General Theory, chapters one and two

by on December 8, 2008 at 6:53 am in Books, Economics | Permalink

I am repeatedly struck by Keynes’s skill as a literary stylist.  Usually this praise is denied the General Theory but I consider the book his Finnegans Wake; the most difficult passages are often the most charming but of course they are not for everyone.

I see three main themes in the book as a whole:

1. Income effects are more important than substitution effects.

2. Expectations matter.

3. The private and social returns to liquidity are very different.

#1
(as applied to macro) and #3 were most original in his time.  The book
as a whole circles around these themes and repeats them in varying
combinations, not always coherently or consistently.  You could also
add the claims that 4. monetary factors render a "natural rate of
interest" problematic and 5. labor markets are special.  Chapter two is
essentially about #1 and #5.

Keynes did go beyond the classics,
even if he did often caricature them.  (Keynes is brilliant as a
historian of thought when praising but almost always wrong when
criticizing.)  Since Keynes never gives us a truly coherent model —
not even verbally — it is easy to pick holes in the GT.
Keynes had so many exciting new ideas that he never decided what his
main point was or exactly under which conditions it would hold.

Much
of chapter two is devoted to establishing the proposition that workers
cannot in any direct way choose a lower real wage.  For Keynes nominal
wage flexibility doesn’t solve the
main problem.  If nominal wages fall across the board in an economy,
prices will fall and real wages will remain high.  Unemployment will
continue while the economy enters a downward spiral.  I’ve already
discussed that point here but to sum up my view Keynes is presenting a special case not a general case.

p.9 puts forward a version of the doctrine of money illusion.

p.15
defines involuntary unemployment, namely if the economy can be inflated
into a higher level of employment.  This pragmatic definition reflects
that Keynes was never sure why workers minded inflation, and a cut in
the real wage, less than they minded a cut in the nominal wage.  But
that is one of his behavioral postulates and it has survived into macro
to this day.

The "neo-Keynesian" models are not so loyal to Keynes.  Keynes held sticky nominal wages to be a policy prescription, but not necessarily a good description of the world.

Chapters
one and two are stunning, as they announce that we are now living on a
different economic terrain.  But we’ve yet to see whether the main
arguments are truly sound.

On Thursday we’ll be doing chapters
three and four — be ready!  And I encourage other bloggers to follow
along and offer their own commentaries.

1 Tyler Cowen December 8, 2008 at 6:55 am

Testing…

2 Tyler Cowen December 8, 2008 at 7:47 am

Testing…

3 George Selgin December 8, 2008 at 8:15 am

Two points: (1) allowing that an outstanding writer can make a virtue out of obscurity and incoherence in a work of fiction, surely to invest a work of nonfiction–and one that is intended to guide the making of macroeconomic policy–with these same qualities is far from praiseworthy. To be really good, a book’s style ought to be fit for it’s purported purpose!

(2) “For Keynes nominal wage flexibility doesn’t solve the main problem. If nominal wages fall across the board in an economy, prices will fall and real wages will remain high. Unemployment will continue while the economy enters a downward spiral.” Not so. An economy faced with a shortage of money is one in which all nominal values are above equilibrium, and need to decline. Otherwise unemployment persists even if the real wage is at its equilibrium level. This is easily shown using simple supply and demand diagrams. Alas, such an exposition would probably not have much literary merit!

4 Jason December 8, 2008 at 8:45 am

This is a great idea Tyler, and I hope more bloggers and commenters participate.

Perhaps something we could do with other classics.

5 Tim December 8, 2008 at 9:43 am

What version (publisher, edition, etc.) are you using. The pages in my copy don’t seem to be matching up with yours. I’m finding the relevant passages, but it is bothersome. Could you find some other way of referencing? Chapter #, Section #, paragraph?

Beyond that, this is terrific. It’s been a while and I’m enjoying getting back into Keyne’s work.

6 Andrew Meyer December 8, 2008 at 10:08 am

Easily the highest IQ book group I’ve ever participated in, but I don’t think I’ll ask any of you out on a date, which is the real reason I usually participate…

7 Tim December 8, 2008 at 10:36 am

Here’s the relevant part of the post on my blog referencing the book club.

I had forgotten much of the first two chapters. I was actually embarrassed at how much. But there were two things I took out of these chapters. One was Keynes’s discussion of real and nominal wages. I think he describes the problem of the “money illusion” quite well in this early chapter. The idea of workers being reluctant to reduce money wages when real wages are rising is important. It could have been even more difficult when most people were not aware of the connection of the true impact of changes in price level. And they were probably also less aware of price behavior outside their local community. Certainly those in larger cities may have better understood the extent of price changes, but those in less populated areas could have seen it as a less pervasive phenomenon. I expect that would affect their expectations.

For me, the second thing was the sense that this was more a general theory about special circumstances.

8 Selfreferencing December 8, 2008 at 11:50 am

Why does Keynes think that the assumptions of classical economics fail to apply under conditions of less-than-full employment when they apply under conditions of full employment? I don’t understand the argument.

I think the thought is this: (1) The economy gets into a state of uncertainty (not risk), (2) this causes people with a high propensity to save to hoard/save rather than consume or spend, (3) this causes the level of interest necessary to attract investment high, (4) the higher level of interest requires that capital make more profits, (5) but under the conditions they have to cut back production to make returns to a smaller number of investors and this involves laying workers off, (6) which in turn creates involuntary unemployment (sticky nominal wages, efficiency wage theory, etc. all help to create the conditions in step 6, right?).

So it’s not the following: IF more than full unemployment, THEN the assumptions of classical economics don’t apply – as if this were a CAUSAL explanation. It’s just a correlation. The assumptions of classical economics stop applying because conditions of UNCERTAINTY somehow suspend them. Is this the idea? That classical economic assumptions only apply when people can take rational risks, i.e. they have some idea of the probabilities of certain outcomes?

9 TheGarbageMan December 8, 2008 at 11:54 am

What exactly is the difference between frictional unemployment and involuntary unemployment? It seems that there’s no difference extensionally, only in terms of what causes it. Frictional unemployment occurs when people want to work but can’t because the economy is restructing and they’re looking for new jobs. But involuntary unemployment occurs when there’s insufficient aggregate demand.

But isn’t the reason that people don’t have jobs in both cases is not that they won’t work at a certain wage (as in voluntary unemployment) but that they can’t find one or haven’t found one yet? It seems to me then that the only difference between frictional and involuntary unemployment is the REASON that workers can’t find jobs when they want them – normal restructuring, or business cycle conditions. Do people agree?

10 Dann Ryan December 8, 2008 at 12:54 pm

I found Keynes’ discussion of workers inability to accept a lower real wage tedious to read. Perhaps this is due to my subscription to sticky nominal wage theory as an accurate representation. I hope that goes on to extrapolate it as a “policy prescription” as you call it.

11 ccm December 8, 2008 at 3:38 pm

“p.15 defines involuntary unemployment, namely if the economy can be inflated into a higher level of employment. This pragmatic definition reflects that Keynes was never sure why workers minded inflation, and a cut in the real wage, less than they minded a cut in the nominal wage. But that is one of his behavioral postulates and it has survived into macro to this day.”

Say what?! Keynes in the passage in italics is giving in words a standard mathematical definition of the conditions required for the real wage to be greater than the marginal disutility of labor at the current equilibrium. The argument has nothing whatsoever to do with inflation.

He is essentially expressing himself in pure Classical economic vocabulary here: “involuntary” unemployment implies identically that there are more workers available at the current wage than are currently working and (given certain assumptions on strictly increasing functions) therefore w > u'(leisure).

12 mb December 8, 2008 at 5:10 pm

I’m trying to wrap my head around Keynes’ Chapter 2 discussion using some recognizable textbook model. Chapter 5.4 of David Romer’s “Advanced Macroeconomics” (“Alternative Assumptions about Price and Wage Rigidity. Case 1: Keynes’s Model”) might be useful for simplified nuts and bolts. For whatever reason, the money wage is fixed. When the price level is ‘low’ the real wage is high and the economy is on the upper left part of the labor demand curve, with involuntary unemployment (and, equivalently, where the real wage is higher than the marginal disutility of work). The economy can only move towards full employment if the price level rises relative to the fixed money wage (e.g. due to a rise in aggregate demand, which increases prices in the goods market). Thus the Aggregate Supply curve is upward sloping – output and employment rise with the price level because this pushes down the real wage, allowing firms to hire more workers.

On the empirics Romer observes that “This view of aggregate supply therefore implies a countercyclical real wage in response to aggregate demand shocks. This prediction has been subject to extensive testing beginning shortly after the publication of the General Theory. It has found little support: most studies have found that the real wage is approximately acyclical, or moderately procyclical.”

13 Felipe December 8, 2008 at 7:34 pm

Seems like the core of Keynes’s theory of wage setting is the stated in the following:

“In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not its average amount per unit of employment, which depends, as we shall see, on a different set of forces. The effect of combination on the part of a group of workers is to protect their relative real wage. The general level of real wages depends on the other forces of the economic system.”

Thus, he argues, workers are not really trading off consumption and leisure. Rather, they are trading off leisure and relative social status or something of the sort, as expressed by their relative wage. Price movements don’t change thiese relative standings and hence have no effect on the labor supply decision.

Whether this is realistic or not, I don’t know. But it is radically different from the two favorite contemporary stories: money illusion (Lucas) or nominal rigidity (Taylor).

14 babar December 8, 2008 at 9:10 pm

“Contemporary thought is still deeply steeped in the notion that if people do not spend their money in one way they will spend it in another.”

this guy is brilliant

15 ionides December 9, 2008 at 12:17 am

On page 7 in my edition, just before section II, K lists the 4 classical means of increasing employment, a thru d.
c and d seem contradictory to me. In c there is an increase in the value of marginal product for labor; in d there is a decrease (altho it takes a bit of analysis to tease it out). here is my take on d: if non-wage-goods rise in price, then workers paid in wage-goods have a lower real wage; morever over a shift in expenditure of non-wage-earners (capital owners? beach bums?) from wage-goods to non-wage goods would lower the relative price of wage-goods, augmenting the decline in the value of marginal wage-good product.

Does anyone else see it this way? Am I missing somthing?

Otherwise, c and d together claim that both a rise and fall of the real wage will increase employment.

16 Ricardo December 9, 2008 at 4:47 am

Regarding Keynes’ views on socialism:

I will heavily preface this with the disclaimer that people change their views all the time (after all the quote about changing ones opinions in light of changing facts comes from Keynes himself). Still, I was knocked off my chair when I read this passage from “Economic Consequences of the Peace.” The context, just so no one can accuse me of unfairly quoting, is provisions in the Treaty of Versailles to expropriate the private property of German citizens located outside Germany:

“…the sharp distinction, approved by custom and convention during the past two centuries, between the property and rights of a state and the property and rights of its nationals is an artificial one, which is being rapidly put out of date by many other influences than the peace treaty, and is inappropriate to modern socialistic conceptions of the relations between the state and its citizens.”

17 ionides December 9, 2008 at 3:35 pm

What does Tyler mean by his main point #1, that income effects outweigh substitution effects? I understand this concept in a micro-economic context, where the price of one commodity changes with respect to another. But what about macro? Does he mean the relative price of bonds and money? Of current and future goods? Of work vs leisure?

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