Friday, 25 May 2012

About Keynes

Keynes's General Theory of Employment, Interest and Money is probably close to the best book on capitalist economics ever written. I doubt whether it is required reading on any economics course these days. In my opinion it should be read before embarking on any such program. The risk is that no course of economics as currently taught would subsequently be of any interest.

It is not any easy book, and the general reader probably needs a few years study of the financial press, at least, to make sense of it. But it is exciting, in the same way that Schumpeter's Capitalism, Socialism and Democracy is, and for similar reasons. It forces economic theory to adapt to the real world of capitalism, rather than forcing capitalism into a sterile theoretical mould.

It can of course be read from beginning to end. But chapter two, which is the real beginning of the book (chapter one is a single page), begins with a complex rebuttal of the theory of supply and demand for labor. Therefore, perhaps the best place to start is on p 27*, where Keynes gives a summary outline of his theory. Here Keynes says:

"The outline of the theory can be expressed as follows. When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income.... Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level....what we shall call the community's propensity to consume.... The amount of current investment will depend in turn on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans.... Thus given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium... But there is no reason in general for expecting it to be equal to full employment."

In this summary we are left with the awareness of the importance to employment of the spending of the community's income. Income is of course spent in consumption. But consumption does not increase by so much as income, because of a psychological tendency Keynes calls the propensity to consume. So there is generally a gap which must be filled in order to maintain employment at its level.

The gap can only be filled by investment. But entrepreneurs' willingness to invest the required amount is not guaranteed. The motivation to invest depends on the expected marginal efficiency of capital (the expected future yield on new investment) as compared to the rate of interest. Keynes might have added that the rate of interest depends on the liquidity preference of the community (the desire to hold cash rather than to lend money at interest). Thus we are left with three critical explanatory variables in Keynes's theory of capitalist economies:

- the propensity to consume;
- the current expectation of future cash flows on new investment; and
- the preference for holding cash rather than making loans at interest.

* Note: I have a First Harvest 1964 edition, with the same pagination as the original.

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