The other day I was talking to an open-minded economist who didn’t appear wedded to Keynesianism. I said I believed that all Keynes’ major nostrums were false and that included the citadel or sine qua non of Keynesianism, his theory of the Marginal Efficiency of Capital, (MEC) on which his postulate that capitalism ends up in mass unemployment depends.My colleague’s response was that whilst one could reasonably chip away at, or even demolish, several other elements of Keynesianism, surely the MEC was simple commonsense. After all it was only a question of marginal utility, which applied to lots of other goods. Indeed the “marginal revolution” which transformed economics was rightly claimed by the Austrian School as its own discovery. How odd that the School, in defiance of commonsense, didn’t support MEC.
This led me to consider MEC as a matter of commonsense. (It has already been demolished many times by both theory and practice*.) Wouldn’t it be wonderful if Joe Bloggs, unclouded by the study of economics, could rebut MEC using simple commonsense? And on the contrary what a blow it would be for the Austrian School if MEC was supported by commonsense – as my colleague claimed.
Initially, I admit I got a bit of a shock. Marginal theory does accord with commonsense. That is why a teeny weeny diamond is more valuable that a huge glass of water if you’ve already got enough drinking water to last a lifetime. It is why you wouldn’t pay as much for your third apple of the day as you would for the first. The more widgets you have, the less valuable is yet another widget.
Joe Bloggs can see this and articulate it, as well as behave in accordance with it. And so it is with capital. Anything that isn’t unlimited has some scarcity value. So the next bit of capital isn’t as valuable as the previous bit – some other desire now takes precedence over it.
It is perhaps permissible to replace “valuable” by “efficient”. The next widget isn’t as “efficient” as the previous one (at least in the operational sense unless other factors such as labour and materials are increased pro-rata). Keynes, however, was notoriously sloppy in justifying his pre-determined agenda. He slipped in yet another replacement – “rate of return”. Now marginal utility has morphed into marginal rate of return – so it’s the rate of return that gets lower.
Yet wouldn’t commonsense suggest that the decreasing marginal utility of capital would mean decreasing prices for it – as it does for everything else? And if you can get the next widget machine for a lower price than the previous one, then all other things being equal wouldn’t this mean you’d enjoy a higher rate of return on it, not a lower one?
In fact all other things are not equal as I discuss below (but they don’t help Keynes’ theory one bit), and I suggest that at this point Mr & Mrs Bloggs may need some help. But certainly they could see that reducing marginal utility means reducing marginal price. If they’d pay less for that 4th glass of iced water then surely they’d pay less for a second fridge to put more iced water in?
The Keynes Agenda
What Keynes wanted to show was something different – decreasing marginal rates of return, to the point where capitalists didn’t see it as worth having at all and would give up or at least reduce their scale of operations, to the point of mass unemployment (so that Government could step in as a saviour of course). I suggest that to do this he had to surreptitiously sneak in “reducing rates of return on capital” under the cloak of marginal utility theory.
Even on its own flawed terms there are (at least) three problems with this and the spectre of mass unemployment:
(i) How was full employment maintained during the build up to this position? And now it has been reached, surely all capitalists have to do is to mothball some of their machinery and we’re back down the track to the point where there was no difficulty.
(ii) In practice entrepreneurs would buy up the mothballed machinery for a song, re-employ the sacked workers, and make a huge return. How can such a huge return be consistent with a marginally diminished low one?
(iii) Nobody is born with a label “employee” or “employer” tattooed on his back. (“Employers” were thin on the ground before the Industrial Revolution but there was plenty to do). Anybody can become gainfully occupied simply by trading with somebody else, irrespective of the nature or existence of their capital equipment.
The consequences of reducing marginal returns
What would happen if, ever so generously, we all ignored all these problems and granted Keynes the idea of reducing marginal returns on capital? Clearly these lower returns will permeate the whole environment. In particular, businessmen will press their suppliers for lower prices, who will do likewise and so on all the way along the chain. At the end of the chain, savers, the original suppliers of the capital used in business, will themselves be pressed into accepting lower returns. Therefore these lower returns will, or will not, be acceptable throughout the economy, including savers. If they are acceptable to savers then they’ll be acceptable to businesses and entrepreneurs. If they’re not acceptable to savers then there’ll be less saving and less capital, which will cure Keynes’ problem. But Keynes could not conceive of chains or indeed anything with a time factor in it at all.
In fact, as Austrians know, the above chain does not represent the order in which things happen; interest rates themselves are determined by consumer time-preferences for goods today versus goods tomorrow. Only if these preferences are low (i.e. if people are prepared to wait, for little reward) would market interest rates be low.
Whilst it is quite possible, indeed some would say likely, that time-preferences reduce as living standards increase, thus accommodating lower returns on capital, these returns are by definition satisfactory throughout the economy as a whole, and have no implications whatsoever for the overall level of employment.
Remember that Keynesian MEC theory is essentially a theory of employment; it holds that full employment can’t exist on the free market. Whichever way you look at it, it doesn’t make sense – common or otherwise!
On the Mises site, amongst many examples, Roger Garrison’s book Time and Money (and other articles) refute MEC and other Keynesian fallacies, whilst Richard Johnsson’s The Liquidity-Trap Myth, discusses the experience of Japan.
www.capitalism.net carries George Reisman’s tour de force, Capitalism, Where Chapter 18 is devoted to a critique of Keynesianism including MEC in particular.
Keynes, Capital, and Commonsense
