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<A HREF="http://www.zolatimes.com/V3.10/pageone.html">Laissez Faire City Times
- Volume 3 Issue 10</A>
The Laissez Faire City Times
March 8, 1999 - Volume 3, Issue 10
Editor & Chief: Emile Zola
-----
John Maynard Keynes
by Milton Friedman
John Maynard Keynes (1883�1946) is the latest in a line of great British
economists who had a profound influence on the discipline of economics.
By common consent, the line starts with Adam Smith (1723�1790), whose
Wealth of Nations (1776) is generally regarded as the founding document
of modern economics. It continues with David Ricardo (1772�1823), whose
Principles of Political Economy (1817) dominated classical economics for
much of the nineteenth century, and, incidentally, provided Karl Marx
with one of his central concepts: the labor theory of value. John Stuart
Mill�s (1806�1873) Principles of Political Economy, published in the
same year, 1848, as the Communist Manifesto by Marx and Engels, became
the standard textbook in the English-speaking world�and beyond�for
decades. William Stanley Jevons�s (1835�1882) Theory of Political
Economy (1871) inaugurated the "marginal revolution," which replaced, or
supplemented, emphasis on cost of production (supply) as determining
value with emphasis on utility (demand). He resolved the classic
diamond-water paradox�diamonds are a luxury, water a necessity, yet
diamonds command a higher price than water�by showing that "marginal
utility"�the utility gained from having one more unit of something�not
"total utility" plays the key role in determining price. Alfred Marshall
(1842�1924), Keynes�s own teacher, guide, and patron, dominated
economics in the English-speaking world from the publication of the
first edition of his classic, Principles of Economics (1890), to the
1930s.
Keynes clearly belongs in this line. In listing "the" classic of each of
these great economists, historians will cite the General Theory as
Keynes�s path-breaking contribution. Yet, in my opinion, Keynes would
belong in this line even if the General Theory had never been published.
Indeed, I am one of a small minority of professional economists who
regard his Tract on Monetary Reform (1923), not the General Theory, as
his best book in economics. Even after sixty-five years, it is not only
well worth reading but continues to have a major influence on economic
policy.
1. KEYNES�S LIFE
>From 1908 to his death in 1946, Keynes was an active Fellow of King�s
College, Cambridge, influencing successive generations of students. For
many years, he was also Bursar of King�s College, and is credited with
making it one of the wealthiest of the Cambridge colleges. From 1911 to
1944, he was the editor or joint-editor of the Economic Journal, at the
time the leading professional economic periodical in the
English-speaking world. Simultaneously, he was also Secretary of the
Royal Economic Society.
Despite his lifelong commitment to economics, the earliest work he
completed�though not the earliest to be published�was in mathematics not
economics�A Treatise on Probability�essentially completed by 1911, but
first published in 1921. It is a mark of Keynes�s range, creative
originality, and insight that much recent work in statistics has
returned to the themes of the Treatise on Probability. In economics, his
first major publication was Indian Currency and Finance (1913), a
product of his service in the India Office of the British government
from 1906 to 1908.
Monetary Reform (1923) was followed in 1930 by the two-volume Treatise
on Money, much of which remains of value, though Keynes himself came to
regard its theoretical analysis as simply a step on the road to the
General Theory, the last of his major works. These major works were
supplemented by numerous articles, reviews, and biographical essays on
some of his predecessors.[1]
Keynes�s interest and influence were by no means limited to the confines
of the academy. For decades he exerted a major influence on public
affairs and played an active role in the world of business. His Economic
Consequences of the Peace (1919), based on his activities as an adviser
to the British Treasury during the negotiation of the Versailles Peace
Treaty, had a major impact on public opinion and public policy, not only
in Britain but throughout the world, and not only immediately. It was
translated into many languages, became a worldwide best-seller, and
first established Keynes as a major public figure. It influenced the
reaction of both victors and vanquished to the Versailles Peace Treaty.
Indeed, in a book, The Carthaginian Peace; or, the Economic Consequences
of Mr. Keynes, published more than two decades later (1946), Etienne
Mantoux pays the Economic Consequences a backhanded compliment by
arguing that Keynes�s debunking of the peacemakers was the source of all
subsequent evil, including World War II.
>From 1919 on, Keynes remained active in public matters, publishing a
steady stream of articles on current affairs in nonprofessional journals
and newspapers, advising and participating in the deliberations of the
Liberal party, serving as chairman of the Nation and Athenaeum when it
was acquired by a group of Liberals in 1922, and later as director of
the combined New Statesman and Nation, leading journals of opinion for
which he wrote frequently. He brought together many of his most
significant pieces on public affairs in Essays in Persuasion (1931). He
served on government commissions, notably the Macmillan Commission, and
advised and consulted with successive governmental ministers. He was
chairman of the National Mutual Insurance Company and director of
several other insurance companies. His interests were truly catholic: E.
A. G. Robinson, who was co-editor of the Economic Journal with Keynes
for some years and succeeded him as editor, begins an Encyclopaedia
Britannica article on Keynes by describing him as "1st Baron . . . ,
British economist who revolutionized economic theories, critic and
architect of national economic policies, political essayist, successful
financier, bibliophile and patron of the arts." His interest in one
particular art, ballet, was both cause and effect of his marriage in
1925 to Lydia Lopokova, a famous Russian ballerina. He established and
largely financed the Cambridge Arts Theater and was a trustee of the
National Gallery.
>From 1919 to World War II, Keynes�s connection with government was
primarily as an influential outsider. From 1940 on, he served in
government in a variety of capacities concerned with the economic
conduct of the war and postwar reconstruction. He was the chief British
representative at Bretton Woods in 1944, where he was a major architect
of the plans for the International Monetary Fund and the World Bank for
Reconstruction and Development. He was the chief negotiator of the large
U.S. loan to Britain in 1945. On his return to Britain, he played an
important role in persuading the British Parliament to adopt the Bretton
Woods agreement. He died shortly thereafter, on April 21, 1946.
2. THE INFLUENCE OF THE GENERAL THEORY
To return to the General Theory: its influence on both economic thinking
and economic practice was profound. The "Keynesian revolution" was far
more than a figure of speech. From shortly after the publication of the
book in 1936 to at least the 1960s, the majority of professional economi
sts, and certainly the most prominent, termed themselves "Keynesians."
Those who called themselves non- or anti-Keynesians were a beleaguered
minority, supplemented, it must be said, by some important writers on
economics who were not members of the professional guild.[2] Governments
around the world hastened to adopt "Keynesian policies," though many an
economist�both Keynesians and anti-Keynesians�regarded some of the
policies, particularly when they led to inflation, as at best "bastard
Keynesianism."[3]
As of this writing (1988), the status and influence of the book has
changed. It continues to have a major influence on economic thinking and
economic policy, and will long continue to do so, but for very different
reasons and in a very different way than it did initially. The catalyst
for the change was the inflation and stagflation of the 1970s. As Robert
Lucas wrote in 1981, "Proponents of a class of models which promised 3
1/2 to 4 1/2 percent unemployment to a society willing to tolerate
annual inflation rates of 4 to 5 percent have some explaining to do
after a decade such as we have gone through [i.e., the 1970s, when
inflation rose to 16 percent and unemployment to 8 percent in the United
States, and to 30 percent and 6 percent in the U.K. Inflation rose as
high as 25 percent in Japan and 7 percent in Germany, though
unemployment remained relatively low]. A forecast error of this
magnitude and central importance to policy has consequences, as well it
should."
The predictions to which Lucas refers were based on the so-called
Phillips curve which linked inflation inversely to
unemployment�allegedly, the higher the rate of inflation, the lower the
level of unemployment. The curve was asserted by many Keynesians to be
stable over time and to specify a menu of combinations of inflation and
unemployment, any of which was attainable by the appropriate monetary
and fiscal policy. Lucas went on to note that "in the late 1960s Milton
Friedman (1968) and Edmund Phelps (1968) had argued . . . that these
predicted Phillips curve trade-offs were spurious." They emphasized the
importance of distinguishing between anticipated and unanticipated
inflation in interpreting the Phillips curve, and Friedman introduced
the concept of a "natural rate of employment" to which the economy would
tend as economic actors adjusted their anticipations.
"The central forecast to which [Friedman�s and Phelps�s] reasoning led,"
Lucas continued, "was a conditional one, to the effect that a
high-inflation decade should not have less unemployment on average than
a low-inflation decade. We got the high-inflation decade, and with it as
clear-cut an experimental discrimination as macro-economics is ever
likely to see, and Friedman and Phelps were right."[4]
The 1980s have been no kinder to the earlier Keynesian models. In the
U.S., inflation was brought down drastically, accompanied by a temporary
increase in unemployment to a peak of nearly 11 percent�a short-term
reaction to unanticipated disinflation along Phillips curve lines. But
then, from 1983 on, unemployment fell concurrently with further declines
in inflation, reaching 6 percent by the end of 1987 when inflation was
about 4 percent�a flat contradiction of the asserted negative relation
between unemployment and inflation embodied in the Phillips curve. In
the U.K., too, an initial decline in inflation was accompanied by a
sharp rise in unemployment, which was very much slower to decline but
has more recently begun to do so. In Germany, inflation has come down
since the early 1980s; unemployment rose initially, as in the U.S. and
the U.K., but, in contrast to them, continued to rise after inflation
had settled down, and has remained high. Japan, which was the first of
the major countries to cut sharply the rate of inflation, has succeeded
in keeping inflation low with little change in its recorded unemployment
rate. All in all, this experience is hardly consistent with a stable
trade-off between inflation and unemployment.
Experience led to disillusionment with initial Keynesianism on the part
not only of professional economists but also of policymakers. The most
dramatic evidence came from James Callaghan, when he was the Labour
prime minister of the U.K.�the party and the country that had gone
farthest in embracing and adopting Keynesian policies. Said Callaghan in
1976, "We used to think that you could just spend your way out of a
recession and increase employment by cutting taxes and boosting
government spending. I tell you, in all candour, that that option no
longer exists; and that insofar as it ever did exist, it only worked by
injecting bigger doses of inflation into the economy followed by higher
levels of unemployment as the next step. That is the history of the past
twenty years."
Despite the widespread rejection of some of the key propositions that
constituted the "Keynesian revolution," the book continues to have a
major impact on economic thinking. Some indication of its influence is
given by the continuing citations to the book in the professional
literature. Data from one citation index, which covers a wide range of
economic journals, are available for sixteen years, 1972 to 1987. In
all, there were 1,558 citations to the General Theory, or an average of
nearly 100 a year. Of the total, 729 occurred in the first eight years,
829 in the second eight, so there is no sign that interest in the book
is declining. However, the character of the book�s influence has
changed. Some years ago, I remarked to a journalist from Time magazine,
"We are all Keynesians now; no one is any longer a Keynesian." In
regrettable journalist fashion, Time quoted the first half of what I
still believe to be the truth, omitting the second half. We all use
Keynesian terminology; we all use many of the analytical details of the
General Theory; we all accept at least a large part of the changed
agenda for analysis and research that the General Theory introduced.
However, no one accepts the basic substantive conclusions of the book,
no one regards its implicit separation of nominal from real magnitudes
as possible or desirable, even as an analytical first approximation, or
its analytical core as providing a true "general theory."
As one, no doubt somewhat idiosyncratic, view of the book, I quote from
a reply that I wrote some years ago to criticisms of my work mostly from
a "Keynesian" point of view:
"One reward from writing this reply has been the necessity of rereading
earlier work, in particular [Keynes�s] . . . General Theory. The General
Theory is a great book, at once more naive and more profound than the
�Keynesian economics� that Leijonhufvud contrasts with the �economics of
Keynes.� . . . [5]
"I believe that Keynes�s theory is the right kind of theory in its
simplicity, its concentration on a few key magnitudes, its potential
fruitfulness. I have been led to reject it, not on these grounds, but
because I believe that it has been contradicted by evidence: its
predictions have not been confirmed by experience. This failure suggests
that it has not isolated what are �really� the key factors in short-run
economic change.
"The General Theory is profound in the wide range of problems to which
Keynes applies his hypothesis, in the interpretations of the operation
of modern economies and, particularly, of capital markets that are
strewn throughout the book, and in the shrewd and incisive comments on
the theories of his predecessors. These clothe the bare bones of his
theory with an economic understanding that is the true mark of his
greatness.
"Rereading the General Theory has . . . reminded me what a great
economist Keynes was and how much more I sympathize with his approach
and aims than with those of many of his followers."[6]
3. THE MESSAGE OF THE GENERAL THEORY
As its title indicates, the General Theory is almost pure abstract
theory. There is only passing reference to applied economics,
statistical magnitudes, or economic policy. Yet, like all of Keynes�s
writings on economics, it was inspired by a major contemporary problem
and written in the hope and expectation of providing a solution. The
book was written during the worldwide Great Depression following 1929,
when idle men, idle machines, and unmet demand coexisted on a large
scale for years on end and produced widespread poverty, misery, and
deprivation. For Britain, it followed a near-decade of economic
stagnation, high unemployment, and long-term dependence of many families
on a government dole. The key problem of the time was how to explain the
apparent paradox, and, more urgently, how to resolve it.
Ups and downs in economic activity involving occasional periods of
wide-spread
unemployment had long occurred and had engaged the attention of numerous
economists under the rubric of "business fluctuations," or "business
cycles." Various theories had been offered to explain them. Most earlier
theories implicitly accepted the proposition that a private-enterprise
capitalist system contained self-correcting forces that would keep
disturbances temporary. By corrective adjustments to changes in
circumstances, the system, it was believed, would tend toward full
employment of both men and machines�save only for fractional and
transitory unemployment implicit in a dynamic economy. However, the long
duration and magnitude of the unemployment during the Great Depression
and the prior years in Britain did not seem to fit this pattern. Could
these be interpreted as simply a temporary, if long-lasting,
disturbance? Or did they indicate a defect in the supposed
self-adjusting forces at work, so that the economy could get stuck for
long periods of time at a position of high unemployment�a position that
might have just as much reason to be regarded as an "equilibrium" as a
position of full employment?
Such a possibility had frequently been asserted by socialist and other
critics of a capitalist system, whom the mainline professional
economists had regarded as "crackpots." Keynes took the possibility
seriously and proceeded to construct an hypothesis that he believed
demonstrated the possibility�indeed the frequent reality�that, without
government intervention, a private-enterprise capitalist system using a
non-commodity money would tend toward a position characterized by a high
level of involuntary unemployment of persons who would willingly be
employed at the current wage rate but could not find jobs.
The classical remedy for idle men, according to Keynes, was a decline in
the real wage rate, which would reduce the number of persons seeking
jobs and increase the number of persons employers wanted to hire. The
classical remedy for idle machines was a reduction in the cost to
enterprises of using and producing such machines, and that was expected
to occur via a reduction in the real interest rate.
In the 1920s and 1930s in Britain, these classical remedies seemed
either inoperative or ineffective. Keynes set himself the task of
explaining why, of constructing an alternative theory that would both
explain what was happening and justify alternative policies�such as the
large public works programs he had been recommending since the
mid-1920s.
In one sense, his approach was strictly Marshallian: in terms of demand
and supply. However, whereas Marshall dealt with specific commodities
and "partial equilibrium," Keynes proposed to deal with what he called
"aggregate demand" and the "aggregate supply function," and with general
not partial equilibrium.
Where he deviated from Marshall was in the key variables that he
regarded as producing equilibrium between demand and supply and in the
process of ad-justment to a change in demand or supply. In Marshallian
analysis, the key role was played by prices, which reacted quickly to
any change in circumstances. Let there be a sudden increase in demand,
in the sense of a demand function relating the quantity demanded to
price. In Marshall�s view, the immediate reaction would be on prices,
which would rise to choke off the quantity demanded to the prior level
plus whatever additional quantities might be made available from
in-ventories.The rise in prices during the "market period" would give
producers an incentive to increase output in the "short run" by using
existing plant and equipment more intensively, and, if the increased
demand persisted, in the longer run by adding to plant and equipment. In
short, prices adjusted rapidly, quantities slowly, and changes in prices
played the major role in producing equilibrium.
To Keynes, it seemed clear that this process had been inoperative or
ineffective with respect to the economy as a whole. Nominal wage rates
had indeed declined, but so had nominal prices, so that real wages had
hardly moved, and may indeed have increased. He concluded that movements
in prices and interest rates could not be counted on. Accordingly, he
reversed Marshall�s presumptions: prices of labor and capital, at least
"real wages" and "real interest rates," are very slow to adjust;
quantities, which is to say consumption, investment, and their sum,
total output, are highly flexible and adjust rapidly. Changes in output
(aggregate supply), not in prices, play the major role in producing
equilibrium. Accordingly, as a first approximation�though one he never r
eally relaxed�he took prices as given by forces outside his analysis. As
a first approximation, also, he abstracted from both government spending
and international trade, but these could readily be integrated into the
analysis without affecting its substance.
Keynes defined aggregate demand and aggregate supply in terms of
employment, in line with his view that he was developing a "theory of
employment."
However, both Keynes and his followers tended to replace employment by
output and to express aggregate demand and aggregate supply in terms of
the value of output demanded by the public and supplied by enterprises.
Aggregate demand, in these terms, is the sum of expenditures on
consumption goods and expenditures on investment goods. Keynes regarded
expenditures on consumption as depending on income, introducing one of
his key concepts: the propensity to consume, or, in his words, "the
functional relationship. . . between. . . a given level of income in
terms of wage-units, and . . . the expenditure on consumption out of
that level of income."
A "fundamental psychological law," which plays a key role in the
Keynesian system, is that "men are disposed . . . to increase their
consumption as their income increases, but not by as much as the
increase in their income"�i.e., the "marginal propensity to consume" is
less than unity.[7]
Keynes defined investment as "the current addition to the value of the
capital equipment which has resulted from the productive activity of the
period." He regarded investment as depending on the "marginal efficiency
of capital," the second of his key concepts, which he defined as "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," i.e., "the cost of producing"
one more unit of the asset. Like the propensity to consume, the marginal
efficiency of capital is a function or schedule relating the amount of
investment to the interest rate, since entrepreneurs would have an
incentive to add to investment so long as the yield exceeded the
interest rate at which they could borrow the funds to finance the
investment.[8]
The interest rate, in turn, he regarded as determined by "liquidity
preference," the third of his key concepts. "An individual�s
liquidity-preference is given by a schedule of the amounts of his
resources, valued in terms of money or of wage-units, which he will wish
to retain in the form of money in different sets of circumstances." He
regarded the amount of their assets that individuals would want to hold
in the form of money as depending on both income and the interest
rate�income because that would affect the amount held for "transactions-
and precautionary-motives," the interest rate, because that would affect
the amount held "to satisfy the speculative-motive." [9]
If, as Keynes did, we let Y be income, identical with the value of
output, C be consumption, I be investment, L liquidity preference, M the
quantity of money, and r the interest rate, then aggregate demand is
given by
Y = C(Y) + I(r) (1)
and the demand for money by
M = L(Y,r) (2)
In line with his implicit assumption about the relative speed of
adjustment of prices and output, Keynes regarded supply as essentially
passive, expanding or contracting as demand expanded or contracted,
subject only to the proviso that employment is less than "full," which
he defined as the point at which an increase in aggregate demand would
call forth no additional workers willing to work at the wage offered.
This leads him to regard aggregate supply as given simply by aggregate
demand, or
YS = YD (3)
and the level of aggregate supply and demand as affecting not a price
but solely employment.
If we regard the interest rate as fixed, along with other prices, then
equations (1) and (3) define the famous Keynesian "multiplier"
(attributed by Keynes to Richard Kahn). For a simple version, assume
that the consumption function is linear:
C = a + bY (4)
with b, of course, less than one. Substituting (4) in (1) and solving
for Y, we have
Y = [a + I(r)]/(1-b) (5)
The multiplier is 1/(1-b), which, given that b is between zero and
unity, is necessarily greater than unity. The multiplicand, (a + I),
came to be termed "autonomous" spending, i.e., spending not dependent on
the level of income. In addition, once government was introduced into
the analysis, autonomous spend-ing was regarded as including not only
autonomous consumption spending (a) and investment (I ) but also
government spending.
Equations (1) and (3) define also the equally famous "Keynesian cross,"
which has been reproduced in literally hundreds of textbooks in the past
half century and is reproduced here in Figure 1.
The graph makes clear the key importance of the "fundamental
psychological law" that the marginal propensity to consume is less than
unity. If it were unity, the YD line would parallel the YS line and
there would be either no or an infinite number of equilibrium positions,
according as the two parallel lines were distinct or identical. If it
exceeded unity, the YD line would slope more steeply than the YS line,
and any point of intersection would be an unstable equilibrium position.
Because it slopes less steeply, the intersection at YO is a stable
equilibrium. If output were temporarily higher than YO, employers would
be making losses, since the aggregate supply price would exceed
aggregate demand, and would seek to contract output. Conversely, if
output were temporarily lower than YO, employers would be making profits
and would seek to expand.
If, for whatever reason, investment were to increase from IO to I�O, the
YD line would shift to Y�D and the new equilibrium would shift to Y�O .
At YF, the point of full employment, the process would end, and "the
crude quantity theory of money," which is the particular object of
Keynes�s scorn and derision�no doubt because of his long earlier
adherence to it�"is fully satisfied."[10]
Marvelously simple. A key that apparently unlocks the mystery of
long-continued unemployment: inadequate autonomous spending or too low a
propensity to consume. Increase either, or both, being careful simply
not to go too far, and full employment could be attained. What a
wonderful prescription: for consumers, spend more out of your income,
and your income will rise; for governments, spend more, and aggregate
income will rise by a multiple of your additional spending; tax less,
and consumers will spend more with the same result. Though Keynes
himself, and even more, his disciples, produced much more sophisticated
and subtle versions of the theory, this simple version contains the
essence of its great appeal to non-economists and especially
governments.
Here was one of the most famous and respected economists in the world
informing governments that the way to full employment was paved with
higher spending and lower taxes. What more attractive advice could
politicians wish for? Long regarded public vices turned into public
virtues! Marvelously simple, yes. But also simply marvelous. How could a
position such as YO in Figure 1 be regarded as a long-term
equilibrium�as was implied in the claim that the theory was "general"?
At that point, men and machines are idle. Would not the excess supply of
men and machines exert downward pressures on the prices of both? Yes,
said Keynes, but, if effective, that would be accompanied by lower money
prices of output that would cancel the lower money wages and money cost
of capital, so that real wages and the real cost of capital would be
unaffected�which is why Keynes expressed all aggregate magnitudes in
"wage-units." Hence, said Keynes, flexible wages and prices would do no
good. Far better to operate directly on spending.
Of course, Keynes recognized that changes in prices, interest rates, and
quantity of money did have effects that provided alternative avenues of
escape from the so-called "underemployment equilibrium." At best, it was
a transitory equilibrium position, the existence of which would set in
motion self-corrective forces. But Keynes tended to rule out these
alternative avenues of escape as of no practical significance because of
his empirical judgment that prices, wages, and interest rates were
highly sluggish. Indeed, some commentators on Keynes maintain that he
deliberately overstated his case in order to shock the economics
profession into paying attention�a tactic that is common to every
innovator, whether it be of an idea or a product.
Only one alternative avenue of adjustment is explicitly present in
equations (1) and (2)�via the interest rate and the quantity of money.
This avenue, analyzed at some length in the General Theory, and found
wanting to produce, by itself, a full employment equilibrium, also was
rapidly incorporated in an alternative, more sophisticated graphical
representation of the Keynesian system developed almost simultaneously
by John Hicks and Roy Harrod.[11] Figure 2 presents Hicks�s IS-LM
version, which very quickly became the orthodox version.
In this diagram, the vertical axis is the interest rate. The horizontal
axis is income expressed in wage-units, so that it is also output and
employment. The IS curve traces equation (5), i.e., it shows the
combinations of interest rate and output that would satisfy equation
(1): the higher the interest rate, the lower investment and hence
income, and conversely, which is why the IS curve has a negative slope.
Put differently, it shows the combinations of interest rate and output
at which the amount some people wish to invest is equal to the amount
other people wish to save, which is what explains the S in IS. But note
that the accommodation of saving to investment is produced not by the
direct effect of the interest rate on saving, but by the effect of the
level of income on saving, via the propensity to consume.
The LM curve traces equation (2) for a fixed quantity of money. Here,
the higher the interest rate, the lower the quantity of money that the
public would want to hold for a given income, and hence the higher
income must be in order for the actual quantity of money to be willingly
held. Hence the positive slope of the LM curve.
The intersection of the IS and LM curve at YO is the counterpart of the
intersection of the aggregate demand and supply curves in Figure 1 at YO
. Similarly, the IS� curve is the counterpart of the Y�O curve in Figure
1, reflecting a higher level of investment. It is the IS curve moved to
the right by the change in income assumed to be produced by the increase
in investment�the change in investment times the investment multiplier.
What is new in Figure 2 are the LM curves. Each LM curve is for a
specific quantity of money: the LM curve for M = MO, the (LM)� curve for
M = M�O , which is larger than MO. For the community to hold the larger
quantity of money willingly, either the interest rate must be lower for
a given income or income higher for a given interest rate, which is why
the (LM)� curve is to the right of the LM curve.
The IS curve in the diagram embodies a possible Keynesian escape from
underemployment via increases in investment (or, more generally,
autonomous spending including government spending). Let autonomous
spending be high enough so that the IS curve intersects the LM curve at
point F, and full em-ployment would be attained with the initial
quantity of money. The LM curve offers an alternative escape via the
quantity of money. Let the quantity of money be large enough so that the
LM curve intersects the IS curve at point F�, and full employment would
be attained with the initial marginal efficiency of capital schedule.
Keynes and his followers rejected this possibility as highly
unrealistic, largely on the alleged empirical grounds that (1) private
autonomous expen-ditures were little affected by changes in the interest
rate while (2) there was a floor to the interest rate at which the
community would be willing to hold assets other than money, so that, in
the neighborhood of this floor, the quantity of money the community wou
ld be willing to hold would be highly sensitive to the interest rate: in
short, a low elasticity of investment, but a high elasticity of
liquidity preference, with respect to the interest rate.
Figure 3 shows an extreme version of these assumptions: perfectly
inelastic investment and perfectly elastic liquidity preference. We are
back to the Keynes-ian cross of Figure 1. No changes in the quantity of
money can produce a full employment equilibrium. This LM curve depicts a
"liquidity trap," of which Keynes wrote, "whilst the limiting case might
become practically important in future, I know of no example of it
hitherto. Indeed, owing to the unwillingness of most monetary
authorities to deal boldly in debts of long term, there has not been
much opportunity for a test."[12] Of course, it is not necessary to go
to this extreme to generate Keynesian unemployment equilibria, and
Keynes and his followers did not, though some of the more enthusiastic
of his disciples came very close during the high tide of the Keynesian
revolution. It is only necessary to suppose a highly inelastic IS curve,
and a highly elastic LM curve, as in Figure 4. In this version, a
negative interest rate would be required for a full employment
equilibrium. The Keynesians ruled out this possibility by the assumption
of given prices.[13]
The avenue of adjustment that is not explicitly allowed for in either
equations (1) and (2) or in the more sophisticated IS-LM diagram is the
level of prices and wages. As already noted, a Keynesian position of
underemployment equilibrium means downward pressure on wages and prices.
Keynes explicitly recognized that a change in real wages would affect
employment by altering both the supply and the demand for labor.[14]
However, he ruled out that avenue of escape on the grounds that prices
and wages would tend to change pari passu leaving real wages largely
unchanged�not a bad empirical approximation for the kind of major
disturbances, such as the Great Depression, whose origin and cure Keynes
was seeking. Keynes discussed two other effects of changes in the level
of prices and wages. The first is on the real quantity of money, and
thence the rate of interest. A lower level of prices is equivalent to a
higher quantity of money, and like an increase in the quantity of money
would shift the LM
curve to the right. The second is the effect of a lower rate of interest
on the consumption function, an effect that has come to be called the
Keynes effect. The lower the interest rate, the higher the capital value
of a given stream of income�such as rent on a piece of land, or coupons
on a bond. Hence, a lower interest rate increases the wealth of the
community. The higher the wealth, the less pressure to add to wealth via
savings, and hence the higher is likely to be the average and marginal
propensity to consume at any income.
Though Keynes recognized the existence of these avenues of adjustment,
he largely dismissed them on empirical grounds. Sluggishness of price
movements had pride of place, but inelasticity of investment and
elasticity of liquidity preference with respect to the interest rate and
inelasticity of consumption with respect to wealth were also important.
A third effect of a pari passu change in prices and wages, which came to
be known as the "Pigou" effect, was not discussed explicitly by Keynes.
The lower the price level, the higher the real value of the fixed
quantity of money. In principle, there is no limit to the real value of
a fixed nominal quantity of money, and hence no limit to the wealth of a
community, and accordingly, no limit to the extent to which the IS curve
could be shifted to the right by the reduction in the incentive to
save.[15] There is much dispute about the empirical importance of this
effect. I personally regard it as minor. However, on the purely abstract
theoretical level of the General Theory, it conclusively demonstrates
that there is no such flaw in the price system as Keynes professed to
demonstrate. His position of underemployment equilibrium, whatever else
it might be, was not a long-run equilibrium position that set in motion
no effective forces tending toward full employment.
What difference does this abstract analysis make? Is it not simply
arguing about how many angels can dance on the point of a pin? The
answer is that it destroys Keynes�s most striking and radical claim made
in the first paragraph of the General Theory: that what he called the
"classical economics," and, in particular, the quantity theory of money,
were fundamentally fallacious, "that the postulates of the classical
theory are applicable to a special case only and not to the general
case, the situation which it assumes being a limiting part of the
possible positions of equilibrium. Moreover, the characteristics of the
special case assumed by the classical theory happen not to be those of
the economic society in which we actually live, with the result that its
teaching is misleading and disastrous if we attempt to apply it to the
facts of experience."[16]
If this extreme claim is wrong, Keynes�s theory becomes not a theory of
"equilibrium" but at best a theory of disequilibrium, readily
encompassed in the earlier orthodoxy. Conventional wisdom prior to the
General Theory had always recognized that fluctuations existed, and that
periods of widespread unemployment did occur from time to time. But it
regarded these as responses to changes in circumstances, plus rigidities
in prices, wages, and other variables that impeded rapid adjustment to
the new circumstances. And, indeed, conventional economic wisdom has by
now come to regard the Keynesian theory as a theory of disequilibrium,
which provides a useful way to analyze the process of adjustment to
changes in circumstances in a world of relatively rigid prices and
wages. It should be added that there does remain a significant number of
respected economists who continue to regard Keynes�s contribution as
providing a truly general theory fully justifying his initial claims,
and continue to regard him as having demolished the so-called classical
theory.[17]
There remains the twin questions of why Keynes, who described himself in
the preface to the German edition as having been "a priest of" the
English classical quantity theory tradition, regarded it as incompetent
to explain the persistence of high unemployment in the 1920s and 1930s,
and of how those of us who disagree with him reconcile that remarkable
phenomenon with the earlier theory. The key to the answer to both
questions is the interpretation of monetary developments, and
particularly monetary policy in the 1930s. Consider first the situation
in the U.S. By contrast with Britain, the 1920s were a period of general
prosperity, high employment, and relatively stable prices.
There was no reason to question the importance of monetary policy.
Indeed, the Federal Reserve System in the United States took for itself
much of the credit for the good performance of the economy. But then
came the Great Depression. Its initial phase, from 1929 to late 1930,
had all the characteristics of a garden-variety recession, though
somewhat more severe than most, and, indeed, had it ended in early 1930,
or even early 1931, as it showed some signs of doing, it would have gone
down in history in that way, not as a major contraction, let alone Great
Depression. But the second phase, from the end of 1930 to 1933, was very
different. It was marked by a succession of banking crises, and the
veritable collapse of the banking system leading to an unprecedented
"bank holiday" in March 1933, during which all the banks of the
country�including the Federal Reserve Banks themselves�were closed for
business. When the holiday ended and "sound banks" reopened, they
numbered only two-thirds as many as were in existence in 1929. This
sequence of events was accompanied by a disastrous increase in
unemployment, and major declines in prices, wages, and national income
both in current and constant prices. From 1929 to 1933, "money income
fell 53 percent and real income 36 percent . . . . Per capita real
income in 1933 was almost the same as in the depression year of 1908, a
quarter of a century earlier . . . . At the trough of the depression one
person was unemployed for every three employed."[18] And what happened
in the United States was duplicated�the banking disaster partly
excepted�around the world.
To Keynes and many of his contemporaries, this sequence of events seemed
a clear contradiction of the earlier theory and of the efficacy of
monetary policy. They tended then, as many still do, to regard monetary
policy as operating via interest rates. Short-term interest rates in the
United States had fallen drastically during the contraction. In
particular, the discount rate charged by the Federal Reserve Banks on
loans to banks that were members of the Federal Reserve System was
steadily reduced from 6 percent in 1929 to 1.5 percent by the fall of
1931, though it was then abruptly increased to 3.5 percent in response
to Britain�s departure from gold in September 1931, and was still 2.5
percent in early 1933. Judged in these terms, monetary policy was
"easy," yet it apparently had been powerless to stem the contraction,
giving rise to widespread apprehension that monetary policy was like a
string: you could pull on it, but not push on it, i.e., monetary policy
could check inflation but could not offset contraction.
>From another, and I would argue far more significant, point of view,
monetary policy was anything but "easy." That point of view regards
monetary policy as operating via the quantity of money. In terms of
annual averages, the quantity of money in the United States fell by
one-third from 1929 to 1933�by 2 percent from 1929 to 1930, just before
the onset of the first banking crisis, and by a further 32 percent from
1930 to 1933. Data on the quantity of money were not published regularly
at that time and were not readily available even with some lag, whereas
interest rates were readily and contemporarily available�both effect and
reinforcement of the tendency to interpret monetary policy in terms of
the interest rate rather than the quantity of money.
Keynes may well not have known what was happening to the quantity of
money, though if he had, he would also have known that "[a]t all times
throughout the 1929�33 contraction, alternative policies were available
to the [Federal Reserve] System by which it could have kept the stock of
money from falling, and indeed could have increased it at almost any
desired rate." Far from demonstrating, as Keynes concluded, that
monetary policy is impotent, "[t]he contraction is in fact a tragic
testimonial to the importance of monetary forces."[19] The contraction
continued and deepened not because there were no equilibrating forces
within the economy but because the economy was subjected to a series of
shocks succeeding one another: a first banking crisis beginning in the
fall of 1930, a second beginning in the spring of 1931, Britain�s
departure from gold in September 1931, and the final banking crisis
beginning in January 1933�all accompanied by a decline in the quantity
of money of 7 percent from 1930 to 1931, 17 percent from 1931 to 1932,
and 12 percent from 1932 to 1933.
Even after the end of the contraction and the start of revival in 1933,
the shocks continued and impeded recovery: major legislative measures
during Franklin Delano Roosevelt�s New Deal that interfered with market
adjustments and generated uncertainty within the business community,
although some of them, particularly the enactment of federal insurance
of bank deposits, reassured the community about the safety and stability
of the financial institutions; then ill-advised monetary measures in
1936 that halted the rapid rise that had been occurring in the quantity
of money and produced an absolute decline from early 1937 to early 1938
that exacerbated if it did not produce the accompanying severe cyclical
decline.
Keynes�s readiness to interpret the U.S. experience as evidence of the
impotence of monetary policy was greatly strengthened by the British
experience. By contrast with the U.S., the 1920s was a period of
stagnation and high unemployment that the severe worldwide contraction
beginning in 1929 intensified. However, the contraction ended earlier in
Britain than in the U.S., shortly after Britain left the gold standard
and thereby cut its monetary link with the U.S. Here, too, a succession
of shocks played an important role: the end of World War I and
demobilization; the pressure to return to gold at the prewar parity,
which required internal deflation; the return in 1925 to gold at a
parity that overvalued the pound sterling, particularly after France
returned to gold at a parity that undervalued the franc; and, finally,
the shock waves that spread from the U.S. after 1929. The effect of
steady deflationary pressure was reinforced by "an unemployment
insurance scheme that paid benefits that were high relative to wages
available subject to few restrictions . . . . Although a few interwar
observers saw clearly the effects of unemployment insurance, Keynes and
his followers did not."[20]
4. KEYNES�S POLITICAL INFLUENCE
In judging Keynes�s overall influence on public policy, it is necessary
to distin-guish his bequest to technical economics from his bequest to
politics. Keynes�s bequest to technical economics was strongly positive.
His bequest to politics, in my opinion, was not. Yet I conjecture that
his bequest to politics has had far more influence on the shape of
today�s world than his bequest to technical economics. In particular, it
has contributed greatly to the proliferation of over-grown governments
increasingly concerned with every phase of their citizens� daily
lives.[21]
I can best indicate what I regard to be Keynes�s bequest to politics by
quoting from his famous letter to Professor Friedrich von Hayek praising
Hayek�s Road to Serfdom. The part generally quoted is from the opening
paragraph of the letter: "In my opinion it is a grand book . . . .
[M]orally and philosophically I find myself in agreement with virtually
the whole of it; and not only in agreement with it, but in a deeply mo
ved agreement."
The part I want to direct attention to comes later:
"I should therefore conclude your theme rather differently. I should say
that what we want is not no planning, or even less planning, indeed I
should say that we almost certainly want more. But the planning should
take place in a community in which as many people as possible, both
leaders and followers wholly share your own moral position. Moderate
planning will be safe if those carrying it out are rightly orientated in
their own minds and hearts to the moral issue.
"What we need therefore, in my opinion, is not a change in our economic
programmes, which would only lead in practice to disillusion with the
results of your philosophy; but perhaps even the contrary, namely, an
enlargement of them . . . . No, what we need is the restoration of right
moral thinking�a return to proper moral values in our social philosophy
. . . . Dangerous acts can be done safely in a community which thinks
and feels rightly, which would be the way to hell if they were executed
by those who think and feel wrongly."[22]
Keynes was exceedingly effective in persuading a broad group�economists,
policymakers, government officials, and interested citizens�of the two
concepts implicit in his letter to Hayek: first, the public interest
concept of government; second, the benevolent dictatorship concept that
all will be well if only good men are in power. Clearly, Keynes�s
agreement with "virtually the whole" of the Road to Serfdom did not
extend to the chapter titled "Why the Worst Get on Top."
Keynes believed that economists (and others) could best contribute to
the improvement of society by investigating how to manipulate the levers
actually or potentially under control of the political authorities so as
to achieve desirable ends, and then persuading benevolent civil servants
and elected officials to follow their advice. The role of voters is to
elect persons with the right moral values to office and then let them
run the country.
>From an alternative point of view, economists (and others) can best
contribute to the improvement of society by investigating the framework
of political institutions that will best assure that an individual
government employee or elected official who, in Adam Smith�s words,
"intends only his own gain. . . is. . . led by an invisible hand to
promote an end that was no part of his intention," and then persuading
the voters that it is in their self-interest to adopt such a framework.
The task, that is, is to do for the political market what Adam Smith so
largely did for the economic market.
Keynes�s view has been enormously influential�if only by strongly
reinforcing a pre-existing attitude. Many economists have devoted their
efforts to social engineering of precisely the kind that Keynes engaged
in and advised others to engage in. And it is far from clear that they
have been wrong to do so. We must act within the system as it is. We may
regret that government has the powers it does; we may try our best as
citizens to persuade our fellow citizens to eliminate many of those
powers; but so long as they exist, it is often, though by no means
always, better that they be exercised efficiently than inefficiently.
Moreover, given that the system is what it is, it is entirely proper for
individuals to conform and promote their interests within it. An appr
oach that takes for granted that government employees and officials are
acting as benevolent dictators to promote in a disinterested way what
they regard as the public�s conception of the "general interest" is
bound to contribute to an expansion in governmental intervention in the
economy�regardless of the economic theory employed. A monetarist no less
than a Keynesian interpretation of economic fluctuations can lead to a
fine-tuning approach to economic policy.
The persuasiveness of Keynes�s view was greatly enhanced in Britain by
historical experience, as well as by the example Keynes himself set.
Britain retains an aristocratic structure�one in which noblesse oblige
was more than a meaningless catchword. What has changed are the criteria
for admission to the aristocracy�if not to a complete meritocracy, at
least some way in that direction. Moreover, Britain�s nineteenth-century
laissez-faire policy produced a largely incorruptible civil service,
with limited scope for action, but with great powers of decision within
those limits. It also produced a law-obedient citizenry that was
responsive to the actions of the elected officials operating in turn
under the influence of the civil service. The welfare state of the tw
entieth century has almost completely eroded both elements of this
heritage. But that was not true when Keynes was forming his views, and
during most of his public activity.
Keynes�s own experience was also influential, particularly to
economists. He set an example of a brilliant scholar who participated
actively and effectively in the formulation of public policy�both
through influencing public opinion and as a technical expert called on
by the government for advice. He set an example also of a
public-spirited and largely disinterested participant in the political
process. And it is not irrelevant that he gained worldwide fame, and a
private fortune, in the process.
The situation was very different in the United States. The United States
is a democratic not an aristocratic society, as Tocqueville pointed out
long ago. It has no tradition of an incorruptible or able civil service.
Quite the contrary. The spoils system formed public attitudes far more
than a supposedly non-political civil service. And it did so even after
it had become very much emasculated in practice. As a result, Keynes�s
political bequest has been less effective in the United States than in
Britain, which partly explains, I believe, why the "public choice"
revolution in the analysis of politics occurred in the United States.
Yet even in the United States, Keynes�s political bequest has been
tremendously effective. Certainly most writing by economists on public
policy�as opposed to scientific and technical economics�has been
consistent with it. Economists, myself included, have sought to discover
how to manipulate the levers of power more effectively, and to
persuade�or educate�governmental officials regarded as seeking to serve
the public interest.
I conclude that Keynes�s political bequest has done far more harm than
his economic bequest and this for two reasons. First, whatever the
economic analysis, benevolent dictatorship is likely sooner or later to
lead to a totalitarian society. Second, Keynes�s economic theories
appealed to a group far broader than economists primarily because of
their link to his political approach. Here again, Keynes, in his letter
to Hayek, said it better than I can: "Moderate planning will be safe if
those carrying it out are rightly orientated in their own minds and
hearts to the moral issue. This is in fact already true of some of them.
But the curse is that there is also an important section who could
almost be said to want planning not in order to enjoy its fruits but
because morally they hold ideas exactly the opposite of yours [i.e.,
Hayek�s], and wish to serve not God but the devil. Reading the New
Statesman and Nation one sometimes feels that those who write there,
while they cannot safely oppose moderate planning, are really hoping in
their hearts that it will not succeed; and so prejudice more violent
action. They fear that if moderate measures are sufficiently successful,
this will allow a reaction in what you think the right and they think
the wrong moral direction. Perhaps I do them an injustice; but perhaps I
do not."
Keynes did not let this analysis prevent him from serving until his
death as chairman of the New Statesman and Nation�presumably in the hope
of influencing the moral views of its editors and writers. I regard
Keynes�s analysis as indicating that the key problem is not how to
achieve a moral regeneration but rather how either to frustrate what
Keynes regards as "bad morals," or to construct a political framework in
which those "bad morals" serve not only the private but also the public
interest, just as, in the economic market, private greed is converted to
public service.
The literature on Keynes and on the General Theory is by now immense. Of
the books specifically devoted to Keynes�s life, two stand out: the
initial authorized biography by his student and disciple, Roy F. Harrod,
The Life of John Maynard Keynes (1951); and the more recent multi-volume
biography by Robert J. A. Skidelsky, John Maynard Keynes, Vol. 1: Hopes
Betrayed, 1883�1920 (London: Macmillan, 1983), and Vol. 2: The Economist
as Prince, 1920�1937 (London: Macmillan, 1988). The Collected Writings
of John Maynard Keynes have been published under the auspices of the
Royal Economic Society in 29 volumes (Macmillan, 1971 to 1982), with a
final Bibliography and Index yet to come. This splendid collection
includes not only his major work but also his published articles on
economics and politics, many previously unpublished items, including
letters, official memoranda and notes, and the like.
Notes
1 The biographical essays on economists are gathered together in his
Essays in Biography (1933), along with similar essays on politicians and
others.
2 In the U.S., the most important was doubtless Henry Hazlitt, The
Failure of the New Economics: An Analysis of the Keynesian Fallacies
(Princeton, N.J.: Van Nostrand, 1959).
3 The phrase was coined by Joan Robinson, one of the earliest and most
dedicated members of Keynes�s inner circle, in her review of Harry
Johnson�s Money, Trade and Economic Growth (1962), Economic Journal,
vol. 72 (September 1962), p. 690. However, she used it to refer to the
theories of some of Keynes�s followers, rather than to policies.
4 Robert E. Lucas, Jr., "Tobin and Monetarism: A Review Article,"
Journal of Economic Literature, vol. 19 (June 1981), p. 560.
5 Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes
(London: Oxford University Press, 1968).
6 Milton Friedman�s Monetary Framework: A Debate with His Critics, ed.
by Robert J. Gordon (Chicago: University of Chicago Press, 1974), pp.
133�34.
7 The General Theory of Employment Interest and Money (London:
Macmillan, 1936), pp. 90, 96, and 114.
8 Ibid., pp. 62 and 135.
9 Ibid., pp. 166 and 199.
10 Ibid., p. 289.
11 John R. Hicks, "Mr. Keynes and the �Classics�: A Suggested
Interpretation," Econometrica, vol. 5 (April 1937), pp. 147�59; Roy F.
Harrod, "Mr. Keynes and Traditional Theory," Econometrica, vol. 5
(January 1937), pp. 74�86.
12 The General Theory, p. 207.
13 The interest rate that is relevant to investment is the "real"
interest rate, i.e., the nominal rate of interest less the rate of
inflation, and the "real" interest rate has often been negative.
14 See, for example, ibid., p. 289.
15 For a fuller theoretical analysis of (a) the possibility of a
negative equilibrium interest rate, and (b) the Keynes and Pigou
effects, see Milton Friedman, Price Theory (Chicago: Aldine Publishing
Co., 1976), pp. 313�21.
16 Ibid., p. 1.
17 The most prominent of this group are the late Joan Robinson, the late
Nicholas Kaldor, in Britain, and Professor Robert Eisner, in the United
States.
18 Milton Friedman and Anna J. Schwartz, A Monetary History of the
United States, 1867�1960 (Princeton: Princeton University Press for the
National Bureau of Economic Research, 1963), p. 301.
19 Ibid., pp. 693 and 300.
20 Daniel K. Benjamin and Levis A. Kochin, "Searching for an Explanation
of Unemployment in Interwar Britain," Journal of Political Economy, vol.
87 (June 1979), p. 441.
21 The rest of this preface up to the final paragraph is drawn largely
from my "Comment on Leland Yeager�s Paper on the Keynesian Heritage," in
The Keynesian Heritage, a symposium by Leland Yeager, Milton Friedman,
and Karl Brunner, Center Symposia Series CS�16 (Rochester, N.Y.: Center
for Research in Government Policy and Business, Graduate School of
Management, University of Rochester, 1985), pp. 12�18.
22 Donald Moggridge, ed., John Maynard Keynes, The Collected Writings,
Vol. XXVII: Activities, 1940�1946, pp. 385, 387, 388.
------------------------------------------------------------------------
Milton Friedman is a Nobel-Prize-winning economist. This essay was
originally published in German in 1989.
-30-
from The Laissez Faire City Times, Vol 3, No 10, March 8, 1999
------------------------------------------------------------------------
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Amen.
Roads End
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