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.