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Today's Economic History: John Maynard Keynes on the Trade Cycle

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John Maynard Keynes: The General Theory of Employment, Interest and Money: 22. Notes on the Trade Cycle: "The essential character of the Trade Cycle, and, especially, the regularity of time-sequence and of duration which justifies us in calling it a cycle...

...is mainly due to the way in which the marginal efficiency of capital fluctuates.... By a cyclical movement we mean that as the system progresses in, e.g., the upward direction, the forces propelling it upwards at first gather force and have a cumulative effect on one another but gradually lose their strength until at a certain point they tend to be replaced by forces operating in the opposite direction... until they too, having reached their maximum development, wane and give place to their opposite.... [And] the substitution of a downward for an upward tendency often takes place suddenly and violently, whereas there is, as a rule, no such sharp turning-point when an upward is substituted for a downward tendency....

The marginal efficiency of capital depends... on the existing abundance or scarcity of capital-goods... the current cost of production... [and] current expectations as to the future yield.... But, as we have seen, the basis for such expectations is very precarious... subject to sudden and violent changes.... [A] typical, and often the predominant, explanation of the crisis is... a sudden collapse in the marginal efficiency of capital. The later stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also.... Wen disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force....

Liquidity-preference... does not increase until after the collapse in the marginal efficiency of capital. It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough....

It is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world.... The return of confidence... is... insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a ‘purely monetary’ remedy have underestimated.... The explanation of the time-element in the trade cycle... is to be sought in the influences which govern the recovery of the marginal efficiency of capital... firstly by the length of life of durable assets... secondly, by the carrying-costs of surplus stocks.... The interval of time, which will have to elapse before the shortage of capital through use, decay and obsolescence causes a sufficiently obvious scarcity to increase the marginal efficiency, may be a somewhat stable function of the average durability of capital....

When once the recovery has been started, the manner in which it feeds on itself and cumulates is obvious. But during the downward phase... the market estimation of the marginal efficiency of capital may suffer such enormously wide fluctuations.... In conditions of laissez-faire the avoidance of wide fluctuations in employment may... prove impossible without a far-reaching change in the psychology of investment markets....

The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom. The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expectation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact deterrent. A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive....

It would be absurd to assert of the United States in 1929 the existence of over-investment in the strict sense. The true state of affairs was of a different character. New investment during the previous five years had been, indeed, on so enormous a scale in the aggregate that the prospective yield of further additions was, coolly considered, falling rapidly.... The rate of interest was high enough to deter new investment except in those particular directions which were under the influence of speculative excitement and, therefore, in special danger of being over-exploited; and a rate of interest, high enough to overcome the speculative excitement, would have checked, at the same time, every kind of reasonable new investment. Thus an increase in the rate of interest, as a remedy for the state of affairs arising out of a prolonged period of abnormally heavy new investment, belongs to the species of remedy which cures the disease by killing the patient....

It may be convenient at this point to say a word about the important schools of thought which maintain, from various points of view, that the chronic tendency of contemporary societies to under-employment is to be traced to under-consumption... to social practices and to a distribution of wealth which result in a propensity to consume which is unduly low. In existing conditions... these schools of thought are, as guides to practical policy, undoubtedly in the right.... Practically I only differ from these schools of thought in thinking that they may lay a little too much emphasis on increased consumption at a time when there is still much social advantage to be obtained from increased investment....

The austere view which would employ a high rate of interest to check at once any tendency in the level of employment to rise appreciably above the average of, say, the previous decade, is, however, more usually supported by arguments which have no foundation at all apart from confusion of mind...

It is quite clear what Keynes's theory of the "trade cycle" is:

  • A boom is produced by overoptimism about future profits, which, when those overoptimistic expectations are disappointed, causes a swing in expectations of future profits from overoptimism to overpessimism, and a slump.

  • The slump cannot be cured by any "practicable reduction in the rate of interest".

  • The slump continues until the existing capital stock has depreciated enough that capital is scarce enough that the rate of profit has risen high enough that even with overpessimism and exaggerated liquidity preference higher investment is profitable again.

  • The recovery then, as investors notice that profits are running ahead of expectations, "feeds on itself and cumulates" in a "manner... which... is obvious".

This is not a theory in which shocks to aggregate demand cause permanent shifts in the level of output, is it? Shocks to aggregate demand reset the phase on the business cycle wave-clock, but the mechanism, and the fact that the average level of output is well below full employment, proceeds until and unless we reconfigure monetary and fiscal policy to take control of the determination of the level of investment from the private marketplace.

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