Tag: Macroeconomics

History: John Maynard Keynes Getting One Very Right: There Is No Medium-Run Full-Employment Sheet-Anchor for the Economy

Posted on by Brad DeLong

Here we see Keynes getting one, I think, very right: denying that the full-employment equilibrium serves as a medium-run sheet anchor sharply damping short-run fluctuations:

John Maynard Keynes (1937): The General Theory of Employment: “Money, it is well known, serves two principal purposes…

…By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence.

In the second place,it is a store of wealth. So we are told, without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit.

Why should anyone outside a lunatic asylum wish to use money as a store of wealth? Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. Even though this feeling about Money is itself conventional or instinctive, it operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded; and importance has been attached to this because it has been supposed to have a direct proportionate effect on the price-level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money-income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of having quite a different effect, namely, in modifying not the amount that is actually hoarded, but the amount of the premium which has to be offered to induce people not to hoard. And changes in the propensity to hoard, or in the state of liquidity-preference as I have called it, primarily affect, not prices, but the rate of interest; any effect on prices being produced by repercussion as an ultimate consequence of a change in the rate of interest.

This, expressed in a very general way, is my theory of the rate of interest. The rate of interest obviously measures–just as the books on arithmetic say it does–the premium which has to be offered to induce people to hold their wealth in some form other than hoarded money. The quantity of money and the amount of it required in the active circulation for the transaction of current business (mainly depending on the level of money-income) determine how much is available for inactive balances, i.e. for hoards. The rate of interest is the factor which adjusts at the margin the demand for hoards to the supply of hoards.

Now let us proceed to the next stage of the argument. The owner of wealth, who has been induced not to hold his wealth in the shape of hoarded money, still has two alternatives between which to choose. He can lend his money at the current rate of money-interest, or he can purchase some kind of capital-asset. Clearly in equilibrium these two alternatives must offer an equal advantage to the marginal investor in each of them. This is brought about by shifts in the money-prices of capital-assets relative to the prices of money-loans. The prices of capital-assets move until, having regard to their prospective yields and account being taken of all those elements of doubt and uncertainty, interested and disinterested advice, fashion, convention and what else you will which affect the mind of the investor, they offer an equal apparent advantage to the marginal investor who is wavering between one kind of investment and another.

This, then, is the first repercussion of the rate of interest, as fixed by the quantity of money and the propensity to hoard, namely, on the prices of capital-assets. This does not mean, of course,that the rate of interest is the only fluctuating influence on these prices. Opinions as to their prospective yield are themselves subject to sharp fluctuations, precisely for the reason already given, namely, the flimsiness of the basis of knowledge on which they depend. It is these opinions taken in conjunction with the rate of interest which fix their price.

Now for stage three. Capital-assets are capable, in general, of being newly produced. The scale on which they are produced depends, of course, on the relation between their costs of production and the prices which they are expected to realize in the market. Thus if the level of the rate of interest taken in conjunction with opinions about their prospective yield raise the prices of capital-assets, the volume of current investment (meaning by this the value of the output of newly produced capital-assets) will be increased; while if, on the other hand, these influences reduce the prices of capital-assets, the volume of current investment will be diminished.

It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation–on the propensity to hoard, and on opinions of the future yield of capital-assets. Nor is there any reason to suppose that the fluctuations in one of these factors will tend to offset the fluctuations in the other. When a more pessimistic view is taken about future yields, that is no reason why there should be a diminished propensity to hoard. Indeed, the conditions which aggravate the one factor tend, as a rule, to aggravate the other. For the same circumstances which lead to pessimistic views about future yields are apt to increase the propensity to hoard.

The only element of self-righting in the system arises at a much later stage and in an uncertain degree. If a decline in investment leads to a decline in output as a whole, this may result (for more reasons than one) in a reduction of the amount of money required for the active circulation, which will release a larger quantity of money for the inactive circulation, which will satisfy the propensity to hoard at a lower level of the rate of interest, which will raise the prices of capital-assets, which will increase the scale of investment, which will restore in some measure the level of output as a whole.

This completes the first chapter of the argument, namely, the liability of the scale of investment to fluctuate for reasons quite distinct (a) from those which determine the propensity of the individual to save out of a given income and (b) from those physical conditions of technical capacity to aid production which have usually been supposed hitherto to be the chief influence governing the marginal efficiency of capital.
If, on the other hand, our knowledge of the future was calculable and not subject to sudden changes, it might be justifiableto assume that the liquidity-preference curve was both stable and very inelastic. In this case a small decline in money-income would lead to a large fall in the rate of interest, probably sufficient to raise output and employment to the full. In these conditions we might reasonably suppose that the whole of the available resources would normally be employed;and the conditions required by the orthodox theory wouldbe satisfied.

My next difference from the traditional theory concerns its apparent conviction that there is no necessity to work out a theory of the demand and supply of output as a whole. Will a fluctuation in investment, arising for the reasons just described,have any effect on the demand for output as a whole, and consequently on the scale of output and employment? What answer can the traditional theory make to this question? I believe that it makes no answer at all, never having given the matter a single thought; the theory of effective demand,that is the demand for output as a whole, having been entirely neglected for more than a hundred years.

My own answer to this question involves fresh considerations. I say that effective demand is made up of two items–investment-expenditure determined in the manner just explained, and consumption-expenditure. Now what governs the amount of consumption-expenditure? It depends mainly on the level of income. People’s propensity to spend (as I call it) is influenced by many factors, such as the distribution of income, their normal attitude to the future and-though probably in a minor degree–by the rate of interest. But in the main the prevailing psychological law seems to be that when aggregate income increases, consumption-expenditure will also increase, but to a somewhat lesser extent. This is a very obvious conclusion…

Must-Read: Maury Obstfeld: Deflation Risks May Warrant Radical New Central-Bank Thinking

Posted on by Brad DeLong

Must-Read: The asymmetry created by the zero lower bound on short-term safe nominal interest rates is not a difficult concept to grasp. The resulting optionality preserved by aiming at policies that overshoot on employment, growth, and inflation, and then dialing-back if necessary, is both important and relatively simple. Yet since the end of 2008, at every stage, this principle has been grossly neglected by economic policymakers. Hank Paulson was the last person to understand–that is why he went for $700 billion for the TARP even though he (wrongly) thought he would not need it.

Maury understands:

Maury Obstfeld: Deflation Risks May Warrant Radical New Central-Bank Thinking: “I worry about deflation globally…

…It may be time to start thinking outside the box…. You can always, always deal with high inflation… [but] at the zero lower bound, our options are much more limited. In order to bring inflation expectations firmly back to 2% in the advanced countries, where we’d like to see it, it’s probably going to be necessary to have some overshooting of the 2% level, or at least to entertain that as a possibility…

Intellectual broker: Secular stagnation vs. Ben Bernanke

Posted on by Brad DeLong

Let me put here my first, much longer draft to what appeared on Project Syndicate: The Tragedy of Ben Bernanke

Ben Bernanke has published his memoir, The Courage to Act.

I am finding it difficult to read. I am finding it hard to read it as other than as a tragedy. It is the story of a man who found himself in a job for which he may well have been the best-prepared person in the world. Yet he soon found himself overmastered by the situation. And he fell and stayed well behind the curve in understanding what was going on.

Those of us with even some historical memory winced when, back in 2003, Robert Lucas flatly declared that the problem of depression-prevention had been solved “for all practical purposes, and has in fact been solved for many decades”. We remembered 1960s Council of Economic Advisers chairs Walter Heller and Arthur Okun saying much the same thing. Indeed, we remembered Irving Fisher in the 1920s saying much the same thing. Fisher’s hubris was followed by nemesis in the form of the Great Depression. Heller’s and Okun’s hubris was followed by nemesis in the form of the 1970s inflation. The joke was on Lucas.

But in a deeper sense the joke was on those of us who winced at Lucas–and also on the people of the North Atlantic. For, as we know, the economy since 2007 has not been a very funny joke the people of the North Atlantic.

Those of us with historical memory knew that the problem of preventing severe macro economic instability had not been solved. But even we believed that even sharp downturns would be transitory and short. Rapid recovery to full prosperity and the supply side-driven trend growth was all but guaranteed. Perhaps full prosperity could be delayed into an extended medium-run by actively-perverse and destabilizing government policies. Perhaps the full-prosperity equilibrium-restoring forces of the market would work quickly.

But they would work.

Indeed, back in 2000 it was Ben Bernanke who had written that central banks with sufficient will and drive could always, in the medium-run at least, restore full prosperity by themselves via quantitative easing. Simply print money and buy financial assets. Do so on a large-enough scale. People would expect that not all of the quantitative easing would be unwound. Thus people would have an incentive to use the extra money that had been printed to step up their spending. Even if the fraction of quantitative easing that thought permanent was small, and even if the incentive to spend was low, the central bank could do the job.

It is to Bernanke’s great credit that the shock of 2007-8 did not trigger another Great Depression. However, what came after was unexpectedly disappointing. Central banks in the North Atlantic–including Ben Bernanke’s central bank, the Federal Reserve–went well beyond the outer limits of what we had thought, back before 2008, would be the maximum necessary to restore full prosperity. And full prosperity continued and continues to elude us. Bernanke pushed the US monetary base up from $800 billion to $4 trillion–a five-fold increase, one that a naïve quantity theory of money would have seen as enough stimulus to create a 400% cumulative inflation. But that was not enough. And Bernanke found himself and his committee unwilling to take the next leap, and do another more-than-doubling to carry the monetary base up to $9 trillion. And so, by the last third of his tenure in office, he was reduced to begging in vain for fiscal-expansionary help closed-eared Congress, which refused. Some leading figures in the dominant Republican party made political hay by calling what he had done “almost treasonous”, and threatening, in the coded language applied a generation ago to civil rights and other agitators, to lynch him should he show up where he was not wanted.

So what went wrong? I have been thinking about this with mixed success, most recently for the Milken Institute Review. So let me try yet again to summarize:

As I understand Ben Bernanke’s perspective, he thinks that nothing fundamental went wrong. It is just that the medium-run it takes for aggressively-expansionary monetary policy to restore full prosperity has been artificially lengthened, and seems long to us indeed. Interventions by non-market–or perhaps it would be better to call them non-risk adjusted return maximizing–financial players have created a temporary global savings glut. Sovereign wealth funds for which loss aversion is key, the emerging-market rich seeing their positions in the North Atlantic as primarily insurance against political risk, and governments seeking to ensure freedom of action have pushed full-prosperity interest rates down substantially, and lengthened the medium-run it takes for shocks to dissipate. But, I believe Bernanke believes, these disturbances are ending. And so, if he were still running the Fed, he would think it appropriate to raise interest rates now.

An alternative view is held by the very sharp Ken Rogoff. He believes, I think, that Bernanke’s cardinal error was to focus on money when he should have been focusing on that. In our simple models which you focus son does not matter: when the money market is in full-prosperity equilibrium, the debt market is too. But in the real world a central bank and a broader government that focused not on expanding the stock of safe money but on buying back and inducing the writing-down of the stock of risky debt would have boosted private spending much more effectively and restored full prosperity much more quickly.

Yet a third possible view is that the Fed could have done it: if it had committed to a higher target inflation rate than 2%/year, and promised to do as much quantitative easing as needed to get to that target, it would have produced full prosperity without requiring anywhere near as much quantitative easing as has been, so far, undertaken without that favorable result.

And then there is fourth view, one that I associate with Larry Summers and Paul Krugman, that we have no warrant for believing that monetary policy can restore full prosperity not only not in the short-run, but not in the medium-run and probably not even in the long-run. As Krugman put it most recently:

In 1998… I envisaged an economy in which the… natural rate of interest… would return to a normal, positive level… [and so] the liquidity trap became a [monetary-]expectations problem… monetary policy would be effective if it had the right kind of credibility…. [But if] a negative Wicksellian [natural] rate… permanent… [then] if nobody believes that inflation will rise, it won’t. The only way to be at all sure… [is] with a burst of fiscal stimulus…

Their position is, after a long detour through the post-World War II neoclassical-Keynesian synthesis, a return to a position set out by John Maynard Keynes in 1936:

It seems unlikely that the influence of [monetary] policy on the rate of interest will be sufficient by itself…. I conceive, therefore, but a somewhat comprehensive socialization of investment will prove the only means the securing an approximation to full employment; though this not need exclude all manner of compromises and of devices by which the public authority will cooperate with private initiative…

The government, that is, will have to be infrastructure-builder, risk-absorber, safe debt-issuer, debt workout-manager, and to a substantial degrees sectoral economic planner of last resort to maintain full prosperity. Milton Friedman’s dream that strategic interventions by the central bank in the quantity of high-powered money would then be just that—a dream. And our confusion, and the attractiveness of Milton Friedman’s monetarism in the half-century starting with a World War II would be an accident of the particular circumstances of the uniquely rapid North Atlantic-wide demographic and productivity growth of the transient post World War II era.

I cannot claim—we cannot claim—to know whether Bernanke he will Rogoff or Krugman and Summers are correct here, or even weather if Bernanke he and his committee had found the nerve, and rolled double-or-nothing one more time to boost the American high-powered money stock to $9 trillion, we might have been back to full prosperity a couple of years ago. But I do think that the debate over this question is the most important debate within macroeconomics since the debate—strangely, a very similar debate, at least with respect to its policy substance—that John Maynard Keynes had with himself in the decade around 1930 that turned him from a monetarist into a Keynesian.

Question: What Are Our Biggest Economic Problems Right Now?

Posted on by Brad DeLong

I have been someone who takes the long-run secular decline in prime-age male employment as a canary in the coal mine: it has seemed to me via sign that information technology which greatly reduces valuable employment of human brains as cybernetic control elements for machines poses us with significant problems that are not necessarily economic but rather in the sociology of social roles. When Case and Deaton on the decline in life expectancy among the white and middle-aged crossed my desk earlier this week, I thought that case was reinforced.

But now I find myself updating and looking at this graph:

Graph Employment Rate Aged 25 54 Females for the United States© FRED St Louis Fed

It now looks quite different from how it looked a couple of years ago.

I had, a couple of years ago, taken the gender gap in trends here as an indication that those trained not to focus on social intelligence were having increasing difficulties finding valued social roles, and thus as a sign that information technology sociological apocalypse was drawing near. But now… relative to 2000, it is much easier to tell a slack-labor-demand-is-most-of-it story.

Thus I am now swinging toward thinking that if we could only focus on expansionary fiscal policy to restore the high-pressure full-employment economy of the Clinton years that we would find our longer-run structural problems solving themselves, or at any rate becoming smaller and moving further away into the distance. And I am now swinging toward understanding Case and Deaton as more evidence on the extremely high sociological costs of a low-pressure economy.

Must-Read: Michael Spence, Danny Leipziger, James Manyika, and Ravi Kanbur: Restarting the Global Economy

Posted on by Brad DeLong

Must-Read: Michael Spence, Danny Leipziger, James Manyika, and Ravi Kanbur: Restarting the Global Economy: “The global economy is not working properly…

…aggregate demand must be expanded, the gap between excessively large pools of capital and huge unmet infrastructure needs must be bridged, and… the distributional downside of rapid technological advances and global integration must be addressed. Change will come only when a global vision is put forth, coupled with political will…. The challenges represented by these mismatches intersect and interact, and play out differently in the short, medium and long term. One normally thinks of aggregate demand deficiency as a short-term challenge of the business cycle, but the current mismatch at the global level has lasted more than seven years…. Deficient labour demand, as the result of weak aggregate demand overall, either lowers wages or causes unemployment if wages are rigid–worsening the distribution of income in either case. This trend towards greater inequality will only worsen as the consequence of long-run trends in labour-displacing technologies….

These three self-reinforcing mismatches are an indication not only of market failure, but also of the failure of governments to address the challenges they pose…. Three areas of concerted public action–boosting global demand (with an emphasis on investment and essential services), unblocking the flow of surplus funds towards unmet investment needs, and mitigating rising inequality–are mutually reinforcing. The analytical arguments behind them are strong. Public policy solutions are possible to deal with many economic challenges if political consensus can be achieved on tackling them, both nationally and globally. What is needed is global vision and political will that can make them a reality and thus restart the global economy so it can meet its potential on growth and on distribution.

Must-Read: Larry Summers: Advanced Economies Are so Sick We Need a New Way to Think About Them

Posted on by Brad DeLong

Must-Read: Larry Summers: Advanced Economies Are so Sick We Need a New Way to Think About Them: “Standard new Keynesian macroeconomics… [and] to an even greater extent… dynamic stochastic general equilibrium (DSGE) models…

…imply that… the only effect policy can have is on the amplitude of economic fluctuations, not on the [average] level of output. This assumption is problematic…. The assumption is close to absurd. It is surely reasonable to assume that better policy could have avoided the Depression or the huge output losses associated with the financial crisis without having shaved off some previous or subsequent peak…. Contrary to the now common view that macroeconomics is best understood by studying the stochastic properties of stationary time series, the most important macroeconomic events are in some sense one off. Think of the Depression or the Great Recession or the high inflation of the 1970s. The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention…

Must-Read: Ken Rogoff: The Fed’s Communication Breakdown

Posted on by Brad DeLong

Must-Read: I guess I must be a foaming polemicist then :-)…

Ken Rogoff: The Fed’s Communication Breakdown: “Personally, I would probably err on the side of waiting longer…

…and accept the very high risk that, when inflation does rise, it will do so briskly, requiring a steeper path of interest-rate hikes later. But if the Fed goes that route, it needs to say clearly that it is deliberately risking an inflation overshoot. The case for waiting is that we really have no idea of what the equilibrium real (inflation-adjusted) policy interest rate is right now, and as such, need a clear signal on price growth before moving.

But only a foaming polemicist would deny that there is also a case for hiking rates sooner, as long as the Fed doesn’t throw random noise into the market by continuing to send spectacularly mixed signals about its beliefs and objectives. After all, the US economy is at or near full employment, and domestic demand is growing solidly…

I look at this graph:

A kink in the Phillips curve Equitable Growth

And I think: One always disagrees with the very sharp Ken Rogoff at one’s grave analytical peril…

But: Inflation expectations anchored at 2%/year, wage growth at 0%/year real, the prime-age employment-population ratio far below historical norms–that does not smell like an economy “at or near full employment” to me. And so I cannot see a “very high risk that, when inflation does rise, it will do so briskly”, or agree that “only a foaming polemicist would deny that there is also a case for hiking rates” not “sooner” but “right now”…

Intellectual Broker: (Trying to) Make Sense of Current (Small) Analytical Disagreements Between Paul Krugman and Larry Summers: Where Is the Can Opener?

Posted on by Brad DeLong

Larry Summers tweets:

David Wessel picks it up:

And I attempt to Twittersplain, with how much success I do not know:

Larry Summers: Where Paul Krugman and I differ on secular stagnation and demand: “Paul Krugman suggests that I have had some kind of change of heart on secular stagnation…

…and converged towards his point of view…. I certainly appreciate the gravity of the secular stagnation issue more than I did…. But I think Paul exaggerates the change in my views considerably. The topic… was: ‘North America faces a Japan-style era of high unemployment and low growth.’ Paul argued in favor. I opposed the motion–not on the grounds that the US economy was in good shape, but on the grounds that our demand deficiency problems should be easier to solve than Japan’s… [because] it is dimensionally much less than the problems that Japan faced in four respects. Japan’s problems were different in magnitude, different in the depth of their structural roots, different in the… perspective… relative to the rest of the world… different in the degree of resilience [of] their system…. Paul responded in part by saying:

The question is, are we going to be stuck in a state of depressed demand of the kind that Larry has talked about. Larry and I agree that that is what has been happening… I think Larry and I agree almost entirely on the economics, on what needs to be done….

I think we have both been focused on demand and the liquidity trap for a long time. There are, though, two areas where I have had somewhat different views from Paul. I believe that structural issues are often important for demand and growth…. Second, I have never related well to Paul’s celebrated liquidity trap analysis. It has always seemed to me be a classic example of economists’ tendency to ‘assume a can opener’. Paul studies an economy in liquidity trap that will, by deus ex machina, be lifted out at some point in the future. He makes the point that if you assume sufficiently inflationary policy after this point, you can drive ex ante real rates down enough to stimulate the economy even before the deus ex machina moment.

This is true and an important insight. But it seems to elide the main issue. Where is the deus ex machina? Where is the can opener? The essence of the secular stagnation and hysteresis ideas that I have been pushing is that there is no assurance that capitalist economies, when plunged into downturn, will over any interval revert to what had been normal. Understanding this phenomenon and responding to it seems the central challenge for macroeconomics in this era. Any analysis that assumes restoration of previous equilibrium is, from this perspective, missing the main issue. I was glad to see Paul recognize this point recently.  I suspect it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.

Paul Krugman: Liquidity Traps, Temporary and Permanent: “Larry Summers reacts to an offhand post of mine, seeking to draw a distinction between our views…

…I actually don’t think our views differ significantly now, but he’s right that what he has been saying differs from the approach I took way back in 1998. And I’ve both acknowledged that and admitted that the approach I took then seems inadequate now…. Japan now looks like an economy in which a negative natural rate is a more or less permanent condition. So, increasingly, does Europe. And the US may be in the same boat, if only because persistent weakness abroad will lead to a strong dollar, and we will end up importing demand weakness. And if we are in a world of secular stagnation–of more or less permanent negative natural rates–policy becomes even harder.

And I commented on Paul’s webpage thus: But, as I was tweeting to David Wessel, you scorn the Confidence Fairy while having some hope for the Inflation-Expectations Imp, while he scorns the Inflation-Expectations Imp but has some hope for the Confidence Fairy, no? And he has more hope for pump-priming small fiscal expansion to trigger virtuous circles and give the economy escape velocity, no? Small differences relative to those of the two of you vis-a-vis Rogoff, Mankiw, Feldstein, Bernanke, and, I think, even Blanchard. But differences, no?…

Must-Read: Paul Krugman: I do not think that word…<

Posted on by Brad DeLong

Must-Read: When did the default definition of “expansionary fiscal policy” become not (1) “the government hires people to build a bridge”, but rather (2) “the government borrows money from some people and writes checks to others, thus raising both current financial assets and expected future tax liabilities”? Or, rather, for what communities did it become (2) rather than (1), and why?

Or, perhaps, when did the deficit become the off-the-shelf measure of the fiscal-policy stance, rather than some other measure that incorporated some role for the balanced-budget multiplier?

This is something I really ought to know, but do not. It is bad that I do not know this:

Paul Krugman: I do not think that word…: “…means what Tyler Cowen and Megan McArdle think it means…

…The word in question is ‘spending.’ Tyler’s latest on temporary versus permanent government consumption clarifies… the confusion…. By ‘government spending’… I mean the government actually, you know, buying something–say, building a bridge. When Tyler says

The Keynesian boost to aggregate demand arises because people consider the resulting bonds to be ‘net wealth’ even when they are not,

the only way that makes sense is if he’s thinking of a rebate check. If the government builds a bridge, the boost to aggregate demand comes not because people are ‘tricked’ into feeling wealthier, but because the government is building a bridge. The question then is how much of that direct increase in government demand is offset by a fall in private consumption because people expect their future taxes to be higher; obviously that offset is smaller if they think the bridge is a one-time expense than if they think there will be a bridge built every year. That’s why temporary government spending has a bigger effect…. I guess there’s an alternative theory of what Tyler is talking about–maybe he doesn’t consider the wages of the bridge-builders count, that only what they do with those wages matters…

Or, rather, that all government expenditure is wasteful, and you might have well have simply handed out checks rather than forced people to engage in pointless useless make-work.

John Maynard Keynes in His High Wicksellian Mode in 1937: Today’s History of Economic Thought

Posted on by Brad DeLong

Today’s History of Economic Thought: Here we have John Maynard Keynes in his High Wicksellian mode:

  • The natural rate of interest depends on unstable and flutuating opinions about the future yield of capital-assets.
  • The market rate of interest depends on the supply of money and the unstable and fluctuating propensity to hoard–liquidity preference.
  • Thus we have large-scale fluctuations in investment (unless a central bank can neutralize fluctuations in liquidity preference and also make the market rate dance in time with the fluctuating natural rate)
  • Add in the multiplier, and we have unemployment business cycles.

This was, I think, the article that made the Swedes whimper: “Why are the citations to Knut Wicksell missing?”

John Maynard Keynes (1937): The General Theory of Employment: “Money, it is well known, serves two principal purposes…

…By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place,it is a store of wealth.

So we are told, without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit.

Why should anyone outside a lunatic asylum wish to use money as a store of wealth? Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. Even though this feeling about Money is itself conventional or instinctive, it operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded; and importance has been attached to this because it has been supposed to have a direct proportionate effect on the price-level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money-income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of having quite a different effect, namely, in modifying not the amount that is actually hoarded, but the amount of the premium which has to be offered to induce people not to hoard. And changes in the propensity to hoard, or in the state of liquidity-preference as I have called it, primarily affect, not prices, but the rate of interest; any effect on prices being produced by repercussion as an ultimate consequence of a change in the rate of interest.

This, expressed in a very general way, is my theory of the rate of interest. The rate of interest obviously measures–just as the books on arithmetic say it does–the premium which has to be offered to induce people to hold their wealth in some form other than hoarded money. The quantity of money and the amount of it required in the active circulation for the transaction of current business (mainly depending on the level of money-income) determine how much is available for inactive balances, i.e. for hoards. The rate of interest is the factor which adjusts at the margin the demand for hoards to the supply of hoards.

Now let us proceed to the next stage of the argument. The owner of wealth, who has been induced not to hold his wealth in the shape of hoarded money, still has two alternatives between which to choose. He can lend his money at the current rate of money-interest, or he can purchase some kind of capital-asset. Clearly in equilibrium these two alternatives must offer an equal advantage to the marginal investor in each of them. This is brought about by shifts in the money-prices of capital-assets relative to the prices of money-loans. The prices of capital-assets move until, having regard to their prospective yields and account being taken of all those elements of doubt and uncertainty, interested and disinterested advice, fashion, convention and what else you will which affect the mind of the investor, they offer an equal apparent advantage to the marginal investor who is wavering between one kind of investment and another.

This, then, is the first repercussion of the rate of interest, as fixed by the quantity of money and the propensity to hoard, namely, on the prices of capital-assets. This does not mean, of course,that the rate of interest is the only fluctuating influence on these prices. Opinions as to their prospective yield are themselves subject to sharp fluctuations, precisely for the reason already given, namely, the flimsiness of the basis of knowledge on which they depend. It is these opinions taken in conjunction with the rate of interest which fix their price.

Now for stage three. Capital-assets are capable, in general, of being newly produced. The scale on which they are produced depends, of course, on the relation between their costs of production and the prices which they are expected to realize in the market. Thus if the level of the rate of interest taken in conjunction with opinions about their prospective yield raise the prices of capital-assets, the volume of current investment (meaning by this the value of the output of newly produced capital-assets) will be increased; while if, on the other hand, these influences reduce the prices of capital-assets, the volume of current investment will be diminished.

It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation–on the propensity to hoard, and on opinions of the future yield of capital-assets. Nor is there any reason to suppose that the fluctuations in one of these factors will tend to offset the fluctuations in the other. When a more pessimistic view is taken about future yields, that is no reason why there should be a diminished propensity to hoard. Indeed, the conditions which aggravate the one factor tend, as a rule, to aggravate the other. For the same circumstances which lead to pessimistic views about future yields are apt to increase the propensity to hoard.

The only element of self-righting in the system arises at a much later stage and in an uncertain degree. If a decline in investment leads to a decline in output as a whole, this may result (for more reasons than one) in a reduction of the amount of money required for the active circulation, which will release a larger quantity of money for the inactive circulation, which will satisfy the propensity to hoard at a lower level of the rate of interest, which will raise the prices of capital-assets, which will increase the scale of investment, which will restore in some measure the level of output as a whole.

This completes the first chapter of the argument, namely, the liability of the scale of investment to fluctuate for reasons quite distinct (a) from those which determine the propensity of the individual to save out of a given income and (b) from those physical conditions of technical capacity to aid production which have usually been supposed hitherto to be the chief influence governing the marginal efficiency of capital.

If, on the other hand, our knowledge of the future was calculable and not subject to sudden changes, it might be justifiable to assume that the liquidity-preference curve was both stable and very inelastic. In this case a small decline in money-income would lead to a large fall in the rate of interest, probably sufficient to raise output and employment to the full. In these conditions we might reasonably suppose that the whole of the available resources would normally be employed;and the conditions required by the orthodox theory wouldbe satisfied.

My next difference from the traditional theory concerns its apparent conviction that there is no necessity to work out a theory of the demand and supply of output as a whole. Will a fluctuation in investment, arising for the reasons just described,have any effect on the demand for output as a whole, and consequently on the scale of output and employment? What answer can the traditional theory make to this question? I believe that it makes no answer at all, never having given the matter a single thought; the theory of effective demand,that is the demand for output as a whole, having been entirely neglected for more than a hundred years.

My own answer to this question involves fresh considerations. I say that effective demand is made up of two items–investment-expenditure determined in the manner just explained, and consumption-expenditure. Now what governs the amount of consumption-expenditure? It depends mainly on the level of income. People’s propensity to spend (as I call it) is influenced by many factors, such as the distribution of income, their normal attitude to the future and-though probably in a minor degree–by the rate of interest. But in the main the prevailing psychological law seems to be that when aggregate income increases, consumption-expenditure will also increase, but to a somewhat lesser extent. This is a very obvious conclusion…

John Maynard Keynes (1937), “The General Theory of Employment”, Quarterly Journal of Economics 51:2 (February), pp. 209-223 http://www.jstor.org/stable/1882087