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 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. 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 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. On returning to England, Keynes immediately embarked
on a book criticizing the amount of reparations, far beyond Germany’s capacity
to pay. This was The Economic
Consequences of the Peace (1919). Secondly, Keynes was deeply involved in the heated controversy over the return to
the Gold Standard in a way that was, as will be explained later, ‘very
ambiguous’.
As we know, Keynes was at one and the same
time a theoretical and an applied economist. Spurred on by upheaval in the actual
economy, and influenced by the new developments in economics, he set out to
analyze the 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 in
between, drawing upon primary material, locating the crucial turning points 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.
And yet, it is crucial in understanding the nature of Keynes’s economics that
we should reconstruct his theoretical development in the 1920s based on 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. 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 are a harm to 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 leads to
impoverishment of both the wage-earning and the business classes, by causing
the latter to restrict production.
Keynes
then goes on to deal with the changes in the value of money brought about by
printing money. He warns that this entails the risk of destroying the monetary
system by affecting the public’s way of using 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 as compared with the advantages … 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 so 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
Based on the equation, Keynes distinguishes
three kinds of inflation/deflation: cash inflation/deflation (an
increase/decrease in n); credit inflation/deflation (a decrease/increase in r);
and real balances inflation/deflation (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 argues, 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 looking at his evaluation of
various theories, we will explain them (??) these core theories (??) and his
policy views.
A. Various Theories
Bank Rate Theories — Keynes identifies four bank rate theories so
far developed, regarding the bank rate, respectively, 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 theory (iv) as expressing the essence of the bank rate, mentioning Wicksell
(1898) as the representative, and states that it 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:
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.
On the other hand, Keynes criticizes
Marshall’s monetary theory, as witnessed in his testimony before the Gold and
Silver Commission (1887) and the Indian Currency Committee (1898) (TM.1, 172- 3).
Keynes describes his theory as an extension
of theory (iv) the “General Theory of Bank Rate”, which runs
as follows:
(i) Suppose 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, which
brings about a decrease in the volume of investment. 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) Moreover, 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 point (i) with the second
fundamental equation in mind. Point (ii)(a) is based on the TM supply function
(to be explained later) in the investment goods sector, (b) on the first
fundamental equation: P=E/O+(I΄-S)/R
where P denotes the price level of consumption goods, I΄ the cost of
production of investment goods, R the volume of output of consumption goods.
Investment and Saving — The distinction between investment and
savings was, according to Keynes, clarified by Mises (1912)7, and introduced
into the Anglo-Saxon world by Robertson (1926)8.
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: (i) those who determine the
division of the total output are not the same as those who determine the
division of the total income; (ii) 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 theory9
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 and asserted the advantage of the “fundamental equations” theory over
the quantity theories (see 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.10
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 of them:
(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, and offers
two reasons for giving priority to the bank rate over the quantity of money.11
B. The Core
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”. 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.12 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 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 is, in substance, equal to the first
fundamental equation. It should be noted that, theoretically speaking, the
first fundamental equation is more important than the second, while in terms of
explanation of the real world the second is more important than the first.
(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 own 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 stability is achieved in price
levels and in the level of output.
“...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 [second] fundamental
equation has shown that, if the rate of investment can be influenced …, then
this can be brought in as a balancing factor to affect ... the price level of
output as a whole” (TM.2,
189).
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 a marginal role while in the Treatise a central).
(2) In the Tract
the fundamental equation does not depart very far from the quantity theory. In
the Treatise the fundamental
equations part company with it.
(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 the view is defended 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.
(5) In the Tract
the whole quantity of savings is assumed to be invested. 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 grasp the actual 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, and that vision is clearly recognizable
in Keynes as a commentator from 1924 on.13
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.14 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.
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.
We will 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 TOC [27.4.26].
a. The Fundamental Equation
TOC [14.7.24] (JMK.13, 15-6), entitled “The Standard of Value”, is the
earliest of the TOCs.15 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 TOC [9.10.24] (Tm/3/2/8-10), “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 TOCs [30.11.24]16 (JMK.13,
18) and [21.3.25] (JMK.13, 27) also
contain, and which TOC [6.4.25] (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.
In the November 1924 manuscript, “A Summary
of the Author’s Theory” (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 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” (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 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 TOC [30.11.24], in which working
capital is stressed, and before the manuscript for Chapter 4, “Working
Capital in Slumps and Booms” (JMK.13,
22-4).
The phrase “the
fundamental equations of money” appears for the first time in 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] (JMK.13, 41-42) and [30.6.25]
(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), 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 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 TOC [27.4.26] (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 TOC [14.7.24] and the phrase “bank rate” in TOCs [9.10.24]
and [30.11.24], followed by “the part played by the rate of discount” in 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
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]17. In a
slump, neither the recovery of business sentiment nor the expenditure of public
money raised by taxation alone is 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” (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” (JMK.13, 23).18
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 probably written between September 1927
and September 1928 (Tm/3/2/33). However, not even 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. 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.
In this controversy he took a “very ambiguous” position.
Barkai (1993, 2) summarizes it as follows:
“Until the Genoa Conference (1922)
and beyond, he explicitly accepted the return to prewar parity. Later,
realizing that his ‘managed currency’ notion, advanced in A Tract on Monetary Reform … (132-40, 147-54), was not practical
politics, he accepted a return to parity as a reasonable policy target. What he
objected to in the final stage of the debate was … the proposed timing”.
In The
Economic Consequences of Mr. Churchill (1925 in Keynes, 1931)19
he argued that the return to the Gold Standard at old parity (which means 10
percent appreciation) together with tight monetary policy would do some harm to
the British economy. The solution he favored was a uniform
reduction of wages by agreement.
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 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 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 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 TOC
[31.8.26] (JMK.13, 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: he advocated an increase in the level of
employment by means of public investment and import controls, and pointed up the
difficulty of increasing the level of employment with a cut in (or ‘by
cutting’) money wages.
E. The Development of the Fundamental
Equation(s)
The most effective method of theoretically
distinguishing the Tract from the Treatise is to examine how the “fundamental
equation(s)” are dealt with.
a. The Transaction Approach
What was described in TOCs [26.5.26] (JMK.13, 44), [6.8.26] (JMK.13, 45) and [31.8.26] (Tm/3/2/28) as
“the
fundamental equation of price”20 first took (??) took the form of (??) “the
fundamental equations of price” in TOC [23.5.27] (JMK.13, 47). What characterizes them is that the equation(s) are
developed along Fisher’s Transaction Approach21, for the elements of
the “fundamental
equation” are 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” enumerated as “the first
and second” equations, in TOCs [2.6.27] (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.22
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” (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.23
Let us call the first two, probably written
between September 1927 and September 192824 (Tm/3/2/29-30 and 33-36),
TOC (1) and TOC (2).
TOC (1)25 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. 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 began 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 TOCs [6.10.28]
(JMK.13, 78-82) and [2.8.29] (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 TOCs [4.9.28] (Tm/3/2/37-38), [6.10.28], and [2.8.29]. In 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” (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”.
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”.26
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 consumption goods.
All the TOCs from [6.10.28] onwards place the
main emphasis on the fundamental equation in terms of monetary factors27,
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 1929 Michaelmas lectures were
delivered along the galley for TOC [2.8.29].
In his letter to Keynes (29 September 1929,
Tm/1/2/42), Kahn wrote that:
“… the
modification in the treatment of the Fundamental Equations that you have now
introduced right at the outset carry, ... big advantages”.
Kahn must refer to “the
modification” of the fundamental equation “for the
purchasing power of money” (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 can also know from Robertson’s letter to
Keynes (5 December) that Keynes seems to refer 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 ....” (JMK.13, 118-9).
Taking this into consideration, the first
fundamental equation possibly came into being, in some form or another, after TOC
(2.8.29).
The preface dated 1 September 1929
(Tm/3/2/56-60) 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 for Keynes’s theoretical
situation in early 1930 is the evidence he submitted in February-March 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).
It is also clear, however, from Keynes’s
letter to Kahn (18 March. 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).
“… 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. … [I]t brings out much more definitely what is
in my mind” (JMK.13,
135).
F. Robertson’s Influences
Keynes had ongoing discussions with
Robertson regarding Robertson (1926)28 in the making. Initially, as
his 28 May 1925 letter29 to Robertson (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)]30 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 TOCs [4.9.28] (Tm/3/2/37), and [6.10.28]
(JMK.13, 79) and [2.8.29] (JMK.13, 114) only as a “Digression”.
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.31
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 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.32
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” (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” (JMK.13,
117).
“I
have now definitely decided to make it a two volume book” (Tm/1/3/107).
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 … / At the moment, I have finished the revision of
the first volume and about half of the second volume” (Tm/1/3/109).
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.33
It was Hawtrey who appeared as a critic at
this stage. On 23 April 1930 (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/1/2/89).
Hawtrey responded to Keynes with long critical
notes34 on 7 and 9 July, the most important source on the end of
April: we see the formulation of the second fundamental equation 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 … produces a tendency to a reduction of output, this has not been … and is not likely to be … a contributory cause
of actual epidemics of unemployment” (Tm/1/2/116).
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 Vol. 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” (Tm/1/3/11).
On 18 July 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” (Tm/1/3/115).
In
the preface dated 14 September, Keynes says:
“…there is a good deal in this book which
represents the process of getting rid of the ideas which I used to have and of
finding my way to those which I now have” (TM.1,
p. xvii).
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 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 (i.e. movements
in investment and saving??) on these elements (i.e. the importance of the bank
rate and movements in investment and saving??). 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 yet wider.
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. 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 states in (TMR, 63) 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).
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, 230) argues that
the Treatise can, “… be explained
along ‘externalist lines’”, while “the General
Theory must …be understood in ‘internalist’ terms”.
6) See TM.1,
176-7.
7) Keynes (1914) reviews it critically,
although he evaluates Part III positively.
8) Keynes was profuse in his acknowledgements
to Robertson, referring to him as “my grandfather” (Keynes (1937). JMK.14, p.202, n.2). See also his letter
to Robertson [13 December 1936] (JMK.14,
p.94).
9) 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.
10) Laidler (1990) appraises the Treatise’s portfolio selection theory as
making good the defect of neo-classical monetary economics.
11) 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).
12) 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.
13) This means a dichotomy between Keynes as
a commentator and Keynes as a theorist. See a “publicist” and an “economist” in
Clarke (1998, 71), and Bridel (1987, 96).
14) “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.
15) 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”.
16) See Skidelsky (1992, 281).
17) In his letter to Lydia [31 Oct. Hill and
Keynes, 1989, 245] Keynes said: “The conversation with Sraffa about Credit
Cycle has made me very eager to begin writing my book”.
18) Robertson stressed fixed capital. See
his comment on Keynes’s draft (JMK. 13, 26).
19) Keynes’s stance as a ‘Monetary Reformer’
is clearly expressed, for example, in “The Problem of the Gold Standard” (NA, 21 March 1925).
20) 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).
21) Possibly Keynes used the Transaction Approach in terms of the short
run, for he argues ‘the variability of [the equation’s] elements’ (Tm/3/2/23;
26).
22) Beside this, Fisher has a “transitional
periods” theory.
23) See Moggridge (1992, 441-2).
24) Patinkin (1976, 28-9) estimates that
the fundamental equations may have appeared in the latter half of 1928.
25) Chapter 1, Book IV seems to be related to
a memo (Tm/2/342-3).
26) See also the expression, “(Earnings
minus Savings) / (Output minus Investment) = Price Level” (undated,
Tm/3/2/86), substantially similar to the first fundamental equation.
27) 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).
28) For “Keynesian parallels” in Robertson
(1926), see Fletcher (2000, Chapter 21). For the collaboration between Robertson and Keynes in the 1920s, see
Presley (1992, 88-90).
29) See also Keynes’s letter to Lydia [18 May. Hill and
Keynes, 1989, 325], which shows he did not like the proof sheets of Robertson
(1926).
30) On Keynes’s
collaboration concerning Robertson (1915) in the making, see Presley (1992,
82-85).
31) See Robertson
(1928) and Bigg (1990, 175-6).
32) For this divergence, see Presley (1992,
90). For Robertson’s criticism of the General
Theory, Presley (1992, 93) is to the point. Also see “Notes on
the Definition of Saving” (esp. JMK.13,
287-8).
33) The material which concerns the Treatise’s Chapter 37 survives in
Tm/2/246-75.
34) For this
impact on Keynes, see Deutscher (1990, 102-5). Keynes’s rejoinder was made on
28 November 1930 (Tm/1/4/14-54).
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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
* Faculty of Economics, Sophia
University , Tokyo La
Sapienza », Italy, in January 2004; the Annual Conference of
the European Society of the History of Economic Thought, Venice=Treviso, Italy,
in February 2004; Prof. Richard Arena’s seminar, the University of Nice-Sophia,
France, in March 2004; Prof. Don Moggridge’s workshop (which Profs. D. Laidler
and O. Hamouda attended), the University of Toronto, Canada, in April 2004, and
the Annual Meeting of the History of Economics Society, Toronto
anonymous referees.
