WEBVTT NOTE 12. "The Marginal Efficiency Of Capital" 1 00:00:00.000 --> 00:00:09.000 Chapter 12, The Marginal Efficiency of Capital 2 00:00:09.000 --> 00:00:13.000 Slippery Terms 3 00:00:13.000 --> 00:00:22.000 We have had frequent occasion to note the ambiguities, inconsistencies and contradictions that run through the general theory. 4 00:00:22.000 --> 00:00:31.000 But in Chapter 11, The Marginal Efficiency of Capital, they reach an even higher level than in the chapters preceding. 5 00:00:31.000 --> 00:00:44.000 We shall see as we go on that Keynes uses the phrase marginal efficiency of capital in so many different senses that it becomes at last impossible to keep track of them. 6 00:00:44.000 --> 00:00:48.000 Let us begin with his first formal definition. 7 00:00:48.000 --> 00:01:10.000 The relation between the prospective yield of a capital asset and its supply price or replacement cost, i.e., the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. 8 00:01:10.000 --> 00:01:17.640 More precisely, I define the marginal efficiency of capital as being equal to that rate of 9 00:01:17.640 --> 00:01:23.880 discount which would make the present value of the series of annuities given by the returns 10 00:01:23.880 --> 00:01:31.520 expected from the capital asset during its life just equal to its supply price. 11 00:01:31.520 --> 00:01:37.000 This gives us the marginal efficiencies of particular types of capital assets. 12 00:01:37.000 --> 00:01:42.620 The greatest of these marginal efficiencies can then be regarded as the marginal efficiency 13 00:01:42.620 --> 00:01:44.880 of capital in general. 14 00:01:44.880 --> 00:01:50.640 The reader should note that the marginal efficiency of capital is here defined in terms of the 15 00:01:50.640 --> 00:01:56.640 expectation of yield and of the current supply price of the capital asset. 16 00:01:56.640 --> 00:02:02.640 It depends on the rate of return expected to be obtainable on money if it were invested 17 00:02:02.640 --> 00:02:05.360 in a newly produced asset. 18 00:02:05.360 --> 00:02:09.360 pages 135 through 136. 19 00:02:09.360 --> 00:02:16.360 Keynes then goes on to tell us that we can build up a schedule of the marginal efficiency of capital, 20 00:02:16.360 --> 00:02:21.360 which we can call alternatively the investment demand schedule, 21 00:02:21.360 --> 00:02:27.360 and that the rate of investment will be pushed to the point on the investment demand schedule 22 00:02:27.360 --> 00:02:33.360 where the marginal efficiency of capital in general is equal to the market rate of interest, 23 00:02:33.360 --> 00:02:38.360 Page 136-137 24 00:02:38.360 --> 00:02:44.360 Keynes next asks how his own definition of capital is related to common usage. 25 00:02:44.360 --> 00:02:56.360 The marginal productivity or yield or efficiency or utility of capital are familiar terms which we have all frequently used. 26 00:02:56.360 --> 00:02:58.360 Page 137 27 00:02:58.360 --> 00:03:02.360 Just why does he adopt the vaguest of them? 28 00:03:02.360 --> 00:03:09.080 It is not easy, by searching the literature of economics, Keynes goes on, to find a clear 29 00:03:09.080 --> 00:03:14.000 statement of what economists have usually intended by these terms. 30 00:03:14.000 --> 00:03:21.100 There are at least three ambiguities to clear up, pages 137 through 138. 31 00:03:21.100 --> 00:03:27.620 It is amusing to find Keynes, that father of so many ambiguities, so persistently worried 32 00:03:27.620 --> 00:03:31.680 about the alleged ambiguities of others. 33 00:03:31.680 --> 00:03:37.240 There is, to begin, the ambiguity whether we are concerned with the increment of physical 34 00:03:37.240 --> 00:03:44.440 product per unit of time due to the employment of one more physical unit of capital, or with 35 00:03:44.440 --> 00:03:50.580 the increment of value due to the employment of one more value unit of capital. 36 00:03:50.580 --> 00:03:56.280 The former involves difficulties as to the definition of the physical unit of capital, 37 00:03:56.280 --> 00:04:00.560 which I believe to be both insoluble and unnecessary. 38 00:04:00.560 --> 00:04:06.200 It is, of course, possible to say that ten laborers will raise more wheat from a given 39 00:04:06.200 --> 00:04:11.460 area when they are in a position to make use of certain additional machines. 40 00:04:11.460 --> 00:04:17.560 But I know of no means of reducing this to an intelligible arithmetical ratio which does 41 00:04:17.560 --> 00:04:19.640 not bring in values. 42 00:04:19.640 --> 00:04:21.680 Page 138. 43 00:04:21.680 --> 00:04:24.040 All this is entirely true. 44 00:04:24.040 --> 00:04:29.940 But it is strange coming from the coiner and adopter of wage units. 45 00:04:29.940 --> 00:04:36.460 On Keynes's own definition, as we have seen, these are measured in proportion to remuneration. 46 00:04:36.460 --> 00:04:43.260 They are therefore not real units or employment units, but units of money value. 47 00:04:43.260 --> 00:04:49.360 If in offering the above illustration, Keynes had remembered that it is also possible to 48 00:04:49.360 --> 00:04:55.620 say that five skilled or efficient laborers will raise as much wheat from a given area 49 00:04:55.620 --> 00:05:02.540 as 10 unskilled or inefficient laborers, he would also have seen that there is no intelligible 50 00:05:02.540 --> 00:05:07.740 way of measuring wage units which does not bring in values. 51 00:05:07.740 --> 00:05:14.540 Why was Keynes so much more acute in detecting the ambiguities of other writers than in detecting 52 00:05:14.540 --> 00:05:18.460 his own? 53 00:05:18.460 --> 00:05:23.760 Interest Rates Embody Expectations 54 00:05:23.760 --> 00:05:28.960 We next come to what Keynes seems to consider his special contribution. 55 00:05:28.960 --> 00:05:34.680 Finally, there is the distinction, the neglect of which has been the main cause of confusion 56 00:05:34.680 --> 00:05:40.440 and misunderstanding, between the increment of value obtainable by using an additional 57 00:05:40.440 --> 00:05:47.140 quantity of capital in the existing situation in the series of increments which it is expected 58 00:05:47.140 --> 00:05:52.960 to obtain over the whole life of the additional capital asset. 59 00:05:52.960 --> 00:05:58.980 This involves the whole question of the place of expectation in economic theory. 60 00:05:58.980 --> 00:06:02.820 Page 138 And again 61 00:06:02.820 --> 00:06:08.460 The most important confusion concerning the meaning and significance of the marginal efficiency 62 00:06:08.460 --> 00:06:14.380 of capital has ensued on the failure to see that it depends on the prospective yield of 63 00:06:14.380 --> 00:06:18.440 capital and not merely on its current yield. 64 00:06:18.440 --> 00:06:20.840 Page 141. 65 00:06:20.840 --> 00:06:26.600 All this is true, and yet one of Keynes's own principal errors in his discussion of 66 00:06:26.600 --> 00:06:32.560 the relation of the marginal efficiency of capital to interest rates is his failure or 67 00:06:32.560 --> 00:06:39.160 refusal to recognize that current interest rates are also determined in large part by 68 00:06:39.160 --> 00:06:42.200 expectations regarding the future. 69 00:06:42.200 --> 00:06:47.960 The comparison is analogous to that between the valuation of a share of stock and the 70 00:06:47.960 --> 00:07:08.960 When the long-term interest rate is 4%, a high-grade bond yielding $4 a year will sell at $100. At the same time, a good stock currently paying a dividend of $5 a year may also sell at $100. 71 00:07:08.960 --> 00:07:21.960 It does not sell at more because the continuation of the dividend is less certain than the continuation of the interest on the bond, and more liable to fluctuation from year to year. 72 00:07:21.960 --> 00:07:34.960 But a stock currently paying a dividend of only $3 a year may sell at $100 because market opinion believes it highly probable that the stock will soon be paying more. 73 00:07:34.960 --> 00:07:36.520 and more. 74 00:07:36.520 --> 00:07:43.360 The current price of both dividend-paying or non-dividend-paying stocks and interest-paying 75 00:07:43.360 --> 00:07:48.560 bonds is determined by expectations regarding the future. 76 00:07:48.560 --> 00:07:56.760 When the interest rate is 4%, some bonds paying $4 a year will be selling much below $100 77 00:07:56.760 --> 00:08:04.260 and yielding, say, 5 or 5.5% interest on their capital value, because they embody greater 78 00:08:04.260 --> 00:08:13.080 In the preceding paragraph, I have used the phrase the interest rate. This is in accordance 79 00:08:13.080 --> 00:08:19.300 with the practice of Keynes and many other economists, who sometimes write of the interest 80 00:08:19.300 --> 00:08:28.280 rate and sometimes of the complex or constellation of interest rates. The interest rate is usually 81 00:08:28.280 --> 00:08:35.560 a simpler and more convenient phrase and concept provided it is not misused, that is, provided 82 00:08:35.560 --> 00:08:41.480 its arbitrary and oversimplified nature is constantly kept in mind. 83 00:08:41.480 --> 00:08:47.420 When I use the term, I shall be taken to mean something like the current average annual 84 00:08:47.420 --> 00:08:53.900 percentage yield on AAA bonds maturing in 20 years or longer. 85 00:08:53.900 --> 00:08:59.620 Even so, it is safer most of the time, at least to make explicit, whether one is talking 86 00:08:59.620 --> 00:09:06.820 of the long-term interest rate or the short-term interest rate, even though each of these phrases 87 00:09:06.820 --> 00:09:13.420 also refers to a whole complex of interest rates, and even though the line dividing short-term 88 00:09:13.420 --> 00:09:17.220 from long-term is an arbitrary one. 89 00:09:17.220 --> 00:09:23.340 Short-term sometimes meaning, say, five years or less to maturity, sometimes one year or 90 00:09:23.340 --> 00:09:32.380 Because Keynes usually refuses to recognize that the interest rate as well as the marginal 91 00:09:32.380 --> 00:09:40.020 efficiency of capital is governed by expectations, he makes unjustified criticisms of other writers 92 00:09:40.020 --> 00:09:44.100 and builds up a false theory of his own. 93 00:09:44.100 --> 00:09:50.580 The expectation of a fall in the value of money stimulates investment, he declares, 94 00:09:50.580 --> 00:09:55.860 Enhanced employment, generally, because it raises the schedule of the marginal efficiency 95 00:09:55.860 --> 00:10:03.300 of capital, i.e. the investment demand schedule, and the expectation of a rise in the value 96 00:10:03.300 --> 00:10:09.580 of money is depressing because it lowers the schedule of the marginal efficiency of capital, 97 00:10:09.580 --> 00:10:13.660 pages 141 through 142. 98 00:10:13.660 --> 00:10:19.900 This is the equivalent of saying that inflation, and even more, the threat of further inflation, 99 00:10:19.900 --> 00:10:26.420 is good because it stimulates investment and employment, and it is because it interferes 100 00:10:26.420 --> 00:10:33.220 with the foregoing theory that Keynes criticizes Irving Fisher's distinction between the money 101 00:10:33.220 --> 00:10:39.340 rate of interest and the real rate of interest where the latter is equal to the former after 102 00:10:39.340 --> 00:10:42.760 correction for changes in the value of money. 103 00:10:42.760 --> 00:10:47.420 Page 142 It is difficult to make sense of this theory 104 00:10:47.420 --> 00:10:52.960 as stated, declares Keynes, because it is not clear whether the change in the value 105 00:10:52.960 --> 00:10:57.340 of money is or is not assumed to be foreseen. 106 00:10:57.340 --> 00:11:02.600 There is no escape from the dilemma that, if it is not foreseen, there will be no effect 107 00:11:02.600 --> 00:11:09.960 on current affairs, whilst, if it is foreseen, the prices of existing goods will be forthwith 108 00:11:09.960 --> 00:11:35.460 Page 142 It is inexcusable in the first place for 109 00:11:35.460 --> 00:11:40.980 Or Keynes to write of Fisher's statement of his theory that it is not clear whether the 110 00:11:40.980 --> 00:11:46.780 change in the value of money is or is not assumed to be foreseen. 111 00:11:46.780 --> 00:11:55.060 Irving Fisher wrote clearly, for example, in The Theory of Interest, 1930, page 37. 112 00:11:55.060 --> 00:12:00.680 The influence of such changes in the purchasing power of money on the money rate of interest 113 00:12:00.680 --> 00:12:05.960 will be different according to whether or not that change is foreseen. 114 00:12:05.960 --> 00:12:12.640 The italics here are not mine, but Fisher's own, and the sentence is followed by paragraphs 115 00:12:12.640 --> 00:12:15.920 of further unequivocal explanation. 116 00:12:15.920 --> 00:12:21.280 It is, moreover, not too difficult to escape from Keynes's Dilemma. 117 00:12:21.280 --> 00:12:27.840 The easiest way is to point to an undeniable and repeated fact of experience that, in the 118 00:12:27.840 --> 00:12:36.840 In the later stages of a hyperinflation, when further inflation is generally expected, interest rates do begin to soar. 119 00:12:36.840 --> 00:12:42.840 This happened, for example, in the Great Inflation in Germany in 1923. 120 00:12:42.840 --> 00:12:52.840 In the first phases of the inflation, the rate of interest tended to rise in Germany, as always happens at a time of monetary depreciation. 121 00:12:52.840 --> 00:13:00.840 But for a long time, the rise in interest rates was appreciably less than the rate of currency depreciation. 122 00:13:00.840 --> 00:13:07.840 Subsequently, the rate of interest became more sensitive to the influence of the currency depreciation. 123 00:13:07.840 --> 00:13:14.840 As the depreciation became more rapid, the premium for the creditor's risk was bound to increase. 124 00:13:14.840 --> 00:13:21.840 And consequently, in the final phase of inflation, the rate of interest was extremely high. 125 00:13:21.840 --> 00:13:30.840 At the beginning of November 1923, the rates for coal money rose as high as 30% per day. 126 00:13:30.840 --> 00:13:37.840 This situation will practically always be found in the later stages of a serious inflation. 127 00:13:37.840 --> 00:13:44.840 For example, as I write this, there is a serious inflation in Chile, and the commercial bank rate, 128 00:13:44.840 --> 00:13:52.600 rate, according to International Financial Statistics, June 1957, published by the International 129 00:13:52.600 --> 00:14:04.200 Monetary Fund, rose from 7.84% in 1937 to 13.95% in 1956. 130 00:14:04.200 --> 00:14:10.240 As I write this, also, the same phenomenon has occurred in England itself, and in large 131 00:14:10.240 --> 00:14:34.240 In June of 1957, the British Treasury 2.5% bonds, which had been issued in 1946, during the last phases of the cheap money policy, could be bought at 50, or half the original purchase price. 132 00:14:34.240 --> 00:14:42.240 But while prime bonds in Britain were going begging in June of 1957 at heavy discounts, 133 00:14:42.240 --> 00:14:47.660 prices of corporate shares were being bid up to levels where, despite the risks they 134 00:14:47.660 --> 00:14:53.680 involved, the return to the investor was in many cases substantially lower than those 135 00:14:53.680 --> 00:14:57.200 available on gilt-edge bonds. 136 00:14:57.200 --> 00:15:03.380 As one leading London investment house explained, clearly the main cause of the trouble lies 137 00:15:03.380 --> 00:15:07.300 is in the barely checked progress of the creeping inflation. 138 00:15:07.300 --> 00:15:13.140 The argument is, indeed, put forward that, since the pound has been depreciating in the 139 00:15:13.140 --> 00:15:19.860 past decade at an average rate of four and three-quarters of a percent per annum, any 140 00:15:19.860 --> 00:15:26.100 investment likely to show a total net return on income and capital accounts over a given 141 00:15:26.100 --> 00:15:33.260 period of less than this amount is giving a negative yield and should be discarded. 142 00:15:33.260 --> 00:15:40.280 A similar development took place in the United States in July 1957, and again in the summer 143 00:15:40.280 --> 00:15:45.180 and fall of 1958. 144 00:15:45.180 --> 00:15:51.680 Effects of Expected Inflation Now, let us look at the theoretical explanation 145 00:15:51.680 --> 00:15:52.680 of this. 146 00:15:52.680 --> 00:15:59.660 It is true that in a period of inflation, and when further inflation is widely foreseen, 147 00:15:59.660 --> 00:16:06.540 Prices of existing goods rise in anticipation, but prices of different goods rise in different 148 00:16:06.540 --> 00:16:12.780 degrees, determined by the nature of the commodity and the nature of its market. 149 00:16:12.780 --> 00:16:18.900 This year's perishable foodstuffs, for example, reflect this year's monetary inflation in 150 00:16:18.900 --> 00:16:25.240 their price, but they cannot reflect next year's expected inflation because they cannot 151 00:16:25.240 --> 00:16:27.780 be held till next year. 152 00:16:27.780 --> 00:16:30.380 They must be consumed now. 153 00:16:30.380 --> 00:16:34.900 The same reasoning applies to current services of all kinds. 154 00:16:34.900 --> 00:16:41.860 A durable good with a two-year life can reflect less expected further inflation in its present 155 00:16:41.860 --> 00:16:48.140 price than a durable good with a five-year life, and that in turn can reflect less than 156 00:16:48.140 --> 00:16:51.380 a durable good with a still longer life. 157 00:16:51.380 --> 00:16:57.660 I do not mean to suggest that the reflection of further expected inflation in present prices 158 00:16:57.660 --> 00:17:05.660 is directly proportional to the lifespan of particular goods. This is only one of the factors involved. 159 00:17:05.660 --> 00:17:15.660 It is sufficient to note that expected further inflation is reflected in different degrees in the current price response of different goods. 160 00:17:15.660 --> 00:17:23.660 Now, when other conditions are such that they would bring about both a real and a money rate of interest of, say, 4%, 161 00:17:23.660 --> 00:17:46.660 But when lenders generally believe that next year's average price level, including both perishable and durable goods, in the proportions in which they are expected to be consumed, will be 3% higher than this year's price level for the same goods mix, they will charge 7% in order to get the real return of 4%. 162 00:17:46.660 --> 00:18:08.660 And borrowers will pay this 7% if they expect to use the borrowed funds for acquiring durable goods or investments that they believe will rise even more than 3% in the year, or at more than that rate over a series of years corresponding to the period of the loan. 163 00:18:08.660 --> 00:18:14.880 Keynes constantly goes wrong, as we shall see, because he chronically thinks in terms 164 00:18:14.880 --> 00:18:22.320 of averages and aggregates that conceal the very causal relations he is trying to study. 165 00:18:22.320 --> 00:18:29.800 This aggregate in block or lump thinking is the exact opposite of economic analysis. Its 166 00:18:29.800 --> 00:18:36.320 recent prevalence, largely under Keynes's influence, represents a serious retrogression 167 00:18:36.320 --> 00:18:42.980 in Economic Thought, Keynes even argues that the rate of interest cannot rise under the 168 00:18:42.980 --> 00:18:49.900 conditions he assumes, because if it did, it would spoil his theory about the stimulating 169 00:18:49.900 --> 00:18:54.660 effect of the expectation of further inflation. 170 00:18:54.660 --> 00:19:00.400 The stimulating effect of the expectation of higher prices is due not to its raising 171 00:19:00.400 --> 00:19:06.220 the rate of interest, that would be a paradoxical way of stimulating output insofar as the 172 00:19:06.220 --> 00:19:12.280 If the rate of interest rises, the stimulating effect is to that extent offset, but to its 173 00:19:12.280 --> 00:19:17.580 raising the marginal efficiency of a given stock of capital. 174 00:19:17.580 --> 00:19:23.820 If the rate of interest were to rise pari passu with the marginal efficiency of capital, 175 00:19:23.820 --> 00:19:29.780 here would be no stimulating effect from the expectation of rising prices. 176 00:19:29.780 --> 00:19:35.700 For the stimulus to output depends on the marginal efficiency of a given stock of capital 177 00:19:35.700 --> 00:19:41.700 Rising Relatively to the Rate of Interest, page 143 178 00:19:41.700 --> 00:19:45.340 Keynes's admissions here are quite correct. 179 00:19:45.340 --> 00:19:51.740 If the rate of interest were to rise pari passu with the marginal efficiency of capital, 180 00:19:51.740 --> 00:19:57.180 there would be no stimulating effect from the expectation of rising prices. 181 00:19:57.180 --> 00:20:02.900 But what is Keynes's reason for supposing that the rate of interest will not rise with 182 00:20:02.900 --> 00:20:06.100 The Marginal Efficiency of Capital 183 00:20:06.100 --> 00:20:12.620 It lies in his assumption that the marginal efficiency of capital embodies expectations 184 00:20:12.620 --> 00:20:15.580 and that the rate of interest does not. 185 00:20:15.580 --> 00:20:23.580 The marginal efficiency of capital, by Keynes's order, has entered the realm of dynamic economics, 186 00:20:23.580 --> 00:20:29.340 but the rate of interest, also by Keynes's order, has been kept in the realm of static 187 00:20:29.340 --> 00:20:31.340 economics. 188 00:20:31.340 --> 00:20:34.060 There is no warrant for his assumption. 189 00:20:34.060 --> 00:20:38.160 It does not correspond with the facts of economic life. 190 00:20:38.160 --> 00:20:44.580 If the marginal efficiency of capital embodies expectations, so do interest rates. 191 00:20:44.580 --> 00:20:51.260 To assume otherwise is to assume that entrepreneurs are influenced by their expectations but that 192 00:20:51.260 --> 00:20:53.520 lenders are not. 193 00:20:53.520 --> 00:21:00.120 Or it is to assume that entrepreneurs as a body can be expecting prices to rise while 194 00:21:00.120 --> 00:21:07.280 Lenders as a body do not expect prices to rise. Or, it is to assume that lenders are 195 00:21:07.280 --> 00:21:12.940 too stupid to know what borrowers know. If the borrowers wish to borrow more because 196 00:21:12.940 --> 00:21:18.600 they expect higher commodity prices, this means, in other words, that they expect to 197 00:21:18.600 --> 00:21:24.800 pay the lenders back in depreciated dollars. And according to Keynes, the lenders will 198 00:21:24.800 --> 00:21:27.840 will be perfectly agreeable to this. 199 00:21:27.840 --> 00:21:33.320 They will not demand a higher interest rate as an insurance premium against the depreciated 200 00:21:33.320 --> 00:21:36.760 dollars in which they expect to be repaid. 201 00:21:36.760 --> 00:21:41.720 They will not even ask a higher interest rate because the demand for their loanable funds 202 00:21:41.720 --> 00:21:43.720 has increased. 203 00:21:43.720 --> 00:21:49.220 In brief, the Keynesian assumption that the marginal efficiency of capital is influenced 204 00:21:49.220 --> 00:21:55.380 by Expectations Regarding the Future, but that the rate of interest is not, rests on 205 00:21:55.380 --> 00:21:58.220 inconsistent premises. 206 00:21:58.220 --> 00:22:04.780 The sad truth is that Keynes has no consistent assumptions regarding any of his major concept 207 00:22:04.780 --> 00:22:06.540 or theses. 208 00:22:06.540 --> 00:22:12.340 The assumption of one sentence is as likely as not to be contradicted in the next. 209 00:22:12.340 --> 00:22:33.340 Thus, on the very page from which the foregoing quotation is taken, Keynes tells us that the expectations which are held concerning the complex of rates of interest for various terms which will rule in the future will be partially reflected in the complex of rates of interest which rule today. 210 00:22:33.340 --> 00:22:45.340 Here is an admission that an expected rise in future interest rates will be reflected in present interest rates, but only partially. 211 00:22:45.340 --> 00:22:53.340 Yet as Keynes promises us that in his chapter 22, we shall show that the succession of boom and slump 212 00:22:53.340 --> 00:22:59.120 Plump can be described and analyzed in terms of the fluctuations of the marginal efficiency 213 00:22:59.120 --> 00:23:04.740 of capital relatively to the rate of interest, page 144. 214 00:23:04.740 --> 00:23:11.600 We shall wait till then to pursue our own analysis of this relationship. 215 00:23:11.600 --> 00:23:15.740 Does Lending Double the Risk? 216 00:23:15.740 --> 00:23:23.140 In Section 4 of Chapter 11, Keynes finds it important to distinguish between two types 217 00:23:23.140 --> 00:23:29.700 of risk affecting the volume of investment, which have not commonly been distinguished. 218 00:23:29.700 --> 00:23:35.820 The first is the entrepreneur's or borrower's risk and arises out of doubts in his own mind 219 00:23:35.820 --> 00:23:41.820 as to the probability of his actually earning the prospective yield for which he hopes. 220 00:23:41.820 --> 00:23:47.580 Page 144 I may point out in passing that to the extent 221 00:23:47.580 --> 00:23:53.680 to which the risk is real, it arises out of the objective situation and not out of the 222 00:23:53.680 --> 00:23:57.140 doubts in the entrepreneur's own mind. 223 00:23:57.140 --> 00:24:03.380 These doubts may overestimate or underestimate the real risk involved, but do not determine 224 00:24:03.380 --> 00:24:05.040 it. 225 00:24:05.040 --> 00:24:11.320 But where a system of borrowing and lending exists, Keynes continues, by which I mean 226 00:24:11.320 --> 00:24:17.620 The granting of loans with a margin of real or personal security, a second type of risk, 227 00:24:17.620 --> 00:24:21.320 is relevant which we may call the lender's risk. 228 00:24:21.320 --> 00:24:28.880 This may be due either to moral hazard, i.e. voluntary default or involuntary default due 229 00:24:28.880 --> 00:24:34.240 to the disappointment of expectation, page 144. 230 00:24:34.240 --> 00:24:40.520 A third source of risk might be added, namely, a possible adverse change in the value of 231 00:24:40.520 --> 00:25:05.520 This sentence is significant because it admits, in the grudging phrase, or most, that not 232 00:25:05.520 --> 00:25:12.800 all the risk to the lender of a possible rise in prices will necessarily be already reflected 233 00:25:12.800 --> 00:25:20.320 in the price of durable real assets. But this admission contradicts the inescapable dilemma 234 00:25:20.320 --> 00:25:26.800 that Keynes had presented only two pages previously to prove that the money rate of interest could 235 00:25:26.800 --> 00:25:31.840 not be raised by lenders to protect themselves against an expected further inflation. 236 00:25:31.840 --> 00:25:37.680 Let us continue, however, with Keynes's two types of risk. 237 00:25:37.680 --> 00:25:43.640 Now, the first type of risk is, in a sense, a real social cost. 238 00:25:43.640 --> 00:25:49.160 The second, however, is a pure addition to the cost of investment, which would not exist 239 00:25:49.160 --> 00:25:52.400 if the borrower and lender were the same person. 240 00:25:52.400 --> 00:25:59.040 Moreover, it involves, in part, a duplication of a proportion of the entrepreneur's risk, 241 00:25:59.040 --> 00:26:05.000 which is added twice to the pure rate of interest to give the minimum prospective yield which 242 00:26:05.000 --> 00:26:11.760 will induce the investment, pages 144 through 145. 243 00:26:11.760 --> 00:26:13.760 This is pure nonsense. 244 00:26:13.760 --> 00:26:19.920 The risk is not duplicated, it is not added twice, it is simply shared. 245 00:26:19.920 --> 00:26:25.320 To the extent that the entrepreneur assumes the risk, the lender is relieved of it. 246 00:26:25.320 --> 00:26:31.880 The lender assumes a risk only to the extent that the entrepreneur fails to assume it. 247 00:26:31.880 --> 00:26:39.400 Suppose entrepreneur E borrows $10,000 from lender L to start a small business. 248 00:26:39.400 --> 00:26:43.640 Suppose the entrepreneur loses the whole $10,000. 249 00:26:43.640 --> 00:26:49.880 Then a total of $10,000 is lost, not $20,000. 250 00:26:49.880 --> 00:26:55.720 If the entrepreneur makes the whole loss good out of his own pocket, none of it falls on 251 00:26:55.720 --> 00:26:57.060 the lender. 252 00:26:57.060 --> 00:27:03.000 If the entrepreneur goes bankrupt or leaves town without repaying the lender a cent, then 253 00:27:03.000 --> 00:27:06.480 the lender takes a loss of $10,000. 254 00:27:06.480 --> 00:27:10.240 But the borrower, E., has lost nothing of his own. 255 00:27:10.240 --> 00:27:14.480 He has simply thrown away L's $10,000. 256 00:27:14.480 --> 00:27:21.140 If the borrower is able to make good $6,000 of the loss out of his own resources but is 257 00:27:21.140 --> 00:27:29.200 compelled to default on the rest, then $4,000 of the loss falls on the lender, not more. 258 00:27:29.200 --> 00:27:34.000 Would Keynes argue that fewer houses are built with the mortgage system than would 259 00:27:34.000 --> 00:27:41.080 be built without it because mortgages double the risk or constitute a pure addition to 260 00:27:41.080 --> 00:27:42.880 the cost of investment? 261 00:27:42.880 --> 00:27:51.000 It is the mortgage, on the contrary, that enables the builder or owner to build or own the house. 262 00:27:51.000 --> 00:27:56.880 The mortgager, on his part, assumes that the market value of the house above the amount 263 00:27:56.880 --> 00:28:03.660 of the mortgage gives him additional security, beyond the good faith of the mortgagee, the 264 00:28:03.660 --> 00:28:10.000 other resources of the mortgagee, and the mortgager's legal recourse against the mortgagee, 265 00:28:10.000 --> 00:28:13.860 which removes or minimizes his own risk. 266 00:28:13.860 --> 00:28:19.980 But if the objective social risk is clearly not increased where a system of borrowing 267 00:28:19.980 --> 00:28:26.860 and lending exists, perhaps it may be said Keynes was arguing that the subjective risk 268 00:28:26.860 --> 00:28:31.840 or the feeling of risk is doubled or added twice. 269 00:28:31.840 --> 00:28:36.480 This too is an incredible and self-contradictory assumption. 270 00:28:36.480 --> 00:28:42.440 For the lender contents himself with a fixed rate of interest and with the eventual return 271 00:28:42.440 --> 00:28:48.960 merely of the original amount, in dollar terms, of his capital investment, on the assumption 272 00:28:48.960 --> 00:28:56.160 that he is leaving the risk of loss as well as the prospect of gain to the borrower. 273 00:28:56.160 --> 00:29:01.040 Corporations have found that they can raise the maximum amount of capital by issuing a 274 00:29:01.040 --> 00:29:08.240 A judicious mixture of common stock, preferred stock, debenture bonds, first mortgage bonds, 275 00:29:08.240 --> 00:29:16.480 etc., partly depending on market and tax conditions at the time of issue, but depending also on 276 00:29:16.480 --> 00:29:23.080 the diverse temperaments and purposes of the different investors to whom they are appealing. 277 00:29:23.080 --> 00:29:28.400 Those who are willing to assume the entrepreneurial risks in exchange for the entrepreneurial 278 00:29:28.400 --> 00:29:34.480 While prospects of profit and capital gain become common stockholders, those who wish 279 00:29:34.480 --> 00:29:40.800 to minimize their risks and are content with a low but presumably dependable and regular 280 00:29:40.800 --> 00:29:46.400 interest rate and the mere return of their dollar capital investment will buy what they 281 00:29:46.400 --> 00:29:49.960 regard as guilt-edge bonds. 282 00:29:49.960 --> 00:29:55.760 They become technically the creditors of the stockholders in the same corporation. 283 00:29:55.760 --> 00:30:02.520 To argue that such an arrangement increases or duplicates either the objective risk or 284 00:30:02.520 --> 00:30:08.760 the subjective sense of risk is as absurd as it would be to argue that the institution 285 00:30:08.760 --> 00:30:14.640 of fire insurance increases the risk or sense of risk of fire. 286 00:30:14.640 --> 00:30:21.620 It is precisely because the institution of insurance shares and diffuses risks that risks 287 00:30:21.620 --> 00:30:26.900 Investments are more freely undertaken, that more houses are built and more investments 288 00:30:26.900 --> 00:30:34.300 made, and it is precisely where a system of borrowing and lending exists that investment 289 00:30:34.300 --> 00:30:41.340 increases enormously compared with what it would be where such a system did not exist. 290 00:30:41.340 --> 00:30:47.500 I regret having taken so much space to point out this elementary error. I have done so 291 00:30:47.500 --> 00:30:53.740 only because it illustrates once more and so clearly the kind of perverse logic typical 292 00:30:53.740 --> 00:30:57.100 of the general theory. 293 00:30:57.100 --> 00:31:02.060 Confusions about Statics and Dynamics 294 00:31:02.060 --> 00:31:08.860 Section 5 of Chapter 11 is less than a page in length, but nonetheless reveals the extraordinary 295 00:31:08.860 --> 00:31:12.380 arbitrariness of Keynes's reasoning. 296 00:31:12.380 --> 00:31:17.880 The schedule of the marginal efficiency of capital is of fundamental importance because 297 00:31:17.880 --> 00:31:22.840 it is mainly through this factor, much more than through the rate of interest, that the 298 00:31:22.840 --> 00:31:27.060 expectation of the future influences the present. 299 00:31:27.060 --> 00:31:32.860 The mistake of regarding the marginal efficiency of capital primarily in terms of the current 300 00:31:32.860 --> 00:31:38.320 yield of capital equipment, which would be correct only in the static state where there 301 00:31:38.320 --> 00:31:43.960 There is no changing future to influence the present, has had the result of breaking the 302 00:31:43.960 --> 00:31:48.040 theoretical link between today and tomorrow. 303 00:31:48.040 --> 00:31:54.040 Even the rate of interest is virtually a current phenomenon, and if we reduce the marginal 304 00:31:54.040 --> 00:32:00.480 efficiency of capital to the same status, we cut ourselves off from taking any direct 305 00:32:00.480 --> 00:32:07.280 account of the influence of the future in our analysis of the existing equilibrium. 306 00:32:07.280 --> 00:32:12.380 The fact that the assumptions of the static state often underlie present-day economic 307 00:32:12.380 --> 00:32:21.560 theory imports into it a large element of unreality, pages 145 through 146. 308 00:32:21.560 --> 00:32:26.000 Few passages even of Keynes are more arbitrary or confused. 309 00:32:26.000 --> 00:32:33.840 Boom and slump, we are told on page 144, are to be described and analyzed in terms of the 310 00:32:33.840 --> 00:32:40.280 The fluctuations of the marginal efficiency of capital relatively to the rate of interest. 311 00:32:40.280 --> 00:32:45.740 But now we are to understand that whereas the marginal efficiency of capital is to be 312 00:32:45.740 --> 00:32:52.840 treated as a dynamic concept, the rate of interest is to be treated as a static concept. 313 00:32:52.840 --> 00:32:58.080 The rate of interest is a current phenomenon, but apparently the marginal efficiency of 314 00:32:58.080 --> 00:33:00.120 capital is not. 315 00:33:00.120 --> 00:33:05.820 The marginal efficiency of capital reflects expectations regarding the future, but the 316 00:33:05.820 --> 00:33:09.440 rate of interest virtually does not. 317 00:33:09.440 --> 00:33:13.440 And then even this contrast is partly repudiated. 318 00:33:13.440 --> 00:33:19.200 For in the passage just quoted, Keynes puts a footnote mark after the word virtually, 319 00:33:19.200 --> 00:33:20.640 and the footnote says, 320 00:33:20.640 --> 00:33:27.680 Not completely, for its, the rate of interests, value partly reflects the uncertainty of the 321 00:33:27.680 --> 00:33:28.680 future. 322 00:33:28.680 --> 00:33:34.940 Moreover, the relations between rates of interest for different terms depends on expectations 323 00:33:34.940 --> 00:33:37.860 – page 145. 324 00:33:37.860 --> 00:33:42.820 But this footnote gives away the point of the passage to which it refers. 325 00:33:42.820 --> 00:33:49.980 The truth is that both static and dynamic analysis are necessary in economics, that 326 00:33:49.980 --> 00:33:57.340 static analysis is a necessary preliminary to dynamic analysis, but that the one unforgivable 327 00:33:57.340 --> 00:34:08.340 One of the chief defects in Keynes's analysis, not only in the passage quoted above, but 328 00:34:08.340 --> 00:34:15.020 throughout the general theory, is his failure to adhere to any fixed meanings for his terms. 329 00:34:15.020 --> 00:34:21.100 He plays particularly fast and loose, as we have seen already and shall see later, with 330 00:34:21.100 --> 00:34:25.060 the term the marginal efficiency of capital. 331 00:34:25.060 --> 00:34:31.220 The ambiguities and bad reasoning that he falls into could have been avoided by dropping 332 00:34:31.220 --> 00:34:37.820 this vague term completely and substituting for it any one of half a dozen different terms, 333 00:34:37.820 --> 00:34:43.460 depending upon which was really appropriate to his meaning in a given context. 334 00:34:43.460 --> 00:34:50.620 A simpler and less vague term than efficiency in connection with capital is yield. 335 00:34:50.620 --> 00:34:56.120 Keynes himself uses it as a synonym, even in the passage quoted above. 336 00:34:56.120 --> 00:35:06.120 Substituting this for greater clarity, we would then have several terms depending upon what we wished to say in a given context. 337 00:35:06.120 --> 00:35:11.120 1. The current yield of a specific capital instrument. 338 00:35:11.120 --> 00:35:17.120 2. The expected future yield of a specific capital instrument. 339 00:35:17.120 --> 00:35:24.120 3. The current marginal yield of a type of capital equipment, like lathes. 340 00:35:24.120 --> 00:35:32.120 4. The expected future marginal yield over its lifespan, say, of a type of capital equipment. 341 00:35:32.120 --> 00:35:37.120 5. The current marginal yield of capital in general. 342 00:35:37.120 --> 00:35:43.120 6. The expected future marginal yield of capital in general. 343 00:35:43.120 --> 00:35:52.120 If Keynes had consistently maintained even the distinction between terms and concepts 5 and 6, he would have avoided a host of errors. 344 00:35:52.120 --> 00:36:04.120 He could have done this, modifying his chosen vocabulary in only a slight degree, if instead of confusing both concepts under the common term marginal efficiency of capital, 345 00:36:04.120 --> 00:36:14.120 He had at least distinguished at all times between the current marginal efficiency of capital and the anticipated marginal efficiency of capital. 346 00:36:14.120 --> 00:36:22.120 But if Keynes had been constantly careful to make such distinctions, he might not have written the general theory at all, 347 00:36:22.120 --> 00:36:27.120 for the theory could not have been born without the confusions that gave rise to it.