“I believe myself to be writing a book on
economic theory which will largely revolutionize—not, I suppose, at once but in
the course of the next ten years—the way the world thinks about economic problems.”
After he published The General Theory, Keynes’s
formulation of economics was received as though it was revolutionary,
especially by his younger followers. Many older economists were not quick to
embrace Keynes’s doctrine. As David Laidler points out, “Pigou and
Knight in particular, were scornful of his claims to novelty (Fabricating the Keynesian Revolution,
21).” In The General Theory Keynes
draws upon arguments from both his contemporaries and past economists, but
especially in the case of his contemporaries, he typically fails to cite them.
So what did Keynes actually contribute to economic theory? His main
contribution was to call attention the need for economic analysis where the
macro-economy fails to reach an equilibrium, but this contribution is obscured
by a framing of the argument that ignored the economic significance of
institutional collapse and his denial of the ability of monetary policy on its
own to aid the process of recovery.
In the
opening chapter of The General Theory,
Keynes immediately clarifies his stance and his goals. “The postulates
of the classical theory,” Keynes writes, “are applicable to a special case only
and not to the general case (3).” The particular case, according to Keynes, is
the case of full employment and the general case includes all states where the
economy operates below full employment. He builds his theory with the belief
that the economy does not typically operate at full employment, but rather
“without any marked tendency either towards recovery or toward complete
collapse (249).” If both of these claims are true, then in most circumstances
the classical model is inadequate to employ in analysis. For the sake of
remaining concise, I shall only briefly state that this proposition is untrue. Empirical
investigation shows that the economy tends to move toward the long-run outcome
predicted by the classical model (Kehoe and Prescott 2007). Only in the case of
a general fall in prices and sticky wages is there a shortfall in demand where
the economy operates below its potential (Galloway and Vedder, 89-97;
Leijonhufvud, 49-50).
It
appears that Keynes’s theory is the “special case”. Not only is it special, it
is so particular as to call into question its applicability altogether.
That is, Keynes questions the efficacy of monetary policy and its ability to
return aggregate demand to its potential. In order for his theory to be useful,
it needs to be better than just a second best option, which, if monetary policy
is effective, is the ranking to which the theory must be relegated. As Hawtrey explained
in a paper critiquing the support of Keynes and others for increased capital
outlays as a remedy for depression,
Currency depreciation is far the
most satisfactory measure of revival. Not only is it better balanced, but it is
quicker and easier to bring about. I have already pointed out that a capital
programme regarded as a measure for breaking the vicious circle of depression
is likely to be too slow and too gradual to be successful, and I have suggested
that, when cheap money fails to bring about a prompt revival, there is more to
be hoped from an open market policy, the purchase of securities by the central
bank. I should be inclined to leave the question at that, confident that a
sufficient purchase of securities would overcome any depression however severe.
For whereas cheap money reaches a limit when the rate of interest approaches
zero, the purchases of securities can be increased indefinitely.
. . . The capital programme has the
grave disadvantage of coming into operation tardily and gradually. Nor is it
possible to say how great a programme will is needed to resolve the deadlock or
whether any practicable programme will be great enough. If a capital programme
were the only means of resolving the
deadlock, we should have to make the best of it, but I believe that there are good
reasons for supposing that a sufficiently liberal measure of open market
purchases by the central bank would be bound to achieve this object.
. . . Since a programme of capital
outlay offers so limited and doubtful a contribution towards revival, I think
it is regrettable that excessive prominence is given to it by economists.
(456-58)
The need for
capital outlays is contingent on Keynes’s claim that the price level will not
respond to an increase in the money supply when the economy is at
less-than-full employment because he proposes that the price level is primarily a function of wages. If interest rates are too low to encourage investment, entrepreneurs will not invest, and therefore, output will remain stagnant.
The acuteness and the peculiarity
of our contemporary problem arises, therefore, out of the possibility that the
average rate of interest which will allow a reasonable average level of
employment is one so unacceptable to wealth-owners that it cannot be readily
established merely by manipulating the quantity of money.
. . . But the most stable, and the
least easily shifted, element in our contemporary economy has been hitherto,
and may prove to be in future, the minimum rate of interest acceptable to the
generality of wealth-owners. If a tolerable level of employment requires a rate
of interest much below the average rates which ruled in the nineteenth century,
it is most doubtful whether it can be achieved merely by manipulating the
quantity of money. (308-9)
As Keynes links changes in the price level with changes in
employment, this is his subtle way of saying that an increase in money will not
lead to an increase in investment as holders of the new money will not lend it
out. As mentioned in my last post on The
General Theory, tremendous deflation occurred in England, Keynes home country, between 1929 and
1931. This continued in gold standard countries generally, including the U.S., until 1933. During this period of deflation, we can expect that the
[hypothetical] equilibrium nominal rate of interest was negative for an
extended period of time. Remember that,
i = π + r
Ex post real rates
for this period are in the double digits during some years! (For example, see
Thayer Watkins calculations for the U.S. here) The dramatic fall of in investment
during this time period suggests that this was out of equilibrium play.
Deflation during these years was the result of a collapse of
the banking system in the U.S. and of the international gold standard. Between
1929 and 1931, U.S. had experienced a tremendous increase in demand for money.
This had made the Depression, to that point, one of the worst on record. Low
levels of output in combination with a fragile unit-banking system that
struggled to remain solvent prevented recovery. Between May 1931 and March 1933,
a series of banking panics led to an increase in cash balances for a fearful
public, and therefore, a continuation of the contraction of the money stock
(Friedman and Schwartz, 308-315). Unit banking in the U.S. prevented the spread
of liquidity which would have likely prevented or slowed the process – banking
panics were prominent in the U.S. during this period, a problem not experienced
by countries lacking this restriction.
Furthermore, some central banks had begun hoarding gold at
the end of the 1920s and continued this practice into the 1930s. The prime
offenders were the Bank of France and the Federal Reserve. The bank of France
increased its holdings from 7 percent to 27 percent of the world’s total gold
reserves (Board of Governors 1943, 544-55). In the U.S. gold holdings shrank
only slightly as a proportion of the world’s gold reserves as board members at
the Federal Reserve refused to adopt a policy of easy money until February
1932. Even then, they did so timidly until prodded by congress in the following months. By this time, the collapse of
the banking system in the U.S. was already under way.
If there were bottlenecks in production that resulted from
interest rates failing to allocate resources across time, the demand
deficiencies were the fault of bad monetary policy. Excessive deflation was the result
of gold hoarding and tight monetary policy more generally. This being the case,
fiscal policy is an unnecessary band-aid if the policy goal is to offset
dramatic falls in aggregate demand. Aggressive monetary policy would have done just fine
to offset the deflation, as is evidenced by the end of the first phase of the Great Depression in 1933 when FDR devalued the dollar.
