2005
How Did Keynes Transform His Theory
from the Tract into the Treatise?
― Consideration through Primary Material
Toshiaki Hirai*
1. Introduction
The issue of reparations and war debts (Britain’s huge loans from the United States, among others) was one of the most serious problems facing the world in the interwar-period. The United States, concerned solely with war debts repayment, turned down not only the Allied proposal to link reparations and war debts, but also the British 1922 proposal to cancel the inter-Allied war debts, thereby demonstrating that pre-eminence had irrevocably passed from the United Kingdom to the United States, both militarily and financially. The return to the Gold Standard at pre-war parity in April 1925 may be seen as an aspect of Britain’s struggle to retain an – ultimately illusory – hegemony.
Keynes was deeply involved in these issues. Firstly, as chief Treasury representative at the Peace Conference, he was extremely critical of the amount of reparations to be imposed on Germany, and eventually handed in his resignation to the Treasury. On returning to England, Keynes immediately embarked on a book criticizing the amount of reparations, far beyond Germany’s capacity to pay. The result was The Economic Consequences of the Peace (1919). Secondly, as author of Indian Currency and Finance (1913) Keynes led the front against the return to the Gold Standard in the heated controversy over the issue.
We know that Keynes was, at the same time, a theoretical and applied economist. Spurred on in his endeavors by upheaval in the real economy on the one hand, and influenced by the new developments in economics on the other, he set out to analyze the real economy. A Tract on Monetary Reform (hereafter the Tract or TMR) published in December 1923 and A Treatise on Money (hereafter the Treatise or TM) published in October 1930 were his major achievements in the 1920s.
Our main concern here is how (and why) Keynes transformed his theory from the Tract into the Treatise. What are the dominant themes of the Tract and Treatise? What is the difference between the two in theory and policy? We will analyze his theoretical development over this interval of time, drawing upon primary material, locating when the crucial turning points occurred and considering why he changed his theory. In sharp contrast with the quantity of studies on Keynes’s theoretical developmental from the Treatise to the General Theory, few serious investigations of this type have so far been attempted1 given the paucity of relevant manuscripts. And yet, it is crucial in understanding the nature of Keynes’s economics that we should reconstruct his theoretical development in the 1920s through the primary material available to us.
In Sections 2 and 3 the frameworks of the Tract and the Treatise are outlined respectively, followed by a brief comparison between the two in Section 4. They are here dealt with in so far as Section 6 is illuminated. Addressing Keynes’s vision which anticipated the Treatise in Section 5, we then go on to examine the intermediate process in Section 6, which is the crux of this paper. Finally, in Section 7, we consider why Keynes came to change his theory.
2. A Tract on Monetary Reform
The Tract stresses the importance of the stability of the value of money and the role of the central bank in creating this stability. It also bears the message that if each country could stabilize its currency value, the foreign exchange would also be stabilized, and the Gold Standard would become more of a hindrance than a help.
The Tract begins by arguing that changes in the value of money have harmful effects on society. Inflation redistributes wealth in a way that penalizes the investing class, with the result that “inflation [destroys] the atmosphere of confidence which is a condition of the willingness to save” (TMR, 29). Deflation, on the other hand, leads to impoverishment of both the wage-earning and the business classes, by causing the latter to restrict production and employment.
Keynes then goes on to deal with the changes in the value of money brought about by printing money — a form of taxation. He warns that this entails the risk of destroying the monetary system by affecting the public’s use of money, and recommends a capital levy.
A. The Fundamental Equation
Keynes puts forward the theory of the domestic value of money and advocates a monetary policy to attain a stable price level. His “fundamental equation”, which belongs to the Marshall-Pigou type quantity theory2, is:
n = p (k + rk΄)
where n denotes cash in circulation, p the price of a consumption unit, k the consumption units equivalent to what the public desire to keep in cash, k΄ the consumption units equivalent to the public’s bank deposits, and r the proportion of their liabilities, k΄, that the banks keep in cash.
The crux here is that ‘the price level [p] … is the resultant of [bankers’ and depositors’] decisions and is measured by the ratio of the volume of the cash balances created [n] to that of the real balances created [k + rk΄]’ (TM.1, 201).
Based on this equation, he argues as follows. The duty of the monetary authority is to keep the price level stable. Both n and r are under its control, while k and k΄ depend partly on the wealth of the community, partly on its habits — “fixed by its estimation of the extra convenience of having more cash in hand as compared with the advantages to be got from spending the cash …” (TMR, 64).
Price stability can be attained (i) by stabilizing k and k΄ directly; or (ii) by manipulating n and r in such a way as that the fluctuations of k and k΄ are cancelled.
Although the bank rate influences k΄ and k to a degree, Keynes doubts “whether bank rate … is always a powerful enough instrument” (TMR, 68); instead, he chooses policy (ii).3
In the light of the equation, Keynes distinguishes three kinds of inflation/deflation: cash inflation/ deflation based on an increase/decrease in n; credit inflation/deflation on a decrease/increase in r; and real balances inflation/deflation on a decrease/increase in k and k΄.
Keynes criticizes the quantity theory that a change in n influences p only. In the long run this is probably true, but what really matters occurs in the short run. The quantity theory, he says, should be expressed in such a way that changes in n also influence k, r, and k΄.
B. The Purchasing Power Parity Theory
Keynes then goes on to consider the role of the “purchasing power parity theory” in accounting for the foreign exchange4:
“...the essence of the … theory [lies] in its regarding internal purchasing power as being ... a more trustworthy indicator of a currency’s value than the market rates of exchange” (TMR, 71).
Keynes stresses the internal purchasing power rather than foreign exchange in maintaining the stability of a currency’s value. On this basis Keynes develops his policy views:
(i) A devaluation policy offers the possibility of “stabilising the value of the currency somewhere near its present value” (TMR, 117);
(ii) When the stability of the internal price level is incompatible with that of its foreign price level, the former should have priority;
(iii) Restoration of the Gold Standard would threaten the stability of the internal price level, while it would bring about foreign exchange stability only if all other countries were to accept it.
3. A Treatise on Money
The Treatise was published after “seven years off and on”. My understanding is that its core is composed of “Keynes’s own theory” and “Wicksellian theory”, both of which are dynamic and monetary in nature.5 After taking a look at his evaluation of various theories, we will explain the core and his policy views.
A. Various Theories
Bank Rate Theories — Keynes identifies four bank rate theories so far developed, variously regarding the bank rate as (i) the means of regulating the quantity of bank money (Marshall, Pigou, and Hawtrey); (ii) the means of protecting a country’s gold reserves (Goschen and Bagehot); (iii) a psychological influence on price levels (Pigou); and (iv) influencing investment and savings. He regards this as expressing the essence of the bank rate. Wicksell (1898) is considered to be the representative of this position and comes close to his own “fundamental equation”6:
Some explanation is required. First, although the bank rate plays a pivotal role in Keynes’s theory, the role of money supply also has a part to play. This may have to do with Keynes’s criticism that Wicksell does not succeed in “linking up his theory of bank rate to the quantity equation” (TM.1, 167). Second, the “fundamental equation” should be the second fundamental equation.
On the other hand, Keynes criticizes Marshall’s monetary theory as found in his testimony before the Gold and Silver Commission (1887) and the Indian Currency Committee (1898) (TM.1, 172- 3).
Keynes calls his theory — an extension of perspective (iv) — the “General Theory of Bank Rate”, which is explained as follows:
(i) Suppose, for instance, that the market rate of interest rises above the natural rate. A rise in the market rate causes the demand price of capital goods (and so of investment goods), to fall, as a result of which the volume of investment decreases. On the other hand, it causes savings to increase, though not by an equal amount. Thus the decrease in investment is greater than the increase in savings.
(ii) (a) A fall in the price level of investment goods causes production to decrease; (b) In addition, since an increase in savings means a decrease in consumption, the price level of consumption goods decreases.
Thus, the price level as a whole falls.
(iii) When producers incur losses, they cut the level of employment at the existing rate of earnings. If this continues, unemployment increases until the rate of earnings is reduced (TM.1, 171).
Keynes argues (i) with the second fundamental equation in mind. The first point in (ii) is based on the TM supply function (to be explained later) in the investment goods sector, the second on the first fundamental equation.
Investment and Saving — According to Keynes, the distinction between investment and savings was clarified by Mises (1912)7, and introduced into the Anglo-Saxon world by Robertson (1926).
Keynes’s understanding of saving and investment runs as follows. The income of society is partly spent on consumption, the rest being saved. Saving is a passive act of individuals while investment is a positive act on the part of entrepreneurs. Keynes takes investment from the supply side, which reflects the fact that the Treatise lacks an investment theory.
Keynes stresses that investment is not usually equal to savings, offering two reasons: one that those who determine the division of the total output are not the same as those who determine the division of the total income, the other that earnings and savings do not include entrepreneurs’ profits (or losses), while the value of investment does.
The Quantity Theory of Money — Keynes criticizes the quantity theory8 with two convictions in mind. One is that unless the influence of the bank rate upon investment and saving and the distinction between earnings and profits are introduced into analysis, the dynamic process of price formation cannot be captured. The other is that any analysis which fails to distinguish between various kinds of transactions will cause confusion.
Keynes arrived at the former conviction to go on and assert the advantage of the "fundamental equations” theory over the quantity theories :
“...we are compelled ... to discard the [quantity theories] when we ... attempt to analyse the actual monetary problems... because...they are … ineffective for handling the [most important] elements” (TM.1, 198-9).
Keynes classifies the demand for money in terms of people’s motives and explains the determination of the price level of investment goods in terms of the relation between savings deposits and equities.9
In Chapter 14 he examines three versions of the quantity theory: the Tract version, the Marshall-Pigou version, and the Fisher version. The following critical observations apply to all three:
(i) they only deal with the various kinds of ambiguous price levels;
(ii) they fail to distinguish between income, business, and savings deposits, so that disturbances arising from changes in the relative proportions of different deposits cannot be explained;
(iii) they cannot analyze a dynamic process in which the disturbance of the price level arises from a divergence between saving and investment.
In contrast to the other Wicksellians, Keynes analyzes the relationship between bank rate and quantity of money, as we see in Chapter 13. He offers two reasons for giving priority to the bank rate over the quantity of money.10
B. The Core11
In our view, the most significant feature of the Treatise theory is the coexistence of a Wicksellian theory and “Keynes’s own theory”.
We designate the monetary economic tradition stemming from Wicksell and developed by several economists as the “Wicksell Connection”.12 Wicksell, approving of a separation between the theory of relative prices and the theory of money prices in neo-classical economics, put forward the “cumulative process” theory, while Myrdal, Hayek and Mises constructed their own brands of monetary economics by criticizing the neoclassical system per se.
The Treatise belongs to the Wicksell Connection.13 Putting the market rate of interest together with the natural rate at its centre, distinguishing between investment and saving, and accepting “Wicksell’s three conditions of monetary equilibrium”, the Treatise explains fluctuations of prices and output in both dynamic and monetary terms with the stability of the price level as an objective. Keynes’s Wicksellian theory, in which the second fundamental equation is used, plays an important role in Volume 2 of the Treatise.
At the same time Keynes develops his own theory consisting of two parts, one of which addressing the determination of variables relating to consumption goods and investment goods in “each period” (Mechanisms 1 and 2, respectively).
(Mechanism 1) The cost of production and the volume of output are determined at the beginning of the current period. Once the expenditure for consumption goods is determined on the basis of earnings, it is automatically realized as the sale proceeds of consumption goods, and the price level and the profit amount are simultaneously determined.
(Mechanism 2) The cost of production and the volume of output are determined at the beginning of the current period. The price level of investment goods is determined either in the stock market (bearishness function) or as the demand price of capital goods. As a result, profit is determined.
The other part of Keynes’s theory concerns the determination of variables between one period and the next.
(Mechanism 3) The TM supply function
The behavior of entrepreneurs is such that, if they make a profit (take a loss) in the current period, they expand (contract) output in the next.
Now “Keynes’s own theory” can be expressed as a dynamic process composed of Mechanisms 1 and 2 working through Mechanism 3. This interpretation sees the Treatise theory as articulating a dynamic process inclusive of price levels and volumes of output.
C. Policy View
The Treatise emphasizes the bank (or discount) rate policy manipulated by the central bank. The policy can make the value of investment move in one direction while savings move in the other until profit disappears, and the stability of the price levels and the level of output is achieved.
“...the governor of the whole system is the rate of discount. ...the only factor ... subject to ... the central authority.../ [T]he control of prices is exercised... through the control of the rate of investment. [O]ur fundamental equation has shown that, if the rate of investment can be influenced at will, then this can be brought in as a balancing factor to affect in any required degree ... the price level of output as a whole” (TM.2, 189).
The “fundamental equation” should be the second fundamental equation:
Π = E/O + (I - S)/O
where Π denotes the price level of output as a whole, E money earnings, O the total output, I the value of investment, and S the volume of savings.
4. Comparison
Having examined the Tract and the Treatise, let us now draw some comparisons. There are seven points of comparison particularly worth making:
(1) The most conspicuous difference between the two books lies in the position ascribed to the rate of interest. In the Tract, the rate of interest plays a rather marginal role in the theoretical system. In the Treatise the rate of interest plays a central role.
(2) In the Tract the determination of the price level is discussed in relation to the fundamental equation, and the credit cycle is understood only as fluctuations of k and k′. The equation does not depart very far from the quantity theory of money. In the Treatise the fundamental equations part company with the quantity theory.
(3) In the Tract public finance is discussed only in relation to the procurement of fiscal funds through inflation induced by printing money. In the Treatise Keynes defends the view that a deficit budget may be necessary in periods of depression.
(4) In the Tract there is only one price level. In the Treatise there are two kinds of price level - that of consumption goods and that of capital goods.
(5) In the Tract the whole quantity of savings is assumed to be invested, while in the Treatise investment and savings are distinguished.
(6) In the Tract unemployment is dealt with only in relation to deflation, but how it relates to the fundamental equation is unclear. In the Treatise unemployment is dealt with more consistently within the theoretical framework.
At the theoretical level the difference between the two books is quite clear-cut, and greater than that between the Treatise and the General Theory.
5. The Treatise Vision
When did Keynes come to see the real economy in terms of the Treatise vision? By ‘vision’ we mean the basic representation of the economy upon which an elaborate theory is constructed with a series of concepts. That vision is clearly recognizable in Keynes as a commentator from 1924 on.14
Immediately after the Tract we find him writing articles that no longer depend on the Tract theory, but which conceive of the economy and prescribe for it in terms of the rate of interest and the distinction between investment and saving. This approach emerged even while Keynes, as a theorist, was still entangled in the Tract theory.
The first clear sign we find of the change is in “Free Trade” (The Nation and Athenaeum [hereafter NA] 24 November and 1 December 1923), where Keynes analyzes the economy in terms of investment, saving, foreign investment, the rate of interest and unemployment.15 In “Does Employment Need a Drastic Remedy?” (NA, 24 May 1924), he insists that the government should use subsidies in order to divert savings from foreign investment to home investment, and that it should spend the sinking fund on domestic capital construction. Similarly, in “A Drastic Remedy for Unemployment” (NA, 7 July 1924), he argues that a high rate of interest abroad causes a drain on domestic saving in the form of foreign investment, and that this in turn results in insufficient domestic investment, leading to unemployment and Balance of Payments disequilibrium. Domestic investment and government subsidies are presented as a second best given the difficulty of lowering the internal rate of interest. He repeated the same argument in “Some Tests for Loans to Foreign and Colonial Governments” (NA, 17 January 1925), “Our Monetary Policy” (The Financial News, 18 August 1925), and “The Autumn Prospects for Sterling” (NA, 23 October 1926).
6. Examination through Primary Material
In this section we examine Keynes’s theoretical development from the Tract to the Treatise drawing upon material in The Collected Writings of John Maynard Keynes, Vol.13 (hereafter JMK.13), Chapter 2 of JMK.29, Chapter 2 of JMK.20, and Keynes Papers. On the zigzag path from the Tract to the Treatise, he continually rewrote his manuscripts, introducing new ideas. Unfortunately, little evidence of these intermediate steps is extant, apart from various Tables of Contents (hereafter TOC or TOCs), a few manuscript fragments, several pieces of correspondence and the Macmillan Committee evidence.
The reader might have an impression that I pay too much attention to various TOCs without entering into argument or theory. This is mainly due to the fact that most of the manuscripts drafted during this period are missing, although I have tried to analyze the manuscripts as far as they are extant,
Our examination shows that Keynes moved through the Transaction Approach on his way from the Tract theory to the Treatise theory, and that the year 1928 marked a crucial turning point.
Below we use the following notation: (example) the TOC [27.4.26]: the Table of Contents dated 27 April 1926; Tm/3/2/6-7: the classification of Keynes Papers, pp.6-7.
A. The Tract Theory
How long did Keynes maintain the Tract theory? The evidence leads us to conclude that he held to this theory up to the TOC [27.4.26].
a. The Fundamental Equation
The TOC [14.7.24] (Tm/3/2/6-7 [in Keynes Papers, Reel 28]; JMK.13, 15-6), entitled “The Standard of Value”, is the earliest of the TOCs.16 Here we find terminology such as cash (m), the price level (p), the purchasing powers (k and k΄), and the relation of credit to cash (r).
In the TOC [9.10.24] (Tm/3/2/8-10; JMK.13, 16-817), “The Monetary Standard”, worthy of note is the heading of Chapter 4, “Prices Regarded as the Ratio of the Supply of Money Credit to the Supply of Real Credit”, which the TOCs [30.11.24]18 (Tm/3/2/12; JMK.13, 18) and [21.3.25] (Tm/3/2/13-5; JMK.13, 27) also contain, and which the TOC [6.4.25] (Tm/3/2/16-7; JMK.13, 28-9) contains in a similar form, but crossed-out. The supply of money credit would then correspond to n, and the supply of real credit to k plus rk΄, so that the price level p as the ratio of the two could correspond to n/ (k +r k΄) in the Tract equation. This idea is closely related to Chapter 2, “The Law or Equation of Money Recapitulated”. We can safely say that these TOCs essentially belong to the Tract theory.19
In the November 1924 manuscript, “A Summary of the Author’s Theory” (Tm/3/2/63-70; JMK.13, 19-22), two sets of conclusions are drawn. One is an argument concerning the stability of the price level, similar to that found in the Tract and apparently related to Chapter 4 of the TOC [9.10.24]:
“I shall argue in this book … that the general price level [p] can be stabilised by giving the [BOE] a control over the volume of bank-money created [n], ..., and by using this control to cause the volume of bank-money to vary in the same proportion as that in which the volume of real balances [k and k΄] varies” (Tm/3/2/69-70; JMK.13, 21).
The other set deals with the trade cycle theory, where the stress comes on circulating capital. Judging from the absence of “circulating capital” from the TOC [9.10.24], the term seems to be introduced here for the first time. Moreover, the lack of reference to working capital suggests that this manuscript may have been written prior to the TOC [30.11.24], in which working capital is stressed, and before the manuscript for Chapter 4, “Working Capital in Slumps and Booms” (Tm/3/2/72-5; JMK.13, 22-4).
The phrase “the fundamental equations of money” appears for the first time in the TOC [6.4.25]. Here we find expressions like “the determination of price by the ratio of the supply of money-credit to the supply of real credit” and “the velocity of circulation” (both of them crossed out). We also see the phrase, “the fundamental equation of money”, in the TOCs [13.6.25] (Tm/3/2/18-20; JMK.13, 41-42) and [30.6.25] (Tm/3/2/21; JMK.13, 42-43).
Noteworthy in the TOCs from [9.10.24] to [13.6.25] is the stress on “money credit” and “real credit”. In the Keynes-Robertson correspondence in May 1925 (Tm/1/2/9-31 [in Keynes Papers, Reel 27]), Keynes investigates the factors determining the volume of money credit and that of real credit, and distinguishes price fluctuations initiated by changes in money credit (inflation/deflation) from those initiated by changes in real credits (boom/slump). These correspond, respectively, to cash inflation/deflation and real balances inflation/deflation in the Tract. The same investigation is also to be seen in the TOCs [30.6.25] and [27.4.26], in which the terms “bank money” and “purchasing power” are used.
Judging from the above, we might suppose that Keynes continued thinking in terms of the Tract theory until the TOC [27.4.26] (Tm/3/2/22; JMK.13, 43-44).
b. The Bank Rate
Keynes takes a particular interest in the bank rate (or discount rate): we see the title heading, “the influence of bank rate on prices” in the TOC [14.7.24] and the phrase “bank rate” in the TOCs [9.10.24] and [30.11.24], followed by “the part played by the rate of discount” in the TOCs [21.3.25] and [6.4.25], and “the modus operandi of bank rate” in the TOCs from [30.6.25] on.
This might not be an entirely new element, however, for these TOCs are argued in terms of the Tract equation.
B. New Elements
In the above-mentioned TOCs we find some new elements leading to the Treatise theory.
a. Working Capital
We find that working capital is stressed from the TOC [30.11.24] on. Working capital is argued in the manuscript, “A Summary of the Author’s Theory” (November 1924), which is closely related to Chapter 3, “Fluctuations in the Demand for Working Capital in Relation to the Trade Cycle” of the TOC [30.11.24]. In a slump, neither the recovery of business sentiment nor the expenditure of public money raised by taxation alone are sufficient to bring about a rapid increase in employment.
“...only through the replenishment of working capital, by new savings becoming...available in liquid form, the position can be restored” (Tm/3/2/72; JMK.13, 23).
Interestingly, he believes that fixed capital might act as an obstacle to employment by depriving working capital of current savings. Thus, he is against “the expenditure, on the production of fixed capital, of public money...raised by borrowing” (Tm/3/2/72; JMK.13, 23).20
b. The Bearishness Function
Although the bearishness function plays an important role in the Treatise, it is very difficult to find any traces of it in the surviving TOCs. Savings deposits (semantically preceded by “investment deposits” in the TOCs from [30.6.25] to [2.6.27], which are closely related to that function, appear for the first time in the TOC estimated to have been written between September 1927 and September 1928 (Tm/3/2/33). However, not even the TOC [2.8.29] reveals any section corresponding to “the price level of new investment goods” (TM.1, 127-31).
As for an investment price theory, we have a fragmentary note (December 1929. Tm/1/2/7-8; JMK.13, 119-20), where Keynes argues that the price of new investment goods, P΄, is “determined by degree of capital inflation which depends on rate of interest and bull-bear sentiment”, while the “price of old capital [P˝] determined by rate of interest and by expectations of future prices”. He then states that “P΄ will be dragged up and down by P˝”.
C. An International Monetary Standard
The TOCs from July 1924 through April 1925 show Keynes preoccupied with an international monetary standard, which suggests that his interest in writing a book was prompted by the controversy over the Gold Standard.
He remained a vociferous critic of the return to the Gold Standard at pre-war parity, against which he lashed out in the Tract and The Economic Consequences of Mr Churchill (1925; both in Keynes, 1931)21.
The TOC [14.7.24], “The Standard of Value”, includes an examination of managed and automatic currency systems, the automatic and the managed Gold Standard, and the controlling authority’s instruments and objectives. In the TOC [9.10.24] entitled “The Monetary Standard”, eighteen of the twenty-three chapters deal with ideal standards in some form or other, and we find an important argument relating to Chapter 38 of the Treatise, “Problems of Supernational Management”, where the requirements of a standard, “short-period adjustability to the fluctuations of real balances and credit”, and “long-period stability of intrinsic value” are pointed out. Moreover, he mentions the tabular standard as an alternative intrinsic value standard.
However, as he proceeds to the TOCs [21.3.25] and [6.4.25], entitled “The Theory of Money with Reference to the Determination of the Principle of an Ideal Standard”, Keynes seems to be increasingly concentrating on the theories of credit money and the credit cycle.
The change of the title from October 1924’s “The Monetary Standard” to early 1925’s “The Theory of Money with Reference, etc.” suggests that his interest was moving from an ideal monetary standard to the theory of money per se. In the TOC [21.3.25], only one of the nineteen chapters deals with the monetary standard, while the rest address working capital, money credit, real credit, and price fluctuations.
In fact, from the second half of 1925 up to the TOC [31.8.26] (Tm/3/2/27; JMK.13, p.45-6), the title “The Theory of Money and Credit” seems to have been related to the United Kingdom’s return to the Gold Standard.
D. Activities in the late 1920s
Throughout the late 1920s Keynes was actively involved in Liberal Party policy-making and was one of the principal contributors to Britain’s Industrial Future (1928). His commitment also extended to participation in several government committees, including the Macmillan Committee in 1929. He played a major role in drafting the Committee’s final report, which included the following noteworthy recommendation and observation: an increase in the level of employment by public investment and import controls, and the difficulty of increasing the level of employment with a cut in money wages.
E. The Development of the Fundamental Equation(s)
The most effective method of theoretically distinguishing the Tract from the Treatise is to keep track of how the “fundamental equation(s)” are dealt with, for they occupy a major position in both books.
a. The Transaction Approach
What was described in the TOCs [26.5.26] (Tm/3/2/23; JMK.13, 44), [6.8.26] (Tm/3/2/26; JMK.13, 45) and [31.8.26] (Tm/3/2/28) as “the fundamental equation of price”22 first took “the fundamental equations of price” in the TOC [23.5.27] (Tm/3/2/31; JMK.13, 47). What characterizes them is that the equation(s) are developed along Fisher’s Transaction Approach23, for the elements of the “fundamental equation” turn out to be the velocity of circulation, the proportion of investment deposits, the volume of total deposits, the volume of transactions, and so on. This is also true of “the fundamental equations”, which are enumerated as “the first and second” equations, in the TOC [2.6.27] (Tm/3/2/32; JMK.13, 47-8) and [22.9.27] (JMK.13, 48-50). These TOCs are entitled “A Treatise on Money”).
Fisher’s formulation is:
MV+M΄V΄= PT
where M denotes the quantity of money, V its velocity of circulation, M΄ bank deposits, V΄ their velocity of circulation.
The equation shows that if M and M΄ are, say, doubled (M΄is assumed to hold a definite relation to M), then P is doubled provided that V, V΄ and T remain unchanged.24
At the same time, however, Keynes maintains the Tract theory. We find headings such as ‘cash balances and real balances’, ‘price level as the factor which brings decisions of bankers and depositors into harmony’ (Tm/3/2/23; 26; 32: JMK.13, 44; 45; 48).
b. The Embryo of the Fundamental Equations of the Treatise
There survive three TOCs from September 1927 to September 1928 that signal the sea change in Keynes’s thinking from the Transaction Approach to the idea which leads to the Treatise.25
Let us call the first two, estimated to have been written between September 1927 and September 192826 (Tm/3/2/29-30 and 33-3627), TOC (1) and TOC (2).
TOC (1)28 contains headings such as “the flow of consumers’ income”, “withholding of consumption and of sales”, “quantity of money versus flow of income”, and “the fundamental equations”, although we do not find savings and investment there. TOC (2) contains headings such as “quantity of money versus flow of income”, “the fundamental equations for the purchasing power of money”, “the relation of the price-level to the rate of earnings and to the rate of employment”, and “savings and investment”, showing that Keynes had begun to turn his attention to the elements that were to comprise the fundamental equations of the Treatise.
In TOC (2) we see for the first time the chapter, “Alternative forms of the Fundamental Equation”, which contains three types ― the “Real Balances” quantity equation, the “Cambridge” quantity equation, and the “Fisher” quantity equation (Tm/3/2/36) ― indicating that he is still under the influence of the Fisher type. It is interesting to compare it with the TOCs [6.10.28] (Tm/3/2/39-45; JMK.13, 78-82) and [2.8.29] (Tm/3/2/46-55; JMK.13, 113-7), which contain a section dealing with the relationship between the Fisher equation and his fundamental equation (Tm/3/2/41; Tm/3/2/48).
TOC (2) is also worth noting for the first appearance of a distinction between savings and investment, which has something to do with the Chapter, “Fluctuations in the Rate of Investment”, followed by the TOCs [4.9.28] (Tm/3/2/37-3829), [6.10.28], and [2.8.29]. In the TOC [2.8.29], we see expressions such as “by restoring equilibrium between saving and investment”, “by stimulating savings”, and “by changing the channels of investment” (Tm/3/2/52; JMK.13, 116). These corroborate our argument that Keynes was slow in adopting the distinction between investment and saving.
The third TOC [4.9.28], includes headings such as “the fundamental equation” and “digression on savings and investment”.
The TOC [6.10.28] contains headings such as “quantity of money versus flow of income”, “the fundamental equation for the purchasing power of money” (which should indicate “the fundamental equation in terms of monetary factors”), “digression on savings and investment”, and “earnings and profits”.30
The TOC [2.8.29], which has headings such as “flow of income versus quantity of money”, “the relation of the price level to the rate of earnings and to profits”, “the rate of employment”, and “earnings and profits” (Tm/3/2/48; all these headings are crossed out), is worth noting, for Keynes distinguishes between the fundamental equation “for the purchasing power of money” and the one “in terms of monetary factors”, which might suggest two ways of expressing the price level of the consumption goods.
All the TOCs from [6.10.28] onwards place the main emphasis on the fundamental equation in terms of monetary factors31, expressed as “the elements of the fundamental equation”. While this indicates that the Transaction Approach is still dominant, we see the direction turning towards the equations of the Treatise. In this respect the year 1928 is crucial.
c. Thereafter
Keynes’s Michaelmas lectures of 1929 were delivered on the basis of the galley belonging to the TOC [2.8.29].
In his letter to Keynes (29 September 1929, Tm/1/2/4232), Kahn wrote that:
“the logical and time sequences which are appropriate to the conception of ideas are not always the best adapted for the purposes of exposition. In particular, the modification in the treatment of the Fundamental Equations that you have now introduced right at the outset carry, ... big advantages”.
Kahn must be referring to “the modification” of the fundamental equation “for the purchasing power of money” (Tm/3/2/48; JMK.13, 114), which can be corroborated with his letter to Keynes (17 December):
“I ... feel that a few simple equations involving the elements of savings and profits that are devoted to the banking system...and to new investment, would make things much clearer” (JMK.13, 121).
We also have Robertson’s letter to Keynes (5 December), on the evidence of which Keynes seems to be referring to the role played by profits, an increase in investment, a rise in prices, and so forth, which indicates something like the first fundamental equation:
“...I find a certain indeterminacy about the role of profits. They first appear as a result... of the rise of P: then, ... in connection with bank-rate, as a motive-force towards the excess of investment which raises P ....” (Tm/1/2/34-5; JMK.13, 118-9).
Taking this into consideration, the first fundamental equation possibly came into being, in some form or another, after the TOC (2.8.29).
The preface dated 1 September 1929 (Tm/3/2/56-6033) is worth noting in comparison with the Treatise’s preface.
In the latter Keynes declares, “In Books III and IV... I propose a novel means of approach to the fundamental problems of monetary theory” (TM.1, p. xvii), while in the former he had expressed his view less clearly: “as the point of the book lies...more in its cumulative effect than in any particular part of it .... the central theory of the book is to be found in chapters 9 [the fundamental equation], 10 [digression on savings and investment] and 16 [the genesis of the price level], …” (Tm/3/2/56).
The best source we can draw on to form an idea of Keynes’s theoretical situation in early 1930 is the evidence he submitted in February-March 1930 in the Macmillan Committee (JMK.20, 38-157).
In his statement concerning the fundamental equations (though these terms are not used) we see him discussing the first (see JMK.20, 74) and second fundamental equations in broad terms, with the TM supply function behind the scene (see JMK.20, 75).
However it is also clear from Keynes’s letter to Kahn (18 March 1930. JMK.13, 125-6) that the fundamental equations had yet to be established.
“... I am unable to arrive at any simple formula connecting the change in the value of investment with the amount of saving which goes on through the banking system...” (JMK.13, 125-6).
Subsequently, he revised the chapter on the fundamental equations, which is confirmed by his letter to Hawtrey (18 July 1930).
“… I have been drastically re-writing the chapter which deals with the fundamental equations. This looks a great deal more different from the old version than it really is. But I think it brings out much more definitely what is in my mind” (Tm/1/2/171. JMK.13, 135).
F. Robertson’s Influences
Keynes had ongoing discussions with Robertson regarding Robertson (1926)34 in the making. Initially, as his 28 May 1925 letter to Robertson (Tm/1/2/18-20. JMK.13, 34-36) shows, Keynes had objected to a “distinction between hoarding and forced effective abort lacking” and the idea of the admitted power of inflation to bring unused resources into use. In his 10 November 1925 letter (JMK.13, 40-1), however, Keynes had come round to essentially agreeing with Robertson’s ideas as a result of Robertson’s revisions (see JMK.13, 40).
The object of Robertson (1926) was “to interweave with the ...‘non-monetary’ argument of [Robertson (1915)] a discussion of the relation between saving [lacking], credit creation and capital growth” (Robertson, 1949, vii-viii). Credit-creation by the banking system plays an important role in the procurement of real capital (required for the increase of production) by entrepreneurs, which in turn induces a rise in the price level.
It was not until two years after Robertson (1926) that a distinction between investment and saving began to make its appearance in Keynes. Moreover, Keynes dealt with “savings and investment” in theTOCs [4.9.28] (Tm/3/2/37), and [6.10.28] (Tm/3/2/41; JMK.13, 79) and [2.8.29] (Tm/3/2/48; JMK.13, 114) only as a “Digression”.
The TOC [2.8.29] is the latest of the surviving TOCs, consisting of thirty-two chapters in the form of one volume with no text surviving except for Chapter 23.
We can recognize Robertson’s influence in Chapter 23, “The Part Played by the Banking System” (JMK.13, 83-113). Two points can be made in this regard.
The first concerns the stability of prices.35 Accepting Robertson’s idea that “[t]he aim of monetary policy should surely be...to permit [price increase] ... necessary to ... appropriate alterations in output” (Robertson, 1949, 39), Keynes came to think that the correct method of achieving price stability
“must be sought...in the discovery of some means to meet the fluctuating demands for...credit without causing those reactions on the stability of the price level” (JMK.13, 90).
The second point concerns forced saving. Keynes considers “methods of adjusting the supply of working capital by means of banking policy”. One of the methods is the use of credit inflation, which induces forced saving. He allows employment and output to increase at the expense of price stability (see JMK.13, 104).
These points are recognizable in the TOCs [6.10.28] and [2.8.29], which include the headings, “the ‘justification’ of credit inflation” and “by forced transfers [or transferences] of purchasing power from ‘unproductive’ consumers”.
It should be noted that thereafter, however, he excluded these phrases. The divergence between Keynes and Robertson widened.36
G. The Final Stage
Keynes planned to publish a one-volume book in May 1929. He wrote to Harcourt (26 September 1928) that “I have devoted the whole of this summer to [the Treatise] … four-fifths ... is... finished” (Tm/1/3/91; JMK.13, 51).
Of the proofing process there survives only the first galley for Chapters 30, and 31, with “16 July 1929” and “27 July 1929” stamped on them respectively. Keynes then changed the arrangement of the Books, and wrote to Harcourt (28 August and 25 September 1929, respectively):
“the rewriting...will prove a great improvement./...the book will probably fall... into two parts of about equal length” (Tm/1/3/103; JMK.13, 117).
“I have now definitely decided to make it a two volume book and am hopeful that the sheets will be ready for dispatch to you by the end of this year. …” (Tm/1/3/10737).
The letters around January 1930 are: Robertson to Keynes (5 December 1929; 8 January 1930; 4 March); Kahn to Keynes (29 September 1929, Tm/1/2/42; 17 December, JMK.13, 120-121; March 1930, JMK.13, 123-4; 12 March, JMK.13, 124-5); and Keynes to Kahn (18 March 1930, JMK.13, 125-6).
Keynes wrote to Harcourt on 18 February 1930;
“Since [25 September] I have been working on the book continuously. But the labour of revision and rearrangement in two-volume form has proved very heavy, and, whilst I am making steady progress, the end is not yet./ At the moment, I have finished the revision of the first volume and about half of the second volume. My expectation is that next Easter vacation will see the completion of the book. …” (Tm/1/3/10938).
From the third galley of the Treatise, there survive only Chapters 21 and 25, on which “4 March” and “28 May 1930” are respectively stamped.39
It was Hawtrey who appeared as a critic at this stage. On 23 April 1930 (Tm/1/2/84-5; JMK.13, 13-2) Keynes sent Hawtrey a batch of the proofs, followed by “a good batch of Volume II; - though unfortunately this still does not include Chapter 30 …” on 24 June (Tm/1/2/8940).
Hawtrey responded to Keynes with long critical notes41 on 7 and 9 July, representing the most important source on the state of development by the end of April: we see the formulation of the second fundamental equation42 as well as the TM supply function;
“The sequence here assumed is first a fall of prices, and then a contraction of output. With that assumption the unemployment inevitably appears as consequential upon the excess of saving over investment, for the excess of saving over investment is merely the fall of prices (relative to costs) under another name” (Tm/1/2/107).
“I am therefore of opinion that, while a windfall loss, taken by itself, produces a tendency to a reduction of output, this has not been in the past and is not likely to be in the future a contributory cause of actual epidemics of unemployment” (Tm/1/2/116).
and the natural rate of interest (Tm/1/2/146-147; Tm/1/2/137).
We find detailed evidence of the gestation on the book as of 30 June 1930 in a letter to R.& R. Clark;
“I could let you have the proofs of the whole of Vol. I and of the first 144 pages of Vo. l. II, finally marked for press, the greater part of them immediately and the rest within a few days, if you told me that you wanted them. The further corrections are by no means extensive, but there are a few small matters to attend to here and there” (Tm/1/3/1143).
On 18 July 1930 Keynes wrote to Harcourt;
“… the book is now at last really reaching its final conclusion. Almost the whole of [the book] is now in type, and I am sending off sheets marked for press every few days./ The book is now a good deal larger than even my last indications to you …” (Tm/1/3/11544).
On 14 September 1930 Keynes wrote to his mother:
“This evening ... I have finished my book. It has occupied me seven years off and on... Artistically it is a failure. I have changed my mind too much during the course” (JMK.13, 176).
7. Conjectural Conclusion
Summarizing our main results, we must now address our unanswered question: why did Keynes change his theory?
(i) Keynes went on working out his theory along the lines of the Tract theory until around April
1926, when he abandoned the “fundamental equation” of the Tract. So, what was it that made
him change his mind?
I conjecture that one reason might be that Keynes was becoming aware of the importance of the bank rate and movements in investment and saving. This is substantiated by a series of topical articles he wrote, starting with 24 November 1923, as we saw in Section 4. He might have thought that the fundamental equation of the Tract could not deal with the rate of interest.
(ii) He then went on to adopt the Transaction Approach up until September 1927.
Although he abandoned the Tract theory, and he was becoming aware of the importance of the bank rate and movements in investment and saving, this did not mean that Keynes tried to construct his theory based on the latter. It seems very likely that he was not too sure of it as theory, and may therefore have tried to seek a new possibility in Fisher’s transaction approach.
(iii) Keynes might have begun to recognize the importance of the bank rate and movements in investment and saving again. I surmise that this has something to do with the fact that he came under the theoretical influence of Robertson (and Wicksell) in terms of the distinction between investment and saving, and a dynamic analysis. As a result of this, there is a possibility that Keynes became dissatisfied with the Transaction Approach, and began to seek a new direction.
(iv) We have stressed the importance of the three TOCs between September 1927 and September 1928 as pointing the way towards the Treatise’s fundamental equations. These TOCs might well mark the breakthrough on the way to the Treatise.
A good reason for Keynes to have been dissatisfied with the Transaction Approach lay in the fact that it was not equipped to deal with the dynamic problem properly (see Section 3 (A(c)) above), prompting endeavors to find a new method. He seems to have wanted to deal with the movement of the price level in a more explicit and quantitative way. Evidence of this endeavor is to be seen in the three TOCs that he produced. Unable to settle on a definite solution, however, he was in no position to abandon the Transaction Approach.
(v) The first fundamental equation possibly appeared around August 1929. However, the fundamental equations had yet to be established. He revised the chapter on the fundamental equations, as is confirmed by his letter to Hawtrey (18 July, 1930). As we saw, by the end of April the second fundamental equation, the TM supply function and the natural rate of interest had made their appearance. We also see that the key elements for the Treatise theory first emerged at a very late stage.
(vi) We cannot draw a clear dividing line on the way from the Tract to the Treatise, for at any stage Keynes’s theory contains old and new ideas sometimes in ambiguous form (see, for example, the Transaction Approach). Even after he entered into the world of the Treatise, Keynes changed his mind so radically (for example, the forced saving doctrine and the loanable fund theory) that the divergence between Keynes and Robertson opened wider — “I have changed my mind too much during the course”
In conclusion, it is our contention in this paper that the three TOCs between September 1927 and September 1928 pointed the way towards the Treatise’s fundamental equations, and might well mark the breakthrough on the way to the Treatise.
Notes
1) Bigg (1990, 96-8, 173-6), Skidelsky (1992, 281-5), Moggridge (1992, 434-43; Chapter 19) are exceptions, albeit not necessarily sufficient. Patinkin (1976, Chapter 3) explains, but does not analyze this point. It is not dealt with in Bridel (1987), Dimand (1988), Meltzer (1988), Amadeo (1989), and Laidler (1999).
2) Keynes in (TMR, 63) states that his equation follows that in Pigou (1917), which allows for variability of its components. For the relation between the two, see Bigg (1990, 75). The Tract equation is used as explaining the short-term economic fluctuations.
3) See TMR, 34.
4) For the theory’s applicability, see TMR, 73-80. For its rejection, see TM. 1, 64-5.
5) Clarke (1988) argues that the Treatise can, “in important respects, be explained along ‘externalist lines’ by invoking the political context in which it was conceived”, while “the General Theory must, in essentials, be understood in ‘internalist’ terms” (“the outcome of a process of intellectual discovery rather than of political invention”) (p. 230). My stance is aimed at understanding the two great books along ‘internalist’ terms, for I think that both of them should and could above all be theoretically understood. I would rather think that Keynes in the late 1920s had two facets – as an advocate of the Liberal Party’s public policy (political economist) and as a theoretical-applied economist.
6) See TM.1, 176-7.
7) Keynes (1914) reviews it critically, although it evaluates Part III.
8) See TM.1, 205. We find three types of interpretation: (i) the Treatise accepts it; (ii) the Treatise is critical of it; and (iii) the Treatise stands in between.
9) Laidler (1990) appraises the Treatise’s portfolio selection theory as well as Lavington’s (1921) as making good the defect of neo-classical monetary economics.
10) See TM.1, 196-7. This shows why the Treatise regards money supply as endogenous. For exogeneity/endogeneity in Keynes’s economics, see Moore (1988) and Graziani (2003).
11) This is examined in Hirai (1997-9, Chapters 3 and 7).
12) I examined the influences of Wicksell’s theory of cumulative process on Keynes, Hayek and Myrdal in Hirai (2005b).
13) When did Wicksell’s theory come to influence Keynes? It is very difficult to ascertain the period, for there survive no relevant documents from 1925-30. I asked Profs. Don Moggridge and Mauro Boianovsky if they knew of any relevant material. Their answers were in the negative. From the 1930s we have two items. One is a letter from Keynes to Kahn (8 September 1935 in Kahn’s Papers 13/57/137), saying that “he [Wicksell] is wonderfully on the right track” (for this letter I owe thanks to Prof. Marcuzzo). Kahn (1984, 74), the translator of Wicksell (1898), doubts “whether [Wicksell’s] influence on Keynes amounted to much more than adopting his distinction between the natural rate of interest and the market rate”. The other, and the only reference concerned in the whole body of JMK, is to be seen at JMK.14, 203n (written in 1937), in which Keynes rather mentions Fisher, rather, as his ‘great-grandparent’.
14) This means a dichotomy, between Keynes as a commentator and Keynes as a theorist, which is the main theme of Hirai (2004), and on which see a ‘publicist’ and an ‘economist’ in Clarke (1998, 71). See also Bridel (1987, 96).
15) “Currency Policy and Unemployment” (NA, 11 August 1923), where a lack of trust in the price level is pointed out as the cause of unemployment, belongs to the Tract theory.
16) See also Skidelsky (1992, 164). The TOC (undated, Tm/3/2/2) of the same period survives, arguing “[t]he control of p by control of n …only requires that [k, k΄, and r] should not be linear functions of n”.
17) JMK.13’s description is not correct as far as Par II is concerned.
18) See Skidelsky (1992, 281).
19) Keynes, in fact, maintains it thereafter. See D (a) below.
20) Robertson stressed fixed capital. See his comment on Keynes’s draft (JMK. 13, 26).
21) For Keynes’s activities in this field, see Moggridge (1992, Chapter 17). Keynes’s stance as a ‘Monetary Reformer’ is clearly expressed, for example, in “The Problem of the Gold Standard” (NA, 21 March 1925). For an analysis of the inter-war period, see Eichengreen (1992), which regards the Gold Standard as “fetters”.
22) The only surviving formula around this period is “P = M / (C1+WT) where … C1 [is] the real value of the investment-deposits, T the volume of transactions, and W the inverse of the “efficiency” of the money deposits” (Tm//2/350).
23) Possibly Keynes used the Transaction Approach in terms of the short run rather than the long run, for he argues ‘the variability of [the equation’s] elements’ (Tm/3/2/23; 26). Keynes (1911) had criticized Fisher’s Transaction Approach from Marshall’s point of view.
24) Beside this, Fisher has a “transitional periods” theory.
25) See Moggridge (1992, 441-2).
26) Patinkin (1976, 28-9) estimates that the fundamental equations may have appeared in the latter half of 1928.
27) These are not contained in JMK.13.
28) Chapter 1 of Book IV seems to be related to a memo (Tm/2/342-3).
29) This is not contained in JMK.13.
30) See also the expression, “(Earnings minus Savings) / (Output minus Investment) = Price Level” (undated, Tm/3/2/86), substantially similar to the first fundamental equation.
31) These are to be moved to Book V of TM.2, after separation from the fundamental equation. See Keynes’s “precautionary word” (TM.2, 4).
32) This is not contained in JMK.13.
33) This is not contained in JMK.13.
34) For “Keynesian parallels” in BPPL, see Fletcher (2000, Chapter 21). For a very lucid and fair evaluation of Robertson’s economics, see Presley in O’Brien and Presley eds. (1981). Robertson always paid attention to the dynamism of the market economy. However, when Presley refers to the similarity of Keynes’s economics and Robertson’s economics by saying that the General Theory is “no more than a simplification of the earlier Robertsonian system [BP]” (1978, 219), he seems to go too far. For the collaboration between Robertson and Keynes, see Presley (1992).
35) See Robertson (1928) and Bigg (1990, 175-6).
36) See “Notes on the Definition of Saving” (esp. JMK.13, 287-8).
37) This letter is not contained in JMK.13.
38) This letter is not contained in JMK.13.
39) The material which concerns the Treatise’s Chapter 37 survives in Tm/2/246-75.
40) This letter is not contained in JMK.13.
41) For this impact on Keynes, see Deutscher (1990, 102-5). Keynes’s rejoinder was made on 28 November 1930 (Tm/1/4/14-54). It should be noted that Hawtrey’s criticism of the Treatise’s fundamental equations and his stress on the importance of effective demand seem to make a great contribution to making Keynes abandon the Treatise framework and move towards the General Theory after some hesitation. For this, see Hirai (2005a, III).
42) See Tm/1/2/102.
43) This letter is not contained in JMK.13.
44) This letter is not contained in JMK.13
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How Did Keynes Transform His Theory from the Tract into the Treatise?
An Abstract
The main purpose of this paper is to clarify on the evidence of primary material how Keynes transformed his theory from the Tract to the Treatise.
Keynes went on working along the lines of the Tract theory until around April 1926, subsequently adopting the Transaction Approach up until September 1927. We stress the importance of the three TOCs between September 1927 and September 1928 as pointing the way towards the Treatise’s fundamental equations --- the breakthrough opening the way to the Treatise. The second fundamental equation, the TM supply function and the natural rate of interest had made their appearance by April 1930.
***
Journal of Economic Literature Classification System
B2 - History of Economic Thought since 1925
B22 – Macroeconomics
B31 – Individuals
E32 - Business Fluctuations; Cycles
E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit
