General Theory Study Guide: Chapter 3, Section I

This Chapter introduces the Keynesian concept of "effective demand".  He does so in the most confusing way possible.  I'll try to simplify as much as I can.

In section I, all Keynes does in this section is define "effective demand".  Here's the theory from Keynes's own words.

The amount of employment... depends on the amount of the proceeds which the entrepreneurs expect to receive from the corresponding output.  For Entrepreneurs will endeavor to fix the amount of employment at the level which they expect to maximize the excess of the proceeds over the factor cost.

In other words, Employers will guess what the most profitable level of employment will be, and that is how many people will be hired.  If entrepreneurs don't believe hiring more people will be profitable, they won't hire them.  The point where the cost of employment meets the expected increase in revenue is the point of "effective demand".

Keynes contrasts this with the classical theory(The belief that supply creates it's own demand).  For that belief to be true, any increase in the number of employed people must mean that the cost of hiring will always be less than or equal to the expected profits .  If that were the case, then entrepreneur's would constantly be hiring people until there was no one left and employment really would be determined by the Marginal Disutility of Labor.

Obviously, Keynes doesn't believe the above paragraph is true.  He will lay out his explanation and theory of why in Chapter 3, section II.

Hopefully, my non-math and non-statistical explanation of his definition of "effective demand" will help you understand Keynes's math heavy explanation in Section I.

General Theory Study Guide: Chapter 2, Sections VI and VII

In Section VI, Keynes gives "Classical Economics" a final blow.  He starts to build his case that Money has an effect on the way an economy works.  The thought that the principles of a barter economy can be applied to a monetized economy was strong.  In fact, it is still strongly believed by Austrian Economics that barter is a useful model for monetized economies.

Keynes starts off section IV by quoting John Stuart Mill and Alfred Marshall.  This is to demonstrate the current thought which is that "supply creates it's own demand" as presumed by Mill.  The Marshall quote goes to show that the belief really is that if a person abstains from spending his income, it somehow automatically triggers a corresponding investment by himself or others.  Keynes claims this is incorrect because the two are using a false analogy between the world in which we live(a monetized economy) and a Robinson Crusoe economy of pure barter.

Keynes makes  a couple guesses as to why people have made this mistake.  The first is the strong case of Says law.  He agrees with the premise that the "income"(things it gets) of an entire community is exactly equal to it's "output"(things it makes).  This concept is confused with a (what Keynes calls a "similar-looking") proposition: "the costs of output are always covered in the aggregate by the sale-proceeds resulting from demand".  So what does that mean?  I found someone who explained it simply:

That is, I do not decide how many ipods will be made this year, but I do decide whether I want to buy one. Apple has to guess whether or not I will buy.

His other guess as to why people make this mistake is that those who believe Say's laws are basing it on individuals.  If an individual "saves" he is richer.  If every individual in the community "saves" then shouldn't the whole community be richer?  Keynes doesn't think so since.  This is his first hint at his fallacy of composition argument.

The two most important concepts from this section are:

1. Money matters.  It changes the way an economy works.  Money is not a "thing veneer" over a pure barter economy.

2.  The "classicals" are "fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption."

This leads Keynes to declare that many theories of "the classicals" need to be re-examined.

Section VII

Section VII is a summary of the rest of the chapter.  Keynes summarizes the 3 biggest ideas of the classical economists(seen below) that he believes are flat out wrong.  The following ideas must all be true, or all not true.

1. The real wage is equal to the marginal disutility of the existing employment;
2. There is no such thing as strictly involuntary unemployment;
3. supply creates its own demand

General Theory Study Guide: Chapter 2, Sections III, IV and V

In these sections, Keynes finishes demolishing the classical understanding of unemployment that he started in section II.  By the end of section V, his theory of employment should start(START!) coming into focus.  If by the end of section V, you don't understand his argument of why there is involuntary unemployment in a money economy, I would reread sections II through V over and over until you do before moving on.

Section III

Section III starts off by repeating that workers have no mechanism to lower their own REAL wages across the economy.  This is such an important point, Keynes can be forgiven if he repeats it a couple (or even a hundred) times.  Workers can only cut their dollar-wages, but that doesn't necessarily lower their REAL wage. Understanding this is critical to Keynesian economics.  From Section III

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

I cannot over stress the criticality of understanding this.  Keynes is pointing out that because people make their deals in money-terms and not REAL-wage terms, there is no way for workers to increase the general level of employment by accepting wage cuts.  Even if workers start a cycle of slashing their wage demands, all that will happen is either the price of what they're making is slashed or their wages will be redistributed to other groups.  If all workers lower their dollar-wage, it redistributes wages to capital or land in the form of interest and rent.

More detail on how and why this is will be explained later and throughout the book.  For now, just understand that Keynes rejects the notion of obstinate workers as an explanation for involuntary unemployment.

Keynes also points out now why it is actually logical(remember how the Classicals thought it illogical) for workers to resist reduction in dollar-pay, but not resist loss of REAL wages from a sudden increase in the cost of living.  A rise in cost-of-living affects all industries equally and happen so often that resisting them is impractical.  Of course, Keynes, being thorough, does point out that there are exceptions when things go to the extreme(i.e. A very high increase in cost of living).

Section IV
Section IV is where Keynes takes up the task of defining involuntary unemployment.  He makes some obvious caveats about his definition and existing definitions first(you shouldn't have a problem with theses).  Then he gets to his definition.  It is a complicated definition:

Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment

Fortunately, if you have a hard time deciphering this "an alternative definition, which amounts to the same thing, will be given in the next chapter".  What he's saying here is if the cost of living rises, but dollar-wages stay about the same, and more people are working after the rise than before the rise, then there was some involuntary unemployment.

Keynes in this section then reiterates that his problem with "the classicals" isn't their reasoning, it is their assumptions.  They have assumed, whether they realize it or not, that "Full Employment" already exists.

Section V
In this section Keynes comes puts and explicitly states that he does believe a reduction in REAL wages will in fact increase employment(assuming land and capital remains even).  He is not disputing this.  Only thing he is disputing is the ability for workers to cut their REAL wages.  At the end of the section he states, "The theory of wages in relation to employment... cannot be fully elucidated, however, until Chapter 19 and its Appendix have been reached."

General Theory Study Guide: Book 1, Chapter 2, Sections I and II

To start off Chapter 2 of "The General Theory of Employment, Interest, and Money", Keynes makes a keen observation of the economics profession.  That there is a tendency to talk more about how an economy distributes its wealth, and not how to produce more wealth as well as what determines the employment of the available resources.  He attributes this to be because classic political economists believe that the answer is so simple and obvious it is barely worth mentioning.   However, since Keynes is planning on refuting much of it, he'll prove that he understands the "classical" position by restating it.  In Section 1,  Keynes restates the classical position on several economic items, including: What determines wages, the "types" of unemployment, and how to reduce unemployment.  In section II, Keynes starts to refute some of these by implying that there is the possibility that there is another type of unemployment.

Section 1 is just a restatement of the "classical" view of wages and unemployment. Keynes uses Professor Pigou's writings as representative of the mainstream understanding of economics.  The reason is that Pigou was, at the time, the head of the world renown school of economics at University of Cambridge.  He studied under Alfred Marshall.  I would probably compare Pigou to Larry Summers or Greg Mankiw.  A well-known, influential economist who mostly adheres to conventional wisdom.

The classical view of wages is the typical supply vs. demand curve, like the one below, that we're all used to seeing.  The value of the worker to the company sets the demand line.  The willingness of workers to give up their time sets the supply line.

The classic postulate allows for only two types of unemployment.  The first is "frictional" That's a fancy way of saying someone is literally "between" jobs for various reasons.  For instance, was just laid-off and is looking for another job.  The other type is 'voluntary' unemployment.  And I purposely use quotes around voluntary.  This is unemployment where a person or persons either doesn't want a job, or is holding out for more pay.

From this, Keynes lists the 4 logical ways to increase employment according to the Classic economists:(I'm paraphrasing)

A)  Better policies to make "frictional" unemployment end quicker.

B)  Make workers more willing to give up their time(to eliminate so-called "voluntary" unemployment)

C) Make workers more productive so that companies are willing to hire more at the current wage

D) All Labor becomes cheaper as compared to everything else a company(or "firm") needs to make its products

Before going to Section two let's look at the two categories of unemployment the classic economists recognize vs. those that we recognize today.  Today, economists recognize "frictional" unemployment, just like pre-Keynes's classic economists.  Today, we also recognize "structural" unemployment.  Since structural unemployment just means workers don't have the skills or knowledge to do the jobs that are available, we could categorize that as long-term frictional unemployment that the classics recognize.  That means the only point of contention between classics and today is Voluntary and "Cyclical".    "Voluntary" unemployment isn't even considered a "type" of unemployment these days.  The other category we have today, "cyclical" is what Keynes is introducing to the world.  It is appropriate that these are the types that the others don't recognize.  Because, in section II, Keynes will introduce what people will one day call "cyclical" unemployment.  However, what we call cyclical unemployment today, classical economists would call "voluntary".

Section II

In this section, Keynes is calling "Bullshit!" on the classical theory as he describes in section I.  the mainstream view of the time was that if unemployed workers would just quit being so obstinate and agree to a decrease in wages, then they could get a job and end mass unemployment.  Therefore, mainstream economists believed that massive "cyclical" unemployment was really just a type of 'voluntary unemployment'.  Keynes takes 2 issues with this.  The first issue is covered in this section and is only a minor issue.  The second issue is the "fundamental" issue and will be described in this book.

To start off explaining his first issue, Keynes again demonstrates his understanding of classic economics.  In classic economics, economists always assume that the money(or dollar) wages workers agree to are always the same as the REAL wage(i.e. adjusted for inflation) that they would work for.  Logically, if a worker would quit if an employer cut his salary by 10%, then a worker would also quit if prices of products rose 10%.  This seems logical because in both scenario's workers are getting 10% less stuff in the end.  Classical economists agree with this logic.

Keynes points out that this doesn't happen in the real world.  Workers will not resist short term REAL wage cuts that come in the form of rising prices, but do resist short term dollar cuts in wages.  As Keynes puts it, "whether logical or illogical, experience shows that this is how labor in fact behaves."  Keynes claims that the  Classical economists actually acknowledge that a short term drop in REAL wages won't lead to workers quitting - but they assume that. since it's a short term thing, it isn't a significant departure from their theory. Keynes disagrees. If dollar-wages aren't solely dependent on REAL wages then the whole classical theory of employment falls apart.

The second issue is the more fundamental issue to Keynes. Wage workers have no way to lower their own REAL wages as a group, they have only the ability to redistribute REAL wages.  Here is what I think Keynes is getting at:  An individual can always agree to lower his or her own wages to get a job.  However, that act alone will not increase employment, instead what will happen is that someone else becomes unemployed.  If labor as a group lowers it's REAL wages as a group, the number of workers won't increase, instead, the income will only be redistributed to non-labor input.  He doesn't say what that input is, but I assume he means capital and land.  Explaining how and why this all happens is the purpose of this book.

General Theory Study Guide, Preface and Book 1, Chapter 1

After reading of the Preface and Introduction(Book 1, Chapter 1) of The General Theory I find four things worth mentioning.  The first is why he wrote the book and the urgency with which he writes it.  The second is who he wrote the book for and why.  The thrd is the books relationship to his earlier writing, "A Treatise on Money".  The last thing I'll discuss is Keynes preview of the book and the significance of his title.

In the preface, Keynes lists his reasons for writing the book.  His goal was to deconstruct current economic theory, refute it, and reconstruct a new theory. He wrote the book during the Great Depression.  A time when unemployment was persistently high and didn't seem to be going down.  Most mainstream economists of the time were offering either conflicting or ineffective advice. Keynes noted that the longer the recession went on, the less the public was listening because the traditional advice(let the markets clear!) wasn't working.  Therefore there was an urgency to get things figured to end the Great Depression.

Keynes also made clear that he was writing this book for his fellow economists.  Apparently, he felt that they needed to be convinced before he had any hope of convincing the general public of his new ideas.  Since Keynes work was directed towards his fellow economists, Keynes really lays down the gauntlet.  He declares his book is going to attack current economic theory by refuting some of it's most basic assumptions.  He also warns that his disagreement isn't because he doesn't understand the mainstream economics of the time, but because he believes that mainstream economics is wrong.  As evidence he offers that he once "held with conviction for many years the theories which I now attack, and I am not , I think, ignorant of their strong points".

In the preface, Keynes mentioned something I found interesting about his earlier work, "A Treatise on Money".  His treatise was not only critiqued by his most-famous-rival Hayek, but his contemporaries piled on.  Keynes makes a bold claim in his preface.  He states that any legitimate criticism of his Treatise wasn't the result of him getting too far away from mainstream economics, but because he hadn't gotten far away enough.  If you don't think that's bold, imagine this:  You have an argument with someone.  The other person clearly loses.  The next day that person comes back and states, "I figured out why I lost our debate,  it was because I underestimated how wrong you are".

The last thing that I learned was from the introduction.  In the introduction, Keynes explains why the book is called "The General Theory".  Having never read the introduction before, I assumed that it was called "The General Theory" because he was laying a high level theory explaining the  economy.  Instead, Keynes had a subtler, more important meaning in mind for the title.

The title of the book, according to Keyne's introduction is that most of economics is based on a certain condition:  That the economy is in perfect equilibrium(everyone and thing is employed at what it is most efficient at).  Keynes says his book is an economic theory for when the economy isn't in equilibrium.  And, based on his intro, I believe that he believes the economy is almost never in that state.  From Keynes:

The characteristics of the special case assumed by the classical theory happen not to be those of the economic society which we actually live.

I specifically call this out because I've read economists that have claimed that Keynes was only writing for the Great Depression and his theory, conclusions, and recommendations didn't apply otherwise(see here, and here).  But his introduction leads me to believe that he was writing for almost every occasion.  He doesn't say 'currently' aren't living in.  He says flat-out, we don't "actually live" in the world assumed by classical economists.  I think this is the most significant thing I read as it refutes many people who suggest that Keynes didn't mean for his analysis to apply to non-depressions.

I didn't mention this in the intro, but be sure to read the footnote in Book 1, Chapter 1.  Keynes defines what he means by "The Classical School".  Apparently, he means any economist who can trace their work and theories back to David Ricardo.

For just a Preface and an Introduction, this was some pretty intense reading.  I have a feeling the rest of the book is going to be like this so I'd better settle in for a long ride.

Reading The General Theory

As much as I've talked about economics on this blog, I've never actually read Keynes's entire Magnum Opus, "The General Theory of Employment, Interest, and Money".  Sure, I've read parts of it here and there, but never all the way through as written.  Normally, I'd feel ridiculous about talking about a subject without reading one of the most famous books on the subject.  But apparently, most "real" economists haven't done so either and some even actively advocate against reading it.

So, I started reading "The General Theory" and very quickly learned new things and other things that I wanted to find more information about.  That's when I discovered there are no free, online study guides for The General Theory that are pro-
Keyensreality (the one I found was written by a very hostile austrian enthusiast).  So, I've decided to start one.  What qualifies me to do this?  Absolutely nothing but a curious intellect and a blog.  But, the way I figure it, until a more qualified person offers the same thing , I've got a monopoly on this niche.

So, what I'm going to do is read a selection.  Then I'll blog about what I read.  In the title, I'll put what section I'm talking about.  I'll point out things that I think are correct, things that I think are wrong, things I found insightful or interesting, and things that I found difficult to understand.  I'll then try to justify why and put in the correct information or summary.  I expect that I may occasionally change my mind or find new information and will have to update a post.  If it's a small change I'll edit the post.  If it's a big change I might just rewrite it and note that the older section is deprecated.

I'll also be creating a new page, The General Theory Study Guide, that puts the readings in order so that future readers can easily find the different sections.  I have no idea how long this will take, but it won't be finished unless I start it.  Hopefully, somebody will eventually find this helpful.  For those who are curious, this is the edition I'll be reading on the eBook reader device of my choosing.