Posts Tagged 'Keynes'



Keynes and Hawtrey: The General Theory

Before pausing for an interlude about the dueling reviews of Hayek and Hawtrey on each other’s works in the February 1932 issue of Economica, I had taken my discussion of the long personal and professional relationship between Hawtrey and Keynes through Hawtrey’s review of Keynes’s Treatise on Money. The review was originally written as a Treasury document for Hawtrey’s superiors at the Treasury (and eventually published in slightly revised form as chapter six of The Art of Central Banking), but Hawtrey sent it almost immediately to Keynes. Although Hawtrey subjected Keynes’s key analytical result in the Treatise — his fundamental equations, relating changes in the price level to the difference between savings and investment — to sharp criticism, Keynes responded to Hawtrey’s criticisms with (possibly uncharacteristic) good grace, writing back to Hawtrey: “it is very seldom indeed that an author can expect to get as a criticism anything so tremendously useful to himself,” adding that he was “working it out all over again.” What Keynes was working out all over again of course eventually evolved into his General Theory.

Probably because Keynes had benefited so much from Hawtrey’s comments on and criticisms of the Treatise, which he received only shortly before delivering the final draft to the publisher, Keynes began sending Hawtrey early drafts of the General Theory instead of waiting, as he had when writing the Treatise, till the book was almost done. There was thus a protracted period of debate and argument between Keynes and Hawtrey over the General Theory, a process that clearly frustrated and annoyed Keynes, though he never actually terminated the discussion with Hawtrey. “Hawtrey,” Keynes wrote to his wife in 1933, “was very sweet to the last but quite mad. One can argue with him a long time on a perfectly sane and interesting basis and then, suddenly, one is in a madhouse.” On the accuracy of that characterization, I cannot comment, but clearly the two Cambridge Apostles were failing to communicate.

The General Theory was published in February 1936, and hardly a month had passed before Hawtrey shared his thoughts about the General Theory with his Treasury colleagues. (Hawtrey subsequently published the review in his collection of essays Capital and Employment.) Hawtrey began by expressing his doubts about Keynes’s attempt to formulate an alternative theory of interest based on liquidity preference in place of the classical theory based on time preference and productivity.

According to [Keynes], the rate of interest is to be regarded not as the reward of abstaining from consumption or of “waiting”, but as the reward of forgoing liquidity. By tying up their savings in investments people forgo liquidity, and the extent to which they are willing to do so will depend on the rate of interest. Anyone’s “liquidity preference” is a function relating the amount of his resources which he will wish ot retain in the form of money to different sets of circumstances, and among those circumstances will be the rate of interest. . . . The supply of money determines the rate of interest, and the rate of interest so determined governs the volume of capital outlay.

As in his criticism of the fundamental equations of the Treatise, Hawtrey was again sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships.

[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment an saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary. [quoted by Alan Gaukroger “The Director of Financial Enquiries A Study of the Treasury Career of R. G. Hawtrey, 1919-1939.” pp. 507-08]

But despite the verbal difference between them, Keynes and Hawtrey held a common view that the rate of interest might be too high to allow full employment. Keynes argued that liquidity preference could prevent monetary policy from reducing the rate of interest to a level at which there would be enough private investment spending to generate full employment. Hawtrey held a similar view, except that, according to Hawtrey, the barrier to a sufficient reduction in the rate of interest to allow full employment was not liquidity preference, but a malfunctioning international monetary system under a gold-standard, or fixed-exchange rate, regime. For any country operating under a fixed-exchange-rate or balance-of-payments constraint, the interest rate has to be held at a level consistent with maintaining the gold-standard parity. But that interest rate depends on the interest rates that other countries are setting. Thus, a country may find itself in a situation in which the interest rate consistent with full employment is inconsistent with maintaining its gold-standard parity. Indeed all countries on a gold standard or a fixed exchange rate regime may have interest rates too high for full employment, but each one may feel that it can’t reduce its own interest rate without endangering its exchange-rate parity.

Under the gold standard in the 1920s and 1930s, Hawtrey argued, interest rates were chronically too high to allow full employment, and no country was willing to risk unilaterally reducing its own interest rates, lest it provoke a balance-of-payments crisis. After the 1929 crash, even though interest rates came down, they came down too slowly to stimulate a recovery, because no country would cut interest rates as much and as fast as necessary out of fear doing so would trigger a currency crisis. From 1925, when Britain rejoined the gold standard, to 1931 when Britain left the gold standard, Hawtrey never stopped arguing for lower interest rates, because he was convinced that credit expansion was the only way to increase output and employment. The Bank of England would lose gold, but Hawtrey argued that the point of a gold reserve was to use it when it was necessary. By emitting gold, the Bank of England would encourage other countries to ease their monetary policies and follow England in reducing their interest rates. That, at any rate, is what Hawtrey hoped would happen. Perhaps he was wrong in that hope; we will never know. But even if he was, the outcome would certainly not have been any worse than what resulted from the policy that Hawtrey opposed.

To the contemporary observer, the sense of déjà vu is palpable.

Advertisements

Hayek v. Hawtrey on the Trade Cycle

While searching for material on the close and multi-faceted relationship between Keynes and Hawtrey which I am now studying and writing about, I came across a remarkable juxtaposition of two reviews in the British economics journal Economica, published by the London School of Economics. Economica was, after the Economic Journal published at Cambridge (and edited for many years by Keynes), probably the most important economics journal published in Britain in the early 1930s. Having just arrived in Britain in 1931 to a spectacularly successful debut with his four lectures at LSE, which were soon published as Prices and Production, and having accepted the offer of a professorship at LSE, Hayek began an intense period of teaching and publishing, almost immediately becoming the chief rival of Keynes. The rivalry had been more or less officially inaugurated when Hayek published the first of his two-part review-essay of Keynes’s recently published Treatise on Money in the August 1931 issue of Economica, followed by Keynes’s ill-tempered reply and Hayek’s rejoinder in the November 1931 issue, with the second part of Hayek’s review appearing in the February 1932 issue.

But interestingly in the same February issue containing the second installment of Hayek’s lengthy review essay, Hayek also published a short (2 pages, 3 paragraphs) review of Hawtrey’s Trade Depression and the Way Out immediately following Hawtrey’s review of Hayek’s Prices and Production in the same issue. So not only was Hayek engaging in controversy with Keynes, he was arguing with Hawtrey as well. The points at issue were similar in the two exchanges, but there may well be more to learn from the lower-key, less polemical, exchange between Hayek and Hawtrey than from the overheated exchange between Hayek and Keynes.

So here is my summary (in reverse order) of the two reviews:

Hayek on Trade Depression and the Way Out.

Hayek, in his usual polite fashion, begins by praising Hawtrey’s theoretical eminence and skill as a clear expositor of his position. (“the rare clarity and painstaking precision of his theoretical exposition and his very exceptional knowledge of facts making anything that comes from his pen well worth reading.”) However, noting that Hawtrey’s book was aimed at a popular rather than a professional audience, Hayek accuses Hawtrey of oversimplification in attributing the depression to a lack of monetary stimulus.

Hayek proceeds in his second paragraph to explain what he means by oversimplification. Hayek agrees that the origin of the depression was monetary, but he disputes Hawtrey’s belief that the deflationary shocks were crucial.

[Hawtrey’s] insistence upon the relation between “consumers’ income” and “consumers’ outlay” as the only relevant factor prevents him from seeing the highly important effects of monetary causes upon the capitalistic structure of production and leads him along the paths of the “purchasing power theorists” who see the source of all evil in the insufficiency of demand for consumers goods. . . . Against all empirical evidence, he insists that “the first symptom of contracting demand is a decline in sales to the consumer or final purchaser.” In fact, of course, depression has always begun with a decline in demand, not for consumers’ goods but for capital goods, and the one marked phenomenon of the present depression was that the demand for consumers’ goods was very well maintained for a long while after the crisis occurred.

Hayek’s comment seems to me to misinterpret Hawtrey slightly. Hawtrey wrote “a decline in sales to the consumer or final purchaser,” which could refer to a decline in the sales of capital equipment as well as the sales of consumption goods, so Hawtrey’s assertion was not necessarily inconsistent with Hayek’s representation about the stability of consumption expenditure immediately following a cyclical downturn. It would also not be hard to modify Hawtrey’s statement slightly; in an accelerator model, with which Hawtrey was certainly familiar, investment depends on the growth of consumption expenditures, so that a leveling off of consumption, rather than an actual downturn in consumption, would suffice to trigger the downturn in investment which, according to Hayek, was a generally accepted stylized fact characterizing the cyclical downturn.

Hayek continues:

[W]hat Mr. Hawtrey, in common with many other English economists [I wonder whom Hayek could be thinking of], lacks is an adequate basic theory of the factors which affect [the] capitalistic structure of production.

Because of Hawtrey’s preoccupation with the movements of the overall price level, Hayek accuses Hawtrey of attributing the depression solely “to a process of deflation” for which the remedy is credit expansion by the central banks. [Sound familiar?]

[Hawtrey] seems to extend [blame for the depression] on the policy of the Bank of England even to the period before 1929, though according to his own criterion – the rise in the prices of the original factors of production [i.e., wages] – it is clear that, in that period, the trouble was too much credit expansion. “In 1929,” Mr. Hawtrey writes, “when productive activity was at its highest in the United States, wages were 120 percent higher than in 1913, while commodity prices were only 50 percent higher.” Even if we take into account the fact that the greater part of this rise in wages took place before 1921, it is clear that we had much more credit expansion before 1929 than would have been necessary to maintain the world-wage-level. It is not difficult to imagine what would have been the consequences if, during that period, the Bank of England had followed Mr. Hawtrey’s advice and had shown still less reluctance to let go. But perhaps, this would have exposed the dangers of such frankly inflationist advice quicker than will now be the case.

A remarkable passage indeed! To accuse Hawtrey of toleration of inflation, he insinuates that the 50% rise in wages from 1913 to 1929, was at least in part attributable to the inflationary policies Hawtrey was advocating. In fact, I believe that it is clear, though I don’t have easy access to the best data source C. H. Feinstein’s “Changes in Nominal Wages, the Cost of Living, and Real Wages in the United Kingdom over Two Centuries, 1780-1990,” in Labour’s Reward edited by P. Schoillers and V. Zamagni (1995). From 1922 to 1929 the overall trend of nominal wages in Britain was actually negative. Hayek’s reference to “frankly inflationist advice” was not just wrong, but wrong-headed.

Hawtrey on Prices and Production

Hawtrey spends the first two or three pages or so of his review giving a summary of Hayek’s theory, explaining the underlying connection between Hayek and the Bohm-Bawerkian theory of production as a process in time, with the length of time from beginning to end of the production process being a function of the rate of interest. Thus, reducing the rate of interest leads to a lengthening of the production process (average period of production). Credit expansion financed by bank lending is the key cyclical variable, lengthening the period of production, but only temporarily.

The lengthening of the period of production can only take place as long as inflation is increasing, but inflation cannot increase indefinitely. When inflation stops increasing, the period of production starts to contract. Hawtrey explains:

Some intermediate products (“non-specific”) can readily be transferred from one process to another, but others (“specific”) cannot. These latter will no longer be needed. Those who have been using them, and still more those who have producing them, will be thrown out of employment. And here is the “explanation of how it comes about at certain times that some of the existing resources cannot be used.” . . .

The originating cause of the disturbance would therefore be the artificially enhanced demand for producers’ goods arising when the creation of credit in favour of producers supplements the normal flow savings out of income. It is only because the latter cannot last for ever that the reaction which results in under-employment occurs.

But Hawtrey observes that only a small part of the annual capital outlay is applied to lengthening the period of production, capital outlay being devoted mostly to increasing output within the existing period of production, or to enhancing productivity through the addition of new plant and equipment embodying technical progress and new inventions. Thus, most capital spending, even when financed by credit creation, is not associated with any alteration in the period of production. Hawtrey would later introduce the terms capital widening and capital deepening to describe investments that do not affect the period of production and those that do affect it. Nor, in general, are capital-deepening investments the most likely to be adopted in response to a change in the rate of interest.

Similarly, If the rate of interest were to rise, making the most roundabout processes unprofitable, it does not follow that such processes will have to be scrapped.

A piece of equipment may have been installed, of which the yield, in terms of labour saved, is 4 percent on its cost. If the market rate of interest rises to 5 percent, it would no longer be profitable to install a similar piece. But that does not mean that, once installed, it will be left idle. The yield of 4 percent is better than nothing. . . .

When the scrapping of plant is hastened on account of the discovery of some technically improved process, there is a loss not only of interest but of the residue of depreciation allowance that would otherwise have accumulated during its life of usefulness. It is only when the new process promises a very suitable gain in efficiency that premature scrapping is worthwhile. A mere rise in the rate of interest could never have that effect.

But though a rise in the rate of interest is not likely to cause the scrapping of plant, it may prevent the installation of new plant of the kind affected. Those who produce such plant would be thrown out of employment, and it is this effect which is, I think, the main part of Dr. Hayek’s explanation of trade depressions.

But what is the possible magnitude of the effect? The transition from activity to depression is accompanied by a rise in the rate of interest. But the rise in the long-term rate is very slight, and moreover, once depression has set in, the long-term rate is usually lower than ever.

Changes are in any case perpetually occurring in the character of the plant and instrumental goods produced for use in industry. Such changes are apt to throw out of employment any highly specialized capital and labour engaged in the production of plant which becomes obsolete. But among the causes of obsolescence a rise in the rate of interest is certainly one of the least important and over short periods it may safely be said to be quite negligible.

Hawtrey goes on to question Hayek’s implicit assumption that the effects of the depression were an inevitable result of stopping the expansion of credit, an assumption that Hayek disavowed much later, but it was not unreasonable for Hawtrey to challenge Hayek on this point.

It is remarkable that Dr. Hayek does not entertain the possibility of a contraction of credit; he is content to deal with the cessation of further expansion. He maintains that at a time of depression a credit expansion cannot provide a remedy, because if the proportion between the demand for consumers’ goods and the demand for producers’ goods “is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed.” But if credit being contracted, the proportion is being distorted by an artificial restriction of demand.

The expansion of credit is assumed to start by chance, or at any rate no cause is suggested. It is maintained because the rise of prices offers temporary extra profits to entrepreneurs. A contraction of credit might equally well be assumed to start, and then to be maintained because the fall of prices inflicts temporary losses on entrepreneurs, and deters them from borrowing. Is not this to be corrected by credit expansion?

Dr. Hayek recognizes no cause of under-employment of the factors of production except a change in the structure of production, a “shortening of the period.” He does not consider the possibility that if, through a credit contraction or for any other reason, less money altogether is spent on intermediate products (capital goods), the factors of production engaged in producing these products will be under-employed.

Hawtrey then discusses the tension between Hayek’s recognition that the sense in which the quantity of money should be kept constant is the maintenance of a constant stream of money expenditure, so that in fact an ideal monetary policy would adjust the quantity of money to compensate for changes in velocity. Nevertheless, Hayek did not feel that it was within the capacity of monetary policy to adjust the quantity of money in such a way as to keep total monetary expenditure constant over the course of the business cycle.

Here are the concluding two paragraphs of Hawtrey’s review:

In conclusion, I feel bound to say that Dr. Hayek has spoiled an original piece of work which might have been an important contribution to monetary theory, by entangling his argument with the intolerably cumbersome theory of capital derived from Jevons and Bohm-Bawerk. This theory, when it was enunciated, was a noteworthy new departure in the metaphysics of political economy. But it is singularly ill-adapted for use in monetary theory, or indeed in any practical treatment of the capital market.

The result has been to make Dr. Hayek’s work so difficult and obscure that it is impossible to understand his little book of 112 pages except at the cost of many hours of hard work. And at the end we are left with the impression, not only that this is not a necessary consequence of the difficulty of the subject, but that he himself has been led by so ill-chosen a method of analysis to conclusions which he would hardly have accepted if given a more straightforward form of expression.

Keynes and Hawtrey: The Treatise on Money and Discovering the Multiplier

In my previous post on Keynes and Hawtrey, I tried to show the close resemblance between their upbringing and education and early careers. It becomes apparent that Keynes’s brilliance, and perhaps also his more distinguished family connections, had already enabled Keynes to begin overshadowing Hawtrey, four years his senior, as Keynes was approaching his thirties, and by 1919, when Hawtrey was turning 40, Keynes, having achieved something close to superstardom with the publication of The Econoomic Consequences of the Peace, had clearly eclipsed Hawtrey as a public figure, though as a pure monetary theoretician Hawtrey still had a claim to be the more influential of the two. For most of the 1920s, their relative standing did not change greatly, Hawtrey writing prolifically for economics journals as well as several volumes on monetary theory and a general treatise on economics, but without making much of an impression on broader public opinion, while Keynes, who continued to write primarily for a non-professional, though elite, audience, had the much higher public profile.

In the mid-1920s Keynes began writing his first systematic work on monetary theory and policy, the Treatise on Money. The extent to which Keynes communicated with Hawtrey about the Treatise in the five or six years during which he was working on it is unknown to me, but Keynes did send Hawtrey the proofs of the Treatise (totaling over 700 pages) in installments between April and July 1930. Hawtrey sent Keynes detailed comments, which Keynes later called “tremendously useful,” but, except for some minor points, Keynes could not incorporate most of the lengthy comments, criticisms or suggestions he received from Hawtrey before sending the final version of the Treatise to the publisher on September 14. Keynes did not mention Hawtrey in the preface to the Treatise, in which D. H. Robertson, R. F. Kahn, and H. D. Henderson were acknowledged for their assistance. Hawtrey would be mentioned along with Kahn, Joan Robinson, and Roy Harrod in the preface to the General Theory, but Hawtrey’s role in the preparation of the General Theory will be the subject of my next installment in this series. Hawtrey published his comments on the Treatise in his 1932 volume The Art of Central Banking.

Not long after the Treatise was published, and almost immediately subjected to critical reviews by Robertson and Hayek, among others, Keynes made it known that he was dissatisfied with the argument of the Treatise, and began work on what would eventually evolve into the General Theory. Hawtrey’s discussion was especially notable for two criticisms.  First Hawtrey explained that Keynes’s argument that an excess of investment over saving caused prices to rise was in fact a tautology entailed by Keynes’s definition of savings and investment.

[T]he fundamental equations disclose . . . that the price level is composed of two terms, one of which is cost per unit and the other is the difference between price and cost per unit.

Thus the difference between saving and investment is simply another name for the windfall gains or losses or for the difference between prices and costs of output. Throughout the Treatise Mr. Keynes adduces a divergence between saving and investment as the criterion of a departure from monetary equilibrium. But this criterion is nothing more or less than a divergence between prices and costs. Though the criterion ostensibly depends on two economic activities, “investment” and “saving,” it depends in reality not on them but on movements of the price level relative to costs.

That does not mean that the price level may not be influenced by changes in investment or in saving in some sense. But Mr. Keynes’s formula does not record such changes till their effect upon the price level is an accomplished fact. (p. 336)

Hawtrey’s other important criticism was his observation that Keynes assumed that a monetary disequilibrium would manifest itself exclusively in price changes and not at all in changes in output and employment. In fact this criticism followed naturally from Hawtrey’s criticism of Keynes’s definitions of savings and investment, from which the fundamental equations were derived, as not being grounded in the decisions of consumers and entrepreneurs.

With regard to savings, the individual consumers decide what they shall spend (or refrain from spending) on consumption. The balance of their earnings is “savings.” But the balance of their incomes (earnings plus windfall gains) is “investment.” Their decisions determine the amount of investment just as truly and in just the same way as they determine the amount of savings.

For all except entrepreneurs, earnings and income are the same. For entrepreneurs they differ if, and only if, there is a windfall gain or loss. But if there is a windfall gains, the recipients must decide what to do with it exactly as with any other receipt. If there is a windfall loss, the victims are deemed, according to Mr. Keynes’s definition of saving, to “save” the money they do not receive. But this is the result of the definition, not of any “decision.” (p. 345)

Preferring the more natural definition of savings as unconsumed income and of investment as capital outlay, Hawtrey proceeded to suggest an alternative analysis of an increase in saving by consumers. In the alternative analysis both output and prices could vary. It was Hawtrey therefore who provided the impetus for a switch to output and employment, not just prices, as equilibrating variable to a monetary disequilibrium.

It has been pointed out above that a difference between savings and investment [as defined by Keynes] cannot be regarded as the cause of a windfall loss or gain, for it is the windfall loss or gain. To find a causal sequence, we must turn to the decisions relating to consumption and capital outlay. When we do so, we find the windfall loss or gain to be one only among several consequences, and neither the earliest, nor necessarily the most important.

Throughout the Treatise Mr. Keynes refers to these decisions, and bases his argument upon them. And I think it is true to say that almost everywhere what he says may be interpreted as applying to the modified analysis which we have arrived at just as well as to that embodied in his fundamental equations. (p. 349)

To a large extent, Hawtrey’s criticisms of Keynes were criticisms of Keynes’s choice of definitions and the formal structure of his model rather than of the underlying theoretical intuition motivating Keynes’s theoretical apparatus. Hawtrey made this point in correcting Keynes’s misinterpretation of Hawtrey’s own position.

Mr. Keynes attributes to me (rather tentatively, it is true) acceptance of the view of “Bank rate as acting directly on the quantity of bank credit and so on prices in accordance with the Quantity Equation” (vol. 1., p. 188). But the passage which he quotes from my Currency and Credit contains no reference, explicit or implicit, to the quantity equation. Possibly I have misled him by using the expression “contraction of credit” for what I have sometimes called more accurately a “retardation of the creation of credit.”

The doctrine that I have consistently adhered to, that an acceleration or retardation of the creation of credit acts through changes in consumers’ income and outlay on the price level and on productive activity, and not through changes in the unspent margin [Hawtrey’s term of holdings of cash], is, I think, very close to Mr. Keynees’s theory. (p. 363)

In drawing attention to his belief “that an acceleration or retardation of the creation of credit acts through changes in consumers’ income and outlay . . . not through changes in the unspent margin,” Hawtrey emphasized that his monetary theory was not strictly speaking a quantity-theoretic monetary theory, as Keynes had erroneously suggested. Rather, he shared with Keynes the belief that there is a tendency for changes in expenditure and income to be cumulative. It was Hawtrey’s belief that the most reliable method by which such changes in income and expenditure could be realized was by way of changes in the short-term interest rate, which normally cause businesses and traders to alter their desired stocks of unfinished goods, working capital and inventories. Those changes, in turn, lead to increases in output and income and consumer outlay, which trigger further increases, and so on. In short, as early as 1913, Hawtrey had already sketched out in Good and Bad Trade the essential concept of a multiplier process initiated by changes in short-term interest rates, by way of their effect on desired stocks of working capital and inventories.

Thus, it is a complete misunderstanding of Hawtrey to suggest that, in the words of Peter Clarke (The Keynesian Revolution in the Making  pp. 242-43) that he was “the man who, having stumbled upon [the multiplier], painstakingly suppressed news of its discovery in his subsequent publications.” The multiplier analysis was not stumbled upon, nor was it suppressed. Rather, Hawtrey simply held that, under normal conditions, unless supported by credit expansion (i.e., a lower bank rate), increased government spending would be offset by reduced spending elsewhere producing no net increase in spending and therefore no multiplier effect. In fact, Hawtrey in 1931 in his Trade Depression and the Way Out (or perhaps only in the second 1933 edition of that book) conceded that under conditions of what he called a “credit deadlock” in which businesses could not be induced to borrow to increase spending, monetary policy would not be effective unless it was used to directly finance government spending. In Keynesian terminology, the situation was described as a liquidity trap, and we no refer to it as the zero lower bound. But the formal analysis of the multiplier was a staple of Hawtrey’s cycle theory from the very beginning. It was just kept in the background, not highlighted as in the Keynesian analysis. But it was perfectly natural for Hawtrey to have explained how Keynes could use it in his commentary on the Treatise.

UPDATE (03/12/13): In reading the excellent doctoral thesis of Alan Gaukroger about Hawtrey’s career at the British Treasury (to view and download the thesis click here) to which I refer in my reply to Luis Arroyo’s comment, I realized that Hawtrey did not introduce the terms “consumers’ income” and “consumers’ outlay” in Good and Bad Trade as I asserted in the post.  Those terms were only introduced six years later in Currency and Credit. I will have to reread the relevant passages more carefully to determine to what extent the introduction of the new terms in Currency and Credit represented an actual change in Hawtrey’s conceptual framework as opposed to the introduction of a new term for an a concept that he had previously worked out.

That Oh So Elusive Natural Rate of Interest

Last week, I did a short post linking to the new draft of my paper with Paul Zimmerman about the Sraffa-Hayek exchange on the natural rate of interest. In the paper, we attempt to assess Sraffa’s criticism in his 1932 review of Prices and Production of Hayek’s use of the idea of a natural rate of interest as well as Hayek’s response, or, perhaps, his lack of response, to Sraffa’s criticism. The issues raised by Sraffa are devilishly tricky, especially because he introduced the unfamiliar terminology of own-rates of interest, later adopted Keynes in chapter 17 of the General Theory in order to express his criticism. The consensus about this debate is that Sraffa got the best of Hayek in this exchange – the natural rate of interest was just one of the issues Sraffa raised, and, in the process, he took Hayek down a peg or two after the startling success that Hayek enjoyed upon his arrival in England, and publication of Prices and Production. In a comment to my post, Greg Ransom questions this conventional version of the exchange, but that’s my story and I’m sticking to it.

What Paul and I do in the paper is to try to understand Sraffa’s criticism of Hayek. It seems to us that the stridency of Sraffa’s attack on Hayek suggests that Sraffa was arguing that Hayek’s conception of a natural rate of interest was somehow incoherent in a barter economy in which there is growth and investment and, thus, changes in relative prices over time, implying that commodity own rates of interest would have differ. If, in a barter economy with growth and savings and investment, there are many own-rates, Sraffa seemed to be saying, it is impossible to identify any one of them as the natural rate of interest. In a later account of the exchange between Sraffa and Hayek, Ludwig Lachmann, a pupil of Hayek, pointed out that, even if there are many own rates in a barter economy, the own rates must, in an intertemporal equilibrium, stand in a unique relationship to each other: the expected net return from holding any asset cannot differ from the expected net return on holding any other asset. That is a condition of equilibrium. If so, it is possible, at least conceptually, to infer a unique real interest rate. That unique real interest rate could be identified with Hayek’s natural rate of interest.

In fact, as we point out in our paper, Irving Fisher in his classic Appreciation and Interest (1896) had demonstrated precisely this point, theoretically extracting the real rate from the different nominal rates of interest corresponding to loans contracted in terms of different assets with different expected rates of price appreciation. Thus, Sraffa did not demonstrate that there was no natural rate of interest. There is a unique real rate of interest in intertemporal equilibrium which corresponds to the Hayekian natural rate. However, what Sraffa could have demonstrated — though had he done so, he would still have been 35 years behind Irving Fisher – is that the unique real rate is consistent with an infinite number of nominal rates provided that those nominal rates reflected corresponding anticipated rate of price appreciation. But, instead, Sraffa argued that there is no unique real rate in intertemporal equilibrium. That was a mistake.

Another interesting (at least to us) point in our paper is that Keynes who, as editor of the Economic Journal, asked Sraffa to review Prices and Production, borrowed Sraffa’s own-rate terminology in chapter 17 of the General Theory, but, instead of following Sraffa’s analysis and arguing that there is no natural rate of interest, Keynes proceeded to derive, using (without acknowledgment) a generalized version of Fisher’s argument of 1896, a unique relationship between commodity own rates, adjusted for expected price changes, and net service yields, such that the expected net returns on all assets would be equalized. From this, Keynes did not conclude, as had Sraffa, that there is no natural rate of interest. Rather, he made a very different argument: that the natural rate of interest is a useless concept, because there are many natural rates each corresponding to a different the level of income and employment, a consideration that Hayek, and presumably Fisher, had avoided by assuming full intertemporal equilibrium. But Keynes never disputed that for any given level of income and employment, there would be a unique real rate to which all commodity own rates had to correspond. Thus, Keynes turned Sraffa’s analysis on its head. And the final point of interest is that even though Keynes, in chapter 17, presented essentially the same analysis of own rates, though in more general terms, that Fisher had presented 40 years earlier, Keynes in chapter 13 explicitly rejected Fisher’s distinction between the real and nominal rates of interest. Go figure.

Bob Murphy wrote a nice paper on the Sraffa-Hayek debate, which I have referred to before on this blog. However, I disagree with him that Sraffa’s criticism of Hayek was correct. In a post earlier this week, he infers, from our statement that, as long as price expectations are correct, any nominal rate is consistent with the unique real natural rate, that we must agree with him that Sraffa was right and Hayek was wrong about the natural rate. I think that Bob is in error on the pure theory here. There is a unique real natural rate in intertemporal equilibrium, and, in principle, the monetary authority could set a money rate equal to that real rate, provided that that nominal rate was consistent with the price expectations held by the public. However, intertemporal equilibrium could be achieved by any nominal interest rate selected by the monetary authority, again provided that the nominal rate chosen was consistent with the price expectations held by the public. In practice, either formulation is very damaging to Hayek’s policy criterion of setting the nominal interest rate equal to the real natural rate. But contrary to Sraffa’s charge, the policy criterion is not incoherent. It is just unworkable, as Hayek formulated it, and, on Hayek’s own theory, the criterion is unnecessary to avoid distorting malinvestments.

My Paper (co-authored with Paul Zimmerman) on Hayek and Sraffa

I have just uploaded to the SSRN website a new draft of the paper (co-authored with Paul Zimmerman) on Hayek and Sraffa and the natural rate of interest, presented last June at the History of Economics Society conference at Brock University. The paper evolved from an early post on this blog in September 2011. I also wrote about the Hayek-Sraffa controversy in a post in June 2012 just after the HES conference.

One interesting wrinkle that occurred to me just as I was making revisions in the paper this week is that Keynes’s treatment of own rates in chapter 17 of the General Theory, which was in an important sense inspired by Sraffa, but, in my view, came to a very different conclusion from Sraffa’s, was actually nothing more than a generalization of Irving Fisher’s analysis of the real and nominal rates of interest, first presented in Fisher’s 1896 book Appreciation and Interest. In his Tract on Monetary Reform, Keynes extended Fisher’s analysis into his theory of covered interest rate arbitrage. What is really surprising is that, despite his reliance on Fisher’s analysis in the Tract and also in the Treatise on Money, Keynes sharply criticized Fisher’s analysis of the nominal and real rates of interest in chapter 13 of the General Theory. (I discussed that difficult passage in the General Theory in this post).  That is certainly surprising. But what is astonishing to me is that, after trashing Fisher in chapter 13 of the GT, Keynes goes back to Fisher in chapter 17, giving a generalized restatement of Fisher’s analysis in his discussion of own rates. Am I the first person to have noticed Keynes’s schizophrenic treatment of Fisher in the General Theory?

PS: My revered teacher, the great Armen Alchian passed away yesterday at the age of 98. There have been many tributes to him, such as this one by David Henderson, also a student of Alchian’s, in the Wall Street Journal. I have written about Alchian in the past (here, here, here, here, and here), and I hope to write about Alchian again in the near future. There was none like him; he will be missed terribly.

Why Are Real Interest Rates So Low, and Will They Ever Bounce Back?

In his recent post commenting on the op-ed piece in the Wall Street Journal by Michael Woodford and Frederic Mishkin on nominal GDP level targeting (hereinafter NGDPLT), Scott Sumner made the following observation.

I would add that Woodford’s preferred interest rate policy instrument is also obsolete.  In the next recession, and probably the one after that, interest rates will again fall to zero.  Indeed the only real suspense is whether they’ll be able to rise significantly above zero before the next recession hits.  In the US in 1937, Japan in 2001, and the eurozone in 2011, rates had barely nudged above zero before the next recession hit. Ryan Avent has an excellent post discussing this issue.

Perhaps I am misinterpreting him, but Scott seems to think that the decline in real interest rates reflects some fundamental change in the economy since approximately the start of the 21st century. Current low real rates, below zero on US Treasuries well up the yield curve. The real rate is unobservable, but it is related to (but not identical with) the yield on TIPS which are now negative up to 10-year maturities. The fall in real rates partly reflects the cyclical tendency for the expected rate of return on new investment to fall in recessions, but real interest rates were falling even before the downturn started in 2007.

In this post, at any rate, Scott doesn’t explain why the real rate of return on investment is falling. In the General Theory, Keynes speculated about the possibility that after the great industrialization of the 19th and early 20th centuries, new opportunities for investment were becoming exhausted. Alvin Hansen, an early American convert to Keynesianism, developed this idea into what he called the secular-stagnation hypothesis, a hypothesis suggesting that, after World War II, even with very low interest rates, the US economy was likely to relapse into depression. The postwar boom seemed to disprove Hansen’s idea, which became a kind of historical curiosity, if not an embarrassment. I wonder if Scott thinks that Keynes and Hansen were just about a half-century ahead of their time, or does he have some other reason in mind for why he thinks that real interest rates are destined to be very low?

One possibility, which, in a sense, is the optimistic take on our current predicament, is that low real interest rates are the result of bad monetary policy, the obstacle to an economic expansion that, in the usual course of events, would raise real interest rates back to more “normal” levels. There are two problems with this interpretation. First, the decline in real interest rates began in the last decade well before the 2007-09 downturn. Second, why does Scott, evidently accepting Ryan Avent’s pessimistic assessment of the life-expectancy of the current recovery notwithstanding rapidly increasing support for NGDPLT, anticipate a relapse into recession before the recovery raises real interest rates above their current near-zero levels? Whatever the explanation, I look forward to hearing more from Scott about all this.

But in the meantime, here are some thoughts of my own about our low real interest rates.

First, it can’t be emphasized too strongly that low real interest rates are not caused by Fed “intervention” in the market. The Fed can buy up all the Treasuries it wants to, but doing so could not force down interest rates if those low interest rates were inconsistent with expected rates of return on investment and the marginal rate of time preference of households. Despite low real interest rates, consumers are not rushing to borrow money at low rates to increase present consumption, nor are businesses rushing to take advantage of low real interest rates to undertake shiny new investment projects. Current low interest rates are a reflection of the expectations of the public about their opportunities for trade-offs between current and future consumption and between current and future production and their expectations about future price levels and interest rates. It is not the Fed that is punishing savers, as the editorial page of the Wall Street Journal constantly alleges. Rather, it is the distilled wisdom of market participants that is determining how much any individual should be rewarded for the act of abstaining from current consumption. Unfortunately, there is so little demand for resources to be used to increase future output, the act of abstaining from current consumption contributes essentially nothing, at the margin, to the increase of future output, which is why the market is now offering next to no reward for a marginal abstention from current consumption.

Second, interest rates reflect the expectations of businesses and investors about the profitability of investing in new capital, and the expectations of households about their future incomes (largely dependent on expectations about future employment). These expectations – about profitability and about future incomes — are distinct, but they are clearly interdependent. If businesses are optimistic about the profitability of future investment, households are likely to be optimistic about future incomes. If households are pessimistic about future incomes, businesses are unlikely to expect investments in new capital to be profitable. If real interest rates are stuck at zero, it suggests that businesses and households are stuck in a mutually reinforcing cycle of pessimistic expectations — households about future income and employment and businesses about the profitability of investing in new capital. Expectations, as I have said before, are fundamental. Low interest rates and secular stagnation need not be the result of an inevitable drying up of investment opportunities; they may be the result of a vicious cycle of mutually reinforcing pessimism by households and businesses.

The simple Keynesian model — at least the Keynesian-cross version of intro textbooks or even the IS-LM version of intermediate textbooks – generally holds expectations constant. But in fact, it is through the adjustment of expectations that full-employment equilibrium is reached. For fiscal or monetary policy to work, they must alter expectations. Conventional calculations of spending or tax multipliers, which implicitly hold expectations constant, miss the point, which is to alter expectations.

Similarly, as I have tried to suggest in my previous two posts, what Friedman called the natural rate of unemployment may itself depend on expectations. A change in monetary policy may alter expectations in a manner that reduces the natural rate. A straightforward application of the natural-rate model leads some to dismiss a reduction in unemployment associated with a small increase in the rate of inflation as inefficient, because the increase in employment results from workers being misled into accepting jobs that will turn out to pay workers a lower real wage than they had expected. But even if that is so, the increase in employment may still be welfare-increasing, because the employment of each worker improves the chances that another worker will become employed. The social benefit of employment may be greater than the private benefit. In that case, the apparent anomaly (from the standpoint of the natural-rate hypothesis) that measurements of social well-being seem to be greatest when employment is maximized actually make perfectly good sense.

In an upcoming post, I hope to explore some other possible explanations for low real interest rates.

Understanding the Balanced-Budget Multiplier Theorem

Scott Sumner recently linked to David Henderson who cited the following comment by Professor T. Norman Van Cott of Ball State University to an op-ed by Alan Meltzer trashing Keynesian economics.

Particularly egregious is something labeled “the balanced budget multiplier.” To wit, an equal increase in government expenditures and taxes leads to an increase in national output equal to the additional government expenditures and taxes. Mr. Samuelson, et al., gives the notion a scientific aura by packaging it in equations and graphs.
Economic surrealism? You bet. Note that national output and taxes rising by the same amount means producers’ after-tax incomes are unchanged. How or why would producers produce more for no increase in after-tax income? Hint: They won’t. Never mind the smoke screen of graphs and equations.

I posted the following comment on Henderson’s blog, but my comment came three days after the previous comment so no one seemed to notice.  So I thought I would post it here to see what people think.

David, Just saw a link to your question on Scott Sumner’s blog. I think that the simple answer is that the balanced-budget multiplier presumes that there is involuntary unemployment. The additional output is produced by the employment of those previously unemployed; those previously employed experience a reduction in their real wage. I am not necessarily endorsing the analysis, but I think that is logic behind it.

A further elaboration is that under Keynes’s definition of involuntary unemployment, the way in which you re-employ the involuntarily unemployed is by raising the price of output while holding the wage constant.  So, under Keynes’s (economic) logic you need inflation to get the involuntarily unemployed reemployed.  That logic somehow gets lost in “the smoke screen of graphs and equations.”


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.

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 2,343 other followers

Follow Uneasy Money on WordPress.com
Advertisements