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Chicago, Keynes, and Fiscal Policy|
Seminar Paper No. 7
Esteban Pérez Caldentey
During the first half of the 1930's, the founders of the Chicago School of
economics and John Maynard Keynes in England advocated public works and as a
cure for unemployment and a way to overcome the Great Depression. Counter
cyclical fiscal policy was seen as a feasible strategy to attenuate the phases
of the economic cycle. The quantity theory of money coupled with the
hypothesis of wage and price rigidity provided the theoretical underpinnings
for this policy proposal. These economists argued that a monetary policy
channeled through the banking system was ineffective. In particular, Chicago
economists identified two key features that exemplified this restriction: the
instability of the circulation velocity of money and the fragility and
underdevelopment of the banking system and financial structure. Fiscal policy
was thus advocated on the basis of market rigidities and the impotency of
By the end of the decade both Chicago economists and Keynes had departed from
this fiscal policy stance. The former became concerned with the inflationary
consequences of expansionary fiscal policies, especially when there was the
temptation to implement them pro cyclically. Ultimately, fiscal issues were
overshadowed by monetary policy concerns.
Keynes remained an advocate of counter cyclical fiscal policy but recanted
from the instruments he had proposed earlier to combat economic fluctuations.
Using the framework he developed in the General Theory (1936), he
extended the division of income (consumption) and non-income (investment)
related categories to the government's budget. Thus, Keynes distinguished
between a current (government consumption) and a capital (government
investment) budget. The current budget was to be balanced or show a surplus
to finance the capital budget, which in turn played the fundamental
This allowed him to advance two different concepts of fiscal policy, capital
and deficit budgeting. Capital budgeting, to which he adhered under the
assumption of capital scarcity, meant rejecting the short-term stabilization
tools associated with deficit budgeting (public works and the use of taxation
to alter consumption patterns). Once the capital saturation point was reached
fiscal policy could change its focus from investment to consumption and
perhaps from capital to deficit budgeting.
During the early 1930's both Keynes and the Chicago economists advanced a
policy of public works as a way to overcome depressions. They argued in favor
of a counter cyclical fiscal policy to dampen variations over the phases of
the economic cycle. Chicago economists drew on a historical tradition that
linked monetary and real variables and their point of view applied to a broad
range of scenarios.
Keynes's case for public works was developed initially to overcome the
limitations imposed by laissez faire economic policies and was later seen to
be applicable to a 'special case', that of a gold standard exchange rate
regime. Ultimately, it became a way of showing how autonomous expenditures can
increase income, rather than prices, under less than full employment
The theory and assumptions underlying both strands of thought were remarkably
similar. Both adhered to some version of the quantity theory of money. In
addition these economists thought that wages and, in general, costs of
production were rigid and that the banking system and monetary policy tools
were unsuitable for the task of stabilizing the economy. Chicago economists,
in particular, viewed the instability of velocity and/or the fragility and
underdevelopment of the banking system as an important limitation on the
effectiveness of monetary policy. Due to the impracticability of reducing
costs they advocated an expansionary economic policy through fiscal means that
could restore the level of profitability. The primacy of fiscal over monetary
policy emanated thus from a combination of market imperfections coupled with
important restrictions on the potency of monetary policy channeled via
the banking system. Finally, Keynes and at least two of the Chicago
economist here considered (Paul Douglas and Aaron Director) justified the
impact of public spending on the level of output by having recourse to Kahn's
Both Chicago economists and Keynes eventually abandoned the idea of
reflationary policies as a fundamental stabilization tool, but for reasons
that were diametrically opposite. The former took the theoretical foundations
of the quantity theory to its full development and became concerned with the
inflationary dangers associated with a fiscal expansion. Moreover, in the
absence of well-defined fiscal rules, expansionary policies could well be used
pro rather than counter cyclically fueling thus an inflationary
Over time, as the belief that the economy operated close to full employment
levels of output gained prominence among Chicago economists and their
followers, fiscal policy lost its relevance. In fact, it became relegated to
"a technique for the exercise of monetary policy".
For Keynes the development of the theory of effective demand meant the
abandonment of the quantity theory of money as well as imperfectionist
arguments to explain unemployment. As a result, his earlier proposals for
fiscal expansion lost their theoretical basis.
Instead, Keynes extended the logic of the separation of expenditure categories
of The General Theory of Employment, Interest and Money (1936)
(GT, hereafter) to include the government and fiscal policy in his analysis.
In the same way that he separated these categories into an income dependent
category (consumption) and an income independent expenditure category
(investment), he distinguished between a current (government consumption) and
a capital budget (investment).
Within this framework the current budget was to be in equilibrium, or show a
surplus, to finance the expenditures of the capital budget which played the
stabilizing role over the economic cycle. For Keynes, capital budgeting was a
fiscal strategy aimed at maintaining economic equilibrium rather than curing
disequilibrium (i.e., deficit budgeting). On this ground he opposed a policy
of public works and the use of taxation to change the patterns of consumption
in the short run while favoring the use of automatic fiscal stabilizers and,
especially, capital expenditures to compensate cyclical fluctuations.
Keynes's fiscal policy views were elaborated under a key assumption of the GT,
that of capital scarcity. As long as the stock of capital was inadequate any
increase in investment would yield a positive return and be beneficial to the
welfare of society. Once the point of capital saturation was reached
investment would be wasteful and thus unnecessary. At this juncture fiscal
policy would change its focus from the regulation of investment to that of
This paper is divided into five parts. The first describes the historical
connection between Chicago economists, the quantity theory and fiscal policy.
The second analyzes the early Chicago view on the business cycle and monetary
and fiscal policy. The third provides a summary of the evolution of Keynes's
thought on public works, deficit spending and counter cyclical fiscal policy
in general. The last two sections examine Keynes's thought on these fiscal
issues prior to and following the publication of the GT.
2. Chicago economists, the quantity theory of money and public works:
the historical connection
During the 1930's the Chicago economists using a quantity theory framework,
argued in favor of a counter cyclical fiscal policy to attenuate the
oscillations of the business cycle. At the same time, they pointed to the
limitations of using monetary policy for stabilization purposes. While their
policy stance had a "Keynesian" flavor, and contradicted some of the basic
postulates of the latter Chicago School of economics, it was founded upon a
long standing tradition linking monetary and real variables whose origins can
be traced to the colonial period.
In colonial America, the belief that money supply could not only stimulate
prices but also business conditions was common and widely shared. The "Want of
some proper medium for Currency" motive was voiced early on in the eastern
part of the colonies as a way to guard against recessions and unemployment.
This belief expanded to the West and eventually found one of its most renowned
supporters in the figure of William Bryan Jennings (1860-1925) and the
Following the 1893 recession, and using the quantity theory as their
theoretical framework Populists and Bryan recommended increasing the money
supply by means of the free coinage of silver to increase prices and improve
business conditions. As well they advocated government spending in public
works as a remedy for unemployment.
The populists were not alone in their beliefs. Jacob Sechler Coxey, who lent
his name to the march of the unemployed to Washington in 1893 ("Coxey's
Army"), proposed two bills which included the issuance for large issues of
legal tender currency to be spent for roads and other public works for the
relief of the homeless.
Bryan and the populists came to be considered monetary cranks and were
eschewed and rejected by prominent economists such as Irving Fisher
(1867-1947) who fought to re-establish the reputation of the quantity theory
as a sound theoretical and empirical basis for the understanding of price
movements. As he put it:
"the 'quantity theory' has become the subject of political dispute, it has
lost prestige and has even come to be regarded by many as an exploded fallacy.
The attempts by promoters of unsound money to make improper use of the
quantity theory ľas in the first Bryan campaign- led many sound money men to
the utter repudiation of the quantity theory. The consequence has been that
especially in America, the quantity theory needs to be reintroduced into
Fisher's restatement of the quantity theory served as a general framework for
its further use and development by Chicago economists such as Aaron Director
and Paul Douglas (1892-1976), Frank Knight (1885-1972), Henry Simons
(1899-1946) and Jacob Viner (1892-1970). However, following pre-Fisherian
tradition and without bringing into disrepute the quantity theory tradition
these economists were led during the Great Depression to advocate public works
and government spending to revamp the stagnant economy.
Three premises formed the basis for their policy recommendations. First,
depressions arose from a lack of synchronization between prices and costs, or
more precisely between the supply and demand prices. Second, costs were
difficult to change due to downward sticky wages. Third monetary policy was
ineffective. Either the institutional configuration of the financial system
was inadequate, the monetary policy instruments useless, or velocity (the
demand for money) was unstable, and thus changes in the money supply would not
necessarily have, per se, a predictable effect on prices. The logical
conclusion was that fiscal policy was the main tool to bring about an economic
3. Chicago economists, the business cycle and fiscal
The Chicago approach to the business cycle is aptly summarized by Simons
(, (1962), p. 55):
"When for any reason business earnings become abnormally favorable, bank
credit expands, driving sensitive product prices farther out of line with
sticky, insensitive costs; earnings become more favorable; credit expands
farther and more rapidly; and so on and on, until costs finally do catch up,
or until some speculative flurry happens to reverse the initial maladjustment.
When earnings prospects are unpromising, credit contracts and earnings become
still smaller and more unpromising. In an economy where costs (especially
wages, freight rates, and monopoly prices in basic industries) are extremely
inflexible downward, the deflation might continue indefinitely..."
According to this view, the triggering factor of changes in the business
cycles were entrepreneurs' profits or losses accompanied by a credit expansion
(contraction) and a disparity between prices of final goods and costs. The
initial determinants of profits are not identified with precision at the start
of an economic expansion, but the reference to "speculative flurry" placed
expectations in the role of a key variable in the downturn phase of the
economic cycle. The upward or downward movement of the cycle was amplified by
the banking system. Finally, the misalignment between prices and a downward
rigid cost structure perpetuated the conditions for an economic boom and paved
the way for a depression.
All of these elements with different emphasis and degrees of importance were
present in the Chicago explanation of the Great Depression. Their distrust of
the banking system, their perception of an underdeveloped financial structure
and the explicit recognition by some of the instability of the circulation
velocity of money, led them to advocate fiscal policy as a means to overcome
economic depressions. More generally, these authors favored counter cyclical
fiscal policy as a way to attenuate economic fluctuations. The recourse to
fiscal policy emanated from the limitations, which they bestowed upon the
workings of the monetary system and monetary policy.
Frank Knight and Henry Simons identified expectations and the behavior of the
circulation velocity of money as triggering factors of the Great Depression
while Paul Douglas and Aaron Director focused on wage and price stickiness
combined with a lack of consumer purchasing power as both triggering and
Frank Knight (, (1963)) analyzed the business cycle in terms of the
behavior of the speculative demand for money combined with lags in the output
of final products. Velocity or the demand for real cash balances was
determined by the speculative demand for money rather than by transaction
purposes. In turn, speculative demand for money responded to the holding of
idle money in the expectation of a rise in its future value. It was ultimately
expectations that determined the demand for real goods and which could ignite
an upward or downwards cumulative movement. As put by Knight (p.211):
"Thus the tendency for increase or decrease in speculative holding of money ... to
feed upon itself cumulatively is subject to no such effective check as results
from the accumulation of a consumable commodity with a fairly definite demand
curve which is fairly well known, like the stock held speculatively. Indeed in
the case of money, just what sets a boundary to a movement of general prices
in either direction, and especially the downward movement, becomes something
of a mystery."
The prevailing structure of the banking system was an important factor in
amplifying changes in hoarding and dishoarding (i.e., in the velocity of
money). According to Simons, low capitalization levels characterized the
banking system. In addition, the practice of making short term loans
representing unsecured claims led to the creation of money substitutes,
increasing thus the variability of the circulation velocity of money.
The existing financial structure generated the conditions for wholesale
liquidation as banks were led to curtail loans when faced with unfavorable
business conditions. Banks were forced to hoard and liquidate existing loans
while individuals converted deposits into currency. In short, according to
Simons (1933), the "speculative temper of the community" caused changes in
velocity, which were magnified by the existing short term banking lending
structure of the economy. Indeed ((, (1962), p.166)),
" ... the economy becomes exposed to catastrophic disturbances as soon as
short term borrowing develops on a large scale. No real stability of
production and employment is possible when short-term lenders are continuously
in a position to demand conversion of their investments, amounting in the
aggregate to a large multiple of the total available circulating media, into
such media. Such an economy is workable only on the basis of a utopian
flexibility of prices and wage-rates. Short-term obligations provide abundant
money substitutes during booms, thus releasing money from cash reserves; and
they precipitate hopeless efforts at liquidation during depressions. The
shorter the period of money contracts, the more unstable the economy will
be ... "
Paul Douglas (1935) was also aware that the banking system was prone to
generate instability. Indeed, three features of the banking system tended to
aggravate rather than to dampen fluctuations in economic activity: the deposit
multiplier, the volatility of credit upon the demand for capital goods and the
fractional reserve banking.
The deposit multiplier tended to aggravate cyclical phases, depending on its
phase, by causing a cumulative contraction or expansion of credit. Finally, a
fractional reserve system could set the basis for a banking
"The bankers have in the past taken heart by assuring themselves that this
could never happen, since people would continue to have confidence in the
banks and would never put the credit system to the test. But what was thought
to be merely an impossible nightmare finally came true ... They ...
in increasing numbers, asked for the money which was supposedly
theirs ... the banks began to fail and as this still further increased
the fears of the public, the demands for cash became so great that virtually
all of the banks had to suspend payments", (pp.173-174).
While Knight and Simons traced the origins of depressions to expectations and
velocity, Douglas focused on the disparity between prices and costs and the
lack of consumer purchasing power.
The former was the result of a rigid downward price structure which reflected
the prevalent influences of monopoly practices upon the workings of
capitalism. According to Chicago economists the analysis of monopoly had been
forgotten by most economists but needed to be re-introduced in order to
understand how to deal with the Great Depression. In this spirit Douglas wrote
(op.cit. p, 234):
" ... the orthodox economists, when they portrayed the
mechanical adjustments of a beautifully adjusted society, were thinking of a
freely competitive system. So far as business depressions are concerned they
went astray in not recognizing the very serious extent to which monopoly price
policies were preventing the smooth functioning which they posited, and were
producing internal strains and frictions which could only end in disaster and
In a similar vein, Viner would still argue three decades later: "monopoly is
so prevalent in the markets of the western world today that discussions of the
merits of the free competitive market ... seem to me academic in the only
pejorative sense of that adjective."
Monopoly practices took the form of cartels or pools and agreements between
companies to increase prices. The stickiness created by private monopoly
practices was exacerbated by government regulation and eventually by labor's
demands for increasing wages to protect its relative income position (Douglas,
1935, p.54; Simons, , 1962).
Douglas fingered management practices as the evil element. As he wrote: "while
it is evident that at least in the United States high wage rates did not
initiate the present depression, but that, on the contrary, the pegging of
prices by management practices was largely responsible for both the initiation
and the continuance of the depression." (p.64)
Regarding the lack of consumer purchasing power, he reasoned as follows. The
increase in profits resulting from the difference between final prices and
costs was invested in mass production industries increasing in this way their
productive capacity. The resulting increase in output was not bought at
current prices due to lack of purchasing power by wages earners and the like.
Moreover, the stickiness in prices assumed by Douglas resulted in accumulation
of inventories of unsold goods. This overproduction translated in a sharp
reduction in prices, which did away with profit margins, and hence business
profits. As he put it:
"It will thus be seen how a growth in output, unaccompanied by
corresponding increases in wages and with heavy reinvestments of the greatly
increased profits, may cause such an increase of production, that in order for
it to be absorbed by the smaller incomes, prices will have to be reduced
appreciably ... profit margins may be swept away and a general crisis
precipitated. " (p.74).
The sought remedy to overcome the depression lay in preventing speculation or
in changing the circulation velocity of money to maintain the prices of final
goods stable. More precisely, when the prospects for the successful control of
the circulation velocity of money were dim, a stable relationship had to be
maintained between product prices and wages by "deliberate action ...
correcting or offsetting incipient tendencies to expansion or contraction."
(Knight, p. 225). That deliberate action would come from the government. As
put by Simons (, (1962)), p.55): " In an economy where costs (especially
wages, freight rates and monopoly prices in basic industries) are sticky
downwards, the deflation might continue indefinitely (until everyone was
unemployed) if governments did not intervene to save the banks or mitigate
Due both to a fragile financial structure and price and wage rigidity, Simons
recommended a price index rule whereby currency issue was adjusted in a
discretionary manner to stabilize the price level. The mode of implementation
of this rule was through fiscal policy, injecting purchasing power through
expenditure and withdrawing it through taxation. Monetary policy was too weak
both in its institutional structure and in providing a stable and measurable
"quantity of money" variable. In this respect, Simons (, (1962), p. 175)
" ... in an adequate scheme for price-level stabilization, the Treasury
would be an administrative agency; and all the fiscal powers of Congress would
be placed behind the monetary rule ... . At present, monetary powers are
dispersed indefinitely, among governmental agencies and private institutions,
not to mention Congress itself. Since the powers of the legislature are
ultimate and decisive, a program looking toward co-ordination and
concentration of responsibility must focus on fiscal as its mode of
Douglas (1935) took the same route. He was not convinced of the efficiency of
monetary instruments to rein in the effects of the depression on output and
employment. For one thing, open-market operations built up commercial bank
reserves and they would use these to cancel out debt rather than to end up
with bad loans. Also lowering the discount rate was simply an "idle gesture"
for it would do little to boost business confidence since the problem lay in
business' dimmed profit prospects, i.e., in demand conditions. Douglas and
Aaron (1931) had voiced earlier a similar concern. They also pointed out the
limitations in the use of monetary policy instruments during a depression:
" ... the difficulty comes form the demand side as to whether business,
exposed to such difficulties, would wish to borrow more". The problem was the
response of aggregate demand. As put by Douglas and Aaron (1931, p. 225): "The
interest of society as a whole does not lie with the fortunes of individual
firms, but in the demand for commodities in the aggregate".
Douglas proposed to separate the function of the creation of credit from the
retailing of credit by putting the creation of purchasing power into the hands
of the government (p.184). The amount of purchasing power to be created would
be in direct relation to the amount of unemployment (p.189). Under conditions
of high unemployment the federal banking authority would create credit and
loan it to the government "for the financing of public works and thus provide
the purchasing power needed to put idle labor back to work". Using Kahn's
concept of the multiplier, he estimated that each dollar spent on public works
would generate an equivalent of 2.80 dollars in the rest of the
Ultimately Douglas advocated a budget policy which would be balanced over a
ten year period but which would allow " ... to have receipts exceed
expenditures during periods of relative prosperity and expenditures exceed
receipts during periods of depression" (p.278). Viner also recommended in 1931
that governments should spend more in recessions and decrease taxation during
These views were echoed in Douglas & Director (1931) as they argued for an
activist counter cyclical fiscal policy: "When private business is very active
and the available supply of labor fully employed, government should contract
its own expenditures; when on the other hand, private business is depressed,
government should expand its own expenditures" (p.196). Regarding public
works, they wrote: "Our analysis so far, indefinite as it is, permits us to
conclude that over a period of time it is possible, through the use of public
expenditures, to reduce somewhat the extreme fluctuations of unemployment. In
the long run ... we may actually expect a reduction in the average level
of unemployment" (p.219). In their analysis they were aware of the "crowding
out effect" but denied its relevance:
"Credit cannot be looked upon as a fixed pool which is emptied by one if not
another. Hence to argue that the demand for credit for public works in time of
expansion acts as a check on private over-expansion, is to disregard the fact
that the public works industry is itself an important branch of the general
construction industry ... . There is no reason for assuming that
contraction of public demand will be offset by increase of private demand and
that a policy of adjusted public works will itself contribute to exaggerate
private fluctuations". (p.221)
As a group Chicago economists advocated on more than one occasion an increase
in aggregate demand to revamp a stagnant economy. In January, 1932,
twenty-four economists participating at a conference at the University of
Chicago urged President Hoover to pursue more aggressively open market
operations and to continue the government's public works program. Later on in
April, 1932, at the request of Congressman Samuel B. Pettengil (Republican of
Indiana), Chicago economists drafted and signed a statement urging a public
works program financed by having resort to the printing press. As they put
"Recovery can be brought about, either by a reduction in costs to a level
consistent with existing commodity prices, or by injecting enough new
purchasing power so that much larger production will be profitable at existing
costs. The first method is conveniently automatic but dreadfully slow ...
. The second method ... only requires a courageous fiscal policy on the
part of the Central Government" (Quoted in Tavlas, (1997), p. 164).
Reliance on reflationary policies had an important drawback. They could fuel
inflation, especially if they were used during the upward phase of the cycle.
Simons (1934) was early on aware of the link between fiscal policy and
inflation, as he labeled reflationary fiscal policy as dangerous. Close to two
decades after the GT was published, Viner criticized Keynes on the grounds
that his definition of true inflation was a means to use government spending
to boost the economy in times of high output and employment.
It was perhaps the concern that reflationary policies would be used pro
cyclically in combination with the assumption that full employment was a
historical norm rather than a historical rarity, that led Chicago economists
to eventually abandon the notion of a counter cyclical fiscal policy as a
fundamental prescription. This, in turn, shifted the analysis of compensatory
finance from its focus on budgetary aspects to monetary ones. This view was
fully articulated by Clark Warburton (1896-1979). According to him, fiscal
policy combined monetary policy and government expenditures. However, only the
former was relevant. Government expenditure was simply a substitute for
individual expenditure and had no extra net effect on the level of activity.
Fiscal issues were thus exclusively seen through their monetary aspects and,
de facto, encapsulated within the analysis of monetary policy.
4. Keynes and fiscal policy: from the need of a jolt to capital
In consonance with the early Chicago view, and prior to the elaboration of the
GT, Keynes advocated public works in times of recession as a means to economic
His advocacy of public works, from the time of "Does Unemployment Need a
Drastic Remedy?" (1924) and "Can Lloyd George Do it?" (1929) to the
Wicksellian framework of the Treatise on Money (1930), sought to
provide a palliative measure for the practical consequences of laissez faire.
This theory made too many stringent assumptions (i.e., full employment), or
was unable to produce the desired results under market imperfections, such as
wage rigidity. As put by Keynes (1924), p. 229:
" ... .we are brought to my heresy ... I bring in
the State; I abandon laissez-faire, -not enthusiastically, not from contempt
of that good old doctrine, but because, whether we like it or not, the
conditions for its success have disappeared ... it entrusted the public
weal to private enterprise unchecked and unaided. Private enterprise is no
longer unchecked, - it is checked and threatened in many different ways".
As he moved on towards the GT, Keynes rested his case for public works
basically on the workings of the multiplier. The idea was to show that, under
less than full employment conditions, an increase in autonomous expenditures
can expand income rather than prices ("The Means to Prosperity" (1933) in CW,
Vol. IX, (1972), pp.335-366).
With the publication of the GT, Keynes broke away from the concept of fiscal
policy as a corrective device, as a method to correct economic disequilibrium.
Fiscal policy became, rather, a way to maintain equilibrium and economic
Following the logic of the GT which separated aggregate demand into income
dependent and independent categories, consumption and investment respectively,
Keynes sought to divide the budget into corresponding categories, a current
and a capital budget. The capital budget included borrowing by the government
agencies, surpluses and deficits of extra budgetary funds and capital
expenditures. The current budget was to be equilibrated or in surplus to
finance the capital budget, which in turn would actively maintain an optimal
level of capital expenditures (CW, 1980, Vol. XXVII, p.378). Thus the capital
budget played the main stabilizing role over the economic cycle.
Underlying this view was a key hypothesis of the GT analysis, namely the
capital non-saturation hypothesis. For Keynes, capital was scarce and this
meant that the return to increasing investment could always be positive and
that investment per-se would increase economic welfare. If the investment
program were to be turned over to public or semi-public bodies this could
reduce further its "potential range of fluctuations". Planning was key to
maintaining full employment: "With a big program carried out at a properly
regulated pace we can hope to keep employment good for many years to come. We
shall, in very fact, have built our New Jerusalem out of the labor which in
our former vain folly we were keeping unused and unhappy in enforced idleness"
(Ibid. p. 270).
Once the capital saturation point was reached (the point at which investment
demand could not be brought to equality with full employment savings without
engaging in wasteful projects) fiscal policy could turn to encourage
consumption instead of investment. However he saw that stage far in the
future: "We most of us, not only expect that we shall reach a point where the
encouragement of consumption is the thing to put first, but we hope for it.
All this, however, is in the future." (Ibid. p. 360).
5. Keynes and fiscal policy before the General Theory
From late 1924 on, Keynes consistently recommended the undertaking of public
works as a way to overcome recessions. Underlying this proposition were two
key ideas that he developed sequentially. First, money wages were rigid and
second, unemployment could be traced to disequilibrium between investment and
savings. Keynes thought that the rigidity of money wages was part of the
institutional transformation that European economies had undergone following
WWI. This hypothesis came to the forefront of Keynes's thinking after the
return of Britain to the gold standard in April, 1925. Later on, he used this
hypothesis to downplay the role that monetary policy could play to turn the
tide in a depression. His analysis of savings and investment was developed as
he worked on the Treatise on Money and was clearly enunciated after the
'Great Slump' had begun.
In his earlier articles "Does Unemployment Need a Drastic Remedy?" and a
"Drastic Remedy for Unemployment" (1924) Keynes analyzed unemployment in terms
of structural causes, wage rigidity and demand considerations. While he
thought structural programs, reconversion and reorganization of depressed
sectors, and wage flexibility could improve competitiveness it was de
facto an impractical solution. He thus favored increasing aggregate demand
through a program of public work expansion. Kahn's multiplier provided,
eventually, the basis for its rationale.
Increasing demand could transfer workers from less to more productive sectors.
Later on, in "How to organize a Wave of Prosperity?" (1928) and in "Can Lloyd
George Do it?" (1929), he combined the idea of an expansion of demand with
that of an increase in labor intensity. This increase in labor intensity was
an alternative to a decrease in nominal wages to reduce production unit costs,
thus restoring business profitability. In this sense, his thinking was very
similar to that of Douglas, Aaron, Simons and Viner. When commenting on a
money wage reduction as a way to cure the ills of unemployment, he argued
"Rather we must seek to submerge the rocks in a rising sea, -not forcing labor
out of what is depressed, but attracting it into what is prosperous; not
crushing the blind strength of organized labor, but relieving its fears; not
abating wages where they are high, but raising them where they are low. And
there is no way in the world of achieving these better alternatives but by
confidence and courage in those who set enterprises in motion".
In The Treatise on Money (1930), Keynes made the case for public works
for an open economy under conditions of wage rigidity and a fixed exchange
rate regime. He focused on what he thought was the essential problem of
monetary theory, the process through which the level of prices changes from
one situation of equilibrium to another. More specifically, the Treatise
centered on the dynamic price change, in the short run, and its consequences
in the level of activity and employment. To this end he used a modified
version of the quantity theory of money which he termed the 'Fundamental
Equations'. In the fundamental equation the price level of output as a whole,
p, was a function of the per unit cost of
production ((1/e* W), where W is the rate of earnings per unit of human effort
and e the coefficient of efficiency), and on per unit profits (expressed as
the difference between investment and savings measured in terms of output,
1. p = (1/e)W + (I-S)/O
According to Eq. (1), the price level of output as a whole (p) would equal its cost of production when savings
equaled investment. Prices and the level of economic activity could vary due
to changes in the per unit cost of production or due to losses or profits. As
such an insufficiency of demand (S>I) would generate losses, prices would
decrease and firms would contract production. The contraction of demand would
cause unemployment and, under conditions of price flexibility, decreased
unitary costs of production. Under rigid wages, the contraction in demand
could perpetuate itself.
Keynes introduced Wicksell's theory of investment and savings and made the
profit per unit of output dependent on the disparity between the natural and
the market or bank rate of interest. In this way fluctuations in the natural
or market rate of interest generated a disparity between savings and
investment (profits or losses) that could contract or expand the level of
activity. Governmental authorities could vary the bank or market rate to
approach the natural rate to maintain price and, hence, output
In a depression, savings exceeded investment (i.e., the market rate was
greater than the natural rate) and thus the fundamental policy prescription of
the Treatise was straightforward: an expansionary policy by a demand stimulus
that, by decreasing the market rate of interest and equating the natural and
market rate of interest, would close the gap between investment and
In an open economy under a fixed exchange rate regime such as the gold
standard the analysis of the Treatise required an extension of the fundamental
equations to incorporate balance of payments consideration. Within this
framework, the price level of output as a whole depends on per unit cost and
on the difference between national investment and savings. National investment
equals to the sum of domestic investment (I1) and the current
account balance (B). National savings equals the sum of domestic savings
(S1) and foreign lending (L) minus gold outflows (G). Thus, Eq. (1)
2. p = (1/e)W + ((I1+
B)-(S1+ L- G))/O
For a given per unit labor cost the equilibrium condition becomes,
3. I1+B = S1+ L - G <-> I1=
S1 and G=0.
Under an open economy with a fixed exchange rate regime, variations in the
interest rate could not fulfill simultaneously both internal (I1=
S1) and external equilibrium (G=0) conditions.
Starting from a position of full equilibrium an increase in thrift will result
in an excess of internal savings over investment (I1<
S1) and the market rate of interest will exceed the natural rate of
interest. A decrease in the market rate of interest to overcome the resulting
deflation and slump would result in gold outflows (G>0) and foreign
exchange reserve losses. If the authorities wanted to abate gold outflows they
could increase the market rate of interest. Whatever the policy options, the
results would be similar: price and profit deflation would ensue resulting in
decreases in output and employment.
Under these circumstances Keynes thought of two possible remedies: a decrease
in the per unit cost of production ((1/e)W) or an increase in home investment
which would restore the natural rate of interest to its previous level. The
reduction in unit labor costs would decrease further the price level of output
as a whole but would restore the balance between profits and costs. However,
Keynes not only explicitly reiterated his earlier posture regarding downward
wage rigidity (" money costs of production show but little resistance to an
upward movement" Treatise, p. 165) due to trade union power (p. 347)
but also argued that it was a dangerous remedy in a capitalistic and
democratic society (p. 346) (see also CW, Vol XIII, p.360). Hence his
preference to increase investment via loan financed public works,
calling it 'my favorite remedy' (Clarke p. 115).
Later on, in "The Means to Prosperity" (1933), Keynes argued for a public
works program, using essentially the logic of the multiplier. Under less than
full employment conditions, an increase in autonomous expenditure translated
into a higher level of income rather than higher prices. Also, the income
generated by the expenditure process created the required savings to 'finance'
the initial investment. In this sense, a loan financed program of public works
need not generate a budget deficit: "...it is a complete mistake to believe
that that there is a dilemma between schemes for increasing employment and
schemes for balancing the budget...Quite the contrary. There is no possibility
of balancing the budget except by increasing the national income, which is
much the same thing as increasing employment" (CW, IX, p.347). However, it was
in this pamphlet that Keynes suggested, perhaps for the first time, the use of
deficit spending (i.e., the use of budget deficits as a stabilization tool).
Indeed, he mentioned tax cuts and thus unbalanced budgets as an alternative
way to increase income.
Keynes's case for demand and output expansion through fiscal policy, in the
guise of public works, was the basis for his recommendations to the Macmillan
Committee, for the views presented in "Can Lloyd George Do It?", and for his
earlier views on the 'Great Slump'. In the GT, Keynes did not advocate a
systematic policy of loan expenditure public works or budget deficits by
governments. In fact, as shown earlier and quite to the contrary of what is
generally believed, the case for budget deficits is more a product of Chicago
economics than that of Keynes. Ironically, these policy recommendations
became, over time, the essence of what was thought to be "Keynesian economics"
i.e., deficit spending and, in general, compensatory finance.
6. Keynes and fiscal policy following the General Theory
Following the publication of the GT Keynes fiscal policy stance was derived
directly from its logic and the views expressed therein.
As mentioned above, the General Theory divided economic categories of final
demand into two types of expenditures: those related to income (consumption)
and those independent of income. The expenditures that were independent of
income were "linked to the amount which it (the community) is expected to
devote for new investment" (Davidson, 1994) and were greatly dependent on
In the GT, Keynes demonstrated that the expenditures not related to income,
i.e. investment, need not equal planned full employment savings. As a result,
he recommended state intervention to encourage investment. Increasing the
scale of investment had clear precedence over expanding the level of
consumption. As he put it:
"The question then arises why I should prefer rather a heavy scale of
investment to increasing consumption. My main reason for this is that I do not
think we have yet reached anything like the point of capital saturation. It
would be in the interests of the standards of life in the long run if we
increased our capital materially. After twenty years of large-scale investment
I should expect to have changed my mind ... " (CW, Vol, XXVII, p.350)
His analysis of budget and fiscal policy followed the expenditure category
logic of the GT: he sought to separate the budget in two components, a current
(government consumption) and a capital budget (government investment). The
capital budget was simply a survey of capital expenditure to keep it at an
optimal level. As he put it: "a regular survey and analysis of the
relationship between sources of savings and different types of investment and
a balance sheet showing how they have been brought into equality for the past
year, and a forecast of the same for the year to come".
In a situation where the "necessary investment is no longer greater that the
indicated level of savings and is capable of being adjusted by encouraging
useful investment". (p.321) (I.e., when the stock of capital was inadequate or
capital was scarce) the capital budget could maintain equilibrium and play the
fundamental stabilizing role. It could and would compensate cyclical
fluctuations if two thirds or three quarters of total investment would be
under public or semi public auspices. This latter idea which had permeated
Keynes's mind early on responded to a Burkean 'query' regarding the
delimitation of the state and the individual competencies and
Keynes (1931) conceived of public or semi public corporations whose operating
criteria were to be found outside the sphere of individual interest. These
corporations were to be autonomous but subject to the control of parliament
and run by technical experts. Later on in 1945 as he became an advocate of
planning, he decided that the government rather than semi public corporations
should oversee the functioning of the capital budget. He wrote:
"At one time I had conceived that this (reporting on the present and
prospective state of the capital budget) should be the task of a
semi-independent statutory authority to be called the National Investment
Board. But with modern developments of policy, decisions on such matters have
become so much part of the government's economic program as a whole that they
should not be dissociated form the Chancellor of the Exchequer as the
responsible minister and his official department" (CW, Vol. XXVII, p.408).
The distinction between a capital and an ordinary budget allowed Keynes to
distinguish, in turn, between two types of fiscal policy: deficit budgeting
(deficit finance) and capital budgeting. Deficit budgeting was a means to cure
disequilibrium whereas capital budgeting "is a method of maintaining
equilibrium". He thus argued against a deficit budgeting strategy to smooth
out the phases over the economic cycle and, in particular, he opposed public
works and the use of taxation to affect the level of consumption. Regarding
the former he asserted: "a fluctuating volume of public works at short notice
is a clumsy form of cure and not likely to be completely successful" (Ibid. p.
319). With regard to the latter he argued:
"In the first place, one has not enough experience to say that short term
variations in consumption are in fact practicable. People have established
standards of life. Nothing will upset them more than to be subject to pressure
constantly to vary them up and down. A remission of taxation on which people
could only rely for an indefinitely short period might have limited effects in
stimulating their consumption. And, if it was successful, it would be
extraordinarily difficult form the political angle to reimpose the taxation
again when employment improved." (Ibid.)
For these reasons Keynes opposed the use of the current budget as a way to
stabilize the cycle. Rather, the current budget should show a surplus, which
would be transferred to the capital budget. He considered unbalancing the
current budget as "a last resort, only to come into play if the machinery of
capital budgeting had broken down" (Ibid.p.352).
However, these recommendations were valid until the saturation point of
investment was reached. Beyond this point where, as Keynes indicated,
"investment demand is so far saturated that it cannot be brought up to the
indicated level of savings without embarking upon wasteful and unnecessary
enterprises" (Ibid. p. 321), savings should be discouraged and consumption
encouraged by increasing leisure hours, vacation time and shorter work hours.
While this stage was seen to be far into the future, it would mark the change
from capital to deficit budgeting as the guiding principle for fiscal
During the early 1930's, Chicago economists and Keynes argued along similar
lines for a cure for unemployment. They saw it as a question of restoring
business profits. They both thought that wages were downwardly rigid and in
particular Keynes did not recommend large cuts in wages on practical grounds
("To attempt it would be to shake the social order of its (Britain's)
foundation" (CW, Vol.XIX, p.360)). As a result, and due to the inability of
the banking system to ignite a recovery, they recommended that a counter
cyclical fiscal policy be followed. As Keynes wrote in his letter to President
Roosevelt: "The object is to start the ball rolling" ((, (1955)
Both used the same framework, the quantity theory of money, though Keynes's
version was more elaborate, focusing on the relationship between investment
and savings and was dubbed "the fundamental equations". The case for counter
cyclical fiscal policy was thus built on a combination of the quantity theory
of money and a rigid price structure. A key difference between both is that,
where as arguments for deficit spending (i.e., using the budget deficit as a
stabilization tool) can be found in the writings of Chicago economists, this
is not the case of Keynes. It is thus ironic that the latter is often
considered as one of the architects of budget finance when that title belongs
rather to the former.
Later, both Chicago economists and Keynes recanted their views on fiscal
policy but for opposite reasons. The Chicago team emphasized the dangers that
a pro cyclical fiscal policy might bring about in terms of inflation. Over
time, this new view of fiscal policy was fully adopted when the view that
monopolistic behavior characterized capitalism was replaced with the axiom
that full employment and perfect competition were good analytical
approximations to the real world. Ultimately, Chicago economists, following
the logic of the quantity theory, became preoccupied basically with price
stability and were not able to build the foundations for an alternative
approach to fiscal policy. Fiscal issues became subsumed in monetary policy
Keynes was well aware of inflationary finance but was simply more concerned
with cost inflation. While demand inflation could be easily brought under
control cost inflation was harder to eradicate. As he put it (CW Vol. XXVII,
"We have been using 'inflation' to mean pressure of demand to raise prices
above current cost of production ... But inflation of this sort is a
temporary factor, ... and one we have learned to keep under good control.
The real question is the price level which is going to be determined by costs
of production, internal and external. If the costs can't be controlled, it is
futile and dangerous to attempt to exercise any general control over the price
His change of vision regarding fiscal policy came about as an intellectual
escape from the confines of the quantity theory of money and the elaboration
of the theory of effective demand. Keynes's new approach to fiscal policy
followed the logic of the GT and distinguished between a current budget and
capital budget just as the GT separated income and non-income related
categories, i.e., investment. The current budget was to be in balance or show
a surplus which would be transferred to the capital account. The idea behind
the separation of a current and a capital budget was not to respond to short
term disequilibria but to maintain the stability of investment, which was
thought to be the "causa causans" of the economic system's behavior. In
consistency with this point of view Keynes discouraged taxation policies that
aimed at tampering with consumption. Consumption habits were far too stable to
be liable to manipulation by the authorities and taxation policies that aimed
at consumption were too costly to be implemented. Underlying this view was an
essential assumption of the GT: capital was scarce and the increment in its
stock would yield a positive return and would thus benefit society as a whole.
In a similar vein, Keynes warned about the limitations of a debt management
As seen through this prism, Keynes's approach to fiscal policy was an integral
part of the theoretical framework put forward in the GT. Given a set pattern
of consumption habits fiscal policy was concerned with maintaining the
stability of investment under conditions of capital scarcity. This needed
above all planning and the elaboration of a long-term program. Keynes thought
this possible for, as he put it, "In the long run almost anything is
possible". The identification of Keynes with deficit spending as a
stabilization tool and short run counter cyclical fiscal policy tools have
little foundation in Keynes earlier writings, and only find a place in his
mature works past the stage of capital saturation.
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