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NOTE 18. The General Theory Restated

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Chapter 18, The General Theory Restated

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Economic Interrelationships

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Keynes's Chapter 18 is called The General Theory of Employment Restated.

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The restatement turns out to be confusion worse confounded.

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On the assumption that we have now reached a point where we can gather together the threads of our argument,

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Keynes thinks,

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It may be useful to make clear which elements in the economic system we usually take as

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given, which are the independent variables of our system, and which are the dependent

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variables.

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Page 245 Now, economics is concerned with human valuations,

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human decisions, and human action.

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Everything in the system is a variable.

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No relationship, unless it is merely two ways of saying the same thing, is a constant.

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Nothing is permanently given.

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Almost anything can be an independent variable, in the sense that a change can originate at

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any point.

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When a change has originated at any point, then the relationship of nearly all the factors

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is one of mutual dependence, of interdependence.

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We take as given, Keynes continues, the existing skill and quantity of available labor, the

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existing quality and quantity of available equipment, the existing technique, the degree

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of competition, the tastes and habits of the consumer, the social structure including the

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forces which determine the distribution of the national income.

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This does not mean that we assume these factors to be constant, but merely that, in this place

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in context, we are not considering or taking into account the effects and consequences

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of changes in them.

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Page 245.

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David McCord Wright contends that this is actually the first point in the general theory,

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R. Keynes states the basic assumptions of his fundamental model, and he uses the foregoing

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italics to stress the point that, in the basic model on which Keynes's system rests, virtually

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all the dynamic social forces are omitted.

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Frank H. Knight, after quoting the same passage as well as a passage on the following two

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2 pages, 246-247, in which Keynes declares, Thus we can sometimes regard our ultimate

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independent variables as consisting of, etc., follows his quotations by a sweeping comment

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on the whole Keynesian system.

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It would surely appear that if one is willing to make assumptions of this sort, along with

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with those already pointed out, namely that there is unemployment, that wages and prices

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cannot fall, but are free to rise, that wages are uninfluenced by the supply offering of

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labor, that the price of capital service is dependent only on the speculative attitude

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of the public toward money, i.e. toward general prices, and the quantity of money fixed by

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By the arbitrary fiat of a central banking authority, entirely uninfluenced either by

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saving or by the demand for capital, one should indeed find little difficulty in revolutionizing

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economic theory in any manner or degree, or in rationalizing any policy which one might

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find appealing.

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On the same page, Keynes continues,

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The division of the determinants of the economic system into the two groups of given factors

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and independent variables is, of course, quite arbitrary from any absolute standpoint.

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Page 247.

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This is entirely true, and if Keynes had recognized this clearly and consistently, the whole general

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theory might not have been written.

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What is given, what is an independent variable, and what is a dependent variable depends entirely

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on the problem with which we are dealing.

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Economic analysis continually involves the setting up and testing of hypotheses.

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It asks, for example, if A and B are given, what will be the value of C?

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Or if A and C change, what will be the effect on B, etc.?

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The basic illustration is, of course, the relationship of supply, demand and price.

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If supply is used in the sense of quantity supplied and demand in the sense of quantity

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demanded, then a change originating in any one of these three factors will change another.

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In other words, if any two of these three factors are, by hypothesis or by assumption,

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the independent variables, then the other becomes, for the purpose of solving the particular

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problem under consideration, the dependent variable.

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If supply is used in the sense of supply schedule or curve, and demand in the sense of demand

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and Schedule or Curve, then orthodox economic analysis would say that a change in either

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one does not necessarily change the other, that a change in either would change price,

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and that, under conditions of perfect competition, price could not change independently, but

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only as a consequence of a change in the supply curve, or the demand curve, or both.

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This, it may be pointed out, is merely a consequence of the meaning of our terms.

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The full name for the demand curve, for example, is the curve of price and quantity demanded.

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In any case, it is characteristic of economic problem-solving that what is given is determined

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by the nature of the problem.

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Conclusions regarding what is dependent and what is independent, what is cause and what

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Effect are determined by our arbitrarily selected starting point.

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In commenting upon Keynes's chapter 18, therefore, I shall not make again any detailed analysis

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of the factors that Keynes regards as independent variables and dependent variables respectively,

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what he regards as cause and what effect.

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It is enough merely to make the general point that his analysis is arbitrary and implausible,

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and sometimes clearly reverses cause and effect.

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A few comments upon some particular sentences or passages, however, seem called for.

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Within the economic framework which we take as given, the national income depends on the

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The Volume of Employment, i.e. on the quantity of effort currently devoted to production,

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in the sense that there is a unique correlation between the two.

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Page 246.

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Our present object is to discover what determines at any time the national income of a given

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economic system and, which is almost the same thing, the amount of its employment.

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Page 247.

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The national income is certainly not the same thing as the amount of employment, nor is

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there a unique correlation between them.

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The United States with heavy unemployment would have an immensely higher income, either

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total or per capita, than India or China with full employment.

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And even within the same nation, say the United States, employment and income do not necessarily

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rise and fall proportionately.

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As employment gets fuller, production per man employed tends to fall.

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As unemployment rises, production per man employed tends to rise.

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This is partly because when unemployment sets in, it is the least efficient workers that

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tend to be dropped first, and when employment rises, it is the less efficient than those

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already employed that must be hired.

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Moreover, when employment is assured and other jobs are easy to obtain, there tends to be

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relaxation of effort on the part of workers, whereas when jobs are insecure, there is an

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increase of individual effort.

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Again, either insistence on excessive wage rates or new inventions and improvements may

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may force the substitution of machinery for workers.

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In one case, there may be a temporary fall in employment without any corresponding fall

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in production or total income.

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In the other case, there may be no net change in employment but a significant rise in production

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and real income.

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The volume of employment does not necessarily mean the quantity of effort currently devoted

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to Production Part of the effort devoted to production consists

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in capital improvement, better management, a better balance of production, etc.

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Full employment can't conceal gross inefficiencies in production, malinvestment, unbalanced output

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of consumer goods, and laxity, all of which Keynes consistently ignores.

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Changes in the rate of consumption are, in general, in the same direction, though smaller

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in amount, as changes in the rate of income.

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Page 248.

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In other words, when a man's income rises, he consumes more.

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The more his income rises, the more he tends to consume, and when a man's income falls,

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he consumes less.

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Stable Unemployment

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Keynes's reasoning leads to the logical conclusion that there must be violent fluctuations in

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prices and employment.

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But these violent fluctuations do not, in fact, seem to occur.

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Instead of concluding, however, that there must be something wrong in his own analysis,

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Keynes concludes that there must be something illogical about economic realities.

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He develops a theory of mysterious, stabilizing forces.

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In particular, it is an outstanding characteristic of the economic system in which we live that,

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whilst it is subject to severe fluctuations in respect of output and employment, it is

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is not violently unstable. Indeed, it seems capable of remaining in a chronic condition

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of sub-normal activity for a considerable period without any market tendency either

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towards recovery or towards complete collapse. Moreover, the evidence indicates that full

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or even approximately full employment is of rare and short-lived occurrence.

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p. 249-250.

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This is a sweeping generalization from a comparatively short and special experience.

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The condition of comparatively stabilized unemployment existed in the United States

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from about 1931 to 1939.

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It began sooner in Britain from about 1925.

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And in both cases, the reason was the same.

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The British pound sterling of gold had fallen from a parity of $4.86 to a low of $3.18 in

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February of 1920.

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It had recovered strongly and in late 1924 and early 1925 stood at approximately 10%

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below the gold parity.

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Mises and wages had adjusted themselves upward, however, to a lower value for the pound.

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In April of 1925, Britain decided to return to a gold standard at the old parity of $4.86.

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This decision would not have been disastrous if British business and labor had recognized

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its implications, which was that wage rates and prices would have to readjust downward

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to compensate for the domestic and international rise in the value of the pound.

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But organized labor in Britain remained adamant against accepting any cut in wage rates.

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It was precisely because organized labor in Britain followed the very course during and

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after 1925 that Keynes applauds in the general theory that it brought about the stable unemployment

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that he deplores and regards as a permanent attribute of the economic system on which

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we live.

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The same thing is true in the United States.

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Prolonged mass unemployment was specifically a phenomenon of the 1930s.

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As a result of the inflation of World War I, wholesale prices in May of 1920 had reached

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a peak at 248% of the 1913 level.

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Then came the most violent price break on record for such a period.

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By August of the following year, 1921, the index of wholesale prices had dropped to 141.

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This resulted temporarily in heavy unemployment.

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But wage rates were fortunately still flexible.

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As compared with wholesale prices, their decline was indeed comparatively small.

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If we compare average wholesale prices with average hourly wages in 1920 and 1922, we

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find that, whereas prices fell an average of 38% between 1920 and 1922, hourly wages

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fell an average of only 11%.

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But this was enough to permit readjustment.

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By the spring of 1923, the United States had reached new high levels in industrial production,

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and there were labor shortages in many lines.

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In brief, the stabilized unemployment in the United States in the 30s, and in Britain in

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the late 20s and the 30s, was not a permanent characteristic of the economic system in which

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which we live, it was a temporarily frozen situation due to the very wage inflexibility

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downwards that Keynes advocates.

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It was not the result of laissez-faire, but the result of labor union policy supported

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by government policy.

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And it was not an unemployment equilibrium, which is a contradiction in terms, but an

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Unemployment Frozen by Policy, by a Refusal to Adjust.

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The Demand for Labor is Elastic.

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When there is a change in employment, money wages tend to change in the same direction

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as, but not in great disproportion to, the change in employment, i.e., moderate changes

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in employment are not associated with very great changes in money wages.

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Page 251 This is a typical instance of Keynes's reversal

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of typical or normal cause and effect.

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The significant thing in most situations is the effect of changes in wage rates on employment.

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Looked at from this side, employment tends, of course, to change in the opposite direction

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from wage rates.

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If there has been prolonged mass unemployment as a result of labor union insistence on excessive

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hourly wage rates in relation to prices and marginal labor productivity, then a fall of

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these wage rates toward the equilibrium point will mean a rise in employment.

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If of course it is prices rather than wage rates that have been above the equilibrium

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In this special case, the relationship stated above by Keynes would hold, but this is a

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is a comparatively rare and short-lived situation.

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Much more frequently, it is a downward adjustment in wage rates or a gradual rise in man-machine-hour

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productivity that will bring a rise in employment.

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What will happen, in short, depends upon the initial situation from which we start, upon

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the assumptions we make regarding the previous state of disequilibrium.

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But Keynes almost never explicitly states his initial assumptions.

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He persistently treats abnormal situations as normal ones, or hopelessly confuses everything

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by calling a state of disequilibrium a state of equilibrium.

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Keynes is correct, though, not for the reasons he gives in declaring that moderate changes

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in Employment are not associated with very great changes in money wages, page 251.

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A much more enlightening way to state this is to say that moderate changes in wage rates

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can bring about much larger changes in employment.

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Paul Douglas, as a result of elaborate statistical studies, came to the conclusion that the demand

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The rule for labor is highly elastic, that a 1% decline in wages can mean a 3 or 4% increase in employment when wages have been held above the point of marginal productivity.

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This could mean, conversely, that a rise of 1% in wage rates under similar conditions could mean a 3 or 4% decrease in employment.

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A. C. Pigot independently came to a similar conclusion.

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I do not personally believe that it is possible to measure, either by statistics or mathematical deduction, the precise elasticity of demand for any service or commodity.

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A better name for elasticity of demand is responsiveness of demand.

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The latter phrase at least makes it clearer that what we are talking about is the decisions

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and actions of employers or consumers and not some inherent quality in the service or

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commodity itself.

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But as changes in price can never be assumed to be the sole reason for changes in the quantity

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demanded and as other conditions, including the demand curve itself, can never safely

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be assumed to be precisely the same for any two years, two days, or two moments in succession,

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it follows that the elasticity or responsiveness of demand is never precisely measurable.

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On what reasonably appear to be fairly persistent relationships, however, we may be reasonably

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justified in basing practical policies.

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Is Wage Rates or Employment?

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If competition between unemployed workers always led to a very great reduction in money wage,

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there would be violent instability in the price level.

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The wage unit might have to fall without limit until it reached a point where the effect

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of the abundance of money in terms of the wage unit on the rate of interest was sufficient

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to Restore a Level of Full Employment, page 253.

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There are more fallacies in this passage than the reader is likely to have patience to examine.

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Keynes is apparently trying to prove that if there were free competition among workers

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instead of union-enforced or law-enforced inflexibility downwards, the result would be

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intolerably and limitlessly violent oscillations in prices.

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The proposition is just as absurd as it sounds. Price changes normally come first and determine

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wage rate changes rather than vice versa. It is far better when the choice must be made

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to have wide oscillations in prices than wide oscillations in production and employment.

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The attempt to stabilize farm prices at levels above those that would be set by a free competitive

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of Market, as American experience has so dramatically proved, merely leaves unsold farm surpluses

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that pile up in government warehouses.

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The attempt to stabilize wages at levels above those that would be set by a free competitive

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market leaves unemployed surpluses of labor that piled up on government unemployment insurance

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or relief rolls.

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We do not stabilize the economy by trying to hold up wages regardless of what happens to

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prices.

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We unstabilize it and create the very mass unemployment that Keynes professes to wish

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to cure.

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It is significant that the Keynesians do not dare to apply their theory both ways.

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They do not urge that wage rates be held down when prices soar in order to stabilize prices

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Keynes' wage theories are useful only as labor union propaganda.

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Their scientific pretensions are pure quackery.

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In the passage quoted above from page 253 of the General Theory, Keynes drags in the

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effect of a reduction of wage rates on the interest rate, of course the interconnection

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One of all prices, and both wage rates and interest rates are prices in the broadest

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sense, is such that there is some interrelationship between wage rates and interest rates.

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But the interrelationship is so complex, and for the most part so indirect, that a lengthy

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discussion of this point would be largely irrelevant to Gresham.

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We have already seen that Keynes had a false theory of interest.

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We shall soon see that he also had a false theory of wage rates, a false theory of money

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and credit, and a false theory of prices.