Keynes’s General Theory, chapter four, *The Choice of Units*

This chapter may seem cryptic but the key is the tiny footnote to Hayek; this chapter is Keynes obsessing over capital theory and the Austrians.

Hayek argued that an economic downturn should be understood as a discombobulation of the capital structure and here is Keynes arguing against that approach.  When you cut through the terminology, Keynes says that capital
heterogeneity isn’t needed to generate aggregate demand analysis and that
his core mechanisms will operate in any case.

Keynes admits that with economic development labor gets very specialized, or very closely connected to particular capital goods, so yes there are capital complementarities of the Austrian kind.  But Keynes thinks such fragilities will only help his argument, while rendering the analytics too messy.  He declares his intention to proceed with homogeneous magnitudes of capital and labor.

This chapter often fails to receive its proper due; it is very important for understanding the location of Keynes in the history of economic thought. 

With this one chapter, Austrian capital theory falls off the map.

Comments

Isn't Keynes simply avoiding the capital measurement problem by defining
capital as labor value? This does not preclude high interest rates
discounting future cash flows.

With this one chapter, Austrian capital theory falls off the map.

And depressions were vanquished once and for all!

From what I see, this chapter actually illustrates Keynes' muddled thinking. Although he is correct to point out that it is not possible to get a meaningful aggregate by adding non-homogeneous capital or commodities he makes an assumption that his argument is not valid for labour and clams that economists can come up with meaningful 'labour-units' by adding up non-homogeneous labour.

The chapter and the entire book are full of such muddled ideas that cannot hold up to careful scrutiny. Keynes and his followers believe that they can understand complex, non-linear systems by making simple assumptions that would allow them to use mathematical tools that are totally inappropriate. That is why Keynesian economics has failed to make meaningful positive contributions to understanding how the real world works and has led to misery and underperformance whenever it was taken seriously.

The biggest problem for Keynes is that he would have had to LEARN capital theory.

Too much work.

Better strategy -- punt.

ALL evidence on this matter points to the fact that Keynes never learned the work of Menger, Bohm-Bawerk & Hayek on capital structure -- and never knowing it, never understood it.

Never.

When are we doing the next chapter(s)?

I clicked on the comments just because I wanted to see what Bob Murphy would write.

Yeah, me too.

Here's my suggestion. Let's do conduct economics as a quantitative, experimental "science". Here's the experiment. Let's fire every single Keynesian macrooeconomist in the country -- force them to get another line of work -- and then get out our measuring tape and look to see if "labor" is indeed a homogeneous input that can be quantified in "labor units".

Vangel wrote:

"and clams that economists can come up with meaningful 'labour-units' by adding up non-homogeneous labour."

Cutting through the terminology FAIL "Keynes says that capital heterogeneity isn't needed to generate aggregate demand analysis and that his core mechanisms will operate in any case."

From the point of view of empirical method Chapter 4 is a brilliant application of classical economic theory. Keynes lays the foundations for what we now know as macroeconomics by directly confronting the challenges of aggregating economic data.

His solutions: Focus on monetary values which can be aggregated. Avoid relying on the measurement of capital since the problem of measuring depreciation is a total boondoggle. To deal with differences in labor quality, he proposes that workers be weighted by their wage (or marginal product -- a brilliant application of classical theory). Having weighted workers by their marginal product, he can now claim that an increase in employment will imply an increase in output.

This latter conclusion may hold even for small changes in the capital stock (I'd have to think about it more to be sure). Overall Chapter 4 establishes Keynes as a brilliant economist.

ccm: "by directly confronting the challenges of aggregating economic data"
Alas he doesn't.

ccm: "Avoid relying on the measurement of capital since the problem of measuring depreciation is a total boondoggle."
Depreciation is not the only problem of capital though. Capital may have different outputs. It is like a giant junkyard that history bequeaths us. We have to sort out what of it is useful. It may serve our present needs or it may not.

If we ignore it then whatever theory is produced is only short term. We can say that the capital today is roughly the same as that last month, but not the same a five years ago.

ccm:"To deal with differences in labor quality, he proposes that workers be weighted by their wage (or marginal product -- a brilliant application of classical theory)"
Well, if that works for Labour why not use it for Capital too?

ccm:"Having weighted workers by their marginal product, he can now claim that an increase in employment will imply an increase in output."
You don't need to weight them by marginal product to do that. Even if you don't the answer is the same.

It's easy. Consumption goods are made by capital goods and labour. If you hold capital goods constant then clearly any difference is down to labour.

Let me try this one again.

Current: "Well, if that works for Labour why not use it for Capital too?"

Labor has the advantage that the unit one worker hour is well defined and the wage of that unit is easily measured. While capital's rent is easily measured, capital does not have comparable units: machinery is much less homogeneous than humans; how does one address working capital and liquid capital where rents may be harder to calculate. Furthermore we rarely have market values for "the junkyard that history bequeaths us", so there is no reliable dollar value of capital, which can be weighted by the rent.

In short, the units in which labor is measured are inherently more homogeneous than units of capital.

//I clicked on the comments just because I wanted to see what Bob Murphy would write.//

I wanted to see what Greg Ransom would post. And I was not disappointed! But I do have a question: I get your point that nobody except for you (and Bob Murphy???) understands Hayek's capital theory, blah blah...but answer this: Exactly how doesn't Keynes understand it? Non-chalantly throwing out accusations like "he doesn't understand," without explaining, makes it seem like you don't understand it either, so do expand please. Or put it in your blog instead of flooding a comments section with something that doesn't contribute to the body of economic knowledge at all.

ccm: "His solutions: Focus on monetary values which can be aggregated."

Sorry? How do you know that things that cannot be aggregated can be safely ignored? Keynes said you so?

I'm just posting this to see whether I can access the set of comments after about comment #24. I don't have a link to those comments.

"liberty" identifies the core issue: macro has no actual mechanics, it is merely a collection of statistics. You can go on and on about aggregate this and that but it's just number and doesn't represent anything that actually exists. Making Aggregate Demand the center of the model and pretending it can be manipulated is like imagining you can rev the engine of a car by tugging on the tachometer needle.

Keynes may have been correct that modeling heterogeneity would only bolster his theory of recessions, but on the flip side it annihilates his theory of recoveries.

There is a deep irony here that has not been noted.
In the first round of debates between Hayek and Keynes, starting
in the late 1920s and into the early 1930s, Piero Sraffa would serve
as the battering ram for Keynes. At that stage, in effect, part of
the argument was that Hayek was in effect aggregating capital by
focusing on the interest rate, and whether it was "too high" or
"too low," although he would argue that its variation would alter
the structure of capital. But the bigger mechanism was the aggregate
amount of capital, with too much being produced when the interest rate
was too low, and then switching.

Later, Hayek would more explicitly confront the heterogeneity of capital
in his Pure Theory of Capital, in which he saw the weaknesses of the more
traditional Austrian view of capital in a world of heterogeneous capital.
In effect, as has been argued by Garrison and others, he anticipated the
sorts of problems that Sraffa would later emphasize when he argued about
reswitching and other capital theoretic paradoxes associated with heterogeneous
capital, which he had already been going on about.

The paradox is that in effect Sraffa and Hayek agreed about a possible
problem with Keynes. I think the response by Keynes would be that he was
concerned about the short run, in which the composition of the capital stock
is less important, and what is important is the pattern of aggregate spending
to get to aggregate demand. Thus he would argue that how spending for investment
is determined is important, but it can be looked at as an aggregate, in effect
as Hayek did in the late 1920s, although emphasizing other factors determining it.
In this view heterogeneous capital becomes important for longer run growth analysis.

Ironically this argument would erupt later in the 1980s among the Post Keynesians,
or if one prefers, between the neo-Ricardian/Sraffian branch of the PKs, led by
Pierangelo Garegnani, and the American Keynes-Post Keynesian branch led by Paul
Davidson, with the latter emphasizing the role of uncertainty and money in bringing
about short term fluctuations of aggregate demand. The Sraffian neo-Ricardians
would look at long run equilibria and compare different ones in their analyses based
on emphasizing heterogeneous capital. The split would become total eventually.

Exactly how doesn't Keynes understand [Bohm-Bawerk's capital theory]?

This would take a journal article, but the hints are everywhere in Keynes. Were are some clues:

1. Check out Keynes footnote on Knight's paper on Bohm-Bawerk and capital theory, then read Hayek's reply to Knight.

2. Keynes says he can't understand economics written in German. There's not a lot of evidence to contradict Keynes' self assessment. Nor is there much evidence that he did look at much German language economics.

3. Keynes' remarks on the trade-offs between saving and investment, and the time structure of production betray a big, enormous, gaping blank spot where it comes to basis Menger / Bohm-Bawerk microeconomics of production goods. Later in the general theory we'll have a chance to re-visit these issues.

Barkley - this is mistaken history. The heterogeneity of capital plays a
role from the very beginning in Hayek -- most especially in his original
LSE and Cambridge lectures of the early 1930s. Read _Prices and Production_
and you will see it.

What Hayek figured out during the mid-1930s was the inadequacy as a temporary
stand in for some limited purposes of Bohm_Bawerk's aggregate "the average period of production".
Note well that this doesn't mean that capital heterogeneity wasn't right there at the heart of
Hayek's explanation -- it _was_. It means that that using the APP as a temporary "cheat" for some
very limited purposes turned out to be problematic.

Barkley - this is mistaken history. The heterogeneity of capital plays a
role from the very beginning in Hayek -- most especially in his original
LSE and Cambridge lectures of the early 1930s. Read _Prices and Production_
and you will see it.

What Hayek figured out during the mid-1930s was the inadequacy as a temporary
stand in for some limited purposes of Bohm_Bawerk's aggregate "the average period of production".
Note well that this doesn't mean that capital heterogeneity wasn't right there at the heart of
Hayek's explanation -- it _was_. It means that that using the APP as a temporary "cheat" for some
very limited purposes turned out to be problematic.

"If we can use the assumption to make a theory that is general and that is supported by evidence then it is useful. The problem though is that we can't."

Let's face reality here: Economics is a social science. This means that there is no work by any economist (and there can be no work by any economist) that presents a theory that is supported by the evidence for the simple reason that it is impossible to test economic theories in a scientific (i.e. controlled) manner.

My approach to this reality is to look for insight everywhere and appreciate neat ideas where I can find them. It is in this light that I read Keynes chapter 4. For example, the fact that Keynes' treatment of capital means that his theory can not be used to analyze the long run is simply a description of his work. It is neither good nor bad, it is simply a modifier of our understanding of his work.

To be honest I think that the assumption that the economy is dominated by forces that drive the wage to equal the marginal product labor (and the rent to equal the marginal product of capital) is an assumption that is typically contradicted by the evidence. I am extremely disappointed to learn that Keynesian theory relies so heavily on classical economics. But that does not mean that Keynes was not a brilliant man in the context in which he operated -- or that his theory is not useful.

Barkley writes:

>>Regarding heterogeneity of capital, yes Hayek had it there originally,
but it is not key to his early business cycle theory. That is all about
an excess of aggregate investment over consumption, those darned aggregates
in the Keynesian national income accounting.<< I guess we read Hayek differently. As to your remarks on housing and capital, you're not going to get an argument from me on this. I take it that theory is theory, and the empirical nature of any particular crisis will have all sorts of different characteristics. The point of Hayek's work is simply to follow the microeconomics where they lead -- including the microeconomic inter-relations between various production goods and various consumption goods. Ag/forestry economist Mason Gaffney is something of an old style capital theorist, and he points out the difference for the macro-economy over time between wealth stored in production goods, and wealth stored in bubble inflated land. I've seen some other folks point to the same issue, re the housing bubble / bust. Gaffney is also something of a Georgist, and sees tax implication in this dichotomy. He may be on to something, but I haven't thought a lot about the matter.

Which reminds me that one curious parallel between now and the 1930s
(and I am not into overdoing such parallels) involves the auto industry.
The most serious case for a sector where there was excessively enthusiastic
and overblown investment in the 1920s was the auto industry, although that
was the decade during which the US went from a minority of people owning
cars to a majority, with a huge multiplier effect in related industries.
At the end of the 1920s there were nearly 100 companies producing cars, and
the industry was in for a major consolidation and downsizing. Looks like we
may be in for another round of that, one way or another.

Perhaps when you get to houses, there is an empirically significant "time structure of consumption". A blog comment is no place to go through all the issues involved in placing houses within the time structure of production goods or the time structure of consumption goods, but certainly it's lost on no one that a house is not an immediate consumable -- and that it is a long term investment, a long term productive facility, and a long term consumable. The significant thing here is where it fits in the time structure of plans -- way out on the time horizon. If you aren't changing your plans and coordinating your activities in order to take into consideration the significant shift in time characteristics of your plans with this one gigantic shift toward the long term, then your plans will be out of whack -- and unsustainable. I.e. if you continue to consume short term stuff at the same rate, and you aren't shifting and coordinating all your resources to maintain a smooth transition, you are going to crash land.

Grant wrote:

"As previously mentioned, there is no fine line between consumer goods and capital goods. So to even presume to seperate capital from consumption is to make an arbitrary decision on what is and is not capital, a decision which splits goods into higher and lower orders in Austrian terminology. Therefore, it seems to me that any theory of over-investment in aggregate capital is in fact the same thing as over-investment in higher-order goods; it all depends on where you draw the line between "high order" and "lower order", or "capital goods" and "consumption goods". The usefulness of the distinction is determined by how closely the line matches reality: an over-investment in the housing sector isn't going to show up on a model that lumps all capital and housing together.

Any analysis of the economy is going to use artificial categories of some sort. I think the question is whether or not those categories highlight or obscure information. If you're trying to analyze the problem of an over-investment in a specific type of capital by looking at aggregate investment, I think you're shooting yourself in the foot."

@Greg Ransom - bravo. Keynes was a poet, not an economist. If his General Theory is a study in anything, it is Keynes' miraculous and near-flawless employment of the logical fallacy.

Mickslam, you are right. This though is physics envy, not economics. Why is something fundamentally _theoretically_ more important just because it can be accurately measured? Clearly it isn't.

The truly scientific way of looking at the problem is to come up with a theory from basic economic facts, then to find out what that implies.

Read Hayek's Nobel prize speech "The Pretence of Knowledge":
http://www.mises.org/story/3229

I'm pretty late to this party as it took me a while to get around to reading it. I'm reading it side by side with Hazlitts Failure of the New Economics and Im finding reading them both and this site all in tandem very informative. I doubt this will get read by anyone but I think I'm going to post just incase there are any other stragglers like me.

I think the whole point of trying to cram labour into the coat of homogeneity is being missed. Hazlitt points it out in total clarity starting on page 63 of his book. To my amazement he starts with a paragraph from Marx that read almost exactly as Keynes description for the numerating of heterogenous labour to the hour wage of unskilled labour. He follows with a refutation by Bohm-Bawerk and then this example which totally destroys the idea of homogenous labour:

"Yet these supposedly independent units of quantity, namely, "quantities of money value" and "quantities of employment,"are both merely quantities of money value. If ten laborers each working for $8 a day are dismissed and two specialists each working for $40 a day are taken on, there is no change in the volume of employment, according to Keynes's method of reckoning in the quotation on page 62.Keynes's "quantity of employment" is not a quantity of employment. It is the quantity of money received by laborers who are employed."

It seems to me that the whole point of the general theory is to provide a course of action for those that are most hurt during recessions, unskilled labour. To homogenize labour and then claim any aggregate increase in this is good for all labour commits the very fallacy Keynes was criticizing only pages earlier.

I'm also finding it interesting how Tyler often iputes meaning onto Keynes' thoeries that dont seem to be there. Now im not well read on the history of the debate, but no where in this chapter did Keynes explicitly call out the Austrians. He criticized Marshall and Pigou, and the one Austrian footnote tyler quotes is actually Keynes using a Hayek footnote to criticize Pigou's attempt at a scientific measurement of depreciating capital.

Anyway, since these posts happened a long time (last year, lol) I can only hope my comments help future readers.

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