Introduction
In the world of economics, few books have had as profound an impact as "The General Theory of Employment, Interest, and Money" by John Maynard Keynes. Published in 1936, this groundbreaking work challenged the prevailing economic theories of its time and introduced revolutionary ideas that continue to shape economic policy and thinking to this day.
Keynes wrote this book in the aftermath of the Great Depression, a time when traditional economic theories seemed inadequate to explain the prolonged unemployment and economic stagnation that gripped much of the world. His goal was to provide a new framework for understanding how economies function, particularly during times of crisis.
The book's central argument is that economies do not always naturally tend towards full employment and stability, as classical economists believed. Instead, Keynes proposed that government intervention could be necessary to stimulate demand and boost employment during economic downturns. This idea, known as Keynesian economics, has since become a cornerstone of modern macroeconomic theory and policy.
In the following summary, we'll explore the key ideas presented in Keynes's work, breaking down complex economic concepts into more digestible pieces. We'll examine how Keynes challenged classical economic theories, his views on employment and unemployment, the relationship between investment and economic growth, and the role of human psychology in economic decision-making.
Challenging Classical Economic Theories
Keynes begins his work by taking aim at the foundations of classical economic theory, particularly its assumptions about employment and wages. He argues that these assumptions fail to account for the reality of involuntary unemployment, a phenomenon that classical economists struggled to explain.
The Flaws in Classical Wage Theory
Classical economists held two main beliefs about wages and employment:
A worker's wage reflects their value to the business. They argued that if a company chose not to employ someone, the company's loss would be equal to the wage that worker would have been paid.
A worker's wage is the lowest amount they'd be willing to work for. This was seen as a point of equilibrium where labor supply meets demand.
Keynes found these assumptions problematic because they couldn't explain a real-world issue: involuntary unemployment. In the real world, there are situations where workers are willing and able to work at the current wage but can't find jobs. Classical economists typically dismissed this as voluntary unemployment, assuming workers were simply refusing to accept lower wages.
The Reality of Involuntary Unemployment
Keynes pointed out that unemployment rates can fluctuate significantly without corresponding changes in workers' wage demands or productivity. This observation suggested that other factors were influencing unemployment rates, factors that classical theory didn't account for.
He argued that during economic downturns, unemployment isn't primarily caused by workers refusing wage cuts. Instead, it's often a result of insufficient demand in the economy. This insight was revolutionary because it shifted the focus from individual behavior to broader economic forces.
By challenging these fundamental assumptions of classical economics, Keynes laid the groundwork for a new understanding of how economies function. He showed that the classical model was too simplistic and failed to capture the complexities of real-world economic systems, particularly during times of crisis.
Keynes's Theory of Employment
Having critiqued classical theory, Keynes then presents his own theory of employment. This theory aims to explain the intricate relationships between employment, income, and spending in an economy.
The Relationship Between Income and Employment
Keynes starts by establishing a direct link between a community's income and its level of employment. He argues that the total income of a community (whether in the form of money or real assets) is a function of the number of people employed. In other words, as employment increases, so does the community's overall income.
The Propensity to Consume
Keynes introduces the concept of the "propensity to consume," which refers to how likely people are to spend their income. He notes that as people earn more, they tend to spend more, but the increase in spending is usually not as large as the increase in earnings. This discrepancy, Keynes argues, plays a crucial role in the overall economic picture.
Effective Demand and Employment Decisions
According to Keynes, businesses make employment decisions based on two factors:
- Expected consumer spending
- The community's planned investment in new ventures
The sum of these two factors is what Keynes calls "effective demand." This concept is crucial to understanding employment levels in an economy.
Equilibrium Employment
Keynes introduces the idea of equilibrium employment, which is determined by three factors:
- The volume of supply
- The propensity to consume
- The volume of new investments
However, Keynes argues that there's a limit to this equilibrium. Employment can't increase beyond the point where the actual wages equal the dissatisfaction workers feel from working.
Contrasting with Classical Theory
This theory contrasts sharply with classical economic theory. Classical economists believed that competition could push employment to its maximum value. Keynes, however, argues that increasing employment doesn't always lead to a sufficient increase in investment to fill the gap between supply price and what entrepreneurs can expect to receive from consumer spending.
The Paradox of Wealthy Communities
Interestingly, Keynes suggests that wealthier communities might actually have a larger gap between their actual and potential production. This is because they tend to consume less of their output relative to their wealth, and they need to find more investment opportunities to provide full employment. If they can't find these opportunities, they might need to reduce their output to match their lower levels of consumption and investment.
This insight highlights a paradox: increased wealth doesn't necessarily lead to increased employment or production. It's a key part of Keynes's argument for why government intervention might be necessary in wealthy economies experiencing high unemployment.
The Interrelation of Investment and Employment
Keynes delves deeper into the complex relationship between investment decisions and employment levels, introducing several key concepts that help explain economic fluctuations.
Marginal Propensity to Consume (MPC) and the Multiplier
Keynes introduces two crucial concepts: the Marginal Propensity to Consume (MPC) and the economic Multiplier. The MPC predicts how a society will divide additional income between consumption and saving. For example, if a society consumes nine out of ten extra dollars it earns, it has a high MPC of 0.9.
The Multiplier, on the other hand, shows how much total income will increase with a rise in investment. Importantly, the higher the MPC, the larger the Multiplier effect will be.
The Employment Multiplier
Alongside the economic Multiplier, Keynes introduces the employment Multiplier. This measures how much total employment will increase in response to an increase in investment-related employment. However, these two multipliers aren't always perfectly aligned due to potential variations across different industries.
Extreme Scenarios
Keynes explores some extreme scenarios to illustrate his points:
If people don't change their consumption despite an income rise, the only employment boost will come directly from increased investment.
If people spend all their additional income, there's a risk of unlimited price inflation.
When the MPC is close to one, even small changes in investment can cause large employment fluctuations.
When the MPC is slightly above zero, small investment changes cause small employment changes, but achieving full employment might require a large investment increase.
Public Works and the Multiplier Effect
Keynes uses the example of public works to illustrate how these concepts play out in practice. He shows that the impact of government hiring isn't as straightforward as simply multiplying the number of new hires by the Multiplier. Various factors can amplify or dampen the effect:
- The financing method could cause interest rates to rise, slowing other investments.
- The government's program could alter confidence, potentially impacting the efficiency of capital.
- In a global economy, some benefits might flow to other countries.
- As employment rises, people might save more of their additional income.
- Changes in income distribution (e.g., increased income for entrepreneurs) could affect the MPC.
The Scale of Investment and the Multiplier
Keynes notes that the scale of investment influences the Multiplier effect. Generally, the Multiplier tends to be higher for small investment increases than for larger ones. For significant changes, we need to consider the average Multiplier over the range in question.
The Power of "Wasteful" Spending
In a provocative argument, Keynes suggests that even seemingly wasteful activities like burying money and paying people to dig it up can stimulate the economy by increasing employment and consumption, especially during times of high unemployment. However, he emphasizes that if there are less wasteful ways to increase employment (like building houses), those should be pursued first.
This argument underscores Keynes's central point: during times of high unemployment, almost any activity that increases employment and puts money in people's pockets can have a positive effect on the economy through the Multiplier effect.
The Role of Expectations and Conventions in Economic Behavior
In the final section of his book, Keynes turns his attention to the psychological aspects of economic decision-making, particularly in relation to investment. He argues that investment decisions aren't always based on rational calculations, but are heavily influenced by expectations, conventions, and mass psychology.
Forming Expectations About the Future
Keynes observes that when forming expectations about the future, we tend to give more weight to what we're confident about, even if it may not directly apply to the situation at hand. Our present circumstances shape our future expectations. When we see big changes on the horizon but don't know the details, our confidence can waver.
The Role of Confidence in Investment Decisions
Confidence plays a crucial role in investment decisions, particularly when it comes to predicting future profits. Keynes points out that for long-term investments like railways or copper mines, predicting profits ten years into the future is essentially a gamble.
He contrasts this with the approach to investment in the 19th century, when business was more like a game of skill and chance. Investments were often gambles, influenced more by ambition and gut feelings than by careful calculations.
The Convention of Stability
Keynes introduces the idea that our investment evaluations are based on a convention - an agreement to assume things will stay the same unless we have reason to expect a change. This convention brings some stability to the market, as long as everyone sticks to it. It makes short-term investments safer, as investors can change their positions before significant changes occur.
However, this convention isn't perfect and can create uncertainty for large, long-term investments. Who wants to commit huge amounts of capital when the future is uncertain?
The Decline of Real Knowledge
Keynes notes a trend that he finds concerning: a decline in real knowledge about businesses among investors. This is due to an increase in ownership by individuals who don't manage or know much about the businesses they invest in. This trend, he argues, weakens the market's ability to make truly informed decisions.
Market Overreactions and Mass Psychology
Keynes observes that investors tend to overreact to temporary fluctuations in investment profits, even when these fluctuations might not significantly influence long-term outcomes. He gives examples like ice manufacturing companies' shares fetching higher prices in summer due to high profits, or the British railway system increasing in value due to a bank holiday.
These examples reveal a tendency in markets to overreact to transient circumstances. Keynes argues that market valuations can swing wildly due to mass psychology, often caused by factors that don't significantly affect the expected yield. These swings can lead to waves of optimism and pessimism that aren't grounded in concrete investment calculations.
The Role of Professional Investors
Keynes is critical of the behavior of professional investors. Instead of correcting market inaccuracies, he argues that they often focus on anticipating short-term changes in valuation, playing into the same psychological dynamics as the general public. He suggests that skilled investment should aim to overcome future uncertainties, rather than just trying to outwit others in the market.
The Interplay of Sentiment, Institutions, and Market Health
In his conclusion, Keynes discusses the complex interplay between investor sentiment, lending institutions, and the overall health of the market. He emphasizes the need for a delicate balance between speculation and enterprise, and the role of spontaneous optimism in driving economic activities.
Keynes leaves us with a caution: economic activities, being deeply human endeavors, are often driven by more than just cold, hard numbers. Understanding the psychological aspects of economic behavior is crucial for anyone seeking to comprehend how economies truly function.
Final Thoughts
"The General Theory of Employment, Interest, and Money" is a landmark work that fundamentally changed how we think about economics. Keynes's insights into the nature of employment, the role of government in managing economic cycles, and the psychological factors that influence economic decisions continue to be relevant today.
Key takeaways from the book include:
Classical economic theories fail to account for involuntary unemployment and the complexities of real-world economies.
Employment levels are determined not just by worker preferences, but by overall demand in the economy, including consumption habits and investment rates.
The concepts of the Marginal Propensity to Consume and the Multiplier effect help explain how changes in investment can have amplified effects on employment and income.
Even seemingly wasteful spending can stimulate economic growth by increasing employment and consumption, especially during times of high unemployment.
Investment decisions are not always rational and are heavily influenced by expectations, conventions, and mass psychology.
The role of confidence and uncertainty in shaping economic outcomes is crucial and often underappreciated.
Keynes's work laid the foundation for modern macroeconomics and continues to influence economic policy around the world. His emphasis on the role of government in managing economic cycles has been particularly influential, shaping responses to economic crises from the Great Depression to the 2008 financial crisis and beyond.
While some of Keynes's ideas have been challenged and refined over the years, the core insights of "The General Theory" remain relevant. In our complex, interconnected global economy, understanding the intricate relationships between employment, investment, and consumption - as well as the psychological factors that influence economic behavior - is more important than ever.
As we face new economic challenges in the 21st century, from growing inequality to the economic impacts of climate change, Keynes's work continues to offer valuable insights. It reminds us that economics is not just about numbers and models, but about understanding human behavior and societal dynamics. It challenges us to think critically about economic orthodoxies and to consider innovative solutions to economic problems.
In essence, "The General Theory of Employment, Interest, and Money" is not just a book about economics - it's a book about how societies function and how we can work to improve them. Its enduring relevance is a testament to Keynes's profound insights into the workings of modern economies.