A Great Improvisation: Keynes’ General Theory

Note: this article is part of our continuing series on notable economic writings. See our previous posts on Adam Smith and Karl Marx.

Of the economists we will cover here, none is likely as widely known as John Maynard Keynes, an economist who had already risen to academic eminence in Britain by the time of the Great Depression, which influenced much of his thinking. Many of his ideas will ring familiar to undergraduates studying micro- or macroeconomics—largely because Keynes lent modern economics a great deal of its terminology, including such monstrosities as “marginal propensity to consume”, etc.

There is much that can astonish us about Keynes’ General Theory of Employment, Interest, and Money, which he first published in 1936. On one hand, he himself admitted that it was less a cohesive magnum opus than a fragmented attempt to challenge the old “classical” school of economic thinking. On the other, he spends most of his ink not on addressing these theories, but on weaving from virtual whole cloth an entirely novel framework of economics, with infrequent reference to or acknowledgement of contemporary economists. Whether he was superbly confident or quintessentially indecisive is difficult to tell; after all, he once told Hayek in response to a question on one of his assumptions, “Oh, never mind, I no longer believe all that.”

Because of this cavalier attitude toward what came before him, Keynes represents a leap in economics whereas Hayek’s work built heavily on prior economic writings. Yet the “conventional wisdom” of economics has taken the leap along with Keynes for most of the past century—for better and worse. The tidy formulas that sum of the whole of a country’s economic activity, the precise-sounding names for nebulous concepts, the laundry lists of “all else equal” causes and effects; this was bequeathed to us by Keynes.

In his preface, Keynes calls the process of reading the book necessarily one of “a long struggle of escape…The difficulty lies, not in the new ideas, but in escaping from the old ones.” Perhaps this is so, but Keynes gives many new ideas in his book. Now his concepts have, to us, become the old ideas, ripe for the same scrutiny which he first applied to classical economics.

As with my post on Marx, I will generally resort to the Americanized spelling of words such as “labor” (rather than “labour”). Another procedural note: Keynes wrote the book chock full of equations and variables. I will intend to convey the substance of his ideas without resorting to these, but will of course describe key relationships to the extent necessary.

A Challenge to Classicals

By classical economists, Keynes refers to the term coined by Marx in reference to James Mill and David Ricardo—two economists active in the early 19^th century—and all who came before them. The most notable and consistent reference is to Pigou, whom Keynes brings up frequently in citing classical economic theories. Keynes describes the “classical theory of employment” as having two fundamental legs.

The wage is equal to the marginal product of labor: that is, “the wage of an employed person is equal to the value which would be lost if employment were to be reduced by one unit.” Keynes does admit that such a postulate would be “disturbed…if competition and markets are imperfect.”
At a given volume of labor, the utility of the wage is equal to the marginal disutility of that amount of employment. That is, the real wage (not nominal wage) of a person is “just sufficient (in the estimation of the employed persons themselves) to induce the volume of labor actually employed to be forthcoming.”

These two postulates, as Keynes explains, furnish the demand and supply sides of the labor market, respectively. Demand for labor is based on how much incremental productivity labor can offer to employers; supply of labor is based on the extent to which the wage incentivizes any exertions on the part of the laborers.

As a result of this supply and demand interaction, “it would follow…that there are only four possible means of increasing employment:”

Lower “frictional” unemployment (unemployment caused by people being “between jobs”, etc.) brought about by “an improvement in organization or in foresight.”
A decrease in margin disutility of labor, which induces more people to work and reduces “voluntary” unemployment.
An increase in marginal productivity of labor specific to the wage-goods industry—using Pigou’s term for “goods upon the price of which the utility of the money-wage depends”. This gets more difficult to intuit without reading two or three times, but we can think of wage-goods as necessities of life that laborers need to be able to afford—thus the price of these goods influences the utility of the wage that workers earn—like bread, clean water, underwear, etc. If these industries are more productive, one might expect the prices of such goods to be lower, thereby increasing the real utility of a given money-wage.
Now we’re getting tricky: “an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.” Even harder to think through, but let’s try. The non-wage-earners Keynes describes will still have some demand for wage-goods—even Lord Grantham needs clean underwear. Yet let us suppose that Lord Grantham decides to forego half of his usual expense on undergarments in order to buy a racehorse. The effect of such a change is increased demand for goods that most workers don’t think about when considering the utility of their own earnings, and decreased demand (and thus decreased prices) for goods that workers do consider. Thus, you can argue that Jeff Bezos buying another superyacht is good for the economy—after all, imagine if he decided to buy up the world’s supply of eggs.

What Classicals Missed, According to Keynes

Writing in the 1930s, Keynes could well ask: “Is it true that the above categories are comprehensive in view of the fact that the population generally is seldom doing as much work as it would like to do on the basis of the current wage?” One shortcoming of the classical thinking is that it fails to explain the Great Depression—but this is a pretty tough standard. Still, this is a central point in Keynes’ work as well as Hayek’s given that their careers happened to coincide with the events of the 1930s.

But Keynes has more related objections: he clarifies that real wages can fall simply due to a rise in prices, thus keeping money-wages (or nominal wages) constant. The classical school would suggest that such a phenomenon would reduce the supply of labor because it reduces the real utility of labor, but this doesn’t hold in practice: “To suppose that it does is to suppose that all those who are now unemployed though willing to work at the current wage will withdraw the offer of their labor in the event of even a small rise in the cost of living.”

Further, the “wage bargain” between workers and businesses does not directly determine a “real” wage, but a “nominal” one, independent of these changes in prices. Indeed, “there may be no [emphasis Keynes’] method available to labor as a whole whereby it can bring the wage-goods equivalent of the general level of money-wages into conformity with the marginal disutility of the current volume of employment.” In short: there is no ready mechanism for labor to “inflation-proof” their paychecks.

That wage bargains focus heavily on nominal wages makes sense. It equally makes sense that “relative” reductions in real wages—relative to other laborers—are more strenuously resisted by workers. Thus the bargaining process for nominal wages “primarily affects the distributions [emphasis Keynes’] of the aggregate real wage between different labor-groups, and not its average amount per unit of employment.”

Keynes defines “involuntary unemployment” as the following: “Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labor willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.” That is, involuntary employment exists when both would-be laborers and prospective employers would accept the current money-wage if it was even slightly lower in real terms. The classical theories, which have set the real wage axiomatically equal to marginal disutility of labor, therefore appear to imply complete absence of involuntary unemployment. Therefore, the classical theory appears “only applicable to the case of full employment, [therefore] it is fallacious to apply it to the problems of involuntary unemployment.”

All of these arguments take issue with the second of the two classical postulates Keynes describes. Yet Keynes largely accepts the first postulate: wages equal the marginal product of labor. If economic output is fixed, employing more people will reduce the real wage—if labor is fixed, a greater output will cause real wages to rise: “real wages and the volume of output are uniquely correlated.”

Finally, Keynes challenges the classical assumption that supply creates its own demand: more precisely, that the aggregate supply price and aggregate demand price for a given output are equal. Yet this assumes that all of a country’s produced output is spent on the purchase of its own product. In a similar vein, classicals assumed that “any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labor and commodities thus released…to be invested in the production of capital wealth.” Keynes’ issue with this assumption is that there does not exist 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.”

The resulting classical assumption, which Keynes disputes, is the “axiom of parallels” between supply or and demand for output. Yet what is noteworthy about Keynes’ critique is the list of ideas he throws in at the end of his first chapter, claiming they rely on this same classical theory: “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 [again, Keynes’ italics] in respect of foreign trade and much else which we shall have to question.”

This is quite the list to tack on to the end, and it gets to the crux of how Keynes’ explanations of economics will offer quite different conclusions, much of which, as he says, “we shall have to question.”

Effective Demand

Keynes identifies two sources of cost from the perspective of entrepreneurs—a term he uses to describe generally any employer.

Factor cost is the cost paid “to the factors of production for their current services”. Keynes tends to equate this to labor cost, although it is not necessarily so: strictly speaking, factor costs are costs paid for any factor “exclusive of [those purchased from] other entrepreneurs”.
User cost is essentially two components in one. The first is “the amounts which he [the entrepreneur] pays out to other entrepreneurs for what he has to purchase from them”, such as raw materials, components, etc. The second is the “sacrifice which he incurs by employing the equipment instead of leaving it idle”. This could be considered wear and tear, or something akin to depreciation.

The value of the output can therefore be divided into factor cost, user cost, and the residual: income to the entrepreneur.

From here, Keynes takes the leap from micro- to macro-economics. Holding the components of cost constant, the amount of employment that entrepreneurs demand will depend on the “amount of the proceeds which the entrepreneurs expect to receive from the corresponding output”. From this expectation, Keynes derives the aggregate conceptions below:

An aggregate supply price “Z” being a function of “N” people employed, essentially referring to the aggregated (or total) cost of all the produce in an economy given N level of employment.
An aggregate demand price “D” also being a function of “N” people employed, referring to the expectations that entrepreneurs have of the proceeds they will receive from this level of output—basically, their estimates of demand for their products.

Two things are worth noting here. For one, Keynes does not go further into the formulae than this—for now. He simply states the concept of aggregate prices as a function of a given level of employment. But more notable is the astounding shift in scope from the sources of cost. He essentially has copied a framework from the micro case of a single business facing certain conditions, and multiplied it out to apply to the entire economic order. In my view, this equivalence between macro and micro should be subject to further scrutiny—but we will set that aside for now.

As Keynes describes them, Z and D interact with each other in the same way that supply and demand would for the case of an individual product or business. If D > Z, this would represent that entrepreneurs would expect more proceeds than they insist on accepting, and this sense they are leaving money on the table will induce them (in aggregate) to increase the level of employment until the equilibrium point where D and Z are equal.

This framework provides further ammunition for Keynes’ salvo against the classical theories, which effectively would suggest that D “always accommodates itself” to Z, independent of how many people are employed. Again, Keynes utterly rejects this argument.

Theory of Employment, Sneak Peek

Instead of diving deeper on these issues, Keynes goes on to illustrate his theory of employment briefly, for which a quick example will suffice now. All else equal, higher employment increases aggregate income, but consumption does not increase as much as income does, as many people opt to save a portion of this incremental income. The level at which this money is spent vs. saved depends on the marginal propensity to consume, or the amount of each marginal dollar (in aggregate) people are disposed to spend upon receipt. In order to compensate employers for this loss in consumption driven by saving, some of the output just be devoted to investment “sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level.”

Thus, Keynes claims that given these factors, “only one” equilibrium level of employment can exist, which cannot be higher than full employment but can certainly be below it. He divides aggregate demand into two parts: D₁ for consumption and D₂ for investment, the sum of which is the original D, or aggregate demand.

From this, “the volume of employment in equilibrium depends on (i) the aggregate supply function…(ii) the propensity to consume…and (iii) the volume of investment…This is the essence of the General Theory of Employment.”

Much Ado About Definitions

Similar to Marx, Keynes takes a fancy to inventing hyphenated words in order to complicate definitions:

Nominal value in money terms becomes “money-value”.
The average wage of the average laborer is the “wage-unit”.
The average laborer is a “labor-unit”.

Further Definitions & Ideas

Expectations Become Reality

Keynes describes business decisions by entrepreneurs as a function of their expectations. In particular, short-term production decisions (how many widgets to produce today) are based on short-term expectations of demand and production cost for widgets. However, given the amount of time required to hire incremental employees (labor-units, dare we say), purchase raw materials, construct the widgets, and bring them to market, any changes in these expectations will not fully affect employment until some time has passed.

He touches also on the concept that, in the short-term, production decisions are dependent on the spread between average selling price and average variable cost, not average total cost. This is because, in the short term, the business would prefer to produce enough to cover some of their fixed overhead, rather than produce nothing and eat the entire overhead as a loss.

Income, Saving, Investment

Now we can add to our categories of cost that Keynes defined earlier. The sum of factor cost and user cost can be called the “prime cost”. There is a “supplementary” cost that relates to any depreciation expected that is beyond what is included in the “user” cost—although this is difficult to quantify, representing “those deductions…which a typical entrepreneur makes before reckoning what he considers his net income for the purpose of declaring a dividend or of deciding the scale of his current consumption.”

These distinctions are necessary to consider when considering just what the entrepreneur’s income results in. This is important because the aggregate income of the economy is the sum of two parts: factor cost (income to labor) and entrepreneur income (income to business).

Income has just been defined, consumption is readily understood. The excess of income over consumption, therefore, can be considered saving. From here, Keynes makes the same equivalence between saving and investment which he appeared to criticize the classical school for making—however, he gets there through a very different route.

Bankers are the Backbone of Society

Indeed, Keynes refers to savings and investment as “necessarily equal, since each of them is equal to the excess of income over consumption.”

Ultimately, Keynes passes over and rejects the arguments of Austrian economists who focused on capital formation and “forced saving”—argument which Hayek will ultimately pick up. To explain his meaning of equivalent saving and investment, he ultimately returns to a simple example. “The prevalence of the idea that saving and investment, taken in their straightforward sense, can differ from one another, is to be explained, I think, by an optical illusion due to regarding an individual depositor’s relation to his bank as being a one-side transaction, instead of seeing it as the two-sided transaction which it actually is.” Here we have the fulcrum of Keynes’ theory. The banking system, by connecting invisible savers to invisible borrowers, determines that everything saved is ultimately invested.

This is made even clearer when he doubles down, again disputing with the Austrian school. “The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others.” This creation of credit, “except in conditions of full employment”, increases both nominal and real incomes. This increase in income will result in more saving, based on the propensity to consume being less than 100% of incremental income.

We see the undercurrent of this line of thinking throughout Keynes’ work: he assumes little to no financial friction. No financial crisis, no money under mattresses, no hoarding cash in wallets or safes. But we therefore have an inconsistency: such an assumption equates to a “nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption”, which is something he criticized the classical theories for assuming. To be fair, Keynes gets to such a state through different premises, but his conclusion is open to the same line of questioning as he applied to the classical theories. It’s as if he criticized the classical school for not surmounting some theoretical obstacle, and blithely assumes the obstacle away in his own theory.

Consumption is More Important Than Saving?

King Consumption

Propensity to consume is the proportion of total income that is spent on current consumption. We’ve already seen the marginal propensity to consume, which can be thought of as the derivative or tangent slope of changes in consumption with respect to changes in income. Keynes identifies six “objective factors” which influence propensity to consume.

Higher average wages (or “wage-units”) will increase the propensity to consume. This is the wealth effect, in which a person’s perception of their own wealth will increase their consumption.
A “change in the difference between income and net income” is equally important. Keynes illustrates net income as the true driver of consumption rather than gross income, so a change in so-called “supplemental cost” as Keynes describes it would cause a concomitant change in the propensity to consume.
“Windfall changes in capital-values”. These are easy enough to visualize—many people in the post-2008 financial crisis whose houses lost value likely felt compelled to reduce their consumption, even if their wages weren’t affected.
Changes in the “rate of time-discounting, i.e. in the ratio of exchange between present goods and future goods.” While admitted this is but an approximation, Keynes claims “we can identify this with the rate of interest.” Yet it is far from a straightforward proposition. The long run effect is likely more noticeable, as “substantial changes in the rate of interest probably tend to modify social habits considerably.” But the short-term market fluctuations that are measured in basis points (hundredths of a percentage point) are not likely to impact consumption decisions. Prospective homebuyers in 2024 can very much feel the difference between 4.5% and 7% mortgage rates—but not so much the difference between 4.5% and 4.55%.
- To go even further, some of the impact of interest rates likely derives from their influence on the values of assets. Lower interest rates tend to raise asset values, producing wealth effect-induced consumption by asset owners.
Changes in fiscal policy: The impacts of government spending are likely to play some role in the propensity to consume. One example of Keynes is a situation in which “fiscal policy is used as a deliberate instrument for the more equal distribution of incomes,” in which case such a policy would increase the propensity to consume (given that poorer people tend to have a higher marginal propensity to consume).
Changes in “expectations of the relation between the present and the future level of income.” While this can vary greatly between individuals, it does not play a large aggregate role, Keynes insists. Yet he calls it necessary to include “for the sake of formal completeness.”

The sum of all this: “in a given situation the propensity to consume may be considered a fairly stable function”. I find this line simply too droll to omit here—Keynes is essentially saying that as long as nothing changes, things will remain the same.

As we’ve seen, the total propensity to consume declines as income rises, because “a man’s habitual standard of life usually has the first claim on his income…if he does adjust his expenditure to changes in his income, he will over short periods do so imperfectly.”

Saving Killed the Roaring 20s

Keynes also advances a related argument on the economic crash of 1929 in the U.S. Rapid capital expansion leading up to 1929 enabled the setting up of prepaid funds for depreciation allowances, “in respect of plant which did not need replacement”. The scale of this meant that a great deal of invested funds went into setting up these provisions, and therefore there was not enough investment left to “provide for such new saving as a wealthy community in full employment would be disposed to set aside.” Therefore, the financial prudence and conservatism of large corporations both caused the slump and proved a “serious obstacle to early recovery.”

Given the previous depression in 2008 was caused by the exact opposite of “financial prudence”, Keynes’ arguments sound strange. Yet such can be expected from the foremost apostle of consumption, which he saw as the “obvious…sole end and object of all economic activity.”

Why We Save

The discussion of saving is inherently tied up in the chapter on consumption, given that the two are mutually exclusive and exhaustive categories. Keynes identifies a list of motivations to saving. For individuals, he lists eight:

For a reserve “against unforeseen contingencies” (emergency fund).
For “an anticipated future relation between the income and the needs of the individual…different from that which exists in the present” (a college fund for the kids).
To enjoy interest in order to consume more in the future.
To look forward to “a gradually improving standard of life rather than the contrary”, such as saving for retirement.
For “a sense of independence”.
To “carry out speculative or business projects”.
To leave a bequest.
To “satisfy pure miserliness”.

Keynes titles these, respectively: “Precaution, Foresight, Calculation, Improvement, Independence, Enterprise, Pride, and Avarice.”

Institutions (banks, governments, companies, etc.) are motivated in different ways:

Enterprise: “to secure resources to carry out further capital investment without incurring debt or raising further capital on the market”.
Liquidity: “to secure liquid resources to meet emergencies”.
Improvement: to grow income gradually over time which “will project the management from criticism, since increasing income due to accumulation is seldom distinguished from increasing income due to efficiency.”
Prudence: to make a “financial provision in excess of user and supplementary cost”, and therefore “write off the cost of assets ahead of, rather than behind, the actual rate of wastage and obsolescence”.

Despite adjustments to consumption resulting from changes in income being done “imperfectly”, Keynes admits that in the short term, this is a predominant factor in determining changes in consumption.

Interest rates, therefore, do not determine much about the propensity to consume—but they still determine a great deal on the “amounts actually saved and consumed.” Higher interest rates may encourage saving, but “aggregate saving is governed by aggregate investment”, and therefore higher interest rates will discourage investment and correspondingly decrease income “by a greater absolute amount than investment…saving and spending will both decrease.”

Again, Keynes is assuming a friction-free financial system, in which no saving can take place unless there is investment to match it. This assumption can only hold if we take the accidental hoarding of cash in wallets or the deliberate hoarding of cash in safes to be some form of investment—despite the fact that it is no nominal yield.

Thus, Keynesian logic that “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…Obstinacy can bring only a penalty and no reward.”

And again: “The rise in the rate of interest might induce us to save more, if our incomes were unchanged. But if the higher rate of interest retards investment, our incomes will not, and cannot, be unchanged. They must necessarily fall, until the declining capacity to save [from lower incomes] has sufficiently offset the stimulus to save given by the higher rate of interest.” Therefore, the individual’s prudence will reduce income for the whole.

The Multiplier Effect of Consumption

Having just established the negative effect on income that reduced investment can have, Keynes turns to the inverse effect: the incremental income from a given increase in investment. He derives this as the reciprocal of one minus the marginal propensity to consume (measured as a percentage). For instance, an “MPC” of 50% results in an “investment multiplier” of 2, an MPC of 90% in a multiplier of 10, etc.

He describes a similar multiplier effect relating to employment, stating a relationship between incremental investment and incremental employment in a specific industry, and its effect to change employment more generally. However, this “employment multiplier” is not necessarily equal to the investment multiplier.

The basic idea behind both of these concepts is that any new employment (which is the result of investment) will in itself spur additional new employment, based on the propensity to consume. Say an entrepreneur invests money to start an investment bank, and hires 12 “finance bros” as employees. Suddenly, the area experiences a surge in sales of Sweet Green salad bowls, Patagonia vests, and all sorts of other stereotypical “finance bro” tastes. The entrepreneur’s investment is going only to fund and operate the bank—but the local Sweet Green just might need to hire an extra chef to keep up with the demand. This is the multiplier in action.

Such a concept comes with some qualifications:

The multiplier deals with “net” investment, which doesn’t account for any offsetting decreases in investment such as pulling funds from one industry to finance another.
The method of financing such investments may be dependent on movements of interest rates.
In open systems (that is, countries without completely self-contained economies), some impacts of investment will ultimately accrue to other nations—such as outsourced employment or investment abroad.

Keynes cites one of his contemporaries (Kahn) who estimated the marginal propensity to consume at around 80% for a “typical modern community”, which would imply an investment multiplier of 5—but given the impacts of foreign trade and unemployment benefits, the multiplier appeared closer to 2 or 3 in practice.

Keynes on Investing

Why We Invest

The inducement to invest is given by the marginal efficiency of capital. We can think of this similarly as the internal rate of return (IRR) concept in finance. Given a “series of annuities [called] the prospective yield,” and the replacement cost of reproducing the asset in question, the marginal efficiency of capital is the interest rate at which the prospective yield’s present value is equal to the replacement cost, which Keynes also calls the “supply price”, of the asset. Therefore, marginal efficiency of capital is both incremental and related to net economic profit.

A higher amount of investment will reduce the marginal efficiency of capital, both from lower prospective yields from overinvestment (diminishing marginal returns) and higher supply prices from producing more of the same type of assets.

In equilibrium, the marginal efficiency of capital should be equal to the rate of interest—this makes sense if you are borrowing capital to deploy. In such a case, the rate of interest is what you’re paying, and the marginal efficiency of capital is what you’re receiving. As Keynes puts it: “it is obvious that the actual rate of current investment will be pushed to the point where there is no longer any class of capital-asset of which the marginal efficiency [of capital] exceeds the current rate of interest.”

From a theoretical standpoint, the marginal efficiency of capital must truly be based on lifetime-long expectations—the entire useful life of the asset in question. Thus, an investment must be evaluated based on its prospective yield, not its “current yield”. However, “this involves the whole question of the place of expectation in economic theory”, and Keynes admits that most discussions of capital’s efficiency tend to focus too heavily on short-term prospects.

Role of Expectations and “Efficient Markets”

Keynes has already explained his claim that the level of investment is calibrated based on the relationship between interest rates and the marginal efficiency of capital. From this, he explains that “the prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money.” However, an expectation for lower rates in the future will discourage investment today, as “it means that the output from equipment produced to-day will have to compete during part of its life with the output from equipment which is content with a lower return.” Such a statement appears to contradict the basic intuition of buying bonds when yields are high and selling when yields are low, but Keynes’ point makes sense when considering current interest rates as a basis for investors’ “required return on capital”.

More generally, Keynes criticizes “our usual practice being to take the existing situation and to project it into the future”. He further laments that most investors do not try to develop true long-run business expectations, and that “those who seriously attempt to make any such estimate are often so much in the minority that their behavior does not govern the market.”

Indeed, the rise of stock exchanges and public capital markets contributed to a phenomenon in which (through the price mechanism which Hayek so admired) “certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange…rather than by the genuine expectations of the professional entrepreneur [emphasis mine].”

Keynes touches here again on the idea of efficient markets—though he does not coin the term. He acknowledges that a great deal of information is rapidly reflected in prices of assets, but with two key caveats:

“We are assuming…that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge…though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation.”
Further, “all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield [emphasis mine].”

Therefore, inasmuch as markets are efficient, they are of imperfect accuracy in being so.

Illusion of Liquidity and Other Problems

On top of this, Keynes points out an inconsistency in the idea of “liquid” investment securities: assets that can be bought and sold reasonably quickly without sacrificing too much of the underlying value. “Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual.”

Four additional problems with investment markets and expectations that Keynes points out:

An increase in accessibility of equity markets eventually led to a “serious decline” in “the element of real knowledge in the valuation of investments.”
Short-term profit fluctuations—even those related to predictable seasonal trends—“tend to have an altogether excessive, and even an absurd, influence on the market.”
The “mass psychology” that a conventional valuation represents is “liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield.” There are no “roots of conviction”.
Professional investors, rather than focusing on developing reasonable long-term expectations, trade on their estimates of changes to consensus expectations reflected in market prices. Indeed, “investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable…There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable…Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional, and rash in the eyes of average opinion.”

To Keynes, true investment based on expectations can be thought of as “enterprise”, while investment based on expectations of market price reactions is “speculation”. He makes no secret of which of these prevailed in the Wall Street of his day: “Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market.” Yet, “these tendencies are a scarcely avoidable outcome of our having successfully organized ‘liquid’ investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.” He correlates the relative calm of British financial markets exactly with their inaccessibility compared with that of American counterparts.

He does not, however, go so far as to insist that one should “make the purchase of an investment permanent and indissoluble,” and recognizes that liquidity comes with some benefits: “the fact that each individual investor flatters himself that his commitment is ‘liquid’ calms his nerves and makes him much more willing to run a risk.”

Interest Rates and Money

Classical Theory of Interest

Again, we exhume the classical theories from Keynes’ works. The classical theory is that the rate of interest is the equilibrium rate “which brings the demand for investment and the willingness to save into equilibrium with one another.” The shortcoming of this theory, according to Keynes, is that it does not account for changes in income based on interest rate changes—and further, that classical economists saw saving and investment as independent variables, when in fact the propensity to consume and the marginal efficiency of capital are the true determinants as Keynes described them.

Keynes’ General Theory of Interest

As a mild skeptic of modern central banking, I find this section particularly interesting.

Keynes’ conceptions of interest rate dynamics hinge heavily on the same concept of liquidity he has just described. The degree of investors’ “liquidity preference” will play a role in determining the interest rate; if liquidity is in low demand, investors will be more “prepared to part with immediate command [of their funds] for a specified or indefinite period”. As the rate of interest is the “reward for parting with liquidity”, a lower liquidity preference will suggest lower rates of interest, and a higher liquidity preference will suggest higher rates of interest.

Incentives to liquidity are easy to conjure forth, and Keynes gives us the following:

The “Income-motive…to bridge the interval between the receipt of income and its disbursement.” If you get paid every two weeks, you may want to keep at least two weeks’ expenses in cash—if you got paid continuously in real-time, perhaps not (wouldn’t that be radical).
The “Business-motive…to bridge the interval between the time of incurring business costs and that of the receipt of the sale-proceeds”. From a business standpoint this can be thought of as operating cash or “cash in the tiller”.
The “Precautionary-motive…for contingencies requiring sudden expenditure and for unforeseen opportunities of advantageous purchases”—that is, to be prepared.
The most elusive to grasp is the “Speculative-motive”. Demand for money driven by the first three motives is generally “irresponsive to any influence except the actual occurrence of a change in the general economic activity and the level of incomes”. By contrast, speculative demand for money “shows a continuous response to gradual changes in the rate of interest…Indeed, if this were not so, ‘open market operations’ [such as central banks’ purchasing and selling securities to add/remove liquidity in financial markets] would be impracticable.” Thus the levers of monetary policy familiar to us—changes in interest rate targets, open market purchases and sales of government securities by monetary authorities, etc.—play upon this speculative motive for money.

The implications for this are that the quantity, M, can be thought of as having two components: M₁ and M₂, referring respectively to money held for transactional/precautionary and speculative motives, respectively. This dual source of demand for money leads demand for liquidity to be the sum of two functions. L₁ is a function of income, and L₂ is a function of interest rate expectations.

From this, the quantity of money held for economic reasons, M₁, will be equal to income divided by the income-velocity of money—that is, how many times on average the cash held for economic reasons changes hands over the period.

Regarding L₂, however, it’s important to bear in mind that this is a function of expectations regarding future interest rates relative to current ones. Therefore the speculative amount of money “will not have a definite quantitative relation to a given rate of interest”. Part of this is because, inherently, “the rate of interest is a highly conventional…phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable.”

For this exact reason, “a monetary policy which strikes public opinion as being experimental in character or easily liable to change may fail in its objective…The same policy, on the other hand, may prove easily successful if it appeals to public opinion as being reasonable and practicable and in the public interest, rooted in strong conviction, and promoted by an authority unlikely to be superseded.”

The Quantity Theory of Money

If future interest rates were completely certain, M₂ will be zero, and L₂ will also be zero. In this case, we can conclude that the quantity times the velocity of money, which is equal to income, will also be equal to aggregate quantity of output and the aggregate price of that output—these latter two variables being the components of aggregate income. This is the Quantity Theory of Money.

Interest Rates: Making It Most Complicated

Having got this far in the exposition of his theory, Keynes reflects that “the rate of interest on money plays a peculiar part in setting a limit to the level of employment, since it sets a standard to which the marginal efficiency of a capital-asset must attain if it is to be newly produced.” He refers specifically to the rate “on money” because, as he describes, interest could also be given in terms of other goods: for instance, the difference between spot and futures prices for grain could be considered the “interest rate” on grain in terms of grain. But this is beyond the thrust of his main point.

The return on any asset, as Keynes describes it, should devolve into three parts:

The yield/output, “by assisting some process of production or supplying services to a consumer.”
The cost of carrying the asset related to wastage, storage, etc.
A liquidity premium “which [investors] are willing to pay for the potential convenience or security given by this power of [easy] disposal”.

The total return on any assets is therefore the yield minus the cost of carrying the asset plus the liquidity premium.

Money is unique among assets because “in the case of money its liquidity-premium much exceeds its carrying cost, whereas in the case of other assets their carrying cost much exceeds their liquidity-premium.”

Rates may be “reluctant to decline adequately” due to the sticky effect of money-wages, which tend not to fall in nominal terms (as opposed to real terms, as the classicals assumed). Money-wages are especially sticky because of money’s liquidity. Further, rates on money cannot fall below the value of the liquidity preference of holding that money; “In other words, beyond a certain point money’s yield from liquidity does not fall in response to an increase in its quantity to anything approaching the extent to which the yield from other types of assets falls when their quantity is comparably increased.”

Putting it All Together

Synthesizing the concepts of aggregate demand/supply, consumption vs. saving, incentives to invest, and interest rates, Keynes now re-summarizes his general theory:

“Our independent variables are…the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest”.
“Our dependent variables are the volume of employment and the national income measured in wage-units.”

In this framework, investment is a function of expected yields, the degree of liquidity preference, the supply of money, and the supply of capital goods. Consumption moves directionally with income based on the propensity to consume. And, as stated before, the investment multiplier is the derivative of income with respect to investment. A lower multiplier creates greater stability in response to changes in investments, and thus a generally more stable economy.

Conclusion & Other Notes

Theory of Prices

Keynes describes the discrepancies between a supply-and-demand oriented “Theory of Value” and the quantity-and-velocity oriented “Theory of Money”. Keynes’ object is to “escape from this double life”, which he suggests is partly due to the following: “the importance of money essentially flows from its being a link between the present and the future.” Because of this, the phenomenon of money is bound to persist “so long as there exists any durable asset”.

The relationship between the quantity of money and employment he explains thus: “So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money.” (Note: Keynes appears to be quoting another source in this line, but it is not clear what this source might be.)

This is, however, subject to some complications in practice:

Effective demand “will not change in exact proportion to the quantity of money”.
Returns will diminish as employment increases.
“Since resources are not interchangeable, some commodities will reach a condition of inelastic supply [shortages] whilst there are still unemployed resources available for the production of other commodities.”
Wages will rise “before full employment has been reached”, preventing the incremental money supply from going to new employment.

Reasons two and three above are partly why “supply price[s] will increase as output from a given equipment is increased.”

In the long run, however, the “relationship between the national income and the quantity of money will depend on liquidity-preferences. And the long-run stability of instability of prices will depend on the strength of the upward trend of the wage-unit compared with the rate of increase in the efficiency of the productive system.”

Trade Cycle Theory

Admitting that the trade cycle is “highly complex”, Keynes nevertheless makes an attempt. Like the rest of his writings, this is greatly colored by the recency of the prosperous 1920s and calamities 1930s.

In late-stage expansions, investors generally develop “optimistic expectations as to the future yield of capital-goods”. Because of the speculation-driven market order (which he has already described), “when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.” Following this, liquidity preferences become stronger, and the marginal efficiency of capital remains weak due to “the uncontrollable and disobedient psychology of the business world.”

This explanation rhymes significantly with the common basic premise of exuberant investors and abrupt corrections, touching somewhat on George Soros’ theory of market reflexivity—but that is a topic for another time.

Economics Meets Society

Based upon his theories, Keynes claims that “the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.” He thereby advocates “a much lower rate of interest than has ruled hitherto”.

In his closing section, Keynes asks: “is the fulfilment of these ideas a visionary hope?” To this he suggests the following (emphasis is mine):

“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. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.”

This sentiment is part of the reason why I wanted to explore this theme. Perhaps Keynes’ conclusion is mere academic arrogance, but having now examined Adam Smith, Karl Marx, and J.M. Keynes, we can trace the historical threads that tie these ideas into the human memory. Just as Marx’s ideas must be inexorably linked to the events they spawned, so must Keynes’ ideas be considered in light of the macroeconomic revolution they produced.

Although Keynes is himself long since “defunct”, his ideas are not. My college economics classes were chock full of Keynesian notions, many of which professors hardly questioned. The tidy formulas and relationships he described lent economics a scientific cachet it may not fully deserve. Not every economist, however, has been satisfied by the wave of axioms and dogma that Keynes left in his wake—his best-known foil, Fredrich Hayek, is our next portrait of ideas.