Theoretical Note: John Maynard Keynes vs. Milton Friedman

TRANSCEND MEMBERS, 3 Aug 2020

Prof. Howard Richards – TRANSCEND Media Service

Keynes was born too soon to benefit from the critical realist philosophy of science by Roy Bhaskar and lets his illuminating insights into social structure in the first three chapters of his General Theory slip out of focus in his next chapter.  He follows them with a chapter four on ‘the choice of units.’  He thinks that he needs exact numbers to do causal analysis.  He feels that he must use the differential calculus, which he eventually succeeds in doing, by defining dCw/dYw as the marginal propensity to consume.  In order to make his definition of ‘income’ yield the exact numbers he believes to be required to tie causes to effects, he ties it to the rules defining income followed by the Inland Revenue Service in the UK, in the 1930s.  Thus, he establishes his credentials as a scientist by conforming with the prevailing philosophy of science of his day.

Nevertheless, the thesis of this note is that what is most important about Keynes was that he called attention to staggering features of the basic structure, namely the chronic insufficiency of effective demand and the chronic insufficiency of the inducement to invest.[i] What is most important to extrapolate from Keynes survives the falsification of some of his empirical claims.

In any event, one can only expect economics to make correct quantitative predictions of future events if one has not read (or perhaps has read but has not believed) Roy Bhaskar, Tony Lawson, or von Hayek’s Nobel lecture  –all of which were written after Keynes’ death.

From Bhaskar and Lawson we learn that an economy is an open system.  Its basic tendencies are regularly offset by any number of cross-currents, some of which depend on unpredictable human choices.  Keynes himself goes back and forth between trying to formulate equations that yield the exact value of the dependent variable when one plugs in the exact values of the independent variables, and being satisfied with approximations derived from business experience and common sense.[ii] .

Although Keynes remarks from time to time that he is writing about the social institutions prevailing at his time and place, and not about truths valid everywhere and always, his theory is not about unbounded organization.  He was no Amartya Sen or Jean Dreze thinking of sales in markets as only one way, and often not the best way, to meet human needs.  He  begins his fifth chapter with the sweeping statement, ‘All production is for the purpose of ultimately satisfying a consumer.’ In the following sentence, Keynes makes it clear that satisfying means ‘the purchase of the output by the ultimate consumer.’  It could not be more clear in Keynes’ text that contrary to what Lionel Robbins would have us believe, economics is not about any and every way to decide how best to assign scarce resources to alternative uses.   It is about the buying and selling game; the rules of that game are the constitutive rules of markets.  Production is for sale.

To be sure, Keynes sees a role for public employment that does not produce for sale, even though his main text is a study of employment generated by investment for the purpose of producing goods for sale.  More importantly, without going anthropological and doing a Polanyi, Keynes gropes his way through an analysis of the standard economic process studied by the standard economic thinkers to a conclusion that changes everything: that process is just as likely to stop as it is to go.

Both the inducement to invest and effective demand are chronically unreliable.  Keynes’ pessimism about  reliability resembles our larger point that commerce (whether or not it is capitalist)  has no inherent tendency to feed the hungry or to heal the sick, just because the calorie intake of the former is dangerously low and cells are dying from lack of nutrients, or just because the latter is in crisis and whether life will continue or death will ensue hangs in the balance. If it does produce use values, it only does so as a by-product of producing exchange values.  One can, of course, argue that market exchange is the best way to produce use-values – but that argument leads to unbounded organization, because, obviously, sometimes it is the best way and sometimes it is not.  Keynes is for the most part, excepting texts like chapter 24 where he steps out of the role of economist and dons the robes of the social philosopher, an inside critic. He addresses his fellow economists and for the most part assumes their assumptions.

Contrary to the teachings of the classical economists, for whom the level of employment was determined by employers bargaining with workers, Keynes finds that the level of employment is determined by the level of output, which is determined by investment, which in turn is determined by expectations, where ‘expectations’ means expectations of sales at prices that cover costs and bring a profit.  It thus becomes essential to Keynes’ inquiry into employment levels to enquire what motivates buyers to buy or not to buy.  As Alvin Hansen noted in a review of the General Theory when it was first published in 1936, for Keynes the determinants of the level of output and therefore employment are

  1. The propensity to consume, i.e. the flip side of the liquidity preference, i.e. to what extent buyers will buy and to what extent they will not buy.
  2. The marginal efficiency of capital, i.e. expected profitability, which depends on expectations of buyers buying and,
  3. Interest rates, which is the main area where central bank policies can hope to influence employment levels.

When one goes behind these three determinants one finds that in Hansen’s words:

 ‘The ultimate causal forces are therefore found outside of the price system, in the mores, customs, habits, and behaviour patterns of the people. The fundamental psychological factors are the psychological propensity to consume, the psychological expectation of future yield from capital assets, and the psychological attitude to liquidity. Psychological propensities, mores, and behaviour patterns are thus the root forces which lie back of and control consumption and investment…’[iii]

In Keynes’ text, the liquidity preference is a preference for holding cash (or assets similar to cash) instead of spending the cash to buy something.[iv] Keynes gives a list of ten psychological reasons why people often prefer having money to spending it.  They are:

  1. To build up a reserve against unforeseen contingencies.
  2. To build up a reserve for foreseen future needs, such as old age, paying for the education of children.
  3. To build up funds to enjoy consumption at a later date.
  4. To build up a reserve for foreseen future needs, such as old age, paying for the education of children.
  5. To build up funds to enjoy consumption at a later date.
  6. To enjoy a gradually increasing expenditure, i.e. instead of taking all one’s enjoyment now.
  7. To enjoy a sense of independence.
  8. To secure a flexible sum of money for carrying out business projects.
  9. To bequeath a fortune.
  10. To satisfy pure miserliness. [v]

Keynes drew up additional lists of motives for not spending money that apply to central and local government and to business enterprises.[vi]

Let me stop here.  This is perhaps enough paraphrasing of Keynes to support what I want to say. What I want to say is that on the whole Keynes was not clear, or what perhaps amounts to the same thing, was not dogmatic, about method.   He only sometimes followed preconceived canons of what the scientific method is supposed to be.  On the whole, he can be described as trying to get a handle, one way or another, on the underlying causal powers of the generative mechanisms that in open systems tend to produce the phenomena observed.  Now let us consider a small sample of Milton Friedman’s rebuttals against Keynes.

Milton Friedman early in his career carried out meticulous empirical examinations of hypotheses derived from Keynes’ liquidity preference theory and found, for example, that contrary to Keynes’ expectations, people often save about the same proportion of their incomes as their incomes go up, rather than larger proportions as Keynes had expected.[vii]  Friedman studied in detail the spending patterns of dentists. When dentists (or at least the particular dentists that fell in the sample) are young they tend to take out mortgages and banks tend to grant them loans on the assumption that as they get older and advance in their careers, they will make more money.  They spend and save somewhat differently than Keynes’ expected.  When they get older and actually do make more money, they tend to spend it at about the same rate as they spent it when they were young.  Later, when he had become a tenured professor and a global celebrity Friedman wrote:

‘One major strand of Keynesian analysis traces the implications of a particular empirical assumption about the demand for money – that its elasticity with respect to interest rates is very high, approaching infinity (in Keynes’ own terms, liquidity preference is, if not absolute, approximately so). Such a situation would have very far-reaching implications: it would greatly limit the effectiveness of price flexibility in correcting unemployment; it would render changes in the quantity of money produced by open market operations impotent to affect economic conditions; it would make the effect of government deficits on income and employment independent of the way in which the deficits are financed.  By now, there is wide agreement that conditions of near-absolute liquidity preference, if they occur at all, are very rare, so that this strand of Keynesian analysis has receded to the status of a theoretical curiosity.’[viii]

We do not want to insist that Friedman attributing a doctrine of absolute liquidity preference to Keynes is a bit of an exaggeration. We could also say that the impotence of central banks that Friedman in 1966 regarded as a false corollary Keynes was committed to asserting, because it followed from his premises, has been recently observed.  One could say these things, but only at the risk of distracting attention from the main point.

What we do want to say is that Friedman is following the precepts of his own (invalid) philosophy of science.[ix]  He is reading Keynes’ book as a series of empirical assertions about alleged patterns of observed events.  Or, what is perhaps more likely, he is reading Keynes as a combination of such empirical assertions and philosophical speculation.  Then he is feeling free to disregard the parts he reads as philosophical speculation.  After deducing testable hypotheses from assertions he reads in Keynes, he gathers data to test them.

One might add that Friedman’s political views quite likely led him to parse Keynes looking for claims about patterns in the data unlikely to be verifiable.  Our view is that what is important about Keynes is not the tip of the iceberg Keynes tried to measure – the liquidity preference – but rather the iceberg itself, which is basic social structure.   [x]

NOTES:

[i] ‘The weakness of the inducement to invest has been at all times the key to the economic problem.’ General Theory, pp. 347-8.

[ii] See for example his discussion of the wage-unit in chapter 6 and of the cost-unit in chapter 21.

[iii] Alvin Hansen, ‘Mr. Keynes on Underemployment Equilibrium,’ Journal of Political Economy, Vol. 44 (1936), pp 667-686 at 671.

[iv] Keynes further distinguishes a category of money not spent on consumption but not held in liquid form either, but rather held as illiquid assets one cannot immediately spend.  General Theory, p. 166.

[v]   Keynes, General Theory.  pp.  107-8.

[vi] Keynes, General Theory. pp. 108-9.

[vii] Milton Friedman, A Theory of the Consumption Function.  Princeton NJ: Princeton University Press, 1957.  The consumption function and the liquidity preference go together, the former being a measure of how much of income is spent and the latter a measure of how much is not spent.

[viii] Milton Friedman, ‘Interest Rates and the Demand for Money.’ Journal of Law and Economics. Volume 9 (1966) pp. 71-85 at p. 71.

[ix] Milton Friedman, Essays in Positive Economics.  Chicago:  University of Chicago Press, 1953.

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Read also the Editorial: A Solution to Keine’s Problem

Prof. Howard Richards now teaches at the University of Santiago and the University of Cape Town.  He is a member of the TRANSCEND Network for Peace Development Environment. He was born in Pasadena, California but since 1966 has lived in Chile when not teaching in other places. Professor of Peace and Global Studies Emeritus, Earlham College, a school in Richmond Indiana affiliated with the Society of Friends (Quakers) known for its peace and social justice commitments. J.D. Stanford Law School, MA and PhD in Philosophy from UC Santa Barbara, Advanced Certificate in Education-Oxford,  PhD in Educational Planning from University of Toronto. Books:  Dilemmas of Social Democracies with Joanna Swanger, Gandhi and the Future of Economics with Joanna Swanger, The Nurturing of Time Future, Understanding the Global Economy (available in PDF on line), The Evaluation of Cultural Action, Following Foucault:The Trail of the Fox (with Catherine Hoppers and Evelin Lindner),  (on Amazon as an e book), Unbounded Organizing in Community (with Gavin Andersson, also on Amazon),  Rethinking Thinking (with Catherine Hoppers),  Hacia otras Economias with Raul Gonzalez, free download available at www.repensar.clSolidaridad, Participacion, Transparencia: conversaciones sobre el socialismo en Rosario, Argentina. Available free on the blogspot lahoradelaetica.


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