor Standard."
 &

Keynes, like Marx, ignores the particular reasons why particular periods of economic trouble have taken place.

 

Keynes appears totally ignorant of the inherent inefficiency of government management.

  Nevertheless, Marx's "mature capitalism" fallacy - for which Keynes cites Marx with approval - is the central feature of the General Theory, and Keynes relies upon some indeterminate concepts of his own to support his "mature capitalism" theme. In the process, Keynes, like Marx, ignores the particular reasons why particular periods of economic trouble have taken place.
 &
  Like Marx, Keynes believes the ownership interest is not an essential element in capitalist productivity. Stock market investors are "functionless." Ignoring Adam Smith's warnings about the weaknesses inherent in the separation of management from ownership, Keynes agrees with Marx that good management and supervision is always readily available and can be procured simply by offer of a suitable salary.
 &
  Like Marx and all socialists, Keynes appears totally ignorant of the inherent inefficiency of government management. See, "Government Futurecast," Part II, "Government Management." He has total faith in the capabilities of government and "community" administered economic systems. While Marx offers broad socialist solutions, Keynes offers narrower administered solutions directed at controlling interest rates, directing investment flows, redistributing wealth, and ultimately directing the activities of major business entities.
 &

  To entice the credulous, Keynes like Marx offers a vision of an impossible utopia. If a capitalist system is resolutely stimulated pursuant to Keynesian policies, it will generate abundant capital assets - "full capitalization" - so that capital assets are no longer scarce. Then, there would no longer be any need for financiers and rentiers. While residual entrepreneurs would continue to be tolerated, Keynes agrees with Marx that the entrepreneur will become unnecessary. See, Keynes, "The General Theory of Employment, Interest, & Money," Part II, "Interest Rates, Aggregate Demand, and the Business Cycle."
 &
  Keynes - also like Marx - assumes that the study of economics is a "scientific" endeavor. He thus avails himself - or at least succumbs to - the "science" propaganda ploy that was a central feature in the propaganda myth created by Karl Marx. His followers would ardently continue this propaganda deception until forced to retreat somewhat by their gross failures in the 1970s.
 &

The savings gap:

 

&

  Keynes provides us with psychological propensities to consume and save. He blames the business cycle and involuntary unemployment on the notion that wealthy nations - "mature" capitalist systems - will inevitably save more than can be profitably invested, leading to periods of economic decline - if not chronic economic decline.  Like Marx's concepts, none of this can be measured, and in fact all the evidence is exactly the opposite.
 &

As assets accumulate, people and businesses can - and observably do - rely more on their asset wealth than on monetary savings.

 

The decline in savings rates in the U.S. in recent prosperous times has been notorious for decades.

  Mature - wealthy -  capitalist systems require and have lower rates of savings - not higher. As assets accumulate, people and businesses can - and observably do - rely more on their asset wealth than on monetary savings. Their asset wealth supports vast increases in the purchasing power of credit, naturally stimulating both consumption and investment, with profit rates and interest rates sensitively adjusting these flows except when other factors undermine the pertinent markets.
 &
  Except during the depths of already developed severe depressions, financial intermediaries and the money markets have no trouble instantly putting all savings to work in commerce. As is repeatedly pointed out throughout the articles on Marx, "Das Kapital," and Keynes, "The General Theory," there is absolutely no evidence that excess savings play any role in initiating periods of economic distress.
 &
  In fact, savings declined substantially in the last full year before the Great Depression - the first decline since WW-I - accompanied by a substantial decline in the number of savings accounts. The decline in savings rates in the U.S. in recent prosperous times has been notorious for decades.
 &

Considering the extent and nature of man's weaknesses - and the stubbornness with which policy stupidities are frequently maintained, it is astounding that capitalism can function as well as it does.

  The roots of the business cycle are to be found in the multitude of pertinent weaknesses of man - NOT in weaknesses alleged in capitalism. Indeed, considering the extent and nature of man's weaknesses - both in the private sector and government sector - and the stubbornness with which policy stupidities are frequently maintained, it is astounding that capitalism can function as well as it does.
 &
  It is always the nitty-gritty of analyzing particular factors involved in particular periods of economic distress that is required for an understanding of the business cycle. Economists who are too lazy or inept for this task - or unwilling to offend political patrons or private employers - have nothing to tell us. No simplistic "General Theory" will suffice.

Labor Market Theory

Labor markets:

  Theories of supply and demand in labor markets are attacked by Keynes. Contemporary theories purported to show how labor markets balance factors of supply and demand to assure reasonable levels of full employment, and to correct periods of anomalous conditions. However, by 1935, when "The General Theory" was published, such theories looked like lame ducks.
 &

Full employment is a "special" case in capitalist economics - labor markets clear at reasonably high levels of employment only during certain special periods of full employment - and the natural course of capitalist economics - the "general" case - is for employment levels to fall well short of full employment.

  The Great Depression had ravaged diverse nations all around the world and left hoards of men unemployed and underemployed for half a decade. Clearly, contemporary labor market theories provided no explanation for what was observably occurring - something Keynes spends an initial chapter emphasizing.
 &
  However, Keynes never addresses the particular reasons why this should be happening. Instead, he merely assumes that full employment is a "special" case in capitalist economics - that labor markets clear at reasonably high levels of employment only during certain special periods of full employment - and that the natural course of capitalist economics - the "general" case - is for employment levels to fall well short of full employment.
 &
  This basic assumption of Keynes is thus very similar to that of Karl Marx. The assumption substitutes for any functional examination of the actual causes of the Great Depression and lesser periodic economic downturns. Like Marx, Keynes presents the prospect of periods of massive and intractable unemployment as a natural feature of capitalist economics.
 &

Professor Pigou:

  Classical theory recognizes the obvious qualification that competitive labor markets like other markets can be prevented from clearing by market imperfections.

Labor markets clear to the point "where the utility of the marginal product balances the disutility of the marginal employment," according the classical theory as presented by Pigou.

  • There is "frictional unemployment" caused by such things as seasonal or other intermittent work, the time required to find new work when a job is terminated for any reason, and similar factors.

  • There is also "voluntary unemployment," which includes those who refuse or are unable to work for any of a variety of reasons.

  • And, of course, market imperfections - such as unions and cartels and government requirements - will impact results.

  "Subject to these qualifications, the volume of employed resources is duly determined, according to the classical theory, by the two postulates" that wages equal the marginal product of labor, and that the utility of the wage when a given volume of labor is employed is equal to the marginal disutility of that amount of employment. The latter postulate, however, is not objectively determinable. It is subjectively determined by each individual worker.
 &
  "But these two categories of 'frictional' unemployment and 'voluntary' unemployment are comprehensive." Classical theory rejects the possibility of "involuntary unemployment" in competitive markets.
 &
  Keynes, however, touches on another factor, but without further comment. The "output" from the employment of labor and capital is determined only after a deduction of all "other costs" besides the costs of wages and capital. (Thus - a far bigger factor today than in the 1930s - regulatory costs and payroll taxes and other non-wage labor costs can have a direct impact on labor markets.)
 &
  Labor markets clear to the point "where the utility of the marginal product balances the disutility of the marginal employment."
 &

  The particular presentation of the classical theory that Keynes uses as his target is that of Professor A. C. Pigou, a prominent  English economist. Pigou provided a macroeconomic econometric description of the national labor market.

 Due to the need for oversimplification in all macroeconomic econometric presentations, Pigou's work is necessarily invalid. Substantial outcome determinative factors are necessarily omitted. Everything that cannot be described as an equation is necessarily omitted. Problems of measurability and definition inherently permeate all macro-econometrics. Macroeconomic statistics inherently include gross inaccuracies. See, "Economic Statistics and Macro Econometrics, The Figures Lie," and Hendry and Ericsson, "Understanding Economic Forecasts."

  Explaining with admirable insight why such problems are inherent in all macro-econometrics, Keynes jumps on those that afflict Pigou's work. He quickly attacks "the tacit assumptions, which  govern the application of his analysis, [that] slip in near the outset of his argument."

  The labor market has significant peculiarities. Its supply and demand schedule is inherently complex because of the nature of the supply - human labor. These factors must be kept in mind when evaluating any labor market theory - including that of Keynes.

  • When goods cannot clear a market, businesses face costs for storage so the goods are sold at discount or are scrapped. When businesses can no longer profitably serve a market, they decline or go out of business. However, unemployed workers don't disappear. They find ways of surviving. The surplus retained inventory problem is thus always more severe.

  • Labor can - and during the Great Depression frequently did - work for food and/or lodging without a "wage" that could be included in the national statistics. Although not sustainable as a permanent matter in those years before the welfare state - such laborers didn't support families - this could suffice even for a period of years. People hung on as farm hands or shop broom pushers or pushcart vendors or as smallholder farmers, yet were properly classified as "unemployed" since they were still anxious to find wage work.

  • Wheat and capital and mass produced goods are fungible. Labor is not fungible. Skills are not fungible. In particular, agricultural skills are of little use in manufacturing or most services. Even unskilled labor varies in levels of strength, dexterity, reliability, educability and education. This became especially important in 1930 and thereafter with the collapse of the export markets for grains and cotton and thus the collapse of the entire U.S. agricultural sector - still a huge segment of the U.S. economy in the 1930s. There was a collapse in auto exports - about 20% of the U.S. market - at the same time.

  • Labor mobility operates under significantly greater constraints than the mobility of products or capital - especially in small nations.

  • Trade unions and collective bargaining, in any event, have an impact on competition not reflected in labor market theory.

  • And, as stated, it is the factors of supply in the labor market that are subjective and fuzzy, not the factors of demand.

  Thus, labor market adjustments are never precise or rapid - even without modern factors of rigidity.

Pigou ignores influences outside the labor sector that may impact "the rate of interest or the state of confidence."

  Pigou assumes there is no "voluntary unemployment," Keynes points out. All who desire work can find it if they are just willing to accept low enough wages. Pigou assumes "that the rate of interest always adjusts itself to the schedule of the marginal efficiency of capital in such a way as to preserve full employment."
 &
  However, this ignores influences outside the labor sector that may impact "the rate of interest or the state of confidence," Keynes properly notes. Both of these factors are major variables, either of which may impact risk-reward ratios and thus investment.
 &
  Without such factors, Pigou's work is limited to the "special case when marginal labour-cost is equal to marginal prime cost" - when all factors extraneous to Pigou's work and affecting employment permit full employment.
 &

A rise in prices relative to wages will create an increased demand for labor that is frequently satisfied without any increase in money-wages. This is proof that involuntary unemployment existed from which such demand could be satisfied.

  Pigou's labor market supply and demand schedule thus explains "what level of real wages will correspond to any given level of employment." It "is not capable of telling us what determines the actual level of employment." It has no bearing on "involuntary unemployment."
 &
  In similar manner, Keynes duly pokes holes in existing labor market theories that purport to explain how market influences tend towards reasonable levels of full employment. Especially during the midst of the Great Depression, such theories clearly didn't reflect reality.
 &
  Workers resist reductions in money wages far more than reductions in real - inflation-adjusted - wages unless the latter reach severe proportions. However, labor market theory assumes that workers respond to fluctuations in real wages. The theoretical relationships between employment levels and real wage rates simply aren't there in the real world. A variety of other factors besides wage levels impact price levels and thus real wages.

  Money wages in fact fell fairly sharply in the first three years of the Great Depression - but not nearly as sharply as prices. Those workers who managed to keep their jobs - the majority of workers - were living quite well. Keynes is quite right that wage rates are simply not as elastic as other prices.

  Keynes points out that a rise in prices relative to wages will create an increased demand for labor that is frequently satisfied without any increase in money-wages. This is proof that involuntary unemployment existed from which such demand could be satisfied. "[If] the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment" which in 1935 was everywhere.
 &
  Keynes, however, does not dispute that real wages - that price levels - "are uniquely correlated" to volume of output, so that an increase in employment can only occur in the short run if accompanied by a decline in real wages as prices move higher and increase the demand for labor. However, prices may decline - causing an increase in real wages (as they did during the Great Depression). Thus, "a willingness on the part of labour to accept lower money-wages is not necessarily a remedy for unemployment." (Indubitably, there are many factors other than prices and wages that impact labor markets.)
 &
   Then, Keynes provides this remarkable segment:

  "The pitfalls of a pseudo-mathematical method, which can make no progress except by making everything a function of a single variable and assuming that all the partial differentials vanish, could not be better illustrated. For it is no good to admit later on that there are in fact other variables, and yet to proceed  without re-writing everything that has been written up to that point."

  As Keynes candidly points out elsewhere, this can be said for ALL macroeconomic econometric models - those even with multiple variables - no matter how complex they may be.

  "A scientific theory cannot require the facts to conform to its own assumptions," Keynes states with profound wisdom. It must explain observable reality. Keynes properly pummels Pigou's work on this basis.

  Keynes himself fails to provide work that meets this basic requirement. However, to his great credit, he candidly attaches suitable warnings of imprecision to his own macro-econometric analyses - and even to some of his non-econometric work - warnings that his followers would generally disregard.

  Then, Keynes touches on a point related to weaknesses in his own approach.

  "Professor Pigou has altogether omitted from his analysis the unstable factor, namely fluctuations in the scale of investment, which is most often at the bottom of the phenomenon of fluctuations in employment."

  The reasons why investment levels fluctuate are many and varied. Except for the generalized over-optimism that afflicts  prosperous times, and the fears that accompany periods of distress, Keynes omits or grossly oversimplifies them.

The Problem With Savings:

  Classical theories of aggregate economic factors purport to demonstrate how economic systems tend towards equilibrium levels of full employment. Goods sold result in income that will be spent for consumption or investment on goods or services of equivalent value, thus maintaining an equilibrium of supply and demand throughout an entire economy.
 &

  However, contemporary economists were backing away from this view because "their thought today is too much permeated with the contrary tendency and with facts of experience too obviously inconsistent with their former view."
 &
  Keynes offers his basic explanation as to why this equilibrium isn't necessarily achieved.

  "[Those supporting an equilibrium theory base it on] an optical illusion, which makes two essentially different activities appear to be the same. They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former.
 &
  "It is, then, the assumption of equality between the demand price of output as a whole and its supply price which is to be regarded as the classical theory's 'axiom of parallels.' Granted this, all the rest follows -- the social advantages of private and national thrift, the traditional attitude towards the rate of interest, the classical theory of unemployment, the quantity theory of money, the unqualified advantages of laissez-faire in respect of foreign trade and much else which  we shall have to question."

The General Theory

Effective Demand:

  The costs of employment are analyzed by Keynes under two headings - "factor costs" and "user costs."
  • "Factor costs" are expenses exclusive of purchases from other entrepreneurs.

  • "User costs" are expenses of purchasing from other entrepreneurs plus a calculation based on the rate of investment in idle supplies and equipment. Actual costs of maintenance and repair required due to usage is included in factor costs and thus excluded from user costs.

  The element based on idle supplies and equipment is minimized or intentionally omitted by other theorists. However, Keynes insists that it has relevance - most noticeable for inventories of consumable supplies like copper. The importance of this factor increases when conditions of surplus and idleness are expected to last for significant periods.

  Everything but land or some precious commodities during inflationary times will become obsolete or deteriorate over time or incur carrying or opportunity costs ultimately in excess of its value, rendering this element of very minimal importance, indeed. For example, the price of copper declined sharply during the first three years of the Great Depression, resulting in massive forced sales of surplus inventories.

The entrepreneur's profit and factor costs together are the total income for the entrepreneur and his employees.

  The profit - which Keynes refers to as "the income" - of the entrepreneur is the excess of the proceeds over factor and user costs. The entrepreneur's profit and factor costs together are the total income for the entrepreneur and his employees.
 &
  With costs of the supply of employment thus defined, Keynes provides a supply and demand schedule for his "General Theory" based on the intersection of aggregate proceeds of employment and aggregate costs of the employment that achieves those proceeds. He uses the phrase "aggregate supply function" for the former and "aggregate demand function" for the latter. The point of intersection is "the effective demand for labor."
 &

  Keynes uses this term - "effective demand" - to distinguish it from previous theories of labor supply and demand that assumed that the market would always clear at a point that could be defined as full employment. "Says Law" - "supply creates its own demand" - is a prominent feature of such views.

  Labor market theories are based on competitive markets. When markets are disturbed because of ordinary excess - such as various "bubbles" in the private sector - the periods of increased unemployment can reasonably be attributed to temporarily increased levels of frictional unemployment while those excesses are sorted out under the pressures of economic decline. Such periods of economic decline are generally less than three years in duration.
 &
  It is when inappropriate private monopoly or cartel polices or government policies stubbornly resist such sorting out that labor markets fail. Conditions of involuntary unemployment can then last for a decade. Indeed, they can and do last indefinitely.
 &
  It is thus more accurate to say that traditional labor market theory is indeed "general" - but only for economic systems and their labor markets that are reasonably flexible and competitive and subject to reasonably competent government policies. During the Great Depression, and during the chronic inflation and stagflation of the 1970s, that was definitely not the case.
 &
  Says Law has its problems - but it was never presumed to operate outside reasonably competitive markets operating in economic systems subject to reasonable government policies.

When income increases, so does "the propensity to consume." However, the latter increases somewhat less than the former, according to Keynes, "since when our income increases our consumption increases also, but not by so much."

  Keynes then explains his theory of employment.

  "When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income. Hence, employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption. Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment. It follows, therefore, that, given what we shall call the community's propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment. The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks."

  Then he asserts his key argument.

  "[There] is no reason in general for expecting that [the point of equilibrium will] be equal to full employment."
 &
  "The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another. This particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed."

  However, during prosperous times, investment levels generally run AHEAD of savings - pushing interest rates and prices higher in a familiar cyclical pattern as businesses compete for savings and productive resources that are at such times always in SHORT supply. Keynes amazingly attributes this last surge in interest rates to "fear." In fact, such surges occur when optimism reigns supreme - "irrational exuberance" - and a lack of caution is in fact the predominant characteristic.
 &
  During times of prosperity, everybody keeps their savings in banks - for superior security and convenience as well as for some interest earnings - and the financing mechanism never has any trouble putting ALL savings to work in commerce. When doubts arise, they strike equity values long before they begin to undermine a modern financial system. So Keynes fails to explain how periods of prosperity initially break down.

  When income increases, so does "the propensity to consume." However, the latter increases somewhat less than the former, according to Keynes, "since when our income increases our consumption increases also, but not by so much."
 &

The greater the volume of employment, "the greater will be the gap" between aggregate income and aggregate consumption that must be filled by investment to retain its stability. Whenever investment does not so rise, full employment cannot be maintained.

  This "psychological law" is the key to the problem. The greater the volume of employment, "the greater will be the gap" between aggregate income and aggregate consumption that must be filled by investment to retain its stability. Whenever investment does not so rise, full employment cannot be maintained.

  "The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wage -- not the other way around. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment."

"The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment."

 

"The richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system."

  Thus, Keynes derives his overall reason for economic dislocations. It has definite Marxian overtones - that he acknowledges in a footnote.

  "This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.
 &
  "Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.
 &
  "But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level, which [is covered later in the book]."

   Marx himself could not have written a more bleak picture of the fate of "mature" capitalist economic systems. However, why, then, is there observably more unemployment - and more intractable conditions of unemployment - in so many poor countries?
 &
  And how convenient this theory is. It relieves the Keynesians - again like the Marxists - of the chore of analyzing the particular causes of particular periods of economic decline. It is all, after all, just a function of mature capitalist systems - a weakness inherent in capitalism - just as Marx said.

  Keynes then acidly criticizes Ricardo and subsequent classical economic theorists for insisting on a theory that observably doesn't explain the facts of the business cycle - resulting at last in the hopelessness of the Great Depression.

  In this Keynes is clearly correct. Classical theory indeed doesn't explain the business cycle. It doesn't deal with the factors of private and government excess and inappropriate policy that can temporarily or permanently undermine competitive markets. However, Adam Smith wrote of several such factors that were thus recognized a century and a half before Keynes was writing his General Theory. See, Adam Smith, "The Wealth of Nations," Part I, "Market Mechanisms," and Adam Smith, "The Wealth of Nations," Part II, "Economic Policy."

Income, Savings, and Investment

Income:

 

&

  Keynes defines the "income" of an entrepreneur as total revenue minus use of inventory, wear and tear of productive assets - including productive equipment and facilities - and also minus sums paid to other entrepreneurs. Calculations for discreet periods include appropriate adjustments for inventory and productive assets at the beginning and end of the period.
 &

  Wages and salaries paid are income to their recipients, but are balanced by the resulting changes in the value of inventories and other assets for the entrepreneur. Inventory values are based on market exchange values - making this a much broader and defensible application of the labor theory of value than that of Marx.
 &
  The determination of equipment and facilities costs is one of the key problems faced by Keynes. He here applies his "user cost" concept - deducting the value of the facilities and equipment at the end of the period from what they would have been worth if left idle with maintenance and improvements reasonable under the economic circumstances. He provides a simplistic econometric formula for the calculation to "measure the sacrifice of value involved in production" of output.

   This is clearly an indeterminate figure. Moreover, except for things with very low carrying costs - like land and precious substances - it is probably a negative figure. High real interest rates will tend to make the figure for even land and precious  substances a negative figure. Keynes later recognizes the impact of carrying costs. Use it or lose it!

A - U, revenues minus user costs, is the aggregate income of the economy.

  Payments to other entrepreneurs for all other purposes are "factor costs." Both factor and user costs are income to others. User costs plus factor costs equal the "prime cost of output," which is deducted from revenues to determine "income."
 &
  "Income" is thus "gross profit." This is what the entrepreneur "endeavors to maximize - - - [a concept] which agrees with common sense."
 &
  With this convenient simplification, Keynes can boil down the entire income of the nation to the "value" of production minus total user costs. Value is measured by revenues - exchange values - rather than by the indeterminate industrial labor use-values of Marx. A - U, revenues minus user costs, is the aggregate income of the economy.

  "Income, thus defined, is a completely unambiguous quantity."

  Keynes here overlooks the ambiguities inherent in the inexact arts of the accountant, including such inherent ambiguities as calculations of wear and tear and depreciation, and the value of private businesses as going concerns, and the value of sweat equity and human know-how. 

  Since the entrepreneur "endeavors to maximize" his income - which is his gross profit - his expectation of such income determines "how much employment to give to other factors of production." "[It] is the quantity which is causally significant for employment."

  • Aggregate consumption is thus the exchange value of aggregate production minus factor costs: S(A -A1).

  • Aggregate investment is thus aggregate factor costs minus user costs: S(A1 -U).

  • User costs are "the individual entrepreneur's disinvestment" - and the sums paid to cover user costs are his investment - "in respect of his own equipment exclusive of what he buys from other entrepreneurs."

  • Consumption - in a completely integrated system - without international commerce - thus equals the exchange value of output, and investment equals user costs.

  • The "effective demand" is thus "simply the aggregate income (or proceeds) which the entrepreneurs expect to receive, inclusive of incomes which they will hand on to the other factors of production, from the amount of current employment which they decide to give."

  "The aggregate demand function relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield; and the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximises the entrepreneur's expectation of profit."

  • "Net profits" are defined to include such factors as obsolescence, depreciation other than wear and tear, both insurable and uninsurable risks, and increases and decreases in market valuations. These play no role in decisions on production, according to Keynes, but do come into play in determining levels of consumption. "The excess of expected depreciation over the user costs" is "supplemental costs" that must be deducted from gross income and gross profit to find "net profit."

  "In [the entrepreneur's] capacity as a producer deciding whether or not to use the equipment, prime cost and gross profit, as defined above, are the significant concepts. But in his capacity as a consumer the amount of the supplementary cost works on his mind in the same way as if it were a part of prime cost."

  • Thus, aggregate net income involves deductions from income of supplemental cost as well as user cost: A -U -V, where V is supplemental costs.

  There are also "windfall" losses and gains - risks and advantages too unforeseeable to be insured against or calculated in advance. These come into play as supplemental costs as realized.

  "Thus we cannot get closer to a quantitative definition of supplemental cost than that it comprises those deductions from his income which a typical entrepreneur makes before reckoning what he considers his net income for the purpose of declaring a dividend - in the case of a corporation - or deciding the scale of his current consumption - in the case of an individual."

Savings and investment:

 

&

  Savings depends on the definitions of purchases by consumers and purchases by entrepreneurs. Reasonably leaving aside disputes over where such lines should be drawn, Keynes states that "expenditures on consumption can be unambiguously defined as S(A -A1) when SA is the total sales made during the period and SA1 is the total sales made by one entrepreneur to another.
 &
  Thus, since income is equal to aggregate sales minus aggregate user costs - and aggregate consumption is equal to aggregate sales minus aggregate transactions between entrepreneurs, savings must be equal to aggregate transactions  between entrepreneurs minus aggregate user costs; or S(A1 -U). For "net savings," aggregate supplemental costs have to also be deducted; or S( A1 -U -V).
 &

Aggregate income that people decide not to consume or invest is "savings."

  Current investment - "the current addition to the value of the capital equipment which has resulted from the productive activity of the period" - is equal to savings as defined above. Omitting the S for convenience, Keynes summarizes aggregative elements as follows:

  "We have seen above that as the result of the production of any period entrepreneurs end up with having sold finished output having a value A and with a capital equipment which has suffered a deterioration measured by U - or an improvement measured by -U where U is negative - as a result of having produced and parted with A, after allowing for purchases A1 from other entrepreneurs. During the same period finished output having a value A -A1 will have passed into consumption. The excess of A -U over A -A1, namely A1 -U, is the addition to capital equipment as a result of the productive activities of the period and is, therefore, the investment of the period. Similarly A1 -U -V, which is the net addition to capital equipment, after allowing for normal impairment in the value of capital apart from its being used and apart from windfall changes in the value of the equipment chargeable to capital account, is the net investment of the period."

  Those "windfall changes," of course, are happening all the time in the markets, and can have dramatic impacts on purchasing power and on all economic activities. Failure is a substantial factor that Keynes does not include. There are always investments that fail with substantial losses, and capital destroyed by the continuing processes of creative destruction. On the other hand, the value of going concerns is generally greater than the value of their physical assets.

  Thus:

 "Income  = value of output = consumption +investment.
Saving = income -consumption.
Therefore, saving = investment."

  Aggregate income that people decide not to consume or invest is "savings."

Psychological Propensities and Inducements

Factors affecting consumption levels:

  Aggregate consumption levels depend on certain objective and certain subjective factors.

The accumulation of government surpluses as "sinking funds" to pay debts - or for any other reason - can result in "severe contractions" of effective demand, according to Keynes. Deficit spending by governments can result in "marked expansion" of effective demand.

  • Real wages - wages adjusted for price inflation or deflation - determine consumption levels more than money-wages. Like Adam Smith, Keynes determines purchasing power by the amount of labor - measured by Keynes in basic "wage-units" - obtainable in the market. If these wage-units change, consumption will change in the same direction, but to a somewhat less extent relative to given levels of employment. This may be altered somewhat by changes in income distribution between entrepreneurs, rentiers and labor.

  • It is net income that affects consumption. Changes in income not reflected in net income won't impact consumption.

  • Windfall changes in capital values - like securities and real estate price fluctuations - will impact the propensity to consume.

  "The consumption of the wealth-owning class may be extremely susceptible to unforeseen changes in the money-value of its wealth. This should be classified amongst the major factors capable of causing short-period changes in the propensity to consume."

  Yet another similarity with the views of Karl Marx. Wealth and the consumption of "luxury" goods increases instability in capitalist systems, according to both Marx and Keynes. However, this is not evident in the historic record. The greatest periods of 20th century instability - the 1930s and 1970s - were clearly caused by colossal stupidity in government policies, not by factors inherent in the private sector of wealthy nations. See, Great Depression Mythology, "Summaries of Controversies and Facts," and "Understanding Inflation."

  • Changes in real interest rates and perceived economic and financial risk levels will impact the propensity to consume. This is more important for longer term tendencies rather than short term tendencies unless the changes are fairly sharp. Short term fluctuations are likely to be overlooked by most people. However, capital asset values do respond more sensitively and immediately to changes in these factors and thus provide a more immediate indirect influence on consumption tendencies.
  • Changes in "fiscal policy" - in taxation and government spending - have an obvious impact. The accumulation of government surpluses as "sinking funds" to pay debts - or for any other reason - can result in "severe contractions" of effective demand, according to Keynes. Deficit spending by governments can result in "marked expansion" of effective demand.

  Somehow, this has never been demonstrated in actual practice. The WW-II experience - widely cited as proof - is seriously flawed. For some reason, economic history is littered with instances of economic crises caused or worsened by government indebtedness.

  • Expectations of future earnings growth or decline may also impact consumption levels. However, this is probably more important for individual consumption than aggregate consumption, since changes will probably average out, with aggregate changes occurring only slowly over extended periods.

  This is probably in error. Even when wage levels remain stationary, individuals generally expect future income to be greater than current income. The onset of a recession can have a dramatic impact here, as can the onset of recovery.

  As long as the wage-unit in terms of money remains fairly stable, Keynes points out, the propensity to consume will likely remain fairly stable.

  "Windfall changes in capital-values will be capable of changing the propensity to consume, and substantial changes in the rate of interest and in fiscal policy may make some difference; but the other objective factors which might affect it, whilst they must not be overlooked, are not likely to be important in ordinary circumstances."

  It is changes in the volume of output and employment that most impact aggregate consumption tendencies.
 &

The savings gap:

  Consumption tendencies adjust to income fluctuations but to lesser degrees and with some delay.
 &

Wealthy societies will save more than poor societies since immediate needs of the poor will require greater proportionate levels of spending. "These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases."

 

"For since consumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap."

  Thus, savings will fluctuate with income fluctuations, but more in the short term than in the long term. Cyclical fluctuations thus have a marked impact on savings rates.

  "Thus, a rising income will often be accompanied by increased saving, and a falling income by decreased saving, on a greater scale at first than subsequently."

  Wealthy societies will save more than poor societies since immediate needs of the poor will require greater proportionate levels of spending. "These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases."

  Except for economic systems that cannot get above subsistence levels, this has not been the case. In fact, savings rates in the wealthiest nations - like the U.S. - have been in notorious decline for decades, while savings rates remain high in nations still only marginally beyond subsistence levels.

  A major factor in the business cycle, according to Keynes, is thus the tendency of consumption increases and decreases to be proportionately less than corresponding income increases and decreases. Thus, Keynes focuses on this mythological savings "gap."

  "For since consumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap."

  Somehow, the statistics generally fail to support this fundamental Keynesian conclusion. Not only have savings rates been in notorious decline in recent U.S. history, they even declined substantially in the last full year before the Great Depression - during the great surge of prosperity between mid 1928 and mid 1929. This savings decline was accompanied by a substantial decline in the number of savings accounts. These were the first declines since WW-I. Keynes is clearly writing in response to Great Depression phenomena - but fails to acknowledge, much less explain, this inconvenient fact.

By accumulating funds for future investments or emergencies, the dreaded savings "gap" is expanded and the investments that might fill the "gap" are delayed.

  Like Marx, Keynes points an accusing finger at financial reserves. By accumulating funds for future investments or emergencies, the dreaded savings "gap" is expanded and the investments that might fill the "gap" are delayed. Such reserves constitute "a drag on employment" during periods of accumulation - "suddenly made good in a lump" when the reserves are expended for the intended investment or emergency. (This stupidity could have been lifted straight out of Das Kapital.)

  "Thus sinking funds, etc., are apt to withdraw spending power from the consumer long before the demand for expenditure on replacements - which such provisions are anticipating - comes into play; i.e. they diminish the current effective demand and only increase it in the year in which the replacement is actually made. If the effect of this is aggravated by 'financial prudence,' i.e. by its being thought advisable to 'write off' the initial cost more rapidly than the equipment actually wears out, the cumulative result may be very serious indeed."

  Then, Keynes provides these remarkably inaccurate sentences:

  "In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump."

  If there were so much excess savings, why were interest rates so high in 1929? Investment demand was expanding exuberantly - clearly outrunning available savings and pushing interest rates high enough to draw substantial funds from as far away as Europe. All types of debt - consumer as well as investment - expanded sharply well into October, 1929.
 &
  While interest rates declined rapidly AFTER economic contraction  began in August of 1929, the decline was from extraordinarily high levels and did not reach nearly normal levels until economic decline became obvious in October, 1929. Indeed, they did not reach levels indicating a lack of investment demand for all available funds until many months thereafter.

  On a more logically firm footing, Keynes points to the problems of excess savings in 1935 - in the midst of the Great Depression, when there was little profit inducement to borrow the accumulated savings. He belabors government "prudence" in accumulating sinking funds for future needs.
 &
  The data Keynes relies on for this point - admittedly less than precise - also shows that "net capital formation" remained high through 1929, and did not decline until thereafter - after the Great Depression had already begun. The decline thus was the result of the slump - not its cause.
 &

Keynes remarkably views the increase in capital in wealthy states as a problem rather than as a strength.

 

"Each time we secure to-day's equilibrium by increased investment we are aggravating the difficulty of securing equilibrium to-morrow."

 

Only if interest rates are managed so as to maintain levels of full employment do the classical models hold and savings retain their status as virtues.

  Prudence and savings thus come under sharp attack by Keynes.

  "We cannot, as a community, provide for future consumption by financial expedients but only by current physical output."

  The terminology is different, but the fallacy is the same as that of Karl Marx.

  Keynes remarkably views the increase in capital in wealthy states as a problem rather than as a strength.

  True, the business cycle naturally involves tendencies to periodically over-expand capital assets and inventories during prosperous periods. Periods of irrational exuberance during prosperous times is a general factor in the business cycle properly recognized by all economists - including Marx and Keynes. Working these excesses off during periods of economic decline poses obvious difficulties. Nevertheless, this is a short term problem that is routinely dealt with during the ordinary business cycle - involving periods of decline of about three years or less. It is not the long term problem that Keynes is talking about.

  According to Keynes - and Marx - as savings increase for wealthy states, investment must also consistently increase to circulate those savings and avoid secular economic decline - a task that gets increasingly difficult in the face of a growing abundance of capital assets.

  "Thus the problem of providing that new capital-investment shall always outrun capital-disinvestment sufficiently to fill the gap between net income and consumption, presents a problem which is increasingly difficult as capital increases. New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase. Each time we secure to-day's equilibrium by increased investment we are aggravating the difficulty of securing equilibrium to-morrow. A diminished propensity to consume to-day can only be accommodated to the public advantage if an increased propensity to consume is expected to exist some  day."

  Keynes - writing during the Great Depression - clearly views the nation's living standards as ultimately static. His mind - thus little better than that of Marx - is incapable of contemplating the constantly increasing standards of living of the 20th century, once the trade wars and financial obstacles of the Great Depression were removed.
 &
  Keynes fails to understand that widely accumulated assets - especially private homes - would DECREASE the need for private savings. Businesses, too, would be able to rely on the equity values of assets and businesses as going concerns as a substitute for savings. Thus, wealthy states with well developed and secure financial systems would have far less need for high savings rates than less developed nations.
 &
  The propensity to save itself declines with the accumulation of capital and durable assets. Anyone who has bought and furnished homes knows there are no natural limits to the propensity to consume.

  Fluctuations in income are the greatest influence on short-period changes in consumption. Thus, substantial increases in interest rates actually reduce savings because of the extent that they reduce economic activity, investment and incomes. Thus, "a rise in the rate of interest must have the effect of reducing incomes to a level at which saving is decreased in the same measure as investment." The more we try to save under such circumstances, the worse it gets.

  "The more virtuous we are, the more determinedly thrifty, the more obstinately orthodox in our national and personal finance, the more our incomes will have to fall when interest rises relatively to the marginal efficiency of capital. Obstinacy can bring only a penalty, not a reward. For the result is inevitable."

  Only if interest rates are managed so as to maintain levels of full employment do the classical models hold and savings retain their status as virtues.
 &

The multiplier:

  A rise in the rate of investment tends to increase employment by more than the sums invested, and a fall tends to similarly decrease employment.
 &

In the normal case, "small fluctuations in investment will lead to wide fluctuations in employment." 

 

Inflation need be of no concern, since true inflation occurs only with full employment.

  The existing propensity to consume changes only slowly in normal circumstances. Given the existing propensity to consume, a given level of investment will not only result in the obvious amount of employment - called "primary employment" - but will also result in additional employment as a result of the consumption activities of those primarily employed.
 &
  This is a "multiplier" factor that can be precisely calculated depending on the existing "marginal propensity to consume" (which cannot be precisely calculated). Keynes provides a simple mathematical formula for determining the extent to which increases in employment with a given level of capital equipment will result in further consumption and employment. This same calculation can explain the further growth of employment that will flow from a given level of investment - the "investment multiplier."
 &
  Thus, if the community tends to consume - say - nine-tenths of any income increment, the multiplier will be 10 - and that will hold as good for public works as for private investment as long as the former doesn't displace the latter. (If it does, real wages will decline due to the significantly lower productivity levels in the government sector.)
 &
  Thus, in the normal case, "small fluctuations in investment will lead to wide fluctuations in employment." The amount of additional investment that will produce full employment is thus small or large depending on the marginal propensity to consume the additional income flowing from increased rates of investment. Inflation need be of no concern, since true inflation occurs only with full employment.

  This last sentence is a common Keynesian assertion refuted by centuries of economic history as well as subsequent experience with Keynesian policies during the stagflation period of the 1970s.

Offsets:

  Applied to public policy - to changes in expenditures for public works - various offsets must be taken into account.
  • Increased borrowing that pushes up interest rates, or increases in taxation, will reduce the multiplier impacts of an increase in public works. Any rise in the cost of capital goods due to the additional demand will reduce their marginal efficiency for private investors. Thus, interest rates must not only be kept steady, they must be pushed down, if increases in public works are to have their full multiplier impact.

  Deficit spending thus doesn't increase employment when the financial system is intact. It is the monetization of debt to keep interest rates down that normally provides all the actual stimulus.

  • "Confused psychology" that causes loss of confidence in the private sector as a result of increases in government works financed by deficits and the expansion of the money supply may produce negative impacts. This may increase savings - "liquidity preference" - for contingency reserves, or diminish the marginal efficiency of capital and thus private investment.

  It may ultimately also cause capital flight and decapitalization as assets are milked rather than maintained.

  • Foreign trade reduces the multiplier for domestic employment. The artificial consumption and investment of Keynesian policies will increase imports - only a minor fraction of which will be recouped as foreign economic systems respond.

  This obvious negative impact on the balance of trade and international payments would be determinedly ignored by Keynesians, who would express amazement at the collapse of the dollar in the 1970s after a decade of Keynesian policy implementation. Today, again, Keynesian policies are accompanied by chronic currency devaluation.

  • As full employment is thus maintained, the marginal propensity to consume will tend to decline as real incomes increase.

  Yet again, Keynes repeats that ridiculous Marxian notion of the weaknesses of "mature" wealthy economic systems.

  • To the extent that public works increase entrepreneurial profits rather than labor wages, the multiplier will be reduced due to the lower propensity to consume of the former.

  But won't higher profits increase the inducement to invest, with even a higher multiplier impact?

  • The reduction in "negative savings" as the newly employed stop consuming their own savings or those of others will increase aggregate savings rates and reduce the multiplier.

  But won't this decrease - or limit the increase - of interest rates?

   Closed economic systems are thus more amenable to Keynesian manipulation. Keynes estimates that modern communities tend to consume about 80% of additional income, providing a multiplier of about 5. However, if foreign trade "accounts for, say, 20% of consumption and where the unemployed receive out of loans or their equivalent up to, say, 50% of their normal consumption when in work, the multiplier may fall as low as 2 or 3 times" the primary employment.
 &
  This, according to Keynes, is why employment fluctuated so much more in the U.S. than in Great Britain during the first years of the Great Depression.

  Foreign trade in the U.S. - artificially restrained by trade war protectionism and naturally limited by the greater extent of the U.S. market - was proportionally much smaller than in England.

Even unwise public works will more than pay for themselves during periods of severe unemployment.

  The multiplier is not instantaneous. Its impacts are gradual. If the change in investment rates is large and abrupt, various immediate impacts will cloud the picture until the multiplier has its logical results.
 &
  When unemployment is high, the multiplier for increased investment or public works is highest due to the higher propensity to consume. Thus, even unwise public works will more than pay for themselves during periods of severe unemployment.

  "Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better."

  Bush (II) could have used Keynes for a speech writer. Somehow, the major increases in public works during the 1930s failed to end the Great Depression. Somehow, vast deficits failed to end Japan's economic malaise during the 1990s. Somehow, numerous nations have suffered financial collapse despite all the benefits of their vast deficits. Somehow, the U.S. is rewarded with a chronically devaluing currency and the corresponding adverse shift in its terms of trade as a result of all the "benefits" of its current vast deficits and rapidly expanding money supply.

The inducement to invest:

  Expected yields and current interest rates determine investment rates. Keynes properly emphasizes expected yields rather than just current yields in drawing his investment demand-schedule - his "marginal efficiency of capital schedule."
 &

Expectations of inflation will stimulate investment and employment because of expectations of higher prices,

  Persistent appreciation or depreciation of currency will create expectations that will impact investment rates, Keynes properly notes. However, then he ignores centuries of economic history. He asserts that expectations of inflation will stimulate investment and employment because of expectations of higher prices, while price deflation will depress investment and employment for fear of lower prices.

  Then, how does one explain stagflation and decapitalization during periods of chronic inflation like the 1970s? Keynes ignores noxious factors that are typical of inflation such as widespread loss of purchasing power due to price increases - the impact of capital flight - and the progressive collapse of credit. Writing in the midst of a world wide Great Depression, such concerns could be overlooked by Keynes.
 &
  Obviously, something is fundamentally wrong with Keynes' schedule of the marginal efficiency of capital. Omitted are the additional risks that accompany rising rates of inflation, as well as the adverse impacts not only of inevitable increases in real interest rates, but even of nominal interest rates. "The time cost of money" has real impacts even when only nominally high.
 &
  No nation has ever prospered with substantial levels of chronic inflation. Indeed, so destructive do the processes of inflation become, that nations invariably ultimately choose to suffer depression from austerity policies just to get out from under inflationary processes. Substantial levels of unemployment not only do not prevent inflation, they are ultimately invariably caused by inflation.
 &
 And, what happens to all that added purchasing power during periods of price deflation? This is a powerful stimulant that helps nations recover from recession unless offset by an economy that is deeply in debt - which is invariably the case for economic systems that have been managed with Keynesian policies.

Only if interest rate increases lag the increases in inflation  will there be any stimulation.

  Keynes recognizes that rising rates of interest will offset this stimulation from inflation. Only if interest rate increases lag the increases in inflation (which is invariably the case during the pleasant early phases of inflation) will there be any stimulation.

  However, real interest rates at or near zero in the 1970s did not prevent the onset of stagflation in the U.S. - with double digit levels of inflation and nearly double digit levels of unemployment at the same time.

  Keynes explains the business cycle in terms of a broad theory, "the fluctuations of the marginal efficiency of capital relative to the rate of interest." Although the theories are somewhat different, this is quite similar to the approach of Karl Marx. It enables them both to ignore all the particular factors that contribute to particular periods of economic distress.

  These sorts of games are quite common in economics. There are always infinite chains of cause and effect in operation, and anything can be "proved" to be a substantive cause by merely choosing where along the chain to begin the examination. Keynes candidly admits that his choices of independent variables are not based just on their merits, but on the basis of whether he believes that they can be conveniently manipulated.

  The risk-reward ratio is properly brought into the picture at this point. Keynes discusses perceptions of risks both for borrowers and lenders, and the tendency of such perceptions to decline to "unusually and imprudently low" levels during periods of prosperity.
 &

Prospective yield:

 

&

  The state of confidence is a key factor in the evaluation of long term prospects, Keynes properly emphasizes. It is one of the "major factors" determining the investment demand-schedule. Unfortunately, unlike other major factors - like the rate of interest - it is very uncertain and nebulous.
 &

Unless investors believed in - or strongly hoped for - success, they would not risk what they have on the uncertain future.

  Businessmen and investors are inherently optimistic, Keynes wisely recognizes. Unless they believed in - or strongly hoped for - success, they would not risk what they have on the uncertain future. Nor is this only a matter of profit.

  "If human nature felt no temptation to take a chance, no satisfaction - profit apart - in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation. - - - The actual results of an investment over a long term of years very seldom agree with the initial expectation." (Yet another viewpoint twisted by the experience of the Great Depression!) 

The liquidity of the market provides support for investor confidence by reducing the great uncertainties of a long period into the much lesser uncertainties of a continuous succession of short periods. Liquidity thus facilitates the raising of capital.

  Stock exchanges make investments liquid - facilitating the raising of capital, as well as directing the allocation of capital. However, this liquidity also increases the volatility of capital asset values.
 &
  Market valuation provides vital guidance on the basis of an implicit assumption that it is "uniquely correct in relation to the existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge." However, this is an obvious fiction. Such knowledge is neither precise nor unmitigated by many other  operative factors. However, the liquidity of the market provides support for investor confidence by reducing the great uncertainties of a long period into the much lesser uncertainties of a continuous succession of short periods. Liquidity thus facilitates the raising of capital.
 &
  Keynes points out several factors that serve to undermine investor confidence.

  • Stock market investors lack the insiders knowledge of how a business is actually doing.
  • Short term fluctuations in profits can have extraordinary impacts on stock valuations.
  • Lack of knowledge renders market investors prey to substantial fluctuations in mass psychology that may be totally unrelated to prospective yield.
  • Professional market traders make matters worse by concentrating on unstable factors of short term valuation.
  • Conditions in either the stock markets or the financial sector may cause a collapse of investment demand - but confidence must recover in both sectors for recovery of investment demand.

  The volatility in stock markets is entirely appropriate, since the capital traded in these markets - equity capital - is the risk capital of the economy. It is flexible and thus able to absorb the winds of change.
 &
  If there is a substantial base of equity capital, it will suitably shield the vast mass of debt capital, which can thus be comparatively stable. This is vital, since debt capital is inflexible and will suffer total failure under strain.
 &
  Even more stable is the human capital of the nation. Human capital will survive for decades, even during catastrophic conflicts. It took seven decades of autocratic socialism to thoroughly destroy the human capital in the Soviet Union.

"[There] is no such thing as liquidity of investment for the community as a whole."

 

Keynes views Wall Street as dominated by speculative interests - rather than investment interests. The markets seem to him as acting like casinos. The culprit is market liquidity.

 

 

 

 

 

  Keynes thus launches into a famous rant against market speculation and "the fetish of liquidity." (Marx, too, liked to invoke the concept of "fetish" to demean economic factors that he wished to disregard.)

  "[There] is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop the future."

  Who should society turn to to challenge these "dark forces" in the market? In fact, there are very few investors or investment advisers who prove themselves capable of beating the market averages over the long haul.

  Writing from the despair of the depths of the Great Depression, Keynes laments that long term investors face greater difficulties due to the greater risks inherent in long term prospects. A large measure of the investment that does exist is due to the "animal spirits" - the impulse towards action - of entrepreneurs and investors, since nobody can truly calculate the long term risks and prospects of enterprise.

  "There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable."

  Once free of the government policy stupidities that caused the Great Depression during the 1930s - the trade wars and vast defaulted debts from WW-I and thereafter -  such evidence of the superiority of long term investments would become abundant. Those long term risks would be dispelled by acknowledgement of the long term vigor and productivity of the U.S. economic system which would increasingly prosper whenever not too encumbered by government policies of gross stupidity. In nations like the U.S. that enjoy the marvelous benefits of capitalism, only optimism pays.
 &
  Of course, Marxists and Keynesians would be too mired in despair over the mythological difficulties of "mature" economic systems to notice. The imminent return of the Great Depression would be a persistent element of their economic expectations.

  Nevertheless, Keynes does score some valid points, here. Institutional investors must justify their performance for each year and even for each quarter, glorifying short term results over long term results. Fund managers adopt the conventional wisdom of their peers rather than risk error on the basis of personal analysis.
 &
  With the recent experience of the 1929 boom and bust, Keynes views Wall Street as dominated by speculative interests - rather than investment interests. The markets seem to him as acting like casinos. The culprit is market liquidity.
 &

"This is the dilemma," Keynes laments. Only the liquidity of the equity markets attract the vast sums of equity capital on which the financial stability of the economy rests.

  Keynes advises an increase in transaction costs by means of a stock transfer tax to reduce this liquidity and speculation. That this would increase the costs of raising equity capital does not escape Keynes' notice. "This is the dilemma," he laments. Only the liquidity of the equity markets attract the vast sums of equity capital on which the financial stability of the economy rests.

  Keynes is probably unaware that all the speculative excess of 1929 was concentrated in about 50 speculative leaders on the NYSE. As for the rest, there were as many losers as gainers in the year prior to October, 1929. Such speculation is certainly a problem, but not of such extent as could justify the limitation of liquidity for the vast bulk of the market.

The crisis of confidence the afflicts the Great Depression world can only be cured by the radical idea of forcing people to either consume or invest their funds.

  Keynes is thus driven to a remarkable radical conclusion. The crisis of confidence that afflicts the Great Depression world can only be cured by forcing people to either consume or invest their funds. The "hoarding" of funds that Keynes believed to be the cause of the crisis might then be ended.

  Again, this Marxian stupidity afflicts Keynes.
 &
  Idle savings were a result of the Great Depression, not its cause.

  See, Keynes, "The General Theory of Employment, Interest, & Money," Part II, "Interest Rates, Aggregate Demand, and the Business Cycle."

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