Lesson 2 of 8
Demand and expectations
Keynes put the cycle in the marginal efficiency of capital: a collapse in the expected yield of new investment, made worse by a rush into liquidity.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The cycle, on this account, is mainly a cyclical movement in the marginal efficiency of capital: the expected yield on new investment, which rests on fragile expectations.
- The crisis is sudden because disillusion is sudden. Liquidity preference rises after the collapse, not before it, which is why a rate cut alone may not revive investment.
- Keynes engages the overinvestment view directly and rejects the remedy of a higher rate, which is the sharpest disagreement with the account in this track.
Chapter 22 of the General Theory, published in 1936, is a short set of notes rather than a treatise, and Keynes says so in its first paragraph. It is also the clearest statement of what he thought a cycle was.
The sequence in chapter 22
- 1Optimistic expectationsLate boom: expected yields strong enough to offset rising costs and abundant capital
- 2Doubt appearsCurrent yields disappoint as the stock of new durable goods grows
- 3Collapse in the marginal efficiency of capitalDisillusion falls on an over-bought market suddenly
- 4Liquidity preference risesDismay follows the collapse and pushes the interest rate up, aggravating it
- 5Slow recoveryGoverned by the life of durable assets and the carrying cost of surplus stocks
What the account says
Keynes accepts that every element of his framework appears in a real cycle: the propensity to consume, liquidity preference and the marginal efficiency of capital all move. But he says the essential character of the cycle, and the rough regularity in its timing, comes mainly from the way the marginal efficiency of capital fluctuates.
The marginal efficiency of capital is the expected yield on new investment. It depends partly on how abundant capital goods already are and what they cost to produce, and heavily on expectations about future returns, which he describes as resting on a precarious basis and therefore liable to sudden and violent change.
That gives him the crisis. The turn is abrupt rather than gradual because disillusion falls suddenly on a market that has been bought by people who do not know much about what they own and by speculators watching each other rather than the assets. There is no equivalent sharp turn at the bottom.
Two features worth noticing
The order of events is deliberate. On his account liquidity preference rises after the marginal efficiency of capital collapses, not before, and the resulting rise in the interest rate deepens the fall in investment. This is why he says the slump is intractable: a lower interest rate may be necessary for recovery and is not sufficient, because the thing that has broken is the expectation of yield.
The timing of recovery has a reason too. He argues the downward phase has a characteristic length, neither one year nor ten, set by the life of durable assets relative to the growth rate and by the carrying cost of surplus stocks.
Where it differs from the account in this track
Keynes takes up the overinvestment view explicitly in section three of the chapter, and the disagreement is precise rather than rhetorical.
He distinguishes two meanings of overinvestment. One is investment destined to disappoint the expectations that prompted it. The other is a state in which capital is so abundant that no further investment would earn its replacement cost even at full employment. Only the second, he says, is overinvestment strictly speaking, and the typical boom is the first: investment made in unstable conditions on expectations that will be disappointed.
From that he draws the conclusion that separates the two accounts most sharply. The remedy for a boom, he argues, is not a higher rate of interest but a lower one, and the right aim is to abolish slumps rather than to abolish booms. He grants that a high rate is more effective against a boom than a low rate against a slump, and rejects using it, because it would deter useful investment and reduce the propensity to consume.
He also grants something the other side presses: that the illusions of a boom can cause particular types of capital assets to be produced in excessive abundance, which is misdirected investment. The difference is that he treats that as a feature alongside the main story rather than as the mechanism.
Check yourself
What does Keynes say the essential character of the cycle comes from?
- Fluctuations in the money supply
- The way the marginal efficiency of capital fluctuates
- Changes in the propensity to consume
Show the answer
Answer: B.
Chapter 22 allows that all three of his variables move, and identifies the marginal efficiency of capital as the one that gives the cycle its character and its rough regularity.When does liquidity preference rise, on this account?
- Before the collapse, causing it
- After the collapse in the marginal efficiency of capital, aggravating it
- It does not change over the cycle
Show the answer
Answer: B.
He is explicit about the order, and draws from it the conclusion that a lower interest rate alone may not be enough to revive investment.What does Keynes say the remedy for a boom is?
- A higher rate of interest, applied early
- A lower rate of interest, on the grounds that the aim should be to abolish slumps rather than booms
- Direct control of investment by the banks
Show the answer
Answer: B.
Section three of chapter 22 states this after distinguishing two meanings of overinvestment and arguing that the typical boom is the milder of the two.Sources
- Keynes, The General Theory of Employment, Interest and Money, 1936, chapter 22, sections one to three: the identification of the cycle with fluctuations in the marginal efficiency of capital, the account of the crisis as a sudden collapse of expectations in organised investment markets, the ordering of liquidity preference after the collapse, the length of the downward phase as governed by the life of durable assets and carrying costs, the distinction between two senses of overinvestment, the rejection of a higher interest rate as the remedy for a boom, and the concession that particular types of capital asset can be produced in excessive abundance.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- This lesson describes chapter 22 only. The wider system of the book and the enormous later literature interpreting it are outside what is claimed here.
- Keynes's policy conclusions are reported because they are part of his argument. Reporting them is not endorsing them, and this track takes no policy position.