When I buy a bottle of wine, the cost to me is income to the seller, and what he spends out of that income will be income to someone else, and so on. So the active investment that produced the income with which I bought the wine will have had a chain-reaction--what Keynes calls a "multiplier"--effect.
And here is the tricky part: the increase in income brought about by an investment is greater the higher the percentage of income that is spent rather than saved. Spending increases the incomes of the people who are on the receiving end of the spending. This derived or secondary effect of consumption is greater the higher the percentage of a person's income that he spends, and so it magnifies the income-generating effect of the original investment.
In the first example, the investment multiplier--the effect of investment on income--was In the second example it is only 2. The difference is caused by the difference in the propensity to consume income rather than save it. No one today, by the way, thinks that investment multipliers are that high.
For Keynes, in other words, it is consumption, rather than thrift, that promotes economic growth. And here the second key claim of Keynes kicks in: that people often save with no particular aim of future spending--they hoard. Keynes mentions a host of reasons why people save that may not promote active investment he also discusses the analogous motives of businesses , at least in the short run.
Savers may want to "bequeath a fortune," "satisfy pure miserliness," "build up a reserve against unforeseen contingencies," "enjoy a sense of independence and the power to do things, though without a clear idea or definite intention of specific action," or, implicitly, obtain a reputation for being thrifty.
This latter motive is reminiscent of the "Protestant ethic" of which Max Weber wrote. Since Keynes was centrally concerned with unemployment, he was suspicious of saving because, as we just saw, the greater the percentage of income that is consumed rather than saved, the greater the demand for goods, and therefore the greater output, and so the lower the unemployment rate. But it is here that Keynes's equating saving with investing becomes particularly confusing.
Isn't investing a good thing? It is what drives income. And if investment is a good thing, mustn't saving, being synonymous with investing as Keynes has told us , be a good thing, too? Keynes's answer, though it is not stated as clearly as one would wish, is that investing increases output, and therefore employment, only when it finances the creation of productive capital. When it takes the form of hoarding, the link between saving and promoting economic activity is broken, or at least frayed.
The third claim that I am calling foundational for Keynes's theory--that the business environment is marked by uncertainty in the sense of risk that cannot be calculated--now enters the picture.
Savers do not direct how their savings will be used by entrepreneurs; entrepreneurs do, guided by the hope of making profits. But when an investment project will take years to complete before it begins to generate a profit, its prospects for success will be shadowed by all sorts of unpredictable contingencies, having to do with costs, consumer preferences, actions by competitors, government policy, and economic conditions generally.
Skidelsky puts this well in his new book: "An unmanaged capitalist economy is inherently unstable. Neither profit expectations nor the rate of interest are solidly anchored in the underlying forces of productivity and thrift.
They are driven by uncertain and fluctuating expectations about the future. But however high-spirited a businessman may be, often the uncertainty of the business environment will make him reluctant to invest. His reluctance will be all the greater if savers are hesitant to part with their money because of their own uncertainties about future interest rates, default risks, and possible emergency needs for cash to pay off debts or to meet unexpected expenses.
The greater the propensity to hoard, the higher the interest rate that a businessman will have to pay for the capital that he requires for investment. And since interest expense is greater the longer a loan is outstanding, a high interest rate will have an especially dampening effect on projects that, being intended to meet consumption needs beyond the immediate future, take a long time to complete.
The "sinking funds" I mentioned illustrate institutional hoarding: money is accumulated to pay off a debt in the future rather than being spent, and its unavailability for investment causes interest rates to rise. High interest rates discourage active investment while making passive investment attractive, and thus deliver a one-two punch to consumption.
True, high interest rates discourage the hoarding of cash by increasing the opportunity cost of such hoarding, but they also encourage forms of passive investment, such as purchasing government bonds, that may have only a remote effect in encouraging active investment. Keynes's analysis provides an explanation--though there is debate among economists whether it is the correct one--for England's persistent high unemployment in the interwar period, or more precisely for the component that represented involuntary unemployment, the plight of unemployed workers who would have preferred to work at a wage below the prevailing rate than to be on the dole.
One might think that wages would have fallen to a level at which anyone who wanted a job could have found one. But Keynes pointed out that since workers are a high proportion of all consumers, a fall in the wage level will reduce incomes, and therefore reduce consumption and investment, unless prices fall proportionately.
They would be likely to fall somewhat, because producers' labor costs will be lower. But a general fall in the price level--deflation--imperils economic stability, and actually cutting workers' wages to make room for the unemployed is a surefire formula for industrial strife. And workers are not fungible. A factory that employs highly skilled workers may have a lower average cost of production than one that employs less-skilled workers at a lower wage.
Only if demand for goods is high may the market have room for a firm that, because it employs those less skilled workers, has higher costs of production than the existing firm.
Although the Keynesian part of the book was originally intended to flesh out my model of the rise and fall of economic theories, it turned out to have very valuable lessons for today. Indeed, the circle appears to have come around to where Keynesian theories are now the best ones we have for dealing with today's economic crisis. One thing I did in the Keynesian section that helped me a lot in my thinking was to largely ignore John Maynard Keynes' technical writings.
What was much more useful in understanding his thinking were his popular writings. For example, Keynes had what today we would call an op-ed article in the New York Times on New Year's Eve that may be the single best thing written during the Great Depression on its cause and what to do about it.
It's certainly more accessible than The General Theory of Employment, Interest and Money, much of which is incomprehensible even today. The General Theory, I think, was really just Keynes' way of making some relatively simple ideas look scientific in order to make them more acceptable to policymakers. Post a Comment. About Me Steve Hsu View my complete profile. Somehow I missed this! Thanks to a reader for pointing it out to me. Posner was as captured by Chicago School nonsense as anyone else, but at least we learn that he can perform a Bayesian update i.
How do Gary Becker and Robert Lucas feel about the recent apostasy of their colleague? We have learned since September that the present generation of economists has not figured out how the economy works.
The vast majority of them were blindsided by the housing bubble and the ensuing banking crisis; and misjudged the gravity of the economic downturn that resulted; and were perplexed by the inability of orthodox monetary policy administered by the Federal Reserve to prevent such a steep downturn; and could not agree on what, if anything, the government should do to halt it and put the economy on the road to recovery.
During our conversation, Posner questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis, which says that the prices of stocks and other financial assets accurately reflect all the available information about economic fundamentals, and the rational-expectations theory, which posits that individuals and firms are hyper-intelligent decision-makers who have a correct model of the economy in their heads.
In rational-expectations theory, the economy is represented in very simplified and spare fashion. Although Posner was unfailingly polite, I detected an edge of anger in his comments about the economics profession and its embrace of such patently unrealistic theories.
I asked what he thought economists had learned from the past two years. Professors have tenure. They have lots of graduate students in the pipeline who need to get their Ph. They have techniques that they know and are comfortable with. It takes a great deal to drive them out of their accustomed way of doing business. Last fall, as the financial crisis intensified, many Chicago economists halted their own research to concentrate on the moment. The entire profession was blindsided.
In the course of a few days, I talked to economists from various branches of the subject. The over-all reaction I encountered put me in mind of what happened to cosmology after the astronomer Edwin Hubble, in , discovered that the universe was expanding, and was much larger than scientists had believed.
The profession fell into turmoil. Some physicists stuck to the existing theories, which posited a stable universe. Still others attempted to come up with a new account of how the galaxies formed; it was this effort that ultimately produced the theory of the big bang. Fama, whom I interviewed in his office at the Booth School, was firmly in the denial camp.
A short, wiry man of seventy, with cropped hair and wearing a short-sleeved flowery shirt, he looked more like a retired marine in Miami Beach than like one of the founders of modern finance. Beginning in the nineteen-sixties and seventies, Fama, who holds the title of Robert R. McCormick Distinguished Service Professor of Finance, propounded the efficient-markets hypothesis, which underpinned the deregulation of the banking system championed by Alan Greenspan and others.
I asked him how this theory had fared in the recent crisis, which many, myself included, have described as an example of gross inefficiency. Fama was unruffled. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline.
That was exactly what you would expect if markets are efficient. The emphasis that Fama placed on the stock market surprised me. Surely, I said, we had experienced a giant credit bubble, which eventually had burst. These words have become popular. That is not necessarily Chicago-led. Chicago once resisted that—people like Ronald Coase and George Stigler. Modern economics is, on the one hand, very mathematical, and, on the other, very skeptical about government and very credulous about the self-regulating properties of markets.
That combination is dangerous. On the other hand, you have an exaggerated faith in the market. But that is not all there is in economics. There is also behavioral economics, which has made a lot of progress. But some of their skepticism is warranted.
And behavioral finance, I find very convincing. I put a lot of emphasis on the Frank Knight a famous Chicago economist who taught at Chicago from the nineteen-twenties to the nineteen-sixties and Keynes view of uncertainty. That makes economists very uncomfortable, because it is very hard to model.
Once you introduce uncertainty, it means that a lot of consumer behavior is not going to be easily modeled as cost-benefit analysis. Paul Davidson, a professor at University of Tennessee is a leading post-Keynesian. So, in sense, you see yourself reviving an older Chicago tradition—Knightian economics—which in some ways is closer to Keynes?
Not only that, but there is a curious link between Keynes and Coase, even though they are at opposite ends of the political spectrum. I never heard Coase mention Keynes, but I am sure he would have regarded him as a dubious left-wing character Coase is very, very conservative.
But they are very similar in their informality. Both of them, they are not concerned with the kind of axiomatic reasoning where you start with human beings assumed to have rational calculators inside them. They are much more likely to take people as they are. And Knight was not at all a formal economist. It really was excellent. Coase in his later work: no math. These people are impossible.
His criticism of me was crazy. He had me fighting a last-ditch stand for Chicago—the exact opposite of what I wrote. Some conservative writing bothers me also. They are not at all reluctant about taking extreme positions in an Op-Ed, or in blogs, and so on. It really demeans the profession. Krugman is obviously a good economist.
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