1. Animal Spirits

“(M)an is a frivolous and incongruous creature, and perhaps, like a chess player, loves the process of the game, not the end of it. And who knows (there is no saying with certainty), perhaps the only goal on earth to which mankind is striving lies in this incessant process of attaining, in other words, in life itself, and not in the thing to be attained, which must always be expressed as a formula, as positive as twice two makes four, and such positiveness is not life, gentlemen, but is the beginning of death.”
Dostoyevsky, Notes from the Underground

Two recent books put Keynes’ reference to animal spirits, as a motivational factor for uncertain long-term investments, at the centre of the understanding and explanation of how capitalist economy works and does not work.

The book by Akerlof and Shiller (2009) discusses five types of animal spirits as psychological traits, within, basically, the approach of behavioural economics. Their aim is to describe the animal spirits and the way that they influence behaviour. Farmer (2008, 2010) develops further his work on self-fulfilling prophecies where animal spirits are random shocks of changing beliefs on investment decisions, which get validated through consequences they produce. His aim is to use the belief function to close a general equilibrium model with search in the labour market. That leads to the existence of multiple equilibria for animal spirits to choose from.

It is not clear, however, how are the notions of animal spirits that are used in these two books related to Keynes’ idea of animal spirits in The General Theory of Employment, Interest and Money?[1] Animal spirits appear in the 7th section of the 12th chapter and not in any other chapter or in any other Keynes’ writings as far as I am aware. The treatment of animal spirits is short and can be cited in full:

„Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death [i.e. puts aside the understanding that “in the long run we are all dead” – comment VG].

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;—it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.”[2]

These statements on animal spirits and the limits of mathematical expectations should be compared to the following treatment of “the application of probability to conduct” to be found in chapter 26 of A Treatise on Probability:[3]

“…I have argued that only in a strictly limited class of cases are degrees of probability numerically measurable. It follows from this that the ‘mathematical expectations’ of goods or advantages are not always numerically measurable; and hence, that even if a meaning can be given to the sum of a series of non-numerical ‘mathematical expectations’ not every pair of such sums are numerically comparable in respect of more and less. Thus even if we know the degree of advantage which might be obtained from each of a series of alternative courses of actions and know also the probability in each case of obtaining the advantage in question, it is not always possible by a mere process of arithmetic to determine which of the alternatives ought to be chosen. If, therefore, the question of right action is under all circumstances a determinate problem, it must be in virtue of an intuitive judgment directed to the situation as a whole, and not in virtue of an arithmetical deduction derived from a series of separate judgments directed to the individual alternatives each treated in isolation.”

“It has been pointed out already that no knowledge of probabilities, less in degree than certainty, helps us to know what conclusions are true, and that there is no direct relation between the truth of a proposition and its probability. Probability begins and ends with probability. That a scientific investigation pursued on account of its probability will generally lead to truth, rather than falsehood, is at the best only probable. The proposition that a course of action guided by the most probable considerations will generally lead to success, is not certainly true and has nothing to recommend it but its probability.”[4]

So, the point Keynes is making is one of logic rather than of psychology. Mathematical expectations either cannot be calculated or are only probable and thus cannot be a sufficient motivation for action. Therefore, a healthy dose of optimism needs to be added to motivate long-term investment decisions. This is what Keynes calls “animal spirits”, a term probably borrowed from Hume as it appears a number of times in his Treatise on Human Nature, though the extent to which Hume influenced Keynes is a separate topic not pursued here.[5] Of course, animal spirits can be dimmed because of swings in expected benefits or in the increase of risks (a topic Keynes also treats in Chapter 26 of A Treatise on Probability). So, the point is that animal spirits complement mathematical expectations, which Keynes equated with the calculation of expected benefits (i.e. with the expected utility hypothesis). Similarly to Hume, Keynes argues that rational expectations are slaves of animal spirits.

However, because mathematical expectations need to be supplemented by animal spirits, stabilizing expectations or updating them with new information will not be enough to influence positively long-term investments. That is the reason that Keynes did not put much emphasis on monetary policy, i.e. on the change in the interest rate and did not believe that recessions are self-correcting due to the increase in the marginal productivity of capital, i.e. of profits. He, however, seems not to have put too much hope on animal spirits also because they can be dimmed and are volatile. That is why he stressed the role of public interest since at least his essay on The End of Laissez-Faire (1926). The public does not have to rely either on expected returns or on animal spirits. Similar view of public investments was taken by Hume and also Smith, partly for the same reasons. Individuals have much shorter decision horizon then the public, at least in principle. Of course, Keynes was aware that public decisions are taken by individuals and they have a rather short term view of their political carriers as for instance do financial investors too (the topic Keynes discusses in preceding sections of chapter 12 where the discussion of animal spirits appears).

In effect, Keynes argued that fiscal policy stabilizes consumption in the short run and investment in the long run. Monetary policy can accomplish neither because it cannot stabilize expectations by targeting the interest rate. This is not to argue that money does not matter; in fact, the opposite is true.

So, that is as far as the role of animal spirits goes in Keynes. Akerlof and Shiller discuss various psychological influences on animal spirits (confidence, fairness, bad faith and corruption, money illusion, and stories). However, their assumption is that those influences exist and are important because expected utility hypothesis is violated. People are not motivated by maximization of expected returns; that is one of the most important claims of behavioural economics. So, animal spirits are a substitute for e.g. rational expectations and not their complement. This is contrary to Keynes’ understanding of the role of animal spirits, because those are relied on when expected utility cannot be calculated as well as when those would suggest caution when action would be required.

Farmer models animal spirits as a random belief function and shows that it may lead to multiple equilibria and be consistent with rational expectations. This is closer to Keynes’ concept of animal spirits. The self-fulfilling part of this sunspot dynamics is more trivial then may sound. If investment is motivated by an expected value and if the calculation is consistent, saying that the prophecy of that value being realized has been self-fulfilled or that the level of investment has led to such value – are indistinguishable propositions. The multiple equilibria part is also obvious because different levels of investment will bring about different levels of returns or output or employment, the latter being Farmer’s main concern as it was Keynes’ too. The difficult part is to show that the existence of multiple equilibria or of a continuum of equlibria is consistent with wide range of assumptions e.g. that of flexible prices, and thus have a general validity, which Farmer accomplishes by the introduction of search in the labour market.

This, however, is different from Keynes’ theory because he did not think that the expected returns could be calculated, at least not with any confidence.[6] Keynes’ long-term investor does not peg its decisions on any value so there is nothing to be self-fulfilled. In fact, Keynes emphasizes that the outcome will generally be quite different from that which was expected. It is the disregard of that difference that animal spirits help to accomplish. Long-term investment begins and ends with uncertainty.

This difference between Farmer and Keynes can account for Farmer’s preference for monetary rather than fiscal policy (he suggests that the central bank should intervene in the stock market to stabilize the prices of assets), which was what Keynes tended to emphasize in both short and long run.

Keynes concept of animal spirits is basically the consequence of his view of induction and probability and is neither an introduction of irrationality nor is it psychological. It is a matter of logic or rather of the deficiencies in inductive logic.

2. Keynes as a Monetarist

In General Theory Keynes states: „The schedule of the marginal efficiency of capital may be said to govern the terms on which loanable funds are demanded for the purpose of new investment; whilst the rate of interest governs the terms on which funds are being currently supplied.”[7] In his debate with Ohlin[8] he makes it clear that his is, to put it the way I understand it, a monetary theory of interest and not an interest theory of money.

This is taken into account in Hicks’ (1937) ISLM model which summarizes Keynes’ theory in three equations:

M = L(I, i);      Ix = C(i);         Ix = S(I)

where M is money, L is liquidity, I is income, Ix is investment, C is consumption, and S is saving. So, money is a function of income and the interest rate, investment depends on the interest rate, while savings adjust to investments. Hicks thought that these three equations form Keynes’ special theory, while in his general theory Keynes, according to Hicks,  makes savings also dependent on the interest rate; i.e. Ix=S(I, i). So, in Keynes’ special theory, demand for liquidity influences the interest rate while investments depend on the marginal efficiency of capital and savings equal investments in an accounting sense. The last point presented a problem to Hicks and also Ohlin (1937a, 1937b) because, inter alia, it seemed like teasing out a causal, behavioural relation from an accounting identity.

There are two problems with Hicks’ interpretation of Keynes’ model. One is that Hicks does not distinguish in the model clearly enough between the interest rate and the marginal efficiency of capital, which perhaps explains his belief that the model can be generalized by making saving dependant on the interest rate. The other is that Keynes insisted that his was the general theory while the classical theory, to the extent that it was not confused, was a special case of that general theory. Putting the second issue aside until later, Keynes’ main point is that supply price of loanable funds may differ from the demand price, i.e. that the prevailing interest rate may diverge from the achievable marginal efficiency of capital. So, if liquidity preference is high, interest rate will be high, given the available supply of money, and as marginal efficiency of capital will fall only as much as to be equal to the interest rate, investments may not be plentiful enough to drive marginal efficiency of capital as far down as it could go to ensure full employment.

Thus, Keynes’ is a monetary theory of interest (and employment). If liquidity preference was low, interest rate could be low and relatively quickly investment could be increased to the point of full employment. Capital is an intermediary factor of production, a produced good, so there can be no genuine shortage of it except if it is not generated by inadequate monetary and financial policies. In that sense, Keynes was a monetarist.

Keynes (1937a, 1937b) did respond to Hicks’ criticism, or rather to Ohlin’s criticism, as he thought those were the same, but the latter he found to be better argued and clearer. In that debate he did address the issue of the causal dependence between saving and investment and agreed that the notion of ex ante investment made sense, but not that of ex ante saving. The issue is not so much that saving does not depend on the interest rate, but that ex ante financial decisions are properly seen as investment decisions and not as decisions to save. Keynes thought that ex ante saving made as little sense as ex ante consumption. So, it is not that savings do not depend on the interest rate, but that the interest rate depends on the demand for money and so the quantity of money as determined by the banking system will set the interest rate.

Thus, it is clear that Keynes thought that there could be shortage of money, in the sense of the interest rate being too high, and thus insufficient investment or shortfall of effective demand, but not shortage of savings. That is how he was a monetarist.

That can be seen also when Keynes’ theory is compared to that of the New-Keynesians, who rely on the interest theory of money. In the simple three equation model (worked out in detail by Woodford, 2003), money does not appear at all. Keynes also differs from the Keynesians, who were keen on the Philips curve, which does not appear in Keynes’ work, as far as I could detect, and is probably inconsistent with his theory of employment. The Old-Keynesian model as interpreted by Leijonhufvud (1968) and formalized by Farmer (2009) still focuses primarily on the labour market imperfections (search costs rather than inflexible prices) and also on the influence of the animal spirits (on which see the discussion in the previous note). Keynes of course was more concerned with involuntary unemployment and argued for the need to stabilize nominal wages, and thus prices, in order to avoid large real fluctuations and especially deflationary pressures.

If Keynes is compared to Friedman and old monetarists, the difference is both in the theory of money and also in the theory of interest. Clearly, Keynes does not accept the classical neutrality assertion (it is not clear that it is a theory). This is because his is a micro-founded theory of money while theirs is not. Still, old monetarists and Keynes shared the concern with nominal instability, did agree that shortage of money can be a serious problem (Friedman’s and Schwartz’s argument in A Monetary History of the United States), and favoured flexible exchange rates. On the last point, the argument for flexible exchange rates in General Theory and in Friedman’s paper is practically the same at least when it comes to effects on wages and employment.

More puzzling is the difference between Keynes and rational expectations macroeconomists. In their paper “After Keynesian Macroeconomics”, Lucas and Sargent (1978) argued that the issue between them and the Keynesians was one of method primarily. They prefer to work with models that feature self-interested individuals and markets that clear. The individuals will have rational expectations and prices will be flexible. Their main point has been that this equilibrium macroeconomics will be a better guide to economic policy. In a nutshell, that policy of stabilizing prices (e.g. policy of great moderation) will deliver much better results than discretionary fiscal policy in whatever form or shape.

Now, Keynes does not discuss fiscal policy all that much in the General Theory. He clearly thinks that a person is better off if employed even on tasks that do not satisfy the requirements of efficiency, which could be provided by the state, and he thinks that the social benefit of such employment is greater than what can be gotten from that person being involuntarily unemployed. Most every reference to fiscal policy (as far as I could tell) in the General Theory is an instance of that policy assessment. If that is correct, it can be argued that equilibrium macroeconomics is radically different because it treats that kind of employment as inferior on efficiency grounds to even significant unemployment as long as it can be consistently fitted into an equilibrium model.

Which is a more general theory? Keynes thought that a model that cannot explain both the occurrence of involuntary unemployment and derive a role for policies that could bring about full employment is not a general one, and that the generality cannot be bought by arguing that short term needs to be modelled like the long term (Lucas’ point and possibly an implication of rational expectations) in order to explain the deviation of the short term from the long term. He also, as far as I can see, did not rely on an idea of market failures in which case an equilibrium theory could in fact be useful. He also argues at the end of the General Theory that the economic problem can be solved and in that he does sound a lot like Frank Ramsey (in “A Mathematical Theory of Saving”, 1928) who can be considered to have been very much an equilibrium type of a thinker.

Overall, I find that Keynes is closer to Lucas (2003) because of the stress on monetary policy and because he does not rely on ad hoc assumptions about rigidities or irrationalities. The difference is in the theory of interest – Keynes’ is a monetary one and is micro-founded (Keynes believed, as did Hicks, 1935, and later Patinkin, 1956, that theories of value and money are not two but one theory) and thus violates monetary neutrality while equilibrium macroeconomics assumes neutrality and thus it is not clear how it could be micro-founded. Money in Keynes can be scarce not because of central bank mismanagement but because of liquidity preferences. That is how I understand the quote I put in the introduction to this short note.

3. Keynes on Spain, UK, India, and by a Stretch the EU

Quantity theory of money, Keynes could be interpreted as arguing, is no theory of money at all, because it is not a theory of interest. It is even less of a guide to monetary policy. Once classical economics is seen as lacking a theory of money and interest, it becomes clear why it has no theory of employment and can suggest no policies to deal with involuntary unemployment. That realization sheds new light on pre-classical and non-classical economics. Especially in the area of international trade and investment that is the proper setting for the theory of money and interest.

In the General Theory, these international economics issues Keynes addresses mainly in the chapter on mercantilism, where his main aim is to criticise the theory of free trade and its policy implications. He does give the classical theory credit in the following way:

“Regarded as the theory of the individual firm and of the distribution of the product resulting from the employment of a given quantity of resources, the classical theory has made a contribution to economic thinking which cannot be impugned. It is impossible to think clearly on the subject without this theory as a part of one’s apparatus of thought. I must not be supposed to question this in calling attention to their neglect of what was valuable in their predecessors.”

But he criticizes its lack of contribution to policy:

“Nevertheless, as a contribution to statecraft, which is concerned with the economic system as whole and with securing the optimum employment of the system’s entire resources, the methods of the early pioneers of economic thinking in the sixteenth and seventeenth centuries may have attained to fragments of practical wisdom which the unrealistic abstractions of Ricardo first forgot and then obliterated. There was wisdom in their intense preoccupation with keeping down the rate of interest by means of usury laws (to which we will return later in this chapter), by maintaining the domestic stock of money and by discouraging rises in the wage-unit; and in their readiness in the last resort to restore the stock of money by devaluation, if it had become plainly deficient through an unavoidable foreign drain, a rise in the wage-unit, or any other cause.”

The key criticism is that the theory of international laissez-faire relies on “the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time.” If international trade does not ensure such self-adjustment, a reconsideration of the theoretical basis of mercantilist policies is warranted: “For we, the faculty of economists, prove to have been guilty of presumptuous error in treating as a puerile obsession what for centuries has been a prime object of practical statecraft”. That leads Keynes to argue that, under the gold standard, mercantilist policies are not completely nonsensical because it is via the balance of trade that domestic interest rates are determined and if they were to be low enough to ensure full employment, influx of money via trade surpluses would be needed. More generally, fixed exchange rates require a “favourable balance of trade”.

After providing for an understanding of the mercantilist focus on the trade balance, he warns of two problems:

“There are, however, two limitations on the success of this policy which must not be overlooked. If the domestic rate of interest falls so low that the volume of investment is sufficiently stimulated to raise employment to a level which breaks through some of the critical points at which the wage-unit rises, the increase in the domestic level of costs will begin to react unfavourably on the balance of foreign trade, so that the effort to increase the latter will have overreached and defeated itself. Again, if the domestic rate of interest falls so low relatively to rates of interest elsewhere as to stimulate a volume of foreign lending which is disproportionate to the favourable balance, there may ensue an efflux of the precious metals sufficient to reverse the advantages previously obtained. The risk of one or other of these limitations becoming operative is increased in the case of a country which is large and internationally important by the fact that, in conditions where the current output of the precious metals from the mines is on a relatively small scale, an influx of money into one country means an efflux from another; so that the adverse effects of rising costs and falling rates of interest at home may be accentuated (if the mercantilist policy is pushed too far) by falling costs and rising rates of interest abroad.”

For these deficiencies he refers to three examples. First, the case of bubbles: “The economic history of Spain in the latter part of the fifteenth and in the sixteenth centuries provides an example of a country whose foreign trade was destroyed by the effect on the wage-unit of an excessive abundance of the precious metals.” Second, the case of deflation: “Great Britain in the pre-war years of the twentieth century provides an example of a country in which the excessive facilities for foreign lending and the purchase of properties abroad frequently stood in the way of the decline in the domestic rate of interest which was required to ensure full employment at home.” Third, an instance of persistent liquidity trap: “The history of India at all times has provided an example of a country impoverished by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth.”

He goes on to discuss various aspects of mercantilist theories and policies, finding more sense in the latter, e.g. in the policy of usury laws. As is often the case with him, Keynes is given to sweeping judgements on controversial issues: “Provisions against usury are amongst the most ancient economic practices of which we have record. The destruction of the inducement to invest by an excessive liquidity-preference was the outstanding evil, the prime impediment to the growth of wealth, in the ancient and medieval worlds. And naturally so, since certain of the risks and hazards of economic life diminish the marginal efficiency of capital whilst others serve to increase the preference for liquidity. In a world, therefore, which no one reckoned to be safe, it was almost inevitable that the rate of interest, unless it was curbed by every instrument at the disposal of society, would rise too high to permit of an adequate inducement to invest.

I was brought up to believe that the attitude of the Medieval Church to the rate of interest was inherently absurd, and that the subtle discussions aimed at distinguishing the return on money-loans from the return to active investment were merely Jesuitical attempts to find a practical escape from a foolish theory. But I now read these discussions as an honest intellectual effort to keep separate what the classical theory has inextricably confused together, namely, the rate of interest and the marginal efficiency of capital. For it now seems clear that the disquisitions of the schoolmen were directed towards the elucidation of a formula which should allow the schedule of the marginal efficiency of capital to be high, whilst using rule and custom and the moral law to keep down the rate of interest.”

After giving each side, the free trade and the mercantilist, their due for their theories, the classicists, and policies, the mercantilists, he offers his alternative to both the international laissez-faire theory and also to mercantilist policies.

“It is the policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment programme directed to an optimum level of domestic employment which is twice blessed in the sense that it helps ourselves and our neighbours at the same time. And it is the simultaneous pursuit of these policies by all countries together which is capable of restoring economic health and strength internationally, whether we measure it by the level of domestic employment or by the volume of international trade.”

Here countries and nations are not defined by being optimal currency areas, a la Mundell but just by the ability to set interest rates. In that sense, the EU is a country, indeed the world is. It only lacks an “investment programme”, which could be understood as a common fiscal policy. So, implicitly, the key issue in a country defined as a currency or monetary union is lack of fiscal integration, which is certainly informative of the troubles the EU faces.

Whether countries or monetary unions can set monetary policy “unimpeded by international preoccupations” is I think a central issue. Keynes has gone from criticising the free-traders for their lack of preoccupation with the trade balance and for their belief in self-adjustment of foreign trade to a position that with “simultaneous pursuit of these policies” in, presumably, the regime of flexible exchange rates, foreign trade will be self-adjusting and the development of the balances of trade can safely be disregarded.

4. Persuasion as Policy

Here is the rather controversial quote from Keynes’ Preface to the German Edition of the General Theory of Employment, Interest, and Money: „..(T)he theory of output as a whole, which is what the following book purports to provide, is much more easily adapted to the conditions of a totalitarian state, than is the theory of the production and distribution of a given output produced under conditions of free competition and a large measure of laissez-faire. The theory of the psychological laws relating consumption and saving, the influence of loan expenditure on prices and real wages, the part played by the rate of interest … these remain as necessary ingredients in our scheme of thought.”

This statement comes as a conclusion to a short history of economic thought in which Ricardo’s influence dominates and German historical school is seen as basically a-theoretical. In the course of this review Keynes states characteristically: “The Manchester School and Marxism both derive ultimately from Ricardo … a conclusion which is only superficially surprising.”[9] Similarly, he sees the Austrian school and Marshall as basically Ricardian. Wicksell he puts aside, but his influence is confined to Sweden mainly because his work in German is misinterpreted by the Austrians. So, German economics should be more susceptible to his ideas because it has remained uncontaminated by Ricardo’s influence given that it has mainly remained descriptive and not really scientific – almost a theoretical tabula rasa. And then totalitarian reality in which German economists find themselves should enable them to be interested in the theory of the output as a whole. Even though, Keynes’ is not a totalitarian, but liberal theory of the output as a whole.

This attitude is not a strange one for Keynes. He was generally disdainful of neoclassical economics and utilitarian moral theory and thought of the socialists and Marxists as being generally their followers. He was impressed by the spirit that prevailed in Communist Russia in mid-1920s when he visited it, but he was not impressed by the Gosplan’s idea of planning because it required calculations of expected costs and benefits that he thought cannot be made – in principle, not because of lack of data or of the appropriate methodology.[10] By contrast, he wrote approvingly of the early totalitarian states, e.g. of Egypt’s building of pyramids which he saw as an effective employment policy. This is how I understand his reference to totalitarian conditions: it is not meant to apply to the current German conditions specifically, but to those prevailing in totalitarian societies whenever and wherever those are to be found. It is a way Keynes is emphasizing that he is proposing a general theory, which is a theory that applies to all political and economic conditions. The real challenge is not, he is saying, to see its applicability to totalitarian states, but its relevance for liberal and market economies. One chooses, he is arguing, liberal and democratic institutions for all the good reasons, but the macroeconomic problems and tasks are still the subject of the same general economic theory.[11]

What are the differences? Three, as it transpires from the quoted passage: one is the understanding of the need for theory and policy of the output as a whole in a decentralized setting of production and distribution; second is the understanding of the psychological laws of consumption and saving (the propensity to save or to consume); and the third, the effect of investments on prices, e.g. the relative ones of wages and the interest rate.

The first issue is perhaps the one that Keynes spent most of his efforts on: how to persuade the policy makers about the ends that they should aim at? The comparison with the way he sees the German economists approaching this issue is quite illuminating. He assumes that without political guidance on the ends of policies, German economists will not rise above description. Once, however, the policy targets have been chosen, they should be more than capable of developing theories and advising on polices that would lead to the implementation of these targets. His is a different political environment. The politicians are slaves of defunct economists both in terms of the definition of the aims of economic policy and of the means to achieve them. Therefore, they need to be persuaded not just to change their ways, but to choose a different policy objective function. This is in essence what persuasion as policy is all about. Or to put it differently, that is why economists have to have persuasions, have to be committed to ends, and not just advice on the most efficient way of achieving them.

The second issue is very much about the way reality enters into the persuasion and the theory. Again, the presumed difference with the German historicist school is useful. Unlike historicism, which believes in the deep rooted cultural differences, Keynes, without disputing those theories, takes an empiricist or inductive approach to psychological issues. He assumes regularities in the propensities to consume and save as he thinks he can find them in the actual behaviour of consumers and business people. In the modern econometric parlance, Germans take that culture determines the deep parameters, while Keynes works with empirical regularities in the shallow parameters that he can induce from the data that is his experience and anything else that can be brought about by systematic or non-systematic collection of data. He is ready to change his psychological assumptions if those are not supported by the reality. So, reality enters inductively, not deductively as in the school of German historicism. His general theory is not really dependent on specific propensities of people to consume or save. There have to be some regularities, psychological laws, but the theory is supposed to be able to accommodate any variation in those, i.e. it should be applicable to any set of actual data, to changing reality as it were.

The third issue is about the role of relative prices. This is the crucial issue because on it the efficiency of policies depends. In a totalitarian setting, relative prices need not concern the policy maker and are thus not a constraint on its actions. Totalitarian states nationalize investment and set the prices. “Under conditions of free competition and a large measure of laissez-faire”, this is different. Here, it may be useful to compare Keynes’ approach to that of the new classical macroeconomics, which is based on rational expectations and the real business cycle. The most straightforward way to draw the difference is to assume the situation when everybody is a price taker. With that, one assumes that the change in the fundamentals, which means the change in preferences, endowments and technologies, leads to a change in relative prices. Investments are determined in the same price-taking manner; policies cannot affect those too much or at least not in the long run. Of course, asymmetric information, or rather the information frictions as well as non-optimal fiscal policy can have a temporary influence and perhaps even long term influences if these frictions are institutionalized, but once there is general price taking, i.e. prices are set under competitive and laissez-faire conditions, there is no scope for effective policy intervention, at least not the one that improves on the overall outcome. If, however, investments are motivated by animal spirits because there is no way that prices for long term investments will be given, the financial conditions matter, there is the need to look at the role that interest on loans plays and how the expenditures on investments influence employment and wages. The idea is not that either relative or nominal prices are sticky, but that policies pursued can influence their development and thus their influence on the development of the output as a whole.

These persuasions raise moral issues as Keynes was aware. In the setting he had to persuade the politicians and the public, he was aware from very early on that one needs to argue that bad is good as he says a number of times and most clearly in the essay on our obligations to our grandchildren.[12] But the same moral challenge is faced by those who need to persuade politicians in totalitarian Russian and German conditions. As far as I can see, his hopes were not high, but I guess he could have argued that once the general theory of the output as a whole is developed, it could prove useful once “the conditions of free competition and a large measure of laissez-faire” return.

5. Models, Rationality, Representation, and Laissez-Faire

Commenting on the draft of Kalecki’s paper on taxation, submitted for publication in The Economic Journal,[13] Keynes first says this: “If the capitalists assume that their income subject to tax will remain the same, the effect of the tax will surely be to reduce their spending. It is only if they have read your article and are convinced by it that their profit will rise by the amount of the tax that they will maintain their spending as before”.

Kalecki answered in the following way: “I do not think they must necessarily read my article in order not to curtail at once their expenditure on consumption and investment… After the introduction of new tax the entrepreneurs even if they expect their incomes to fall cannot immediately reduce their investment because it is the result of the previous investment decisions which require a certain time to be completed. Thus their savings remain unaltered in the first period of new taxation regime. Their consumption remains unaltered, if their propensity to consume is not changed. This latter is of course an additional assumption, for the expectation of future fall of income can influence the present propensity to consume. I think, however, that the capitalists’ consumption is rather insensible to expectations and that it is only the actual fall of their income which can compel them – and this is often only with a time lag – to reduce their standard of living.”

Keynes then replied as follows: “1. I regard the assumption that investment is fixed as unplausible. Firstly, because it ignores the possibility of fluctuation in stocks. Secondly, because it ignores the possibility of altering the pace at which existing investment decisions are carried out, and thirdly, because at best it can be overcome after a time lag, which may be very short indeed. 2. I think it unplausible to suppose that capitalists’ consumption is insensitive to their expectations, for the latter are affected by a change in the taxes on their income. 3. Much more important than the above, with all these assumptions you can prove something much more drastic and general than you have put down, from which your particular conclusions can be easily derived. But, of course, these more drastic conclusions would not look very plausible if applied to real life.”[14]

First, models matter. If capitalists consider primarily the partial equilibrium effects, that is effects on their income ceteris paribus, they will react differently than they would if they were to calculate the general equilibrium effects of increased taxes on income from capital on consumption and conclude that they should in fact not change their production and investment because their profits will increase. In both cases, the macroeconomic balances will be satisfied, so those cannot be used to infer the behaviour, in this case, of capitalists.

This is sometimes somewhat misleadingly called self-fulfilling prophecy. What Keynes is saying here is that one needs micro-foundations for macroeconomics – both for analytical and also policy purposes. One needs to assume what a representative capitalist will do in response to a policy intervention. Kalecki argues that the reaction is causally determined, at least in the short run, by past decisions or habits, while Keynes is concerned with the influence of expectations. The reason that micro-foundations are needed is that macroeconomic balances do not determine the behaviour of, in this case, capitalists.

When it comes to micro-foundations, the model relied on, and not only the expectations, is important. It is not enough, for instance, to assume that capitalists have rational expectations, because those do not uniquely select the model on which those are based. Muth has argued that: “(E)xpectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.”[15] However, expectations do not choose the relevant theory or model – one needs to be assumed.[16] In the often cited passage from the chapter on long-term expectations in the General Theory, Keynes states:

“A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.”

John Muth deals with this problem in this way: “The [rational expectation] hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of the outcomes).”

Lucas in his famous paper on policy evaluation adds the political economy foundation to rational expectations: „(I)t appears that policy makers, if they wish to forecast the response of citizens, must take the latter into their confidence. This conclusion, if ill suited to current econometric practice, seems to accord well with a preference for democratic decision making.“[17] But of course this opens up more questions than it answers, as democratic decision making is just another model with the same micro-macro problems. Even if a representative actor is assumed, there is no presumption that the aggregation in the market place will deliver the same representation as the political process. And indeed, the new-classical macroeconomics relies on game theoretical equilibrium concepts (mainly on Nash equilibrium), but those have problems of their own.

Second, expectations matter not only for investments, but also for consumption. There is, however, an interesting asymmetry between the behaviour of capitalists and workers. In chapter 19 of General Theory on changes in money-wages (and also in chapter 21 on the theory of prices), Keynes argues that workers tend to smooth their consumption and that has a stabilizing effect on employment and prices. He does not assume that prices are inflexible, but that the general level of prices tends to be stable due to the behaviour of labour. That is not inconsistent with the beneficial effect of the wage flexibility on the micro or the level of particular industries. However, flexibility of wages in general would lead to the instability of the general level of prices and in cases of deflation to additional negative contribution to growth – except to the extent that foreign trade plays a significant role or there is perhaps increase of consumption by capitalists and those living on rents.

So, Keynes does not simply argue that lower wages will lead to lower consumption and thus would lead to negative economic developments. He micro-founds the stability of prices on the workings of the labour market and, in the end, on the behaviour of workers. That makes it possible to rely on fiscal policies to increase consumption and employment. In that, he relies on the multiplier, which mostly works through increased consumption of the unemployed or those additionally employed. In that way, he combines price stability with growing consumption and employment. In that sense, his analysis satisfies Muth’s requirement on dynamic models: “Our [rational expectations] hypothesis is based on the … point of view: that dynamic economic models do not assume enough rationality.” This is one way in which Keynes’ model assumes rationality:

“(I)t is fortunate that the workers, though unconsciously, are instinctively more reasonable economists than the classical school, inasmuch as they resist reductions of money-wages, which are seldom or never of an all-round character, even though the existing real equivalent of these wages exceeds the marginal disutility of the existing employment; whereas they do not resist reductions of real wages, which are associated with increases in aggregate employment and leave relative money-wages unchanged, unless the reduction proceeds so far as to threaten a reduction of the real wage below the marginal disutility of the existing volume of employment. Every trade union will put up some resistance to a cut in money wages, however small. But since no trade union would dream of striking on every occasion of a rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment which is attributed to them by the classical school.”

He makes a similar argument for the debt financing of public spending. It pays for itself through increased public revenues. That happens because of the stability of the propensity to consume and of prices with growing incomes and employment. That policy of debt financing of public expenditures, in addition, is consistent with sound fiscal management of balanced budgets.[18]

The third point Keynes makes is perhaps the most important one. For a theory to explain there has to be an appropriate relation between it and the reality. If assumptions piled up lead to what amounts to a set of definitions and their substitution, the theory will lose its explanatory power. This is how he describes his own realism:

“I see no reason to suppose that the existing system seriously misemploys the factors of production which are in use. There are, of course, errors of foresight; but these would not be avoided by centralising decisions. When 9,000,000 men are employed out of 10,000,000 willing and able to work, there is no evidence that the labour of these 9,000,000 men is misdirected. The complaint against the present system is not that these 9,000,000 men ought to be employed on different tasks, but that tasks should be available for the remaining 1,000,000 men. It is in determining the volume, not the direction, of actual employment that the existing system has broken down.”

This view of the market economy could be contrasted with that of, for example, Hayek and maybe with real business cycle theorists. Keynes rejects the Say‘s Law, but does not suggest that market economy is not efficient. He has no quarrel with the classical (now neoclassical) microeconomics. It just does not deliver full employment without policy interventions – what works on the micro level, does not work in the aggregate. Hayek and others that explain business cycles by one or the other shock, endogenous or exogenous, assume or imply that markets do not function efficiently on the micro level. Otherwise, it would be hard to explain the equilibrating role of business cycles in the neoclassical framework. Also, Keynes assumes away the existence of structural over-employment or unemployment as well as of structural over-investment or underinvestment. He has no room for microeconomic market failures unlike the proponents of structural or real business cycles theories. So, in a way, Keynes relies more on laissez-faire than the advocates of the equilibrium theory of business cycles.


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Peščanik.net, 09.01.2012.


  1.  See also Howitt and McAfee (1992), De Grauwe (2011).
  2. Keynes (1937c) basically repeats this argument in his answer to some of the critics, though he does not refer to animal spirits.
  3. At the beginning of Chapter 12 of the General Theory Keynes refers to Chapter 6 of A Treatise on Probability, which deals with the difference between the weight of evidence and the probability of an argument. Clearly, an argument may have more weight, i.e. is based on more evidence, and be less probable for that very reason at the same time. Keynes refers to this consideration in Chapter 26 of A Treatise on Probability, from which the above quotes are taken, but the connection between the two does not seem to be altogether straightforward. In any case, the point must be to reiterate the problems that induction faces, which could be another reason that intuition or animal spirits are needed. This would be in concert with Hume’s view on those matters.
  4. These quotes are intended only to show the consistency of Keynes’ thinking on mathematical expectation and should not be taken as a claim that Keynes did not change his understanding of probability after the criticism he received from Frank Ramsey in his „Truth and Probability“ (1926). Keynes acknowledges that he accepts part of that criticism in his piece on Frank Ramsey printed in his Essays on Biography. But while he accepts that he is wrong to treat probability as part of logic of partial belief, he still maintains that as a matter of logic the hold of probability on action is only partial. This can be seen in that part of the quote above where he starts with “if the question of right action is under all circumstances a determinate problem,…”.
  5.  Matthews (1984) cites Keynes’ notes on philosophy in which it is noted that Descartes used the term animal spirits. Matthews’ paper is very accurate in the interpretation of what Keynes’ actually meant by animal spirits.
  6.  This is in fact recognized in Benhabib and Farmer (1999: 389).
  7.  Keynes (1936), Ch. 13, p. 159. Ramsey (1928) says the following (p. 556): „The difficulty is that the rate of interest functions as a demand price for a whole quantity of capital, but as a supply price, not for a quantity of capital, but for a rate of saving.”
  8.  Ohlin (1937a, 1937b), Keynes (1937a, 1937b)
  9.  However, he credits Marx for understanding the importance and the role of effective demand: “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 could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas”.
  10.  “A Short View of Russia“ (1925), reprinted in Essays in Persuasion.
  11. This is not in fact different from the position that Mises, Hayek, and also Friedman took on the issue of the generality of economic theory and its importance for understanding totalitarian as well as market economies. Of course, theirs was a different economic theory.
  12.  “Economic Possibilities for our Grandchildren” (1930), reprinted in Essays in Persuasion.
  13.  Eventually published as Kalecki (1937).
  14. This exchange of letters can be found in M. Kalecki, Collected Works Vol. I, pp. 559-562. Clarendon Press, 1990. See an extensive discussion in De Vecchi (2008).
  15.  Muth (1961).
  16.  See e.g. R. Frydman, E. Phelps (1983).
  17.  Lucas (1976), p. 46.
  18. See Keynes (1933), ch. 3.

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Vladimir Gligorov (Beograd, 24. septembar 1945 – Beč, 27. oktobar 2022), ekonomista i politikolog. Magistrirao je 1973. u Beogradu, doktorirao 1977. na Kolumbiji u Njujorku. Radio je na Fakultetu političkih nauka i u Institutu ekonomskih nauka u Beogradu, a od 1994. u Bečkom institutu za međunarodne ekonomske studije (wiiw). Ekspert za pitanja tranzicije balkanskih ekonomija. Jedan od 13 osnivača Demokratske stranke 1989. Autor ekonomskog programa Liberalno-demokratske partije (LDP). Njegov otac je bio prvi predsednik Republike Makedonije, Kiro Gligorov. Bio je stalni saradnik Oksford analitike, pisao za Vol strit žurnal i imao redovne kolumne u više medija u jugoistočnoj Evropi. U poslednje dve decenije Vladimir Gligorov je na Peščaniku objavio 1.086 postova, od čega dve knjige ( Talog za koju je dobio nagradu „Desimir Tošić“ za najbolju publicističku knjigu 2010. i Zašto se zemlje raspadaju) i preko 600 tekstova pisanih za nas. Blizu 50 puta je učestvovao u našim radio i video emisijama. Bibliografija