Keynes’s General Theory: A Solution in Search of a Problem
ABSTRACT: This article is an evaluation of the General Theory largely on its own terms. Extensive quotations from The General Theory of Employment, Interest, and Money are used in order to allow Keynes himself to expound the theory. The goal of this article is to show that even on its own terms the General Theory must be considered a failure, for the problem it purports to solve, involuntary unemployment, does not exist. Many of the individual points made here have been made before, but no references are provided. Benjamin Anderson (1980), for example, remarks on the counter-intuitive (indeed, worthless) nature of Keynes’s “volume of employment,” and Henry Hazlitt ( 2007) points out that one parts with liquidity whenever one buys anything. I think at least two points here have not been made before: 1) that deficit-spending plays an insignificant or non-existent role in the General Theory, and 2) that involuntary unemployment (used in the manner in which Keynes uses the phrase) is incapable of being known to exist—which removes any justification for the assertion that full employment does not exist.
Carlton Smith ([email protected]) is an independent scholar.
Keynes’s General Theory purports to provide a solution to a problem. That problem is not generic unemployment but rather a species of it that Keynes calls involuntary unemployment. What is involuntary unemployment?
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. (Keynes 1965, 15)
What is the criterion by means of which we detect the presence of involuntary unemployment? The effect that something has had on the volume of employment. What does Keynes mean by the phrase “volume of employment”? 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. (Keynes 1965, 41)
Calling Keynes’s measure of employment dubious (at the very least, curious) seems warranted. Consider a community with four adults, Tom, Dick, Richard, and Harry. On Tuesday Tom was unemployed; Dick and Richard both worked for eight hours and were paid $20 per hour; and Harry worked for eight hours and was paid $600 per hour. On Wednesday Tom was still unemployed; so, alas, was Dick, who was fired; Richard worked for eight hours and was paid $20 per hour; and Harry worked for eight hours and was paid $650 per hour (he received a raise). Tom and Dick, fortunately, were not disgruntled, for the quantity of employment had increased.
But wait—there is more. Not only did the quantity of employment increase, so, too, did the quantity of output. For the measure of output as a whole—a vague concept as Keynes himself admits (1965, 43) —is nothing other than the quantity of employment:
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. (Keynes 1965, 44)
This is fun. Not only did Harry’s raise produce an increase in employment, it also produced an increase in output. Want to increase employment and output? Raise the wages of the well-paid!
Now let us return to the test that we use to detect the existence of involuntary unemployment. The mere fact that people are unemployed does not mean that involuntary unemployment exists, for Keynes expressly allows for the existence of voluntary unemployment and excludes from 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.” (Keynes 1965, 15) It should be obvious that Keynes’s volume of employment tells us nothing about the level of unemployment (the volume of employment can increase when the number of workers employed and the number of hours worked both decrease). Can it tell us something about the level of involuntary unemployment?
It certainly cannot tell us what the level of involuntary unemployment is—or even if there is any involuntary unemployment—for the test for the existence of involuntary unemployment is what the effect on the volume of employment would be if the price of wage-goods rose relatively to the money-wage. Can we use the volume of employment to detect the previous existence of involuntary unemployment? Let us construct a case favorable to Keynes’s position.
On Tuesday Tom is unemployed; Dick, Richard, and Harry each work for eight hours and are paid $20 per hour. On Wednesday the price of wage-goods has risen relatively to the money-wage, which we will assume has remained the same. Tom, Dick, Richard, and Harry all have jobs: each works for eight hours and is paid $20 per hour. The volume of employment has increased. We may not know if there is still any involuntary unemployment on Wednesday, but surely we know that there was involuntary unemployment on Tuesday? Unfortunately, we do not. Tom’s unemployment on Tuesday may have been the result of his decision not to “work for less than a certain real reward.” His employment on Wednesday may stem from his decision to accept a lower real reward on Wednesday than he was willing to accept on Tuesday. Nothing in the facts of the case—the increase in the volume of employment that has occurred after a rise in the price of wage-goods relative to the money-wage—permits us to infer that there was any involuntary unemployment on Tuesday.
The unavoidable conclusion is that Keynes’s test for the existence of involuntary unemployment cannot be used to detect the existence of involuntary unemployment. Keynes himself seems to have realized that the existence of involuntary unemployment is problematic, for he informs us that “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?).” (Keynes 1965, 16) I do not profess to be able to decipher the meaning of his remark with complete assurance, but I do not see how it can be taken not to include an admission that there may be no such thing as involuntary unemployment.
Full employment is “the absence of ‘involuntary’ unemployment.” (Keynes 1965, 15) The problem associated with the concept of full employment is therefore the problem associated with the concept of involuntary unemployment. Because we can never know that involuntary unemployment exists, we can never know that full employment does not exist. At the risk of pointing out what should be obvious, a remedy for a problem which is not known to exist—indeed, which cannot be known to exist—might not be much of a remedy.
Keynes’s system contains given factors, independent variables, and dependent variables. (Keynes 1965, 245) We may ignore the given factors because they are the “factors in which the changes seem to be so slow or so little relevant as to have only a small and comparatively negligible short-term influence on our quaesitum….”(Keynes 1965, 247)
The “independent variables are, in the first instance, the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest….” (Keynes 1965, 245) We soon learn that “the rate of interest depends partly on the state of liquidity-preference (i.e. on the liquidity function) and partly on the quantity of money measured in terms of wage-units.” (Keynes 1965, 246) For that reason we need to include liquidity-preference and the quantity of money among the independent variables. (Keynes 1965, 246–47) The remaining independent variable that Keynes identifies is the wage-unit, (Keynes 1965, 246–47) which he defines as “the money-wage of a labour-unit.” (Keynes 1965, 41) The dependent variables are “the volume of employment and the national income (or national dividend) measured in wage-units.” (Keynes 1965, 245)
What is the propensity to consume? Keynes defines 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.” (Keynes 1965, 90) Keynes’s definition suffers from at least one defect: it suggests that the decision to consume depends only on current income and not on other factors such as assets that one owns. Keynes seems to recognize the defect, for he tells us later that the people who take an active interest in their Stock Exchange investments “are, perhaps, even more influenced in their readiness to spend by rises and falls in the value of their investments than by the state of their income.” (Keynes 1965, 319)
What is the marginal efficiency of capital? Although Keynes defines the marginal efficiency of capital in a manner that connects it exclusively with the continued ownership of a capital-asset, (Keynes 1965, 135) I think the concept needs to be expanded. Keynes seems to think so too, for in other places it is the gap between the price at which a good sells and the cost of producing it which has causal significance.1 I think we are justified in using the phrase “marginal efficiency of capital” to refer to the expected return (excess of price received over costs incurred) from production.
The rate of interest is determined by liquidity-preference and the quantity of money. What is liquidity-preference? I see no reason not to call it the desire to acquire or retain the ownership of money,2 a desire often called the demand for money.3 What effect does it have on the rate of interest? Keynes tells us that
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…. Thus the rate of interest… is a measure of the unwillingness of those who possess money to part with their liquid control over it. (Keynes 1965, 167)
In Keynes’s terminology, when one lends money to someone else, one has parted with liquidity. The smaller the supply of liquidity (money) offered for sale, the higher its price will be.
The link that Keynes draws between the demand for money and the rate of interest is unwarranted. To start with, it is too narrow. The demand for money clearly has an effect on all transactions, not merely on transactions in the loan-market. If the demand for money rises, the prices of other goods will fall. After all, one parts with liquidity whenever one buys anything. In addition, Keynes tells us that the demand for money has an effect on the rate of interest within the context of the psychological time-preferences of an individual. (Keynes 1965, 166) If those preferences are sufficient to account for the rate of interest, nothing is gained by the introduction of the demand for money. I will not pursue the subject,
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