The Philosopher's Zone

Written by John Maynard Keynes

Chapter 1

The General Theory
I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

Chapter 2
The Postulates of the Classical Economics
Most treatises on the theory of value and production are primarily concerned with the distribution of a given volume of employed resources between different uses and with the conditions which, assuming the employment of this quantity of resources, determine their relative rewards and the relative values of their products.
The question, also, of the volume of the available resources, in the sense of the size of the employable population, the extent of natural wealth and the accumulated capital equipment, has often been treated descriptively. But the pure theory of what determines the actual employment of the available resources has seldom been examined in great detail. To say that it has not been examined at all would, of course, be absurd. For every discussion concerning fluctuations of employment, of which there have been many, has been concerned with it. I mean, not that the topic has been overlooked, but that the fundamental theory underlying it has been deemed so simple and obvious that it has received, at the most, a bare mention.
The classical theory of employment — supposedly simple and obvious — has been based, I think, on two fundamental postulates, though practically without discussion, namely:
I. The wage is equal to the marginal product of labour
That is to say, the wage of an employed person is equal to the value which would be lost if employment were to be reduced by one unit (after deducting any other costs which this reduction of output would avoid); subject, however, to the qualification that the equality may be disturbed, in accordance with certain principles, if competition and markets are imperfect.
II. The utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment.
That is to say, the real wage of an employed person is that which is just sufficient (in the estimation of the employed persons themselves) to induce the volume of labour actually employed to be forthcoming; subject to the qualification that the equality for each individual unit of labour may be disturbed by combination between employable units analogous to the imperfections of competition which qualify the first postulate. Disutility must be here understood to cover every kind of reason which might lead a man, or a body of men, to withhold their labour rather than accept a wage which had to them a utility below a certain minimum.
This postulate is compatible with what may be called ‘frictional’ unemployment. For a realistic interpretation of it legitimately allows for various inexactnesses of adjustment which stand in the way of continuous full employment: for example, unemployment due to a temporary want of balance between the relative quantities of specialised resources as a result of miscalculation or intermittent demand; or to time-lags consequent on unforeseen changes; or to the fact that the change-over from one employment to another cannot be effected without a certain delay, so that there will always exist in a non-static society a proportion of resources unemployed ‘between jobs’. In addition to ‘frictional’ unemployment, the postulate is also compatible with ‘voluntary’ unemployment due to the refusal or inability of a unit of labour, as a result of legislation or social practices or of combination for collective bargaining or of slow response to change or of mere human obstinacy, to accept a reward corresponding to the value of the product attributable to its marginal productivity. But these two categories of ‘frictional’ unemployment and ‘voluntary’ unemployment are comprehensive. The classical postulates do not admit of the possibility of the third category, which I shall define below as ‘involuntary’ unemployment.
Subject to these qualifications, the volume of employed resources is duly determined, according to the classical theory, by the two postulates. The first gives us the demand schedule for employment, the second gives us the supply schedule; and the amount of employment is fixed at the point where the utility of the marginal product balances the disutility of the marginal employment. It would follow from this that there are only four possible means of increasing employment:
(a) An improvement in organisation or in foresight which diminishes ‘frictional’ unemployment;
(b) a decrease in the marginal disutility of labour, as expressed by the real wage for which additional labour is available, so as to diminish ‘voluntary’ unemployment;
(c) an increase in the marginal physical productivity of labour in the wage-goods industries (to use Professor Pigou’s convenient term for goods upon the price of which the utility of the money-wage depends);
or (d) an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.
This, to the best of my understanding, is the substance of Professor Pigou’s Theory of Unemployment — the only detailed account of the classical theory of employment which exists.
II
Is it true that the above categories are comprehensive in view of the fact that the population generally is seldom doing as much work as it would like to do on the basis of the current wage? For, admittedly, more labour would, as a rule, be forthcoming at the existing money-wage if it were demanded. The classical school reconcile this phenomenon with their second postulate by arguing that, while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc.
This calls for two observations, the first of which relates to the actual attitude of workers towards real wages and money-wages respectively and is not theoretically fundamental, but the second of which is fundamental.
Let us assume, for the moment, that labour is not prepared to work for a lower money-wage and that a reduction in the existing level of money-wages would lead, through strikes or otherwise, to a withdrawal from the labour market of labour which is now employed. Does it follow from this that the existing level of real wages accurately measures the marginal disutility of labour? Not necessarily. For, although a reduction in the existing money-wage would lead to a withdrawal of labour, it does not follow that a fall in the value of the existing money-wage in terms of wage-goods would do so, if it were due to a rise in the price of the latter. In other words, it may be the case that within a certain range the demand of labour is for a minimum money-wage and not for a minimum real wage. The classical school have tacitly assumed that this would involve no significant change in their theory. But this is not so. For if the supply of labour is not a function of real wages as its sole variable, their argument breaks down entirely and leaves the question of what the actual employment will be quite indeterminate. They do not seem to have realised that, unless the supply of labour is a function of real wages alone, their supply curve for labour will shift bodily with every movement of prices. Thus their method is tied up with their very special assumptions, and cannot be adapted to deal with the more general case.
Now ordinary experience tells us, beyond doubt, that a situation where labour stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods. It is sometimes said that it would be illogical for labour to resist a reduction of money-wages but not to resist a reduction of real wages. For reasons given below (p. 14), this might not be so illogical as it appears at first; and, as we shall see later, fortunately so. But, whether logical or illogical, experience shows that this is how labour in fact behaves.
Moreover, the contention that the unemployment which characterises a depression is due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts. It is not very plausible to assert that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing. Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labour or in its productivity. Labour is not more truculent in the depression than in the boom — far from it. Nor is its physical productivity less. These facts from experience are a prima facie ground for questioning the adequacy of the classical analysis.
It would be interesting to see the results of a statistical enquiry into the actual relationship between changes in money-wages and changes in real wages. In the case of a change peculiar to a particular industry one would expect the change in real wages to be in the same direction as the change in money-wages. But in the case of changes in the general level of wages, it will be found, I think, that the change in real wages associated with a change in money-wages, so far from being usually in the same direction, is almost always in the opposite direction. When money-wages are rising, that is to say, it will be found that real wages are falling; and when money-wages are falling, real wages are rising. This is because, in the short period, falling money-wages and rising real wages are each, for independent reasons, likely to accompany decreasing employment; labour being readier to accept wage-cuts when employment is falling off, yet real wages inevitably rising in the same circumstances on account of the increasing marginal return to a given capital equipment when output is diminished.
If, indeed, it were true that the existing real wage is a minimum below which more labour than is now employed will not be forthcoming in any circumstances, involuntary unemployment, apart from frictional unemployment, would be non-existent. But to suppose that this is invariably the case would be absurd. For more labour than is at present employed is usually available at the existing money-wage, even though the price of wage-goods is rising and, consequently, the real wage falling. If this is true, the wage-goods equivalent of the existing money-wage is not an accurate indication of the marginal disutility of labour, and the second postulate does not hold good.
But there is a more fundamental objection. The second postulate flows from the idea that the real wages of labour depend on the wage bargains which labour makes with the entrepreneurs. It is admitted, of course, that the bargains are actually made in terms of money, and even that the real wages acceptable to labour are not altogether independent of what the corresponding money-wage happens to be. Nevertheless it is the money-wage thus arrived at which is held to determine the real wage. Thus the classical theory assumes that it is always open to labour to reduce its real wage by accepting a reduction in its money-wage. The postulate that there is a tendency for the real wage to come to equality with the marginal disutility of labour clearly presumes that labour itself is in a position to decide the real wage for which it works, though not the quantity of employment forthcoming at this wage.
The traditional theory maintains, in short, that the wage bargains between the entrepreneurs and the workers determine the real wage; so that, assuming free competition amongst employers and no restrictive combination amongst workers, the latter can, if they wish, bring their real wages into conformity with the marginal disutility of the amount of employment offered by the employers at that wage. If this is not true, then there is no longer any reason to expect a tendency towards equality between the real wage and the marginal disutility of labour.
The classical conclusions are intended, it must be remembered, to apply to the whole body of labour and do not mean merely that a single individual can get employment by accepting a cut in money-wages which his fellows refuse. They are supposed to be equally applicable to a closed system as to an open system, and are not dependent on the characteristics of an open system or on the effects of a reduction of money-wages in a single country on its foreign trade, which lie, of course, entirely outside the field of this discussion. Nor are they based on indirect effects due to a lower wages-bill in terms of money having certain reactions on the banking system and the state of credit, effects which we shall examine in detail in chapter 19. They are based on the belief that in a closed system a reduction in the general level of money-wages will be accompanied, at any rate in the short period and subject only to minor qualifications, by some, though not always a proportionate, reduction in real wages.
Now the assumption that the general level of real wages depends on the money-wage bargains between the employers and the workers is not obviously true. Indeed it is strange that so little attempt should have been made to prove or to refute it. For it is far from being consistent with the general tenor of the classical theory, which has taught us to believe that prices are governed by marginal prime cost in terms of money and that money-wages largely govern marginal prime cost. Thus if money-wages change, one would have expected the classical school to argue that prices would change in almost the same proportion, leaving the real wage and the level of unemployment practically the same as before, any small gain or loss to labour being at the expense or profit of other elements of marginal cost which have been left unaltered. They seem, however, to have been diverted from this line of thought, partly by the settled conviction that labour is in a position to determine its own real wage and partly, perhaps, by preoccupation with the idea that prices depend on the quantity of money. And the belief in the proposition that labour is always in a position to determine its own real wage, once adopted, has been ina~ntained by its being confused with the proposition that labour is always in a position to determine what real wage shall correspond to full employment, i.e. the maximum quantity of employment which is compatible with a given real wage.
To sum up: there are two objections to the second postulate of the classical theory. The first relates to the actual behaviour of labour. A fall in real wages due to a rise in prices, with money-wages unaltered, does not, as a rule, cause the supply of available labour on offer at the current wage to fall below the amount actually employed prior to the rise of prices. To sthat it does is to suppose that all those who are now unemployed though willing to work at the current wage will withdraw the offer of their labour in the event of even a small rise in the cost of living. Yet this strange supposition apparently underlies Professor Pigou’s Theory of Unemployment, and it is what all members of the orthodox school are tacitly assuming.
But the other, more fundamental, objection, which we shall develop in the ensuing chapters, flows from our disputing the assumption that the general level of real wages is directly determined by the character of the wage bargain. In assuming that the wage bargain determines the real wage the classical school have slipt in an illicit assumption. For there may be no method available to labour as a whole whereby it can bring the wage-goods equivalent of the general level of money wages into conformity with the marginal disutility of the current volume of employment. There may exist no expedient by which labour as a whole can reduce its real wage to a given figure by making revised money bargains with the entrepreneurs. This will be our contention. We shall endeavour to show that primarily it is certain other forces which determine the general level of real wages. The attempt to elucidate this problem will be one of our main themes. We shall argue that there has been a fundamental misunderstanding of how in this respect the economy in which we live actually works.
III
Though the struggle over money-wages between individuals and groups is often believed to determine the general level of real-wages, it is, in fact, concerned with a different object. Since there is imperfect mobility of labour, and wages do not tend to an exact equality of net advantage in different occupations, any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is a sufficient justification for them to resist it. On the other hand it would be impracticable to resist every reduction of real wages, due to a change in the purchasing-power of money which affects all workers alike; and in fact reductions of real wages arising in this way are not, as a rule, resisted unless they proceed to an extreme degree. Moreover, a resistance to reductions in money-wages applying to particular industries does not raise the same insuperable bar to an increase in aggregate employment which would result from a similar resistance to every reduction in real wages.
In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not its average amount per unit of employment, which depends, as we shall see, on a different set of forces. The effect of combination on the part of a group of workers is to protect their relative real wage. The general level of real wages depends on the other forces of the economic system.
Thus it is fortunate that the workers, though unconsciously, are instinctively more reasonable economists than the classical school, inasmuch as they resist reductions of money-wages, which are seldom or never of an all-round character, even though the existing real equivalent of these wages exceeds the marginal disutility of the existing employment; whereas they do not resist reductions of real wages, which are associated with increases in aggregate employment and leave relative money-wages unchanged, unless the reduction proceeds so far as to threaten a reduction of the real wage below the marginal disutility of the existing volume of employment. Every trade union will put up some resistance to a cut in money-wages, however small. But since no trade union would dream of striking on every occasion of a rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment which is attributed to them by the classical school.
IV
We must now define the third category of unemployment, namely ‘involuntary’ unemployment in the strict sense, the possibility of which the classical theory does not admit.
Clearly we do not mean by ‘involuntary’ unemployment the mere existence of an unexhausted capacity to work. An eight-hour day does not constitute unemployment because it is not beyond human capacity to work ten hours. Nor should we regard as ‘involuntary’ unemployment the withdrawal of their labour by a body of workers because they do not choose to work for less than a certain real reward. Furthermore, it will be convenient to exclude ‘frictional’ unemployment from our definition of ‘involuntary’ unemployment. My definition is, therefore, as follows: Men are involuntarily unemployed If, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment. An alternative definition, which amounts, however, to the same thing, will be given in the next chapter (Chapter 3).
It follows from this definition that the equality of the real wage to the marginal disutility of employment presupposed by the second postulate, realistically interpreted, corresponds to the absence of ‘involuntary’ unemployment. This state of affairs we shall describe as ‘full’ employment, both ‘frictional’ and ‘voluntary’ unemployment being consistent with ‘full’ employment thus defined. This fits in, we shall find, with other characteristics of the classical theory, which is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity. A classical economist may sympathise with labour in refusing to accept a cut in its money-wage, and he will admit that it may not be wise to make it to meet conditions which are temporary; but scientific integrity forces him to declare that this refusal is, nevertheless, at the bottom of the trouble.
Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment — if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight — as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.
V
In emphasising our point of departure from the classical system, we must not overlook an important point of agreement. For we shall maintain the first postulate as heretofore, subject only to the same qualifications as in the classical theory; and we must pause, for a moment, to consider what this involves.
It means that, with a given organisation, equipment and technique, real wages and the volume of output (and hence of employment) are uniquely correlated, so that, in general, an increase in employment can only occur to the accompaniment of a decline in the rate of real wages. Thus I am not disputing this vital fact which the classical economists have (rightly) asserted as indefeasible. In a given state of organisation, equipment and technique, the real wage earned by a unit of labour has a unique (inverse) correlation with the volume of employment. Thus if employment increases, then, in the short period, the reward per unit of labour in terms of wage-goods must, in general, decline and profits increase. This is simply the obverse of the familiar proposition that industry is normally working subject to decreasing returns in the short period during which equipment etc. is assumed to be constant; so that the marginal product in the wage-good industries (which governs real wages) necessarily diminishes as employment is increased. So long, indeed, as this proposition holds, any means of increasing employment must lead at the same time to a diminution of the marginal product and hence of the rate of wages measured in terms of this product.
But when we have thrown over the second postulate, a decline in employment, although necessarily associated with labour’s receiving a wage equal in value to a larger quantity of wage-goods, is not necessarily due to labour’s demanding a larger quantity of wage-goods; and a willingness on the part of labour to accept lower money-wages is not necessarily a remedy for unemployment. The theory of wages in relation to employment, to which we are here leading up, cannot be fully elucidated, however, until chapter 19 and its Appendix have been reached.
VI
From the time of Say and Ricardo the classical economists have taught that supply creates its own demand;— meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product.
In J.S. Mill’s Principles of Political Economy the doctrine is expressly set forth:
What constitutes the means of payment for commodities is simply commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange.
As a corollary of the same doctrine, it has been supposed that any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labour and commodities thus released from supplying consumption to be invested in the production of capital wealth. The following passage from Marshall’s Pure Theory of Domestic Values illustrates the traditional approach:
The whole of a man’s income is expended in the purchase of services and of commodities. It is indeed commonly said that a man spends some portion of his income and saves another. But it is a familiar economic axiom that a man purchases labour and commodities with that portion of his income which he saves just as much as he does with that he is said to spend. He is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labour and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.
It is true that it would not be easy to quote comparable passages from Marshall’s later work or from Edgeworth or Professor Pigou. The doctrine is never stated to-day in this crude form. Nevertheless it still underlies the whole classical theory, which would collapse without it. Contemporary economists, who might hesitate to agree with Mill, do not hesitate to accept conclusions which require Mill’s doctrine as their premiss. The conviction, which runs, for example, through almost all Professor Pigou’s work, that money makes no real difference except frictionally and that the theory of production and employment can be worked out (like Mill’s) as being based on ‘real’ exchanges with money introduced perfunctorily in a later chapter, is the modern version of the classical tradition. Contemporary thought is still deeply steeped in the notion that if people do not spend their money in one way they will spend it in another. Post-war economists seldom, indeed, succeed in maintaining this standpoint consistently; for their thought to-day is too much permeated with the contrary tendency and with facts of experience too obviously inconsistent with their former view. But they have not drawn sufficiently far-reaching consequences; and have not revised their fundamental theory.
In the first instance, these conclusions may have been applied to the kind of economy in which we actually live by false analogy from some kind of non-exchange Robinson Crusoe economy, in which the income which individuals consume or retain as a result of their productive activity is, actually and exclusively, the output in specie of that activity. But, apart from this, the conclusion that the costs of output are always covered in the aggregate by the sale-proceeds resulting from demand, has great plausibility, because it is difficult to distinguish it from another, similar-looking proposition which is indubitable, namely that the income derived in the aggregate by all the elements in the community concerned in a productive activity necessarily has a value exactly equal to the value of the output.
Similarly it is natural to suppose that the act of an individual, by which he enriches himself without apparently taking anything from anyone else, must also enrich the community as a whole; so that (as in the passage just quoted from Marshall) an act of individual saving inevitably leads to a parallel act of investment. For, once more, it is indubitable that the sum of the net increments of the wealth of individuals must be exactly equal to the aggregate net increment of the wealth of the community.
Those who think in this way are deceived, nevertheless, by an optical illusion, which makes two essentially different activities appear to be the same. They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former.
It is, then, the assumption of equality between the demand price of output as a whole and its supply price which is to be regarded as the classical theory’s ‘axiom of parallels’. Granted this, all the rest follows — the social advantages of private and national thrift, the traditional attitude towards the rate of interest, the classical theory of unemployment, the quantity theory of money, the unqualified advantages of laissez-faire in respect of foreign trade and much else which we shall have to question.
VII
At different points in this chapter we have made the classical theory to depend in succession on the assumptions:
1. that the real wage is equal to the marginal disutility of the existing employment;
2. that there is no such thing as involuntary unemployment in the strict sense;
3. that supply creates its own demand in the sense that the aggregate demand price is equal to the aggregate supply price for all levels of output and employment.
These three assumptions, however, all amount to the same thing in the sense that they all stand and fall together, any one of them logically involving the other two.
Chapter 3
The Principle of Effective Demand
I
We need, to start with, a few terms which will be defined precisely later. In a given state of technique, resources and costs, the employment of a given volume of labour by an entrepreneur involves him in two kinds of expense: first of all, the amounts which he pays out to the factors of production (exclusive of other entrepreneurs) for their current services, which we shall call the factor cost of the employment in question; and secondly, the amounts which he pays out to other entrepreneurs for what he has to purchase from them together with the sacrifice which he incurs by employing the equipment instead of leaving it idle, which we shall call the user cost of the employment in question. The excess of the value of the resulting output over the sum of its factor cost and its user cost is the profit or, as we shall call it, the income of the entrepreneur. The factor cost is, of course, the same thing, looked at from the point of view of the entrepreneur, as what the factors of production regard as their income. Thus the factor cost and the entrepreneur’s profit make up, between them, what we shall define as the total income resulting from the employment given by the entrepreneur. The entrepreneur’s profit thus defined is, as it should be, the quantity which he endeavours to maximise when he is deciding what amount of employment to offer. It is sometimes convenient, when we are looking at it from the entrepreneur’s standpoint, to call the aggregate income (i.e. factor cost plus profit) resulting from a given amount of employment the proceeds of that employment. On the other hand, the aggregate supply price of the output of a given amount of employment is the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment.
It follows that in a given situation of technique, resources and factor cost per unit of employment, the amount of employment, both in each individual firm and industry and in the aggregate, depends on the amount of the proceeds which the entrepreneurs expect to receive from the corresponding output. For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of the proceeds over the factor cost.
Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = φ(N), which can be called the aggregate supply function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called the aggregate demand function.
Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.
The classical doctrine, on the other hand, which used to be expressed categorically in the statement that ‘Supply creates its own Demand’ and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. For ‘Supply creates its own Demand’ must mean that f(N) and φ(N) are equal for all values of N, i.e. for all levels of output and employment; and that when there is an increase in Z ( = φ(N)) corresponding to an increase in N, D ( = f(N)) necessarily increases by the same amount as Z. The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.
If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment. In the previous chapter we have given a definition of full employment in terms of the behaviour of labour. An alternative, though equivalent, criterion is that at which we have now arrived, namely a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output. Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.
II
A brief summary of the theory of employment to be worked out in the course of the following chapters may, perhaps, help the reader at this stage, even though it may not be fully intelligible. The terms involved will be more carefully defined in due course. In this summary we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, with which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money-wages, etc., are liable to change.
The outline of our theory can be expressed as follows. When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income. Hence employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption. Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment. It follows, therefore, that, given what we shall call the community’s propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment. The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks.
Thus, given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium; since any other level will lead to inequality between the aggregate supply price of output as a whole and its aggregate demand price. This level cannot be greater than full employment, i.e. the real wage cannot be less than the marginal disutility of labour. But there is no reason in general for expecting it to be equal to full employment. The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another. This particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consurnption when it is fully employed.
This theory can be summed up in the following propositions:
(1) In a given situation of technique, resources and costs, income (both money-income and real income) depends on the volume of employment N.
(2) The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.
(3) The amount of labour N which the entrepreneurs decide to employ depends on the sum (D) of two quantities, namely D1, the amount which the community is expected to spend on consumption, and D2, the amount which it is expected to devote to new investment. D is what we have called above the effective demand.
(4) Since D1 + D2 = D = φ(N), where is the aggregate supply function, and since, as we have seen in (2) above, D1 is a function of N, which we may write χ(N), depending on the propensity to consume, it follows that φ(N) − χ(N) = D2.
(5) Hence the volume of employment in equilibrium depends on (i) the aggregate supply function, (ii) the propensity to consume, and (iii) the volume of investment, D2. This is the essence of the General Theory of Employment.
(6) For every value of N there is a corresponding marginal productivity of labour in the wage-goods industries; and it is this which determines the real wage. (5) is, therefore, subject to the condition that N cannot exceed the value which reduces the real wage to equality with the marginal disutility of labour. This means that not all changes in D are compatible with our temporary assumption that money-wages are constant. Thus it will be essential to a full statement of our theory to dispense with this assumption.
(7) On the classical theory, according to which D = φ(N) for all values of N, the volume of employment is in neutral equilibrium for all values of N less than its maximum value; so that the forces of competition between entrepreneurs may be expected to push it to this maximum value. Only at this point, on the classical theory, can there be stable equilibrium.
(8) When employment increases, D1will increase, but not by so much as D; since when our income increases our consumption increases also, but not by so much. The key to our practical problem is to be found in this psychological law. For it follows from this that the greater the volume of employment the greater will be the gap between the aggregate supply price (Z) of the corresponding output and the sum (D1) which the entrepreneurs can expect to get back out of the expenditure of consumers. Hence, if there is no change in the propensity to consume, employment cannot increase, unless at the same time D2 is increasing so as to fill the increasing gap between Z and D1. Thus — except on the special assumptions of the classical theory according to which there is some force in operation which, when employment increases, always causes D2 to increase sufficiently to fill the widening gap between Z and D1 — the economic system may find itself in stable equilibrium with N at a level below full employment, namely at the level given by the intersection of the aggregate demand function with the aggregate supply function.
Thus the volume of employment is not determined by the marginal disutility of labour measured in terms of real wages, except in so far as the supply of labour available at a given real wage sets a maximum level to employment. The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages — not the other way round. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment.
This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.
Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.
But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which ‘brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level, which will occupy Book IV.
Thus the analysis of the propensity to consume, the definition of the marginal efficiency of capital and the theory of the rate of interest are the three main gaps in our existing knowledge which it will be necessary to fill. When this has been accomplished, we shall find that the theory of prices falls into its proper place as a matter which is subsidiary to our general theory. We shall discover, however, that money plays an essential part in our theory of the rate of interest; and we shall attempt to disentangle the peculiar characteristics of money which distinguish it from other things.
III
The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of effective demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.
The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.
But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;— a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.
The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our economy to behave. But to assume that it actually does so is to assume our difficulties away.
Chapter 4
The Choice of Units
I
In this and the next three chapters we shall be occupied with an attempt to clear up certain perplexities which have no peculiar or exclusive relevance to the problems which it is our special purpose to examine. Thus these chapters are in the nature of a digression, which will prevent us for a time from pursulng our main theme. Their subject-matter is only discussed here because it does not happen to have been already treated elsewhere in a way which I find adequate to the needs of my own particular enquiry.
The three perplexities which most impeded my progress in writing this book, so that I could not express myself conveniently until I had found some solution for them, are: firstly, the choice of the units of quantity appropriate to the problems of the economic system as a whole; secondly, the part played by expectation in economic analysis; and, thirdly, the definition of income.
II
That the units, in terms of which economists commonly work, are unsatisfactory can be illustrated by the concepts of the national dividend, the stock of real capital and the general price-level:
(i) The national dividend, as defined by Marshall and Professor Pigou, measures the volume of current output or real income and not the value of output or money-income. Furthermore, it depends, in some sense, on net output;— on the net addition, that is to say, to the resources of the community available for consumption or for retention as capital stock, due to the economic activities and sacrifices of the current period, after allowing for the wastage of the stock of real capital existing at the commencement of the period. On this basis an attempt is made to erect a quantitative science. But it is a grave objection to this definition for such a purpose that the community’s output of goods and services is a non-homogeneous complex which cannot be measured, strictly speaking, except in certain special cases, as for example when all the items of one output are included in the same proportions in another output.
(ii) The difficulty is even greater when, in order to calculate net output, we try to measure the net addition to capital equipment; for we have to find some basis for a quantitative comparison between the new items of equipment produced during the period and the old items which have perished by wastage. In order to arrive at the net national dividend, Professor Pigou deducts such obsolescence, etc., ‘as may fairly be called “normal”; and the practical test of normality is that the depletion is sufficiently regular to be foreseen, if not in detail, at least in the large’. But, since this deduction is not a deduction in terms of money, he is involved in assuming that there can be a change in physical quantity, although there has been no physical change; i.e. he is covertly introducing changes in value.
Moreover, he is unable to devise any satisfactory formula to evaluate new equipment against old when, owing to changes in technique, the two are not identical. I believe that the concept at which Professor Pigou is aiming is the right and appropriate concept for economic analysis. But, until a satisfactory system of units has been adopted, its precise definition is an impossible task. The problem of comparing one real output with another and of then calculating net output by setting off new items of equipment against the wastage of old items presents conundrums which permit, one can confidently say, of no solution.
(iii) Thirdly, the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of a causal analysis, which ought to be exact.
Nevertheless these difficulties are rightly regarded as ‘conundrums’. They are ‘purely theoretical’ in the sense that they never perplex, or indeed enter in any way into, business decisions and have no relevance to the causal sequence of economic events, which are clear-cut and determinate in spite of the quantitative indeterminacy of these concepts. It is natural, therefore, to conclude that they not only lack precision but are unnecessary. Obviously our quantitative analysis must be expressed without using any quantitatively vague expressions. And, indeed, as soon as one makes the attempt, it becomes clear, as I hope to show, that one can get on much better without them.
The fact that two incommensurable collections of miscellaneous objects cannot in themselves provide the material for a quantitative analysis need not, of course, prevent us from making approximate statistical comparisons, depending on some broad element of judgment rather than of strict calculation, which may possess significance and validity within certain limits.
But the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical or social curiosity, a purpose for which perfect precision — such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact — is neither usual nor necessary. To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth — a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis.
III
On every particular occasion, let it be remembered, an entrepreneur is concerned with decisions as to the scale on which to work a given capital equipment; and when we say that the expectation of an increased demand, i.e. a raising of the aggregate demand function, will lead to an increase in aggregate output, we really mean that the firms, which own the capital equipment, will be induced to associate with it a greater aggregate employment of labour. In the case of an individual firm or industry producing a homogeneous product we can speak legitimately, if we wish, of increases or decreases of output. But when we are aggregating the activities of all firms, we cannot speak accurately except in terms of quantities of employment applied to a given equipment. The concepts of output as a whole and its price-level are not required in this context, since we have no need of an absolute measure of current aggregate output, such as would enable us to compare its amount with the amount which would result from the association of a different capital equipment with a different quantity of employment. When, for purposes of description or rough comparison, we wish to speak of an increase of output, we must rely on the general presumption that the amount of employment associated with a given capital equipment will be a satisfactory index of the amount of resultant output;— the two being presumed to increase and decrease together, though not in a definite numerical proportion.
In dealing with the theory of employment I propose, therefore, to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment. The first of these is strictly homogeneous, and the second can be made so. For, in so far as different grades and kinds of labour and salaried assistance enjoy a more or less fixed relative remuneration, the quantity of employment can be sufficiently defined for our purpose by taking an hour’s employment of ordinary labour as our unit and weighting an hour’s employment of special labour in proportion to its remuneration; i.e. an hour of special labour remunerated at double ordinary rates will count as two units. We shall call the unit in which the quantity of employment is measured the labour-unit; and the money-wage of a labour-unit we shall call the wage-unit. Thus, if E is the wages (and salaries) bill, W the wage-unit, and N the quantity of employment, E = N × W.
This assumption of homogeneity in the supply of labour is not upset by the obvious fact of great differences in the specialised skill of individual workers and in their suitability for different occupations. For, if the remuneration of the workers is proportional to their efficiency, the differences are dealt with by our having regarded individuals as contributing to the supply of labour in proportion to their remuneration; whilst if, as output increases, a given firm has to bring in labour which is less and less efficient for its special purposes per wage-unit paid to it, this is merely one factor among others leading to a diminishing return from the capital equipment in terms of output as more labour is employed on it. We subsume, so to speak, the non-homogeneity of equally remunerated labour units in the equipment, which we regard as less and less adapted to employ the available labour units as output increases, instead of regarding the available labour units as less and less adapted to use a homogeneous capital equipment. Thus if there is no surplus of specialised or practised labour and the use of less suitable labour involves a higher labour cost per unit of output, this means that the rate at which the return from the equipment diminishes as employment increases is more rapid than it would be if there were such a surplus. Even in the limiting case where different labour units were so highly specialised as to be altogether incapable of being substituted for one another, there is no awkwardness; for this merely means that the elasticity of supply of output from a particular type of capital equipment falls suddenly to zero when all the available labour specialised to its use is already employed. Thus our assumption of a homogeneous unit of labour involves no difficulties unless there is great instability in the relative remuneration of different labour-units; and even this difficulty can be dealt with, if it arises, by supposing a rapid liability to change in the supply of labour and the shape of the aggregate supply function.
It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behaviour of the economic system as a whole; reserving the use of units of particular outputs and equipments to the occasions when we are analysing the output of individual firms or industries in isolation; and the use of vague concepts, such as the quantity of output as a whole, the quantity of capital equipment as a whole and the general level of prices, to the occasions when we are attempting some historical comparison which is within certain (perhaps fairly wide) limits avowedly unprecise and approximate.
It follows that we shall measure changes in current output by reference to the number of hours of labour paid for (whether to satisfy consumers or to produce fresh capital equipment) on the existing capital equipment, hours of skilled labour being weighted in proportion to their remuneration. We have no need of a quantitative comparison between this output and the output which would result from associating a different set of workers with a different capital equipment. To predict how entrepreneurs possessing a given equipment will respond to a shift in the aggregate demand function it is not necessary to know how the quantity of the resulting output, the standard of life and the general level of prices would compare with what they were at a different date or in another country.
IV
It is easily shown that the conditions of supply, such as are usually expressed in terms of the supply curve, and the elasticity of supply relating output to price, can be handled in terms of our two chosen units by means of the aggregate supply function, without reference to quantities of output, whether we are concerned with a particular firm or industry or with economic activity as a whole. For the aggregate supply function for a given firm (and similarly for a given industry or for industry as a whole) is given by
Zr = φr(Nr),
where Zr is the proceeds (net of user cost) the expectation of which will induce a level of employment Nr. If, therefore, the relation between employment and output is such that an employment Nr results in an output Or, where Or = ψr(Nr), it follows that
Zr + Ur(Nr) φr(Nr) + Ur(Nr)
p = ——————— = —————————
Or ψr(Nr)
is the ordinary supply curve, where Ur(Nr) is the (expected) user cost corresponding to a level of employment Nr.
Thus in the case of each homogeneous commodity, for which Or = ψr(Nr) has a definite meaning, we can evaluate Zr = φr(Nr) in the ordinary way; but we can then aggregate the Nr’s in a way in which we cannot aggregate the Or’s, since ΣOr is not a numerical quantity. Moreover, if we can assume that, in a given environment, a given aggregate employment will be distributed in a unique way between different industries, so that Nr is a function of N, further simplifications are possible.
Chapter 5
Expectation as Determining Output and Employment
I
All production is for the purpose of ultimately satisfying a consumer. Time usually elapses, however — and sometimes much time — between the incurring of costs by the producer (with the consumer in view) and the purchase of the output by the ultimate consumer. Meanwhile the entrepreneur (including both the producer and the investor in this description) has to form the best expectations he can as to what the consumers will be prepared to pay when he is ready to supply them (directly or indirectly) after the elapse of what may be a lengthy period; and he has no choice but to be guided by these expectations, if he is to produce at all by processes which occupy time.
These expectations, upon which business decisions depend, fall into two groups, certain individuals or firms being specialised in the business of framing the first type of expectation and others in the business of framing the second. The first type is concerned with the price which a manufacturer can expect to get for his ‘finished’ output at the time when he commits himself to starting the process which will produce it; output being ‘finished’ (from the point of view of the manufacturer) when it is ready to be used or to be sold to a second party. The second type is concerned with what the entrepreneur can hope to earn in the shape of future returns if he purchases (or, perhaps, manufactures) ‘finished’ output as an addition to his capital equipment. We may call the former short-term expectation and the latter long-term expectation.
Thus the behaviour of each individual firm in deciding its daily output will be determined by its short-term expectations — expectations as to the cost of output on various possible scales and expectations as to the sale-proceeds of this output; though, in the case of additions to capital equipment and even of sales to distributors, these short-term expectations will largely depend on the long-term (or medium-term) expectations of other parties. It is upon these various expectations that the amount of employment which the firms offer will depend. The actually realised results of the production and sale of output will only be relevant to employment in so far as they cause a modification of subsequent expectations. Nor, on the other hand, are the original expectations relevant, which led the firm to acquire the capital equipment and the stock of intermediate products and half-finished materials with which it finds itself at the time when it has to decide the next day’s output. Thus, on each and every occasion of such a decision, the decision will be made, with reference indeed to this equipment and stock, but in the light of the current expectations of prospective costs and sale-proceeds.
Now, in general, a change in expectations (whether short-term or long-term) will only produce its full effect on employment over a considerable period. The change in employment due to a change in expectations will not be the same on the second day after the change as on the first, or the same on the third day as on the second, and so on, even though there be no further change in expectations. In the case of short-term expectations this is because changes in expectation are not, as a rule, sufficiently violent or rapid, when they are for the worse, to cause the abandonment of work on all the productive processes which, in the light of the revised expectation, it was a mistake to have begun; whilst, when they are for the better, some time for preparation must needs elapse before employment can reach the level at which it would have stood if the state of expectation had been revised sooner. In the case of long-term expectations, equipment which will not be replaced will continue to give employment until it is worn out; whilst when the change in long-term expectations is for the better, employment may be at a higher level at first, than it will be after there has been time to adjust the equipment to the new situation.
If we suppose a state of expectation to continue for a sufficient length of time for the effect on employment to have worked itself out so completely that there is, broadly speaking, no piece of employment going on which would not have taken place if the new state of expectation had always existed, the steady level of employment thus attained may be called the long-period employment corresponding to that state of expectation. It follows that, although expectation may change so frequently that the actual level of employment has never had time to reach the long-period employment corresponding to the existing state of expectation, nevertheless every state of expectation has its definite corresponding level of long-period employment.
Let us consider, first of all, the process of transition to a long-period position due to a change in expectation, which is not confused or interrupted by any further change in expectation. We will first suppose that the change is of such a character that the new long-period employment will be greater than the old. Now, as a rule, it will only be the rate of input which will be much affected at the beginning, that is to say, the volume of work on the earlier stages of new processes of production, whilst the output of consumption-goods and the amount of employment on the later stages of processes which were started before the change will remain much the same as before. In so far as there were stocks of partly finished goods, this conclusion may be modified; though it is likely to remain true that the initial increase in employment will be modest. As, however, the days pass by, employment will gradually increase. Moreover, it is easy to conceive of conditions which will cause it to increase at some stage to a higher level than the new long-period employment. For the process of building up capital to satisfy the new state of expectation may lead to more employment and also to more current consumption than will occur when the long-period position has been reached. Thus the change in expectation may lead to a gradual crescendo in the level of employment, rising to a peak and then declining to the new long-period level. The same thing may occur even if the new long-period level is the same as the old, if the change represents a change in the direction of consumption which renders certain existing processes and their equipment obsolete. Or again, if the new long-period employment is less than the old, the level of employment during the transition may fall for a time below what the new long-period level is going to be. Thus a mere change in expectation is capable of producing an oscillation of the same kind of shape as a cyclical movement, in the course of working itself out. It was movements of this kind which I discussed in my Treatise on Money in connection with the building up or the depletion of stocks of working and liquid capital consequent on change.
An uninterrupted process of transition, such as the above, to a new long-period position can be complicated in detail. But the actual course of events is more complicated still. For the state of expectation is liable to constant change, a new expectation being superimposed long before the previous change has fully worked itself out; so that the economic machine is occupied at any given time with a number of overlapping activities, the existence of which is due to various past states of expectation.
II
This leads us to the relevance of this discussion for our present purpose. It is evident from the above that the level of employment at any time depends, in a sense, not merely on the existing state of expectation but on the states of expectation which have existed over a certain past period. Nevertheless past expectations, which have not yet worked themselves out, are embodied in the to-day’s capital equipment with reference to which the entrepreneur has to make to-day’s decisions, and only influence his decisions in so far as they are so embodied. It follows, therefore, that, in spite of the above, to-day’s employment can be correctly described as being governed by to-day’s expectations taken in conjunction with to-day’s capital equipment.
Express reference to current long-term expectations can seldom be avoided. But it will often be safe to omit express reference to short-term expectation, in view of the fact that in practice the process of revision of short-term expectation is a gradual and continuous one, carried on largely in the light of realised results; so that expected and realised results run into and overlap one another in their influence. For, although output and employment are determined by the producer’s short-term expectations and not by past results, the most recent results usually play a predominant part in determining what these expectations are. It would be too complicated to work out the expectations de novo whenever a productive process was being started; and it would, moreover, be a waste of time since a large part of the circumstances usually continue substantially unchanged from one day to the next. Accordingly it is sensible for producers to base their expectations on the assumption that the most recently realised results will continue, except in so far as there are definite reasons for expecting a change. Thus in practice there is a large overlap between the effects on employment of the realised sale-proceeds of recent output and those of the sale-proceeds expected from current input; and producers’ forecasts are more often gradually modified in the light of results than in anticipation of prospective changes.
Nevertheless, we must not forget that, in the case of durable goods, the producer’s short-term expectations are based on the current long-term expectations of the investor; and it is of the nature of long-term expectations that they cannot be checked at short intervals in the light of realised results. Moreover, as we shall see in chapter 12, where we shall consider long-term expectations in more detail, they are liable to sudden revision. Thus the factor of current long-term expectations cannot be even approximately eliminated or replaced by realised results.
Chapter 6
The Definition of Income, Saving and Investment
I. Income
During any period of time an entrepreneur will have sold finished output to consumers or to other entrepreneurs for a certain sum which we will designate as A. He will also have spent a certain sum, designated by A1, on purchasing finished output from other entrepreneurs. And he will end up with a capital equipment, which term includes both his stocks of unfinished goods or working capital and his stocks of finished goods, having a value G.
Some part, however, of A + G − A1 will be attributable, not to the activities of the period in question, but to the capital equipment which he had at the beginning of the period. We must, therefore, in order to arrive at what we mean by the income of the current period, deduct from A + G − A1 a certain sum, to represent that part of its value which has been (in some sense) contributed by the equipment inherited from the previous period. The problem of defining income is solved as soon as we have found a satisfactory method for calculating this deduction.
There are two possible principles for calculating it, each of which has a certain significance;— one of them in connection with production, and the other in connection with consumption. Let us consider them in turn.
(i) The actual value G of the capital equipment at the end of the period is the net result of the entrepreneur, on the one hand, having maintained and improved it during the period, both by purchases from other entrepreneurs and by work done upon it by himself, and, on the other hand, having exhausted or depreciated it through using it to produce output. If he had decided not to use it to produce output, there is, nevertheless, a certain optimum sum which it would have paid him to spend on maintaining and improving it. Let us suppose that, in this event, he would have spent B’ on its maintenance and improvement, and that, having had this spent on it, it would have been worth G’ at the end of the period. That is to say, G’ − B’ is the maximum net value which might have been conserved from the previous period, if it had not been used to produce A. The excess of this potential value of the equipment over G − A1 is the measure of what has been sacrificed (one way or another) to produce A. Let us call this quantity, namely
(G’ − B’) − (G − A1),
which measures the sacrifice of value involved in the production of A, the user cost of A. User cost will be written U. The amount paid out by the entrepreneur to the other factors of production in return for their services, which from their point of view is their income, we will call the factor cost of A. The sum of the factor cost F and the user cost U we shall call the prime cost of the output A.
We can then define the income of the entrepreneur as being the excess of the value of his finished output sold during the period over his prime cost. The entrepreneur’s income, that is to say, is taken as being equal to the quantity, depending on his scale of production, which he endeavours to maximise, i.e. to his gross profit in the ordinary sense of this term;— which agrees with common sense. Hence, since the income of the rest of the community is equal to the entrepreneur’s factor cost, aggregate income is equal to A − U.
Income, thus defined, is a completely unambiguous quantity. Moreover, since it is the entrepreneur’s expectation of the excess of this quantity over his outgoings to the other factors of production which he endeavours to maximise when he decides how much employment to give to the other factors of production, it is the quantity which is causally significant for employment.
It is conceivable, of course, that G − A1 may exceed G’ − B’, so that user cost will be negative. For example, this may well be the case if we happen to choose our period in such a way that input has been increasing during the period but without there having been time for the increased output to reach the stage of being finished and sold. It will also be the case, whenever there is positive investment, if we imagine industry to be so much integrated that entrepreneurs make most of their equipment for themselves. Since, however, user cost is only negative when the entrepreneur has been increasing his capital equipment by his own labour, we can, in an economy where capital equipment is largely manufactured by different firms from those which use it, normally think of user cost as being positive. Moreover, it is difficult to conceive of a case where marginal user cost associated with an increase in A, i.e. dU/dA, will be other than positive.
It may be convenient to mention here, in anticipation of the latter part of this chapter, that, for the community as a whole, the aggregate consumption (C) of the period is equal to Σ(A − A1), and the aggregate investment (I) is equal to Σ(A1 − U). Moreover, U is the individual entrepreneur’s disinvestment (and − U his investment) in respect of his own equipment exclusive of what he buys from other entrepreneurs. Thus in a completely integrated system (where A1 = 0) consumption is equal to A and investment to − U, i.e. to G − (G’ − B’). The slight complication of the above, through the introduction of A1, is simply due to the desirability of providing in a generalised way for the case of a non-integrated system of production.
Furthermore, the effective demand is simply the aggregate income (or proceeds) which the entrepreneurs expect to receive, inclusive of the incomes which they will hand on to the other factors of production, from the amount of current employment which they decide to give. The aggregate demand function relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield; and the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximises the entrepreneur’s expectation of profit.
This set of definitions also has the advantage that we can equate the marginal proceeds (or income) to the marginal factor cost; and thus arrive at the same sort of propositions relating marginal proceeds thus defined to marginal factor costs as have been stated by those economists who, by ignoring user cost or assuming it to be zero, have equated supply price to marginal factor cost.
(ii) We turn, next, to the second of the principles referred to above. We have dealt so far with that part of the change in the value of the capital equipment at the end of the period as compared with its value at the beginning which is due to the voluntary decisions of the entrepreneur in seeking to maximise his profit. But there may, in addition, be an involuntary loss (or gain) in the value of his capital equipment, occurring for reasons beyond his control and irrespective of his current decisions, on account of (e.g.) a change in market values, wastage by obsolescence or the mere passage of time, or destruction by catastrophe such as war or earthquake. Now some part of these involuntary losses, whilst they are unavoidable, are — broadly speaking — not unexpected; such as losses through the lapse of time irrespective of use, and also ‘normal’ obsolescence which, as Professor Pigou expresses it, ‘is sufficiently regular to be foreseen, if not in detail, at least in the large’, including, we may add, those losses to the community as a whole which are sufficiently regular to be commonly regarded as ‘insurable risks’. Let us ignore for the moment the fact that the amount of the expected loss depends on when the expectation is assumed to be framed, and let us call the depreciation of the equipment, which is involuntary but not unexpected, i.e. the excess of the expected depreciation over the user cost, the supplementary cost, which will be written V. It is, perhaps, hardly necessary to point out that this definition is not the same as Marshall’s definition of supplementary cost, though the underlying idea, namely, of dealing with that part of the expected depreciation which does not enter into prime cost, is similar.
In reckoning, therefore, the net income and the net profit of the entrepreneur it is usual to deduct the estimated amount of the supplementary cost from his income and gross profit as defined above. For the psychological effect on the entrepreneur, when he is considering what he is free to spend and to save, of the supplementary cost is virtually the same as though it came off his gross profit. In his capacity as a producer deciding whether or not to use the equipment, prime cost and gross profit, as defined above, are the significant concepts. But in his capacity as a consumer the amount of the supplementary cost works on his mind in the same way as if it were a part of the prime cost. Hence we shall not only come nearest to common usage but will also arrive at a concept which is relevant to the amount of consumption, if, in defining aggregate net income, we deduct the supplementary cost as well as the user cost, so that aggregate net income is equal to A − U − V.
There remains the change in the value of the equipment, due to unforeseen changes in market values, exceptional obsolescence or destruction by catastrophe, which is both involuntary and — in a broad sense — unforeseen. The actual loss under this head, which we disregard even in reckoning net income and charge to capital account, may be called the windfall loss.
The causal significance of net income lies in the psychological influence of the magnitude of V on the amount of current consumption, since net income is what we suppose the ordinary man to reckon his available income to be when he is deciding how much to spend on current consumption. This is not, of course, the only factor of which he takes account when he is deciding how much to spend. It makes a considerable difference, for example, how much windfall gain or loss he is making on capital account. But there is a difference between the supplementary cost and a windfall loss in that changes in the former are apt to affect him in just the same way as changes in his gross profit. It is the excess of the proceeds of the current output over the sum of the prime cost and the supplementary cost which is relevant to the entrepreneur’s consumption; whereas, although the windfall loss (or gain) enters into his decisions, it does not enter into them on the same scale — a given windfall loss does not have the same effect as an equal supplementary cost.
We must now recur, however, to the point that the line between supplementary costs and windfall losses, i.e. between those unavoidable losses which we think it proper to debit to income account and those which it is reasonable to reckon as a windfall loss (or gain) on capital account, is partly a conventional or psychological one, depending on what are the commonly accepted criteria for estimating the former. For no unique principle can be established for the estimation of supplementary cost, and its amount will depend on our choice of an accounting method. The expected value of the supplementary cost, when the equipment was originally produced, is a definite quantity. But if it is re-estimated subsequently, its amount over the remainder of the life of the equipment may have changed as a result of a change in the meantime in our expectations; the windfall capital loss being the discounted value of the difference between the former and the revised expectation of the prospective series of U + V. It is a widely approved principle of business accounting, endorsed by the Inland Revenue authorities, to establish a figure for the sum of the supplementary cost and the user cost when the equipment is acquired and to maintain this unaltered during the life of the equipment, irrespective of subsequent changes in expectation. In this case the supplementary cost over any period must be taken as the excess of this predetermined figure over the actual user cost. This has the advantage of ensuring that the windfall gain or loss shall be zero over the life of the equipment taken as a whole. But it is also reasonable in certain circumstances to recalculate the allowance for supplementary cost on the basis of current values and expectations at an arbitrary accounting interval, e.g. annually. Business men in fact differ as to which course they adopt. It may be convenient to call the initial expectation of supplementary cost when the equipment is first acquired the basic supplementary cost, and the same quantity recalculated up to date on the basis of current values and expectations the current supplementary cost.
Thus we cannot get closer to a quantitative definition of supplementary cost than that it comprises those deductions from his income which a typical entrepreneur makes before reckoning what he considers his net income for the purpose of declaring a dividend (in the case of a corporation) or of deciding the scale of his current consumption (in the case of an individual). Since windfall charges on capital account are not going to be ruled out of the picture, it is clearly better, in case of doubt, to assign an item to capital account, and to include in supplementary cost only what rather obviously belongs there. For any overloading of the former can be corrected by allowing it more influence on the rate of current consumption than it would otherwise have had.
It will be seen that our definition of net income comes very close to Marshall’s definition of income, when he decided to take refuge in the practices of the Income Tax Commissioners and — broadly speaking to regard as income whatever they, with their experience, choose to treat as such. For the fabric of their decisions can be regarded as the result of the most careful and extensive investigation which is available, to interpret what, in practice, it is usual to treat as net income. It also corresponds to the money value of Professor Pigou’s most recent definition of the national dividend.
It remains true, however, that net income, being based on an equivocal criterion which different authorities might interpret differently, is not perfectly clear-cut. Professor Hayek, for example, has suggested that an individual owner of capital goods might aim at keeping the income he derives from his possessions constant, so that he would not feel himself free to spend his income on consumption until he had set aside sufficient to offset any tendency of his investment-income to decline for whatever reason. I doubt if such an individual exists; but, obviously, no theoretical objection can be raised against this deduction as providing a possible psychological criterion of net income. But when Professor Hayek infers that the concepts of saving and investment suffer from a corresponding vagueness, he is only right if he means net saving and net investment. The saving and the investment, which are relevant to the theory of employment, are clear of this defect, and are capable of objective definition, as we have shown above.
Thus it is a mistake to put all the emphasis on net income, which is only relevant to decisions concerning consumption, and is, moreover, only separated from various other factors affecting consumption by a narrow line; and to overlook (as has been usual) the concept of income proper, which is the concept relevant to decisions concerning current production and is quite unambiguous.
The above definitions of income and of net income are intended to conform as closely as possible to common usage. It is necessary, therefore, that I should at once remind the reader that in my Treatise on Money I defined income in a special sense. The peculiarity in my former definition related to that part of aggregate income which accrues to the entrepreneurs, since I took neither the profit (whether gross or net) actually realised from their current operations nor the profit which they expected when they decided to undertake their current operations, but in some sense (not, as I now think, sufficiently defined if we allow for the possibility of changes in the scale of output) a normal or equilibrium profit; with the result that on this definition saving exceeded investment by the amount of the excess of normal profit over the actual profit. I am afraid that this use of terms has caused considerable confusion, especially in the case of the correlative use of saving; since conclusions (relating, in particular, to the excess of saving over investment), which were only valid if the terms employed were interpreted in my special sense, have been frequently adopted in popular discussion as though the terms were being employed in their more familiar sense. For this reason, and also because I no longer require my former terms to express my ideas accurately, I have decided to discard them — with much regret for the confusion which they have caused.
II. Saving and Investment
Amidst the welter of divergent usages of terms, it is agreeable to discover one fixed point. So far as I know, everyone is agreed that saving means the excess of income over expenditure on consumption. Thus any doubts about the meaning of saving must arise from doubts about the meaning either of income or of consumption. Income we have defined above. Expenditure on consumption during any period must mean the value of goods sold to consumers during that period, which throws us back to the question of what is meant by a consumer-purchaser. Any reasonable definition of the line between consumer-purchasers and investor-purchasers will serve us equally well, provided that it is consistently applied. Such problem as there is, e.g. whether it is right to regard the purchase of a motor-car as a consumer-purchase and the purchase of a house as an investor-purchase, has been frequently discussed and I have nothing material to add to the discussion.
The criterion must obviously correspond to where we draw the line between the consumer and the entrepreneur. Thus when we have defined A1 as the value of what one entrepreneur has purchased from another, we have implicitly settled the question. It follows that expenditure on consumption can be unambiguously defined as Σ(A − A1), where A is the total sales made during the period and A1 is the total sales made by one entrepreneur to another. In what follows it will be convenient, as a rule, to omit and write A for the aggregate sales of all kinds, A1 for the aggregate sales from one entrepreneur to another and U for the aggregate user costs of the entrepreneurs.
Having now defined both income and consumption, the definition of saving, which is the excess of income over consumption, naturally follows. Since income is equal to A − U and consumption is equal to A − A1, it follows that saving is equal to A1 − U. Similarly, we have net saving for the excess of net income over consumption, equal to A1 − U − V.
Our definition of income also leads at once to the definition of current investment. For we must mean by this the current addition to the value of the capital equipment which has resulted from the productive activity of the period. This is, clearly, equal to what we have just defined as saving. For it is that part of the income of the period which has not passed into consumption. We have seen above that as the result of the production of any period entrepreneurs end up with having sold finished output having a value A and with a capital equipment which has suffered a deterioration measured by U (or an improvement measured by − U where U is negative) as a result of having produced and parted with A, after allowing for purchases A1 from other entrepreneurs. During the same period finished output having a value A − A1 will have passed into consumption. The excess of A − U over A − A1, namely A1 − U, is the addition to capital equipment as a result of the productive activities of the period and is, therefore, the investment of the period. Similarly A1 − U − V; which is the net addition to capital equipment, after allowing for normal impairment in the value of capital apart from its being used and apart from windfall changes in the value of the equipment chargeable to capital account, is the net investment of the period.
Whilst, therefore, the amount of saving is an outcome of the collective behaviour of individual consumers and the amount of investment of the collective behaviour of individual entrepreneurs, these two amounts are necessarily equal, since each of them is equal to the excess of income over consumption. Moreover, this conclusion in no way depends on any subtleties or peculiarities in the definition of income given above. Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumption — all of which is conformable both to common sense and to the traditional usage of the great majority of economists — the equality of saving and investment necessarily follows. In short-
Income = value of output = consumption + investment.
Saving = income − consumption.
Therefore saving = investment.
Thus any set of definitions which satisfy the above conditions leads to the same conclusion. It is only by denying the validity of one or other of them that the conclusion can be avoided.
The equivalence between the quantity of saving and the quantity of investment emerges from the bilateral character of the transactions between the producer on the one hand and, on the other hand, the consumer or the purchaser of capital equipment.
Income is created by the value in excess of user cost which the producer obtains for the output he has sold; but the whole of this output must obviously have been sold either to a consumer or to another entrepreneur; and each entrepreneur’s current investment is equal to the excess of the equipment which he has purchased from other entrepreneurs over his own user cost. Hence, in the aggregate the excess of income over consumption, which we call saving, cannot differ from the addition to capital equipment which we call investment. And similarly with net saving and net investment. Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.
It might be, of course, that individuals were so tête montée in their decisions as to how much they themselves would save and invest respectively, that there would be no point of price equilibrium at which transactions could take place. In this case our terms would cease to be applicable, since output would no longer have a definite market value, prices would find no resting-place between zero and infinity. Experience shows, however, that this, in fact, is not so; and that there are habits of psychological response which allow of an equilibrium being reached at which the readiness to buy is equal to the readiness to sell. That there should be such a thing as a market value for output is, at the same time, a necessary condition for money-income to possess a definite value and a sufficient condition for the aggregate amount which saving individuals decide to save to be equal to the aggregate amount which investing individuals decide to invest.
Clearness of mind on this matter is best reached, perhaps, by thinking in terms of decisions to consume (or to refrain from consuming) rather than of decisions to save. A decision to consume or not to consume truly lies within the power of the individual; so does a decision to invest or not to invest. The amounts of aggregate income and of aggregate saving are the results of the free choices of individuals whether or not to consume and whether or not to invest; but they are neither of them capable of assuming an independent value resulting from a separate set of decisions taken irrespective of the decisions concerning consumption and investment. In accordance with this principle, the conception of the propensity to consume will, in what follows, take the place of the propensity or disposition to save.
Chapter 6a: Appendix on User Cost
I
User cost has, I think, an importance for the classical theory of value which has been overlooked. There is more to be said about it than would be relevant or appropriate in this place. But, as a digression, we will examine it somewhat further in this appendix.
An entrepreneur’s user cost is by definition equal to
A1 + (G’ − B’) − G,
where A1 is the amount of our entrepreneur’s purchases from other entrepreneurs, G the actual value of his capital equipment at the end of the period, and G’ the value it might have had at the end of the period if he had refrained from using it and had spent the optimum sum B’ on its maintenance and improvement. Now G − (G’ − B’), namely the increment in the value of the entrepreneur’s equipment beyond the net value which he has inherited from the previous period, represents the entrepreneur’s current investment in his equipment and can be written I. Thus U, the user cost of his sales-turnover A, is equal to A1 − I where A1 is what he has bought from other entrepreneurs and I is what he has currently invested in his own equipment. A little reflection will show that all this is no more than common sense. Some part of his outgoings to other entrepreneurs is balanced by the value of his current investment in his own equipment, and the rest represents the sacrifice which the output he has sold must have cost him over and above the total sum which he has paid out to the factors of production. If the reader tries to express the substance of this otherwise, he will find that its advantage lies in its avoidance of insoluble (and unnecessary) accounting problems. There is, I think, no other way of analysing the current proceeds of production unambiguously. If industry is completely integrated or if the entrepreneur has bought nothing from outside, so that A1 = 0, the user cost is simply the equivalent of the current disinvestment involved in using the equipment; but we are still left with the advantage that we do not require at any stage of the analysis to allocate the factor cost between the goods which are sold and the equipment which is retained. Thus we can regard the employment given by a firm, whether integrated or individual, as depending on a single consolidated decision — a procedure which corresponds to the actual interlocking character of the production of what is currently sold with total production.
The concept of user cost enables us, moreover, to give a clearer definition than that usually adopted of the short-period supply price of a unit of a firm’s saleable output. For the short-period supply price is the sum of the marginal factor cost and the marginal user cost.
Now in the modern theory of value it has been a usual practice to equate the short-period supply price to the marginal factor cost alone. It is obvious, however, that this is only legitimate if marginal user cost is zero or if supply price is specially defined so as to be net of marginal user cost, just as I have defined (p. 24 above) ‘proceeds’ and ‘aggregate supply price’ as being net of aggregate user cost. But, whereas it may be occasionally convenient in dealing with output as a whole to deduct user cost, this procedure deprives our analysis of all
reality if it is habitually (and tacitly) applied to the output of a single industry or firm, since it divorces the ‘supply price’ of an article from any ordinary sense of its ‘price’; and some confusion may have resulted from the practice of doing so. It seems to have been assumed that ‘supply price’ has an obvious meaning as applied to a unit of the saleable output of an individual firm, and the matter has not been deemed to require discussion. Yet the treatment both of what is purchased from other firms and of the wastage of the firm’s own equipment as a consequence of producing the marginal output involves the whole pack of perplexities which attend the definition of income. For, even if we assume that the marginal cost of purchases from other firms involved in selling an additional unit of output has to be deducted from the sale-proceeds per unit in order to give us what we mean by our firm’s supply price, we still have to allow for the marginal disinvestment in the firm’s own equipment involved in producing the marginal output. Even if all production is carried on by a completely integrated firm, it is still illegitimate to suppose that the marginal user cost is zero, i.e. that the marginal disinvestment in equipment due to the production of the marginal output can generally be neglected.
The concepts of user cost and of supplementary cost also enable us to establish a clearer relationship between long-period supply price and short-period supply price. Long-period cost must obviously include an amount to cover the basic supplementary cost as well as the expected prime cost appropriately averaged over the life of the equipment. That is to say, the long-period cost of the output is equal to the expected sum of the prime cost and the supplementary cost; and, furthermore, in order to yield a normal profit, the long-period supply price must exceed the long-period cost thus calculated by an amount determined by the current rate of interest on loans of comparable term and risk, reckoned as a percentage of the cost of the equipment. Or if we prefer to take a standard ‘pure’ rate of interest, we must include in the long-period cost a third term which we might call the risk-cost to cover the unknown possibilities of the actual yield differing from the expected yield. Thus the long-period supply price is equal to the sum of the prime cost, the supplementary cost, the risk cost and the interest cost, into which several components it can be analysed. The short-period supply price, on the other hand, is equal to the marginal prime cost. The entrepreneur must, therefore, expect, when he buys or constructs his equipment, to cover his supplementary cost, his risk cost and his interest cost out of the excess of the marginal value of the prime cost over its average value; so that in long-period equilibrium the excess of the marginal prime cost over the average prime cost is equal to the sum of the supplementary, risk and interest costs.
The level of output, at which marginal prime cost is exactly equal to the sum of the average prime and supplementary costs, has a special importance, because it is the point at which the entrepreneur’s trading account breaks even. It corresponds, that is to say, to the point of zero net profit; whilst with a smaller output than this he is trading at a net loss.
The extent to which the supplementary cost has to be provided for apart from the prime cost varies very much from one type of equipment to another. Two extreme cases are the following:
(i) Some part of the maintenance of the equipment must necessarily take place pari passu with the act of using it (e.g. oiling the machine). The expense of this (apart from outside purchases) is included in the factor cost. If, for physical reasons, the exact amount of the whole of the current depreciation has necessarily to be made good in this way, the amount of the user cost (apart from outside purchases) would be equal and opposite to that of the supplementary cost; and in long-period equilibrium the marginal factor cost would exceed the average factor cost by an amount equal to the risk and interest cost.
(ii) Some part of the deterioration in the value of the equipment only occurs if it is used. The cost of this is charged in user cost, in so far as it is not made good pari passu with the act of using it. If loss in the value of the equipment could only occur in this way, supplementary cost would be zero.
It may be worth pointing out that an entrepreneur does not use his oldest and worst equipment first, merely because its user cost is low; since its low user cost may be outweighed by its relative inefficiency, i.e. by its high factor cost. Thus an entrepreneur uses by preference that part of his equipment for which the user cost plus factor cost is least per unit of output. It follows that for any given volume of output of the product in question there is a corresponding user cost, but that this total user cost does not bear a uniform relation to the marginal user cost, i.e. to the increment of user cost due to an increment in the rate of output.
II
User cost constitutes one of the links between the present and the future. For in deciding his scale of production an entrepreneur has to exercise a choice between using up his equipment now and preserving it to be used later on. It is the expected sacrifice of future benefit involved in present use which determines the amount of the user cost, and it is the marginal amount of this sacrifice which, together with the marginal factor cost and the expectation of the marginal proceeds, determines his scale of production. How, then, is the user cost of an act of production calculated by the entrepreneur?
We have defined the user cost as the reduction in the value of the equipment due to using it as compared with not using it, after allowing for the cost of the maintenance and improvements which it would be worth while to undertake and for purchases from other entrepreneurs. It must be arrived at, therefore, by calculating the discounted value of the additional prospective yield which would be obtained at some later date if it were not used now. Now this must be at least equal to the present value of the opportunity to postpone replacement which will result from laying up the equipment; and it may be more.
If there is no surplus or redundant stock, so that more units of similar equipment are being newly produced every year either as an addition or in replacement, it is evident that marginal user cost will be calculable by reference to the amount by which the life or efficiency of the equipment will be shortened if it is used, and the current replacement cost. If, however, there is redundant equipment, then the user cost will also depend on the rate of interest and the current (i.e. re-estimated) supplementary cost over the period of time before the redundancy is expected to be absorbed through wastage, etc. In this way interest cost and current supplementary cost enter indirectly into the calculation of user cost.
The calculation is exhibited in its simplest and most intelligible form when the factor cost is zero, e.g. in the case of a redundant stock of a raw material such as copper, on the lines which I have worked out in my Treatise on Money, vol. ii. chap. 29. Let us take the prospective values of copper at various future dates, a series which will be governed by the rate at which redundancy is being absorbed and gradually approaches the estimated normal cost. The present value or user cost of a ton of surplus copper will then be equal to the greatest of the values obtainable by subtracting from the estimated future value at any given date of a ton of copper the interest cost and the current supplementary cost on a ton of copper between that date and the present.
In the same way the user cost of a ship or factory or machine, when these equipments are in redundant supply, is its estimated replacement cost discounted at the percentage rate of its interest and current supplementary costs to the prospective date of absorption of the redundancy.
We have assumed above that the equipment will be replaced in due course by an identical article. If the equipment in question will not be renewed identically when it is worn out, then its user cost has to be calculated by taking a proportion of the user cost of the new equipment, which will be erected to do its work when it is discarded, given by its comparative efficiency.
III
The reader should notice that, where the equipment is not obsolescent but merely redundant for the time being, the difference between the actual user cost and its normal value (i.e. the value when there is no redundant equipment) varies with the interval of time which is expected to elapse before the redundancy is absorbed. Thus if the type of equipment in question is of all ages and not ‘bunched’, so that a fair proportion is reaching the end of its life annually, the marginal user cost will not decline greatly unless the redundancy is exceptionally excessive. In the case of a general slump, marginal user cost will depend on how long entrepreneurs expect the slump to last. Thus the rise in the supply price when affairs begin to mend may be partly due to a sharp increase in marginal user cost due to a revision of their expectations.
It has sometimes been argued, contrary to the opinion of business men, that organised schemes for scrapping redundant plant cannot have the desired effect of raising prices unless they apply to the whole of the redundant plant. But the concept of user cost shows how the scrapping of (say) half the redundant plant may have the effect of raising prices immediately. For by bringing the date of the absorption of the redundancy nearer, this policy raises marginal user cost and consequently increases the current supply price. Thus business men would seem to have the notion of user cost implicitly in mind, though they do not formulate it distinctly. If the supplementary cost is heavy, it follows that the marginal user cost will be low when there is surplus equipment. Moreover, when there is surplus equipment, the marginal factor and user costs are unlikely to be much in excess of their average value. If both these conditions are fulfilled, the existence of surplus equipment is likely to lead to the entrepreneur’s working at a net loss, and perhaps at a heavy net loss. There will not be a sudden transition from this state of affairs to a normal profit, taking place at the moment when the redundancy is absorbed. As the redundancy becomes less, the user cost will gradually increase; and the excess of marginal over average factor and user cost may also gradually increase.
IV
In Marshall’s Principles of Economics (6th ed. p.360) a part of user cost is included in prime cost under the heading of ‘extra wear-and-tear of plant’. But no guidance is given as to how this item is to be calculated or as to its importance. In his Theory of Unemployment (p.42) Professor Pigou expressly assumes that the marginal disinvestment in equipment due to the marginal output can, in general, be neglected: ‘The differences in the quantity of wear-and-tear suffered by equipment and in the costs of non-manual labour employed, that are associated with differences in output, are ignored, as being, in general, of secondary importance’. Indeed, the notion that the disinvestment in equipment is zero at the margin of production runs through a good deal of recent economic theory. But the whole problem is brought to an obvious head as soon as it is thought necessary to explain exactly what is meant by the supply price of an individual firm.
It is true that the cost of maintenance of idle plant may often, for the reasons given above, reduce the magnitude of marginal user cost, especially in a slump which is expected to last a long time. Nevertheless a very low user cost at the margin is not a characteristic of the short period as such, but of particular situations and types of equipment where the cost of maintaining idle plant happens to be heavy, and of those disequilibria which are characterised by very rapid obsolescence or great redundancy, especially if it is coupled with a large proportion of comparatively new plant.
In the case of raw materials the necessity of allowing for user cost is obvious;— if a ton of copper is used up to-day it cannot be used to-morrow, and the value which the copper would have for the purposes of to-morrow must clearly he reckoned as a part of the marginal cost. But the fact has been overlooked that copper is only an extreme case of what occurs whenever capital equipment is used to produce. The assumption that there is a sharp division between raw materials where we must allow for the disinvestment due to using them and fixed capital where we can safely neglect it does not correspond to the facts;— especially in normal conditions where equipment is falling due for replacement every year and the use of equipment brings nearer the date at which replacement is necessary.
It is an advantage of the concepts of user cost and supplementary cost that they are as applicable to working and liquid capital as to fixed capital. The essential difference between raw materials and fixed capital lies not in their liability to user and supplementary costs, but in the fact that the return to liquid capital consists of a single term; whereas in the case of fixed capital, which is durable and used up gradually, the return consists of a series of user costs and profits earned in successive periods.
Chapter 7
The Meaning of Saving and Investment Further Considered
I
In the previous chapter saving and investment have been so defined that they are necessarily equal in amount, being, for the community as a whole, merely different aspects of the same thing. Several contemporary writers (including myself in my Treatise on Money) have, however, given special definitions of these terms on which they are not necessarily equal. Others have written on the assumption that they may be unequal without prefacing their discussion with any definitions at all. It will be useful, therefore, with a view to relating the foregoing to other discussions of these terms, to classify some of the various uses of them which appear to be current.
So far as I know, everyone agrees in meaning by saving the excess of income over what is spent on consumption. It would certainly be very inconvenient and misleading not to mean this. Nor is there any important difference of opinion as to what is meant by expenditure on consumption. Thus the differences of usage arise either out of the definition of investment or out of that of income.
II
Let us take investment first. In popular usage it is common to mean by this the purchase of an asset, old or new, by an individual or a corporation. Occasionally, the term might be restricted to the purchase of an asset on the Stock Exchange. But we speak just as readily of investing, for example, in a house, or in a machine, or in a stock of finished or unfinished goods; and, broadly speaking, new investment, as distinguished from reinvestment, means the purchase of a capital asset of any kind out of income. If we reckon the sale of an investment as being negative investment, i.e. disinvestment, my own definition is in accordance with popular usage; since exchanges of old investments necessarily cancel out. We have, indeed, to adjust for the creation and discharge of debts (including changes in the quantity of credit or money); but since for the community as a whole the increase or decrease of the aggregate creditor position is always exactly equal to the increase or decrease of the aggregate debtor position, this complication also cancels out when we are dealing with aggregate investment. Thus, assuming that income in the popular sense corresponds to my net income, aggregate investment in the popular sense coincides with my definition of net investment, namely the net addition to all kinds of capital equipment, after allowing for those changes in the value of the old capital equipment which are taken into account in reckoning net income.
Investment, thus defined, includes, therefore, the increment of capital equipment, whether it consists of fixed capital, working capital or liquid capital; and the significant differences of definition (apart from the distinction between investment and net investment) are due to the exclusion from investment of one or more of these categories.
Mr Hawtrey, for example, who attaches great importance to changes in liquid capital, i.e. to undesigned increments (or decrements) in the stock of unsold goods, has suggested a possible definition of investment from which such changes are excluded. In this case an excess of saving over investment would be the same thing as an undesigned increment in the stock of unsold goods, i.e. as an increase of liquid capital. Mr Hawtrey has not convinced me that this is the factor to stress; for it lays all the emphasis on the correction of changes which were in the first instance unforeseen, as compared with those which are, rightly or wrongly, anticipated. Mr Hawtrey regards the daily decisions of entrepreneurs concerning their scale of output as being varied from the scale of the previous day by reference to the changes in their stock of unsold goods. Certainly, in the case of consumption goods, this plays an important part in their decisions. But I see no object in excluding the play of other factors on their decisions; and I prefer, therefore, to emphasise the total change of effective demand and not merely that part of the change in effective demand which reflects the increase or decrease of unsold stocks in the previous period. Moreover, in the case of fixed capital, the increase or decrease of unused capacity corresponds to the increase or decrease in unsold stocks in its effect on decisions to produce; and I do not see how Mr Hawtrey’s method can handle this at least equally important factor.
It seems probable that capital formation and capital consumption, as used by the Austrian school of economists, are not identical either with investment and disinvestment as defined above or with net investment and disinvestment. In particular, capital consumption is said to occur in circumstances where there is quite clearly no net decrease in capital equipment as defined above. I have, however, been unable to discover a reference to any passage where the meaning of these terms is clearly explained. The statement, for example, that capital formation occurs when there is a lengthening of the period of production does not much advance matters.
III
We come next to the divergences between saving and investment which are due to a special definition of income and hence of the excess of income over consumption. My own use of terms in my Treatise on Money is an example of this. For, as I have explained on p. 60 above, the definition of income, which I there employed, differed from my present definition by reckoning as the income of entrepreneurs not their actually realised profits but (in some sense) their ‘normal profit’. Thus by an excess of saving over investment I meant that the scale of output was such that entrepreneurs were earning a less than normal profit from their ownership of the capital equipment; and by an increased excess of saving over investment I meant that a decline was taking place in the actual profits, so that they would be under a motive to contract output.
As I now think, the volume of employment (and consequently of output and real income) is fixed by the entrepreneur under the motive of seeking to maximise his present and prospective profits (the allowance for user cost being determined by his view as to the use of equipment which will maximise his return from it over its whole life); whilst the volume of employment which will maximise his profit depends on the aggregate demand function given by his expectations of the sum of the proceeds resulting from consumption and investment respectively on various hypotheses. In my Treatise on Money the concept of changes in the excess of investment over saving, as there defined, was a way of handling changes in profit, though I did not in that book distinguish clearly between expected and realised results. I there argued that change in the excess of investment over saving was the motive force governing changes in the volume of output. Thus the new argument, though (as I now think) much more accurate and instructive, is essentially a development of the old. Expressed in the language of my Treatise on Money, it would run: the expectation of an increased excess of investment over saving, given the former volume of employment and output, will induce entrepreneurs to increase the volume of employment and output. The significance of both my present and my former arguments lies in their attempt to show that the volume of employment is determined by the estimates of effective demand made by the entrepreneurs, an expected increase of investment relatively to saving as defined in my Treatise on Money being a criterion of an increase in effective demand. But the exposition in my Treatise on Money is, of course, very confusing and incomplete in the light of the further developments here set forth.
Mr D. H. Robertson has defined to-day’s income as being equal to yesterday’s consumption plus investment, so that to-day’s saving, in his sense, is equal to yesterday’s investment plus the excess of yesterday’s consumption over to-day’s consumption. On this definition saving can exceed investment, namely, by the excess of yesterday’s income (in my sense) over to-day’s income. Thus when Mr Robertson says that there is an excess of saving over investment, he means literally the same thing as I mean when I say that income is falling, and the excess of saving in his sense is exactly equal to the decline of income in my sense. If it were true that current expectations were always determined by yesterday’s realised results, to-day’s effective demand would be equal to yesterday’s income. Thus Mr Robertson’s method might be regarded as an alternative. attempt to mine (being, perhaps, a first approximation to it) to make the same distinction, so vital for causal analysis, that I have tried to make by the contrast between effective demand and income.
IV
We come next to the much vaguer ideas associated with the phrase ‘forced saving’. Is any clear significance discoverable in these? In my Treatise on Money (vol.1, p. 171, footnote [JMK, vol. V, p.154] I gave some references to earlier uses of this phrase and suggested that they bore some affinity to the difference between investment and ‘saving’ in the sense in which I there used the latter term. I am no longer confident that there was in fact so much affinity as I then supposed. In any case, I feel sure that ‘forced saving’ and analogous phrases employed more recently (e.g. by Professor Hayek or Professor Robbins) have no definite relation to the difference between investment and ‘saving’ in the sense intended in my Treatise on Money. For whilst these authors have not explained exactly what they mean by this term, it is clear that ‘forced saving’, in their sense, is a phenomenon which results directly from, and is measured by, changes in the quantity of money or bank-credit.
It is evident that a change in the volume of output and employment will, indeed, cause a change in income measured in wage-units; that a change in the wage-unit will cause both a redistribution of income between borrowers and lenders and a change in aggregate income measured in money; and that in either event there will (or may) be a change in the amount saved. Since, therefore, changes in the quantity of money may result, through their effect on the rate of interest, in a change in the volume and distribution of income (as we shall show later), such changes may involve, indirectly, a change in the amount saved. But such changes in the amounts saved are no more ‘forced savings’ than any other changes in the amounts saved due to a change in circumstances; and there is no means of distinguishing between one case and another, unless we specify the amount saved in certain given conditions as our norm or standard. Moreover, as we shall see, the amount of the change in aggregate saving which results from a given change in the quantity of money is highly variable and depends on many other factors.
Thus ‘forced saving’ has no meaning until we have specified some standard rate of saving. If we select (as might be reasonable) the rate of saving which corresponds to an established state of full employment, the above definition would become: ‘Forced saving is the excess of actual saving over what would be saved if there were full employment in a position of long-period equilibrium’. This definition would make good sense, but a sense in which a forced excess of saving would be a very rare and a very unstable phenomenon, and a forced deficiency of saving the usual state of affairs.
Professor Hayek’s interesting ‘Note on the Development of the Doctrine of Forced Saving’ shows that this was in fact the original meaning of the term. ‘Forced saving’ or ‘forced frugality’ was, in the first instance, a conception of Bentham’s; and Bentham expressly stated that he had in mind the consequences of an increase in the quantity of money (relatively to the quantity of things vendible for money) in circumstances of ‘all hands being employed and employed in the most advantageous manner’. In such circumstances, Bentham points out, real income cannot be increased, and, consequently, additional investment, taking place as a result of the transition, involves forced frugality ‘at the expense of national comfort and national justice’. All the nineteenth-century writers who dealt with this matter had virtually the same idea in mind. But an attempt to extend this perfectly clear notion to conditions of less than full employment involves difficulties. It is true, of course (owing to the fact of diminishing returns to an increase in the employment applied to a given capital equipment), that any increase in employment involves some sacrifice of real income to those who were already employed, but an attempt to relate this loss to the increase in investment which may accompany the increase in employment is not likely to be fruitful. At any rate I am not aware of any attempt having been made by the modern writers who are interested in ‘forced saving’ to extend the idea to conditions where employment is increasing; and they seem, as a rule, to overlook the fact that the extension of the Benthamite concept of forced frugality to conditions of less than full employment requires some explanation or qualification.
V
The prevalence of the idea that saving and investment, taken in their straightforward sense, can differ from one another, is to be explained, I think, by an optical illusion due to regarding an individual depositor’s relation to his bank as being a one-sided transaction, instead of seeing it as the two-sided transaction which it actually is. It is supposed that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no saving corresponds. But no one can save without acquiring an asset, whether it be cash or a debt or capital-goods; and no one can acquire an asset which he did not previously possess, unless either an asset of equal value is newly produced or someone else parts with an asset of that value which he previously had. In the first alternative there is a corresponding new investment: in the second alternative someone else must be dis-saving an equal sum. For his loss of wealth must be due to his consumption exceeding his income, and not to a loss on capital account through a change in the value of a capital-asset, since it is not a case of his suffering a loss of value which his asset formerly had; he is duly receiving the current value of his asset and yet is not retaining this value in wealth of any form, i.e. he must be spending it on current consumption in excess of current income. Moreover, if it is the banking system which parts with an asset, someone must be parting with cash. It follows that the aggregate saving of the first individual and of others taken together must necessarily be equal to the amount of current new investment.
The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment. Moreover, except in conditions of full employment, there will be an increase of real income as well as of money-income. The public will exercise ‘a free choice’ as to the proportion in which they divide their increase of income between saving and spending; and it is impossible that the intention of the entrepreneur who has borrowed in order to increase investment can become effective (except in substitution for investment by other entrepreneurs which would have occurred otherwise) at a faster rate than the public decide to increase their savings. Moreover, the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth. Yet employment, incomes and prices cannot help moving in such a way that in the new situation someone does choose to hold the additional money. It is true that an unexpected increase of investment in a particular direction may cause an irregularity in the rate of aggregate saving and investment which would not have occurred if it had been sufficiently foreseen. It is also true that the grant of the bank-credit will set up three tendencies —(1) for output to increase, (2) for the marginal product to rise in value in terms of the wage-unit (which in conditions of decreasing return must necessarily accompany an increase of output), and (3) for the wage-unit to rise in terms of money (since this is a frequent concomitant of better employment); and these tendencies may affect the distribution of real income between different groups. But these tendencies are characteristic of a state of increasing output as such, and will occur just as much if the increase in output has been initiated otherwise than by an increase in bank-credit. They can only be avoided by avoiding any course of action capable of improving employment. Much of the above, however, is anticipating the result of discussions which have not yet been reached.
Thus the old-fashioned view that saving always involves investment, though incomplete and misleading, is formally sounder than the new-fangled view that there can be saving without investment or investment without ‘genuine’ saving. The error lies in proceeding to the plausible inference that, when an individual saves, he will increase aggregate investment by an equal amount. It is true, that, when an individual saves he increases his own wealth. But the conclusion that he also increases aggregate wealth fails to allow for the possibility that an act of individual saving may react on someone else’s savings and hence on someone else’s wealth.
The reconciliation of the identity between saving and investment with the apparent ‘free-will’ of the individual to save what he chooses irrespective of what he or others may be investing, essentially depends on saving being, like spending, a two-sided affair. For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.
The above is closely analogous with the proposition which harmonises the liberty, which every individual possesses, to change, whenever he chooses, the amount of money he holds, with the necessity for the total amount of money, which individual balances add up to, to be exactly equal to the amount of cash which the banking system has created. In this latter case the equality is brought about by the fact that the amount of money which people choose to hold is not independent of their incomes or of the prices of the things (primarily securities), the purchase of which is the natural alternative to holding money. Thus incomes and such prices necessarily change until the aggregate of the amounts of money which individuals choose to hold at the new level of incomes and prices thus brought about has come to equality with the amount of money created by the banking system. This, indeed, is the fundamental proposition of monetary theory.
Both these propositions follow merely from the fact that there cannot be a buyer without a seller or a seller without a buyer. Though an individual whose transactions are small in relation to the market can safely neglect the fact that demand is not a one-sided transaction, it makes nonsense to neglect it when we come to aggregate demand. This is the vital difference between the theory of the economic behaviour of the aggregate and the theory of the behaviour of the individual unit, in which we assume that changes in the individual’s own demand do not affect his income.
Chapter 8
The Propensity to Consume:
I. The Objective Factors
I
We are now in a position to return to our main theme, from which we broke off at the end of Book I in order to deal with certain general problems of method and definition. The ultimate object of our analysis is to discover what determines the volume of employment. So far we have established the preliminary conclusion that the volume of employment is determined by the point of intersection of the aggregate supply function with the aggregate demand function. The aggregate supply function, however, which depends in the main on the physical conditions of supply, involves few considerations which are not already familiar. The form may be unfamiliar but the underlying factors are not new. We shall return to the aggregate supply function in chapter 20, where we discuss its inverse under the name of the employment function. But, in the main, it is the part played by the aggregate demand function which has been overlooked; and it is to the aggregate demand function that we shall devote Books III and IV.
The aggregate demand function relates any given level of employment to the ‘proceeds’ which that level of employment is expected to realise. The ‘proceeds’ are made up of the sum of two quantities — the sum which will be spent on consumption when employment is at the given level, and the sum which will be devoted to investment. The factors which govern these two quantities are largely distinct. In this book we shall consider the former, namely what factors determine the sum which will be spent on consumption when employment is at a given level; and in Book IV we shall proceed to the factors which determine the sum which will be devoted to investment.
Since we are here concerned in determining what sum will be spent on consumption when employment is at a given level, we should, strictly speaking, consider the function which relates the former quantity (C) to the latter (N). It is more convenient, however, to work in terms of a slightly different function, namely, the function which relates the consumption in terms of wage-units (Cw) to the income in terms of wage-units (Yw) corresponding to a level of employment N. This suffers from the objection that Yw is not a unique function of N, which is the same in all circumstances. For the relationship between Yw and N may depend (though probably in a very minor degree) on the precise nature of the employment. That is to say, two different distributions of a given aggregate employment N between different employments might (owing to the different shapes of the individual employment functions — a matter to be discussed in Chapter 20 below) lead to different values of Yw. In conceivable circumstances a special allowance might have to be made for this factor. But in general it is a good approximation to regard Yw as uniquely determined by N. We will therefore define what we shall call the propensity to consume as the functional relationship between Yw a given level of income in terms of wage-units, and Cw the expenditure on consumption out of that level of income, so that
Cw = (Yw) or C = W (Yw).
The amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased). The motives to spending interact and the attempt to classify them runs the danger of false division. Nevertheless it will clear our minds to consider them separately under two broad heads which we shall call the subjective factors and the objective factors. The subjective factors, which we shall consider in more detail in the next chapter, include those psychological characteristics of human nature and those social practices and institutions which, though not unalterable, are unlikely to undergo a material change over a short period of time except in abnormal or revolutionary circumstances. In an historical enquiry or in comparing one social system with another of a different type, it is necessary to take account of the manner in which changes in the subjective factors may affect the propensity to consume. But, in general, we shall in what follows take the subjective factors as given; and we shall assume that the propensity to consume depends only on changes in the objective factors.
II
The principal objective factors which influence the propensity to consume appear to be the following:
(1) A change in the wage-unit. Consumption (C) is obviously much more a function of (in some sense) real income than of money-income. In a given state of technique and tastes and of social conditions determining the distribution of income, a man’s real income will rise and fall with the amount of his command over labour-units, i.e. with the amount of his income measured in wage-units; though when the aggregate volume of output changes, his real income will (owing to the operation of decreasing returns) rise less than in proportion to his income measured in wage-units. As a first approximation, therefore, we can reasonably assume that, if the wage-unit changes, the expenditure on consumption corresponding to a given level of employment will, like prices, change in the same proportion; though in some circumstances we may have to make an allowance for the possible reactions on aggregate consumption of the change in the distribution of a given real income between entrepreneurs and rentiers resulting from a change in the wage-unit. Apart from this, we have already allowed for changes in the wage-unit by defining the propensity to consume in terms of income measured in terms of wage-units.
(2) A change in the difference between income and net income. We have shown above that the amount of consumption depends on net income rather than on income, since it is, by definition, his net income that a man has primarily in mind when he is deciding his scale of consumption. In a given situation there may be a somewhat stable relationship between the two, in the sense that there will be a function uniquely relating different levels of income to the corresponding levels of net income. If, however, this should not be the case, such part of any change in income as is not reflected in net income must be neglected since it will have no effect on consumption; and, similarly, a change in net income, not reflected in income, must be allowed for. Save in exceptional circumstances, however, I doubt the practical importance of this factor. We will return to a fuller discussion of the effect on consumption of the difference between income and net income in the fourth section of this chapter.
(3) Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income. The consumption of the wealth-owning class may be extremely susceptible to unforeseen changes in the money-value of its wealth. This should be classified amongst the major factors capable of causing short-period changes in the propensity to consume.
(4) Changes in the rate of time-discounting, i.e. in the ratio of exchange between present goods and future goods. This is not quite the same thing as the rate of interest, since it allows for future changes in the purchasing power of money in so far as these are foreseen. Account has also to be taken of all kinds of risks, such as the prospect of not living to enjoy the future goods or of confiscatory taxation. As an approximation, however, we can identify this with the rate of interest.
The influence of this factor on the rate of spending out of a given income is open to a good deal of doubt. For the classical theory of the rate of interest, which was based on the idea that the rate of interest was the factor which brought the supply and demand for savings into equilibrium, it was convenient to suppose that expenditure on consumption is cet. par. negatively sensitive to changes in the rate of interest, so that any rise in the rate of interest would appreciably diminish consumption. It has long been recognised, however, that the total effect of changes in the rate ofinterest on the readiness to spend on present consumption is complex and uncertain, being dependent on conflicting tendencies, since some of the subjective motives towards saving will be more easily satisfied if the rate of interest rises, whilst others will be weakened. Over a long period substantial changes in the rate of interest probably tend to modify social habits considerably, thus affecting the subjective propensity to spend — though in which direction it would be hard to say, except in the light of actual experience. The usual type of short-period fluctuation in the rate of interest is not likely, however, to have much direct influence on spending either way.
There are not many people who will alter their way of living because the rate of interest has fallen from 5 to 4 per cent, if their aggregate income is the same as before. Indirectly there may be more effects, though not all in the same direction. Perhaps the most important influence, operating through changes in the rate of interest, on the readiness to spend out of a given income, depends on the effect of these changes on the appreciation or depreciation in the price of securities and other assets. For if a man is enjoying a windfall increment in the value of his capital, it is natural that his motives towards current spending should be strengthened, even though in terms of income his capital is worth no more than before; and weakened if he is suffering capital losses. But this indirect influence we have allowed for already under (3) above. Apart from this, the main conclusion suggested by experience is, I think, that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant, except, perhaps, where unusually large changes are in question. When the rate of interest falls very low indeed, the increase in the ratio between an annuity purchasable for a given sum and the annual interest on that sum may, however, provide an important source of negative saving by encouraging the practice of providing for old age by the purchase of an annuity.
The abnormal situation, where the propensity to consume may be sharply affected by the development of extreme uncertainty concerning the future and what it may bring forth, should also, perhaps, be classified under this heading.
(5) Changes in fiscal policy. In so far as the inducement to the individual to save depends on the future return which he expects, it clearly depends not only on the rate of interest but on the fiscal policy of the government. Income taxes, especially when they discriminate against ‘unearned’ income, taxes on capital-profits, death-duties and the like are as relevant as the rate of interest; whilst the range of possible changes in fiscal policy may be greater, in expectation at least, than for the rate of interest itself. If fiscal policy is used as a deliberate instrument for the more equal distribution of incomes, its effect in increasing the propensity to consume is, of course, all the greater.
We must also take account of the effect on the aggregate propensity to consume of government sinking funds for the discharge of debt paid for out of ordinary taxation. For these represent a species of corporate saving, so that a policy of substantial sinking funds must be regarded in given circumstances as reducing the propensity to consume. It is for this reason that a change-over from a policy of government borrowing to the opposite policy of providing sinking funds (or vice versa) is capable of causing a severe contraction (or marked expansion) of effective demand.
(6) Changes in expectations of the relation between the present and the future level of income. We must catalogue this factor for the sake of formal completeness. But, whilst it may affect considerably a particular individual’s propensity to consume, it is likely to average out for the community as a whole. Moreover, it is a matter about which there is, as a rule, too much uncertainty for it to exert much influence.
We are left therefore, with the conclusion that in a given situation the propensity to consume may be considered a fairly stable function, provided that we have eliminated changes in the wage-unit in terms of money. Windfall changes in capital-values will be capable of changing the propensity to consume, and substantial changes in the rate of interest and in fiscal policy may make some difference; but the other objective factors which might affect it, whilst they must not be overlooked, are not likely to be important in ordinary circumstances.
The fact that, given the general economic situation, the expenditure on consumption in terms of the wage-unit depends in the main, on the volume of output and employment is the justification for summing up the other factors in the portmanteau function ‘propensity to consume’. For whilst the other factors are capable of varying {and this must not be forgotten), the aggregate income measured in terms of the wage-unit is, as a rule, the principal variable upon which the consumption-constituent of the aggregate demand function will depend.
III
Granted, then, that the propensity to consume is a fairly stable function so that, as a rule, the amount of aggregate consumption mainly depends on the amount of aggregate income (both measured in terms of wage-units), changes in the propensity itself being treated as a secondary influence, what is the normal shape of this function?
The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. That is to say, if Cw is the amount of consumption and Yw is income (both measured in wage-units) ΔCw has the same sign as ΔYw but is smaller in amount, i.e. dCw/dYw is positive and less than unity.
This is especially the case where we have short periods in view, as in the case of the so-called cyclical fluctuations of employment during which habits, as distinct from more permanent psychological propensities, are not given time enough to adapt themselves to changed objective circumstances. For a man’s habitual standard of life usually has the first claim on his income, and he is apt to save the difference which discovers itself between his actual income and the expense of his habitual standard; or, if he does adjust his expenditure to changes in his income, he will over short periods do so imperfectly. Thus a rising income will often be accompanied by increased saving, and a falling income by decreased saving, on a greater scale at first than subsequently.
But, apart from short-period changes in the level of income, it is also obvious that a higher absolute level of income will tend, as a rule, to widen the gap between income and consumption. For the satisfaction of the immediate primary needs of a man and his family is usually a stronger motive than the motives towards accumulation, which only acquire effective sway when a margin of comfort has been attained. These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases. But whether or not a greater proportion is saved, we take it as a fundamental psychological rule of any modern community that, when its real income is increased, it will not increase its consumption by an equal absolute amount, so that a greater absolute amount must be saved, unless a large and unusual change is occurring at the same time in other factors. As we shall show subsequently, the stability of the economic system essentially depends on this rule prevailing in practice. This means that, if employment and hence aggregate income increase, not all the additional employment will be required to satisfy the needs of additional consumption.
On the other hand, a decline in income due to a decline in the level of employment, if it goes far, may even cause consumption to exceed income not only by some individuals and institutions using up the financial reserves which they have accumulated in better times, but also by the government, which will be liable, willingly or unwillingly, to run into a budgetary deficit or will provide unemployment relief; for example, out of borrowed money. Thus, when employment falls to a low level, aggregate consumption will decline by a smaller amount than that by which real income has declined, by reason both of the habitual behaviour of individuals and also of the probable policy of governments; which is the explanation why a new position of equilibrium can usually be reached within a modest range of fluctuation. Otherwise a fall in employment and income, once started, might proceed to extreme lengths.
This simple principle leads, it will be seen, to the same conclusion as before, namely, that employment can only increase pari passu with an increase in investment; unless, indeed, there is a change in the propensity to consume. For since consumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap.
IV
We must not underestimate the importance of the fact already mentioned above that, whereas employment is a function of the expected consumption and the expected investment, consumption is, cet. par., a function of net income, i.e. of net investment (net income being equal to consumption plus net investment). In other words, the larger the financial provision which it is thought necessary to make before reckoning net income, the less favourable to consumption, and therefore to employment, will a given level of investment prove to be.
When the whole of this financial provision (or supplementary cost) is in fact currently expended in the upkeep of the already existing capital equipment, this point is not likely to be overlooked. But when the financial provision exceeds the actual expenditure on current upkeep, the practical results of this in its effect on employment are not always appreciated. For the amount of this excess neither directly gives rise to current investment nor is available to pay for consumption. It has, therefore, to be balanced by new investment, the demand for which has arisen quite independently of the current wastage of old equipment against which the financial provision is being made; with the result that the new investment available to provide current income is correspondingly diminished and a more intense demand for new investment is necessary to make possible a given level of employment. Moreover, much the same considerations apply to the allowance for wastage included in user cost, in so far as the wastage is not actually made good.
Take a house which continues to be habitable until it is demolished or abandoned. If a certain sum is written off its value out of the annual rent paid by the tenants, which the landlord neither spends on upkeep nor regards as net income available for consumption, this provision, whether it is a part of U or of V; constitutes a drag on employment all through the life of the house, suddenly made good in a lump when the house has to be rebuilt.
In a stationary economy all this might not be worth mentioning, since in each year the depreciation allowances in respect of old houses would be exactly offset by the new houses built in replacement of those reaching the end of their lives in that year. But such factors may be serious in a non-static economy, especially during a period which immediately succeeds a lively burst of investment in long-lived capital. For in such circumstances a very large proportion of the new items of investment may be absorbed by the larger financial provisions made by entrepreneurs in respect of existing capital equipment, upon the repairs and renewal of which, though it is wearing out with time, the date has not yet arrived for spending anything approaching the full financial provision which is being set aside; with the result that incomes cannot rise above a level which is low enough to correspond with a low aggregate of net investment. Thus sinking funds, etc., are apt to withdraw spending power from the consumer long before the demand for expenditure on replacements (which such provisions are anticipating) comes into play; i.e. they diminish the current effective demand and only increase it in the year in which the replacement is actually made. If the effect of this is aggravated by ‘financial prudence’, i.e. by its being thought advisable to ‘write off’ the initial cost more rapidly than the equipment actually wears out, the cumulative result may be very serious indeed.
In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump. And, furthermore, since ‘financial prudence’ of this kind continued to be exercised through the slump by those great corporations which were still in a position to afford it, it offered a serious obstacle to early recovery.
Or again, in Great Britain at the present time (1935) the substantial amount of house-building and of other new investments since the war has led to an amount of sinking funds being set up much in excess of any present requirements for expenditure on repairs and renewals, a tendency which has been accentuated, where the investment has been made by local authorities and public boards, by the principles of ‘sound’ finance which often require sinking funds sufficient to write off the initial cost some time before replacement will actually fall due; with the result that even if private individuals were ready to spend the whole of their net incomes it would be a severe task to restore full employment in the face of this heavy volume of statutory provision by public and semi-public authorities, entirely dissociated from any corresponding new investment. The sinking funds of local authorities now stand, I think, at an annual figure of more than half the amount which these authorities are spending on the whole of their new developments. Yet it is not certain that the Ministry of Health are aware, when they insist on stiff sinking funds by local authorities, how much they may be aggravating the problem of unemployment. In the case of advances by building societies to help an individual to build his own house, the desire to be clear of debt more rapidly than the house actually deteriorates may stimulate the house-owner to save more than he otherwise would;— though this factor should be classified, perhaps, as diminishing the propensity to consume directly rather than through its effect on net income. In actual figures, repayments of mortgages advanced by building societies, which amounted to £24,000,000 in 1925, had risen to £68,000,000 by 1933, as compared with new advances of £103,000,000; and to-day the repayments are probably still higher.
That it is investment, rather than net investment, which emerges from the statistics of output, is brought out forcibly and naturally in Mr Colin Clark’s National Income, 1924−1931. He also shows what a large proportion depreciation, etc., normally bears to the value of investment. For example, he estimates that in Great Britain, over the years 1928−1931, the investment and the net investment were as follows, though his gross investment is probably somewhat greater than my investment, inasmuch as it may include a part of user cost, and it is not clear how closely his ‘net investment’ corresponds to my definition of this term:
(£ million)
1928 1929 1930 1931
Gross Investment-Output 791 731 620 482
‘Value of physical wasting of old capital’ 433 435 437 439
Net Investment 358 296 183 43
Mr Kuznets has arrived at much the same conclusion in compiling the statistics of the Gross Capital Formation (as he calls what I call investment) in the United States, 1919−1933. The physical fact, to which the statistics of output correspond, is inevitably the gross, and not the net, investment. Mr Kuznets has also discovered the difficulties in passing from gross investment to net investment. ‘The difficulty’, he writes, ‘of passing from gross to net capital formation, that is, the difficulty of correcting for the consumption of existing durable commodities, is not only in the lack of data. The very concept of annual consumption of commodities that last over a number of years suffers from ambiguity’. He falls back, therefore, ‘on the assumption that the allowance for depreciation and depletion on the books of business firms describes correctly the volume of consumption of already existing, finished durable goods used by business firms’ On the other hand, he attempts no deduction at all in respect of houses and other durable commodities in the hands of individuals. His very interesting results for the United States can be summarised as follows:
(Millions of dollars)
1925 1926 1927 1928 1929
Gross capital formation (after allowing for net change in business inventories) 30,706 33,571 31,157 33,934 34,491
Entrepreneurs’ servicing, repairs, maintenance, depreciation and depletion 7,685 8,288 8,223 8,481 9,010
Net capital formation (on Mr Kuznets’ definition) 23,021 25,283 22,934 25,453 25,481
(Millions of dollars)
1930 1931 1932 1933
Gross capital formation (after allowing for net change in business inventories) 27,538 18,721 7,780 14,879
Entrepreneurs’ servicing, repairs, maintenance, depreciation and depletion 8,502 7,623 6,543 8,204
Net capital formation (on Mr Kuznets’ definition) 19,036 11,098 1,237 6,675
Several facts emerge with prominence from this table. Net capital formation was very steady over the quinquennium 1925−1929, with only a 10 percent increase in the latter part of the upward movement. The deduction for entrepreneurs’ repairs, maintenance, depreciation and depletion remained at a high figure even at the bottom of the slump. But Mr Kuznets’ method must surely lead to too low an estimate of the annual increase in depreciation, etc.; for he puts the latter at less than 1½ per cent per annum of the new net capital formation. Above all, net capital formation suffered an appalling collapse after 1929, falling in 1932 to a figure no less than 95 per cent below the average of the quinquennium 1925−1929.
The above is, to some extent, a digression. But it is important to emphasise the magnitude of the deduction which has to be made from the income of a society, which already possesses a large stock of capital, before we arrive at the net income which is ordinarily available for consumption. For if we overlook this, we may underestimate the heavy drag on the propensity to consume which exists even in conditions where the public is ready to consume a very large proportion of its net income.
Consumption — to repeat the obvious — is the sole end and object of all economic activity. Opportunities for employment are necessarily limited by the extent of aggregate demand. Aggregate demand can be derived only from present consumption or from present provision for future consumption. The consumption for which we can profitably provide in advance cannot be pushed indefinitely into the future. We cannot, as a community, provide for future consumption by financial expedients but only by current physical output. In so far as our social and business organisation separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being, as there are many examples to testify. The grcater, moreover, the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance, and the greater our dependence on present consumption as a source of demand. Yet the larger our incomes, the greater, unfortunately, is the margin between our incomes and our consumption. So, failing some novel expedient, there is, as we shall see, no answer to the riddle, except that there must be sufficient unemployment to keep us so poor that our consumption falls short of our income by no more than the equivalent of the physical provision for future consumption which it pays to produce to-day.
Or look at the matter thus. Consumption is satisfied partly by objects produced currently and partly by objects produced previously, i.e. by disinvestment. To the extent that consumption is satisfied by the latter, there is a contraction of current demand, since to that extent a part of current expenditure fails to find its way back as a part of net income. Contrariwise whenever an object is produced within the period with a view to satisfying consumption subsequently, an expansion of current demand is set up. Now all capital-investment is destined to result, sooner or later, in capital-disinvestment. Thus the problem of providing that new capital-investment shall always outrun capital-disinvestment sufficiently to fill the gap between net income and consumption, presents a problem which is increasingly difficult as capital increases. New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase. Each time we secure to-day’s equilibrium by increased investment we are aggravating the difficulty of securing equilibrium to-morrow. A diminished propensity to consume to-day can only be accommodated to the public advantage if an increased propensity to consume is expected to exist some day. We are reminded of ‘The Fable of the Bees’— the gay of tomorrow are absolutely indispensable to provide a raison d’être for the grave of to-day. It is a curious thing, worthy of mention, that the popular mind seems only to be aware of this ultimate perplexity where public investment is concerned, as in the case of road-building and house-building and the like. It is commonly urged as an objection to schemes for raising employment by investment under the auspices of public authority that it is laying up trouble for the future. ‘What will you do,’ it is asked, ‘when you have built all the houses and roads and town halls and electric grids and water supplies and so forth which the stationary population of the future can be expected to require?’ But it is not so easily understood that the same difficulty applies to private investment and to industrial expansion; particularly to the latter, since it is much easier to see an early satiation of the demand for new factories and plant which absorb individually but little money, than of the demand for dwelling-houses.
The obstacle to a clear understanding is, in these examples, much the same as in many academic discussions of capital, namely, an inadequate appreciation of the fact that capital is not a self-subsistent entity existing apart from consumption. On the contrary, every weakening in the propensity to consume regarded as a permanent habit must weaken the demand for capital as well as the demand for consumption.
Chapter 9
The Propensity to Consume:
II. The Subjective Factors
I
There remains the second category of factors which affect the amount of consumption out of a given income — namely, those subjective and social incentives which determine how much is spent, given the aggregate of income in terms of wage-units and given the relevant objective factors which we have already discussed. Since, however, the analysis of these factors raises no point of novelty, it may be sufficient if we give a catalogue of the more important, without enlarging on them at any length.
There are, in general, eight main motives or objects of a subjective character which lead individuals to refrain from spending out of their incomes:
(i) To build up a reserve against unforeseen contingencies;
(ii) To provide for an anticipated future relation between the income and the needs of the individual or his family different from that which exists in the present, as, for example, in relation to old age, family education, or the maintenance of dependents;
(iii) To enjoy interest and appreciation, i.e. because a larger real consumption at a later date is preferred to a smaller immediate consumption;
(iv) To enjoy a gradually increasing expenditure, since it gratifies a common instinct to look forward to a gradually improving standard of life rather than the contrary, even though the capacity for enjoyment may be diminishing;
(v) To enjoy a sense of independence and the power to do things, though without a clear idea or definite intention of specific action;
(vi) To secure a masse de manoeuvre to carry out speculative or business projects;
(vii) To bequeath a fortune;
(viii) To satisfy pure miserliness, i.e. unreasonable but insistent inhibitions against acts of expenditure as such.
These eight motives might be called the motives of Precaution, Foresight, Calculation, Improvement, Independence, Enterprise, Pride and Avarice; and we could also draw up a corresponding list of motives to consumption such as Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance.
Apart from the savings accumulated by individuals, there is also the large amount of income, varying perhaps from one-third to two-thirds of the total accumulation in a modern industrial community such as Great Britain or the United States, which is withheld by central and local government, by institutions and by business corporations — for motives largely analogous to, but not identical with, those actuating individuals, and mainly the four following:
(i) The motive of enterprise — to secure resources to carry out further capital investment without incurring debt or raising further capital on the market;
(ii) The motive of liquidity — to secure liquid resources to meet emergencies, difficulties and depressions;
(iii) The motive of improvement — to secure a gradually increasing income, which, incidentally, will protect the management from criticism, since increasing income due to accumulation is seldom distinguished from increasing income due to efficiency;
(iv) The motive of financial prudence and the anxiety to be ‘on the right side’ by making a financial provision in excess of user and supplementary cost, so as to discharge debt and write off the cost of assets ahead of; rather than behind, the actual rate of wastage and obsolescence, the strength of this motive mainly depending on the quantity and character of the capital equipment and the rate of technical change.
Corresponding to these motives which favour the withholding of a part of income from consumption, there are also operative at times motives which lead to an excess of consumption over income. Several of the motives towards positive saving catalogued above as affecting individuals have their intended counterpart in negative saving at a later date, as, for example, with saving to provide for family needs or old age. Unemployment relief financed by borrowing is best regarded as negative saving.
Now the strength of all these motives will vary enormously according to the institutions and organisation of the economic society which we presume, according to habits formed by race, education, convention, religion and current morals, according to present hopes and past experience, according to the scale and technique of capital equipment, and according to the prevailing distribution of wealth and the established standards of life. In the argument of this book, however, we shall not concern ourselves, except in occasional digressions, with the results of far-reaching social changes or with the slow effects of secular progress. We shall, that is to say, take as given the main background of subjective motives to saving and to consumption respectively. In so far as the distribution of wealth is determined by the more or less permanent social structure of the community, this also can be reckoned a factor, subject only to slow change and over a long period, which we can take as given in our present context.
II
Since, therefore, the main background of subjective and social incentives changes slowly, whilst the short-period influence of changes in the rate of interest and the other objective factors is often of secondary importance, we are left with the conclusion that short-period changes in consumption largely depend on changes in the rate at which income (measured in wage-units) is being earned and not on changes in the propensity to consume out of a given income.
We must, however, guard against a misunderstanding. The above means that the influence of moderate changes in the rate of interest on the propensity to consume is usually small. It does not mean that changes in the rate of interest have only a small influence on the amounts actually saved and consumed. Quite the contrary. The influence of changes in the rate of interest on the amount actually saved is of paramount importance, but is in the opposite direction to that usually supposed. For even if the attraction of the larger future income to be earned from a higher rate of interest has the effect of diminishing the propensity to consume, nevertheless we can be certain that a rise in the rate of interest will have the effect of reducing the amount actually saved. For aggregate saving is governed by aggregate investment; a rise in the rate of interest (unless it is offset by a corresponding change in the demand-schedule for investment) will diminish investment; hence a rise in the rate of interest must have the effect of reducing incomes to a level at which saving is decreased in the same measure as investment. Since incomes will decrease by a greater absolute amount than investment, it is, indeed, true that, when the rate of interest rises, the rate of consumption will decrease. But this does not mean that there will be a wider margin for saving. On the contrary, saving and spending will both decrease.
Thus, even if it is the case that a rise in the rate of interest would cause the community to save more out of a given income, we can be quite sure that a rise in the rate of interest (assuming no favourable change in the demand-schedule for investment) will decrease the actual aggregate of savings. The same line of argument can even tell us by how much a rise in the rate of interest will, cet. par., decrease incomes. For incomes will have to fall (or be redistributed) by just that amount which is required, with the existing propensity to consume to decrease savings by the same amount by which the rise in the rate of interest will, with the existing marginal efficiency of capital, decrease investment. A detailed examination of this aspect will occupy our next chapter.
The rise in the rate of interest might induce us to save more, if our incomes were unchanged. But if the higher rate of interest retards investment, our incomes will not, and cannot, be unchanged. They must necessarily fall, until the declining capacity to save has sufficiently offset the stimulus to save given by the higher rate of interest. The more virtuous we are, the more determinedly thrifty, the more obstinately orthodox in our national and personal finance, the more our incomes will have to fall when interest rises relatively to the marginal efficiency of capital. Obstinacy can bring only a penalty and no reward. For the result is inevitable.
Thus, after all, the actual rates of aggregate saving and spending do not depend on Precaution, Foresight, Calculation, Improvement, Independence, Enterprise, Pride or Avarice. Virtue and vice play no part. It all depends on how far the rate of interest is favourable to investment, after taking account of the marginal efficiency of capital. No, this is an overstatement. If the rate of interest were so governed as to maintain continuous full employment, virtue would resume her sway;— the rate of capital accumulation would depend on the weakness of the propensity to consume. Thus, once again, the tribute that classical economists pay to her is due to their concealed assumption that the rate of interest always is so governed.
Chapter 10
The Marginal Propensity to Consume and the Multiplier
We established in chapter 8 that employment can only increase pari passu with investment unless there is a change in the propensity to consume. We can now carry this line of thought a stage further. For in given circumstances a definite ratio, to be called the multiplier, can be established between income and investment and, subject to certain simplifications, between the total employment and the employment directly employed on investment (which we shall call the primary employment). This further step is an integral part of our theory of employment, since it establishes a precise relationship, given the propensity to consume, between aggregate employment and income and the rate of investment. The conception of the multiplier was first introduced into economic theory by Mr R. F. Kahn in his article on ‘The Relation of Home Investment to Unemployment’ (Economic Journal, June 1931). His argument in this article depended on the fundamental notion that, if the propensity to consume in various hypothetical circumstances is (together with certain other conditions) taken as given and we conceive the monetary or other public authority to take steps to stimulate or to retard investment, the change in the amount of employment will be a function of the net change in the amount of investment; and it aimed at laying down general principles by which to estimate the actual quantitative relationship between an increment of net investment and the increment of aggregate employment which will be associated with it. Before coming to the multiplier, however, it will be convenient to introduce the conception of the marginal propensity to consume.
I
The fluctuations in real income under consideration in this book are those which result from applying different quantities of employment (i.e. of labour-units) to a given capital equipment, so that real income increases and decreases with the number of labour-units employed. If, as we assume in general, there is a decreasing return at the margin as the number of labour-units employed on the given capital equipment is increased, income measured in terms of wage-units will increase more than in proportion to the amount of employment, which, in turn, will increase more than in proportion to the amount of real income measured (if that is possible) in terms of product. Real income measured in terms of product and income measured in terms of wage-units will, however, increase and decrease together (in the short period when capital equipment is virtually unchanged). Since, therefore, real income, in terms of product, may be incapable of precise numerical measurement, it is often convenient to regard income in terms of wage-units (Yw) as an adequate working index of changes in real income. In certain contexts we must not overlook the fact that, in general, Yw increases and decreases in a greater proportion than real income; but in other contexts the fact that they always increase and decrease together renders them virtually interchangeable.
Our normal psychological law that, when the real income of the community increases or decreases, its consumption will increase or decrease but not so fast, can, therefore, be translated — not, indeed, with absolute accuracy but subject to qualifications which are obvious and can easily be stated in a formally complete fashion into the propositions that ΔCw and ΔYw have the same sign, but ΔYw > ΔCw, where Cw is the consumption in terms of wage-units. This is merely a repetition of the proposition already established in Chapter 3 above. Let us define, then, dCw/dYw as the marginal propensity to consume.
This quantity is of considerable importance, because it tells us how the next increment of output will have to be divided between consumption and investment. For ΔYw = ΔCw + ΔIw, where Cw and Iw are the increments of consumption and investment; so that we can write ΔYw = kΔIw, where 1 − 1/k is equal to the marginal propensity to consume.
Let us call k the investment multiplier. It tells us that, when there is an increment of aggregate investment, income will increase by an amount which is k times the increment of investment.
II
Mr Kahn’s multiplier is a little different from this, being what we may call the employment multiplier designated by k’, since it measures the ratio of the increment of total employment which is associated with a given increment of primary employment in the investment industries. That is to say, if the increment of investment ΔIw leads to an increment of primary employment ΔN2 in the investment industries, the increment of total employment ΔN = k’ΔN2.
There is no reason in general to suppose that k = k’. For there is no necessary presumption that the shapes of the relevant portions of the aggregate supply functions for different types of industry are such that the ratio of the increment of employment in the one set of industries to the increment of demand which has stimulated it will be the same as in the other set of industries. It is easy, indeed, to conceive of cases, as, for example, where the marginal propensity to consume is widely different from the average propensity, in which there would be a presumption in favour of some inequality between ΔYw/ΔN and ΔIw/ΔN2, since there would be very divergent proportionate changes in the demands for consumption-goods and investment-goods respectively. If we wish to take account of such possible differences in the shapes of the relevant portions of the aggregate supply functions for the two groups of industries respectively, there is no difficulty in rewriting the following argument in the more generalised form. But to elucidate the ideas involved, it will be convenient to deal with the simplified case where k = k’.
It follows, therefore, that, if the consumption psychology of the community is such that they will choose to consume, e.g. nine-tenths of an increment of income, then the multiplier k is 10; and the total employment caused by (e.g.) increased public works will be ten times the primary employment provided by the public works themselves, assuming no reduction of investment in other directions. Only in the event of the community maintaining their consumption unchanged in spite of the increase in employment and hence in real income, will the increase of employment be restricted to the primary employment provided by the public works. If, on the other hand, they seek to consume the whole of any increment of income, there will be no point of stability and prices will rise without limit. With normal psychological suppositions, an increase in employment will only be associated with a decline in consumption if there is at the same time a change in the propensity to consume — as the result, for instance, of propaganda in time of war in favour of restricting individual consumption; and it is only in this event that the increased employment in investment will be associated with an unfavourable repercussion on employment in the industries producing for consumption.
This only sums up in a formula what should by now be obvious to the reader on general grounds. An increment of investment in terms of wage-units cannot occur unless the public are prepared to increase their savings in terms of wage-units. Ordinarily speaking, the public will not do this unless their aggregate income in terms of wage-units is increasing. Thus their effort to consume a part of their increased incomes will stimulate output until the new level (and distribution) of incomes provides a margin of saving sufficient to correspond to the increased investment. The multiplier tells us by how much their employment has to be increased to yield an increase in real income sufficient to induce them to do the necessary extra saving, and is a function of their psychological propensities. If saving is the pill and consumption is the jam, the extra jam has to be proportioned to the size of the additional pill. Unless the psychological propensities of the public are different from what we are supposing, we have here established the law that increased employment for investment must necessarily stimulate the industries producing for consumption and thus lead to a total increase of employment which is a multiple of the primary employment required by the investment itself.
It follows from the above that, if the marginal propensity to consume is not far short of unity, small fluctuations in investment will lead to wide fluctuations in employment; but, at the same time, a comparatively small increment of investment will lead to full employment. If, on the other hand, the marginal propensity to consume is not much above zero, small fluctuations in investment will lead to correspondingly small fluctuations in employment; but, at the same time, it may require a large increment of investment to produce full employment. In the former case involuntary unemployment would be an easily remedied malady, though liable to be troublesome if it is allowed to develop. In the latter case, employment may be less variable but liable to settle down at a low level and to prove recalcitrant to any but the most drastic remedies. In actual fact the marginal propensity to consume seems to lie somewhere between these two extremes, though much nearer to unity 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.
When full employment is reached, any attempt to increase investment still further will set up a tendency in money-prices to rise without limit, irrespective of the marginal propensity to consume; i.e. we shall have reached a state of true inflation. Up to this point, however, rising prices will be associated with an increasing aggregate real income.
III
We have been dealing so far with a net increment of investment. If, therefore, we wish to apply the above without qualification to the effect of (e.g.) increased public works, we have to assume that there is no offset through decreased investment in other directions,— and also, of course, no associated change in the propensity of the community to consume. Mr Kahn was mainly concerned in the article referred to above in considering what offsets we ought to take into account as likely to be important, and in suggesting quantitative estimates. For in an actual case there are several factors besides some specific increase of investment of a given kind which enter into the final result. If, for example, a government employs 100,000 additional men on public works, and if the multiplier (as defined above) is 4, it is not safe to assume that aggregate employment will increase by 400,000. For the new policy may have adverse reactions on investment in other directions.
It would seem (following Mr Kahn) that the following are likely in a modern community to be the factors which it is most important not to overlook (though the first two will not be fully intelligible until after Book IV has been reached):
(i) The method of financing the policy and the increased working cash, required by the increased employment and the associated rise of prices, may have the effect of increasing the rate of interest and so retarding investment in other directions, unless the monetary authority takes steps to the contrary; whilst, at the same time, the increased cost of capital goods will reduce their marginal efficiency to the private investor, and this will require an actual fall in the rate of interest to offset it.
(ii) With the confused psychology which often prevails, the government programme may, through its effect on ‘confidence’, increase liquidity-preference or diminish the marginal efficiency of capital, which, again, may retard other investment unless measures are taken to offset it.
(iii) In an open system with foreign-trade relations, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries, since a proportion of the increased consumption will diminish our own country’s favourable foreign balance; so that, if we consider only the effect on domestic employment as distinct from world employment, we must diminish the full figure of the multiplier. On the other hand our own country may recover a portion of this leakage through favourable repercussions due to the action of the multiplier in the foreign country in increasing its economic activity.
Furthermore, if we are considering changes of a substantial amount, we have to allow for a progressive change in the marginal propensity to consume, as the position of the margin is gradually shifted; and hence in the multiplier. The marginal propensity to consume is not constant for all levels of employment, and it is probable that there will be, as a rule, a tendency for it to diminish as employment increases; when real income increases, that is to say, the community will wish to consume a gradually diminishing proportion of it.
There are also other factors, over and above the operation of the general rule Just mentioned, which may operate to modify the marginal propensity to consume, and hence the multiplier; and these other factors seem likely, as a rule, to accentuate the tendency of the general rule rather than to offset jt. For, in the first place, the increase of employment will tend, owing to the effect of diminishing returns in the short period, to increase the proportion of aggregate income which accrues to the entrepreneurs, whose individual marginal propensity to consume is probably less than the average for the community as a whole. In the second place, unemployment is likely to be associated with negative saving in certain quarters, private or public, because the unemployed may be living either on the savings of themselves and their friends or on public relief which is partly financed out of loans; with the result that re-employment will gradually diminish these particular acts of negative saving and reduce, therefore, the marginal propensity to consume more rapidly than would have occurred from an equal increase in the community’s real income accruing in different circumstances.
In any case, the multiplier is likely to be greater for a small net increment of investment than for a large increment; so that, where substantial changes are in view, we must be guided by the average value of the multiplier based on the average marginal propensity to consume over the range in question.
Mr Kahn has examined the probable quantitative result of such factors as these in certain hypothetical special cases. But, clearly, it is not possible to carry any generalisation very far. One can only say, for example, that a typical modern community would probably tend to consume not much less than 80 per cent of any increment of real income, if it were a closed system with the consumption of the unemployed paid for by transfers from the consumption of other consumers, so that the multiplier after allowing for offsets would not be much less than 5. In a country, however, where foreign trade accounts for, say, 20 per cent of consumption and where the unemployed receive out of loans or their equivalent up to, say, 50 per cent of their normal consumption when in work, the multiplier may fall as low as 2 or 3 times the employment provided by a specific new investment. Thus a given fluctuation of investment will be associated with a much less violent fluctuation of employment in a country in which foreign trade plays a large part and unemployment relief is financed on a larger scale out of borrowing (as was the case, e.g. in Great Britain in 1931), than in a country in which these factors are less important (as in the United States in 1932).
It is, however, to the general principle of the multiplier to which we have to look for an explanation of how fluctuations in the amount of investment, which are a comparatively small proportion of the national income, are capable of generating fluctuations in aggregate employment and income so much greater in amplitude than themselves.
IV
The discussion has been carried on, so far, on the basis of a change in aggregate investment which has been foreseen sufficiently in advance for the consumption industries to advance pari passu with the capital-goods industries without more disturbance to the price of consumption-goods than is consequential, in conditions of decreasing returns, on an increase in the quantity which is produced.
In general, however, we have to take account of the case where the initiative comes from an increase in the output of the capital-goods industries which was not fully foreseen. It is obvious that an initiative of this description only produces its full effect on employment over a period of time. I have found, however, in discussion that this obvious fact often gives rise to some confusion between the logical theory of the multiplier, which holds good continuously, without time-lag, at all moments of time, and the consequences of an expansion in the capital-goods industries which take gradual effect, subject to time-lag and only after an interval.
The relationship between these two things can be cleared up by pointing out, firstly that an unforeseen, or imperfectly foreseen, expansion in the capital-goods industries does not have an instantaneous effect of equal amount on the aggregate of investment but causes a gradual increase of the latter; and, secondly, that it may cause a temporary departure of the marginal propensity to consume away from its normal value, followed, however, by a gradual return to it.
Thus an expansion in the capital-goods industries causes a series of increments in aggregate investment occurring in successive periods over an interval of time, and a series of values of the marginal propensity to consume in these successive periods which differ both from what the values would have been if the expansion had been foreseen and from what they will be when the community has settled down to a new steady level of aggregate investment. But in every interval of time the theory of the multiplier holds good in the sense that the increment of aggregate demand is equal to the product of the increment of aggregate investment and the multiplier as determined by the marginal propensity to consume.
The explanation of these two sets of facts can be seen most clearly by taking the extreme case where the expansion of employment in the capital-goods industries is so entirely unforeseen that in the first instance there is no increase whatever in the output of consumption-goods. In this event the efforts of those newly employed in the capital-goods industries to consume a proportion of their increased incomes will raise the prices of consumption-goods until a temporary equilibrium between demand and supply has been brought about partly by the high prices causing a postponement of consumption, partly by a redistribution of income in favour of the saving classes as an effect of the increased profits resulting from the higher prices, and partly by the higher prices causing a depletion of stocks. So far as the balance is restored by a postponement of consumption there is a temporary reduction of the marginal propensity to consume, i.e. of the multiplier itself, and in so far as there is a depletion of stocks, aggregate investment increases for the time being by less than the increment of investment in the capital-goods industries,— i.e. the thing to be multiplied does not increase by the full increment of investment in the capital-goods industries. As time goes on, however, the consumption-goods industries adjust themselves to the new demand, so that when the deferred consumption is enjoyed, the marginal propensity to consume rises temporarily above its normal level, to compensate for the extent to which it previously fell below it, and eventually returns to its normal level; whilst the restoration of stocks to their previous figure causes the increment of aggregate investment to be temporarily greater than the increment of investment in the capital-goods industries (the increment of working capital corresponding to the greater output also having temporarily the same effect).
The fact that an unforeseen change only exercises its full effect on employment over a period of time is important in certain contexts;— in particular it plays a part in the analysis of the trade cycle (on lines such as I followed in my Treatise on Money). But it does not in any way affect the significance of the theory of the multiplier as set forth in this chapter; nor render it inapplicable as an indicator of the total benefit to employment to be expected from an expansion in the capital. goods industries. Moreover, except in conditions where the consumption industries are already working almost at capacity so that an expansion of output requires an expansion of plant and not merely the more intensive employment of the existing plant, there is no reason to suppose that more than a brief interval of time nced elapse before employment in the consumption industries is advancing pari passu with employment in the capital-goods industries with the multiplier operating near its normal figure.
V
We have seen above that the greater the marginal propensity to consume, the greater the multiplier, and hence the greater the disturbance to employment corresponding to a given change in investment. This might seem to lead to the paradoxical conclusion that a poor community in which saving is a very small proportion of income will be more subject to violent fluctuations than a wealthy community where saving is a larger proportion of income and the multiplier consequently smaller.
This conclusion, however, would overlook the distinction between the effects of the marginal propensity to consume and those of the average propensity to consume. For whilst a high marginal propensity to consume involves a larger proportionate effect from a given percentage change in investment, the absolute effect will, nevertheless, be small if the average propensity to consume is also high. This may be illustrated as follows by a numerical example.
Let us suppose that a community’s propensity to consume is such that, so long as its real income does not exceed the output from employing 5,000,000 men on its existing capital equipment, it consumes the whole of its income; that of the output of the next 100,000 additional men employed it consumes 99 per cent, of the next 100,000 after that 98 per cent, of the third 100,000 97 per cent and so on; and that 10,000,000 men employed represents full employment. It follows from this that, when 5,000,000 + n 100,000 men are employed, the multiplier at the margin is 100/n, and [n(n + i)]/[2(50 + n)] per cent of the national income is invested.
Thus when 5,200,000 men are employed the multiplier is very large, namely 50, but investment is only a trifling proportion of current income, namely, 0.06 per cent; with the result that if investment falls off by a large proportion, say about two-thirds, employment will only decline to 5,100,000, i.e. by about 2 per cent. On the other hand, when 9,000,000 men are employed, the marginal multiplier is comparatively small, namely 2½, but investment is now a substantial proportion of current income, namely, 9 per cent; with the result that if investment falls by two-thirds, employment will decline to 6,900,000, namely, by 19 per cent. In the limit where investment falls off to zero, employment will decline by about 4 per cent in the former case, whereas in the latter case it will decline by 44 per cent.
In the above example, the poorer of the two communities under comparison is poorer by reason of under-employment. But the same reasoning applies by easy adaptation if the poverty is due to inferior skill, technique or equipment. Thus whilst the multiplier is larger in a poor community, the effect on employment of fluctuations in investment will be much greater in a wealthy community, assuming that in the latter current investment represents a much larger proportion of current output.
It is also obvious from the above that the employment of a given number of men on public works will (on the assumptions made) have a much larger effect on aggregate employment at a time when there is severe unemployment, than it will have later on when full employment is approached. In the above example, if, at a time when employment has fallen to 5,200,000, an additional 100,000 men are employed on public works, total employment will rise to 6,400,000. But if employment is already 9,000,000 when the additional 100,000 men are taken on for public works, total employment will only rise to 9,200,000. Thus public works even of doubtful utility may pay for themselves over and over again at a time of severe unemployment, if only from the diminished cost of relief expenditure, provided that we can assume that a smaller proportion of income is saved when unemployment is greater; but they may become a more doubtful proposition as a state of full employment is approached. Furthermore, if our assumption is correct that the marginal propensity to consume falls off steadily as we approach full employment, it follows that it will become more and more troublesome to secure a further given increase of employment by further increasing investment. It should not be difficult to compile a chart of the marginal propensity to consume at each stage of a trade cycle from the statistics (if they were available) of aggregate incorne and aggregate investment at successive dates. At present, however, our statistics are not accurate enough (or compiled sufficiently with this specific object in view) to allow us to infer more than highly approximate estimates. The best for the purpose, of which I am aware, are Mr Kuznets’ figures for the United States (already referred to, p.103 above), though they are, nevertheless, very precarious. Taken in conjunction with estimates of national income these suggest, for what they are worth, both a lower figure and a more stable figure for the investment multiplier than I should have expected. If single years are taken in isolation, the results look rather wild. But if they are grouped in pairs, the multiplier seems to have been less than 3 and probably fairly stable in the neighbourhood of 2.5. This suggests a marginal propensity to consume not exceeding 6o to 70 per cent — a figure quite plausible for the boom, but surprisingly, and, in my judgment, improbably low for the slump. It is possible, however, that the extreme financial conservatism of corporate finance in the United States, even during the slump, may account for it. In other words, if, when investment is falling heavily through a failure to undertake repairs and replacements, financial provision is made, nevertheless, in respect of such wastage, the effect is to prevent the rise in the marginal propensity to consume which would have occurred otherwise. I suspect that this factor may have played a significant part in aggravating the degree of the recent slump in the United States. On the other hand, it is possible that the statistics somewhat overstate the decline in investment, which is alleged to have fallen off by more than 75 per cent in 1932 compared with 1929, whilst net ‘capital formation’ declined by more than 95 per cent;— a moderate change in these estimates being capable of making a substantial difference to the multiplier.
VI
When involuntary unemployment exists, the marginal disutility of labour is necessarily less than the utility of the marginal product. Indeed it may be much less. For a man who has been long unemployed some measure of labour, instead of involving disutility, may have a positive utility. If this is accepted, the above reasoning shows how ‘wasteful’ loan expenditure may nevertheless enrich the community on balance. Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.
It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly ‘wasteful’ forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict ‘business’ principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.
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 if there are political and practical difficulties in the way of this, the above would be better than nothing.
The analogy between this expedient and the goldmines of the real world is complete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value and importance to civilisation. Just as wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining is the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance; and each of these activities has played its part in progress — failing something better. To mention a detail, the tendency in slumps for the price of gold to rise in terms of labour and materials aids eventual recovery, because it increases the depth at which gold-digging pays and lowers the minimum grade of ore which is payable.
In addition to the probable effect of increased supplies of gold on the rate of interest, gold-mining is for two reasons a highly practical form of investment, if we are precluded from increasing employment by means which at the same time increase our stock of useful wealth. In the first place, owing to the gambling attractions which it offers it is carried on without too close a regard to the ruling rate of interest. In the second place the result, namely, the increased stock of gold, does not, as in other cases, have the effect of diminishing its marginal utility. Since the value of a house depends on its utility, every house which is built serves to diminish the prospective rents obtainable from further house-building and therefore lessens the attraction of further similar investment unless the rate of interest is falling pari passu. But the fruits of gold-mining do not suffer from this disadvantage, and a check can only come through a rise of the wage-unit in terms of gold, which is not likely to occur unless and until employment is substantially better. Moreover, there is no subsequent reverse effect on account of provision for user and supplementary costs, as in the case of less durable forms of wealth.
Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth, in that it possessed two activities, namely, pyramid-building as well as the search for the precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance. The Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York. Thus we are so sensible, have schooled ourselves to so close a semblance of prudent financiers, taking careful thought before we add to the ‘financial’ burdens of posterity by building them houses to live in, that we have no such easy escape from the sufferings of unemployment. We have to accept them as an inevitable result of applying to the conduct of the State the maxims which are best calculated to ‘enrich’ an individual by enabling him to pile up claims to enjoyment which he does not intend to exercise at any definite time.
Chapter 11
The Marginal Efficiency of Capital
I
When a man buys an investment or capital-asset, he purchases the right to the series of prospective returns, which he expects to obtain from selling its output, after deducting the running expenses of obtaining that output, during the life of the asset. This series of annuities Q1 , Q2 , . . . Q n it is convenient to call the prospective yield of the investment.
Over against the prospective yield of the investment we have the supply price of the capital-asset, meaning by this, not the market-price at which an asset of the type in question can actually be purchased in the market, but the price which would just induce a manufacturer newly to produce an additional unit of such assets, i.e. what is sometimes called its replacement cost . The relation between the prospective yield of a capital-asset and its supply price or replacement cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More precisely, I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.
The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over.
If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase; the second of these factors being usually the more important in producing equilibrium in the short run, but the longer the period in view the more does the first factor take its place. Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital.
Now it is obvious that the actual rate of current investment will be pushed to the point where there is no longer any class of capital-asset of which the marginal efficiency exceeds the current rate of interest. In other words, the rate of investment will be pushed to the point on the investment demand-schedule where the marginal efficiency of capital in general is equal to the market rate of interest.
The same thing can also be expressed as follows. If Qr is the prospective yield from an asset at time r , and dr is the present value of £1 deferred r years at the current rate of interest, ΣQrdr is the demand price of the investment; and investment will be carried to the point where ΣQrdr becomes equal to the supply price of the investment as defined above. If, on the other hand, ΣQrdr falls short of the supply price, there will be no current investment in the asset in question.
It follows that the inducement to invest depends partly on the investment demand-schedule and partly on the rate of interest. Only at the conclusion of Book IV will it be possible to take a comprehensive view of the factors determining the rate of investment in their actual complexity. I would, however, ask the reader to note at once that neither the knowledge of an asset’s prospective yield nor the knowledge of the marginal efficiency of the asset enables us to deduce either the rate of interest or the present value of the asset. We must ascertain the rate of interest from some other source, and only then can we value the asset by ‘capitalising’ its prospective yield.
II
How is the above definition of the marginal efficiency of capital related to common usage? The Marginal Productivity or Yield or Efficiency or Utility of Capital are familiar terms which we have all frequently used. But it is not easy by searching the literature of economics to find a clear statement of what economists have usually intended by these terms.
There are at least three ambiguities to clear up. There is, to begin with, the ambiguity whether we are concerned with the increment of physical product per unit of time due to the employment of one more physical unit of capital, or with the increment of value due to the employment of one more value unit of capital. The former involves difficulties as to the definition of the physical unit of capital, which I believe to be both insoluble and unnecessary. 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 no means of reducing this to an intelligible arithmetical ratio which does not bring in values. Nevertheless many discussions of this subject seem to be mainly concerned with the physical productivity of capital in some sense, though the writers fail to make themselves clear.
Secondly, there is the question whether the marginal efficiency of capital is some absolute quantity or a ratio. The contexts in which it is used and the practice of treating it as being of the same dimension as the rate of interest seem to require that it should be a ratio. Yet it is not usually made clear what the two terms of the ratio are supposed to be.
Finally, there is the distinction, the neglect of which has been the main cause of confusion and misunderstanding, between the increment of value obtainable by using an additional quantity of capital in the existing situation, and the series of increments which it is expected to obtain over the whole life of the additional capital asset; — i.e. the distinction between Q1 and the complete series Q1 , Q2 , . . . Qr , . . . .This involves the whole question of the place of expectation in economic theory. Most discussions of the marginal efficiency of capital seem to pay no attention to any member of the series except Q1 . Yet this cannot be legitimate except in a Static theory, for which all the Q ‘s are equal. The ordinary theory of distribution, where it is assumed that capital is getting now its marginal productivity (in some sense or other), is only valid in a stationary state. The aggregate current return to capital has no direct relationship to its marginal efficiency; whilst its current return at the margin of production (i.e. the return to capital which enters into the supply price of output) is its marginal user cost, which also has no close connection with its marginal efficiency.
There is, as I have said above, a remarkable lack of any clear account of the matter. At the same time I believe that the definition which I have given above is fairly close to what Marshall intended to mean by the term. The phrase which Marshall himself uses is ‘marginal net efficiency’ of a factor of production; or, alternatively, the ‘marginal utility of capital’. The following is a summary of the most relevant passage which I can find in his Principles (6th ed. pp. 519-520). I have run together some non-consecutive sentences to convey the gist of what he says:
In a certain factory an extra £100 worth of machinery can be applied so as not to involve any other extra expense, and so as to add annually £3 worth to the net output of the factory after allowing for its own wear and tear. If the investors of capital push it into every occupation in which it seems likely to gain a high reward; and if, after this has been done and equilibrium has been found, it still pays and only just pays to employ this machinery, we can infer from this fact that the yearly rate of interest is 3 per cent. But illustrations of this kind merely indicate part of the action of the great causes which govern value. They cannot be made into a theory of interest, any more than into a theory of wages, without reasoning in a circle. . . Suppose that the rate of interest is 3 per cent. per annum on perfectly good security; and that the hat-making trade absorbs a capital of one million pounds. This implies that the hat-making trade can turn the whole million pounds’ worth of capital to so good account that they would pay 3 per cent. per annum net for the use of it rather than go without any of it. There may be machinery which the trade would have refused to dispense with if the rate of interest had been 20 per cent. per annum. If the rate had been 10 per cent., more would have been used; if it had been 6 per cent., still more; if 4 per cent. still more; and finally, the rate being 3 per cent., they use more still. When they have this amount, the marginal utility of the machinery, i.e. the utility of that machinery which it is only just worth their while to employ, is measured by 3 per cent.
It is evident from the above that Marshall was well aware that we are involved in a circular argument if we try to determine along these lines what the rate of interest actually is. In this passage he appears to accept the view set forth above, that the rate of interest determines the point to which new investment will be pushed, given the schedule of the marginal efficiency of capital. If the rate of interest is 3 per cent, this means that no one will pay £100 for a machine unless he hopes thereby to add £3 to his annual net output after allowing for costs and depreciation. But we shall see in chapter 14 that in other passages Marshall was less cautious — though still drawing back when his argument was leading him on to dubious ground.
Although he does not call it the ‘marginal efficiency of capital’, Professor Irving Fisher has given in his Theory of Interest (1930) a definition of what he calls ‘the rate of return over cost’ which is identical with my definition. ‘The rate of return over cost’, he writes, ‘is that rate which, employed in computing the present worth of all the costs and the present worth of all the returns, will make these two equal.’ Professor Fisher explains that the extent of investment in any direction will depend on a comparison between the rate of return over cost and the rate of interest. To induce new investment ‘the rate of return over cost must exceed the rate of interest’. ‘This new magnitude (or factor) in our study plays the central rôle on the investment opportunity side of interest theory.’ Thus Professor Fisher uses his ‘rate of return over cost in the same sense and for precisely the same purpose as I employ ‘the marginal efficiency of capital’.
III
The most important confusion concerning the meaning and significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield. This can be best illustrated by pointing out the effect on the marginal efficiency of capital of an expectation of changes in the prospective cost of production, whether these changes are expected to come from changes in labour cost, i.e. in the wage-unit, or from inventions and new technique. The output from equipment produced to-day will have to compete, in the course of its life, with the output from equipment produced subsequently, perhaps at a lower labour cost, perhaps by an improved technique, which is content with a lower price for its output and will be increased in quantity until the price of its output has fallen to the lower figure with which it is content. Moreover, the entrepreneur’s profit (in terms of money) from equipment, old or new, will be reduced, if all output comes to be produced more cheaply. In so far as such developments are foreseen as probable, or even as possible, the marginal efficiency of capital produced to-day is appropriately diminished.
This is the factor through which the expectation of changes in the value of money influences the volume of current output. The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital.
This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called ‘Appreciation and Interest’ — the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another.
The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output — in so far as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulus to output depends on the marginal efficiency of a given stock of capital rising relatively to the rate of interest. Indeed Professor Fisher’s theory could be best re-written in terms of a ‘real rate of interest’ defined as being the rate of interest which would have to rule, consequently on a change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. It is worth noting that an expectation of a future fall in the rate of interest will have the effect of lowering the schedule of the marginal efficiency of capital; since it means that the output from equipment produced to-day will have to compete during part of its life with the output from equipment which is content with a lower return. This expectation will have no great depressing effect, since the expectations, which are held concerning the complex of rates of interest for various terms which will rule in the future, will be partially reflected in the complex of rates of interest which rule to-day. Nevertheless there may be some depressing effect, since the output from equipment produced to-day, which will emerge towards the end of the life of this equipment, may have to compete with the output of much younger equipment which is content with a lower return because of the lower rate of interest which rules for periods subsequent to the end of the life of equipment produced to-day.
It is important to understand the 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. In chapter 22 below we shall show that the succession of boom and slump can be described and analysed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.
IV
Two types of risk affect the volume of investment which have not commonly been distinguished, but which it is important to distinguish. The first is the entrepreneur’s or borrower’s risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant.
But where a system of borrowing and lending exists, by which I mean the ranting of loans with a margin of real or personal security, a second type of risk is relevant which we may call the lender’s risk. This may be due either to moral hazard, i.e. voluntary default or other means of escape, possibly lawful, from the fulfilment of the obligation, or to the possible insufficiency of the margin of security, i.e. involuntary default due to the disappointment of expectation. A third source of risk might be added, namely, a possible adverse change in the value of the monetary standard which renders a money-loan to this extent less secure than a real asset; though all or most of this should be already reflected, and therefore absorbed, in the price of durable real assets.
Now the first type of risk is, in a sense, a real social cost, though susceptible to diminution by averaging as well as by an increased accuracy of foresight. The second, however, is a pure addition to the cost of investment which would not exist if the borrower and lender were the same person. Moreover, it involves in part a duplication of a proportion of the entrepreneur’s risk, which is added twice to the pure rate of interest to give the minimum prospective yield which will induce the investment. For if a venture is a risky one, the borrower will require a wider margin between his expectation of yield and the rate of interest at which he will think it worth his while to borrow; whilst the very same reason will lead the lender to require a wider margin between what he charges and the pure rate of interest in order to induce him to lend (except where the borrower is so strong and wealthy that he is in a position to offer an exceptional margin of security). The hope of a very favourable outcome, which may balance the risk in the mind of the borrower, is not available to solace the lender.
This duplication of allowance for a portion of the risk has not hitherto been emphasised, so far as I am aware; but it may be important in certain circumstances. During a boom the popular estimation of the magnitude of both these risks, both borrower’s risk and lender’s risk, is apt to become unusually and imprudently low.
V
The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to-day and to-morrow. Even the rate of interest is, virtually, a current phenomenon; and if we reduce the marginal efficiency of capital to the same status, we cut ourselves off from taking any direct account of the influence of the future in our analysis of the existing equilibrium.
The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality. But the introduction of the concepts of user cost and of the marginal efficiency of capital, as defined above, will have the effect, I think, of bringing it back to reality, whilst reducing to a minimum the necessary degree of adaptation.
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.
Chapter 12
The State of Long-Term Expectation
I
We have seen in the previous chapter that the scale of investment depends on the relation between the rate of interest and the schedule of the marginal efficiency of capital corresponding to different scales of current investment, whilst the marginal efficiency of capital depends on the relation between the supply price of a capital-asset and its prospective yield. In this chapter we shall consider in more detail some of the factors which determine the prospective yield of an asset.
The considerations upon which expectations of prospective yields are based are partly existing facts which we can assume to be known more or less for certain, and partly future events which can only be forecasted with more or less confidence. Amongst the first may be mentioned the existing stock of various types of capital-assets and of capital-assets in general and the strength of the existing consumers’ demand for goods which require for their efficient production a relatively larger assistance from capital. Amongst the latter are future changes in the type and quantity of the stock of capital-assets and in the tastes of the consumer, the strength of effective demand from time to time during the life of the investment under consideration, and the changes in the wage-unit in terms of money which may occur during its life. We may sum up the state of psychological expectation which covers the latter as being the state of long-term expectation;— as distinguished from the short-term expectation upon the basis of which a producer estimates what he will get for a product when it is finished if he decides to begin producing it to-day with the existing plant, which we examined in chapter 5.
II
It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.
The state of long-term expectation, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast — on how highly we rate the likelihood of our best forecast turning out quite wrong. If we expect large changes but are very uncertain as to what precise form these changes will take, then our confidence will be weak.
The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule.
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.
For convenience of exposition we shall assume in the following discussion of the state of confidence that there are no changes in the rate of interest; and we shall write, throughout the following sections, as if changes in the values of investments were solely due to changes in the expectation of their prospective yields and not at all to changes in the rate of interest at which these prospective yields are capitalised. The effect of changes in the rate of interest is, however, easily superimposed on the effect of changes in the state of confidence.
III
The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.
In former times, when enterprises were mainly owned by those who undertook them or by their friends and associates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not really relying on a precise calculation of prospective profit. The affair was partly a lottery, though with the ultimate result largely governed by whether the abilities and character of the managers were above or below the average. Some would fail and some would succeed. But even after the event no one would know whether the average results in terms of the sums invested had exceeded, equalled or fallen short of the prevailing rate of interest; though, if we exclude the exploitation of natural resources and monopolies, it is probable that the actual average results of investments, even during periods of progress and prosperity, have disappointed the hopes which prompted them. Business men play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand. If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.
Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and II in the morning and reconsider whether he should return to it later in the week. But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. 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. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice?
IV
In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention — though it does not, of course, work out quite so simply — lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. 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. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield.
Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.
For if there exist organised investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose hiS sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably ‘safe’ for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual.
It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.
V
Some of the factors which accentuate this precariousness may be briefly mentioned.
(1) As a result of the gradual increase in the proportion of the equity in the community’s aggregate capital investment which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or prospective, of the business in question, the element of real knowledge in the valuation of investments by whose who own them or contemplate purchasing them has seriously declined.
(2) Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market. It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seasonally high than in winter when no one wants ice. The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.
(3) A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result ofa sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.
(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.
Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called ‘liquidity’. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.
This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional;— it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.
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 judgment, are really the prettiest, nor even those which average opinion genuinely thinks 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.
If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how thc crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough;— human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
(5) So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.
VI
These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, ‘for income’; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. 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. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.
These tendencies are a scarcely avoidable outcome of our having successfully organised ‘liquid’ investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive. The jobber’s ‘turn’, the high brokerage charges and the heavy transfer tax payable to the Exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the trinsaction characteristic of Wall Street. The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.
The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.
The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-asset which, even though it be on precarious evidence, impresses him as the most promising investment available to him. It might be that, at times when he was more than usually assailed by doubts concerning the future, he would turn in his perplexity towards more consumption and less new investment. But that would avoid the disastrous, cumulative and far-reaching repercussions of its being open to him, when thus assailed by doubts, to spend his income neither on the one nor on the other.
Those who have emphasised the social dangers of the hoarding of money have, of course, had something similar to the above in mind. But they have overlooked the possibility that the phenomenon can occur without any change, or at least any commensurate change, in the hoarding of money.
VII
Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;— though fears of loss may have a basis no more reasonable than hopes of profit had before.
It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.
This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;— it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.
We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.
VIII
There are, moreover, certain important factors which somewhat mitigate in practice the effects of our ignorance of the future. Owing to the operation of compound interest combined with the likelihood of obsolescence with the passage of time, there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future. In the case of the most important class of very long-term investments, namely buildings, the risk can be frequently transferred from the investor to the occupier, or at least shared between them, by means of long-term contracts, the risk being outweighed in the mind of the occupier by the advantages of continuity and security of tenure. In the case of another important class of long-term investments, namely public utilities, a substantial proportion of the prospective yield is practically guaranteed by monopoly privileges coupled with the right to charge such rates as will provide a certain stipulated margin. Finally there is a growing class of investments entered upon by, or at the risk of; public authorities, which are frankly influenced in making the investment by a general presumption of there being prospective social advantages from the investment, whatever its commercial yield may prove to be within a wide range, and without seeking to be satisfied that the mathematical expectation of the yield is at least equal to the current rate of interest,— though the rate which the public authority has to pay may still play a decisive part in determining the scale of investment operations which it can afford.
Thus after giving full weight to the importance of the influence of short-period changes in the state of long-term expectation as distinct from changes in the rate of interest, we are still entitled to return to the latter as exercising, at any rate, in normal circumstances, a great, though not a decisive, influence on the rate of investment. Only experience, however, can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment.
For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. 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 described above, will be too great to be offset by any practicable changes in the rate of interest.
Chapter 13
The General Theory of the Rate of Interest
I
We have shown in chapter 11 that, whilst there are forces causing the rate of investment to rise or fall so as to keep the marginal efficiency of capital equal to the rate of interest, yet the marginal efficiency of capital is, in itself; a different thing from the ruling rate of interest. The schedule of the marginal efficiency of capital may be said to govern the terms on which loanable funds are demanded for the purpose of new investment; whilst the rate of interest governs the terms on which funds are being currently supplied. To complete our theory, therefore, we need to know what determines the rate of interest.
In chapter 14 and its Appendix we shall consider the answers to this question which have been given hitherto. Broadly speaking, we shall find that they make the rate of interest to depend on the interaction of the schedule of the marginal efficiency of capital with the psychological propensity to save. But the notion that the rate of interest is the balancing factor which brings the demand for saving in the shape of new investment forthcoming at a iven rate of interest into equality with the supply of saving which results at that rate of interest from the community’s psychological propensity to save, breaks down as soon as we perceive that it is impossible to deduce the rate of interest merely from a knowledge of these two factors. What, then, is our own answer to this question?
II
The psychological time-preferences of an individual require two distinct sets of decisions to carry them out completely. The first is concerned with that aspect of time-preference which I have called the propensity to consume, which, operating under the influence of the various motives set forth in Book III, determines for each individual how much of his income he will consume and how much he will reserve in some form of command over future consumption.
But this decision having been made, there is a further decision which awaits him, namely, in what form he will hold the command over future consumption which he has reserved, whether out of his current income or from previous savings. Does he want to hold it in the form of immediate, liquid command (i.e. in money or its equivalent)? Or is he prepared to part with immediate command for a specified or indefinite period, leaving it to future market conditions to determine on what terms he can, if necessary, convert deferred command over specific goods into immediate command over goods in general? In other words, what is the degree of his liquidity-preference — where an individual’s liquidity-preference is given by a schedule of the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circumstances?
We shall find that the mistake in the accepted theories of the rate of interest lies in their attempting to derive the rate of interest from the first of these two constituents of psychological time-preference to the neglect of the second; and it is this neglect which we must endeavour to repair.
It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period. For the rate of interest is, in itself; nothing more than the inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time.
Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. The rate of interest is not the ‘price’ which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the ‘price’ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash;— which implies that if the rate of interest were lower, i.e. if the reward for parting with cash were diminished, the aggregate amount of cash which the public would wish to hold would exceed the available supply, and that if the rate of interest were raised, there would be a surplus of cash which no one would be willing to hold. If this explanation is correct, the quantity of money is the other factor, which, in conjunction with liquidity-preference, determines the actual rate of interest in given circumstances. Liquidity-preference is a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L(r). This is where, and how, the quantity of money enters into the economic scheme.
At this point, however, let us turn back and consider why such a thing as liquidity-preference exists. In this connection we can usefully employ the ancient distinction between the use of money for the transaction of current business and its use as a store of wealth. As regards the first of these two uses, it is obvious that up to a point it is worth while to sacrifice a certain amount of interest for the convenience of liquidity. But, given that the rate of interest is never negative, why should anyone prefer to hold his wealth in a form which yields little or no interest to holding it in a form which yields interest (assuming, of course, at this stage, that the risk of default is the same in respect of a bank balance as of a bond)? A full explanation is complex and must wait for chapter 15. There is, however, a necessary condition failing which the existence of a liquidity-preference for money as a means of holding wealth could not exist.
This necessary condition is the existence of uncertainty as to the future of the rate of interest, i.e. as to the complex of rates of interest for varying maturities which will rule at future dates. For if the rates of interest ruling at all future times could be foreseen with certainty, all future rates of interest could be inferred from the present rates of interest for debts of different maturities, which would be adjusted to the knowledge of the future rates. For example, if 1dr is the value ln the present year 1 of £1 deferred r years and it is known that ndr will be the value in the year n of £1 deferred r years from that date, we have
1dn + r
ndr = ———— ;
1dn
whence it follows that the rate at which any debt can be turned into cash n years hence is given by two out of the complex of current rates of interest. If the current rate of interest is positive for debts of every maturity, it must always be more advantageous to purchase a debt than to hold cash as a store of wealth.
If, on the contrary, the future rate of interest is uncertain we cannot safely infer that ndr will prove to be equal to 1dn + r / 1dn when the time comes. Thus if a need for liquid cash may conceivably arise before the expiry of n years, there is a risk of a loss being incurred in purchasing a long-term debt and subsequently turning it into cash, as compared with holding cash. The actuarial profit or mathematical expectation of gain calculated in accordance with the existing probabilities — if it can be so calculated, which is doubtful — must be sufficient to compensate for the risk of disappointment.
There is, moreover, a further ground for liquidity-preference which results from the existence of uncertainty as to the future of the rate of interest, provided that there is an organlsed market for dealing in debts. For different people will estimate the prospects differently and anyone who differs from the predominant opinion as expressed in market quotations may have a good reason for keeping liquid resources in order to profit, if he is right, from its turning out in due course that the 1dr’s were in a mistaken relationship to one another.
This is closely analogous to what we have already discussed at some length in connection with the marginal efficiency of capital. Just as we found that the marginal efficiency of capital is fixed, not by the ‘best’ opinion, but by the market valuation as determined by mass psychology, so also expectations as to the future of the rate of interest as fixed by mass psychology have their reactions on liquidity-preference;— but with this addition that the individual, who believes that future rates of interest will be above the rates assumed by the market, has a reason for keeping actual liquid cash, whilst the individual who differs from the market in the other direction will have a motive for borrowing money for short periods in order to purchase debts of longer term. The market price will be fixed at the point at which the sales of the ‘bears’ and the purchases of the ‘bulls’ are balanced.
The three divisions of liquidity-preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e. the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources; and (iii) the speculative-motive, i.e. the object of securing profit from knowing better than the market what the future will bring forth. As when we were discussing the marginal efficiency of capital, the question of the desirability of having a highly organised market for dealing with debts presents us with a dilemma. For, in the absence of an organised market, liquidity-preference due to the precautionary-motive would be greatly increased; whereas the existence of an organised market gives an opportunity for wide fluctuations in liquidity-preference due to the speculative-motive.
It may illustrate the argument to point out that, if the liquidity-preferences due to the transactions-motive and the precautionary-motive are assumed to absorb a quantity of cash which is not very sensitive to changes in the rate of interest as such and apart from its reactions on the level of income, so that the total quantity of money, less this quantity, is available for satisfying liquidity-preferences due to the speculative-motive, the rate of interest and the price of bonds have to be fixed at the level at which the desire on the part of certain individuals to hold cash (because at that level they feel ‘bearish’ of the future of bonds) is exactly equal to the amount of cash available for the speculative-motive. Thus each increase in the quantity of money must raise the price of bonds sufficiently to exceed the expectations of some ‘bull’ and so influence him to sell his bond for cash and join the ‘bear’ brigade. If, however, there is a negligible demand for cash from the speculative-motive except for a short transitional interval, an increase in the quantity of money will have to lower the rate of interest almost forthwith, in whatever degree is necessary to raise employment and the wage-unit sufficiently to cause the additional cash to be absorbed by the transactions-motive and the precautionary-motive.
As a rule, we can suppose that the schedule of liquidity-preference relating the quantity of money to the rate of interest is given by a smooth curve which shows the rate of interest falling as the quantity of money is increased. For there are several different causes all leading towards this result.
In the first place, as the rate of interest falls, it is likely, cet. par., that more money will be absorbed by liquidity-preferences due to the transactions-motive. For if the fall in the rate of interest increases the national income, the amount of money which it is convenient to keep for transactions will be increased more or less proportionately to the increase in income; whilst, at the same time, the cost of the convenience of plenty of ready cash in terms of loss of interest will be diminished. Unless we measure liquidity-preference in terms of wage-units rather than of money (which is convenient in some contexts), similar results follow if the increased employment ensuing on a fall in the rate of interest leads to an increase of wages, i.e. to an increase in the money value of the wage-unit. In the second place, every fall in the rate of interest may, as we have just seen, increase the quantity of cash which certain individuals will wish to hold because their views as to the future of the rate of interest differ from the market views.
Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For a large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the precautionary-motive may be strengthened; whilst opinion about the future of the rate of interest may be so unanimous that a small change in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. 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.
III
We have now introduced money into our causal nexus for the first time, and we are able to catch a first glimpse of the way in which changes in the quantity of money work their way into the economic system. If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip. For whilst an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of intere~t; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off. Finally, if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money. And when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest.
IV
Whilst liquidity-preference due to the speculative-motive corresponds to what in my Treatise on Money I called ‘the state of bearishness’, it is by no means the same thing. For ‘bearishness’ is there defined as the functional relationship, not between the rate of interest (or price of debts) and the quantity of money, but between the price of assets and debts, taken together, and the quantity of money. This treatment, however, involved a confusion between results due to a change in the rate of interest and those due to a change in the schedule of the marginal efficiency of capital, which I hope I have here avoided.
V
The concept of hoarding may be regarded as a first approximation to the concept of liquidity-preference. Indeed if we were to substitute ‘propensity to hoard’ for ‘hoarding’, it would come to substantially the same thing. But if we mean by ‘hoarding’ an actual increase in cash-holding, it is an incomplete idea — and seriously misleading if it causes us to think of ‘hoarding’ and ‘not-hoarding’ as simple alternatives. For the decision to hoard is not taken absolutely or without regard to the advantages offered for parting with liquidity;— it results from a balancing of advantages, and we have, therefore, to know what lies in the other scale. Moreover it is impossible for the actual amount of hoarding to change as a result of decisions on the part of the public, so long as we mean by ‘hoarding’ the actual holding of cash. For the amount of hoarding must be equal to the quantity of money (or — on some definitions — to the quantity of money minus what is required to satisfy the transactions-motive); and the quantity of money is not determined by the public. All that the propensity of the public towards hoarding can achieve is to determine the rate of interest at which the aggregate desire to hoard becomes equal to the available cash. The habit of overlooking the relation of the rate of interest to hoarding may be a part of the explanation why interest has been usually regarded as the reward of not-spending, whereas in fact it is the reward of not-hoarding.
Chapter 14
The Classical Theory of the Rate of Interest
I
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.
It is fairly clear, however, that this tradition has regarded the rate of interest as the factor which brings the demand for investment and the willingness to save into equilibrium with one another. Investment represents the demand for investible resources and saving represents the supply, whilst the rate of interest is the ‘price’ of investible resources at which the two are equated. Just as the price of a commodity is necessarily fixed at that point where the demand for it is equal to the supply, so the rate of interest necessarily comes to rest under the play of market forces at the point where the amount of investment at that rate of interest is equal to the amount of saving at that rate.
The above is not to be found in Marshall’s Principles in so many words. Yet his theory seems to be this, and it is what I myself was brought up on and what I taught for many years to others. Take, for example, the following passage from his Principles: ‘Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming at that rate’. Or again in Professor Cassel’s Nature and Necessity of Interest it is explained that investment constitutes the ‘demand for waiting’ and saving the ‘supply of waiting’, whilst interest is a ‘price’ which serves, it is implied, to equate the two, though here again I have not found actual words to quote. Chapter vi of Professor Carver’s Distribution of Wealth clearly envisages interest as the factor which brings into equilibrium the marginal disutility of waiting with the marginal productivity of capital. Sir Alfred Flux (Economic Principles, p. 95) writes: ‘If there is justice in the contentions of our general discussion, it must be admitted that an automatic adjustment takes place between saving and the opportunities for employing capital profitably. . . Saving will not have exceeded its possibilities of usefulness. . . so long as the rate of net interest is in excess of zero.’ Professor Taussig (Principles, vol. ii. p. 29) draws a supply curve of saving and a demand curve representing ‘the diminishing productiveness of the several instalments of capital’, having previously stated (p.20) that ‘the rate of interest settles at a point where the marginal productivity of capital suffices to bring out the marginal instalment of saving’. Walras, in Appendix I (III) of his Éléments d’économie pure, where he deals with ‘l’échange d’épargnes contre capitaux neufs’, argues expressly that, corresponding to each possible rate of interest, there is a sum which individuals will save and also a sum which they will invest in new capital assets, that these two aggregates tend to equality with one another, and that the rate of interest is the variable which brings them to equality; so that the rate of interest is fixed at the point where saving, which represents the supply of new capital, is equal to the demand for it. Thus he is strictly in the classical tradition.
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 brings down the rate of interest, that this 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.
Now the analysis of the previous chapters will have made it plain that this account of the matter must be erroneous. In tracing to its source the reason for the difference of opinion, let us, however, begin with the matters which are agreed.
Unlike the neo-classical school, who believe that saving and investment can be actually unequal, the classical school proper has accepted the view that they are equal. Marshall, for example, surely believed, although he did not expressly say so, that aggregate saving and aggregate investment are necessarily equal. Indeed, most members of the classical school carried this belief much too far; since they held that every act of increased saving by an individual necessarily brings into existence a corresponding act of increased investment. Nor is there any material difference, relevant in this context, between my schedule of the marginal efficiency of capital or investment demand-schedule and the demand curve for capital contemplated by some of the classical writers who have been quoted above. When we come to the propensity to consume and its corollary the propensity to save, we are nearer to a difference of opinion, owing to the emphasis which they have placed on the influence of the rate of interest on the propensity to save. But they would, presumably, not wish to deny that the level of income also has an important influence on the amount saved; whilst I, for my part, would not deny that the rate of interest may perhaps have an influence (though perhaps not of the kind which they suppose) on the amount saved out of a given income. All these points of agreement can be summed up in a proposition which the classical school would accept and I should not dispute; namely, that, if the level of income is assumed to be given, we can infer that the current rate of interest must lie at the point where the demand curve for capital corresponding to different rates of interest cuts the curve of the amounts saved out of the given income corresponding to different rates of interest.
But this is the point at which definite error creeps into the classical theory. If the classical school merely inferred from the above proposition that, given the demand curve for capital and the influence of changes in the rate of interest on the readiness to save out of given incomes, the level of income and the rate of interest must be uniquely correlated, there would be nothing to quarrel with. Moreover, this proposition would lead naturally to another proposition which embodies an important truth; namely, that, if the rate of interest is given as well as the demand curve for capital and the influence of the rate of interest on the readiness to save out of given levels of income, the level of income must be the factor which brings the amount saved to equality with the amount invested. But, in fact, the classical theory not merely neglects the influence of changes in the level of income, but involves formal error.
For the classical theory, as can be seen from the above quotations, assumes that it can then proceed to consider the effect on the rate of interest of (e.g.) a shift in the demand curve for capital, without abating or modifying its assumption as to the amount of the given income out of which the savings are to be made. The independent variables of the classical theory of the rate of interest are the demand curve for capital and the influence of the rate of interest on the amount saved out of a given income; and when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is given by the point of intersection between the new demand curve for capital and the curve relating the rate of interest to the amounts which will be saved out of the given income. The classical theory of the rate of interest seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down. The position could only be saved by some complicated assumption providing for an automatic change in the wage-unit of an amount just sufficient in its effect on liquidity-preference to establish a rate of interest which would just offset the supposed shift, so as to leave output at the same level as before. In fact, there is no hint to be found in the above writers as to the necessity for any such assumption; at the best it would be plausible only in relation to long-period equilibrium and could not form the basis of a short-period theory; and there is no ground for supposing it to hold even in the long-period. In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.
The above can be illustrated by a diagram as follows:

In this diagram the amount of investment (or saving) I is measured vertically, and the rate of interest r horizontally. X1X1′ is the first position of the investment demand-schedule, and X2X2′ is a second position of this curve. The curve Y1 relates the amounts saved out of an income Y1 to various levels of the rate of interest, the curves Y2, Y3, etc., being the corresponding curves for levels of income Y2, Y3, etc. Let us suppose that the curve Y1 is the Y-curve consistent with an investment demand-schedule X1X1′ and a rate of interest r1. Now if the investment demand-schedule shifts from X1X1′ to X2X2′, income will, in general, shift also. But the above diagram does not contain enough data to tell us what its new value will be; and, therefore, not knowing which is the appropriate Y-curve, we do not know at what point the new investment demand-schedule will cut it. If, however, we introduce the state of liquidity-preference and the quantity of money and these between them tell us that the rate of interest is r2, then the whole position becomes determinate. For the Y-curve which intersects X2X2′ at the point vertically above r2, namely, the curve Y2, will be the appropriate curve. Thus the X-curve and the Y-curves tell us nothing about the rate of interest. They only tell us what income will be, if from some other source we can say what the rate of interest is. If nothing has happened to the state of liquidity-preference and the quantity of money, so that the rate of interest is unchanged, then the curve Y2′ which intersects the new investment demand-schedule vertically below the point where the curve Y1 intersected the old investment demand-schedule will be the appropriate Y-curve, and Y2′ will be the new level of income.
Thus the functions used by the classical theory, namely, the response of investment and the response of the amount saved out of a given income to change in the rate of interest, do not furnish material for a theory of the rate of interest; but they could be used to tell us what the level of income will be, given (from some other source) the rate of interest; and, alternatively, what the rate of interest will have to be, if the level of income is to be maintained at a given figure (e.g. the level corresponding to full employment).
The mistake originates from regarding interest as the reward for waiting as such, instead of as the reward for not-hoarding; just as the rates of return on loans or investments involving different degrees of risk, are quite properly regarded as the reward, not of waiting as such, but of running the risk. There is, in truth, no sharp line between these and the so-called ‘pure’ rate of interest, all of them being the reward for running the risk of uncertainty of one kind or another. Only ln the event of money being used solely for transactions and never as a store of value, would a different theory become appropriate.
There are, however, two familiar points which might, perhaps, have warned the classical school that something was wrong. In the first place, it has been agreed, at any rate since the publication of Professor Cassel’s Nature and Necessity of Interest, that it is not certain that the sum saved out of a given income necessarily increases when the rate of interest is increased; whereas no one doubts that the investment demand-schedule falls with a rising rate of interest. But if the Y-curves and the X-curves both fall as the rate of interest rises, there is no guarantee that a given Y-curve will intersect a given X-curve anywhere at all. This suggests that it cannot be the Y-curve and the X-curve alone which determine the rate of interest.
In the second place, it has been usual to suppose that an increase in the quantity of money has a tendency to reduce the rate of interest, at any rate in the first instance and in the short period. Yet no reason has been given why a change in the quantity of money should affect either the investment demand-schedule or the readiness to save out of a given income. Thus the classical school have had quite a different theory of the rate of interest in volume I dealing with the theory of value from what they have had in volume II dealing with the theory of money. They have seemed undisturbed by the conflict and have made no attempt, so far as I know, to build a bridge between the two theories. The classical school proper, that is to say; since it is the attempt to build a bridge on the part of the neo-classical school which has led to the worst muddles of all. For the latter have inferred that there must be two sources of supply to meet the investment demand-schedule; namely, savings proper, which are the savings dealt with by the classical school, plus the sum made available by any increase in the quantity of money (this being balanced by some species of levy on the public, called ‘forced saving’ or the like). This leads on to the idea that there is a ‘natural’ or ‘neutral’ or equilibrium’ rate of interest, namely, that rate of interest which equates investment to classical savings proper without any addition from ‘forced savings’; and finally to what, assuming they are on the right track at the start, is the most obvious solution of all, namely, that, if the quantity of money could only be kept constant in all circumstances, none of these complications would arise, since the evils supposed to result from the supposed excess of investment over savings proper would cease to be possible. But at this point we are in deep water. ‘The wild duck has dived down to the bottom — as deep as she can get — and bitten fast hold of the weed and tangle and all the rubbish that is down there, and it would need an extraordinarily clever dog to dive after and fish her up again.’
Thus the traditional analysis is faulty because it has failed to isolate correctly the independent variables of the system. Saving and investment are the determinates of the system, not the determinants. They are the twin results of the system’s determinants, namely, the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest. These determinants are, indeed, themselves complex and each is capable of being affected by prospective changes in the others. But they remain independent in the sense that their values cannot be inferred from one another. The traditional analysis has been aware that saving depends on income but it has overlooked the fact that income depends on investment, in such fashion that, when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment.
Nor are those theories more successful which attempt to make the rate of interest depend on ‘the marginal efficiency of capital’. It is true that in equilibrium the rate of interest will be equal to the marginal efficiency of capital, since it will be profitable to increase (or decrease) the current scale of investment until the point of equality has been reached. But to make this into a theory of the rate of interest or to derive the rate of interest from it involves a circular argument, as Marshall discovered after he had got half-way into giving an account of the rate of interest along these lines. 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. The significant conclusion is that the output of new investment will be pushed to the point at which the marginal efficiency of capital becomes equal to the rate of interest; and what the schedule of the marginal efficiency of capital tells us, is, not what the rate of interest is, but the point to which the output of new investment will be pushed, given the rate of interest.
The reader will readily appreciate that the problem here under discussion is a matter of the most fundamental theoretical significance and of overwhelming practical importance. For the economic principle, on which the practical advice of economists has been almost invariably based, has assumed, in effect, that, cet. par., a decrease in spending will tend to lower the rate of interest and an increase in investment to raise it. But if what these two quantities determine is, not the rate of interest, but the aggregate volume of employment, then our outlook on the mechanism of the economic system will be profoundly changed. A decreased readiness to spend will be looked on in quite a different light If, instead of being regarded as a factor which will, cet. par., increase investment, it is seen as a factor which will, cet. par., diminish employment.
Appendix to Chapter 14
Appendix on the Rate of Interest in Marshall’s Principles of Economics, Ricardo’s Principles of Political Economy, And Elsewhere
I
There is no consecutive discussion of the rate of interest in the works of Marshall, Edgeworth or Professor Pigou,— nothing more than a few obiter dicta. Apart from the passage already quoted above (p. 139) the only important clues to Marshall’s position on the rate of interest are to be found in his Principles of Economics (6th edn.), Book VI. p. 534 and p. 593, the gist of which is given by the following quotations:
‘Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming there at that rate. If the market, which we are considering, is a small one — say a single town, or a single trade in a progressive country — an increased demand for capital in it will be promptly met by an increased supply drawn from surrounding districts or trades. But if we are considering the whole world, or even the whole of a large country, as one market for capital, we cannot regard the aggregate supply of it as altered quickly and to a considerable extent by a change in the rate of interest. For the general fund of capital is the product of labour and waiting; and the extra work, and the extra waiting, to which a rise in the rate of interest would act as an incentive, would not quickly amount to much, as compared with the work and waiting, of which the total existing stock of capital is the result. An extensive increase in the demand for capital in general will therefore be met for a time not so much by an increase of supply, as by a rise in the rate of interest; which will cause capital to withdraw itself partially from those uses in which its marginal utility is lowest. It is only slowly and gradually that the rise in the rate of interest will increase the total stock of capital’ (p.534).
‘It cannot be repeated too often that the phrase “the rate of interest” is applicable to old investments of capital only in a very limited sense. For instance, we may perhaps estimate that a trade capital of some seven thousand millions is invested in the different trades of this country at about 3 per cent net interest. But such a method of speaking, though convenient and justifiable for many purposes, is not accurate. What ought to be said is that, taking the rate of net interest on the investments of new capital in each of those trades [i.e. on marginal investments] to be about 3 per cent; then the aggregate net income rendered by the whole of the trade-capital invested in the various trades is such that, if capitalised at 33 years’ purchase (that is, on the basis of interest at 3 per cent), it would amount to some seven thousand million pounds. For the value of the capital already invested in improving land or erecting a building, in making a railway or a machine, is the aggregate discounted value of its estimated future net incomes [or quasi-rents]; and if its prospective income-yielding power should diminish, its value would fall accordingly and would be the capitalised value of that smaller income after allowing for depreciation’ (p.593).
In his Economics of Welfare (3rd edn.), p. 163, Professor Pigou writes: ‘The nature of the service of “waiting” has been much misunderstood. Sometimes it has been supposed to consist in the provision of money, sometimes in the provision of time, and, on both suppositions, it has been argued that no contribution whatever is made by it to the dividend. Neither supposition is correct. “Waiting” simply means postponing consumption which a person has power to enjoy immediately, thus allowing resources, which might have been destroyed, to assume the form of production instruments. The unit of “waiting” is, therefore, the use of a given quantity of resources — for example, labour or machinery — for a given time. . . In more general terms we may say that the unit of waiting is a year-value-unit, or, in the simpler, if less accurate, language of Dr Cassel, a year-pound. . . A caution may be added against the common view that the amount of capital accumulated in any year is necessarily equal to the amount of “savings” made in it. This is not so, even when savings are interpreted to mean net savings, thus eliminating the savings of one man that are lent to increase the consumption of another, and when temporary accumulations of unused claims upon services in the form of bank-money are ignored; for many savings which are meant to become capital in fact fail of their purpose through misdirection into wasteful uses.’
Professor Pigou’s only significant reference to what determines the rate of interest is, I think, to be found in his Industrial Fluctuations (1st edn.), pp. 251−3, where he controverts the view that the rate of interest, being determined by the general conditions of demand and supply of real capital, lies outside the central or any other bank’s control. Against this view he argues that: ‘When bankers create more credit for business men, they make, in their interest, subject to the explanations given in chapter xiii. of part i., a forced levy of real things from the public, thus increasing the stream of real capital available for them, and causing a fall in the real rate of interest on long and short loans alike. It is true, in short, that the bankers’ rate for money is bound by a mechanical tie to the real rate of interest on long loans; but it is not true that this real rate is determined by conditions wholly outside bankers’ control.’
My running comments on the above have been made in the footnotes. 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. ‘Interest’ has really no business to turn up at all in Marshall’s Principles of Economics,— it belongs to another branch of the subject.
Professor Pigou, conformably with his other tacit assumptions, leads us (in his Economics of Welfare) to infer that the unit of waiting is the same as the unit of current investment and that the reward of waiting is quasi-rent, and practically never mentions interest, which is as it should be. 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. Moreover, the rate of interest scarcely plays a larger part in Professor Pigou’s Industrial Fluctuations (which is mainly a study of fluctuations in the marginal efficiency of capital) or in his Theory of Unemployment (which is mainly a study of what determines changes in the volume of employment, assuming that there is no involuntary unemployment) than in his Economics of Welfare.
II
The following from his Principles of Political Economy (p. 511) puts the substance of Ricardo’s theory of the rate of interest:
‘The interest of money is not regulated by the rate at which the Bank will lend, whether it be 5, 3 or 2 per cent., but by the rate of profit which can be made by the employment of capital, and which is totally independent of the quantity or of the value of money. Whether the Bank lent one million, ten millions, or a hundred millions, they would not permanently alter the market rate of interest; they would alter only the value of the money which they thus issued. In one case, ten or twenty times more money might be required to carry on the same business than what might be required in the other. The applications to the Bank for money, then, depend on the comparison between the rate of profits that may be made by the employment of it, and the rate at which they are willing to lend it. If they charge less than the market rate of interest, there is no amount of money which they might not lend;— if they charge more than that rate, none but spendthrifts and prodigals would be found to borrow of them.’
This is so clear-cut that it affords a better starting-point for a discussion than the phrases of later writers who, without really departing from the essence of the Ricardian doctrine, are nevertheless sufficiently uncomfortable about it to seek refuge in haziness. The above is, of course, as always with Ricardo, to be interpreted as a long-period doctrine, with the emphasis on the word ‘permanently’ half-way through the passage; and it is interesting to consider the assumptions required to validate it.
Once again the assumption required is the usual classical assumption, that there is always full employment; so that, assuming no change in the supply curve of labour in terms of product, there is only one possible level of employment in long-period equilibrium. On this assumption with the usual ceteris paribus, i.e. no change in psychological propensities and expectations other than those arising out of a change in the quantity of money, the Ricardian theory is valid, in the sense that on these suppositions there is only one rate of interest which will be compatible with full employment in the long period. Ricardo and his successors overlook the fact that even in the long period the volume of employment is not necessarily full but is capable of varying, and that to every banking policy there corresponds a different long-period level of employment; so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority.
If Ricardo had been content to present his argument solely as applying to any given quantity of money created by the monetary authority, it would still have been correct on the assumption of flexible money-wages. If, that is to say, Ricardo had argued that it would make no permanent alteration to the rate of interest whether the quantity of money was fixed by the monetary authority at ten millions or at a hundred millions, his conclusion would hold. But if by the policy of the monetary authority we mean the terms on which it will increase or decrease the quantity of money, i.e. the rate of interest at which it will, either by a change in the volume of discounts or by open-market operations, increase or decrease its assets — which is what Ricardo expressly does mean in the above quotation — then it is not the case either that the policy of the monetary authority is nugatory or that only one policy is compatible with long-period equilibrium; though in the extreme case where money-wages are assumed to fall without limit in face of involuntary unemployment through a futile competition for employment between the unemployed labourers, there will, it is true, be only two possible long-period positions — full employment and the level of employment corresponding to the rate of interest at which liquidity-preference becomes absolute (in the event of this being less than full employment). Assuming flexible money-wages, the quantity of money as such is, indeed, nugatory in the long period; but the terms on which the monetary authority will change the quantity of money enters as a real determinant into the economic scheme.
It is worth adding that the concluding sentences of the quotation suggest that Ricardo was overlooking the possible changes in the marginal efficiency of capital according to the amount invested. But this again can be interpreted as another example of his greater internal consistency compared with his successors. For if the quantity of employment and the psychological propensities of the community are taken as given, there is in fact only one possible rate of accumulation of capital and, consequently, only one possible value for the marginal efficiency of capital. Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits, of adopting a hypothetical world remote from experience as though it were the world of experience and then living in it consistently. With most of his successors common sense cannot help breaking in — with injury to their logical consistency.
III
A peculiar theory of the rate of interest has been propounded by Professor von Mises and adopted from him by Professor Hayek and also, I think, by Professor Robbins; namely, that changes in the rate of interest can be identified with changes in the relative price levels of consumption-goods and capital-goods It is not clear how this conclusion is reached. But the argument seems to run as follows. By a somewhat drastic simplification the marginal efficiency of capital is taken as measured by the ratio of the supply price of new consumers’ goods to the supply price of new producers’ goods. This is then identified with the rate of interest. The fact is called to notice that a fall in the rate of interest is favourable to investment. Ergo, a fall in the ratio of the price of consumers’ goods to the price of producer’s goods is favourable to investment.
By this means a link is established between tncreased saving by an individual and increased aggregate investment. For it is common gound that increased individual saving will cause a fall in the price of consumers’ goods, and, quite possibly, a greater fall than in the price of producers’ goods; hence, according to the above reasoning, it means a reduction in the rate of interest which will stimulate investment. But, of course, a lowering of the marginal efficiency of particular capital assets, and hence a lowering of the schedule of the marginal efficiency of capital in general, has exactly the opposite effect to what the above argument assumes. For investment is stimulated either by a raising of the schedule of the marginal efficiency or by a lowering of the rate of interest. As a result of confusing the marginal efficiency of capital with the rate of interest, Professor von Mises and his disciples have got their conclusions exactly the wrong way round. A good example of a confusion along these lines is given by the following passage by Professor Alvin Hansen: ‘It has been suggested by some economists that the net effect of reduced spending will be a lower price level of consumers’ goods than would otherwise have been the case, and that, in consequence, the stimulus to investment in fixed capital would thereby tend to be minimised. This view is, however, incorrect and is based on a confusion of the effect on capital formation of (i) higher or lower prices of consumers’ goods, and (2) a change in the rate of interest. It is true that in consequence of the decreased spending and increased saving, consumers’ prices would be low relative to the prices of producers’ goods. But this, in effect, means a lower rate of interest, and a lower rate of interest stimulates an expansion of capital investment in fields which at higher rates would be unprofitable.’
Chapter 15
The Psychological and Business Incentives to Liquidity
I
We must now develop in more detail the analysis of the motives to liquidity-preference which were introduced in a preliminary way in chapter 13. The subject is substantially the same as that which has been sometimes discussed under the heading of the demand for money. It is also closely connected with what is called the income-velocity of money;— for the income-velocity of money merely measures what proportion of their incomes the public chooses to hold in cash, so that an increased income-velocity of money may be a symptom of a decreased liquidity-preference. It is not the same thing, however, since it is in respect of his stock of accumulated savings, rather than of his income, that the individual can exercise his choice between liquidity and illiquidity. And, anyhow, 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.
In my Treatise on Money I studied the total demand for money under the headings of income-deposits, business-deposits, and savings-deposits, and I need not repeat here the analysis which I gave in chapter 3 of that book. Money held for each of the three purposes forms, nevertheless, a single pool, which the holder is under no necessity to segregate into three water-tight compartments; for they need not be sharply divided even in his own mind, and the same sum can be held primarily for one purpose and secondarily for another. Thus we can — equally well, and, perhaps, better — consider the individual’s aggregate demand for money in given circumstances as a single decision, though the composite result of a number of different motives.
In analysing the motives, however, it is still convenient to classify them under certain headings, the first of which broadly corresponds to the former classification of income-deposits and business-deposits, and the two latter to that of savings-deposits. These I have briefly introduced in chapter 13 under the headings of the transactions-motive, which can be further classified as the income-motive and the business-motive, the precautionary-motive and the speculative-motive.
(i) The Income-motive. One reason for holding cash is to bridge the interval between the receipt of income and its disbursement. The strength of this motive in inducing a decision to hold a given aggregate of cash will chiefly depend on the amount of income and the normal length of the interval between its receipt and its disbursement. It is in this connection that the concept of the income-velocity of money is strictly appropriate.
(ii) The Business-motive. Similarly, cash is held to bridge the interval between the time of incurring business costs and that of the receipt of the sale-proceeds; cash held by dealers to bridge the interval between purchase and realisation being included under this heading. The strength of this demand will chiefly depend on the value of current output (and hence on current income), and on the number of hands through which output passes.
(iii) The Precautionary-motive. To provide for contingencies requiring sudden expenditure and for unforeseen opportunities of advantageous purchases, and also to hold an asset of which the value is fixed in terms of money to meet a subsequent liability fixed in terms of money, are further motives for holding cash.
The strength of all these three types of motive will partly depend on the cheapness and the reliability of methods of obtaining cash, when it is required, by some form of temporary borrowing, in particular by overdraft or its equivalent. For there is no necessity to hold idle cash to bridge over intervals if it can be obtained without difficulty at the moment when it is actually required. Their strength will also depend on what we may term the relative cost of holding cash. If the cash can only be retained by forgoing the purchase of a profitable asset, this increases the cost and thus weakens the motive towards holding a given amount of cash. If deposit interest is earned or if bank charges are avoided by holding cash, this decreases the cost and strengthens the motive. It may be, however, that this is likely to be a minor factor except where large changes in the cost of holding cash are in question.
(iv) There remains the Speculative-motive. This needs a more detailed examination than the others, both because it is less well understood and because it is particularly important in transmitting the effects of a change in the quantity of money.
In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income. But it is by playing on the speculative-motive that monetary management (or, in the absence of management, chance changes in the quantity of money) is brought to bear on the economic system. For the demand for money to satisfy the former motives is generally irresponsive to any influence except the actual occurrence of a change in the general economic activity and the level of incomes; whereas experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest as given by changes in the prices of bonds and debts of various maturities.
Indeed, if this were not so, ‘open market operations’ would be impracticable. I have said that experience indicates the continuous relationship stated above, because in normal circumstances the banking system is in fact always able to purchase (or sell) bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount; and the larger the quantity of cash which they seek to create (or cancel) by purchasing (or selling) bonds and debts, the greater must be the fall (or rise) in the rate of interest. Where, however, (as in the United States, 1933−1934) open-market operations have been limited to the purchase of very short-dated securities, the effect may, of course, be mainly confined to the very short-term rate of interest and have but little reaction on the much more important long-term rates of interest.
In dealing with the speculative-motive it is, however, important to distinguish between the changes in the rate of interest which are due to changes in the supply of money available to satisfy the speculative-motive, without there having been any change in the liquidity function, and those which are primarily due to changes in expectation affecting the liquidity function itself. Open-market Operations may, indeed, influence the rate of interest through both channels; since they may not only change the volume of money, but may also give rise to changed expectations concerning the future policy of the central bank or of the government. Changes in the liquidity function itself; due to a change in the news which causes revision of expectations, will often be discontinuous, and will, therefore, give rise to a corresponding discontinuity of change in the rate of interest. Only, indeed, in so far as the change in the news is differently interpreted by different individuals or affects individual lnterests differently will there be room for any increased activity of dealing in the bond market. If the change in the news affects the judgment and the requirements of everyone in precisely the same way, the rate of interest (as indicated by the prices of bonds and debts) will be adjusted forthwith to the new situation without any market transactions being necessary.
Thus, in the simplest case, where everyone is similar and similarly placed, a change in circumstances or expectations will not be capable of causing any displacement of money whatever;— it will simply change the rate of interest in whatever degree is necessary to offset the desire of each individual, felt at the previous rate, to change his holding of cash in response to the new circumstances or expectations; and, since everyone will change his ideas as to the rate which would induce him to alter his holdings of cash in the same degree, no transactions will result. To each set of circumstances and expectations there will correspond an appropriate rate of interest, and there will never be any question of anyone changing his usual holdings of cash.
In general, however, a change in circumstances or expectations will cause some realignment in individual holdings of money;— since, in fact, a change will influence the ideas of different individuals differently by reasons partly of differences in environment and the reason for which money is held and partly of differences in knowledge and interpretation of the new situation. Thus the new equilibrium rate of interest will be associated with a redistribution of money-holdings. Nevertheless it is the change in the rate of interest, rather than the redistribution of cash, which deserves our main attention. The latter is incidental to individual differences, whereas the essential phenomenon is that which occurs in the simplest case. Moreover, even in the general case, the shift in the rate of interest is usually the most prominent part of the reaction to a change in the news. The movement in bond-prices is, as the newspapers are accustomed to say, ‘out of all proportion to the activity of dealing’;— which is as it should be, in view of individuals being much more similar than they are dissimilar in their reaction to news.
II
Whilst the amount of cash which an individual decides to hold to satisfy the transactions-motive and the precautionary-motive is not entirely independent of what he is holding to satisfy the speculative-motive, it is a safe first approximation to regard the amounts of these two sets of cash-holdings as being largely independent of one another. Let us, therefore, for the purposes of our further analysis, break up our problem in this way. Let the amount of cash held to satisfy the transactions- and precautionary-motives be M1, and the amount held to satisfy the speculative-motive be M2. Corresponding to these two compartments of cash, we then have two liquidity functions L1 and L2. L1 mainly depends on the level of income, whilst L2 mainly depends on the relation between the current rate of interest and the state of expectation. Thus
M = M1 + M2 = L1(Y) + L2(r),
where L1 is the liquidity function corresponding to an income Y, which determines M1, and L2 is the liquidity function of the rate of interest r, which determines M2. It follows that there are three matters to investigate: (i) the relation of changes in M to Y and r, (ii) what determines the shape of L1, (iii) what determines the shape of L2.
(i) The relation of changes in M to Y and r depends, in the first instance, on the way in which changes in M come about. Suppose that M consists of gold coins and that changes in M can only result from increased returns to the activities of gold-miners who belong to the economic system under examination. In this case changes in M are, in the first instance, directly associated with changes in Y, since the new gold accrues as someone’s income. Exactly the same conditions hold if changes in M are due to the government printing money wherewith to meet its current expenditure;— in this case also the new money accrues as someone’s income. The new level of income, however, will not continue sufficiently high for the requirements of M1 to absorb the whole of the increase in M; and some portion of the money will seek an outlet in buying securities or other assets until r has fallen so as to bring about an increase in the magnitude of M2 and at the same time to stimulate a rise in Y to such an extent that the new money is absorbed either in M2 or in the M1 which corresponds to the rise in Y caused by the fall in r. Thus at one remove this case comes to the same thing as the alternative case, where the new money can only be issued in the first instance by a relaxation of the conditions of credit by the banking system, so as to induce someone to sell the banks a debt or a bond in exchange for the new cash.
It will, therefore, be safe for us to take the latter case as typical. A change in M can be assumed to operate by changing r, and a change in r will lead to a new equilibrium partly by changing M2 and partly by changing Y and therefore M1. The division of the increment of cash between M1 and M2 in the new position of equilibrium will depend on the responses of investment to a reduction in the rate of interest and of income to an increase in investment. Since Y partly depends on r, it follows that a given change in M has to cause a sufficient change in r for the resultant changes in M1 and M2 respectively to add up to the given change in M.
(ii) It is not always made clear whether the income-velocity of money is defined as the ratio of Y to M or as the ratio of Y to M1. I propose, however, to take it in the latter sense. Thus if V is the income-velocity of money,
Y
L1(Y) = —— = M1.
V
There is, of course, no reason for supposing that V is constant. Its value will depend on the character of banking and industrial organisation, on social habits, on the distribution of income between different classes and on the effective cost of holding idle cash. Nevertheless, if we have a short period of time in view and can safely assume no material change in any of these factors, we can treat V as nearly enough constant.
(iii) Finally there is the question of the relation between M2 and r. We have seen in chapter 13 that uncertainty as to the future course of the rate of interest is the sole intelligible explanation of the type of liquidity-preference L2 which leads to the holding of cash M2. It follows that a given M2 will not have a definite quantitative relation to a given rate of interest of r;— what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level of r, having regard to those calculations of probability which are being relied on. Nevertheless, there are two reasons for expecting that, in any given state of expectation, a fall in r will be associated with an increase in M2. In the first place, if the general view as to what is a safe level of r is unchanged, every fall in r reduces the market rate relatively to the ‘safe’ rate and therefore increases the risk of illiquidity; and, in the second place, every fall in r reduces the current earnings from illiquidity, which are available as a sort of insurance premium to offset the risk of loss on capital account, by an amount equal to the difference between the squares of the old rate of interest and the new. For example, if the rate of interest on a long-term debt is 4 per cent, it is preferable to sacrifice liquidity unless on a balance of probabilities it is feared that the long-term rate of interest may rise faster than by 4 per cent of itself per annum, i.e. by an amount greater than 0.16 per cent per annum. If, however, the rate of interest is already as low as 2 per cent, the running yield will only offset a rise in it of as little as 0.04 per cent per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level. Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.
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 below the rate which corresponds to full employment; because at such a level a state of true inflation will be produced, with the result that M1 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. The short-term rate of interest is easily controlled by the monetary authority, both because it is not difficult to produce a conviction that its policy will not greatly change in the very near future, and also because the possible loss is small compared with the running yield (unless it is approaching vanishing point). But the long-term rate may be more recalcitrant when once it has fallen to a level which, on the basis of past experience and present expectations of future monetary policy, is considered ‘unsafe’ by representative opinion. For example, in a country linked to an international gold standard, a rate of interest lower than prevails elsewhere will be viewed with a justifiable lack of confidence; yet a domestic rate of interest dragged up to a parity with the highest rate (highest after allowing for risk) prevailing in any country belonging to the international system may be much higher than is consistent with domestic full employment.
Thus a monetary policy which strikes public opinion as being experimental in character or easily liable to change may fail in its objective of greatly reducing the long-term rate of interest, because M2 may tend to increase almost without limit in response to a reduction of r below a certain figure. The same policy, on the other hand, may prove easily successful if it appeals to public opinion as being reasonable and practicable and in the public interest, rooted in strong conviction, and promoted by an authority unlikely to be superseded.
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. In particular, when M1 is increasing faster than M, the rate of interest will rise, and vice versa. But it may fluctuate for decades about a level which is chronically too high for full employment;— 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 range of rates of interest.
The difficulties in the way of maintaining effective demand at a level high enough to provide full employment, which ensue from the association of a conventional and fairly stable long-term rate of interest with a fickle and highly unstable marginal efficiency of capital, should be, by now, obvious to the reader.
Such comfort as we can fairly take from more encouraging reflections must be drawn from the hope that, precisely because the convention is not rooted in secure knowledge, it will not be always unduly resistant to a modest measure of persistence and consistency of purpose by the monetary authority. Public opinion can be fairly rapidly accustomed to a modest fall in the rate of interest and the conventional expectation of the future may be modified accordingly; thus preparing the way for a further movement — up to a point. The fall in the long-term rate of interest in Great Britain after her departure from the gold standard provides an interesting example of this;— the major movements were effected by a series of discontinuous jumps, as the liquidity function of the public, having become accustomed to each successive reduction, became ready to respond to some new incentive in the news or in the policy of the authorities.
III
We can sum up the above in the proposition that in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions-motive or the precautionary-motive, which will realise itself in actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash. It is this potentiality which is summed up in the liquidity function L2. Corresponding to the quantity of money created by the monetary authority, there will, therefore, be cet. par. a determlnate rate of interest or, more strictly, a determinate complex of rates of interest for debts of different maturities. The same thing, however, would be true of any other factor in the economic system taken separately. Thus this particular analysis will only be useful and significant in so far as there is some specially direct or purposive connection between changes in the quantity of money and changes in the rate of interest. Our reason for supposing that there is such a special connection arises from the fact that, broadly speaking, the banking system and the monetary authority are dealers in money and debts and not in assets or consumables.
If the monetary authority were prepared to deal both ways on specified terms in debts of all maturities, and even more so if it were prepared to deal in debts of varying degrees of risk, the relationship between the complex of rates of interest and the quantity of money would be direct. The complex of rates of interest would simply be an expression of the terms on which the banking system is prepared to acquire or part with debts; and the quantity of money would be the amount which can find a home in the possession of individuals who — after taking account of all relevant circumstances — prefer the control of liquid cash to parting with it in exchange for a debt on the terms indicated by the market rate of interest. Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management.
To-day, however, in actual practice, the extent to which the price of debts as fixed by the banking system is ‘effective’ in the market, in the sense that it governs the actual market-price, varies in different systems. Sometimes the price is more effective in one direction than in the other; that is to say, the banking system may undertake to purchase debts at a certain price but not necessarily to sell them at a figure near enough to its buying-price to represent no more than a dealer’s turn, though there is no reason why the price should not be made effective both ways with the aid of open-market operations. There is also the more important qualification which arises out of the monetary authority not being, as a rule, an equally willing dealer in debts of all maturities. The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect reactions from the price of short-term debts;— though here again there is no reason why they need do so. Where these qualifications operate, the directness of the relation between the rate of interest and the quantity of money is correspondingly modified. In Great Britain the field of deliberate control appears to be widening. But in applying this theory in any particular case allowance must be made for the special characteristics of the method actually employed by the monetary authority. If the monetary authority deals only in short-term debts, we have to consider what influence the price, actual and prospective, of short-term debts exercises on debts of longer maturity.
Thus there are certain limitations on the ability of the monetary authority to establish any given complex of rates of interest for debts of different terms and risks, which can be summed up as follows:
(1) There are those limitations which arise out of the monetary authority’s own practices in limiting its willingness to deal to debts of a particular type.
(2) There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.
(3) The most striking examples of a complete breakdown of stability in the rate of interest, due to the liquidity function flattening out in one direction or the other, have occurred in very abnormal circumstances. In Russia and Central Europe after the war a currency crisis or flight from the currency was experienced, when no one could be induced to retain holdings either of money or of debts on any terms whatever, and even a high and rising rate of interest was unable to keep pace with the marginal efficiency of capital (especially of stocks of liquid goods) under the influence of the expectation of an ever greater fall in the value of money; whilst in the United States at certain dates in 1932 there was a crisis of the opposite kind — a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms.
(4) There is, finally, the difficulty discussed in section IV of chapter 11, p. 144, in the way of bringing the effective rate of interest below a certain figure, which may prove important in an era of low interest-rates; namely the intermediate costs of bringing the borrower and the ultimate lender together, and the allowance for risk, especially for moral risk, which the lender requires over and above the pure rate of interest. As the pure rate of interest declines it does not follow that the allowances for expense and risk decline pari passu. Thus the rate of interest which the typical borrower has to pay may decline more slowly than the pure rate of interest, and may be incapable of being brought, by the methods of the existing banking and financial organisation, below a certain minimum figure. This is particularly important if the estimation of moral risk is appreciable. For where the risk is due to doubt in the mind of the lender concerning the honesty of the borrower, there is nothing in the mind of a borrower who does not intend to be dishonest to offset the resultant higher charge. It is also important in the case of short-term loans (e.g. bank loans) where the expenses are heavy;— a bank may have to charge its customers 1½ to 2 per cent., even if the pure rate of interest to the lender is nil.
IV
At the cost of anticipating what is more properly the subject of chapter 21 below it may be interesting briefly at this stage to indicate the relationship of the above to the quantity theory of money.
In a static society or in a society in which for any other reason no one feels any uncertainty about the future rates of interest, the liquidity function L2, or the propensity to hoard (as we might term it), will always be zero in equilibrium. Hence in equilibrium M2 = 0 and M = M1; so that any change in M will cause the rate of interest to fluctuate until income reaches a level at which the change in M1 is equal to the supposed change in M. Now M1 V = Y, where V is the income-velocity of money as defined above and Y is the aggregate income. Thus if it is practicable to measure the quantity, O, and the price, P, of current output, we have Y = OP, and, therefore, MV = OP; which is much the same as the quantity theory of money in its traditional form.
For the purposes of the real world it is a great fault in the quantity theory that it does not distinguish between changes in prices which are a function of changes in output, and those which are a function of changes in the wage-unit. The explanation of this omission is, perhaps, to be found in the assumptions that there is no propensity to hoard and that there is always full employment. For in this case, O being constant and M2 being zero, it follows, if we can take V also as constant, that both the wage-unit and the price-level will be directly proportional to the quantity of money.
Chapter 16
Sundry Observations on the Nature of Capital
I
An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand,— it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.
If saving consisted not merely in abstaining from present consumption but in placing simultaneously a specific order for future consumption, the effect might indeed be different. For in that case the expectation of some future yield from investment would be improved, and the resources released from preparing for present consumption could be turned over to preparing for the future consumption. Not that they necessarily would be, even in this case, on a scale equal to the amount of resources released; since the desired interval of delay might require a method of production so inconveniently ’roundabout’ as to have an efficiency well below the current rate of interest, with the result that the favourable effect on employment of the forward order for consumption would eventuate not at once but at some subsequent date, so that the immediate effect of the saving would still be adverse to employment. In any case, however, an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order. Thus, since the expectation of consumption is the only raison d’être of employment, there should be nothing paradoxical in the conclusion that a diminished propensity to consume has cet. par. a depressing effect on employment.
The trouble arises, therefore, because the act of saving implies, not a substitution for present consumption of some specific additional consumption which requires for its preparation just as much immediate economic activity as would have been required by present consumption equal in value to the sum saved, but a desire for ‘wealth’ as such, that is for a potentiality of consuming an unspecified article at an unspecified time. The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.
It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment. Moreover, in order that an individual saver may attain his desired goal of the ownership of wealth, it is not necessary that a new capital-asset should be produced wherewith to satisfy him. The mere act of saving by one individual, being two-sided as we have shown above, forces some other individual to transfer to him some article of wealth old or new. Every act of saving involves a ‘forced’ inevitable transfer of wealth to him who saves, though he in his turn may suffer from the saving of others. These transfers of wealth do not require the creation of new wealth — indeed, as we have seen, they may be actively inimical to it. The creation of new wealth wholly depends on the prospective yield of the new wealth reaching the standard set by the current rate of interest. The prospective yield of the marginal new investment is not increased by the fact that someone wishes to increase his wealth, since the prospective yield of the marginal new investment depends on the expectation of a demand for a specific article at a specific date.
Nor do we avoid this conclusion by arguing that what the owner of wealth desires is not a given prospective yield but the best available prospective yield, so that an increased desire to own wealth reduces the prospective yield with which the producers of new investment have to be content. For this overlooks the fact that there is always an alternative to the ownership of real capital-assets, namely the ownership of money and debts; so that the prospective yield with which the producers of new investment have to be content cannot fall below the standard set by the current rate of interest. And the current rate of interest depends, as we have seen, not on the strength of the desire to hold wealth, but on the strengths of the desires to hold it in liquid and in illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other. If the reader still finds himself perplexed, let him ask himself why, the quantity of money bcing unchanged, a fresh act of saving should diminish the sum which it is desired to keep in liquid form at the existing rate of interest.
Certain deeper perplexities, which may arise when we try to probe still further into the whys and wherefores, will be considered in the next chapter.
II
It is much preferable to speak of capital as having a yield over the course of its life in excess of its original cost, than as being productive. For the only reason why an asset offers a prospect of yielding during its life services having an aggregate value greater than its initial supply price is because it is scarce; and it is kept scarce because of the competition of the rate of interest on money. If capital becomes less scarce, the excess yield will diminish, without its having become less productive — at least in the physical sense.
I sympathise, therefore, with the pre-classical doctrine that everything is produced by labour, aided by what used to be called art and is now called technique, by natural resources which are free or cost a rent according to their scarcity or abundance, and by the results of past labour, embodied in assets, which also command a price according to their scarcity or abundance. It is preferable to regard labour, including, of course, the personal services of the entrepreneur and his assistants, as the sole factor of production, operating in a given environment of technique, natural resources, capital equipment and effective demand. This partly explains why we have been able to take t