CHAPTER 8

The Economics of Keynes's

General Theory

Without question, the greatest advances in economic thinking in the twentieth century have been associated with the name and work of John Maynard Keynes. His most important contributions were produced in the years of the Great Depression. It was then that he formulated his General Theory of Employment, Interest and Money, a work that broke sharply with the orthodox neo-classical tradition. The reorientation of approaches to economic policy in the past three decades has, in large measure, been shaped by Keynesian economic analysis.

1. JOHN MAYNARD KEYNES (1883-1946)

Throughout the greater part of his adult life, Keynes was associated with King's College, Cambridge. But his career was not that of a cloistered academic. Upon completion of his undergraduate studies in 1905, he joined the Civil Service and was assigned to the India Office. His first published works in economics - dealing with monetary questions in India - were a by-product of this experience. For a brief period before the First World War, he returned to Cambridge to take up a college fellowship, but shortly thereafter he was called back to public duties as an adviser to the Treasury. In this capacity he accompanied the British delegation to the Paris Peace Conference. He resigned this post in June 1919, in protest against terms of settlement with Germany that he regarded as vindictive, immoral, and impracticable. His outspoken attack on the work of the conference in a book entitled The Economic Consequences of the Peace made him both an international figure and persona non grata in British official circles for nearly two decades.

Between the wars Keynes divided his time between studies in economics and editorship of the journal of the Royal Economic Society, participation in public debates on the leading issues of the day, and the administration of the financial affairs of his Cambridge college. His early theoretical works were concerned with monetary and financial problems. His competence in these matters was by no means confined to theoretical analysis. Both his college's resources and his personal estate were considerably enriched by his skill in portfolio management. When he wrote of the significance of speculative activity (as he did in the General Theory), he knew whereof he spoke.

In 1940 Keynes re-entered public service as a principal economic adviser to the government. During the darkest days his main preoccupation was with the mobilization of the British economy in support of the war effort. In this task the tools of national income analysis he had forged proved to be invaluable. Later his attention shifted to post-war reconstruction of the international economy. The establishment of two institutions - the International Monetary Fund and the International Bank for Reconstruction and Development - owes much to his inspiration and to his powers of persuasion as a negotiator.

Even the most abbreviated sketch of Keynes's life would do the man less than justice should it fail to mention another facet of his interests. A distinguished bibliophile and patron of the arts himself, he was anxious that the arts should be adequately supported and that they should be accessible to a wide audience. His initiative was instrumental in the creation of the Arts Council.

As a literary craftsman, Keynes was also an artist in his own right. The quality of his prose is alone sufficient to assure him a unique place in the economists' hall of fame. This skill has been recognized by no less competent a critic than T. S. Eliot, who wrote of him: 'In one art, certainly, he had no reason to defer to any opinion: in expository prose he had the essential style of the clear mind which thinks structurally and respects the meaning of words.'1 This quality of the man is reflected in a toast he once offered to his fellow economists, whom he described as 'the trustees, not of civilization, but of the possibility of civilization'.2

2. THE ANALYTICAL PROBLEM OF THE

GENERAL THEORY

Keynes's principal work focused on one central issue: the determination of levels of national income and employment in industrial economies and the cause of economic fluctuations. Earlier schools of economic thought had given little systematic attention to this problem. The classicists were too preoccupied with questions of long-period economic growth to concern themselves directly with short-period instability; in any event - apart from the post-Napoleonic war years - the matter was not of major significance in their day and age. Marx came closer to Keynesian concerns but his work was always overlaid with the pre-judgement that the downfall of capitalism was inevitable; in his view widespread fluctuations were the result of an incurable malignancy within the capitalist system. Though some neo-classical writers made reference to 'industrial fluctuations' and to the 'inconstancy of employment', they were far more interested in the forces influencing output in particular markets than in those governing the output of the economy as a whole. Moreover, they were persuaded that full employment was the long-run equilibrium position toward which the economy naturally gravitated and their analysis was built on this premiss.

Even before his doubts about neo-classical presuppositions had crystallized, Keynes was suspicious of this attitude -'in the long run,' he observed, `we are all dead'. As his thought took shape in the General Theory, economic analysis was reconstructed to bring short-period aggregative problems to the centre of the stage. The microeconomic questions around which the neo-classical tradition had been organized were pushed toward the wings. At the same time, Keynes was at pains to dissociate his position from the Marxist contention that capitalism was doomed. The essentials of the system, he maintained, could be preserved if reforms were made in time. An unregulated capitalism, however, was incompatible with the maintenance of full employment and economic stability.

Keynes had moved part way towards this conclusion in the mid-1920s with the recognition that conventional laissez-faire was inadequate to the increasingly complex problems of industrialized societies. But his thought was then still in the mould of Marshallian neo-classicism. The writing of the General Theory in the early 1930s was, as he described it, 'a struggle of escape from habitual modes of thought and expression'3 - a struggle made more difficult because 'I myself held with conviction for many years the theories which I now attack. . . .'4 His professional upbringing had taught him to respect the analytical strengths of the neo-classical theory and alerted him to the sources of its staying power. As an elegant logical structure, it had an unquestioned appeal. Nevertheless, the neo-classical system (which in the General Theory he referred to as 'classical theory') Keynes held to represent `the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away.'5

While Keynes declared war on the aggregative strand of the neo-classical tradition, it was not his objective to re-write neo-classical micro-economics. Apart from expressing reservations about its postulates on the degree of competition and their relevance to the prevailing market structure, he largely by-passed this component of the neoclassical model.

3. THE ATTACK ON SAY'S LAW AND THE

INTERPRETATION OF MONEY

Keynes saw clearly that the mainstay of orthodox confidence in the self-adjusting properties of a market system to a full employment equilibrium was the neo-classical version of Say's Law and he made this strand of theory a primary target of criticism. As originally formulated, Say's Law had distinguished between 'general' and `partial' overproduction; the former was held to be impossible, while the latter - though it could occur - could not persist in an economy in which there were no significant impediments to the mobility of productive resources.

Subsequent re-interpretations of Say's Law (and particularly the version implicit in latter-day neo-classical thought) could be translated into the proposition that all income would be spent. In other words, there would be no important leakages from the income stream in the form of hoarding. In standard neo-classical reasoning this conclusion was held to be a self-evident truth. It was not, of course, denied that an occasional miser might mar the image. But this type of behaviour could be dismissed as irrational and likely to be so rare that, for all practical purposes, it could be ignored. After all, who in his right mind would accumulate idle funds in substantial volume when, by lending them, he could add to his income? Consumption expenditure was the main object of economic activity. Rational economic agents could only be induced to restrain their consumption - i.e. to save part of their income - when offered a reward in the form of a rate of interest for so doing.

Around these postulates the whole structure of neoclassical thinking about saving and investment in the aggregate had been built. The community was expected to respond positively to higher rewards for saving; an increase in the rate of interest would swell the volume of loanable funds. Borrowers, on the other hand, would adjust the quantity of loanable funds for which they were prepared to pay as the rate of interest changed; at low rates of interest the quantity of loanable funds demanded would be augmented and at higher rates, curtailed. The rate of interest was thus interpreted as a sensitive mechanism for producing an equilibrium between saving and investment. In turn, this equilibrium insured that the portion of income not spent on consumption goods would be spent on investment goods.6

This line of argument was further reinforced by the standard neo-classical interpretation of the role of money. In this view the primary function of money was as a medium of exchange. It was sought for the command over goods and services that it provided. But money per se was sterile and lacking in intrinsic value. This perspective, of course, was both consistent and closely inter-related with the judgement that hoarding was irrational. Money was economically interesting only as it was spent and circulated throughout the system. Indeed, this presupposition underlay the various versions of the quantity theory of money worked out by neo-classical economists.

Keynes's assault on the Say's Law tradition centred on this analysis of money. He set about the task by reversing the perspective from which money was viewed. Whereas neo-classical writers looked first at money in motion - i.e. when spent - Keynes chose to analyse money as it was held. The primary question to be answered was: how and for what reasons is the community induced to hold the stock of money that exists at a given moment? Obviously the community required some minimum stock of money to lubricate the wheels of commerce and to provide a reserve against contingencies. These motives for holding money were thoroughly compatible with neo-classical thinking. But Keynes insisted that there was also another reason for holding cash - the speculative motive for liquidity. This concept was essential to the opening of space for the analytical innovations of the General Theory.

Why should anyone wish to hold money in excess of the amounts required for transactions and precautionary purposes when he sacrificed thereby an income he might have gained as a lender? Keynes's reply rested on the inverse relationship between interest rates and the capital values of paper assets. The essentials of the point he had in mind can most readily be conveyed through a moment's consideration of the yield and market price on a consol (a type of government debt issue familiar in Britain, though not in the United States). As a negotiable perpetual bond the consol is convenient for purposes of illustration because it permits the general principle to be established without the complications presented when debts with differing maturity dates enter the picture.

For purposes of argument, let us assume that a 3 per cent consol has been issued at a par value of £100; i.e. the holder is assured of £3 per year. Let it further be assumed that, subsequently, the rate of interest on new debt of comparable quality rises to 6 per cent. The holder of the 3 per cent consol, should he wish to sell, would be exposed to a considerable capital loss. At interest rates now prevailing those seeking an assured income of £3 per year could obtain it by placing £50 and would not be prepared to pay more for the consol originally valued at £100. Actual - as opposed to hypothetical - market situations are, of course, less tidy because of the variety of paper assets of widely differing quality available as alternatives to holding cash. Nevertheless, there will still be a tendency for interest rates and capital values on interest-bearing assets to move in opposite directions. Rising interest rates will be associated with capital losses to the holders of old issues, while falling interest rates will bring windfall gains. In the light of this relationship Keynes argued that there might be circumstances in which it would be prudent to hoard as a hedge against risks of capital loss. Indeed the speculative motive for liquidity might be forceful when the rate of interest was already low (and the sacrifice of income through hoarding was not great) and when it was thought that rates of interest in the future would probably move up (and expose the owners of debt instruments to substantial capital losses).

When this consideration was taken into account, money could no longer be interpreted exclusively as a medium of exchange. Instead it also performed an important function as a store of value. This insight undercut the line of reasoning upon which Say's Law had rested. Hoarding could no longer be ruled out by assumption, nor treated as an irrational activity. Once this link in the neo-classical analytical chain had been broken, confidence in the self-adjusting properties of the economy to a full-employment level of equilibrium could no longer be sustained. On the contrary, an underemployed economy might tend to get stuck at a level of income well below its potential if part of its income stream leaked into the build-up of idle hoards.

In developing this view of money Keynes found intellectual companions among mercantilist writers of the seventeenth and eighteenth centuries. He was prepared to argue that the mercantilist tradition contained clearer insights into the nature of money than those offered by the teachings of the classical and neo-classical schools. In doing this he associated himself with doctrines that had been viewed as heresy for more than a century and a half.

4. THE RE-INTERPRETATION OF THE

RATE OF INTEREST

Both the Keynesian model and the aggregative strand of the neo-classical system manipulated the same variables: income, saving, investment, money, and the rate of interest. These pieces of analytical furniture, however, occupied quite different places on the stage. Shifting the relationships between any of them meant that new positions had to be found for them all.

It is already apparent that Keynes gave a different twist to one of the variables - money. His view of money, in turn, opened up a new perspective on the rate of interest. He described the problem in the following manner: `The habit of overlooking the relation of the rate of interest to hoarding may be part of the explanation why interest has been usually regarded as the reward of not-spending, whereas in fact it is the reward of not-hoarding'.7

But how was the level of the rate of interest determined? As Keynes saw the matter, the rate of interest was governed - not by the supply of and demand for loanable funds (as neo-classical writers had maintained) - but by the supply of and demand for money. The supply of money (consisting of currency and coin issued by governments and bank money held in the form of checking accounts) could, of course, be regulated by the government and the central bank. The demand for money, on the other hand, was established by the preferences of the community. At any moment, of course, all of the money in existence would be held by someone. But it did not necessarily follow that those who held money would wish to continue to do so. At the earliest opportunity they might prefer to exchange money for goods or for income-yielding assets. The explanation of the determination of an equilibrium between the supply and demand for money called for an answer to the question: what factors would induce the public to hold the available stock of money?

In working out a solution to this puzzle, Keynes built further on the foundation laid by his revisionist interpretation of the motives for holding money. The amount of money the public would be prepared to hold was, he maintained, governed by two factors: the level of national income and the rate of interest. The community clearly required a certain stock of money for transactions and precautionary purposes and the amounts required were likely to vary with the level of economic activity. In all probability, rising national income would swell these components of the demand for money and falling national income would diminish them. But the public might also demand money for speculative reasons. Balances held in this form amounted to hoarding and their size was likely to be influenced primarily by the rate of interest and by expectations about its future course. At high rates of interest the community was likely to prefer income-yielding assets to idle balances. At low rates of interest, on the other hand, hoarding might be preferred as a safeguard against possible capital losses.

An example may be helpful in conveying the Keynesian argument on the mechanics of this process. Let us suppose that the monetary authorities increase the supply of money (say by buying government securities held by the banks or by the public and thus increasing the money balances of those who formerly held these securities). How would a new equilibrium position be reached? In the absence of a change in national income there would be no reason to expect a change in the amount of money the public would be prepared to hold for transactions and precautionary purposes. Presumably, many of those who received increased money balances in exchange for government securities would prefer to hold income-yielding assets. As they acquired them, however, the market price of these assets would be bid up; simultaneously, the effective rate of interest would be depressed. Lower rates of interest would reduce the reward for parting with liquidity. This adjustment, in turn, would increase the willingness of the community to hold an enlarged quantity of money. Through this process of interaction between interest rates and the supply of money a new equilibrium would be established at which the increased supply of money could be absorbed into the system.

This interpretation of the determination of interest rates completely scuttled the orthodox neo-classical view that interest rates were established by the interaction of the demand for and supply of loanable funds. The Keynesian argument held that the rate of interest was primarily a monetary phenomenon - and one, moreover, detached from the real factors of thrift and the productivity of capital to which the neo-classical mind had linked it. This position further implied that the rate of interest could no longer be invoked as the delicate mechanism for equilibrating intended saving and intended investment. These relationships played no part in the determination of the rate of interest itself. Saving and investment might respond to changes in the rate of interest but they were not its primary determinants.

In addition this analysis implied that the ability of the monetary authorities to influence interest rates might, in periods of depression, be severely restricted. The Central Bank could continue to expand the money supply. But if the increment simply swelled idle balances, no reduction in interest rates would ensue. The economic system would find itself locked into what Keynes described as a `liquidity trap'. This situation might arise for institutional reasons quite independent of the intentions of the parties directly involved. Banks, for example, do not exist to hold idle balances; on the contrary, they seek to augment their earnings by lending at interest. In the circumstances of a deep depression, however, their ability to lend is curtailed because the pool of eligible borrowers largely dries up. Involuntarily banks may thus find themselves holding idle balances in substantial volume as excess reserves. While it is still possible for bankers to acquire earning assets (such as government securities) with idle reserves, this course may not be desirable if the market prices of fixed-interest assets are already high and interest rates low. Financial institutions, no less than the public at large, may choose to protect themselves against capital losses by hoarding for speculative reasons.

5. THE KEYNESIAN ANALYSIS OF SAVING

AND CONSUMPTION

With his monetary theory of interest Keynes unhinged saving and investment from their neo-classical moorings. He was therefore obliged to supply some new connexions to explain the determination of these two variables. Only after this manoeuvre had been satisfactorily executed was he equipped to present an alternative theory of the determination of national income.

In neo-classical thought, the rate of interest had been regarded as the primary regulator of the volume of saving. This is not to say that neo-classical writers entirely neglected changes in national income as an influence on saving. But this relationship was given little attention and, within the framework of their thought, for ample reason. National income, after all, was regarded as a rather stable variable, fluctuating only slightly and temporarily from the normal equilibrium of full employment. Fortified by this presupposition, it appeared to be more pertinent to concentrate attention on the rate of interest. Once Keynes had demonstrated that equilibrium at full employment was far from assured - indeed it was perhaps the least likely of a range of possibilities - the emphasis assigned to income and to the rate of interest in the interpretation of savings decisions was reversed. The level of income became the crucial determinant, while the rate of interest was cast in a secondary role.

Keynes's decision to tie the theory of savings more closely to the level of income had more than this analytical reason to recommend it. He also argued that this interpretation offered a more realistic account of the behaviour of savers than did the neo-classical explanation. Few people, he maintained, were highly sensitive to interest rate changes in their decisions to save. `Interest to-day', he argued, `rewards no genuine sacrifice, any more than does the rent of land.’8 In his view, people sought first an acceptable level of consumption and undertook to save only when their income was more than sufficient to cover consumption requirements. Saving was thus a residual, varying in amount with changes in the level of income. Few people were likely to be influenced by changes in the rate of interest when allocating their income between consumption and saving.

An important corollary was attached to this part of Keynes's argument. Not only was the level of income the most forceful influence on the volume of saving but - as income rose - saving was likely to rise both absolutely and as a proportion of income. Expenditures on consumption, though still rising in absolute terms, would claim a diminishing share of total income. This point had sweeping implications for a rich society's efforts to achieve and maintain full employment. It indicated that a high and rising volume of investment expenditure would be required to bring saving and investment into equilibrium with one another at a full employment level of activity. As Keynes saw the problem:

... the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members.9

6. THE DETERMINATION OF INVESTMENT

In the neo-classical tradition, as we have seen, decisions to save and to invest were interpreted as determined by the same influence: the rate of interest. It could thus be argued that the economic system, by its nature, would tend to produce an automatic equilibrium between saving and investment. Keynes shattered the symmetry of this argument by severing the link between saving and the rate of interest. Decisions to save and to invest, he maintained, were largely independent of one another and often undertaken by different groups of people for quite different reasons.

If the rate of interest now largely dropped out of the account of saving it still retained an important place in investment analysis. On this point Keynes accepted much of the neo-classical approach. His argument presupposed that the volume of private investment would be governed largely by two considerations - the cost of borrowing and the anticipated rate of return. If expected net yields exceeded the cost of capital (i.e. the rate of interest) then capital expenditures would be worthwhile; on the other hand, should the rate of interest exceed expected rates of return, spending on plant, equipment, and inventories would not be undertaken.

This element of continuity between the Keynesian and neo-classical systems should not, however, conceal an important difference in their interpretations of the expected rate of return on investment (in Keynes's terminology, the marginal efficiency of capital). At first glance it might appear that Keynes worked with a concept closely allied to the neo-classical notion of the marginal productivity of capital. In part, he had this relationship in mind; as the capital stock grew (other things being equal), he expected that returns to the additional units would tend to fall. But his concept also embraced another matter relevant to the analysis of investment decisions - the expectations of entrepreneurs. Keynes insisted that `the most important confusion concerning the meaning and significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield'.10

Throughout his work Keynes assigned much more weight to the influence of psychological factors on the economic process than had his neo-classical predecessors. Just as expectations were crucial to his discussion of liquidity preference, so also did they lie at the core of his investment analysis. On this basis Keynes could assert that investment expenditures might not be undertaken even when conventional calculations of returns indicated them to be profitable. This might occur if entrepreneurial expectations were bearish. Fears of capital loss might then deter outlays which, on paper, appeared to be attractive.

It will be recalled that neo-classical writers commented on the waves of optimism and pessimism within the business community in their discussions of cyclical fluctuations. These disturbances, of course, were always assumed to be confined within narrow limits. No cases of extreme and stubborn unemployment had then been experienced and there was little reason to attach major importance to psychological considerations. Keynes saw the problem quite differently. Once he had established that the equilibrium level of income was subject to a wide range of variation it was possible to argue that entrepreneurial temperament was both volatile and highly important to the behaviour of the economy. Indeed the marginal efficiency of capital was so much a matter of expectations that the shifting moods of the business community might easily swamp the rate of interest's influence on investment expenditure.

This phenomenon highlighted one of the central policy concerns of Keynesian analysis. High levels of income were likely to generate savings in substantial volume. If full employment was to be achieved, investment expenditure on a scale sufficient to match a full-employment level of saving would be necessary. There was little basis for confidence, however, that investment spending in the amounts required for full employment would be undertaken on private initiative. As capital accumulated, the marginal rate of return would be expected to decline unless the offsets provided by technological progress were forceful. Moreover, it could not safely be assumed that substantial increases in investment could be induced by monetary measures designed to lower the costs of borrowing. In the circumstances of a depression, bearish entrepreneurial expectations might neutralize the effects of reductions in interest rates. An active monetary policy to push interest rates down was still desirable. But it was important to recognize the limitations of this procedure. Should the situation of the liquidity trap be approximated, monetary measures would be incapable of reducing interest rates.

In short, conventional techniques of economic policy were insufficient to remedy the deficiency of aggregate demand. A more active role for government as a spender was called for if prosperity was to be restored. Keynes maintained:

Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him.11

7. KEYNESIAN ANALYSIS AND THE
DETERMINATION OF AGGREGATIVE EQUILIBRIUM

Though so fundamentally different in many important respects, Keynes and the neo-classical writers spoke in unison in their definitions of aggregative equilibrium. In both traditions the necessary condition was an equilibrium between intended saving and intended investment. Neoclassical economists maintained that this equilibrium was achieved through allegedly sensitive adjustments in the rate of interest. Keynes, having severed the direct connexion between saving and the rate of interest, was obliged to offer an alternative account of the mechanisms for the determination of equilibrium.

Stated in its simplest form, Keynes's alternative solution linked the mechanism of adjustment to variations in the level of income. Neo-classical writers, of course, had largely neglected this relationship as, within the framework of their thought, national income was subject to fluctuation only within rather narrow limits. For Keynes, on the other hand, a wide spectrum of equilibrium income positions was possible. The pertinent question was: at what level would equilibrium in the national income be established?

Keynes's development of this problem drew upon the concept of the multiplier first formulated by his Cambridge colleague, R. F. Kahn. The essentials of this ingenious argument can be set out in a simple example. Let it be assumed that an initial equilibrium between intended saving and intended investment is disturbed by the decision of investors to spend more on plant and equipment. What adjustments would then follow? Clearly an increase in investment expenditure would add to total income. But the achievement of a new equilibrium would require saving to rise by as much as investment had increased. This condition could be satisfied when income had risen enough to generate the required increment in saving. How much would income have to grow before equilibrium was restored? The multiplier concept permitted a theoretically precise answer to be given. If, for example, the community saved one-third of its incremental income and consumed two-thirds, total income would grow by three times the amount of the increase in investment spending. In other words, changes in investment had a multiple effect on income.

The mechanics of this process can also be illustrated in more everyday terms. An increase in investment expenditure will generate higher total demand and call for more workers and more raw materials in the industries producing capital goods. A substantial part of the additional income paid out to workers and suppliers of raw materials is likely to be spent. Additional rounds of spending and re-spending are thus likely to follow. In this manner the stimulus of increased investment radiates throughout the economy, raising income and employment.

The magnitude and timing of the increase in national income touched off by a rise in investment expenditure would, of course, be affected by a number of factors - among them, the lags between the receipt of income and its expenditure. Obviously a considerable time period would be required before the total process of expansion had worked itself out. The pace and magnitude of the rise in income might also be dampened by leakages from the expenditure stream. Part of the additional spending, for example, might be directed to imported rather than to home-produced goods. To that extent, the stimulus to domestic income and employment would be weakened. Though the multiplier does not operate quite as tidily in practice as it appears in theory, it highlights relationships that are vital to an understanding of economic fluctuations.

Keynes used the multiplier concept to explain the manner in which the level of income was determined and to emphasize the crucial importance of investment expenditure to recovery from depression. The same analytical argument, however, can be applied to a fully employed economy. In such circumstances, an increase in investment would still have multiplier effects but only an increase in money income would then be produced. Prices would be bid up, but real output could not be augmented to match the increase in demand.12

Later theoretical writing has integrated the Keynesian multiplier scheme with a concept known as the 'acceleration principle'. Whereas the multiplier is concerned with the connexion between changes in investment and subsequent spending on consumption, the acceleration principle refers to the manner in which increases in income and consumption may also stimulate investment and give rise to further rounds of income expansion. This line of analysis is perfectly compatible with the argument of the General Theory, though Keynes did not make use of it. J. B. Clark, writing in 1916, had spelled out the basic structure of the accelerator mechanism. Keynes may perhaps be excused for his failure to draw upon this insight in the 1930s. His concern was then with the problems of a depression economy. In such circumstances, the accelerator is unlikely to have a forceful impact until income has risen enough to wipe out idle plant capacity. So long as excess capacity exists the growth in demand generated by rising income can be satisfied without additional investment to augment productive capacity.

Keynes's analysis of the determination of aggregative equilibrium opened an entirely new vista for economic investigation and inquiry. For the first time, income was recognized as a primary variable and one, moreover, that was subject to extreme fluctuations. The prominence assigned to changes in national income in the Keynesian theoretical system gave quite a different orientation to a number of familiar analytical building blocks. The treatment of the rate of interest in the Keynesian model provides a significant case in point. Keynes denied that it had much influence on decisions to save and consume, but it did not follow from this conclusion that the rate of interest bore no connexion with saving. He maintained that:

... the influence of moderate changes in the rate of interest on the propensity to consume is usually small. It does not mean that changes in the rate of interest have only a small influence on the amounts actually saved and consumed. Quite the contrary. The influence of changes in the rate of interest on the amount actually saved is of paramount importance, but is in the opposite direction to that usually supposed. For even if the attraction of the larger future income to be earned from a higher rate of interest has the effect of diminishing the propensity to consume, nevertheless we can be certain that a rise in the rate of interest will have the effect of reducing the amount actually saved.13

The resolution of this apparent paradox can be seen when one considers the nature of the Keynesian argument on the determination of aggregative equilibrium. Investment can be influenced by changes in interest rates. Thus, should a fall in rates of interest stimulate activity, national income would grow via the multiplier process. Higher levels of income, in turn, would produce a larger volume of saving. This result would follow from the establishment of a new equilibrium at increased levels of investment and income. A connexion between interest rates and saving was thus retained, but in a manner far removed from the one neo-classical economists had in mind. In the Keynesian formulation the causal linkage was indirect, running from interest rates to investment, from investment to aggregate income, and from aggregate income to actual saving.

8. THE KEYNESIAN THEORY OF EMPLOYMENT

In the discussion thus far, much has been said about the determination of national income, but nothing directly about the level of employment. As its title indicated, the General Theory was intended as an analysis of employment in the first instance. Quite clearly variations in the level of economic activity have a major impact on employment and unemployment. But Keynes was fully aware that the relationship between national income and the aggregate demand for labour was difficult to establish precisely. In his search for leverage on this problem he introduced the concept of the wage unit.

As an analytical device, the Keynesian wage unit has much in common with the manoeuvres performed by those classical economists who attempted to measure the value of goods in terms of labour. They were obliged to explain how various grades and skills of labour could be reduced to a common denominator. Normally, they treated an hour of unskilled labour as the basic unit. The same unit of time input on the part of members of the labour force whom the market rewarded more highly could be expressed as a multiple of the standard unit. In most classical accounts, however, this technique was not free of internal contradiction.

Keynes adopted a similar procedure for purposes of relating the volume of employment to national income. Differentiation within the labour force could be accommodated by assigning higher weights to the time inputs of persons possessing the more highly remunerated skills.14 Keynes was on more secure logical ground in this exercise than were the classical economists. The latter were at a loss to find a basis for the weighting of skills without appealing to valuations assigned by market place. This introduced supply and demand considerations into an argument which was supposedly based exclusively on physical inputs. Keynes, who had no interest in searching for a criterion of value independent of the market, was not troubled by this complication.

This procedure, though logically sound, was still not ideal. Empirically the relationship between changes in income and changes in employment has been found to be far from tight. The relationship breaks down most conspicuously when employment is reckoned (as it commonly is in popular discussions as well as in official statistics) in terms of the number of persons at work. Employment, when calculated in Keynesian wage units, can be linked more reliably to changes in income. For practical purposes this technique of measurement - in terms of the number of standard hours of labour employed - is unwieldy. None of the employment statistics presently gathered lend themselves to a wage unit type of measurement without enormously time-consuming adjustments.

9. THE IMPLICATIONS OF THE

ANALYSIS FOR ECONOMIC POLICY

Keynes's work had clearly assaulted the main props to confidence in the usual instruments of economic policy. The major policy weapon in the orthodox arsenal - i.e. monetary controls - could now be seen to be too blunt to be fully effective. As the argument of the General Theory had demonstrated, the power of the monetary authorities to influence the rate of interest (and thereby to affect investment spending) was limited. It was most seriously handicapped, of course, during periods of depression. When the liquidity trap emerged, the rate of interest could be pushed no lower. While the monetary authorities could add to the supply of money, they were unable to control the demand for money.

But this was not the only point at which reliance on monetary policy was attacked. No less important was the Keynesian argument that highly volatile expectations were likely to have a forceful bearing on decisions to invest. Indeed, reductions in the rate of interest, though desirable as stimulants to investment, might be more than offset by increasing bearishness within the business community.

If full employment and economic stability were to be achieved, it was imperative to assign a much more active role to fiscal policy. By contrast with orthodox views holding that governments should operate with balanced budgets, Keynes called for deliberate deficits to swell aggregate demand. He recognized, however, that public expenditure financed by borrowing would have favourable effects on total demand only to the extent that a net increase in total spending was thereby accomplished. Should projects launched by governments merely displace those that would otherwise have been undertaken by the private sector, the intended growth in total spending would not be realized. Moreover, he was also cognizant of the political resistance his recommendations were likely to encounter. Some types of non-conventional measures might be more acceptable, though less beneficial to society, than others - a consideration which brought out the puckish quality in his style:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal-mines 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 the 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. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.15

Keynes called for a re-thinking of the instruments of economic policy and for the rejection of the policy prescriptions associated with neo-classical analysis. Not only did he warn against excessive reliance on monetary controls, but he also attacked vigorously the view that unemployment could be cured through measures aimed at the inflexibility of wages. He regarded trade unions as legitimate bargaining agents and their role in wage-setting to be an established institutional fact. But quite independent of the existence of labour organizations he maintained that wage-cutting offered no cure for unemployment. Such tactics were more likely to aggravate the problem by curtailing effective demand still further.

The results of a programme of wage reduction would, of course, be happier if real wages did not fall - i.e. if output prices fell by at least as much as money wages. But this outcome was doubtful in view of the substantial market power exercised by many businessmen and their reluctance to reduce prices in face of declining demand. But even if the economic system approximated to perfect competition more closely than was in fact the case, price reductions might still have unfortunate consequences. Price cutting was likely to have depressing effects on expectations and would increase the real burden of outstanding debt. Investment on the scale required to restore full employment might thus be discouraged.

10. THE LARGER CONSEQUENCES

The message of the General Theory was sharply critical of unregulated laissez-faire. Most neo-classical theorists, it will be recalled, expressed reservations about the circumstances in which unchecked market arrangements could be counted on to yield socially desirable results. Their anxieties, however, were usually associated with the consequences of growth of large-scale enterprises. The usual rules of competitive behaviour could not be expected to apply to these situations and a case could be made for public regulation or ownership.

Keynes's critique of laissez-faire rested on quite different foundations. The burden of his argument was to demonstrate that an unregulated market system was likely to be chronically unstable and incapable of assuring the full utilization of productive resources. Not only did his analysis demonstrate the need for active government intervention in the economy, but it also proclaimed that thrift was not necessarily a social virtue. Indeed, when resources were under-employed, thrift was a social vice. To a public schooled in the puritan ethic, this insight was not easy to grasp.

It is not remarkable that these unconventional views should have been misunderstood when first expounded. Some critics regarded Keynes's doctrines as dangerously radical and as a threat to the perpetuation of a capitalist order. A considered judgement of the content of Keynes's thought supports quite the opposite conclusion. Revolutionary though the General Theory was in its approach to economic analysis, the policy recommendations derived from it were largely prompted by conservative considerations. Keynes hoped that the essential features of the capitalist system could be preserved. But its virtues could be safeguarded only if the social unrest generated by mass unemployment could be eliminated by appropriate reforms. Laissez-faire, as he had demonstrated, was essentially a fair weather system. It was capable of remarkably productive performance when conditions were favourable, but it was also inherently unstable. Governments had a major responsibility for regulating the economic climate in ways that would permit the market system to achieve its full potential.

In large measure Keynesian teaching has been absorbed into economic thought and policy in most Western countries. Indeed, the adoption of a Keynesian approach by Western governments has not been least among the factors responsible for the high degree of stability exhibited by their economies in the years since the Second World War.