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.