Lesson 4 of 7
Demand, and the floor
Keynes runs the slump through a collapse in the expected yield on new capital, and the limits of what a lower interest rate can do once it has collapsed.
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 engine is the marginal efficiency of capital: the yield investors expect on newly produced capital goods. Keynes's cycle is a collapse in that expectation and a slow recovery of it.
- His claim about the floor is specific. In a downswing the expected yield may fall so low that no practicable reduction in the interest rate can restore a satisfactory rate of new investment.
- He also argues the fall feeds on itself through the propensity to consume, because a collapse in equity values reduces the spending of those who own shares.
Keynes's account of the cycle is fourteen pages in chapter 22 of The General Theory of Employment, Interest and Money, published in 1936. It is worth reading in his own terms rather than through the caricature of it.
Where the three accounts put the failure
Keynes
- Expected yield on new capital collapses and stays low.
- Interest rate cannot fall far enough to offset it.
- Equity losses cut consumption at the worst moment.
- Recovery waits on durable goods wearing out.
The other two accounts
- Monetarist: the money stock collapsed and the central bank could have prevented it.
- Austrian: capital was in the wrong places and the correction was obstructed.
- Both locate the failure outside the expectations of investors.
- Both therefore see a different remedy.
All three see the same collapse in investment and explain its persistence differently.
The mechanism
While a boom runs, new investment shows a satisfactory current yield. Disillusion comes, on Keynes's account, when doubts arise about the reliability of the prospective yield, perhaps because the current yield starts falling as the stock of newly produced durable goods increases. Once doubt begins it spreads quickly, and at the outset of a slump much capital has a marginal efficiency that is negligible or negative.
He then explains the length of the downswing by two things that take time. The life of durable assets, which sets how long it takes for scarcity to reappear through use, decay and obsolescence. And the carrying cost of surplus stocks, which forces their absorption within a period he puts at three to five years.
The claim about the interest rate
This is the part that separates him from the monetarist account. He argues that in the downward phase the schedule of the marginal efficiency of capital may fall so low that it can scarcely be corrected, so as to secure a satisfactory rate of new investment, by any practicable reduction in the rate of interest.
His reason is about magnitudes: the market's estimate of the marginal efficiency of capital can swing so widely that offsetting movements in the interest rate cannot match it. He also notes that it is easier for a high rate to stop a boom than for a low rate to end a slump.
The second channel
The stock market. He argues that a serious fall in the marginal efficiency of capital also depresses the propensity to consume, because it involves a severe decline in the market value of equities, and that this hits the spending of the people who hold them at exactly the wrong moment.
That is a wealth channel, and it makes the collapse self-reinforcing rather than self-limiting.
What he says about 1928 and 1929
Something worth noticing in a course that sets accounts side by side. Keynes writes that except during the war he doubts there is recent experience of a boom strong enough to reach full employment, that employment in the United States was very satisfactory by normal standards in 1928 and 1929, that he saw no evidence of a labour shortage outside a few specialised groups, and that output as a whole was still capable of expanding.
That is a factual claim about the boom, and it bears directly on the account in the previous two lessons.
His conclusion
That the duty of ordering the current volume of investment cannot safely be left in private hands. It is a policy conclusion, it is his, and this academy neither adopts nor rejects it.
Check yourself
What is the marginal efficiency of capital?
- The productivity of existing machines
- The yield investors expect on newly produced capital goods
- The interest rate net of inflation
Show the answer
Answer: B.
Keynes's cycle is a collapse in that expectation followed by a slow recovery, governed by the life of durable assets and the carrying cost of surplus stocks.What is his claim about the interest rate in a slump?
- That it always rises
- That the expected yield can fall so low that no practicable reduction in the rate secures a satisfactory rate of new investment
- That it has no effect on investment at any time
Show the answer
Answer: B.
He also observes that a high rate is more effective against a boom than a low rate is against a slump.What did Keynes say about US employment in 1928 and 1929?
- That there was a severe labour shortage
- That employment was very satisfactory by normal standards, with no evidence of shortage outside a few specialised groups, and output still capable of expanding
- That unemployment was already high
Show the answer
Answer: B.
It is a factual claim about the boom that bears directly on accounts locating the cause in an overextended expansion.Sources
- Keynes, The General Theory of Employment, Interest and Money, 1936, book VI, chapter 22, for the collapse in the marginal efficiency of capital and the reasons doubt spreads, for the two stable time factors of durable asset life and the carrying cost of surplus stocks, for the claim that the schedule may fall so low that no practicable reduction in the rate of interest corrects it, for the effect on the propensity to consume through the market value of equities, for the observation that a high rate is more effective against a boom than a low rate against a slump, for his remarks on United States employment in 1928 and 1929, and for his conclusion about the ordering of investment.
- Keynes, The General Theory, 1936, book IV, chapter 17, for own rates of interest, which is the argument the sixth course of this track uses.
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.
- The firm and the rates in the example are invented round figures chosen to show the arithmetic of the gap. No company is described.
- Keynes's conclusion about the ordering of investment is a policy position held by him. It is reported and neither endorsed nor rejected here, as are the policy positions of every other author in this course.
- Modern economics that traces its descent from Keynes has developed well beyond chapter 22, and nothing in this lesson is attributed to that later literature.