Saturday, February 19, 2011

Keynes - The General Theory - Chapter XIV

Section I: After expounding his own theory, in this next chapter, as well as in the Appendix that follows it, Keynes criticizes what he calls the classical theory of interest. This theory he has trouble stately precisely, for lack of "an explicit account of it in the leading treatises of the modern classical school." Not the adjective "modern": Keynes is referring mainly to Marshall and Pigou, whose works I have not read.

Still, Keynes manages a summary:

It is fairly clear, however, that this tradition has regarded the rate of interest as the factor which brings the demand for investment and the willingness to save into equilibrium with one another. Investment represents the demand for investable resources and saving represents the supply, whilst the rate of interest is the “price” of investable resources at which the two are equated. Just as the price of a commodity is necessarily fixed at that point where the demand for it is equal to the supply, so the rate of interest necessarily comes to rest under the play of market forces at the point where the amount of investment at that rate of interest is equal to the amount of saving at that rate.

He notes that "the ordinary man", who was "brought up on the traditional theory" believes: "that whenever an individual performs an act of saving he has done something which automatically brings down the rate of interest, that this automatically stimulates the output of capital." He also believes that this "takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority." Yet: "the analysis of the previous chapters will have made it plain that this account of the matter must be erroneous."

Let's try to unpack this paragraph a bit. First, it's characteristic of Keynes to criticize a common sense approach to economics. Clearly common sense is not infallible, but it is curious how often Keynes's thought tends toward paradoxes. In this case, the man in the street is correct: an increase in savings will have the tendency to lower the rate of interest, thereby increasing investment, which assists in the output of capital. As savings increases, lenders have a larger pool from which to borrow; this competition among savers drives down the rate of interest. In addition, this competition occurs--or would occur--on the open market. The grandmotherly care of the central bank, on the other hand, distorts the rate of interest by increasing the money supply. This lowers the rate of interest, true, but it does so without demanding an increase in savings; hence it leads to malinvestment in certain sectors of the economy.

Returning to Keynes: "The independent variables of the classical theory of the rate of interest are the demand curve for capital and the influence of the rate of interest on the amount saved out of a given income; and when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is given by the point of intersection between the new demand curve for capital and the curve relating the rate of interest to the amounts which will be saved out of the given income." We are told that this is nonsense. For a shift in either curve will necessarily cause income to change. He then walks us through an example to demonstrate that the classical theory must be corrected to account for changes in income. The chart he uses can be seen here.

The general idea is that the rate of interest is determined by the income: "The traditional analysis has been aware that saving depends on income but it has overlooked the fact that income depends on investment, in such fashion that, when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment." Even having read this far along in his book, I confess confusion as to this aspect of his theory.

Granted that a change in income could alter the rate of savings, and therefore alter the interest rate, it does not follow that, if I increase my savings out of my unchanged stream of income, I will somehow see my salary reduce--or vice versa. If the investment proves propitious, and allows business to produce more goods at a lower cost, I can purchase these; this redounds to my benefit, but it has no effect on my income. And, in fact, the increased purchasing power is not a short-term benefit.

I have glanced over a matter of some importance. When faced with the notion that the money supply ought to remain constant, so that lending and borrowing can be properly coordinated by the market, Keynes notes: "The wild duck has dived down to the bottom — as deep as she can get — and bitten fast hold of the weed and tangle and all the rubbish that is down there, and it would need an extraordinarily clever dog to dive after and fish her up again.” Unfortunately, this is hardly an argument. It would have been more interesting for him to analyze what would happen if the money supply was kept constant.

The conclusion of this section--the only one in this chapter--is very important, so I will quote it at some length:

For the economic principle, on which the practical advice of economists has been almost invariably based, has assumed, in effect, that, cet. par., a decrease in spending will tend to lower the rate of interest and an increase in investment to raise it. But if what these two quantities determine is, not the rate of interest, but the aggregate volume of employment, then our outlook on the mechanism of the economic system will be profoundly changed. A decreased readiness to spend will be looked on in quite a different light if, instead of being regarded as a factor which will, cet. par., increase investment, it is seen as a factor which will, cet. par., diminish employment.

Here we have Keynesianism in a nutshell. Consumption is the engine which drives the economy. Reducing one's consumption leads to diminishing employment. As George W. Bush explained after 9/11, Americans ought to go to malls to spend money so as to stimulate the economy. Denigrated is the role played by the saver, who allocates funds for capital investment so as to extend the productive process, which provides the things we then consume.

Appendix: Since most of this section deals with extended quotations from Marshall, Pigou and Ricardo--as well as commentary from Keynes--I will refrain from commenting on this section. I did notice, however, that our author was familiar with the theory of interest of Ludwig von Mises as well as F. A. Hayek, who was a good friend of Keynes.

We've made far too many digressions into the realm of Austrian theory to pardon another one, but interested parties can discover the time-preference theory of interest in Mises's Theory of Money and Credit, which was restated in his magnum opus, Human Action, particularly in Chapter XIX.

Tuesday, February 15, 2011

Timorous Tyrants

The Gitche Gummee Gamut is shutting down. I had sent in one additional column to my editor, so I'll post it here. It's unfortunate that the website didn't last very long. Selfishly, I appreciated the wider audience; and as an exceptionally lazy writer, a weekly deadline proved useful to my productivity.

But there's another reason the event is unfortunate. All politics is and ought to be local. We like to obsess over whichever bozo will take over the executive branch, but aside from ruining everything, a president is mostly useless. On the other hand the local school board can influence the education of the children who reside in the district--at least in theory. Anyone can write editorials about national politics--I know, because I do it. But to cover the minutiae requires diligence and a drive I can only vaguely fathom.

To a large extent, newspapers have abdicated their responsibility to the local communities; their inevitable destruction is well merited. Still, we'll miss something when the newspapers have gone away; it remains far from clear whether or not the Internet can and will fill this void--though my pessimistic prognostication is that it will fail to do so.

Anyway, here's a rosy column to warm your hearts:

"There are three basic ways to win obedience: by force, by buying consent with wealth, and by persuasion. Each of these three leads us to another level (military, economic, or intellectual) outside the political level." - Carroll Quigley, Tragedy and Hope

It should always be remembered, both by the rulers as well as the ruled, that all government depends on the consent of the governed. As our philosophers tell it, this does not require the threat of force, but in the real world, the implicit danger of violence is ever lurking, cajoling the citizenry into handing over consent. If this be doubted, try avoiding paying one's taxes. Unless one is politically well-connected, the government will force the taxpayer to consent to pay every last penny.

Good government tries to rule by persuasion. In the long-run, any other foundation is unstable. This is especially so when it comes to government by force. Maintaining a semblance of order requires drastic action without regard to ethical sensibilities. Thus Robespierre guillotined his fellow countrymen with impunity, and Stalin imprisoned millions of unfortunate "wreckers". Buying consent with wealth may seem a better option, but this too has its drawbacks. The main problem with this approach is that the government has no wealth of its own; anything it attains must be appropriated from the citizenry. Therefore, only a small portion thereof—what Angelo Codevilla dubbed the ruling class—can benefit from the pilfering. Consent bought can only come at the expense of content stolen from someone else. A witty saying of Frederic Bastiat's is relevant here: "The state is that great fiction by which everyone tries to live at the expense of everyone else."

For a good, which is to say, limited, government, persuasion is not terribly difficult. But if government intends to grow, it must depend on the people remaining ignorant of the harm being done to them. Thus trusting souls may have believed that the bailout of the bankers was for the good of the republic. But while the executives of Goldman-Sachs will no doubt consent to legislation from which they benefit so handsomely, it takes only a little bit of skepticism for the commoner to see that he is no better off than he was before--rather the opposite, probably. From the prospective of those in power, it would have made more sense to have paid off everyone's mortgage. It would also have been cheaper. But the complexities of our fraudulent banking system prevented those who wished to maintain the charade from taking this step. In return for the postponement of a greater recession, the elites gave up an opportunity to reinforce the always shaky consent of the governed.

While we should not discount the prospect of a demagogue rising to give hope to the masses—or, I should say, an effective one, since Obama lacks the gravitas to be a competent demagogue—I want to examine a less obvious route. So long as the people remain insensible to the harm caused to them by their own government, the elites may continue to rule, however tenuously. Hence the need for propaganda, to ensure that the truth must compete against the noble lies of the government. Previously in this space we've examined how the metrics used by the government to gauge the health of the economy have been willfully distorted over time to understate inflation and unemployment and to boost GDP. This is an excellent example of the sort of propaganda which benefits the government.

This approach works well, but for one thing. The Internet has leveled the playing field, reducing the influence of propaganda. These distortions of which I speak have been thoroughly documented on the web. Not for nothing, then, was there talk of an Internet kill switch, recently put into practice, with some success, by the Egyptian authorities during their recent revolution. Hence legislation is again being introduced into the U.S. Senate to inhibit the free exchange of ideas over the web. The supporters of the legislation will no doubt insist that they would only shut down the Internet for reasons of national security. At this point, terrorism is invoked to justify the fondling of children, the torturing of prisoners, the invasion of foreign countries, the indefinite detainment of suspects, as well as other violations of our Constitution, so I'd suggest taking the reasoning with a sizable grain of salt.

As Gary North has pointed out, shutting off the Internet will severely cripple economic productivity. This will cause even more unrest in the masses, so if the Internet is shut off, it will only happen temporarily. Moreover, once the Internet is restored, the threat, such that it is, will reemerge. From the perspective of the rulers, it would be more helpful if the government could simply whisk away a few of the leaders of any potential revolts—PATRIOT ACT them, so to speak, indefinitely. But, as we saw when the government went after Julian Assange of Wikileaks, even this does nothing to obstruct the dissemination of information; that of his organization become readily available on mirror sites all across the world.

I remain very much the pessimist about the future of our country. Conventional wisdom insists that, since the truth is more readily available on the Internet, it will help restore the lost liberty of the people. Yet there is no evidence that people care much for liberty—or truth. There is more than enough information available now to demonstrate the wretchedness of our government. Still, the people remain insensible.

However, in a sense, the revival of the legislation to shut down the Internet is a good sign for libertarians. This is true, not simply because, cut off from a steady supply of pornography and celebrity gossip, the rabble may become roused from its stupor. It is also because the leaders are revealing the extent of their fear of the people. While this may not restrain them from acting against us, it may cause them to overreach. The prospect of a third American revolution is not altogether dim.

Monday, February 14, 2011

Keynes - The General Theory - Chapter XIII

Using some of the conclusions he made in the previous chapters, Keynes attempts to explain his interest theory.

Section I: Keynes begins by stating that the rate of interest depends on the schedule of the marginal efficiency of capital and the psychological propensity to save. He continues that it is wrong to conclude that, "the rate of interest is the balancing factor which brings the demand for saving in the shape of new investment forthcoming at a given rate of interest into equality with the supply of saving which results at that rate of interest from the community’s psychological propensity to save." Essentially, there is some other factor - that has been glossed over by other economists - that properly explains interest theory.

Section II: Here Keynes introduces us to this other factor, liquidity-preference. Keynes argues that when an individual decides how much of his income to consume now rather than later we are dealing with the propensity to consume. After this decision, an individual must decide what to do with this income for future consumption. Liquidity-preference is the schedule that shows how much of that income should be held as money, and what should be invested. Keynes continues that the rate of interest is not the "price" which brings into equilibrium the "demand for resources to invest with the readiness to abstain from present consumption." Rather, it is the reward for parting with liquidity.

Here Keynes makes the mistake of assuming that humans are incapable of thinking in terms of three margins. Why must a person decide between consumption and saving, and then after determine what to do with the savings? It is much more likely that people decide to consume, invest, and hoard at the same time. Thus, liquidity-preference has no real value in economic analysis. We once again conclude that interest rates are determined by individual time preferences, no more, no less.

Liquidity-preference does have its uses to Keynes, because from his conclusion Keynes deduces that the other factor affecting the interest rate must be the money supply. For if the rate of interest is lowered significantly, the amount of cash the public wishes to hold would exceed the available supply of money. To prove this point, Keynes turns to his trusted mathematical equations. Keynes writes, "Liquidity-preference fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L(r)."

Here again, Keynes' analysis fails a thorough examination. As any student of Austrian Economics - or even someone familiar with their theories - knows, Economics is an a priori science. Disregarding this fact, Keynes uses mutual determination to deduce the influence of the money supply on interest rates. When originally discussing liquidity-preference Keynes wrote that the mistake of accepted interest theories lies in their attempts to deduce the rate of interest while neglecting liquidity-preference. Then, as I quoted above, he writes how changes in the interest rate change a person's desire to hold cash, or simply change their liquidity preference. The interest rate can not both be determining and determined by liquidity preference. That completely contradicts the idea that Economics follows cause-and-effect relationships.

Keynes end this section with a gem worth quoting. "Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ." Interpreted: Ideally, we should be able to predict the future, but since we cannot we should control the money supply to drive the economy. If that fails, blame everyone for having the same opinions.

Section III: This section is essentially the fine print for his interest theory. For example, Keynes writes, "an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money." He then follows this same formula for several different scenarios.

Section IV: A simple disclaimer that liquidity-preference as mentioned in this text is not the same thing as the "state of bearishness" in his Treatise on Money. Since I have not read that text, nor do I have any interest in reading it, I will withhold comment.

Section V: Keynes finishes this chapter by introducing us to hoarding. He does not say much on the subject for now, with his main point being the rate of interest is not the reward for not-spending, but not-hoarding. The fallacy of this conclusion has already been demonstrated above.