Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 4, by Clark Johnson)

Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson


Keynes essential claim in the General Theory was that unemployment could persist for years, even if wages and other factor costs were flexible.  The point was that even if factor costs fell, the marginal efficiency of capital might not recover because it was driven by market expectations — which were volatile, and trending downward.  Falling costs might even be taken, not as restorative, but as evidence of weak demand and sagging investment prospects.  Investment might then stay below the level needed to maintain full employment.  Keynes was not claiming that general equilibrium was maintained in the face of unemployment, as critics were later to assert.  He used the term “equilibrium” more modestly to mean that unemployment could persist, and that it was not self-correcting.

Keynes never really explained why he thought monetary policy worked mainly through its effect on interest rates, rather than directly on demand.  This paper suggests the hypothesis that he saw accumulation of physical capital as inexorably leading to lower capital efficiency and declining profits.  With this premise, an attempt to reboot investment by increasing money and prices – even if it succeeded in the short run — would just mean more rapid accumulation of capital, and hence more rapid decline in profits, in a self-reinforcing stagnationist circle.  This conclusion was falsifiable, and has been falsified.  To be fair, it pushes Keynes’ suppositions to the edge of what his text might support, and Keynes never wrote it down, not in so many words.

Keynes was more inclined to dodge the whole topic, either by indirection or deliberately.  The best example of his dodge on monetary factors comes near the beginning of the General Theory, where Keynes quotes John Stuart Mill’s description of Say’s Law, the classical doctrine according to which “supply creates its own demand.”  Keynes sets up Say’s Law as a counterpoint for his own theoretical grand design.  Keynes quoted Mill to demonstrate that “classical” economists thought it possible to “double the purchasing power” merely by “doub[ling] the supply of commodities in every market.”[1]  Astonishingly, Keynes then chopped off the rest of Mill’s paragraph, in which was included –

…money is a commodity; and if all commodities are supposed to be doubled in quantity, we must suppose money to be doubled too, and then prices would no more fall than values would.[2]

Algebraically, an excess supply in one market must be matched by an excess demand in another.  A shortfall of demand for goods implies a matching excess (unsatisfied) demand for money.  Mill and other Classics recognized this – it was not Mill but Keynes who typically neglected discussion of such monetary dynamics.  Mundell highlighted this omission decades ago:

…Keynes perpetrated an historical error in the economics profession lasting several years, a distortion of the classical position that to this day remains in the elementary textbooks.  By thus attacking the logic of the central feature of the classical theory through carelessness or mischievous omission of its essential parts, Keynes was able to win disciples over to the belief that there was a fatal logical defect, an absurd premise, in the classical system.[3]

With somewhat more effect, Keynes did provide a critique of the conventional Quantity Theory   of money – which he had himself endorsed in his earlier Tract on Monetary Reform.  In the Treatise, he argued the case over several chapters that some cost and other factor price increases were tied directly to increases in the quantity of money, while price increases that feed into profits might be less correlated with changes in the money supply.  Indeed, where demand for money increases, a higher quantity of money might even correlate with lower aggregate profits and hence with lower prices.[4] Slaying the Quantity Theory, so to speak, was important to many of Keynes’ early followers, in whose understanding it opened the way to an active role for the State and to deploying an array of fiscal “multipliers.”

It is otherwise less important.  Monetary economics has by now moved past the Quantity Theory, or growth of the money supply, as a policy marker.  Lars Svensson and Scott Sumner recommend that central banks stabilize expectations by targeting a steady rate of growth in Nominal GDP.  Svensson has written that Milton Friedman told him late in his life that monetarists should target nominal GDP rather than growth in the money supply.[5]  I would qualify their recommendation with the suggestion, given the dollar’s role as the world economy’s key liquid asset, that US monetary authorities should also target foreign exchange rates during financial crises, especially the dollar-euro rate.  But nothing about moving beyond the Quantity Theory makes monetary policy less important, or makes interest rates the only channel, or they main channel, through which it can be effective.

The historical illustrations in the opening section suggest that economic slumps and unemployment persisted because effective monetary expansion did not occur.  This was true even where interest rates were already very low and where the marginal efficiency of capital was falling sharply.  The de-stabilizing factor was inept monetary policy, or inability to change such arrangements as the international gold standard.  The irony is that Keynes, the acclaimed revolutionary of Depression economics, had so little to say about the uses of monetary policy when interest rates fell to historic lows and anticipated investment returns went even lower.  Perhaps this was because he sought changes in the relationship between State and Market for which considerations of monetary economics were a distraction.

But faced with the aftermath of the 2008 financial sector crisis and the ongoing Euro-zone crisis, we should avoid such distraction.

[1] General Theory, p. 18.

[2] J. S. Mill, Principles of Political Economy, 1909 edition; p. 558.)

[3] Mundell, Man and Economics, 1968; p. 110

[4] See also, General Theory, pp. 208-209.

[5] Lars E.O. Svensson, What have economists learned about monetary policy over the past 50 years?  January 2008.  At

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