John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 3–22.

Chapter 1

This chapter acts more as an introduction to what Keynes sets out to do, and those who are particularly adverse to Keynes will like it since it is only one paragraph long. Keynes establishes his aim as that of dethroning the Classical school, defined as “the followers of Ricardo.”

I will take this space to lay out my own objective. I am going to post notes on the book and refrain, as much as possible, to insert my own criticism. My goal is to understand Keynes’ “general theory,” assuming that this understanding will allow me to better critique the book in the future (in a series of review articles). However, those who want to criticize something, you are welcome to do so in the comments! I will happily give my own two cents, as well (as I usually do).

Chapter 2

“Most treatises,” begins Keynes, “on the theory of Value and Production are primarily concerned with the distribution of a given volume of employed resources between different uses and with the conditions which, assuming the employment of this quantity of resources, determine their relative rewards and the relative values of their products.” That is, the purpose of the Ricardian tradition is not so much to study what contributes to the stock of wealth, but to explain how this wealth is distributed amongst those who contribute to its production (Keynes, ftn#1, quotes a latter from Ricardo to Malthus, saying much of the same). Keynes adds to this objective of economics the study of what decides which resources, including (especially?) labor, are employed where and when. He holds that these two questions have not been adequately addressed in Classical economics, pointing specifically to the contributions of Arthur Pigou.

I.

Keynes observes that the Classical theory of employment is based on two postulates,

Wages are equal to the marginal productivity of labor; Wages (their utility to the laborer) are equal to the marginal disutility of labor.

The former is the demand-side and the latter the supply-side in the Classical determination of the level of employment. These two postulates are compatible with the idea of “frictional” and “voluntary” unemployment. The former refers to those who are laid off for whatever reason and have troubles immediately finding a new job (time-lags). In a “non-static” society (or one in disequilibrium), where there are always changes, there will be frictionally unemployed persons. Those who are naturally unemployed are those who prefer not to sell their labor at the market price.

Keynes wants to reformulate the theory of labor, because according to him the Classical theory does not allow for a third category, or those who are “involuntarily” unemployed. I imagine that this goes beyond “cyclical” unemployment, and deals more with an issue of finding full employment at the market clearing price. It is a more fundamental issue than price rigidities and things of that nature.

In any case, in the Classical theory there are four ways to increase employment,

Improvement in what today we might call “search functions” (my own term), where the disequilibrating factors which lead to frictional unemployment may be solved; A fall in the marginal disutility of labor, so that a voluntarily unemployed person may accept a lower wage (a fall in the reservation wage); An increase in the marginal productivity of labor in the “wage-goods industries” (i.e. an increase in the number of employable persons in a firm); “An increase in the price of non-wage-goods compared with the price of wage-goods associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.” If I understand the terminology correctly, what Keynes is referring to is a fall in the prices of goods (bought by wage-earners), increasing real wages.

This is Keynes’ summary of the theory of employment as elucidated in Pigou’s Theory of Unemployment (he chooses Pigou’s book, because he claims that this is the only comprehensive treatment from the Classical perspective).

II.

Keynes looks to introduce to us the gist of his argument against the Classical theory of employment. He poses the question: can the Classical theory account for the fact that at any given wage level there are always those who would like a job, but cannot find one?

The Classical economists, Keynes argues, attribute involuntary unemployment to wage rigidity, or an agreement “amongst themselves” (i.e. labor unions) to refuse to work for a lower wage. In other words, there is something stopping wages from falling to a level which would employ all those willing and able to work (minus the frictionally unemployed). Keynes presents two arguments against this claim, one of them casual and the second fundamental.

First, nominal wages may not be equal to real wages, in the sense that the hypothetical market clearing wage is tied to the marginal productivity of labor. For example, while a fall in nominal wages might cause a certain number of workers to leave the labor market, out of protest, these same workers may not respond the same way if there were a reduction in their real wage as a result of an increase in prices. This brings in an element of subjectivity: how do workers themselves decide what their reservation wage is (on the basis of real wages or nominal wages)? According to the Classical theory, a fall in real wages (due to an increase in prices) ought to increase voluntary unemployment, yet empirically we can verify that the exact opposite has occurred.

Neither does Keynes buy the argument that mass cyclical unemployment is caused by a refusal to accept lower wages (amongst those who are employed). He suggests that, empirically (the Great Depression), we see “wide variations in the volume of employment” despite the fact that the we see no change in the “minimum real demands of labor” nor in its marginal productivity. Keynes also notes that the relationship between nominal and real wages tends to be inversely direct, in that as nominal wages rise real wages fall and vice versa.

Concludes Keynes, if it were true that below the market clearing price no greater supply of labor would make itself available, then in reality we would not see involuntarily unemployed persons despite a fall in real wage rates (i.e. as occurs during periods of depression). Therefore, real wages are not a good indication for what the marginal distutility of labor is (a subjective factor).

As aforementioned, there is a second, more fundamental, criticism Keynes makes. He notes that the second postulate of the Classical theory of employment stems from the understanding that real wages are decided through bargaining between labor and the employer (or, in more familiar terms, that the wage rate agreed upon in a labor contract is based on real wages). It is accepted that all wages are money wages, but it is held that a reduction in the nominal wage will lead to a reduction in the real wage. Thus, there is a tendency for real wages to fall to the marginal disutility of labor. (Keynes will return to this topic in chapter 19, to discuss some more specific factors which relate to the topic.)

Keynes, interestingly, observes that if one adopts the Classical theory of value, where the price of labor is a prime determinant of the prices of goods, changes in nominal wages will lead to changes in real wages in the same direction, so that in the end there is no change in the ratio between the two. To clarify between what was mentioned in the above paragraph, there is no contradiction in what Keynes writes. What the Classicals argued is that by accepting a reduction in nominal wages, the wage level can return to that dictated by the marginal productivity of labor (i.e. in a situation where the nominal wage is too high). What Keynes is saying is that this cannot possibly be true within the Classical paradigm, given that according to their theory of prices the ratio between nominal and real wages will always be the same (so, no nominal wage can ever be “too high”). In short, there is no means by which labor, in general, can adjust its nominal wage to match the marginal productivity of labor.

III.

Keynes looks to point out that labor unions cannot possibly be the only, or even the principal, factor to blame for cyclical unemployment. He already postulated that real wages are not set in the bargaining process between employers and employees, thus the purpose of bargaining must be something else. This something else is the avoidance of relative losses in real wages. In other words, bargaining between employee and employer simply affects the distribution of wages between industries. It does not stop a fall in real wages due to an increase in prices, nor is it an “insuperable bar” against any overall reduction in real wage rates.

Thus, while labor unions might combat changes in nominal wages, where they affect the singular industry (or firm), they cannot be to blame for a failure for the overall real wage rate to fall to the marginal productivity of labor, leaving relative wages unchanged.

IV.

How does Keynes define “involuntary unemployment?” He, of course, admits that there is a limit to what can be described as unemployment. For example, that an individual could work beyond an eight hour workday does not mean that each of those hours not worked constitutes as hours unemployed. Nor are those whose reservation wage is higher than the given nominal wage included. Finally, Keynes also leaves out those “frictionally” unemployed. Involuntary unemployment, therefore, is constituted by those, who in the event of a small fall in real wages (and a rise in the aggregate demand for their labor), are willing and able to work.”

The second postulate of the Classical theory of employment does not allow for the advent of involuntary unemployment, even though we witness it empirically. The Classical theory describes the distribution of wages in an environment of full employment, or where a reduction in real wages would not lead to a rise in the amount of those willing and able to work. Keynes concludes that given that we know involuntary unemployment exists, we cannot possibly accept the Classical theory. He suggests that there needs to be some change in the study of economics, similar to the transition from Euclidean geometry to non-Euclidean geometry.

V.

One should note that the first postulate of the Classical theory is not in dispute. At least in the short run, where capital is held fixed, an increase in employment must come with a fall in real wages. That is, the employment of n + 1 laborer will lead to a fall in the wage level, and would also transfer some income to profit. Keynes notes that this is the obverse of the principle of marginal decreasing returns. His intentions, rather, are only to throw over the second postulate, since Keynes believes that a cyclical rise in real wages is not due to a demand for greater real wages, nor is a willingness for workers to accept a lower nominal wage a remedy for cyclical unemployment. (We will understand his own theory of wages by chapter 19, according to Keynes).

VI.

[Ludwig von Mises’ article “Lord Keynes and Say’s Law” is relevant to this section, although I, personally, would have held Mises to a higher standard (not that this necessarily means I endorse Keynes’ criticism of Say’s Law).]

This section contains Keynes’ famed refutation of Say’s Law (or his failed attempt, depending on who you ask).

Say’s Law, as defined by J.S. Mill (Keynes quotes a paragraph from Mill’s Principles of Political Economy, Book III, chapter 14, paragraph two), basically amounts to the idea that supply creates its own demand. This is true in the sense that “the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product.” In the same sense, income unconsumed is necessarily income spent on productive activities (i.e. a demand for labor and commodities). Keynes attaches blame on the notion that money is but a veil on the economy — where the real economy is simply in the exchange of goods. Keynes also suggests that some confusion stems from a false equivocation of Say’s Law with the fact that the income derived from an aggregate stock of wealth is equal to the value of output.

Thus, Classical economists believe that an act of saving must necessarily be met by an increase in investment. Keynes argues that this is a mistake, as the two acts are separate, and that the motives of the saver are not the same as the motives of the entrepreneur. From Say’s Law stems several beliefs, including the classical theory of unemployment, the loanable funds theory of interest, the quantity theory of money, and the advantages of “thrift.”

VII.

Keynes summarizes his characterization of the Classical school in the following way. The latter makes the following assumptions,

Real wages = the marginal disutility of those current employed; There is no such thing as involuntary unemployment, strictly speaking; Supply creates its own demand.

As such, Keynes claims that as these assumptions are proven wrong, they collapse on each other.