Chapter IV OVERTURE

1. “Effective Demand”

Chapter 3 of the General Theory bears the impressive title, “The Principle of Effective Demand,” but the title gives a wrong impression of its contents. Its function in Keynes’s book is rather like that of an overture to a light opera, in which the composer weaves together and writes variations on the principal themes that are to follow.

The chapter consists of three sections. The first two are technical and “scientific,” the third gay and satiric. As the whole chapter merely foreshadows what is to be unfolded in detail in the following pages, we need not make a lengthy analysis of it here. But as the first two sections purport to present “the essence of the General Theory of Employment,” some general comments seem called for.

The whole of the General Theory might be described as an exercise in obfuscation, and the obfuscation begins at an early point. L. Albert Hahn has compared the reading of Keynes to watching “a sort of trick film. Everything happens in a manner that is exactly the opposite of what [the non-Keynesian] is used to.” ¹

The comparison is apt. Keynes is constantly reversing cause and effect, putting the cart before the horse. “Entrepreneurs,” he tells us, “will endeavor to fix the amount of employment at the level which they expect to maximize the excess of the proceeds over the factor cost” (pp. 24-25).

Now this statement is not flatly untrue; but it is certainly a misleading way of describing what happens. Entrepreneurs do not “endeavor to fix the amount of employment” at any preconceived “level.” Each entrepreneur is trying to make a profit by producing and selling a certain product. The product having been decided upon, he then decides what sort of factory to put up, what sort of equipment to install, what raw materials to order, and what particular kinds of labor to employ. His decision regarding his total output will depend in part upon the amount of capital he can raise and upon his estimate of comparative gross receipts and costs. In determining the relative amounts of equipment he will buy or labor he will hire, he will be guided by the prices of the first and the wage-rates of the second; his proportions may vary depending upon this price-wage relationship. As a result of this complex of decisions, a certain number of workers of different kinds will be hired. But this is simply one of the consequences of the total complex of decisions. Entrepreneurs are certainly not “endeavoring to fix,” in advance, any given “level” of employment. The amount of employment is not their object; it is merely incidental to their object.

If the foregoing sentence from Keynes had existed in isolation, it would not be worth all this discussion. But Keynes repeatedly and chronically describes the matter in this way. His mathematical equations implicitly take for granted that entrepreneurs think in this way and decide the amount of employment they will provide. His equations also often seem to imply that all entrepreneurs are organized as a monopoly. This way of thinking and of stating the case, in fact, seems to be essential to his theory.

And Keynes launches early upon a great deal of quite unnecessary and merely confusing algebra, which he makes still more confusing by the use of symbols which have no simple and natural connection with the thing they symbolize. In fact, it may be doubted whether this algebra is either appropriate or valid as applied to the loose abstractions with which Keynes deals.

The first equations in his book occur on page 25:

Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = ø(N), which can be called the Aggregate Supply Function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being D = f(N), which can be called the Aggregate Demand Function.

As “aggregate supply price” in this context merely means aggregate cost or marginal cost, this paragraph could have been simply written, without any mathematical ostentation, about as follows: “The total cost of producing a given output will vary with the number of men employed, and the proceeds that entrepreneurs expect to receive from the sale of that output will also vary with the number of men employed.”

Roughly speaking, this may often be true. But Keynes, by putting his statements into the form of mathematical equations, affects to be speaking precisely. To assert, in a mathematical equation, that one quantity is a function of another, is to assert that, at least within a specified range of values, there is always a precise, determinate, and predictable relationship between the two quantities. I choose a definition from the nearest algebra text on my shelves: “If a variable y is related to a variable x in such a way that each assignment of a value to x definitely determines one or more values of y, then y is called a FUNCTION of x.” ² (My italics.)

As soon as we apply rigorous standards, Keynes’s equations simply fade away. Is there a constant, precise, determinate, and predictable relationship between the number of men a manufacturer employs and either his costs or his gross receipts? Obviously not. Both his costs and his receipts will depend, not merely upon the number of men he employs, but upon the quality of the individual men and the nature of their skills. His costs will depend not only upon the individual and total wage-rates he pays, but upon his plant, the equipment he installs, the raw materials he buys, his transport costs, and the changing prices of all of these. His receipts will depend upon the changing prices he gets for his output. The price he pays for raw materials may change in relation to the price he gets for his finished product, and the prices he pays or gets will constantly change in relation to the wage-rates he has to pay. Changes in relative costs, or technical progress, may constantly alter the relationship of the number of men employed to the total product. In short, any relationship between payrolls and total costs on the one hand, and payrolls and expected gross receipts on the other, will exist only for an instant of time. There is no assurance whatever that any change in the number of men employed—i.e., any change in N—will mean any precise or predeterminable change in either Z or D.

Many other things are wrong with Keynes’s formulation, besides its mere invalidity. No manufacturer says to himself: “I shall hire N number of men, and this will give me total cash costs of Z and total cash receipts of D.” He begins the other way round. He begins by deciding either how much money he can afford to lay out, say Z, or how much of a product he could make or sell, getting receipts of D. And then he decides how many men he will need or can afford. So if a functional relationship could be posited at all, it ought to be the converse of the one posited by Keynes, and N would be, say, a function of D or a function of Z.

There are further difficulties with the formulation. Z is apparently defined as a real sum, and N is certainly defined as a real sum, but D is defined merely as an expectation. “Let D be the proceeds which entrepreneurs expect to receive from the employment of N men.” No doubt expectations concerning the future, if reasonable, can bear a rough relationship to present realities. But can we posit a constant, determinate, or precise relationship of expectations to realities? Can we put expectations into a meaningful mathematical equation?

If Keynes, here or elsewhere, used the word “function” as a mere figure of speech, we might let it pass. But to put these alleged relationships solemnly into the form of an equation, without attempting to support this equation with any rigorous deductive argument, or any appeal to statistical confirmation, or anything but a bald dogmatic ipse dixit, is another matter.

Moreover, Keynes continues: “The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.” (His italics, p. 25.) But as D has been defined as “the proceeds which entrepreneurs expect to receive,” surely this should be called only the expected effective demand. If it is merely expected, it can hardly be called “effective.”

The whole term “effective demand” is today either nonsensical or confusing anyway. Modern economists do not need the adjective “effective” in front of “demand.” Demand is effective by definition. If it is not effective, it is not called demand but need, desire, wish, or longing. The word “demand” implies the requisite desire along with the requisite purchasing power. If Keynes meant aggregate demand, then that is the adjective he should have used and stuck to. If he meant aggregate monetary demand or aggregate monetary purchasing power, then these are the terms he ought to have used when this was what he meant.

The confusions in his terminology merely compound the confusions in his thought. Immediately after the equation and the definition I have just quoted, Keynes tells us: “This is the substance of the General Theory of Employment” (p. 25). And on the baseless fabric of this vision are all his cloud-capp’d towers built!

This invalid equation is part of Keynes’s “disproof” of Say’s Law.

The classical theory assumes [he writes] that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price.... Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment (p. 26).

This passage misstates both “classical theory” and the substance of Say’s Law. Classical theory ³ does not assume that demand price (aggregate or otherwise) “always” accommodates itself to (aggregate) supply price. Neo-classical theory asserts that under conditions of equilibrium, such-and-such consequences or corollaries follow. But it does not assert that conditions will necessarily be in equilibrium. It does assert that under conditions of free competition, with flexible and fluid prices and wages, there will always be a tendency toward equilibrium. Say’s Law, of course, does not declare, either actually or by implication, that “there is no obstacle to full employment.” It does declare that the only obstacle to full employment is lack of equilibrium somewhere.

2. The Propensity to Consume

The second section of Chapter 3 gives us our first introduction to “the propensity to consume.” This is the proposition that: “The psychology of the community is such that when aggregrate real income is increased aggregate consumption is increased, but not by so much as income” (p. 27).

There will be plenty of time later for full analysis of this curious proposition, about which there has been so much ado, but one or two observations may be made here. By speaking of the “psychology” of the community, and by using the slightly contemptuous term “propensity,” Keynes manages to insinuate the notion that the way people spend their incomes is essentially non-rational or irrational.

It will also be noticed that his proposition is vague, and open to several different interpretations. If the community, as it grows richer, spends the same proportion of its income on consumption, then of course consumption will not increase by the same absolute amount as income; but the difference will presumably be made up by the same proportional increase in investment. If the community, as it grows richer, spends a smaller proportion of its income on consumption, then of course it must spend a larger proportion on investment. But Keynes never tells us unequivocally which, or what, he means. In drawing inferences from his “psychological law,” he goes on to declare: “Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level” (p. 27).

Here is a truism introduced under the guise of a great discovery. Naturally if we divide all spending under a full-employment equilibrium into two kinds—“consumption” and “investment” spending—there must be sufficient “investment” spending to make up the difference between “consumption” spending and total spending if we are to have full employment. But this portentous discovery could be applied not only to “investment” but to anything whatever. If we divide the amount of spending necessary for full employment into spending on everything else but beer, plus the spending on beer, then full employment depends on the amount spent on beer. Or, putting it into the same Keynesian phraseology as that quoted above: “To justify any given amount of employment there must be an amount of beer consumed sufficient to absorb the excess of total output over what the community chooses to spend on everything else but beer when employment is at the given level.” And you can also put all this into an impressive set of mathematical equations.

(I may anticipate later discussion here by pointing out that the difference between “consumption” and “investment” is at least to some extent arbitrary, and not at all as clear-cut as Keynes sometimes makes it out to be. Is the purchase of a house a consumption expenditure or an investment? If you buy it as a home it is considered a consumption good; but if you buy it to rent to somebody else it is an investment. This would apply as well to an automobile or a power mower. “Consumption” and “investment” goods are not necessarily different kinds of goods: they change their nature with their state of processing, whose hands they are in, or the changing purposes of their owners.)

Having made his great division between “consumption” and “investment” goods, Keynes proceeds to build the whole of Keynesian economics upon it. He sums this up in the following paragraph (on p. 28) and in a series of eight propositions on the next page. These two pages might be called the heart of Keynesian economics. As I have already stated, the propositions will be analyzed at length in the following pages; but as this is our first acquaintance with them, we may make some preliminary remarks.

“Given the propensity to consume,” he begins, “and the rate of new investment, there will be only one level of employment consistent with equilibrium” (p. 28). The independent clause in this sentence would be completely true, especially without the dependent phrases. There is only one level of employment consistent with full equilibrium, and that is full employment. This is true by definition. If there is unemployment, there must be disequilibrium somewhere. When Keynes writes: “The effective demand associated with full employment is a special case, only realized when the propensity to consume and the inducement to invest stand in a particular relationship to one another” (p. 28), he is either resorting to inexcusable mystification or he is writing nonsense. With equilibrium there is always full employment.

We could, of course, write the foregoing sentence from Keynes like this: “Full employment is a special case, only realized when there is full equilibrium, which in turn is only realized when consumption and investment are together sufficient to provide full employment.” This would be true, but it would all be true by the very definition of our terms. We would only put the statement in that form as a sort of joke, as if one were to say: “A week is a special case, only realized when it contains just seven days, no more and no less, in succession.”

Equilibrium, in short, exists only when the conditions of equilibrium are fulfilled. One of those conditions is full employment. And full employment always exists when there is equilibrium.

When Keynes speaks, therefore, as he does here and elsewhere, of “equilibrium” with underemployment, he is talking nonsense. This is a contradiction in terms, like talking of an orderly chaos or a triangular circle. When Keynes speaks, in short, of an “equilibrium” with unemployment, he is not really speaking of a position of equilibrium at all, but of something quite different. He is speaking of a frozen situation, a frozen disequilibrium, a situation in which some price, interest rate, or wage-rate, or many prices, interest rates, and wage-rates, are prevented, either by contract, labor-union resistance, or government intervention, from adjusting to an equilibrium level.

This flagrant misuse of terms is one of the central fallacies of the whole Keynesian system. When this misuse is recognized, his whole system collapses.⁴

All this is not to argue—as Keynes sometimes likes to pretend the neo-classical economists do argue—that unemployment or disequilibrium is impossible, or even that full employment or full equilibrium is the usual state of affairs. On the contrary, the best neo-classical economists have always recognized that completely full employment or perfect equilibrium is never a fact, any more than perfection in any human condition.

The concept of “equilibrium” is primarily an economist’s methodological tool of thought. Nor because perfect equilibrium is never realized in practice can this be dismissed as a useless tool of thought. An engineer speaks of a frictionless engine or one of 100 per cent efficiency, realizing quite well that no engine is frictionless and no machine 100 per cent efficient. But he needs these concepts as bench marks, standards, tools of thought. A mathematician deals conceptually with points without dimensions and lines without thickness, though the points and lines in his textbook do have dimensions and thickness or they could not be seen. The mathematician finds it highly valuable, and even indispensable, to use concepts of “irrational” numbers and “imaginary” numbers—such as the square root of minus one —the reality or rationality of which he may find it embarrassing to explain.

The economist too finds logical difficulties when he tries to think through the concept of perfect equilibrium. But such difficulties are encountered with nearly all the leading concepts of economics: “perfect competition,” “full employment,” “a stationary economy,” “supply curves,” “demand curves,” etc. It is not my purpose here to discuss the merits of any particular concept. But most of those just named are useful and necessary tools of thought. The concept of equilibrium is indispensable, either for so-called “static” or so-called “dynamic” theory. The error comes either when “equilibrium” is thought of as an existing fact, or ridiculed merely because it is not an existing fact. What is real is an ever present tendency toward equilibrium. Equilibrium tends to be more and more closely and quickly approached in proportion as competition, prices, and wages are fluid and free.

Keynes’s error lies in using the word equilibrium in two quite different senses, one of which is entirely invalid. This is the confusion of “equilibrium” with a situation that for one reason or another is merely frozen, such as prolonged mass unemployment because of a prolonged maladjustment between prices of different commodities, or between individual wage-rates, or most often between prices and wage-rates. All of Keynes’s propositions and deductions on pages 28-31 are the result of a misconception or misstatement of neo-classical theory.

We need not, therefore, try here to disentangle the errors in detail. But one general comment should be made. Keynes absurdly talked as if no classical economist had ever heard of panics, depressions, or unemployment. Of course the assumptions of static equilibrium, or the assumptions of a “stationary economy,” are not in themselves sufficient to deal with business cycles. But they are necessary methodological pre-conditions for the understanding of business cycles. Unless we understand “static” assumptions, we cannot understand “dynamic” assumptions.

3. Derision of Thrift

In Section III of Chapter 3 Keynes really lets himself go for two and a half pages (32-34). There is, strictly speaking, no argument here—merely derision of the classical economists and of whatever they happened to think was an economic virtue. I quote some of his sentences seriatim, in separate paragraphs, followed by my own counterstatement.

“Ricardo conquered England as completely as the Holy Inquisition conquered Spain.” The Inquisition conquered Spain by force and torture; the only force Ricardo used was the force of logic. If we bring Keynes’s comparison up to date, we shall have to say that Keynes has conquered the present Anglo-American academic world, and the present Western political world, almost as completely as Marx has conquered Russia and China.

“Not only was [Ricardo’s] theory accepted by... statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed.” This has almost been the fate today, alas, at least in the universities, of non-Keynesian economics.

“The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment.” It was provincial of Keynes to treat his Cambridge teachers as representing the highest point reached by economics prior to his own emergence. After all, among his predecessors, there were Menger and Böhm-Bawerk in Austria, Walras in Switzerland, Wicksell in Sweden, John Bates Clark and Irving Fisher in America, and Jevons and Wicksteed in his own country. And among Keynes’s contemporaries such figures as Mises, Hayek, Anderson, Knight and Röpke were carrying the logical rigor and unity of economics much beyond the point where Marshall had left it.

“It [the great puzzle of Effective Demand] could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.” “Economic underworld” is a felicitous description of this literature. But Keynes seemed to imagine that his avowed association with it would suddenly make it respectable.

“The completeness of the Ricardian victory is something of a curiosity and a mystery.” Far less of a mystery than the completeness of the Keynesian victory. The Ricardian system, at least, had an elegant self-consistency; it was logical within its assumptions, within its limited frame of reference; and it did not hopelessly confuse, as the Keynesian system does, short-term effects with long-term effects, or “static” theory with “dynamic” theory.

“It [the completeness of the Ricardian victory] must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected.” As the Keynesian victory must have been due to the political environment of 1936?

“That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige.” Keynes certainly reached conclusions quite different from what the ordinary uninstructed person would expect—for instance, that saving is a sin and squandering a virtue. And perhaps this had added to its current intellectual prestige.

“That its teaching, translated into practice, was austere and often unpalatable, lent it virtue.” The “virtue” of Keynes’s teaching is that it praised thriftlessness, reckless spending, and unbalanced budgets and was therefore extremely palatable to the politicians in power.

“That it was adapted to carry a vast and consistent logical superstructure, gave it beauty.” This is true. As much, unfortunately, cannot be said for Keynesian economics, which is jerry-built and inconsistent, without economy or elegance.

“That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority.” As Keynes’s doctrine of government spending, artificially low interest rates, and printing-press money commends it to present-day political authorities?

“That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.” This is pure Marxian demagogy, which attributes beliefs to discreditable motives rather than to disinterested logic. A reply in kind might be that the popularity of Keynes’s theory in academic circles reflects the poorly paid academician’s envy of the successful businessman.

“But although the [Ricardian] doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners.” The implied claim that Keynesian economics can make possible “scientific prediction” of future business fluctuations is pure claptrap. No system of economics can do this. The most that any economic reasoning can do is to say that such-and-such conditions, if they existed in isolation, would tend to have such-and-such results.⁵ The Ricardian system, for all its shortcomings, did this much better than the Keynesian system. Forecasts based on Keynesian theory have had a pathetically bad record.

“For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation.” This “lack of correspondence” existed mainly in Keynes’s mind. Keynes never troubled to compare his own theory with “the facts of observation.” As we shall see later, he was fond of making sweeping statements, not only without any attempt at statistical proof, but even where statistical proof already existed of their “lack of correspondence” with “the facts of observation.”

The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand.

Keynes here allows his own rhetoric to carry him so far away from reality that it is hard to know where to begin in dissecting the passage. First of all, traditional economic theory was not celebrated in the popular mind for optimism but for pessimism. Carlyle’s famous epithet, “the dismal science,” sums up the popular nineteenth-century judgment of the economic theory of the day. Malthus’s “laws of population” were thought to condemn the world to eternal existence at the merest subsistence level for the masses of the people. Ricardo’s so-called “iron law of wages” (never his own description) was thought to make improvement in real wages impossible, at least without a slow increase in the “wages fund.” Still again, it was not Candide who was the incurable optimist of Voltaire’s blistering novel, but Pangloss; and Candide did not decide to cultivate his own garden until after his optimistic illusions had been completely shattered. Finally, the neo-classical economists never assumed prosperity and full employment except on the assumption of equilibrium. They did not assume that there was always equilibrium, but they did assume that there was a constant tendency back to equilibrium, however much disturbed, as long as competition and free prices and wages prevailed.

For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does is to assume our difficulties away.

This passage merely shows that Keynes did not understand what the neo-classical postulates really were. It is because the labor unions and the politicians intervened to prevent the self-adjustments that would otherwise have taken place in the economy that prolonged mass unemployment and underemployment of resources occurred. Keynes blamed on the “classical postulates” the very stagnation caused by policies based on the Keynesian postulates.

For the Keynesian postulates and the Keynesian policies existed years before Keynes approved and tried to systematize them in the General Theory. They were, as we shall see, simply the old, old postulates and policies of inflationism (building up to an inevitable crash), government restrictionism, government “price-stabilization” policies, and wage-rates inflexible in the downward direction. The flexibility of wages, prices, and markets postulated by the neoclassical economists was prevented; and then the consequences were blamed on the neo-classical economics.

¹Common Sense Economics, (New York: Abelard-Schuman, 1956), p. ix.

² Gerald E. Moore, Algebra, (New York: Barnes & Noble, 1956 edition), p. 50.

³ It is often difficult to know precisely how to treat Keynes’s terminology. When he speaks of “classical” theory he usually means what it would be more accurate to call neo-classical theory or, still more specifically, Marshallian or Pigovian theory. He seldom means modern subjective-value theory, the existence of which he most often prefers to ignore. Still less does he consider the actual divergence of theories among economists. Is it in order to be considered original that he tries to lump all other views than his own under the common epithet “classical” or “orthodox”? It would be tedious, however, to pick him up each time on his misuse of terms. I shall try to economize the reader’s time by accepting some of his terms, after filing the requisite caveat on their first appearance, in order to get on with the analysis.

⁴ Sir William Beveridge, writing in 1931, stated the “classical” position as it was clearly understood before the Keynesian obfuscation: “Demand and supply in the long run are adjusted and production is directed only by movements of prices; if what should be flexible in the economic system is made rigid, there comes disequilibrium and a breaking strain. Is not that what is happening with labor and its prices in Britain today—a rigidity of money wages out of accord with economic conditions, leading to incurable disequilibrium?” Tariffs: The Case Examined (London: Longmans, 1931), p. 240.

⁵ For the reasons why economic forecasting cannot be “scientific” see Ludwig von Mises, Human Action, 1949, pp. 649, 866-868.