The Keynes Perplex.

• Author: Butos, William N.
• Position: John Maynard Keynes' "The General Theory of Employment, Interest, and Money" - Critical essay

The publication of The General Theory of Employment, Interest, and Money (hereafter GT) in 1936 by John Maynard Keynes (1883-1946) marks one of the great watersheds in the history of macroeconomics. Keynes was no unknown upstart--even before 1936, he had become a highly influential economist and civil servant, editing the prestigious Economic Journal in 1911 (at twenty-eight years of age) and authoring several important books. (1) After World War II, GT quickly swept away the existing "classical" orthodoxy in Britain and America, instigating the "Keynesian Revolution." GT changed the course of how economists think about macroeconomics; it is actively discussed to this day, and its theoretical merits and policy implications are still debated. (2)

In this essay, I have selected certain main ideas in GT to discuss. My approach is, I hope, a useful but certainly not an exclusive way to understand an important economist. In a nutshell, Keynes claimed that insufficient aggregate investment causes high unemployment. Interest rates can be too high and uncertainties for private investors too great to ensure full-employment investment. The economy, he argued, cannot rely on the self-correcting mechanisms of the market. Although standard macroeconomic countercyclical policy was largely muted in GT, Keynes's policy vision stretched beyond standard fiscal and central-bank policies beginning in his earlier years (see Meltzer 1988; Salerno 1992). Keynes was not dismissive of standard macroeconomic policies, but he did not have great confidence in their reliability to solve the problem of slumps.

Context and the Run-Up to GT: The Treatise and the Return to Gold

Keynes considered his general theory a major and pathbreaking theoretical contribution to economics, but his earlier work included antecedents that he adapted for GT, especially A Treatise on Money ([1930] 1981). The Treatise uses a Wicksellian business-cycle model to analyze fluctuations--episodes of deflation and inflation--caused by imbalances in the flows of savings and investment. If saving exceeds investment, the model calls for a cumulative contraction with falling prices and output as well as higher unemployment; the contraction ceases only if savings are reduced and investment increased. (3) Because "saving" in the Treatise means reduced demand for consumption goods, "the cruse becomes a Danaid jar which can never be filled up" because "the effect of this reduced expenditure is to inflict on the producers of consumption goods a loss of an equal amount" (Keynes [1930] 1971, 125). Although Keynes dropped the Wicksellian model in GT, the Danaid jar metaphor is central to GT in that "saving" is depressive to the economy. (4)

In both the Treatise and GT, Keynes claimed that private-investment instability is central to the explanation of the business cycle. In the Treatise, however, the fear of falling prices induces destabilization and motivates the financial market "bears." Investment instability is also central to GT, but the explanation there refers to "the dark forces of time and ignorance which envelop our future" in the context of modern "organized investment markets" (155, 150). Keynes claimed that such markets may produce outcomes in the form of a cumulative price deflation and recession and also a level of aggregate output insufficient for full employment. Also, importantly, Keynes emphasized the fragility of expectations in both the Treatise and GT, but he treated expectations differently in each case.

The Treatise centers on unstable short-run expectations of firms' future profits and stable long-term expectations in the context of business cycles; in GT, however, short-run expectations are stable, but long-run expectations are not. (5) In both cases but in different contexts, there are presumed to be very weak self-correcting processes endogenous to the system. The Treatise was written five years after Britain resumed the prewar parity of sterling against gold in 1925. (6) Keynes argued that sterling was at least 10 percent overvalued and that this overvaluation would result in large-scale unemployment. In Britain, the strength of trade unions in keeping nominal wages rigid would also be played out by falling prices and rising unemployment and after World War I would include other institutional factors that would keep Britain relatively uncompetitive in world markets. (7) For example, unemployment in 1921 reached 11 percent during the recession of 1920-21, gradually settling in at 8 percent in 1923 until 1929. In short, Britain's recovery lagged after the war and did not show a robust upturn during the decade of the 1920s. (8)

Britain's economic woes continued with a recession in the early 1930s: the unemployment rate peaked at 16 percent in 1932 and was still at 8 percent at the onset of the recession in 1937. And it was just a year after the Treatise was published that Britain went off the gold standard in 1931. These events were probably crucial for Keynes's writing of GT: his explanation of the possibility of a prolonged slump was very timely, given the widespread disenchantment with the workings of the market economy after years of depression; he could also dispense with the "shackles of gold" as a monetary constraint by providing more latitude for domestic-policy options. With GT, he was able to rebound from the Treatise's disappointing professional reception. (9)

The Problem with "Classical Economics"

Keynes argued that Britain's unemployment problem was caused by large-scale involuntary unemployment. According to him, the classical school assumed frictionless adjustment that always brings the labor market to equilibrium. (10) But, he argued, workers cannot change the price level or easily adjust the money-wage components of real wages. So if the demand for labor shifts leftward, real wages cannot easily adjust to their equilibrium values, thus generating involuntary unemployment.

This explanation of the unemployment problem ties into Keynes's interpretation of Jean-Baptiste Say's classical Law of Markets. Keynes argued that Say's Law was defined as an equilibrium state in which "supply creates its own demand" (GT, 18). (11) He apparently meant that classical economists claimed that "effective demand" (as discussed later) would be equal to full-employment aggregate supply. Keynes asserted that according to Say's Law all markets are in equilibrium, implying full employment such that "the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output" (GT, 26). he claimed that the classical default position was full employment equilibrium; Say's Law, in his reading, cannot explain business cycles or persistent high unemployment.

Yet the salient proposition that Keynes overlooked and that was implicit for pre-Keynesians is that markets provide "incentives to correct any nonuse of also valuable (and hence demanded) resources of men and assets" (Hutt 1979, 53, italics in original). Also, Joseph Schumpeter argued that "competition between firms always tends to lead to an expansion of output up to the point of full utilization of resources.... And this is the proposition to which Keynes really meant to object" (1954, 624, italics in original). More recently, Steven Kates (1998, 2010) has defended Say's Law and criticized Keynes's interpretation of it. Most pre-Keynesian economists, Kates (1998) finds, were very much aware that recessions occur (and with involuntary unemployment) because of disparities in the composition of commodities supplied and the array of commodities desired by buyers; in such cases, Kates says, recessions are due to "structural problems" and not to insufficient aggregate demand (2010, 16).

Keynes's critique of "classical economics" (with some exceptions--for instance, Malthus) seems to obscure important aspects of the classical system. Nevertheless, the force of his argument was meant to displace important work by postmarginalists, including the Swedish and Austrian Schools and, indeed, his English contemporaries. In this aim, Keynes succeeded handsomely. (12) In contrast to the emphasis in modern macroeconomic textbooks, Keynes's policy playing field centered primarily on prolonged slumps with high unemployment, which Britain was experiencing, and only secondarily on the trade cycle. Contrary to "classical economics," Keynes carved out a theory of the slump with no obvious self-adjusting market...