Keynes Theory Of Saving Unemployment

Keynes’s Theory Of Saving, Unemployment And Crises

The greatest reproach that can be levelled against Keynes's theory, as elaborated in his world-famous General Theory of Employment, Interest and Money in 1936, and outlined before that in his Treatise on Money in 1930, is that it has not taken account of all the complexities of the mechanism of saving that are revealed by careful analysis. It has been made into a simplified conception—exactly opposite to that of Adam Smith—which is summed up in the idea that saving reduces consumption, absolutely or relatively. And the whole of the demonstra­tion is concerned with this conception.

What happens, asks Keynes, when saving reduces the demand for products? It reduces at the same time the number of employed workers. Now, if the total amount of remuneration forming the aggregate incomes of the workers is diminished, the total money income to be spent by the community is diminished, as well as the aggregate demand for products; the forecasts of the entrepreneurs will be falsified; production will be restricted by the disappearance of profit, the principal stimulus to production; unemployment will thereby be increased; the reduction of incomes to be shared will be intensified—leading to a new shrinking of aggregate demand, accom­panied by a new reduction of profits and production. And so the process continues, until the impoverished community falls from prosperity into the depths of misery. So saving, far from being a benefit, becomes a curse, and everything should be done to discourage it and stimulate consumption. Unproductive expenditure, luxury building, public works would all be preferable to this descent into the abyss through the excessive practice of a false virtue that has yet been preached unceasingly by economists, moralists, and statesmen ever since the days of Adam Smith, the thrifty Scot who was the first to undertake its defence.

Such, in broad outline, is Keynes's thesis, already elaborated more than a century earlier by Dupont de Nemours in his note on Saving appended to Turgot's Reflexions, paragraph 77. Here is the essential passage, whose interest needs no emphasis, despite its ungainly style.

In countries where incomes are paid in money, if those incomes which represent the disposable portion of the harvest, are not spent by their owners, there will be a corresponding portion of the harvest which is not sold, though the cultivator will have paid its price to the owners, without having withdrawn it from his sales by which alone he had planned to be able to pay this owner every year the sum agreed upon. This unsold portion of the harvest, which the farmer would nevertheless like to dispose of, will of necessity fall very low in price. This low price will also of necessity affect other prices, which naturally find their level, as Turgot has very clearly shown (in paragraphs 30, 31, and 32 of his book). But the fall in prices will necessitate in the same way a diminution of production, as we have just seen in speaking of production which only repays its cost, and also a diminution of incomes, which are always propor­tional to the quantity of products to be sold, combined with the price at which they are sold, and compared with the costs of produc­tion. But the reduction of income will still be a loss to the thrifty owners, who will find it hard to understand what they have done to ruin themselves by saving and will see nothing for it but to increase their savings, which will hasten their ruin until they reach the point where absolute destitution makes saving impossible and compels them to throw themselves, too late, into the ranks of the workers.

This is the very thesis adopted by Keynes, who certainly had not read Dupont. He intended it to explain both the unemployment from which Great Britain had j'ust suffered, and the continued fall of prices after 1930. It accounted for the most recent 'great depression' as well as for long-term falls in general; it provided a comprehensible and simple substitute for the much-criticized quantity theory of money, by putting the theory of prices back in the lower rank of 'subsidiary' theories (p. 32); and, finally, it set economic science free from that 'fatalism' which in all ages has made it appear as "the dismal science," and substituted for it a conception that opened up vast prospects for successful State intervention.

A scientific revolution of this kind could be attempted only by a writer gifted not only with great expository powers but also with a fertile imagination—one, moreover, who has given brilliant proof in his earlier books of his mastery of financial and monetary problems.

The essence of the argument is contained in what Keynes himself calls the "parable" of the bananas. This occurs in an earlier work called A Treatise on Money, which appeared in 1930, some of whose conceptions were to be renounced in the later book, though on this point its principal ideas were retained. Imagine, says Keynes, a community living exclusively on the production and consumption of bananas, but using money for its purchases and sales. Suppose that certain members of this community, smitten by a mania for saving, decide not to buy a portion of the bananas they had hitherto con­sumed, and suppose, finally, that they do not employ the income thus 'saved' in creating new plantations that would increase their con­sumption in the future. Saving then "exceeds investment." What will be the result of the operation? Obviously a fall in the price of bananas, which will delight the hearts of all consumers. But there will also be a diminution of the profits of producers, which will fill them with sorrow and compel them to reduce production or dismiss their work­men. So at the following stage—the next harvest—total production will have diminished, and there will be some unemployed. If the group of savers continues every year to reduce its consumption, the impoverishment of the community will continue without limit. In this way saving will have led to disaster, under the cloak of virtue.

There is nothing to be said against this reasoning—except that Keynes, by using the same word for both, is confusing 'saving' with 'hoarding.' 'Saving,' as we have said earlier, in conformity with the classical meaning of the word in the English economy—since adopted by all continental economists—is defined not as 'non-expenditure' but as expenditure of a special kind—the employment of income in the creation of new capital. Now, the saving of our banana-growers consists, it is true, in not consuming, but without employing in new produc­tion the income thus set free, so the result will naturally be quite different. That hoarding reduces demand, no one will dispute. But (we may note in passing) it is difficult to see any plausible motive in the action of Keynes's banana-growers. If it was not to buy more bananas sooner or later, or to increase the growing of bananas at once, what purpose could be served by their saving? Was it a mere display of asceticism?

We can see here the inconvenience of negative definitions. To define saving as 'non-consumption' is inadequate to denote the economic action we have in mind. For 'not to consume' income is necessarily to employ it 'otherwise' than in the purchase of consump­tion goods, and we must therefore say what 'otherwise' we are think­ing of. The sums that are 'not consumed' may be either destroyed or lost or hoarded or invested or used to pay debts. The more numerous the ways of using income the more will their effects on the general economy differ. In the traditional language of economics saving is identified with investment and distinguished from hoarding, and Keynes is here playing with words.

In his more recent book he does not return to the example of the bananas. At the same time he abandons the idea that there can be any divergence in a community between saving and investment. On this divergence he had previously built up (by a curious union with Wicksell's theories) the whole of his theory of price movements. Now he rejects it, and admits that by definition saving and investment are of necessity identical. But among the forms of investment he includes investment in money—i.e., hoarding—so that the parable of the bananas remains incorporated in the system.

None the less, his conception of saving is no longer entirely the same. Henceforth to save is no longer to reduce consumption; it is only to reduce the proportion of income that is spent in consumption. When income increases, he says, there is a tendency for the recipients to increase their consumption, but not to the extent of the whole increase of income. There is no absolute reduction of consumption, therefore, though in more than one place Keynes returns to his old formula. But the saved income grows proportionally faster than consumption as income increases. In cases of reduced income the opposite process takes place: the proportion saved falls as the reduction proceeds.

Even if the proportion of increased income consumed to that which is saved remains equal to what it was before the income increased, the absolute amount saved will be greater, since the income is greater. Thus "the larger our incomes, the greater, unfortunately, is the margin between our incomes and our consumption" (p. 105). The problem of finding an investment for savings, therefore, becomes more and more difficult as income increases and the community grows richer. If, however, no solution is found—i.e., if investments do not absorb savings (in other words, if hoarding takes place)—then the employment of labour will at once diminish. This means a reduction in the aggregate income of the community, an increase in unemployment, and so forth. Here again we may quote the actual words of Keynes:

An act of individual saving means—so to speak—a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day's dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand,—it is a net diminution of such demand. . . . If saving consisted not merely in abstaining from present consump­tion but in placing simultaneously a specific order for future con­sumption, the effect might indeed be different. . . . The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold invest­ments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished. It is of this fallacy that it is most difficult to disabuse men's minds. . . . For this overlooks the fact that there is always an alternative to the ownership of real capital-assets, namely the owner­ship of money and debts (pp. 210-212).

If this be admitted, the whole problem of maintaining a community in a state of full employment is, therefore, to find enough opportunities for the investment of the saved portion of income. For it is useless to try to influence saving itself, which is only a residue, the result of the public's "tendency to consumption." "Saving, in fact, is a mere residual" (p. 64). What is necessary, then, is either to increase consumption in order to reduce saving, or to find new openings for investment in order to absorb the savings.

One objection at once springs to mind. Why should an increase in consumption goods necessarily cause a fall in prices? Are there not periods of rising prices despite a great increase of products, as, for instance, when production from gold-mines is in rapid progress? But, says Keynes, the increase in incomes, and consequently in prices, that is due to the exploitation of gold-mines comes about simply because new workers are put to work in the gold-mines, and thus receive incomes and increase the general demand for products. This result might just as well be attained by a quite different method. For instance,
If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again . . . there need be no more unemployment and, with the help of the repercussions, the real wealth of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political or practical difficulties in the way of this, the above would be better than nothing. The analogy between this expedient and the gold-mines of the real world is com­plete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is available, our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value and importance to civilization (pp. 129-130).

If, then, the exploitation of gold-mines facilitates the raising of prices, it does so, according to Keynes, only by providing a supple­mentary source of labour. This is a strange thesis, not hitherto adopted by any economist, and it leads to the conclusion that any other kind of labour of equal amount, whether to provide necessaries or luxuries, would produce the same effect, so long as enough paper money is made to pay for it. The Egyptians invented the pyramid, and the Middle Ages the building of cathedrals. Only the modern age is too short-sighted to discover a way of utilizing the unemployed, providing them with incomes, and thus restoring general prosperity by the consumption of products.

In default of this unproductive expenditure new investments must be found. But the richer we become the rarer become these openings for investment. "The greater . . . the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance" (i.e., to invest in) "and the greater our dependence on present consumption as a source of demand" (p. 105). Here we touch the weak spot in Keynes's theory—a point of far greater importance than all the other objections often raised against it in matters of detail. It can be put briefly as the fear of the disap­pearance of openings for productive investment, the idea that the world, having made all possible inventions, will one day find that there are no more discoveries to be made, and that when the entre­preneurs have exploited every conceivable opening they will be faced by a public no longer able to absorb their improved or increased products. Investment will cease when satisfaction is universal and all desires are met.

Is this a real risk? Keynes is not the first to utter these fears. So far they have always been belied by facts. Every age has unwisely boasted that it has reached the height of human knowledge and attainments. Every age, enraptured with its own achievements, has had its enthusiasts to proclaim that the human race will go no farther. And every time the following age has proved it wrong. We speak constantly of the Industrial Revolution of the late eighteenth century, but since then that Revolution has never ceased. After steam came electricity as a motive force; after the railway came the motor-car and the aeroplane to take the lead in transport. Then, after the revolution in power and transport, has come the revolution in raw materials, with plastics replacing cotton, wool, silk, and wood, and cement superseding stone. After the revolution in industry have come the changes brought about in agriculture by the use of artificial fertilizers and the extraction of nitrogen from the air. Is it likely that these changes are at an end? Are science and invention on the verge of bankruptcy? Can we really believe this? On the contrary, what frightens industry is the rapidity with which new inventions follow one upon another, causing such swift obsolescence that the profits of a business are swallowed up by the need to provide for renewal of plant in a few years. Even if invention ceased, it would be a long time before inventions already made brought benefit to entire peoples still living in sordid poverty, and entire classes, even in rich countries, who have as yet no share in the progress of hygiene and general well-being. There is a vast field open to enterprise here.

Other economists have answered the same question by a profession of faith in precisely opposite terms. Among them are Marshall, in a celebrated passage, and more recently Snyder, who sings a hymn of praise to the might of invention and saving that have brought economic greatness to the United States. Divisia, in an eloquent chapter in his book on Saving, draws the same conclusion, and quite rightly regards the building of the Pyramids on the one hand and the construction of machinery on the other as marking the essential difference between ancient and modern civilizations. And Hayek, in his article on Savins in the American Encyclopedia, is of the same opinion.

Keynes's theory applies in principle to the general evolution of the economic system. But as it arose in connexion with an acute crisis, with whose circumstances the author was plainly preoccupied, it should also provide an explanation of crises. And here he does not intro­duce excessive saving, as might have been expected, but the sudden fall of profits. The essential character of the cycle, which is its regularity, is due, he says, to variations in the marginal efficiency of capital, or, as we should say, to the sudden fall of profits . Hoarding does not arise till afterwards (p. 316). To remedy the crisis, then, it would apparently suffice to lower the rate of interest and thus supply the entrepreneur with new chances of profit. Unfor­tunately a reduction of the rate of interest, in face of what he calls "the uncontrollable and disobedient psychology of the business world," is generally powerless to cause "the return of confidence . . . which is so insusceptible to control in an economy of individualistic capitalism" (p. 317). It will be useless, then, to reduce the rate of interest, for the pessimistic outlook of the entrepreneurs will make it impossible to persuade them to make new investments.

The remedy will therefore lie in investments by the State, on the one hand—i.e., public works that will give employment to the unem­ployed, thus increasing the incomes to be spent and helping to increase consumption—and, on the other hand, in measures aimed at the direct increase of consumption. Here, after asserting that the sudden collapse of profits is the origin of the crisis, and having declared him­self not far from agreeing with the theory of over-investment, Keynes returns to the explanation by under-consumption. He differs only slightly from the under-consumption school, he says, and "I should readily concede that the wisest course is to advance on both fronts at once" (p. 325).

But if it is so difficult to contend with a crisis when once it has started, would it not be possible to prevent it? Would it not be a good preventive to raise the rate of discount, which is always identified by Keynes with the rate of interest?2 This also he considers inadvisable. When pessimism gives way to optimism in the minds of entrepreneurs, new investment must be encouraged. "Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest!" (p. 322). He recognizes, however, that in certain circumstances the raising of the rate may be the only method to employ.

But although the reduction of the rate of interest provides new openings for entrepreneurs, it also drives people to hoard their savings instead of investing them. What is to be done to prevent one of these effects counteracting the other? We should have to adopt a policy of a continuous fall in the rate of interest, for it is uncertainty as to the later direction of the rate of interest rather than its actual level that leads to hoarding. At the same time we should increase the quantity of money, which is the best way of reducing the rate of interest.

Would not another solution be to reduce the cost of production by lowering wages? Keynes protests against such a suggestion, and makes a vigorous attack on Rueff and Robbins, though without naming them. The only purpose served by lowering wages, he says, is that by putting additional money into the hands of the entrepreneurs it makes the rate of interest fall and thereby increases the margin of possible profit. But there is a much simpler way of obtaining the same result: increasing the supply of money—and only a person who is at the same time "foolish," "unjust," and "inexperienced" would prefer the first method to the second.

Here is another suggestion: could not work be redistributed by reducing the length of the working day and increasing the number of workers employed? That is what the French working-classes demanded when they asked for a forty-hour week. Keynes does not favour this solution: "I see no sufficient reason for compelling those who would prefer more income to enjoy more leisure" (p. 326).

Keynes concludes (p. 270) that the best plan would be the main­tenance of a stable level of money wages. Such a policy, he says, would work best in a closed economic system, but it is still advisable in an open system, provided that equilibrium of prices with the rest of the world can be secured by means of fluctuating exchanges. This applies particularly for short periods. With regard to long periods the question arises whether it is better to keep wages stable while letting prices fall, or, conversely, to keep prices stable while letting wages rise.

"On the whole," he says, "my preference is for the latter alternative." But as no essential point of principle is involved, he decides not to develop in detail the arguments on either side.

We will not dwell on these suggestions, which seem so simple when thus formulated. Keynes was too experienced a man to be unaware himself of the enormous difficulties concealed under this apparent simplicity. We live not in a closed system, but in an open one. Each economy is affected by what happens in other rival economies, and a system of exchange variations adopted by one country might have violent repercussions and arouse the sharpest conflicts, political as well as economic. The policy of 'exchange dumping' during the years from 1930 to 1939 provoked the liveliest international animosities and led to reprisals everywhere.

Keynes, on the other hand, speaks of the choice between a policy of wage stabilization and a policy of price stabilization as if it were easy to make, and as if States had not so far found it absolutely im­possible, despite all their efforts, to keep either prices or wages stable. It is unwise to let the public think that the State has the means at its disposal to achieve such complicated ends. It was a sound observa­tion by Mr Burgess, one of the directors of the Federal Bank of New York and closely associated with that bank's efforts at stabilization, that the price-level has never varied so much as since attempts were made to control it.

In short, the practical remedy proposed by Keynes, as at an earlier date by T. R. Malthus, resolves itself into the setting-up of public works, and to calculate its effects in reducing unemployment he has constructed a complete theory—that of the 'multiplier'—which has failed to convince the British Government as well as the majority of economists.

Compared with his theory of saving Keynes's subsidiary theories are really only of secondary importance. We could go farther, and say that they are manifestly theories of circumstance, aimed at buttress­ing his main theme. So we shall not deal with them here, but leave it to the reader to refer to them himself. The General Theory, like the author's earlier books, has given rise to very lively controversies. The best-known English economists, like Pigou and Hawtrey, have con­centrated on defining their attitude to certain aspects of the theory and Keynes has replied to them, but it cannot be said that any really new ideas have emerged from the conflict. On the other hand we must pause for a moment to mention a couple of very important articles by the Swedish economist Ohlin, who, in connexion with these discussions, summed up in the Economic Journal1 some of the fundamental views of the Stockholm school on the subjects treated by Keynes and the methods of research that he advocates. These views were developed in connexion with the unemployment that began in Sweden, as elsewhere, after the 1930 crisis, and they contain several suggestions of great theoretical interest. We shall mention only the two that we consider particularly useful for analysing dynamic eco­nomic phenomena, a subject in which the Stockholm school is specially interested.

First there is the very ingenious system of notation used by Ohlin to define on the one hand the different elements in the income of a community, and on the other the different elements in its expendi­ture, whereby he expresses the equality of expenditure and income. I must refer the reader to the book itself, for it cannot be summarized more concisely than Ohlin has himself done. Starting from this nota­tion he concludes that by definition the saving and the investment of a community are necessarily equal.

But then, asks Ohlin, why should Keynes be so worried about how to get savings absorbed by investment, since by definition the two are identical? The reason is, he says, that Keynes has not sufficiently realized the importance of a distinction that is fundamental in the study of dynamic problems—the distinction between forecasts and realizations. Undoubtedly, say the Swedes, if we take up a prospective position there is no equality between the sums that some people wish to invest and those that others wish to save. But when they both prepare to realize their intentions, their very actions result afterwards, through the machinery that they put into operation, in the inevitable equality of savings and investments. And he proves it. In short, Ohlin reaches the conclusion that what Proudhon would have called the "economic contradiction," so brilliantly expounded by Keynes, does not exist. Keynes put the question wrongly, and Ohlin shows how it should be put and the consequences that follow from it. The same conclusions were arrived at by a more complicated method by another eminent member of the Swedish school, Lindhal, in his Etudes sur la Theorie de la monnaie et du capital, translated into English in 1939.
The theoretical solution given by the Swedish economists, and in particular by Ohlin, is at once simple and ingenious. It takes us back to the Classical conception of creative saving. It enriches economic science by views that are true and ingenious, and should be regarded as a precious acquisition. It differs in many respects from Keynes's views. Among other points, it rejects his conception of interest and his idea of the 'multiplier,' agreeing in this with Pigou and Hawtrey.