Thursday, June 20, 2013

Greg Hill on “The Moral Economy: Keynes’s Critique of Capitalist Justice”

Hill (1996) is an important article on the fundamental economic issues in Keyes’s General Theory, and it set off an epic debate with the Austrian economist Steve Horwitz that can be read in Horwitz (1996), Hill (1996a), Horwitz (1998), and Hill (1998).

I will concentrate below on Keynes’s view of saving and loanable funds theory.

Hill (1996: 34) points out that, while Keynes certainly was a supporter of capitalism in the general sense of allocating scarce factor inputs to provide consumer goods, he argued that capitalist economies do not necessarily provide a high enough level of private investment and employment, nor that all income distribution generated by capitalism is just.

Thus Keynes’s argument for managed capitalism is both an economic and a moral case.

At the heart of Walrasian neoclassical economics is the price system. Walras’s metaphor for modeling a capitalist economy is that of the auctioneer who can announce quantities and prices of goods, and adjust prices in the process of tâtonnement until a set of market clearing prices is discovered to achieve equilibrium (Hill 1996: 35). The metaphor is utterly unrealistic, since the auctioneer must have perfect or near perfect information about different plans and trades, all expectations are fulfilled, the process is almost timeless, and stripped of the fundamental uncertainty which characterises economic life.

Under such a theoretical framework, neoclassical economics envisages a just earning of all wages, profits, and interest from all work, investment, and thrift respectively (Hill 1996: 36).

Keynes strongly challenged this paradigm.

First, the link between saving and investment. It is assumed in the neoclassical theory that saving will induce capital goods investment (Hill 1996: 38). Real resources “saved” in the sense of not being used to make consumption goods consumed today will be used in capital goods projects to make goods in the future.

But the link is not automatic nor reliable. Hill quotes a classic a passage on the general theory on the reality of any act of saving:
“An act of individual savings means –so to speak – a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day's dinner without stimulating the business of making ready for some future act of consumption.” (Keynes 1936: 210).
There is no necessary reason why an act of saving of money today must entail a future act of consumption (Hill 1996: 40), either in nominal money terms or real purchasing power terms. Money income may be spent on (1) goods and services, (2) second hand assets (whether real or financial), or (3) hoarded.

Certainly as a person’s income rises, they are more likely to spend money on (2), rather than (1).

Furthermore, the inducement to investment is complex and a function of demand, expected demand and expectations. Saving may well result in reduced demand and expected demand, and in reduced capital expenditures.

Of course, loanable funds theory gives capitalist apologists an imagined escape hatch here, as Hill notes:
“Neoclassical and Austrian economists reject this deflationary interpretation of the act of saving. In their version of Keynes’s parable, when someone reduces his consumption spending (e.g., by no longer dining out), the total supply of savings rises, and the rate of interest falls. This reduction in the cost of borrowing increases the number of profitable investment projects, and, in response, entrepreneurs increase their level of investment spending. In short, the act of saving supplies the wherewithal necessary for investment, and the falling rate of interest, which signals the public’s desire to trade current for future consumption, assures a commensurate increase in investment.” (Hill 1996: 40).
Keynes’s own critique of this was, firstly, that an individual act of saving may in fact decrease the aggregate level of savings: one saving decision reduces the incomes and hence saving of a business, and then has knock-on effects as that business reduces its own spending and hence savings of other businesses (Hill 1996: 40).

This brings out the well known fallacy of composition called the paradox of thrift: if everyone increases their savings, then the aggregate effect may be in fact decreased income and ultimately saving and investment (Hill 1996: 40).

A secondary criticism is the alleged coordinating role of interest rates in loanable funds:
“suppose that there is a flow of saving per year, and a flow of investment per year, and that the rate of interest adjusts so as to bring these two flows into balance. Now, if the interest rate were only required to equilibrate these flows of new lending and borrowing, it might well be able to perform the coordinating role assigned to it by the neoclassical school. There is, however, another important dimension to the problem, for the market in which new bonds are issued is the same market in which existing bonds are traded. And the very same scheme of interest rates that must balance the supply and demand for new bonds must also balance the supply and demand for old bonds. What would happen, then, if there were a conflict between 1) the rate of interest that would balance the flows of new saving and investment and 2) the rate of interest that would balance the supply and demand for existing bonds? According to Keynes’s account, the outcome will be determined by decisions concerning the existing stock of bonds because, at any given moment in time, the quantity of old bonds that can be released onto the market dwarfs the quantity of new bonds entering the market, just as the stock of money being held in anticipation of a fall in bond prices dwarfs the quantity of new additions to savings. Against the massive, preexisting stocks of old bonds and of money poised to enter the market in response to a change in the interest rate, the relatively small flows of new lending and borrowing can have little effect. It is because the rate of interest must balance these great stocks of existing wealth that it cannot, at the same time, effectively coordinate the flow of saving and investment.” (Hill 1996: 41–42).
The crucial issue here is the way interest rates in a real world capitalist economy involve much more than just some equating of investment with saving. There is vast stock of money and a vast stock of secondary financial assets bought with money as well as lending for capital goods projects.

Once one adds to this the possibility that business expectations can be shattered, it follows that lowering interest rates will not necessarily induce sufficient investment to create high employment and growth. A better solution is increasing demand and expected demand by greater spending.

In short, Keynes “turned the virtue of thrift on its head” (Hill 1996: 43) and undermined the classical argument for inequality of wealth.

Hill, Greg. 1996. “The Moral Economy: Keynes’s Critique of Capitalist Justice,” Critical Review 10: 411–434.

Hill, Greg. 1996a. “Capitalism, Coordination, and Keynes: Rejoinder to Horwitz,” Critical Review 10: 373–387.

Hill, Greg. 1998. “An ultra-Keynesian Strikes Back: Rejoinder to Horwitz,” Critical Review 12: 113–126.

Horwitz, S. 1996. “Keynes on Capitalism: Reply to Hill,” Critical Review 10.3: 353–372.

Horwitz, S. 1998. “Keynes and Capitalism One More Time: A Further Reply to Hill,” Critical Review 12: 95–111.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.


  1. "What would happen, then, if there were a conflict between 1) the rate of interest that would balance the flows of new saving and investment and 2) the rate of interest that would balance the supply and demand for existing bonds?"

    There would simply be a different interest rate on 1) rather than 2).

    Interest rates will reflect risk-adjusted expectations about future earnings streams of specific assets and if investors had different view on new v old bonds then this would be reflected in their prices.

    1. Rob,

      Before Keynes, it was widely thought that the rate of interest is a price determined at the margins of production, bringing into balance the supply of saving and the demand for investible funds. Keynes’s point was that the rate of interest is not causally determined by the supply and demand for *new loans* at the margin. Rather, the demand and supply conditions for new loans are determined by the market prices of existing loans of similar types. And these market prices, in turn, depend on vague expectations about the future course of interest rates, the degree of confidence people have in their expectations, and a variety of other factors.

      I think you missed this point because you assume that investors might have a "different view on new [versus] old bonds" with regard to their expected flow of earnings. In fact, there are very few cases where new bonds differ from existing bonds of the same issuer (a second lien bond would be an example). In general, the risk associated with holding a newly issued Treasury Bond is the same as the risk of holding an existing Treasury Bond. Hence, there's no price difference between old and new Treasuries with the same effective term.

  2. I always found the notion about one "natural" rate of interest to be an absurd and useless concept. Economists, from Keynes on the left, to Austrians on the right, talk about "interest in the vaguest and most slippery terms. What is supposed to happen in a neoclassical contraction, is that the average rate of interest falls, and can even turn negative. What this mean in effect is that creditors suffer losses on their bonds. That's what a negative Wicksellian equilibrium rate means. That's the hard way. the easier way is to create inflation in order to generate the negative wicksellian rate .

    I find Keynes MORAL case against capitalism to be absurd, as recessions are by definition failures of the treasury to deficit spend or the central bank to stimulate. Thats the governments job. This cannot be emphasized enough. Asset bubbles don't matter if the government acts after they pop. Like the austrians, I say the government is at fault. Unlike the austrians however, it is at fault in the OPPOSITE DIRECTION in which they claim

    Didn't Keynes also say something about capitalism working well except for demand? Something about "magneto trouble" and if that was fixed, the neoclassical paradigm would actually work as it was supposed to?
    Of course, Keynes was the most fickle minded economic thinker in history, so we never will know what he actually meant.

    1. Edward,

      I think you're confused about a number of things. First, when interest rates fall, bond prices rise, so bondholders enjoy capital gains. Second, when you say "recessions are by definition failures of the treasury to deficit spend or the central bank to stimulate," you are, in effect, supporting Keynes's view that individual workers aren't to blame for (involuntary) unemployment. Third, although Keynes did change his mind on some matters ("when the facts change, I change my mind, what do you do sir?"), he wasn't fickle and his meaning is rarely obscure.

  3. Off topic Lord Keynes,but i saw they put up a editited very nice
    quality version of the Bob Murphy-Mosler debate on youtube right now.MMT vs. Austrian School Debate

  4. "Once one adds to this the possibility that business expectations can be shattered, it follows that lowering interest rates will necessarily induce sufficient investment to create high employment and growth. A better solution is increasing demand and expected demand by greater spending"

  5. I do agree with Keynes on aggregate demand. He wasn't all bad.
    His economic bequest was very good, his political bequest was quite bad
    (Milton Friedman)

  6. This article, and this debate as a whole, did more to influence my current overall thinking than any other article or debate. Greg Hill does an excellent job at explaining the problems of loanable funds theory and free market economics in general in very simple terms. This debate should be on every Austrian's reading list