The Most Important Text in Economics

This is the most important paragraph ever written in macroeconomics:

An act of individual saving 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. It is not a substitution of future consumption-demand for present consumption-demand, - it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-good and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand. 

 Yes, of course it is the opening statement of chapter 16,  Sundry Observations on the Nature of Capital, from the General Theory of Employment Interest and Money. 

 I mentioned in an earlier article that in order to become a good macroeconomist, one has to learn the meaning, analytical function and interaction of five concepts: consumption, saving, investment, liquidity and uncertainty. The above quote from Keynes is an excellent “hub” for these five concepts. 

Before we get to the concepts, let us walk through the Keynes quote step by step. Keynes’s intention is to explain a fundamental behavioral principle in macroeconomics, namely the collective response of economic agents – consumers, investors and entrepreneurs – to changes in the basic conditions of economic activity. The most basic of those conditions is our confidence in the future; in Keynes’s terms, confidence is illustrated with its flip side, uncertainty. 

The first two sentences…

An act of individual saving 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. 

…put uncertainty squarely in the middle of macroeconomic analysis. In doing so, he refutes two long-held beliefs in non-Keynesian economics: 

1. Economic agents have perfect foresight or something close to it. Without realizing it, many economists practice their discipline under the assumption that individuals can make informed intertemporal choices about when to spend their money, and on what. They can do so, Keynes says, only under strictly defined conditions, namely conditions that allow them to set aside any concerns about the future. If these conditions are not present to a sufficient degree, then economic agents will have a preference for preserving their possessions as they are, and correspondingly a preference against taking risks. 

2. There is no such thing as a long-term macroeconomic equilibrium. This is a direct challenge to one of the most fundamental premises in modern economics. Standard macroeconomic forecasting is based on the idea that the economy, after a downturn in a recession, returns to a state of employment, growth and spending where it was prior to the recession. By stating that a decision not to spend money today has no equivalent in spending tomorrow, Keynes opens the door for the possibility that there will be no spending tomorrow, or at least that we have no idea how much money will be spent tomorrow. Therefore, it would be foolish of us to assume that one specific spending level will return, namely that which is equal to some historic trend.

Historically, recessions have been followed by growth periods where macroeconomic activity has closely resembled its own pre-recession past. However, this holds true if and only if we assume that “historically” is a period limited enough in time to exhibit regular business cycles. Such a period is most conveniently observable during the 1950s and early 1960s, both in North America and in Europe. With a different pattern in terms of the length of growth periods and brevity of recessions, one could also include the 1980s, 1990s and 2000s under the umbrella of “regular” business cycle patterns (though the growth periods from the 1980s and on were notably longer than during the 1950s and 1960s).

The problem for this argument is that while there has been a regularity in growth and recessions, not only has that regularity changed but it has also, slowly but steadily, followed a more depressed pathway. Growth in the Western economies has simply shifted down, while the pattern of growth periods and recessions has been largely maintained. At the same time, it looks like the same economies hare having increasing difficulties recovering from recessions, a problem that is probably caused by the same forces that slowly have depressed average, long-term growth.

In other words: traditional theory of long-term equilibrium cannot explain permanent changes to economic activity without auxiliary theories (of which there are a few). Keynes, on the other hand, would attribute the long-term decline in economic activity to a weakening in confidence in the factors that constitute the basis for our confidence.

This last sentence was long and deserves a more careful explanation. We will get back to it; for now, though, I will have to refer to the intriguing literature that exists on confidence, uncertainty and macroeconomics.

The next part of the Keynes quote:

Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, - it is a net diminution of such demand.

Here, Keynes lets the consumption multiplier go to work. Consumers feel more uncertain about the future (for any given reason) and cut their spending, which in turn spreads to businesses, compelling them to reduce their activities as well, including the purchase of inputs and the assignment of hours to their employees.

So far so good. What is often overlooked in modern macroeconomics is the fact that Keynes’s multiplier is not a symmetric mechanism: just because macroeconomic activity declines, does not mean that it will also increase again. The downturn does not cause a future upturn. The downturn has a separate cause from the upturn – if it ever happens. Once the negative multiplier effect has worked its way fully through the economy, then unless something new happens the economy will remain at its new, lower level of activity for the foreseeable future.

Because negative multiplier effects have different causes than positive multipliers, it is also perfectly possible (and, in real life, generally true) that negative multipliers are stronger and faster than positive multipliers.

Back to the Keynes quote:

Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-good and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

Here, Keynes explains why a depression of economic activity happens – and, more importantly, why the economy can very well get stuck in a depression. His point here is again directed at a superstition that has come to define far too big a body of economic thought and economic research. Our expectations of the future are not independent of the present; it is not the case that we form our expectations based on some metaphysical phenomenon independent of our present life (think “rational expectations” and “perfect foresight”).

Our expectations of the future as based on what we know about the present; if all we know about the present is that there are no jobs, it is impossible to make a decent living and everyone always tries to cheat each other out of a buck or two; then that is what we will expect of the future. If our current life is good, then we have no reason to believe that it will change in the foreseeable future unless something happens to make us change our forecast.

When expectations change, we are in a state of increased uncertainty. During that time we default back to basics in what to expect and how to manage our daily lives: we prefer what we can predict, preserve what we have and put off commitments of time and money that are not absolutely, positively reliable.

This is why negative multipliers are fast and merciless.

Once we land in a new, stable state of economic affairs, either a recession or the deeper hole known as a depression, our expectations once again become settled in the present. We learn to live in a “new normal” without any expectations that the world will become a better place – until something specific happens to motivate a more optimistic outlook.

With his paragraph, Keynes sets the stage for the entire sub-discipline of economics that we now know as macroeconomics. It is built around the five key concepts uncertainty, consumption, saving, investment and liquidity.