High Interest, Low Demand, and Keynes: Rejoinder to Hill and Felix
Roger W. Garrison
Both Greg Hill(1) and David Felix(2) call attention to the liquidity-preference theory of interest in their discussions of Keynes's General Theory, Meltzer's interpretation, and my review article. Both draw from Keynes's Chapter 13, "The General Theory of the Rate of Interest," which argues that interest is "the reward for parting with liquidity," (3) or "the compensation received for parting with liquidity for a specified period of time, that is, for not hoarding." (4) Interestingly, this critical aspect of Keynes's analytical framework is highlighted by the two commentators for radically different reasons. Hill restates the liquidity-preference theory and defends it on his way to arguing that the market has no mechanism to govern the rate of investment--and that government should step in and fill the void or, at least, lead the way; Felix points to a single sentence that captures the essence of the liquidity-preference theory and offers it as conclusive evidence that Keynes's views on interest-rate determination are "nonsensical" and that "his pure theory is the purest piffle." Both commentators hint that I have misread or not read Keynes.
Keynes's liquidity-preference theory of interest, which was the focus of the earliest critical analysis, follows almost trivially from his idiosyncratic way of framing the issue. Individuals earn incomes, which permit them to buy goods and interest-earning assets and to hold money. Keynes formulates his theory by imposing a particular sequence on the income-earner's decision process:
Both Hill and Felix point to another aspect of Keynes's theory, namely, the supposed waning of spending propensities as wealth increases, as critical to interpreting his message. As people earn higher incomes and accumulate wealth, their spending does not increase proportionally. The increasing gap between spending and earning works as a drag on the economy. Each year investment spending needs to rise in order to turn the increased savings into more income but is likely to fall in anticipation of a still further weakening of consumption demand. According to Hill, "Keynes reasoned that a redistribution of wealth would increase the propensity to spend and, therefore, the inducement to invest"(14) This aspect of Keynesian theory is offered as evidence that "it is the economic analysis which produces the social vision and not the other way around." Felix characterizes the notion of spending waning with wealth as an "unproven ... proposition"(15) and argues elsewhere that the supposed relationship between spending propensities and wealth levels was no more than an assumption and that modern empirical research reveals a lack of supporting evidence.(16)
The general notion that the economy is beset by demand deficiencies--whether or not these deficiencies are believed to increase proportionally or only absolutely with income--has given scope to alternative interpretations of Keynes's central message. Is the widespread unemployment of labor and of other resources ultimately attributable to the mispricing of these factors of production--and to a corresponding mispricing in product markets? Or does the deficiency persist even when the economy is in equilibrium (in the sense of market clearing) in both factor and product markets? Keynes's willingness to state the problem by comparing the business of pyramid building in Ancient Egypt to the business of railway construction in modern England suggests that his theory did not hinge on the difference between equilibrium and disequilibrium. "Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York." (17) They are twice as good not because pyramid markets clear while railway markets do not but because two--or twenty--can be ordered up from on high independent of any waning of consumption propensities. The ultimate solution to the problem of demand deficiencies, then, is not to be found in policies that encourage wage and price flexibility or even in monetary and fiscal policies that add to total demand. The ultimate solution, in Keynes's final reckoning, is reform in the direction of a command economy. This is the general thrust of Keynesian Splenetics.
Hill finesses the critical question about the nature of demand deficiency. Whether the spending gap is conceived as a disequilibrium or an equilibrium phenomenon, Hill sees a vital role for government in leading the business community back to full employment. During a slump, an individual firm that expands its own operations would be doing more good for society than would be reflected in its own profits. But, expecting modest profits at best and fearing losses in the event that no general economic expansion develops, each individual firm is unlikely to expand. The role for government, then, according to Hill, is one of converting some of the largest firms to public ownership and allowing those firms' decisions to be based on the benefits to society as a whole. Alternatively, the government could orchestrate the expansion of privately owned firms through some sort of indicative planning. Envisioning such roles for government entails a dramatic departure from the fiscal and monetary policies associated with the Keynesian Hydraulics of modern textbooks, but Keynes himself provides clear supporting text: "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 general social advantage, taking an ever greater responsibility for directly organizing investment ... .(18) There is not much distance between Hill's (and Keynes's) idea of government as bellwether or sheepdog and Keynes's hint in Chapter 24 of a comprehensive socialization of investment.
Instincts and Visions
Finally, let me comment on Keynes's wisdom, as judged by Felix, in seeing the darker side of the socialist development. Felix quotes from the first paragraph of a letter to F. A. Hayek in which Keynes praises Hayek's Road to Serfdom: "morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in a deeply moved agreement."(19) A critical difference between Keynes's and Hayek's thinking, however, is revealed in the two final paragraphs: "Moderate planning will be safe if those carrying it out are rightly orientated in their own minds and hearts to the moral issue ... . Dangerous acts can be done safely in a community which thinks and feels rightly, which would be the way to hell if they were executed by those who think and feel wrongly." (20) In sharp contrast to Hayek, Keynes was an elitist. He believed that the agencies of government would--or should--be populated by an elite who take the long view, who act with a eye toward social advantage, and who respect the rights and liberties of those over whom they have power. Hayek hoped for institutions that would uphold the rule of law--that would protect people's rights and liberties no matter which particular individuals populate the agencies of government. Felix uses this letter to Hayek to suggest that Keynes was "true in instinct and realistically in equilibrium with economics and politics"; I see the letter as clear evidence of the difference between Keynes and Hayek in terms of their contrasting visions of the macroeconomy and of the potential for government to compensate for the market's perceived shortcomings.
I do not intend to suggest, as Hill hints that I may, that having a pre-analytic vision about economic relationships is, in and of itself, a corrupting influence on the analytics. I do suggest, following Meltzer and Schumpeter, that a difference in vision, e.g., as between Keynes and Hayek, is more fundamental than differences in analytics. According to Schumpeter, "analytic effort is of necessity preceded by a preanalytic cognitive act [which he calls a vision] that supplies the raw material for the analytic effort." (21) Schumpeter cites Keynes as the most telling example of intellectual development illustrating his point. He argues that the Keynesian "vision, as yet analytically unarmed," was clearly present in Keynes's 1919 book The Economic Consequences of the Peace.(22) In my judgment, Meltzer's book contributes importantly toward substantiating Schumpeter's methodological views.
Can Keynes's General Theory be seen as a collection of mutually reinforcing and jointly supportable propositions about the functioning of a market system and about the implied policy prescriptions and needed reform? After more than a half-century of debate, it is difficult to answer this question in the affirmative. There are too many loose arguments, too many inconsistencies, and too much scope for interpretation. There is some textual evidence to weigh in favor of each of the many competing interpretations. But Meltzer has come the closest, in my judgment, to producing the proverbial smoking gun--in the form of Keynes's social philosophy. His interpretation, which maximizes the fit between Keynes's macroeconomic theories and his early beliefs, gets high marks as a plausible interpretation having a substantial basis in the text. Assessing the economy's performance under actual as compared to ideal circumstances, as Meltzer does, or comparing capitalism-as-it-is with socialism-as-it-has-never-been, as I do, captures much of both the substance and the spirit of Keynes's book. My own interpretation differs from Meltzer's largely in its being less complimentary to Keynes. I can readily accept Hill's summary of my review article, according to which I have added a critical dimension to Meltzer's analysis by arguing that Keynes's vision is so utopian as to weaken his case against allowing markets to work.(23) But this difference aside, I find Meltzer's interpretation more plausible and truer to Keynes than any of those that have gained wider acceptance.
*Roger W. Garrison, Department of Economics, Auburn University, Auburn, AL 36849, telephone (205) 844-2920, telefax (205) 844-4016, wishes to thank Thomas J. McQuade and Leland B. Yeager for their helpful comments.
8. I leave aside the question of whether a market price (of liquidity, credit, labor, or goods and services) is usefully thought of as a reward. Is the price of a movie ticket the theater owner's reward for allowing a patron to watch a movie? Hayek argues, in effect, against conceiving the wage rate as the reward for parting with leisure. "Reward" implies a meritorious act, which parting with leisure (or liquidity) does not necessarily entail. His arguments apply with greater force, in my judgment, to the interest rate. See Friedrich A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960), Chapter 6.
13. Keynes's General Theory contains several passages in which a zero marginal efficiency of capital in equilibrium (which implies a zero rate of interest, too) is taken to be an attainable goal: "a properly run community ... ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation" (220). "If I am right in supposing it to be comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism" (221). And: "only experience can show ... how far it is safe to stimulate the average propensity to consume, without forgoing our aim of depriving capital of its scarcity-value within one or two generations" (377).