Keynes’ … Employment
John Maynard Keynes The General Theory of Employment The Quarterly Journal of Economics, February 1937
This is Keynes’ reply to reviews of his General Theory of Employment, Interest and Money. While the ostensible subject is important, here I draw out issues that are relevant to the discussion of any complex problem.
Mr. Leontief is right, I think, in the distinction he draws between my attitude and that of the ‘orthodox’ theory to what he calls the ‘homogeneity postulate.’ I should have thought, however, that there was abundant evidence from experience to contradict this postulate; and that, in any case, it is for those who make a highly special assumption to justify it, rather than for one who dispenses with it, to prove a general negative.
This view has relevance to many current economic and social theories and simulations.
[T]he increased demand for money resulting from an increase in activity has a backwash which tends to raise the rate of interest; and this is, indeed, a significant element in my theory of why booms carry within them the seeds of their own destruction.
It may be delusional to think of booms without busts. It is also unfortunate one has too narrow a conception of a boom, and thus fails to recognize one until the bust.
… at any given time facts and expectations were assumed to be given in a definite and calculable form; and risks, of which, though admitted, not much notice was taken, were supposed to be capable of an exact actuarial computation. The calculus of probability, though mention of it was kept in the background, was supposed to be capable of reducing uncertainty to the same calculable status as that of certainty itself; just as in the Benthamite calculus of pains and pleasures or of advantage and disadvantage, by which the Benthamite philosophy assumed men to be influenced in their general ethical behaviour.
Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even though time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences. Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely, wealth. The whole object of the accumulation of wealth is to produce results, or potential results, at a comparatively distant, and sometimes indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth accumulation the more essential does such amendment become.
Conventional decision and probability theories assume that one is repeatedly making a series of short-term decisions, the ‘no-strategy strategy’. But if we are trying to build up ‘wealth’, such as social capital, a mature garden or a sustainable existence, then one may need a different logic. (See Keynes’ Treatise.) Since the time of writing, at least in the UK, it has been usual for businesses to demand that governments provide ‘stability’ and for citizens to demand that they supply a kind of long-term insurance (health and welfare), so business and citizens are (supposedly) less affected by long-run effectiveness and hence can focus their efforts on short-run efficiency. But they seem unable to discharge their promise.
By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters their (sic) is no scientific basis on which to form any calculable probability whatever. We simply do not know.
Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.
This may be what we do do, but what would we do if we understood the issues better?
How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:
(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.
(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.
(3) Knowing that our individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behaviour of the majority or the average. The psychology of a society of individuals each of whom is endeavouring to copy the others lead to what we may strictly term a conventional judgment.
This type of reasoning is largely regarded as pragmatic, and not confined to bankers.
Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled board room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.
Note that one tends, after a transitional period, to reach a new conventional basis: one tends not to reconsider the implicit assumptions, conceptions and habits.
If, on the other hand, our knowledge of the future was calculable and not subject to sudden changes, it might be justifiable to assume that the liquidity preference curve was both stable and very inelastic. In this case a small decline in money income would lead to a large fall in the rate of interest, probably sufficient to raise output and employment to the full. In these conditions we might reasonably suppose that the whole of the available resources would normally be employed; and the conditions required by the orthodox theory would be satisfied.
If there is no Keynesian uncertainty then one should focus on the economy and employment will sort itself out. If there is uncertainty then one needs to pay attention to both. (Modern economies tend to support the unemployed, thus complicating the situation. But nonetheless, taking account of uncertainty can affect the whole shape of policy. This may also be true outside economics.
On general issue Keynes notes that:
[I]t is usual in a complex system to regard as the causa causans that factor which is most prone to sudden and wide fluctuation.
This appears to me to be completely wrong. It seems to me to be much more common to pay attention to regular variations, analysable by statistical means, and from which one can gain a ‘rational’ advantage through data, computation and short-run analysis. Most complex systems of interest are adaptive, and evolve or learn from shocks, so that the factors which are most liable to cause sudden and wide fluctuations are novel, and not ones that are considered as probable. Perhaps Keynes meant that ‘it is usual to think that we should regard …’. Thus we should, but do not, regard uncertainty as critical, and our policies should be developed taking full account of uncertainty.
[M]y suggestions for a cure … are not meant to be definitive; they are subject to all sorts of special assumptions and are necessarily related to the particular conditions of the time. But my main reasons for departing from the traditional theory go much deeper than this. They are of a highly general character and are meant to be definitive.
I sum up, therefore, the main grounds for my departure as follows:
(1) The orthodox theory assumes that we have a knowledge of the future of a kind quite different from that which we actually possess. This false rationalisation follows the lines of the Benthamite calculus. The hypothesis of a calculable future leads to a wrong interpretation of the principles of behaviour which the need for action compels us to adopt, and to an underestimation of the concealed factors of utter doubt, precariousness, hope and fear. …
Keynes’ academic Treatise on Probability describes in detail why even the best techniques of statistical inference rely on assumptions about reality that may not hold. But there he concludes by supposing that in practice, they normally do, so that he approves of habits (1)-(3), considering them as ‘axiomatic’. In this paper we see that, based on his considerable experience, he now regards his former view as dangerously delusional.
Keynes’ Economic Consequences of the Peace.