Mr. Hicks and "Mr Keynes and the 'Classics': A Suggested Interpretation"

by: Brad DeLong

In his "Mr. Keynes and the 'Classics': A Suggested Interpretation," John Hicks says that he is building a model of John Maynard Keynes's General Theory of Employment, Interest and Money. He is not. What he is actually doing is creating a framework that combines the monetarist theories of Irving Fisher, the financial-market insights of Knut Wicksell, and the multiplier insights of Richard Kahn into one package.

Irving Fisher had a model with two markets: a market for the flow of goods-and-services currently being produced on the one hand and a market for the economy's stock of "money"--of liquid assets generally accepted as and held in people's portfolios because of their usefulness as means of payment. Excess demand for money was, by Walras's Law, associated with excess supply of goods and services--and thus with falling production, employment, capacity utilization, and consumer prices. Excess supply of money was, by Walras's Law, associated with excess demand for goods and services--and rising production, employment, capacity utilization, and consumer prices. In Fisher's framework the way to restore the economy to full-employment balance is to boost or shrink the money stock to its proper level, via gold mining, gold shipments, open-market operations, internal drains or the reverse, or changes in bank reserve-to-deposit ratios. Return the money stock to it's proper full-employment equilibrium value and you have solved yours depression problem.

Knut Wicksell had a model with two markets: a market for the flow of goods-and-services currently being produced, on the one hand, and a market for the stock of bonds on the other. Excess demand for bonds--a "market" rate of interest above the "natural" rate of interest that balanced demand for and supply of bonds at full employment--was associated with excess supply of goods and services, ewe deter. Excess supply of bonds--a "market" rate of interest lower than the "natural" rate--was associated with excess demand for goods and services, et cetera.

Wicksell paid special attention to dynamics: an excess demand for bonds that sets in motion a decline in the price level would, he thought, drive the natural rate of interest down: seeing deflation and expecting more deflation, businesses would be loath to issue more bonds unless they could do so on very good terms indeed. Thus the gap between the (nominal) market and the natural rate of interest would increase--the disequilibrium would widen--as the market system reacted to the initial depression-causing disequilibrium. This cumulative process, as Wicksell called it, meant that at least over a range the economy was unstable: depression begat greater depression, and boom begat greater boom.

By contrast, Fisher's dynamics were stabilizing: a depression produces a deflation which raises the real money stock and so diminishes the excess demand for money.

Richard Kahn had yet another analysis: consumption spending depends positively on income; production is the sum of consumption spending and autonomous spending; and--by Walras's Law once again--total income equals total production. Thus, Kahn thought, a reduction in autonomous spending would reduce production and income--and that reduction in income would reduce consumption spending, which would set off another round of reductions in production and income.

Irving Fisher's monetarism had two markets--"money" and "goods-and-services"--and one price-that-moved, the consumer price level. The key to fixing depressions was to get the consumer price level to the right level given the nominal money stock (or get the money stock to the right value given the price level). Knut Wicksell's flow-of-funds model also had two markets--"bonds" and "goods-and-services"--and one price-that-moved: the (nominal) market interest rate. The key to fixing depressions was to get the banking system to set the market interest rate at a value that matched the natural interest rate at which savings equalled investment at full employment and thus demand equalled supply in the market for goods-and-services. Richard Kahn's multiplier analysis had one market, the goods-and-services market, and had no prices: just a dependence on consumption spending on income and an assertion that income equalled spending.

Hicks's "Mr. Keynes and the 'Classics'" throws all these together into a stewpot, mixes them together, and cooks them up in a formally-consistent way: three markets--goods-and-services, money, and bonds--two prices that can move--the interest rate and the consumer price level--and the multiplier in the form of the dependence of savings on total income which is the amount of production and spending in the goods-and-services market. And it works. That is what has made it such an effective workhorse for thinking about depressions in the real world for three generations now.

But what does all this have to do with John Maynard Keynes and his General Theory? Keynes was very anxious not to get tied down to any particular formalism--either the one he set out in the General Theory or Hicks's IS-LM. Instead, he wrote in the 1937 Quarterly Journal of Economics:

I am more attached to the comparatively simple fundamental ideas which underlie my theory than to the particular forms in which I have embodied them, and I have no desire that the latter should be crystallised at the present stage of the debate. If the simple basic ideas can become familiar and acceptable, time and experience and the collaboration of a number of minds will discover the best way of expressing them. I would, therefore, prefer to... re-express some of these ideas....

[W]e 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.... But sometimes we are intensely concerned with them.... 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....

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.... 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 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.... How do we manage?... (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.... (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.... (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....

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.... 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.

Perhaps the reader feels that this general, philosophical disquisition... is somewhat remote from the economic theory.... But I think not.... [O]ur first step must be to elucidate more clearly the functions of money... money of account... facilitates exchanges... is a convenience... devoid of significance.... [Money as] a store of wealth.... But in the world of the classical economy, what an insane use to which to put it! For it is a recognised characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit. Why should anyone outside a lunatic asylum wish to use money as a store of wealth?

Because... our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.... The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded... supposed to have a direct proportionate effect on the price level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of... modifying... the premium which has to be offered to induce people not to hoard. And changes in... liquidity preference... affect, not [consumer] prices, but the rate of interest....

The owner of wealth, who has been induced not to hold his wealth in the shape of hoarded money, still has two alternatives.... He can lend his money at the current rate of money interest or he can purchase some kind of capital asset.... The prices of capital assets move until, having regard to their prospective yields... they offer an equal apparent advantage to the marginal investor.... This does not mean, of course, that the rate of interest is the only fluctuating influence on these prices. Opinions as to their prospective yield are themselves subject to sharp fluctuations, precisely for... the flimsiness of the basis of knowledge on which they depend.... It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation—on the propensity to hoard and on the opinions of the future yield of capital assets.... This completes the first chapter of the argument, namely, the liability of the scale of investment to fluctuate for reasons quite distinct (a) from those which determine the propensity of the individual to save out of a given income and (b) from those physical conditions of technical capacity to aid production....

My next difference from the traditional theory concerns its apparent conviction that there is no necessity to work out a theory of demand and supply of output as a whole. Will a fluctuation in investment, arising for the reasons just described, have any effect on the demand for output as a whole, and consequently on the scale of output and employment? What answer can the traditional theory make to this question? I believe that it makes no answer at all, never having given the matter a single thought.... My own answer... involves... investment expenditure... consumption expenditure... [which] depends mainly on the level of income.... [T]he consequences which follow from [this multiplier] are at the same time unfamiliar and of the greatest possible importance.... [A]ggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital assets, on the propensity to spend and on the social factors which influence the level of the money wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little. This that I offer is, therefore, a theory of why output and employment are so liable to fluctuation. It does not offer a ready-made remedy as to how to avoid these fluctuations and to maintain output at a steady optimum level....

Naturally I am interested not only in the diagnosis, but also in the cure.... But I consider that my suggestions for a cure, which, avowedly, are not worked out completely, are on a different plane from the diagnosis. They 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.... (2) The orthodox theory... ignored the need for a theory of the supply and demand for output as a whole. I doubt if many modern economists really accept Say’s Law that supply creates its own demand. But they have not been aware that they were tacitly assuming it...