Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the first and second post in this series)

Arguments for Fiscal Activism

a) New Money and Money Demand

Keynes’ premise is not credible. Monetary economics routinely identifies channels other than interest rates through which additional money creation can affect demand. For example, Frederic Mishkin, former member of the Fed Board of Governors, has identified channels of exchange rates, financial asset prices, real estate prices, wealth effects on consumption, and increase in bank lending capacity (among others) through which demand can be increased.[1] Pertinent here, Keynes himself sometimes made the argument that monetary expansion could boost demand directly, independent of impact on interest rates.

For example, in the Treatise chapter on “Monetary Factors,” Keynes noted that monetary stimulus might bring together a previously “unsatisfied fringe of would-be entrepreneur borrowers who were ready to borrow … even at the old terms [i.e., without lowering interest rates], and … an unemployed fringe of the factors of production [workers] to offer employment to additional quantity of the factors of production.” In an additional impact, he wrote that “certain entrepreneurs may now be willing to increase their output even if this means making higher offers than before to the factors of production because (as the ultimate result of the influx of new money) they forsee profits.”[2] As Keynes here demonstrates, the underlying goal of monetary expansion is to satisfy an unmet demand for money. The consequence may be to lower interest rates, but it may also work by directly increasing demand for goods and services, and for credit to purchase them.

The General Theory has comparable passages. In Ch. 11, on the “Marginal Efficiency of Capital,” he linked changes in investment prospects to prior changes in prices. He wrote, “the expectation of a fall in the value of money [i.e., inflation] stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand schedule.” Consider that it is just this link between higher prices – as a result of the dollar depreciation — and the large increase in industrial production that Keynes minimized in his earlier-cited comments on the US recovery in 1933. In Ch. 21, on the “Theory of Prices,” Keynes noted that “new money” could lead directly to increases in effective demand, which would be “divided between the rise of prices, the rise of wages, and the volume of output and employment.”[3] Turning again to the illustrations in the Section 1, in three of them – the 1890s commodity deflation, the slump of 1930, and the near-depression of 1937-1938 — lack of “new money” was at the heart of the downturn.

The way Keynes understood monetary policy to work did not require him generally to reject monetary measures in order to boost aggregate demand. Most likely, Keynes was instead motivated by a deeper structural view of the economic system in crisis, one driven by a transformative vision. His views on monetary policy and his social philosophy came together in the forecast for a declining marginal efficiency of capital.

In Ch. 16 of the General Theory, Keynes anticipated a future “where capital goods would be so abundant” that the average marginal efficiency of capital would fall to zero.[4] It was a logical extension of his view of financial markets, driven by fickle expectations, and of what in the early 1930s was growing “bear” sentiment. He added in the final chapter, “Concluding Notes on the Social Philosophy Toward Which a General Theory Might Lead,” that such an abundance of capital would bring about the “euthanasia of the rentier, of the functionless investor,” which he described as an “aim” of public policy, one perhaps to be realized “within one or two generations.”[5] His notion was similar to the Marxian concept of a declining rate of profit — following accumulation of physical capital. The stagnationist thesis, Keynesian or Marxian, resonated with the Left, especially during the depressionary Thirties. It was a thesis about the real sector, about production and distribution, about capitalism and power. Keynes’ proposed remedy was to scale back the reach of market relations, and to replace them with an expanded role for the State. And there was no room in this vision for anything so apparently skin-deep as expansionary monetary policy to restore growth and boost the marginal efficiency of capital. It is unusual to find a Marxian or Socialist economist who will consider monetary policy as other than a distraction. Keynes’ own goals were more moderate – to overcome deficiency of demand and, thereby, to undermine the appeal of Communism and Fascism.[6]

Leaving the longer term horizon and returning to the causes of Depression in the early 1930s, Keynes wrote at the end of the General Theory: “It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated – and in my opinion, inevitably associated – with present day capitalistic individualism.”[7] Had Keynes proposed monetary easing through open market operations, his inferred premise would have been that the capitalist system was structurally sound – merely that money demand was, for the moment, not being satisfied – hardly the stuff of a self-described revolution in economic thinking.

The case since the 1930s for a collapsing rate of profit following accumulation of capital has little evidence to support it. Keynes underestimated potential demand for new investment, not to mention ongoing obsolescence of previous investment, in a world with seven billion people, most of them seeking to enhance their material comfort and social status. A. C. Pigou, Keynes’ oft-times nemesis, dismissed the stagnationist thesis almost immediately, noting “An era that has witnessed the development of electrical apparatus, motor cars, aircraft, gramophone and wireless, to say nothing of tanks and other engines of war, is not one in which we can reasonably forecast a total disappearance of openings for new investment.”[8]

Keynes’ view that the world depression of the 1930s was caused by “capitalistic individualism” has done more damage. As we have seen, the major downturns during the decade of depression were driven by gold standard rigidity, reserve shortages, inopportune central bank sterilization, and to a lesser extent by anti-market micro-economic policies associated with the New Deal. Major economic boosts came from currency depreciations against gold and subsequent monetary ease. The problem was not markets run amuck, irrational pessimism on stock exchanges, excessive capital accumulation, or lack of government stimulus. Whatever the all-in contribution of the General Theory, it had the unfortunate consequence of diverting attention from the monetary dynamics that had brought depression. Alas, Keynes’ legacy as received some three generations on has contributed to the confusion that fiscal stimulus is the best way to boost demand, while monetary policy is often perceived as either ineffective or as just tinkering – when, some would have it — drastic structural change is necessary.

[1] Frederic S. Mishkin, The Channels of Monetary Transmission: Lessons for Monetary Policy, NBER Working Paper 5424, Feb. 1996. [2] Treatise, Ch. 17 (i). [3] General Theory, p. 298. [4] General Theory, pp. 213f, 218. [5] General Theory, p. 376. [6] Robert Skidelsky, John Maynard Keynes 1883-1946: Economist, Philosopher, Statesman (2003), p. 538. [7] General Theory, p. 381. [8] Pigou quoted in Skidelsky, e.g., p. 539.