16. Continental European Pre-Keynesianism

In contrast to most of his followers, Keynes was well aware that his ideas were not entirely original. Every age has brought forth a crop of books on “easy money,” having in common the thesis that economic disturbances, especially unemployment, are caused largely by monetary maladjustments and can be corrected by monetary measures. Keynes himself points out in his General Theory the merits of the Mercantilists.

When a young man I read with great interest a book called The Gold Craze,¹ written by an American living in Germany, which anticipated the arguments in favor of a domestic easy-money policy and of external devaluation. It was considered the product of a crank and went more or less unnoticed by economists.

Another precursor of Keynes was the “unduly neglected prophet, Silvio Gesell,” ² the proponent of Schwundgeld (vanishing money). Gesell’s book, Die Verstaatlichung des Geldes (1891), was well known in continental Europe, especially in Switzerland. But despite wide propaganda by clubs formed to spread his theories, it was not taken seriously either. The proposition that depressions could be postponed indefinitely by keeping money rolling through fear of its depreciation rather than by correcting maladjustments seemed too absurd.

Keynes could have discovered an even closer spiritual relative in his contemporary, Gottfried Feder, who promised full employment through Breaking the Slavery of Interest.³ The Nazis, before they came to power, used his theories in their campaign against democracy and the free enterprise system, but afterwards threw him out of his high office, recognizing that, if put into practice, his theories would immediately ruin the Reich’s currency and credit.

Furthermore, my own Volkswirtschaftliche Theorie des Bankkredits, containing essential parts of Keynes’ ideas, appeared as long ago as 1920. Influenced by it, a whole crop of easy-money books sprouted on the Continent. However, the counterarguments advanced during the next decade⁴ were so convincing that in my third edition I modified my theory in essential respects.

As I think it rather important to show that the arguments against my theory apply also to Keynes’, I have tried to demonstrate that the basic ideas of my Volkswirtschaftliche Theorie des Bankkredits were in substance, if not in form, very similar to those of his General Theory. To this end I have summarized what I consider essential and common to the two theories, supplementing each statement by quotations of some characteristic passages from the two books. Many other passages that show similarities can, incidentally, be found in the two books.

THE CONSUMPTION DEFICIT

1. Employment and production are dependent upon demand, but demand is not automatically created by production or employment. A consumption deficit threatens when employment increases, because part of the larger income is saved (Keynes’ “psychological law”).

Hahn, p. 148:

“The smaller consumption has its origin in the psychological attitude of the member of the economy: a worker, an industrialist, a business man is not inclined to spend more just because he earns more. The conservatism inherent in all his social activities, and above all, in his living standard, keeps his consumption constant within certain limits. A man does not consume more simply because he produces more. He does not, to be sure, forego remuneration for his activity but he demands it in another form, namely, in the form of means for future spending. The desire for consumer goods to raise the current living standard is replaced by the desire for means of hoarding and saving to ensure the future living standard. As soon as their wants are covered to a certain extent, people begin to feel, so to speak, mercantilistic rather than physiocratic.”

Keynes, p. 97:

“But, apart from short-period changes in the level of income, it is also obvious that a higher absolute level of income will tend, as a rule, to widen the gap between income and consumption. For the satisfaction of the immediate primary needs of a man and his family is usually a stronger motive than the motives towards accumulation, which only acquire effective sway when a margin of comfort has been attained. These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases. But whether or not a greater proportion is saved, we take it as a fundamental psychological rule of any modern community that, when its real income is increased, it will not increase its consumption by an equal absolute amount, so that a greater absolute amount must be saved, unless a large and unusual change is occurring at the same time in other factors.”

p. 98:

“This simple principle leads, it will be seen, to the same conclusion as before, namely, that employment can only increase pari passu with an increase in investment; unless, indeed, there is a change in the propensity to consume.”

2. An increase in income leads to an absolute increase not only in saving but also in the proportion of the income saved, i.e., in the saving-income ratio (Keynes’ “psychological law” in its stronger form⁵).

Hahn, pp. 153-54:

“Credit expansion accelerates as well as increases the building up of savings accounts. . . . Credit expansion not only builds bigger savings accounts but builds them faster.”

Keynes, p. 127:

“. . . the marginal propensity to consume falls off steadily as we approach full employment.”

THE INVESTMENT GAP

1. The consumption deficit can be harmful because the purchasing power withdrawn by saving does not necessarily come into the hands of entrepreneurs seeking funds to invest.

Hahn, p. 147:

“The argument that every production leads automatically to a corresponding consumption appears incorrect if the producers of consumer goods save their purchasing power and if the resulting purchasing power deficit is not always automatically made up by the granting of new credits by banks.

“If, concerning the reasons for depressions and crises, we return to Malthus’ ideas, we see that the stagnation on the market for goods that occurs in the course of the boom phase of a business cycle is due to the fact that the purchasing power of working individuals, which normally comes back to the entrepreneur in the form of demand, no longer finds its way back to him. Checking accounts are transformed into savings accounts, are ‘consolidated,’ and no longer cause demand on the markets for goods.”

Keynes, p. 165:

“But the notion that the rate of interest is the balancing factor which brings the demand for saving in the shape of new investment forthcoming at a given rate of interest into equality with the supply of saving which results at that rate of interest from the community’s psychological propensity to save, breaks down as soon as we perceive that it is impossible to deduce the rate of interest merely from a knowledge of these two factors.”

2. Certain preclassicists, especially Malthus, deserve praise because they saw much better than Ricardo and other classicists that savings can interrupt the flow of demand.

Hahn, p. 147, note 138:

“It is astonishing how clearly Malthus recognized these interrelations. His opponents argued that every saving automatically increases the demand for producer goods: against them Malthus asserted that their chief error lay in the assumption that accumulation automatically creates demand (Principles of Political Economy, Ch. 7, 3d par.). The same holds true today for those who, with the prevailing opinion, assume an absolute dependence of investment on saving.”

Keynes, p. 362:

“. . . in the later phase of Malthus the notion of the insufficiency of effective demand takes a definite place as a scientific explanation of unemployment.”

p. 364:

“. . . Ricardo, however, was stone-deaf to what Malthus was saying.”

INTEREST AND LIQUIDITY

1. Savings are not automatically absorbed by investments because money is essential also as a means of liquidity. Interest must therefore be considered as the price for acquiring and the compensation for parting with liquidity. As lending money entails risks, interest can also be considered as a compensation for taking risks.

In discussing interest and liquidity, Keynes’ argument is phrased almost exactly like mine, except that he attributes the supply of credit to the liquidity preference of individuals, whereas I attribute it to the liquidity preference of banks, for the simple reason that banks are the marginal lenders in an economy.

Hahn, p. 102:

“If the amount of the credit advanced by banks is dependent on their individual liquidity, interest, i.e., the price that has to be paid for the credit, is merely the reward for the loss of liquidity caused by the granting of the credit. From the viewpoint of the bank, interest is the reward for running the risk.”

Keynes, pp. 166-67:

“It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period. For the rate of interest is, in itself, nothing more than the inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time.”

p. 182:

“The mistake originates from regarding interest as the reward for waiting as such, instead of as the reward for not-hoarding; just as the rates of return on loans or investments involving different degrees of risk, are quite properly regarded as the reward, not of waiting as such, but of running the risk. There is, in truth, no sharp line between these and the so called ‘pure’ rate of interest, all of them being the reward for running the risk of uncertainty of one kind or another. Only in the event of money being used solely for transactions and never as a store of value, would a different theory become appropriate.”

2. Liquidity requirements are a highly subjective matter, depending upon confidence and speculation.

Hahn, pp. 59-60:

“. . . the means of banks are determined by the latter’s liquidity. The creation of claims against a bank leads in fact only to the one important consequence that its balance sheet is lengthened and its liquidity impaired.

“However, the actual state of liquidity or non-liquidity is merely a center around which the considerations of the individual bank manager oscillate. For opinions about liquidity are in highest degree subjective. With more or less strong confidence in the future, a higher or lower degree of liquidity will be deemed adequate. The supply of credit offered by banks, which, as shown above, constitutes fundamentally a supply of confidence, depends upon the strength of the prevailing confidence.”

Keynes, pp. 196-97:

“In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income. But it is by playing on the speculative-motive that monetary management (or, in the absence of management, chance changes in the quantity of money) is brought to bear on the economic system.”

p. 148:

“The state of long-term expectation, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast—on how highly we rate the likelihood of our best forecast turning out quite wrong.”

3. Interest rates are in large degree determined conventionally.

Hahn, p. 104:

“The owners of checking and deposit accounts owe their income to historical chance rather than economic necessity. Unlike every other payment in economic life, payment of interest does not serve to stimulate supply. For the owners of checking and deposit accounts would—as the example of England teaches—leave their funds, which they need as a means of payment, in banks even if interest were not paid.”

Keynes, p. 203:

“It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological phenomenon.”

4. The liquidity of even long-term investments can be improved by creating what I have called “indirect liquidity.”

Hahn, pp. 94, 95, 96:

“. . . a special technique of credit granting was gradually developed with the aim of lessening the dangers of the illiquidity inherent in investments. It makes investments, so to speak, artificially liquid by granting them what we would like to call an ‘indirect liquidity.’ . . . The illiquidity of the investment disappears as soon as the assets of the bank need no longer be turned into cash by withdrawal but can be liquidated by sale.

“The chief example of such an indirectly liquid investment is the ordinary commercial bill. . . . Other examples are all transactions that lead to the creation of stocks and bonds.”

Keynes, pp. 150-51:

“Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails today and with the development of organized investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system.”

p. 153:

“Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual.”

INTEREST AND EMPLOYMENT

1. If lack of investment—caused by interest rates too high to guarantee that investments will absorb savings—makes for a deficiency of effective demand, and thereby unemployment, a reduction in interest rates must bring about employment. This is contrary to the classicists’ view; they thought that a reduction in interest rates leads at best to inflation.

Hahn, p. 132:

“Reducing interest rates . . . causes, as will be shown, also increase of production. Thus the argument of the quantity theorists must be wrong; namely, that the lower interest rates achieved by increasing the quantity of money could never raise industrial employment, because more goods could not be bought as prices would be higher.”

Keynes, p. 292:

“If we reflect on what we are being taught and try to rationalise it, in the simpler discussions it seems that the elasticity of supply must have become zero and demand proportional to the quantity of money.”

Hahn, pp. 140-41:

“. . . the opinion of the quantity theorists, shared by nearly all interest, credit, and capital theorists, that money and credit expansion do not increase production, is not only inexact but entirely wrong. By altering distribution, every expansion of credit increases the quantity of goods. Credit creates goods out of the nothingness in which they would have remained unproduced.”

p. 149, note 142:

“Herein lies a further reason why the quantity theory is to be considered merely a quite rough solution of the problem of the relation between the quantity of money and the prices of goods, and why the banking theory, which assumed the automatic elimination of additional and superfluous money, contained a correct kernel. . . . It shows too the validity of the assumption that the level of incomes determines the level of prices. It would be much more correct to say that the level of expenditures is the determinant.”

Keynes, p. 375:

“. . . the extent of effective saving is necessarily determined by the scale of investment and . . . the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment. Thus it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of capital at which there is full employment.”

2. The reason a reduction in interest rates must bring about employment is that it alters the distribution of income in favor of entrepreneurs, enabling them to use additional labor profitably despite its diminishing marginal productivity. The change in the income distribution takes place at the cost of the rentier class.

According to Keynes, the worker too bears a part of the cost, because he can buy less with his wages when prices rise following the credit expansion that takes place after interest rates are reduced. This argument is, to my mind, unrealistic.

Hahn, p. 137:

“As shown above, the expansion of credit has the consequence that through competition of enterprises, expanded in the wake of interest reductions, wages begin to rise. . . .

“To those who have been unwilling to work . . . the value of the wage now appears higher than the value of leisure. They change from ‘marginal non-workers’ to ‘marginal workers’ because the fundamental facts of their valuations have changed. The remuneration offered for work has become greater. And this is really the case and does not depend merely upon a kind of self-deception on the part of the worker due to the nominal increase in wages. To be sure, the increase in labor’s earnings causes the prices of consumer goods to rise because of the larger demand. Nevertheless, the increase in wages is not only nominal but real; for the prices of goods always tend, because of the competition of entrepreneurs, to equal the costs. But as the latter have risen to compensate only for the additional outlays for wages, not for capital, the prices of goods have risen only to this degree, that is, less than wages. There thus remains a real increase in the remuneration paid labor which appears the more important for economic calculation the more one considers that compensation of other participants, although nominally still the same, has been devaluated through the rise in the prices of goods.”

Keynes, p. 290:

“Since that part of his profit which the entrepreneur has to hand on to the rentier is fixed in terms of money, rising prices, even though unaccompanied by any change in output, will re-distribute incomes to the advantage of the entrepreneur and to the disadvantage of the rentier. . . .”

p. 8:

“. . . The supply of labor is not a function of real wages.”

p. 284:

“. . . if the classical assumption does not hold good, it will be possible to increase employment by increasing expenditure in terms of money until real wages have fallen to equality with the marginal disutility of labor, at which point there will, by definition, be full employment.”

3. The limit to increasing employment by reducing interest rates is reached when the labor supply cannot be augmented by further wage increases.

Hahn, p. 145:

“Credit expansion as a means of raising production and consumption, and thereby the well-being of the nation, is effective . . . up to the point where new credit is no longer able to induce new labor forces to enter production, when through wage increases the last reserves have been tapped.”

Keynes, p. 289:

“Consequently, as effective demand increases, employment increases, though at a real wage equal to or less than the existing one, until a point comes at which there is no surplus of labour available at the then existing real wage; i.e. no more men (or hours of labour) available unless money-wages rise (from this point onwards) faster than prices. The next problem is to consider what will happen if, when this point has been reached, expenditure still continues to increase.

“Up to this point the decreasing return from applying more labour to a given capital equipment has been offset by the acquiescence of labour in a diminishing real wage. But after this point a unit of labour would require the inducement of the equivalent of an increased quantity of product, whereas the yield from applying a further unit would be a diminished quantity of product.”

4. The net effect of an increase in effective demand following an expansion of credit is in general twofold: on prices, on the one hand; on production, on the other. For the unutilized reserves of workers give elasticity to modern economy.

Hahn, pp. 135-36:

“. . . in the modern economy . . . the increase in the demand for goods and labor on the part of enterprises whose purchasing power has been augmented by an expansion in credit leads to a rise not only in prices but also in production, to prosperity. . . . One reason is the enormous progress in the techniques of production, especially in the greater use of machines. . . . The other reason is that the modern economy, as a result of this progress in techniques, possesses—in the persons of rentiers, women, and workers willing to work overtime—a tremendous reserve of unoccupied, half occupied, and workers who can be induced to work harder. From this labor reserve the relatively small amount of labor necessary to step up production can easily be won. The two factors together cause the phenomenon that can best be called the ‘elasticity’ of the modern economy.”

Keynes, p. 285:

“Effective demand spends itself, partly in affecting output and partly in affecting price, according to this law.”

p. 296:

“. . . and the increase in effective demand will, generally speaking, spend itself partly in increasing the quantity of employment and partly in raising the level of prices. Thus instead of constant prices in conditions of unemployment, and of prices rising in proportion to the quantity of money in conditions of full employment, we have in fact a condition of prices rising gradually as employment increases.”

GENERAL RECOMMENDATIONS TO COMBAT UNEMPLOYMENT

1. Technological progress tends to reduce prices directly or through the pressure it exerts on wages through labor-saving machinery. To counteract these undesirable by-effects of technological progress, credit expansion is recommended.

Hahn, pp. 139-40:

“In the modern economy, as far as credit is not expanded, a certain number of workers are thrown out of work each year because labor-saving methods of production are constantly being adopted. Furthermore, the urban population is still growing today in modern industrial countries. As the possibilities for work, as such, do not grow as fast as the population, a certain part of the addition to the population becomes unemployed. The excess supply of labor thus created tends to press on wages and thereby also on the prices of goods until, on the one hand, the supply of labor contracts through the elimination of those for whom the lower wages no longer seem an equivalent for leisure; in other words, until ‘marginal workers’ become ‘marginal non-workers.’ . . . Here credit expansion steps in as a corrective and an eminently social factor. It increases the demand for labor, thereby preventing the decline of wages and the prices of goods, and putting to work new strata of workers who, with static credit, would have to remain outside the production process. It thus prevents the raising of the capitalist’s share that would otherwise follow from falling prices.”

Keynes, p. 271:

“In the long period, on the other hand, we are still left with the choice between a policy of allowing prices to fall slowly with the progress of technique and equipment whilst keeping wages stable, or of allowing wages to rise slowly whilst keeping prices stable. On the whole my preference is for the latter alternative, on account of the fact that it is easier with an expectation of higher wages in future to keep the actual level of employment within a given range of full employment than with an expectation of lower wages in future, and on account also of the social advantages of gradually diminishing the burden of debt, the greater ease of adjustment from decaying to growing industries, and the psychological encouragement likely to be felt from a moderate tendency for money-wages to increase.”

2. Employment can be increased either by lowering wages or by expanding credit. In the general case the latter is to be preferred. My statement was, however, much more cautious than Keynes’.

Hahn, p. 141:

“Every expansion of credit increases the quantity of goods. But whether for this reason an expansion of credit is always a boon for a country is not decided thereby. Moreover, whether expropriation of money owners and rentiers is not too high a price for a larger total output can be decided only from certain non-economic viewpoints. The problem, seemingly theoretical, is in reality political.”

Keynes, p. 268:

“Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter.”

RECOMMENDATIONS TO COMBAT CYCLICAL DEPRESSIONS: AN EASY-MONEY POLICY AND GOVERNMENT SPENDING

1. As booms end when demand becomes deficient, new demand must be created. This can be done by making new investments profitable by lowering interest rates, i.e., through an easy-money policy.

Interest rates should be reduced at the top of the boom instead of raised in the traditional way long before the peak; by such a method the boom can be protracted indefinitely.

This is the statement I regret most and the one that aroused most opposition when my book was published.

Hahn, p. 150:

“Since production is hindered by the stagnation of consumption . . . is it possible to induce the entrepreneur to continue production even when he cannot sell goods, so that he produces for stock rather than for consumption?

“Such possibilities exist, at least in theory. One possibility is to grant larger and, above all, cheaper credit, the moment consumption begins to stagnate, so that entrepreneurs will be spurred to continue producing.”

Keynes, p. 164:

“. . . we are still entitled to return to the latter [i.e., the interest rate] as exercising, at any rate, in normal circumstances, a great, though not a decisive, influence on the rate of investment. Only experience, however, can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment.”

p. 322:

“Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”

2. If, despite lower interest rates, demand is not created, the government must and can replace private demand by public spending.

Hahn, p. 151:

“The other way to continue production in an economy and have its results stored, despite lack of consumption, is to have the results of production that are ready for consumption taken over by a large scale buyer. This way, however, is open only if the buyer, who would of course need immense amounts of credit, enjoys the privilege of not having to pay interest. Otherwise he would be unable to ‘hold’ the goods.

“Such a privileged debtor exists in every economy in the person of the government. For although the state has to pay interest on its loans, it can transfer the burden to the taxpayer, so that it practically enjoys credit without charge; and, in any case, does not have to calculate the interest burden as a cost in the way an ‘economic’ subject must.”

Hahn, p. 136, note 125:

“Had houses, means of transportation, and labor-saving machinery been built, with the same methods of financing, instead of war materials, the golden age would have dawned through the ensuing abundant satisfaction of every demand.”

Keynes, p. 164:

“ I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.”

RECEPTION AND INFLUENCE OF MY BOOK IN CONTINENTAL EUROPE

The reader may not feel that Keynes’ and my theories coincide as closely as I feel they do. To me, the similarities evident in the above quotations are amazing, especially in view of the fact that my book was written sixteen years before Keynes’, in another tongue, in another economic environment, and before the demand-supply-curve language was as entrenched as it is today. One is struck by the similarity of the gist of the two books. Consider, for example, that the leitmotif of Keynesianism—that it is better to produce nonsense than nothing—which led him to praise pyramid-building,⁶ can be found in my book where it is expressed as follows: “The time that passes without production and is thus unused can never be recouped,” and “The saying ‘time is money’ is applicable also to the wealth of nations.”⁷

Incidentally I have never been able to understand why Keynes did not quote my work in his General Theory although there is no doubt he knew it, for he quotes me in the German translation of his Treatise on Money⁸ when he refers to the approach of German scholars to the savings-investment problem.

As mentioned above, my theories were widely discussed in business and academic circles. A second edition of my Volkswirtschaftliche Theorie des Bankkredits had to be published in 1924, and a third in 1930. As in the case of Keynes’ General Theory, opinions about my book went to extremes of approval and disapproval. Some critics, especially older men, dubbed it the height of scientific nonsense, cynicism, and carelessness; in short, just a bluff. The great economist and statistician Bortkiewicz, for example, was very hostile. Others, especially younger students, looked upon it as an entirely new discovery of immense theoretical and economic-political importance. To my followers—for instance to Hans Honegger, author of Der schöpferische Kredit, 1929—there seemed no limit to what credit and monetary expansion could achieve. When their publications came to my notice, I wrote, paraphrasing the exclamation from Schiller’s Wallenstein that I quoted in an early chapter of this book: “God defend me from my friends; from my enemies, I can defend myself!” Compared with what some of Keynes’ followers in this country advocate, however, these recommendations seem highly conservative and orthodox.

I am now of the opinion that my ideas, as expressed in the first and second editions of my book—and consequently also the corresponding ideas of Keynes—are bad economic theory, leading to fatal economic policy, mainly for the reasons developed in the preceding chapters in this book. To a certain degree I had already taken them into account in my third edition.

The development of money and credit theory on the Continent during the ‘thirties might be summarized as follows: theory at first turned away from the classical concept of a more or less inelastic economy to a concept that emphasized strongly the possibility of stimulating production and avoiding depression by monetary manipulations. The pendulum had swung back to an almost preclassic Mercantilistic concept. However, after a short time the exaggerations were recognized and the pendulum swung back, though only part way. A sort of synthesis of classical and pre- and post-classical theory was reached: a synthesis that avoided the undeniable inadequacies of classical theories as well as the mistakes of Mercantilist, free-money, vanishing-money, easy-money theorists and monetary illusionists in general.

¹ W. Lincoln Hausmann, Der Goldwahn, Berlin, 1905.

² Keynes, General Theory, p. 353.

³Das Manifest zur Brechung der Zinsknecktschaft des Geldes, 1932.

⁴ This literature was reviewed in the preface to the third edition, 1930.

⁵ See Chapter 15, “The Investment Gap.”

⁶ Keynes, op. cit., p. 131.

⁷ Hahn, Volkswirtschaftliche Theorie des Bankkredits, p. 148.

⁸ Munich and Leipzig, 1932, p. 140, note 2.