The Critics of Keynesian Economics

IX

BENJAMIN M. ANDERSON was born in 1886 and died in 1949. He took his doctor’s degree in economics, philosophy, and sociology at Columbia University in 1911. Between 1911 and 1918 he was on the economic faculties of Columbia and Harvard universities. He became economist of the Chase National Bank in 1920. His chief works are Social Value (1911), The Value of Money (1917: reprinted 1922, 1926, and 1936), and Economics and the Public Welfare (1949). The following essay, “Digression on Keynes,” appeared as Chapter 60 of Economics and the Public Welfare.1 It had already appeared in substance, however, in a symposium published by the Twentieth Century Fund in 1945, in their publication entitled Financing American Prosperity, as an appendix to Anderson’s contribution, under the title: “A Refutation of Keynes’ Attack on the Doctrine that Aggregate Supply Creates Aggregate Demand—Basic Fallacies in the Keynesian System.”

DIGRESSION ON KEYNES

BENJAMIN M. ANDERSON

1. A REFUTATION OF KEYNES’S ATTACK ON THE DOCTRINE THAT AGGREGATE SUPPLY CREATES AGGREGATE DEMAND

The central theoretical issue involved in the problem of postwar economic readjustment, and in the problem of full employment in the postwar period, is the issue between the equilibrium doctrine and the purchasing power doctrine.

Those who advocate vast governmental expenditures and deficit fianancing after the war as the only means of getting full employment, separate production and purchasing power sharply. Purchasing power must be kept above production if production is to expand, in their view. If purchasing power falls off, production will fall off.

The prevailing view among economists, on the other hand, has long been that purchasing power grows out of production. The great producing countries are the great consuming countries. The twentieth century world consumes vastly more than the eighteenth century world because it produces vastly more. Supply of wheat gives rise to demand for automobiles, silks, shoes, cotton goods, and other things that the wheat producer wants. Supply of shoes gives rise to demand for wheat, for silks, for automobiles and for other things that the shoe producer wants. Supply and demand in the aggregate are thus not merely equal, but they are identical, since every commodity may be looked upon either as supply of its own kind or as demand for other things. But this doctrine is subject to the great qualification that the proportions must be right; that there must be equilibrium.

On the equilibrium theory occasional periods of readjustment are inevitable and are useful. An active boom almost inevitably generates disequilibria. The story in the present volume of the boom of 1919-1920 and the crisis of 1920-1921 gives a classical illustration. The period of readjustment may be relatively short and need not be severe, but a period of shakedown, a period in which overexpanded industries are contracted and opportunities made for under-developed industries to expand, a period in which prices and costs come into equilibrium, a period in which weak spots in the credit situation are cleaned up, a period in which excessive debts are liquidated—such periods we must have from time to time. The effort to prevent adjustment and liquidation by the pouring out of artificial purchasing power is, from the standpoint of the equilibrium doctrine, an utterly futile and wasteful and dangerous performance. Once a reëquilibration is accomplished, moreover, the equilibrium doctrine would regard pouring out new artificial purchasing power as wholly unnecessary and further as dangerous, since it would tend to create new disequilibria.

The late Lord Keynes was the leading advocate of the purchasing power doctrine, and the leading opponent of the doctrine that supply creates its own demand. The present chapter is concerned with Keynes’s attack on the doctrine that supply creates its own demand.

Keynes was a dangerously unsound thinker.1 His influence in the Roosevelt Administration was very great. His influence upon most of the economists in the employ of the Government is incredibly great. There has arisen a volume of theoretical literature regarding Keynes almost equal to that which has arisen around Karl Marx.2 His followers are satisfied that he has destroyed the long accepted economic doctrine that aggregate supply and aggregate demand grow together. It seems necessary to analyze Keynes’s argument with respect to this point.

Keynes Ignores the Essential Point in the Doctrine He Attacks. Keynes presents his argument in his The General Theory of Employment, Interest and Money, published in 1936. But he nowhere in the book takes account of the law of equilibrium among the industries, which has always been recognized as an essential part of the doctrine that supply creates its own demand. He takes as his target a seemingly crude statement from J. S. Mill’s Principles of Political Economy (Book III, chap. 14, par. 2) which follows:

What constitutes the means of payment for commodities is simply commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply: everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange.

Now this passage by itself does not present the essentials of the doctrine. If we doubled the productive power of the country, we should not double the supply of commodities in every market, and if we did, we should not clear the markets of the double supply in every market. If we doubled the supply in the salt market, for example, we should have an appalling glut of salt. The great increases would come in the items where demand is elastic. We should change very radically the proportions in which we produced commodities.

But it is unfair to Mill to take this brief passage out of its context and present it as if it represented the heart of the doctrine. If Keynes had quoted only the three sentences immediately following, he would have introduced us to the conception of balance and proportion and equilibrium which is the heart of the doctrine—a notion which Keynes nowhere considers in this book. Mill’s next few lines, immediately following the passage torn from its context, quoted above, are as follows:

It is probable, indeed, that there would now be a superfluity of certain things. Although the community would willingly double its aggregate consumption, it may already have as much as it desires of some commodities, and it may prefer to do more than double its consumption of others, or to exercise its increased purchasing power on some new thing. If so, the supply will adapt itself accordingly, and the values of things will continue to conform to their cost of production.

Keynes, furthermore, ignores entirely the rich, fine work done by such writers as J. B. Clark and the Austrian School, who elaborated the laws of proportionality and equilibrium.

The doctrine that supply creates its own demand, as presented by John Stuart Mill, assumes a proper equilibrium among the different kinds of production, assumes proper terms of exchange (i.e., price relationships) among different kinds of products, assumes proper relations between prices and costs. And the doctrine expects competition and free markets to be the instrumentality by means of which these proportions and price relations will be brought about. The modern version of the doctrine3 would make explicit certain additional factors. There must be a proper balance in the international balance sheet. If foreign debts are excessive in relation to the volume of foreign trade, grave disorders can come. Moreover, the money and capital markets must be in a state of balance. When there is an excess of bank credit used as a substitute for savings, when bank credit goes in undue amounts into capital uses and speculative uses, impairing the liquidity of bank assets, or when the total volume of money and credit is expanded far beyond the growth of production and trade, disequilibria arise, and, above all, the quality of credit is impaired. Confidence may be suddenly shaken and a countermovement may set in.

With respect to all these points, automatic market forces tend to restore equilibrium in the absence of overwhelming governmental interference.

Keynes has nothing to say in his attack upon the doctrine that supply creates its own demand, in the volume referred to, with respect to these matters.

Indeed, far from considering the intricacies of the interrelations of markets, prices and different kinds of production, Keynes prefers to look at things in block. He says:

In dealing with the theory of employment I propose, therefore, to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment. The first of these is strictly homogeneous, and the second can be made so. For, in so far as different grades and kinds of labor and salaried assistance enjoy a more or less fixed relative remuneration, the quantity of employment can be sufficiently defined for our purpose by taking an hour’s employment of ordinary labor as our unit and weighing an hour’s employment of special labor in proportion to its remuneration; i.e., an hour of special labor remunerated at double ordinary rates will count as two units. [Italics mine.] 4 . . .

It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labor, when we are dealing with the behavior of the economic system as a whole . . .5

Procedure of this kind is empty and tells us nothing about economic life. How empty it is becomes apparent when we observe that these two supposedly independent units of quantity, namely, “quantities of money value” and “quantities of employment,” are both merely quantities of money value. If ten laborers working for $2 a day are dismissed and two laborers working for $10 a day are taken on, there is no change in the volume of employment, by Keynes’s method of reckoning, as is obvious from the italicized portion of the quotation above. His “quantity of employment” is not a quantity of employment. It is a quantity of money received by laborers who are employed.6

Throughout Keynes’s analysis he is working with aggregate, block concepts. He has an aggregate supply function and an aggregate demand function.7 But nowhere is there any discussion of the interrelationships of the elements in these vast aggregates, or of elements in one aggregate with elements in another. Nowhere is there a recognition that different elements in the aggregate supply give rise to the demand for other elements in the aggregate supply. In Keynes’s discussion, purchasing power and production are sharply sundered.

The Function of Prices. It is part of the equilibrium doctrine that prices tend to equate supply and demand in various markets: commodities, labor, capital, and so on. If prices go down in particular markets this constitutes a signal for producers to produce less, and a signal for consumers to consume more. In the markets, on the other hand, where prices are rising we have a signal for producers to produce more, for consumers to consume less, and a signal for men in fields where prices are less satisfactory to shift their labor and, to the extent that this is possible, to shift their capital to the more productive field. Free prices, telling the truth about supply and demand, thus constitute the great equilibrating factor.

The Function of the Rate of Interest. Among these prices is the rate of interest. The traditional doctrine is that the rate of interest equates supply and demand in the capital market and equates saving and investment. Interest is looked upon as reward for saving and as inducement to saving. The old doctrine which looked upon consumer’s thrift as the primary source of capital is inadequate. It must be broadened to include producer’s thrift, and especially corporate thrift, and direct capitalization, as when the farmer uses his spare time in building fences and putting other improvements on his farm, or when the farmer lets his flocks and herds increase instead of selling off the whole of the annual increase, and so forth. It must include governmental thrift, as when government taxes to pay down public debt or when government taxes for capital purposes instead of borrowing—historically very important! The doctrine needs a major qualification, moreover, with respect to the use of bank credit for capital purposes.8

Keynes’s Attack on the Interest Rate as Equilibrator. It is with respect to the interest rate as the equilibrating factor that Keynes has made his most vigorous assault upon prevailing views. Where economists generally have held that saving and avoiding unnecessary debt and paying off debt where possible are good things, Keynes holds that they are bad things. He deprecates depreciation reserves for business corporations. He deprecates amortization of public debt by municipalities. He deprecates additions to corporate surpluses out of earnings. His philosophy is responsible for the ill-fated undistributed profits tax which we adopted in 1936 and which we abandoned with a great sigh of relief, over the President’s plaintive protest, in 1938.

Keynes gives two reasons for his rejection of prevailing ideas with respect to interest and savings, and the equilibrating function of the rate of interest. The first will be found on pages 110 and 111 of his General Theory. He says:

The influence of changes in the rate of interest on the amount actually saved is of paramount importance, but is in the opposite direction to that usually supposed. For even if the attraction of the larger future income to be earned from a higher rate of interest has the effect of diminishing the propensity to consume, nevertheless we can be certain that a rise in the rate of interest will have the effect of reducing the amount actually saved. For aggregate saving is governed by aggregate investment; a rise in the rate of interest (unless it is offset by a corresponding change in the demand-schedule for investment) [italics mine] will diminish investment; hence a rise in the rate of interest must have the effect of reducing incomes to a level at which saving is decreased in the same measure as investment. Since incomes will decrease by a greater absolute amount than investment, it is, indeed, true that, when the rate of interest rises, the rate of consumption will decrease. But this does not mean that there will be a wider margin for saving. On the contrary, saving and spending will both decrease.9

This is an extraordinarily superficial argument. The whole case is given away by the parenthetical passage, “(unless it is offset by a corresponding change in the demand-schedule for investment).” The usual cause of an increase in the rate of interest is a rise in the demand-schedule for investment. Interest usually rises because of an increased demand for capital on the part of those who wish to increase their investments, of businesses which wish to expand, of speculators for the rise, of home-builders, and so on. Usually, when the interest rate rises, it rises because investment is increasing, and the increased savings which rising interest rates induce are promptly invested. Indeed, investment often precedes saving10 in such a situation, through an expansion of bank credit, also induced by the rising rate of interest.

Keynes is assuming an uncaused rise in the rate of interest, and he has very little difficulty in disposing of this. But economic phenomena do not occur without causes.

Keynes’s second argument against the prevailing doctrine will be found in his Chapter 14 (ibid.) called “The Classical Theory of the Rate of Interest.” Here (with a diagram on page 180) he complains that the static theory of interest has not taken account of the possibility of changes in the level of income, or the possibility that the level of income is actually a function of the rate of investment.

Now it may be observed that Keynes is here introducing dynamic considerations into a static analysis. By this device one may equally destroy the law of supply and demand, the law of cost of production, the capitalization theory, or any other of the standard working tools of the static analysis. Thus the static law of supply and demand is that a decrease in price will lead to an increase in the amount demanded. But with a sudden, violent general fall in prices the tendency is for buyers to hold off and wait until they see where prices are going to settle.

The static economist has known all this almost from the beginning. He has been aware that he was making abstractions. He has protected himself in general by the well-known phrase, “ceteris paribus” (other things equal), and the general level of income has been among those other things assumed to be unchanged. Moreover, the static economist has concerned himself with delicate marginal adjustments, and with infinitesimal variations in the region of the margin, a device which Keynes is very glad to borrow from static economics in his conception of the “marginal propensity to consume” and in his initial conception of the “marginal efficiency of capital.”

The Multiplier. Rejecting the function of the interest rate as the equilibrator of saving and investment, Keynes is so impressed with the danger of thrift that he finally convinces himself in one of his major doctrines that no part of an increase in income which is not consumed is invested; that all of the unconsumed increase in income is hoarded. This major doctrine is the much-praised Keynesian “investment multiplier theory.”11 If an investment is made it gives a certain amount of employment, but that is not the end of the story. Investment tends to multiply itself in subsequent stages of spending. The recipients of the proceeds of the investment spend at least part of it, and the recipients of their spending spend part of what they get, and so on. How many times does the original investment multiply itself? Keynes gives a definite mathematical answer in which his investment multiplier rests solely on what he calls “the marginal propensity to consume.” The multiplier figure rests on the assumption that the subsequent spending consists entirely of purchases for consumption. None of the unconsumed increase in income is invested. If any of the recipients of the proceeds of the investment should add to their expenditures for consumption any investment at all, the mathematics of the Keynes multiplier would be upset, and the multiplier would be increased. It is a source of satisfaction to find this view in agreement with that of Professor James W. Angell on this point.12

The multiplier concept is an unfruitful notion. In times when the business cycle is moving upward, particulary in the early stages of revival, increased expenditure, whether for investment or consumption, tends to multiply itself many fold, as Wesley Mitchell13 has shown.

In times of business reaction there may be very little multiplication. The soldiers’ bonus payments by the Government under Mr. Hoover made no difference in the business picture. On the other hand, the soldiers’ bonus payments under Mr. Roosevelt in 1936, at a time when the business curve was moving upward sharply, appear to have intensified the movement.

The Relation of Savings to Investment. The preoccupation with the varying relationship of saving to investment is superficial. Investment tends to equal saving in a reasonably good business situation, when bank credit is not expanding. In a strong upward move, when bank credit is readily obtainable, investment tends to exceed saving because men borrow at the banks and because expanding bank credit facilitates the issue of new securities. In a crisis and in the liquidation that follows a crisis, saving exceeds investment. Men and businesses are saving to pay down debts and especially to repay bank loans—a necessary preliminary to a subsequent revival of business. But the reasons for these changes in the relation of saving to investment are the all-important things. The relation of saving to investment is itself a very superficial thing. The reasons lie in the factors which govern the prospects of profits, including the price and cost equilibrium, the industrial equilibrium, and the quality of credit.

Keynes strives desperately to rule out bank credit as a factor in the relation of savings to investment. At one point he does it very simply indeed:

We have, indeed, to adjust for the creation and discharge of debts (including changes in the quantity of credit or money); but since for the community as a whole the increase or decrease of the aggregate creditor position is always exactly equal to the increase or decrease of the aggregate debtor position, this complication also cancels out when we are dealing with aggregate investment.14

But bank credit is not so easily canceled out as a factor in the volume of money available for investment. The borrower at the bank is, of course, both debtor to and creditor of the bank when he gets his loan. But his debt is an obligation which is not money, and his credit is a demand deposit, which is money. When he uses this money for investment, he is making an investment in addition to the investment which comes from savings.

On pages 81 to 85 of the same book, Keynes engages in a very confused further argument on this point.

It is supposed that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no saving corresponds. But no one can save without acquiring an asset, whether it be cash or a debt or capital-goods; and no one can acquire an asset which he did not previously possess, unless either an asset of equal value is newly produced or someone else parts with an asset of that value which he previously had. In the first alternative there is a corresponding new investment: in the second alternative someone else must be dissaving an equal sum. For his loss of wealth must be due to his consumption exceeding his income . . ..

But the assumption that a man who parts with an asset for cash is losing wealth, and that this must be due to his consumption exceeding his income, is purely gratuitous. The man who sells an asset for cash may hold his cash or he may reinvest it in something else. It is not “dis-saving” unless he spends it for current consumption, and he does not have to do that unless he wants to. Indeed on the next page (page 83) the man who holds the additional money corresponding to the new bank-credit is said to be saving. “Moreover the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth.”

Keynes’s confusion here could be interpreted as due to his effort to carry out a puckish joke on the Keynesians. He had got them excited in his earlier writings about the relation between savings and investment. Then, in his General Theory, he propounds the doctrine that savings are always equal to investment.15 This makes the theology harder for the devout follower to understand, and calls, moreover, for a miracle by which the disturbing factor of bank credit may be abolished. This miracle Keynes attempts in the pages cited above, with indifferent success.

One must here protest against the dangerous identification of bank expansion with savings, which is part of the Keynesian doctrine. This fallacy is discussed at length in the chapters dealing with the expansion of bank credit in the 1920’s and the discussion of the doctrine of oversaving in connection with the undistributed profits tax. This doctrine is particularly dangerous today, when we find our vast increase in money and bank deposits growing out of war finance described as “savings,” just because somebody happens to hold them at a given moment of time. On this doctrine, the greater the inflation, the greater the savings! The alleged excess of savings over investment in the period, 1924-1929, was merely a failure to invest all of the rapidly expanding bank credit. All of the real savings of this period was invested, and far too much new bank credit in addition.

The Wage-rate as Equilibrator of the Supply and Demand of Labor. Keynes also tries to destroy the accepted doctrine regarding the rate of wages as the equilibrating factor between the supply and demand of labor. He attempts at various places to suggest that a reduction in money wages “may be” ineffective in increasing the demand for labor (e.g., ibid., p. 13), but he nowhere, so far as I can find, positively states this. He does suggest (p. 264) that a fall in wages would mean a fall in prices, and that this could lead to embarrassment and insolvency to entrepreneurs who are heavily indebted, and to an increase in the real burden of the national debt. On this point it is sufficient to say that the fall in wages in a depression usually follows, and does not precede, the fall in prices, and that it is usually more moderate than the fall in prices. It does not need to be so great as the fall in prices in order to bring about a reëquilibration, since wages are only part of cost of production, and since the efficiency of labor increases in such a situation.

Keynes accuses other economists of reasoning regarding the demand schedule for labor on the basis of a single industry, and then, without substantial modification, making a simple extension of the argument to industry as a whole (pp. 258-259). But this is merely additional evidence that he has ignored John Bates Clark’s Distribution of Wealth, and the theory of costs of the Austrian School, for whom the law of costs, including wages, is merely the law of the leveling of values among the different industries. Moreover, the studies of Paul Douglas, dealing with the elasticity of the demand for labor as a whole, constitute a sufficient answer to Keynes on this point. Douglas holds that the demand for labor is highly elastic; so much so that a 1% decline in wages can mean a 3% or 4% increase in employment, when wages are held above the marginal product of labor.16

But the practical issue does not usually relate to wages as a whole. The wages of nonunion labor, and especially agricultural labor, usually recede promptly and sometimes to extremes, in a depression, The issue usually relates to union wage scales held so high in particular industries that employment falls off very heavily in these industries, and that the industries constitue bottlenecks.17

But Keynes does not come to the theoretical conclusion that a reduction in money wages could not bring about an increase in employment. He rather reaches the practical conclusion that this is not the best way to do it. Instead, he would prefer in a closed economy, i.e., one without foreign trade, to make such readjustments as are necessary by manipulations of money, and for an open economy, i.e., one with large foreign trade, to accomplish it by letting the foreign exchanges fluctuate (p. 279).

The fact seems to be that Keynes entertains a settled prejudice against any reduction in money wages. He is opposed to flexibility downward in wage scales. He has, however, no such prejudice against flexibility upward. On the contrary, in the Keynes plan for an International Clearing Union of April 8, 1943, Keynes proposes, as a means of maintaining stability in foreign exchange rates, that a member state in the Clearing Union whose credit balance is increasing unduly, shall encourage an increase in money rates of earnings (meaning wages).18 This would increase the cost of its goods in foreign trade, and consequently reduce its exports, and consequently hold down its credit balance. But Keynes makes no corresponding demand on the country whose debit in the Clearing Union is increasing unduly that it should encourage a decrease in money rates of earnings.

II. KEYNES’S CONSTRUCTIVE THEORY

The foregoing discussion of Keynes’s doctrines has been primarily concerned with refuting his attack upon the long-established view that, given equilibrium, aggregate supply creates aggregate demand, that consumption keeps pace with production, and that the power to consume grows out of production. Now, however, it is planned to go further and to demonstrate that Keynes’s constructive substitute for prevailing economic doctrine is essentially fallacious. Keynes builds his positive doctrine around three central notions: (1) the propensity to consume, (2) the schedule of the marginal efficiency of capital, and (3) the rate of interest. These three Keynes regards as independent variables. These three independent variables govern the dependent variables, namely, the volume of employment, and national income measured in “wage-units.” 19

There are two main criticisms of this scheme, either of which would invalidate it. (1) Keynes does not adhere to fixed meanings for his terms in the case of the rate of interest or in the case of the marginal efficiency of capital. (2) The three independent variables are not independent of one another, either in fact or on Keynes’s own showing.

Keynes’s Terms Lack Fixed Meanings. Let us consider first Keynes’s failure to adhere to fixed meanings for his terms.

Keynes at times uses the rate of interest to mean a rate of discount, measuring the premium on present goods over future goods. This is implied in his initial definition of the marginal efficiency of capital, to which later reference is made on page 135 of this book. It is, moreover, made explicit by Keynes on page 93 of his book, where he says that, as an approximation, we can identify the rate of time-discounting, i.e., the ratio of exchange between present goods and future goods, with the rate of interest. Later, however, Keynes gives us a radically different theory of interest. He makes the rate of interest depend on liquidity preference and the quantity of money. And he holds that interest is not paid for the purpose of inducing men to save but for the purpose of inducing men not to hoard. He holds that if money is made sufficiently abundant so that it can satiate liquidity preference, it will pull down, not merely the short time rate of interest or the short time money rates, but also the whole complex of interest rates, long and short.20 The whole complex of interest rates (with a given liquidity preference scale) can be governed, and is governed, in his system, by the abundance or scarcity of money. Interest becomes a phenomenon of money par excellence. Strangely enough, however, we find Keynes playing with the notion of commodity rates of interest, or “own rates of interest,” the rate between future wheat and present wheat, and designating this rate as the “wheat rate of interest.” Every commodity can have its own rate of interest in terms of itself, and Keynes says that there is no reason why the wheat rate of interest should be equal to the copper rate of interest, because the relation between the spot and future contracts as quoted in the markets is notoriously different for different commodities.21 The reader will find whatever he pleases in Keynes about the rates of interest, though his formal theory is the doctrine that the quantity of money, taken in conjunction with liquidity preference, governs the rate of interest.

But Keynes does not adhere long to his own theory of interest. In the same volume, 29 pages later, he has abandoned it. After saying, on pages 167-168, that the supply of money in relation to liquidity preference will govern the whole complex of interest rates, long and short, on page 197 he critizes the Federal Reserve banks for their open market policy, 1933-1934, on the ground that they purchased only short term securities, the effect of which “may, of course, be mainly confined to the very short term rate of interest and have little reaction on the much more important long term rates of interest.” And he calls upon the central banks to regulate all rates of interest by having fixed rates at which they will buy obligations of differing maturities, long and short.22

There is no consistency in Keynes’s use of the term “rate of interest” in this volume.

The conception of “the marginal efficiency of capital” has an even more extraordinary history in this volume. His initial definition of the marginal efficiency of capital (pp. 135-136) appears in the following passage:

Over against the prospective yield of the investment we have the supply price of the capital-asset, meaning by this, not the market-price at which an asset of the type in question can be purchased in the market, but the price which would just induce a manufacturer newly to produce an additional unit of such assets, i.e., what is sometimes called its replacement cost. The relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More precisely, / define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. [Italics in this sentence are mine.] This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.

The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over . . ..

For each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital.

Keynes seems here to be talking about the calculation which an entrepreneur would make in deciding whether or not to buy a machine or other productive capital instrument. This impression is intensified when he states that the definition which he has given is fairly close to what Marshall intended to mean by the term, Marshall’s phrase being the “marginal net efficiency” of a factor of production, or alternatively, the “marginal utility of capital,” and by the passage which he quotes from Marshall’s Principles, from which the following is taken:

“There may be machinery which the trade would have refused to dispense with if the rate of interest had been 20 per cent per annum. If the rate had been 10 per cent, more would have been used; if it had been 6 per cent, still more; if 4 per cent, still more; and finally, the rate being 3 per cent, they use more still. When they have this amount, the marginal utility of the machinery, i.e., the utility of that machinery which it is only just worth their while to employ, is measured by 3 per cent.23 [Italics mine.]

We seem, in the initial definition, to have the marginal efficiency of capital tied up with specific instruments of production, and the “expectation” regarding the future to be tied up with the anticipated returns from these specific instruments of production. These are familiar notions of static economics. But Keynes, before he has finished this chapter, gives us a warning against static economics, and indicates that the notion of the marginal efficiency of capital is going to be a dynamic concept, much more so even than the rate of interest, which is a current phenomenon.

In what follows in his volume, the marginal efficiency of capital becomes dynamic by ceasing to be a fixed notion. It goes through more metamorphoses than even Ovid knew about! In Chapter 12 of the book, dealing with “The State of Long-Term Expectation,” the expectation factor becomes everything and the efficiency of specific capital goods is forgotten, except for one footnote later to be quoted. This chapter develops a fantastic economic theory based on the somewhat less fantastic behavior of the New York stock market in 1928 and 1929. Expectation comes to mean expectations regarding expectations, and expectations regarding the reactions of different buyers and sellers of securities who are anticipating future expectations. It would seem that this, at best, could explain the selling prices of securities representing industries with a great variety of physical capital assets, rather than the marginal efficiency of specific capital-goods. Keynes, however, does not hesitate to identify the two. He says in a footnote on page 151 of that chapter, “ . . . a high quotation for existing equities involves an increase in the marginal efficiency of the corresponding type of capital. . . .”

At times the marginal efficiency of capital means simply expectation regarding business profits, which may be due to entrepreneurial efficiency or to labor efficiency, quite as much as to the efficiency of capital instruments, or which may be due to maladjustments in the proportions of the industries, or between prices and costs, or to a war or war scare. On page 149 he makes “the state of confidence” one of the major factors governing the marginal efficiency of capital, and here he is clearly making the marginal efficiency of capital mean business profits rather than the specific return to a specific instrument of production. On page 315, talking about the business cycle, he suggests that “a more typical, and often the predominant, explanation of the crisis, is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.” Here, clearly, marginal efficiency of capital means anticipations regarding business profits rather than any specific return to specific capital instruments.

Keynes’s doctrine that the schedule of the marginal efficiency of capital is today, and presumably for the future, much lower than it was in the nineteenth century (pages 307-309) seems to rest primarily on the view that employers were strong enough in the nineteenth century to prevent wages from rising much faster than the efficiency of labor, whereas they are not strong enough to do this today or presumably in the future. Here the “marginal efficiency of capital” would seem to depend on the relation between wages and the marginal efficiency of labor.

Finally, on page 207, the marginal efficiency of capital, “(especially of stocks of liquid goods),” comes to mean the speculative money profits which a man can anticipate from holding goods in a wild inflation, under the expectation of an ever greater fall in the value of money.

The maker of a new system of economics may be expected to adhere more closely than Keynes does to the meanings of his terms if he is to be taken seriously. Lumping all the causes of changes in anticipations regarding business profits under the one term, “marginal efficiency of capital,” does not represent progress in the economic analysis of cause and effect.

Keynes’s “Independent Variables” Not Independent. We come now to the second main criticism of Keynes’s constructive system. As shown above, he takes as his three independent variables (1) the propensity to consume, (2) the schedule of the marginal efficiency of capital, and (3) the rate of interest. Now, these supposedly independent variables are in fact dependent on one another, and are even dependent on Keynes’s own showing.

The schedule of the marginal efficiency of capital is said, on page 136, to be the equivalent of the investment demand schedule. But on page 106 we have been told that every weakening in the propensity to consume, regarded as a permanent habit, must weaken the demand for capital. On Keynes’s own showing, the schedule of the marginal efficiency of capital is, in part, dependent on the propensity to consume.

The propensity to consume is, in part, dependent upon the rate of interest. From the standpoint of the old analysis, the rate of interest, the propensity to consume, and the propensity to save are all three interdependent variables. The rate of interest is, indeed, the equilibrating factor which brings savings and consumption into balance. Human nature being more concerned with present consumption than with future consumption,24 there is need for an inducement to make men save. The future looks smaller than the present. The pressure to consume today is great. Human wants of specific kinds are often satiable, but human wants in general are not. As old wants are satisfied, new wants spring up. The pressure to consume is insistent. Men must be induced to save for the future by a reward, and that reward is interest.

When savings are large and capital increases, the rate of interest goes down. When interest is high because accumulated capital is scarce, men are forced to make savings that they would not otherwise make, or are induced to make savings that they would not otherwise make. The farmer who can borrow at 4% to buy additional capital goods for his farm, will have a higher propensity to consume than the farmer who must pay 10%. If he can borrow at 4%, he will let his wife have a new dress and his family buy a new automobile. If he must pay 10%, the new dress and the new automobile are not bought and new savings go into fertilizer, harrows, and combines. The propensity to consume is definitely dependent on the rate of interest.

The interdependence of the rate of interest, savings, and the propensity to consume, Keynes escapes formally, in part, by giving us the new theory of interest stated above. He makes the rate of interest dependent, not on the necessity of paying interest to induce men to save, but rather on the necessity to induce them not to hoard what they save. Interest rates are governed (given the scale of liquidity preference) by the quantity of money. We have seen above that he adheres to this theory for 29 pages.

But even this emancipation of the rate of interest from time preference does not emancipate the propensity to consume from interest rates. If interest rates are high, whether from scarcity of money of from scarcity of real savings, men will be forced or induced to save more than would otherwise be the case, and the propensity to consume will be lower. The independence of the interest rate would still leave the propensity to consume dependent upon interest rates.

It has been shown above that, on Keynes’s own showing, his schedule of marginal efficiency of capital, as initially defined, is dependent upon the propensity to consume. In the later meanings of the marginal efficiency of capital, however, it becomes dependent upon both the other variables. When marginal efficiency of capital comes to mean speculative profits in the stock market, or general business profits, it is clear that changes in the rate of interest, or in the propensity to consume, can radically alter the schedule of the marginal efficiency of capital. Keynes’s three great independent variables are not independent.

3. STATIC ECONOMIC THEORY AND THE BUSINESS CYCLE

One reason why Keynes has found inadequate resistance among the younger economists to his casual throwing aside of the sound and subtle work of the great masters of static economic theory is that increasingly in the last two or three decades economists have been interested in the laws of the business cycle, in the ups and downs of business, and too many of them have felt that they could get very little help in the study of the business cycle from the generalizations of static economics.

The economic theorist has indeed devoted himself much too exclusively to the laws of completed equilibrium, to theory concerned with what prices and costs, and the proportions of the productive forces, would be if markets were fluid and if industry were in perfect balance. Students of the business cycle, on the other hand, have been concerned much too exclusively with the sequence and flow of events, losing sight of the goal in watching the motions of the runners.

It must be apparent, however, that in ignoring the static conceptions, the business forecaster is throwing away a most valuable aid. Static theory does describe underlying economic forces. If it tells nothing about the rate at which they will move, it does at least indicate the directions in which they move. It indicates their relative power and it indicates their relations inter se. The student of change who knows the goal toward which his forces are tending is certainly much better informed than the man who does not know what the goal is, but merely knows that change is taking place and that some things change first and others later.

Wesley C. Mitchell’s Business Cycles could not have been written by a man who was not deeply learned in static theory and the equilibrium notion. Mitchell objects to the expression “the static state,” but his interpretation of the business cycle constantly employs equilibrium notions. The later stages of prosperity generate abnormalities, stresses, and strains. Costs rise faster than prices. There are inequalities in the rise of costs and prices. Other abnormalities occur, such as shortages of particular kinds of raw materials, with excess industrial equipment in some lines and inadequate equipment in others. A crisis comes and corrects these abnormalities, restoring equilibrium—not a previous equilibrium, but a new equilibrium—roughly and approximately. Then revival comes.

Mitchell’s analysis makes business profits and the prospect of business profits the dynamo in the ups and downs of business. When the outlook for profits is good, business expands. When profits are cut, business contracts. The analysis runs in highly realistic terms, taking account of labor costs, rentals, and raw material costs as well as interest charges, taking account of rigidities and fluidities, of rigid prices and flexible prices.

There is no more startling instance of deterioration in a great science than the recent trends, largely influenced by Keynes, to turn away from an analysis that takes account of all the changing factors in economic life, and to concentrate attention almost exclusively upon monetary and budgetary phenomena, in explaining the business cycle and in formulating public policy with respect to prosperity and employment.

The present writer’s testimony, after a quarter of a century devoted very largely to the study of markets and the ups and downs of business, would be to the effect that the equilibrium notion is the most useful tool of thought to be found. When economic forces are working toward balance, we may trust the situation. When they are obviously working toward unbalance, we should grow increasingly concerned. From theoretical concepts of the Keynesian type we receive no help at all.

1 Published by D. Van Nostrand Co., Inc., Princeton, N. J.

1 Lord Keynes was a man of genius. He had great abilities and great personal charm.

2 I have not read much of this elaborate literature. Keynes himself I have studied with care. I think it probable that other critics have anticipated many of the points I make here, and I would gladly give them credit if I knew.

3 See the Chase Economic Bulletin, Vol. XI, No. 3, June 12, 1931.

4 The General Theory of Employment, Interest and Money, p. 41.

5 Ibid., p. 46.

6 See my criticism of the analogous procedure by Irving Fisher in his “Equation of Exchange,” in my Value of Money, New York, 1917 and 1936, pp. 158-162.

7 Ibid., p. 29.

8 See my Value of Money, New York, 1917 and 1936, pages 484, n; 484-489; ch. XXIV; my address before the Indiana Bankers Association, published in The Chase, the house organ of the Chase National Bank, November, 1920; the Chase Economic Bulletin, November, 1926, and May, 1936. See also my article on “The Future of Interest Rates” in the Commercial & Financial Chronicle of Aug. 26, 1943.

9 Harold G. Moulton, whose book, The Formation of Capital, was published at about the same time that Keynes’s book appeared, independently presents essentially the same argument, which Moulton calls “The Dilemma of Savings.” I have discussed Moulton’s view in the Chase Economic Bulletin, Vol. XVI, No. 2, May 12, 1936, “Eating the Seed Corn,” and in my discussion of the undistributed profits tax in the present volume.

10 The Keynesian reader will observe that I am using the word “savings” in the ordinary sense, and not in Keynes’s peculiar sense. I am under no obligation to use Keynes’s terminology, since Keynes himself, as shown in the first sentence of the passage quoted above, is discussing the usual view of the relation of the rate of interest to savings. To the extent that there is any shift in the meaning of the terms in the course of the argument, it is done by Keynes and not by me. I use the word “savings” in the ordinary sense throughout.

11 Ibid., pp. 113-119.

12 James W. Angell, Investment and Business Cycles, New York, 1941, pp. 190-191.

13 Business Cycles, University of California Press, 1913, pp. 453-454.

14 General Theory, etc., p 75.

15 ibid., pp. 61-65.

16 Paul H. Douglas, The Theory of Wages, New York, 1934, pp. 113-158 and 501-502.

17 See the figures showing the wide disparities of wage reductions as among different groups, in 1931, in the Chase Economic Bulletin, Vol. XI, No. 3.

18 op. cit., (9) (b)

19 General Theory of Employment, p. 245.

20 Ibid., p. 167 and note 2.

21 Ibid., pp. 223-224.

22 ibid., pp. 205-206.

23 ibid., pp. 139-140.

24 Keynes does not believe this, but offers no evidence against it.