Bruce Bartlett considers the title of John M. Keynes’ magnum opus, The General Theory of Employment, Interest, and Money, an “unfortunate error.” According to Bartlett, Keynes’ core insight is the liquidity trap, which he defines as a situation where both inflation and interest rates are low, making bonds and money close substitutes. Thus, Keynes’ economics are mostly applicable only when an economy is in a liquidity trap. I think Bartlett has it mostly wrong. The liquidity trap only plays a small role in The General Theory, and the book’s major contribution — at least, as intended by Keynes — is its business cycle theory.

If you’re wondering what the liquidity trap is, I give an overview of the development of the theory in a June 2010 Mises Daily, “Krugman contra Hayek.” Most of my overview is based on a paper by Mauro Boianovsky, “The IS-LM Model and the Liquidity Trap Concept: from Hicks to Krugman.” A modern interpretation of the liquidity trap theory is provided by Paul Krugman, in his 1998 paper on Japan. Krugman’s definition is a bit more general: when conventional monetary policy no longer stimulates, otherwise known as the zero lower bound (ZLB).

How big of a role does the liquidity trap play in The General Theory? In Keynes’ 1936 book, the liquidity trap is mentioned, in passing, in chapter 15,

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.

— p. 207.

Keynes suggested, with healthy skepticism, that the early 1930s may be an example of a liquidity trap, but that these cases are indeed very rare. It certainly is not the centerpiece of Keynes’ theoretical exposition. In fact, the liquidity trap is probably better identified with John R. Hicks (who later repudiated much of his work from “Mr. Keynes and the Classics“), who also introduced the IS/LM diagram taught in intermediate macroeconomics. In any case, none of the theories that Keynes developed in his book were specific to the liquidity trap, nor require the liquidity trap as a precondition for their validity.

Keynes’ main argument, in my opinion, consists of an integration of R.F. Kahn’s multiplier with the macroeconomic framework Keynes began to develop in his A Treatise on Money (and volume II). The main purpose of The General Theory is to explain how an underemployment equilibrium may arise, and Keynes’ theory is that cyclical fluctuations are caused by increases in the stock of savings which cannot be met with greater investment. The theory is similar to monetary disequilibrium, but rather than an increase in the demand for money and sticky prices, the shock in aggregate demand is caused by a sudden reversal of entrepreneurs’ expectations (more on the differences between the two theories here).

The most well known term associated with Keynes is “animal spirits,” but at first he actually frames his theory as a secular outcome of economic growth. As an economy becomes more productive and incomes grow, the propensity to save tends to grow at a faster rate than the marginal propensity to consume. In other words, the proportion of saving to consumption increases over time. A tenet of the Keynes–Kahn multiplier is that present investment is directly derived, by and large, from present consumption. As consumption falls, the scope of investment falls, and vice versa. It follows that at some point savings is bound to increase beyond the point it can be profitably invested, causing an aggregate demand shock. Drawing on “animal spirits” helps with the application of this theory, since recurring waves of optimism and pessimism can cause the sudden changes in expectations that leads to a shortage of investment. But, “animal spirits” is not a central component of the “general theory.”

In the course of explaining his theory, and its many components, Keynes offered two main challenges to what he termed Classical economics. The first, early on, is that wages aren’t sticky, rather they may not be able to fall in real terms, at all. He posited that since labor makes up a significant portion of the costs of production, a nominal reduction in wages will lead to a proprotional nominal reduction in the price of output, leaving real wages the same. By doing this, he circumvented the typical explanation for mass unemployment: the artificial rigidities created by interventionism. Second, he engaged the believe that savings and investment is well equilibrated by the rate of interest. He argued that the interest rate is not only determined by time preference, but also by liquidity preference — interest on non-cash assets have to include a premium to make up for their relative illiquidity. If a high liquidity preference increases the rate of interest well beyond its equilibrium, or natural, level, there will be some discoordination between savings and investment, leading to or aggravating a demand shock.

What’s the general theory, then? All of this is explained within the context of a novel macroeconomic framework. Keynes was advancing a theory of the coordination of several macroeconomic aggregates: investment, savings, consumption, interest, et cetera. He argued that capitalist economies are prone to demand shocks — not under special circumstances, but generally. And, actually, referring to Keynes’ theory as a business cycle theory may be somewhat misleading, because the business cycle theory is really only secondary to the macro framework Keynes was attempting to construct. That is, demand shortages are only a part of the broader theory of Keynes’ vision of how economies work on aggregate: investment, and therefore employment, is determined by the expected demand for final output. Keynes relegated supply-side considerations to the back burner.

Maybe by “core insight” Bartlett means the key concept that economists took from Keynes. But, even then, I think he’s wrong. The key, and in my opinion erroneous, belief is that present demand for consumers’ goods output determines the scope of present investment, especially without considering supply side qualifiers that would radically change the implications of Keynes’ general theory. It’s this idea that informs the opinion that consumption drives the economy (and that to restore aggregate demand we must stimulate consumption). It’s this relationship which is one of the most important facets of Keynes’ general theory of macroeconomic coordination.

Also, briefly, I’m not sure just how skeptical of monetary policy Keynes was. I recommend two papers on the topic: D. Moggridge and S. Howson, “Keynes on Monetary Policy;” and E. Dickens, “Keynes’s Theory of Monetary Policy.” Also, Hicks discussed some differences on monetary policy between Keynes and Ralph Hawtrey, in his book Economic Perspectives.