Software, value and competition

Another day, another half-baked over-long comment. In this case it’s a comment at Le Colonel Chabert about software and the implications for Marx’s theory of value. I’m posting this here because 1) commenting elsewhere at length uses up my blogging time for the day; and 2) it kind of relates to my post yesterday on value – I want to keep these together because otherwise they’re scattered all over the place. Keynes returns soon, I promise!

Competition is a crucial element in Marx’s theory of value and price of production. Where the forces of competition are suspended (or, rather, transformed since there is always some possibility of competition) there will be exceptions to the general law of value. Land rent is the classic case.

We need to be clear about ‘competition’, though, because Marx’s use is different from (and superior to) the neoclassical sense of competition (‘perfect’ or ‘imperfect’) many are more familiar with. For the neoclassicals it is solely competition between sellers in the commodity market. For Marx it crucially also includes the ability of capital to move between different branches of production. Also, for Marx there is no need for ‘perfect’ mobility of capital or a large number of competitors in the commodity market. The mere potential for new entrants into the industry is enough to discipline production processes. Even a monopolist in an industry is disciplined by the need to chase the average rate of return on capital or it will find it harder to obtain funds on the capital market. The law of value assumes a tendency towards the equalisation of profit rates. Firms with long-run higher-than-average profit rates are a good indicator that the normal disciplines of competition have been evaded to some extent – though in capitalist history higher-than-average profit rates have inevitably been eventually eroded.

The question to ask about software is, then, what are the unusual features of competition in this industry, and what is normal? First, in the commodity market: Intellectual property laws protect specific articles of software. But they do not protect them from close substitutes. There are use-value specific things about software that in combination with IP laws give more protection – the famous ‘lock-in’ and network effects, for example, that have made Windows so dominant in the operating system market. There is little doubt that Microsoft has benefited for a long time from these effects, accordingly winning very high rates of return on capital. But it has not been immune from competition – from Apple, from Linux.

The second thing about the software market is the extremely low marginal cost: that is, it costs next to nothing to produce additional items, though the initial outlay (design and programming) is expensive. This makes software firms extremely vulnerable from new entrants and piracy. The latter explains intellectual property law – without it capitalism is unable to allocate labour and capital properly to do the initial outlay. (Exceptions – state subsidy a la university research; cross subsidisation from advertising revenue a la the media; or cross-subsidisation from service/support/consulting work, which has been the strategy of many open-source oriented firms, including large ones like IBM.) Piracy is not the only threat here, though – there is also the risk of perfectly legal competition from a close substitute with an alternative lower-cost business model. Netscape vs IE is the classic case, also witness the tantrums Microsoft was throwing about open source not so long ago.

The third thing is that these firms are subject to competition on the capital markets just like any other capitalist firm. If the rate-of-return is high, capital will drift into the industry in some way and get in the incumbents’ faces (unless there is a true barrier to entry, in which case capital may flow to the incumbents). If it is low, capital will flow out: the incumbents will face higher costs to borrow and issue equity.

So to sum up, software firms are subject to fairly intense competition. To some extent it has followed the pattern of many previous new industries before their maturity, and as with them we would expect some time to pass before competitive conditions (including labour processes) settle down. But the low marginal cost issue (i.e. the ease of duplicating the product) will always haunt it and I expect make competition quite chaotic and unpredictable. It is interesting in that the high initial costs are skilled labour costs rather than fixed capital costs as in airlines (which also have high initial costs and low marginal costs and are therefore prone to debilitating bouts of price warfare). But this underscores the point that it is labour at the bottom of it all, and what makes it seem so weird is the disjuncture between the labour-time necessary to do the initial creative work (lots) and the labour-time necessary to reproduce the product (very little).

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Marx’s theory of value, ‘the transformation’ and skilled labour

I haven’t noticed anyone avidly waiting for each Keynes post – but just in case, there has been a delay, a result of having too much other work to do. I’ll continue through the book but at a slower pace for the remaining few chapters.

The following is a comment I posted at Rough Theory – go there for context. As a comment, it is itself very rough, typed in a hurry on account of the above-mentioned too much other work. I wanted to post it here because I’d appreciate feedback on my interpretation of Capital and have not yet got around to posting the second part of my talk on Marx from earlier in the year, where I mentioned some of this stuff.

In the first chapter, Marx is trying to establish the form of value, against those who argued it was only determined by exchange. In early vol 1 (I’m a little hazy on which chapters exactly) Marx shows that we can speak of value as something seemingly inherent in the commodity only because of the social structure of production and exchange. The need to sell in competition with other producers rationalises the labour process but there is some minimum labour time necessary to produce a particular kind of commodity, and this will determine its value relative to other commodities, including money.

This was a simplification of what actually determines relative prices. Marx talks in vol 1 (and vol 2 for that matter) as if value is relative price. But he was well aware that commodities did not in fact exchange at rates determined entirely by the labour time required to produce them. (There is some dispute as to whether he thought that in reality labour-time gave a rough guide to relative prices, or whether there would be wide divergences.) He was well aware of this while writing vol 1, Engels urged him to clear this up at the beginning, but Marx deliberately left it to vol 3. (Though of course the later vols were never completed for publication, we only have drafts predating the final version of vol 1.)

I think the reason he left it out in vol 1 was that he first wanted to establish the social dimension of value – that it is determined by competition enforcing certain efficient production processes in a given historical context where one class monopolises ownership of the means of production. This is fundamental to Marx’s whole work and he needs to establish that before anything else. But he starts out simple because it would confuse people to introduce everything at once. The real nature of how relative price is determined cannot be explained until competition is investigated (vol 3), which first requires a comprehensive investigation of ‘capital’ (vol 1, 2 and 3), which in turn requires a rough concept of value.

When Marx finally deals with the detailed workings of competition, it modifies the simplistic vol 1 explanation of how the relative prices of commodities are determined. Marx continues to use the term ‘value’ in the original sense related to labour-time. He adds a new term, ‘price-of-production’, for actual relative prices, still denominated in value as measuring unit (rather than being observable money-prices). But in fact price-of-production is what most people think of as value, so it can be confusing.

Value then becomes a macroeconomic unit of labour-time, only relevant in talking about commodity relations as a whole. It is still useful in considering vol 1 concepts like surplus value, but only macroeconomically – i.e., it tells you the shares of the total product going to labour and capital, but not at the level of individual or firm. Price-of-production is the microeconomic concept for discussing relative prices – and for discussing concepts like the circuit of capital at the level of the firm.

The transformation problem (of labour-values into prices-of-production) is not a real issue. Except that Marx stuffed up the arithmetic – easily fixed. I think the Sraffians are right that prices-of-production can be determined for empirical work without reference to labour-time values. But the Sraffians then leave indeterminate the rate of profit and the distribution of the social product, although these are key determinants of relative prices. And good old concepts like ‘value’ and ‘surplus-value’, ‘labour-time’ and ‘the value of labour-power’ are useful for investigating the determinants of distribution. At a macro level, of course.

The trouble with this interpretation is how to treat skilled labour. Marx only treated skilled labour in value terms, and did not return to it later. In fact, it is treated very early in the piece indeed; as Isaak Rubin writes: “In the theory of value, when he explains the value of commodities produced by qualified labour, Marx analyses the relations among people as commodity producers, or the simple commodity economy; at this stage of the examination, the value of labour-power in general, and of qualified labour in particular, do not yet exist for Marx.” [Ch 15 of Essays on Marx’s Theory of Value]

But skilled labour can create commodities of higher price-of-production than those created by unskilled labour independently of the price-of-production of capital involved. How do we investigate this, and how do we deal with the resulting unequal distribution among the working class?

I think Rubin is on the right track in dealing with it as competition in the labour market (and the commodity market) – between workers; between labour and capital; and between capitals. This is consistent with the vol 3 discussion of competition, and it is realistic. But it must be admitted that we are now some distance from a ‘labour theory of value’ as is commonly understood. But then I don’t think Marx held a labour theory of value in that sense anyway.

15: The Psychological and Business Incentives to Liquidity

In this chapter Keynes elaborates on the discussion of liquidity preference in Chapter 13. He starts with a brief consideration of how liquidity preference is related to the ‘income-velocity of money’. Liquidity preference, as we have seen, is about how much money units want to hold. Income-velocity is about how fast money travels around the economy on average during a period. Velocity is usually measured in terms of income (thus income-velocity): velocity equals income (in nominal terms, i.e. at current prices) divided by the quantity of money.

Liquidity preference is the inverse of income-velocity. Velocity is about how fast the average bit of money travels around the economy in a period; liquidity preference is about how much money is held idle in a period. Both concepts contain the same information; it’s really a question of which metaphor helps the intuition. Keynes prefers liquidity preference: “… the term ‘income-velocity of money’ carries with it the misleading suggestion of a presumption in favour of the demand for money as a whole being proportional, or having some determinate relation, to income, whereas this presumption should apply, as we shall see, only to a portion of the public’s cash holdings; with the result that it overlooks the part played by the rate of interest.” [p. 194]

Those parts of money held by units for other purposes than transactions will still show up in the velocity statistic – a rise in idle balances means a lower velocity of money as a whole. Keynes is right that the idea of velocity can be misleading. But so can the concept of ‘idle balances’ at the level of the economy as a whole, since we tend to use as money and near-money the liabilities of financial institutions, who are certainly not holding our funds idle. But since Keynes is discussing individual units’ decisions to hold money, it is better to look at it from the point of view of liquidity preference and idle balances, since individuals and firms decide how much liquidity to hold (though from inflows not of their own choosing!), and don’t have much control over the ‘velocity’ of those funds they send shooting off into the market.

Recall from Chapter 13 that Keynes split the motives for holding money into three categories: the transactions-motive, the precautionary-motive, and the speculative-motive. Now he splits the transactions-motive further, into the income-motive and the business-motive. This is basically a distinction between the transactions-motive for households and the transactions-motive for firms. Both depend on income and the normal periods between which money flows in and out of the units’ holdings. These periods are likely to be quite different for firms and households: though for the economy as a whole, business net expenditure is household net income (government excluded), there are a whole lot of transactions between businesses, which need to be included when you are thinking about the flow of money.

These two aspects of the transactions-motive and also the precautionary motive are clearly related to the interest rate, both as a gauge of how cheap money can be borrowed and how much is sacrificed in not lending it. These things work in opposite directions: a low interest rate means money is cheap to borrow when needed, so you don’t need to hold so much of it, but also means that not much is gained from not holding it.

So Keynes plays down the effect of monetary policy on the demand for money for these motives. Money demand for transactions and precautionary purposes mainly depends on the level of income and the structure of the payments system, and not so much on the interest rate. So the main impact of policy is through the speculative-motive. Effectively, the quantity of money demanded for other purposes can be subtracted from the total money supply, leaving the equilibrium interest rate to be determined by the rest of the money supply and the speculative-demand for money. Fortunately for money policy, the speculative-demand is continuously responsive to changes in the interest rate – there is a clear negative relationship between the interest rate and the speculative demand for money.

However, changes in the money supply by monetary authorities is not the only influence on the interest rate, because speculative expectations can change independently. In fact, changes in the money supply will affect interest rates not only directly, but also by affecting expectations of future rate changes.

When new money enters the economy, the effect on income and interest rates depends at first on how it enters. (No helicopters randomly scattering cash over the country here.) If it enters via the government’s deficit spending, it arrives as income. It will therefore have an affect on transactions and precautionary balances (which depend on income) as well as speculative balances. More money will be held to meet the needs of transactions and precautions, but not as much as the whole injection of money. Some of the injection will therefore find its way into the securities market, putting downward pressure on the interest rate – with the extent of the pressure dependent on the speculative demand for money. However, as the interest rate falls, investment will be stimulated to some extent, which will increase income further, and raise the transactions and precautionary demands for money again. There will be some equilibrium position where all demands will find balance with the money supply, and the end result of the whole business will probably be higher income and a lower interest rate.

If new money enters the economy without being part of somebody’s income, it will have its initial effect on the interest rate, but still increase income to some extent as the lower rate induces investment. How is it possible for money to enter the economy without being someone’s income? Through a financial transaction where a financial asset is purchased from outside the system. Keynes gives the example of a bank relaxing its credit standards and buying bonds with a self-created deposit. (Does this not complicate the story with regard to Keynes’ general assumption that the government controls the money supply?) But it might be easier to think about in terms of open market operations by the central bank: the central bank buys bonds, thus injecting money into the economy but into wealth portfolios rather than income.

At any rate, any increase in the money supply lowers interest rates (all else being equal), and a new equilibrium is reached partly by inducing greater holdings of money for speculative purposes, and partly by raising incomes and thereby increasing the need for money for transactions and precautionary purposes. Keynes is not entirely clear whether it makes a difference to the final equilibrium income and interest rate outcome if the money enters the system via income or not.

Keynes then gives his own definition of the income-velocity of money. For him it is related only to that part of the money supply which is held for transactions and precautionary purposes. This is clearly not a statistically functional definition, since there is no way to separate these balances from speculative balances. But, for what it’s worth, Keynes argues that income-velocity is constant, at least in the short-run, and the interest rate has no direct effect on it.

So (again) the equilibrium point between the rest of the money supply and the interest rate depends on the speculative demand for money. There is no constant relationship where a given rate is always in equilibrium with a given amount of money. That’s because “what matters is not the absolute level of [the interest rate] but the degree of its divergence from what is considered a fairly safe level of [the interest rate], having regard to those calculations of probability which are being relied upon.” [p. 201] As we saw in Chapter 13, the speculative demand for money depends on diverse assessments of where interest rates are going to go next, or at least in the medium term. But generally, a fall in the interest rate will be associated with an increase in the speculative demand for money, as more speculators will expect a rise in the future. (The considerations are actually a little more complex than this, also involving what is sacrificed in forgoing interest while wealth is held as money.)

Unless, that is, the fall in rates is associated with a fall in the general expectation of the ‘normal’ rate. Because in that case not so many speculators will expect a rise.

It is evident, then, that the rate of interest is a highly psychological phenomenon. We shall find, indeed, in Book V. that it cannot be in equilibrium at a level belowthe rate which corresponds to full employment; because at such a level a state of true inflation will be produced, with the result that [the transactions and precautionary demand for money] will absorb ever-increasing quantities of cash. But at a level above the rate which corresponds to full employment, the long-term market-rate of interest will depend, not only on the current policy of the monetary authority, but also on market expectations concerning its future policy. [p. 202]

The first part of that is very interesting, confirming again that Keynes converges with the classicals if full employment is assumed. The difference is that the classicals assume full employment.

Keynes now discusses the spread of interest rates rather than treated them as a homogeneous rate. Monetary authorities have much more influence over short-term rates than long-term rates precisely because they are expected to not aim at the same rate forever. Thus speculators can be reasonably sure that policymakers will maintain the rate in the short term. But because conditions will change over a longer horizon, policymakers are likely to change rates at some point, and this likelihood means they have less control over long-term rates in the present. This is especially so if speculators see the rate aimed at by policy as unsustainable, say, because it is lower that that prevailing overseas.

Of course, it is long-term rates that are more important in their effect on investment. So this is interesting – Keynes is implying that monetary authorities do not have the power to set rates as they please. If a broad spectrum of speculators thinks interest rates are going to rise in the long run, demand for money will rise to a high point “almost without limit” so absorbing whatever quantity of money authorities inject into the system in their attempt to lower rates. [p. 203]

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. [p. 203]

There is no reason why that conventional rate should be the rate consistent with full employment, even in the long run – “… particularly if it is the prevailing opinion that the rate of interest is self-adjusting, so that the level established by convention is thought to be rooted in objective grounds much stronger than convention, the failure of employment to attain an optimum level being in no way associated, in the minds either of the public or of authority, with the prevalence of an inappropriate rate of interest.” [p. 204]

This means that keeping effective demand at full-employment level is very difficult, especially since the marginal efficiency of capital is also unstable. But Keynes is optimistic that because the rate is malleable, so too can be long-run expectations about the rate, and so authorities might be able to cajole speculators step by step to a more appropriate rate if they are persistent enough.

Who benefits from the doubt?

Sydneysiders: there will be a rally this Thursday, 25 October, 5.30pm at the New Zealand consulate, 55 Hunter St, against the continued detention of those arrested in terrorism raids last week. 

The first ray of light today: Rongomai Bailey is out on bail.

Everyone else could be in for quite a while before anything comes to trial. This is why I find it so hard to just wait until the evidence plays out in court.

If you read nothing else about the case right now, read this excellent piece by Wellington journalist Alistair Thompson. It’s long, but straightforward. It summarises the facts as are allowed to be revealed to the public.

Best of all it expresses so well something that makes this case so surreal, quoting Matt McCarten: “The only problem is that New Zealand is such a small country, everybody knows everybody else.”

The evidence is entirely suppressed, so few facts can be reported in the media except the existing charges (“collective possession of an illegal weapon”) and that the police are considering applying to the government to lay terrorism charges.

Then there are the rumours, anonymous interviews, unnamed sources.

Then there are the people connected to the case at one remove – to police or to the accused – each assuring the public that if they could see the evidence which was being suppressed, they would have no doubt as to guilt or innocence.

Then you have long-time lefties saying they trust the police on this, and old-school police hardmen saying the cops have fucked up big time.

It is understandable that a lot of people’s judgement is to wait and see. Even people who are not naive about the police and are very sceptical about ‘terrorism’.

But on the other hand, there are not many degrees of separation in New Zealand. So it’s not surprising either that this incident has immediately launched a movement. For activists it is personal, knowing the accused and knowing that talk of terrorism is bullshit. It is scary that the police still hold a sword of Damocles over so many heads, brandishing phone-tap transcripts, searching homes and offices and threatening more arrests. There is no sense that those who did nothing wrong have nothing to fear. There is a sense of arbitrariness, that anyone could be next. In Tuhoe country a whole community is under threat (again), and has generated the strongest show of resistance.

So the question that Thompson answers so well is, who benefits from the doubt?

An alternative to simply breathing through the nose and waiting would be to survey the evidence that is in the public domain already, talk to family members and lawyers of the accused (and those caught up in the police raids) and then attempt to come to a position on the wisdom of allowing this case to continue.

There is a brief window of opportunity in the next few weeks – before charges under the TSA are decided upon – during which political influence over the course of this case will be possible.

After charges are laid under the Terrorist Suppression Act the course of events will likely be dictated by the courts alone, and as everybody has learned through the case of Ahmed Zaoui, that can be a very frustrating process…

If evidence remains suppressed – as it most probably will – then in the absence of an organised effort to put the other side of the story – to tell people who the accused really are – public ignorance about the real nature of the evidence and the accused is likely to compound…

There is a window of opportunity in the next two or three weeks which needs to be taken advantage of.

Before the Attorney General decides whether to grant leave for charges under the Terrorist Suppression Act the public need to be assisted to understand as best they can what actually happened in the Ureweras over the past year.

At this point it is hard to imagine how the truth could be any more damaging that what has to date made it into the newspapers.

If you are sitting on the fence, go read Thompson’s piece.

Update 24/10

There will be a solidarity demo in Mebourne also this Saturday, 27/10, at noon in Federation Square. I’m assuming any Kiwis reading this are already well aware of the actions over there.

I should also admit I was wrong to say you can get away with reading nothing else about this affair than the Thompson piece. Check out the reportage and history from our friend and correspondent Reading the Maps, who spent last week in Tuhoe Country and around the East Coast.

14: The Classical Theory of the Rate of Interest

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. [p. 175]

Nevertheless, for Keynes it means the doctrine that the rate of interest is what brings savings and investment in line. As we have seen, for Keynes savings and investment are equal by definitionand causally, the motivation to invest comes first. The classical view implies that investment requires a prior pool of savings; for Keynes investment creates the savings by raising incomes. For the classicals, a high interest rate induces savings but restrains investment. For Keynes a high interest rate may reduce savings because it restrains investment.

There is also a large strand in (neo)classical economics linking the interest rate to the marginal disutility of abstaining from immediate consumption. The implication (again, Keynes writes that he has “not found actual words to quote” [p. 176]) is that the interest rate brings the marginal disutility of ‘waiting’ in equilibrium with the marginal productivity of capital. This suggests that capitalism has a tidy mechanism for allocating exactly the right proportion of resources to increasing production for the future – no more and no less than is necessary to meet everyone’s preferences for consuming what they want to consume, when they want to consume. Keynes quotes several passages which seem to me to say this pretty much outright – I don’t know why Keynes is so reticent about accusing the classicals of making this argument.

I think this is still true today:

Certainly the ordinary man – banker, civil servant or politician – brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly – and this is an even more general belief, even to-day – each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save. [p. 177]

We have already seen where Keynes disagrees with this, in Chapter 9. Keynes accepts that the interest rate may have some impact on the marginal propensity to save. But income will have a much bigger effect, and if a higher interest rate lowers income (because it lowers investment), people will be saving a slightly larger proportion of substantially smaller incomes. Keynes accuses the classicals of ignoring this effect on the level of aggregate income. They consider the effect of changes in the interest rate on saving ‘assuming all else is equal’, but forget that it is impossible that everything else remain equal if the interest rate changes. Ceteris cannot be paribus.

Interestingly, in proving this point we get a graph, the only one in the whole book. It is the IS (investment-savings) section of what would later become known as Hicks’ IS-LM system (LM standing for liquidity preference-money). IS-LM is a bit of a bugbear for post-Keynesians as a bastardisation of Keynes, though Keynes gave some support to the interpretation himself. Here the only point is to show that the classical theory gives the IS section by itself. That is, out of any given income, a savings curve can be given linking the rate of interest to the amount of saving. This curve would be upward-sloping in saving/investment – interest space; i.e., the higher the rate of interest, the more saved. In the same space, the investment curve would slope down: the higher the rate of interest, the lower the investment. Thus the point where the curves cross gives the equilibrium interest rate and the amount saved and invested.

But Keynes points out that the two curves are interrelated, because if investment rises, income also rises. So a move along the investment curve could shift the whole savings curve. Therefore, there are a number of different equilibrium positions – the interest rate cannot be determined with reference to the propensity to save and the marginal productivity of capital alone. There is thus a need to bring in a whole other set of curves relating the state of liquidity preference and the quantity of money. Then, with the interest rate given, the classical system relating savings and investment can determine the level of income. Or, if the rate of income is given, the classical system can tell us what the rate of interest has to be. It cannot tell us both.

The alternative (neo)classical theory of the rate of interest – that it equals the marginal productivity of capital – also fails, for reasons addressed in Chapter 11: it is a circular argument. “For the ‘marginal efficiency of capital’ partly depends on the scale of current investment, and we must already know the rate of interest before we can calculate what this scale will be.” [p. 184]

Appendix on the Rate of Interest in Marshall’s ‘Principles of Economics’, Ricardo’s ‘Principles of Political Economy, and elsewhere

The title says it all really – this is just a closer look at what exactly the ‘classical theory of the rate of interest’ is. It is an extension of the argument in the chapter about what the (neo)classicals imply rather than say outright in scattered observations, and about the lack ofa coherent theory. Keynes thinks their problem boils down to the fact that money is mostly ignored in their vision of economics:

The perplexity which I find in Marshall’s account of the matter is fundamentally due, I think, to the incursion of the concept ‘interest’, which belongs to a monetary economy, into a treatise which takes no account of money… Nevertheless these writers are not dealing with a non-monetary economy (if there is such a thing). They quite clearly presume that money is used and that there is a banking system. [pp. 189-90]

13: The General Theory of the Rate of Interest

Keynes argues that it is impossible to determine the rate of interest with reference to only the demand for savings and the propensity to save, though he leaves a detailed look at the classical theory of interest to the next chapter.

The gap comes from the fact that the form in which people save matters. To what extent are savings held in money and money-like assets that can be spent at any time, and to what extent in assets which cannot be converted back into a set amount of purchasing power immediately? This can be conceived in terms of liquidity preference – a high preference for liquidity means most savings held as money; a low liquidity preference means people are more prepared to hold bonds, etc.

The interest rate is the reward for parting with liquidity, i.e., with money, not for saving as such. In a footnote Keynes gives a pragmatic definition of money, which it is important to understand. It is not defined as ‘cash’ or ‘cash plus current accounts’. It is defined in terms of how quickly its holder can turn it into purchasing power, and the line can be drawn in different places depending on the context:

… we can draw the line between ‘money’ and ‘debts’ at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for ‘three months’ one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. [p. 167]

However, as a rule, in this book he is treating as ‘money’ bank deposits. The second thing to note is that ‘money’ and ‘debt’ exist on a scale; they are not binary opposites.

One more definitional thing: Keynes uses the word ‘interest’ to stand in for “the complex of the various rates of interest current for different periods of time, i.e. for debts of different maturities.” The spread between them is treated as constant, or not considered important, and there is an assumption that rate differentials reflect differences in maturity, and not, say, risk.

So the interest rate equlibrates the desire to hold money with the available quantity of money, not the supply of savings with the demand for savings. Here we have another parallel with Marx, because Marx was also clear in opposition to doctrines that determined the interest rate with reference to the ‘real’ economy. For both Keynes and Marx the interest rate cannot be determined without reference to money. For Marx, the rate reflects supply and demand for ‘loanable funds’.

Finally, Keynes treats the supply of money as a fixed quantity, independent of demand. This is dubious in a world where private bank liabilities are money. Opinions differ on whether Keynes was using this as a simplifying assumption, or genuinely considered the money supply to be under the control of the state. Though this was no different from the majority of the (neo)classical economists of Keynes’ time, it was not universal, and apparently Keynes did not rely on this assumption in his earlier Treatise on Money. But he was certainly attacked for using this assumption in the General Theory, for example by Schumpeter in his History of Economic Analysis.

Anyway, treating the money supply in this way certainly makes things less complicated. We get an equation stating that the amount of money supplied equals the amount of money demanded. The supply is fixed, so demand must adjust. The interest rate moves to equalise the amount of money people want to hold with the amount there is to hold.

The only question, then, is what determines the relationship between the interest rate and the amount of money people want to hold, i.e., liquidity preference. First, Keynes upholds the “ancient distinction” between the demand for money to carry out transactions and the demand for money as a store of wealth. [p. 168] Obviously it is convenient to hold a certain amount of money between payment inflows to cover expenses. You don’t want to have to phone your broker to sell bonds every time you need to get some milk. But the amount held as money for transactions will be influenced by the interest rate, because at a higher rate it is worthwhile to sacrifice convenience to get a higher reward by holding bonds. So transactions demand for money is inversely related to the interest rate, and this is pretty obvious. (Note that there is an assumption that current accounts do not pay interest, or at least not much relative to bonds. Also, interest-paying term deposits are assumed to be equivalent to bonds.)

The demand for money as a store of wealth is more complex. If it were not for the fact that interest rates vary in unpredictable ways, there would seem little point in holding as money more than is needed for transactions. (Though I am sure I am far from alone in not caring enough to bother moving what spare money I have out of a current account.) But since we can’t predict when the rate will change, we could easily lose money by holding a bond – either relative to what we could have got with different decisions, or even in absolute terms.

Remember that in Keynes’ world, the only alternative to holding non-interest-paying money is buying a bond. The price of a bond changes in inverse proportion to the rate of interest. If the interest rate rises, existing bonds paying the old interest rate will fall in value because new bonds are available paying a higher rate. Therefore holding bonds carries some risk of capital loss. Therefore, there is an additional motive for holding some wealth in money rather than bonds. This is the precautionary motive for holding money.

Furthermore, some people will try to second-guess changes in interest rates. If they expect interest rates to rise, it makes sense to sell bonds now and hold money until they do, then buy the new bonds. If they expect interest rates to fall, it makes sense to borrow short-term to buy bonds, then sell them for capital gains when rates do fall. Because different market participants have different expectations, “the market price will be fixed at the point at which the sales of the ‘bears’ and the purchases of the ‘bulls’ are balanced.” [p. 170] This is the speculative motive for holding money

Remember that it is the aggregate demand and supply of bonds that determines the interest rate (though Keynes neglects the supply), so a general expectation of higher rates will lead to a sell-off of bonds, which will lower their price and thereby raise the rates – a self-fulfilling prophecy. But there are other independent influences on the rate – most importantly, the money supply.

So we have three motives for holding money: transactions, precautionary and speculative. Now we come to another paradox of the development of capital markets: deeper capital markets make it easier for individuals to sell (liquidate) their assets, so reduce the need for precautionary money balances, but open the possibility of speculation and cause fluctuations in liquidity preference because of the speculative motive. Keynes believes the interest rate will have more effect on money holdings via the speculative motive than via the transactions and precautionary motives. It is the balance between bull and bears on the bond market, then, that determines the interest rate for a given supply of money.

However, individual speculators are not bears and bulls permanently, but relative to the price pertaining presently in the market. As the rate rises, the number of people expecting it to rise further declines – some bears cross to the bull camp, or at least to a more neutral position. And vice versa. High interest rates tend to mean more people expecting them to fall, and vice versa.

Overall, we can imagine a schedule of liquidity preference, a smooth curve, such that as the money supply increases, the interest rate falls, and, again, vice versa. Keynes lists a couple of paths to equilibrium after an increase in the money supply leads to lower rates.

(1) As the interest rate falls, it is likely to cause increased investment, and therefore increased income, and therefore more money required for transactions. Thus some of the extra supply of money is absorbed.

(2) At the same time, the demand for money for speculative reasons will also rise, because a growing proportion of speculators expect the interest rate to rise again.

However, we can also think of circumstances in which things will not work so neatly. For example, suppose a small fall in the interest rate leads a large number of speculators to increase their expectation of a future rise, and the increased demand for money for speculative purposes is larger than the expansion of the money supply. Stability requires, then, a variety of opinions about the future.

Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ. Thus this method of control is more precarious in the United States, where everyone tends to hold the same opinion at the same time, than in England where differences of opinion are more usual. [p. 172]

Ooooh! No wonder they hated him at Bretton Woods.

Keynes cautions the reader against thinking that this analysis means that the quantity of money moves the whole system. This is because the analysis above assumes stable parameters: in the real world, liquidity preference, the marginal efficiency of capital, expectations, etc. will all be moving at the same time, so state control of the money supply alone will not be an all-powerful lever.

Keynes’ theory of the interest rate basically boils down to this: the entire money supply must be held by somebody; the interest rate adjusts to bring the demand for money balances in line with this supply.

12: The State of Long-Term Expectation

Investment in the current period depends to a large extent about expectations about the future. Since capital equipment can last a long time, what entrepreneurs expect about the state of demand, production techniques, etc., some years in the future matters in the present. It is not just the expectations that matter, but the confidence with which those expectations are held. Uncertainty can make entrepreneurs hold back as much as do negative expectations held with some certainty.

This is an interesting chapter because while expectations and confidence are obviously of major importance, they are difficult to formalise.

There is, however, not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book. [p. 149]

No-one can pretend to predict economic conditions five or ten years down the track. But firms do have to make decisions now that have a major impact on the fixed capital they will be stuck with at that point in time. Keynes makes a very interesting point about how financial change has modified how investors deal with uncertainty. Back in the day, when enterprises were run by the individuals who owned them, this was very much a lottery and “investment depended on a sufficient supply of individuals who embarked on business as a way of life, not really relying on a precise calculation of prospective profit.” [p. 150]

But with the dispersal of ownership through the sharemarket, individuals can rearrange their risks over time; they are not stuck with what they invested in. Changing prospects for a firm, or an industry, are reflected in their share prices, and those share prices affect the cost of capital to that firm or industry – because when those involved in the enterprise or similar ones, the price they can get for new shares depends on the price of the existing ones. So a high share price has an equivalent effect to a low interest rate, with the difference that it is localised to a firm or industry. Share prices will be related to the supply price and marginal efficiency of capital goods in the industry.

For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. [p. 151]

Because the future is unknowable, entrepreneurs and financial investors work with a convention: “assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” [p. 152] Of course, the one thing we can be certain of is that the existing state of affairs is not going to continue indefinitely. But the best we can do is assume that current market valuations of assets are a correct guide to the future.

(Incidentally, Keynes mocks an idea that is later at the core of rational expectations theory:

Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. [p. 152])

The advantage of the convention of assuming present market valuations are correct is that it gives stability to the economy, even if the assumption is wrong. Because investors can sell out if the convention changes, they only risk a small loss; they are not liable for the immense loss if the underlying capital asset turns out to be worthless in five or ten years. The risks are there for the community as a whole, but the potential losses are spread more widely across the economy: “Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual.” [p. 153]

However, there are drawbacks to this system. First, because the ultimate owners (shareholders) are removed from the day-to-day business of the firm, their knowledge of the real conditions of the firm and the industry are impaired. Second, minor and unimportant changes in profitability may have an exaggerated effect on the share price. Third, because market conventions are formed by a mass of agents who are ignorant of the real business conditions of the underlying firms, the conventions have no strong roots and may fluctuate violently for no rational reason.

Fourth – and Keynes discusses this at length – professional, well-informed investors’ arbitrage activities (where they buy what seems undervalued and sell what seems overvalued) will not be a stabilising force. This is because they make their judgements on what is over- or under-valued based not on some ‘fundamentals’ (as we call them these days) but based on trying to second-guess what the herd will do next. Investors with long time horizons are likely to be pushed out by those with shorter horizons. This is another patch of great stinging writing, including one the best-known Keynes quotes:

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks is the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees. [p. 156]

Fifth, Keynes notes that a high state of confidence on the part of investors is a necessary but not sufficient condition for a boom. Also necessary is the confidence of those who lend to the investors and to the entrepreneurs. A collapse on the sharemarket may be induced by a fall in the confidence of lenders, and a sudden lack of availability of funds, rather than that of speculators themselves. Of course this is very familiar to us in late 2007.

Really, this whole section is brilliant and worth reading in the original, full of bites like: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” [p. 158] The point is quite ambiguous though. Keynes is having the most fun when he is unleashing his righteousness against speculation. There is a conventional element of moralising in this. But also a serious point – that there is no such thing as ‘liquidity’ for society as a whole, and the fact that individual investors can sell out of positions at a moment’s notice still leaves the underlying assets in existence, in somebody’s hands. Again we have a case where functionality for the individual is dysfunctional for the whole (or, if you prefer to think about individuals, for most individuals). But before this tirade started, Keynes was explaining how the tradeability of ownership shares had brought more stability to capitalism, had induced investment because it lowered the risks to the investor. It appears that capitalism can’t live with financial markets, and can’t live without them. Somebody else we know might call this a contradiction.

Another famous quote:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. [p. 159]

This has a more specific meaning in context, because Keynes has just defined ‘speculation’ as “the activity of forecasting the psychology of the market” and ‘enterprise’ as “the activity of forecasting the prospective yield of assets over their whole life”. [p. 158] Keynes is disputing the idea that the sharemarket allocates funds for investment to where a rational (but not prescient) person would allocate funds if they were interested in maximum profitability over the whole economy in the long run. (Since Keynes believes in the (neo)classical theory of distribution this may be the same as saying that such a rational allocator would be directing funds where they would have the highest pay-off for society as a whole – but this does not follow if you don’t accept that theory of distribution.) The goal of short-term capital gains warps the allocation of capital for long-term productive ends.

But again Keynes is led back to the paradox that the sharemarket improves the liquidity of investments for individual investors, and therefore facilitates investment. Instability is built into developed capitalism. The only thing that could prevent it, he writes in a cryptic comment, would be if individuals were not able to hold any savings in the form of money – either they would have to consume income immediately, or they would have to invest in some specific physical capital asset. How this would work is left unclear. Money and finance, it seems, are for Keynes capitalism’s original sin. But capitalism had to eat the fruit and leave the garden and hence is condemned to waves of instability.

Finally, Keynes concludes that in fact investment is driven more by ‘animal spirits’ of optimism and adventure rather than rational calculation. This is probably a good thing, but the side-effect is that irrational lack of confidence is also possible, say from “fear of a Labour Government or a New Deal”. The rest of the community depends on the “nerves and hysteria and even the digestions and reactions to the weather” of investors. [p. 162]

Consequently, Keynes thinks the rate of interest will be swamped by swings in expectations as a determinant of investment, and therefore monetary policy will be less effective. Hence, investment is likely to be more surely undertaken by the State. Keynes seems careful not to say whether or not he thinks this is a good thing, and gives no indication of the form this will take:

I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have decided above, will be too great to be offset by any practicable changes in the rate of interest. [p. 164]

11: The Marginal Efficiency of Capital

Now we are moving away from consumption to discuss what determines the swinging investment component of aggregate income. Any capital asset can be valued in two ways: first, the supply price, which depends on the cost of actually producing the asset; second, the demand price, which depends on what entrepreneurs expect to make from using the asset. The marginal efficiency of capital is the difference between the expected yield on one more unit of a type of asset, and the cost of producing that unit. The marginal efficiency of that kind of capital whose marginal efficiency is the largest is the marginal efficiency of capital as a whole.

As investment increases, the marginal efficiency of capital falls, because the cost of producing assets rises and their yield falls as the supply of capital rises. Current investment is determined by the amount of investment that will push the marginal efficiency of capital down to the rate of interest. At equilibrium, the marginal efficiency of capital will equal the rate of interest.

Keynes makes clear that the rate of interest is independent from the marginal efficiency of capital – in contrast with (neo)classical theories that determine the rate of interest by the productivity of capital.

The yield on capital must be defined in value, not physical terms, because of the problems in defining the quantity of capital in physical terms: “It is, of course, possible to say that ten labourers will raise more wheat from a given area when they are in a position to make use of certain additional machines; but I know of no means of reducing this to an intelligible arithmetical ratio which does not bring in values.” [p. 138] This is a profound point – though Keynes does not highlight the profundity – and quite devastating to the idea of a ‘natural’ interest rate reflecting the physical productivity of ‘capital’ which somehow has some homogeneous quantity independent of its value.

Keynes quotes Marshall and Fisher to show that they sometimes use concepts very similar to his value-based concept of the marginal efficiency of capital. Marshall is even aware that it is circular to see the rate of interest as determined by the rate of return on capital, and the rate of return on capital as determined by the interest rate. But he fudges the issue elsewhere in his work.

Interestingly, in a footnote Keynes has a throwaway line: “But was [Marshall] not wrong in supposing that the marginal productivity theory of wages is equally circular?” [p. 140] Was he? I’ve mentioned a couple of times that I think it is unfortunate Keynes accepts the neoclassical theory that the real wage is equal to the marginal productivity of labour. In fact I think it does fail for the same reason as the neoclassical theory of capital. We saw in Chapter 4 that Keynes could only develop a homogeneous  labour unit by assuming that the wage accurately reflected individual workers’ marginal productivity. So the quantity of labour is defined partly by real wages, and real wages are partly determined by the quantity of labour.

Keynes emphasises that it is expectations of prospective yields on an asset over the whole life of the asset, not just the current yield, that determines the marginal efficiency of capital. Eventually any long-lived asset is likely to become obsolete, producing the same commodity less efficiently than newer assets, and this probability is factored into present investment decisions. Also, anticipated inflation will stimulate investment, but only if it is anticipated.

He also emphasises that it is expectations of prospective yields that count, and because expectations are volatile, so is investment: “…it is chiefly this dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle.” [pp. 143-44] But let’s not forget that when Keynes discussed expectations in Chapter 5, it was tied up with the intersectoral relationship between producers of consumer goods and producers of investment goods, i.e., dynamic problems of balanced growth. Come to think of it, this was also at stake in Chapter 10, in the discussion of the dynamics of the multiplier: it mattered whether or not the producers of consumer goods anticipated expansion in the investment goods sector. I mention this because of theories linking the business cycle to imbalances between these sectors.

Next comes a discussion of risk: the riskiness of a venture will add to the anticipated yield required to undertake it. This is a fairly obvious point, but Keynes points out that the effect of risk may be doubled if borrowing is undertaken to pay for the project: it will be counted once in the entrepreneur’s calculations and again in the lenders’. And this is likely to accentuate cyclical movements, because “during a boom the popular estimation of the magnitude of both these risks… is apt to become unusually and imprudently low.” [p. 145] This statement is clearly influential on Minsky.

Keynes ends the chapter with a statement that it is the dynamic element that sets apart his theory of investment:

It is by reason of the existence of durable equipment that the economic future is linked to the present. It is, therefore, consonant with, and agreeable to, our broad principles of thought, that the expectation of the future should affect the present through the demand price for durable equipment. [p. 146]

10: The Marginal Propensity to Consume and the Multiplier

This chapter looks difficult. But it’s not really. The reason is that everyone who learns anything about Keynes learns about the multiplier, or how increases in investment boost aggregate income by some multiple of the original increase, because the receivers of the original injection spend most of it on other stuff, and then the people who get that income spend most of it, and so on. Keep in mind that this is basically what Keynes is getting at and you can work through it. My main interest here is to see how closely the chapter as Keynes wrote it matches what we get taught in Keynes 101.

First, Keynes defines the multiplier as the “definite ratio… between income and investment and, subject to certain simplifications, between the total employment and the employment directly employed on investment…” [p. 113] This ratio is ‘definite’ given a certain propensity to consume – if that propensity changes, so does the multiplier. But since we are mainly interested in changes in the rate of investment, we need the concept of the marginal propensity to consume. That is, what proportion of an increase in income will be consumed. Remember from the last two chapters that as income rises, consumption rises, but not as much.

The change in aggregate income equals the change in consumption plus the change in investment. Since the change in consumption is dependent on the change in investment, we can remove consumption from the equation: The change in aggregate income equals the investment multiplier times the change in investment. (Remember everything is denominated in wage-units.)

Note that this investment multiplier is not the same thing as the plain old multiplier defined above, which is about the relationship between the proportion of income consumed and the proportion invested. The investment multiplier is related to the marginal propensity to consume: The marginal propensity to consume is 1 minus [one divided by the investment multiplier].

Keynes doesn’t show how this is derived but it is pretty basic, ignore this if it’s obvious or you don’t care: (In the following Δ represents change; C = consumption; c = marginal propensity to consume; I = investment; Y = income; k = the investment multiplier)

ΔC = c(ΔY) (The change in consumption equals the marginal propensity to consume times the change in income.)

ΔY = kΔI (The change in income equals the investment multiplier times the change in investment)

ΔY = ΔC + ΔI (The change in income also equals the change in consumption plus the change in investment)

→ kΔI = c(kΔI) + ΔI (Therefore, the investment multiplier times the change in investment equals the marginal propensity to consume times the investment multiplier times the change in investment)

→ kΔI – c(kΔI) = ΔI

→ kΔI(1-c) = ΔI

→ 1-c = 1/k

→ c = 1-1/k

(Now I see the ridiculousness of promising to write out the equations in words!)

In the next section, Keynes discusses the relationship between the investment multiplier and Kahn’s ’employment multiplier’, which expresses the relationship between a change in employment in investment goods industries (directly related to a change in investment spending), and the total flow-on change in employment. There is no reason the two multipliers will be equal, because production in the investment goods sector may be more (or less) labour intensive than production in the consumer goods sector. But this caveat can be ignored to explain the general relationship between investment spending and employment.

In general, then, an increase in investment spending (private or public) will employ people immediately in the investment goods industry, and have a multiplied effect, employing some multiple of additional people elsewhere in the economy. This is just an obvious extension of the idea that spending on investment will be re-spent. But this does hint at another issue – that the real output of the economy is limited (to output at full employment), and spending multiplied past this point will simply raise prices. If people try to spend the whole of their increased incomes triggered by the increase in investment, without saving any, “there will be no point of stability and prices will rise without limit”. [p. 117]

That people in fact do not spend all of additions to their income is an empirical claim – it is not logically necessary. But assuming they increase saving out of the new income, the multiplier tells us how much extra income it takes to bring saving in line with the increase in investment: “If saving is the pill and consumption is the jam, the extra jam has to be proportioned to the size of the additional pill.” [p. 117]

The proportion of additional income spent (i.e. the marginal propensity to consume) is the lever by which investment moves aggregate income and employment: if it is high, a little initial extra investment will raise employment a lot; if it is low, it takes a lot of investment to have a serious impact on employment. Keynes thinks that in reality the propensity to consume is closer to one than to zero:

… with the result that we have, in a sense, the worst of both worlds, fluctuations in employment being considerable and, at the same time, the increment in investment required to produce full employment being too great to be easily handled. Unfortunately the fluctuations have been sufficient to prevent the nature of the malady from being obvious, whilst its severity is such that it cannot be remedied unless its nature is understood. [p. 118]

Next Keynes makes clear that we are talking about additions to net investment. We can’t say for sure that any given investment project (public or private) will raise income and employment with the full force of the multiplier, because that decision to invest may take the place of investment that would have happened in its absence. For example, funding it might raise interest rates and discourage other investments, or compete with other projects for labour. This anticipates notions of ‘crowding out’ which are to this day raised against stimulatory macroeconomic policies. This argument is often thought to be a rebuttal of Keynes, but he was clearly aware of it from the start, though he does not dwell on it.

Here he also raises the issue of foreign trade – that to the extent that spending ‘leaks’ out to foreign producers, it diminishes domestic income and the multiplier. On the other hand, the domestic economy gets the benefit from other countries’ expenditure via exports. Note the classic Keynesian ontology of the world economy as a collection of interrelated national economies. The national economy is conceptualised primarily as a self-contained system, except for flow relationships with other national economies.

Dynamics

So far we have been discussing an equilibrium position following from the logical fact that an increase in investment must increase aggregate income by a greater amount (unless the marginal propensity to consume is zero or less). In the next section Keynes considers the dynamics: how do we get to equilibrium from an initial decision to invest? This is tricky, because the multiplier is a logical relation “which holds good continuously, without time-lag, at all moments of time”. [p. 122] But if an increase in investment is unforeseen, the effect will not be instantaneous. These two statements seem contradictory. I think what Keynes is getting at is that there are two senses in which we are interested in the multiplier: as a logical relation and as an equilibrium relation.

Say we look at a period as short as a day. That day a decision to invest is put into effect: a firm makes a purchase of some piece of machinery. The funds are transferred into the bank account of the machinery manufacturer. And there they stay for the rest of the day. In this period we have an increase in investment, but no multiplier. The multiplier effect still holds – as it logically must. But effectively, the marginal propensity to consume out of this piece of income from investment is zero, for the period of the single day. But on some day soon afterwards, the extra sale figures in the machinery firm’s reckonings, and it employs more staff to increase production. On the day of their first paycheck, consumption rises, this time without any prior increase in investment. The marginal propensity to consume rises.

Of course it is ridiculous to define a period as short as a day. But this is the logic behind Keynes’ statement that unforeseen investment “may cause a temporary departure of the marginal propensity to consume away from its normal value, followed, however, by a gradual return to it.” [p. 123] Keynes’ examples examine periods longer than a day, but in which the initial investment expenditure has taken place without yet being followed by expansion in the consumer goods sector. As those employed in the investment goods sector begin to spend out of the addition to their incomes, at first consumer goods prices will rise, and only later will output follow. In the meantime, higher prices will cause some to defer spending, redistribute income to lower-spending entrepreneurs, etc., so that the propensity to consume temporarily declines.

Eventually, though, production of consumer goods will catch up and the full effect of the multiplier is felt. While it was never suspended, we can distinguish between its operation in shorter periods of time during which the marginal propensity to consume oscillates, and the period of rest once the forces set in motion by the initial increase in investment have fully played themselves out. Over this longer period, the marginal propensity to consume is (more or less) constant.

This dynamic story is not entirely satisfying, especially since Keynes implies that it is partly an explanation for the business cycle – which seems like too long a period over which to be considering the effects of an increase in net investment. But the fundamental point is sound. It is interesting that again there are echoes of Marx’s concept of balanced growth. In regular times, Keynes thinks most expansion of investment will be foreseen and planned for, so that the multiplier effect will play out fairly quickly and not work through this oscillation.

Marginal and average propensities to consume

Keynes notes that at first glance, a poor economy which saves little might be assumed to suffer from very large fluctuations in output and employment, because the multiplier would be so large. But this ignores the fact that in such an economy, investment would also be a much smaller proportion of output (and therefore employment) as a whole, so fluctuations in the rate of investment would have a correspondingly smaller effect on overall income, counteracting the effects of the larger multiplier. He gives a general formula for working out the combined effects on page 126: it is straightforward.

It also follows that for a given economy, the multiplier effect of an increase in investment will be greater if employment is initially low than if it is initially high. So “public works even of doubtful utility will pay for themselves many times over” if unemployment is high, but perhaps not at full employment. [p. 127]

Finally, we get a passage that Keynes is notorious for. For the involuntarily unemployed, employment may have positive utility, instead of being an unwelcome sacrifice. So it may be worth the government investing in producing useless goods just to create employment. He caustically notes that in practice it is often easier to make politically acceptable useless make-work projects, or handing out money in unemployment benefits, than it is to make a case for real public investment, which tends to be judged on commercial grounds.

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but it there are political and practical difficulties in the way of this, the above would be better than nothing. [p. 129]

Ouch! Even more cuttingly, he notes that “wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable” and gold-mining helps recovery from recessions because the barbarous relic’s price rises in downturns and motivates expeditions to dig it out of the ground. [p. 130]

Free NZ!

So there’s going to be a Sydney solidarity demo with those activists arrested under NZ anti-terror laws tomorrow morning, Wednesday, 8.45am, New Zealand Consulate-General, 55 Hunter Street.

The lawyer for the Tuhoe activists, Annette Sykes, did well in interviews last night and on morning TV this morning – check these out if you want to get a better sense for what is going on. The second interview also includes John Minto, veteran of the Springbok protests of the 1980s, who talks about the situation of the city activists. Warning: second presenter may induce teeth-grinding.