Keynes on the Theory of Interest

In my previous post, I asserted that Keynes used the idea that savings and investment (in the aggregated) are identically equal to dismiss the neoclassical theory of interest of Irving Fisher, which was based on the idea that the interest rate equilibrates savings and investment. One of the commenters on my post, George Blackford, challenged my characterization of Keynes’s position.

I find this to be a rather odd statement for when I read Keynes I didn’t find anywhere that he argued this sort of thing. He often argued that “an act of saving” or “an act of investing” in itself could not have an direct effect on the rate of interest, and he said things like: “Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income”, but I don’t find him saying that savings and investment could not determine the rate of interest are identical.

A quote from Keynes in which he actually says something to this effect would be helpful here.

Now I must admit that in writing this characterization of what Keynes was doing, I was relying on my memory of how Hawtrey characterized Keynes’s theory of interest in his review of the General Theory, and did not look up the relevant passages in the General Theory. Of course, I do believe that Hawtrey’s characterization of what Keynes said to be very reliable, but it is certainly not as authoritative as a direct quotation from Keynes himself, so I have been checking up on the General Theory for the last couple of days. I actually found that Keynes’s discussion in the General Theory was less helpful than Keynes’s 1937 article “Alternative Theories of the Rate of Interest” in which Keynes responded to criticisms by Ohlin, Robertson, and Hawtrey, of his liquidity-preference theory of interest. So I will use that source rather than what seems to me to be the less direct and more disjointed exposition in the General Theory.

Let me also remark parenthetically that Keynes did not refer to Fisher at all in discussing what he called the “classical” theory of interest which he associated with Alfred Marshall, his only discussion of Fisher in the General Theory being limited to a puzzling criticism of the Fisher relation between the real and nominal rates of interest. That seems to me to be an astonishing omission, perhaps reflecting a deplorable Cambridgian provincialism or chauvinism that would not deign to acknowledge Fisher’s magisterial accomplishment in incorporating the theory of interest into the neoclassical theory of general equilibrium. Equally puzzling is that Keynes chose to refer to Marshall’s theory (which I am assuming he considered an adequate proxy for Fisher’s) as the “classical” theory while reserving the term “neo-classical” for the Austrian theory that he explicitly associates with Mises, Hayek, and Robbins.

Here is how Keynes described his liquidity-preference theory:

The liquidity-preference theory of the rate of interest which I have set forth in my General Theory of Employment, Interest and Money makes the rate of interest to depend on the present supply of money and the demand schedule for a present claim on money in terms of a deferred claim on money. This can be put briefly by saying that the rate of interest depends on the demand and supply of money. . . . (p. 241)

The theory of the rate of interest which prevailed before (let us say) 1914 regarded it as the factor which ensured equality between saving and investment. It was never suggested that saving and investment could be unequal. This idea arose (for the first time, so far as I am aware) with certain post-war theories. In maintaining the equality of saving and investment, I am, therefore, returning to old-fashioned orthodoxy. The novelty in my treatment of saving and investment consists, not in my maintaining their necessary aggregate equality, but in the proposition that it is, not the rate of interest, but the level of incomes which (in conjunction with certain other factors) ensures this equality. (pp. 248-49)

As Hawtrey and Robertson explained in their rejoinders to Keynes, the necessary equality in the “classical” system between aggregate savings and aggregate investment of which Keynes spoke was not a definitional equality but a condition of equilibrium. Plans to save and plans to invest will be consistent in equilibrium and the rate of interest – along with all the other variables in the system — must be such that the independent plans of savers and investors will be mutually consistent. Keynes had no basis for simply asserting that this consistency of plans is ensured entirely by way of adjustments in income to the exclusion of adjustments in the rate of interest. Nor did he have a basis for asserting that the adjustment to a discrepancy between planned savings and planned investment was necessarily an adjustment in income rather than an adjustment in the rate of interest. If prices adjust in response to excess demands and excess supplies in the normal fashion, it would be natural to assume that an excess of planned savings over planned investment would cause the rate of interest to fall. That’s why most economists would say that the drop in real interest rates since 2008 has been occasioned by a persistent tendency for planned savings to exceed planned investment.

Keynes then explicitly stated that his liquidity preference theory was designed to fill the theoretical gap left by his realization that a change income not in the interest rate is what equalizes savings and investment (even while insisting that savings and investment are necessarily equal by definition).

As I have said above, the initial novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory. But the result of it was to leave the rate of interest in the air. If the rate of interest is not determined by saving and investment in the same way in which price is determined by supply and demand, how is it determined? One naturally began by supposing that the rate of interest must be determined in some sense by productivity-that it was, perhaps, simply the monetary equivalent of the marginal efficiency of capital, the latter being independently fixed by physical and technical considerations in conjunction with the expected demand. It was only when this line of approach led repeatedly to what seemed to be circular reasoning, that I hit on what I now think to be the true explanation. The resulting theory, whether right or wrong, is exceedingly simple-namely, that the rate of interest on a loan of given quality and maturity has to be established at the level which, in the opinion of those who have the opportunity of choice -i.e. of wealth-holders-equalises the attractions of holding idle cash and of holding the loan. It would be true to say that this by itself does not carry us very far. But it gives us firm and intelligible ground from which to proceed. (p. 250)

Thus, Keynes denied forthrightly the notion that the rate of interest is in any way determined by the real forces of what in Fisherian terms are known as the impatience to spend income and the opportunity to invest it. However, his argument was belied by his own breathtakingly acute analysis in chapter 17 of the General Theory (“The Properties of Interest and Money”) in which, applying and revising ideas discussed by Sraffa in his 1932 review of Hayek’s Prices and Production he introduced the idea of own rates of interest.

The rate of interest (as we call it for short) is, strictly speaking, a monetary phenomenon in the special sense that it is the own-rate of interest (General Theory, p. 223) on money itself, i.e. that it equalises the advantages of holding actual cash and a deferred claim on cash. (p. 245)

The huge gap in Keynes’s reasoning here is that he neglected to say at what rate of return “the advantages of holding actual cash and a deferred claim on cash” or, for that matter, of holding any other real asset are equalized. That’s the rate of return – the real rate of interest — for which Irving Fisher provided an explanation. Keynes simply ignored — or forgot about — it, leaving the real rate of interest totally unexplained.

124 Responses to “Keynes on the Theory of Interest”


  1. 1 andrew lainton October 22, 2015 at 10:36 pm

    You are right I think in claiming Keynes had ‘half a theory of interest’ so what was the other half? The reference is in the intro to the General Theory about Gesell having ‘half a theory of interest’ the other half. Gesell was a theory of depreciation. Expressed verbally but the same as Hotelling’s mathematisation – which is the exact flip side of the Ray/Fisher theory – as each addition to the physical capital stock requires a matching fund of depreciation to replace at the end of its life.

  2. 2 Alfred Garnett October 23, 2015 at 1:26 am

    The decision to save is determined by income.What form the savings are held in is determined by the interest rate; eg should savings be held in cash or in bonds? The latter auestion is answered by the interest rate

  3. 3 JKH October 23, 2015 at 4:16 am

    Keynes quote:

    “The novelty in my treatment of saving and investment consists, not in my maintaining their necessary aggregate equality, but in the proposition that it is, not the rate of interest, but the level of incomes which (in conjunction with certain other factors) ensures this equality. (pp. 248-49)”

    It does seem odd for him to have said this. It might have been more understandable if he had said something like “ensures the level of this equality” – i.e. the level of saving and investment – “other factors” including the investment/consumption mix at a given level of income. But even that is an awkward statement.

    If it is possible for a firm to invest without borrowing (i.e. finance investment from retained earnings), then there is no rate of interest involved in the equivalence of saving (i.e. retained earnings) and investment in that case. That might immediately call into question a theory of interest that depends on saving and investment, since the same aggregate quantity of saving and investment can give rise to many different configurations of financial intermediation, each featuring a different quantity of funds that will be subject to an interest rate as a result of financial intermediation.

    But a theory of interest that is monetary can apply equally to cases of direct or intermediated saving and investment, since the choice in both cases is one of deploying liquidity in investment or lending, whether that liquidity is borrowed or already on hand.

    Also, I don’t see why the Fisher interest rate decomposition can’t apply to a theory of interest that is independent of the notion of an equilibrium for saving and investment. A liquidity driven interest rate could still be decomposed that way, couldn’t it?

  4. 4 Biagio Bossone October 23, 2015 at 4:32 am

    Keynes’ liquidity preference is the decision about the degree of liquidity at which savings should be held, and it is determined by agents’ expectations and state of mood. It is a decision concerning the stock of savings – wealth – at any point in time, rather than the flow of saving. The rate of interest is hence not determined by the supply of and demand for flows of saving, but by the supply of and demand for assets into which holdings of the stocks of wealth can be placed.

    “The current rate of interest depends not on the strength of the desire to hold wealth, but on the strengths of the desire to hold it in liquid and illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other. (Collected Writings VII, p 213)

    It is important to understand liquidity preference in these broad terms, rather than as concerned solely with the demand for money (which follows from Keynes’s familiar three motives). The theory of liquidity preference is concerned with the demand for assets of various degrees of liquidity, and the rate of interest depends on both the demand for and supplies of assets across the whole spectrum of assets available.

    Money, however, has a key role: while illiquid assets offer holders a reward in the form of interest, the reward for holding money is the essence of liquidity itself.

    The low interest rates prevailing during the crisis may well be explained by the extremely large liquidity preference in all sectors of the economy (including the financial one), drive by fears and pessimism, rather than by “a persistent tendency for planned savings to exceed planned investment”.

    Regarding saving and investment, Keynes’ main point may be reflected in this passage:

    “S = I at all rates of investment. Y either definable as C+S or as C+I. S and I were opposite facets of the same phenomenon they did not need a rate of interest to bring them into equilibrium for they were at all times and in all conditions in equilibrium.” (CW XXVII, pp 388–9)

    And if one reasons in terms of Keynes’ (multiplier) model of income determination process, one notices that saving is always a residual.

  5. 5 Rob Rawlings October 23, 2015 at 7:27 am

    Excellent post !

    Perhaps I have oversimplified but I am seeing Keynes views as something like:

    – Decisions to invest are made independent of the interest rate, and are not to any great degree affected by them
    – Investment via the multiplier (and the accounting identity) determines the level of income that equalizes actual saving and investment
    – Investment and income are derived to a very large degree by these 2 things. It is the real interest rate that must change to cause people’s desire to hold money to match the money supply and this will happen independent of what is happening to people’s time preference
    – Therefore a change in planned I or planned S will lead to adjustments in investment and/or income that are independent of the change in interest rate that may be needed to match the demand and supply of money.

    I need to think this through a bit but I do not see an obvious contradiction between this and the ‘own rate” theory. Beyond the short term the own rate of interest on money (which will take into account the fact that money comes with a liquidity premium) will be equilibriated against the return on other assets. It is the expected return on these other assets rather than the rate of interest on money that is driving investment that starts the whole cycle going.

  6. 6 Henry October 23, 2015 at 3:38 pm

    “The equivalence between the quantity of saving and the quantity of investment emerges from the bilateral character of the transactions between the producer on the one hand and, on the other hand, the consumer or purchaser of capital equipment.” (GT p.63)

    “Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.” (GT p.64) (The prior part of the containing paragraph is very relevant but I can’t be bothered transcribing it all.)

    “The amounts of aggregate income and aggregate saving are the results of the free choices of individuals whether or not to consume and whether or not to invest; but they are neither of them capable of assuming an independent value resulting from a separate set of decisions concerning consumption and investment.” (GT p.65)

  7. 7 Lord October 23, 2015 at 4:43 pm

    That is how I see it too with the interest rate largely determined by the marginal productivity of capital and a rather static propensity to save with falls in investment forcing falls in savings though unemployment, or how can the interest rate equate savings and investment at the zero bound?

  8. 8 Biagio Bossone October 24, 2015 at 12:24 am

    A comment on Lord:

    “That is how I see it too with the interest rate largely determined by the marginal productivity of capital”

    Quite the contrary. In Keynes’ model, it is the marginal efficiency of capital that, in equilibrium, has to equate the interest rate, the latter being determined exogenously, based on psychological and conventional beliefs. In fact, as Keynes himself indicates:

    “It is evident, then, that the rate of interest is a highly psychological phenomenon (…) It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal.” (CW VII p202-204).

    Therefore, in a situation with a very strong liquidity preference (take the global crisis as an example), where people attach a high premium on liquidity in the form an implicit return (everybody refrains from spending and tries to move into as much liquid assets as possible), the equilibrium marginal efficiency of capital must be high (in fact, it must equate the implicit return on liquidity), which obviously discourages (risky and illiquid) capital accumulation.

    In Keynes’ theory, it is the ‘real’ economy that must adjust to conventional and psychological beliefs, not vice versa.

    As to Lord’s further point:

    “… how can the interest rate equate savings and investment at the zero bound?”

    Well, in Keynes’ theory, saving is a residual and always equals investment. If investment is low, income is low, and savings are low. The fact that during a crisis many people reduce consumption and may hold excess savings (with respect to normal times) is compensated by people who see their income fall or lose their income and save less than before or may even dissave or live on others’ income and wealth, while overall aggregate saving adjusts and equals investment at a lower income level. This is all in Keynes’ multiplier model.

    Keynes’ general theory must be seen as the integration of three pillars: 1) the theory of consumption (leading to the income multiplier – interestingly, the multiplier has been rediscovered in these times of crisis!); 2) the theory of investment determined by states of mood (animal spirits); and 3) the liquidity preference theory, based on conventional beliefs.

  9. 9 Egmont Kakarot-Handtke October 24, 2015 at 12:33 am

    Interest and profit
    Comment on ‘Keynes on the Theory of Interest’

    At the immediately preceding thread ‘Keynes and Accounting Identities’ the rigorous formal proof has been given that Keynes’s elementary accounting identities are false. From this follows first of all for economic policy that the familiar multiplier is formally defective. The correct employment multiplier is displayed here (2015a, eq. (15)):

    The elementary Keynesian multiplier follows from the saving-equals-investment condition and the consumption function. Because I=S is provably false* it follows that the complementary story of the interest rate mechanism is false by logical implication. Because of this, a complete analytical reset is needed.

    For good methodological reasons, one has to start — NOT from individual behavior but — from the institutional fact that an elementary consumption economy (no investment, no government, no foreign trade) consists of the banking sector, represented for a start by the central bank, and the production sector, represented for a start by a single firm. Now, there are TWO rates of interest — for overdrafts and deposits to begin with — and the difference between the two is a co-determinant of profit of the central bank, which produces, as the saying goes, money (= deposits) and credit (= overdrafts) out of nothing.

    So, the interest rates on both sides of the central bank’s balance sheet and profit are closely intertwined. By consequence, if the profit theory is false the interest theory is false by logical implication. Now, in has been shown that Keynes’s profit theory is definitively false. Because of this, his theory of interest is unacceptable. An alternative is needed.

    To make a long argument short: the relation of rate of interest to product price, the so-called real interest rate, has to be derived for the most elementary case from the production conditions of the sub-sectors of the elementary monetary economy (2013, eq. (28)), see also (2011, eq. (30)) and (2011) and (2015b, Sec. 7).

    Roughly speaking, in the most elementary case the real rate of interest is OBJECTIVELY determined by the respective productivities in the consumption good sector and the banking sector. Needless to stress that things become a bit more complex as soon as different term structures on the asset and liability side and the financing of investment expenditures is taken into the picture.

    As Keynes realized, there is no direct connection between saving/dissaving and “the” rate of interest. Roughly speaking, the households can accumulate their period savings on a zero interest deposit account as long as they wish, no matter what the actual rate for overdrafts/loans is. Hence the intertemporal allocation of consumption expenditures (= period saving/dissaving) is — as a matter of principle — independent from the rate of interest. Because of this, Fisher’s subjective time preference approach cannot explain anything. Therefore, Keynes was right to ignore it.

    It should be noted in passing that the stock of deposits/overdrafts is, in the most elementary case, the numerical integral of period saving/dissaving of the household sector. The two interest rates refer to the respective stocks and not to period saving/dissaving. The quantity of money is endogenously determined.

    Take away: if profit theory is false, interest theory is false; this is the case with both Keynes’s and Fisher’s approach; I=S is always false and cannot explain interest.

    Egmont Kakarot-Handtke

    References
    Kakarot-Handtke, E. (2011a). The Emergence of Profit and Interest in the Monetary Circuit. SSRN Working Paper Series, 1973952: 1–22. URL
    http://ssrn.com/abstract=1973952
    Kakarot-Handtke, E. (2011b). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL http://ssrn.com/abstract=1895268.
    Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL http://ssrn.com/abstract=2220651
    Kakarot-Handtke, E. (2015a). Essentials of Constructive Heterodoxy: Employment. SSRN Working Paper Series, 2576867: 1–11. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2576867
    Kakarot-Handtke, E. (2015b). Major Defects of the Market Economy. SSRN
    Working Paper Series, 2624350: 1–40. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2624350

    * The correct relationship is given here:

  10. 10 Fed Up October 24, 2015 at 3:02 pm

    JKH, I need some help with the accounting.

    Assume a 2 person economy. Each one sells a service to the other one for currency.

    Each one sells $5,000 of service to the other one.

    Income = $10,000 overall. There is no savings and no investment. S = I = 0.

    This goes on for awhile.

    Next, one of them saves $500 in currency and only consumes $4,500. The other one only consumes $4,500 also.

    Income = $9,000 overall. S = $500. What/Where is the I?

  11. 11 llordliege October 24, 2015 at 5:55 pm

    Biagio
    I don’t think future expectations are entirely free from the past, through calculation and experience which convention brings us, so I would not go as far as entirely exogenous, but self fulfilling until not anyway, the not being when expectations are revised, otherwise I couldn’t have said it better.

  12. 12 djb October 24, 2015 at 8:12 pm

    Response to

    FED UP

    Investment is any addition of preexisting wealth that goes into the economy in the given time period

    In the initial time period each had 5000 preexisting wealth which they used to pay for their consumption

    That counts as 10000 investment income

    There was no consumption during that given time period from current income

    So all of the income comes from investment (consumption from preexisting wealth)

    And all of it gets save, ie is preserved as wealth of the two people

    10000 invested 10000 saved

    —————–

    Second scenario

    9000 invested (consumption from preexisting wealth) 9000 saved

    500 plus 500 =1000 stays in savings, might have changed where you kept it but still stayed in your savings

    ———!—

    I’ll add a 3rd scenario

    5000 plus 5000 spent from preexisting wealth

    So 10000 investment goes into current income of the two individuals

    Then each of these individuals uses 500 of their current income to buy something else from someone

    We then get 500 + 500 = 1000 consumption (from current income)

    And 5000 + 5000 = 10000 investment (consumption from preexisting wealth)

    Assuming no more spending from current income the 500 + 500 ends up preserved as savings for whoever they bought from

    So we get total income 11000

    Investment 10000. …….. preserved as savings is 9000 for the two guys….and 1000 for whom they bought from (assuming those people kept it didn’t spend it)

    Consumption 1000

    Income = investment plus consumption

    Ps

    They could have used their 500 they spent from current income to buy from each other… keeping the economy a 2 person economy

    Guess that would just be increasing the velocity of money

  13. 13 JKH October 25, 2015 at 3:11 am

    Fed U.,

    Your example includes an internal inconsistency/contradiction.

    If consumption is $ 9,000, then income is $ 9,000. For it to be otherwise, there must either be a stated assumption regarding an explicit quantity of investment, or a stated assumption regarding an explicit difference between income and consumption. There isn’t either. So investment is $ 0 by implication.

    And because there is no investment by implication, there cannot be any saving in the form of currency or anything else.

    (The form that saving takes doesn’t matter to the relationship between investment, consumption, and income. From a financial accounting standpoint, the form of saving such as currency might enter into a hyper-detailed flow of funds financial statement, but not into an expenditure/income financial statement.)

    As importantly, in your example, somebody must start out the accounting period with currency already on hand in order to start the process of exchange. That could be $5,000 in currency held by one of the two persons. But that currency has nothing to do with income or saving in the current period. It is just a medium of exchange that already exists on a balance sheet at the start of the accounting period. It may have been the result of saving in a prior accounting period, but not the period in question. So not spending $ 500 by using currency from the opening balance sheet is not the same as saving $ 500 from current period income. There is no saving from current period income in the example, and there is no investment.

  14. 14 Henry October 25, 2015 at 3:04 pm

    “The huge gap in Keynes’s reasoning here is that he neglected to say at what rate of return “the advantages of holding actual cash and a deferred claim on cash” ”

    I don’t think this is a fair statement at all. Keynes gave an explanation in Chap 15 when dealing with his speculative motive and the notion of the propensity to hoard.

  15. 15 Fed Up October 25, 2015 at 5:15 pm

    Let me try it this way.

    Assume a 2 person economy. Each one sells a service to the other one for currency.

    The time period(s) is/are one week.

    Week one, the first person gets a gift of $5,000 of currency and buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.

    Week two, the first person buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.

    Week three, the first person buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.

    Week four, the first person buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.

    Week five, the first person saves $500 and buys $4,500 in services from the other person. The other person buys $4,500 in services from the first person.

    Total income = $9,000.

    What are S and I in each period? Thanks!

  16. 17 Henry October 25, 2015 at 7:11 pm

    “What are S and I in each period? Thanks!”

    I would say S and I are zero in each period.

  17. 18 Frank Restly October 25, 2015 at 7:52 pm

    David,

    Curious remark by Keynes:

    “This can be put briefly by saying that the rate of interest depends on the demand and supply of money…”

    Any rate of interest is not the price of money, it is the price of time. And so, “a rate of interest that depends on the demand and supply of money” as Keynes describes it misses that time can be a finite resource unto itself.

    In fact, we can conceive of debt and interest rates in a barter economy without any money.

  18. 19 Biagio Bossone October 26, 2015 at 1:42 am

    Fed up:

    If for each of the 2 agents income is the expense of the other ($5000 in the first of your example, and $4500 in the second), there is no saving out of current income in either case. In the second example, it would be wrong to define as saving the $500 non spent out of previously accumulated wealth. In fact, the income of both is $4500 and they spend all the income they receive. So, you have 0 saving and 0 investment in both cases. You would have saving of $500 in the case, for example, where one of the agent would spend $5000 and the other would spend only $4500 out of the $5000 she receives. You would notice, though, that the first agent would receive now only a $4500 income and so she either dissaves $500, if she wants to keep her consumption constant, or she would reduce her consumption and thus reduce the income of the other agent in turn. The (sequential) multiplier dynamics would make sure that at the end of the process, the economy (the 2 agents in your model) would dissave exactly $500 and you would end up, again, with 0 saving and 0 investment. In Keynes’ model you have consistently to follow through the principle that one’s expense is another’s income, which binds you necessarily to have a sequential dynamics; you also have to bear in mind the definition of saving as non spent resources out of current income, and not out of previously accumulated wealth.

  19. 20 Biagio Bossone October 26, 2015 at 2:17 am

    Frank Restly:

    “Any rate of interest is not the price of money, it is the price of time. And so, “a rate of interest that depends on the demand and supply of money” as Keynes describes it misses that time can be a finite resource unto itself.
    In fact, we can conceive of debt and interest rates in a barter economy without any money.”

    No, Keynes didn’t miss the time factor at all and, yes, introducing money changes the whole perspective from barter.
    The liquidity preference motive that Keynes talked about is the preference of people for holding their resources in a way that gives them maximum flexibility ‘now’ in the face of the uncertainty and ignorance regarding the ‘future’. It is the motive that pushes them to abstain from taking any risky decision ‘now’ and be able to take a wait-and-see attitude toward a ‘future’ they don’t know. And money is the only asset that ensures them that 1) they can spend it immediately in case of need, at no cost of liquidation and 2) the value they hold in its form is safe from risks and shocks.

    So, the interest rate that is determined by the demand and supply of money, results from the preference of being being liquid versus that of being illiquid, depending on circumstances, expectations and states of mood: the higher the liquidity preference, the higher the equilibrium rate on return on less liquid assets as a premium to their illiquidity: the interest rate is the price of illiquidity in the face of an uncertain future, not of time it itself. And there may be extreme circumstances where fear or pessimism may be so high that whatever rate of interest is offered on less liquid assets, people are willing to stick to their liquid assets and absorb even additional quantities of money that is supplied, simply because they want to be able to have immediate command on real resources ‘just in case’, stay away from risks, and be able to wait and see what happens next.

    The global crisis of 2008 triggered a situation where people in all sectors of the economy (including financial institutions) wanted to be as liquid as possible. In such extreme cases, people’s liquidity preference is such that monetary policy becomes ineffective and there is a need for somebody to take the initiative and start spending, so as to bring the economy out of the trap: and the only one who can do that is the public sector.

  20. 21 JKH October 26, 2015 at 2:31 am

    Fed U.,

    Very good explanation from Biagio Bossone above.

    I’d say essentially the same thing this way:

    The “gift” of $ 5,000 in currency comes from “nowhere” in context, meaning that it should be considered as the residue of a prior accounting period and as an assumption concerning opening period wealth.

    Currency is a form of wealth and it is also the medium of exchange. It is of no direct consequence in the measurement of current period expenditure, income, or saving.

    Under the stated assumptions, in all periods under consideration, expenditure on services equals income, investment is 0, and saving is 0.

    Regarding the switch from $ 10,000 income to $ 9,000 income:

    Saving is 0 for both the $ 10,000 economy and $ 9,000 economy.

    ‘Saving’ means saving from current period income, and it means saving from current period income rather than spending it on consumer goods and services provided in the current period. Because of this definition, the quantity of saving ends up equalling the quantity of investment, since income gets spent either on consumption or investment.

    Saving does not mean such things as – ‘not spending wealth’ or ‘not spending currency’ or ‘not spending the same amount as a prior period’. That just leads to a free-for-all in personalized, unhelpful definitions.

  21. 22 Biagio Bossone October 26, 2015 at 7:34 am

    Thanks, JKH.

    In fact, I didn’t notice that in an earlier message Henry had noted that S and I are 0 in both of Fed up’s examples.

    Anyway, just to add to my previous considerations on Keynes’ theory of interest, I report a couple of other important quotes from Keynes himself:
    .
    “Because, partly on reasonable and partly on instinctive grounds, our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future … The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude (Keynes,1937, “The General Theory of Employment.” Quarterly Journal of Economics 51:209–223).

    “A liquidity premium … is not even expected to be rewarded. It is a payment, not for the expectation of increased tangible income at the end of the period, but for an increase sense of comfort and confidence during the period.” (Keynes, 1938, Letter to Hugh Townshend dated 7 December, 293–294. Volume 14 of Keynes (1971-1989)).

    Keynes’ conception of interest as a psychological or conventional economic entity should not really surprise mainstream economists, whose knowledge is grounded on neoclassical theory of value, whereby the economic value of traded goods is not an intrinsic property of the goods themselves but the reflection of subjective preferences of individuals who draw some kind of utility or satisfaction from possessing or using them. The value of the goods is therefore the result of the interaction in the marketplace of those different individual subjective preferences. Similarly, according to Keynes, the value of money reflects the interaction in the marketplace of the different degrees of comfort and confidence that individuals derive from holding money (as immediately available purchasing power capacity) in the face of an uncertain and unknown future.

  22. 23 djb October 26, 2015 at 9:28 am

    yes Keynes said it was uncertainty which caused people to want to hold cash
    or immediately available assets

    because if we were certain of everything we could arrange our investments so that just the exact right amount of cash would become available at the just right time, to enable all our financial transactions to go as planned

  23. 24 djb October 26, 2015 at 9:36 am

    “The global crisis of 2008 triggered a situation where people in all sectors of the economy (including financial institutions) wanted to be as liquid as possible”

    and it wasn’t just wanting to be ready for the next opportunity, it was also the fact that they were afraid that those assets would disappear if they didn’t cash them in

  24. 25 TravisV October 26, 2015 at 4:03 pm

    Dr. Glasner, have you written your review of Sumner’s “Midas Paradox” book yet?🙂🙂 http://www.amazon.com/The-Midas-Paradox-Government-Depression/dp/1598131508

  25. 26 djb October 26, 2015 at 4:57 pm

    to FED UP

    I address your scenario using the definition of investment as the addition of pre-existing wealth to the economy, buying something with preexisting wealth counts as investment

    and savings as wealth left over at end of process

    and consumption as spending using currently earned income

    currently means during the given time period

    —————————————-

    “Let me try it this way.

    Assume a 2 person economy. Each one sells a service to the other one for currency.

    The time period(s) is/are one week.

    Week one, the first person gets a gift of $5,000 of currency and buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.
    ———————————–
    the gift of 5000 dollars is preexisting wealth therefore when he buys the 5000 in services it is investment

    the person who earned that 5000 dollars buys 5000 in services with income he earned in this time period, which is consumption

    total income =5000 investment plus 5000 consumption = 10,000

    if we stopped at this point we would have 5000 investment preserved in the first guys pocket as savings of 5000

    savings equals investment

    but you go on:
    __________________________________

    Week two, the first person buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.<- incorrect

    ———————————————
    now we have the 1st person using 5000 thousand they just earned for consumption and the then the other person used the 5000 they earned for consumption

    total invested still 5000, 5000 is still the total wealth left as savings

    but total income now is the original 10000 from first week, plus 5000 consumption plus another 5000 consumption

    total income equal 20,000

    ——————————————————

    Week three, the first person buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.<- incorrect

    —————————————

    total investment is still the original 5000 ……….
    savings, i.e. money left over is still 5000

    savings equals investment

    consumption of 5000 by the one guy then another 5000 by the second guy, both from current income gives us another 10000 in consumption

    added to previous total income = 20,000 + 10000 = 30,000 total income

    ——————————————–

    Week four, the first person buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000.<- incorrect

    ———————————————————-

    again still have the original 5000 investment and have 5000 still saved at the end of this exchanged

    so another 10000 in purchases from current income= 10000 consumption

    total income now 30,000 plus 10,000 = 40,000 total income

    of which 35,000 is consumption and 5000 investment

    _________________________________

    Week five, the first person saves $500 and buys $4,500 in services from the other person. The other person buys $4,500 in services from the first person.

    Total income = $9,000.<-incorrect

    ———————————————————-

    so total investment still equals the original 5000

    and the person saves 500 of his current income and spends 4500

    then the other guy spends 4500 of his current income

    so total income is increased by this 9000 dollars in consumption

    total income = 40000 plus 9000 = 49000

    of which 5000 was investment and 44000 consumption

    now that first guy has back in his possession that 4500 plus he also has that 500 he saved, the total preserved wealth equals 4500 plus 500 = 5000

    savings 5000 equals the original 5000 investment that came from preexisting wealth which came from the gift

    savngs equals investment

    ————————————————————-

    What are S and I in each period? Thanks!

    ———————————————

    that's if you considered all those weeks together as "the given time period"

    if you considered them separate

    then the 5000 you had at the beginning of each time period would be preexisting wealth and count as investment

    and at the end of each time period you would have 5000 left as savings

  26. 27 Fed Up October 26, 2015 at 8:29 pm

    Let me change week 5 and add week 6.

    Week five, the first person buys $5,000 in services from the other person. The other person saves $500 and buys $4,500 in services from the first person.

    Total income = $9,500.

    Week six, the first person buys $4,500 in services from the other person. The other person buys $4,500 in services from the first person.

    Total income = $9,000.

  27. 28 Fed Up October 26, 2015 at 8:39 pm

    “Currency is a form of wealth”

    Can currency be considered a savings vehicle?

    Also, isn’t S = I about flows?

  28. 29 djb October 27, 2015 at 5:36 am

    “Let me change week 5 and add week 6.

    Week five, the first person buys $5,000 in services from the other person. The other person saves $500 and buys $4,500 in services from the first person.

    Total income = $9,500.

    Week six, the first person buys $4,500 in services from the other person. The other person buys $4,500 in services from the first person.

    Total income = $9,000.”

    then at the end of week 6 person number 2 has 500 dollars in savings, and person number 1 has 4500 dollars in savings

    total savings = 4500 (person 1) plus 500 dollars(person 2) = 5000 dollars

    total income would then be 40,000 plus 9,500 plus 9000 = 58,500

  29. 30 Frank Restly October 27, 2015 at 12:24 pm

    Biagio,

    “The liquidity preference motive that Keynes talked about is the preference of people for holding their resources in a way that gives them maximum flexibility ‘now’ in the face of the uncertainty and ignorance regarding the ‘future’. It is the motive that pushes them to abstain from taking any risky decision ‘now’ and be able to take a wait-and-see attitude toward a ‘future’ they don’t know.”

    I argue that liquidity preference is only one aspect to consider in determining an interest rate. In an economy there are real time limitations on the introduction of new goods into that economy.

    For instance, I have a bunch of apples that I just picked and I want to trade them for a train (locomotive). The train manufacturer tells me that I can get my new train a year from now. I can hold onto my apples and let them rot, or I can lend my apples (at interest) to the train manufacturer and receive either a new train / or replacement apples a year from now.

    In this case, the apple / train interest rate isn’t a reflection of my liquidity preference (I can’t hold onto the apples forever, they will rot). Rather it will be an interest rate that both I and the train manufacturer can agree too.

    Now maybe Keynes was more comfortable discussing debt and interest solely from a monetary perspective, but this is an incomplete analysis in my opinion.

  30. 31 George H. Blackford October 27, 2015 at 9:42 pm

    I have always been willing to cut Keynes some slack when it comes to semantic issues, because it seems to me that he was trying to explain new ideas and, as a result, was forced to develop the vocabulary within which to explain these ideas as he went along. Terms such as ex-ante and ex-post were not well defined or understood when Keynes tried to explain his theory of interest in the 1930s, and distinctions between definitions and equilibrium conditions were not clearly drawn by the Classical Economists he criticized. And while everyone knew that sales equal purchases, by definition, and that the quantity demanded did not always equaled the quantity supplied, there were different words to describe these two kinds of phenomena when talking about markets for goods. Prior to the LP-LF debate that began in the 1930s, Economists did not have the words to clearly draw this kind of distinction when talking about saving and investment.

    As a result, when I see Keynes saying something like: “The novelty in my treatment of saving and investment consists, not in my maintaining their necessary aggregate equality, but in the proposition that it is, not the rate of interest, but the level of incomes which . . . ensures this equality” I do not see this as being either profound or a contradiction any more than if he had said: “The novelty in my treatment of the supply and demand for apples consists, not in my maintaining the necessary aggregate equality of sales and purchases of apples, but in the proposition that it is, not the price of oranges, but the price of apples which . . . ensures the equality of the supply and demand for apples.” I just don’t understand why anyone would assume he meant anything other than this sort of thing when he said that income equates saving and investment, and the rate of interest equates the demand and supply of money.

    I spent a great deal of time in an earlier life plodding through the LP-LF debate that followed Keynes’ publication of the GT and was astounded by the extent to which the conventional wisdom within the discipline of economics was out of touch with reality when it came to the substance of this debate. By the late 1970s it seemed that the debate had already become a classic in the sense that everyone knew about it, but no one had had actually read it, and I found the debate itself to be surreal.

    As best I can remember from my reading those many years ago, before and during the early part of the War the debate was in explicitly Marshallian, partial-equilibrium terms. Keynes argued that there was a fundamental difference between the two theories in that in the LP theory the rate of interest is determined by the supply and demand for money and in the LF theory it is determined by savings and investment while Robertson et al argued that the two theories were the same and that Keynes just didn’t understand the mechanism by which savings and investment determine the rate of interest within this framework.

    After the War, when Keynes was no longer around to defend his theory, the Keynesians came along and the debate entered a Walrasian phase as the Keynesians argued that the two theories were essentially the same in that it didn’t make any difference whether one assumed the rate of interest was determined by savings and investment or by the demand and supply of money since the short-run equilibrium that was implied by either assumption was the same. At this point the Robertsonians decided that the two theories were not the same, that Keynes was wrong, and that the rate of interest was determined by savings and investment (presumably in a Marshallian sense) irrespective of whether the short-run equilibrium was the same or not. And so it went until the early 1960s when Robertson left us, and the debate just sort of petered out.

    At that point we were left with two schools of thought within mainstream economics (though the Post Keynesians upheld the tradition of Keynes outside mainstream economics): one that argued the rate of interest is determined by savings and investment and one that argued it didn’t make any difference what you assumed about how the rate of interest was determined. It seemed to me, and still does seem to me that both of these schools of thought were totally out of touch with the reality of what Keynes had to say about the way in which the rate of interest is determined.

    I find that a great deal of the controversy we see in the discipline of economics today arises from a failure to resolve the issues of this debate in Marshallian terms, and I wrote a number of papers back in the early 1980s that attempted to resolve these issues that no one found to be very interesting at the time, or at least no one found them to be interesting enough to publish. Most of those papers are either lost or are only to be found on 5.25” floppy disks that are difficult to access with today’s computers, but I did manage to find one paper from 1983 (which has my name on it, but, quite frankly, I don’t know where it came from as I don’t actually remember having written it back then) that basically explains how I saw the issues then (and still see them today) after having reviewed the literature on the LP-LF debate in the late 1970s and early 1980s.

    This paper examines the issues that divided Robertson and Keynes in terms of the nature of causality within the context of the dynamics by which the equilibrium price is assumed to be achieved within the context of a Marshallian partial equilibrium framework. Now there are many grounds on which one can criticize this framework, but most economists recognize its essential validity, and few economists are willing to go to the wall trying to defend the proposition that it makes more sense to explain the market for apples by assuming that the price of oranges adjusts to equate the supply and demand for apples rather than by assuming this equality is brought about through an adjustment in the price of apples. And yet, this is exactly what I found the adherents to the LF theory of interest willing to do.

    The conclusion of this paper is quite simply that Robertson’s theory of causality makes no sense at all within a Marshallian context; it only makes sense within a Walrasian tatonnement context, and, even then, only to the extent that causality makes any sense at all within a Walrasian tatonnement context. The paper is quite long, but, aside from the double spacing, that is because it quotes extensively from the contributors to this debate so that you can see what they actually said rather than just my interpretation of what they said. In the event that someone might be interested in this paper I have made it available here: http://rweconomics.com/htm/RvK.htm

  31. 32 JKH October 28, 2015 at 5:59 am

    I had a first run through the paper.

    This toward the end is an excellent and essential summary:

    “Once the actual constraints on decision making units are specified properly, saving and investment, as they enter the supply and demand for loanable funds schedules, are no longer defined independently of each other. A change in one must be accompanied by an equal change in the other and, thus, must increase or decrease the loanable funds supply and demand schedules by exactly the same amount leaving the rate of interest at which these schedules intersect unchanged. The only way in which the supply and demand for loanable funds schedules, so defined, can change relative to one another is if there is a change in the supply or demand for money. Thus, the rate of interest is a purely monetary phenomenon in Keynes general theory, determined at each and every point in time by the interactions of decision making units with regard to the supply and demand for money. Saving and investment play no direct role at all, and the only thing that can be explained by the supply and demand for loanable funds is the mechanism by which the size of the revolving fund of money in circulation changes through the effect of disequilibrium in the credit market on the accumulations of excess reserves (in the case of banks) and of money (in the case of wealth holders).”

    This is reflected in the necessary equivalence of saving and investment through proper income accounting (which in logic amounts to “actual constraints on decision making units”), and in potentially variable levels of money balances through proper balance sheet and flow of funds accounting.

  32. 33 Egmont Kakarot-Handtke October 28, 2015 at 11:43 am

    Accounting basics
    Comment on FedUp of Oct 24 on ‘Keynes on the Theory of Interest’

    The most elementary economy is the pure consumption economy and it consists of the business and the household sector. For a start, the business sector produces and sells one consumption good.

    First period: the business sector pays 100 units to the household sector and the household sector spends exactly this amount on the consumption good. There is no saving of the household sector. The business sector’s profit is zero and the price of the consumption good is equal to unit wage costs.

    Second period: the household sector saves 10 units (S=10) and spends 90 units. Now, the business sector makes a loss (Q=-10). The market clearing price is lower than unit wage costs.

    Accounting result: saving=loss or S+Q=0. The complementary notion to saving is NOT investment but loss. Because of this I=S NEVER holds. And because of this the whole discussion of whether the interest rate or the income mechanism establishes the equilibrium/equality of saving and investment is pointless. There is NO such thing.

    At the central bank’s balance sheet we have at the end of the 2nd period 10 units of current deposits of the household sector and the equal amount of current overdrafts of the business sector. Without going further into details it should be obvious that the rate of interest on the asset side and the rate of interest on the liability side must be such that their difference covers at least the costs of the central bank under the condition of zero profit.

    This is how the accounting identity and the TWO rates of interest are OBJECTIVELY connected in the most elementary case. There is no need at all of silly psycho-sociological filibuster about liquidity preference, animal spirits, or ‘comfort and confidence that individuals derive from holding money in the face of an uncertain and unknown future’. No way leads from behavioral storytelling to the understanding of how the monetary economy works. Standard economics — Keynesianism included — is in the wood and will be left behind there.

    For a more detailed depiction of the accounting relationships see ‘The Profit Law’.
    http://axecorg.blogspot.de/2015/01/the-profit-law.html

    Egmont Kakarot-Handtke

  33. 34 nafisa riaz October 28, 2015 at 12:58 pm

    can you please tell me that why it is so that saver is compensated for inflation in fisher equation when no other factor of production is compensated, if so, in the same period for inflation??

  34. 35 Henry October 28, 2015 at 1:41 pm

    Egmont,

    “Second period: the household sector saves 10 units (S=10) and spends 90 units.”

    How can the household sector save 10 units and spend 90 units?

    It must have acquired the whole 100 units.

    Your model is replete with definitional confusions.

  35. 36 MarkanKone October 28, 2015 at 2:28 pm

    Henry,

    I think Egmont assumed in his example that households do continue working for the businesses also in the second period earning 100 units.

    Egmont,

    If we define business saving as undistributed profits (profits after all expenses including dividends, which are zero in your example), then, if the business sector makes a loss, would it be incorrect to say that business sector has negative saving in the accounting period?

    If this is not incorrect statement, then total saving in your example is 0 (households saving +10 business saving -10).

    And if it is not incorrect statement, your example does not in my understanding contradict I=S identity, because it means that in your example S=I (both are zero).

  36. 37 Egmont Kakarot-Handtke October 29, 2015 at 4:16 am

    ICYMI (comment on Henry of Oct 28)

    Total wage income Yw is 100 in period 1, and consumption expenditures C are 100. Saving Sm=Yw-C is zero.

    Total wage income Yw is 100 in period 2, and consumption expenditures C are 90. Saving Sm=Yw-C is 10. Profit Qm=C-Yw is -10.

    Accounting check: the balances of both sectors add up to zero: Sm+Qm=0.

    QED

  37. 38 djb October 29, 2015 at 8:33 am

    Henry

    , I believe that ultimately any contribution edk’s efforts bring to table is to recognize that profits occurred because of net production

    Nonmonetary but of course convertible to cash

    I agree that savings = Investment is limited to preservation of the original investment

    This keeps wealth constant…. no way for total wealth to increase

    Increased wealth comes from production… or rather net production

    He adds that to his equation as profits

    He seems to adds it as income

    You can do this but I prefer to add this new wealth produced as savings

    Defining total savings = total capital = total wealth

    Savings is the wealth we have left over by the way

    Other than that I don’t see where he has disproved all of economics that has come before him

    As he seems to allege

    But what do I know because as he says about me:

    “Confusion is the default state of the representative economist (2013). Obviously, you cannot get out of Keynes’s accounting mess by nonstop introducing new concepts like wealth, capital, consumption function etc. The solution lies exactly in the opposite direction.

    So there is absolutely no need for endless confused blather.”

    (And I wouldn’t want endless confused blather)

  38. 39 Egmont Kakarot-Handtke October 29, 2015 at 9:39 am

    Comment on djb of Oct 29

    Analysis starts with the minimum number of elementary propositions. This is known since the ancient Greeks invented science: “When the premises are certain, true, and primary, and the conclusion formally follows from them, this is demonstration, and produces scientific knowledge of a thing.”*

    When you come clear with saving, investment, and profit then the growth of real and nominal wealth emerges immediately as a result. Wealth cannot be assumed as given but must be derived from the most elementary economic configuration with zero wealth.

    Keynes started from faulty premises and because of this the conclusion I=S is provably false. History from Keynes onwards, though, has shown that proper methodology is beyond the mental capacities of the representative economist. There is no hope for the present generation of economists (in particular for Henry, JKH, djb).

    Nevertheless, for the consistent derivation of wealth see the working paper ‘Primary and Secondary Markets’

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1917012

    * See Wikipedia, resume of Aristotle’s Posterior Analytics
    http://en.wikipedia.org/wiki/Posterior_Analytics

  39. 40 Egmont Kakarot-Handtke October 29, 2015 at 10:13 am

    Comment on MarkanKone of Oct 28

    The introduction of distributed/retained profit and the redefinition of saving cannot rescue I=S. No semantic maneuver can. I have clarified this case in Section 17 of the working paper ‘Keynes’s Missing Axioms’
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1841408

  40. 41 Fed Up October 29, 2015 at 10:27 am

    I want to move on from S = I for now and change the scenario slightly.

    Assume a 2 person economy. Each one sells a service to the other one for currency. Both people want to balance their budgets until week five where one person changes. They both balance their budgets after that.

    Week zero, there is no currency. The first person buys $0 in services from the other person. The other person buys $0 in services from the first person.

    Total income = $0 for week zero.

    Week one, the first person gets a gift of $5,000 of currency and buys $5,000 in services from the other person. The other person buys $5,000 in services from the first person.

    Total income = $10,000 for week one.

    Week five, the first person buys $5,000 in services from the other person. The other person saves $500 (*** no longer wanting to balance that person’s budget ***) and buys $4,500 in services from the first person.

    Total income = $9,500 for week five.

    Week six, the first person buys $4,500 in services from the other person. The other person buys $4,500 in services from the first person.

    Total income = $9,000 for week six.

    Now I call that saving(s) in the medium of account (MOA) / medium of exchange (MOE). That saving(s) causes a recession.

    Now what should it be called?

  41. 42 djb October 29, 2015 at 12:49 pm

    Yes proof that decreased spending can cause a recession

    Want to get out of the recession?

    Add more prexisting wealth to the economies income which we’ll call investment
    (And which now includes that 500 dollars, if you want put it back in play)

    Running out of preexisting wealth?

    Have an economy that preserved current wealth or has positive net production of wealth

    Now that wealth can be distributed amongst investors or workers or different firms…. but that is how wealth grows

    Yours truly,

    Blathering on

  42. 43 Egmont Kakarot-Handtke October 29, 2015 at 1:27 pm

    Comment on FedUp of Oct 29

    Keynesian economics is about the monetary production economy: “The entrepreneur economy was one of Keynes’ ways of showing how and why monetary and financial matters must be integrated with real factors from the start of the analysis of a monetary production economy. It is this insight that is missing from virtually all strands of modern mainstream theory.” (Harcourt, 2010, p. 49)

    The most elementary monetary production economy consists of the business and the household sector. Your two person exchange example is obviously no acceptable representation of Keynes’s approach.

    Here is a picture of the most elementary monetary production economy:

    References
    Harcourt, G. C. (2010). The Crisis in Mainstream Economics. real-world economics review, (53): 47–51. URL http://www.paecon.net/PAEReview/issue53/Harcourt53.pdf.

  43. 44 Biagio Bossone October 29, 2015 at 2:07 pm

    George H. Blackford,

    excellent comment. Only one counterargument to one of your passages, which I report below:

    “…when I see Keynes saying something like: “The novelty in my treatment of saving and investment consists, not in my maintaining their necessary aggregate equality, but in the proposition that it is, not the rate of interest, but the level of incomes which . . . ensures this equality” I do not see this as being either profound or a contradiction any more than if he had said: “The novelty in my treatment of the supply and demand for apples consists, not in my maintaining the necessary aggregate equality of sales and purchases of apples, but in the proposition that it is, not the price of oranges, but the price of apples which . . . ensures the equality of the supply and demand for apples.” I just don’t understand why anyone would assume he meant anything other than this sort of thing when he said that income equates saving and investment, and the rate of interest equates the demand and supply of money.

    It is not the case that Keynes didn’t have the words to speak about inequality of ex-ante and ex-post saving. Based on his income multiplier process theory, he derived aggregate saving as a pure residual variable, strictly determined by aggregate investment in a way that S = I always and invariably, both ex ante and ex post.

    From the GT:

    “The error lies in proceeding to the plausible inference that, when as individual saves, he will increase aggregate investment by an equal amount. it is true that when an individual save he increases his own wealth. But the conclusion that he also increases aggregate wealth fails to allow for the possibility that an act of individual saving may react on someone else’s saving and hence on someone else’s wealth.” (p. 83-84)

    “For although the amount of his [the individual’s] own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the income of others make it impossible for all individuals simultaneously to save any given sum. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. it is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure equal to the amount of investment (p. 84)

    Later on, Keynes would note:

    “…there will always be exactly enough ex post saving to take up the ex post investment and so release the finance which the latter had been previously employing. The investment market can become congested through shortage of cash. It can never become congested through shortage of saving. This is the most fundamental of my conclusions within this field.” (The ‘ex ante’ theory of the rate of interest, The Economic Journal, Vol. 47, No. 188, Dec. 1937, p. 669)

    Frank Restly,

    “… In this case, the apple / train interest rate isn’t a reflection of my liquidity preference (I can’t hold onto the apples forever, they will rot). Rather it will be an interest rate that both I and the train manufacturer can agree too.”

    Indeed, it is! The very fact that you lend your apples and cannot use them during the lending period in exchange for something else that you might need or like is actually making you illiquid. It is not that you sacrifice apples consumption today for more apples consumption tomorrow; it is, instead, that you are temporarily surrendering the generalized purchasing power that holding apples gives you today (and until they rot). That’s why you are charging an interest rate for lending them out to start with (even assuming risk premium considerations away). And if LP rises, meaning that for reasons relating to changes in expectations, state of mood or confidence, you happen to attach a higher disquietude to your being illiquid, your required interest rate on apples lending would rise by implication. More generally, what Keynes implied with his LP theory is that equilibrium returns on assets characterized by different degrees of liquidity, including risky and illiquid productive capital, are determined by the implicit reward (comfort) that the agents receive from holding money as most liquid type of assets, that is generalized purchasing power that can be used immediately and at no cost of liquidation. LP theory does implies (or requires) a real change in perspective as one moves from barter to a monetary production economy where time and uncertainty put a premium on liquidity.

  44. 45 Henry October 29, 2015 at 2:41 pm

    MarkanKone,

    “I think Egmont assumed in his example that households do continue working for the businesses also in the second period earning 100 units.”

    OK, if that’s the case then the firm sold 100 units and the household purchased 100 units. How is it that the goods price has fallen (“The market clearing price is lower than unit wage costs”)?

  45. 46 Henry October 29, 2015 at 2:44 pm

    Egmont,

    “Profit Qm=C-Yw is -10.”

    That might be how you define profit.

    I would define it as sales – costs (i.e wages in this case):

    = 100 – 100 = 0 (not -10).

  46. 47 George H. Blackford October 29, 2015 at 3:14 pm

    Biagio Bossone

    I don’t disagree with you on this. My only point is that Keynes was looking at the economic system from a different perspective and talking about it in a different way. That often led to confusion on the part of those who tried to understand his words from their perspective and were unable to view them from his perspective.

  47. 48 Egmont Kakarot-Handtke October 29, 2015 at 3:24 pm

    Comment on Henry of Oct 29 2:44 pm

    Sales, as seen from the business sector, is the same thing as consumption expenditures, as seen from the household sector.

    In period 2 we have: 90-100=-10 (not 0).

    In the pure consumption economy, the business sector cannot recoup its wage costs if the household sector saves. This is how loss comes into the world.

  48. 49 Henry October 29, 2015 at 3:27 pm

    I agree with George.

    You cannot attempt to view Keynes’ work thru a neoclassical prism.

    If you have neoclassical predilections, you have to suspend these to facilitate further understanding – and of course that doesn’t mean that you have to accept what Keynes proposed.

  49. 50 Henry October 29, 2015 at 3:29 pm

    Egmont,

    “Sales, as seen from the business sector, is the same thing as consumption expenditures, as seen from the household sector.”

    Then the contradiction you have created is purely of your own making, contingent on the definitions you apply.

  50. 51 Egmont Kakarot-Handtke October 29, 2015 at 4:00 pm

    Comment on Henry of Oct 29 3:29 pm

    This is not a matter of definition but of hard, cold cash. The household sector spends C=90 units as consumption expenditures and the business sector receives exactly this amount but calls it sales. This in not way affects the formula for monetary profit Qm=C-Yw. Together with the formula for monetary saving Sm=Yw-C this gives Qm=-Sm. Look at the formulas and forget the names. It is the formal proof that counts and nothing else.

  51. 52 Henry October 29, 2015 at 4:04 pm

    Egmont,

    Your definition of sales is absurd. The firm has sales of 100 units in period 2.

    “It is the formal proof that counts and nothing else.”

    The formal proof relies on absurd definitions.

  52. 53 Egmont Kakarot-Handtke October 29, 2015 at 4:24 pm

    Comment on Henry of Oct 29 4:04 pm

    Then give me your formal proof with the correct definitions.

  53. 54 Henry October 29, 2015 at 4:49 pm

    Seeing it’s what we started with, I will complete the analysis of your period 2 example, as I see it.

    income = household income + enterprise income

    => = 100 + 0 = 100

    also,

    income = consumption + savings

    => = 90 + 10 = 100

    Remembering the definition of investment:

    investment = change in capital stock + change in inventory

    => = 0 + 10 = 10

    (In this case, the investment is not by the enterprise but by the household.)

    => saving = investment

    I have to step out now, so we can continue later if you wish.

  54. 55 Frank Restly October 29, 2015 at 5:57 pm

    Biagio,

    “Indeed, it is! The very fact that you lend your apples and cannot use them during the lending period in exchange for something else that you might need or like is actually making you illiquid.”

    But the reason that I lend them / don’t lend them has little to do with my liquidity preference. I have excess apples (more apples than I can eat). I want to trade those excess apples for something else (a choo choo train). The choo choo train builder tells me that it will take a year for him to build me the train. I have a couple of choices:

    1. Lend him the apples at an interest rate
    2. Let the apples rot

    If I let the apples rot, I can replace them by growing more apples. My preference for liquidity can be fulfilled by growing more apples. What I can’t replace is the time I spent harvesting the apples. That is why I charge interest – not to recover apples (my non precious resource) but to recover time (my precious resource).

    When you move away from looking at interest rates from a monetary perspective (especially money backed by precious metals) then it becomes apparent that the scarce resource is not the medium of exchange (apples, gold coins, whatever) but rather the precious resource is time.

    In an infinite agent model, all interest rates ultimately collapse to zero precisely because time is no longer a fixed resource.

  55. 56 djb October 30, 2015 at 1:47 am

    “There is no hope for the present generation of economists (in particular for Henry, JKH, djb).”

    That is an assumption by ekh

    Just like he makes all sorts of assumptions and restrictions in his “proofs”

    That restrict its usefulness

    I do acknowledge that his models allow some accounting for net production of capital nonmonetary assets ….. which is the only way to increase wealth

    And that Keynes savings = Investment did not account for that

    If we think of savings = wealth = capital then net production should be added to the savings, he adds it to profits

    But there is no hope that I will 100% agree with ehk

  56. 57 Egmont Kakarot-Handtke October 30, 2015 at 2:05 am

    Comment on Henry of Oct 29 4:49 pm

    The accounting approach deals with variables that are the product of price and quantity like income and expenditure. Normally, it is not necessary to deal with each component of the product individually. Here it is indeed necessary because you fetch inventory investment out of thin air. Inventory changes occur if the quantity produced and the quantity sold are different.

    So let us look closer at consumption expenditures which are given as product of price and quantity, i.e. C=PX. We start with the case of full market clearing that is quantity produced and quantity sold are equal and do not change because labor input and productivity do not change either. That is, the real part of the pure consumption economy is frozen.

    Now, if consumption expenditures C drop from 100 to 90 in period 2 and the quantity X remains constant the price P must fall in C=PX. The market clearing price in period 2 is now below the unaltered unit wage costs and this means that the zero profit of period 1 turns into a loss.

    Note that the quantities produced and sold are equal in both period 1 and 2. So there is NO change of inventory and therefore inventory investment does not occur. We have I=0 and S=10, so saving and investment are unequal.

    Of course, the product market is normally not cleared and there are inventory changes. I have dealt with this general case in ‘Primary and Secondary Markets’

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1917012

    The inclusion of inventory changes, though, does not alter the fact that saving and investment are NEVER equal. And for this simple reason the familiar story of the interest mechanism cannot be true.

  57. 58 JKH October 30, 2015 at 5:09 am

    Considering again the same Keynes quote noted October 23, 2015 4:16 am :

    “The novelty in my treatment of saving and investment consists, not in my maintaining their necessary aggregate equality, but in the proposition that it is, not the rate of interest, but the level of incomes which (in conjunction with certain other factors) ensures this equality. (pp. 248-49)”

    Having pondered this a bit more, here is what I think it means:

    Assume a 2 sector model for the economy (firms and households).

    And assume all economic activity to the present point has been accounted for in the form of consumption, investment, and saving.

    Now assume some additional activity:

    A new investment creates new income according to payments made to the factors of production.

    From a macroeconomic perspective, this new income cannot be spent on new consumer goods and services, because no such additional consumer goods and services have been produced.

    Therefore it is income that must be saved.

    (This is the case whether the income is used to purchase finished investment goods, or is used to finance investment goods still held in the inventory of the firms that produced them. New investment = new saving.)

    In short, investment creates an equivalent amount of saving.

    But as described above, the logical order in which this happens is:

    new investment = new income = new saving

    As Keynes also put it, “it is the level of incomes which ensures equality between saving and investment” – because the saving that is required to come into equality with investment is the saving from the new income that results from the investment.”

    I.e. the new level of income is what provides the capacity to save from income in the same amount as the new investment.

    So I would interpret Keynes as noting the logic in the flow of causality: from investment to income to saving.

    Income is the necessary middle man between the equality of investment and saving.

  58. 59 Egmont Kakarot-Handtke October 30, 2015 at 6:11 am

    Comment on Biagio Bossone of Oct 30

    You say: “It is not the case that Keynes didn’t have the words to speak about inequality of ex-ante and ex-post saving. Based on his income multiplier process theory, he derived aggregate saving as a pure residual variable, strictly determined by aggregate investment in a way that S = I always and invariably, both ex ante and ex post.”

    It is not the case that we do not know what Keynes said, but it is the case that Keynesians have not realized since the General Theory that Keynes’s formal argument is provably false (2011). This has only been papered over with the exante/expost filibuster. This Keynesian verbiage is the very proof of deeper confusion that lasts until this very day.

    “Throughout the 1920s and 1930s the focus was increasingly on the role of the equality of saving and investment, but the semantic squabbles that dominated much of the debate (the distinctions between ‘ex ante,’ and ‘ex post,’ ‘planned’ and ‘realized’ saving and investment, the discussion of whether the equality of saving and investment was an identity or an equilibrium condition) reflected a deeper confusion.” (Blanchard, 2000, p. 1378)

    This includes Keynes “But Keynes, too, sometimes gave the impression of not having fully grasped the logic of his own system.” (Laidler, 1999, p. 281)

    Beyond Keynes’s manifest confusion, the correct relationship is ‘always and invariably’ given with

    Keynes, indeed, had the words to speak about inequality of exante/expost saving/investment. A lack of words had never been the problem of any economist — what has always been in short supply was logic and argumentative consistency.

    “The currently prevailing pattern of economic theorizing exhibits the following three characteristics: (1) a syncopated style of argument fluctuating back and forth between literary and symbolic modes of expression, (2) naive translation, or the loose paraphrasing of formulae into sentences, and (3) loose verbal reasoning for certain aspects of theoretical argumentation where explicit symbolic formulation is lacking.” (Dennis, 1982, p. 698)

    The exante/expost argument squarely falls into the category of loose verbal reasoning, a.k.a. blather. And this carries over to the theory of interest.

    References
    Blanchard, O. (2000). What Do We Know about Macroeconomics that Fisher and Wicksell Did Not? Quarterly Journal of Economics, 115(4): 1375–1409. URL
    http://www.jstor.org/stable/2586928.
    Dennis, K. (1982). Economic Theory and the Problem of Translation (I). Journal of Economic Issues, 16(3): 691–712. URL http://www.jstor.org/stable/4225211.
    Kakarot-Handtke, E. (2011). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. URL http://ssrn.com/abstract=1966438.
    Laidler, D. (1999). Fabricating the Keynesian Revolution. Cambridge: Cambridge University Press.

  59. 60 Henry October 30, 2015 at 2:26 pm

    djb

    “I do acknowledge that his models allow some accounting for net production of capital nonmonetary assets ….. which is the only way to increase wealth

    And that Keynes savings = Investment did not account for that”

    Can you explain this some more. What do you precisely mean by “capital nonmonetary assets”? Physical assets? Isn’t this what Keynes included in “capital” and “investment”?

  60. 61 Henry October 30, 2015 at 2:42 pm

    Egmont,

    You continue to ignore the fact that the household purchased 100 units (of which it consumed 90). That is, the enterprise sold 100 units not 90 units. I cannot understand why you persist with this confusion.

    Adding more confusion you say:

    “if consumption expenditures C drop from 100 to 90 in period 2”

    Here you talk of “expenditures” (i.e. monetary value) while in your original post you talk of “units” i.e. physical quantities.

    As for inventory, of the 100 units purchased by the household, 10 units were not consumed, so they reside in the inventory of the household.

  61. 62 djb October 30, 2015 at 3:28 pm

    yes absolutely

    but its a little long winded

    (and bear with me because is keep it really simple)

    Keynes basically said that investment and savings were two sides of the same thing ,

    that is they were the same thing,

    so lets say that whatever capital is used for investment its converted into cash, then invested

    that is I in Y = I + C

    which means we are talking about the investment that goes into income, because y is income

    hold that thought for a minute

    now the investment income, I ,goes into the economy, and via the multiplier causes and expands the total income more that the income from investment alone

    and we end up with the expanded income Y (from k*I)

    now the multiplier works because the income earners spend a portion of the money in consumption , (in the proportion known as marginal propensity to consume

    then you got savings = what’s left of y after consumption

    savings = y – c = I

    s=I

    you know all that

    ——————————————

    so the investment came from somewhere, preexisting wealth

    and we see that the investment or value of the investment is preserved as savings

    what’s important about this ??

    NO NEW WEALTH !!!

    its all just savings being the preservation of the original investment wealth

    ———————-

    ok but we know that in reality we CAN have new wealth

    so where does it come from????

    well after thinking long and hard about it i realized that it must come from net production

    capital produced minus capital used up in the given time period

    (so unless you are producing counterfeit money you are producing stuff and its not money

    so that’s why I say that the wealth gets increased by production of nonmonetary assets)

    ———————————————

    there is more and it involves an explanation of user cost

    Keynes had user cost as expenses, and prior to being able to add any money to income he had to pay the expenses, which he called user cost (and called it disinvestment)

    so after paying off the user cost what is left over goes to investment in the y = I +c

    again the investment I of Keynes refers to that which goes into income

    this works for the firm, but it doesn’t work for the whole economy

    but for the firm you have to pay all expenses plus peoples income

    ……..

    the equivalent situation in the macro would be that you would have to pay all the loss of wealth in the whole economy before you could pay income for anyone

    again before you could have any investment income , in the macro you would have to replace all the losses in the economy prior ot having any income

    that’s what would analogous to user cost in the macro

    which means the worlds wealth could never decrease…..

    in reality that’s ridiculous

    so therefore I looked at preexisting capital that goes into income as investment, because that is consistent with what Keynes meant

    and all preexisting capital that goes into to raw materials as capital depleted

    and that is subtracted off the capital produced, to get net capital production

    so added to the economy’s wealth is net capital production

    so we end up with savings equals investment plus net capital production

    so saving equals preservation of the original investment income, plus new wealth created

    total savings equals total wealth equals total capital

    that why I prefer to call our capital appreciation as savings, rather than income because savings is what we have left over

    now the new wealth is created as nonmonetary assets, but any portion of it could be traded for money, so the non monetary new wealth and the investment can get traded for each other and all mixed together when everything is being divvied up

    so those are some of my thoughts

  62. 63 Egmont Kakarot-Handtke October 31, 2015 at 2:08 am

    Comment on Henry of Oct 30

    The accounting approach deals always with nominal magnitudes, which carry a monetary dimension like euro/dollar/yen, and never with real magnitudes. Hence, ‘unit’ invariably means ‘monetary unit’ in the given context. By not realizing that the I=S debate runs in nominal terms your whole argumentation has been empty from the outset. Perhaps it is some comfort that you share this sad fate with djb, FedUp and JKH.

    My working paper ‘Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist’
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2207598
    could be of some help to deconfuse yourself.

  63. 64 Henry October 31, 2015 at 4:22 am

    Egmont,

    “Hence, ‘unit’ invariably means ‘monetary unit’ in the given context.”

    OK. Reworking your period 2 example:

    income = household income + enterprise income

    => = 100 + (-10) = 90

    saving = income – consumption

    => = 90 – 90 = 0

    investment = 0 (neither the household nor the enterprise engaged in investment)

    => S = I

  64. 65 Henry October 31, 2015 at 4:47 am

    “My working paper ‘Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist’
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2207598
    could be of some help to deconfuse yourself.”

    Egmont, I think I will stick to thinking like an economist (well, at least try to).

  65. 66 Egmont Kakarot-Handtke October 31, 2015 at 9:46 am

    Comment on Henry of Oct 31 4:22

    Your definition of income (income = household income + enterprise income) is wrong. Total income Y is wage income Yw=WL plus distributed profit Yd=DN. Distributed profit Yd is different from profit Q.

    For the complete and consistent set of foundational propositions, which includes the nominal accounting variables as subset, see this overview

    For details about the difference between profit Q and distributed profit Yd and retained profit Qre (and why Y=Yw+Q is deadly wrong) see ‘Economics for Economists’
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2517242

    It’s not so easy, indeed, Keynes and many others got the distinction between profit and income wrong, and this is exactly why they all ended in the I=S cul-de-sac.* This is the correct relationship: Q=Yd+I-S. This equation tells you how the profit of the business sector as a whole is generated and how important it is that the business sector’s investment is GREATER than household sector’s saving, i.e. I>S. This equation tells you also how beneficial the dissaving (S with negative sign) of the American consumer (=growth of private debt) is for the world economy (until it is reversed). But this advanced topic is forever beyond the horizon of those who are stuck with I=S.

    * See the post ‘I=S: Mark of the Incompetent’
    http://axecorg.blogspot.de/2015/10/is-mark-of-incompetent.html

  66. 67 Henry October 31, 2015 at 6:19 pm

    Egmont,

    Looking at your “Confused Confusers….” paper, from my perspective, your definitional problems begin with your equation (1) viz.:

    Household Income = Wage Income + Distributed Firm Profits

    i.e using your terms, except I use lower case d instead of upper case D :

    => Y = Yw + Yd

    I accept this equation, however, you are a looking at the wrong income, as far as I am concerned. You should be looking at total economy income:

    Total Eco. Income = Wages Income + Dist Firm Profs + Retained Firm Profs

    Using Yt for total income and your Qre for retained firm profits:

    => Yt = Yw + Yd + Qre

    Similarly, your equation (15) deals with household savings not total economy savings viz.:

    Household Savings = Household Income – Consumption

    i.e. using your terms:

    => Sm = Y – C

    I accept this equation, however, again I believe you should be looking for total economy saving:

    Total Eco. Saving = Household Income + Retained Firm Profs – Consump.

    Using St for total savings:

    => St = Y + Qre – C

    Rearranging:

    => St = Y – C + Qre

    and given Sm = Y – C

    => St = Sm + Qre

    Rearranging:

    => Sm = St – Qre

    Taking your equation (20):

    => Qre = I – Sm (I you define as investment)

    and substituting into this equation for Sm as above:

    => Qre = I – (St – Qre)

    => I = St

    That is, removing the definitional impediments you impose, your equations reduce to the Keynesian relationship of equality between investment and savings.

    When you say investment is never equal to savings and hence Keynes’ relationship does not hold, you are comparing apples to oranges. Your definitional schema (based on the household perspective) precludes you from comparing its results from those of the schema used by Keynes (that is, the conventional macro accounting one).

    I’m heading up country for a few days – I’ll be interested to see your response when I return.

  67. 68 Henry October 31, 2015 at 8:09 pm

    Egmont,

    “Your definition of income (income = household income + enterprise income) is wrong.”

    I believe you go too far. As I have demonstrated above, by removing your definitional constraints, your equations reduce to the conventional Keynesian relationships. I do not believe you can argue your position from the result you obtain from your manipulations. I think you have to begin by justifying the application of your definitions. Shouting from the top of the Zugspitze that Keynes’ I=S is bunkum is the wrong place to start. Keynes takes the whole of economy perspective – you start from the perspective of the household. It seems to me you are caught somewhere between Keynesian macroeconomics and a Neoclassical individual choice theoretic position (but not quite).

    See you in a few days.

  68. 69 Egmont Kakarot-Handtke November 1, 2015 at 3:52 am

    Humpty Dumpty is back again
    Comment on Henry Oct 31 on ‘Keynes on the Theory of Interest’

    “Research is in fact a continuous discussion of the consistency of theories: formal consistency insofar as the discussion relates to the logical cohesion of what is asserted in joint theories; material consistency insofar as the agreement of observations with theories is concerned.” (Klant, 1994, p. 31)

    So, science is about formal and material consistency. Economists fail on both counts since Adam Smith and for this reason economics is not a science. It is as simple as that.

    What has the outer appearance of a science is in fact a proto-science until this very day. This includes Orthodoxy and Heterodoxy and Keynesianism in particular. With regard to consistency Keynesians have conveniently defined their own methodological rules. “For Keynes as for Post Keynesians the guiding motto is ‘it is better to be roughly right than precisely wrong!’” (Davidson, 1984, p. 574)

    With regard to definitions the representative economist easily takes side with Humpty Dumpty. “’When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’ ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’ ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all’.” (Carroll, Through the Looking-Glass)

    That is not how science works. The freedom or arbitrariness of definition is a methodological illusion. It applies only to the first definition. Subsequently, one has to make sure that every new definition is consistent with the preceding ones. Overall consistency cannot be achieved in the economist’s cavalier fashion: “The only way to arrive at coherent languages is to set up axiomatic systems implicitly defining the basic concepts.” (Schmiechen, 2009, p. 344)

    Keynes got the fundamental concepts income and profit wrong. The formal core of the General Theory is given with: “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (1973, p. 63)

    This is rather elementary mathematics and it should not be too hard to get it right. Actually, Keynes got it provably wrong; and neither Keynesians, nor Post-Keynesians nor New Keynesians nor the Anti-Keynesians ever spotted the logical blunder.

    The correct relationship is given here

    It says: the business sector’s monetary profit Qm is equal to distributed profit Yd plus investment expenditure I minus the household sector’s monetary saving Sm (2014, Sec. 3). Alternatively: The business sector’s retained profit Qm-Yd is equal to the difference between investment and saving. In short, household sector saving is never equal to business sector investment, that is, all I=S models including IS-LM are provably false. And this in turn means that all theories of interest which are predicated on the equalization/equilibrium of investment and saving are false. All attempts to filibuster this fact away are self-defeating.

    Is is pretty obvious that Henry goes off into a parallel universe with what Keynes rightly condemned as ‘method of blind manipulation’ (1973, p. 297).

    As mentioned above, there is no such thing as freedom or arbitrariness of definition. This freedom is restricted by the requirement of consistency. The fault in Henry’s argument lies in the redundant on-top definitions of total income and total saving which yields: I = St.

    What Henry does not notice is that St is different from S, so the intended proof of I=S fails. This has already been demonstrated in Section 17 of ‘Keynes’s Missing Axioms’

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1841408

    There is no hope that the Keynesian Humpty Dumpties will ever understand what formal consistency is all about. After all, they did not get it the last 80 years.

    Egmont Kakarot-Handtke

    References
    Davidson, P. (1984). Reviving Keynes’s Revolution. Journal of Post Keynesian Economics, 6(4): 561–575. URL http://www.jstor.org/stable/4537848.
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money.
    The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
    Klant, J. J. (1994). The Nature of Economic Thought. Aldershot, Brookfield, VT: Edward Elgar.
    Schmiechen, M. (2009). Newton’s Principia and Related ‘Principles’ Revisited, volume 1. Norderstedt: Books on Demand, 2nd edition. URL
    http://books.google.de/books?id=3bIkAQAAQBAJ&printsec=frontcover&hl=
    de&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false.

  69. 70 Fed Up November 1, 2015 at 11:44 pm

    “In short, household sector saving is never equal to business sector investment, that is, all I=S models including IS-LM are provably false.”

    I would not say never, but probably. You deaggregated there. I seem to remember talking about this somewhere.

    S overall = I overall

    If I am remembering correctly, deaggregated is:

    S household plus S business = I household plus I business

  70. 71 Egmont Kakarot-Handtke November 2, 2015 at 1:13 am

    Comment on FedUp Nov 1

    Imagine that, starting at zero, the national accountant records every single transaction between the business sector and the household sector in the investment economy. At any arbitrary point in time he may close the books and draw the balances. What the balances show is with mathematical certainty Q=Yd+I-S. Let us simplify matters with Yd=0, then the accountant ends up with Q=I-S. Accounting is the natural measurement instrument in economics and the underlying math is indeed elementary. The sad fact is that the representative economist does not even understand the principles of accounting.

    With closing the books and arriving at Q=I-S the accountant’s job is done. Like a physicist he has taken a correct measurement with the accuracy of two decimal places. Every time he makes his measurement, i.e. entirely independent of the period length, he verifies the formula.

    Enters the representative economist in his full smartness and says. Let’s play with the symbols and make a new definition, that is, let total saving ß be the sum of household sector saving S and profit Q which we rename as business sector’s saving, so ß=S+Q. Note in passing that renaming profit as saving is semantic idiotism, hence the concept of total saving is a nonentity.

    But now, look what we get: I=ß, i.e. total saving is invariably equal to investment. Yes, but look carefully, this is different from I=S. What this formal shell game amounts to is a substitution of ß and S and an unnoticed verbal equalization of saving and total saving.

    Every accountant who carries out the economist’s redundant add-on book entry is either fired for incompetency or jailed for cooking the books.

  71. 72 Nick Edmonds November 2, 2015 at 1:41 am

    “That’s why most economists would say that the drop in real interest rates since 2008 has been occasioned by a persistent tendency for planned savings to exceed planned investment.”

    I think that many of those economists would expand on that by saying something along the lines of “A persistent tendency for planned savings to exceed planned investment has created a deflationary pressure, to which central banks have responded by reducing interest rates, which they do through monetary operations.” This seems to me entirely consistent with the point that I understand Keynes to have been making.

  72. 73 JKH November 2, 2015 at 2:39 am

    Fed Up – November 1, 2015 at 11:44 pm

    You are correct of course.

    From the paper of the moment:

    “The fact that retained profit is different from zero in the real world can be taken as an empirical proof of the logically equivalent inequality of household saving and business investment. That is, all I=S models are logically deficient.”

    S is not saving by households – when such models are competently and correctly specified.

    S is saving by the private sector.

    Saving by the private sector is saving by households plus saving by firms.

    Saving by firms amounts to their retained profit

    Regarding the paper in question, a consumption only economy is a strange foundation from which to spawn a new age theory of profit, saving, and investment. The ensuing notions of “super symmetric clearing”, “general complementarity” and “special complementarity” are grandiose flights but quite unnecessary.

    The author might try some financial accounting to get past this

    And better internet manners, if at all possible

  73. 74 Egmont Kakarot-Handtke November 2, 2015 at 6:06 am

    Comment on JKH Nov 2

    In Keynes’s derivation of I=S neither profit nor retained profit appears (Keynes, 1973, p. 63).

    Now, you assert “Saving by firms amounts to their retained profit.” This add-on definition is nowhere to be found in the General Theory. The simple reason is that Keynes never understood what profit is: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson and Bezemer, 2010, pp. 12-13, 16)

    Because Keynes never came clear with either profit, distributed profit or retained profit — not to speak of those who came after him — one will not find a correct definition of these concepts in all of Keynesianism. Yet, one can find the consistent definitions in Allais or in my paper ‘Keynes Missing Axioms’.

    The final result of correct accounting is invariably Qre=I-S. Your definitions are (i) a superfluous add-on (ii) formally illegitimate (iii) a semantic shell game that proves, if anything, a complete lack of understanding of the mechanisms of profit generation and distribution.

    Keynesianism has been formally deficient from the very beginning. Because the multiplier and IS-LM relies on Keynes profitless I=S all Keynesian policy advice has been nothing more until this very day than reading tea leaves and telling the silly exante/expost story. Monetary policy that relies on the familiar interest mechanism has no theoretically sound foundation.

    The equality/equilibrium of saving and investment has been academically declared dead with Allais’s publication of 1993. In the history of science I=S will forever stand out as a monument of scientific incompetence.

    References
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
    Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and
    Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL http://mpra.ub.uni-muenchen.de/20557/

  74. 75 Henry November 3, 2015 at 12:39 am

    “What Henry does not notice is that St is different from S, so the intended proof of I=S fails. This has already been demonstrated in Section 17 of ‘Keynes’s Missing Axioms’”

    Actually, you did not notice that I explicitly defined the term in my post.

    St is economy wide aggregate saving, that is, that which is normally denominated in the Keynesian models by “S”. The “Sm” you use is household saving.

    As I have demonstrated, your system of equations devolves into Keynes’ equations once your definitional impositions are removed. You define income as household income. Why not use wages income? Why not use entrepreneur’s income? In your posts, you have yet to justify the use of household income. (As a matter of interest, Keynes in his “Treatise on Money”, did actually develop a model using entrepreneur’s income – he ended up with a relationship similar to yours i.e. saving – investment = normal enterprise profit – actual enterprise profit. He discarded this approach in the GT. See p. 60-61 of GT.)

    You have constructed a theoretical edifice based on an arbitrary definition of income, which reduces to that in the GT once your defintional conditions are removed – you then call this schema scientific, hoping to confer upon your analysis an air of legitimacy.

  75. 76 Egmont Kakarot-Handtke November 3, 2015 at 4:59 am

    Down and out
    Comment on Henry Nov 3 on ‘Keynes on the Theory of Interest’

    You bring in a seemingly new aspect “As a matter of interest, Keynes in his ‘Treatise on Money’, did actually develop a model using entrepreneur’s income – he ended up with a relationship similar to yours i.e. saving – investment = normal enterprise profit – actual enterprise profit. He discarded this approach in the GT. See p. 60-61 of GT.”

    Correct, Keynes caught a glimpse of the solution and then went the other way. But, as is obvious from the General Theory, in this direction he did not come to grips with profit. Let this sink in: Keynes had no idea of the essential phenomenon of the market economy! An economist who does not understand how the actual economy works lectures politicians who know even less.

    Now, the new aspect you bring in is not new at all. I have dealt with it in Section 16 ‘Treatise and General Theory as limiting cases’ of ‘Keynes’s Missing Axioms’ see here
    http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=1210665

    And I have refuted your redundant definition of “economy wide aggregate saving” in Section 17. There is, though, no need to read or understand the paper because to stay behind the curve is the natural place for After-Keynesians.

    You ask rhetorically “You define income as household income. Why not use wages income? Why not use entrepreneur’s income?” Because the definition of income and profit is by no means arbitrary. It is known since Senior that it is all-important to state ‘consciously and explicitly’ the basic concepts: “To Senior belongs the signal honor of having been the first to make the attempt to state, consciously and explicitly, the postulates that are necessary and sufficient in order to build up … that little analytic apparatus commonly known as economic theory, or to put it differently, to provide for it an axiomatic basis.” (Schumpeter, 1994, p. 575)

    Only dilettantes think that they can define whatever seems convenient. “In fact, the history of every science, including that of economics, teaches us that the elementary is the hotbed of the errors that count most.” (Georgescu-Roegen, 1970, p. 9)

    These errors are fatal because they bring down the whole theoretical superstructure: “For it can fairly be insisted that no advance in the elegance and comprehensiveness of the theoretical superstructure can make up for the vague and uncritical formulation of the basic concepts and postulates, and sooner or later … attention will have to return to the foundations.” (Hutchison, 1960, p. 5)

    The irony is that Keynes understood the crucial methodological point better than the After-Keynesians. “Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics.” (1973, p. 16) and “For if orthodox economics is at fault, the error is to be found not in the superstructure, which has been erected with great care for logical consistency, but in a lack of clearness and of generality in the premises.” (1973, p. xxi)

    The unfortunate fact of the matter is that Keynes messed up his ‘non-Euclidean’ axioms. Again: the formal foundations of Keynesianism are provably false until this very day.*

    This is not a minor point but has consequences for the scientific status of Keynesianism in particular and economics in general. Because economics does not satisfy the scientific criteria of material and formal consistency and cannot even tell what income and profit is it has to leave the academic community of sciences.**

    Egmont Kakarot-Handtke

    References
    Georgescu-Roegen, N. (1970). The Economics of Production. American Economic
    Review, Papers and Proceedings, 60(2): 1–9. URL http://www.jstor.org/stable/
    1815777.
    Hutchison, T.W. (1960). The Significance and Basic Postulates of Economic Theory.
    New York, NY: Kelley.
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money.
    The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke:
    Macmillan. (1936).
    Schumpeter, J. A. (1994). History of Economic Analysis. New York, NY: Oxford
    University Press.

    * It is recommended that Keynesians make a full mental reset and start with this new curriculum which correctly applies the axiomatic-deductive method
    http://axecorg.blogspot.de/2015/04/new-curriculum-cross-references.html
    ** See ‘Free the academy from economics’
    http://axecorg.blogspot.de/2015/11/free-academy-from-economics.html

  76. 77 Henry November 3, 2015 at 10:57 am

    Egmont,

    Polemical and rhetorical flourish does not an argument make.

    Please explain the rationale for your definitional perspective.

  77. 78 djb November 3, 2015 at 12:30 pm

    henry, thanks for helping me increase my vocabulary

    if response to a previous question

    the simple response is we increase wealth (capital , savings) by production

    since we produce stuff (goods and services, plus the enduring effects of services)

    then new wealth will be non monetary assets

    (of course you could trade it for money)

  78. 79 Egmont Kakarot-Handtke November 4, 2015 at 12:46 am

    Comment on Henry Nov 3

    Theories do not consist of a heap of statements that describe a certain part of reality, they have an architectonic structure. In purely formal terms they consist of premises and logical conclusions. The well-structured whole has to meet the criteria of material and formal consistency. “The chief demerit is inconsistency, including inconsistency with the results of experiments that a competing theory can explain.” (Popper, 1994, p. 160)

    Methodologically, therefore, J. S. Mill’s Starting Problem has always to be dealt with first. The crucial question is: “What are the propositions which may reasonably be received without proof? That there must be some such propositions all are agreed, since there cannot be an infinite series of proof, a chain suspended from nothing. But to determine what these propositions are, is the opus magnum of the more recondite mental philosophy.” (2006, p. 746)

    At present, economics is not built upon a set of acceptable premises or axioms. Orthodoxy is based on the behavioral axiom of constrained optimization. Heterodoxy lacks a consistent foundation. That is, both approaches do not meet the formal minimum standards of theoretical economics.* There is nothing to choose.

    Conclusion: “Scrap the lot and start again!” (Joan Robinson). A paradigm shift is not to be delayed.** The correct formal foundations of economics are given here

    The next step is to reconstruct the theoretical superstructure. In the course of reconstruction it turns out that the Keynesian I=S is untenable and has to be replaced by Q=Yd+I-S (see preceding posts). This immediately affects the theory of interest.

    Whether the new axiomatic foundations are acceptable is not to be decided by argument but by empirical testing of propositions that are deductively derived from the axioms (the employment multiplier for example, or the Profit Law).

    Keynes explicitly addressed (with his call for ‘non-Euclidean’ axioms) but failed to solve Mill’s Starting Problem. Because its formal basis is defective, Keynesianism is irrevocably out of science. Keynesian policy proposals have no sound theoretical foundation.

    References
    Mill, J. S. (2006). Principles of Political Economy With Some of Their Applications to Social Philosophy, volume 3, Books III-V of Collected Works of John Stuart Mill. Indianapolis, IN: Liberty Fund. URL http://www.econlib.org/library/Mill/mlP.html. (1866).
    Popper, K. R. (1994). The Myth of the Framework. In Defence of Science and Rationality., chapter Models, Instruments, and Truth, pages 154–184. London, New York, NY: Routledge.

    * See ‘How Orthodoxy buffaloed Heterodoxy’
    http://axecorg.blogspot.de/2015/09/how-orthodoxy-buffaloed-heterodoxy.html
    ** See ‘Replacing sand by granite’
    http://axecorg.blogspot.de/2015/02/new-foundations-replacing-sand-by.html

  79. 80 Henry November 4, 2015 at 11:08 am

    More polemics and assertions unsupported by a rationale.

  80. 81 Egmont Kakarot-Handtke November 5, 2015 at 3:50 am

    Are economists methodological retards?
    Comment on Henry Nov 4 on ‘Keynes on the Theory of Interest’

    “Thousands upon thousands of scholars, as well as thousands of statesmen and men of affairs, have contributed their efforts to the attempt to understand the course of events of the economic world. And today this field of investigation is being cultivated more extensively, than ever before. How is it, then, that in all these years, and with all the undoubted talent that has been lavished upon it, the subject of economics has advanced so little?” (Schoeffler, 1955, p. 2)

    On closer inspection economics has not advanced at all compared to the contemporaneous evolution of physics, for example. What obscures the de facto regression is that economists have always taken in edge-of-science tools that have been developed elsewhere. Thus, over more than two centuries now, economics gave the impression of scientific progress while it has not moved one millimeter above the proto-scientific level of Adam Smith: “… we know little more now about ‘how the economy works,’ or about the modus operandi of the invisible hand than we knew in 1790, after Adam Smith completed the last revision of The Wealth of Nations. (Clower, 1999, p. 401)

    When economists are occasionally sober after feasting in best-of-all possible-worlds and queen-of-social-sciences storytelling they seek an explanation for their dismal performance and they rate themselves readily down to a science with a lowercase s.

    “Economics is a strange sort of discipline. The booby traps I mentioned often make it sound as it is all just a matter of opinion. That is not so. Economics is not a Science with a capital S. It lacks the experimental method as a way of testing hypotheses. . . . There are always differences of opinion at the cutting edge of a science, . . . . But they last longer in economics . . . and there are reasons for that. As already mentioned, rival theories cannot be put to an experimental test. All there is to observe is history, and history does not conduct experiments: too many things are always happening at once. The inferences that can be made from history are always uncertain, always disputable, . . . You can’t even count on a long and undisturbed run of history, because the ‘laws’ of behavior change and evolve. Excuses, excuses. But the point is not to provide excuses.” (Solow, 1998, pp. x-xi)

    Given a recalcitrant reality, clearly, the idea that there must be something wrong with economists seems rather farfetched. Just the contrary “Given these difficulties it is extraordinary that economics has achieved as much as it has.” (Dow, 2006, p. 51)

    So we could perhaps agree upon this: economics is not a failed science, only a lowercase-s science, and this is ultimately the fault of the subject matter.

    The actual fact of the matter is, though, that economists have never managed to come clear with the fundamental concepts of their trade. It is a bit like physics before the concept of energy was fully understood.

    — Walrasianism/Neoclassics. Krugman famously gave the following definition: “So, what is neoclassical economics? … I think we mean in practice economics based on maximization-with-equilibrium.”*

    And in this two-liner lies the whole explanation why neoclassics is a failed approach: because it is based on two nonentities. For good methodological reasons, economics cannot take a behavioral assumption (constrained optimization or otherwise) and equilibrium into the premises. Economics is, to begin with, not a science of the behavior of humans but of the behavior of the economics system. As a matter of principle, no way leads from the understanding of human behavior to the understanding of how the economic system works.

    — Keynesianism. Keynes famously defined the fundamental macroeconomic relations such: “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (1973, p. 63)

    This two-liner is provably false because Keynes never came to grips with profit. The equality/equalization of saving and investment is, in the Keynesian and in any other context, the absolutely reliable indicator of a fatal conceptual and logical defect.

    — Heterodoxy has never come up with a serious alternative to both Walrasianism and Keynesianism and is rather content with knowing nothing and the pluralism of false theories. As Syll put it “Heterodoxy is different, you know, we do not lull us into the comforting thought that we know everything and that everything is measurable and we have everything under control. We just admit that we often simply do not know, and that we have to live with that uncertainty as well as it goes.”

    The ultimate fault of Walrasianism and Keynesianism does not lie in any policy proposals but deep in the premises. As Keynes correctly realized with regard to Orthodoxy “For if orthodox economics is at fault, the error is to be found not in the superstructure, which has been erected with great care for logical consistency, but in a lack of clearness and of generality in the premises.” (1973, p. xxi)

    The original logical defect of the representative economist consists in not having a consistent definition of the pivotal concepts income and profit. The profit theory is false since Adam Smith and every economist can know this from the Palgrave Dictionary “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10)

    Let this sink in. Neither Classicals, nor Walrasians, nor Marshallians, nor Marxians, nor Keynesians, nor Institutionialists, nor Monetary Economists, nor MMTers, nor Austrians, nor Sraffaians, nor Evolutionists, nor Game theorists, nor EconoPhysicists, nor RBCers, nor New Keynesians, nor New Classicals ever came to grips with profit. Hence, they fail to capture the essence of the market economy.

    That is the current abysmal state of economics. And, let us be clear: this is not the fault of the subject matter.

    Egmont Kakarot-Handtke

    References
    Clower, R. W. (1999). Post-Keynes Monetary and Financial Theory. Journal of Post Keynesian Economics, 21(3): 399–414. URL http://www.jstor.org/stable/4538639.
    Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume
    (Eds.), The New Palgrave Dictionary of Economics Online, pages 1–11. Palgrave Macmillan, 2nd edition. URL http://www.dictionaryofeconomics.com/article?id=pde2008_P000213.
    Dow, S. C. (2006). Economic Methodology: An Inquiry. Oxford: Oxford University Press.
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
    Schoeffler, S. (1955). The Failures of Economics: A Diagnostic Study. Cambridge, MA: Harvard University Press.
    Solow, R. M. (1998). Foreword, volume William Breit and Roger L. Ranson: The Academic Scribblers. Princeton, NJ: Princeton University Press, 3rd edition.

    * Unreferenced quotes have already been used and referenced on the AXEC-blog
    http://axecorg.blogspot.de/

  81. 82 Henry November 5, 2015 at 8:48 am

    “Let this sink in. Neither Classicals, nor Walrasians, nor Marshallians, nor Marxians, nor Keynesians, nor Institutionialists, nor Monetary Economists, nor MMTers, nor Austrians, nor Sraffaians, nor Evolutionists, nor Game theorists, nor EconoPhysicists, nor RBCers, nor New Keynesians, nor New Classicals ever came to grips with profit. Hence, they fail to capture the essence of the market economy.”

    You forgot to include Humpty Dumpty.

  82. 83 David Glasner November 8, 2015 at 8:36 pm

    Apologies again for being even slower than usual to respond to comments. Just can’t keep up with you guys. I will only be responding, if at all, to comments addressed directly to me.

    Andrew, I don’t think that I quite follow what you are saying. But if you mean that Keynes’s discussion had to be based, on or reconciled with Fisher’s, we are in agreement. Keynes unfortunately thought that he was saying something different from Fisher, even though his discussion in chapter 17 is clearly an extension — a brilliant extension, to be sure – of Fisher.

    Alfred, I don’t think the dichotomy that you are proposing is as tidy as you suggest it is.

    JKH, I actually don’t like the savings equals investment theory of interest. I think the better way to think about the determination of interest rates is in terms of the valuation of all capital assets which can be thought of as representing future cash flows (in some cases the cash flows being fixed in some cases being variable). In the Keynesian framework of chapter 17, the valuations must be such as to ensure that the net expected return from holding any asset be equal to the expected net return from any other asset. Keynes in effect asserted that the net expected return is exactly equal to the liquidity premium (or more precisely to the expected liquidity service flow), but that is clearly wrong. There is also a real return associated with holding assets that are providing no liquidity services. But certainly it’s true that the Fisher decomposition into real and nominal is possible for the liquidity service component of the overall yield from holding capital assets.

    Biagio, I agree that the interest rate is determined in the markets for existing capital assets (i.e., in terms of stocks) not in terms of current savings and current additions to the stock of capital assets (i.e., in terms of flows). Keynes unfortunately gave the impression, and seemed to be arguing, that the liquidity yield fully explained the phenomenon of interest. There is a liquidity yield on holding cash and there is a return to holding real capital, the fact that the two yields are equal in equilibrium does not mean that the liquidity service flow provides a full account of the yield on holding real capital assets.

    Rob, Thanks. I don’t think Keynes believed that decisions to invest are made independently of the interest rate, although in the General Theory he emphasized that shifts in expectations were more important than changes in interest rates in explaining observed fluctuations in the amount of investment spending over time.

    Lord and Biagio, In my view there is interaction between liquidity preference and the productivity of capital and time preference that jointly determine the rates of interest. For Keynes to assert that the causation was strictly in the direction from liquidity preference to the yield on capital was a misunderstanding.

    Egmont, Just wondering, have you considered the possibility that banks pay interest on deposits and how that might affect the conclusions you draw from your model?

    Henry, Sorry, but I don’t see the relevance chapter 15 to my criticism. As I recall chapter 15 is an detailed explanation of the motives for liquidity preference. I can totally accept his theory of liquidity preference without knowing what the real rate of interest is either expressed as an intertemporal rate of substitution, or as a yield on physical capital, as a psychological rate of time preference, or as a rate of discount. For liquidity preference to be a self-sufficient theory of interest, Keynes would have had to show that the equilibrium real rate in a barter economy was always zero, and he never provided, or even attempted to provide, any such proof.

    Frank, I don’t think it’s quite right to describe the rate of interest as the price of time, but I think I agree with the rest of your comment.

    Biagio, There may be situations in which liquidity preference becomes so intense that it is the dominant influence on the rate of interest. That seems to be an exceptional situation. Keynes’s assertion that liquidity preference is the sole explanation of the phenomenon of interest is a kind of reductionism which he really didn’t need to make the substantive points he was advancing in the GT. Again, I don’t dispute the basic insight Keynes was developing in the theory of liquidity preference, only the idea that it provides a self-sufficient explanation of the phenomenon of interest.

    Travis, Actually, I am planning to write a review, but not for Amazon.

    George, I think that Axel Leijonhufvud has argued that in Marshallian terms the loanable funds theory is more realistic than the liquidity preference theory, because interest rate is implicit in the value of a bond, so changes in the interest rate would be reflected in changes in the value of bonds which result from excess supplies of or excess demands for bonds. However, I would say that interest rates emerge from the valuation of all assets, not just bonds, and that any moment, this valuation takes place in terms of a stock of assets that will be willingly held at a certain set of prices implying a certain structure of interest rates.

    Nafisa, The saver is only compensated for inflation if the inflation is expected. If inflation is expected it will also be reflected in the wages paid to workers and the payments to other factors of production insofar as future payments are being determined in contracts made in the present, so there is no difference between the treatment of savers and other factors of production.

  83. 84 George H. Blackford November 10, 2015 at 9:32 am

    “I think that Axel Leijonhufvud has argued that in Marshallian terms the loanable funds theory is more realistic than the liquidity preference theory, because interest rate is implicit in the value of a bond, so changes in the interest rate would be reflected in changes in the value of bonds which result from excess supplies of or excess demands for bonds.” I don’t remember Leijonhufvud arguing this, but if he did, I’m pretty sure Keynes would have disagreed with him.

    Keynes’ basic argument against a Marshallian formulation of the loanable funds theory is that you can’t assume that the savings and investment schedules will describe the actual behavior of decision-making units in a partial-equilibrium analysis of shifts in these schedules if income is assumed to be fixed. It just makes absolutely no sense at all to assume this. Income will have to change before the interest rate can change, and when income changes it will cause the savings schedule to shift. Hence, you cannot simply look at a shift in the savings or investment schedule and assume that the rate of interest will move to the new intersection of these schedules, because it can’t move to the new intersection of these schedules until income changes, and when income changes the new intersection will change. These kinds of shifts in the supply and demand curves are not consistent with Marshallian supply and demand analysis.

    As I documented in http://rweconomics.com/htm/RvK.htm , Keynes made this point over and over and again in the LP-LF debate beginning in his Treatise on Money, and no one has ever refuted him on this.

  84. 85 Nat Clarke November 10, 2015 at 11:43 am

    Thanks for this great discussion. I have reconciled this difference based on Mankiw’s (Macro Principles) presentation that separates the classical long run full employment view from the short run business cycle view. Output and income in the long run are determined by capital/labor/technology etc.(long run full employment output in the aggregate S/D model). The LF model applies to the long run where income is fixed. Keynes addresses cases of deficits in aggregate demand where the changes in interest rates shift income.

    I am interested in comments on Brad DeLong’s thoughts in http://equitablegrowth.org/john-maynard-keynes-getting-one-very-wrong-todays-history-of-economic-thought/.

  85. 86 Henry November 10, 2015 at 12:19 pm

    I would like to endorse what George has said above about income effects shifting the savings and investment schedules about. Keynes made several “big” statements in the GT (p 85), one of them being:

    “This is the vital difference between the theory of the economic behaviour of the aggregate and the theory of the behaviour of the individual unit, in which we assume changes in individual’s own demand do not affect his income.”

    These feedbacks are ignored by classical/neoclassical theory. You begin to wonder what happens to the stability of equilibrium when these feedbacks are taken into consideration.

    In any event, even to think about the savings and investments schedules representing a market is something that needs closer examination. It seems to me a market for saving and investment can’t be thought of in the same way as a market for apples is. I would rather think that there is a market for capital goods which sets the price of capital goods, with movements along the MEC schedule causing shifts in the capital goods demand schedule.

  86. 87 George H. Blackford November 10, 2015 at 12:32 pm

    From DeLong: “The LM-curve and the IS-curve relations jointly determine Y and r. You can use either. In fact, you have to use both in order to get an answer, even if you are not aware that you are using both. That is what Hicks made clear. But Keynes does not know it. And I see no signs that Viner knows it either.”

    The answer you get from using both is the new short-run equilibrium for Y and r. What Keynes is talking about in the quoted passage is the dynamic process by which you get to this new short-run equilibrium. When Keynes says:

    “When, as happens in a crisis, liquidity-preferences are sharply raised, this shows itself not so much in increased hoards–for there is little, if any, more cash which is hoardable than there was before–as in a sharp rise in the rate of interest, i.e. securities fall in price until those, who would now like to get liquid if they could do so at the previous price, are persuaded to give up the idea as being no longer practicable on reasonable terms. A rise in the rate of interest is a means alternative to an increase of hoards for satisfying an increased liquidity-preference.”

    he is obviously right here. When LP increases sharply there is no reason to believe hoards will increase immediately, i.e,, that the velocity of circulation will fall. It takes time for the system to adjust to an increase in LP, and the way it adjusts to this increase is through 1) an increase in the rate of interest/fall in the prices of assets, followed by 2) a decrease in the quantity of investment goods demanded which, in turn, leads to 3) a fall in income and employment which, again, in turn, will lead to 3) a decrease in the demand for transactions balances making them available to be hoarded and, as thee balances become available to be hoarded they will facilitate a subsequent fall in the rate of interest.

    Keynes’ basic point in his rejection of a theory of interest that assumes that the rate of interest is determined by saving and investment is that you cannot make this kind of sensible, logical, rational, causal explanation as to how the system works if you begin by assuming that the rate of interest is, somehow, determined by saving and investment. When economists attempt to provide this kind of dynamic, causal analysis in terms of saving and investment they end up with nonsense.

  87. 88 David Glasner November 10, 2015 at 1:01 pm

    George, Nat and Henry, I agree that there are dynamic issues that make it problematic whether variations in the rate of interest can restore equilibrium. I also agree that savings and investment (i.e., flows) is not a good way to think about the determination of the rate of interest. However, within the framework of the (in my view) misguided loanable funds/liquidity preference debate, my point, derived from Leijonhufvud, is that the interest rate would adjustment would be registered in the market for loans and would be governed by whether there is an excess demand for loans or an excess supply of loans at any particular moment. The feedback effects could very easily result in an unstable dynamic that does not converge on a new equilibrium, but still one can think of the interest rate adjustments being governed at any moment by whether there is an excess demand or supply in the market for loans. Hicks’s point was that analytically, given Walras’s Law, you can — you must — eliminate one market to solve for an equilibrium solution because there’s an extra equation, so it doesn’t matter whether you eliminate the excess demand for money equation or the excess demand for loans equation. But that’s a static analysis, if you want to describe an actual adjustment process, and you want to see how the interest rate is changing, you may want to look at the excess demand for loans. Again, I don’t think that’s the right way to think about the determination of interest rates, but that’s a stock vs flow issue.

  88. 89 George H. Blackford November 10, 2015 at 1:16 pm

    You can, of course, “think of the interest rate adjustments being governed at any moment by whether there is an excess demand or supply in the market for loans.” The problem arises when you try to include savings as a supply of loans and investment as a demand for loans. Once you do this you end up tying yourself up in knots trying to give a causal explanation as to how an increase in savings causes a fall in the rate of interest if income is constant. Keynes argued that there is no reason to think it will fall until income falls in a response to a fall in income.

    What does it mean to say that the rate of interest is determined by saving if changes in the propensity to save can only “cause” changes in the rate of inters (other things equal) after there has been a change in income?

  89. 90 George H. Blackford November 10, 2015 at 1:19 pm

    Keynes argued that there is no reason to think it will fall until income falls in a response to fall in the propensity to save.

    What does it mean to say that the rate of interest is determined by saving if changes in the propensity to save can only “cause” changes in the rate of interest (other things equal) after there has been a change in income? (Sorry about that.)

  90. 91 David Glasner November 10, 2015 at 6:44 pm

    George, Suppose that savings constitutes the supply of loans and investment constitutes the demand for loans, then if savings is greater than investment, the excess supply of loans will force down interest rates. The reduction in the rate of interest may or may not eliminate the excess supply of loans and excess of savings over investment. Equilibrium may only be restored via a decline in income, the only here is whether the rate of interest does or does not respond to a market excess demand or supply of loans. Nothing in Keynes’s argument precludes that possibility. If you have a system with n endogenous variables and n+1 equations the equilibrium values of the endogenous variables are in general simultaneously determined by any n of the n+1 equations. It’s only in a special case that you can partition the system so that each endogenous variable is determined by just one of the n+1 equations. Keynes did not prove that the rate of interest is determined solely by the excess demand for money; he just showed that the excess demand for money influences the rate of interest. Perhaps I will write a post about this.

  91. 92 Fed Up November 10, 2015 at 8:07 pm

    “What the balances show is with mathematical certainty Q=Yd+I-S. Let us simplify matters with Yd=0, then the accountant ends up with Q=I-S.”

    I believe that I and S there should be I household private and S household private, respectively.

    “But now, look what we get: I=ß, i.e. total saving is invariably equal to investment.”

    That looks like it is still I household private. If it is, I am pretty sure that it needs to be changed to I total private.

    That means I total private = S total private.

    Now back to Q=I-S. With foreign = 0, gov’t = 0, and any other sector = 0, dissavings private firms = savings private households. With the 100 example, the firms start with 100, and households start with 0. Wages of 100 get paid to the household sector. The household sector saves 10. 90 goes back to the firms. That means the firms dissaved 10. At the end, firms have 90 (dissaved 10), and households have 10 (saved 10).

  92. 93 Henry November 11, 2015 at 3:21 am

    David,

    “Keynes unfortunately thought that he was saying something different from Fisher, even though his discussion in chapter 17 is clearly an extension — a brilliant extension, to be sure – of Fisher.”

    I find this a very strange thing to say.

    Fisher’s theory of the interest rate is based on time preference.

    In Chapter 17, Keynes is building and adding to a case for why money determines interest rates and not commodities whose costs of handling and storage greatly exceed their liquidity premium (unlike money).

  93. 94 Henry November 11, 2015 at 4:01 am

    David,

    Thinking about my previous post, I may have to eat my words.

    Fisher’s time preference has a lot to do with uncertainty about future income – if your income is low, you prefer to consume it now, if your income is high then you are not so preoccupied with current consumption.

    In a similar fashion, Keynes’ propensity to hoard is a function of uncertainty and the propensity to hoard sits at the bottom of the liquidity preference function.

    So is this why you say Keynes was extending Fisher?

    Even so, I think there is something different about the case Keynes is building in Chapter 17.

  94. 95 JKH November 11, 2015 at 4:29 am

    “Keynes did not prove that the rate of interest is determined solely by the excess demand for money; he just showed that the excess demand for money influences the rate of interest.”

    That sounds right to me – except I don’t think it was his intention to prove that.

    Having studied the numerous Keynes quotes from both David and George (in his paper), I would say in addition:

    Keynes maintained that the demand for money influenced interest rates in a way in which the equality of saving and investment did not. It’s pretty clear that he maintained that saving and investment were always equal (a number of quotes directly support this). And an increase in the supply of loanable funds was offset by an increase in the demand for loanable funds. A good example of this is the increased inventory financing demand that results from a consumer choice to buy securities rather than spend on consumption. There is no way to systematically ascribe which of these two equal and opposite loanable funds forces prevails in setting the interest rate. This is quite different from the case of liquidity preference, where there is a clear systematic directional correlation between the demand for money and interest rates – as a marginal effect. And at the end of the day, this is logically reflected in the fact that one paradigm consists of double entry and balanced bookkeeping (SI, loanable funds), whereas the other is pushing on a fixed object (money supply, until the banks change it.) And when Keynes said that the equality of saving and investment was ensured by the level of income, I feel pretty confident that what he meant was that investment creates income (payments to the factors of production) in the same quantity, and that the income created has to be saved (because no incremental consumer goods are assumed), and that therefore it is the income created (level of income) and its inevitable use (saving) that ensures the equality of saving and investment. This is essentially the logical explanation of a tautology by construction (which is different than direct definition – because in fact saving and investment are not the same thing at all – but they are in the same quantity).

    So the marginal effect of liquidity preference on interest rates is valid in a way in which the marginal effect of saving and investment is not.

    There are other adjustments of course, including everything having to do with investment elasticity in itself, the multiplier, and changes in the marginal propensity to consume, but none should be ascribed to an inequality of saving and investment or an inequality in the supply and demand for loanable funds.

  95. 96 djb November 11, 2015 at 7:29 am

    The first 10 chapters of the general theory are dedicated to introducing concepts like aggregate demand, effective demand , consumption , need for investment income to have a viable economy, the multiplier, marginal propensity to consume

    The concept of savings equals investment falls out of all that and simplistically can be looked at as preservation of the money invested….it will contribute to income and cause increase in total income via increased consumption and the multiplier

    Starting in chapter 11 he introduces the concepts of marginal propensity to consume. …the role of interest and the idea that the supply of liquid cash mediates between money (simplistically again) going to interest bearing accounts balancing out cash going into investments presumably jobs creating ventures. ….

    The latter. ..investment in jobs creating ventures. ..is like the first 10 chapters

    Any invested money will be preserved at the end as savings in someone’s pocket

    The money sent the other way into interest bearing account as “savings” is not the savings that is preserved preserved investment in the first 10 chapters

    I have more comments but no time right now

  96. 97 George H. Blackford November 11, 2015 at 10:05 am

    David,

    “Suppose that savings constitutes the supply of loans and investment constitutes the demand for loans, then if savings is greater than investment, the excess supply of loans will force down interest rates. The reduction in the rate of interest may or may not eliminate the excess supply of loans and excess of savings over investment. Equilibrium may only be restored via a decline in income, the only [question] here is whether the rate of interest does or does not respond to a market excess demand or supply of loans.”

    Keynes argued that it doesn’t make sense to assume that savings constitutes the supply of loans and that investment constitutes the demand for loans. If you try to do this you run into the problem that if you try to examine how an increase in the propensity to save affects the rate of interest when income is held constant you can’t assume the demand for loanable funds schedule will remain unchanged since, until income falls, businesses and individuals will be forced to increase their borrowing in order to finance their expenditures.

    It defies the rules of logic and of reason to ignore this simple reality. What does it mean to say that savings and investment determine the rate of interest in a Marshallian supply-and-demand, partial-equilibrium analysis in a situation where, given income, an increase in the propensity to save will force an increase in borrowing so that there is no reason for the rate interest to fall until income falls? When the supply of apples increases we can reasonably argue that, given the incomes of demanders, competition among sellers will lead to a fall in the price of apples. How would Marshall’s analysis of the market for apples work if an increase in the supply of apples created a situation in which demanders for apples were somehow forced to buy the increased supply of apples until their incomes fell?

    That kind of thing doesn’t happen in the market for apples, and that’s why a Marshallian analysis of the market for apples makes sense and why it makes sense to say that the price of apples is determined by the supply and demand for apples. That kind of thing does happen in the loanable funds market when savings and investment are included in this market. That’s why Keynes argued it doesn’t make sense to talk about the supply and demand for loanable funds determining the rate of interest as if this market were no different than a market for apples.

    The loanable funds market is fundamentally different from every other competitive market in this regard. It makes sense to argue that it is possible for competition to force the price of apples to its partial-equilibrium value in the market for apples given income. It also makes sense to argue that decision makers will be able to force the level of income/output to the partial-equilibrium value determined by the savings and investment schedules given the rate of interest. But it does not make sense to argue that it is possible for competition to force the rate of interest to the partial-equilibrium value in the market for loanable funds given income.

    When economists look at the world through the lens of a static general-equilibrium model where everything determines everything else this problem doesn’t arise. And if they wish to do dynamic analysis within such a model they can assume that the changes in a price are determined by any excess demand they wish, but that choice is generally not made arbitrarily. That choice is generally made in a way that makes sense in terms of a Marshallian partial-equilibrium analysis. Following this convention, it makes sense to assume that changes in the rate of interest are determined by the excess demand for money, and the only way the loanable funds theory makes sense by this convention is if the supply and demand for loanable funds are defined in such a way that the excess demand for loanable funds is, by definition, always equal to the excess demand for money. This was a point the Robertson was never able to accept, yet neither he, nor any of his fellow anti-Keynesians, were never able to specify a sensible model in which this wasn’t the case.

    Perhaps this can be made clear by considering the excess supply of loans in your example. Suppose this excess supply was created by a fall in the propensity to consume that arose as a result of a national catastrophe such as 9/11. People felt insecure and in response they simply allowed a larger portion of their incomes to accumulate in their bank accounts than they otherwise would with no offsetting increase in the money supply. How would this increase in the supply of loanable funds lead to a fall in the rate of interest before there was a fall in income?

    In the LP theory, this would represent an increase in the demand for money through an increase in the demand for precautionary balances. Businesses would find they could no longer replenish their transactions balances from sales and would be forced to sell assets or increase borrowing to replenish these balances and the rate of interest would be bid up.

    How can this be explained within the loanable funds theory? The only way it makes sense to me (or to Keynes) is to assume that the increase in the propensity to save (the loanable funds supply schedule) caused an increase in the loanable funds demand schedule that is greater than the increase in the propensity to save schedule. But once you do that you have, in effect, defined the excess demand for loanable funds to be equal to excess demand for money. The only alternative that I can see is to deny that the rate of interest will increase in this situation and assert that it will fall without any explanation as to what will cause it to fall.

    That’s what Robertson and his anti-Keynesian friends did throughout the LP/LF debate, and every time they got backed into a corner on this issue they would declare that they didn’t actually mean what they had said, reformulate their arguments, and renew the attack until they were backed into a corner on this issue again. This went on and on until the early 1960s when Robertson died and the Keynesians didn’t bother to respond to them anymore. Since no one bothered to respond to them anymore the issue never got resolved. Both camps declared they had won the debate, and we still have people who think it makes sense to think the rate of interest is determined by saving and investment and that all we have to do to increase growth is increase saving. I see this as a very sad chapter in the history of economic thought.

  97. 98 Fed Up November 12, 2015 at 8:40 pm

    Off-topic

    http://charleshughsmith.blogspot.com/2015/11/if-we-dont-change-way-money-is-created.html

    “The bank, on the other hand, can perform magic with the $100,000 they obtain from the central bank. The bank can issue 19 times this amount in new loans—in effect, creating $1,900,000 in new money out of thin air.

    This is the magic of fractional reserve lending. The bank is only required to hold a small percentage of outstanding loans as reserves against losses. If the reserve requirement is 5%, the bank can issue $1,900,000 in new loans based on the $100,000 in cash: the bank holds assets of $2,000,000, of which 5% ($100,000) is held in cash reserves.”

    JKH, is that right?

  98. 99 David Glasner November 13, 2015 at 11:08 am

    George, Have a look at my latest post in which I register my agreement with you that the loanable funds theory is insupportable. I think our reasoning may be similar, but I’m not sure. See what you think. Thanks for prodding me to see that it simply doesn’t make sense at any level.

  99. 100 JKH November 15, 2015 at 7:18 am

    David,

    Laggard comment.

    Above I said:

    “And when Keynes said that the equality of saving and investment was ensured by the level of income, I feel pretty confident that what he meant was that investment creates income (payments to the factors of production) in the same quantity, and that the income created has to be saved (because no incremental consumer goods are assumed), and that therefore it is the income created (level of income) and its inevitable use (saving) that ensures the equality of saving and investment.”

    I’ve spent some time looking at the GT in the last couple of days. And while I don’t think what I said above is necessarily wrong, I think I see the kind of inconsistency to which you refer. Interestingly, without having read the relevant portions of the GT as closely before, its the same type of inconsistency that I attempted to discredit in my view through lengthy explanation some months ago at an earlier post of yours as to how I interpret the evolution of saving within the multiplier process (i.e. that the equality of saving and investment is not the consequence of the equilibrium achieved by the multiplier process but rather is set firmly at the beginning and maintained throughout every logical step of the multiplier process as it is typically represented through algebra. In effect, it is consumption that is multiplicative – not saving). This is tentative.

    Perhaps to be revisited in discussion at some future point.

  100. 101 djb November 15, 2015 at 7:38 am

    Y = k*I
    I = Y/k

    Y = I + C

    C = Y – I = k*I – I = (k-1)*I

    C = (k – 1)*I

    C is the part of income expanded by the multiplier. …. actually C determines the multiplier

    C is the part of income that is increased by the multiplier. … ( or c C determines the multiplier)

  101. 102 David Glasner November 15, 2015 at 8:54 am

    Henry, Fisher’s theory was based on both time preference and the productivity of capital. Think of a production possibility curve and an indifference curve drawn in a Cartesian space with current income drawn along one axis and future income along the other axis. The slope of the production possibility curve represents the marginal productivity of capital, and the slope of the indifference curve represents the marginal rate of time preference. The tangency of the production possibilities curve with the highest indifference curve represents an intertemporal equilibrium and the slope of the two curves at the point of tangency represents the intertemporal exchange rate between current and future income and output which can be expressed as one plus the rate of interest. This is a perfect foresight real exercise, so it is clearly not the case that Fisherian time preference is related to uncertainty or liquidity preference. Fisher certainly was aware of and discussed uncertainty and money, but those were add-ons to his basic theory of interest.

  102. 103 George H. Blackford November 15, 2015 at 9:51 am

    I find only one place in the General Theory where Keynes offered a direct criticism of Fisher’s work, and in that discussion it was quite clear that Keynes’ criticisms were concerned with the mechanism by which inflationary expectations were assumed to affect investment, output, and employment rather than the determination of the rate of interest:

    “This is the factor through which the expectation of changes in the value of money influences the volume of current output. The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital.” (GT
    http://cas.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf , pp. 91-2.)

    Keynes then criticized Fisher’s exposition of the mechanism by which the distinction between the money rate of interest and the real rate of interest affects the economic system as being unclear:

    “This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called ‘Appreciation and Interest’ — the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another.” (GT p. 92.)

    I can’t say whether or not this is a valid criticism of Fisher (it’s been fifty years since I read The Theory of Interest), but this does sound like a very solid argument: If a change in the value of money is not foreseen it will have no effect on current affairs in that people will have missed the opportunity to have taken advantage of this change, and if it is foreseen asset prices as well as the rate of interest will adjust very rapidly, if not instantly, as people react to their changing expectations such that there will be very little chance for people to take advantage of this change even if it is foreseen. If some foresee and others do not then some will be able to take advantage of others until prices fully adjust, but what Keynes is arguing here is that it is the effects of the increase in asset prices and the resulting rise the marginal efficiency of capita schedule that will stimulate the economy in this situation, not the concomitant changes in the rates of interest:

    “The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. [see Footnote at end] The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output — in so far as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulus to output depends on the marginal efficiency of a given stock of capital rising relatively to the rate of interest. Indeed Professor Fisher’s theory could be best re-written in terms of a ‘real rate of interest’ defined as being the rate of interest which would have to rule, consequently on a change in the state of expectation as to the future value of money, in order that this change should have no effect on current output[6].” (GT p. 92)

    Again, I do not know if this is a legitimate criticism of Fisher, but the argument put forth in this paragraph (save the last sentence which I leave as an open question) seems quite sound to me since there is every reason to believe that whether the expectation of higher prices will result in a stimulus to the economy depends on the size of the increase in the rate of interest relative to the size of the concomitant shift in the marginal efficiency of capital (investment demand schedule) in this situation whatever the relationship between the real and nominal rate of interest may be.

    The only other place in which I find Keynes even remotely criticizing Fisher in the General Theory is the section in which Keynes discusses the work of Gesell (GT pp. 219-22.), and here the criticisms are, at most, indirect, and the discussion contains more praise of Fisher than admonition. The most damming thing he says (indirectly) about Fisher in this discussion, and I hardly think it damming, is:

    “This led [Gesell] to the famous prescription of ‘stamped’ money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher. . . .

    “The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes—bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth.” (GD p. 221)

    Again, whether this is a legitimate criticism of Fisher or not, it seems to me to be a sound argument. My point is that I don’t find any criticism of Fisher’s theory of interest, as such, in the General Theory other than the above, and the arguments in the passages quoted above seem to be valid. In addition, I don’t remember any controversy between Fisher and Keynes concerning the theory of interest following the publication of the General Theory, so I just can’t understand what the issue is here.

    It has always seemed clear to me that Keynes saw the determination of the rate of interest as a portfolio balance problem in which asset prices and the rate of interest adjust to induce wealth holders to hold the existing stocks of assets. In the search for the market in which prices are determined in a Marshallian sense it is clear that there are supply and demands that can be thought of as determining the prices of all assets save one: the price of money. The reason this price is unique is that, since money is the unit of account, the price of money is, by definition, $1/$ and cannot adjust to equate the willingness to hold money with the existing stock of money. This makes the money rate of interest unique in that the own rate of interest must adjust to equate the willingness to hold money with the existing stock of money since the price of money cannot change. If wheat were used as the unit of account then its price could not change, and the supply and demand for wheat in terms of wheat would determine the own rate of interest of wheat in a Marshallian sense and the price of money in terms of wheat would have to adjust to equate the willingness to hold money to the existing stock of money.

    I don’t see this as being very complicated, and it seems to me that to reject this kind of analysis is to deny the usefulness of Marshall’s partial-equilibrium paradigm in explaining the way in which prices are determined in individual markets, which I don’t see many economists willing to do except when it comes to finding an excuse to reject Keynes’ liquidity preference theory of interest in favor of the loanable funds theory of interest. I personally can’t even imagine what it would be like trying to make sense out of economics to students in a principles course without Marshall, and I find criticisms of Keynes for using the Marshallian paradigm to explain the determination of the rate of interest in terms of the supply and demand for money akin to criticizing economists for using the Marshallian paradigm in a principles course to explain the determination of the price of apples in terms of the supply and demand for apples. The fact that economists universally use this paradigm doesn’t mean they don’t understand its limitations or how it applies to the overall working of the economic system. There is no reason to assume that Keynes, a protégé of Marshal, was an exception in this regard, and I have never found any reason to believe that Keynes was not fully aware of the intertemporal relationships between and across all asset markets in determining asset prices.

    Finally, it seems to me that the Marshallian paradigm is the sine qua non of general equilibrium analysis. If you can’t start with an explanation of the way in which individual prices and quantities are determined by supply and demand in individual markets, how is it possible to explain or justify any of the relationships that are included in a general equilibrium model?

    ————–

    Footnote: The assertion that it is a mistake to assume that prospective changes in the value of money will directly react on the rate of interest may sound like Keynes is denying that inflationary expectations will have an effect on the rate of interest, but why would anyone assume he is saying this? It’s fairly safe to assume Keynes would be the last person in the world to deny that expected price increases will decrease the demand for precautionary balances and increase the demand for transactions balances and, therefore—through its effects on the demand for money—affect the rate of interest. What Keynes is talking about here is the mechanism by which an expected increase in prices will stimulate the economy, and he is quite clear in what follows that he believes that stimulus will come from the direct effects of inflationary expectations on the marginal efficiency of capital as a result of price increases, not through its effects on the rate of interest.

  103. 104 Henry November 15, 2015 at 1:18 pm

    David,

    You say:

    “Fisher’s theory was based on both time preference and the productivity of capital.”

    “Fisher certainly was aware of and discussed uncertainty and money, but those were add-ons to his basic theory of interest.”

    I have not read Fisher’s “Nature of Capital and Income” or “The Theory of Interest” so I cannot speak to what Fisher has written therein. I am not in any way an expert on Fisher (and clearly I am not an expert on anything, just a dumb arse nobody scratching around trying to understand what he missed as an economics undergraduate over 40 years ago.🙂 )

    Take a look at the Preface of “The Rate of Interest” p. viii:

    “The solution here offered is that the rate of interest depends on the character of the income-stream, – its size, composition, probability, and above all, its distribution in time.”

    See p. 1-2:

    “Experience shows that nearly every student of economic science has almost unconsciously acquired a number of crude and usually false ideas on this important subject. Such…..is the idea that the rate of interest…..represents the “productivity” of capital…..Before the correct theory of interest can be securely implanted in any mind, these ideas must be first eradicated.”

    Somewhat in contrast, p. 28:

    “It is, however, quite true that the productivity of capital does effect the rate of interest; for it affects the relative valuation of present and future goods….”

    Fisher comes to his theory of interest in this book by looking at it under various assumptions (summed up in a table on p.221) until he comes to removing the assumption of income uncertainty in Chapter XI – he devotes a whole chapter to the discussion. Hardly an add-on.

    So I believe the cut and dry way you characterise Fisher’s theory of interest is not entirely supportable. It seems to me, when looked at it in the round, it has affinities with Keynes’ propensity to hoard.

  104. 105 David Glasner November 15, 2015 at 6:46 pm

    George, Keynes’s criticism of Fisher is one of the mysteries of the General Theory, especially inasmuch as one of Keynes’s great contributions before the General Theory was his theorem on covered interest arbitrage in foreign exchange markets which is a direct implication of Fisher’s distinction between real and marginal rates and his discussion in Chapter 17 is also a direct application of Fisher’s analysis. I think the only way to understand Keynes is that he believed that under certain circumstances the real rate of interest depends on the expected rate of inflation, so that changing the expected rate of inflation may operate on the real rate of interest while in chapter 17 Keynes is comparing different own rates of interest under the assumption that the real rate of interest at that moment is given (because the real rate of interest is given by whatever the expected rate of inflation is at the moment).

    You are right that, apart from the kerfuffle over the real and nominal rates of interest, Keynes did not criticize Fisher directly, but that in itself is a mystery, because with all due respect to Marshall, to cite Marshall, rather than Fisher, as the highest authority on the orthodox theory of interest is like citing Kepler rather than Newton as the highest authority on the classical theory of mechanics. And for Fisher to reject the orthodox theory of interest based on supposed shortcomings in Marshall’s analysis without citing Fisher’s work is just bad – and I mean really bad — scholarship.

    You said:

    “It has always seemed clear to me that Keynes saw the determination of the rate of interest as a portfolio balance problem in which asset prices and the rate of interest adjust to induce wealth holders to hold the existing stocks of assets.”

    I think that is exactly the right way to think about the determination of interest rates. But Keynes seems to think that liquidity preference explains the real rate of interest, which is completely wrong. There has to be a real rate of return and a nominal rate of return and there has to be a liquidity premium. The liquidity premium explains the difference between the real rate of return and the real rate of return on holding cash; it doesn’t explain the real rate of return on capital. Keynes argues as if explaining the liquidity premium is sufficient to explain the real and nominal rates of interest. That’s wrong, his system is underdetermined. That’s where Fisher comes in.

    I won’t comment on Marshall for whom I have great respect, even though he fell far short of Fisher on the theory of capital and interest, except to say that Marshall’s focus was on partial equilibrium, not general equilibrium, and his theory of price adjustment was predicated on an implicit assumption that all markets except one are in equilibrium.

    Frank, Time preference is a preference for sooner rather than later, it can be for the same good or for different goods or for goods in general. Otherwise I think I agree with your explanation of the difference between liquidity preference and time preference.

    Henry, If you can quote from Fisher’s The Rate of Interest you are a scholar in my estimation.

    By an “add-on,” I mean that he has already provided an approximate solution to the problem of the determination of the rate of interest under the simplifying assumption of no uncertainty. Relaxing that assumption does not change the basic character of the solution, but provides a more realistic understanding of the factors that influence the determination of the rate of interest. Fisher’s theory may have affinities with Keynes’s theory; Fisher was a great monetary theorist as well as a great pure theorist, so he certainly had some understanding of liquidity preference even though he didn’t work out that particular aspect of monetary theory as well as Keynes did. My point is that Keynes tried to explain the theory of interest entirely in terms of the demand for money (liquidity preference), leaving out all the factors, i.e., time-preference and the productivity of capital, that Fisher relied on to explain the rate of interest.

    Biagio, I agree with your characterization of what Keynes was trying to do. I deny that he was successful in accomplishing what he set out to do. Uncertainty does not obliterate the phenomena of time preference and capital productivity. Liquidity preference cannot bear by

  105. 106 Henry November 15, 2015 at 7:16 pm

    David,

    Why does the real rate of return have to be determined? It could be said that this is almost a neoclassical fetish. I don’t think Keynes set out to describe the way in which the real rate is determined. I think the things you have said about Keynes’ purpose in Chapter 17, above and in your latest blog on Fisher, particularly the first paragraph, are puzzling. Keynes was interested in the determination of the money rate – the money rate then set the level of investment. The MEC schedule did not have to be couched in real terms. I don’t think Keynes “imagined” (as you say in your Fisher blog) he explained the real yield on assets, because it was of no interest to him per se and had no place in his theory.

  106. 107 George H. Blackford November 15, 2015 at 11:40 pm

    David,

    I don’t find Keynes’ criticism of Fisher to be much of a mystery. It seems quite clear to me that Keynes did not think the real rate of interest made a difference in the decision-making process once you made a distinction between expected and realized rates of inflation in defining the real rate of interest:

    If the real rate of interest is defined as the difference between the nominal rate of interest and realized inflation then the only way in which the real rate of interest can have an effect on the system is through its affects on expectations with regard to future price changes.

    If the real rate of interest is defined as the difference between the nominal rate of interest and the expected rate of interest then the real rate of interest will be determined by the system as the nominal rate of interest and asset prices adjust to the expected rate of inflation.

    This really isn’t very complicated, and if the above understanding of the role played by the real rate of interest conflicts with what Keynes wrote about covered interest arbitrage in foreign exchange markets, so be it. That only means that at some point he changed his mind as he expanded the role of expectations in the process of developing his general theory.

    Now I could be wrong in this, but it seems to me that the only reason you find Keynes’s criticism to be a mystery is that you don’t see that even though Keynes undertook an analysis of own rates of interest in the General Theory he also completely rejected the relevance of the concept of a real rate of interest in this analysis once he had taken into account the role of expectations since, once he had done that, there was no need to explain the real rate of interest.

    As for Keynes not citing Fisher as the highest authority on the orthodox theory of interest, I have always seen Keynes discussion of the classical theory of interest as building a straw man that he could tear down. He explicitly states:

    “What is the classical theory of the rate of interest? It is something upon which we have all been brought up and which we have accepted without much reserve until recently. Yet I find it difficult to state it precisely or to discover an explicit account of it in the leading treatises of the modern classical school[1].

    “It is fairly clear, however, that this tradition has regarded the rate of interest as the factor which brings the demand for investment and the willingness to save into equilibrium with one another. Investment represents the demand for investible resources and saving represents the supply, whilst the rate of interest is the ‘price’ of investible resources at which the two are equated. Just as the price of a commodity is necessarily fixed at that point where the demand for it is equal to the supply, so the rate of interest necessarily comes to rest under the play of market forces at the point where the amount of investment at that rate of interest is equal to the amount of saving at that rate.

    “The above is not to be found in Marshall’s Principles in so many words. Yet his theory seems to be this, and it is what I myself was brought up on and what I taught for many years to others.” (GT
    http://cas.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf p. 112.)

    It would have been highly inappropriate for Keynes to have attributed this straw-man theory to Fisher (or to anyone else) in the absence of some kind of quote from Fisher (or anyone else) that indicated he in some way agreed with the straw man that Keynes was building. Instead, he admits that he himself had taught this theory for many years and cites a number of passages from other economists who presented arguments that seem to be consistent with this theory without attributing to them a belief in all of the aspects of his straw man theory.

    I suspect that the only reason there is no passage from Fisher quoted by Keynes is because he couldn’t find a quote by Fisher that indicated Fisher believed in this straw-man theory, and your comment on this sort of thing in an earlier post indicates that you are not surprised by Keynes’s failure to find such a quote.

  107. 108 George H. Blackford November 15, 2015 at 11:44 pm

    I, of course, meant to say:

    If the real rate of interest is defined as the difference between the nominal rate of interest and the expected rate of INFLATION then the real rate of interest will be determined by the system as the nominal rate of interest and asset prices adjust to the expected rate of inflation.

    Sorry about that.

  108. 109 David Glasner November 17, 2015 at 7:16 pm

    Henry, In chapter 17, Keynes, talks about an expected net rate of return which, in equilibrium, every asset will yield. That rate of return, has got to be a real rate, because the service slows associated with those assets, such as liquidity services, are real service flows. When Keynes talks about an increase in expected prices increasing the marginal efficiency of capital and increasing total investment he is talking about an increase in real investment, not an increase in nominal investment.

    George, You said:

    “it seems to me that the only reason you find Keynes’s criticism to be a mystery is that you don’t see that even though Keynes undertook an analysis of own rates of interest in the General Theory he also completely rejected the relevance of the concept of a real rate of interest in this analysis once he had taken into account the role of expectations since, once he had done that, there was no need to explain the real rate of interest.”

    I am sorry, but I have no idea what you are talking about. You and Henry seem to be making the same point, but whatever that point is I just don’t get it.

    You said:

    “I suspect that the only reason there is no passage from Fisher quoted by Keynes is because he couldn’t find a quote by Fisher that indicated Fisher believed in this straw-man theory, and your comment on this sort of thing in an earlier post indicates that you are not surprised by Keynes’s failure to find such a quote.”

    But just before that you said:

    “The above is not to be found in Marshall’s Principles in so many words. Yet his theory seems to be this, and it is what I myself was brought up on and what I taught for many years to others.”

    So he couldn’t find a quote from Marshall either. Again, Keynes is talking about the orthodox theory of interest, and does not address the position of the guy who wrote the book (actually several books) about the orthodox theory of interest.

    I am not trying to bash Keynes here, I am just observing that there are some very problematic issues here that, as far as I can tell, have yet to be resolved.

  109. 110 Henry November 18, 2015 at 3:37 am

    David,

    Just so we are clear, I was responding to what you said here in your latest blog:

    “Unfortunately, Keynes imagined that by identifying and explaining the liquidity premium on cash, he had thereby explained the real yield on holding physical capital assets; he did nothing of the kind, as the marvelous exposition of the theory of own rates of interest in chapter 17 of the General Theory unwittingly demonstrates.”

    And here from your last response post above:

    “But Keynes seems to think that liquidity preference explains the real rate of interest, which is completely wrong.”

    George and I are probably saying the same thing except George mounts a sophisticated argument about Keynes’ lack of interest in the real rate of interest and why it does not feature in the investment decision process while I merely make assertions about what Keynes’ was doing specifically in Chapter 17, viz. building a case for why the money rate of interest is the central rate of return determining the level of investment.

    While I believe this is the case, I’m not sure I understand fully the flow of the exposition in Chapter 17 as much as I would like to. Chapter 17 is convoluted and complicated and ranges over considerable territory.

    In the first quote above you are saying he unwittingly demonstrates that the liquidity preference explains the real return on physical capital. In the second quote you say he thinks he’s done this. It can’t be both.

    On my reading of Chapter 17, I can’t see that he thinks he’s explained the real rate of return because that does not serve his purpose, as I see it. Because I don’t fully understand Keynes’ argument in Chapter 17, I am not confident in arguing against the idea that he unwittingly explained the real rate of return on capital. More work for me to do on Chapter 17.

    Apparently Hansen writes of Chapter 17 that ‘not much would have been lost if it had never been written’. Perhaps he didn’t get it either? Or perhaps he did? 

  110. 111 JKH November 18, 2015 at 5:15 am

    David,

    You say in comment:

    “In chapter 17, Keynes, talks about an expected net rate of return which, in equilibrium, every asset will yield. That rate of return, has got to be a real rate, because the service flows associated with those assets, such as liquidity services, are real service flows.”

    I don’t understand; what about this:

    “It will also be useful to call a1 + q1, a2 − c2 and l3, which stand for the same quantities reduced to money as the standard of value, the house-rate of money-interest, the wheat-rate of money-interest and the money-rate of money-interest respectively. With this notation it is easy to see that the demand of wealth-owners will be directed to houses, to wheat or to money, according as a1 + q1 or a2 − c2 or l3 is greatest. Thus in equilibrium the demand-prices of houses and wheat in terms of money will be such that there is nothing to choose in the way of advantage between the alternatives; — i.e. a1 + q1, a2 − c2 and l3 will be equal.”

    I interpret that those are all money rates in equilibrium – not real rates.

    It seems to me that the real rate analysis is used subsequently to determine the most “significant” rate for purposes of establishing the type of interest rate that should be the hurdle rate for the marginal efficiency of capital.

    Chapter 17 really is a major challenge to get through, so maybe I misunderstand something here.

  111. 112 JKH November 18, 2015 at 6:30 am

    From Chapter 17 again:

    “Our conclusion can be stated in the most general form (taking the propensity to consume as given) as follows. No further increase in the rate of investment is possible when the greatest amongst the own-rates of own-interest of all available assets is equal to the greatest amongst the marginal efficiencies of all assets, measured in terms of the asset whose own-rate of own-interest is greatest.”

    I interpret that as the generalized analytic framework for his elaborate development whereby he concludes that money turns out to be “the asset whose own-rate of own-interest is greatest” in that context. Accordingly (it seems to me), if equilibrium is then interpreted as the state in which “no further increase in the rate of investment is possible” – then the relevant measure of “the marginal efficiencies of all assets” in that equilibrium state is in terms of money (because its own-rate of own-interest is greatest) – not in terms of the own-rates of other assets.

    That said, the comparison against the behavior of the real rates of other assets is critical in determining how money interest ends up being the “significant” rate of interest in this context – because it is slower to decline in an environment of generally increasing production than alternative “own rates” (i.e. real rates) of interest. And that is what happens as investment approaches a maximum, which perhaps is the role of real interest own-rates you are referring to (in reaching that sort of “equilibrium” ?).

  112. 113 George H. Blackford November 18, 2015 at 1:06 pm

    David,

    I have obviously been taking way too much for granted here, and I apologize for that. It may help if I try to translate my understanding of Keynes’s objection to Fisher’s work into modern economic jargon.

    In general, when economists specify a model it includes parameters, exogenous variables, and endogenous variables. The model is supposed to explain the determination of the endogenous variables in terms of the exogenous variables and parameters. I believe the problem Keynes poses in his criticism of Fisher’s discussion of the real rate of interest can be explained within this context as one of determining whether the real rate of interest, as Fisher defined it, is an endogenous or an exogenous variable.

    If the real rate of interest is defined as the difference between the nominal rate of interest and the actual (realized) rate of inflation the real rate of interest becomes an endogenous variable because the actual rate of inflation and the nominal rate of interest cannot be known until the nominal rate of interest and all of the prices in the system are known. Thus, the real rate of interest can have no effect on the system because it is determined within the system, and introducing the role of expectations into the model does not change this.

    Even if the real rate of interest is defined as the difference between the nominal rate of interest and the expected rate of inflation the real rate of interest is still an endogenous variable since it still can’t be known until the nominal rate of interest is known. If the expected rate of inflation is assumed to be endogenous then it must be solved for along with all of the other variables in the system before the real rate of interest can be known, and the real rate of interest is still an endogenous variable determined within the system.

    The only way in which the real rate of interest can affect the system in this kind of model is through its effect on expectations in determining the rate of interest (nominal or real), prices, and quantities in the future, not in the present. If expectations are assumed to be exogenous, and the expected rate of inflation or the expected real rate of interest change, then the real rate of interest along with all of the other endogenous variables in the system will change, but it is the exogenous change in expectations that will cause the rate of interest (nominal and real), prices, and quantities to change, not the resulting change in the real rate of interest or inflation.

    Once Keynes introduced expectations into his analysis there was no need for him to explain the real rate of interest, however it is defined, because the real rate of interest is, by definition, determined within the system, and can only change in response to a change in an exogenous variable or a parameter. That doesn’t mean that the concept isn’t useful or that you can’t define the demand for investment, for example, in terms of the real rate of interest within Keynes’s theoretical framework if you want to. It only means that there is a definitional relationship between the real-rate-of-interest investment demand schedule and Keynes’s marginal efficiency of capital schedule within this framework rather than a behavioral difference. That is, the two schedules simply describe the same behavior in a different way.

    Note that I am using the idea of determination in a different sense here than in the specific sense in which I used this term when I was talking about the direct effect of an increase in the propensity to save on the rate of interest. There I was talking about determination in a Marshallian sense to explain the way in which the rate of interest is directly determined by the supply and demand for money with everything else held constant. Here I am talking about determination in the short-run general equilibrium sense (however ‘short’ the short run may be defined) of explaining how the rate of interest is determined (along with all of the other endogenous variables in the system) by the exogenous variable and parameters in the model.

    It was the determination of the rate of interest in the Marshallian sense (the shortest of short runs) that Keynes was most concerned about. The reason for his concern was that economists could, and did (and, unfortunately, many economists still do) use the idea that the rate of interest is determined by savings and investment in the Marshallian sense to argue that an increase in the propensity to save will lead to fall in the rate of interest which will, in turn, lead to an increase in the quantities of investment goods demanded as the demands and quantities for consumer goods fall which will, thereby, force up the prices of investment goods and down the prices of consumer goods leading to a transfer of resources out of the consumer goods industries and into the investment goods industries without any change in employment, output, or income. This kind of argument, in turn, can lead to the conclusion that an increase in the propensity to save will increase economic output and wellbeing in the future as a result of the increased the rate of capital accumulation implicit in the increased quantities of investment goods produced.

    Keynes saw this kind of argument and the resulting conclusion as fallacious—pure and utter nonsense both empirically and theoretically.

    Keynes argued that there is no reason to think the rate of interest will fall in this situation (in the absence of an accompanying increase in the supply of money) until after employment, output, and income fall. And if employment, output, and income fall, there is no reason to think that this fall will not affect expectations regarding the profitability of investments in the consumer goods industries as the effective demands for consumer goods fall. And since Keynes believed the raison d’être for production and investment is to satisfy the ultimate demands of consumers, he also believed that there was no reason to believe that the effect on expectations with regard to investment would not cause the marginal efficiency of capital schedule to fall as the rate of interest fell in a way that lead to a fall in the quantities of investment goods produced. As a result, Keynes thought it was absurd to argue that an increase in the propensity to save will increase economic output and wellbeing in the future as a result of an increased the rate of capital accumulation implicit in the increased quantities of investment goods produced, because there was no reason to believe that there would be an increase in the quantities of investment goods produced as a result of there being an increase in the propensity to save.

    Keynes made this kind of argument throughout the General Theory as he discussed saving, investment, and the rate of interest in an attempt to show the absurd nature of the kind of fallacious argument put forth in the penultimate paragraph above, and it was Keynes’s argument and the refutation of the fallacious kind of argument put forth above that Keynes was concerned with when he created his straw-man, classical theory of interest. He was not concerned with the orthodox theory of interest put forth by Fisher and he did not accuse Fisher of putting forth or believing in this kind of fallacious argument. He only accused Fisher of being unclear in the way he defined the real rate of interest and criticized his failure to make clear the mechanism by which the real rate of interest affects the economic system through its effects on expectations.

    Now when I reviewed the literature on the controversy over Keynes’s theory of interest those many years ago I don’t remember running across any objection by Fisher to Keynes’s criticism in this regard. I may have missed something there (and if I did miss something there please show me where I can find Fisher’s objection as I will deeply appreciate knowing what Fisher had to say on this), but if there was no objection by Fisher, and I really don’t know if there was, I think it is fairly reasonable to assume that Fisher understood Keynes’s criticism more or less along the lines I have tried to explain it above and that Fisher saw this criticism as being valid and simply accepted it as such.

    What I find really sad about the entire sordid liquidity-preference/loanable-funds debate is that, in spite of Keynes’s valiant efforts to discredit the fallacious arguments that were embraced by the economists of his day with regard to the rate of interest, saving, investment, and future economic wellbeing—and in spite of Fisher’s possible agreement with Keynes on the fallaciousness of these arguments—an entire school of economists to this day seem to have a fetish with regard to the absurd, defunct economists’ ideas that lead to the absurd conclusion that Keynes attempted to eradicate in The General Theory back in the 1930s, namely, that an increase in the propensity to save today will necessarily increase economic wellbeing in the future.

    Arguing that an increase in the propensity to save today will increase economic wellbeing in the future is like arguing that if a pig had wings it could fly—which reminds me of the infamous WKRP Thanksgiving Day promotion: https://www.youtube.com/watch?v=lf3mgmEdfwg . I see a moral to that story in that I firmly believe it is defunct economists’ arguments like the one examined above that underlie a great deal of economic thinking today, and it is these kinds of arguments that have led us into the world-wide crisis we face today: http://www.rweconomics.com/LTLGAD.htm

  113. 114 Henry November 18, 2015 at 1:13 pm

    David,

    You say in your last post:

    “Keynes, talks about an expected net rate of return which, in equilibrium, every asset will yield. That rate of return, has got to be a real rate, because the service slows associated with those assets, such as liquidity services, are real service flows. When Keynes talks about an increase in expected prices increasing the marginal efficiency of capital and increasing total investment he is talking about an increase in real investment, not an increase in nominal investment.”

    I can’t see where he makes the distinction between real and nominal investment. He talks about the MEC schedule and as far as I can see he never couches the MEC schedule in real terms. I can’t see that your point holds. The effects might be real, but they are couched in nominal terms.

    I think LKH’s two posts have focussed on critical sections of Chapter 17. The last passage from 17 that LKH quotes in his last post is the essence,however circular it sounds.

    Keynes also talks about those characteristics of money which give it its peculiar place in his schema, viz. small elasticity of production, zero/near zero elasticity of production and that its supply is not fixed. He goes on to examine why the rate of money interest will not decline under certain conditions – here he is talking about the liquidity trap and the problem of sticky wages and expectation of changes in the money wage – the last two discussions becoming esoteric, for me.

    Chapter 17 is a neuron numbing nightmare, reflecting at times, Keynes’ labyrinthine and byzantine thought processes.

  114. 115 George H. Blackford November 18, 2015 at 1:19 pm

    I think I should add that I really don’t know if Keynes’s criticism was a valid criticism. All I am saying is that Keynes’s argument against his straw-man theory of interest made sense, and his objection to how he interpreted Fisher made sense even if his interpretation of Fisher was wrong.

  115. 116 JKH November 19, 2015 at 1:38 am

    David,

    Returning to the same chapter 17 quote:

    “Our conclusion can be stated in the most general form (taking the propensity to consume as given) as follows. No further increase in the rate of investment is possible when the greatest amongst the own-rates of own-interest of all available assets is equal to the greatest amongst the marginal efficiencies of all assets, measured in terms of the asset whose own-rate of own-interest is greatest.”

    I think your last comment would be more precisely reflective if this quote had read something to the effect that all those own rates had converged to and remained at a single value, instead of being ranked according to “greatest” etc. as he describes there. He seems to allow for a range of sub-par MEC’s in equilibrium.

    But maybe that’s just a quibble beyond the more important point that it is the declining MEC’s in terms of own/real rates that result in those assets getting “knocked” out of production due to the fact that the own/real rate on the “significant” asset (normally money) remaining relatively sticky. I’m not sure of anything here, but I think that’s your main point above.

  116. 117 David Glasner November 26, 2015 at 10:54 am

    Henry, I didn’t mean that the liquidity preference theory explains the real rate of return on capital, though it seems that Keynes believed that was the case. I am saying that the liquidity preference theory explains why the pecuniary rate of return on capital does not equal the pecuniary rate of return on holding money. He doesn’t explain why the pecuniary return on capital is what it is. Moreover, he also asserts that there are many natural rates of interest each one corresponding to a different level of employment. I don’t disagree with that assertion, but if you believe that liquidity preference explains the rate of return on capital then it must be that there is a different rate of liquidity preference corresponding to each level of employment. I don’t see why that should be the case at all. Sorry, I haven’t read Hansen since I was in grad school, so I can’t comment on what he meant by his comment on chapter 17. (If I remember, I’ll try to look up what he says.)

    JKH, Since the rates of return, adjusted for expected appreciation, depreciation, storage costs, and real service flows are equalized, the equalized rate of return, having been adjusted for expected appreciation or depreciation, must be a real rate. Otherwise, it wouldn’t make sense to say that the expected return from holding any asset is the same as the expected return from holding another asset.

    George, The real rate of interest must be an endogenous variable. To say it is exogenous means that it is unexplained. The nominal rate of interest is also endogenous. The expected rate of inflation is typically not endogenous, but exogenous because inflation is presumed to be a policy variable and because the typical assumption in GE models is that money is neutral.

    Your explanation of what Keynes is trying to do is interesting, but still difficult for me to follow. By the time the General Theory came out, Fisher’s career as an economist was in its last phase, and I don’t know enough about Fisher’s life to know if he ever wrote or commented on the GT. Robert Dimand is probably our greatest living expert on Fisher, and a Keynes scholar to boot, so I will try to ask him if he knows anything about how Fisher felt about the GT. If I hear from him, I will certainly pass it along. However, it seems to me that in a Fisherian model, an increase in time preference (analogous to an increase in the propensity to save) would result, ceteris paribus, in an increase in the value of assets, making it profitable for producers to shift resources into the production of such assets increasing consumption in the long run. Now it might be argued that an increase in time preference would lead to expectations of lower profits and cash flows in the future, so that the positive effect on the value of assets of a reduced discount rate would be reduced or even reversed by pessimistic expectations, but that argument is hardly straightforward.

    Henry, Keynes does not explicitly make a distinction between real and nominal rates of interest in chapter 17, but he includes as one of the factors that affects the own rate of interest of each asset the expected rate of appreciation or depreciation of the asset, and the expected equality of returns of all assets is net of expected appreciation or depreciation, so that equalized expected rate of return from any asset must therefore be a real rate not a nominal rate.

    JKH, I have to go back and look at what Keynes says about the “greatest own rate.” I’m not recalling that particular part of his argument.

  117. 118 JKH November 29, 2015 at 1:22 pm

    David,

    “I have to go back and look at what Keynes says about the “greatest own rate.” I’m not recalling that particular part of his argument.”

    I must be reading a different chapter 17, because the “greatest own rate” is at the heart of his argument as to why the money rate of interest on money becomes the standard against which profitable production of new capital assets must be judged.

    Anyway, I’ve found chapter 17 to be quite fascinating, so I’ve written my understanding of it in more detail here. Sorry for the longish comment, but I see little point in making such a specialized topic a blog post somewhere else:

    I interpret Chapter 17 analysis as comprising 2 stages of argument:

    The first is the logical argument that determines the commodity whose own rate of interest becomes the interest rate standard that serves as the effective hurdle rate for MEC in the production of new capital assets. This amounts to a competition among candidate own rates (e.g. houses, wheat, money) as to which rate best resists a tendency to decline as production proceeds. Money wins the competition.

    The second stage is how the victorious money interest rate standard operates as a constraint on the expansion of other new capital assets by production. The constraint is measured in terms of a comparison between the MEC for other capital assets expressed as a money rate (not an own rate) and the money rate of interest on money as the standard. In this phase, there is no convergence of commodity own rates of interest. It is commodity rates of money interest (Keynes’ term for commodity specific nominal rates, in effect) that are equivalent in equilibrium – not own or real rates.

    With regard to the first stage, and from the first page of Chapter 17:

    “This, we shall find, will lead us to the clue we are seeking. For it may be that it is the greatest of the own-rates of interest (as we may call them) which rules the roost (because it is the greatest of these rates that the marginal efficiency of a capital-asset must attain if it is to be newly produced); and that there are reasons why it is the money-rate of interest which is often the greatest (because, as we shall find, certain forces, which operate to reduce the own-rates of interest of other assets, do not operate in the case of money).”

    In other words, it must be the asset whose own rate of interest is most resistant to the tendency of increasing production to put downward pressure on the MEC’s of all assets, where the MECs are measured in this case in terms of the respective commodities themselves (i.e. a measure that is parallel in technique to the own rate of interest for that commodity.) This establishes the commodity that will end up being used for the interest rate standard that is most critical to the continuation of production. It is a competition among own/real rates of interest to see which one ends up being “the last man standing” in the face of increasing production. This is the one that ends up being the cost of capital hurdle for all MECs in the context of Keynes’ general analysis of the interest rate. And that ends up being the money rate of interest on money.

    The argument he makes in this first phase is reductio ad absurdum, because if not the “winning asset” as described, some other asset would have to offer a rate of interest that became a more constraining standard to be met by the MEC of newly produced assets, MEC being measured in terms of that chosen standard. But that is a contradiction. So it turns out that money is the most constraining choice (“the greatest own rate”) according to this criterion. And there are reasons for its superiority, which he goes on to explain in terms of its low production elasticity, its low substitution elasticity, the absence of significant carrying costs, and its high liquidity premium.

    And he says regarding these last two factors:

    “But it is an essential difference between money and all (or most) other assets that in the case of money its liquidity-premium much exceeds its carrying cost, whereas in the case of other assets their carrying cost much exceeds their liquidity-premium.”

    With regard to the second stage of the argument:

    The logic that determines the superior own rate and interest rate standard is not the same as the logic of how equilibrium interest rate relationships are established through the operation of that own rate standard. Equilibrium is determined by the interaction of the winning own rate with the nominal MEC’s of all other capital assets – where those MEC’s are expressed not in the same way as their own rate measures but in terms of the own rate that is the standard. For example, when the money rate of interest on money is the standard, the MEC’s for other commodities are expressed in terms of money. Production ceases when MECs so measured no longer exceed the interest rate standard.

    This consistency of measurement applies to the interest rate side through such expressions as (q1 + a1), (a2 – c2), and l3, which represent the house rate of money interest, the wheat rate of money interest, and the money rate of money interest:

    “It will also be useful to call a1 + q1, a2 − c2 and l3, which stand for the same quantities reduced to money as the standard of value, the house-rate of money-interest, the wheat-rate of money-interest and the money-rate of money-interest respectively.”

    These are all equal in equilibrium. Using his example, the wheat rate of interest on money is a (2) per cent own rate for wheat (represented by – c2 above) plus a 7 per cent appreciation rate for wheat (a2 above) for a total of 5 per cent as a wheat rate of money interest, which is equivalent to the money rate of money interest.

    Thus, equilibrium is specified in terms of commodity rates of money interest – not in terms of their own/real rates. The latter may differ.

    The “wheat rate of money interest” is in effect a rate of interest on money whose Fisher decomposition consists of the own rate for wheat and the expected inflation rate for wheat. It is a commodity specific Fisher decomposition of the interest rate on money.

    The MEC of a capital asset expressed in terms of the standard must at least be as great as the standard rate in order for production of that commodity to take place. Thus, the hurdle MEC rate is a nominal rate – not the own rate or real rate of return of the commodity. For example, if the wheat rate of interest is (2) per cent, and expected appreciation is 8 per cent, a corresponding 6 per cent MEC beats a 5 per cent hurdle rate of interest on money and production of wheat would proceed – until the MEC is driven down to 5 per cent by some change in the combination of the own rate and the expected appreciation.

    The fact that real rates cannot be equalized across the board is intuitively evident in the example of wheat, where the own rate is (2) % and the expected appreciation is 7 per cent, for an all-in rate of 5 per cent, equivalent to the money rate of interest on money of 5 per cent. That sort of wheat rate of interest is obviously well below that of the own rate of 5 per cent on money as the standard. It’s inconceivable in such an example that such an already low own rate on wheat would ever rise back up to the money own rate with further production – in fact if anything it might become more negative.

    As another example, if the house own rate is 3 per cent and the expected appreciation in terms of money is 4 per cent, then the house rate of money interest is 7 per cent. If the money own rate of interest is the standard, and if the money rate of interest on money is 5 per cent, then houses would continue to be produced according to the corresponding MEC of 7 per cent. They would be produced until the marginal efficiency of house capital declines to 5 per cent in money terms. Similar to wheat, the own rate of interest for houses was already lower than the own rate for money, consistent with housing not being a great candidate for the interest rate standard. So the housing own rate of interest gets knocked out as a candidate for the interest rate standard implicitly within this process, while the production of housing gets knocked out as the housing rate of interest on money (in which a declining own rate is embedded) declines to the level of the standard money rate of money interest.

    Thus, equilibrium is achieved when rates of interest are equalized in terms of measurement of interest rates on all commodities according to the interest rate standard – not in terms of commodity own rates. The own rates diverge for a variety of reasons, including differences in yield, carrying cost, and liquidity premium. The relevant rates in equilibrium are nominal rates consisting of the own rate plus expected appreciation – as in his example of houses where the house rate of money interest is (q1 + a1). This is the same thing as a house-specific Fisher decomposition of the house rate of money interest into the house own/real rate and expected house inflation.

  118. 120 George H. Blackford December 7, 2015 at 7:01 am

    David,

    To summarize my argument as succinctly as I can: Given the way in which the real rate of interest is defined, it is an endogenous variable whenever the nominal rate of interest is an endogenous variable whether the real rate of interest is defined in terms of expected inflation or in terms of realized inflation. In either case the nominal rate of interest must be known (determined/solved for) before the real rate of interest can be known. Keynes’s point is that it is appropriate to talk about the rate of interest as being a causal factor in examining any situation that assumes the rate of interest (nominal or real) is given (exogenous), but it is not appropriate to talk about the rate of interest as being a causal factor in any situation in which the rate of interest is assumed to be determined within the system (endogenous).

    Keynes’s criticism of Fisher, whether Fisher was guilty of this criticism or not, boils down to this: Any argument based on a confusion with regard to cause and effect is fallacious, and, therefore, its conclusions are meaningless. Keynes did not directly accuse Fisher of having made this mistake. He only criticized him for being “unclear” and suggested that he may have made this mistake.

    When Keynes says: “The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital” he is saying, in effect, that the rate of interest is an endogenous variable that is determined within the system. As such, there is no mechanism by which the nominal rate of interest can be affected directly through the effect of prospective changes in the value of money even though the real rate of interest will, by definition, be directly affected. The nominal rate of interest can only be affected indirectly through shifts in those schedules (such as the marginal efficiency of capital schedule) that are directly affected by prospective changes in the value of money.

    Now I see this as a very simple argument that every economist should be able to understand, and, as I have said before, I don’t know if Fisher is actually guilty of having made this kind of mistake—i.e., assuming that a change in inflationary expectations will have a direct effect on the nominal rate of interest in a situation where the nominal rate of interest is assumed to be endogenous—but I do have some insight as to why most economists would fail to see the relevance or significance of this kind of criticism or why they might think that Keynes’s criticism can’t be that simple.

    Economists are trained, myself included, to think of the economic system from the prospective of systems of simultaneous equations the properties of which are assumed to tell us something about how the real economic system works. A great deal of effort is put into specifying those equations and examining their equilibrium and stability properties and how changes in exogenous variables affect endogenous variables, but relatively little effort is put in to examining the dynamic mechanisms by which the system gets from one point of equilibrium to another over time. When it comes to dynamics we find a collection of superficial specifications of dynamic relationships, based on simplifying assumptions that are chosen primarily for their mathematical tractability rather than their correspondence to reality, and virtually no attention is paid to issues of causality.

    Keynes clearly understood this kind of economics, and he clearly understood its importance as well as its shortcomings, but he avoided, whenever possible, this approach to the exposition of economic theory in his own work. He did not present his general theory in terms of a system of simultaneous equations. That was done by Hansen, Hicks, Samuelson, Patinkin, and countless other Keynesians in spite of the fact that Keynes emphatically rejected this kind of approach to the exposition of his work:

    “The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking. Any other way of applying our formal principles of thought (without which, however, we shall be lost in the wood) will lead us into error. It is a great fault of symbolic pseudo-mathematical methods of formalising a system of economic analysis, such as we shall set down in section vi of this chapter, that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep ‘at the back of our heads’ the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials ‘at the back’ of several pages of algebra which assume that they all vanish. Too large a proportion of recent ‘mathematical’ economics are merely concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.” (GT, http://cas.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf , p. 188.)

    This paragraph accurately described the discipline of economics when I was in academia from in the 1960s through the 1980s, and judging from the magnificent work that has been accomplished in RBC and DSGE modeling that was coming to the fore at the time—work that led mainstream economists to support deregulation of the domestic and international financial systems while ignoring the insights of Irving Fisher’s groundbreaking work, Booms and Depressions, as well as those in Keynes’s General Theory—it is fairly obvious to me that nothing much has changed since then.

    Keynes did not follow the tradition of specifying sophisticated mathematical models and ignoring the details. He spent his life examining the details in an attempt to discover the casual relationships that drove the economic system through time. In so doing, among many other things, it became obvious to him 1) that understanding the economic system required a clear distinction between endogenous and exogenous variables (to express the idea of the direction of causality in modern jargon), 2) that the true causal variables in an economic system in which the processes of production takes place over time are expectations with regard to the future rather than the values of the endogenous variables that are the object of these expectations, 3) having lived in England during the 1920s and through the onset of the Great Depression he saw it as meaningless to assume income, output, and employment were constant in trying to understand the economic problems of his day, 4) it became clear to him that if one thinks of saving as that portion of income not consumed it makes no sense at all to assume the rate of interest is determined in a causal sense by the propensities to save and invest, and 5) that it is absurd to argue that the real wage would necessarily adjust to achieve full employment in the absence of price rigidities or that there is no such thing as involuntary unemployment.

    Now it may be that “in a Fisherian model, an increase in time preference (analogous to an increase in the propensity to save) would result, ceteris paribus, in an increase in the value of assets” (though I do not know exactly how time preference is analogous to the propensity to save so I may be missing something in what follows as I will be thinking in terms of Keynes’s propensity to save) but even if this does occur, Keynes would reject the notion that this will make “it profitable for producers to shift resources into the production of such assets increasing consumption in the long run.”

    Given Keynes’s insights, when faced with this kind of proposition Keynes would most certainly ask: If we accept the standard definition of saving as being the difference between income and consumption (and if we don’t accept this definition of saving it is not at all clear what we are talking about until the definition of saving is explained), how is this ceteris paribus increase in the value of assets suppose to occur in response to an increase in the propensity to save? What are the cause and effect chain of events that are suppose to lead to the increase in asset prices as a result of an increase in the propensity to save where, by definition, this means a decrease in the propensity to consume?

    The point that is missed by those who accept this definition of saving and, at the same time, make the kind of ceteris paribus assertion posed above is that it is not the fact of saving that affects the prices of assets (or other aspects of the economic system). It is what people do with their savings and the way in which the concomitant decrease in the propensity to consume that, by definition, must accompany their increase in the propensity to save that affect the markets for assets which, in turn, determines what happens to asset prices in this hypothetical situation. Given this almost universal definition of saving, the fact of saving means only that people consume less than their total income, nothing more!

    I have already shown, and I believe we agree, that if savers choose to hold the increase in savings that will accumulate in this ceteris paribus situation in the form of money this—by virtue of the arguments of Keynes’s liquidity preference theory and the fact that the drop in cash flow in the consumer goods industries will force these industries to increase their demands for borrowed money in order to sustain their cash flow so long as income, output, and employment remain constant—will cause the rate of interest to increase and, hence, the prices of bonds to fall, and I can’t think of any reason to expect the prices of other assets to increase in this situation.

    What will happen if the increased accumulation of savings takes the form of an increase in the propensity to hold assets other than money? It is reasonable to assume that in this situation the prices of assets may increase, but it is important to understand what we are talking about here. To the extent the increased propensity to save is accompanied by an increase in the accumulation of newly produced real assets we are talking about investment, not saving! By definition, saving is the act of not consuming one’s income. This is not the same thing as investing. Investing is the accumulation of newly produced real assets. It is the increased demand for real assets that will cause the prices of real assets to increase in this situation that leads to the increase in the prices of real assets in this situation, not the increase in the propensity to save (i.e., the decrease in the propensity to consume).

    In addition, even if asset prices do increase in this situation there is no reason to believe this will make it profitable for producers to shift resources into the production of these assets so as to increase consumption in the long run. The reason is that to the extent the supply price (i.e., the replacement cost) of these assets increases as a result of increased production it will cause a fall in the marginal efficiency of capital which will limit the extent to which asset prices can increase. At the same time, and most important, the concomitant fall in the demands for consumer goods must lead to a fall in the realized return earned on assets associated with the production of consumer goods.

    In discussing this problem Keynes argued:

    “All production is for the purpose of ultimately satisfying a consumer. Time usually elapses, however—and sometimes much time—between the incurring of costs by the producer (with the consumer in view) and the purchase of the output by the ultimate consumer. Meanwhile the entrepreneur (including both the producer and the investor in this description) has to form the best expectations he can as to what the consumers will be prepared to pay when he is ready to supply them (directly or indirectly) after the elapse of what may be a lengthy period; and he has no choice but to be guided by these expectations[1], if he is to produce at all by processes which occupy time.” (GT, p. 37.)

    And further on Keynes argued:

    “An act of individual saving means—so to speak—a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand,—it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.” (GT, p. 134.)

    In other words, Keynes argued that the way in which wealth holders react to the fall in the return on assets that will accompany an increase in the propensity to save (i.e., a decrease in the propensity to consume) will depend on how it affects their expectations with regard to the expected future returns on assets, and he also argued that since expectations are greatly affected by current experiences there is no reason to assume that an increase in the propensity to save will have a positive effect on these expectations or that the net result would be an increase in the demand for investment goods.

    Now it may be that to argue “an increase in time preference would lead to expectations of lower profits and cash flows in the future, so that the positive effect on the value of assets of a reduced discount rate would be reduced or even reversed by pessimistic expectations . . . is hardly straightforward,” but this is, in fact, the kind of argument Keynes made, and it seems to me that the only reason this argument does not appear to be straightforward is that the Keynesians who codified Keynes’s theory were either unable or unwilling to incorporate this kind of argument into their mathematical models. Instead, they simply ignored this kind of argument and pretended that this kind of argument is not important to the effect that the mathematical models they and other mainstream economists created, and to this day still do create, apply only to a fantasy world that is totally out of touch with the real world—models that describes a world in which markets are efficient; expectations are rational; speculative bubbles are a figment of the imagination; fraud is not a problem; increasing the propensity to save increases economic growth to the benefit of all; rising debt relative to income is irrelevant; monopolies, monopsonies, and oligopolies are nonexistent; factors of production receive the value of their marginal products and the distribution of income is a nonissue; there is no need to regulate international capital flows or exchange rates; the economic system automatically adjusts to achieve full employment; and in which financial institutions are fully capable of regulating themselves for the good of all humanity due to the enlightened self interest of bankers.

    In any event, to get back to the substantive issue at hand, what does it mean in terms of cause and effect to believe:

    1) All production is for the purpose of ultimately satisfying a consumer.
    2) Producers have no choice but to be guided by their expectations in deciding how to employ resources in a world in which production takes time.
    3) Expectations with regard to the future are greatly influenced by current experiences.
    4) The willingness to employ resources is determined by the expectations of producers with regard to their ability to sell the output they produce in the future.
    5) Saving is that portion of income/output that is not consumed and, as such, contains no commitment with regard to future consumption,

    and to then put together an argument by which all we have to do to increase consumption in the future is increase the propensity to save today?

    Keynes argued that production is driven by the expectation of being able to make a profit in the future from the expected demand for consumer and investment goods in the future. This argument makes sense to me. It seems to me that any argument to the effect that increasing the propensity to save today will increase consumption in the future is an argument that assumes production is driven by the expectation of being able to make a profit in the future from the expected demand for consumer and investment goods in the future irrespective of the decrease in the demand for consumption goods today. Now it may be possible to imagine some kind of situation where such an argument makes sense (as I point out in Where Did All The Money Go? this actually did happen during World War II though not through the workings of a free market), but as a general rule this just doesn’t make any sense at all to me, and it didn’t make any sense to Keynes either.

    All of this seems rather straightforward to me. The real mystery to me is why so many economists have invested so much of their time and energy over the years in trying to prove that Keynes was wrong in this regard. As I document in Where Did All The Money Go?, and summarize in http://rweconomics.com/LTLGAD.htm , the end result of all the magnificent, out of touch with reality mathematical model building that followed the publication of Keynes’s General Theory is the world-wide catastrophe we are in the midst of today brought on by economic policies that led to the crisis in 2008—policies that were justified by mainstream economic models and recommended by mainstream economists who totally ignored the insights of Keynes and Fisher. It seems quite clear to me that the primary cause of this crisis and the reason mainstream economists are unable to understand its cause or the nature of the catastrophe that followed is the fact that the profession has ignored those aspects of Keynes’s General Theory and Fisher’s Booms and Depressions that they were either unable or unwilling to incorporate into their mathematical models—the very aspects of Keynes’s General Theory and Fisher’s Booms and Depressions that contain the essence of their cause and effect insights as to how the economic system actually works in the real world.

  119. 121 Henry December 10, 2015 at 3:46 am

    George and JKH,

    Thanks very much for your respective detailed last posts. I found them very instructive.

    I think the p.188 quote from the GT by George explains a lot about why the way the GT is written. Keynes must have had in his mind an intricate conception of the workings of the macroeconomy – he could see in one view the vast array of interconnections between the various variables with their feedback loops and functional relationships within functional relationships. He could with easy facility focus on one area of his “model” and describe its functioning while holding steady the working of feedback loops and then letting the analysis flow on to the consideration of relaxed control of these feedback loops. In essence, every variable was at the behest of some expectational operator or function which would link it to a myriad of other variables. This is why the Hicks-Hansen IS/LM portrayal of the GT is grossly inadequate if not completely misleading.


  1. 1 Links for 10-23-15 | Economics Blogs Trackback on October 23, 2015 at 12:15 am
  2. 2 Thinking about Interest and Irving Fisher | Uneasy Money Trackback on November 13, 2015 at 11:03 am
  3. 3 Keynes on the Theory of the Rate of Interest | Uneasy Money Trackback on December 18, 2015 at 10:11 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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