The legacy of John Maynard Keynes - An examination and analysis of the General Theory
Before John Maynard Keynes, few economists had taken such an exhaustive look at how investment influenced business cycles. But this all changed when Keynes' published his General Theory of Employment, Interest and Money. In this staple of economic literature, Keynes put forth a new theory of investment which examined how businesses make decisions and included new thoughts on expectations and money demand. Keynes' theory of investment takes economic researchers one step closer to solving a centuries long puzzle - why do economies have a tendency to slow down?
At the heart of Keynes' investment theory is the Marginal Efficiency of Capital, an idea which explains how businesses make decisions. According to lecture, businesses rank investment opportunities by their potential profitability. They do this by examining an investment's Marginal Efficiency of Capital (MEK) which represents the market rate of interest on that project. If the MEK is greater than the natural rate of interest, a business will invest because they will be earning a profit. Likewise, if MEK is less than the natural interest rate, the business will turn to other opportunities - it does not make sense to invest in a project which will yield less profit than cash in a money market account, for example. Lecture provides an equation which shows how MEK affects decisions:
Investment = Marginal Efficiency of Capital - natural rate of interest
But the above equation alone does not tell the whole story. Indeed, marginal efficiency of capital is composed of two parts - prospective yield and replacement cost of capital. When these two are taken into account, the equation now looks like this:
Investment = Prospective yield - replacement cost of capital - natural rate of interest
Keynes' introduction of prospective yield, also called the rate of return, is especially important because this rate is based upon expectations of future market conditions. But because the future is uncertain, expectations may fluctuate due to the state of confidence at the time. For instance, as the events of the Great Depression unfolded, the state of confidence was abysmal, as the stock market crash and large unemployment rates sent shudders through the economy. Keynes would suggest that investors at the time would be less likely to put money into new products because the rate of return was expected to be very low. However, as the economy improved, investors would have a greater willingness to invest because they sensed a recovery and profitable opportunities on the horizon. Ultimately, Keynes implies that the state of confidence drives investment, as it determines whether or not the future will be profitable.
The implications of Keynes' MEK suggest how investment drives an economy overall. Over the cycle, companies will move from more profitable activities to less profitable ones. These less profitable opportunities will have a lower MEK, as the prospective yield is lower. But in the pursuit of profit, companies will take on more debt and find that their replacement cost of capital continues to rise. At some point, investment will stop when companies find see that the opportunities that are left have an MEK which equals the natural rate of interest. When investment stops, the economy will start to falter.
But the other half of Keynes' formula includes interest rates and these should not be excluded from the discussion. Unlike the classical economists who felt that interest rates represented the "cost of waiting" for one's cash to appreciate, Keynes felt interest was the price investors paid in exchange for giving up liquidity. This difference allows Keynes to develop what he called a "liquidity preference," which according to lecture measures an investor's willingness to tie up their money. For example, during a recession, investors will have a much higher liquidity preference because they are afraid of their money depreciating. Because they would prefer holding cash, investors will demand a higher rate of interest on non-money assets in order to compensate for risk.
But if money demand becomes a factor during downturns, this means using interest rates as a policy tool may be ineffective. Keynes says that a central bank can try lowering interest rates to zero, as an attempt to stimulate the money supply, but they face a problem - the liquidity trap. According to lecture, a liquidity trap occurs when a monetary authority cannot lower interest rates any further, but still can't stimulate investment (it also can't raise rates because this move would harm the economy further). The liquidity trap occurs because companies are not willing to accept any return for liquidity because they anticipate conditions will remain negative for awhile. Indeed, while nominal interest rates fall to zero, real interest rates will rise. Thus, although the money supply is increasing, its affect is outweighed by growing money demand, ie. hoarding. In order to address this problem, Keynes offers a different solution - instead of stimulating investment, a government should address consumption. If a government is unable to boost consumer demand, it should undertake public spending in order to lift an economy out of a downturn.
Keynes' legacy lies in the marginal efficiency of capital schedule, which is a realistic view of how businesses pursue investments during a cycle. This vision was most expanded upon by Hyman Minsky, a prominent Post-Keynesian who suggested that as businesses move towards less profitable investments, their debt burden threatens the system as a whole. Minsky takes Keynes' ideas about animal spirits and the dangers of speculation and transforms them into a more developed work, the "Financial Instability Hypothesis," which examined the role of finance in great detail. In this theory he suggests that the evolution of financial institutions over the cycle causes the endogenous slowdowns that Smith, Ricardo, Marx and Keynes noticed. Corporate evolution over the cycle can be broken down as follows: in the beginning, businesses start out with hedge financing, where the cost of their financing and debt is repaid by existing cash flows. However, as companies continue to pursue profits, they must take on more debt in order to finance new, less profitable ventures. Sometimes, these new profits can only be found through developing new tools, like securitizing financial instruments. Minksy points out how banks often are at the heart of financial innovation: "Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers . . . are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market" (Minksy 7). But as the piling debt starts to overwhelm their cash flow, corporations have to roll over their debt as their revenues can only cover their interest payments. This form, speculative financing, is somewhat unstable. However, the pursuit of profits continues and firms eventually fall into a trap - they must borrow more to pay off their old debts. However, this type of financing, Ponzi financing, is inherently unstable and will eventually lead to busts. Minsky suggests that as a whole, the pursuit of profits will lead to greater financial innovation, but this innovation in itself will cause instability. In order to prevent more busts, serious institutional reform must be conducted.
In recent decades, different schools of thought have attempted to challenge Keynes' ideas. But one that appears to have the most convincing argument is the Real Business Cycle theory (REBCT). This school of thought, led by Lucas and Prescott, harkens back to the neoclassical era and seeks to explain both growth and fluctuations through the consistent appearance of business cycles. Gone are Keynes' ideas about expectations - instead, investment and economic growth as a whole are determined by exogenous, random technology shocks. Such work has been proposed before by people like Schumpeter, but the REBCT school takes his thought even further. Unlike Keynes, who proposes solutions to fix fluctuations, the REBCT school believes "instability is the outcome of rational economic agents responding optimally to changes in the economic environment." Therefore, "observed fluctuations should not be viewed as welfare-reducing deviations from some ideal trend path of output" (Snowdon, Vane 331). For economic scholars who believe REBCT, recessions and depressions are natural market reactions to excess and should be allowed to happen. This belief has large implications because "The idea that the government should in any way attempt to reduce these fluctuations is therefore anathema to real business cycle theorists. Such policies are almost certain to reduce welfare" (Snowdon, Vane 331). Real Business Cycle theory is interesting because there is evidence that government intervention during downward cycles has harmed the natural recovery process. Theorists point to the actions of the Roosevelt Administration during the early years of the Great Depression. They say that when Roosevelt passed the National Industrial Recovery Act (NIRA), it encouraged anticompetitive behavior and caused the nation to recover far more slowly than if the cycle had been allowed to play out. Thus, "for Prescott the Keynesian explanation of the slump is upside down. A collapse in investment did not cause the decline in employment. Rather employment declined as a result of changes in industrial and labor market policies that lowered employment!" (Snowdon, Vane 337).
But while Keynes has constantly been challenged, his ideas must speak to some economic truth, as nations have consistently turned to his solutions. Indeed, during the recent financial crisis, Keynes's ideas have been brought to the forefront of government policy once again. As the government cracks down on speculators while pursuing an expansionary fiscal policy, it will be interesting to watch some of Keynes' ideas put into action. Because the theory of investment is an important - but often contentious theory - it would be wise for economics students to at least have a grasp on how it operates if they want to understand how large corporations can suddenly collapse overnight and how the largest economy in the world can falter.
1,756 words, 6 pages
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