Keynes - The General Theory - Chapter VII

Section I: Keynes defines savings for us: "So far as I know, everyone agrees in meaning by Saving the excess of income over what is spent on consumption."

Fair enough. He then explains how, although savings and investment are equal--he states that they are identical, though in not so many words, in the previous chapter--an apparent inequality may come about: "Thus the differences of usage arise either out of the definition of Investment or out of that of Income."

Section II: He then defines investment for us: "In popular usage it is common to mean by this the purchase of an asset, old or new, by an individual or a corporation. Occasionally, the term might be restricted to the purchase of an asset on the Stock Exchange. But we speak just as readily of investing, for example, in a house, or in a machine, or in a stock of finished or unfinished goods..." Disinvestment is thus the opposite, namely, the selling of an investment.

Although Keynes seems to be aware of this, the distinction between goods to be consumed and those to be resold--investments--is very blurry. I don't see that it changes his definitions.

On a graver note, it is obvious that, according to these definitions, savings does not equal investment. I have some cash in my wallet, and I have money in a checking account. Neither of those could be construed as investments, according to Keynes's definition, though both are assuredly savings.

Continuing, he writes: "Investment, thus defined, includes, therefore, the increment of capital equipment, whether it consists of fixed capital, working capital or liquid capital; and the significant differences of definition (apart from the distinction between investment and net investment) are due to the exclusion from investment of one or more of these categories."

Unless I missed something, Keynes does not include liquid capital in his definition of investment. So by his own standard, the equality fails. Or, I should say, by one of his standards, it fails. There is still much confusion in trying to understand what Keynes means by his terms.

In this section, Keynes mentions the Austrian school, with which he was probably familiar from his time spent with his friend F. A. Hayek. But if he was aware of the school's existence, he demonstrates that he did not appreciate the importance its adherents laid on the role savings plays in the accumulation of capital: "The statement, for example, that capital formation occurs when there is a lengthening of the period of production does not much advance matters."

Section III: Keynes introduces us to the term "normal profit", which I do not see defined. He claims that this accounts for the discrepancy between income and savings which he postulated in one of his previous books. But the problem is far bigger than that.

We've constantly referred to the confusing nature of Keynes's prose. Here's a prime example: "As I now think, the volume of employment (and consequently of output and real income) is fixed by the entrepreneur under the motive of seeking to maximise its present and prospective profits (the allowance for user cost being determined by his view as to the use of equipment which will maximise his return from it over its whole life); whilst the volume of employment which will maximise his profit depends on the aggregate demand function given by his expectations of the sum of the proceeds resulting from consumption and investment respectively on various hypotheses."

If anyone can explain what that may mean, I would be indebted to you. I am wholly unable to extract value from this section, so I move onward.

Section IV: We come to the concept of "forced savings." The general idea here is clear: something alters the purchasing power of the wage-unit, thereby increasing savings. Keynes, of course, connects it, with the help of his confusing terminology, to the coordinated efforts of entrepreneurs to maximize employment, but this need not concern us.

While it is true, in a certain sense, that if the purchasing power of the currency were to rise due to a general reduction in prices, this would be "forced savings", this is misleading. For one, there is no compulsion: the consumer may divest himself of these forced savings by purchasing items. For another, if a consumer can suddenly get the things he desires for a cheaper price, this is a glorious thing. It need not be given a negative connotation.

On the other hand, if the purchasing power of the currency is falling, due to inflationary policies of a central bank, the consumer finds his savings reduced. This is truly compulsory, and cannot be easily avoided. It's telling that Keynes doesn't focus on that which is truly forced--what Ron Paul calls the inflation tax.

Keynes is rightly critical of the concept of forced savings--which evidently stems from Bentham: "Thus “forced saving” has no meaning until we have specified some standard rate of saving." We may chuckle to ourselves, since this rejoinder occurs shortly after Keynes uses "normal profit" without defining it. For some reason, too, he thinks that "forced savings" only pertain to an economy in full employment. Since it is essentially a monetary phenomenon--at least insofar as inflation is concerned--I am not sure why this is the case.

Section V: Keynes struggles to understand the purpose of a bank: "It is supposed that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no saving corresponds."

This is basically true of our current system, but there is no reason a bank must loan the money depositors leave in their checking accounts. In fact, as I pointed out in a recent column, the demand deposits which comprise checking accounts must not be invested or else the bank will not be able to make good on withdrawal demands.

Keynes offers a reasonable statement, which is nonetheless false: "It follows that the aggregate saving of the first individual and of others taken together must necessarily be equal to the amount of current new investment." Since we have a fractional reserve banking system, every dollar which is deposited in a bank is lent out--ten times or more--to borrowers. This is the "money multiplier" effect. It explains why the banks are so hosed whenever a bubble bursts. It is, in fact, the cause of the bubble in first place--though an inflationary central bank is a necessary prerequisite. Even if you reject the Austrian explanation for the business cycle, it must be admitted that Keynes is wrong here.

He examines the consequences of credit expansion by the banks. "It is also true that the grant of the bank-credit will set up three tendencies (1) for output to increase, (2) for the marginal product to rise in value in terms of the wage-unit (which in conditions of decreasing return must necessarily accompany an increase of output), and (3) for the wage-unit to rise in terms of money (since this is a frequent concomitant of better employment)..."

Let us take these one at a time. The first is generally true; the expanded credit will fuel investment, especially in a particular sector. In other words, there would be a boom, say, in housing. But while output may rise in one sector, it will not necessarily rise uniformly; some sectors may even see a reduction in output.

This tendency to think only in aggregates harms Keynes's second point. During the housing bubble, the marginal product of homes was rising in terms of the wage unit; but this did not hold true of every good in the economy. Computers were falling in prices, both absolutely as well as relative to the wage-unit.

The third is not completely false, but it is mostly so. Certainly, some people saw an increase of income in real terms during the housing boom--real estate agents, for instance. However, since the creation of credit was not backed by savings, these increases were offset by decreases in other sectors. Moreover, much of this production was malinvestment; we did not need so many houses in Vegas. This impoverishes people and leads to a reduction in wages. Keynes is right to an extent, but only ephemerally, and in the short term. In the long run, bubbles pop.

Keynes asserts that "the reactions of the amount of [the individual's] consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself." We shall see if he proves this at a later point, and leave off for now.