Chapter 18, The General Theory Restated
Economic Interrelationships
Keynes's Chapter 18 is called The General Theory of Employment Restated.
The restatement turns out to be confusion worse confounded.
On the assumption that we have now reached a point where we can gather together the threads of our argument,
Keynes thinks,
It may be useful to make clear which elements in the economic system we usually take as
given, which are the independent variables of our system, and which are the dependent
variables.
Page 245 Now, economics is concerned with human valuations,
human decisions, and human action.
Everything in the system is a variable.
No relationship, unless it is merely two ways of saying the same thing, is a constant.
Nothing is permanently given.
Almost anything can be an independent variable, in the sense that a change can originate at
any point.
When a change has originated at any point, then the relationship of nearly all the factors
is one of mutual dependence, of interdependence.
We take as given, Keynes continues, the existing skill and quantity of available labor, the
existing quality and quantity of available equipment, the existing technique, the degree
of competition, the tastes and habits of the consumer, the social structure including the
forces which determine the distribution of the national income.
This does not mean that we assume these factors to be constant, but merely that, in this place
in context, we are not considering or taking into account the effects and consequences
of changes in them.
Page 245.
David McCord Wright contends that this is actually the first point in the general theory,
R. Keynes states the basic assumptions of his fundamental model, and he uses the foregoing
italics to stress the point that, in the basic model on which Keynes's system rests, virtually
all the dynamic social forces are omitted.
Frank H. Knight, after quoting the same passage as well as a passage on the following two
2 pages, 246-247, in which Keynes declares, Thus we can sometimes regard our ultimate
independent variables as consisting of, etc., follows his quotations by a sweeping comment
on the whole Keynesian system.
It would surely appear that if one is willing to make assumptions of this sort, along with
with those already pointed out, namely that there is unemployment, that wages and prices
cannot fall, but are free to rise, that wages are uninfluenced by the supply offering of
labor, that the price of capital service is dependent only on the speculative attitude
of the public toward money, i.e. toward general prices, and the quantity of money fixed by
By the arbitrary fiat of a central banking authority, entirely uninfluenced either by
saving or by the demand for capital, one should indeed find little difficulty in revolutionizing
economic theory in any manner or degree, or in rationalizing any policy which one might
find appealing.
On the same page, Keynes continues,
The division of the determinants of the economic system into the two groups of given factors
and independent variables is, of course, quite arbitrary from any absolute standpoint.
Page 247.
This is entirely true, and if Keynes had recognized this clearly and consistently, the whole general
theory might not have been written.
What is given, what is an independent variable, and what is a dependent variable depends entirely
on the problem with which we are dealing.
Economic analysis continually involves the setting up and testing of hypotheses.
It asks, for example, if A and B are given, what will be the value of C?
Or if A and C change, what will be the effect on B, etc.?
The basic illustration is, of course, the relationship of supply, demand and price.
If supply is used in the sense of quantity supplied and demand in the sense of quantity
demanded, then a change originating in any one of these three factors will change another.
In other words, if any two of these three factors are, by hypothesis or by assumption,
the independent variables, then the other becomes, for the purpose of solving the particular
problem under consideration, the dependent variable.
If supply is used in the sense of supply schedule or curve, and demand in the sense of demand
and Schedule or Curve, then orthodox economic analysis would say that a change in either
one does not necessarily change the other, that a change in either would change price,
and that, under conditions of perfect competition, price could not change independently, but
only as a consequence of a change in the supply curve, or the demand curve, or both.
This, it may be pointed out, is merely a consequence of the meaning of our terms.
The full name for the demand curve, for example, is the curve of price and quantity demanded.
In any case, it is characteristic of economic problem-solving that what is given is determined
by the nature of the problem.
Conclusions regarding what is dependent and what is independent, what is cause and what
Effect are determined by our arbitrarily selected starting point.
In commenting upon Keynes's chapter 18, therefore, I shall not make again any detailed analysis
of the factors that Keynes regards as independent variables and dependent variables respectively,
what he regards as cause and what effect.
It is enough merely to make the general point that his analysis is arbitrary and implausible,
and sometimes clearly reverses cause and effect.
A few comments upon some particular sentences or passages, however, seem called for.
Within the economic framework which we take as given, the national income depends on the
The Volume of Employment, i.e. on the quantity of effort currently devoted to production,
in the sense that there is a unique correlation between the two.
Page 246.
Our present object is to discover what determines at any time the national income of a given
economic system and, which is almost the same thing, the amount of its employment.
Page 247.
The national income is certainly not the same thing as the amount of employment, nor is
there a unique correlation between them.
The United States with heavy unemployment would have an immensely higher income, either
total or per capita, than India or China with full employment.
And even within the same nation, say the United States, employment and income do not necessarily
rise and fall proportionately.
As employment gets fuller, production per man employed tends to fall.
As unemployment rises, production per man employed tends to rise.
This is partly because when unemployment sets in, it is the least efficient workers that
tend to be dropped first, and when employment rises, it is the less efficient than those
already employed that must be hired.
Moreover, when employment is assured and other jobs are easy to obtain, there tends to be
relaxation of effort on the part of workers, whereas when jobs are insecure, there is an
increase of individual effort.
Again, either insistence on excessive wage rates or new inventions and improvements may
may force the substitution of machinery for workers.
In one case, there may be a temporary fall in employment without any corresponding fall
in production or total income.
In the other case, there may be no net change in employment but a significant rise in production
and real income.
The volume of employment does not necessarily mean the quantity of effort currently devoted
to Production Part of the effort devoted to production consists
in capital improvement, better management, a better balance of production, etc.
Full employment can't conceal gross inefficiencies in production, malinvestment, unbalanced output
of consumer goods, and laxity, all of which Keynes consistently ignores.
Changes in the rate of consumption are, in general, in the same direction, though smaller
in amount, as changes in the rate of income.
Page 248.
In other words, when a man's income rises, he consumes more.
The more his income rises, the more he tends to consume, and when a man's income falls,
he consumes less.
Stable Unemployment
Keynes's reasoning leads to the logical conclusion that there must be violent fluctuations in
prices and employment.
But these violent fluctuations do not, in fact, seem to occur.
Instead of concluding, however, that there must be something wrong in his own analysis,
Keynes concludes that there must be something illogical about economic realities.
He develops a theory of mysterious, stabilizing forces.
In particular, it is an outstanding characteristic of the economic system in which we live that,
whilst it is subject to severe fluctuations in respect of output and employment, it is
is not violently unstable. Indeed, it seems capable of remaining in a chronic condition
of sub-normal activity for a considerable period without any market tendency either
towards recovery or towards complete collapse. Moreover, the evidence indicates that full
or even approximately full employment is of rare and short-lived occurrence.
p. 249-250.
This is a sweeping generalization from a comparatively short and special experience.
The condition of comparatively stabilized unemployment existed in the United States
from about 1931 to 1939.
It began sooner in Britain from about 1925.
And in both cases, the reason was the same.
The British pound sterling of gold had fallen from a parity of $4.86 to a low of $3.18 in
February of 1920.
It had recovered strongly and in late 1924 and early 1925 stood at approximately 10%
below the gold parity.
Mises and wages had adjusted themselves upward, however, to a lower value for the pound.
In April of 1925, Britain decided to return to a gold standard at the old parity of $4.86.
This decision would not have been disastrous if British business and labor had recognized
its implications, which was that wage rates and prices would have to readjust downward
to compensate for the domestic and international rise in the value of the pound.
But organized labor in Britain remained adamant against accepting any cut in wage rates.
It was precisely because organized labor in Britain followed the very course during and
after 1925 that Keynes applauds in the general theory that it brought about the stable unemployment
that he deplores and regards as a permanent attribute of the economic system on which
we live.
The same thing is true in the United States.
Prolonged mass unemployment was specifically a phenomenon of the 1930s.
As a result of the inflation of World War I, wholesale prices in May of 1920 had reached
a peak at 248% of the 1913 level.
Then came the most violent price break on record for such a period.
By August of the following year, 1921, the index of wholesale prices had dropped to 141.
This resulted temporarily in heavy unemployment.
But wage rates were fortunately still flexible.
As compared with wholesale prices, their decline was indeed comparatively small.
If we compare average wholesale prices with average hourly wages in 1920 and 1922, we
find that, whereas prices fell an average of 38% between 1920 and 1922, hourly wages
fell an average of only 11%.
But this was enough to permit readjustment.
By the spring of 1923, the United States had reached new high levels in industrial production,
and there were labor shortages in many lines.
In brief, the stabilized unemployment in the United States in the 30s, and in Britain in
the late 20s and the 30s, was not a permanent characteristic of the economic system in which
which we live, it was a temporarily frozen situation due to the very wage inflexibility
downwards that Keynes advocates.
It was not the result of laissez-faire, but the result of labor union policy supported
by government policy.
And it was not an unemployment equilibrium, which is a contradiction in terms, but an
Unemployment Frozen by Policy, by a Refusal to Adjust.
The Demand for Labor is Elastic.
When there is a change in employment, money wages tend to change in the same direction
as, but not in great disproportion to, the change in employment, i.e., moderate changes
in employment are not associated with very great changes in money wages.
Page 251 This is a typical instance of Keynes's reversal
of typical or normal cause and effect.
The significant thing in most situations is the effect of changes in wage rates on employment.
Looked at from this side, employment tends, of course, to change in the opposite direction
from wage rates.
If there has been prolonged mass unemployment as a result of labor union insistence on excessive
hourly wage rates in relation to prices and marginal labor productivity, then a fall of
these wage rates toward the equilibrium point will mean a rise in employment.
If of course it is prices rather than wage rates that have been above the equilibrium
In this special case, the relationship stated above by Keynes would hold, but this is a
is a comparatively rare and short-lived situation.
Much more frequently, it is a downward adjustment in wage rates or a gradual rise in man-machine-hour
productivity that will bring a rise in employment.
What will happen, in short, depends upon the initial situation from which we start, upon
the assumptions we make regarding the previous state of disequilibrium.
But Keynes almost never explicitly states his initial assumptions.
He persistently treats abnormal situations as normal ones, or hopelessly confuses everything
by calling a state of disequilibrium a state of equilibrium.
Keynes is correct, though, not for the reasons he gives in declaring that moderate changes
in Employment are not associated with very great changes in money wages, page 251.
A much more enlightening way to state this is to say that moderate changes in wage rates
can bring about much larger changes in employment.
Paul Douglas, as a result of elaborate statistical studies, came to the conclusion that the demand
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.
This could mean, conversely, that a rise of 1% in wage rates under similar conditions could mean a 3 or 4% decrease in employment.
A. C. Pigot independently came to a similar conclusion.
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.
A better name for elasticity of demand is responsiveness of demand.
The latter phrase at least makes it clearer that what we are talking about is the decisions
and actions of employers or consumers and not some inherent quality in the service or
commodity itself.
But as changes in price can never be assumed to be the sole reason for changes in the quantity
demanded and as other conditions, including the demand curve itself, can never safely
be assumed to be precisely the same for any two years, two days, or two moments in succession,
it follows that the elasticity or responsiveness of demand is never precisely measurable.
On what reasonably appear to be fairly persistent relationships, however, we may be reasonably
justified in basing practical policies.
Is Wage Rates or Employment?
If competition between unemployed workers always led to a very great reduction in money wage,
there would be violent instability in the price level.
The wage unit might have to fall without limit until it reached a point where the effect
of the abundance of money in terms of the wage unit on the rate of interest was sufficient
to Restore a Level of Full Employment, page 253.
There are more fallacies in this passage than the reader is likely to have patience to examine.
Keynes is apparently trying to prove that if there were free competition among workers
instead of union-enforced or law-enforced inflexibility downwards, the result would be
intolerably and limitlessly violent oscillations in prices.
The proposition is just as absurd as it sounds. Price changes normally come first and determine
wage rate changes rather than vice versa. It is far better when the choice must be made
to have wide oscillations in prices than wide oscillations in production and employment.
The attempt to stabilize farm prices at levels above those that would be set by a free competitive
of Market, as American experience has so dramatically proved, merely leaves unsold farm surpluses
that pile up in government warehouses.
The attempt to stabilize wages at levels above those that would be set by a free competitive
market leaves unemployed surpluses of labor that piled up on government unemployment insurance
or relief rolls.
We do not stabilize the economy by trying to hold up wages regardless of what happens to
prices.
We unstabilize it and create the very mass unemployment that Keynes professes to wish
to cure.
It is significant that the Keynesians do not dare to apply their theory both ways.
They do not urge that wage rates be held down when prices soar in order to stabilize prices
Keynes' wage theories are useful only as labor union propaganda.
Their scientific pretensions are pure quackery.
In the passage quoted above from page 253 of the General Theory, Keynes drags in the
effect of a reduction of wage rates on the interest rate, of course the interconnection
One of all prices, and both wage rates and interest rates are prices in the broadest
sense, is such that there is some interrelationship between wage rates and interest rates.
But the interrelationship is so complex, and for the most part so indirect, that a lengthy
discussion of this point would be largely irrelevant to Gresham.
We have already seen that Keynes had a false theory of interest.
We shall soon see that he also had a false theory of wage rates, a false theory of money
and credit, and a false theory of prices.