The second war produced a watershed in twentieth-century economics. Together with the dominance of the profession by purely academic economists came the disappear¬ance of what might be called financial macroeconomists whose principal concern was the explanation of the interaction of finance and investment in the context of economic fluctuations. Although there has been a renewed interest in business cycles, it has concen-trated on ‘real’ factors, while ‘finance’ has become a separate discipline concentrating on the microeconomics of efficient markets and some aspects of rational expectations.

One of the founders of the financial macroeconomics approach was Irving Fisher. He was part of a group of economists which included Hayek, Böhm-Bawerk, Schumpeter, Wicksell, Hawtrey, Robertson and Keynes to name a few. Although these economists came from diverse theoretical backgrounds, a common denominator was active par¬ticipation in financial markets, either through private or public sector experience. This background of institutional knowledge provided support for their distinctive theoretical approach, which recognized that monetary and financial factors are important deter¬minants of the behavior of the economy. This common background may also be noted from the fact that despite theoretical difference, Keynes was outspoken in acknowledg¬ment that ‘it was Irving Fisher who … first influenced me strongly towards regarding money as a “real” factor’ (1973, pp. 202–203, n.2). In particular, Keynes suggested that his theory of investment, based on the marginal efficiency of capital, ‘was first intro¬duced by Irving Fisher in his Theory of Interest (1930) under the designation “the rate of return over cost”. This conception of his is, I think, the most important and fruitful of his recent conceptions’ (Fisher, 1930, p. 103). Indeed, the modern financial analyst would be surprised to discover in The Nature of Capital and Income (1906) and The Theory of Interest, most of the basic tools of time value analysis of investment including spot and forward yield curves.

It is unfortunate that much of this part of Fisher's work has fallen from the standard economics curriculum. In the post-war view of economics, Fisher is generally character¬ized as a forerunner of modern monetarism in which money has no permanent influ¬ence, and as the proponent of the rule that nominal interest rates reflect the adjustment of underlying, stable real rates of interest to rationally anticipated inflation. These sug¬gest the rather extreme position that the rate of interest is determined by productivity and that monetary factors have no permanent impact.

When I arrived as a research student under Joan Robinson's supervision in the University of Cambridge Faculty of Economics and Politics in the late 1980s the capital theory controversies were still dominating students and faculty discussions. These debates had only arrived on the periphery of graduate education in the US, but I had the benefit of what was then considered an alternative training in Keynes from Paul Davidson's tutelage which required detailed knowledge of Keynes’ Treatise on Money and General Theory supplemented by Sidney Weintraub's influence on Davidson and Smolensky's Aggregate Supply and Demand textbook presentation of Keynes. How Joan Robinson's “big book”, as the Accumulation of Capital was known, fit into this framework was far from clear to Davidson and his students. In the US economists were more concerned with the impact of the “classical dichotomy” on Keynes's monetary theory.

In England the focus was on the derivation of an alternative to the marginal theory of distribution implicit in the capital aggregate in the production function represented by Keynesian aggregate theories of growth and distribution formulated by Kaldor, Robinson and Kalecki. By the time I arrived in Cambridge criticism of capital the-ory had evolved to accommodate the more direct attack based on Sraffa's Production of Commodities, reinforced by Pierangelo Garegnani's own developments and presence to highlight the lacunae in marginal price theory. The state of the debate was presented in Geoff Harcourt's popular representation in Some Cambridge Controversies in the Theory of Capital.

At the time it was common to refer to all this as the “Anglo-Italian” theory, but there was little that was common to the two approaches. Joan Robinson sat in the centre of this combination, having credited Sraffa with the hint that produced her classic book on imperfect competition, while adopting a Marshallian framework, which the same work by Sraffa had criticized, as the framework for understanding the generalization of the General Theory to the long period reflecting Harrodian dynamics. My arrival in Cambridge was to understand where money and uncertainty fit into all this, but instead my attention was refocused on answering the question of “what determines the rate of profit” – which implicitly bridged the differences between the attack on one-commodity models with aggregate capital and the alternative Italian criticism since the response required an understanding of the denominator.

I. BACKGROUND: KEYNES AND THE 1914 CRISIS

According to Hicks (1977, p. 45) monetary economics differs from other branches of economics because “a large part of the best work on Money is topical … prompted by particular episodes, by particular experiences of the writer's own time”. This reflects his earlier (1967, p. 156) opinion that “monetary theories arise out of monetary dis¬turbances. This is obviously true of the General Theory, which is the book of the Great Depression - the World Depression - of the nineteen-thirties”.

Yet the great slump could have had only a relatively small impact on Keynes’ work in monetary economics which had started well before the generalised conditions of either British or World depression. A relatively more important influence must have been the “monetary disturbance” of 1914.

Indeed, Keynes at the early age of thirty-one was piloted from Cambridge to London in the side-car of his brother-in-law's motor cycle in order to advise the government on the incipient bank crisis at the outbreak of the First War. It was as a result of this activ¬ity that he literally became the international financial system during the war period: “I was in the Treasury throughout the war and all the money we either lent or borrowed passed through my hands” (JMK, XVI, p. 3, the editor of the volume comments “He hardly exaggerated, as he was directly concerned with the strategy of financing Britain's war expenditure and that of her allies, and finally took charge of a division of his own responsible for all of Britain's inter-allied financial arrangements”).

This early experience of the 1914 financial crisis introduced Keynes to certain fea¬tures of the monetary system which were to remain a permanent part of his theoretical approach to economic analysis. One characteristic feature of this system was that “the bill upon London was an international currency which could be negotiated anywhere … A mountain of credit of unprecedented size was reared up internally upon the reserve of the Bank of England, and that reserve was amazingly small” (Feaveryear, 1931, p. 299.) In general terms the City operated just as an international bank relending to the Empire the proceeds of their export surpluses on England which were held on deposit in sterling (an excellent analysis of the operation of the system is given in de Cecco, 1974).

The circuit approach has done much to reawaken interest in Keynes's monetary theory of production and to extend it in new directions. Yet, it appears to remain confined within the limits of the industrial circulation of Keynes's Treatise; it thus does not deal with the determination of investment goods prices nor can it deal with the differential determination of the prices of assets and liabilities introduced in the General Theory in terms of the marginal efficiency of capital and liquidity preference. Since the impor¬tance of money in Keynes's theory is intimately linked with these concepts, it leads us to conclude that circuit theory needs further development in order to capture Keynes's views on the dominance of money over the real sector in a capitalist economy.

Who Is the Prince of Denmark?

The Cambridge-based Keynesian theories of growth and distribution developed in the 1950s and 1960s were presented as extensions or ‘generalizations’ of Keynes's General Theory. While they were sharply criticized by neoclassical economists, their develop¬ment was also accompanied by ‘internal’ criticism which only became externally evi¬dent sometime after the ‘Cambridge Debates’ had come to be classified as a history of economic thought. The first of these internal criticisms was associated with neo-Ricard¬ian economists who emphasized the differences between capital theory based on the generalization of Keynes's General Theory and on Sraffa's Production of Commodities. The second came from American post Keynesians such as Davidson and Minsky, as well as from Austrian economists such as Ludwig Lachmann, who criticized the emphasis on static or steady-state analysis when it was the process of history that the theory was trying to explain. Both of these criticisms concerned the role of uncertainty and expec-tations in the theory, the former was critical because it was too great, the latter because it was too small.

A third line of criticism, usually, but not always linked to the second, came from economists who considered Keynes's revolution to have been primarily concerned with monetary theory and considered the long-run models of steady growth in which money played no active role as unacceptable, if not unKeynesian. They argued that Keynes's conception of liquidity should play a crucial role in long-period analysis or else such analysis should be abandoned.

I INTRODUCTION

One of the most perplexing facts in interpreting post-war developments of Keynes's theory is his comment on Hicks's now-famous ‘Mr Keynes and the Classics’. Although Hicks himself has in recent years become critical of the uses to which his IS–LM appa¬ratus has been put, he still stands by it as representing the essence of Keynes's theory and supports his contention by reference to what he interprets as Keynes's tacit agree¬ment with the contents of his 1937 paper: ‘Keynes accepted the IS–LM diagram as a fair statement of his position’ (Hicks, 1977, p. 146).

The present chapter has two goals. The first is to assess Keynes's pointed criticism of the representation of the rate of interest upon which Hicks's 1937 paper was based. The second is to attempt an explanation of IS–LM which might be interpreted as a ‘fair representation’ of Keynes's theory. These two goals permit discussion of what I believe to be the most often overlooked aspect of Keynes's theory, the indissoluble rela¬tion between the multiplier and the liquidity preference explanation of money prices.

II KEYNES's CRITICISM OF ‘MR KEYNES AND THE CLASSICS’

The careful reader of Keynes's comments in his exchange of letters with Hicks (CW, XIV: pp. 74ff.) will note two points. Hicks centred his comparison of Keynes and the Classics on the effect of an increase in expenditure on the rate of interest. What Hicks calls ‘Mr Keynes's special theory’, ‘yields the startling conclusion that an increase in the inducement to invest, or in the propensity to consume, will not tend to raise the rate of interest, but only to increase employment’ (Hicks, 1982, p. 107). Keynes comments on this characterisation of his position:

This is the term used by Keynes in his General Theory (1936 ) to represent the forces deter¬mining changes in the scale of output and employment as a whole. Keynes attributed the first discussions of the determinants of the supply and demand for output as a whole to the classical economists, in particular the debate between Ricardo and Malthus con¬cerning the possibility of ‘general gluts’ of commodities, or what has come to be known as Say's Law of Markets. Indeed, Keynes's theory was intended to replace Say's Law, although the emergence of effective demand from his Treatise on Money (1930) critique of the quantity theory of money, and his insistence on its application in what he origi¬nally called a ‘monetary production economy’, suggests that it should also be seen in antithesis to classical monetary theory. For Adam Smith (1776, p. 285), ‘A man must be perfectly crazy who … does not employ all the stock which he commands, whether it be his own or other peoples’ on consumption or investment. As long as there was what Smith called ‘tolerable security’, economic rationality implied that it was impossible for demand for output as a whole to diverge from aggregate supply. Although Smith (p. 73) did call the demand ‘sufficient to effectuate the bringing of the commodity to the market’, the ‘effectual demand’ ‘of those who are willing to pay the natural price’ of the commodity, the idea referred to divergence of market from natural price of particular commodities and the process of gravitation of prices to their natural values. J.B. Say's discussion of the problem of the ‘disposal of commodities’ adopted Smith's position. Against those who held that ‘products would always be abundant, if there were but a ready demand, or market for them,’ Say's ‘law of markets’ argued ‘that it is production which opens a demand for products’ (1855, pp. 132–3); if production determined ability to buy, then demand could not be deficient. While excesses in particular markets were admitted, they would always be offset by deficiencies in others.

Unlike other postwar interpretations, the Post Keynesian approach starts with a “mon¬etary” theory of production. Keynes introduced this terminology to emphasize the fact that money was not a “veil,” but a “real” factor determining production decisions in a modern economy. Not only was this approach innovative in its treatment of money, it built on Keynes’ original formulations of a number of basic propositions in the theory of finance. In addition to the well-known “finance motive,” Keynes employed his original theory of interest rate parity and carried out his analysis in terms of forward, futures, and options contracts. Economists working in the Keynesian tradition have usually cho¬sen to ignore these aspects of Keynes’ work, while finance theorists have incorporated them into their basic theory and instead concentrate on Keynes’ approach to probabil¬ity, dismissing it as based on a “subjective” approach.

This essay calls attention to Keynes’ contributions to the modern theory of finance that might serve in the development of a Post Keynesian approach to finance. Three areas are highlighted. The first is the treatment of expectations, and inevitably, the relationship between risk and uncertainty. The second is the importance of this diverse approach to expectations for the determination of prices, in particular of financial assets. The third is the reciprocal of the theory of asset price formation as found in the theory of interest, and in particular the explanation of the yield curve.

The theory of monetary production: the influence of changing views about the future

The characteristic feature is that “changing ideas about the future” have a determi¬nant influence on present decisions. The first requirement for a theory of monetary production is thus specification of the way the “changing ideas about the future” are formulated.

Irving Fisher is frequently credited, in the General Theory, in articles written immediately after its publication, and in private correspondence, by Keynes as having been an important influence on his work. These influences refer to two points: Keynes’ treatment of money as a real factor in the determination of economic equilibrium and Keynes’ concept of the marginal efficiency of capital.

For example in “Alternative theories of the rate of interest”, one of a number of articles published in 1937 to distinguish his position, Keynes indicates the authors who most influenced his work: “I regard Mr Hawtrey as my grandparent and Mr Robertson as my parent […] I might also adopt […] Wicksell as my great-grandparent, […] I find, looking back, that it was Professor Fisher who was the great-grandparent who first influenced me strongly towards regarding money as a “real” factor” (JMK: XIV, pp. 202–3, n. 2). In “The Theory of the Rate of Interest”, published in a Festschrift for Fisher, Keynes writes: “I have thought it suitable to offer a short note on this subject in honour of Irving Fisher, since his earliest and latest contributions have been concerned with it, and since during the whole thirty years that I have been studying economics he has been the outstanding authority on this problem” (JMK: XIV, p. 101, n. 1). Indeed, it is in this same article that Keynes set out the difference between his own approach and that of traditional theory in terms of money being a “real” variable in his own theory: “Put shortly, the orthodox theory maintains that the forces which determine the com¬mon value of the marginal efficiency of various assets are independent of money […] My theory, on the other hand, maintains that this is a special case and that […] almost the opposite is true …” (Ibid., p. 103).

The second area of Fisher's influence appears in the following footnote in the same article; Keynes reconfirms an affirmation originally made in the General Theory, credit¬ing Fisher with “The […] “marginal efficiency of capital” […] first introduced by Irving Fisher in his Theory of Interest (1930¬¬ ), under the designation “the rate of return over cost”. This conception of his is, I think, the most important and fruitful of his recent sugges¬tions” (Ibid.).

1. Keynesian Stabilisation Policy and Deficit Spending

In conditions in which economic debate is dominated by the “New Keynesian” Economics and New Macroeconomics and governments claim that they can do nothing to remedy the enduring conditions of recession in the industrialised countries because of the excessive size of their budget deficits it seems pure folly to discuss the role of “Keynesian” policy to further economic growth. But, as the current recession persists, pressures build for something to be done, and as Dennis Robertson noted of highbrow opinion, if you stand in one place long enough it comes back round to you. It thus seems appropriate to recall a number of generally overlooked aspects of Keynes’ approach to economic policy so that if like the hunted hare, opinion does come this way again, it might be diverted from past errors.

The first problem is to define Keynes’ economic policy views. Even before Keynes published the General Theory proposals for public works financed by public debt to com¬bat the depression were promoted by a wide range of economists of various political per¬suasion. Public spending as an anti-cyclical policy tool was part of the economic legacy of the Hoover administration, and Franklin Roosevelt's first presidential campaign was based on balancing the budget (providing Ronald Reagan with cutting quotations for the same purpose). Something more precise than deficit spending is required.

2. Offensive Policy to Cure an Existing Depression Keynes supported those who proposed deficit spending, but made a sharp distinction between what I will call “defensive” and “offensive” economic policy. The latter relates to the policy to apply in depressed conditions, while the former is to be ever-present in order to provide a defence against depressions.

On the offence Keynes tried to shock received views by suggesting such schemes as burying jars filled with banknotes in order to dig them up again. Many critics did not notice that although this was “make-work”, at least it was “work” and not an entitle¬ment or a handout. They also failed to notice that Keynes quickly added that such schemes were rather foolish, and that the “make-work” should better be “real” work on things that might actually serve some useful purpose such as schools, hospitals and the like.

INTRODUCTION

The first edition of this book was directed to my fellow economists. At that time it was reasonable to presume that they would be sufficiently familiar with my prior work that a few brief references would be sufficient to indicate the extent to which it was incor¬porated in the present book. With the passage of time this presumption is no longer true; indeed, despite precise indications in the text and in footnotes, few readers of the original edition seem to have recognized the genesis of certain important innovations, such as user costs, in my earlier Treatise on Money (1930a, b). This problem was particu¬larly acute in Chapter 17, which built on the interest rate parity theorem first set out in my Tract on Monetary Reform (1923), and on an extension of what I had called the ‘short-period’ theory of prices in Volume II of the Treatise on Money (1930b).

Although I alerted readers of the first edition to what I considered to be the impor¬tant differences with respect to the Treatise on Money, they could only be appreciated by those familiar with my earlier work, and I was perhaps remiss in failing to stress suffi¬ciently the continuity that remained. For example, in the Preface (page vii) I noted that:

I went on to summarize ‘the general relationship between the two books’, noting that in the first:

Fisher's question: If the price of wheat in terms of gold rises at a rate d per period, and the rate of interest on gold is i = 10% per period and the rate of growth of wheat is j = 4% per period, what is the relation between i and j that must be paid to lenders to make them indifferent between denominating the loan contract in gold or wheat.

Being indifferent means lending either 1D or 1B today and receiving either D(1 + i) or B(1 + j) at the end of the period, or D(1 + i) = B(1 + j). Since B = D(1 + d) this can be rewritten as D(1 + i) = D(1 + d)(1 + j) substituting for B. Simplifying yields the Fisher relation for the rate of inflation of the price of wheat in terms of gold that would leave lenders indifferent between lending in gold or wheat:

i = (1 + d)(1 + j) = j + d + dj which simplifies to i = j + d since dj will be small.

If we use the rates assumed above, then 0.10 = 0.04 + d + 0.04 d or

0.10 − 0.04 = 1.04 d

0.06 = 1.04 d

d = 0.577 or money must depreciate in terms of purchasing power by 5.77% relative to wheat.

The same result can be reached on the basis of a market arbitrage:

Borrow 1B of wheat today and sell it for 1D of gold.

Lend the gold to receive 1.10D gold at the end of the period.

Buy 1.04 B of wheat for 1.04D

Repay wheat loan and interest of B(1.04)

Keep the difference in Profit of 1.10D − 1.04D = 0.06D

To eliminate this arbitrage profit, either the cost of wheat in terms of money today will have to fall or will have to rise tomorrow to eliminate the 6% arbitrage profit.

INTRODUCTION

It is ironic that the breakdown of the golden age of post-war capital accumulation in the 1970s should have signalled the crisis of Keynesian economics. Ironic, for as Fausto Vicarelli pointed out, Keynes's entire theoretical edifice was constructed in order to interpret the instability of capitalism, indeed ‘the stimulus to his analysis was always some moment of capitalist crisis’. In contrast to those announcing the ‘crisis of Keynesian economics’ in the face of the increasing instability of the 1970s, Vicarelli argued forcefully ‘that Keynes's thought has direct relevance to the present moment of capitalist crisis’ (Vicarelli, 1984, p. 184). Yet, as a result of the crisis, the majority of economists have abandoned Keynes's theory in favour of what has come to be called the ‘New Classical’ economics, which seems to exclude instability by definition, or the inappropriately named ‘New Keynesian’ economics, which seems to rely on the failure of the perfectly competitive market to allocate information efficiently.

Vicarelli's carefully argued case that Keynes's economics was even more appropri¬ate to periods of crises than to the Golden Age of post-war stability has been completely ignored by most professional economists. The present paper will try to recall and rein¬force some of Vicarelli's arguments, drawing on his interpretation of Keynes to inte¬grate it with some more modern theory.

THE EXPLANATION OF ECONOMIC INSTABILITY

Even before Keynes wrote there was broad agreement that economic instability was caused by ‘imperfections’ which were represented by mistaken forecasts of the future and associated disappointment in expectations (cf. Kregel, 1977), or from mistaken gov¬ernment policies (extending to the very existence of government) producing inappropri¬ate expectations (which is what the Treasury View seems to have been), or most simply the absence of competitive conditions. By and large they tended to be maintained after Keynes and were still prevalent at the time of the ‘crisis in Keynesian economics’. All of these explanations implicitly accepted the self-adjusting operation of the market mech¬anism. This explains why the rational expectations hypothesis had such a powerful and immediate impact, for it simply brought expectations formation within the already accepted self-adjusting mechanism.

During the last few days much has been said and written about “long-period” and “short-period” theories of “effective demand”. While the original purpose of this paper was to try to clarify, from a Keynesian perspective, what may be meant by the term effective demand, it is obvious that the terms long- and short-period also bear definition. I shall thus commence with a digression on what I shall intend by these terms.

1 DIGRESSION ON LONG- AND SHORT-PERIOD

Marshall is only apparently the source of the problem. Yet, Marshall did not have a short- and a long-period theory of value and distribution (perhaps it would be more correct to say “price”). There is one, and only one, theory of price in Marshall. He did, however, use the market period, the short period and the long period to separate out the analysis of all the various aspects of the relevant forces operating to determine prices. The major operative force was substitution-instigated competition or as Knight was to summarize it, the “law” of one price. The market period concentrates on the operation of competitive forces on prices alone; substitution is only possible among final outputs. In the short period an additional aspect, substitution of existing productive capacity is added. Finally, in the long period substitution operates on all inputs and outputs. The full operation of these forces was thought to produce the tendency towards full employ¬ment of all inputs and the sale of all outputs.

In the same way, the Classical economists had only one theory of value and distribu¬tion. It emphasized the fundamental forces of competition which lead entrepreneurs to invest in those sectors yielding the highest rates of profit; what is now summarised by the “tendency to a uniform rate of profit”. The operation of these forces was analyzed by separating market values from natural values and both from the stationary state. In the case of market values, chance factors could completely offset the fundamental forces; while in the stationary state their work had been brought to the limit set by population growth and technical progress.

Kalecki was always quite clear that he considered his theory to apply to long periods only when viewed as a series of short-period situations. The distinction of Kalecki's approach is that it uses price determination to produce an explanation of the level of output.

KEYNES's CHALLENGE TO MONETARY AUTHORITIES IN 1930: INTRODUCE ZIRP AND QE

At the end of 1930, as the US stock market crash was starting to have a negative impact on the real economy in the form of falling commodity prices, falling output, and ris¬ing unemployment, John Maynard Keynes, in the concluding chapters of his Treatise on Money, launched a challenge to monetary authorities: take ‘deliberate and vigorous action’ to reduce interest rates and reverse the crisis. He argued that until ‘extraordi¬nary’, ‘unorthodox’ monetary policy action ‘has been taken along such lines as these and has failed, need we, in the light of the argument of this treatise, admit that the banking system can not, on this occasion, control the rate of investment, and, therefore, the level of prices’ (Keynes 1930a: 387). The ‘unorthodox’ policies that Keynes rec¬ommends are virtually identical to the Japanese central bank's experiment with zero interest rate policy (ZIRP) in the 1990s and the US Federal Reserve's experiment with ZIRP, accompanied by quantitative easing (QE1 and QE2), during the recent crisis. While too late to be considered a response to Keynes's challenge, these modern policy measures provide a clear test of Keynes's belief in the power of monetary policy to coun¬ter financial crisis. This modern response to Keynes's challenge would appear to be a clear admission of the inability of monetary policy to influence the rate of investment as a means of responding to the crisis. Indeed, Keynes himself seems to have modified his position as his thinking evolved towards the analysis of the General Theory.

THE OBJECTIVES OF MONETARY POLICY

In the penultimate chapter of volume 2 of the Treatise, Keynes raises ‘the crux of the whole matter’ of monetary policy: ‘[D]oes it lie within the power of a central bank in actual practice to pursue a policy which will have the effect of fixing the value of money at any prescribed level?’ (Keynes 1930a : 339).

Despite some residual doubts, Keynes nonetheless answers his own question in the affirmative, urging central bankers to adopt ‘extraordinary’, ‘unorthodox’ measures to reduce interest rates to near zero in an attempt to counter the deepening recession.