THE DURATION OF THE TREATISE PERIOD
― KEYNES UP TO OCTOBER 1932
BY
TOSHIAKI HIRAI
I. INTRODUCTION
After “seven years off and on” Keynes published A Treatise on Money (October 1930. Hereafter the Treatise). Apart from the traces left by Robertson’s great influence on his thought, Keynes was setting off on his own path, but the Treatise still received an extraordinary degree of attention.1
As we shall see later, the Treatise has two theories: “Keynes’s own theory” (hereafter KOT) and a “Wicksellian theory”. For some time after the publication Keynes went on using and extending KOT, stressing the TM supply function, against various critics such as Robertson, Hawtrey, the “Cambridge Circus” and Hayek (interestingly enough, Keynes seldom refers to a “Wicksellian theory”.)
When, then, did this state of affairs come to an end and did a new situation leading to the General Theory begin? This is definitively important in clarifying his theoretical development. Determining this point, in our view, hinges on how long the TM supply function continued to be used and when it was given up. We have already clarified that the function was abandoned at the end of 19322 – an abandonment that greatly contributed to opening the way to the General Theory.
The main purpose of this paper is to examine the sustained period of KOT. Taking the Treatise theory as preparation, our examination proceeds as follows: (1) Hawtrey’s criticism; (2) the sources from June 1931 to early 1932; (3) a manuscript consisting of four chapters (JMK.13, pp. 381-396; hereafter “The Monetary Theory of Production” or MTP); (4) Criticism of the “Cambridge Circus”; and (5) two 1932 tables of contents (JMK.29, pp. 49-50, hereafter TOC(1) and TOC(2))).
II. THE TREATISE THEORY
In our view, the most significant feature of the Treatise theory is the coexistence of a Wicksellian theory and KOT.
1. THE WICKSELL CONNECTION3
We designate the monetary economics stemming from Wicksell and developed by various economists as the “Wicksell Connection”. 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 criticizing the neoclassical system.
The Treatise belongs to the Wicksell Connection. 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, it explains fluctuations of prices and output in 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 a crucial role in the Treatise, II.
2. KEYNES’S OWN THEORY (KOT)4
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”.
(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 of consumption goods proceeds, and the price level and amount of profit are simultaneously determined.
It should be noted that Mechanism 1 is substantially the same as the first fundamental equation.
(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 from one period to the next.
(Mechanism 3) The TM supply function (hereafter TMSF)
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 KOT can be expressed as a dynamic process composed of Mechanisms 1 and 2 working through Mechanism 3. As a result, the economy may or may not reach long-period equilibrium. This interpretation sees the Treatise theory as articulating a dynamic process inclusive of price levels and volumes of output.
III. HAWTREY’S CRITICISM
1. HAWTREY’S ECONOMICS
Hawtrey’s trade cycle theory originates in Hawtrey (1913). It is a cumulative process theory of the banker-dealer connection based on two lags: the lag of the rate of interest behind the change to rising or falling prices; the lag of the demand for currency behind a change in credit.
It is in Hawtrey (1919) that he used his key concepts of “consumers’ income” and “consumers’ outlay”, although the theory is a version of that in Hawtrey (1913).5
Then we have Hawtrey (1928) and Chapter III of Hawtrey (1932). Let us explain his theory by starting with the key concepts:
The total of the incomes which people … have to spend I call the consumers’ income; the total which they do spend I call the consumers’ outlay (Hawtrey, 1928, p. 83).
He finds the essence of the trade cycle in the variations of “effective demand”, that is, those of consumers’ outlay and the cause of the variations in the movement of bank credit .6
The trade cycle takes place in the transitional period during which consumers’ income diverges from consumers’ outlay. The banks, if they judge that the level of their reserves relatively to the amount of credit money is lower (higher) than is appropriate, raise (lower) the rate of interest. Then the dealers, who hold stock of commodities and stand between manufacturers and consumers, accordingly contract (expand) bank credit and decrease (or increase) their orders to the manufacturers who produce less and reduce employment.
A contraction (expansion) of bank credit induces a return of currency to the banks (release of currency) and a decrease (increase) of consumers’ income, which in turn brings about a decrease (increase) of consumers’ outlay. A decrease (increase) in consumers’ outlay brings about an accumulation of unsold stocks, so that dealers give fewer orders to producers, who in turn reduce their production and employment. Production then decreases and unemployment increases, which induces a decrease (increase) of consumers’ income. During this process prices and profits fall (rise), followed by wages with a lag.
This process has a tendency of acceleration. That is, the divergence between consumers’ income and consumers’ outlay becomes wider and wider, assisted by the above-mentioned lags.
Eventually the banks notice that the reserves/the amount of credit money is higher (higher) than is appropriate, they lower (raise) the rate of interest.
Thus Hawtrey concludes that trade depressions must be due to a deficiency of consumers’ outlay owing to a restriction of credit.
2. HAWTREY’S CRITICISM
Hawtrey testified before the Macmillan Committee on 10 and 11 April 1930, and subsequently submitted three papers to the Committee.
On 23 April (Tm/1/2/84) Keynes sent Hawtrey a batch of the proofs of the Treatise, followed by a batch of Volume II on 24 June (Tm/1/2/89). Hawtrey responded to Keynes with long critical notes on 7 and 9 July.
On those occasions Hawtrey persistently followed his theory outlined above.
Here we shall quote a few passages from his critical notes.
Mr Keynes’ formula only takes account of the reduction of prices in relation to costs, and does not recognise the possibility of a reduction of output [through] a contraction of demand without [a] fall of price (Tm/1/2/106).
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, [i.e.] the fall of prices (relative to costs) (Tm/1/2/107).
It is … misleading to treat the discrepancy between investment and saving as an operative cause of monetary phenomena. … The cause of the divergence [between prices and costs] … [should] be found in a change in … the consumers’ outlay (Tm/1/2/111).
… while a windfall loss … produces a tendency to a reduction of output, this has not been … a contributory cause of actual … unemployment (Tm/1/2/116).
Hawtrey, questioning TMSF, emphasizes “present demand” based on the consumers’ “income” and “outlay”. He also stresses the role which the adjustment of goods in stock plays, attributing unemployment to a contraction of demand.
3. KEYNES’S RESPONSE
Keynes responded to Hawtrey on 19 November, from which we see how much TMSF occupied his thoughts.
Firstly, Keynes thinks that realized profits influence anticipated profits.
… I have laid too much stress on realised profits in respect of the production period just ended as influencing anticipated profits in respect of the production just beginning … (Tm/1/4/48-49).
… there is not likely to be more than a transitory departure from the optimum level of output unless there is an actual or anticipated profit disequilibrium … (Tm/1/4/48).
Secondly, he explains that because ‘how much reduction of output’ is not a monetary problem, it is not dealt with in detail.
The question how much reduction of output is caused, … by a … fall of price …, is important, but not strictly a monetary problem. I have not attempted to deal with it in my book, though I have done a good deal of work at it (Tm/1/4/48).
Thirdly, he feels the need to link monetary theory to the theory of short-period supply.
… I am not dealing with the complete set of causes … determin[ing] volume of output. For this would have led me an endlessly long journey into the theory of short-period supply and a long way from monetary theory…. If I were to write the book again, I should probably attempt to probe further into [making the two theories run together]; but I have already probed far enough to know [its complication].
… I have gone no further than that anticipated windfall loss or profit affects the output of entrepreneurs …; … I have left … the question how much output is affected and … whether output can be affected in any other way (Tm/1/4/49).
Although Keynes refers to a “book”, he did not start on his way to the General Theory until late 1932.
It should be noted that Hawtrey’s theory anticipates the General Theory albeit it is not a theory of employment or income, but a theory of income-outlay repercussion induced by bank credit. 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.8
IV. JUNE 1931-EARLY 1932
1. JUNE 1931
In June 1931 Keynes delivered the lectures9, “An Economic Analysis of Unemployment”10 in Chicago (JMK.13, pp. 343-367. Hereafter EAU). Here he discussed a trade cycle mechanism, emphasizing TMSF:
... when ... the value of current investment [I] is less than the savings [S] …, the receipts of the entrepreneurs will be less than their costs, so that they make a loss [profit = I - S]. That is … the clue to the scientific explanation of booms and slumps .... [W]hen [I] increases [decreases] (with no change in S) business profits increase [decrease] (JMK.13, p. 353).
A given deficiency of investment causes a given decline of profit [which] … causes a given decline of output (JMK.13, pp. 355-356).
In these lectures Keynes argued that the economy is inclined to proceed cumulatively, and might reach “a kind of spurious equilibrium”11 (JMK.13, p. 356). For the Great Depression he emphasized the re-establishment of investment:
The cure of unemployment involves improving business profits [, which] can come about only by an improvement in new investment relative to saving (JMK.13, p. 362).
The solution for increasing investment, he argues, is to lower the long-term rate of interest.12 For this Keynes suggests three ways, although he believes the effect of the short-term rate on the long-term rate
(i) to increase the quantity of liquid assets;
(ii) to diminish the attractions of liquid assets by lowering the deposit rate of interest;
(iii) to increase the attractions of non-liquid assets.
He also mentions three lines of approach for the Great Depression, attaching great value to (3):
(1) restoration of confidence to lender and borrower;
(2) new construction programs under the auspices of the public authorities;
(3) a reduction in the long-term rate of interest.
He then goes on to question the practicality of (2), while fully accepting its theoretical validity.
Theoretically… [(2)] can play an extremely valuable part in breaking the vicious circle. … I applaud the idea and only hesitate to depend too much in practice on this method alone … (JMK.13, p. 364).
Beside the lectures, Keynes participated in the Round Table on “Unemployment as a World Problem” (JMK.13, pp. 367-373. Hereafter UWP). In a noteworthy contribution he proposed:
… let us consider the totality of industries. You have over a short period something of the nature of a supply curve which tells you that for a given level of prime profit there will be a given level of output… Every increase in aggregate prime profit will enable somebody to expand, … so if you have a supply curve…, you could only increase … output by increasing prime profit (JMK.13, p. 368).
[Y]ou then aggregate all the curves and you can get a supply curve for industry as a whole in which the quantity of output is unequivocally related to the aggregate [profit] (JMK.13, p. 372).
These statements show Keynes’s view that the quantity of output, both for an individual industry and for the whole industry, is related to profit.
2. 20 SEPTEMBER 1931 AND TWO MANUSCRIPTS
In his letter to Kahn (20 September 1931. GTE/1/20-22)13, Keynes argues out the possibility of underemployment equilibrium, which makes its first appearance:
… if, starting with equilibrium, an increase of I makes Q positive, O increases and S increases but Q/O gradually diminishes. If Q/O reaches zero before O reaches maximum, we have ‘long-period unemployment’, i.e. an equilibrium position short of full employment (JMK.13, pp. 374-375).
For the same period we also have the manuscripts, “Why Are the Equations for Consumption-Goods and Investment-Goods Asymmetrical?”14 (Hereafter WECI) and “The Determination of Price”15 (Hereafter DP).
In WECI, Keynes argues that given E, Q, and M, P1 depends on the difference between saving and investment, while P2 depends on the propensity to hoard (E denotes the earnings, Q profit, M money supply, P1 and P2 the price level of consumption goods, and of investment goods, respectively). The propensity to save is defined as S = φ (E, Q, P1, P2), and the propensity to hoard as M = ψ (H, P2), where S denotes saving and H hoarding.
In DP, two things in particular are worth noting. One is that the supply schedules are defined as P1= f1 (A1) and P2 = f2 (A2), where A1= O1+ Δ B1 and A2= O2+Δ B2. The other is the equations, P1 = (E - S)/O1 and P2 =ΔM/ΔB2 = ψ (M). (Ai, Oi and Bi respectively denote assets, output, and bond concerning goods i [i= 1, 2], where goods 1 are consumption goods and goods 2 investment goods. Δ X denotes an increment in X.)
Both manuscripts probably precede MTP, for they adopt the same line as the Treatise on the bearishness function, and on the determination of the price levels of consumption and investment goods.
V. “THE MONETARY THEORY OF PRODUCTION”
MTP is probably preceded by the preface to the Japanese edition of the Treatise (5 April 1932. Tm/1/3/244-255) which states the determination of the price level of capital goods in terms of “bearishness” (“the propensity to hoard”) but contains neither the determination of the rate of interest nor the term “liquidity preference”, whereas MTP reveals the seeds of the liquidity preference theory.
Let us review the main points of MTP, and then assess it in terms of Keynes’s theoretical development.
1. THE SHORT-PERIOD ANALYSIS
In MTP, the fluctuations of the economy and its possibility of cumulative deterioration are analyzed by means of TMSF.
(A) TMSF
The following passage clearly demonstrates the importance which Keynes attaches to TMSF:
The essence of the monetary theory of production...can be expressed quite briefly, starting from the equation
Δ Q =Δ I - Δ S,
or, …
Δ Q = Δ I + Δ F -Δ E,
or Δ Q = Δ D - Δ E
where Q stands for profit, I for investment, S for saving, F for spending, and D for disbursement. …
…we have started with the assumption that …entrepreneurs tend to increase [decrease] their output according as their profit is increasing [decreasing]. Thus we are led to…the vital generalisation that increases [decreases] in the volume of output … depend upon the changes in disbursement relatively to earnings ... or in investment relatively to savings.... Throughout this Book we shall be engaged in developing … this central generalisation (JMK. 13, p. 381. E denotes earnings).
Q is formulated as either I - S or D - E. To obtain the first formulation from the second, the equation F = E - S is required.
MTP assumes an economy in which the total volume of output, fixed at the beginning of each period, is sold in that period. This is related to TMSF, in the context of which, as in the Treatise, both investment I and spending F are taken to be the sale proceeds realized as a result of the total volume of output being sold. The intrinsic logic of this function is developed as follows.16
The quantitative effect on output of a given decrease - Δ Q … will depend on: (i) the margin between each entrepreneur’s receipts and his variable costs...; (ii) the distribution of the total reduction - Δ Q between different entrepreneurs; and (iii) the duration of the period of diminished profit relatively to the durability of his fixed capital....[If (i) is sufficiently large initially, (ii) equal and (iii) short], … there is no reason to expect any significant decline of output, ....
Nevertheless, even so, an initial movement - Δ Q is likely to aggravate itself.... As a net result of … [a cumulative deterioration of - Δ Q, and the existence of firms in which the initial (i) is insufficient, the inequality of (ii) and the prolongation of (iii)], it is … reasonable to expect that a point will be reached at which there is some elasticity of supply in response to diminished profit, the initial reduction in entrepreneurs’ profit aggravating itself until, having reached an amount - Δ Q, it causes a reduction - Δ O … and a reduction - Δ E … (JMK.13, pp. 382-383).
We can gather from this that Keynes regards TMSF as a useful analytical tool operating with some time lag.
(B) THE POSSIBILITY OF CUMULATIVE DETERIORATION
Using profit and TMSFs as pivotal concepts, Keynes argues that the economy might proceed along a course of cumulative deterioration:
... an initial movement - Δ Q is likely to aggravate itself. For the reduction in entrepreneurs’ profit will have a tendency to retard new capital development [investment] in respect both of value and volume…; and at the same time it may stimulate economy by diminishing both the [consumption] expenditure of entrepreneurs whose incomes are reduced and also the [consumption] expenditure of other consumers who can maintain their previous standard of life at a lower money cost. In short, the initial decline in disbursement is likely to generate ... a further decline in disbursement... (JMK.13, pp. 382-383).
Here Keynes argues that a reduction in profit generates a further decline in disbursement, which in turn generates a further decline in profit, so that the deterioration becomes self-reinforcing. Behind this argument lies the idea that the volume of production of both investment goods and consumption goods is determined by TMSF.
He also discusses the case in which the economy deteriorates cumulatively even if the extent of the decline in profit remains the same as before:
Let us...assume that … the amount of disbursement declines by about the same amount as the decline in earnings....On this assumption, the deficiency in the profit of entrepreneurs as a whole will remain exactly the same in absolute amount as it was before. But it will be spread over a smaller number of units of production, as a result of a certain number having fallen out of production. Consequently the average loss will be greater than it was, with the result that the next most vulnerable section of entrepreneurs now falls out of production...
Thus if we can imagine the entrepreneurs ranged in a continuous series according to what percentage reduction in their receipts impels them to close down production, it might be that a very small diminution -ΔQ in the total receipts of entrepreneurs might by a sort of inverse tontine process gradually close down one after another of them, until production was at a total standstill (JMK.13, pp. 384-385).
Thus Keynes argues that the economy in which a decline in disbursement initially generates a decline in profit can enter on a process of cumulative deterioration, due either to a falling off in profit itself or to an increase in the average loss as a result of a decrease in the number of units of production.
2. THE LONG-PERIOD EQUILIBRIUM
How long does the economy continue to deteriorate cumulatively? Is there a possibility that it reaches a long-period state of equilibrium? Keynes answers the latter question in the affirmative.
In MTP he emphasizes the relation between spending (consumption expenditure) and earnings (income). This relation is similar to that in the Treatise, and not directly connected with the GT consumption function. The following passage is to be read in this context:
... it is natural to expect that, as the earnings of the public decline, a point will eventually be reached at which the decline in total expenditure … will cease to be so great as the decline in [earnings] (JMK.13, p. 386).
Here “total expenditure” does not mean disbursement but consumption expenditure: the passage implies that the marginal propensity to consume (in terms of GT) increases as earnings increase.
In the Treatise, the relation between spending and earnings is a factor causing a collapse in the credit cycle while, in the MTP, it is regarded as warranting a kind of long-period equilibrium after a series of short-period equilibria. What the two share is the idea that spending has no influence on the production of consumption goods, but determines its price level, and that the profit from consumption goods determines its volume of production in the next period.
Keynes argues that the long-period equilibrium thus attained is characterized as a state of underemployment:
… provided that spending always increases [decreases] less than earnings increase [decreases] … [with investment stable] ...any level of output is a position of stable equilibrium. For any increase [decrease] of output will bring in a retarding [stimulating] factor, since ΔS will be positive [negative] and consequently I being assumed constant, Δ Q will be negative [positive] … (JMK.13, p. 387).
Here it is regarded as an important condition for stable equilibrium that the rate of the change in spending be smaller than that in earnings. Equilibrium generally brings about a state of underemployment equilibrium.17
... there is no presumption…that the equilibrium output will be anywhere near the optimum output. The essence of the above process is that the real income of the community has to be forced down to a level at which the rate of saving is not so excessive relatively to investment at the current rate of interest as to produce a crescendo of business losses… (JMK.13, p. 387).
3. THE RELATION OF INVESTMENT TO THE LEVEL OF OUTPUT
MTP stresses the role of investment in determining the level of output, and of the government in promoting investment. However, it is no easy task:
... if we regard the response of individual spending to any given conditions of earnings and profits as something …determined by nature and habit…, then the level of output, which will be a stable level, entirely depends on the policy of the authorities as affecting the amount of investment.... [W]hen the output of the community increases a point comes eventually … when its spending … ceases to increase as rapidly as its earnings; … though we may … for a time maintain disbursement as a whole by increasing investment as rapidly as [savings] rises, a critical point comes when…we cease to be able to increase investment at an adequate pace, with the result that forces come into operation which prevent a further increase of output (JMK.13, p. 388).
We need to consider the relation between the short-period analysis by means of TMSF and the proposition that the level of output depends on investment. Keynes seems to be saying that if investment increases in the initial period, then output will continue to increase over a period of time, resulting in an increase in output at a new long-period equilibrium. When he says “the level of output, which will be a stable level, entirely depends on the policy of the authorities as affecting the amount of investment”, he is stressing the influence that both investment and the investment policy of the authorities have on the level of output at a long-period equilibrium.
Keynes also says that “output will finally settle down to a position of equilibrium which is stable, so long as no extraneous influence interposes to change the value of I” (JMK.13, p. 388). He may seem here to be expressing reliance on an automatic mechanism driving the economy towards long-period equilibrium, but actually this is not the case. Having serious doubts about any such mechanism, he stresses the importance of a low interest rate policy for attaining optimum output: “there is no safeguard against savings increasing faster than … investment, except a monetary policy deliberately aimed at making a rate of interest sufficiently stimulating to investment” (JMK.13, p. 396).
As for the relation between monetary policy and long-period equilibrium, Keynes explains it clearly in the lecture draft for 14 November 1932.
4. THE ORIGIN OF THE THEORY OF LIQUIDITY PREFERENCE
The Treatise stresses a portfolio selection between money as bearing interest, and equities — the “degree of bearishness”. By contrast, the General Theory, which does not assume an identity of equities and capital goods, stresses a portfolio selection between money as bearing no interest, and debts — liquidity preference.18
In MTP we see liquidity preference making its first appearance.
... as output and prices decline, the proportion of the stock of money to income will...tend to increase. This growing relative abundance of money will, unless the general desire for liquidity relatively to income is capable of increasing without limit, lead…to a decline in the rate of interest (JMK.13, p. 395).
This may be read in terms of the General Theory as follows:
(i) a decrease in the demand for money due to the transactions motive makes money relatively abundant;
(ii) the abundance of money causes a decline in the rate of interest, unless the liquidity preference due to the speculative motive is infinitely elastic.
Here MTP abandons two of the ideas in the Treatise: (i) the price level of investment goods is determined in the financial market dealing with savings deposits and equities19; (ii) the rate of interest is a policy variable.
In short, the role of the financial market switches from determining the price level of investment goods to determining the rate of interest. The rate of interest thus determined is expected to influence investment, which in turn influences the level of output through TMSF.
This change represents an enormous transformation in monetary theory. From the viewpoint of Keynes’s theoretical development, however, it is nothing like the change in the theory of the commodity market, for it does not undermine the grounds for MTP to be argued within the Treatise framework.
5. THE PLACE OF MTP20
We are now in a position to evaluate the place of MTP21 in the development from the Treatise to the General Theory. Five points are worth noting in particular.
(1) Its fundamental framework belongs to the Treatise theory, for it maintains (i) profit and TMSF as determining the level of output, (ii) the relation, similar to Mechanism 1, between consumption and earnings, in that it determines not the level of output but the price level of consumption goods, and (iii) the value of investment as is determined in the same way as in Mechanism 2.
(2) The basic theoretical structure is put forward as the dynamic process of Mechanisms 1 and 2 working through TMSF, while the fundamental equations are abandoned.
(3) TMSF and profit are discussed in detail. This is of special significance, for they are insufficiently
discussed in the Treatise.22
(4) The theory of liquidity preference appears for the first time – an important advance in monetary
theory.
(5) We can trace three features of MTP – (i) the possibility of cumulative deterioration, (ii) underemployment equilibrium, and (iii) the role of investment and its fragility – back to the Treatise23 in (i) and the first half of (iii), and to “An Economic Analysis of Unemployment”24 in (ii) and the second half of (iii).
In MTP Keynes describes the fluctuations of the economy using TMSF. He also describes long-period equilibrium as the economy reaching through a series of short-period equilibria, thereby attempting to analyze short-period disequilibrium and long-period equilibrium in tandem. This was to come in for criticism from the Cambridge Circus – criticism which, although he resisted it for some time, was eventually to prompt a great transformation in Keynes’s thinking.
VI. THE CRITICISMS OF THE CAMBRIDGE CIRCUS: MAY 1932
Immediately after the publication of the Treatise, several economists, including Kahn, Sraffa, Meade, and Austin and Joan Robinsons formed a group – the “Cambridge Circus” (January - May 1931) – to study it. The members attended Keynes’s lecture of 2 May 1932 and responded with a “Manifesto”, to which Keynes replied.
1. THE 2 MAY 1932 LECTURE
We can reconstruct Keynes’s lecture from some surviving fragments probably, probably from his preparatory notes (JMK.29, pp. 39-42). The picture that emerges is substantially similar to MTP, for the proposition, ‘the volume of output and employment depends predominantly on the amount of investment’, is stressed in terms of TMSF.
The argument begins by making two assumptions: (i) Δ O and Δ E΄ have the same sign; and (ii) Δ E΄ - Δ F and Δ E΄ have the same sign, where O denotes the volume of output, E΄ earnings plus profit, F spending, and Δ X an increment in X.
On these assumptions Keynes attempts to establish a positive relation between the volume of output and that of investment.
He then goes on to examine the case in which this relation does not hold. By looking closely into his procedure we can understand the relation between the positive output/investment relation and TMSF:
If..., whenever there was an increase in investment, there should also be such an increase in rates of earnings that the increase in aggregate earnings on the basis of the old output was greater than the increase in investment, and if earners were to save these increased earnings whilst entrepreneurs maintained their expenditure at their previous level, then every increase in investment would be associated with a decrease in profit and therefore in output. / Thus we are left with the remarkable generalisation that…the volume of employment depends on [that] of investment, and that anything which increases [decreases] the latter will increase [decrease] the former (JMK.29, p. 40).
Keynes argues for this relation in the context of “generalisations of far-reaching practical importance” (JMK.29, p. 40), stressing Δ Q = Δ I + Δ F - Δ E, which appeared in MTP. He discusses the relation between the positive output/investment relation and TMSF in terms of not only the long period but also the short:
The general upshot of this…seems to be that the fluctuations of output and employment for a given community over the short period…depend almost entirely on the amount of current investment (JMK.29, p. 41).
.
The key to a proper understanding of the lecture lies in Keynes’s attempt to link the positive output/investment relation with TMSF. His analysis centers around the short-period process; long-period equilibrium is only the point towards which the economy is moving. This is essential in understanding the differences between Keynes and the Circus.
2. THE CAMBRIDGE CIRCUS
The lecture drew criticism from the Circus — the “Manifesto” by Kahn and the Robinsons (JMK.29, pp. 42-45), which, arguing that Keynes’s procedure for the proposition ‘an increase in investment (I) brings about an increase in the volume of output (O)’ lacks generality, puts forward an alternative way of proving it:
The problem seems to us to be susceptible to treatment by the method of Supply and Demand. For the truth of the proposition … , the two following conditions appear to us to be sufficient…:
(a) That an increase in I will lead per se to a rise in the demand for consumption goods, ….
(b) That the conditions of supply of consumption goods are not affected by a change in I.
When these conditions are fulfilled, an increase in I will lead to a rise in the demand curve for consumption goods without raising the supply curve, and so must lead to an increase of output of consumption goods, and a fortiori to an increase in total output (JMK.29, pp. 43-44).
Keynes put forward the proposition in terms of TMSF, while the Circus did so in the framework constructed by Kahn (1931)25, disregarding the function. The Circus’s position is very clear in Joan Robinson’s letter to Keynes:
You begin by increasing I. Now … tell me the elasticity of supply of capital goods i.e. how much increase in output does this ΔI entail. Then I will tell you for any set of conditions of supply of consumption goods what increase in E would be necessary to prevent O from increasing ....
In this sense I consider our method more general than yours. You announce in advance that yours only works when Δ Q and Δ O have the same sign. Ours is designed to overcome that limitation (JMK.29, p. 47).
The Circus’s argument was based on two considerations: (i) the elasticities of supply in capital and consumption goods industries; and (ii) the influence of an increase in investment on the demand for consumption goods.
On 8 May Keynes discussed the whole matter with Kahn and Joan Robinson. On the next day he wrote a letter to Robinson, revealing some doubt about his own argument, while having no less doubt about Robinson’s:
[W]hich is the best of two alternative exegetical methods [?] ... my present belief is that ... your way would be much more difficult and cumbersome. … I lack at present sufficient evidence to the contrary to induce me to scrap all my present half-forged weapons (JMK.13, p. 378).
The “two alternative exegetical methods” are: (a) the credit cycle theory by way of TMSF; (b) the multiplier theory, including the method of supply and demand. The point of contention is unmistakably the supply function.
Robinson replied to Keynes on 10 May.26
Then the supply price for each output is (on your view) the average prime cost + the profit per unit just sufficient to retain the marginal entrepreneurs .... I believe that like the rest of us you have had your faith in supply curves shaken by [Sraffa]. But what he attacks are just the one-by-one supply curves that you regard as legitimate. His objections do not apply to the supply curve of output …27 (JMK.13, p. 378).
In mid-1932 Keynes was still using the average principle of the Treatise. The first sentence can be taken to mean that profit per unit is defined as the difference between the (supply) price as determined in the period, and the (average) prime cost as determined at the beginning of the period.
Let us now see how the quotation continues. First, Robinson suggests that Keynes thinks that a supply curve, in the ordinary sense, is useful for the analysis of an individual firm or an individual industry, while Sraffa rejects this. Second, the supply curve of output [of the economy as a whole] lies outside Sraffa’s theory.
Here Robinson’s reference is to an article by Sraffa (1926) of epoch-making importance for the imperfect competition revolution. He maintains that increasing returns are applicable to the industry in the narrower range:
the more nearly [an industry] includes … only those undertakings which produce a given type of consumable commodity ― the greater will be the probability that the forces which make for increasing returns will predominate … [if the more nearly [an industry] includes all the undertakings, … decreasing returns will predominate] (Sraffa, 1926, p. 538).
Thus the “supply curve of output” works under diminishing returns, while the “one-by-one supply curves” work under increasing returns.28 Robinson seems to have this in mind.
If we understand Robinson’s comments aright, it follows that she fails to recognize that: (i) Keynes thinks that TMSF is useful for analysis not only of the economy as a whole, but also of an individual industry, considering that the ordinary supply curve is not useful in either case; (ii) Keynes had so far never used the “supply curve in the ordinary sense”. It was in mid-1933 that he came to accept the so-called “first postulate of the classical economics”.29
Indeed, Keynes stressed TMSF in a letter to Joan Robinson of 12 May:
About all one can say is that ... an increment in aggregate profit can reasonably be expected to produce an increment of aggregate output ― which is in substance what I have said.
… even when one is dealing with separate industries, or separate groups of industries, my supply curve is one which relates output and profit, not one which relates output and price (JMK.13, p. 380).
By the end of 1932, however, he had come to accept the Circus criticisms. He abandoned TMSF and adopted “the method of Supply and Demand”, following the lines laid down by Kahn and Robinson.
VII. TWO TABLES OF CONTENTS (1932)
1. KEYNES AND KITOH
In the preface to the Japanese edition of the Treatise (5 April 1932), Keynes announced his intention “to publish a short book of a purely theoretical character, extending and correcting the theoretical basis … in Books III and IV …” (Tm/1/3/255). Kitoh, the translator, asked Keynes about the progress of the book (30 June. Tm/1/3/270). Keynes replied that “…[it] is…still many months off” (20 July. Tm/1/3/271). On 18 September he remarked to his mother that “I have written nearly a third of my new book on monetary theory” (JMK. 13, p. 380).
Kitoh again asked Keynes: “…I shall be greatly obliged if you kindly inform me … some outlines of the contents” (20 October 1933. Tm/1/3/273), to which he replied: “…[My book] may possibly be published some time next year” (9 November. Tm/1/3/272), followed by a letter saying that “I am hard at work on my further book on the Pure Theory of Money …. But it will be some months more before … printing” (22 June 1934. Tm/1/3/274).
2. TWO TABLES OF CONTENTS
We have two tables of contents drawn up in 1932. As we shall see below, the work to which Keynes referred in his letters of 1932 both to Kitoh, dated 20 July, and to his mother, dated 18 September is probably related to a third (missing) TOC.
(A) TOC (1)
TOC(1) entitled “The Monetary Theory of Production” has several points worth noting:
(i) The titles of Chapters 1 - 4 (Book I) suggest that they may argue disbursement, profit, earnings, and output in the same way as MTP in terms of the equation ΔQ = ΔI +ΔF - ΔE =ΔD - ΔE;
(ii) The title of Chapter 2, “The Relation of Profit to Output”, may point to TMSF;
(iii) Chapter 6, “Generalisations” (Book I) may have to do with the “vital generalisation” referred to in Section 4 (1(A));
(iv) Chapter 7, “Historical Retrospect” (Book I) may be related to a note, “Historical Retrospect” (JMK.13, pp. 406-407);
(v) Chapter 1, “The Differential of Consumption-Goods and Capital-Goods” (Book II) may be related to WECI;
(vi) The title of Chapter 2, “The Meaning and Consequences of ‘Bearishness’” (of Book III) may suggest the Treatise theory of money.
(B) TOC (2)
The untitled TOC(2), whose main chapters are almost the same as in TOC(1), shows the following features:
(i) The title of Chapter 20, “The Factors Determining Liquidity Preference”, may propose the liquidity preference theory;
(ii) Chapters 23 - 27 (Book IV) bear titles regarding economic policy. No such chapters re-appear thereafter.
(C) Chronological Order
Let us consider the chronological order of these materials. Obviously TOC(1), referring to “bearishness”, precedes TOC(2), referring to “liquidity preference”.
MTP was probably written on the basis of a third TOC after these two TOCs. Justification for this is provided:
(i) by the chapter titles of MTP, which have no corresponding titles in the two TOCs;
(ii) by the fact that MTP contains the seeds of the theory of liquidity preference.
However, this is not to deny that the two TOCs are closely related to MTP.
VIII. Conclusion
We clarified the following two.
(i) A clarification of how Keynes tried to defend and extend his own theory.
Through EAU and UWP we saw how much stress Keynes placed on TMSF in his analysis.
We also argued that MTP analyzes the fluctuations of the economy and its possibility of cumulative deterioration by means of TMSF, and describes a long-period equilibrium as a point reaching after a series of short-period equilibria. Moreover, we saw that MTP stresses the role of investment in determining the level of output, and of the government in promoting investment, and contains the seeds of liquidity preference.
(ii) The significance of two criticisms of the Treatise.
The first criticism came from Hawtrey, who, questioning TMSF, emphasized effective demand.
The second came from the “Cambridge Circus”, which, questioning TMSF, put forward the proposition in terms of Kahn (1931).
Against these criticisms Keynes tried to defend his own theory. After some hesitation, however, he came to accept the criticisms.30
The core of the Keynesian Revolution, of course, lies in the theory of underemployment equilibrium. This took place in 1933, for which we have three manuscripts. 31
What we would stress is that Keynes could reach his employment theory as a result of abandoning KOT and accepting these criticisms.
Notes
1) On which, see Keynes Papers TM/1/3.
2) On which, see Hirai (2004).
3) On which, see Hirai (1997-9, Chapter 3).
4) On which, see Hirai (1997-9, Chapter 7).
5) See Hawtrey (1913, pp. 42-44, 107-110 and 124-126).
6) See Hawtrey (1928, p.84 and p.94).
7) See, Hawtrey(1928, p. 98).
8) See Davis (1980), Cain (1982) and Deutscher (1990, p. 105).
9) See two sets of lecture notes prepared for the NSSR in New York (11 June 1931. Keynes Papers, AV/1/40-53). He advocates raising prices by increasing investment through lowering the long-term rate of interest. The first fundamental equation and a kind of multiplier theory underlie his argument.
10) Bridel (1987, p. 152) regards the lectures as belonging to the Treatise framework while Vicarelli (1984, p. 106) as a fundamental break.
11) Patinkin (1976, p. 83) states that this differs from GT’s unemployment equilibrium. It is to lead to the long-period equilibrium of MTP.
12) See JMK.13, p. 366.
13) Although Patinkin (1976, p. 84) regards the letter as showing an equilibrating mechanism, it is still within the Treatise framework.
14) Keynes Papers, GTE/1/23-41.
15) Keynes Papers, GTE/2/24.
16) Chapter 8 of MTP initially contained the following passage, subsequently crossed out: “if we did not distinguish between S and S΄, we should have no clue to the effect on output of changes in the Investment and Economy Factors. But the problem can be attacked starting from the equation Δ Q =Δ I +Δ F - Δ E. …”.
17) Keynes expresses this with the term “involuntary unemployment” in a note, “Historical Retrospect” (1932. JMK.13, pp. 406-408), which is still argued in terms of the I-S difference. Here Keynes refers to Mercantilist and protectionist policies, anti-usury laws, etc..
18) The term appears for the first time in the title of Chapter 20 in the TOC, “The Monetary Theory of Production”.
19) MTP maintains an idea that the price level of investment goods is determined by discounting the prospective yields at the rate of interest.
20) Patinkin (1976, pp. 86-88) finds several original ideas leading to the General Theory, although he regards MTP as being within the Treatise framework. Patinkin (1976; 1977), however, fails to examine “The Parameters of a Monetary Economy” at the end of 1932 and the three manuscripts of 1933. Amadeo (1989, p. 74) sees the embryo of the multiplier mechanism in MTP.
21) There exist two materials related to MTP: (i) “Notes on the Definition of Saving”, where TMSF (JMK.13, p. 279) and the possibility of a cumulative deterioration of the economy (pp. 288-289) are argued; (ii) the 1932 spring lectures (JMK.29, pp. 35-48): the draft for the lecture of 2 May is in line with MTP.
22) (2) and (3) are not mentioned in Patinkin (1976; 1977).
23) See TM. 1, pp. 259-261.
24) See JMK.13, pp. 355-358 and 364 respectively.
25) Kahn’s fellowship dissertation (Kahn, 1989) was submitted to King’s College in 1929. The “short period” was evidently based on Marshall’s idea, which Robinson (1962) admired. The dissertation was to influence greatly Keynes’s path to the General Theory.
26) See Robinson remark made in the summer of 1931; “Actually the supply of goods in the short period is likely to be fairly inelastic ..., but not completely so” (1933, p. 82).
27) For a theoretical cleavage between Kahn=Robinson and Sraffa, see Marcuzzo (2003).
28) Sraffa (1926, p. 543) says that “a very large number of undertakings … work under … diminishing costs”.
29) Keynes first discussed it critically in ‘The First Manuscript’ (1933. JMK.29, p. 66). He accepted it in ‘the Second Manuscript’ (1933. JMK.29, p. 72) as well as in the 1933 Michaelmas lectures (JMK.13, p. 420).
30) Contrastingly Keynes did not accept Roberson’s and Hayek’s criticisms.
31) On which, see Hirai (1997-9, Chapter 10).
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