The General Theory of Employment, Interest and Money (John Maynard Keynes)
The uber-philosopher Bertrand Russell, mentor to Wittgenstein and Popper, and friend of Albert Einstein and T.S.Eliot was once asked who he regarded to be the most intelligent person he had ever met, to which he replied “Keynes”. Did he really regard him as more intelligent than himself? “Oh yes, every time I argued with him I felt as though I were taking my life in my hands”.
It is obviously a matter of opinion as to what is the most important economics book of all time, but one would be hard pressed to find a credible list in which John Maynard Keynes’ General Theory of Employment, Interest & Money was not in the top three. Written in 1936 at the peak of his fame and influence, this period was one of The Great Depression, of Hitler’s Germany, Mussolini’s Italy and Stalin’s Russia. The General Theory revolutionised macroeconomics, simultaneously giving intellectual weight to the socialist left, whilst wrapping capitalism in a protective theoretical cloak against the forces of communism and fascism. Some economists have dismissed Keynes’ influence as a product of his fame (he shot to celebrity by writing a bestseller ‘The Economic Consequences Of The Peace’ in 1919, in which he lambasted the post war settlement and the allies’ leadership), or of his literary skill or political appeal, but none can deny it.
The first thing to say about The General Theory is that it passes the true test of one's opinion of a book - I will read it again. Described by some as confusing, whilst it can be difficult going, the book is wonderfully written with each conceptual or algebraic exposition followed up by vivid prose drenching his arguments in common sense explanations. There is no point at which the book veers into the emotionally-charged ideology to be found in Marx; indeed, despite what I expected, The General Theory is not an especially political book, and certainly cannot be described as socialist. Considering how forcibly the arguments were being made at that time for central planning (to get an idea read the news articles and essays of George Orwell in the late 1930s), The General Theory is a measured and scientifically-grounded work of genius. Those who argue that Stagflation in the 1970s invalidates Keynes’ argument have likely not read the book. The Phillips Curve is not once mentioned, and is associated with Keynes because of later attempts to reconcile Keynesianism with the classical economists, by Paul Samuelson and his ilk. Keynes doesn’t argue for further empowerment of trade unions or mass nationalisation of industry, factors that eventually would embed inflation into British and US economies, in a mechanistic way unforeseen and unintended by Keynes.
I will attempt now a simplified version of Keynes’ argument.
Classical economists based their theory of employment on two postulates. Firstly, the demand for labour is based on its marginal product, ie. firms will hire all the workers at a given wage that it is profitable to do so. Secondly, the utility of a wage when a given volume of labour is employed, is equal to the marginal disutility of that amount of employment. In other words, wages at a given level of employment are just enough for that number of workers to bother leaving the house in the morning.
Together, these two assertions represent the supply and demand curves for labour, and so the point at which they intersect determines the level of employment. Since, if people were willing to work for a lower wage it would be profitable for companies to hire them, there is, according to the classical economists, only voluntary unemployment.
Classical economists also subscribe to Say’s Law, the idea that supply creates its own demand. In the act of producing goods for sale, workers are paid and profits made; these monies are spent on other goods for which other workers are paid, and so on. Therefore supply will equal demand overall in an economy.
If we take an economy as a whole, and say that there is an aggregate supply price for any level of employment (the price at which it is just worth producing this level of output), and an aggregate demand price for any level of employment (the level of proceeds an entrepreneur will receive), we can say that it is at equilibrium where supply and demand intersect - and that level of equilibrium will determine the level of employment. However, if one agrees with the classical economist’s ideas above, supply and demand will intersect at all levels of employment (since ‘supply creates its own demand’). In this case, competition between entrepreneurs will always lead to expansion up to the point of full employment. This, in 1936, with the mass (and obviously involuntary) unemployment of the Great Depression still a reality, was how many economists were still describing the world.
Keynes states that the volume of employment in equilibrium in an economy is a function of aggregate supply and aggregate demand. Demand is made up of consumption and investment. If income in a community increases, we naturally will increase our consumption, but not by as much as the increased income (especially if we are already reasonably affluent). So a lower quantity of money is going back into the system, unless investment makes up the shortfall. If less money is going back in, employers cannot justify the level of output and will employ fewer people. It was assumed prior to Keynes that any money not spent on consumption was saved, and saving equals investment, so their theory (and Say’s Law) should hold. This, Keynes calls an “optical illusion”. Whilst saving equals investment, the amount we save is caused by the level of investment, not the other way around. So if levels of saving (and investment) are lower than the difference between the increase in income and the increase in consumption, the economy will find an equilibrium at a lower level of employment. This is the conclusion the classical economists couldn’t reach, because of the assumptions described above.
So if an economy will only be at full employment when investment makes up that shortfall between increased income and increased consumption, the classical model is in fact a special case (or rather the optimal case), as opposed to an accurate description of how the world works at all times.
What was described as the marginal disutility of labour (simply, the wage at which people choose to stay at home), isn’t actually the level of wages in an economy in normal times, it is the level of full employment - the ceiling for maximum output. Classical economists thought that workers were able to increase employment by reducing their real wage demands, but Keynes showed this to be a fallacy. Firstly, they were only ever able to negotiate nominal wages, and only on an individual, company, or industry (with trade unions) level - in the knowledge that a fall that wasn’t mirrored in all industries would leave them worse off. Secondly, workers or trade unions couldn’t influence the price level or predict the effect of wage negotiations on prices. Thus the idea that wages are ‘sticky’, and won’t adjust downwards easily is not a market failure as such, but a feature of the real world to be factored into macro-economic models. In the real world, if the propensity to consume and the rate of new investment result in deficient effective demand, there will be people willing to work at the current wage rate, but involuntarily unemployed. Keynes’ theory had the convenient advantage, unlike his rivals, of being a good description of the world as it was at the time of his writing.
To complete the model, we must now turn to the question of what determines the level of investment, given that as stated above, an economy can only reach full employment when investment bridges the gap between our output and our consumption.
What Keynes calls the Marginal Efficiency of Capital, is simply, the expected return during the lifetime of a capital asset (say, a taxi or a hammer), discounted at a rate making it equal to the replacement cost of that asset. When we are deciding whether or not to invest, this rate is compared to the rate of interest - if I think the taxi will give me a return higher than the rate of interest I will invest, if not, to invest is pointless. In an efficient economy the level of investment will be pushed to the point where the marginal efficiency of capital is equal to the rate of interest. Therefore in order to know the level of investment, we need to know the marginal efficiency of capital, and the rate of interest.
Moving yet further down the ladder of the logic of Keynes’ model, from employment partly depending on the level of investment, to investment being partly dependent upon the rate of interest, we must finally explore the causes of the level of interest rates in an economy.
Rather than all saving automatically becoming investment, people will choose to keep some of their income in the form of cash, what Keynes calls the ‘liquidity preference’. It is the rate of interest, he states, that is the reward for not holding cash (or ‘propensity to hoard’). If the rate is too low, we will wish to hold more cash, and so either the quantity of money or the rate of interest must rise. If neither happens, output and employment will fall. The classical economists saw the rate of interest as being the bridge between savings and investment - if more people wish to save than firms wished for capital to invest, interest rates would fall, and vice versa. But this is based on a fixed level of income and therefore says Keynes, on a logical fallacy. Interest rates do not always adjust to bridge the gap between saving and investment, since interest rates maintain the equilibrium between the supply and demand for money, and so output & employment must adjust instead.
Having laid out a crude version of Keynes’ argument, its implications are easier to assess. Firstly, the propensity to consume, liquidity preference and marginal return to capital are all psychological determinants of the major drivers of employment and output in an economy. How much of my income I spend on pizza relative to placing it in an ISA will very much depend on my assessment of the future. Whether an entrepreneur decides to invest in new machinery is based on their personal assessment of the marginal return to capital, which is a judgement call influenced not least by optimism or pessimism about the future. In this way, Keynes demonstrated how demand could fall below supply in the long run, and how pessimism could keep an economy in a permanent state of equilibrium well below its potential output. Again, since this reflected rather accurately the 1930s in both the U.S. and Britain, his argument gained immediate credence.
Keynes’ solution to this problem was to increase aggregate demand (the investment part of it), using government deficit spending, preferably on public works. Since wages paid to public employees would be spent with private businesses, there would be a multiplier effect, increasing employment to a level higher than the initial investment. In this way he states, "If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing." Sadly, the expansion of demand, and consequent return to full employment did come in the form of World War 2.
Paul Krugman (Nobel-winning economist and avowed Keynesian) says that economists can be divided into those who internalise Book One of The General Theory, and ‘Chapter Twelvers’. Book One contains the nuts and bolts of the theory itself, whilst chapter twelve concerns itself with the psychology of investment, and our general behaviour in the face of uncertainty. Keynes’ general point is that investment decisions are not only unscientific and inherently inaccurate, they rarely reflect actual opinions about the future. In the context of the stock market, investors are choosing not which company will succeed, but which companies they think other investors think will succeed, and so on. It’s an illuminating and inherently quotable discussion useful for economists and investors alike.
My own conclusion from reading The General Theory is that the majority of the criticisms of Keynesian Economics are attributable not to this book, or even to Keynes, but to the consequences of the actions of his disciples, both politicians and economists.
Firstly, to many, the switch in emphasis by policymakers to ‘the supply-side’ in the 1980s, implied that supply-side and demand-side economics are incompatible creeds, and Keynes’ demand-side policies were obsolete. Many times in the book Keynes describes the moving parts of the economy ‘from a fixed level of technique’. This is working on the assumption that supply in the short term is unchanging (for reasons of convenience when explaining the model). In fact all real growth in an economy will result from the improvement of ‘technique’ (meaning technology and innovation). We become richer as a society because we invent ways to harness electricity, or improve the yield of a crop, or reduce the cost of manufacturing paper coffee cups. This is true whether or not we as society become better at managing aggregate demand. Investment in education or deregulation of firms to encourage innovation are not barriers to managing demand shocks. We can see today that it is a Conservative government in Britain that is reacting to the shock of Covid-19 by a furlough scheme designed to avoid a collapse in aggregate demand, which in the short term is no barrier to innovation or the growth of aggregate supply.
Where the above example does bring into conflict supply-side and demand-side economics is if government intervention were to impinge on innovation, by destroying the market-system as a mechanism for the selection of good ideas (for example, if furlough were to last 5 years, and companies unable to adapt to the new paradigm were propped up regardless, innovation would suffer). Which brings us to a more significant, and altogether more political criticism of The General Theory. Friedrich Hayek, Ludwig Von Mises and others from the Austrian School argue that government intervention in an economy destroys incentives, and that without a price mechanism there can be no way to gain knowledge of what truly works; that a government bureaucrat can order the production of a quantity of goods, but would never know the true demand of such goods without the market mechanism. Keynesian interventionism they argue, destroys the allocative efficiency of the market by crowding out private enterprise in favour of government spending.
I sympathise with this view. Any reading of the perverse outcomes of state planning in Soviet Russia, where some outputs were measured and rewarded based on physical weight, leading to chandeliers too heavy to hang, and the mass killing of whales (useless for food but heavy), shows how far things can go wrong on the road of government planning. The arguments in the late 1970s in Britain and the USA were that the supply side had been neglected, and politicians simply used deficit spending as a proxy for growth. I think this is both true and correctly identified as a policy error. A lack of efficiency and a lack of reward for innovation will kill long term growth regardless of how well (or poorly) demand is being managed by politicians trying to win elections. But this is not an argument against Keynes’ insistence that aggregate demand is managed in a crisis. Yes, we must have a market economy for capitalism to innovate (and for personal freedom), but equally, we must manage at a macro-level in an economic emergency.
Keynes makes this point in a letter to Hayek, in response to his seminal The Road To Serfdom, stating: “You admit here and there that it is a question of knowing where to draw the line. You agree that the line has to be drawn somewhere [between free-enterprise and planning], and that the logical extreme is not possible. But you give us no guidance whatever as to where to draw it. In a sense this is shirking the practical issue. It is true that you and I would probably draw it in different places. I should guess that according to my ideas you greatly underestimate the practicability of the middle course. But as soon as you admit that the extreme is not possible, and that a line has to be drawn, you are, on your own argument, done for since you are trying to persuade us that as soon as one moves an inch in the planned direction you are necessarily launched on the slippery path which will lead you in due course over the precipice.” Keynes is saying that no one in their right mind would argue for zero state intervention in an economy, and very few people will today argue for total management either. To argue otherwise is plain silly. Tax receipts fall during a shock, and unemployment benefits increase. This is automatic deficit spending. Does it impinge on freedom or the workings of the market? In fact, Hayek’s list of areas in which government should involve itself is far greater than purists seem to realise (including advocating a form of universal basic income).
Overall, The General Theory was a revelation. Far more informative than any economics textbook I have ever read, and far more lucid. Reading foundational texts cuts out the slander, distortion and false attribution of the ideologue, and allows a fleeting glimpse into the mind of genius. Read this book.