Lecture Six

1. Lecture Six From Keynes (& Fisher) to the Interpretation of Keynes IS-LM Analysis Achievements: The Keynesian Era (1950-1973) versus Neoclassical/Monetarist (1975 till now)

2. UWS Comedy Festival • The UWS Comedy Festival is on at The Enmore Theatre on October 22 & 23 and all profits are going to theStarlight Children's Foundation. • As well as our students performing, our guest acts include Peter Hellier, Corinne Grant and Vince Sorrenti - and tickets can be bought from Ticketek. • This has been in the making for over six months now so it would be GREAT if our students could support it so we have more people from the uni than residents of inner city suburbs.

3. Changed arrangements for discussants • Apologies for stuff-up to seminars because of short semester/trip/October Long Weekend • Allowances for discussants who have already presented • Suggestion: Discussants to present on the day as now, but have a week to write full critique • Also, does anyone need a copy of OREF?

4. Pre-Keynesian Macro • Conventional neoclassical macroeconomic theory less elaborate than Walras’s “General Equilibrium” model (discussed last week): • Assumed fixed capital stock in short run, variable labor supply, etc., rather than “everything variable” as in Walras (but with other strong assumptions needed) • Example: Hicks’s “typical classical theory” (outlined in “Mr Keynes and the Classics”) • 2 industries: Investment goods X & consumption goods Y • 2 factors of production: labor (variable); capital (fixed in short run) • Given capital stock in both industries:

5. Hicks’s “typical classical theory” • Output a function of employment Nx & Ny • X=fx(Nx); Y=fy(Ny) where f has diminishing marginal productivity • Prices equal marginal costs = marginal product of labour times wage rate (since labour is only variable input): • Marginal cost is increase in labor input (dNx & dNy) for each increment to output (dx & dy) • Px=w.dNx/dx; Py=w.dNy/dy • Income = value of output = price times quantity: • I = Ix + Iy = w.(dNx/dx) .x + w.(dNy/dy) .y

6. Supply I (Interest rate) Demand Ix (output of capital goods) Hicks’s “typical classical theory” • Quantity of Money M a given, and fixed relation between M and income I (transactions demand for money only: money “a veil over barter”): • M = k.I (k constant “velocity of money”) • Demand for investment goods a function of interest rate: • Ix=C(i) • Supply of savingsa function of interest rate: • Ix=S(i) • Higher savings meanshigher investment (a familiar argument?) Determines Nx

7. Hicks’s “typical classical theory” • Causal chain: • M determines I (total output) • i determines Ix (output of investment goods) • Ix determines Nx (given w) • I-Ix determines Iy (output of consumption goods is a residual…) • Iy determines Ny (given w) • Lower money wage means higher employment: • Lower wage means lower prices • Unchanged money I means higher income relative to prices, so higher sales • Higher sales mean increased employment (and lower real wage due to diminishing marginal product)

8. Neoclassical Macro • Asserted unemployment due to excessive wages, until... The Great Depression Arguably began with Stock Market Crash Just one week before…

9. The economists were saying… • “Stock prices have reached what looks like a permanently high plateau. • I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.” (Irving Fisher, October 15 1929) • In the next few years, Irving Fisher lost12 million dollars! • That’s $102 million in today’s prices • Crash occurred on October 23rd 1929:

10. A 120 Point Break in just 15 Days... Crash continued for another 3 years:

11. The Great Wall Street Crash and that’s the index; the S&P of 1948 had many stocks which didn’t exist in 1929, while many of the 1929 entrants had gone bankrupt S&P 500 from 32 at its zenith 25 years to recover To below 5at its nadir in less than 3 years Not only theStockmarketcrashed…

12. 10 years to restore output levels 30% fall in output in 4 years The Great Depression WW II

13. The Great Depression To 25% in 3 years WW II Brings Sustained Recovery From effectively zero...

14. Keynes’s “Revolution” • A (partial) rejection of (neo)classical economics • Kept marginal product theory of factor returns, etc.; but • Rejected theory of investment, money, savings • Key innovation: proper treatment of uncertainty • Investment: • in certain world, would be determined by interest rate • in uncertain world, motivated by expectations of profit • Expectations of profit volatile & based on flimsy foundations: • Expect current state of affairs to continue; • Trust current prices, etc., as correct • Trust mass sentiment

15. Keynes’s “Revolution”: Investment & Savings • Investment (determined by expectations, output, capital stock) determines income via multiplier • I=f(E,Y,K) (E component highly volatile) • Y=f(I) • Consumption a function of income • C=a + c.Y (stable relationship) • Y=C+I=C+S (ex-post Investment = ex-post Savings) • Savings a residual function of income: • S=Y-C • Investment determines Savings • Attempt to increase Savings (by reducing MPC) may reduce investment & hence output

16. Keynes’s “Revolution”: Money • Neoclassical theory: • money a “veil over barter” • transactions motive only for holding money • Keynes • Money ultimate source of liquidity in uncertain world • Speculative, precautionary & finance motives for holding money (latter not in General Theory book, but in 1937 papers) • Rate of interest the return for foregoing liquidity • Liquidity preference highly volatile because based on expectations (like Investment)

17. Keynes’s “Revolution”: Critique “Say’s Law” • Expenditure has 2 components: • D1, related to current output (consumption) • D2, not related to current output (investment) • Say’s Law (rejected by Keynes) requires: • either D2=0; or • Increased savings causes increased D2 • But • Decision to invest based on expectations of profit in uncertain future • Increased savings means decreased consumption now • May lead to lower expectations and less investment

18. In a nutshell... • “The theory can be summed up by saying that, given the psychology of the public, the level of output and employment as a whole depends on the amount of investment... More comprehensively, aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital-assets, on the propensity to spend and on the social factors which influence the level of the money-wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little.” [OREF ]

19. Keynes and Investment under Uncertainty • In most of General Theory, Keynes argued that investment motivated by relationship between marginal efficiency of investment schedule (MEI) and the rate of interest • In Chapter 17 of General Theory, “The General Theory of Employment” and “Alternative theories of the rate of interest” (1937), instead spoke in terms of two price levels • investment motivated by the desire to produce “those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228) • Demand price determined by prospective yields, depreciation and liquidity preference. • Supply price determined by costs of production

20. Keynes and Investment under Uncertainty • Two price level analysis becomes more dominant subsequent to General Theory: • The scale of production of capital assets “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217) • MEI analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus”, whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214)

21. What is “uncertainty”? • Very hard to grasp, even though essential aspect of our world: we do not know the future • But we have worked out how to calculate risk • Most of Keynes’s examples were about how uncertainty is not risk • Negative examples—what uncertainty is not—rather than what it is:

22. Keynes on Uncertainty • ‘By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.’

23. What is “uncertainty”? • Imagine you are very attracted to a particular person • This person has accepted invitations from 1 in 5 of the people who have asked him/her out • Does this mean you have a 20% chance of success? • Of course not: • Each experience of sexual attraction is unique • What someone has done in the past with other people is no guide to what he/she will do with you in the future • His/her response is not “risky”; it is uncertain. • Ditto to • individual investments • success/failure of past instances give no guide to present “odds”

24. How to cope with relationship uncertainty? • We try to “find out beforehand” • ask friends—eliminate the uncertainty • We do nothing… • paralysed into inaction • We ask regardless… • compel ourselves into action • We follow conventions • “follow the herd” of the social conventions of our society • “play the game” & hope for the best • So what about investors?

25. Keynes and Investment under Uncertainty • In the midst of incalculable uncertainty, investors form fragile expectations about the future • These are crystallised in the prices they place upon capital asset • These prices are therefore subject to sudden and violent change • with equally sudden and violent consequences for the propensity to invest • Seen in this light, the marginal efficiency of capital is simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)

26. Keynes on Uncertainty and Expectations • Three aspects to expectations formation under true uncertainty • Presumption that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” • Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects” • Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214) • Fragile basis for expectations formation thus affects prices of financial assets

27. Keynes on Finance Markets • Conventional theory says prices on finance markets reflect net present value capitalisation of expected yields of assets • But, says Keynes, far from being dominated by rational calculation, valuations of finance markets reflect fundamental uncertainty and are driven by whim: • “all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield” (1936: 152) • ignorance • day to day instability • waves of optimism and pessimism • “the third degree”

28. Keynes on Finance Markets • Ignorance due to dispersion of share ownership (shades of Telstra?): • “As a result of the gradual increase in the proportion of equity ... owned by persons who ... have no special knowledge ... of the business... the element of real knowledge in the valuation of investments ... has seriously declined” (1936: 153) • Anyone here got T2 shares?… • Impact of day to day fluctuations • “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” (1936: 153-54)

29. Keynes on Finance Markets • Waves of optimism and pessimism • “In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual ... 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.” (1936: 154) • “The Third Degree” • Professional investors further destabilise the market by attempting to anticipate its short term movements and react more quickly • As Geoff Harcourt once remarked, Keynes “writes like an angel”. The next few slides are in Keynes’s own words.

30. Keynes on Finance Markets • “It might have been supposed that competition between expert professionals ... would correct the vagaries of the ignorant individual... However,... 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... 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.” (1936: 154-55)

31. Keynes on Finance Markets • “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 most skilled investment today 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.” (1936: 155)

32. Keynes on Finance Markets • “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; ... 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.” (1936: 156)

33. Keynes on Finance Markets • “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 investment 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.”

34. Keynes on Finance Markets • “Investment based on genuine long-term expectation is so difficult today 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 the 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 ignorance than to beat the gun.”

35. Keynes on Finance Markets • “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 tolerably 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...”

36. Keynes on Finance Markets • “Finally it is the long-term investor ... who will in practice come in for most criticism, wherever investment funds are managed by committees 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 us that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes 1936: 156-58) • At the same time as Keynes was writing the General Theory, Irving Fisher put forward the very similar “Debt Deflation Theory of Great Depressions”:

37. Fisher on Depression • Fisher’s reputation was destroyed by prediction of no crash, but afterwards, he turned to developing theory to explain the crash • “The Debt Deflation Theory of Great Depressions” • Neoclassical theory assumed equilibrium • but real world equilibrium short-lived since “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium” (1933: 339) • As a result, any real world variable is likely to be over or under its equilibrium level--including confidence & speculation

38. Debt Deflation Theory of Great Depressions • Key problems debt and prices • The “two dominant factors” which cause depressions are “over-indebtedness to start with and deflation following soon after” • “Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 341) • When overconfidence leads to overindebtedness, a chain reaction ensues:

39. Debt Deflation Theory of Great Depressions • “(1) Debt liquidation leads to distress selling and to • (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes • (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be • (4) A still greater fall in the net worths of business, precipitating bankruptcies and

40. Debt Deflation Theory of Great Depressions • (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make • (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to • (7) Pessimism and loss of confidence, which in turn lead to • (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause • (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (1933: 342)

41. Debt Deflation Theory of Great Depressions • Fisher thus concurs with ancient charge against usury, that “it maketh many bankrotts” (Jones 1989: 55) • While such a fate largely individual in a feudal system, in a capitalist economy a chain reaction ensues which leads the entire populace into crisis • Theory nonequilibrium in nature • argues that “we may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, towards a stable equilibrium” • but though stable, equilibrium is “so delicately poised that, after departure from it beyond certain limits, instability ensues” (Fisher 1933: 339).

42. Debt Deflation Theory of Great Depressions • Two classes of far from equilibrium events explained: • Great Depression, when overindebtedness coincides with deflation • with deflation on top of excessive debt, “the more debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing” (Fisher 1933: 344). • Cycles, when one occurs without the other • with only overindebtedness or deflation, economic growth eventually corrects situation; it • “is then more analogous to stable equilibrium: the more the boat rocks the more it will tend to right itself. In that case, we have a truer example of a cycle” (Fisher 1933: 344-345)

43. Debt Deflation Theory of Great Depressions • Fisher’s new theory ignored • Old theory made basis of modern finance theory • Debt deflation theory revived in modern form by Minsky (a future lecture) • Fisher’s macroeconomic contribution (which emphasised the need for reflation and “100% money” during the Depression) overshadowed by Keynes’s “General Theory” • Many similarities and synergies in Keynes and Fisher, but different countries meant one largely unaware of others work

44. Keynes and Debt-deflation • Some consideration of debt-deflation in General Theory when discussing reduction in money wages (the neoclassical proposal for ending the Great Depression--see last lecture): • “Since a special reduction of money-wages is always advantageous to an individual entrepreneur ... a general reduction ... may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital... On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partially offset any cheerful reactions from the reductions of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency--with severe adverse effects on investment.” (Keynes 1936: 264)

45. Keynes and Debt-deflation • “The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (1936: 268-69) • Thus 2 reasons for favouring reflation/inflation as means to end Great Depression: • accepted neoclassical argument that real wage had to fall for employment to rise (next slide) • impact of rising price level on debt far safer than that of a falling price level.

46. Keynes on Wages • Since accepted marginal product theory, accepted that real wages had to fall for employment to rise: Increased output Output • But argued • cutting money wage would cut prices--no effect on real wage • solution to depression was reflation, not deflation: increase output, real wages will fall Employment (But remember Sraffa’s critique of diminishing marginal productivity [last lecture]) =real wage Marginal Product of Labour Nu Nf Reduces real wage

47. Keynes on Policy • Reflate domestic economy to escape Depression: • Government deficit funding of public works • Multiplier impact on output, employment • Boost to investor expectations • Maintain low interest rates • International Balance of Payments system to avoid “beggar my neighbour” currency devaluations • Central world monetary authority • Fixed exchange rates, IMF approval for variation • Trade deficit economies must deflate economies to reduce imports • Trade surplus economies must reflate to boost imports

48. Keynesian Policy in Practice • Domestic policy recommendations became the norm • Budget deficits to increase employment during slumps (but surpluses rarely achieved during booms for political reasons) • Low interest rates • International recommendations only half followed in “Bretton-Woods” agreement: • Fixed exchange rates, IMF, etc. (US as standard) • Pressure on deficit countries to deflate; but • No pressure on trade surplus countries to reduce surplus (USA then major creditor--trade surplus--nation)

49. The interpretation of Keynes • General Theory highly influential, but read by few economists (let alone economic journalists!) • Most relied upon summaries and textbook interpretations • GT itself not precise; plenty of room for interpretation • Key interpretation: Hicks 1937, “Mr Keynes & the Classics” [OREF II] IS-LM rendition of Keynes • Hicks sets out “typical classical theory”: • M=k.I (money supply & output), Ix=C(i) (investment demand), Ix=S(i) (savings supply) • Argues that Keynes’s innovation is the proposition that the demand for money should obey marginal analysis:

50. A “marginal” interpretation of Keynes • “On grounds of pure value theory, it is evident that the direct sacrifice made by a person who holds a stock of money is a sacrifice of interest; and it is hard to believe that the marginal principle does not operate at all in this field” [Hicks, OREF II] • Proposes that • M=L(i) (demand for money a decreasing function of interest rate) is “Liquidity Preference” • this Keynes’s main innovation • Multiplier [Ix = S(I)] comparatively “insignificant”