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John Maynard Keynes

The Art of Choosing the Right Model

M. G. Hayes

polity

Copyright © Mark G. Hayes 2020

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First published in 2020 by Polity Press

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Description: Medford, MA : Polity, 2019. | Series: Key contemporary thinkers | Includes bibliographical references and index.

Identifiers: LCCN 2019014897 (print) | LCCN 2019981313 (ebook) | ISBN 9781509528240 (hardback) | ISBN 9781509528257 (pbk.) | ISBN 9781509528288 (ebook)

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List of Tables

Table 2.1 Diminishing returns in terms of average product of labour

Table 2.2 Diminishing returns in terms of marginal product of labour

Table 2.3 Diminishing returns in terms of marginal net product of capital

Table 2.4 The distribution of income in accordance with marginal productivity

Table 3.1 The time structure of income

Table 3.2 Stock adjustment and the multiplier

List of Figures

Figure 1.1 Causation in the classical model

Figure 1.2 Causation in Keynes's general model

Figure 2.1 The demand for labour on one farm

Figure 2.2 The total demand for and supply of labour: The classical labour market

Figure 2.3 Classical unemployment

Figure 2.4 Investment demand

Figure 2.5 Investment demand at 10% interest

Figure 2.6 Investment demand at 30% interest

Figure 2.7 The balance between saving and investment: The classical capital market

Figure 2.8 The determination of rent: The market for land

Figure 2.9 The neoclassical labour market

Figure 2.10 The neoclassical capital market

Figure 3.1 The point of effective demand: The Z diagram

Figure 3.2 Effective demand and the multiplier

Figure 3.3 The multiplier and the Z diagram

Figure 4.1 The IS–LM diagram

Figure 4.2 The IS–LM diagram and crowding out

Figure 6.1 The United Kingdom's real exchange rate and current account

Figure 6.2 The United Kingdom's real exchange rate against the United States in Keynes's A Tract on Monetary Reform

Figure 6.3 World trade and UK income growth

Figure 6.4 World trade and US income growth

Figure 6.5 Sterling/dollar exchange rate, 1883–2015

Figure 7.1 UK growth of income, exports and income per head

Figure 7.2 G17 growth of income, exports and income per head

Figure 7.3 UK unemployment, inflation and interest rates

Figure 7.4 G17 unemployment, inflation and interest rates

Figure 7.5 US growth of income, exports and income per head

Figure 7.6 US unemployment, inflation and interest rates

Figure 7.7 UK public borrowing and investment

Figure 7.8 US public borrowing and investment

Figure 7.9 UK investment and public sector consumption

Figure 7.10 US investment and public sector consumption

Figure 7.11 Volatility in the UK data

Figure 7.12 Volatility in the US data

Figure 7.13 The rate of profit in the United Kingdom

Figure 8.1 UK investment and unemployment

Figure 8.2 US investment and unemployment

Figure 8.3 UK public borrowing and unemployment

Figure 8.4 US public borrowing and unemployment

Acknowledgements

I am most grateful to Roger Backhouse, Robert Bigg, Victoria Chick, Matteo Iannizzotto and Robert Skidelsky, together with three anonymous referees, for their comments on drafts of various parts of the manuscript, although this should not be taken as endorsement of my approach or opinions. Simon Perry read through the draft as a non-economist and provided valuable feedback on presentation. Any remaining errors, omissions or shortcomings are mine alone.

George Owers, Julia Davies and Manuela Tecusan at Polity have provided great support in the process of writing and production and helpful guidance on the interests of the intended readership. My thanks to them and all the production team.

I am grateful to the Royal Economic Society for permission to reproduce extracts from The Collected Writings of John Maynard Keynes, edited by Elizabeth Johnson and Donald Moggridge © The Royal Economic Society 2013, published by Cambridge University Press.

Preface

This book sets out in plain English the essence and implications of the economic thought of John Maynard Keynes. It is aimed at undergraduate students in the social sciences, including economics, but without the commitment to more advanced mathematics found in economics textbooks. It should be accessible to a bright A-level student and to any fairly determined intelligent reader.

This preface is mainly addressed to teachers, lecturers and professional economists who will ask why they should read or recommend this particular introduction to Keynes's thought. On the one hand, the present book is in the tradition of Robinson (1937), Dillard (1948), Hansen (1953), Stewart (1967) and, more recently, Davidson (2017). Each has its own perspective, style and approach. This book places emphasis on the elements of continuity in the development of Keynes's thinking over the course of his life and covers all his major economic writings, not only The General Theory. The final chapters place the Keynesian era in its long-term historical context and relate Keynes's thinking to the state of economic theory and policy today. The Further Reading contains references for the economics student who wishes to delve deeper. On the other hand, this book makes a good supplement to Collins (2017), which offers a highly structured modular text suitable for classroom teaching at an introductory level.

It is the richness and complexity of Keynes's thought that makes it possible to say something new about it several decades later. This book reflects a study of Keynes's works over a period of more than forty years, which is rather longer than what he took to write them. It embodies a distinctive understanding of Keynes's central ideas of expectation, liquidity and effective demand, one that does not fit any of the pigeonholes in Coddington (1976). It includes recognition that Keynes assumes flexible, not fixed, prices; recognition that, for Keynes, income, wages and interest are intrinsically monetary; and recognition of Keynes's paradoxical use of liquidity to mean that stock markets are illiquid, while land can be liquid. The detailed case for this interpretation can be found in my research papers and previous book (Hayes, 2006a to Hayes, 2018). This perspective reinforces Keynes's claim to have offered a general theory encompassing the classical theory – against the current convention to the contrary, that his theory is a special case of the classical theory.

Mark Gerard Hayes
Robinson College, Cambridge
18 March 2019

How to Read This Book

Those who want just a basic introduction in order to decide for themselves whether Keynes is relevant today can read chapters 1 and 8 in isolation, referring back to chapter 7 for historical context.

Economics students will also want to read chapters 3 and 4 as a minimum. Beginner economists, students of other social sciences and lay readers will need to read chapter 2 in order to understand the elements of classical economics before tackling chapter 3. The Glossary allows quick reference to some of the technical terms.

Chapters 5 and 6 address more advanced questions within the context of the development of Keynes's economic thought throughout his life.

Glossary

Words in bold type are cross-references: they refer to other entries in the glossary.

aggregate | the total for the whole economy
aggregate demand | the aggregate income expected by employers as a whole to result from expenditure on investment and consumption
aggregate demand function or curve | the mathematical relation between aggregate demand and aggregate employment
aggregate supply | the minimum aggregate income expected by employers as a whole at which it is profitable to offer a particular level of aggregate employment
aggregate supply function or curve | the mathematical relation between aggregate supply and the aggregate employment offered
balance of payments | the overall balance on the current and financial accounts of one region with another
Bretton Woods | the 1944 international conference at Bretton Woods, New Hampshire, which established the International Monetary Fund and the World Bank
budget deficit | an excess of government expenditure over income
capital | durable goods used in production or as a store of value
capital budget | government investment and its funding
competitive equilibrium | the state in which competition in supply and demand leads to a market price at which supply and demand are equal
current account | exports including foreign income, minus imports and income earned by foreign residents
current budget | the balance of government income and consumption expenditure
demand | offers to buy new goods or services; not to be confused with expenditure
demand function or curve | the mathematical relation between demand and price, often drawn as a straight line for illustration
effective demand | the aggregate income expected by employers as a whole to result from the aggregate employment they find it most profitable to offer
expectation | the expected value of a future price, quantity or income
expenditure | purchase of goods or services
financial account | borrowing from foreign residents minus lending to them
forward market | a market for delivery of goods or services at a future date
gold standard | a monetary system in which the value of a currency is defined in terms of a quantity of gold
income | the money value of net output
investment | expenditure on the production of capital
liquidity | the property of an asset of maintaining its sale value when the state of expectation changes
long-term expectation | investors’ expectations of income from the production of goods or services using the capital in which they invest
macroeconomics | the study of the economy as a whole
marginal product | the extra net output expected to result from the employment of an extra unit of labour or capital
medium-term expectation | dealers’ expectations of expenditure by customers
microeconomics | the study of the economic decisions of individuals and firms
net output | output minus the quantity of product consumed in production, e.g. the harvest of corn minus the seed-corn planted
output | the quantity of a finished good produced during a period
SDR | special drawing right – the monetary unit of the International Monetary Fund
short-term expectation | employers’ expectations of income from production and employment, best understood as their order books
spot market | a market for immediate delivery of goods or services
supply | offers to sell new goods or services; not to be confused with output
supply function or curve | the mathematical relation between supply and price; often drawn as a straight line for illustration.
trade deficit | an excess of imports over exports
Versailles | the 1919 Peace Conference after World War I at Versailles, near Paris

1 
Why Study Keynes?

Few will deny that John Maynard Keynes (1883–1946) was the most outstanding economist of the twentieth century. Undoubtedly his reputation is based not only upon his scholarship, which remains controversial, but also on his roles as a prominent public figure, as a newspaper journalist and broadcaster, as an official representative of the UK government during the two world wars, and as Lord Keynes of Tilton. Nevertheless he was, first and foremost, a Cambridge economist. He wrote about economics and economists in the following terms:

An easy subject, at which very few excel! The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher – in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of human nature or institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician. (CW 10, 173–4; references to Keynes's Collected Writings are explained in the Bibliography)

Although Keynes was writing about his mentor Alfred Marshall (1842–1924), he was really describing himself. There are only a handful of other individuals – perhaps Adam Smith (1723–90), David Ricardo (1772–1823), John Stuart Mill (1806–73) or Karl Marx (1818–83) – who might fit the bill. Not many of today's economists are historians; only a tiny minority are philosophers, let alone statesmen. Most are content to be mathematicians.

The Use of Models and Mathematics in Economics

Economics has come to be distinguished from the other social sciences mainly by its use of mathematics rather than by its subject matter. There is a difference between mathematics and numbers. It is true that economics studies quantifiable aspects of human behaviour; yet students of other social sciences, together with the intelligent lay reader who is quite capable of reading a chart, find themselves excluded by the mathematical language of economics.

Economists use mathematics to build models of the real world. Any model, whether physical or mathematical, is necessarily an abstraction from reality. For example, a map is a model of terrain; a map at a scale of 1:1 is not useful. Niels Bohr's model of the atom as a tiny solar system with electrons orbiting a nucleus is not a complete representation of reality, yet it allows us to understand the properties of atoms well enough to do advanced chemistry.

Undergraduate, let alone graduate, degree courses in economics involve learning a series of mathematical models of such complexity that most students have no time or energy left to question their limitations as an explanation of the world around us. Leading employers of economists such as the UK Government Economics Service and the Bank of England have complained that an economics degree no longer equips a student to be an economist outside a self-perpetuating academia. Many economics students are fed up and, remarkably for such short-lived creatures, have organised themselves into a permanent global association, Rethinking Economics, which demands what its name declares: a rethinking of economics.

Yet Keynes himself was a modeller. He wrote to Roy Harrod (1900–78):

It seems to me that economics is a branch of logic, a way of thinking; and that you do not repel sufficiently firmly attempts … to turn it into a pseudo-natural science … Progress in economics consists almost entirely in a progressive improvement in the choice of models. The grave fault of the later classical school, exemplified by Pigou, has been to overwork a too simple or out-of-date model, and in not seeing that progress lay in improving the model …

Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time. The object of a model is to segregate the semi-permanent or relatively constant factors from those which are transitory or fluctuating so as to develop a logical way of thinking about the latter, and of understanding the time sequences to which they give rise in particular cases. Good economists are scarce because the gift for using vigilant observation to choose good models, although it does not require a highly specialised intellectual technique, appears to be a very rare one. (CW 14, 296–7)

However, even if economics is a branch of logic, a science of thinking in terms of models, it does not follow that models can be expressed only in mathematics. Keynes writes:

The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems … Too large a proportion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. (CW 7, 297–8)

Furthermore Keynes understood that economics is also an essay in persuasion:

When we write economic theory, we write in a quasi-formal style; and there can be no doubt, in spite of the disadvantages, that this is our best available means of conveying our thoughts to one another. … [Yet in] economics you cannot convict your opponent of error; you can only convince him of it. And, even if you are right, you cannot convince him, if there is a defect in your own powers of persuasion and exposition or if his head is already so filled with contrary notions that he cannot catch the clues to your thought which you are trying to throw to him … Time rather than controversy … will sort out the true from the false. (CW 13, 469–471)

The Models in This Book

As I have noted, modern economics is full of models, most of which are written in mathematical squiggles incomprehensible to the untrained reader. The models in this book are simple. There are a few tables, charts and the odd equation but rather less than is demanded of today's 16-year-old. Economics has to use models to say anything coherent, because everything connects and changes together. Without a model, however simple, we lose our way in a shifting maze.

The use of a simple model leads to the accusation of setting up a straw man in order to demolish it. This is not the intention. The corn model used to explain classical theory in chapter 2 is a simplification of more advanced mathematical models, but not a distortion. The purpose is to show the essence of classical analysis and to demonstrate the power of its central ideas, notably the concepts of competitive equilibrium and marginal productivity.

If those terms make you groan, please ask yourself whether you really want to understand Keynes. His thought cannot be understood, especially in the light of the classical restoration, without understanding the essence of the classical model. You cannot understand his revolution without a grasp of what he was revolting against, let alone of what he actually wrote. Many criticisms of both classical economics and Keynes's are misinformed. As he himself wrote,

The worst of economics is that it really is a technical and complicated subject. One can make approximate statements in a common-sense sort of way which may appear superficially satisfactory. But if someone begins to ask one intelligent and penetrating questions it is only possible to deal with them by means of something much more complicated. (CW 20, 469)

Nevertheless this book tries to make the learning process as painless as possible. Readers who already know what is meant by competitive equilibrium and marginal productivity will find chapter 2 an easy read. The intention is that students beginning economics, students of other social sciences, and interested lay readers should find that chapter 2 equips them with the basic knowledge required to understand the real issues at stake.

The Nature of This Book

This book is a biography of sorts, but not of Keynes the man. There are several hundred books about Keynes. Many better qualified authors have written about his life and his loves, the extraordinary, sparkling combination of statesman, journalist, philosopher, scientist, financial wizard, patron of the arts and bon vivant that he was. Recommendations of some such biographies can be found in the Further Reading at the end.

Rather, this book charts the development of Keynes's economic thought over the course of his life and considers its legacy. The method is analytical. That means tracing the progression of economic models from the ‘classical’ theory – as he called it – that he inherited, through to the final form of his own models in The General Theory and, beyond that, to the model implicit in his contribution to the Bretton Woods conference at the end of his life. Most of the biographical element is contained in chapters 5 and 6; the story is not told in chronological order.

The principal purpose of this book is to restate Keynes's critique of classical economics in terms accessible to today's students of both economics and other social sciences. The arguments dividing Keynes from the classicals have become clearer now than they were eighty years ago. So, too, are the differences between Keynes and the Keynesians of the Keynesian era – and even between Keynes and the post-Keynesians, the ‘keepers of the flame’ today.

However, the book is not just about theoretical models and what may have been going on inside Keynes's head. Chapter 7 looks at the historical record in some detail and considers the extent of Keynes's influence on subsequent events. Chapter 8 considers the relevance of his thinking and policy ideas to today's problems.

The Book in a Nutshell

What is the central difference between the conclusions of Keynes and those of the classicals? On the one hand, classical theory holds that in a free society everyone willing to work at the going rate can, in the long run, find employment. Unemployment is the result of a poorly functioning labour market, for which the remedy is greater flexibility, that is, more competition. On the other hand, Keynes holds that much unemployment and consequent loss of national income are the result of a failure of the system as a whole, not of the hapless workers alone.

Yet the answer, for Keynes, is not the revolution of Karl Marx. The remedy for unemployment and the precondition for sustained economic growth lie in the financial and monetary system, both at national and at international level. In his view, the free enterprise system can be made to work for everyone if we are clever enough to create the right institutions – if only the world is wise enough to adopt them.

Why do Keynes and the classicals reach such different policy conclusions? To explain this is the burden of the next five chapters. Chapter 2 sets out the classical theory of employment, interest and money using a simple model. Chapter 3 sets out Keynes's alternative general theory of employment, interest and money, a theory that furnishes the title of his magnum opus. The interpretation offered here is markedly different from the standard treatment of Keynesian economics in economics textbooks. Chapter 4 addresses the great confusion between saving and money that plays a major role in allowing modern classical economists to continue resisting Keynes's technical critique. Chapter 5 charts the development of Keynes's thinking about money and inflation over the course of his life, during his long struggle to escape from classical theory. Chapter 6 addresses the international economy, the real world of sovereign states and multiple currencies, and explains the thinking that led Keynes from walking out of the Versailles Peace Conference in 1919 to supporting the compromise at the Bretton Woods Conference in 1944.

An Outline of the Argument

A summary of the argument of the forthcoming chapters may be helpful, even if at this stage it is perhaps not fully comprehensible. Classical theory (chapter 2) is built upon the foundation created by the concepts of diminishing returns and marginal productivity. Under conditions of free competition, these concepts are sufficient to explain the levels of production, employment and investment, together with the distribution of income between wages and other incomes. Classical theory is a remarkable achievement: it has produced powerful and compelling results from a few key ideas. So long as wages are flexible, in line with productivity, everyone who wants to work will be fully employed. In a similar fashion, the rate of interest balances the forces of productivity and thrift; investment has to be attractive enough for savers to be persuaded to be patient and postpone jam today for more jam tomorrow.

Money does not play an essential role in the classical model. All the key results can be worked out without money. The theory of value and distribution is distinct from the theory of money and prices, which comes later. This separation is justified by what is known as Say's law, the proposition that there cannot be a general glut or shortfall of demand for what is produced as a whole, at least not in the long run. Keynes can be understood in part as refuting Say's law by showing how money does indeed play an essential role in the market economy.

At the heart of Keynes's critique, in The General Theory (chapter 3), is the concept of expected income. The level of production and employment depends upon the income expected by employers. In a monetary economy, this expected income may not be enough to make it profitable to employ everyone who is willing to work at the going rate. In the classical model, the level of production and employment is determined by the wage that workers are willing to accept. In Keynes's model, expected income also depends on the spending decisions of investors and consumers. Consumption, in turn, depends on income, so that expected income turns out to depend mainly on investment.

Why does investment not adjust so as to ensure full employment, in line with Say's law? This is the question addressed by chapter 4. In the classical model, the rate of interest governs the division of income between consumption and investment. Income is determined first, then divided between consumption and investment (see Figure 1.1). In Keynes's model, consumption follows investment according to a relation called the multiplier. Investment is determined first, then income and consumption follow (see Figure 1.2).

Figure 1.1 Causation in the classical model

Figure 1.2 Causation in Keynes's general model

In both models, investment depends on the rate of interest. In the classical model, the rate of interest balances saving (i.e. the decision not to consume) and investment. In Keynes's model, the rate of interest is independent of saving; it balances instead the supply of and the demand for money, which is quite different from saving or savings. The rate of interest, then, determines investment – and hence income, consumption, employment and the real wage.

The rate of interest depends on confidence in expectations about the inherently uncertain long-term future. The future cannot be reduced to an extrapolation from the present and the past. When confidence is lacking in the face of such uncertainty, people want to hold on to their liquid money, and a higher rate of interest is required if they are to lend or spend money for investment. When money is plentiful or confidence is high, the rate of interest falls and investment increases.

In fact expectations about the long-term future have a direct influence on investment, and not only through the rate of interest. It is irreducible, unquantifiable uncertainty that requires the ‘animal spirits’ of enterprise and makes investment, especially in new products and processes, the engine of capitalism. Fluctuations, in both confidence and long-term expectation itself, lead to cycles in production and employment. There is no market mechanism to regulate the level of investment, certainly not the rate of interest, so as to ensure that investment is neither above nor below what is necessary to warrant full employment. Say's law does not hold.

It took Keynes most of his working life to develop his final understanding of the nature and role of money in the market economy (chapter 5). Money does not appear at all in Figure 1.1. He began as an advocate of the Cambridge version of the quantity theory of money, the idea – dating back at least to David Hume (1711–76) – that price inflation is the result of an excessive increase in the quantity of money. This theory seemed well supported by the experience of hyperinflation in the 1920s.

Over time Keynes probed the nature of money and the motives for holding it. He came to place more emphasis on changes in the demand for money than on changes in its supply. Money can affect prices only through spending, but then it is clear that spending can affect output and employment as well as prices. He developed and discarded a series of sophisticated models within the classical framework to explain the role of money in the economy before arriving at The General Theory. He remained as concerned about inflation as ever and his analysis helped prevent its recurrence in Britain during the Second World War.

Keynes's entire working life was concerned with the problems of the international economy (chapter 6). The problems of an economy such as Britain's cannot be understood except within the international context. This in turn requires an understanding of the relationships and exchange rates between different currencies. Keynes's views on the gold standard and on free trade reflected, and changed with, his views on the impact of the international monetary system on national economies as circumstances changed. In his policy work, from Versailles to Bretton Woods, he was painfully aware of the importance of the current account of the balance of payments and of the absolute necessity of foreign currency reserves for national sovereignty and even for survival.

Although Keynes was too ill or too busy to write another academic treatise after The General Theory, his thinking on the international economy was embodied in plans for a postwar international economic order. He recognised that a persistent tendency towards surplus on the current account had the same depressing effect on global economic activity as a tendency towards excessive saving within a national economy. His understanding of the nature of money led him to propose a radical solution for removing the balance of payments as an obstacle to full employment. His solution was too radical for the Americans at the time. Nevertheless the international agreements that formed the International Monetary Fund, the World Bank, and ultimately the World Trade Organisation owe a great deal to Keynes.

The Legacy of Keynes

Chapter 7 considers the impact of Keynes's ideas on the world during the thirty-year period after his death – the Keynesian era. A number of charts present the economic data for the 140 years from 1874–2013 for 17 countries and from 1874–2015 for the United Kingdom. The period is divided into five subperiods that correspond to major changes in economic policy: gold standard, interwar, Keynesian, neoliberal and austerity.

The bare fact is that the Keynesian era delivered on average the high income and low unemployment sought by Keynes without either excessive inflation or additional public borrowing. Keynes's primary prescription was to use monetary policy to reduce the long-term real rate of interest and stimulate investment. This policy was adopted during both the Keynesian and the austerity eras. The full employment and the high rate of investment of the Keynesian era were also underpinned by public consumption and by export growth, encouraged by the free trade regime established at Bretton Woods.

Although historical events never have one single cause, the outstanding reason for the end of the Keynesian era was the United States’ decision to unpeg the dollar from gold in 1971, itself the outcome of underlying political and economic changes. The years 1973–9 saw inflation and unemployment rise together to unprecedented levels, a phenomenon known as ‘stagflation’. In 1976 the prime minister ended the United Kingdom's political commitment to full employment. Although President Carter persisted for another few years in the United States, the writing was on the wall.

From about 1980 the influence of Keynes on economic theory became divided into two main currents, which represent alternative responses to the internal contradictions of the attempt to integrate Keynesian and classical economics during the 1950s. One current returns to a modified version of the classical theory of the equilibrium of supply and demand, which abandons Keynes's key insights and reduces them to a special case – the very opposite of his intent. The other current has largely abandoned supply and demand theory and, while accepting Keynes's insights and method of progression through the development of new and relevant models, has now moved substantially beyond and away from his Marshallian framework.

Finally, chapter 8 considers the relevance of Keynes's thought to us today. Here I have tried to distinguish the voice of Keynes himself from those of his followers of all shades. Keynes was a market-friendly economist who sought to reform classical theory, not to abandon it. He was pragmatic and politically astute in his policy recommendations and politically liberal in the British sense. He was an elite member of the establishment, with no particular loyalty to working people, but he despised the waste and stupidity of high unemployment. Today's economic policy is much closer to Keynes than is generally admitted, but academic theory remains stubbornly resistant to his insights.

In the current geopolitical environment, I suggest that his recommendations for a reform of the international monetary system would be limited to what he regarded as feasible rather than extending to what he considered ideal. In particular, he would regard the reform of the euro as an urgent priority, not only for the European Union but for the prosperity of the world as a whole. Drawing on this book's analysis, I venture to suggest what he might have proposed in today's circumstances.

By the time we reach the end of the book, you should be equipped to form your own conclusions about what Keynes means for us today. This book is a journey upwards, through Keynes's economic thought, and we start in chapter 2 where he did: from the classical theory that he inherited. The ascent is steep in places, but the view from the summit is worth it.

2 
The Classical Theory of Employment, Interest and Money

In 1935, on the eve of the publication of The General Theory, Keynes wrote to George Bernard Shaw: ‘I believe myself to be writing a book on economic theory which will largely revolutionise – not, I suppose, at once but in the course of the next ten years – the way the world thinks about economic problems’ (CW 13, 492). The remarkably short first chapter of the book itself reads:

I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case … 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.

(CW 7, 3)

This audacious claim drew an acid response from his senior colleague A. C. Pigou (1877–1959), the professor of political economy at Cambridge, who wrote: ‘Einstein actually did for physics what Mr Keynes believes himself to have done for economics. He developed a far-reaching generalisation, under which Newton's results can be subsumed as a special case’ (Pigou, 1936). Although Keynes was in fact right about the impact of his book, the classical theory proved more durable than he anticipated. The Keynesian revolution lasted for about forty years, from 1936 until about 1975, when Milton Friedman (1912–2006) and the Chicago School successfully led a restoration of classical theory amid the ruins of the postwar consensus that the state could, and should, maintain full employment. Keynes's theory was reduced, at best, to a special case of classical theory.

By 1980, the Chicago economist Robert Lucas (1937–) could write: ‘Keynesian economics is dead … At research seminars, people don't take Keynesian theorizing seriously any more – the audience starts to whisper and giggle to one another’ (Lucas, 1980). The financial crash of 2008 has failed to dislodge the renewed hegemony of the classical theory, even if for a brief moment Keynes's name was back in the headlines, as Lucas admitted: ‘we are all Keynesians in a foxhole, but I don't think we are there yet’ (Fox, 2008).

Was Keynes simply wrong? We cannot hope to understand and assess his arguments unless we have a clear grasp of his points of departure from the classical theory. This chapter will present classical theory in the terms of a simple model, with a view to taking it seriously, not to setting up a straw man. The durability of classical theory reflects its considerable strengths as a body of thought. Classical theory may perhaps be ‘misleading and disastrous’ as a guide to policy, but it is not incoherent.

The following model is not a complete representation of classical theory, let alone of reality, yet it will allow me to explain two key and interlocking claims of the theory. The first is that free enterprise normally leads to full employment. The second is that any unemployment is the result of some form of restriction on that freedom of enterprise. The ‘invisible hand’ of the market will deliver the best outcome, given other social and political realities. Underpinning those two claims are theories of the level of production and employment, of the division of production between present consumption and investment for the future, and of the distribution of the income from production between wages, profits, interest and rent. These are some of the fundamental questions in economics.

A Corn Model: Diminishing Returns and Marginal Productivity

The first element of our model is that there is a single product (corn), which can be eaten, stored in granaries, or planted as seed. Corn is produced over the course of a year and harvested at the end of the year, when it is initially placed in the granaries before distribution for the coming year. After each harvest there is a quantity of corn in the granaries. This corn can be consumed during the year, before the next harvest; planted as seed corn, in order to produce the next harvest; or simply held over as stocks, to cover the lean years.

We assume the property rights of a capitalist economy, so people are landlords, farmers or workers. The landlords own the land and rent it to farmers, who hire workers, perhaps borrow corn from other people, and organise production. Once the harvest is in, the farmers have to decide how much land to cultivate, how much seed corn to plant and perhaps borrow, and how much labour to employ in sowing and reaping, so as to yield themselves the best profit during the next season. In other words, the farmers have to decide the levels of production, investment and employment.

Into this calculation enters the amount of corn they will have to pay to the landlords as rent, to the workers as wages, and to the lenders of seed corn as interest. So what determines how much the workers receive in wages, the landlords as rent, the lenders as interest and the farmers as profit? In other words, what determines the distribution of income? The classical answer to these questions is based on two fundamental concepts: the law of diminishing returns and the theory of marginal productivity.

It is important to stress that Keynes accepted these classical concepts throughout his work, including in The General Theory. The law of diminishing returns he takes as given without discussion. The theory of marginal productivity appears explicitly in what is now called his ‘first classical postulate’, according to which the wage is equal to the marginal product of labour, and, with important qualifications, in his ‘marginal efficiency of capital’. Before we can discuss Keynes's approach we need to understand these concepts in their basic form.

Why use an agricultural model to explain a modern economy? It is a proper question. The virtue of the corn model is that the fundamental classical concepts make perfect sense in that context. It is easy to see how the model works and produces the standard results. I shall argue later that more sophisticated classical models produce those results precisely because they unwittingly assume what amounts to a corn model.

The law of diminishing returns means that for technical reasons there is a certain number of workers per acre of land that is the most productive in physical terms. Fewer workers cannot get the best out of the land. More workers will increase the harvest per acre, but an increase in yield is more hard-won. For reasons that will become clear, it is always profitable to employ more workers than the physical optimum, but the return from employing each worker diminishes as employment increases.

For example, to make this concrete, let us assume that ten workers can produce a net output of 480 bushels of corn from twenty acres of land. I use archaic units because their absolute size does not matter here, although they are roughly in line with preindustrial agriculture. ‘Net output’ designates the quantity of corn harvested minus the quantity planted as seed and this is precisely the same thing as the total income from production. The net output of corn or total income per worker is 48 bushels, although this does not mean the worker receives all that income. The effect of diminishing returns can be seen in Table 2.1. As the number of workers increases from ten to fifteen, the total net output increases from 480 to 600. However, note that the net output per worker (the average product) falls from forty-eight to forty bushels. If we increase the number of workers from fifteen to twenty, the total net output remains unchanged. Therefore the average product falls with twenty workers to thirty bushels of corn.

Table 2.1 Diminishing returns in terms of average product of labour

Number of workers | Total net output of corn | Net output of corn per worker
10 | 480 | 48
12 | 540 | 45
15 | 600 | 40
20 | 600 | 30

Table 2.2 next illustrates the concept of marginal versus average productivity. This time we look at an increase of one worker at a time, from the twelfth to the fifteenth. The fourth column shows how, if we have twelve workers and increase this number to thirteen, the increment of total net output is twenty-five bushels of corn. This is defined as the marginal product of the extra worker, marginal because the extra worker is at the margin of production. Note that the marginal product (twenty-five bushels) is lower than the average product (forty-three bushels) of thirteen workers, because employment is higher than the physical optimum and diminishing returns set in.

Table 2.2 Diminishing returns in terms of marginal product of labour

Number of workers | Total net output of corn | Net output of corn per worker | Extra net output of one extra worker | Total surplus | Total wages
12 | 540 | 45 | 28 | 204 | 336
13 | 565 | 43 | 25 | 240 | 325
14 | 588 | 42 | 23 | 266 | 322
15 | 600 | 40 | 12 | 420 | 180
20 | 600 | 30 | - | 600 | -

The marginal product of the fourteenth worker is lower than that of the thirteenth, at only twenty-three bushels, since the return to labour is diminishing. For the fifteenth worker the marginal product is only twelve bushels. After the fifteenth worker, additional labour does not increase production at all, so the marginal product of labour is zero. We can say that labour is underemployed, because the twenty workers can produce only as much as fifteen could.

The theory of marginal productivity (as opposed to the concept) is that the levels of investment, production and employment, together with the distribution of income between wages, rents, interest and profits, are all determined by marginal productivity. This is a remarkably powerful result to draw from a single, relatively simple concept. I begin by considering wages and employment before considering the other relationships, although in practice everything is determined simultaneously, as we shall see.

The Classical Labour Market

The core feature of a free enterprise economy is competition. We assume that there are many workers and many farmers. The workers compete for jobs and the farmers compete for workers. The marginal product of labour is lower than the average product because of diminishing returns to labour. Since the farmers get the difference between the marginal and the average product, it will be profitable for each farmer to offer employment, and compete for workers, up to the point where the wage equals the marginal product of labour on the land they have rented. Competition ensures that any farmer who tried to offer a wage lower than the marginal product of labour would lose workers to other farmers. Similarly, if there were more workers available than the employment offered by the farmers, competition between the workers would drive the wage down.

I can now propose a causal relationship running from wages to employment. For example, let us assume the wage is twenty-three bushels of corn per year. When the farmer employs thirteen workers, as in our example, the marginal product is twenty-five bushels of corn. So the farmer makes a profit of two bushels on that thirteenth worker. The marginal product of the fourteenth worker is twenty-three bushels, so the farmer is indifferent about employing the extra worker. However, the marginal product of the fifteenth worker is only twelve bushels, so that, if the farmer has to pay a wage of twenty-three bushels, he will make a loss of eleven bushels. So the farmer will choose to employ no more than fourteen workers, given the wage of twenty-three bushels. A lower wage makes it profitable to expand the employment offered to the point where the new wage equals the reduced marginal product. A higher wage requires a reduction in the employment offered so as to increase the marginal product.

Note the substantial difference between the average and the marginal product of labour. This is reflected in the share of wages in total income and the surplus kept by the farmer. When there are fourteen workers, the average net output is forty-two bushels and the marginal net output is twenty-three bushels. The basic proposition in our model is that each worker receives only the marginal product of twenty-three bushels, while the difference between the average and marginal product of nineteen bushels per worker goes to the farmers. Added up across all the workers (see the two rightmost columns of Table 2.2) this means the total net output of 588 bushels is divided between a surplus of 266 bushels to farmers and wages of 322 bushels to workers.

As employment increases, the wage falls and, in this example (not necessarily in general), the total wage bill falls, while the surplus increases. The wage has to fall if employment is to increase, not because the land cannot support the workers overall, but because extra workers are less and less productive on a given land area. As we move from thirteen to fifteen workers, the average net output falls only from forty-three to forty bushels per worker, even though the marginal product and the wage fall by more than half from twenty-five bushels to twelve.

Employment cannot increase above fifteen workers, because the marginal product would fall to zero, meaning zero wages, and therefore all the workers would starve. Underemployment (where the marginal product is zero or below subsistence) is possible only when the workers themselves are tenants of the land, not employed by farmers. This illustrates the importance of the assumptions about ownership and wage labour. If the workers own the land, perhaps as a family, each has a claim on the average rather than on the marginal product. If the net output is divided equally, 20 workers can each receive 30 bushels.

We can capture these tables in a diagram (Figure 2.1), which is a method of illustrating a mathematical relationship without using algebra. This diagram measures the marginal product on the vertical axis and employment on the horizontal axis. The downward-sloping line is called the labour demand curve, which plots all the coordinates of wage values and the corresponding number of jobs that will be offered at each wage. If you go back to Table 2.2 you can see these coordinate pairs in the columns for the number of workers and their marginal products, so (13,25) (14,23) (15,12). Since the marginal product falls as the number of workers increases, the line is downward-sloping. The direction of causation runs from wages to the corresponding marginal product and to the related employment. Given that labour is available at a certain wage in the market, the farmer will offer a particular number of jobs.

Figure 2.1 The demand for labour on one farm

At this point we move from using specific numbers to using algebraic symbols to represent numbers. Don't panic! All this means is that a symbol can represent any of the specific values that a variable, such as the number of workers, can take. So in Figure 2.2 we label the horizontal axis, which measures the number of workers, with the symbol N. We label the vertical axis, which measures the amount of wage, with the symbol ω. N and ω are conventional symbols for these variables.

Figure 2.2 The total demand for and supply of labour: The classical labour market

Figure 2.1 showed the demand curve for a single farmer, but in a corn model we can add the demand for labour from all the farmers taken together and create an aggregate labour demand curve: it looks just the same, but there are a lot more workers on the horizontal axis (Figure 2.2). To keep it simple, I use straight lines rather than curves. The vertical line stands for the total number of workers looking for jobs, which is represented by the point where the line cuts the horizontal axis; and we render this number through a symbol, Nmax – the maximum possible employment. In this case Nmax is a single number (e.g. 5,000,000), but we do not have to specify its exact value. The line is vertical because the number of workers available is – we assume here – unaffected by the amount paid as the wage; I will relax that assumption later. The intersection of the two lines gives us the wage (marked ω*), which will induce the farmers to offer enough jobs to employ all the available workers (i.e. Nmax workers).

What we are doing here in mathematical terms is solving a pair of simultaneous equations: we want to know the values of N and ω that satisfy at the same time the two separate relationships between N and ω represented by each line. The answer is given by the intersection. The wage ω* is called ‘equilibrium wage’, because it brings the supply of and the demand for workers into balance. We can imagine a hiring day when all the farmers and workers meet in the marketplace to negotiate the wage for the coming year through an auction. No one goes home until a wage has been agreed, at which no job is unfilled and no worker is idle. In equilibrium, the labour market clears (i.e. there are no more workers looking for jobs or farmers looking for workers), so that all the available labour is employed at a wage equal to the marginal product of the last worker employed on any of the farms.

What happens if the wage is set above the equilibrium level? Figure 2.3 shows a horizontal line that represents a higher wage, ω₁. This line picks out the point on the aggregate labour demand curve that corresponds to an offer of employment in the amount N₁. This means that the number of workers represented by the difference between Nmax and N₁ will be unemployed; this number is indicated by the double-headed arrow. The labour market does not clear; some workers are left standing around in the marketplace.

Figure 2.3 Classical unemployment

That is the classical theory of wages, production, employment and unemployment in a nutshell. As long as wages are flexible, in line with productivity, everyone who wants to work will be fully employed. Attempts to increase wages above the equilibrium rate are wrong-headed, whether they are motivated by militant unions or by well-meaning people who point out that the equilibrium wage is not enough to live on or bring up a family. Interference with the free market will only produce unemployment. Conversely, if general unemployment is observed to exist, the only solution, however harsh, is to reduce either wages or the labour force.

The Classical Capital Market

So far our model has allowed us to explain the level of production, employment and wages. The next relationships to consider are the division of production between consumption and investment and the division of the surplus between profit, interest and rent.

The terms ‘interest’ and ‘rent’ both refer to a return on capital; the only difference is that, by convention, rent designates a charge for the use of land and interest a charge for the use of money. We have no money in our corn model, so we use interest to designate the charge for the loan of corn to the farmers. Profit is a residual element: it is the farmers’ income after paying wages to the workers and rent to the landlord. Interest on capital is paid out of the farmers’ profits.

The central proposition is that capital commands a return because it is scarce. Each piece of land is unique and fixed. The supply of capital in the form of seed corn is scarce to the extent that society is reluctant to postpone consumption and to save and invest some of its income in order to provide for future consumption. To state the conclusion of the argument at the outset, interest is determined by the balance between productivity and thrift; rent is determined by differences in the fertility of land. Rent, interest and wages are determined in exactly the same way, by marginal productivity.

Recall the labour demand curve, which is equivalent to the marginal product of labour curve, in Figure 2.2. We can draw a similar diagram for capital, treated as seed corn in our model (see Figure 2.4). We assume that diminishing returns apply to capital as well as to labour. There is again some quantity, per worker, of seed planted that will produce the maximum physical output per worker, as the yield from extra seed increases up to, then decreases below, this figure. As with labour, I consider only the section where returns are diminishing, since this is the section along which the farmers’ profits are maximised. Table 2.3 sets out some concrete numbers by way of example.

Table 2.3 Diminishing returns in terms of marginal net product of capital

Bushels of seed corn per worker | Total output of corn per worker in bushels | Increment of total output for one extra bushel of seed corn | Increment of net output for one extra bushel of seed corn
5 | 35.5 | 1.60 | 60%
6 | 37.0 | 1.50 | 50%
7 | 38.4 | 1.40 | 40%
8 | 39.7 | 1.30 | 30%
9 | 40.9 | 1.20 | 20%
10 | 42.0 | 1.10 | 10%
11 | 43.0 | 1.00 | 0%
12 | 43.9 | 0.90 | -10%
13 | 44.7 | 0.80 | -20%
14 | 45.4 | 0.70 | -30%
15 | 46.0 | 0.60 | -40%

The first column sets out an increasing amount of seed corn – from five to fifteen bushels – that each worker is given to plant. The farmer expects this planting to produce the amount of corn per worker at harvest, in the second column. The third column shows the increase in the harvest per worker expected from giving one more bushel to each worker to plant. Finally, the fourth column shows the corresponding net output, after deducting the bushel of seed corn planted, which is the marginal product of capital. Note that this number can be negative, meaning that the harvest per worker increases by less than the bushel of seed corn planted. It is helpful to express the marginal net product as a percentage, in order to compare it with the rate of interest.

Under the law of diminishing returns, after a certain point, more work or more seed goes to waste and adds nothing to the output. In the case of labour, if the marginal product falls below the subsistence wage, the result is not equilibrium but emigration or starvation, until the workforce falls: a ‘Malthusian’ result. In the case of seed, the marginal product can fall below zero, as low as –100 per cent, representing a total loss of the extra capital invested.

Again, we can plot these numbers as a curve (Figure 2.4). This curve, which I shall call the investment demand curve, looks very much like the labour demand curve. What this curve plots is the net return expected from the planting of each additional bushel of corn – the marginal bushel – in just the same way as we previously considered the marginal product of an extra worker.

Figure 2.4 Investment demand

In Figure 2.4 we draw the curve as a straight line. The return is expressed as a percentage rate of profit after recovery of the outlay (r), measured on the vertical axis, plotted against the amount of seed corn planted (K) on the horizontal axis. It slopes downwards because, as more corn is planted, the return on the marginal bushel falls as returns diminish. The important difference between the labour demand curve and the investment demand curve is that the marginal product of capital can become negative down to 100 per cent, as I have noted.

As in the case of labour, I have jumped from a curve that describes the marginal product to a demand curve. The curve is simply the relation between the expected rate of profit and the amount of capital invested – that is, of seed planted. However, this curve also represents the demand for seed corn, because it will not be worth planting more corn per worker when it costs more to borrow seed corn than the corn is expected to earn when planted. Figures 2.5 and 2.6 illustrate the point with the concrete numbers of my example. With the interest rate at 10 per cent, it is profitable to invest ten bushels of seed corn per worker. However if the market interest rate is 30 per cent, it is profitable to invest only eight bushels.

Figure 2.5 Investment demand at 10% interest

Figure 2.6 Investment demand at 30% interest

What, then, determines the actual rate of interest (and profit) and the actual rate of investment or planting of seed corn? Which point on the investment demand curve will be chosen by the farmers? For this we need another curve to represent the supply of seed corn offered by savers. Where the curves intersect, supply and demand are equal and we can read off the rate of interest that brings them into equilibrium (see Figure 2.7).

Figure 2.7 The balance between saving and investment: The classical capital market

In our story, the farmers place each year's harvest in the granary. We imagine that they receive receipts or tickets for their deposits of corn, each of which entitles the bearer to (say) one peck of corn (a peck is one quarter of a bushel). These tickets can then be transferred to other people or redeemed for corn during the year, minus any storage charge for the period since harvest.

In Mesopotamia from 3500 BC and then in Egypt, the temples ran the granaries and issued receipts to the farmers; the first bankers were priests. In Sumeria, the receipt was inscribed on a clay tablet encased in something like a clay pot, which also carried an inscription of the amount, so that the tablet could not be tampered with. Medieval tally sticks were a similar idea.

At harvest time, everyone gathers in the marketplace to receive from farmers the tickets for their agreed share of the harvest and to negotiate with the farmers over next year's production. In the labour market, farmers and workers haggle as described earlier. Workers offer to work for a certain number of tickets – the supply price; farmers offer to hire workers for a certain number of tickets – the demand price. The auctioneer calls out prices until no farmer is willing to bid more and no worker is willing to accept less.

There is also a capital market in which farmers bid for tickets for corn to plant as seed. The farmers may have some corn of their own but, as we have seen, it may be profitable to borrow more, provided that the rate of interest on the corn loan is no higher than the expected rate of profit. Conversely, if the farmers have more corn than they can plant profitably, they can offer to lend the balance. Indeed anyone (whether worker, landlord or farmer) with savings, that is, anyone who has tickets for more corn than they plan to consume over the coming year, may be willing to lend spare tickets to the farmers. This is finance in its simplest form, in an economy without money.

The farmers promise to repay an agreed number of tickets for corn at the next harvest in exchange for tickets from this one. The number of tickets depends on the balance of supply and demand. If we assume that corn only keeps for a year or two in the granary (which is reflected in the storage charge), there is pressure on those with savings to lend them to the farmers. Farmers may find that they have to repay less corn than they borrow, which represents a negative interest rate. Conversely, if the demand to consume corn is strong, the farmers have to pay a premium for the loan – a positive interest rate.

We can see all this in Figure 2.7 by drawing a vertical line that represents the supply of corn saved by the community as a whole and available to the farmers for investment. The point where this line cuts the investment demand curve indicates the equilibrium interest rate consistent with a given amount of saving, say 10 per cent, as in Figure 2.5. If the supply of saved corn is lower, the interest rate is higher, say 30 per cent, as in Figure 2.6. The rate of return can be either higher or lower than zero, whatever is required to balance supply and demand in the capital market so as to clear the market of unsatisfied bids or offers.

The Market for Land and the Distribution of Income

Now, in addition to the markets for labour and capital there is also a market for land. In the land market, the farmers negotiate with the landlords over how much land they will rent for cultivation. These farmers are busy people, negotiating on three fronts at once. Once again, the theory of rent depends on competition at the margin; but there is a difference this time, in that each piece of land is unique. So farmers will compete with one another in the rent they will offer in order to cultivate a given piece of land. Their total profit from any piece of land needs to provide them with a rate of profit on the capital invested in production no lower than the rate of interest, as well as with a return for their personal labour, effort and risk. If they expect to earn a higher rate of profit on that land than this minimum, they will be willing to pay the landlord rent. The more fertile the land, the higher the rent. The literally marginal land will earn the lowest rent, or no rent at all if there is free land.

I stated earlier that profit was a residual after paying wages and rent. This is certainly the case for an individual farmer; but, when we look at the economy as a whole, we can see that in one sense rent is also a residual. The division between rent and profits depends on the market rate of interest, which is determined in the capital market and depends on the willingness to save, or thrift. So causation in the system runs broadly as follows:

The marginal product of labour determines the level of employment and the market wage.

The marginal product of capital (seed corn) determines the level of investment and the market rate of interest.

These two together determine the amount of land under cultivation and the rental each piece of land commands.

Again we can draw the familiar diagram, this time (Figure 2.8) with the rental per acre (u) on the vertical axis and the quantity of land under cultivation (H) on the horizontal axis, and ranking the land in descending order of fertility from left to right. We assume some free land, as on the US frontier, so the rent falls to zero. The amount of land cultivated is determined by the level of employment; this is in turn determined in the labour market, given the amount of seed per worker, which is determined simultaneously in the capital market. The curve cuts the horizontal axis at the amount of land needed (H₁) to support the level of employment. The curve shifts to the right or to the left, as the level of employment varies. The amount of rent on any given piece of land is therefore a residual and the total rent is shown by the area under the curve. If the level of employment and the land under cultivation fall to H₂, the total rent reduces.

Figure 2.8 The determination of rent: The market for land

We can use this model as a first exercise in understanding a debate about economic policy. David Ricardo and Thomas Robert Malthus (1766–1834) argued over whether to repeal the Corn Laws. These laws prevented the import of corn into the United Kingdom so that the needs of the population had to be met by cultivating more and more marginal land, thereby increasing landlords’ rents. This is illustrated in Figure 2.8 by a shift in the curve from H₂ to H₁. The repeal of the Corn Laws had the effect of increasing the amount of corn that had to be paid in wages, which meant increasing the required marginal product of labour and therefore reducing the level of agricultural employment and the rent along with it. Ricardo argued that the released labour could then be employed profitably in industry – something our little model cannot cope with.

This model assumes free competition between a large number of workers, farmers and landlords. Workers compete with each other in the labour market and may compete in the capital market either to lend or to borrow. Landlords compete in the land market, and again may compete in the capital market. Farmers compete in all three markets and may be lenders as well as borrowers in the capital market. It is the force of competition together with the technical conditions of production that determine the levels of production, employment, investment and consumption, together with the distribution of income.

Table 2.4 sets out the distribution of income from a single farm implied by our model, assuming a wage rate of twenty-three bushels and a rate of profit of 30 per cent. The wage means that fourteen workers will be employed, 112 bushels of seed corn will be planted (= 8 × 14), and the total output expected at harvest will be 700 bushels. This produces a net output of 588 (= 700 – 112), divided between wages, interest, rent and profit, as shown.

Table 2.4 The distribution of income in accordance with marginal productivity

Wage per worker | 23
Rate of profit and interest | 30%
Workers | 14
Seed corn per worker | 8
Total seed corn planted (investment) | 112
Total output | 700
Net output | 588
Wages = 14 × 23 | 322
Interest = 30% × (322 + 112) | 130
Rent (just assumed) | 46
Profit (the remainder) | 90
| 588

The Neoclassical Contribution

At this point we have covered the classical theory as set forth by Ricardo around 1820. In the late nineteenth century, the theory was further developed by the neoclassical economists, including Mill and Marshall. They applied the marginal principle, successfully employed by Ricardo in the analysis of rent and wages, to the concept of utility proposed by Jeremy Bentham (1748–1832). So far we have assumed that the amounts of labour available and of saving are fixed; the neoclassicals allowed these quantities to vary, extending the scope of the theory of supply and demand.

In the terms of our corn model, the difference is that the vertical lines representing the supplies of labour and saving are allowed to slope, as shown by Figures 2.9 and 2.10. This means that the quantity of labour available depends on the wage that is offered and the amount of saving depends on the interest rate. A higher wage attracts more labour into the marketplace, and a higher interest rate prompts people to offer more savings by reducing their planned consumption for the year. Conversely, if we think in terms of the harvest-time auction, as the auctioneer calls out too low a wage, workers go home. Similarly, if the auctioneer calls out too low an interest rate, people decide to consume more and offer fewer tickets to the farmers.

Figure 2.9 The neoclassical labour market

Figure 2.10 The neoclassical capital market

The neoclassical approach introduces extra degrees of freedom into classical theory (see Figures 2.9 and 2.10). In the case of labour, competition in the market does not simply determine the market-clearing wage that ensures that all the available labour is employed; it also determines the quantity of available labour. In the case of saving, competition in the market does not simply determine the market-clearing interest rate that ensures that all the available saving is invested; it also determines the quantity of saving. In each case, the equilibrium quantity (N*, K*) is determined simultaneously with the equilibrium price (ω*, r*).

The Role of Money in the Classical Theory

So far I have said nothing about money. Until now I have been discussing what was called the theory of value and distribution: a theory concerned with relative prices and incomes, notably the wage and the rate of interest. Money was dealt with separately, in the theory of money and prices, which explains the average level of prices in terms of the quantity of money. Money is not needed in the theory of value and distribution any more than it is in our corn model. There is no need for money in our model, since the only good is corn, which can easily be obtained by redeeming tickets at the granary. We have derived all the results of the classical theory of value and distribution without using money at all.

To illustrate the classical theory of money and prices, first imagine that, instead of issuing tickets for deposits of corn at harvest, the granary buys the corn for money. Instead of issuing one ticket for each peck of grain, the granary buys the corn, say, at £1 per peck, and credits £1 to the farmer's account, or £4 per bushel. The (monopoly) granary has become a central bank. We then imagine the granary selling corn during the year rather than redeeming tickets for fixed amounts of corn.

Provided that the money value of the corn in the granary matches the value in the bank accounts, there is no difference from issuing tickets: the price of corn remains stable. Indeed, if the granary fixes permanently the price at which it will buy or sell corn, there is no difference: the money is on a ‘corn standard’. However the granary-bank can create money, not only by buying corn but also by making money loans, perhaps to the state. The granary-bank credits money to an account not in exchange for corn, but against a contract to repay money in the future. This allows the borrower to buy corn today without having made a prior deposit. The total value of money in bank accounts can now exceed the value of corn in the granary at its original price.

It is not difficult to see that, if all try to spend all their money on corn during the year, either there will not be enough corn to go round or the price will have to rise to choke off some of the demand. We have a case of too much money chasing too few goods. Nevertheless, inflation does not affect the production decision. If inflation is expected, it will be taken into account when calculating marginal products, wages and interest rates. If inflation is unexpected, it cannot be taken into account but instead results in a one-off redistribution of wealth. The holders of corn, notably farmers and the granary, gain from the price increase at the expense of workers and lenders, who have agreed wages and interest in money terms.

I have now set out the essence of the classical theory, which Keynes later considered to be a special case of his general theory. Even in this highly simplified form, it is a powerful tool. Free enterprise, together with the technical conditions of production and the preferences of individuals, determines the levels of production, employment, investment and consumption, together with the distribution of income. The main results can be reached without reference to money. In more sophisticated classical models such as we shall consider in chapters 4 and 5, monetary changes can affect output as well as prices in the short run. Nevertheless, in the long run, changes in the quantity of money affect only prices – or, looking at it another way, the value of money. In the long run, money is neutral and does not alter the results of an analysis conducted solely in terms of corn. This division between the theory of value and distribution and the theory of money and prices, traditionally called the classical dichotomy, is what Keynes calls into question.

Say's Law of Markets

In our corn model there is no distinction between the supply of and the demand for total net output. The rate of interest determines the division of net output between investment and consumption, but not the total demand for net output as a whole. It is always profitable for farmers to employ all the available workers, provided that these will accept a wage equal to their marginal product. Classical economists carried this conclusion over to their analysis of a monetary economy, on the strength of the law of markets proposed by Jean-Baptiste Say (1767–1832).

Say pointed out that, if people produce something new of value (i.e. of market value), they have created not only extra supply, but extra purchasing power to match. When they sell the new goods they have produced, they acquire money to spend on goods produced by others. Purchasing power and supply grow together, so there is no need to fear an overall shortfall of demand or glut of goods that would lead to unemployment. In brief, supply creates its own demand.

It is true that there may be a glut of a particular type of good, so that its price must fall if the additional production is to be sold. This means that the value of each new good produced is lower than before, but, as far as the new production is concerned, equal value and purchasing power have still been created. Existing producers lose income because of the fall in price, but this is offset by the increased purchasing power of their buyers, so that total demand still grows in proportion to the supply. It is also true that money can be hoarded rather than spent, but apart from a few misers, people earn money in order to spend it, necessarily either on consumption or on investment. The goods or services they supply are in effect exchanged for the consumption or the capital goods supplied by others.

Say's law is clear enough in the case of consumption. If money income is spent on consumption, then it can fairly be said that the earners of the income are exchanging their own form of output for another. The case is less clear with saving and investment. In a corn model, saving and investment are physically the same, even though households and farmers act independently. Households as a group can save in the form only of corn, or of loans of corn to farmers. In a monetary economy, people save money, not goods, and make loans of money. If they do not keep their money under a mattress, they must lend the money they earn either to a bank, in the form of a deposit, or to a firm, in the form of a loan or shares. Although few households lend directly to firms, their savings find their way to firms indirectly, so it is argued, through the banks and other forms of financial intermediary, such as pension funds. Thus saving becomes investment and Say's law is preserved.

Looking Forward: Keynes's Critique of the Classical Theory

This all seems pretty convincing. It is clearly an important insight that new investment and increasing production create additional demand. Indeed, this is the essence of economic growth. When steam drove down the price of textiles and put handloom weavers out of business during the Industrial Revolution, total employment and income rose. The additional supply was associated with increased demand.

The flaw in the argument behind Say's law is subtle, and Keynes's critique will take some work to explain and understand. For the moment, we note that the application of the classical theory to a monetary economy requires two tacit assumptions. First, the application assumes that in a monetary economy an increase in saving (a decision to consume less) does not reduce output and employment. Just as in the corn model, it must be the case that net output and employment are first determined by the wage bargain, and the net output is then divided between investment (saving) and consumption. Second, the application assumes that in a monetary economy an increase in saving will make the interest rate on money loans fall until investment increases to match saving, just as in the corn model the interest rate on loans of seed corn brings supply and demand into balance.

These two assumptions – together with the classical dichotomy by which the quantity of money and the overall level of money prices make no difference, in the long run, to the production, employment, consumption and investment decisions of the real economy – turn out to be invalid in a monetary economy. In order to explain why, which I do in chapter 4, we must first get to grips, in chapter 3, with Keynes's own theory of how a monetary economy works.

3 
The General Theory of Employment, Interest and Money

By now you may be thinking that this is an odd sort of biography. Chapter 2 scarcely mentioned Keynes at all. This chapter and the next will make no mention of any events during his life and it is only chapters 5 and 6 that map the development of his thinking against his books and against major historical events. This chapter is pure Keynes but we start towards the end of his life, with the near-final form of his thinking in his magnum opus, The General Theory of Employment, Interest and Money (CW 7), published in 1936.

The General Theory was in fact his second attempt at a ‘great work’; A Treatise on Money (CW 5–6), published a few years earlier, in 1930, was the first. Chapter 5 will explain how A Treatise on Money represents an unsuccessful effort to integrate money with the classical theory of value and distribution. Keynes wrote of ‘a long struggle to escape’ and that the continuity between A Treatise on Money and The General Theory would be clearer to himself than to others (CW 7, xxi–xxiii). The twists and turns of his struggle are easier to follow with hindsight, with a clear view of the destination, so that is where we start.

In the quotation from the first chapter of The General Theory at the beginning of my chapter 2, Keynes states with great confidence that he is offering a general theory that encompasses the special theory represented by the classical model. The purpose of the present book is to restate Keynes's critique in accessible terms so that his claim to have overturned classical theory can be understood and assessed on its true merits by today's students. The reading of The General Theory presented here is rather different from others, not only from those presented in current textbooks but also from those of many Keynes scholars. My hope is that this reading of Keynes's own text will pay dividends by flushing out the essential differences between Keynes and the classicals while avoiding several large red herrings.

The first section sets out the principle of effective demand, which is the title of chapter 3 of The General Theory and the core of that work. The meaning of this principle, so central to Keynes's thought, has proved elusive down the years. Part of the difficulty lies in his definition of effective demand and in the concepts of expected income and of income itself. The second section explains the significance of expected income and its relationship with time and with money in an economy that produces and exchanges many different goods.

This will lead us to the state of expectation and the distinction between short, medium and long-term expectations of income, which corresponds to the distinction between employers of labour, dealers in goods and investors in capital equipment. The fourth and fifth sections explain at some length how demand affects short-term expectation; then they introduce the famous multiplier. The multiplier is an idea that has been badly mangled in transmission and the matter is here cleared up.

Having established the meaning of the principle of effective demand, the remaining sections mop up three major areas of persistent confusion: the vital difference between money wages and real wages; the reason for money wage ‘stickiness’ and its irrelevance to underemployment; and the lack of importance, for this principle, of whether short-term expectations are correct. The principle of effective demand equips us to address Say's law and the greatest confusion of all, between saving and money, in chapter 4.

The Principle of Effective Demand

In the corn model there is always full employment, provided that the workers accept their marginal product as their wage: farmers expect to find it most profitable to employ all the available workers. The big question is whether full employment is equally automatic in a competitive monetary economy. Keynes's answer is ‘no’, and his reason is the principle of effective demand.

The term ‘effective demand’ has been used in a variety of ways by economists over the past 250 years. Keynes's usage is peculiar and is not what it may appear to be at first sight. Demand usually means purchase or spending. Some economists have distinguished effective demand from notional demand, where ‘effective’ indicates a desire to spend that is backed by the purchasing power of money. By contrast, for Keynes in this particular context, demand means not spending itself, but the income expected to arise from delivering goods for purchase.

Effective demand is the income expected by employers as a whole to result from the level of employment they find it most profitable to offer. Keynes's critical insight is that expected income depends on the level of employment, so that causation runs both ways – from expected income to employment and from employment to expected income. The first relation, running from expected income to employment, he calls the ‘aggregate supply function’, and the second, running from employment to expected income, the ‘aggregate demand function’.

In mathematical terms, these functions are a pair of simultaneous equations, similar to the supply and demand functions we have used in the corn model. The effective demand corresponds to the solution point, which satisfies both equations at the same time. In terms of a diagram, the point of effective demand is the intersection between the aggregate supply and aggregate demand curves.

Figure 3.1, often referred to as the Z diagram, is rather different from the standard supply-and-demand diagram for an individual product. First, the axes measure employment and expected income rather than quantity and price. Second, both curves are upward sloping, although they cross because the demand curve is flatter than the supply curve.

Figure 3.1 The point of effective demand: The Z diagram

Keynes uses the symbol Z to denote expected income in the supply curve; D for expected income in the demand curve; and N for employment. The intersection where D = Z corresponds to the effective demand, for which I write a symbol D*, where the asterisk indicates an equilibrium value. It is the level of aggregate demand that comes into effect because employers as a whole expect to find it most profitable to supply that demand. Victoria Chick (1936–) writes that it might equally be called the effective supply, ‘for it really refers to the output that will be supplied; in general there is no assurance that it will also be demanded’ (Chick, 1983, 65). For the corresponding equilibrium level of employment we write the symbol N*.

In the corn model the aggregate demand curve corresponds exactly to the aggregate supply curve. All production is accepted by the granary. There was no need to construct an explicit aggregate supply curve for comparison with the aggregate demand.¹ Since farmers expect to find it most profitable to employ all the available labour at a wage equal to its marginal product, the equilibrium (i.e. chosen) level of employment is full employment (Nmax in Figure 3.1). In other words, they maximise the total expected income, including their own, by employing all the available labour at the market wage. By contrast, the principle of effective demand implies that, in a monetary economy, employers may expect to find it most profitable to employ less than all the available workers, leaving some workers in a state of involuntary unemployment.

The unemployment is involuntary because the workers are willing to work for a wage equal to or lower than their marginal product, but employers do not expect to find it profitable to offer them work at that wage. This state of unemployment is as much a state of equilibrium as the full employment of the corn model is. It is chosen by employers because they expect to find it most profitable and they have no incentive to offer a different level of employment.

The principle of effective demand allows us to understand the words omitted from my earlier quotation of Chapter 1 of The General Theory: ‘I shall argue 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 point of the possible positions of equilibrium’ (CW 7, 3). In Figure 3.1, the special case is where Z meets Nmax. The general case is where Z crosses D.

Income: An Essential but Surprisingly Tricky Concept

In order to proceed further and, in particular, to understand the various interpretations and critiques of Keynes's theory, we have to grapple with the concept of expected income. It cannot be emphasised enough that most of the confusion over Keynes's thought stems from a failure to grasp the meaning and significance of the concept of income as the money value of net output. This is a failure of the economics curriculum; most economists are mathematicians who like models. Few are trained in accounting or take it seriously, in spite of the fact that in The General Theory Keynes devoted to this problem forty-nine pages – an eighth of the entire book (CW 7, Book II).

In our corn model, income simply is net output, measured in bushels or tons: the harvest minus the replacement of the corn that was planted as seed. There is no difficulty about combining the incomes of different farmers and workers to produce a measure of national income in terms of corn. In the real world, there are many different types of goods and services. How, then, can income be measured? For example, a farmer starts with one tractor, a ton of diesel and half a ton of seed corn. She ends with one slightly older tractor, half a ton of diesel, seven tons of corn, and five tons of straw. What is her net output? No answer is possible without assigning prices to each type of good, which allows income to be calculated as a sum of money.

Classical economists using advanced mathematical ‘general equilibrium’ models recognise the multiplicity of goods, but their work necessarily assumes full employment. Less sophisticated but more practical classical models use the symbol Y to represent a number for ‘real income’, but Y has no physical counterpart that we can observe and measure directly. This is not a harmless simplification; to write Y for net output is to assume a corn model. Despite its direct correspondence with net output, income is an intrinsically monetary concept. Only in a corn model can income be measured as a single number, directly, in physical terms. This matters, as Keynes emphasises with the help of a memorable analogy:

The fact that two incommensurable collections of miscellaneous objects cannot in themselves provide the material for a quantitative analysis need not, of course, prevent us from making approximate statistical comparisons, depending on some broad element of judgment rather than of strict calculation, which may possess significance and validity within certain limits …

To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth – a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis.

(CW 7, 39–40)

Money enters into the heart of production, since workers must be paid their wages in money, not in the goods or services produced by their employer. Workers can eat corn, but not ball bearings. Only with money can they buy the things they work for. Money is not a veil, concealing bargains made in physical terms. Workers necessarily bargain over money wages, not over real wages. A ‘real’ wage is the result of dividing a money wage by the money price of a basket of goods. Employers make their calculations in terms of money income, that is, the money value of net output, not in terms of net output itself.

The multiplicity of goods creates three further major complications; in fact these arise, more precisely, from the nature of time. First, even in the corn model, the farmers do not actually know, at the time when they decide to plant the seed and hire the workers, what the harvest will yield at the end of the year. Production may well be affected by disease or by the weather. Employment always depends on expected income, although not much hangs on this in a corn model.

At harvest time the farmers will be able to reckon their realised income for the past year. This income may exceed or disappoint their original expectations, yet their production decision will once again depend solely upon their current expectations of income for the next year. Expectations may be revised in the light of experience; nevertheless, the expected income for next year remains conceptually quite distinct from the income realised for the past year.

Second, in the corn model there is not only a single form of output but also a single process of production, with a period of one year from harvest to harvest. My calculations have compared input and output for the year as a whole, so that the year is the unit of time. Once we allow for multiple forms of output, the question of timing becomes more complex. Each type of output has a different process and production period. It takes different lengths of time to produce a loaf of bread, a bicycle or a computer. New processes are being set in motion every day, and their production periods are all different and overlapping. Each process may well require, as inputs, the outputs of other processes.

On any given day, most workers start with existing work in progress and capital equipment and perform certain tasks. Even if each individual operation takes only a short time, the nature of production usually involves so many stages that at the end of each day most output will be in the form of slightly more advanced work in progress rather than in the form of finished output. Only the workers placed at the very end of each production process will be producing finished goods every day, and those goods will largely embody work done by others on several previous days.

Third, when you go into a shop and buy something off the shelf, your expenditure does not wholly represent income for the retailers but partly reduces their stock. When the grocer sells you an apple, the price paid for the apple represents the value of the grocer's stock of goods used up, together with the grocer's profit. Less visibly, as you walk through the door into the shop, the door wears out very slightly, using up the grocer's capital in a different form.

Accordingly, apart from services provided directly to consumers or to other employers, production adds to the stock of miscellaneous capital goods, for example raw materials, work in progress and goods on shelves, while consumption uses up part of the existing stock. There is no direct relationship during any given interval of time between the finished output delivered, the labour and land employed, and the capital used up, as in the annual cycle of the corn model. There is no single production period for the economy as a whole. It does remain possible to value the net output of the economy as a whole in any interval of time, that is, to measure the income (in terms of money, of course) for that interval. Yet this realised income is not the same thing as the expected income that motivates employers to hire labour and to invest in new capital goods.

Table 3.1 illustrates the point for an individual product. In this example, the production period is seven days from the date of order; this period includes an initial two days devoted to organising the production. Wages are earned each day as work is done. The final sale and profit are made on day 7. The sale value is £500 and the user cost (Keynes's term for the value of the capital used up in production – a value that corresponds to seed corn in the corn model) is £130, so the total income is £370. Income is divided between profit of £150 and wages of £220. The quantity and timing of labour are related to the process as a whole, not to a particular day. We see that on day 4, for example, the income equals £50 in wages. This is not £370, the expected income against which the employer accepts the order and employs those workers on day 4, or even £220, the total wage bill the employer expects to pay in order to produce the order.

Table 3.1 The time structure of income

Day | Wages | Profit | Income | User cost | Sale value
1 | – | – | – | – | –
2 | – | – | – | – | –
3 | 30 | – | 30 | 50 | –
4 | 50 | – | 50 | 30 | –
5 | 60 | – | 60 | 20 | –
6 | 50 | – | 50 | 20 | –
7 | 30 | 150 | 180 | 10 | 500
total | 220 | 150 | 370 | 130 | 500

Keynes's solution to this problem of time is to work from the other end and to take as the unit of time not the production period, but the individual day. Rather than focusing on the finished output, he considers the employment decision itself. Each day employers decide how much labour to employ; and they can change their minds since the previous day. What matters to them is the income they expect to result from the labour employed today. Accordingly Figure 3.1 relates today's employment to the corresponding expected income.

Except in the case of services, today's expected income is not normally the same thing as the income employers expect from a unit of finished output; nor is it the amount that consumers or investors spend today. However, from the point of view of the workers employed, effective demand and income are the same thing; they are paid a fixed sum for their work whatever the value of the finished product. The difference between effective demand and income, expected and realised income, is experienced only by employers (or dealers, as we shall suggest) when the finished goods are delivered to the final customer. The equivalence of effective demand and income for workers (and for other suppliers of productive resources such as landlords and lenders) is important when we come to explain the aggregate demand function.

The State of Expectation

Effective demand is the expected income from today's employment that satisfies the requirements of both supply and demand, as represented by the intersection of the aggregate supply and demand curves. The previous section identified the monetary nature of income and how it is earned through production over time. Time makes it inevitable that decisions about income are based on expectations about the future. The challenge now is to understand how the equilibrium illustrated by the Z diagram can come about in practice.

Keynes divides expectations of income into three categories: short-term, medium-term and long-term expectations. Short-term expectations are the expectations of employers engaged in the production of goods, who specialise in managing the risks of production and generally produce to order. Medium-term expectations are the expectations of dealers or distributors, who specialise in managing the risks of marketing finished goods and customer services. Long-term expectations are the expectations of investors (including employers and dealers), who have to decide what income they can expect from investing in a capital good such as a machine or a building, which yields productive services over a long interval of time. Keynes's term for income that an investment is expected to earn is ‘prospective yield’.

These distinctions do not appear in the corn model. While farmers may well worry about the weather and about crop disease, they are not concerned about the price the harvest will fetch in terms of other goods (since there is none) when they deliver it to the granary. So they do not need orders and their production is limited only by what they expect to find profitable in terms of productivity; it is a matter of supply conditions alone. The farmers ‘produce for stock’ and there is no need for dealers. The time horizons for the return on labour and on capital (seed corn) are the same: both returns are reaped at harvest time. There is no distinction between long-term and other expectations. No more do sophisticated classical models make Keynes's distinctions.

The effective demand, which matches today's expected income and employment for both aggregate supply and demand, corresponds to the state of short-term expectation. How exactly does this state come about? Keynes's aggregate supply and demand functions relate expected income to employment. Yet how can expected income be defined or observed for the economy as a whole? Expectations are usually thought of as an individual matter, inside people's heads. How can the expectations of a myriad of individual employers be coordinated so that Keynes can properly speak of a singular, shared state of expectation for the economy as a whole?

As the example of farming with tractors illustrates, the expected income is a composite of the prices and quantities of many different outputs and inputs. In a competitive market, both prices and quantities of goods vary depending on supply and demand. The law of diminishing returns implies that the quantity of each type of good that employers will offer to produce or supply rises, while the demand falls, as the price rises. The price that matches supply and demand is the equilibrium price that will clear the market.

Contrary to conventional wisdom, Keynes does not assume fixed prices or wages. The principle of effective demand holds that prices and quantities are determined simultaneously by supply and demand. Furthermore these are the expected prices and quantities that lead employers to hire workers today to produce output for delivery at various dates.

The best way to understand Keynes's thinking is to suppose that employers produce only to order and that orders are placed in competitive wholesale markets. These orders are placed today for delivery of the goods at a future date, which makes them ‘forward’ orders. We assume that dealers, together with employers and other investors, place orders for goods in the wholesale market, while dealers also accept orders for goods in the retail market, usually for delivery ‘on the spot’. Thus dealers buy in forward markets and sell in spot markets, holding stocks of goods to meet a fluctuating spot demand. They play a key role in the determination of the prices and quantities that make up the expected income.

Using this device we can separate aggregate supply, which is based on short-term expectation (the domain of employers), from aggregate demand, which is based on both medium-term expectation (the domain of dealers) and long-term expectation (the domain of investors, including employers). We can think of the state of short-term expectation as the employers’ order books. Dealers place orders on the basis of their medium-term expectations of final demand from customers. Employers and other investors place orders on the basis of their long-term expectations. Competition among dealers, employers and other investors establishes a single forward market price for all the orders of similar goods. The value of the orders allows employers to calculate their expected income and how much labour to employ on any given day.

It is the value of the orders received that determines the level of employment, while the level of employment ultimately determines the value of the orders placed. The dealers provide a loose coupling, such that the orders placed on any given day need not, and in practice will not, correspond precisely to the final demand from consumers and others on the same day. The orders placed will vary with dealers’ expectations of customer demand over the medium term – which will depend, as we shall now explore, on employment.

Aggregate Demand and the Multiplier

Effective demand is the expected income from today's employment that satisfies the requirements of both supply and demand, as represented by the intersection of the aggregate supply and demand curves. Aggregate supply, while more complicated in a monetary form, involves the same considerations as the supply decision in the corn model. Keynes is entirely classical in that respect. Where he parts company with the classical theory is over aggregate demand.

We saw that the corn model can be understood as assuming that the aggregate demand curve coincides with the aggregate supply curve, so that only the full employment position will be chosen. By contrast, Keynes argues that the aggregate demand curve is flatter than the aggregate supply curve, so that there can be a point of intersection below full employment, an underemployment equilibrium, as shown in Figure 3.1. So what determines the aggregate demand curve?

Income (Y) is defined as the value of net output and – leaving aside international trade and the distinction between private and public sectors for another chapter – is necessarily equal to the sum of the values of consumption (symbol C) and investment (symbol I). This ‘national income identity’, in its simplest form, is written

– where the symbol ≡ means equal by definition.

A statement of identity or a definition explains nothing by itself. A causal explanation is required. For the most part, investment (I) depends not on employment but on long-term expectation, which I consider in the next chapter. Consumption (C) varies with current income (Y), a relation that Keynes himself calls ‘the propensity to consume’ and later writers call ‘the consumption function’. Keynes calls the ratio between changes in consumption (ΔC) and income (ΔY) ‘the marginal propensity to consume’ (Δ means an increase in a number). If we assume that this ratio is a constant fraction c, we have ΔC = c × ΔY = cΔY.

Here we run into a complication. The aggregate demand function is an equation that relates employment (N) to expected income (D), the causation running from employment to expected income. The consumption function is a relation between income (Y) and consumption expenditure (C). Some translation is required. It turns out to be reasonable to substitute effective demand (D*) for both employment (N) and income (Y), and consumption expenditure (C) for part of expected income (Keynes calls it D₁).

Effective demand (D*) can stand in for employment (N) because, for workers, effective demand and today's income are the same thing and both are directly associated with today's employment, since wages are paid for the time employed. Non-wage income, the balance of Y, differs in value from non-wage expected income, the balance of D*, only if expectations prove wrong. Lenders and landlords are in the same position as workers: their income accrues by the day. Our assumption that employers produce only to order protects them if expectations prove wrong. Thus the difference between today's expected and future actual income exists only for dealers and arises at various future dates. If we can reasonably assume that dealers are in a position to consume today on the basis of their expected (rather than realised) income, D* can stand in for Y.

However, consumption (C) is an expenditure – not at all the same kind of thing as expected income (D₁). This is where the distinction between employer and dealer becomes important. The expected income from producing output for consumption (D₁) is expressed in dealers’ orders to employers; consumption expenditure (C) is met from dealers’ stocks. For the moment we assume that consumption expenditure (C) translates directly into dealers’ orders (D₁). This assumption will be justified in the next section.

Given the above substitutions, we can turn the tautological national income identity into a causal aggregate demand equation

– where A represents the expected income from today's production of goods for which the demand does not vary with employment (e.g. capital goods purchased by investors and some goods for consumption) and cD* represents the expected income from today's production of goods for which the demand does vary with employment (e.g. goods consumed by workers). This equation is not the aggregate demand function itself (which relates D to N, not D*) but it is a close cousin.

The equation is represented by a line in Figure 3.2, which plots D on the vertical axis and D* on the horizontal axis. The diagram contains a second line, at 45°, along which at each point D equals D*, as they must in equilibrium. Line D cuts the vertical axis where D equals A and the slope of the line equals c, which is smaller than 1, so line D is less steep than the 45° line and cuts that as well. The intersection of the two lines gives the values of D and D*, which are consistent with the aggregate demand function.

Figure 3.2 Effective demand and the multiplier

Given the role that a 45° diagram very similar to this one has played in the misinterpretation of The General Theory, it is vital to emphasise that this diagram is NOT a representation of aggregate supply and demand, as in Figure 3.1. The 45° line is not the aggregate supply curve (Z), and line D is not the aggregate demand function (D) from Figure 3.1. For example, curve Z need not be a straight line, but the 45° line always is; they represent quite different things.

The meaning of the diagram lies solely in the intersection, which tells us that there is only one level of aggregate demand (D) and effective demand (D*) – and hence of employment (N) – that is consistent with the level of investment (included in A) and the consumption function. The value of the diagram is that it allows us to understand what happens to aggregate demand if there is a change in either investment or the consumption function.

Consider a change in investment, here meaning an increase in the expected income from producing investment goods, ΔI. This is represented in the diagram by an upward shift in the D line. The shift moves the point of intersection so that effective demand increases by ΔD*. What is interesting is that ΔD* is greater than ΔI. The ratio ΔD* : ΔI is called ‘the multiplier’ because total effective demand increases by a multiple of the increase in expected income from investment demand.²

It can be seen that the size of the multiplier depends directly on the marginal propensity to consume (the slope of line D). The multiplier becomes lower as the line becomes flatter. For this consumption function, the multiplier equals 1/(1 – c). If the marginal propensity to consume is 0.6, the multiplier is 1/(1–0.6) = 2.5. In other words, an increase in expected income from producing for investment by £1 requires an increase in total expected income (effective demand) by £2.50.

Figure 3.3 relates Figure 3.2 back to Figure 3.1. The change in investment shifts the aggregate demand curve upward, so that effective demand changes from DA* to DB* in both Figures 3.2 and 3.3. Employment moves from NA* to NB* in Figure 3.3.

Figure 3.3 The multiplier and the Z diagram

The multiplier is perhaps the most famous aspect of The General Theory, remembered by generations of students after they have forgotten everything else. Popular critics suggest that it means trying to get something for nothing; and this is not helped by Keynes's sense of humour. At one point he suggests burying old bottles filled with banknotes in landfill sites, in order to create employment and income by digging them up again.

Yet the multiplier simply connects the proportions of net output devoted to consumption and investment, given that decisions to consume and invest are made independently and that consumption rises and falls with income. The multiplier explains why a fall in investment relative to the amount that the community would save at full employment does not cause total income to fall to zero and the population to starve to death (as in the banana parable of A Treatise on Money; see chapter 5 here). By putting a precise figure on the change in income that results from a change in investment, the multiplier secures the concept of underemployment equilibrium below full employment.

Income, Expenditure, Effective Demand and the Multiplier

For Keynes, causation always starts with expectation. The aggregate demand function involves an expected income. The expected income from the production of capital goods is based on the long-term expectations of employers and investors. The expected income from producing consumption goods is based on the medium-term expectations of dealers. An increase in aggregate demand may begin with a change in long-term expectation, which increases employment in the production of capital goods. The increased employment and income increase the expenditure on consumption goods, which in turn requires increased employment in the production of consumption goods. The multiplier tells us by how much total income has to increase to bring production and consumption into line with each other.

The level of employment always reflects the state of short-term expectation, which we have interpreted as employers’ order books. It is vital to emphasise that these orders are the outcome of a process of competitive equilibrium; employers, dealers and investors are ‘in equilibrium’ with each other each day. Nevertheless, there can be a mismatch between dealers’ expectations and the actual consumer demand on any given day.

On any given day, consumers plan to spend a certain amount. The dealers can meet this demand in various ways. In modern retail markets, most dealers set prices from time to time and accommodate demand until the shelves are empty, although they aim to restock as quickly as sales are made. Rationing is rare: even if one store runs out, there is usually another with supplies on hand. So customers can normally incur the expense they wish each day. In other words, their expenditure plans are fulfilled so that they, too, are ‘in equilibrium’.

Expenditure is independent of the finished output that happens to arrive in warehouses on the day. Any mismatch is the dealers’ concern. The value of any consumer expenditure that reduces the dealers’ stocks reduces aggregate investment by an equal amount, so that aggregate income is unaffected, extra consumption being balanced by less investment.

Table 3.2 sets out a traditional example, where dealers change their expectations mechanically, in line with the demand from consumers the previous day. The method is similar to the exposition of a multiplier given in 1931 by one of Keynes's students, Richard Kahn (1905–1989).

Table 3.2 Stock adjustment and the multiplier

Day | ΔI gross | ΔC | Δ stocks | ΔI net | ΔY | multiplier
1 | 1,000 | 600 | −600 | 400 | 1,000 | 2.5
2 | 1,000 | 960 | −360 | 640 | 1,600 | 2.5
3 | 1,000 | 1,176 | −216 | 784 | 1,960 | 2.5
4 | 1,000 | 1,306 | −130 | 870 | 2,176 | 2.5
5 | 1,000 | 1,384 | −78 | 922 | 2,306 | 2.5
6 | 1,000 | 1,431 | −47 | 953 | 2,384 | 2.5
7 | 1,000 | 1,459 | −28 | 972 | 2,431 | 2.5
8 | 1,000 | 1,476 | −17 | 983 | 2,459 | 2.5
9 | 1,000 | 1,486 | −10 | 990 | 2,476 | 2.5
10 | 1,000 | 1,492 | −6 | 994 | 2,486 | 2.5
11 | 1,000 | 1,496 | −4 | 996 | 2,492 | 2.5
12 | 1,000 | 1,498 | −2 | 998 | 2,496 | 2.5
13 | 1,000 | 1,499 | −1 | 999 | 2,498 | 2.5
14 | 1,000 | 1,500 | −1 | 999 | 2,499 | 2.5
15 | 1,000 | 1,500 | 0 | 1,000 | 2,500 | 2.5

To begin with, an increase in the production of capital goods requires an increase in employment, which increases the daily income (ΔY) by £1,000. On day 1, the newly employed workers spend £600 on consumption (ΔC), in line with the consumption function. Since this was unexpected, dealers’ stocks fall by the same amount, leaving the increase in income unchanged at £1,000.

On day 2, the dealers increase their orders for consumption goods by £600, which is matched by increased income from employment in consumption industries. With income now increased to £1,600 (ΔY), the increase in consumption (ΔC) rises to £960, which still exceeds the increased orders for consumption goods by £360 – so stocks fall again.

This process continues, as income and employment converge (by day 15) on values consistent with gross investment and the consumption function. Note that every day the value of the multiplier is the same (at 2.5), but the value of investment, net of stocks used up, gradually increases in line with income, until stocks catch up with the new state of expectation. Income is always determined by effective demand and by the current state of expectation, not directly by expenditure.

It is important not to confuse this process of adjustment of dealers’ expectations with the principle of effective demand, although nearly every economics textbook does so. Three different concepts of equilibrium are in play at once:

TYPE I: the precise daily equilibrium of production, established in competitive markets between profit-maximising employers and their customers and leading to the state of short-term expectation embodied in employers’ order books and the effective demand;

TYPE II: the equilibrium of consumers, who can usually carry out their planned expenditure from one day to another, because dealers’ stocks automatically adjust to match; and

TYPE III: the looser equilibrium of dealers, who adjust their medium-term expectations of consumer demand in line with changes in their stocks, among other things. This is a matter of tendency towards a shifting point of equilibrium rather than of its achievement; it is unlikely that dealers will ever be in equilibrium at any time, given the uncertainty of demand.

Much confusion has arisen from interpreting Figure 3.2 in terms of type III equilibrium. If the vertical axis is marked E for expenditure rather than D for expected income, the diagram can be used to represent the process of adjustment of dealers’ expectations to equilibrium, as in Table 3.2. The mathematics remains the same; but unfortunately this presentation radically changes the economics, obscuring the principle of effective demand and type I equilibrium.

The standard textbook bypasses the principle of effective demand by substituting Y for D* on the horizontal axis of Figure 3.2 and by assuming fixed prices, so that Y represents ‘real income’ or, in effect, corn. Equilibrium is then defined by the equality of Y (planned net output) and E (actual expenditure) along the 45° line. This is the ‘Keynesian cross’ promulgated by Alvin Hansen (1887–1975) and Paul Samuelson (1915–2009).

Doing this implies that expenditure creates real income directly, with no reference to its effect on prices; prices are assumed to be fixed. The further step, of linking effective demand D* to employment N through the aggregate supply function Z, is left out. The supply side and the determination of price expectations disappear.

This approach leads ultimately to the claim that Keynesian economics is valid only for a short run of indefinite length, during which prices are fixed and within which equilibrium is defined solely by the fulfilment of sales expectations. In the long run, it is argued, price competition will deliver the classical full-employment result: Keynes's general theory becomes a special case based on fixed or sticky prices. The standard textbook account of Keynesian economics is seriously misleading as a guide to the economics of Keynes.

Now that we have established the meaning of the principle of effective demand, I can turn in the following sections to mop up three major areas of persistent confusion: the vital difference between money wages and real wages; the reason for money wage ‘stickiness’ and its irrelevance to underemployment; and the unimportance for the principle of whether short-term expectations are correct.

Changes in Money Wages

In the corn model, the demand for labour is related to the real wage. Provided that the workers accept their marginal product as their wage, farmers expect to find it most profitable to employ all the available workers. So the remedy for any unemployment is a wage cut.

In a monetary economy, workers must be paid their wages in money and necessarily bargain over money wages, not over real wages. It is true that a reduction in the money wage of an individual worker or group of workers does reduce their real wage in relation to that of others and may protect or increase their employment. However, the classical claim goes further: it states that a cut in money wages across the board will increase total employment, as in the corn model.

The principle of effective demand itself is the main answer to this key policy question. Expected income is always a money value; and it can be measured not only in terms of currency but also in terms of the money wage of a unit of standard labour, or ‘wage unit’. For example, if the income is £20,000 and the minimum wage for an hour of labour is £10, the income is 2,000 wage units. If aggregate demand and supply are specified in wage units, effective demand is independent of the money wage; no change in money wages can directly affect something measured in wage units. Any effect has to be indirect, occurring through the complex repercussions of changes in money wages on aggregate demand, measured in wage units.

Aggregate supply is independent of the money wage because the employment decision involves comparing marginal revenue (the money value of the marginal physical product) with the marginal cost of labour (the wage unit). What matters for employment is the relation between the two, the price of goods in terms of labour, not the absolute level of money wages and prices. This is captured by measuring prices and costs in wage units.

Aggregate demand is independent of the money wage, first of all because consumption ultimately depends on what money can buy rather than on money income itself. Indeed, Keynes specifies the propensity to consume in terms of wage units. Second, as we shall see in the next chapter, investment creates a claim on future income. If money wages and incomes change today, so will future incomes. Again, what matters is the relationship between present and future prices, not the absolute level of prices. It is therefore reasonable to measure investment demand in wage units, provided that changes in wages do not affect long-term expectations.

Accordingly, in a monetary economy the level of employment is determined by employers on the basis of the expected spending, measured in wage units, of consumers and investors. The productivity of labour affects the profitability of employment through the aggregate supply function (Z), constructed by Keynes in thoroughly classical terms. Given classical diminishing returns, a lower level of employment will be associated with a higher real wage, and vice versa. However, the higher real wage is the consequence of the lower employment; the lower employment is not caused by workers as a whole demanding higher money wages.

Why are Money Wages Sticky?

Most economists have reduced Keynesian economics, at best, to a theory of short-run fluctuations in output. This has been achieved partly by fixing upon Keynes's reference to the stickiness of money wages and by misrepresenting this stickiness as a failure of competition. It is argued that, if prices and wages are allowed to adjust to changes in the scale and mix of demand, they can clear markets and ensure that resources are redeployed in order to maintain full employment.

The blame is not always placed on trade union refusal to accept wage cuts. The New Keynesians have put forward technical reasons, based on imperfect competition, why it may not be profitable in the short run to change prices or wages. They argue that, when in the long run prices and wages do adjust, the classical outcome emerges.

Keynes utterly rejects the idea that, in a monetary economy, money wages can ever clear the markets for the services of labour as a whole. Money wages fall ‘outside the model’. Their overall level cannot be explained in terms of the equilibrium of supply and demand.

This claim is anathema to the classical (including New Keynesian) economist, who demands a consistent and universal application of the concept of equilibrium. The inconsistency is not in Keynes, but in classical theory. The classical dichotomy holds that money is neutral and only relative prices matter. Yet how are markets to clear in a monetary economy except through changes in money prices? Relative prices cannot clear markets.

To be outside the model does not automatically make money wages sticky, but there has to be an anchor for the price level if the price system is not to break down. As we have seen, the price level is related to the money wage by standard classical marginal productivity. However, if there is involuntary unemployment, the labour market is not clearing and the money wage is not an equilibrium value in the classical sense. This means, not that money wages are unaffected by the balance of supply and demand, but that market pressures may move wages up or down from where they happen to be, not from one position of equilibrium to another. Wages do not rush towards zero or infinity, they are necessarily ‘sticky’. By contrast, Keynes is quite content to allow that the prices of produced goods are determined within the model by the competitive equilibrium of supply and demand. The imperfect competition of the New Keynesians plays no role in his analysis. As Keynes wrote in response to a critic who suggested otherwise, ‘[t]he reference to imperfect competition is very perplexing. I cannot see how on earth it comes in’ (CW 14, 190).

Change in and Fulfilment of Expectation

The principle of effective demand makes no reference to the fulfilment of expectations. It simply does not matter, for the employment decision taken each day, whether expectations are correct. Effective demand and the corresponding employment reflect, in themselves, a daily competitive equilibrium between supply offers from employers and demand bids from dealers, employers and investors. No further equilibration is needed.

Even so, medium- and long-term expectations can change from day to day, so that the point of equilibrium shifts and the effective demand changes accordingly. New orders will be negotiated in line with the new expectations, at different prices and quantities from before. Existing orders remain in place, so that the expected income from those orders and the corresponding employment will be largely unaffected until the orders are delivered. Dealers will make windfall gains or losses on goods in stock and in production under order, but these profits or losses do not affect the production and employment decisions of employers.

There will be a period of transition while the level of effective demand and the structure of order books, production and capital equipment adjust to the change in expectation, assuming that it persists. Even if dealers fully and correctly (‘rationally’) anticipate the consequences of the change and place their orders accordingly, there will still be some transitional dynamics. There may be temporary changes in the consumption function in response to price rises, because it takes time to produce the new capital goods needed to support the new level of production for consumption. Employment may overshoot before converging on its final level.

Like the ripples when a bucket of water is poured into a bath, there will be some wave-like oscillation before production and employment settle down at their new ‘long-period’ level, as Keynes puts it. Only if water is added very slowly and steadily will the level rise without disturbing the surface. Yet in practice another bucket will be poured in without ceremony, before the surface settles down; the state of expectation will change again. Expectations change for many reasons; forecasting error is only one factor.

The concept of equilibrium as the fulfilment of expectations – which lies behind the Keynesian cross diagram – is neither the only nor the most relevant concept of equilibrium. For analytical purposes, we are most interested in changes in the long term that are associated with policy or some other autonomous change, even though we do not expect fluctuations ever to die away completely in practice. We want to know how full the bath will be and whether it will overflow; we are not interested in the ripples on the water's surface.

Having stated from the outset that the fulfilment of short-term expectations is not directly relevant to Keynes's central principle of effective demand, I must add here that he was certainly interested in how expectations change and in the likelihood that they would do so suddenly. In particular, he argued that the state of long-term expectation, which determines investment and therefore drives his whole model of employment, does change in a cyclical manner. Furthermore, the disappointment of long-term expectation plays an important role in the genesis of crisis. The nature of long-term expectation is addressed in the next chapter.

Say's Law Through the Back Door?

Even if we accept Keynes's theory of employment in a monetary economy as set out in this chapter, the question remains whether some market mechanism exists to bring aggregate demand into line with aggregate supply at full employment. Keynes writes that the fallacy of classical theory is to suppose that there exists ‘a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former’ (CW 7, 21). In the corn model, the rate of interest in the capital market coordinates the consumption and investment demands so as to match the net output of full employment. The next chapter considers what happens in a monetary economy.

Notes

1 The ingredients for constructing an aggregate supply curve for the corn model can be found in Table 2.2. Expected income in bushels of corn is given in column 2. However, Keynes's Z function is measured in terms of money or wage units (the money wage of a unit of labour). The latter amounts to measurement in terms of units of labour. It is necessary to divide the expected income in bushels of corn by the marginal product of labour in column 4 to arrive at the equivalent of Z measured in units of labour. In general Z will have an increasing slope. In Table 2.2 the expected income has to be the equivalent of about nineteen labour units for it to be worth employing twelve workers (= labour units), but about twenty-six units to employ fourteen and fifty units to employ fifteen. A useful explanation can be found in Hartwig (2017).

2 For the reader who understands calculus, the multiplier is an example of comparative statics. It is a partial derivative showing the change in the equilibrium value of an endogenous variable (one determined inside the model) that results from a change in an exogenous variable (one outside the model, or given). Starting from the equilibrium condition D* = A + cD* and differentiating with respect to A produces ∂D*/∂A = 1/(1 − c). This can be done for any pair of endogenous and exogenous variables. In the notes to chapters 6 and 7 I use this technique to calculate the effect of a cut in government spending on the trade and fiscal deficits.

4 
The Great Confusion

The controversy over Keynes's claim to have overturned Say's law and superseded the classical theory of employment centres in practice around the theory of interest and its relation to saving and investment. Keynes himself tried to sort this out in a series of exchanges he had, after The General Theory, with his close colleague Dennis Robertson (1890–1963) and several other distinguished economists – but without success (CW 14, 179–233).

Most economists have been persuaded by John Hicks (1904–89) and Axel Leijonhufvud (1933–) that Keynes did not succeed in refuting the classical theory of interest. They argue that Keynes's theory of interest is a special case of a more general ‘loanable funds’ theory of interest, which applies classical thinking to the monetary economy. The theory of interest is, accordingly, central to their dispute with Keynes's directly opposite claim that The General Theory encompasses classical theory.

Investment plans are mostly made by employers and other businesses, while saving plans are made separately, by everyone who receives an income. Why should these plans add up to the same amount? In the corn model, they are brought into balance through the capital market by the interest rate. The interest rate is, famously, the offspring of productivity and thrift.

In a monetary economy, people experience income as a sum of money. If I do not consume all my income, surely the money left constitutes saving, which I can offer to lend to others for a rate of interest. How is this any different from the corn model, in which I can offer to lend my surplus corn? Keynes's perhaps startling answer is that in a monetary economy the rate of interest on money is entirely a matter of money and finance in which saving plays no part at all.

Keynes argues that investment and saving (or, strictly, consumption) plans are brought into balance by changes in income, in accordance with the principle of effective demand and the multiplier, not by changes in the rate of interest. This balance represents a stable equilibrium from which there is no pressure to depart, even if income is low so that some workers are unemployed. The interest rate can indeed affect investment and even saving, but unemployment does not create automatic pressure to reduce the interest rate and increase investment or consumption, so as to restore full employment.

Keynes argues that the rate of interest is determined not by the balance between planned investment and saving but by the balance between the supply and the demand for money. Saving follows investment and has no independent influence upon it. Investment may depend on finance, but finance is a matter of money and not of saving.

Who among these heavyweight economists is right and what hope does the economics student have of making a valid choice between them? The next section comes down in support of Keynes, while explaining how his distinguished opponents could get it wrong.

The Great Confusion Over Loanable Funds

The loanable funds doctrine accepts that the relevant rate of interest is the rate on loans of money, not the ‘real’ rate or rates of interest on corn or any other real goods. The argument is that money can be lent from saving, from the creation of new money, or from the release of money from hoards (taken together, ‘loanable funds’). Thus saving and money are interchangeable. Conversely, loanable funds can be absorbed by either borrowing for investment or adding to hoards. Leaving aside hoarding and the creation of new money, the interest rate is determined by the balance between saving and investment, just as in the corn model.

Keynes himself had written in 1929, in Can Lloyd George Do It?: ‘The rate of interest can fall for either of two opposite reasons. It may fall on account of an abundant supply of savings, i.e. of money available to be spent on investments; or it may fall on account of a deficient supply of investments, i.e. on [sic] desirable purposes on which to spend the savings’ (CW 9, 123). Thus here Keynes himself treats saving, or at least savings, as equivalent to money; at this point he appears to be a loanable funds theorist.

In this context we need to be precise in the use of words. ‘Money’ offers little difficulty for the present purpose (although see chapter 5 on the nature and definition of money). ‘Saving’ should be reserved to mean income not consumed. ‘Savings’ can be used to mean saving accumulated over time; or it can refer to money or other short-term securities. ‘Savings’ is an ambiguous term, which is best avoided in a discussion of this type.

By the time we reach The General Theory Keynes has clarified that, for the economy as a whole, saving is essentially never in the form of money. Money and saving require separate treatment. We might call this ‘the Keynesian dichotomy’, in contrast with the classical dichotomy of chapter 2. The only exceptions are foreign money acquired through exports, which we consider in chapter 6, and (in past times) money defined as gold or silver, that is, money dug out of the ground. The Keynesian dichotomy reflects the equality of aggregate investment and saving.

Saving means not consuming income, which is the value of net output. Net output can only be consumed or invested (I consider later where exports fit in). Income can only be consumed or saved. Society as a whole can save only in the form of physical goods, whether these goods are subsequently used up in the short term (e.g. flour) or in the long term (e.g. flour mills). The output represented by the income saved by one individual must be either consumed by another's dissaving (consumption in excess of income) or added to investment. For the economy as a whole, since income (consumption plus saving) is the value of net output (consumption plus investment), the value of investment must equal the value of saving as a matter of accounting.

In the corn model this is fairly obvious. People can use the tickets that represent their share of net output in three ways: to draw corn for consumption; to make loans to farmers, who draw corn for planting; or just to hold on to the tickets as a store of wealth for future years. Whether the corn remains in store in the granary or is planted in the ground, both represent investment. We can see directly that net output not consumed equals both investment and saving.

The equivalence in value of aggregate saving and investment is less self-evident in a monetary economy. People experience income as a sum of money, and this leads to the confusion of loanable funds thinking. We must hold fast to the idea that income is the value of net output. There is no difference in this respect from the corn model, except that we measure money value, not physical quantity.

It may be hard to accept that saving is never in the form of money for the economy as a whole, when most individuals experience income as a receipt of money that accumulates in their bank account as ‘savings’ if it is not spent. This is why the precise definition of saving is so important. For example, you may receive a monthly salary, but you earn income every day you go to work (as you soon learn, if you leave your job halfway through a month and find your final pay cheque halved). Every day that you turn up for work creates a debt from your employer. Your daily income is the same whether you are paid every day, week, or month. Payday is simply the day when your employer settles the debt, not the day when you earn your income. At the same time you may be incurring expense on credit, such as your daily consumption of electricity or the rental of housing.

Your saving in any period is the difference between income earned and expense accrued – whether it is payday or whether you pay your bills. Cash flow and the settlement of debts are a matter separate from income and expense. There is no automatic relation between saving and cash flow, between income and expense (measured in terms of money, of course) on the one hand and receipts and payments of money on the other. All accountants understand this, but few economists.

An example of the deep-seated confusion is the circular flow diagram found in every macroeconomics textbook (e.g. Mankiw and Taylor, 2014). In its simpler form, this diagram explains the relationship between income and expenditure. Employers pay households for productive services, and households pay firms for finished goods and services. In return, employers deliver finished goods and services to households, and households deliver productive services to employers. This is correct if we understand ‘pay’ as purchase for money value, but not if ‘pay’ means a transfer of money.

However, later in the same textbook we find an extended circular flow that includes financial markets, into which money flows as households save and out of which it flows again as investment. Saving is clearly presented as a flow of money payments, which is quite wrong. This misuse of the circular flow diagram illustrates the essential importance of understanding income as the value of net output and expenditure as a purchase of output. Neither income nor expenditure can be correctly understood as a transfer of money.

As a matter of bookkeeping, aggregate investment and saving are equal. It is not simply a truism that all the capital goods in the economy belong to somebody, as Hicks scoffed. As we saw in chapter 3, consumers are always in equilibrium, having spent (and saved) out of their income what they planned to. Employers are also always in equilibrium, because they produce to order. Dealers may find their stocks higher or lower than expected, which indicates that the separate plans of employers and consumers are not consistent with each other. This change in stocks is where any difference between planned and actual investment is revealed, which in turn reflects a difference between the expenditure on and the production of consumption goods.

Any disappointment of dealers’ past expectations does not directly affect currently expected income or the equality of investment and saving. The mismatch may, or may not, lead to a change in dealers’ expectations. If dealers’ expectations do not change, employers and consumers remain in equilibrium. If dealers’ expectations do change, so will expected income.¹

Accordingly the reconciliation of planned investment and saving (or consumption) in a monetary economy is achieved by changes in income, not by changes in the rate of interest. A reduction in the propensity to consume, a decision to increase the proportion saved out of a given income will reduce income through a reduction in expected consumption demand; it will not create additional saving. True, in the first instance, the reduced propensity to consume will increase the proportion of saving and investment in current income through an increase in dealers’ stocks. Yet, as soon as dealers reduce their orders for consumption goods in line with their revised expectations, income will fall to a level consistent with the new multiplier.

Since aggregate investment and saving are always equal and maintained in equilibrium by changes in income, there is no role for the rate of interest to bring them into balance. Money and saving are never substitutes. For investment to take place, it is money that is needed, not saving. The saving is created automatically when investment takes place. Somewhere in the economy, domestic or foreign, saving increases to match the additional investment.

Finance may be necessary to obtain the money that is needed for investment to take place. A loan does not by itself create income or involve saving, it simply moves money between lenders and borrowers, enabling the borrower to invest. Finance is a matter of getting people with money to lend it to others or, for a bank, a matter of creating money by lending.

The rate of interest is the price of lending, not of saving. The immediate alternative to lending money is not spending but holding on to it. We require a new theory of the demand for money and how it is brought into balance with the supply of money created by the banking system. We are nearly ready to consider Keynes's theory of interest. Before we can do so, we must first understand Keynes's theory of investment and its relation to the rate of interest.

Investment and the Interest Rate

Keynes's theory of the demand for new capital goods looks at first rather classical. He has a downward-sloping investment demand curve such that the rate of investment increases as the interest rate falls. However, the differences are important.

To begin with, in a monetary economy the profitability of an investment has to be calculated in terms of money. It is a matter of efficiency in converting present into future cash rather than of physical productivity alone, as in the case of seed corn. Efficiency depends on the price obtained for the output, something of no concern in the corn model.

The most significant difference relates to time. In the corn model, the marginal product of capital is a matter of one single harvest. In the real world, capital equipment can last a long time and normally delivers its yield not in a single harvest, but as a stream of income over time.

In the corn model, expected income and the expected marginal products of capital and labour have the same time horizon: a single period. In Keynes's terms, they are all a matter of short-term expectation. When we move to considering investment in general, we are concerned with the expected income from using or renting capital goods (their prospective yield) over their expected economic life: we are concerned with the state of long-term expectation.

We have represented the short-term expectation embodied in the principle of effective demand by employers’ order books. We have left forecasts of consumer demand to the dealers’ medium-term expectations. Dealers specialise in managing retail uncertainty; they turn over standard stock quickly and adjust their orders to employers rapidly, in line with changes in expectation. For special requirements such as a suit made to measure, they, too, require an order from a customer before placing one with an employer.

When we come to long-term investment, the uncertainty is more intractable. There are some special cases, such as long-term leases of buildings and vehicles, which represent orders for the use of the asset for most of its economic life. There are some dealers, in the form of rental companies for standard equipment and vehicles, who manage short-term hires. However, most capital goods are specialised for one application, like a steel plant, and have a poor resale value; intangible assets, such as start-up losses to create brand value, may have none at all outside a going concern. Their prospective yield depends on the uncertain distant future.

Sophisticated classical models assume the existence of a complete set of forward markets (what this means will be explained in a moment) as the basis of the ‘rational expectations’ consistent with full-employment equilibrium; they make no distinction between short-term and long-term expectation. It is reasonable to assume short–term forward markets, as I have done, for capital and consumer goods currently in production. It is a tall order to assume these markets for the goods that will be produced in the future with the new capital goods ordered today. Some assets have an economic life of fifty years or longer.

As Frank Hahn (1925–2013) put it, the assumption of complete forward markets means that you can place today an order for the delivery of a pair of shoes to your unborn grandchild. Saving means deferring consumption from the present to the future; but consumption of what, exactly? It is to the assumption (tacit, in his time) of complete forward markets that Keynes objects: ‘An act of individual saving means – so to speak – a decision not to have dinner today. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date’ (CW 7, 210).

Furthermore, even if one does wish to buy a future grandchild's shoes, it may not be profitable to make physical provision today. Capital goods incur carrying costs, through storage or deterioration over time: the shoebox has to be stored somewhere and the leather may perish. Fashions and technology will change, violating standard classical assumptions. The alternative of building a shoe factory (or of buying a share in one) is no better; the time it takes to produce and deliver a newly ordered pair of shoes is quite short. Without a forward market for delivery in fifty years (or even in five years), there is nowhere to register a decision to postpone consumption today in favour of an order for future consumption, so that employers and investors can organise future production to meet that demand.

In the corn model, if the demand for investment in seed corn is lower than what people wish to save, the interest rate can fall all the way to –100 per cent. The classical model assumes that, faced with a low, even negative return on investment, people will either consume more or work less: the supply of labour will reduce if people do not want so much corn, yet full employment remains. For this trade-off to be possible in a monetary economy would require long-term forward markets for each type of good. It is not enough for individuals to save in the form simply of money or money's worth (as Hicks maintained), since this leaves the composition and timing of future demand undetermined. Without the necessary long-term forward markets, there is no mechanism in a monetary economy by which the classical ‘intertemporal’ trade-offs between present and future consumption, between work and leisure can be made – as presented, for example, in Barro (1997).

Without the firm backing of customer orders, the state of long-term expectation is fundamentally uncertain. As Keynes puts it:

By uncertain knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject in this sense to uncertainty … Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest 20 years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

(CW 14, 113–14)

Keynes is here distinguishing uncertainty from insurable risk and drawing upon his early work on the nature of probability (A Treatise on Probability, CW 8). It is possible to insure your life, or buy insurance against your house burning down, because these risks depend on recurrent physical regularities. For a large population they follow a probability distribution, where the average loss in any period of time can be calculated within the limits of random variation.

Sophisticated classical models assume not only long-term forward markets but also insurance markets, for example to cover the risk that you do not have grandchildren. Together, the insurance and forward markets allow you to place an order today at a fixed price for delivery of the shoes in fifty years, if your grandchildren exist. The assumption of long-term ‘rational expectations’ implies that uncertainty can be reduced to insurable risk and that the future can be modelled on the experience of the past and of the present. This is something all financial advisors tell us not to assume when managing our personal affairs. It is ironic that pricing models for financial securities still make precisely that assumption, despite 2008, although banks are now subject to stress tests based on more extreme non-statistical worst cases.

Political and social changes and technological progress in creating new products and processes, the very stuff of capitalism, are inherently unpredictable. Prices in the long-term future will depend on unforeseeable conditions of demand, supply and competition. Uncertainty introduces a new factor: the state of confidence. There is a ‘difference between the best estimates we can make of probabilities and the confidence with which we make them’ (CW 7, 240). This difference corresponds to the distinction Keynes made in A Treatise on Probability between the balance of evidence and the weight of evidence. Keynes's ‘animal spirits’ or spontaneous optimism relate to the state of confidence in long-term expectations and have their counterpoise in liquidity preference, ‘the degree of our distrust of our own calculations and conventions concerning the future’ (CW 14, 116).

Confidence is weak when we know that we are likely to change our minds but have no idea in what direction. Our current best estimate is just that: the best we can do on the available evidence. There is no room in classical theory for uncertainty in this sense – or for confidence, animal spirits or liquidity preference.

In particular, Keynes's concept of liquidity has always been misunderstood simply as easy convertibility into money. There is much more to liquidity than that. Liquidity for Keynes means stability of value when the state of long-term expectation changes. Capital goods differ in their degree of liquidity. The cars and trucks leased by a vehicle rental business are more liquid than a steel plant, because a vehicle is more versatile. If one customer fails, the vehicle can be leased to another and the demand for transport is fairly stable. By contrast, a steel plant has no other uses and the demand for steel is volatile in the absence of government controls. The most liquid asset is money, because consumer goods, the ultimate purpose of production and investment, are priced in terms of money.

Uncertainty means that decisions to invest follow a logical sequence. The potential investor starts with money or an equivalent access to credit and is faced with investment opportunities. Money can be lent to others or used to purchase capital goods, either directly or indirectly, through shares. Most investors build a balanced portfolio that includes a mixture of money, debts (deposits or bonds) and shares, where they expect the net advantage from holding each asset to be the same. Given a choice between two assets, they will choose the asset with the higher return, after allowing for the risk of loss. The risk of loss includes not only the insurable risk but also the possibility that their expectation may be wrong, the liquidity risk. The less liquid an asset, the more vulnerable it is to changes in the state of expectation and the higher the premium required in its expected return to compensate.

Money, debts and shares present a hierarchy of liquidity in which money is at the top, shares are at the bottom, and debts are in-between. Debts offer a prospective yield fixed by contract, an interest rate for an agreed period. Secure debts, such as long-term government bonds, involve negligible insurable risk (i.e. risk of default) but carry a liquidity risk relative to money and other short-term debts, since their value at any time prior to maturity, which may occur in thirty years or more, depends on future market conditions.

This liquidity risk arises because the market price of a bond is different from the nominal value on which the contractual interest is paid. If market conditions change, investors can require a higher ‘yield to redemption’ or interest rate on the price they pay than the fixed interest rate on the nominal value of the bond. They obtain this higher yield by paying less for existing bonds than their nominal value. Conversely investors bid up the prices of bonds with a high nominal yield and obtain only the market yield to redemption. New bonds have to offer a nominal yield in line with current yields to redemption.

Shares are exposed not only to market conditions, in the same way as bonds, but also to uncertainty about the profitability of the underlying capital goods on the value of which they represent a claim. Thus, in terms of liquidity, the choice is first between money and debts, then between debts and shares in capital goods.

The rate of interest is, accordingly, the measure of our distrust of calculations about the future. The relevant interest rate is on long-term debts of a similar maturity to the economic life of the capital goods, such as the bonds issued by corporations and governments. Investors, especially the employers engaged in production, will expect a return on new capital goods at least to match the interest rate on bonds, allowing for higher risk and expected inflation. Hence we can draw an investment demand curve to represent an inverse relation between the rate of investment and the long-term interest rate, just as in the corn model.

Nevertheless, uncertainty changes the character of the investment decision. The difference is the defining characteristic of the entrepreneur:

Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; – though fears of loss may have a basis no more reasonable than hopes of profit had before.

(CW 7, 162)

The defining role of the entrepreneur is to create new combinations of resources, to initiate a process of creative destruction, making decisions that are crucial in the sense defined by George Shackle (1903–92) and literally change the world. Disruption is nothing new; entrepreneurs have always undermined the status quo, seizing upon new technologies, creating new products and markets, changing the way we live. Yet Joseph Schumpeter (1883–1950), who first introduced the term ‘creative destruction’ into economics, notes that the entrepreneur has no place within the classical system. Entrepreneurs are much more than the shrewd negotiators of our corn model. In the entrepreneurial decision,

everything depends upon intuition, the capacity of seeing things in a way which afterwards proves to be true, even though it cannot be established at the moment, and of grasping the essential fact, disregarding the inessential, even though one can give no account of the principles by which this is done.

(Schumpeter, 1961 [1934], 85)

Furthermore, it is not only the character of the decision to invest in physical capital goods that is changed by uncertainty. Also altered is the decision to invest at one remove through financial markets, in shares and other securities. An organised market enables individual investors to change their minds and their investments at short notice; but someone has to hold the underlying physical assets, like the Old Maid in a game of cards. Since long-term expectation is uncertain, share prices can fluctuate unpredictably and are heavily influenced by changes in market sentiment. As Keynes writes,

The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

(CW 7, 155)

In such a context it is only rational to pay more attention to tomorrow's market price than to tentative and unreliable expectations of ‘fundamental’ value, the value that, with hindsight, should be placed on the prospective yield of a capital asset. Even long-term investors who think that current prices are low in relation to the fundamentals will be better off waiting until tomorrow before they buy, if they expect that prices are going to fall. The real business of the professional investor has to be the study of market sentiment, the intentions of other investors. These intentions may bear some relation to serious estimates of fundamental value – or they may not.

Keynes illustrates the point with his famous ‘beauty contest’ metaphor. A prize is given for choosing the six prettiest faces from a hundred photographs, where ‘prettiest’ means as voted by all the competitors as a whole. He continues:

each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

(CW 7, 156)

For my immediate purpose, stock markets are largely irrelevant. Their main business is the transfer of existing assets across the portfolios of financial investors, including the buying and selling of entire companies. Investment, in the sense of demand for new capital goods, is the province of what I have called employers, dealers and landlords. Most of the finance for investment comes indeed from past corporate saving, being supplemented by borrowing from banks and from bond markets. Yet past saving simply provides a money balance to draw upon in the present and has nothing to do with current investment and saving.

Keynes believes that, while the state of long-term expectation can be volatile and vulnerable to speculation, it can also be steady for long intervals. For this reason he continues to regard the rate of interest as important for investment, so I turn now to his theory of what does determine the rate of interest, since it has nothing to do with saving.

Money and the Interest Rate

Keynes holds that the long-term rate of interest is the measure of our distrust of calculations about the future. It was convenient for Keynes to draw the line between long-term bonds and other capital assets because UK or US government bonds carry no risk of default in terms of their own currency and offer only liquidity risk, so that their interest rate (strictly, the excess over short-term deposit rates) represents the premium required to overcome liquidity preference, the aversion to that risk. He draws this line also in order to identify correctly the role of the interest rate in a monetary economy and to contrast this with the classical theory.

On the basis of the confusion of money with saving (Robertson) or of the tacit assumption of a corn model (Hicks), the classical theorists invite us to consider the interest rate as the price that matches an inflow of loanable funds into the bond market with an outflow drawn by borrowers. Keynes points out that, rather than balancing inflow and outflow during an interval of time, the interest rate balances the total demand to hold money with the actual stock of money created by the banking system and outstanding at any point in time.

The demand for money derives from its functions as a means of payment and a store of value. While in practice a particular sum of money may be held for a mixture of motives, the demand for means of payment is created by the timing of receipts and payments in the ordinary course of daily life. There is no material difference between Keynes and the classicals over these ‘active’ balances. Where he parts company is over the demand for money as a store of value, as idle or ‘inactive’ balances, also called ‘hoards’.

The very word ‘hoard’ suggests a pathological miserliness. The classical theory sees no role for hoards beyond the short-term need for means of payment; surplus money should be lent at interest. For Keynes, the rational ground for holding money (i.e. a bank deposit, which may offer some interest) purely as a store of value – rather than lending the money for (additional) interest guaranteed by the state – is the liquidity risk on long-term bonds.

The risk is partly that a bondholder will incur a loss if there is an unexpected need to sell before the bond matures, if market interest rates have increased. For Keynes, this precautionary demand is overshadowed by the speculative demand from the professional investors, including banks, who seek to profit by anticipating changes in market conditions. The speculative demand is the one that adjusts to bring the demand for money into line with the stock created by the banks. Put more colourfully, it is the propensity to hoard that adjusts to accommodate the size of the available hoard.

If an excess demand for money, a shortage of liquidity, comes about, those who need liquidity are prepared to sell bonds, new or old, at a lower price (meaning a higher yield to redemption or market interest rate) in order to obtain money. Other investors become willing to buy more bonds and hold less money, if today's interest rate is bid up above the level they expect to prevail tomorrow. In aggregate, the higher interest rate allows a given stock of money to be transferred from those willing to reduce their demand for money to those with an increased demand. Speculators expect that, when the shortage of liquidity is eased, bond prices will rise again and their holders will make a profit.

Keynes is concerned with equilibrium at a point in time: today. Given the state of confidence in long-term expectations, there will be a convention in the market that a particular long-term rate of interest is normal. Keynes argues that the speculative demand for money varies inversely with the difference between today's rate of interest and the conventional norm. As today's rate of interest rises, the speculative demand falls, and vice versa.

The conventional norm reflects the state of confidence. If investors are very confident about future interest rates, the long-term rate of interest can be very low, as at present. In Keynes's time, he argued correctly that the convention could be managed downwards to bring about a regime of ‘cheap money’, provided that the regime itself was perceived as stable and sustainable.

Conversely Keynes points out that in earlier times, before the creation of central banks and of a corresponding well-organised bond market, the rate of interest could remain stubbornly high. Indeed he argues that, historically, banking developed in response to a shortage of liquidity. The money stock increased to meet the demand for means of payment. The signature of a banker on a bill of exchange unlocks the timing differences between deliveries of goods and services, or between spending and taxation. Bankers convert debts into money. Saving plays no part in the matter.

IS–LM: The Model as Trap

Hicks created a simple model to represent the key message of The General Theory as he saw it. The IS (investment–saving)–LM (liquidity–money) diagram has had a profound effect on the teaching of economics, as great as that of the Keynesian cross discussed in chapter 3. For many, IS–LM is Keynesian economics. Its resemblance to a standard supply and demand diagram makes it very accessible to students. While Keynes himself acknowledged that it was formally correct, so far as it goes, the diagram can be interpreted, as Hicks intended, to argue that The General Theory is only a special case within classical theory. As we have seen with the Keynesian cross, the same diagram can represent quite different economic theories.

The formally correct version of the IS–LM diagram (Figure 4.1) is drawn with income (Y), measured in wage units, on the horizontal axis and the long-term money rate of interest (i) on the vertical axis. Two curves intersect to define equilibrium values (Y*, i*). The IS curve (here drawn as a line, for simplicity) plots the values of income that correspond to each value of the interest rate. Income varies because investment changes with the interest rate and, through the multiplier, determines a change in effective demand and income. The IS curve is downward-sloping because investment and income increase as the interest rate falls.

Figure 4.1 The IS–LM diagram

The LM curve plots the interest rate that corresponds to each value of income. The interest rate rises with income, because the demand for money as means of payment rises with the volume of business. The supply of money – again, measured in wage units – is given. With less money available to satisfy the demand for money as store of value for precautionary and speculative motives, the price of bonds must fall and the interest rate rise to make bonds more attractive than money. With investors more willing to hold bonds, the demand for money as store of value reduces to match what is available.

The diagram is telling us that only one pair of values of income and interest rate is compatible both with the equilibrium of aggregate demand and supply (‘the goods market’) and with equilibrium in the supply and demand for money (‘the money market’). The diagram is used to teach the effects of autonomous changes in demand (horizontal shifts of the IS curve) or of changes in the supply of money (vertical shifts of the LM curve), leading to different equilibrium pairs (Y*, i*). More detailed stories can be told about the sensitivity of income to changes in the interest rate (the slope of the IS curve) and the sensitivity of the demand for money to changes in the interest rate (the slope of the LM curve).

One important story is that, unless the LM curve is horizontal, an increase in aggregate demand (whether private investment or government deficit spending) will raise interest rates. In Figure 4.2, the horizontal shift in the IS curve to IS′ increases equilibrium income only to Y₁*, corresponding to higher interest rate i₁*, rather than to Y₂*, as it would if the LM curve were horizontal (drawn as LM′), meaning that the interest rate remains at i*.

Figure 4.2 The IS–LM diagram and crowding out

This conclusion, drawn as it is both from a Keynesian (IS–LM) model and from the classical model, is claimed to support the generality of the loanable funds theory. It means that government deficit spending will crowd out private investment, the classical argument against government intervention to increase employment. Nevertheless, the underlying mechanism is entirely different from the classical. If income increases because of an increase in the propensity to consume, without any reduction in the level of aggregate investment and saving, the rate of interest will rise with the income, because of the increased demand for means of payment. The correct conclusion is that the central bank should not choke off an increase in real income by allowing interest rates to rise, whatever its source. There is a shortage of money, not of saving.

The most serious problem with the diagram is that it can be interpreted in purely classical terms, the IS curve representing the market for loanable funds and the LM curve the quantity theory. Mankiw and Taylor (2014) argues that the IS curve slopes downward because saving rises with income and drives down the interest rate to bring investment into equilibrium with saving. The LM curve slopes upward because a higher interest rate increases the velocity of circulation of money (see chapter 5) to support a higher income.

Thus the IS–LM diagram contributes to the continuing confusion about the nature of Keynes's contribution and the convention that it is a special case of classical theory. A helpful suggestion is to rename the diagram as IY (investment–income)–LM, so that at least it becomes clear that saving has nothing to do with the matter (O’Donnell and Rogers, 2016).

Money and Saving: A Back Door?

The last hope for Say's law is the idea that an increase in the quantity of money affects not only the rate of interest but also – and directly – the propensity to consume. In particular, since we are looking for an automatic adjustment brought about by the competition in supply and demand, we note that the quantity of money is increased in real terms (i.e. when measured in wage units) if the price level falls. Keynes accepts that unexpected windfalls can increase the propensity to consume a given income. The wealth of a holder of money increases with the value of the money she holds. In this way, might not the gap between investment and full-employment saving be closed? It was once quipped that the entire output of the United States could be bought for a dime, if prices and wages fell far enough.

This so-called Pigou effect does not stand up to theoretical or practical scrutiny, yet it still appears in textbooks. The suggestion is that, if prices and wages are allowed to fall across the board in the presence of general unemployment, consumption will increase in real terms in order to restore full employment. Note that we are no longer discussing a single price that brings investment and saving into balance in a capital market but a simultaneous fall in a multitude of prices, each governed by supply and demand in a particular market.

In a modern economy, all money is a debt. Even coins are government IOUs that can be set against taxes. My creditor's gain from deflation (falling prices) is my loss, since the value of my debt in terms of my wages has increased. Key prices like housing rents are fixed by contract for long periods. The government may have to raise tax rates as prices fall, in order to service its fixed money debts. Deflation redistributes wealth from debtor to creditor, which often enough is from poor to rich. Unless all prices and incomes are marked down simultaneously, as in a monetary reform, deflation causes destitution, bankruptcy and disruption to production, reducing income. The alternative to a monetary reform as the precondition for a Pigou effect is a bank-free and debt-free economy – precisely what a monetary economy is not.

To the extent that an increase in the real value of the quantity of money can address a shortage of aggregate demand, the same result can be achieved more easily by increasing the quantity of money rather than by cutting wages and prices. Keynes objected to Churchill's return to the gold standard in 1925 because it prevented such an increase in the quantity of money, requiring instead a policy of industrial warfare to impose wage cuts. Either way, the state must act; there is nothing automatic about it.

Summing Up

In the corn model with tickets, investment and saving plans are brought into balance by the rate of interest (on loans of corn tickets). The attempt to include money in the corn model leads to the confusions of the loanable funds doctrine, in which newly created money adds to saving. Both versions of the corn model fail to capture the true nature of a monetary economy in which there are many goods, not just corn.

In a monetary economy, time really matters. There is a vast difference, not recognised in the classical model, between short-term and long-term expectation. Short-term expectation is about the value of the goods that are in production today. Long-term expectation is about the value of the goods that will be produced in the future with the new capital goods ordered today.

Classical theory tacitly assumes that there is no difference, so that you can place an order today for the delivery of a pair of shoes to your unborn grandchild. The assumption of forward markets for the long term, and not simply the short, is what permits the classical trade-offs between present and future consumption and between work and leisure. Without these markets, there is no channel through which Say's law can operate.

Lacking firm backing by customer orders, long-term expectation becomes fundamentally uncertain. There is no room in the classical model for uncertainty, animal spirits, confidence or liquidity preference; there is no room for either the entrepreneur or the miser. The classical model tacitly assumes that all risk is insurable, that the past and the present are reliable guides to the future within the limits of random error. Without uncertainty, investment becomes a very pedestrian affair and Keynes's concept of liquidity is incomprehensible.

Liquidity means, first and foremost, that an asset keeps its value when the state of long-term expectation changes: it is a safe haven in a storm. Capital assets, including debts, possess liquidity to varying degrees. There is a hierarchy of liquidity, in which money (including short-term deposits) ranks above long-term debts or bonds, which in turn rank above physical capital goods. Investors must first decide between holding money or holding bonds; only then must they choose between bonds or capital goods. The rate of interest is, first, the price needed to get investors to hold bonds rather than money and, next, as in the classical model, the benchmark against which new capital goods must compete.

In a monetary economy, the rate of interest is not determined by saving; it is a matter solely of money and finance. The rate of interest brings the demand for money into balance with the stock of money created by the banking system; it cannot reconcile saving and investment, as in the corn model. There is no other mechanism by which Say's law can hold.

Keynes's primary concern was to refute the claim of classical theory that a monetary economy tends automatically towards full-employment equilibrium. This chapter has concentrated on the rate of interest because of the central role this rate plays in maintaining the total demand for full employment output in classical theory. Nevertheless, the key insight is that investment creates saving. As James Meade (1907–95) puts it:

Keynes's intellectual revolution was to shift economists from thinking normally in terms of a model of reality in which a dog called savings wagged his tail labelled investment to thinking in terms of a model in which a dog called investment wagged his tail labelled savings.

(Meade, 1975, 82)

Furthermore, the investment dog has a will of its own, only weakly restrained or led on by changes in the rate of interest. Investment is largely an independent variable, governed mainly by forces other than the rate of interest, which lie outside the model. Although Keynes himself did not go much further than this, he paves the way for a full-bodied theory of investment, in which entrepreneurs and financiers come to life in their pursuit of new technologies and markets and in which boom and slump, confidence and crisis, are recognised as the stuff of capitalism.

Note

1 Hicks makes much of the difference between plan and outcome. He interprets a rise in dealers’ stocks as the sign of an excess supply of goods, to which there must correspond an excess demand either to hold or to lend money. He argues that an excess demand to lend will drive down the interest rate and stimulate investment and consumption, tending to raise income and employment. Accordingly, if we start from full employment, a temporary shortfall in aggregate demand (a fall in consumption and rise in planned saving, leading to increased dealer stocks) will reduce the interest rate and restore aggregate demand to full employment equilibrium by increasing the planned investment to match the increase in saving. Say's law is maintained. Although Hicks (1939) presents a sophisticated general equilibrium model with multiple goods, his argument amounts to the corn model. There we can see that an increase in saving means either holding on to extra corn tickets (which is investment in itself) or offering them to farmers in the capital market, reducing the interest rate. Whether stored in the granary or planted in the fields, the extra saving will be invested. Hicks writes: ‘If [the state of expectation is] given, the demand for securities can be taken as formally equivalent to a demand for given quantities of physical commodities to be supplied in the future; the price of these commodities (the only part of their price which can vary) being the rate of interest … the individual behaves exactly as if he were buying the commodities now’ (1939, 249). It is precisely to this claim that Keynes objects, as will be seen in the following section.

5 
The Long Struggle to Escape

Keynes was always a monetary economist. For most of his working life he was a ‘monetarist’ in the sense that he considered the cause of inflation to be an excessive quantity of money. The relationship between money and inflation was one of his central concerns and, despite some of his own statements and the policies of some of his followers in the United States, he was not in favour of printing money to fund government spending. In The Economic Consequences of the Peace he wrote: ‘Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency’ (1919, CW 2, 149) – something that Keynes, unlike Lenin, did not advocate.

In A Tract on Monetary Reform, published in 1923, he accepts the quantity theory of money and prices as ‘fundamental. Its correspondence with fact is not open to question’ (CW 4, 61). His three major works of economic theory – A Tract, A Treatise on Money in 1930 (CW 5–6) and The General Theory in 1936 (CW 7) – can be understood as an extended process of working out the precise mechanism and limits of the relationship between money and inflation. How to Pay for the War, published in 1940 (CW 9), was all about the control of inflation, although by this stage Keynes was no longer a monetarist.

This chapter charts the development of Keynes's thinking as he struggled to escape from the theory of money and prices, which lies on the other side of the classical dichotomy from the theory of value and distribution I have mainly considered so far. Starting from the quantity theory of money, as introduced in chapter 2, I follow in outline his painstaking analysis of its key elements. Keynes clarifies that too much money chasing too few goods can only mean an excess demand for goods and is not the automatic outcome of an increase in the quantity of money. Yet his analysis was used in the first instance to restrain demand and contain inflation in the United Kingdom during the Second World War. It will no doubt come as a surprise to some that Keynes advocated something very much like today's policy of inflation targeting.

The Quantity Theory

The relation between money and inflation (meaning increasing prices) is traditionally defined by a quantity equation. In the terms of our corn model with money, we can imagine that the granary is only a temporary resting place for the harvest. The farmers deliver the corn and receive £1 per peck, which they use to pay workers, landlords and lenders. The annual labour, land and capital market days take place and all the corn is sold at auction. If the granary creates more money than the value paid for the harvest by making a loan to the state, and if all the money is spent, the auction price of corn must rise above the harvest price. We can write down the quantity equation as:

– where M is the total quantity of money created (often called the money supply), O is the volume of net output (corn in the granary) and P is the price of corn. Since O is predetermined, an increase in M (ΔM) must be associated with an increase in P (ΔP).

Monetarism holds that causation runs from money to prices in this fashion. Accordingly, inflation can be controlled by controlling the quantity of money (the quantity theory). Many post-Keynesian economists argue that causation in the quantity equation runs the other way, from prices to money, so that the quantity of money rises to accommodate inflation. In our example, this could mean that workers would demand and get higher money wages and that farmers rather than the granary would set the harvest price. The granary would then have to create more money than in the previous year, in order to purchase the harvest at the higher price.

The first case, in which an increase in money spending raises prices – ‘too much money chasing too few goods’ – is called ‘demand-pull inflation’. The second, in which an increase in wages and prices requires more money to be created, is called ‘cost-push inflation’. The quantity equation itself says nothing about causation. In claiming a causal role for money, Keynes was maintaining that its quantity is under the ultimate control of the central bank and the state. In other words, he sees it as a political choice whether to accommodate cost-push inflation by allowing the quantity of money to increase.

The quantity equation is usually written slightly differently:

T (for transactions) recognises that money is spent on existing as well as on newly produced goods. Mathematically V is just a scale factor that makes the equation balance. However, the traditional quantity theory (in the form expounded by Irving Fisher, 1867–1947) uses the term ‘velocity’ to interpret V as the number of times money is spent during a period of account. Velocity is the speed at which money circulates from hand to hand. Thus employers pay workers, workers pay dealers, dealers pay employers, and so round again.

In our corn model example, V = 1. More generally, workers might be paid monthly, shopping might take place daily, deliveries of goods to dealers might be weekly, and so on. There is a demand for money as a means of payment to bridge these intervals. The timings are determined by the needs of production, by the structure of trade credit, and by custom and habit and are unaffected by the amount of money spent. If there is no other reason to hold money, rational people will either spend it or lend it to others who will spend it. So an increase in the quantity of money will increase spending and, since net output and existing stocks are predetermined, prices rise.

Keynes in A Tract and A Treatise on Money follows Marshall and Pigou in interpreting the scale factor rather differently. The ‘Cambridge’ quantity equation can be written:

– where mathematically k is simply 1/V but its meaning is quite altered. k is the amount of purchasing power – the amount of money (M), divided by the price of goods (P), effectively the quantity of goods that money can buy – that people wish to hold in the form of money as a proportion of their real income or net output (O). The Cambridge approach moves away from a mechanical interpretation of the Quantity Equation in terms of payment patterns towards a more general theory of the demand for money.

Keynes's entire work from A Tract to The General Theory could be described as an exhaustive investigation into the nature of and relationship between the four variables M, k, P and O. I follow this template in what follows. First, what exactly is money?

The Definition and Nature of Money (M)

‘Control the money supply’ cries the monetarist – but which one? In the United Kingdom, there are coins issued by the Royal Mint; notes issued by the Bank of England and by Scottish and Northern Irish banks; and sterling deposits at the Bank of England. These, together, Keynes calls ‘state money’. Then there are sterling deposits at private banks, whether repayable on demand (current) or at fixed terms, which Keynes calls ‘bank money’.

The Bank of England used to define a host of M's, from M0 to M5, with variants of each. Each of these measures of money can grow at quite different rates. An attempt to restrict or expand the quantity of state money may have no influence on the quantity of bank money. Does monetarism fail at the first hurdle?

In A Tract Keynes discusses the European inflations after the First World War in terms of state money. He demonstrates how printing money (literally as banknotes) allows a government that lacks the power or means to collect explicit taxes (as in Germany, or in the Soviet Union in the 1920s) to impose an inflation tax. In our corn model example, the state owns the granary, so that the inflation tax accrues as the difference between auction and harvest prices. This profit or ‘seignorage’ equals the amount of the granary's loan to the state, so the state remains solvent, provided that the banknotes cannot be ‘cashed in’ for corn.

Keynes shows that such a policy can be sustained, provided that the state does not push it too far. Although hyperinflation leads people to minimise the amount of purchasing power they hold (k falls) by spending it as fast as they can, money survives as long as prices continue to be expressed in terms of money. If the state collapses, the alternative is not a barter economy but the adoption of a foreign currency for domestic prices and transactions, for example dollarisation.

While Keynes argues that inflation may be sustainable as a method of taxation, he is in no doubt that it is inequitable and dangerous. Not only does inflation impose a stealth tax on workers and pensioners on fixed incomes, it redistributes wealth from all creditors to all debtors, not only to the state. Savers who hold or have lent money find the reward of their thrift evaporating. A businessman who owns goods and owes money becomes a profiteer rather than a captain of enterprise. Keynes writes: ‘No man of spirit will consent to remain poor if he believes his betters to have gained their goods by lucky gambling … The individualistic capitalism of today … presumes a stable measuring rod of value, and cannot be efficient – perhaps cannot survive – without one’ (CW 4, 24 and 36).

From state money we turn to bank money. A deposit with a bank is a sum of money owed to the depositor, a debt. In fact at present all money is a token of debt, including coins and the bank notes issued by the central bank. The note says ‘I promise to pay the bearer on demand the sum of ten pounds’. What, then, is a pound, and where do pounds come from? Furthermore, how does money differ from any other debt? If I write an IOU for £10, is that money too?

Most money in circulation is bank money; notes and coins account for only 4 per cent of M4, the Bank of England's current measure of broad money. Banks create money by lending. The direct relationship between state finance and state money that existed in the Weimar Republic does not apply to the growth of bank money, which mainly reflects lending to the private sector rather than to the state. When a bank grants a loan, its customer agrees to repay a sum of money and in return the bank credits this sum to the customer's account. Two equal and opposite debts are created. The customer can then spend the money in the bank account by transferring this claim against the bank to someone else. No cash need come into the matter; there is no need to withdraw cash in order to pay someone else.

The bank's debt can be used as a medium of exchange because it is transferable. So too is an IOU, so where is the difference? From the monetarist perspective, where is the line to be drawn between money and other debts and what is to stop banks from creating money without limit?

In A Treatise on Money, Keynes argues that the state defines the ‘thing’ that answers to the ‘description’ of money, for example a pound, a dollar or an euro. Money can exist only in relation to a money of account (the description) in which prices and debts are expressed. The pound has been a unit of account since the time of Charlemagne. Yet in 2017 the pound coin changed from round to twelve-sided; Jane Austen now graces the £10 note instead of Charles Darwin. In the eighteenth-century North American colonies, when the sovereign state was remote, prices were still expressed in shillings (£1 = 20s), but the means of payment could be dried fish or tobacco. The rate of exchange between shillings and fish or tobacco was fixed by the local legislators and tax authorities.

What distinguishes money is that a creditor, including the state itself when owed taxes, cannot refuse payment offered in the form of the ‘money thing’. This normally applies even when that thing is simply another debt, whether of a bank or of the state itself, as in the case of a £10 note. Payment is not a matter for negotiation, as it is in the case of anything else used as a medium of exchange, such as IOUs or indeed foreign currency, cigarettes or bitcoins. Keynes recounts the tale of the British imperial official in Uganda required to judge whether a particular goat represented a standard goat for the purpose of settling a local debt (expressed in goats), presumably because the creditor did not like the look of it.

This characteristic of money as the means of final settlement helps to explain why it continues to be used during a hyperinflation. In a monetary economy incomes are received in money. Even a barrow load of money is more convenient as a medium of exchange than a sack of ball bearings. Civil servants and the military can be paid only in money. Most suppliers of goods and services must continue to accept money if they are to sell anything and in turn to settle debts for labour and materials. The haggling is limited to the money price of the goods and services purchased, judged in relation to the rising money prices of other goods and services, rather than having to extend also to the value of the medium of exchange itself.

The quantity of bank money depends on the relationship between the private banks, the central bank and the state itself. Private bank money is acceptable when there is no doubt that it can be converted into state money. Traditionally, UK banks were run conservatively, in order to maintain confidence that they could meet any claim with state money. This was certainly the case during Keynes's time, although bank failures did occur from time to time.

Bank runs such as Northern Rock's in 2008 happen when doubt arises. Bank runs have become much less frequent since the introduction of an explicit or implicit state deposit guarantee. The state will only insure deposits with approved institutions. The need for approval allows the state to regulate the private banks and in principle to control the amount of bank money.

The Bank of England's power initially rested on its ability to lend state money to the private banks at a time of crisis and to set the interest rate (known as ‘Bank Rate’). The US Federal Reserve Board was formed to play a similar role but was unable to stop a series of bank failures prior to the introduction of a federal deposit insurance in 1933. The central bank will lend to private banks only against good collateral. Bankers need enough capital to withstand losses on private lending. If they lend too much and their losses are too great in a crisis, they can be left with insufficient collateral for the central bank to bail them out. Thus deposit insurance has to be accompanied by active bank supervision to keep lending risk in line with capital.

Keynes is clear that, while the relationship between central and private banks is complex, the quantity of money is a matter of overall banking policy, which includes (in modern parlance) questions of regulation and capital adequacy. The ultimate decision to lend and create money lies with the banking system as a whole, not with its borrowers. Thus the quantity of money is not a passive variable that responds to the needs of production, as some post-Keynesian economists maintain.

One of the complexities is that the central bank has to choose whether it will control the quantity of state money or the price at which it will supply state money to the private banks – that is, Bank Rate. These days the emphasis is on using Bank Rate to influence the total amount of bank lending (and therefore of bank money), while lending state money to the banks as required, so as to ensure that all payments can be made. Nevertheless, after reducing Bank Rate to near zero after 2008, central banks themselves created state money by purchasing government debt and some private debt; this process was called ‘quantitative easing’. Thus the proportion of state money in the total quantity of money increased sharply. Although state money remains a small proportion of the total, it plays an important role in maintaining the cash reserves of the private banks.

The Bank of England used to maintain another measure of money, M5, which added to M4 bank deposits with fixed terms over five years, which cannot be withdrawn as state money on demand. In what sense are such deposits money? Here the concept of money moves beyond means of payment towards store of value. The original name for M5 was private sector liquidity. This leads us to Keynes's analysis of the demand for money.

The Demand for Money (k)

Traditional quantity theory considers the demand for money solely as means of payment, as a store of value until the next payment falls due. This still leaves room for reserves of money (or ‘hoards’) to meet payments at an indefinite date. What matters is that these customary patterns of payment and reserves lead people to hold a stable amount of purchasing power in the form of money as a proportion of income (the Cambridge k). Given the Cambridge quantity equation (see p. 79 in this chapter), a stable demand for ‘real balances’ (kO) implies a direct relation between the quantity of money (M) and the price level (P).

In A Tract Keynes begins to develop a more sophisticated analysis. First he rewrites the quantity equation so that it can take explicit account of bank money:

– where n is the quantity of state money (cash), p the price level, k the public demand for purchasing power as cash, k′ the public demand for purchasing power as bank money and r the banks’ demand for cash reserves to meet withdrawals. The equation expresses the demand for cash, which arises both directly and indirectly, through the banks’ need to hold a cash reserve against their customers’ deposits. The level of net output does not appear and is tacitly constant.

Keynes then questions the assumption of the quantity theory that k, r and k′ are constant and independent of changes in n, and therefore in p. He argues that these factors vary in the short run, even if they may be stable in the long run. This is the context in which he writes his most famous dictum: ‘In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again’ (CW 4, 65). His comment was not about The General Theory, as might be expected, but about the quantity theory!

The sources of variability are several: the tendency of central banks to hang on to gold receipts and to part with them reluctantly; the farmer's difficulty to distinguish a rise in incomes that is due to an increase in produce prices from a general inflation; and the reduction of k in the face of hyperinflation, discussed earlier. Keynes distinguishes an inflation of cash (n) from one of credit, defining the credit cycle as a tendency of k and k′ to fall in the boom and rise in the slump – a fall and rise in real balances, measured in purchasing power. Thus inflation can arise either from an increase in the quantity of money or from a fall in the demand for money. Conversely, deflation can result not only from a fall in the quantity of money but also from an increase in the demand for money.

This analysis leads Keynes to the conclusion that the stability of the price level (or of the rate of inflation, in a modern context) requires a discretionary monetary policy. It is not enough to control the quantity of state money or the reserve policy of the banks. One must also offset the cyclical changes in the public's habits, if necessary by varying the quantity of state money and the reserve policy of the banks. He reaches this conclusion without questioning the essence of the quantity theory – namely that money causes inflation.

In A Treatise on Money Keynes takes another step forward and changes his scheme of classification. Now ‘cash deposits’ include bank money held as means of payment (‘income’ deposits M₁ and ‘business’ deposits M₂), while ‘savings deposits’ M₃ are bank deposits held as investments. M₁ + M₂ + M₃ = M, the total stock of money (M5 on the Bank of England's definition).

The total demand for purchasing power (k + k′ in A Tract) is now divided in A Treatise between k₁ and k₂, the respective proportions of income and business deposits to net output, which now makes its appearance. There is no k₃, because the quantity of savings deposits M3 bears no steady relation to the level of net output. Rather, M3 is governed by fluctuating perceptions of the relative attractions of money and securities as investments.

After a detailed analysis, Keynes concludes that income deposits M₁ and business deposits M₂ can be treated together as the ‘industrial circulation’, varying as it does with money income, and savings deposits M₃ as the ‘financial circulation’. When we reach The General Theory, the classification becomes further simplified; the demand for money from the industrial circulation becomes M₁ and the demand from the financial circulation M₂, such that M₁ + M₂ = M.

It is in the analysis of the financial circulation in A Treatise on Money that Keynes starts to move away from the traditional quantity theory. The ‘bulls and bears’ of the stock exchange and the speculative demand for money make their first appearance. The main difference from The General Theory is that in A Treatise on Money Keynes does not distinguish between bonds and equities, or between the long- and the short-term rates of interest. The concept of liquidity makes an entrance but is not fully developed. A term savings deposit is liquid, not because it can be easily converted into means of payment (since it cannot), but because its value is certain in terms of money.

In a complex analysis he examines how ‘the state of bearishness’ affects the demand for money. A strong bull market will reduce the demand for money and a strong bear market increase it – in the first instance. However, if the consensus breaks down and opinion divides between bulls and bears, some borrowing from banks to buy securities and others selling securities to hold bank deposits, the financial demand for money can move either way. What is clear is that the financial demand need not relate directly to the industrial circulation. Again, Keynes calls for discretion in the use of monetary policy in order to protect the industrial circulation from the vagaries and fluctuations of the financial circulation. He argues that the central bank should provide state money to the system as required and should use Bank Rate to control the rate of physical investment, so as to avoid fluctuations in prices and output.

At this point Keynes still remains committed to the quantity theory, in the sense that he regards the money available to the industrial circulation as the ultimate determinant of the price level. However, the source of his final break with the quantity theory is also to be found in A Treatise on Money. It lies in his detailed analysis of the relationship between money, spending, prices and output. The quantity equation, in its various forms, describes positions of static equilibrium. In A Treatise on Money, Keynes still accepts the quantity theory's concept of long-run equilibrium but seeks to explain the dynamic process of change over time, by which a monetary economy moves from one equilibrium price level to another. He rises to the task he set economists in the famous passage from A Tract quoted above: what causes the storm and disturbs the equilibrium?

In place of the quantity equation, Keynes puts forward two fundamental equations. These start not from the quantity of money, but directly from the income that results from the expenditure of money and the balance between the components of income and expenditure. This raises the question of what we mean by ‘price level’ in the quantity equation.

The Meaning of Price Level (P)

In A Treatise on Money Keynes distinguishes two price levels: the average price of consumption goods, which corresponds to the purchasing power of money, and the average price of investment goods. Where the quantity theory considers only a single average level of prices, Keynes's fundamental equations allow for different causal mechanisms to determine the two price levels. This represents a first step away from a corn model of net output.

The first fundamental equation determines consumer prices and the second determines the overall price level (the concern of the quantity theory) as an average of consumer and investment prices. The notation of the equations is complex and confusing in the light of The General Theory, hence the equations themselves will not be reproduced here. At their core is the idea that disequilibrium denotes an imbalance between the division of production on the one hand and of spending on the other, between consumption and investment: put another way, an imbalance between investment and saving.

This creates a major confusion for today's reader. We know that in The General Theory Keynes insists on the equality of the values of aggregate investment and saving. By contrast, in A Treatise on Money Keynes insists that they can be different; in fact the difference defines disequilibrium and causes the move from one overall price level to another.

In A Treatise on Money Keynes is still wedded to the long-run equilibrium of classical theory. With this comes the concept of ‘cost of production’, which corresponds to the ‘normal’ level of income from production in equilibrium. This concept allows Keynes to define profit as the difference between investment and saving.

By ‘profit’ he means a windfall or temporary profit above what businesses can normally earn, which can only exist in disequilibrium. Profit is the signal that prompts entrepreneurs to change their level of production and to move the system to restore equilibrium at the same price level or at a new one. In terms of his later definitions in The General Theory, Keynes excludes profit from income and saving, which is what allows investment and saving to be different.

Profit (Q) has two sources, which correspond to the two price levels. Profit from producing for consumption (Q₁) arises when the cost of production for investment (I′) exceeds saving (S). Profit from producing for investment (Q₂) arises when spending on investment (I) exceeds its cost of production (I′). Thus:

Profit on consumption output (Q₁) arises when saving falls short of the income from producing investment output. This is the same as consumer spending exceeding the cost of production of consumer goods, so that consumer prices rise. Profit on investment output (Q₂) arises when the price of investments, both old and new, rises above the cost of their production. This happens when investors become ‘bullish’, preferring securities to savings deposits. The price of investments is the outcome of the interplay of ‘the state of bearishness’ with the lending policy of the banks.

Keynes uses four terms to distinguish different types of inflation. ‘Commodity’ and ‘capital’ inflations are, both, examples of ‘profit inflation’. A commodity inflation reflects the emergence of profits Q₁ and means that consumer prices are rising above the cost of production. A capital inflation reflects the emergence of profits Q₂ and means that investment prices are rising above the cost of production. An ‘income inflation’ means that the cost of production itself is rising, which broadly means that wages are rising.

Equilibrium means that investment equals saving and total profits Q are zero. Keynes shows that in this case the second fundamental equation reduces to the traditional quantity equation. Thus at this point he regards himself as still working within that framework. A Treatise on Money fills in the gaps between states of equilibrium, explaining how equilibrium is restored.

Keynes follows Knut Wicksell (1851–1926) in treating the market rate of interest as the price that brings investment and saving into equilibrium, when it equals the ‘natural’ rate captured by our corn model. Wicksell recognises that the natural rate is not fixed and may vary for classical reasons. For example, an increased propensity to consume reduces saving and requires an increase in the natural rate, in order to reduce the investment to match. Alternatively, better expectations of yield may increase the marginal product of capital and the demand for investment at the previous natural rate. Unless saving rises to match, the natural rate must rise in line with the increased marginal product of capital. Thus for Wicksell disequilibrium – a state where the market and natural rates are unequal – may arise for various reasons, including fluctuations in either the natural or the market rate of interest. In all cases it is the market rate of interest that must move to restore equilibrium to the price level, since the natural rate is determined by real forces.

Starting from equilibrium, an increase in the quantity of money reduces the market interest rate and increases investment prices; this means capital inflation. The profits lead entrepreneurs to increase output and employment and to bid up wages, which leads to commodity and income inflation. The rise in the cost of production increases the demand for money by the industrial circulation until it matches the increased quantity of money, by when the rate of interest returns to its starting point. Although there may be further repercussions, eventually profits return to zero and the new overall price level matches the increased cost of production. The increase in the quantity of money has duly translated into an increase in the price level, in accordance with quantity theory.

The Level of Net Output (O)

The seed of the break with the quantity theory in the analysis of A Treatise on Money is the explicit allowance for changes in the level of net output. These changes play the key role in altering the cost of production through an income inflation or deflation. Over- and underemployment are the source of a rise and fall in wages.

Keynes now defines the credit cycle, unlike he did in A Tract, in terms of commodity inflation and deflation, which corresponds to a cycle in the purchasing power of money, of consumer prices around the cost of production. Although credit cycles unfold with as much variety as games of chess, a typical cycle begins with a ‘shock’ such as a technical innovation, which makes investment more attractive. Investment prices rise, profits (Q₂) appear and investment output and employment increase. Consumer spending and prices rise and profits (Q₁) appear, stimulating consumption output. The profits lead entrepreneurs to expand employment by offering higher wages, raising the cost of production. Thus a capital inflation leads to a commodity inflation and from there to an income inflation.

The capital inflation creates a bull market in securities, reducing the demand for savings deposits and releasing money to the industrial circulation, reducing interest rates, and further stoking the demand for investment. Meanwhile the commodity and income inflations make increasing demands upon the industrial circulation, tending to raise the interest rate.

Eventually the boom breaks as interest rates rise, capital inflation turns to deflation and the demand for savings deposits increases sharply. The industrial circulation is squeezed, and interest rates also rise sharply; the cycle ends in a crisis. Now the process goes into reverse, profit deflation leading to unemployment and to income deflation. As the cost of production falls, interest rates fall, investment prices recover and equilibrium is restored – at the original price level and cost of production, unless the quantity of money has changed.

In A Treatise on Money, it is the level of output that plays the key role in changing the cost of production. Over- and underemployment are the source of the rise and fall in wages. However, neither A Tract nor A Treatise on Money contain a new theory of the level of output as such. Tacitly, the equilibrium level of output represents full employment in the classical sense and the analysis considers only temporary departures from that position.

Nevertheless, the analysis in A Treatise on Money leads to some pregnant asides. Since a commodity inflation produces an increase in profits (Q₁), the entrepreneurs to whom these profits accrue can increase their profits by increasing their consumption. No matter how much they devote to riotous living (as a class, at any rate), their aggregate profits will keep pace with it. Conversely, in a commodity deflation, entrepreneurs cannot in aggregate reduce their losses by reducing their consumption; the widow's cruse that can never be emptied becomes a Danaid jar that can never be filled.

Keynes illustrates this further with his ‘banana parable’. A thrift campaign in a community of banana farmers leads to a fall without limit in production, and the entire population starves to death. In these stories we have the beginnings of a theory of aggregate demand. What is missing from them is the idea that output can find a different equilibrium, below full employment, rather than falling to zero. That is the contribution of The General Theory.

The Quantity Theory and The General Theory

Money can cause inflation only if it leads to increased spending on a given net output. A Treatise on Money offers a sophisticated account of how money influences spending and how changes in spending can result from changes in the demand for money (the credit cycle) without a change in the quantity of money. While output can change in the short run in response to spending, the fundamental equations intrinsically assume that net output always reverts in the long run to an equilibrium position, the classical full employment equilibrium.

Thus the quantity theory is preserved for the long run even if the relation between money and inflation is more complex in the short run. Keynes's analysis can be interpreted as a study of changes in the velocity of money within the framework of the quantity theory. Milton Friedman wrote approvingly of A Treatise on Money.

The break with the quantity theory comes with the elimination of the distinction between the short run and the long run. In The General Theory net output and employment are always in equilibrium, as determined by the principle of effective demand. One may no longer speak of short-run disequilibrium fluctuations from classical long-run full employment. Output and employment may change from day to day, but they move from one position of equilibrium to another. The long run is no more than a series of short runs.

In the place of quantity theory, the relation between money and inflation becomes a compound of responses: effective demand responds to changes in the quantity of money or in the demand for it; output responds in turn to changes in effective demand, measured in money; and finally, wages respond to changes in output and employment. The quantity theory becomes a special case in which effective demand rises in full proportion to a change in the quantity of money, yet output is fixed and wages rise in full proportion to the change in effective demand.

In general, a rise in the quantity of money may be absorbed by a rise in the demand for money without translating wholly or partly into increased spending. On the other hand, a fall in the demand for money may take place without any change in the quantity of money. An increase in effective demand may be divided between increases in output and in prices. If wages rise in proportion to spending, the rise in spending does not translate into an increase in effective demand (measured in wage units), so that output and employment remain unchanged. There are many possible permutations and it is no longer helpful to single out the quantity of money as the key to inflation.

For Keynes, the task of managing inflation can no longer be left to monetary policy alone. Managing inflation becomes a matter of managing total spending and avoiding cost-push inflation, where wages rise independently of demand. This brings me to Keynes's ideas on the management of inflation during the Second World War.

How to Pay for the War

The outbreak of war transformed the economic problem from one of underemployment and excess capacity to one of full employment and shortages – from excess of supply over demand to the opposite. Although war production represents public consumption, it has the same effect on income and private consumption as an increase of investment. Keynes foresaw that, in the absence of a deliberate policy, the books would be balanced – in the terms of A Treatise on Money – by commodity inflation, through profits (Q₁) that accrued to the owners of business. The increased incomes generated by full employment would accrue not to the workers but to ‘profiteers’ and, through taxation, to the state. Keynes believed that this was not only unjust but also bad as an incentive and bad for morale – a criterion crucial from the point of view of the war effort.

Inflation would occur unless a sufficient proportion of the income from increased employment was saved to match the war spending. Keynes calculated that about 20 per cent of income could not be spent on private consumption, after taking into account the possibilities of taxation and voluntary saving. His favoured solution was a system of deferred pay or compulsory saving. His final proposals in response to criticism also included some rationing linked to an incomes policy, family allowances and a postwar capital levy.

Keynes emphasised that any attempt by workers to offset an inflation through pay increases would simply lead to a wage–price spiral, unless it were accompanied by a deferral of consumption – in which case inflation would not arise in the first place. He conceded the case for an ‘iron ration’ of necessities subject to price control in order to secure worker agreement to a wage standstill.

Keynes was opposed to comprehensive rationing and favoured allowing people to spend a reduced disposable income as they wished. The loss of immediate personal consumption was an inevitable consequence of producing the materials of war. The question was whether the workers’ loss of consumption would be permanent – through inflation and the transfer of real income from wages to profits – or temporary – whether by compulsory saving or by rationing alone, to force saving by default.

In retrospect, the most enduring aspect of Keynes's How to Pay for the War is its method of analysis. His use of national income accounting and statistics is an early exercise in macroeconomic forecasting and planning. This was the first step towards the deliberate management of demand (even if in this case it was a matter of restriction) to match full-employment output. It was the first exercise in ‘demand management’, as it became known. His analysis shows how inflation can occur even if the government avoids printing money and can fund its spending through taxation and voluntary lending.

For Keynes, monetarism was dead. He accepts a very long-term historical association between money and inflation down the centuries, but the causation is quite different from quantity theory. When money is tight and interest rates high, there is pressure for financial innovation to create new forms of money. Examples include paper money and bank deposits themselves. On the contrary, when money is plentiful, as when the Spanish brought back gold from South America, income and output are buoyant and money wages tend to rise. Thus the quantity of money responds to rising demand, and the demand for money responds to rising supply.

Money Wages and Inflation

Nevertheless, unlike many post-Keynesian economists, Keynes is clearly on the side of demand pull rather than on the side of cost push. He certainly holds that income inflation in the sense of A Treatise on Money or changes in the wage unit in the sense of The General Theory determine inflation in the long run. Yet in his various theories income inflation and changes in money wages are always induced as a response to changes in output, employment and demand. Even in A Tract and How to Pay for the War, the power of workers to press for compensation for rises in the cost of living (and more) depends on a state of full employment and on the presence of excess profits from which to concede wage rises.

Keynes does not regard spontaneous rises in money wages as a primary source of inflation. It is useful to compare and contrast his approach with today's policy of inflation targeting. The latter has its origins in the concept of a classical ‘natural’ rate of output that corresponds to a natural rate of unemployment, which amounts to the application of the concept of full employment to a changing environment. Unlike in a corn model, jobs appear and disappear as technology changes and workers move from job to job through different stages of their lives. Even at full employment, there will be a ‘natural’ proportion of the workforce between jobs at any time, something Keynes himself recognised and referred to as frictional and voluntary unemployment. Indeed, he thought that full employment after the war would mean an observed rate of unemployment of 5 per cent.

The natural rate of output gives rise in turn to the concept of the ‘output gap’. If demand pushes output above its natural rate (‘overheating’), a positive output gap leads to an increase in inflation; and, if the output gap is negative, inflation falls. The policy implication is obvious: do not overheat the economy. Since governments may be tempted to do so if unemployment is high, entrust monetary policy to an independent central bank. The natural rate of unemployment should be addressed through a policy of labour market flexibility.

Inflation targeting claims to use monetary policy to control inflation via the output gap, in a manner similar to that of A Treatise on Money. In practice, the natural rates of output and interest appear to move around, as does the natural rate of unemployment; they are clearly not physical constants. Central banks have quietly dropped the word ‘natural’ and now define the level of ‘potential output’ and the ‘equilibrium rates’ of unemployment and interest empirically and pragmatically. This is one way of interpreting what Keynes defined as the neutral or optimum rate of interest at the end of chapter 17 of The General Theory.

The equilibrium rate is whatever appears to be consistent with constant inflation; this is a subtle decoupling of policy from classical theory. Interest rates did not move for a decade, between 2007 and 2017, while output fluctuated significantly. This simple fact undermines any notion of a stable ‘natural’ rate. The attempt to explain the fluctuations in terms of a changing but unobservable natural rate is reminiscent of Ptolemy's attempt to explain the erratic movements of the planets in terms of epicycles.

The primary purpose of inflation targeting is the management of expectations: inflation will be 2 per cent mainly because everyone plans for it to be 2 per cent. This expectation is based on the belief that the central bank will raise interest rates in order to restrict aggregate demand and create unemployment and business losses, if there is any permanent increase in inflation expectations. Yet we are not so far from Keynes's proposal in A Treatise on Money that monetary policy should aim to stabilise the purchasing power of money – in today's parlance, the consumer price index (CPI).

How did writing The General Theory affect Keynes's thinking? The idea of a ‘natural’ rate has to go; there is nothing natural or self-fulfilling about full employment. Only at full employment can demand cause true inflation in the classical sense. Yet an increase in demand below full employment can only become effective if wages and prices do not rise to offset it.

Keynes does not regard the relationship between money wages, employment and unemployment as a matter of pure economic equilibrium, as he regards the relation between the real wage and employment, which is governed by effective demand. Money wages are determined by sociological forces, by conventions of fairness, including concerns for proper differentials and the cost of living, and by bargaining power. This is not to deny that money wages are affected by excess supply or demand for labour. As noted in chapter 3, it simply means that market pressure moves money wages up or down from where they happen to be, not from one position of equilibrium to another. As Keynes puts it, these are matters for historical generalisation rather than pure theory. Money wages fall outside the model.

If money wages are ‘wrong’, this is a matter of the economic system as a whole rather than simply of the labour market alone. If money wages are too high (e.g. because of a political choice to return to the gold standard), unemployment may be the only policy the authorities can use to reduce them, in the absence of an effective incomes policy. However, the use of unemployment to reduce money wages (or their rate of growth) represents a deliberate policy and not an automatic response to the overheating of a system above its natural rate of output. Norman Lamont (UK Chancellor of the Exchequer, 1990–3) later referred to unemployment as a ‘price well worth paying’ to reduce inflation: a brutal but honest description of the method.

For Keynes, both inflation and high unemployment are symptoms of problems with the system as a whole that market forces cannot resolve painlessly, if at all. Their complete solution requires a degree of genuine political economy and statecraft not yet achieved. The reduction of inflation to a problem of monetary policy for implementation by central bank technocrats is a political sleight of hand. It veils the state's inability – or abdication from the responsibility – to maintain what used to be considered full employment at the same time as price stability.

6 
From Versailles to Bretton Woods

It is curious that Keynes's economics is generally held to apply only to a closed economy, that is, to an isolated country or to the world as a whole. Throughout his career he wrote at length about the international monetary system. The General Theory makes extensive reference to foreign trade and investment. His policy work for government during both world wars was almost entirely devoted to the problems of international trade and finance.

So far this book, too, has made little reference to a key feature of the real world: political geography. There exist many regions, sovereign states and currencies. Both effective demand and the real wage depend on the exchange rate between currencies, which can also play an important role in inflation. Effective demand depends heavily on policies about the degree of freedom of trade and finance across borders.

This chapter begins, once again, by constructing a simple classical model of an international economy in order to establish a benchmark for Keynes's contribution. This model is quite sufficient for understanding Keynes's arguments against the Versailles Treaty, which imposed reparations on Germany after the First World War. The next step is to extend the analysis to a monetary economy, with exchange rates between different currencies. Much of Keynes's early work, still within the classical framework, reflects the fact that money prices and exchange rates do not move smoothly to maintain equilibrium in the balance of payments, as in our benchmark model.

When effective demand is taken into account, the growth of external trade and the balance of payments matter greatly, even within a monetary union such as the Eurozone. A single currency solves one set of problems only by creating others. What are the obstacles to managing the international monetary system so as to promote global full employment? Is the choice, in practice, solely between floating exchange rates and a single currency? The chapter concludes by comparing Keynes's own proposals for reform with the compromise agreed at Bretton Woods.

A Corn Model for the International Economy

I can use a variant of the corn model to explain the relevant aspects of the classical model of an international economy as they relate to Keynes's thought. In this variant, in addition to the wage and the interest rate, the exchange rate provides a third price for taking account of cross-border trade and finance. I distinguish two regions according to two different types of grain.

The ‘home’ region produces only barley and the ‘foreign’ produces only wheat. The exchange rate is the price of barley in terms of wheat. If 1 kg of barley can be exchanged for 500 g of wheat, the exchange rate is 0.5. A stronger exchange rate means that home-produced barley buys more foreign wheat, so, if the exchange rate goes up to 0.8, 1 kg of barley buys 800 g of wheat (and, conversely, 1 kg of wheat buys 1.25 kg of barley). This exchange rate in terms of goods is traditionally referred to as ‘the terms of trade’.

Each region has an annual harvest that ends up in its granary in exchange for tickets. People consume barley and wheat in both regions, which is why trade takes place. The only reason for exporting is to obtain in exchange the other grain for consumption. Investment is in the form of grain stored in granaries or planted in fields. The level of employment in each region depends on the marginal product of labour and the level of investment depends on the marginal product of capital (seed corn), both measured in terms of the produced crop.

You cannot get something for nothing, so there has to be a balance of payments between the two regions. In this model payment means a transfer of tickets in which tickets for barley and wheat are valued in terms of each other, at the exchange rate. The exchange rate is determined in the foreign exchange market, where tickets for barley and wheat are offered in exchange for each other. The balance of payments is divided between the current and the financial accounts.

The current account records trade in goods and services, including incomes. In a corn model, exports include wheat earned abroad as wages and interest and remitted home in exchange for barley. In similar fashion, imports include barley earned at home as wages and interest and remitted abroad in exchange for wheat. Accordingly, the home current account means exports of barley minus imports of wheat, all measured in terms of barley at the exchange rate.

A surplus on the home current account means that foreign residents must find tickets for a certain amount of barley, for which home residents do not currently want wheat in return. Foreign residents ultimately have only wheat to pay for barley with. To purchase barley, they must obtain barley tickets in exchange for their wheat tickets, in the foreign exchange market.

A surplus on the home current account, then, implies one of two things. First, home residents can accept, in exchange for tickets for barley at the current exchange rate, tickets for wheat held in the foreign granary. This is equivalent to a willingness to hold foreign currency reserves. Alternatively, where governments permit, home and foreign residents can allow credit to each other, in other words they can make cross-border loans. Loans are advanced and repaid, together with interest, by the transfer of tickets for either grain.

The financial account records the changes in these mutual claims on home and foreign granaries and residents. If regions were unwilling to hold any cross-border claims, the current account would have to balance at zero every day. There would be no financial account. The exchange rate would have to rise or fall until the current demand for barley tickets by foreign residents was brought into exact balance with the current demand for wheat tickets by home residents. Cross-border lending, if only in the form of holding foreign reserves, allows the current account to balance over time rather than continuously. The exchange rate can remain stable while the current account swings between surplus and deficit.

We can use the corn model to show how the exchange rate is arrived at. Trade takes place only because both barley and wheat are consumed in both regions, so workers must be paid in both barley and wheat tickets. Since barley is grown only at home and wheat is grown only abroad, the farmers in each region have to trade barley for wheat for delivery at the next harvest in order to pay their workers.

The farmers now operate on four fronts, in the labour, capital, land and foreign exchange markets. Although busier than ever, the principle remains the same. The farmers bargain with workers, lenders and landlords, including foreign residents through the exchange markets, to determine the level of production and employment they expect to maximise their profit. Chapter 2 showed how this competition also determines the real wage, the interest rate and the rental of land. In a similar fashion, the equilibrium exchange rate will match the wheat demand for paying wages to workers at home and interest to foreign lenders with the barley demand for paying wages to workers abroad and interest to home residents lending abroad.¹

A balanced current account is the norm in the classical model. A surplus or deficit, with corresponding cross-border lending, is the result of temporary and seasonal variations in production or consumption, or of adjustment to a new long-term equilibrium after a ‘shock’. In the textbook intertemporal macroeconomic models, cross-border lending is the result of ‘consumption smoothing’. People are better off borrowing or lending against their expected income over the long term, hence spreading the impact of the shock rather than adjusting their consumption exactly in line with their current income. Thus a current account deficit is not in itself a bad thing. It may reflect something bad, such as a war, or something good, such as opportunities for investment, either of which is best funded over time by foreign saving rather than by cutting home consumption now to provide the necessary home saving.

The Finance of War

Keynes made his name by resigning from his position as an official representative of the UK Treasury at the Versailles Peace Conference in 1919 and publishing The Economic Consequences of the Peace (CW 2) in protest at the terms of the Treaty. Its rhetorical brilliance and acerbic biography alone make for compelling reading. Its foundation is the claim that the reparations imposed on Germany for the First World War were unpayable. The analysis is entirely classical and can be understood in the terms of the corn model just outlined.

Keynes estimates the material damages to the Allies somewhere between £1,600 and £3,000 million (roughly £64–120 billion in today's income, i.e. 40 times more). To these the Treaty added claims for pensions of £5,000m and interest at 5 per cent, which made a total of £13,000m over 15 years (£520bn in today's terms). The minimum annual cost of servicing this debt would be £780m. Keynes's central point is that a foreign debt can be paid only from a current account surplus and reserves – with tickets for wheat in the terms of the corn model. The German current account surplus could not exceed £100m per annum and its net reserves were not more than £230m. He calculates that the maximum that Germany could pay was £2,000m over 30 years (£80bn in today's terms). In the event, Germany paid £1,000m (£40bn) by 1932, when the balance was cancelled. Keynes's figures, while open to criticism in detail, were substantially correct.

Britain's financial predicament in the Second World War can also be understood along these lines. The total current account deficit resulting from the cost of the war between 1939 and 1945 was £10,000m (£400bn today), a figure somewhere above a year's national income with the economy running at full employment. Fifty-five per cent of the cost of the war was met by American exports (imports of ‘wheat’) free of immediate charge under Lend-Lease; a further 35 per cent by running up a sterling debt for imports from the British Empire (‘issuing barley tickets for wheat imports’); and 10 per cent by the sale of foreign assets (‘to obtain wheat tickets’). At the end of the war, Keynes had to negotiate a loan of $3,750m (‘a loan of wheat tickets’, roughly £40bn today) from the United States to finance Britain's continuing trade deficit while production switched from military to civilian goods for export and domestic markets; the final repayment was made only in 2006.

Exchange Rates between Currencies

In the corn model, the equilibrium or ‘fundamental’ exchange rate corresponds to full employment in both countries and current account equilibrium, the wheat demand (for paying wages to workers at home and interest to foreign lenders) matching the barley demand (for paying wages to workers abroad and interest to home residents lending abroad), measured at the exchange rate. In a monetary model, the exchange rate depends on the balance of supply and demand for currencies, not for individual goods such as barley or wheat.

The equivalent concept of an equilibrium exchange rate where there are different currencies is that of purchasing power parity (PPP). This means that under competitive conditions the price of a basket of home-produced goods should equal the price of a similar basket of imported goods, measured in either currency. Otherwise goods will be exported from where they are cheaper to where they are more expensive, disturbing the balance of trade and exchange rate. Another way of putting this is that PPP means the currency exchange rate should reflect the real exchange rate in the pure corn model, the terms of trade. Unfortunately any long-term tendency towards PPP is weak and does not prevent significant short-term divergences. The exchange rate may well move the wrong way in the short term from the perspective of restoring current account equilibrium in the long term.

Figure 6.1 plots the United Kingdom's real exchange rate index (solid line, left-hand scale) and current account balance (dashed line, right-hand scale) for the period 1980–2016. The main thing to note is that the solid line would be horizontal if it reflected purchasing power parity. In fact it oscillates severely, losing 20 per cent of its 1981 value by 1987; partly recovering to 1991 before falling back to a loss of 24 per cent in 1995; recovering sharply to 1998 before dipping again in 2009; recovering to above its 1981 value in 2015 before finally losing 10 per cent in 2016. A firm investing in industrial plant with a twenty-five-year life for production for the export market could be faced with either an exchange loss of 24 per cent or an exchange gain of 34 per cent, depending on the timing of its investment during this period.

Figure 6.1 The United Kingdom's real exchange rate and current account

SOURCE: IMF International Financial Statistics and UK Office for National Statistics

The current account also oscillates over the period, between a surplus larger than 1 per cent of national income in 1981 and a deficit larger than 5 per cent in 2015. Although the exchange rate was clearly not in equilibrium during this period, the oscillations in the current account are not the mirror image of those in the exchange rate, as a naïve theory might suggest. However, we would not expect them to reflect each other, given the free movement of capital during this period. There is no correlation between the two series.

In A Tract on Monetary Reform (CW 4), Keynes presents data for the period 1919–23 that show a similar picture (Figure 6.2), although his figures are monthly rather than annual. This was the first period of a floating exchange rate after Britain had left the gold standard in 1919. The volatility was a product of fluctuations in both prices and the exchange rate. Keynes argues that priority should be given to stabilising domestic prices and employment; but, perhaps surprisingly in the light of his later views, he states: ‘Stability of exchange is in the nature of a convenience which adds to the efficiency and prosperity of those who are engaged in foreign trade’ (CW 4, 26). He displays faith in the power of a floating exchange rate ‘as a most rapid and powerful corrective of real disequilibria in the balance of international payments from whatever causes, and a wonderful preventive in the way of countries which are inclined to spend abroad beyond their resources’ (CW 4, 130).

Figure 6.2 The United Kingdom's real exchange rate against the United States in Keynes's A Tract on Monetary Reform

SOURCE: Author's calculations from Keynes's price and exchange rate data (CW 4, 84)

Nevertheless, Keynes notes that much of the volatility is the result of seasonality in trade. Under the gold standard the fluctuations in the current account could be offset by cross-border bank lending without risk of loss on the exchange rate. Under a floating regime this role can be played only by speculators (including Keynes) who are prepared to accept an exchange risk. Much larger spreads are required to attract speculative capital and, at the time of his writing in the 1920s, foreign exchange markets were undeveloped and far from competitive. So, he argues, this shows that the free market is not, in practice, as efficient at meeting the needs of international trade as it might be in theory.

Keynes argues that the central bank can do much to reduce volatility and the exchange risk in international trade by offering to buy and sell currency in the forward as well as the spot market. A forward market allows payments deficits to be financed without exchange risk, through private lending, rather than through movements in foreign currency reserves. Nevertheless, swaps of spot for forward currency do not involve exchange risk on the part of the central bank. Keynes's idea that the central bank should actively trade in currencies was eventually put into practice through the Exchange Equalisation Account of the Bank of England, which was established in 1932, after Britain had come off the gold standard for the second time.

In A Tract, Keynes argues, in 1923, against the restoration of the gold standard – let alone at the prewar parity of $4.86. His objection to the parity is that it will require deflation, unemployment and consequent domestic hardship and strife. His main objection to the gold standard itself lies in the irreconcilable conflict between unstable internal and external price levels. He argues that the rational course is to stabilise the internal price level and let the exchange rate find its own level – almost exactly the policy of the early twenty-first-century United Kingdom and United States.

In The Economic Consequences of Mr Churchill (CW 9), Keynes spells out in greater detail his objections to returning to gold at the prewar parity, which took place in April 1925, when Churchill was Chancellor of the Exchequer. In this pamphlet we see Keynes recognising the importance of the diversity of industries and of workers characteristic of a monetary economy. The return to gold increased British export prices by about 10 per cent. The tacit assumption of its advocates was that the internal price level would fall to match, relatively easily in line with PPP. This in turn required a fall in money wages across the board.

Keynes, restating his case from A Tract, points out that the major problem with PPP is the difference between what we now call tradable and non-tradable goods. The internal price level moves independently of the exchange rate. While the price of coal or cotton tracks the world price on an hourly basis, the same cannot be said of ‘the money wages of dockers or of charwomen and the cost of postage or of travelling by train’ (CW 9, 213).

There are no institutions to allow wages to be reduced simultaneously in all employments, although Keynes ends his polemic with that very proposal, in a plea for rationality. Wages can be cut only one industry at a time and, for each group of workers, a cut in money wages means a cut in real wages, since there is no guarantee that all other workers will in turn concede, so as to ensure that the internal price level falls. To reduce wages in industries otherwise unaffected by unemployment requires the deliberate creation of unemployment by restricting credit. The return to gold was a recipe for social unrest and injustice.

Effective Demand

We know that the level of production and employment depends on effective demand, the income expected by employers as a whole to result from the level of employment they find it most profitable to offer. Effective demand depends on both aggregate supply (the conditions of production) and aggregate demand, which in a monetary economy ultimately depends on expenditure decisions.

In chapter 3 we studied aggregate demand using the equation D = A + cD*. The symbol A represents the income expected from production for investment and for consumption that does not vary with employment. Consumption that varies with employment is represented by cD*, where c is the marginal propensity to consume.

A (for autonomous from employment) can include not only investment but also consumption by government and from non-wage income, and, importantly for the present purpose, export demand from outside the region. Similarly, c can be understood as the proportion of additional income spent on home production, rather than on imports or saving. Money spent on foreign production or not spent at all does not represent demand for home production. The simple aggregate demand function, properly understood, encompasses exports and imports.

The effective demand in a region depends on the autonomous demand, including the foreign demand for its production, and on the extent to which home income is recirculated within the region rather than spent on foreign production. One implication is that the multiplier is lower in a region that is highly integrated with its neighbours. To balance the imports, A will need to include a substantial proportion of export demand. Figure 6.3 plots the United Kingdom's income growth (dashed line) against world trade growth (solid line) for the period 1977–2016. The correlation is quite striking. These data illustrate how heavily the United Kingdom's effective demand depends upon export demand.

Figure 6.3 World trade and UK income growth

SOURCE: World Bank (BX.GSR.TOTL.CD and NY.GDP.MKTP.CD)

By contrast, Figure 6.4 shows the equivalent data for the United States, which is a large, relatively closed, economy for which international trade is much less important (less than 10 per cent of its income comes from exports, by comparison with over 30 per cent for the United Kingdom). The variation in US income growth is largely independent of the growth of world trade. US income is mainly governed by domestic factors.

Figure 6.4 World trade and US income growth

SOURCE: World Bank (BX.GSR.TOTL.CD and NY.GDP.MKTP.CD)

Regions and Currencies

The current account balance is important for effective demand even within a monetary union without exchange rates between regions. An old exam question asked whether we should worry about the balance of payments between London and Birmingham as well as between Britain and Germany. This question has become highly pertinent in the context of the current account imbalances within the Eurozone, for example between Germany and Greece. It is no accident that these led to a major banking crisis and may yet lead to the breakup of the monetary union.

As we see in the corn model, one region can run a current account deficit by borrowing from another. This borrowing need not be just between governments; the financial account includes cross-border claims by individuals and banks. Cross-border borrowing is particularly easy in a monetary union where banks can create money by lending in one region (e.g. Greece or Spain), money that is spent on imports from another (e.g. Germany or the Netherlands). The German exporter receiving the euro deposit or note ultimately holds a claim on the European Central Bank, not on Greece.

A monetary economy differs significantly from the corn model because the reasons for a current account deficit and the way it is financed matter very much to the level of employment and income. If foreign borrowing is invested in competitive export production, the region can generate additional export revenue to repay the foreign borrowing, with interest, from a future surplus on current account. The initial investment, followed by continuing increased export demand, will increase home employment (by raising A).

By contrast, if the borrowing finances consumption, military or other, the future current account surplus may have to be generated by cutting imports. Without trade restrictions, this can be done only by cutting total consumption – usually through higher taxation and government spending cuts (i.e. by reducing both c and A) – which leads to lower home production and employment, together with money wage cuts designed to improve export competitiveness.

Falling production, falling employment and falling incomes affect the solvency of both government and private borrowers and, next, the solvency of home banks. The consequent demand for bailouts creates further pressure on government finances, in a vicious circle. In a monetary union, this transmits into pressure on the solvency of foreign banks and, from there, on their governments. A country such as Greece is then faced with demands for austerity from a phalanx of angry neighbours – and, when this happened, it led to a reduction in its real income by 25 per cent.²

To every current account deficit there corresponds a surplus. The world as a whole cannot run either deficit or surplus. While ruthless pressure is placed on deficit regions to adjust their economies in order to repay foreign debts, no multilateral sanctions are exercised against regions that run chronic surpluses. Such is the power of money. Yet, within a monetary union as a whole, a current account surplus has the same dampening effect on aggregate demand as does saving within a single region.

A current account surplus transfers employment from the deficit region to the surplus region. The surplus region may enjoy full employment while the deficit region suffers unemployment. Total employment across the union is restricted until surpluses are either reduced – by encouraging imports to rise and exports to fall, which is achieved when money wages and the propensity to consume are allowed to rise throughout the surplus regions – or else channelled through long-term finance into additional productive export-oriented investment in the deficit regions.

In this context it is easy to understand the value of a region's having its own sovereignty and currency. Through trade protection and currency devaluation, it can compete for a larger share of employment in a world that suffers as a whole from a lack of effective demand. Such competition is a potent source of nationalism and ultimately of conflict.

The International Exchange of Money

The international monetary system was a matter of central concern to Keynes throughout his working life. There is a basic choice between fixed and floating exchange rates, managed and market regimes. The difficulties in this area are ultimately political rather than technical.

The default regime is one of floating exchange rates determined by the market, since a fixed exchange rate requires the intervention of one or more states and central banks. After the fall of the Roman Empire, many currencies flourished, in accordance with the proliferation of sovereign territories across Europe. These currencies were exchanged with one another, like any other commodity, at market prices.

The rise of banking during the Middle Ages had its roots in international trade; the traditional fairs acted as clearing houses and as foreign exchange markets set up to enable the settlement of debts in different currencies. Although money need have no intrinsic value within a sovereign territory, in the early centuries of the last millennium coinage of different currencies would get exchanged in line with the value of the metal. Bills of exchange in different currencies would be exchanged at varying rates, in order to clear the market. There were plenty of opportunities for profitable arbitrage between different coinages and bills of exchange, all in different currencies.

In 1816 Britain defined a sovereign containing 160/623 troy ounces (about eight grams) of 22-carat gold as the ‘thing answering to the description’ of £1 sterling. This ‘gold standard’ underpinned the growth of Britain's international trade and foreign investment over the next century, until 1914. Britain's leadership of the Industrial Revolution, its merchant navy, and its role as the financial centre of its empire gave it a strong current account surplus, which was largely invested in foreign bonds traded in London. Movements in Bank Rate worked mainly by influencing the level of cross-border lending by Britain so as to maintain equilibrium in the balance of payments; movements of gold across borders certainly took place but were the exception rather than the rule. Other states were able to maintain a fixed exchange rate against sterling by fixing their own currency either against gold or against sterling itself. As Keynes noted in A Tract, the fixed exchange rates permitted banks and others to lend without the risk of exchange loss. Cross-border trade and finance became no different in this respect from domestic trade and finance, in what was a first era of globalisation.

Keynes's early years were the final years of the gold standard. During and after the First World War, with the world political situation radically altered and largely in disarray, the gold standard could not be maintained. Britain's decision to return to gold in 1925 can be understood as an attempt to re-establish the prewar framework and to restart international trade and finance. For the reasons outlined earlier, Keynes opposed the return to gold as unsustainable; the gold standard duly collapsed again in 1931. The Bretton Woods system, established in 1944 as a ‘gold exchange’ or indirect gold standard, depended on a high degree of international consensus, which was in turn underwritten by the more subtle, but no less dominant, power of the United States.

When the system came under pressure and the United States withdrew its undertaking to redeem dollars for gold in 1971, the managed exchange rate system collapsed. Since then, the world has continued to use the dollar as its major unit of account for international trade and finance, but the dollar's exchange rate has floated. The dollar is now a medium of exchange but not international money, since it cannot be used to settle debts in another currency unilaterally but only by negotiation. The euro was in part a response to the instability of exchange rates that followed the dollar float. As genuinely international (though not global) money, the euro could be created only by an unprecedented pooling of sovereignty within the European Monetary Union.

Figure 6.4 plots the sterling exchange rate against the US dollar between 1883, the year of Keynes's birth, and 2015. For all but sixteen years of Keynes's life and twenty-five more afterwards, the exchange rate was fixed against gold. For the first thirty years the rate was held at $4.86, with full convertibility into gold, which was suspended during the world wars. The periods of free floating, between 1919 and 1925 and from 1931 to 1939, are clearly visible, alongside the period of Churchill's return to gold from 1925. Sterling was then devalued three times, in 1940, 1949 and 1967, over another thirty-year period before the United States suspended convertibility in 1971. The steps in its rate and volatility for the forty-five years after 1971 are also clearly visible.

Figure 6.5 Sterling/dollar exchange rate 1883–2015

SOURCE: Federal Reserve Bank of St Louis (USUKFXUKQ)

The reason for fixed (or ‘pegged’) exchange rates is not only the desire to avoid exchange loss and to have the consequent growth of international trade, with its benefits in terms of effective demand and employment for an open economy like Britain's. The primary motive behind Bretton Woods was to avoid the trade protection, competitive devaluations and banking crises of the interwar period – to avoid a positive decline of international trade and a return to depression. Without fixed exchange rates and private capital flows, governments can depend only on their reserves to stabilise the exchange rate during periods of current account deficit.

National autonomy is closely related to the possession of foreign currency reserves. No government is prepared, if it has a choice, to leave the value of its currency to the mercy of the markets or to make it dependent upon loans from the reserves of other governments, which always come with strings attached. As Britain found during the Second World War, American support through Lend-Lease and the 1945 loan came at a high political price, which included the dismantling of the economic apparatus of the empire and semi-permanent leases of British military bases such as Bermuda, as well as the subordination of sterling to the dollar at Bretton Woods. These were the price of national survival.

The consensus was that, without Bretton Woods, each state would seek to protect its foreign currency reserves by returning to beggar-my-neighbour policies of protection and devaluation. The American plan adopted at Bretton Woods – drafted by Harry Dexter White, the US Treasury representative – was not Keynes's and contained the seeds of its eventual demise. Keynes's own plan was rather different.

The International Clearing Union and Bretton Woods

Keynes argued for the creation of ‘bancor’, paper gold – a new reserve asset acceptable to all member states in the settlement of international debts. Historically this role had been played by gold itself, or by sterling as a ticket for gold. The quantity of precious metals is relatively fixed and Keynes maintained that the world needed a managed kind of international money, issued by a supranational bank.

Reserves could then be created rationally, as required, in line with the needs of economic growth and development. However, this was only a part of his solution: there would also need to be provision to prevent both the hoarding of reserves by countries that ran payment surpluses, and the use of these reserves by others to fund permanent deficits. In other words, the question of reserves is bound up with the nature of the international monetary system as a whole.

States have favoured gold as an international reserve asset because, unlike national currencies, it is not a claim upon another state and so not vulnerable to the profligate or hostile exercise of sovereignty. In terms of the corn model, the home granary can store physical wheat as well as barley in case of need, not simply hold tickets for wheat. Gold is portable and durable with low transport and storage costs relative to value.

Keynes's 1942 proposal for an International Clearing Union (ICU) recognised the limits of trust between states and was intended to remove the balance of payments constraint only in the short term. Balance of payments equilibrium remained the goal. As the name suggests, the Clearing Union would allow states to pay for imports from one country with exports to a third country. A state could export shirts to obtain wine from another state, which did not need shirts; the ICU would permit multilateral rather than simply bilateral trade to take place without any need for gold to settle accounts.

The ICU would fulfil the textbook role of money in overcoming the need for barter. It would deal with the seasonal fluctuations of agricultural production and consumer demand. It would provide access to the imports necessary to increase production for export. It would provide working capital to pay for the import content of wages, raw materials and machinery. The ICU would solve the ‘cash flow problem’ of timing differences, just like the overdraft facilities provided by a domestic bank.

Like an overdraft facility, the quantity of international money created would vary automatically with the volume of trade. As exports were made, the overdraft would be repaid and the money would disappear. The supply of international money would correspond to the industrial circulation of A Treatise on Money, providing the necessary means of payment to sustain a larger volume of international trade and therefore of global employment.

The common ground between the United States and Britain in July 1944 was the need to rebuild world trade and avoid another Great Depression after the war. The precondition was a monetary system that provided the stability of exchange rates and sufficient reserves to sustain them. Without a solution to the reserve problem Britain could not permit the free trade required by the United States and the dismantling of its imperial tariffs. Yet the United States did not favour a proposal that could leave it as the major holder of a newly created paper currency instead of gold.

The International Monetary Fund (IMF) was the American-drafted alternative to Keynes's ICU that emerged from the famous conference at Bretton Woods, alongside the International Bank for Reconstruction and Development (the World Bank). Rather than creating money, the IMF initially only allowed its members to borrow foreign currency against the collateral of a ‘quota’ of home currency plus some gold, which each member paid into the fund. The IMF was a credit union rather than a central bank. It was only twenty-five years later that the IMF created for the first time a small amount of its own money: the special drawing right (SDR).

The SDR largely meets the principle of Keynes's bancor. The allocation of SDRs to each member state amounts to the same as the granting of an overdraft facility. The SDR is money because member states can spend it unconditionally and be required by the IMF to accept it in exchange for their home currency. Its value is determined by fiat as the value of a basket of the major national currencies. However, despite a tenfold increase in 2009 in the wake of the financial crisis, SDRs represent only about 3 per cent of the value of total reserves.

The central flaw in Harry Dexter White's IMF was intrinsic to his political goal that the US dollar should replace sterling as the world's gold-backed reserve currency. The flaw, later christened ‘the Triffin paradox’, was that the supply of international reserves depended on the US balance of payments. If the United States ran a large surplus, international reserves would fall, stifling world trade. Conversely, additional reserves could only be supplied from a persistent US payments deficit. Sooner or later other states would demand conversion of their dollars into gold, which became more likely as more dollars were created; dollars held by non–residents exceeded the value of US gold reserves by 1959.

As the United States was reluctant either to see Fort Knox emptied or to devalue the dollar against gold, the dollar's peg to gold could hold only so long as it was not severely tested. Ironically, the ability of the United States to underpin the exchange rate system disappeared just as the IMF became fully functional. The system operated more or less as originally envisaged only between 1959 and 1971, between the dates of the restored convertibility of most European currencies into dollars and the suspension of dollar convertibility into gold by President Nixon in 1971.

It is no accident that the SDR has an obscure name with a meaning impenetrable to most. The idea that a supranational bank should create money, so dear to Keynes, remains anathema to most states, and especially to the US Congress. The political dynamic of 1944 was similar to that of the creation of the euro half a century later. Germany, with the strongest currency, would only accept the euro if other member states ceded sovereignty over their monetary and fiscal policies to the European level, where Germany has (at the very least) great influence.

In 1999 the Deutsche mark in effect became the euro. In 1944 the dollar replaced sterling as the ticket for gold. After 1971 the dollar itself became the world's paper gold. The world had little choice but to accept it. When someone owes $6,000 and is unable to repay, that person has a serious problem; when a country owes $6,000,000,000,000 and is unable to repay with anything other than more dollars, the world has the problem.

International Money as Politics Rather Than Economics

The immediate motive behind Keynes's ICU proposal was the expected postwar shortage of both gold and dollars outside the United States and Britain's pressing need for reserves. His wider aim was to set the world free to pursue full employment. The balance of payments would remain a monetary problem to be addressed, but not at the expense of income and employment.

The prime obstacle to Keynes's scheme is and always was national sovereignty. Money is power, and nations do not cede sovereignty lightly. It is a paradox that a system that might best promote full employment and individual freedom across the globe requires that sovereign states surrender some of their freedom in favour of the community of nations.

The required transfer of sovereignty includes the need for surplus countries to spend, lend or transfer their surplus; the need to accept adjustments in their exchange rate, judged by independent experts to be necessary for long-term current account equilibrium; the need to fund adequately the development banks needed to channel surpluses across borders into long-term productive investment; the need to accept that, to be sustainable, net foreign investment must yield a return in terms of net exports; and the need for taxation to transfer surpluses to fund education, health and other human needs in poor countries.

In the corn model, full employment and balance of payments equilibrium are continuous from one year to another. More sophisticated classical models allow time lags for adjustment and cycles, yet still assume that automatic movements in exchange rates and wages can lead the market economy to equilibrium. By contrast, in a monetary world, to set out tomorrow to achieve global full employment would require a pattern of pronounced current account imbalances and major cross-border flows of capital, especially from advanced to developing countries – including aid.

In the absence of – indeed in preference to – such coordinated multilateral action and institutions, a policy of financial liberalisation and industrial globalisation, dominated as before by the United States, has been promoted. Financial liberalisation has, for the present, resolved the balance of payments problems of the United States and of the United Kingdom. Financial liberalisation has even survived a crisis of its own making in 2008, although only with the help of extensive state bailouts. No one has calculated whether a managed system would have been cheaper, or for whom. There is no doubt that millions have suffered in the series of banking crises that have beset the world since the era of financial liberalisation began.

Deep capital markets and floating exchange rates have allowed foreign purchases of domestic debt and shares in industrial and financial corporations to finance large deficits on the current accounts of both the United States and the United Kingdom. The balance of payments can be brought to equilibrium through the sale of existing securities, to finance private and public consumption of imported goods without the need for new investment, at least until all domestic securities are held by foreigners. More positively, provided that increases in share values and debt issues reflect increased domestic investment and profitability, the export of securities may be seen as an alternative to the export of goods. However, as noted above, foreign borrowing in any form is sustainable only if it generates net exports in the long run.

The questions of exchange rate stability, reserves and the growth of world trade were firmly linked at Bretton Woods by both White and Keynes, despite their differences of approach. Subsequent history has shown that world trade and employment can grow under a regime of floating rates, with reserves provided by national currencies. It must be acknowledged that the era of floating rates since 1973 has endured far longer than the Bretton Woods regime.

Conversely, the instability of exchange rates led most of the European Union in the other direction, to form a monetary union. The euro is much easier to understand than the SDR. Yet, unlike Bretton Woods, neither system has the promotion of full employment as a primary objective. They may work for the dominant states and for international bankers, but not for the unemployed and for depressed regions.

In the next two chapters I consider the extent to which Keynes's ideas shaped the postwar world, and what has become of them.

Notes

1 In the corn model with tickets, the exchange rate matches the wheat demand for paying wages to workers at home and interest to foreign lenders with the barley demand for paying wages to workers abroad and interest to home residents lending abroad. This note is for the more determined reader who wishes to understand in outline how market forces determine the exchange rate in the classical model.To make the model work more easily, we assume that all workers are paid a wage divided between fixed shares of barley and wheat tickets. Going further, it is simpler and fairly realistic to assume that workers do not move between regions, so that wages need not be equal in the two regions – just composed of a fixed ratio of the two grains.In addition, there will be a balance of trade for consumption by non-workers, which will shift the exchange rate up or down. We assume that such consumption does not vary significantly with employment and investment, which in this model drive the tendency towards equilibrium. It is the existence of an equilibrium exchange rate that is of interest to us, not its precise level, so we do not attempt to model non-wage demand.Consider what happens if the exchange rate rises above the equilibrium rate. This means that home farmers can obtain wheat in exchange for barley more cheaply and the real wage in terms of barley will be lower. The demand for home labour increases. If the labour supply is fixed, the higher demand leads to a higher wage in terms of barley. If more labour comes forward at a higher wage, production and employment will increase as well. Either way, since the demand for wheat follows the wage bill, the higher exchange rate leads to a higher demand for wheat and to consequent offers of more barley in the exchange market.Conversely, the high exchange rate means that foreign farmers find it more expensive to obtain barley in exchange for their wheat, so that the real wage in terms of wheat will be higher. The demand for foreign labour is reduced, so that the foreign wage falls, and perhaps employment and production as well. This reduces the demand for barley, so that less wheat is offered in the exchange market. Taking both sides together, the offers of barley in excess of those of wheat will drive the exchange rate back down towards equilibrium. These competitive forces operate the other way if the exchange rate is too low.How does cross-border lending affect the exchange rate in this model? The argument is complex and needs to be taken in stages. First, until now we have not discussed the timing of wages, as this does not affect the essence of the classical theory of employment. Bear in mind that marginal products and the exchange rate are determined in relation to the next harvest, one year ahead of the market day when employment and lending contracts are agreed. So workers only receive their full marginal product if they are paid at the next harvest. If they are paid in advance, or by instalments over the year, the wage they actually receive will be at a discount from the marginal product by the rate of interest.For the purpose of discussing cross-border lending, it is convenient to assume that workers are paid in advance. This allows us to consider the seed and payroll required for the same harvest at the same time. In more technical parlance, the labour and capital markets are spot (they take place when the harvest is delivered) and the goods market is forward (planning for the next harvest). There are both spot and forward exchange markets, each with its own exchange rate.Whether or not a farmer borrows or already holds tickets for seed and payroll at the start of the season does not affect the calculation. The farmer will either pay interest on borrowed tickets or take into account the interest that could have been earned by lending tickets. The argument is symmetrical whether home farmers can lend or borrow either grain; but, to keep it simpler, we assume farmers borrow only in the grain produced by their own region, in other words borrow only for planting.Farmers in both regions calculate the amounts of barley and wheat they need to borrow in order to pay wages in advance and plant seed. The amounts required depend on the expected marginal products of labour and capital in each region. The marginal products measured in terms of each grain also depend on the spot and forward exchange rates. The farmers have a complex simultaneous system to solve by bargaining at the same time in all four markets (for labour, capital, land and foreign exchange).If cross-border lending is unrestricted, both home and foreign residents can lend or borrow in either barley or wheat. Competition in the capital and foreign exchange markets means that the total return, in either grain, has to be equal. A home resident lending barley will receive the barley interest rate. If home residents want to lend wheat, they must first exchange barley tickets for wheat tickets in the spot market in order to make the advance and then, in the forward market, exchange the wheat tickets to be received in repayment and interest for barley tickets. A foreign resident wanting to lend barley must carry out the opposite exchange deals.Yet barley grows only at home and wheat only abroad. There is no reason, in the absence of cross–border lending, why the marginal products of planted wheat and barley should be equal. The interest rate on each grain will be determined by productivity and thrift: by the expected marginal product and by the willingness of residents in each region to save by lending to farmers. Let us assume that the foreign interest rate on wheat is higher than the home interest rate on barley. If cross-border lending becomes allowed, home residents will want to lend abroad and foreign farmers will want to borrow from them. Competition will increase investment in the foreign region, reducing the expected marginal product of wheat, and will reduce investment in the home region, increasing the expected marginal product of barley. The home region will accordingly run a current account surplus equal to the gap between home saving and investment, which also represents net lending on the financial account. The foreign region's accounts will show the mirror image. The equilibrium spot exchange rate will fall in order to be consistent with a current account surplus, and this will have repercussions on wages and employment in each region. In the real world, the total return received by a cross-border lender includes not only the interest rate but also the difference between the spot and the forward exchange rates. For example, barley lenders must receive in addition an exchange gain to match the wheat interest rate, if the latter is higher. These exchange gains do not appear in this model because production and the return on both labour and capital all take place in a single year. Since we assume a forward exchange market in which farmers can fix their expected marginal products in terms of either grain, competition equalises the interest rates on both grains, together with the spot and forward exchange rates.

2 The comparative statics of a standard Keynesian model show exactly how a cut in government spending (G, financed by income tax tY and lump sum tax T) can improve the trade balance or net exports (NX = X – M). Starting from the equilibrium condition and equations for consumption in terms of disposable income and for imports in terms of total final expenditure,

produces (eventually)

If c = 0.8, m = 0.2 and t = 0.25, the value of the multiplier ∂NX/∂G is –0.38. If initially government spending is 50% of national income (G = 0.5Y) and the trade deficit is 5% of national income (NX = –0.05Y), government spending has to be cut by 26% [(0.05 ÷ 0.38) ÷ 0.5)] to eliminate the trade deficit and causes a drop of 20% in national income [(0.05 ÷ 0.38) × 1.54]. Income falls because the spending cut has a multiplier effect on income (∂Y/∂G is 1.54 in this case) as well as on the trade deficit. The fall in imports depends on reductions in both government spending (G) and private consumption (C), which moves with income.

7 
The Keynesian Era

The Keynesian era can be defined as a period of three decades – les trente glorieuses – during which western governments were committed to full employment. The beginning of the period was marked by the United Kingdom's 1944 White Paper on Employment Policy and by the United States’ 1946 Full Employment Act. Its end came shortly after the breakdown of the Bretton Woods exchange rate system and the subsequent oil crisis in 1973–4.

How much Keynes had to do with the Keynesian era is another question altogether. After meeting a group of American economists in 1943, Keynes famously remarked that he was the only one present not a Keynesian! This chapter begins by reviewing the historical statistics in order to identify how the Keynesian era differed from what went before and what came after. The next question is the extent to which Keynes can be praised or blamed for what was done in his name. I then examine what went wrong at the close of the Keynesian era. The chapter ends by considering the nature of Keynesian economics and what became of it.

The Historical Record

Economic historians have now produced consistent national income data running from the third quarter of the nineteenth century.¹ This allows me to place the Keynesian era in its historical context. Five periods can be identified that correspond to major changes in the economic policy regime in the United Kingdom and fit roughly with similar periods in the United States. All such divisions are generalisations, yet can be helpful for our understanding, provided that not too much weight is placed upon them. It must be acknowledged that policy changes were prompted by events over much shorter time periods. Each period runs from one peak of the economic cycle to another, so that short-term variation be removed.

The period 1874–1913 spans the gold standard era from the end of the Great Victorian Boom until the First World War. For the United Kingdom, 1925–37 defines the interwar period, which started with Britain's return to gold in 1925. For the United States, 1929–37 defines the Great Depression and the period of recovery under Roosevelt's New Deal. The years 1951–73 I define as the Keynesian era itself. This was followed by the neoliberal era from 1979 until 2007, between the election of Margaret Thatcher (and Ronald Reagan immediately after, in 1980) and the financial crisis. Finally we have the United Kingdom's austerity period, from 2007 until 2015 – the last full year before the Brexit referendum and the election of Donald Trump. US policy under Barack Obama did not have the same commitment to austerity as UK policy, but we use the same label for convenience.

The world wars and the subsequent periods of reconstruction are omitted, as periods of command economy and disruption, together with the turbulent period in the 1970s after the breakdown of the fixed exchange rate system and subsequent oil crisis. Placing the end of the Keynesian era in 1973 rather than (say) in 1976 may be contested. The logic of doing so is dictated not only by the fact that 1973 was a peak of the cycle, but also by the fact that the years 1951–73 correspond to the period of operation of the Bretton Woods exchange rate system, which was an integral part of the Keynesian era policy regime. As we shall see, the period from 1973 to 1979 was one of confusion and breakdown of the previous policy.

Figure 7.1 charts the annual growth rates of the United Kingdom's total income, exports and income per head (the last being the usual measure of economic growth) for each of the five periods. The Keynesian era saw the highest rates of income growth, both in total and per head, while the austerity period saw the lowest. Exports fell during the interwar period, but during the Keynesian and neoliberal eras they grew at about the same high rate of 4.5 per cent. Apart from the interwar period, exports grew faster than income.

Figure 7.1 UK growth of income, exports and income per head

SOURCE: See note 1

Figure 7.2 places the United Kingdom within its international context, charting the equivalent figures for seventeen advanced economies, including the United States. The pattern is very similar. Again, the Keynesian era leads in terms of income growth. UK export growth was a little higher than the G17 average during the neoliberal era. UK income growth was a little lower during the austerity era (but note that the G17 data runs only to 2013).

Figure 7.2 G17 growth of income, exports and income per head

SOURCE: See note 1

Figures 7.3 and 7.4 make similar comparisons for the average rates of unemployment, inflation and interest. The pattern of UK unemployment is striking: it rises to over 10 per cent in the interwar period, falls below 3 per cent in the Keynesian era, then returns to above 7 per cent in the neoliberal and austerity periods – a higher value than the 5 per cent of the gold standard era. For the G17, unemployment data are not available before 1955, but the historical evidence of high global unemployment during the interwar period is beyond question. The steady rise from 4 per cent during the Keynesian era to about 8 per cent in the austerity period is clear.

Figure 7.3 UK unemployment, inflation and interest rates

SOURCE: See note 1

Figure 7.4 G17 unemployment, inflation and interest rates

SOURCE: See note 1

The gold standard era saw price stability, on average, and the interwar period saw slight deflation, both in the United Kingdom and in G17. There is no significant difference between the average rates of inflation in the Keynesian and neoliberal eras in either the United Kingdom or G17.² Inflation fell slightly to about 2 per cent in the austerity period for both the United Kingdom and G17.

The real rate of interest on long-term UK bonds fell to 1 per cent in both the Keynesian era and the austerity period and was over 4 per cent in both the interwar and the neoliberal periods. These rates compare with 2.5 per cent during the gold standard era. G17 rates were slightly higher than the United Kingdom's until 1973 but similar after 1979.

Figures 7.5 and 7.6 present comparable data for the United States alone. There is less difference than in the United Kingdom between the gold standard and the Keynesian eras in terms of growth of income, growth of exports, and income per head, as shown in Figure 7.5. The Keynesian era remains the period of the highest growth rate of income per head. The Great Depression hit the United States much harder: income per head actually fell and export growth was severely negative. The United States’ determination to enforce free trade after 1945 can be understood in this light. The United States performed significantly better than the United Kingdom during the austerity era on all three measures.

Figure 7.5 US growth of income, exports and income per head

SOURCE: See note 1

Figure 7.6 shows a pattern of unemployment, inflation and interest broadly similar to that of the G17. US unemployment during the interwar period averaged 16.6 per cent, which went off the top of the scale. However, inflation was lower in the Keynesian era than in the subsequent neoliberal era – as was also the case in the G17, even if not the United Kingdom (by a small margin, though).

Figure 7.6 US unemployment, inflation and interest rates

SOURCE: See note 1. Note that unemployment during 1929–37 was off the scale, at 16.6%.

Figure 7.7 presents the UK government's borrowing and investment over the four periods since 1925 as a proportion of national income. UK public investment substantially exceeded public borrowing in the first three periods. Only during the austerity era did borrowing exceed investment. The difference between these two values in each case represents either the government's saving (which happens when investment exceeds borrowing) or borrowing for consumption (which happens when borrowing exceeds investment). Government saving, the balance of current revenue over current expense, was at its highest during the Keynesian era.

Figure 7.7 UK public borrowing and investment (% of GDP)

SOURCE: See note 1

Figure 7.8 shows a similar picture for the United States, although greater reliance on borrowing to fund public investment is visible throughout. The average for the period 1979–2007 masks significant differences between the Republican presidents, who borrowed heavily for consumption after granting large tax cuts, and the Democrats, who delivered a positive and increasing level of government saving, in proportion to the level of income: not at all the conventional stereotype.

Figure 7.8 US public borrowing and investment (% of GDP)

SOURCE: See note 1

The picture confirms that the Keynesian era was markedly different from the rest of this 140-year timespan. Its distinctive features were the highest level of economic growth and the lowest level of unemployment of all five periods. Its low interest rate was matched only in the austerity era – another time when monetary policy was deliberately used to keep the interest rate low.

These statistics are very broad. However, they do address two major myths. First, as already noted, there is no significant difference in average inflation in the United Kingdom between the Keynesian and the neoliberal eras; and in the United States inflation was lower during the Keynesian era. Second, on average, both the United Kingdom's and the United States’ governments invested more than they borrowed before 2008, and their saving was at its highest during the Keynesian era.

Thus the bare facts are that the Keynesian era delivered on average the high income and low unemployment sought by Keynes without either excessive inflation or borrowing for public consumption. The next questions are to what extent this performance reflected Keynes's work and thought and, if they did, whether his legacy extended to the later periods.

Full Employment and Stabilisation Policy

The main forces behind the adoption of a commitment to full employment were the experience itself of full employment during the Second World War and the political climate that emanated from Roosevelt's prewar New Deal in the United States and from the two Beveridge Reports – respectively on full employment and social security – in the United Kingdom. Keynes provided the intellectual framework and justification for a policy whose time had come.

The first Keynesian budget in Britain in 1941, on which Keynes himself had a major influence, was concerned with restraining demand in order to avoid inflation under conditions of full employment. Following the analysis of How to Pay for the War, this was nevertheless the first step towards the deliberate management of demand so as to match full employment output. Followers of Keynes such as James Meade and Abba Lerner (1903–82) developed a ‘demand management’ framework, so that peacetime government tax and spending decisions (‘fiscal policy’) came to be seen within the context of the economy as a whole rather than simply as a matter of the public finances; Lerner coined the phrase ‘functional finance’ to describe this new outlook. These ideas were picked up and rapidly diffused in the United States, especially through members of Hansen's Harvard seminar and their connections in government.

In particular the concept of the ‘balanced budget multiplier’ helped to justify the maintenance of high government spending during the Keynesian era. It can be shown that an increase in government spending raises aggregate demand by the same amount – so that the multiplier equals 1 – even if that spending is fully funded through increased taxation and in consequence the budget remains in balance. There need be no ‘crowding out’ of private investment, as the UK Treasury had argued, in opposition to proposals for public works to reduce unemployment in the 1920s and 1930s.

Figure 7.9 compares UK private and public investment and public consumption over the five periods as a proportion of income. The Keynesian era saw large increases in all three by comparison to the interwar period. The division between private and public investment was affected by nationalisation and subsequent privatisation, yet total investment increased during the neoliberal era. The distinctive feature of the Keynesian era in this respect was public consumption, which was some 6.5 per cent points higher.

Figure 7.9 UK investment and public sector consumption (% of GDP)

SOURCE: See note 1

Figure 7.10 presents the equivalent data for the United States. Again, the Keynesian era saw large increases in all three by comparison to the interwar period. Vis-à-vis the United Kingdom the balance between private investment and public consumption was reversed, private investment matching public consumption during the Keynesian era and becoming somewhat greater during the later periods. US public investment was at its highest during the Keynesian era and has since fallen to the same level as during the interwar era.

Figure 7.10 US investment and public sector consumption (% of GDP)

SOURCE: See note 1

Critics argue that demand management increases rather than reduces the fluctuations of the economy. Attempts to ‘fine-tune’ the economy by using demand management to offset short-run fluctuations in unemployment may be counterproductive because of time lags. Time elapses between the economic shocks themselves, their observation in the data, policy decisions taken in response, and the implementation of those policy decisions in terms of tax and spending. These time lags mean that demand management can make things worse, destabilising rather than stabilising the economy. The problem was more acute in the United States than in the United Kingdom because of the different constitutional arrangements for setting the fiscal budget.

This feedback problem was recognised and understood at the time, which is why policy was based on forecasts rather than on actual events. The question thus becomes, partly, whether forecasts were sufficiently reliable to allow demand management to dampen rather than widen fluctuations. The problem is also reduced through the design of appropriate ‘automatic stabilisers’ (the structure of income taxes and unemployment benefits), which operate counter-cyclically, to adjust demand without a time lag.

What light can the data shed on this? The previous charts were based on period averages that take no account of year-to-year fluctuations. Figure 7.11 presents a simple measure of the volatility in the UK data for each period (the standard deviation). Figure 7.12 presents the equivalent data for the United States, although the volatility for the interwar period runs off the scale, for income at 8.7 per cent and for unemployment at 6.7 per cent. Exports are entirely excluded because the volatility of exports in the interwar period (9.2 per cent in the United Kingdom, 19.5 per cent in the United States) would swamp everything else.

Figure 7.11 Volatility in the UK data

SOURCE: See note 1

Figure 7.12 Volatility in the US data

SOURCE: See note 1

The charts confirm that the interwar period was the most unstable on all counts.³ In both countries, the Keynesian era was the most stable in terms of unemployment and more stable in terms of inflation than the neoliberal era. However, the criticism that demand management can increase instability has more force when we come to the very end of the Keynesian era, as will be discussed further on.⁴

How Keynesian Was the Keynesian Era?

The myth that Keynes advocated government borrowing for consumption as a permanent state of affairs must owe something to his impish sense of humour when he wrote this, for example:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. (CW 7, 129)

This passage has probably done more damage than any other to Keynes's reputation in conservative circles. What is forgotten is the context, which is well worth reading in full. Keynes's point is that digging up gold in South Africa to bury it in New York bank vaults is just as socially wasteful as digging other kinds of hole in the ground, yet is regarded as a sound investment. His target is the refusal to invest, for example, in new public housing at an expected return below the rate of interest, while borrowing in order to finance war or unemployment benefit.

Be that as it may, the widespread US perception of Keynes as an inflationist also reflects the views of his American followers, as exemplified by Abba Lerner and Randall Wray (1953–) – views that are now known as the Modern Monetary Theory (MMT) and have become influential in Democrat circles. MMT follows Keynes in recognising the source of money in the sovereign power of the state and the autonomous character of government spending. The argument is that a government has no budget limit when it comes to its own currency and should run whatever deficit is necessary to ensure full employment, printing money if and as required. In its modern form, this policy is linked to the idea of the employer of last resort (ELR) – that is, the idea that the state should employ at a minimum wage anyone unemployed and willing to work. (For a full account, see Wray, 1998 and the critique by Sawyer, 2003).

It is no accident that MMT is mainly a US phenomenon. The theory rules out borrowing in a foreign currency, which implies the need for either a balanced current account or a willingness of foreign (and indeed domestic) residents to hold the domestic currency or securities. The exchange rate cannot be fixed against an external standard and must be allowed to find its own level. The lower the exchange rate, the better it is for domestic production and employment.

Such a policy can be sustained only by a country with highly elastic supply capacity, such that effective demand rises easily, in line with aggregate demand. It must also be self-sufficient in natural resources, so that the price of imports does not matter and a current account surplus can always be generated if the exchange rate falls far enough. The experiences of Weimar Germany, Zimbabwe and, most recently, Venezuela suggest that the policy cannot be adopted as a general rule, even if the United States might get away with it for a time (some would say that it is already doing so).

Keynes referred to Lerner's scheme as humbug or worse at the 1943 Washington seminar, after which he stated that he was no Keynesian (Colander and Landreth, 1996). Keynes had earlier written in a letter to James Meade: ‘[Lerner's] argument is impeccable. But, Heaven help anyone who tries to put it across to the plain man at this stage of the evolution of our ideas’ (CW 27, 320). It is easy to see why Keynes would dismiss a policy that denies the need for foreign exchange reserves and displays indifference to the exchange rate, in the midst of his difficult negotiations with the United States over Lend-Lease, Bretton Woods and the 1945 Loan.

Keynes's own primary policy proposal for the management of a national economy was that monetary policy should be used so as to reduce the interest rate on long-term bonds, in order to stimulate both private and public investment. Figures 7.3 and 7.6 show that this policy was implemented on both sides of the Atlantic, not only during the Keynesian era but also during the austerity era. To this extent 2008 indeed saw ‘the return of the master’, as Skidelsky (2009) put it in his title. Figures 7.9 and 7.10 suggest that the policy was successful in substantially increasing investment during the Keynesian era by comparison to the interwar period and then in maintaining investment during the austerity period, at least as a proportion of income.

Apart from monetary policy, Keynes anticipated in 1935 that increased investment would require a degree of institutional reform. He did not make detailed recommendations but expected ‘an ever greater [state] responsibility for directly organising investment’ and ‘a somewhat comprehensive socialisation’. He appears to have been referring mainly to buildings, roads and utilities but also to public investment in general. Yet he takes pains to state that ‘beyond this no obvious case is made for a system of State Socialism which would embrace most of the economic life of the community’ (CW 7, 164, 378).

There was a substantial increase in public investment during the Keynesian era. In the United Kingdom it almost matched private investment (Figure 7.9). Some of this took place through the nationalised industries; but there were also substantial capital investments in health, education and housing. Keynes was silent about the welfare state but accepted that full employment might equally be achieved through an increase in public consumption financed by the taxation of higher incomes and inheritances. Figure 7.9 indicates the increase in public consumption during the Keynesian era; the rolling back of such taxes became a priority of the neoliberal era. Keynes was much in favour of public patronage of the arts. He founded the Cambridge Arts Theatre, helped establish the Royal Ballet, and was the first chair of the Arts Council. Note that public consumption excludes payments for welfare and social security and represents the direct employment and spending of government.

In the United States public consumption did not rise as high as in the United Kingdom (Figure 7.10), but neither did it fall back as far as it did in the United Kingdom after the Keynesian era. There are important differences in economic structure between the two countries, notably in the commitment to the health and military sectors. Again, these figures do not include payments made through the social security fund. Nevertheless, the chart makes it clear that ‘big government’ has not significantly receded in the United States since the Keynesian era.

Keynes did not distinguish between raising the level of employment and reducing its fluctuations. He offered a theory of the trade cycle but did not explicitly present demand management as its solution. Rather he argued that ‘[t]he right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom’ (CW 7, 322).

The achievement of full employment through a policy of cheap money and high investment would make physical capital less scarce and thereby reduce the rate of profit. Keynes saw this as an additional benefit of full employment and thought that it might take only one generation to eliminate the rate of return to the rentier investor. This ‘euthanasia’ and the corresponding reduction in income inequality led him to prefer this route to full employment over an increase in public consumption, although he did not insist that the two were strict alternatives.

Figure 7.13 (which is based on calculations by Thomas Piketty) indicates that the rate of profit in the United Kingdom did indeed halve during the Keynesian era, going from about 11 per cent to 5.5 per cent. This fall returned the rate to the level obtained during the gold standard era. The lower rate has persisted throughout the neoliberal and austerity eras and does not appear to follow the rate of interest. Piketty does not supply comparable figures for the United States.

Figure 7.13 The rate of profit in the United Kingdom

SOURCE: See note 1

Underpinning the high rate of UK investment during the Keynesian era were not only the low rate of interest and the high government spending but also the high rate of growth of exports (Figures 7.1, 7.2 and 7.5). Exports grew significantly faster then than during the gold standard era, let alone the interwar period. As Figure 6.3 shows, the growth of UK income shadows the growth of its exports. Keynes's theory suggests that, of the two, exports drive income, although there is a complex two-way relationship between investment and exports (e.g. export markets create investment opportunities and investment makes exports more competitive).

The overall verdict appears to be as follows. The Keynesian era saw no government borrowing for consumption, only for investment. One of the main ideas with which Keynes's name and legacy are associated turns out to be a myth, or at least has been wrongly attributed to him rather than to some of his followers. He preferred instead to see full employment achieved mainly by reducing the long-term rate of interest through monetary policy and by stimulating investment to the point where the rate of return on rentier capital was eliminated. However, where private investment was not forthcoming, the state should borrow to invest.

His monetary policy was implemented in the Keynesian era and, again, in the austerity period. The rate of profit was reduced during the Keynesian era, but only from a historically high level, and it shows no sign of disappearing. The full employment and high rate of investment of the Keynesian era was underpinned by public consumption (to which Keynes was neutral, though not opposed, especially for the long run) and export growth.

Export growth reflected the return to free trade permitted by the Bretton Woods system, which Keynes certainly helped to deliver. Free trade is not a specifically Keynesian policy and continued during the neoliberal era and after, despite the breakdown of the Bretton Woods exchange rate system. Nevertheless international trade continues, for the present at any rate, to be based on multilateral rules of the sort advocated by Keynes among others.

The End of the Keynesian Era

The Keynesian era ended with a series of unfortunate events that brought to a head the flaws in the design of the Bretton Woods system and undermined confidence in the government's ability to deliver full employment.

The main concern at Bretton Woods had been the prospect of a shortage of international reserves, as the United States continued to run the current account surplus necessary to underpin its commitment to gold convertibility. The United States’ current account moved into deficit in early 1968, partly because of the increasing cost of the Vietnam War. Nevertheless, the US balance of payments remained in surplus during 1968 and 1969, as a result of short-term capital inflows in response to a tightening of monetary policy and higher interest rates. In 1969 the International Monetary Fund (IMF) was permitted to create its own money in the form of the special drawing right (SDR), as a complement to the dollar and sterling (the latter had been in disgrace after the 1967 devaluation), in order to relieve an expected dollar shortage. As recession began in 1970, the United States reduced interest rates, which led to a large outflow of short-term capital; this meant sales of US financial assets by non-residents in exchange for foreign assets, which involved selling dollars for other currencies.

This outflow substantially increased the dollar holdings of other central banks, held not only with the United States but also with the growing international banking sector based in London, the Eurocurrency market. The increase in reserves relieved the balance-of-payments constraint that was binding on many countries and permitted a synchronised increase in demand, beginning in 1971, in order to offset the recession. The timing, in retrospect, could not have been worse.

Several European central banks decided to convert their dollar holdings to gold; France sent a gunboat to New York to collect. President Nixon suspended convertibility on 15 August 1971, effectively ending the Bretton Woods system. Although a new set of fixed exchange rates was agreed at the Smithsonian in December 1971, these did not survive beyond February 1973. The world returned to a regime of floating exchange rates. As the value of the dollar was called into question, oil producers fixed the price of oil to gold itself rather than to the dollar.

The period 1972–3 witnessed a perfect storm. Global income grew rapidly; between 1970 and 1973 real income grew by over 14 per cent in both the United States and the United Kingdom. The UK growth rate of 6.5 per cent in 1973 was the highest since 1941. The global multiplier in a synchronised expansion is higher than the multiplier of an individual economy, as one country's imports are another's exports. World export prices, both of commodities and of manufactured goods, responded to the sharp increase in demand.

At this moment crops failed in the Soviet Union and elsewhere and world grain stocks fell to low levels. Prices of industrial materials doubled in a scramble for supplies. Then in October 1973 war broke out again between Israel and its Arab neighbours. The Arab-led Organisation of Petroleum Exporting Countries (OPEC) imposed an oil embargo on the United States, cut production and quadrupled the price of oil. From an Arab perspective, oil in the ground was as good a store of value as gold or depreciating currencies.

Incomes policies had been adopted on both sides of the Atlantic as a counterpart to the full employment policy. The sharp rise in the price of commodities, including oil, delivered a large shock to inflation. In the United States, Nixon introduced extensive wage and price controls in August 1971, when he took the dollar off the gold standard. These controls were quite effective in reducing inflation from 5.9 per cent in 1970 to 3.3 per cent in 1972, but were unable to cope with the rise in commodity prices and lapsed in April 1974, after which inflation peaked at 12.3 per cent. In Britain the oil crisis coincided with the introduction, in November 1973, of indexation into the incomes policy. The intention was to reduce inflation by protecting real wages as the rate of increase in money wages fell, in line with commodity prices returning to normal. As oil prices increased, indexation backfired and wage inflation peaked at over 30 per cent in 1975.

As unions battled with government and with one another to maintain the real wages of their members, the most powerful, the National Union of Miners, chose this moment to demand a 35 per cent increase supported by an overtime ban, thus reducing coal production. The government reacted by introducing wartime controls on electricity use in the form of the Three-Day Week. When the miners escalated their action to a strike, Prime Minister Edward Heath called a general election. The government fell and the miners got their 35 per cent.

During 1973 the stance of demand management in most countries had tightened to slow down growth as the only remaining way to reduce inflation. The oil price rise sucked demand from the industrialised economies and created unprecedented payments imbalances with the oil producers, who were quite unable to spend their new surpluses. Growth continued during the first half of 1974 as non-oil-producing countries spent the proceeds of the commodity boom. The deflationary effect of the oil crisis hit between mid-1974 and mid-1975, creating the deepest peacetime recession since the interwar period.

In the United Kingdom confidence was shattered; the stock market lost 80 per cent of its value in real terms between 1972 and 1974. Many small UK banks, which had overexpanded after credit restrictions were relaxed in 1971, had to be bailed out. The United Kingdom among other countries borrowed to finance the oil-induced balance of payments deficits. This borrowing made perfect sense for the United Kingdom, especially as North Sea oil was coming on stream, and was subsequently repaid without difficulty. However, the exchange rate was now determined by the views of financial markets, and sterling fell against the dollar by 30 per cent between 1973 and 1977 before returning abruptly to its former level in 1980. In 1976 the United Kingdom was forced to arrange a standby facility from the IMF. The facility was never used, nevertheless there arose, however unwarranted, a sense of national bankruptcy.

In the United States, Gerald Ford took office just as the economy turned down in August 1974, his main priority being to deal with inflation. A half-hearted attempt at a voluntary incomes policy involved issuing faintly ridiculous buttons (lapel badges) marked WIN – ‘Whip Inflation Now’. Unemployment rose to a peak of 9.2 per cent in 1975, by comparison with 3.5 per cent in 1969, and inflation fell back from 12.3 per cent to 4.9 per cent.

In 1977 Jimmy Carter reinstated the goal of full employment, now defined as 5 per cent unemployment, and implemented a major fiscal expansion to achieve it. Real income grew fast, by over 13 per cent between 1976 and 1979. However, inflation also rose sharply. This at least had the benefit that the government captured increasing tax revenue, so that government saving turned positive and improved over the period. Incomes policies proved ineffective. At the end of 1979 there was revolution in Iran, which led to the second oil crisis. US inflation reached a postwar peak of 14.8 per cent, global demand slowed and US income fell by 0.5 per cent.

UK unemployment rose to 5.5 per cent by 1977, not a high rate in retrospect but poor relative to the 2.5 per cent average of the previous two decades and for the 1.5 million individuals concerned. Between 1977 and 1978 inflation fell by 10 percentage points to 7.5 per cent, with a small fall in the unemployment rate. The problem was that demand management no longer appeared able to reduce unemployment to its previous levels. In September 1976, Prime Minister Jim Callaghan addressed the Labour Party Conference: ‘We used to think that you could 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’ (Callaghan, 1976). Whatever its merits as a comment on the effectiveness of demand management, Callaghan's statement marked the end of the political commitment to full employment in the United Kingdom. Although Carter persisted for another few years in the United States, the writing was on the wall.

By the end of the 1970s, there was a general sense of confusion and loss of direction. At the international level, national governments’ commitment to global institutions, which had never been strong, did not recover from the breakdown of the exchange rate system. The confidence of the electorates in the ability of democratic governments to manage the economy had dissipated.

The political climate had become unstable, with conflict simmering in the Middle East and constant industrial disputes in the United Kingdom. ‘Beer and sandwiches’ at 10 Downing Street captured the mood that it was the unions and not the queen's ministers that governed the United Kingdom, as inflation turned up again in 1978. In the United States, gasoline price controls and panic buying led to shortages at the pumps. Even though the American people were much better off under Carter in terms of real income, they did not feel like it. The middle classes were squeezed by the higher tax burden, as tax allowances did not rise with inflation (a situation known as ‘fiscal drag’). The Iran hostage crisis confirmed a growing impression of presidential incompetence and impotence. The scene had been set on both sides of the Atlantic for a political shift to the right.

The End of Keynesian Economics?

I began chapter 2 with a quotation from 1980 about people giggling at Keynesian theorising in research seminars. What was so wrong with Keynesian economics and why was it abandoned, both by mainstream economists (who also largely abandoned Keynes) and by post-Keynesian economists (who did not)?

As we have seen, the Keynesian era was in great part a matter of politics rather than economics. Politicians had their own reasons for their commitment to full employment. Economists, even of the stature of Keynes, should not flatter themselves that their ideas gain traction solely on their merits. It should come as no surprise that different schools of economic thought flourish or wither as the political weather changes.

For example, the Cambridge Economic Policy Group (CEPG) within the Department of Applied Economics at Cambridge, of which Keynes was a founder, was brought to an abrupt end in 1982. The CEPG under Wynne Godley (1926–2010) had correctly predicted in 1977 that UK unemployment would rise above 3 million during the 1980s in the absence of measures to manage imports and to invest in manufacturing industry the proceeds of North Sea oil. Its demise had nothing to do with the technical accuracy of its forecasts, only with their implications.

Keynesian economics was a simplification of The General Theory, in which prices were taken as given. The assumption of given prices allows an abstraction from the complexity of Keynes's concept of effective demand, including the formation of short-term price expectations and the profitability of production. Effective demand is reduced to aggregate demand, which in turn becomes aggregate expenditure. Spending creates output, or at least the two are brought into equilibrium through the adjustment of stocks that I have ascribed to dealers in chapter 3. Supply accommodates demand, up to the point where full employment is reached and further spending translates into inflation rather than more output. No significant role is given to the profitability of different levels of output or to the extent to which suppliers of all kinds respond to increases in demand by raising prices.

Nevertheless this simplification proved very useful. It allowed the construction of government budgets designed to identify gaps between spending and full employment output. In an environment of low inflation, the simplification that extra spending would translate into extra output was by no means far-fetched. Furthermore, the empirical evidence that larger businesses set prices as a mark-up over cost was (and remains) compelling. Keynesian economics was the workhorse of demand management for nearly four decades.

Keynesian economics allowed governments to resist the ‘commonsense’ notion that the best way to balance the budget is to cut spending and to recognise instead that, unlike a household, the government's spending affects its income. As we have seen, high levels of government spending during the Keynesian era translated into higher income, tax revenue and budget surplus. Keynes wrote: ‘The boom, not the slump, is the right time for austerity at the Treasury’ (CW 21, 390). ‘Common sense’ returned to the United Kingdom during the austerity era, when the forecast date for the budget to balance would recede every year and fiscal deficits persisted.⁵

During the Keynesian era economic analysis and models became increasingly sophisticated, aided by ever-increasing computing power. The 1980 UK Treasury model contained seven hundred equations rather than the two or three I used in chapter 3.The analysis of aggregate demand became finely detailed: full account was taken of international trade and granular input–output tables were constructed in order to model the composition of demand. Prices were not assumed to be fixed, but to be determined independently of output and driven by costs, ultimately wages, global commodity prices and exchange rates.

Economic models have always been unreliable predictors of events; their main role is to provide a coherent framework for the comparison of alternative policy responses to changing events. Large-scale Keynesian economic models were based on statistical (econometric) analysis of historical data. This approach made no direct allowance for the possibility that a change in policy, based on historical structural relationships, would itself change the behaviours that governed those relationships. For example, a low rate of crime in an area does not mean that the police force can safely be reduced.

Charles Goodhart (1936–) had pointed out this problem in relation to monetary policy: an attempt to control any measure of the quantity of money or bank lending would lead banks to find a way to work around the restriction. Robert Lucas applied this critique to Keynesian economic models in general, arguing that it made them useless as a guide to policy. For example, if the government made a temporary tax cut in order to increase consumer demand, people would bank the tax rebate as a windfall and maintain their spending unchanged, in line with their expectations of future income. The Keynesian consumption function was not stable, he claimed.

At the level of pure theory, mainstream economics had attempted to assimilate Keynes through an uneasy compromise known as the neoclassical synthesis. Keynesian economics replaced the quantity theory and business cycle theory in macroeconomics, while classical economics continued to be used at the microeconomic level of the individual firm and household and to answer questions about matters such as income distribution, taxation and tariffs, and economic welfare. The prime example is Paul Samuelson's (1915–2009) textbook Economics (Samuelson and Nordhaus, 1989, first published in 1948), which superseded Marshall's (1920) Principles in the United Kingdom and Taussig's (1939) in the United States.

Economists continued, as Keynes had put it, ‘to find ourselves sometimes on the one side of the moon and sometimes on the other, without knowing what route or journey connects them, related, apparently, after the fashion of our waking and our dreaming lives’ (CW 7, 292). This inconsistency produced two equal and opposite reactions. Some insisted that macroeconomics be based on microeconomic foundations, meaning the classical model of equilibrium. Others argued that traditional supply and demand analysis had to be abandoned altogether. Keynes, it should be noted, thought he had reconciled the two, but his voice from the past went unheard and he was no longer around to make his case.

At the end of the Keynesian era, the influence of Keynes on macroeconomics was dividing into two main currents that represented these alternative responses to the shortcomings of the neoclassical synthesis. The first, which has achieved political and academic dominance, represents a return to a modified form of classical theory. Although there are many significant nuances among different economists, this main stream can be labelled, as a rough category, New Keynesian economics. Keynes's insights are consigned to the short run, in which prices are fixed, while classical theory is reinstated for the long run, in which prices are flexible and competition on its own can restore the economy to (full employment) equilibrium. The only thing Keynesian about New Keynesian economics is the implication that there may be a temporary role for demand management, particularly monetary policy, in speeding the return to equilibrium.

The other current is post-Keynesian economics. At present this school of thought is in the academic wilderness, although its practitioners cling on in a variety of posts, usually outside economics departments, and do have some influence with policymakers. Post-Keynesian economics sets out from Keynes's fundamental idea that employment and unemployment are matters of the system as a whole and not of the labour market alone. Competition alone cannot be relied upon to bring the system to full employment, however flexible labour may be. Demand and money matter in the long run as well as in the short.

All post-Keynesians accept four of Keynes's key propositions: (1) investment determines income and saving, not the reverse, and hence employment; (2) investment depends on confidence in irreducibly uncertain expectations about the future and is not rooted firmly in ‘fundamentals’; (3) the rate of interest is a matter of the supply and demand for money, not of saving; and (4) exports (together with government spending) and imports (together with taxation) have effects on demand that are similar to investment and saving respectively.

However, most post-Keynesians turned away from Keynes's Marshallian framework of competitive supply and demand. The majority follow Michał Kalecki (1899–1970) – a colleague of Keynes at Cambridge for a brief spell – in their formulation of effective demand. There is some evidence that Kalecki hit upon his version of the principle independently. Kaleckian models start from a given rate of profit, which is the primary form of saving and is created by investment, so that ‘workers spend what they get and employers get what they spend’ (Robinson and Eatwell, 1973, 109). Adopting a class analysis of income distribution based on monopoly capital places Kaleckian models in the tradition of Karl Marx, giving them inevitable political overtones.

Piero Sraffa (1898–1983), another colleague of Keynes at Cambridge, produced early in his career a devastating critique of the assumption of diminishing returns in the classical analysis. Although Keynes addressed and partly overcame this critique through his construction of the aggregate supply function, Sraffa's work helped to push classical theory away from Marshall and towards Léon Walras (1834–1910), and into the use of advanced mathematics in the construction of general equilibrium models. Towards the end of his career, Sraffa published a slim volume that reinstated Ricardo's theory of value (i.e. of relative prices) and resolved Marx's tangle over prices and labour values. Sraffa insisted that the term ‘classical’ be restricted to economists prior to the neoclassical or marginalist economists of the second half of the nineteenth century, whom Marx called ‘the vulgar economists’. Between them, Kalecki and Sraffa provided solutions to the modelling puzzles that had defeated Marx.

Nevertheless, not all post-Keynesians are Marxists, or even sympathetic to Marxian analysis. Much post-Keynesian work during the Keynesian era simply ignored (neo)classical analysis as obsolete and pressed on with more interesting technical problems. As Keynes had advised, post-Keynesians made progress by inventing a variety of models to suit the question in hand, unconstrained by the straitjacket of competitive equilibrium.

At Cambridge, Joan Robinson (1903–83), Nicholas Kaldor (1908–86) and the scholars around them wrote on many questions well beyond those addressed directly by Keynes. Geoff Harcourt (1931–) became the primary conduit through which the Cambridge Keynesian tradition was codified and orally transmitted to new generations of students. The Cambridge Journal of Economics was established in 1977 and became the school of thought's academic centre, as mainstream journals turned back to classical economics.

In America, post-Keynesian economics took a different, if complementary, line. Hyman Minsky (1919–96) developed a powerful ‘Wall Street’ analysis of the role of debt, starting from some pregnant asides in The General Theory and relaxing Keynes's abstraction from the finance of individual enterprises. Minsky identified cyclical phases in debt finance, from hedged to speculative to Ponzi balance sheets, moving with changes in confidence and long-term expectation. A key insight is that stability creates instability. This time is never different; recurrent banking crises are inevitable in the absence of strict regulation, against which the banks are a powerful lobby. Minsky's analysis was a good predictor of the 2008 financial crisis.

Paul Davidson (1930–) has in many respects preserved the authentic voice of Keynes, restoring the concept of aggregate supply in the 1960s, adhering to Marshallian analysis throughout and placing emphasis on uncertainty and liquidity alongside Keynes's proposals for the international monetary system. He co-founded in 1978 and edited for over three decades the Journal of Post Keynesian Economics, which remains the leading US journal in the field.

Post-Keynesian economics has developed substantially beyond the thought of these founding figures and several new journals have been established in recent years. A comprehensive review would require another book: an introduction can be found in King (2015) and, beyond that, in Lavoie (2014).

Summing Up

There certainly was a Keynesian era. The world saw the highest level of sustained economic growth and the lowest level of unemployment since records began. It was genuinely Keynesian, as government used monetary policy to reduce the long-term real rate of interest and to stimulate private investment in pursuit of its political commitment to full employment, although public consumption and investment were also historically high. The full employment and high rate of investment were underpinned by export growth, encouraged by the free trade regime established at Bretton Woods, which Keynes helped to deliver. Contrary to myth, inflation was no higher during the Keynesian era than in the neoliberal era that followed. The fiscal budget remained in surplus on current account (i.e. government saving was positive) and the national debt fell in proportion to income.

Historical events never have a single cause, yet certain decisions are pivotal. It cannot be coincidence that the Keynesian era corresponded to the period when the Bretton Woods exchange rate system was operational. It was only a question of time before the flaws in its design would emerge. The United States in 1971 followed the path taken by Britain in 1931, as it placed its national interest ahead of its international commitment to peg its currency to gold.

This decision led to a chain reaction of events, including an ill-timed increase in global demand and a sharp rise in commodity prices that was exacerbated by harvest failures and the oil crisis, leading to unprecedented levels of inflation against which incomes policies were ineffective. The simultaneous presence of both unemployment and inflation (‘stagflation’) seemed to confirm that demand management was no longer able to deliver full employment. In 1976, the United Kingdom's political commitment to full employment was ended by a Labour government. The commitment lasted a little longer in the United States under President Carter, but ended in a political shambles. The Keynesian era was over.

The influence of Keynes on macroeconomic theory then divided into two main currents, which represented alternative responses to the internal contradictions of the neoclassical synthesis by which Keynes's thought had been assimilated into mainstream economics. New Keynesian economics returned to competitive equilibrium theory, abandoning Keynes's key insights and reducing them to a special case of classical theory – the very opposite of his intent. Post-Keynesian economics largely abandoned the classical concept of competitive equilibrium and, while accepting Keynes's key insights and method of progression through the development of new and relevant models, has now moved substantially beyond and away from his Marshallian framework.

So what is left now of the economics of Keynes? Can Keynes's own insights, particularly as distinct from those of the post-Keynesians, shed new light on today's problems? These questions are explored in the final chapter.

Notes

1 UK data are taken from the Bank of England's dataset A Millennium of Macroeconomic Data, version 3.1.The seventeen countries in the global sample are Australia, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United States. Data for these are taken mostly from the dataset provided by the Macrohistory Lab, Bonn (JSTDatasetR2, Release 2, November 2016, from Òscar Jordà, Moritz Schularick, and Alan M. Taylor, 2017: ‘Macrofinancial History and the New Business Cycle Facts’, in NBER Macroeconomics Annual 2016, volume 31 (1), edited by Martin Eichenbaum and Jonathan A. Parker. Chicago, IL: University of Chicago Press), pp. 213–63.US data are taken from the JSTDataset above with the addition of figures for government receipts and expenditure taken from the NIPA tables published by the US Bureau of Economic Analysis.Unemployment data for 2000–13 come from the ILOSTAT dataset of the International Labour Organisation and exclude Italy. Apart from data for the United Kingdom, unemployment data for 1955–99 contain only OECD data for the United States, Canada and Japan (Unemployment rate indicator doi: 10.1787/997c8750-en). For 1929–54, additional US unemployment data come from the Bureau of Labour Statistics. The calculations for the charts based on these data are the author's. Growth rates of real income and exports are calculated peak-to-peak for the four earlier periods (2015 was not a peak). G17 averages are weighted by real GDP at purchasing power parity exchange rates. The period's average rates for unemployment, inflation, interest, and so on are arithmetic. Although the Great Victorian Boom is usually defined as ending in 1873, real output peaked the following year, despite the sharp fall in prices. G17 data were available only to 2013 at the time of writing.Inflation means consumer prices, and interest means the real long-term interest rate. For the United Kingdom, an ex ante figure for the real interest rate – a figure that is based on expectations – is provided by the dataset; for G17 it is an ex post figure calculated from the nominal interest rate and the inflation rate.‘Government saving’ is here used as shorthand, to designate the difference between public investment and net borrowing. This does not correspond to the macroeconomic definition of saving as the value of net output not consumed. Data in Figure 7.7 are in current prices, while those of Figure 7.9 are in constant prices, which creates a difference in the figures for public investment for the earlier periods.Figure 7.13 uses the data for the observed rate of profit behind figure 6.3 in Piketty (2014).

2 For the benefit of those who might question my dating of the Keynesian era on these grounds, UK annual inflation for the period 1951–76 averaged 6.2% (G17: 4.0%) by comparison with 4.5% (G17: 3.2%) from 1951 to 1973. For the period 1979–2007, UK annual inflation averaged 3.9% (G17: 3.5%).

3 If the period 1918–25 is included, the interwar period was the most unstable in terms of inflation for the United Kingdom.

4 Volatility in inflation (UK 5.2%, US 2.7%) was higher if the Keynesian era is extended to include 1974–6.

5 The comparative statics of a standard Keynesian model show exactly how a cut in government spending (G, funded by income tax tY and lump sum tax T) can improve the fiscal deficit (F). Starting from the equilibrium condition and from equations for consumption in terms of income and for imports in terms of total final expenditure:

produces

If c = 0.8, m = 0.2 and t = 0.25, the value of this multiplier is 62%. This means that cutting the deficit by £100 requires a cut in government spending of £162 (£100 ÷ 62%). This is because the deficit depends on tax revenue, which depends on income, and the cut in spending has a multiplier effect on income (about 1.5 in this case). The budget can be balanced by spending cuts, but only by depressing the national income, in this case by 2.5 times the amount of the deficit (£250 = £162 × 1.54).

8 
Keynes for Today

What would Keynes say to us today? A silly question, responded the historian Peter Clarke in 2010. Either Keynes would have been 126 years old and somewhat bemused by current events; or, if we imagine him half that age, he would have been born in 1946, the year of his death, and would have escaped all the experiences that actually formed him and his thinking as an economist. Clarke (2010) remarked: ‘There is a name for people who tell us with enormous confidence what Keynes would say today, and that name is ventriloquists’.

We study the history of economic thought partly in order to draw lessons for our own time, which is perfectly legitimate. The temptation is to invoke the name of Keynes, whether as an ally or as an opponent, as authority for our own views and to put words into his mouth. Even in his own lifetime he was distancing himself from Keynesians, both in America and to some extent at Cambridge. It is no easy matter to distinguish his own voice after several decades, let alone apply his ideas to the circumstances of today. The attempt to do so that follows is, accordingly, more than fallible; yet it should provoke the reader to justify his or her own view, if different.

There are large areas of economic theory and policy on which Keynes wrote very little, if anything. He was principally a monetary economist. He accepted, at least for the sake of formal argument, the classical orthodoxy of Marshall and Pigou on the economics of the consumer and the firm, of welfare and of the distribution of income. He accepted their theory of international trade under conditions of full employment. Like them, he wrote very little about economic growth and development.

Keynes was not omniscient. He was quite wrong about the long-term prospects for the distribution of income. While due recognition must be given to its playful nature and timing to counter the pessimism of 1930, the three-hour day of Economic Possibilities for Our Grandchildren (CW 9, 321–32) is as remote as ever. Although the real rate of interest has fallen close to zero despite low inflation, there is no sign of the euthanasia of the rentier that Keynes envisaged in The General Theory. In 1926 he correctly anticipated the managerial capitalism of the Keynesian era, in The End of Laissez-Faire (CW 9, 289–90), but underestimated the ability of shareholder power to reassert itself during the neoliberal era. As noted in chapter 7 of this book, the rate of profit on rentier equity capital has not fallen in line with the rate of interest, to say nothing of the rental value of land in the United Kingdom.

Keynes does not offer any kind of economic cure-all. He was not a utopian or any kind of socialist. Politically he was a liberal, who in 1925 described Labour's democratic left as the party of catastrophe (CW 9, 299) and in 1944 made favourable comments to F. A. Hayek (1899–1992) on his The Road to Serfdom (CW 27, 385–8). He was cautious in his views on the redistribution of income and wealth. Keynes's concern for social justice found expression in criticism of the malfunctioning of the market system through high unemployment or inflation; but this concern did not extend to calling the system fundamentally into question. He was a member of the ruling establishment and accustomed to government, familiar with Whitehall and the realities of domestic and international politics. He understood that politics is the art of the possible and wrote that ‘[t]he task of transmuting human nature must not be confused with the task of managing it’ (CW 7, 374).

This chapter proceeds by proposing two of Keynes's major insights as being of enduring theoretical relevance. These are the very nature of the equilibrium of a market economy and the importance of demand in the long run. I then consider, one by one, each area of macroeconomic policy from the perspective of Keynes's thought: employment, fiscal and monetary, exchange rate and trade policies. Finally I imagine a policy for the reform of the European monetary system that seems consistent with Keynes's thought and might have attracted his support, given what we know of his attitudes.

Keynes's Continuing Relevance to Theory

The one-page first chapter of The General Theory sets out Keynes's central theoretical claim: that classical theory addresses only the special case of full employment, as explained in chapter 2 of this book. More precisely, classical theory defines equilibrium in terms of full employment, admitting that unemployment can exist but only as a symptom of disequilibrium. Keynes's primary and enduring contribution to economic theory is to challenge this notion of equilibrium. Yet, curiously, his own definition of equilibrium in terms of the principle of effective demand (as set out in chapter 3 of this book) remains misunderstood and ignored by most of the economics profession.

Roger Backhouse (1951–) writes: ‘The term equilibrium is used in so many different ways that there is considerable confusion’ (Backhouse, 2004, 296). Most of this confusion relates to the treatment of time. Keynes noted that Marshall himself wrote that ‘the element of time “is the centre of the chief difficulty of almost every economic problem”’ (CW 10, 207). The principle of effective demand is Keynes's solution to this difficulty.

The classical concept of equilibrium underpins the modern idea of Adam Smith's ‘invisible hand’, as it is understood today. Not only does equilibrium represent full employment; competitive market forces will drive the economy back to full employment if it is knocked out of equilibrium. Governments can help by promoting flexible markets, by removing or overcoming any obstacles to competition, but need do no more to secure full employment.

By contrast, Keynes's principle of effective demand defines a range of possible points of equilibrium short of full employment. Furthermore, what is generally not understood is that in The General Theory employers are in continuous equilibrium from day to day. As explained in chapter 3 of this book, the effective demand is the income expected by employers as a whole to result from the level of employment they find it most profitable to offer.

This expected income is determined in The General Theory by the daily equilibrium of supply and demand in wholly Marshallian fashion. This is best understood as supply and demand determining the employers’ order books, which adjust from day to day as new orders are placed and some old ones are completed. This concept of equilibrium is compatible with unemployment of labour and capital equipment; unemployment is not always a sign of disequilibrium, as in the classical model.

Robert Lucas rightly insists that equilibrium must be observable and, conversely, that observable values must be treated as equilibrium values, if equilibrium is to be useful to economic science. Keynes would entirely agree; but he differs in his conception of equilibrium. Underpinning Keynes's claim for the superiority of his conception is his recognition that income, wages and interest are intrinsically monetary. When workers consume a basket of goods, they must be paid in money. Once income is understood as the value of net output, so that aggregate saving never takes the form of money, the theory of interest becomes clear.

New Classical theory has addressed the problem of time by asserting that ‘rational expectations’ are based on the classical equilibrium. Keynes accepts that the short-term expectations of employers may be treated as ‘rational’ equilibrium values but denies that medium- and long-term expectations can be. Rational short-term expectations are consistent with unemployment equilibrium. By contrast, New Classical theory does not accept that the nature of time requires that short-term and longer-term expectations be treated differently.

The modern classical solution is both too simple and too ambitious. Keynes recognises the strengths of competitive equilibrium analysis but limits its application to the present moment, today. Expectations can shift from day to day, leading to discontinuities fatal to mathematical models. Equilibrium is not a suitable tool for the analysis of real-world economic dynamics, such as theories of the business cycle and economic growth. The implication of Keynes's critique is that these topics need to be studied from a pluralist perspective, which takes into account history and institutions and uses different models to answer different questions.

Keynes's second key insight of relevance today is that demand matters in the long run as well as in the short. Modern classical economics in its New Keynesian form allows demand to matter in the short run but asserts that, once relative prices have time to adjust, competition will restore the classical equilibrium. By contrast, effective demand can remain consistently below full employment. It becomes important to study the determinants of aggregate demand.

Figures 1.1 and 1.2 in chapter 1 of this book illustrate the difference in the causation at work in each of the classical and Keynes's models. Chapter 3 explained how investment is the key driver of effective demand in The General Theory, and in chapter 6 we recognised that exports and government spending can play a similar role. The common factor is that all three types of spending are to a great extent autonomous or independent of domestic income.

Among these three, investment plays the starring role in The General Theory partly because Keynes needed to refute the idea that the money rate of interest is the price that brings saving and investment into equilibrium at full employment, as the real rate of interest does in the classical model. Chapter 4 of this book explained his refutation of the loanable funds doctrine and of Say's law. For today's purposes, his crucial result is that investment is an independent variable, one that saving follows and that is governed largely by forces other than the rate of interest. Investment in turn determines employment and unemployment.

Figures 8.1 and 8.2 plot investment and unemployment for the United Kingdom and the United States. The unemployment data have been inverted in order to demonstrate more clearly how unemployment falls when investment rises. These are annual figures for the period 1979–2017, when each government was no longer committed to full employment. Despite the multitude of other factors at work, especially in the United Kingdom as a more open economy, the correlation is remarkably good. Certainly it is not possible to maintain that unemployment is uncorrelated with investment, as the pure classical theory would have us believe.

Figure 8.1 UK investment (chained volume per available worker) and unemployment (%)

SOURCE: See note 1 to chapter 7

Figure 8.2 US investment (chained volume per available worker) and unemployment (%)

SOURCE: See note 1 to chapter 7

Private investment depends heavily on enterprise, on the animal spirits of entrepreneurs and on the state of confidence. Investment can be unstable at times of crisis and subdued for long periods when expectations are depressed. Since low investment means low income, high unemployment and low consumption, recovery can take a long time. Any suggestion that the way to stimulate investment is to reduce the cost of borrowing by encouraging more saving should be resisted, as chapter 4 of this book shows. It is indeed important to reduce the cost of, and remove obstacles to, the finance of investment, but this is a matter of mobilising money for the purchase of securities, not a matter of more saving.

Keynes has nothing to say in his works of theory about the distinctive features of large corporations and financial institutions: he abstracts from all such detail, and the institutions of his day were very different from today's. Although post-Keynesian economists have made fruitful use of Keynes's concept of liquidity when they wanted to study institutions and markets, including Minsky's theory of financial fragility and Chick's studies of banking, Keynes himself wrote little about institutional particulars. Hence this chapter says nothing about the vitally important topic of financial reform. However, he did express doubt about the capacity of the free enterprise system to maintain investment at a level high enough for full employment. He envisaged a need for new types of institution, in which government would play at least some role.

Similarly, Keynes's plans for an International Clearing Union recognised that a tendency towards surplus on the current account of the balance of payments could depress demand at the international level just as a tendency towards excessive saving within a national economy would. The free enterprise system inclines heavily towards mercantilism, the hoarding of liquid foreign reserves. This may be good for domestic employment but is bad for global employment. Under the gold standard, the protection of the reserves was given priority over domestic economic policy and employment.

Keynes's Continuing Relevance to Policy

This brings me to specific questions of policy. The key implication of Keynes's theoretical work is that we cannot trust the market to deliver full employment in the long run, we cannot simply adopt a laissez-faire attitude if we care about the common good. We need policies and institutions that create sufficient effective demand in the long run to channel free enterprise towards that goal. This implies a role for the state; yet what exactly is that role, in Keynes's view?

Keynes wrote mostly on what is now considered macroeconomic policy (fiscal and monetary, exchange rate and trade policies), yet his work is also relevant to employment policy. Employment policy should come first, since for Keynes full employment represents the purpose of the other policies; it is a necessary condition of establishing a good society. Employment policy covers the commitment to full employment, the case for incomes policy, and working-age benefits.

Full Employment and Unemployment

Chapter 7 of this book noted that the post-1945 commitment to full employment reflected the actual experience of full employment in time of war, together with a political determination to extend this experience to the peace. Keynes, like Beveridge, thought of full employment in terms of low unemployment rather than simply as a high proportion of the population in the workforce. Writing in 1942, he expected full employment in peacetime to imply 5 per cent unemployment, which would reflect frictional and structural factors in a changing economy. He might have been surprised by the 2 per cent achieved during the Keynesian era, but not by the 4.25 per cent considered to be the equilibrium rate by the Bank of England in August 2018.

Keynes was not an advocate of incomes policy, unlike his followers Sidney Weintraub (1914–83) in the United States or James Meade in the United Kingdom. As noted in chapter 5, he regarded income inflation as a consequence rather than a primary cause of inflation. Although he pleaded for collective action to reduce wages in order to mitigate the pain of deflation in The Economic Consequences of Mr Churchill and for wage restraint in How to Pay for the War, he did not regard a general, permanent incomes policy as practical politics. In 1945 he wrote: ‘One is also, simply because one knows no solution, inclined to turn a blind eye to the wages problem in a full employment economy’ (as quoted in Skidelsky, 2003, 722). The implication is that he would have accepted today's pragmatic definition of the full employment rate of unemployment as the rate that keeps wage inflation (or, more precisely, the rate of increase of unit labour costs) constant: the Bank of England's so-called ‘equilibrium rate of unemployment’.

Keynes would not regard this rate as a natural constant, emphasising the sociology of the link between money wages and unemployment. Coordinated wage-bargaining institutions, such as in Germany and Sweden, may reduce the unemployment rate compatible with wage and price stability. He would support measures for its reduction by addressing frictional and structural unemployment. Frictional unemployment represents employable people between available jobs and should be short term. Structural unemployment is a mismatch between workers and jobs, to some extent in terms of skills but especially in terms of location, and dominates long-term unemployment.

Structural unemployment follows general unemployment with a lag, the phenomenon of ‘hysteresis’. Reducing structural unemployment requires both high employment in general and targeted investment. It also requires classical measures to retrain or relocate unemployed workers. Similarly, 4 per cent unemployment nowadays omits a significant level (2.6 per cent in the United Kingdom in the fourth quarter of 2018) of ‘disguised unemployment’ in the form of part-time workers who would prefer a full-time job. The only remedy for this is a higher level of effective demand.

When it comes to support for the unemployed, we can be confident that Keynes would have condemned the rhetoric used to justify welfare cuts and sanctions by UK Chancellor of the Exchequer George Osborne (2010–16). Osborne's political agenda was clear: to reduce the size of the state. To attempt this at a time of severe recession required a frontal assault on the welfare system, with hateful talk of ‘strivers and skivers’.

Keynes was not unaware of the importance of incentives. In a 1930 radio conversation with Sir Josiah Stamp, he said: ‘The existence of the dole undoubtedly diminishes the pressure on the individual man to accept a rate of wages or a kind of employment which is not just what he wants or what he is used to’ (Keynes and Moggridge, 2010, 45). At that time he was writing from the classical perspective of A Treatise on Money. His later analysis implies that, while this concern may be relevant to frictional (including voluntary) unemployment, the worker cannot properly be blamed for either structural or the wider demand-deficient involuntary unemployment explained in The General Theory.

For Keynes, unemployment is a problem for society as a whole and not simply the responsibility of the individual worker. The meagre level of financial support and the generally hostile attitude towards UK working-age benefit claimants finds its moral justification, such as it is, in the classical theory of unemployment. The United States has never accepted that the taxpayer should meet the cost of unemployment. The Social Security Act provides for the federal government to act, in theory, only as a conduit for equalising employer contributions across states, although in practice there has been temporary federal subsidy during major recessions. Two thirds of the unemployed are not eligible for unemployment insurance, which was designed for full-time unionised workers temporarily between jobs.

Figure 8.3 UK public borrowing (% of GDP) and unemployment (%)

SOURCE: See note 1 to chapter 7

Figure 8.4 US public borrowing (% of GDP) and unemployment (%)

SOURCE: See note 1 to chapter 7

Keynes's mature theory implies that the state should treat the unemployed as valued citizens who need constructive support in finding suitable work and whose unemployment is a loss to society as well as to themselves. When the private sector is not creating sufficient jobs of the right type in the right places, through general recession or structural unemployment, the state neglects at its peril the duty to take action in order to preserve peace and prosperity. Such action will even raise offsetting revenue: the best way to reduce the cost of unemployment to the Exchequer is to reduce unemployment. ‘Look after the unemployment and the Budget will look after itself’, he said (Keynes and Moggridge, 2010, 104).

The truth of Keynes's statement can be seen clearly in Figures 8.3 and 8.4. These charts compare the rate of unemployment with government borrowing for consumption (broadly, the current budget deficit) for the United Kingdom and United States, each year for the period 1979–2017. This period, spanning the neoliberal and austerity eras, was not associated with an explicit commitment to full employment. Borrowing for consumption is the difference between government borrowing and investment shown in Figures 7.7 and 7.8. A perfect fit is not to be expected, but the correlation is good.

This brings us to the central areas of macroeconomic policy: fiscal and monetary policy. What action should the state take to reduce unemployment? How can politicians and civil servants be expected to raise effective demand to the level of full employment?

Fiscal and Monetary Policy

Keynes's primary recommendation was a policy of ‘cheap money’, the use of monetary policy to reduce the long-term rate of interest and encourage both private and public investment. We saw in chapter 7 that this policy was implemented both in the Keynesian era and again in the austerity era, up to the present day. Keynes has won that argument hands down in the long run.

Monetary policy is also concerned with inflation. Today's policy of inflation targeting is surprisingly true to Keynes in practice, if certainly not in theory. As I noted in chapter 5 of this book, Keynes was always in favour of stabilising the domestic purchasing power of money (the CPI, in today's terms) rather than the exchange rate or the price of gold. Although his analysis changed between A Tract on Monetary Reform and How to Pay for the War, he clearly saw inflation in the first instance as a matter of demand, while recognising that high levels of employment would lead to shortages of particular types of labour, consequent pressure on wage differentials, and the possibility of a wage–wage spiral. I have noted his scepticism about the ability of incomes policies to contain these forces, at least in the United Kingdom.

Nevertheless, it is implausible that monetary policy operates through tiny changes in Bank Rate or in the Federal Reserve's discount rate, in accordance with the current model used to justify and explain inflation targeting. Rather it is the central bank's power to implement, without political restraint, very large increases in its lending rate in order to nip any incipient income inflation in the bud that anchors inflation expectations. This is exactly what happened at the beginning of the 1980s, under Paul Volcker (chairman of the US Federal Reserve Board, 1979–87) and Geoffrey Howe (UK Chancellor of the Exchequer, 1979–83). Short-term interest rates reached 21 per cent in the United States and 17 per cent in the United Kingdom.

Central bank independence (from 1997 in the United Kingdom) and the inflation-targeting mandate provide the confidence that allows long-term interest rates to be managed down as Keynes envisaged, assisted after 2008 by quantitative easing to maintain the supply of money and liquidity when banks stop lending to the private sector and to one another. This is not to suggest that such measures are sufficient to induce investment at the rate required for full employment, or even to reduce the interest rates at which banks lend.

Turning to fiscal policy, it helps to discuss public borrowing for investment separately from borrowing for consumption. Keynes certainly did so; when he spoke of budget deficits, he meant only the budget for government's direct revenue and consumption (‘the Exchequer budget’) and excluded ‘loan expenditure’ for capital projects and most transfer payments. He sought to recover the cost of past public investments from the Exchequer budget over time, although in his view the ‘sinking fund’ charges should be credited to capital account and used for new investment rather than repaying debt. However, he also included on capital account any temporary deficit or surplus on the social security or national insurance fund (i.e. what we now call the automatic stabilisers of employment taxes and unemployment benefits). Keynes's distinctive approach to public accounting was broadly reflected much later in the fiscal ‘golden rule’ set out by Gordon Brown (UK Chancellor of the Exchequer, 1997–2007): balancing the current budget over the cycle and otherwise borrowing only to invest.

The golden rule is almost entirely Keynesian. Keynes was not in favour of current budget deficits outside time of war, but he accepted that short-term borrowing for the national insurance fund and a reduction in sinking fund charges (i.e. a reduction in the current budget surplus) might be both unavoidable and desirable during a downturn. Fund deficits in recession should be recovered by running a surplus during the boom. What Keynes called for was public borrowing to invest, especially in housing and infrastructure, in order to offset any shortfall in private investment, both in the long and in the short term.

There is no question of public investment crowding out private investment, short of full employment; crowding out can only mean a shortage of labour, land or other physical resources. Only then do judgements have to be made about the relative merits of public and private projects. Public investment is now only about 15 per cent of total investment in both the United Kingdom and the United States. Indeed a key role of public investment is to ‘crowd in’ private investment. Strategic public investment can draw private money into depressed regions to address structural unemployment.

Public investment is long term in its planning and execution; it is not in practice a suitable tool for short-term demand management. US public investment has been more or less constant in real terms since 2002, at about $600bn each year, with a small temporary increase in 2009–10; in the United Kingdom, it rose by 50 per cent in real terms between 2007 and 2010 to £50bn and has been maintained at that level, despite severe cuts to the current spending budget.

This brings us to the other, short-term aspect of fiscal policy: running a deficit on the current budget, namely by undertaking public borrowing for consumption. Figures 8.3 and 8.4 show how borrowing in order to consume tracks unemployment. These charts show a cyclical fluctuation, in which periods of repayment offset periods of borrowing. The golden rule appears to have been followed in practice, whether consciously, as a matter of deliberate policy, or as an inevitable outcome of the political process, regardless of who was in power on either side of the Atlantic.

A simple chart cannot show the direction of causation between unemployment and borrowing. In fact there are at least two channels in operation. The more direct and obvious one is that higher unemployment reduces tax revenue and increases welfare spending. These are the automatic stabilisers, offsetting the fall in demand to some extent. The indirect channel operates if government increases its own consumption together with its welfare payments, or cuts tax rates, in response to a rise in unemployment, in order to limit the rise still further. These two channels represent the use of fiscal policy respectively for passive and active demand management, to offset fluctuations in income and employment.

The case for an active fiscal policy is that it offsets temporary reductions in private spending. The 2008 crash was a major shock to confidence that resulted in a sudden reduction in both investment and consumption spending. The downward movement can be expected to reverse once the immediate crisis is over, although not necessarily to return to the same level as before. Fiscal policy can provide temporary additional demand to reduce the size of the downturn, while the additional borrowing can be repaid once income, including tax revenue, recovers.

A major difficulty with the public and political perception of active fiscal policy is that its assessment requires a counterfactual analysis using an economic model. People can see the actual government spending and borrowing and become worried by the accumulating debt. They cannot see the income and job losses and the higher borrowing that were averted, any more than these are visible in our charts. Fortunately, this political obstacle did not deter the United States and the United Kingdom from implementing a very Keynesian stimulus in response to the 2008 crisis. However, politics and the rising debt soon led to a turn towards austerity. The year 2010 saw Labour lose power in the United Kingdom to a coalition committed to austerity, while the US president lost his majority support in the House of Representatives.

The most spectacular use of active demand management was President Obama's American Recovery and Reinvestment Act 2009, which represented a fiscal stimulus of $800bn divided equally between tax cuts, payments to states and individuals, and infrastructure. This amounted to 5.5 per cent of income, compared with the actual total borrowing for consumption in 2009 of 8.8 per cent shown in Figure 8.4. Without the fiscal stimulus (together with the simultaneous monetary and financial assistance packages), income might well have fallen by 12 per cent rather than 4 per cent, and unemployment would have reached 16 per cent rather than 10 per cent – a second Great Depression (Blinder and Zandi, 2010). Government borrowing for consumption could have reached 20 per cent of income. As Figure 8.4 (repeated opposite for convenience) shows, borrowing fell rapidly as the economy recovered and was heading for zero by 2017.

Figure 8.4 US public borrowing (% of GDP) and unemployment (%)

SOURCE: See note 1 to chapter 7

In the United Kingdom, Chancellor of the Exchequer Alistair Darling (2007–10) applied a smaller fiscal stimulus totalling about 2 per cent of income, by comparison with the actual total borrowing for consumption in 2009 of 5.6 per cent shown in Figure 8.3. Most of the £30bn stimulus was in the form of tax cuts, easily implemented and reversed; the balance was achieved by bringing forward the already planned public investment. However the financial crash badly affected the United Kingdom's long-term tax revenue, which had become heavily dependent on financial services and a buoyant property market. Although George Osborne subsequently made austerity his watchword, Darling's 2008–10 budgets contain similar prospective cuts in public spending. The 2010 change in government affected only the mix between tax rises and spending cuts, not the need for several years of fiscal tightening to prevent the public debt from exploding.

Figure 8.3 UK public borrowing (% of GDP) and unemployment (%)

SOURCE: See note 1 to chapter 7

This brings me to the question of how much the state can safely borrow. In the short term, a state with its own currency has no credit limit. The US government in 2009 could spend without difficulty an astronomical $2 trillion dollars in excess of its revenue; it did not need to find the money. Similarly the United Kingdom could project a £175bn deficit while interest rates reached record lows. The question arises of the willingness of the public to hold the additional currency or the government securities, be they short term or long term, that are the interest-bearing alternative denominated in domestic money. If this willingness is lost, the alternative becomes foreign assets and the exchange rate will fall, as residents sell domestic securities and cash for foreign. As discussed in chapter 7, there is a significant difference between a fairly closed, potentially self-sufficient economy like the United States and the open island economy of the United Kingdom in terms of the implications of a major fall in the exchange rate.

To understand how much the state can safely borrow, we need to return to the first principles of the distinction between consumption and investment. Consumption is for its own sake, while investment requires a monetary return. Both types of spending can create current income for someone else when resources are unemployed. However, investment is expected, in addition, to create future income for the investor. Borrowing for consumption mortgages the borrower's future income without adding to it. Borrowing to invest can be repaid from the expected additional future income.

The economic case for public investment, apart from its immediate effect on employment and its social benefits, is that it should pay for itself, taking into account the economic benefits to the economy as a whole. However, the monetary return on investment made by government itself usually accrues only in the form of increased tax revenue. For example, a new road creates income for its builders and then additional income for its users (through savings in transport costs, or new opportunities to earn income). Unless a toll is charged, the additional income accrues to the users and not to the government. Unless the multiplier is very high – which is possible in the United States but unlikely in a more open economy such as the United Kingdom – the extra tax revenue arising from a public investment may not be sufficient on its own to service the required borrowing.

Many Keynesians of all stripes neglect this crucial point. Having recognised that the investment dog wags the saving tail, that investment automatically creates saving and no prior saving is required, it is easy to overlook the problem of finance. For example, public spending cannot be financed by a current account deficit, even though the latter represents foreign saving; the deficit may be financed by an outflow of foreign currency reserves.

In this context, Victoria Chick's distinction between finance and funding is helpful. She limits ‘finance’ to mean credit, that is, access to the means of payment for the initial expenditure. ‘Funding’ means the issue of securities that allow the cost of this expenditure to be recovered from future income. The Modern Monetary Theory (MMT) Keynesians discussed in chapter 7 are correct that a state with its own currency has unlimited credit. Nevertheless, unlimited credit does not mean unlimited budget. There is no credit limit on my American Express charge card, but that does not mean I can afford everything I could buy. Affordability depends on how I am going to fund repayment of the card balance at the end of the month.

Keynes was against funding public deficits by printing money, which means that government must also issue securities. If the only source of revenue to service public debt is taxation, given the rate of tax on the national income, there is a prudential limit on the level of public debt as a proportion of income (the public sector debt ratio). The absolute size of the debt in terms of currency is not important. The exact figure for the maximum safe ratio depends on the rates of taxation, inflation, interest and economic growth: the rate of economic growth has to match or exceed the real after-tax rate of interest on public debt.

The prudential limit on the public sector debt ratio was 40 per cent under Gordon Brown's golden rule and is 60 per cent under the European fiscal compact (from which the United Kingdom, at nearly 90 per cent in 2018, has opted out). In 2018, the US public sector debt ratio was just over 100 per cent, where it had stabilised towards the end of the Obama administration. This figure was only a little short of the US historic peak of 112 per cent at the end of the Second World War. Between a quarter and a third of the United Kingdom's and United States’ government debt is held by foreign investors. Japan sustains a ratio of about 240 per cent without difficulty, less than a tenth being held by foreign investors. Capital markets seem less concerned about the exact number than about whether the sovereign debt is under control: whether it is exploding or converging to a stable figure.

Where constrained by a prudential limit, the state has to find creative ways to mobilise capital in areas where investment falls short, particularly in regions of structural unemployment where the need is not just cyclical but more enduring. Keynes famously wrote:

I conceive … that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society. (CW 7, 378)

One way for the state to capture the cash return on investment is to run industry itself. Keynes wrote before most of Britain's major industries were nationalised after the war. Chapter 7 of this book records that total investment (public and private) more than tripled as a share of income in the Keynesian era from what it had been in the gold standard era. Although privatisation changed the mix between public and private after 1979, the share of total investment continued at this higher level (about 17.5 per cent of income) in the later periods.

Keynes's concern with investment can accommodate a wide spectrum of political views on how best the state should get involved. The United Kingdom's autumn 2017 budget was full of bright ideas as to how public authority can cooperate with private initiative in the context of a renewed UK industrial strategy, which plans major roles for a national productivity investment fund for larger investments and for the British Business Bank in mobilising finance for smaller firms. Keynes himself favoured the concept of private corporations with a public purpose, which could embrace cooperatives and mutuals, but these have never played a central role in government policy. At the other end of the spectrum, the 2017 British Labour Party manifesto proposed borrowing an extra £500bn (roughly 25 per cent of national income) for investment. This is not necessarily imprudent if the monetary return on investment can be captured directly and not only through taxation.

Labour's £500bn was to be divided equally between a national transformation fund, funding infrastructure investment in transport and utilities alongside housing, and a national investment bank. Labour proposed to renationalise the railways and utilities so that the extra borrowing could be serviced directly by revenue from providing services, although this was not spelled out. The capital invested in public housing and the national investment bank should earn a higher return than the government's cost of borrowing.

Public borrowing by nationalised industries is recognised as a separate category of borrowing that should not count against the normal prudential limit of what can be serviced by general taxation. The real question is whether nationalised or municipal industries can generate the necessary returns on the investment. That is a matter of management and governance. The private sector does not have a monopoly on good practice. If the private sector is not investing enough, particularly not enough to address structural unemployment, there is no inherent financial reason why the state should not step in. The objections are practical or political.

For his own part, Keynes appears to have accepted unwittingly – there is no evidence he was aware of it – the principle of subsidiarity set out by Pope Leo XIII in 1891 and incorporated into the law of the European Union a century later, at Maastricht. In a national context, subsidiarity means that the state should undertake what individuals and private institutions cannot achieve effectively, no less and no more. Keynes put a premium on the maintenance of individual freedom and parliamentary democracy. His idea of state planning was not a Soviet-style command economy. He said in 1932:

It is of the essence of state planning to do those things which in the nature of the case lie outside the scope of the individual. It differs from Socialism and from Communism in that it does not seek to aggrandise the province of the state for its own sake. It does not aim at superseding the individual within the field of operations appropriate to the individual, or of transforming the wage system, or of abolishing the profit motive. Its object is to take hold of the central controls and to govern them with deliberate foresight and thus modify and condition the environment within which the individual freely operates with and against other individuals. (Keynes and Moggridge, 2010, 81)

It is difficult to avoid the conclusion that the present Anglo-American macroeconomic policy framework – the golden rule (whether followed by accident or design); cheap money; inflation targeting; the fiscal response to the 2008 crash – is broadly Keynesian, if this term is meant to describe Keynes's own thought. There are significant differences between Keynes himself and the Keynesians of all vintages. There are also significant structural differences between the United Kingdom and the United States, particularly in the area of responsibility for the budget. Policy within the Eurozone remains more classical.

The United Kingdom's and the United States’ fiscal and monetary policies have evolved pragmatically by trial and error, emerging from the cauldron of politics under the pressure of events. It is self-evident that Ronald Reagan and Margaret Thatcher – or, later, George Osborne – did not implement policies with Keynesian intent. Yet it appears after all that ‘the ideas of economists and philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood’ (CW 7, 383). Keynes's influence on fiscal and monetary policy did not end with the Keynesian era.

Exchange Rates and Trade Policy

The name of Keynes is rightly associated with the Bretton Woods system. Yet the politically astute Keynes would regard a return to a globally managed exchange rate system in the geopolitical circumstances of the end of the second decade of the twenty-first century as an utopian goal. He would regard the European monetary union as a bungled project, inspired by good intentions but dangerously misled by classical economic theory.

Keynes's clear policy touchstone was that domestic economic stability should not be subordinated to the balance of payments. This subordination occurred under the interwar return to the gold standard and, arguably, again in Britain under the ‘stop-go’ cycle of the Keynesian era. It is what has happened to Greece and other Eurozone deficit countries in recent years. Keynes's touchstone led him to oppose the return to the gold standard in 1925 and to consider protection as a serious policy option (given the fact of the gold standard) in 1931. As noted in chapter 6 of this book, his later support for Bretton Woods was partly designed to avoid the protectionist policies, competitive devaluations and banking crises of the interwar period.

Keynes saw Bretton Woods as being in Britain's interest, given the American insistence upon free trade and in effect upon a dismantling of the British Empire. The agreement was seen to provide Britain and other countries with assured access to foreign exchange reserves without which free trade could not be risked; at the same time Britain needed access to export markets to survive. By contrast, the experience since 1973 is that world trade can grow under a regime of floating exchange rates.

Two major reasons why world trade has grown despite fluctuating exchange rates are the growth of international financial markets, which allow short-term currency risks to be hedged by contract, and the growth of transnational production, such that long-term production costs are matched by sales in each currency. International markets in securities have developed to such an extent that the size of investment portfolios dwarfs the balance on the current account. Accordingly the value of a major currency now reflects the valuation of assets rather than trade and income flows alone. Thus the second era of globalisation has not depended upon the gold standard or a similarly managed exchange rate system.

Robert Mundell (1932–) and Marcus Fleming (1911–76) articulated clearly in 1962 that sovereign states face a policy trilemma under which only two out of three options can be combined: a fixed exchange rate, free movement of capital and monetary policy autonomy. Since 1973 the world has divided into two sectors: major convertible currencies have floated, permitting the free movement of capital and enjoying monetary policy autonomy; others have pegged their currencies against a major currency and either accepted the loss of monetary policy independence (Saudi Arabia) or restricted their capital movements (China).

The economic success of floating rates has come at the price of losing a different sort of autonomy. The growth of financial markets and transnational production that has permitted continued growth of world trade has also undermined national sovereignty. By undertaking or permitting foreign currency borrowing, states subject themselves to their creditors, unless the borrowing is matched by lending or generates net exports. Opening up the ownership of enterprise to non-residents has further sharpened the conflict of interest between the employee and the shareholder. Once-imperial Britain finds the tables turned and is now experiencing the reality of working for foreign investors. Whether in the form of debt or in that of equity, the free movement of capital cedes sovereignty to financial markets.

Keynes was explicit in 1941 that the free movement of capital could not be permitted under a managed exchange rate system:

The whereabouts of the ‘better ’ole’ will shift with the speed of the magic carpet. Loose funds may sweep around the world disorganising all steady business. Nothing is more certain than that the movement of capital funds must be regulated – which in itself will involve far-reaching departures from laissez-faire arrangements. (CW 25, 31)

In 1933 he had expressed a strong sentiment against globalisation:

I sympathise, therefore, with those who would minimise, rather than with those who would maximise, economic entanglement between nations. Ideas, knowledge, art, hospitality, travel – these are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible; and, above all, let finance be primarily national.

The decadent international but individualistic capitalism, in the hands of which we found ourselves after [the First World War], is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous – and it doesn't deliver the goods. In short, we dislike it and we are beginning to despise it. But when we consider what to put in its place, we are extremely perplexed. (CW 21, 236–9)

Despite the uncertainties of Brexit and renewed protectionism in the United States, it is hard now to imagine a voluntary retreat from the globalisation of production. No doubt, it must be admitted, the same was the case at the end of the first era of globalisation in June 1914. Nevertheless, given the nature of modern technology, in 2019 the industrial and financial structure of Britain, at least, appears irreversibly entangled with that of the rest of the world, for good or ill.

If so, given that his views on globalisation seem out of step with present realities, and also given the claim that his views on the management of domestic macroeconomic policy have in practice been accepted, does Keynes have anything more to offer us now? To be clear, the question is not whether post-Keynesian economics, inspired partly by Keynes, has anything to offer: that is a subject for another book entirely. Rather the question is whether there still remains something unused in Keynes's own writings that could be applied today.

The main unfinished business is in the area of international monetary reform. While at present global reform continues to be beyond reach, the analysis in this book suggests that a specific and feasible reform of the European monetary system can be derived from Keynes's proposal for an International Clearing Union (ICU). The aim would be to promote employment in the deficit countries of the Eurozone while preserving the political unity of the Eurosystem.

Repairing the Euro

The creation of the monetary union in 1999 led to the emergence of persistent current account imbalances between the old Deutsche Mark (DM) bloc – Germany, Austria and Benelux – and other members of the union, notably Greece, Ireland, Italy, Portugal and Spain. These were a consequence of the different compositions of national output and different wage-bargaining institutions, which led to lower growth in unit labour costs and greater competitiveness in the surplus countries than in the deficit countries. Until 2008 the deficits were financed mainly through short-term lending by private banks. Since there were no restrictions on cross-border lending, the funds were used (directly or indirectly, since much of this was interbank lending) to finance budget deficits in the case of Greece and speculative construction in Spain and Ireland. Neither form of spending could lead to net exports.

The 2008 global financial crisis triggered a crisis within the eurozone. Some question whether the source of the crisis was the current account imbalances themselves or rather the fragility of the manner in which they were financed. The financial account was an independent source of instability, as the cross-border lending before the crisis far exceeded the requirements of the imbalances. For example, in the case of Ireland, the banks both took and made cross-border loans totalling several times the national income. Either way, the recall of short-term private bank lending meant that the cumulative current account imbalances became imbalances between the central banks of the Eurosystem, standing at some €1,300bn in 2018.

My concern is how Keynes would react to this debt overhang and to its major underlying source, the current account imbalances. There can be no doubt that he would regard the monetary union as possessing the worst features of the gold standard, without even the possibility of devaluation. He would emphasise the need to channel surpluses into export-oriented investment in the deficit countries to create employment. The pre-1914 gold standard was stable only because Britain invested its surplus overseas.

The previous comments about the scope and limits of the United Kingdom's public investment apply here too. Powerful institutions with great potential already exist in the form of the European Investment Bank and the European Bank for Reconstruction and Development. Yet such investment ultimately requires a reversal of the imbalances such that the DM bloc runs, for the necessary period, a current account deficit that corresponds to new surpluses run by the former deficit countries. Only if the rest of the world – notably the United States – runs deficits can all the eurozone countries run German-style surpluses. Such strategic dependence, even if it were possible, would be unwise and probably unsustainable. Furthermore, while large-scale cross-border public investment might conceivably reverse the imbalances on its own, it would not be consistent with the fiscal compact as it stands.

The architects and governors of the euro are committed to a conservative classical model of the economy. The only forms of economic adjustment countenanced to address the imbalances are austerity in the short run, as explained in chapter 6 of this book, together with wage cuts and ‘flexible labour markets’ in the long run. These are recipes for political discontent and put at risk not only the monetary union, but the European Union itself.

The problem could be solved, in theory, through transfers of tax revenue across borders, for example to fund an integrated European welfare state with health, education, pension and social security systems. This would certainly create an ever closer union and a renewed identification of citizens with Europe. It would, however, require the transfer of large parts of national budgets to the European level and additional taxation in surplus countries at a level at least equal to the current account imbalances. We can be confident that Keynes would regard such proposals as wishful thinking in the present circumstances.

Equally improbable is an acceptance, by Germany and other surplus countries, of an internal revaluation, a rise in money wages that would make exports less competitive and eliminate the surpluses. This would require a major reallocation of production towards the domestic market; and increased public investment would probably be needed in order to avoid higher unemployment, at least in the transition. The interests of major German industries and the country's fiscal conservatism would not favour this plan any more than they did in 1971, when Germany and France refused to revalue their currencies against the dollar, helping to bring about the end of the Bretton Woods system. Furthermore, Germany's loss of export markets to (say) the United Kingdom or the United States would not help Greece or Italy. It is much easier to make a deficit country admit the need for devaluation than to make a surplus country admit the need for revaluation. Hence the need for cross-border investment of surpluses in productive export industry, combined with devaluation by the deficit countries, in order to increase the net exports made by the deficit countries.

Although the monetary union has been disastrous in certain respects, it does represent an unprecedented achievement in others. The member states have pooled their sovereignty so that the euro has the same reserve status for them as the special drawing right (SDR). They have accepted the discipline of the fiscal compact, in an attempt to exorcise the spectre of the Weimar inflation that continues to haunt the European Central Bank. There is progress towards a banking union. The pooling of sovereignty already achieved provides the opportunity for a reformed monetary system that learns and recovers from the mistake of the premature adoption of a single currency.

Keynes's ICU envisaged the creation of a new supranational currency by treaty; such indeed is the euro. However, he did not propose the abolition of national currencies; in his scheme bancor would be used for settlements among central banks only, like the SDR today. Keynes would propose three elements as necessary for a successful reform of the European monetary system: the freedom for a member state to return to a national currency, without this being seen as the failure of the European project; the acceptance of the need for capital controls for that currency; and the reform of the fiscal compact towards a golden rule.

The exchange rate of the national currency against the euro would initially be set to generate a current account surplus in order to repay outstanding euro debt. The exchange rate would subsequently be adjusted monthly, in line with the difference in inflation, for it to maintain its real effective value. This crawling peg would be mandatory and administered automatically by the Eurosystem. Any payments deficit would be funded with euros and the deficit country would have unlimited short-term recourse, as at present and as under Keynes's ICU. This underwriting would eliminate any risk of speculative crisis, as seen in the case of sterling's ignominious exit in 1992. However, as at present, the deficit country would have to accept conditionality for long-term funding; this should include an industrial strategy and the possibility of further devaluation in real terms, in the event of a structural current account deficit re-emerging.

Such conditionality would be linked to the capital control regime. In particular, the principle would be adopted that foreign currency borrowing must be matched either by foreign currency lending (as in the banking sector) or by the prospect of additional net exports over the term of the loan. Any permission for cross-border lending would need to look through to the application of the funds; it would not be sufficient for a Spanish bank to make a euro loan, funded from the Netherlands, for a domestic project that could only earn pesetas.

The benefits of this reform would be to achieve, in deficit countries, the universal wage cut required to renew export competitiveness, while simultaneously cutting all other costs, such as rents, taxes and domestic debt repayments. There is no denying the real wage cut; but the cut will be less painful and less unjustly distributed than if unbalanced deflation is allowed to continue. The return of monetary sovereignty would allow the national government to finance capital projects with its own currency and, if necessary, run a current budget deficit for a period. The crawling peg would provide a guarantee to the sceptical that any inflationary consequences of deficit financing would affect only that state and not the eurozone.

Such a proposal remains a pipe dream unless it addresses the problem of capital flight during the negotiation period. The sort of imaginative solution Keynes might have come up with is to separate the devaluation from the question of debt relief. There could be a capital guarantee in the form of a reverse capital levy on the date of creation of the national currency. The levy would automatically compensate for the devaluation on day 1.

For example, assume that the new national currency (say, ducats) is initially defined by law at par to the euro, so €1 = 1 ducat. On Ducat Day all national incomes, prices and debts are redenominated in ducats – the nominal amounts stay the same. Assume that a 25 per cent devaluation is necessary, so 360 ducats now buys only €270. The simultaneous reverse capital levy adds 33 per cent to the amount of all debts in ducats. Someone originally holding a €270 bank deposit before redenomination holds 360 ducats after the levy, still worth €270. Conversely, someone who owed 270 ducats now owes 360 ducats, but this still represents €270. There is no redistribution from creditor to debtor, as normally takes place in a devaluation or inflation.

There would be no immediate incentive for capital flight to beat the change, at least for home residents concerned about the price of home output. Foreign residents, while also protected from the devaluation, might still seek to avoid prospective capital controls. It is possible that a proposal of this sort would only be implemented as a response to crisis, when capital controls had become necessary in their own right.

This is a proposal not to abandon the euro but to save it. The Eurosystem can be more than the single currency. Financial interests would oppose any imposition of capital controls, of course. The EU is facing a test of democratic legitimacy: have the interests of the peoples, especially those of the deficit countries, been reduced simply to those of international capital?

The readoption of a national currency would be undertaken as part of a multilateral agreement, underpinned by the euro itself, that continues to impose discipline on the retiring state. Ultimately, if the European Union does achieve its ever-closer union and approaches the reality of a federation, it would be easy enough for a member state with its own currency to rejoin the euro at the appropriate exchange rate. Adoption of the euro as a national currency makes long-term capital controls impractical, since banknotes can always be taken across open borders. Nevertheless, the current account of the balance of payments, wholly neglected by the classical model of the euro and by the convergence criteria for accession, remains of central policy importance. If differences in industrial and institutional structure make the emergence of imbalances inevitable under a single currency, such a currency should not be adopted without additional measures such as fiscal transfers.

Keynes would set great store by the need to preserve the European Union in the interests of peace, prosperity and civilisation. From The Economic Consequences of the Peace onwards, it is clear that Keynes would regard the failure of the EU and a return to the fragmented Europe of his own time as a disaster of epic proportions. He would be working energetically to devise and implement the reforms necessary to protect the EU from itself and from classical economists and to allow its further development as a force for peace and democratic freedom.

In Conclusion

Throughout this book I have tried to avoid ventriloquism. The picture of Keynes's thought that emerges may well seem unfamiliar. Some of my post-Keynesian colleagues will be surprised by the conservative tone of this chapter. My personal view is that the good society sought by Keynes, if it is ever to be realised, will require the reform of corporate governance and of labour rights to bring about a shift in the balance of power – and responsibility – from capital towards labour, as well as substantial increases in public revenue and spending on current account. However, I can find no warrant for such policies in Keynes's own thought.

There are many reasons why economic theory has had a love–hate relationship with Keynes. The aim of this book has been to dispel the myths and get back to the real issue, which is the nature of the equilibrium of a market economy. Economics will remain unscientific, despite its use of mathematics, until it recognises the force of Keynes's critique. Economists need to admit that, as a matter of logic, in an economy producing multiple goods through wage labour, income, wages and interest are intrinsically monetary. In a monetary economy we cannot rely upon the invisible hand to deliver full employment, even under a competitive regime of fully flexible markets. Without agreement on these central points, debate about policy will always be confused and contentious.

Most of Keynes's policy arguments have been incorporated into the framework of macroeconomic policy. The golden rule of fiscal policy explains long-term movements in UK and US government borrowing fairly well, whatever the intentions of those in power may have been. The policy of inflation targeting combined with a floating exchange rate is almost exactly what Keynes proposed and underpins a policy of cheap money. His primary concern to see private investment raised and sustained has been achieved, to a greater degree than he expected, while public investment continues to provide stability and to ‘crowd in’ private investment. Equally he would not rule out on principle the socialist proposals for extra public investment in the UK 2017 Labour manifesto, provided that these were sensibly implemented and funded. The Bank of England's equilibrium rate of unemployment is in line with what Keynes considered feasible, although that is no reason for complacency.

Only on free trade did Keynes ever seriously question, for a time, what is now conventional wisdom. Nevertheless he went on to support the free trade commitment of Bretton Woods that ultimately led to the World Trade Organisation. The main benefit of the Bretton Woods exchange rate system, in contrast with the floating rate system Keynes had preferred earlier, was the avoidance of competitive devaluation and of protection, in order to promote trade.

Today the European Union is the largest single market outside a nation state. We can be confident that Keynes would be working to preserve the Union as it remains, and in particular to correct the mistake of the premature adoption of a single currency. This chapter has set out the sort of proposal Keynes might have made today. It is possible to formulate a return to a national currency within a reformed European monetary system that includes a managed exchange rate with the euro. Such a reform would be good for employment, for democracy and for the future of the EU.

In policy terms, much of what Keynes worked for has been achieved. Economic theory has been more intractable. Classical theory has continued to prove misleading and disastrous in the way it has been used to justify austerity as the solution for recession and trade imbalances and to legitimise hateful attitudes towards the unemployed.

Keynes saw his revolution in thinking, not as setting aside the classical theory altogether, but as encompassing it within a more general theory. He demonstrates the importance and the art of choosing the right model when we want to explain the world in which we live. In his almost final published sentence he said something that could apply to all his work: ‘Here is an attempt to use what we have learnt from modern experience and modern analysis, not to defeat, but to implement the wisdom of Adam Smith’ (CW 27, 445).

Further Reading

There are several recent biographies of Keynes for those who want to get beyond the models and pure economics of this book. They come in a variety of flavours, all highly digestible.

Robert Skidelsky's (2010) Very Short Introduction is exactly that, while his John Maynard Keynes (Skidelsky 2003) is an abridged version (only 1,000 pages!) of his definitive biography in three volumes. Robert Cord's (2007) Keynes is an alternative, beautifully presented and illustrated, concise introduction.

Peter Clarke's (2009) Keynes and Skidelsky's (2009) The Return of the Master were prompted by the 2008 financial crisis, as Keynes re-emerged into public discourse; while Roger Backhouse and Bradley Bateman's (2011) Capitalist Revolutionary takes stock a little later, once austerity had set in as the preferred political response.

Richard Davenport-Hines's (2015) Universal Man plays down the economics and paints a colourful portrait of Keynes the man. Benn Steil's (2013) Battle of Bretton Woods pits Keynes against Harry Dexter White as a well-told drama and underlines the difficulties Keynes faced during his negotiations with the United States.

For the economics student who wishes to delve deeper after reading this book, Minsky (1975), Chick (1983), Trevithick (1992), Sheehan (2006) and Temin and Vines (2014) are rather more demanding but may suit.

Bibliography

Primary: Keynes, Collected Writings (CW)

Quotations from Keynes are taken, with a few exceptions, from the 30-volume The Collected Writings of John Maynard Keynes (CW), edited by Elizabeth Johnson and Donald Moggridge and published in 1971–89 by Macmillan at London for the Royal Economic Society. Cambridge University Press at Cambridge published a digital version in 2012: doi.org/10.1017/CBO9781139524308. References cite the siglum CW, the volume number, and the page (e.g. CW 27, 445). I have used the following volumes:

CW 2: The Economic Consequences of the Peace

CW 4: A Tract on Monetary Reform

CW 5: A Treatise on Money: The Pure Theory of Money

CW 6: A Treatise on Money: The Applied Theory of Money

CW 7: The General Theory of Employment, Interest and Money

CW 8: A Treatise on Probability

CW 9: Essays in Persuasion

CW 10: Essays in Biography

CW 13: The General Theory and After. Part 1: Preparation

CW 14: The General Theory and After. Part 2: Defence and Development

CW 20: Activities 1929–1931: Rethinking Employment and Unemployment Policies

CW 21: Activities 1931–1939: World Crises and Policies in Britain and America

CW 25: Activities 1940–1944: Shaping the Post-War World: The Clearing Union

CW 27: Activities 1940–1946: Employment and Commodities

Secondary

Backhouse, R. E. (2004) ‘History and equilibrium: A partial defense of equilibrium economics’. Journal of Economic Methodology 11(3): 291–305.

Backhouse, R. E. and Bateman, B. W. (2011) Capitalist Revolutionary: John Maynard Keynes. Cambridge, MA: Harvard University Press.

Barro, R. J. (1997) Macroeconomics (5th ed.). Cambridge, MA: MIT Press.

Blinder, A. S. and Zandi, M. (2010) ‘How the great recession was brought to an end’. https://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf.

Callaghan, J. (1976) Leader's speech, Labour Party Conference, Blackpool, 28 September. http://www.britishpoliticalspeech.org/speech-archive.htm?speech=174.

Chick, V. (1983) Macroeconomics after Keynes: A Reconsideration of the General Theory. Cambridge, MA: MIT Press.

Clarke, P. (2009) Keynes. London: Bloomsbury.

Clarke, P. (2010) ‘Pragmatic and dogmatic Keynesianism: The relevance of Keynes's thinking today’. Podcast (talk only). Robinson College, Cambridge. http://www.robinson.cam.ac.uk/postkeynesian/keynes.html.

Coddington, A. (1976) ‘Keynesian economics: The search for first principles’. Journal of Economic Literature 14 (4): 1258–73.

Colander, D. C. and Landreth, H. (1996) The Coming of Keynesianism to America: Conversations with the Founders of Keynesian Economics. Cheltenham: Edward Elgar.

Collins, J. (2017) An Analysis of John Maynard Keynes's The General Theory of Employment, Interest and Money. London: Routledge.

Cord, R. (2007) Keynes. London: Haus.

Davenport-Hines, R. P. T. (2015) Universal Man: The Seven Lives of John Maynard Keynes. London: William Collins.

Davidson, P. (2017) Who's Afraid of John Maynard Keynes? Challenging Economic Governance in an Age of Growing Inequality. Basingstoke: Palgrave Macmillan.

Dillard, D. (1948) The Economics of John Maynard Keynes: The Theory of a Monetary Economy. New York: Prentice Hall.

Fox, J. (2008) ‘The comeback Keynes’. Time, 3 November (as corrected by Lucas on 28 October). [Published online on 23 October.]

Hansen, A. H. (1953) A Guide to Keynes. New York: McGraw-Hill.

Hartwig, J. (2017) ‘The comparative statics of effective demand’. Review of Political Economy 29 (3): 360–75 .

Hayes, M. G. (2006a) The Economics of Keynes: A New Guide to The General Theory. Cheltenham: Edward Elgar.

Hayes, M. G. (2006b) ‘Value and probability’. Journal of Post Keynesian Economics 28(3): 527–38.

Hayes, M. G. (2007a) ‘Keynes's Z function, heterogeneous output and marginal productivity’. Cambridge Journal of Economics 31(5): 741–53.

Hayes, M. G. (2007b) ‘The point of effective demand’. Review of Political Economy 19(1): 55–80.

Hayes, M. G. (2008) ‘Keynes's degree of competition’. European Journal of the History of Economic Thought 15(2): 275–91.

Hayes, M. G. (2010) ‘The loanable funds fallacy: Saving, finance and equilibrium’. Cambridge Journal of Economics 34(4): 807–20.

Hayes, M. G. (2013) ‘The state of short-term expectation’. Review of Political Economy 25(2): 205–24.

Hayes, M. G. (2018) ‘The liquidity of money’. Cambridge Journal of Economics 42(5): 1205–18.

Hicks, J. R. (1939) Value and Capital. Oxford: Oxford University Press.

Keynes, J. M. and Moggridge, D. E. (2010) Keynes on the Wireless. Basingstoke: Palgrave Macmillan.

King, J. E. (2015) Advanced Introduction to Post Keynesian Economics. Cheltenham: Edward Elgar.

Lavoie, M. (2014) Post-Keynesian Economics. Cheltenham: Edward Elgar.

Lucas, R. E. (1980) ‘The death of Keynesian economics’. Issues and Ideas. Winter.

Mankiw, N. G. and Taylor, M. P. (2014) Macroeconomics (2nd European edn). New York: Worth Publishers.

Marshall, A. (1920) Principles of Economics: An Introductory Volume (8th edn). London: Macmillan.

Meade, J. E. (1975) ‘The Keynesian revolution’, in M. Keynes (ed.), Essays on John Maynard Keynes. Cambridge: Cambridge University Press, pp. 82–8.

Minsky, H. P. (1975) John Maynard Keynes. New York: Columbia University Press.

O’Donnell, R. M. and Rogers, C. (2016) ‘IYLM: A General Theory-compatible replacement for ISLM’. Cambridge Journal of Economics 40(1): 349–64.

Pigou, A. C. (1936) ‘Mr. J. M. Keynes’ General Theory of Employment, Interest and Money’. Economica 3: 115–32.

Piketty, T. (2014) Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press.

Robinson, J. (1937) Introduction to the Theory of Employment. London: Macmillan.

Robinson, J. and Eatwell, J. (1973) An Introduction to Modern Economics. Maidenhead: McGraw-Hill.

Samuelson, P. A. and Nordhaus, W. D. (1989) Economics (13th edn). New York: McGraw-Hill.

Sawyer, M. C. (2003) ‘Employer of last resort: Could it deliver full employment and price stability?’. Journal of Economic Issues 37(4): 881–907.

Schumpeter, J. A. (1961) [1934] The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle. Cambridge, MA: Harvard University Press.

Sheehan, B. (2006) Understanding Keynes’ General Theory. Basingstoke: Palgrave Macmillan.

Skidelsky, R. J. A. (2003) John Maynard Keynes, 1883–1946: Economist, Philosopher, Statesman. New York: Penguin.

Skidelsky, R. J. A. (2009) Keynes: The Return of the Master. London: Allen Lane.

Skidelsky, R. J. A. (2010) Keynes: A Very Short Introduction. Oxford: Oxford University Press.

Steil, B. (2013) The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order. Princeton, NJ: Princeton University Press.

Stewart, M. (1967) Keynes and After. Harmondsworth: Penguin Books.

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Temin, P. and Vines, D. (2014) Keynes: Useful Economics for the World Economy. Cambridge, MA: MIT Press.

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Wray, L. R. (1998) Understanding Modern Money. Cheltenham: Edward Elgar.

Index

Page numbers in italic refer to figures and tables.

aggregate demand 44, 45–9, 53, 56, 72, 74, 90, 94, 104, 105, 107, 124, 129, 137, 146, 173

curve 19, 37, 43, 44, 45, 48

function 37, 46, 47–8, 49, 105, 140, 172

aggregate investment 50, 59, 61, 72, 87

aggregate saving 61, 87

aggregate supply 44, 45, 53, 56, 72, 104

curve 37, 43, 44, 172

function 37, 52, 53–4, 140

‘animal spirits’ 8, 65, 67, 75, 147

Arab–Israeli War 133

assets

capital assets 68, 69, 75

economic life of 63

intangible 63

liquid 65

see also capital goods

atom, model of 2

austerity 10, 119, 121, 122, 123, 129, 130, 131, 132, 137, 153, 156, 166, 171

Austria 165

automatic stabilisers 126, 154, 155

Backhouse, Roger 145

balance of payments 9, 96–7, 109, 111, 114, 115, 132, 133, 134, 149, 162

balance of trade 100, 173

banana parable 90

bancor 111, 112, 167

Bank of England 2, 80, 81, 82, 83, 85, 150, 170

Exchange Equalisation Account 103

bank money 81–3, 84, 85

Bank Rate 82, 83, 86, 153

banking 76, 80, 81, 82–3, 108

bailouts 107, 115, 134

bank runs 82

business deposits 85

cash deposits 85

central banks 70, 73, 82, 83, 84, 86, 93–4, 95, 103, 133, 153, 154, 165

crises 82, 106, 110, 114–15, 140, 162

deposits 80, 81, 83, 84, 85, 92

development of 70, 108–9

foreign banks 107

income deposits 85

reserve policy 84, 85

savings deposits 85

see also specific banks

banking union 167

bear markets 85, 87

beauty contest metaphor 68

Benelux 165

Bentham, Jeremy 29

Beveridge, William 149

Beveridge Reports 124

Bohr, Niels 2

bonds 66, 69, 69–70, 72, 75–6, 85, 109, 121, 129

liquidity risk 69–70

borrowing

by nationalised industries 161

for consumption 153, 154, 155–6, 158

for investment 154–5, 158

safe borrowing limits 156, 158, 161

unemployment and 151–3, 152, 155

see also debt

Bretton Woods system 6, 10, 109, 110, 111, 115, 116, 117, 132, 133, 141, 162–3, 166, 170

Brexit 117, 164

British Business Bank 160

Brown, Gordon 154, 159

budget deficits 154, 155, 165, 168

bull markets 85, 87, 89

business cycle theory 138, 146

Callaghan, James 135

Cambridge Economic Policy Group (CEPG) 136

Cambridge Keynesian tradition 140

Cambridge quantity equation 79, 84

Can Lloyd George Do It? 58

capital

capital assets 68, 69, 75

capital inflation 88, 89

classical capital market 21–6, 25

marginal efficiency of 14

marginal product of 22–3, 62

neoclassical capital market 31

capital flight 168

capital goods 41, 43, 49, 50, 55, 61, 62, 63, 65–6, 68, 75–6

liquidity 65

Carter, Jimmy 10, 135, 142

cash flow 60, 112

central banks 70, 73, 82, 83, 84, 86, 93–4, 95, 103, 133, 153, 154, 165

cheap money policy 70, 131, 153, 161, 170

Chicago School 13

Chick, Victoria 37, 148, 159

China 163

Churchill, Winston 74, 103–4

circular flow diagram 60

Clarke, Peter 143

classical dichotomy 32, 34, 54

classical theory 4, 5, 6, 12–35, 171

application to monetary economy 34

capital market 21–6, 25

causation 7

corn model 4, 12–34

of employment 6, 7, 13–21, 30, 53

general equilibrium 10, 39, 138, 140, 145, 146

of income 39–40

of interest 6, 7, 21, 57, 69

key claims 13

Keynes's critique of 5, 11, 34, 35–56, 144–5

labour market 16–21, 19

of money 6, 31–2, 54

return to 4, 13, 139, 140

Say's law 7, 9, 33–4, 57, 74, 75, 76, 147

see also corn model

command economy 117, 161

commodity deflation 89, 90

commodity inflation 88, 89, 90, 91

commodity prices 134, 137, 141

competition 5, 6, 16–17, 27, 28–9, 30, 45, 139

imperfect 54, 55

competitive equilibrium 4, 50, 55, 140, 142, 146

confidence 8, 65, 70, 139

consumer price index (CPI) 94, 153

consumption 33, 41, 50, 58, 59, 87, 89, 90, 158

borrowing for 153, 154, 155–6, 158

deferral of 92

income and 7, 59

propensity to consume 46, 48, 53, 61, 72, 74, 88, 104, 107

public 10, 91, 115, 123, 124, 125, 130, 131, 132, 141

Say's law 33

wartime 91, 92

consumption function 46, 48, 50, 51, 55, 138

consumption smoothing 99

Corn Laws 28

corn model 4, 33, 37, 43, 52–3, 56, 59, 106

classical theory 4, 12–34

diminishing returns 22, 22

employment 13–21, 30, 36, 45, 114

exchange rates 100, 173–5

income 39–41, 43

interest 21, 56, 57

international economy 97–9, 100, 111, 114

investment 33, 59, 62, 64, 75

land market 27–9, 28

money 31–2, 78

profit 21

saving 33, 59

cost-push inflation 78–9, 91, 93

‘creative destruction’ 67

credit cycle 84, 89, 90

cross-border loans 98, 99, 103, 106–7, 109, 165, 167–8, 174–5

cross-border trade 97, 109

currencies

currency risk 163

devaluation 108, 110, 111, 113, 133, 166, 167, 168

exchange rates see exchange rates

purchasing power parity (PPP) 100–1, 104

see also individual currencies

current account 9, 98, 102, 115, 169

balanced 99, 106, 129, 163

deficits 99, 100, 102, 106, 107, 110, 115, 159, 166, 167

equilibrium 100, 101, 114

imbalances 106, 114, 165, 166

oscillations 102, 103

surpluses 9, 98, 99, 100, 102, 107–9, 129, 132, 141, 149, 166, 167, 175

current budget 151, 154, 155, 168

Darling, Alistair 156

Davidson, Paul 140–1

dealers’ expectations 49, 50, 51, 52, 61

debt 66, 74, 75, 83, 140

bank debt 81, 82

foreign debt 99–100, 107, 111

foreign purchase of domestic debt 115

prudential limit on 159

public sector debt ratio 159

quantitative easing 83, 154

secure 66

settlement 60, 109, 111

see also bonds

deflation 74, 84, 89, 90, 103, 150, 168

demand 36–7, 92, 124, 125–6, 134, 135, 137, 139, 141, 155, 156

effective 36–9, 38, 42–3, 44, 45–9, 47, 52, 53, 55, 56, 58, 62, 90, 91, 94, 96, 104–6, 129, 137, 139, 145, 146, 150, 153

notional 37

shortfall 7

demand curve 18, 19, 20–1, 23, 25, 26, 37, 43, 45, 48, 62, 66

see also aggregate demand curve; investment demand curve; labour demand curve

demand function 37, 43, 44, 46, 47, 49, 105

demand price 26

demand-pull inflation 78, 93

Deutsche Mark 113, 165

devaluation 108, 110, 111, 113, 133, 166, 167, 168

diminishing returns 6, 14–15, 15, 16, 22, 22, 44, 54, 140

disequilibrium 87, 88, 90, 103, 145

distribution 6, 31, 32, 35, 77

see also income distribution

dollar 109, 113, 133, 134

dollarisation 80

The Economic Consequences of Mr Churchill 103–4, 150

The Economic Consequences of the Peace 77, 99, 169

economic growth 34

precondition for 5

see also diminishing returns

economic models 2–4

fallibility of 137–8

Economic Possibilities for Our Grandchildren 144

economics

economic models 2–4

essay in persuasion 3

matter of logic 3, 170

use of mathematics 2

see also classical theory; neoclassical theory; New Classical theory; New Keynesian economics; post-Keynesian economics

effective demand 36–9, 38, 42–3, 44, 45–9, 47, 51, 52, 53, 55, 56, 58, 62, 72, 90, 91, 94, 96, 104–6, 129, 137, 139, 145, 146, 150, 153

Egypt 25

employer of last resort (ELR) 129

employment

classical theory of 6, 7, 13–21, 30, 53

corn model 13–21, 30, 36, 45, 114

cycles 8

employment policy 149

equilibrium 38, 90, 150

full employment 6, 9, 10, 13, 21, 36, 38, 53, 74, 89, 90, 91, 93, 94, 95, 100, 114, 124, 130, 131, 132, 133, 135, 136, 137, 139, 141–2, 145, 149–50, 173

government intervention, classical argument against 72, 145

Keynes's thinking about 6, 36–52, 56, 94

overemployment 89

wartime 91–2, 124

see also unemployment/underemployment

The End of Laissez-Faire 144

entrepreneurs 67, 75, 76, 87, 88, 90

equilibrium 51–2, 54, 56, 88, 89, 90, 138, 140, 145–6, 170

balance of payments 114, 115

classical 10, 39, 138, 140, 145, 146

competitive 4, 50, 55, 140, 142, 146

consumers 51, 61

current account 100, 101, 114

dealers 51–2, 61

employers 61, 145

employment 38, 90, 150

exchange rates 98, 99, 100

interest rates 26, 94

output 89

unemployment 45, 94, 150, 170

wages 20, 21

equilibrium price 31, 44, 86

equilibrium wage 20, 21

euro, Eurozone 11, 97, 106, 109, 113, 115, 162, 164, 166, 167, 169

reform proposal 165–9

European Bank for Reconstruction and Development 165

European Central Bank 107, 167

European Investment Bank 165

European Union 161, 166, 169, 170

euthanasia of the rentier 131, 144

exchange rates 96, 96–9, 100–11, 129, 158

Bretton Woods system 6, 10, 109, 110, 111, 115, 116, 117, 132, 133, 141, 162–3, 166, 170

corn model 100, 173–5

crawling peg 97–8, 167, 168

equilibrium rate 98, 99, 100

fixed 108, 109, 110, 117, 133, 163

floating 97, 102, 103, 108, 109, 115, 133, 163, 170

gold exchange standard 109

managed system 109

reform proposals 167

stability of 102, 115

sterling/dollar exchange rate 109–10, 110

volatility 98, 102, 103

exchange risk 103

Exchequer budget 154

expectations 8, 36, 40, 43–5, 46, 49–52, 53, 55–6, 61, 62, 63, 66, 88, 94, 138, 148, 153

confidence in 8

fulfilment of 55, 56

long-term 8, 36, 43, 44, 45, 49, 55, 56, 62, 64, 65, 67, 68–9, 70, 75, 140, 146

medium-term 36, 43, 44, 49, 55, 62, 146

rational 63, 65, 146

short-term 43, 44, 50, 56, 62, 75, 137, 146

expected income 7, 36, 37, 38, 39, 43, 44, 45, 48, 49, 53, 99

non-wage 46

see also expectations

exports 10, 59, 97, 98, 104, 105, 107, 112, 114, 115, 117, 118, 119, 121, 126, 128, 131, 132, 133, 139, 141, 146, 163, 165, 166, 167, 175

financial account 97, 98, 106, 165, 175

financial circulation 85, 86

financial crash (2008) 13, 65, 114–15, 117, 155, 156, 165

financial fragility 148

financial liberalisation 114–15

first classical postulate 14

fiscal compact 159, 166, 167

fiscal drag 136

fiscal policy 124, 154–62, 170

fiscal stimulus 156

fiscal ‘golden rule’ 154, 155, 159, 161, 167

Fisher, Irving 79

Fleming, Marcus 163

Ford, Gerald 135

foreign currency

adoption of 80

borrowing/lending 163, 167

reserves 9, 98, 103, 110, 111, 113, 129, 149, 159, 162

see also exchange rates

foreign debt 99–100, 107, 111

foreign exchange markets 98, 99, 103

see also exchange rates

forward markets 44, 45, 63, 64, 75, 103, 174, 175

France 133, 166

free market 5–6, 21, 32, 103

full employment and 13, 21, 148–9

see also competition

free movement of capital 102, 163–4

free trade 9, 10, 95, 112, 121, 132, 162, 170

Friedman, Milton 13, 90

full employment 6, 9, 10, 13, 21, 36, 38, 53, 74, 89, 90, 91, 93, 94, 95, 100, 114, 124, 130, 131, 132, 133, 135, 136, 137, 139, 141–2, 145, 149–50, 173

functional finance 124

G17 118, 119, 120, 121, 122, 176–7

The General Theory of Employment, Interest and Money 7, 9, 12, 14, 35–56, 57, 59, 71, 77, 85, 87, 93, 94, 96, 136, 144–5, 146, 151

Germany 80, 81, 96, 99–100, 106, 107, 113, 129, 150, 165, 166

globalisation 109, 114, 163, 164

gluts 7, 33

Godley, Wynne 136

gold convertibility 109, 110, 132, 133, 141

gold and silver 59, 84, 111

gold standard 9, 74, 102, 103, 104, 108, 109, 110, 117, 119, 121, 149, 162, 165

Goodhart, Charles 138

government spending 72, 77, 107, 124, 128, 130, 131, 135, 137, 139, 146, 156, 175–6, 177

Great Depression 112, 117, 121

Greece 106, 107, 162, 165

Hahn, Frank 63

Hansen, Alvin 52, 124

Harcourt, Geoff 140

Harrod, Roy 2

Hayek, F. A. 144

Heath, Edward 134

Hicks, John 57, 61, 64, 69, 71, 172–3

hoarding 33, 58, 69, 70, 83, 149

How to Pay for the War 77, 91–2, 93, 124, 150

Howe, Geoffrey 153–4

Hume, David 9

hyperinflation 9, 80, 82, 84

hysteresis 150

imperfect competition 54, 55

imports 98, 100, 105, 107, 112, 129, 139

income 39–43, 146

classical theory 39–40

consumption and 7, 59

corn model 39–41, 43

distribution 6, 13, 14, 29, 29, 139, 143

effective demand and 42–3, 51, 145

expected income 7, 36, 37, 38, 39, 40, 41, 42, 43, 44, 45, 48, 49, 53, 99

income–expenditure relationship 60

measurement of 39–40

monetary nature of 39, 43, 57

national income 39, 46–7, 122

non-wage income 46, 104

realised income 40, 41, 42

time structure of 41–2, 42

as value of net output 39, 60

see also consumption; investment; saving

income inflation 88, 89, 93, 150

incomes policies 92, 133, 134, 135, 150, 153

industrial circulation 85–6, 88, 89, 112

Industrial Revolution 34, 108

inflation 6, 9, 10, 32, 77, 78, 84, 85, 96, 153, 167

as a stealth tax 80

capital inflation 88, 89

commodity inflation 88, 89, 90, 91

cost-push inflation 78–9, 91, 93

demand-pull inflation 78, 93

European inflation 80

expectation management 94

hyperinflation 9, 80, 82, 84

income inflation 88, 89, 93, 150, 153

Keynes's thinking about 6, 77–85, 88–95

managing 91–2

money wages and 93–5

money–inflation relationship 77, 78–80, 85, 90, 91

stagflation 10, 141

wartime 91–2

see also under United Kingdom; United States

inflation targeting 78, 93, 94, 153, 154, 161, 170

inflation tax 80

insurable risk 64, 65, 66, 75

insurance markets 64

interest 6, 21, 57

classical theory of 6, 7, 21, 57, 69

corn model 21, 56, 57

investment and 8, 57, 58, 62–9

Keynes's thinking about 6, 7–8, 57

loanable funds theory of 57, 58–62, 69, 72, 73, 147

interest rates 7–8, 32, 33, 57, 58, 129, 139, 154

Bank Rate 82, 83

determination of 58, 62, 72–3, 76

disequilibrium 88

equilibrium rate 26, 94

fall in 58, 89, 123

investment and 8, 57, 58, 62–9

IS–LM model 71–3, 71, 73

Keynes's thinking about 7–8, 62–9

long-term rate 10, 69, 70, 85, 132, 153, 154

market rate 27, 30, 88

money and 69–70

natural rate 88, 93

negative 26

positive 26

real rate 10, 141, 144, 146–7

rise in 72–3, 89

short-term rate 85, 154

see also under United Kingdom; United States

International Clearing Union (ICU) 111–12, 114, 149, 164, 167

international financial markets 163

International Monetary Fund (IMF) 10, 112, 113, 132–3, 135

international monetary system 6, 9, 96–115

corn model 97–9, 100, 111, 114

effective demand 104–6

exchange rates see exchange rates

foreign currency reserves 9, 98, 103, 110, 111, 113, 129, 149, 159, 162

reform of 11, 164, 165–9

special drawing right (SDR) 112–13

war finance 99–100

interwar period 110, 117, 119, 121–2, 124, 125, 126–7, 128, 129, 131, 134, 162, 177

investment 6, 8–9, 21, 27, 33, 58, 97, 130, 141, 146, 147–8, 158

aggregate investment 50, 59, 61, 72, 87

balanced portfolio 66

borrowing for 154–5, 158

consumption and 7, 59

corn model 33, 59, 62, 64, 75

cross-border 166

export-oriented 131, 165

interest and 8, 57, 58, 62–9

investment output 87, 89

investment plans 57

investment prices 86, 88, 89

IS–LM model 71–3, 71, 73

Keynes's thinking about 62–9, 160

long-term 45, 63, 68

market sentiments 68

private 147, 153, 154, 155, 168

profitability 62, 87

public 130, 132, 153, 154–5, 158, 170

saving–investment relationship 33–4, 74, 76, 139, 147, 158

state of confidence 8, 65, 70

stimulation of 10, 129, 132, 148

uncertainty and 64, 65, 67, 75

see also expectations; and under United Kingdom; United States

investment demand 24

investment demand curve 23, 23, 25, 66

invisible hand of the market 13, 145, 170

Iranian hostage crisis 136

Iranian revolution 135

Ireland 165

IS–LM model 71–3, 71, 73

Italy 165

Japan 159

Journal of Post Keynesian Economics 141

Kahn, Richard 50

Kaldor, Nicholas 140

Kalecki, Michal 139, 140

Keynes, John Maynard

classical theory, critique of 5, 11, 34, 35–56, 144–5

continuing relevance to policy and theory 11, 144–62

on economists 1

fiscal and monetary policy, influence on 154–62

inflationist, myth of Keynes as 128–9, 141

legacy of 10–11, 141–2

liberal politics 11, 144

modeller 2–3, 171

‘monetarist’ 77, 143

see also Keynesian era

Keynesian cross 52, 56, 71

Keynesian dichotomy 59

Keynesian era 5, 10, 116–42

abandonment of Keynesian economics 136–53

beginning and end of 10, 116, 117, 132–6

historical context and record 5, 116–28

labour

average product of 16, 17, 18

marginal product of 14, 16, 17, 18, 27, 28, 38, 52–3, 97

labour demand curve 18, 18, 19, 20–1, 23

labour market

classical 16–21, 19

competition 5, 28, 30

flexibility 5, 93, 166

neoclassical 30–1, 30

see also employment; unemployment; wage

Labour Party 135, 144, 156, 160, 161

laissez-faire arrangements 149, 164

Lamont, Norman 95

land market 27–9, 28

land ownership 18

leases 63, 65

Leijonhufvud, Axel 57

Lend-Lease 100, 111, 129

Lenin, Vladimir 77

Lerner, Abba 124, 128, 129

liquidity 75, 85, 141, 148, 154

hierarchy of 66, 75

preference 65, 69, 75

risk 66, 69–70

shortage of 70

loanable funds doctrine 57, 58–62, 69, 72, 73, 75, 147

loans 33–4, 61, 81

cross-border 98, 99, 103, 106–7, 109, 165, 167–8, 174–5

long-run equilibrium 86, 87

Lucas, Robert 13, 138, 145

macroeconomics 92, 99, 138, 142, 149, 153, 170

Malthus, Thomas Robert 28

maps 2

marginal efficiency of capital 14

marginal principle 29

marginal product 22–3, 32, 36

of capital 23, 27, 62

of labour 14, 16, 17, 18, 27, 28, 38, 52–3, 97

net product 22

marginal productivity 4, 6, 14, 15–16, 16, 21, 29, 54

market mechanism 8, 56

market sentiments 68

Marshall, Alfred 1, 29, 143, 145

Marx, Karl 2, 139, 140

Meade, James 76, 124, 129, 150

mercantilism 149

Mesopotamia 25

microeconomics 138

Mill, John Stuart 2, 29

Minsky, Hyman 140, 148

Modern Monetary Theory (MMT) 128–9, 159

monetarism 78, 80, 92

monetary economy 33, 34, 36, 53, 54, 57, 58, 74, 75, 76, 86, 96, 104, 107, 170

monetary policy 10, 84, 86, 91, 93, 94, 95, 129, 132, 138, 139, 141, 153, 163

see also exchange rates; inflation targeting; interest rates

monetary union 97, 106, 107, 109, 115, 162, 165, 167, 168, 169, 170

see also euro; Eurozone

money

bank money 80, 81–3, 84, 85

causal role for 78–9

‘cheap money’ 70, 131, 153, 161, 170

circulation of 73, 81, 85, 88, 89, 112

classical theory of 6, 31–2, 54

confusion between saving and 6, 58, 59, 60, 69, 75

corn model 31–2, 78

economy without money 26

hoarding 33, 58, 69, 70, 83, 149

interest rate and 69–70

Keynes's general theory of 6, 52–5

Keynes's thinking about 6, 7, 9, 52–5, 77–95

liquidity 65, 66

as means of final settlement 82

money–inflation relationship 77, 78–80, 85, 90, 91

nature and definition of 80–3

neutrality of 32, 54

purchasing power 80, 83, 84, 85, 89, 100–1, 104, 153

quantity theory of 31–2, 73, 74, 77, 78–80, 83–6, 88, 89, 90–1

rational ground for holding 69

speculative demand for 70, 85

state money 80–1, 82, 83, 84, 85, 86

supply of and demand for 7–8, 9, 58, 62, 69, 70, 72, 78, 80, 83–6, 85, 91, 92, 139, 154

velocity of 79, 90

see also liquidity

money wages 36, 40, 53, 54–5, 93–5, 104, 150, 156

multiplier 7, 36, 45–9, 47, 49, 50, 51, 58, 72, 105, 124, 133, 158, 172

Mundell, Robert 163

national income 39, 46–7, 122

National Union of Miners 134

nationalisation 124, 130, 160, 161

neoclassical synthesis 138, 142

see also IS–LM model

neoclassical theory 29–31, 140

neoliberal era 117, 119, 121, 122, 123, 124, 130, 131, 153

net exports 114, 115, 163, 165, 166, 167, 175

net output 15, 17, 22, 33, 34, 39, 40, 41, 48, 59, 78, 86, 89–90

New Classical theory 146

New Deal 117, 124

New Keynesian economics 54, 55, 139, 142, 146

Nixon, Richard 133, 134

nominal yield 66

non-wage income 46, 104

Northern Rock 82

notional demand 37

Obama, Barack 117, 156

oil crisis (1973–4) 116, 117, 133, 134, 141

oil crisis (1979) 135

OPEC 133

order books 44, 50, 55, 62, 145

Osborne, George 151, 156, 162

output

equilibrium level of 89

natural rate of 93

net 15, 17, 22, 33, 34, 39, 40, 41, 48, 59, 78, 86, 89–90

output gap 93

overheating 93, 95

short-term fluctuations in 8, 54, 90, 94

overemployment 89

Pigou, A. C. 2, 12, 143

Pigou effect 74

Piketty, Thomas 131

political geography 96

Portugal 165

post-Keynesian economics 5, 78, 83, 139–41, 142, 148, 164

price levels 86–8

average price of consumption goods 86

average price of investment goods 86

equilibrium 86

internal and external 103, 104

prices 6, 31, 32, 77, 137, 139

classical theory of 31, 77

equilibrium price 31, 44

falling 33, 74

price competition 52

price control 92, 134, 136

price expectations 52, 137

rises 55, 88, 89

stability 95, 119, 150

stickiness 52

supply and demand price 26

wage–price spiral 92

see also inflation

pricing models for financial securities 65

printing money 80, 92, 159

privatisation 124, 160

productivity 6, 21, 57

marginal versus average 15–16, 16

profit, profitability 21, 27, 62, 66, 87, 88, 89, 90, 131, 131, 132, 137, 139, 144

property rights 14, 18

prospective yield 43, 62, 63, 66, 68

protectionist policies 108, 110, 111, 162, 164

purchasing power 80, 83, 84, 85, 89, 153

purchasing power parity (PPP) 100–1, 104

quantitative easing 83, 154

quantity equation 78, 79, 84, 86, 88

Cambridge quantity equation 79, 84

quantity theory of money 31–2, 73, 74, 77, 78–80, 83–6, 88, 89, 90–1

rational expectations 63, 65, 146

Reagan, Ronald 117, 162

recessions 112, 117, 121, 134, 151

rentier equity capital 131, 132, 144

rents 21, 27, 28, 74, 99

Rethinking Economics 2

reverse capital levy 168

Ricardo, David 2, 28, 29, 140

risk

aversion 69

currency risk 163

exchange risk 103

insurable risk 64, 65, 66, 75

liquidity risk 66, 69–70

of loss 66

management 43

Robertson, Dennis 57, 69

Robinson, Joan 140

Samuelson, Paul 52, 138

Saudi Arabia 163

saving 7, 30, 33, 58, 64, 80, 87, 89, 146, 148, 149, 158

compulsory 92

confusion between money and 6, 58, 59, 60, 69, 75

corn model 33, 59

excessive 9

IS–LM model 71–3, 71

nature and definition of 59, 60

saving–investment relationship 33–4, 74, 76, 139, 147, 158

savings deposits 85

savings plans 57

Say's law 7, 9, 33–4, 74, 75, 76

Keynes's refutation of 7, 57, 147

Schumpeter, Joseph 67

Second World War 91–2, 100, 111

seignorage 80

Shackle, George 67

share price fluctuation 66, 67

Shaw, George Bernard 12

shocks, economic 99, 125, 134, 155

single currency see monetary union

sinking fund charges 154

Smith, Adam 2, 145

social justice 144

socialism 130, 160, 161, 170

sovereignty 9, 108, 109, 110, 111, 113, 114, 163, 167, 168

pooling of 167

Soviet Union 80, 133

Spain 165

special drawing right (SDR) 112–13, 132–3, 167

spot markets 44, 103

Sraffa, Piero 139–40

stagflation 10, 141

state deposit guarantee 82, 83

state money 80–1, 82, 83, 84, 85, 86

sterling 80, 108, 109, 111, 113, 133, 134, 167

devaluation 110, 133

sterling/dollar exchange rate 109–10, 110

stock adjustment 50–1, 51, 61, 137

subsidiarity 161

subsistence wage 22–3

Sumeria 25–6

supply curve 37, 45, 47, 172

supply and demand theory 10, 25, 26, 33, 34, 37, 38, 55, 74, 137, 138, 139, 145

see also Say's law

supply price 26

supranational currency 167

see also bancor

Sweden 150

taxation 92, 107, 114, 124, 126, 130, 136, 137, 155, 158, 159, 166

tax cuts 122, 138, 156

Thatcher, Margaret 117, 162

thrift 6, 21, 57, 80

time 36, 41–2, 62, 75, 125, 146

see also expectations

A Tract on Monetary Reform 77, 79, 80, 84, 86, 89, 93, 102, 103, 104, 109

trade

cross-border 97, 109

cycle 130

deficit 100, 176

trade unions 54, 134, 136

transnational production 163

A Treatise on Money 35, 49, 77, 79, 81, 85, 86, 87, 88, 89, 90, 91, 93, 151

A Treatise on Probability 64, 65

Triffin paradox 113

Trump, Donald 117

uncertainty 64, 65, 67, 75, 141

unemployment/underemployment 10, 17–18, 36, 58, 89, 91, 149–51, 166

classical theory of 13–21, 20, 145, 151

deliberate creation of 104

disguised 150

equilibrium rate of 45, 94, 150, 170

frictional 93, 150, 151

involuntary 38, 54

and money wage reduction 95

natural rate of 93

public borrowing and 151–3, 152, 155

remedy for 5, 21

structural 150

voluntary 93, 151

see also under United Kingdom; United States

United Kingdom

Anglo-American macroeconomic policy framework 161–2

austerity period 117, 119, 121, 122, 123, 131, 137, 156

current account balance 101–2, 101

data volatility 126, 127, 128

exports growth rate 117, 118, 119, 131

full employment policy 10, 130, 135, 141–2

gold standard era 9, 74, 102, 103, 104, 108, 109, 110, 117, 119, 121, 149, 162, 165

income growth rate 105, 105, 117, 118, 119, 131, 133

incomes policies 134

industrial disputes 134, 136

inflation 119, 119, 123, 135, 177

interest rates 119, 119, 121, 154

Keynesian budget 124

Keynesian era 116–42

neoliberal era 119, 121, 123, 124, 130, 131

public borrowing 122, 122, 123, 132, 147, 147, 151, 152, 153

public consumption 124, 125, 125, 130

public investment 122, 122, 123, 124–5, 125, 130, 131, 132, 147, 147, 154–5, 158, 160–1, 165, 170

public sector debt ratio 159

rate of profit 131, 131

real exchange rate 101, 101, 102

sterling/dollar exchange rate 109–10, 110

Three Day Week 134

unemployment 119, 119, 135, 136, 147, 147, 151, 152, 153

wage inflation 134

see also Bretton Woods system

United States 82

American Recovery and Reinvestment Act 156

Anglo-American macroeconomic policy framework 161–2

austerity era 117, 156

balance of payments 132

borrowing and investment 122–3, 123

data volatility 126, 127, 128

exports growth rate 120, 121

Federal Reserve Board 82

gold convertibility 10, 110, 113, 132, 141

Great Depression 117, 121

income growth rate 105–6, 106, 120, 121, 133, 135

income per head 120, 121

incomes policies 134, 135

inflation 121, 122, 123, 134, 135

interest rates 121, 154

investment 147, 148

Keynesian era 116–42

Modern Monetary Theory (MMT) 128–9

New Deal 117, 124

protectionism 164

public borrowing 122–3, 123, 151, 152, 153, 170

public consumption 125, 126, 130

public investment 122–3, 123, 125, 126, 154–5, 158

public sector debt ratio 159

real exchange rate 102

sterling/dollar exchange rate 109–10, 110

unemployment 121–2, 121, 135, 147, 148, 151, 152, 153

see also Bretton Woods system

utility 29

value 6, 31, 32, 35, 72, 75, 77, 140

fundamental 68

stability of 65

velocity of money 79, 90

Venezuela 129

Versailles Treaty 6, 96, 99

Vietnam War 132

Volcker, Paul 153

wages 14, 21, 32, 88, 153

cuts 17, 53, 54, 74, 104, 107, 166, 168

deferred pay 92

equilibrium wage 20, 21

flexibility 6, 21

inflation and 93–5

market wage 27, 30, 38

money wages 36, 40, 53, 54–5, 93–5, 104, 150, 166

‘real’ wage 36, 40, 52–3, 54, 94, 96, 99

rise and fall in 89, 91, 93

‘stickiness’ 36, 54–5

subsistence wage 22–3

wage inflation 150

wage restraint 150

wage units 53, 71, 72, 91, 93, 172

wage-bargaining 53, 150

wage–price spiral 92

Walras, Léon 140

war finance 99–100

war production 91

war reparations 96, 99–100

Weintraub, Sidney 150

welfare cuts 151

welfare system 130, 151, 155, 166

White, Harry Dexter 111, 113, 115

Wicksell, Knut 88

World Bank 10, 112

World Trade Organisation 10, 170

Wray, Randall 128

yield to redemption 66

Z diagram 37, 38, 39, 49, 172

Zimbabwe 129

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