32
John Maynard Keynes
(1937)
It
is generally recognized that the Ricardian analysis was concerned with what we
now call long‑period equilibrium. Marshall's contribution mainly
consisted in grafting on to this the marginal principle and the principle of
substitution, together with some discussion of the passage from one position of
long‑period equilibrium to another. But he assumed, as Ricardo did, that
the amounts of the factors of production in use were given and that the problem
was to determine the way in which they would be used and their relative
rewards. Edgeworth and Professor Pigou and other later and contemporary writers
have embroidered and improved this theory by considering how different
peculiarities in the shapes of the supply functions of the factors of
production would affect matters, what will happen in conditions of monopoly and
imperfect competition, how far social and individual advantage coincide, what
are the special problems of exchange in an open system and the like. But these
more recent writers like their predecessors were still dealing with a system in
which the amount of the factors employed was given and the other relevant facts
were known more or less for certain. This does not mean that they were dealing
with a system in which change was ruled out, or even one in which the
disappointment of expectation was ruled out. But at any given time facts and
expectations were assumed to be given in a definite and calculable form; and
risks, of which, tho admitted, not much notice was taken, were supposed to be
capable of an exact actuarial computation. The calculus of probability, tho
mention of it was kept in the background, was supposed to be capable of
reducing uncertainty to the same calculable status as that of certainty itself;
just as in the Benthamite calculus of pains and pleasures or of advantage and
disadvantage, by which the Benthamite philosophy assumed men to be influenced
in their general ethical behavior.
*
The Quarterly Journal of Economics, Cambridge, Mass.: Harvard University
Press Copyright, 1937, by the resident and Fellows of Harvard College, vol. 51,
pp. 212-223.
Actually,
however, we have, as a rule, only the vaguest idea of any but the most direct
consequences of our acts. Sometimes we are not much concerned with their
remoter consequences, even tho time and chance may make much of them. But
sometimes we are intensely concerned with them, more so, occasionally, than
with the immediate consequences. Now of all human activities which are affected
by this remoter preoccupation, it happens that one of the most important is
economic in character, namely, Wealth. The whole object of the accumulation of
Wealth is to produce results, or potential results, at a comparatively distant,
and sometimes at an indefinitely distant,
date. Thus the fact that our knowledge of the future is fluctuating, vague and
uncertain, renders Wealth a peculiarly unsuitable subject for the methods of
the classical economic theory. This theory might work very well in a world in
which economic goods were necessarily consumed within a short interval of their
being produced. But it requires, I suggest, considerable amendment if it is to
be applied to a world in which the accumulation of wealth for an indefinitely
postponed future is an important factor; and the greater the proportionate part
played by such wealth‑accumulation the more essential does such amendment
become.
By
"uncertain" knowledge, let me explain, I do not mean merely to
distinguish what is known for certain from what is only probable. The game of
roulette is not subject, in this sense, to uncertainty; nor is the prospect of
a Victory bond being drawn. Or, again, the expectation of life is only slightly
uncertain. Even the weather is only moderately uncertain. The sense in which I
am using the term is that in which the prospect of a European war is uncertain,
or the price of copper and the rate of interest twenty years hence, or the
obsolescence of a new invention, or the position of private wealth‑owners
in the social system in 1970. About these matters there is no scientific basis
on which to form any calculable probability whatever. We simply do not know.
Nevertheless, the necessity for action and for decision compels us as practical
men to do our best to overlook this awkward fact and to behave exactly as we
should if we had behind us a good Benthamite calculation of a series of
prospective advantages and disadvantages, each multiplied by its appropriate
probability, waiting to be summed.
How
do we manage in such circumstances to behave in a manner which saves our faces
as rational, economic men? We have devised for the purpose a variety of
techniques, of which much the most important are the three following:
(1) We assume that the present is a much more
serviceable guide to the future than a candid examination of past experience
would show it to have been hitherto. In other words we largely ignore the
prospect of future changes about the actual character of which we know nothing.
(2) We assume that the existing state of opinion as expressed
in prices and the character of existing output is based on a correct summing up of future prospects,
so that we can accept it as such unless and until something new and relevant
comes into the picture.
(3)
Knowing that our own individual judgment is worthless, we endeavor to fall back
on the judgment of the rest of the world which is perhaps better informed. That
is, we endeavor to conform with the behavior of the majority or the average.
The psychology of a society of individuals each of whom is endeavoring to copy
the others leads to what we may strictly term a conventional judgment.
Now
a practical theory of the future based on these three principles has certain
marked characteristics. In particular, being based on so flimsy a foundation,
it is subject to sudden and violent changes. The practice of calmness and
immobility, of certainty and security, suddenly breaks down. New fears and
hopes will, without warning, take charge of human conduct. The forces of disillusion
may suddenly impose a new
conventional
basis of valuation. All these pretty, polite techniques, made for a wellpanelled
Board Room and a nicely regulated market, are liable to collapse. At all times
the vague panic fears and equally vague and unreasoned hopes are not really
lulled, and lie but a little way below the surface.
Perhaps
the reader feels that this general, philosophical disquisition on the behavior
of mankind is somewhat remote from the economic theory under discussion. But I
think not. Tho this is how we behave in the market place, the theory we devise
in the study of how we behave in the market place should not itself submit to
marketplace idols. I accuse the classical economic theory of being itself one
of these pretty, polite techniques which tries to deal with the present by
abstracting from the fact that we know very little about the future.
I
daresay that a classical economist would readily admit this. But, even so, I
think he has overlooked the precise nature of the difference which his
abstraction makes between theory and practice, and the character of the
fallacies into which he is likely to be led.
This
is particularly the case in his treatment of Money and Interest. And our first
step must be to elucidate more clearly the functions of Money.
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 tho 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 would be 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 -‑tho 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. It
simply amounts to saying that an increase in income will be divided in some
proportion or another between spending and saving, and that when our income is
increased it is extremely unlikely that this will have the effect of making us
either spend less or save less than before. This psychological law was of the
utmost importance in the development of my own thought, and it is, I think,
absolutely fundamental to the theory of effective demand as set forth in my
book. But few critics or commentators so far have paid particular attention to
it.
There
follows from this extremely obvious principle an important, yet unfamiliar,
conclusion. Incomes are created partly by entrepreneurs producing for
investment and partly by their producing for consumption. The amount that is
consumed depends on the amount of income thus made up. Hence the amount of
consumption‑goods which it will pay entrepreneurs to produce depends on
the amount of investment‑goods which they are producing. If, for example,
the public are in the habit of spending nine‑tenths of their income on
consumption‑goods, it follows that if the entrepreneurs were to produce
consumption‑goods at a cost more than nine times the cost of the
investment‑goods they are producing, some part of their output could not
be sold at a price which would cover its cost of production. For the
consumption‑goods on the market would have cost more than nine‑tenths
of the aggregate income of the public and would therefore be in excess of the
demand for consumption‑goods, which by hypothesis is only the ninetenths.
Thus entrepreneurs will make a loss until they contract their output of
consumption‑goods down to an amount at which it no longer exceeds nine
times their current output of investment goods.
The
formula is not, of course, quite so simple as in this illustration. The
proportion of their income which the public will choose to consume will not be
a constant one, and in the most general case other factors are also relevant.
But there is always a formula, more or less of this kind, relating the output
of consumption goods which it pays to produce to the output of investment‑goods;
and I have given attention to it in my book under the name of the Multiplier. The fact that an increase in
consumption is apt in itself to stimulate this further investment merely
fortifies the argument.
That
the level of output of consumption‑goods, which is profitable to the
entrepreneur, should be related by a formula of this kind to the output of
investment‑goods depends on assumptions of a simple and obvious
character. The conclusion appears to me to be quite beyond dispute. Yet the
consequences which follow from it are at the same time unfamiliar and of the
greatest possible importance.
The
theory can be summed up by saying that, given the psychology of the public, the
level of output and employment as a whole depends on the amount of investment.
I put it in this way, not because this is the only factor on which aggregate
output depends, but because it is usual in a complex system to regard as the causa
causans that factor which is most prone to sudden and wide fluctuation.
More comprehensively, aggregate output depends on the propensity to hoard, on the
policy of the monetary authority as it affects the quantity of money, on the
state of confidence concerning the prospective yield of capital‑assets,
on the propensity to spend and on the social factors which influence the level
of the money‑wage. But of these several factors it is those which
determine the rate of investment which are most unreliable, since it is they
which are influenced by our views of the future about which we know so little.
This that I offer is, therefore, a theory of why output and employment
are so liable to fluctuation. It does not offer a ready‑made remedy as to
how to avoid these fluctuations and to maintain output at a steady optimum
level. But it is, properly speaking, a Theory of Employment because it
explains why, in any given circumstances, employment is what it is. Naturally I
am interested not only in the diagnosis, but also in the cure; and many pages
of my book are devoted to the latter. But I consider that my suggestions for a
cure, which, avowedly, are not worked out completely, are on a different plane
from the diagnosis. They are not meant to be definitive; they are subject to
all sorts of special assumptions and are necessarily related to the particular
conditions of the time. But my main reasons for departing from the traditional
theory go much deeper than this. They are of a highly general character and are
meant to be definitive.
I sum up, therefore, the
main grounds of my departure as follows:
(1)
The orthodox theory assumes that we have a knowledge of the future of a kind
quite different from that which we actually possess. This false rationalization
follows the lines of the Benthamite calculus. The hypothesis of a calculable
future leads to a wrong interpretation of the principles of behavior which the
need for action compels us to adopt, and to an underestimation of the concealed
factors of utter doubt, precariousness, hope and fear. The result has been a
mistaken theory of the rate of interest. It is true that the necessity of
equalizing the advantages of the choice between owning loans and assets
requires that the rate of interest should be equal to the marginal efficiency of capital. But this does not tell
us at what level the equality will be
effective. The orthodox theory regards the marginal efficiency of capital as
setting the pace. But the marginal efficiency of capital depends on the price
of capital‑assets; and since this price determines the rate of new
investment, it is consistent in equilibrium with only one given level of money‑income.
Thus the marginal efficiency of capital is not determined, unless the level of
moneyincome is given. In a system in which the level of money‑income is
capable of fluctuating, the orthodox theory is one equation short of what is
required to give a solution. Undoubtedly the reason why the orthodox system has
failed to discover this discrepancy is because it has always tacitly assumed
that income it given, namely, at the level corresponding to the employment of
all the available resources. In other words it is tacitly assuming that the
monetary policy is such as to maintain the rate of interest at that level which
is compatible with full employment. It is therefore, incapable of dealing with
the general case where employment is liable to fluctuate. Thus, instead of the
marginal efficiency of capital determining the rate of interest, it is truer
(tho not a full statement of the case) to say that it is the rate of interest
which determines the marginal efficiency of capital.
(2)
The orthodox theory would by now have discovered the above defect, if it had
not ignored the need for a theory of the supply and demand of output as a
whole. I doubt if many modern economists really accept Say's Law that supply
creates its own demand. But they have not been aware that they were tacitly
assuming it. Thus the psychological law underlying the Multiplier has escaped
notice. It has not been observed that the amount of consumption‑goods
which it pays entrepreneurs to produce is a function of the amount of
investment‑goods which it pays them to produce. The explanation is to be
found, I suppose, in the tacit assumption that every individual spends the
whole of his income either on consumption or on buying, directly or indirectly,
newly produced capital goods. But, here again, whilst the older economists
expressly believed this, I doubt if many contemporary economists really do
believe it. They have discarded these older ideas without becoming aware of the
consequences.