Integrating the profit rate and the bond and stock markets in a theory of financial and economic instability

In chapter 22, Keynes brought the analytical apparatus developed earlier in the book to an analysis of the business cycle. In Keynes's cycle theory, developed in the midst of the Great Depression, financial markets not surprisingly play a crucial role in creating cyclical instability.

He starts his description of the cycle when the economy begins to expand following a recession. The actual rate of profit starts to rise, which causes the expected rate of profit or mec to follow suit. The actual profit rate will continue to increase until it peaks at some point in mid-expansion; it then declines as the expansion continues due to the rapid rise in and decreasing scarcity of the capital stock.¹ He said that this is what actually happened at the end of the late-1920s US boom. The mec or expected profit rate will continue to increase for some time after the actual profit rate peaks because most investors will initially see this leveling off as a temporary deviation from its upward trend. Keynes used a numerical example in which the actual rate of profit hits 6 percent in mid-boom and falls thereafter. If the expansion reached full employment, he assumed the profit rate would reach an expansion low of 2 percent.

The continuation of the economy past its profit-rate maximum by itself might not cause a crisis and economic downturn; it could simply lead to a slowdown in the rate of growth. What creates the crisis is that extrapo­lative expectation and confidence formation cause the mec to continue to rise for some time after the actual profit rate has peaked.

At this point in the analysis, Keynes repeated his chapter 12 claim that the mec is effectively set in the stock market and that financial investors are more susceptible to boom euphoria than the managers of nonfinancial firms. He believed that those directly responsible for making the capital

The theory of the business cycle 265 investment decision "will find it advantageous, and often unavoidable, to fall in with the ideas of the market, even though they themselves are better instructed" (CW 7, p. 316). The problem is that financial investors are likely to be overly optimistic after mid-boom, extrapolating the recent rise of the actual profit rate to levels at or beyond its 6 percent mid-expansion peak. They will thus continue to push stock higher even as the actual profit rate begins to decline.

This situation, which I am indicating as typical, is not one in which capital is so abundant that the community as a whole has no reason­able use for any more capital, but where investment is being made under conditions which are unstable and cannot endure, because it is prompted by expectations which are destined to disappointment.

(CW 7, p. 321)

It "is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expectation of a yield of, say, 6 per cent, and are valued accordingly" (CW 7, p. 321).

The "valued accordingly" assumption is the key to the market collapse for Keynes. It means that stock prices are based on the assumption of a 6 percent return, so that when the actual return declines toward 2 per­cent, it will reveal that the market is badly overpriced and capital losses are unavoidable. If the upward phase of the cycle was sluggish, the over­valuation of security prices might be modest and the exit from the market orderly. But if the upward phase was long and strong, the revelation that prices are substantially overvalued can trigger a rush to exit the market.

Moreover, it seems reasonable to assume that if firms confidently expected a 6 percent return on capital investment, they would have been willing to borrow at, say, 4 percent, which could cause heavy losses for borrowing firms when the rate of profit fell to 2 percent. It could also lead to capital losses for banks and bond-holders. This would lead to rising interest rates. Though Keynes did not adequately stress the role of increasing leverage used by real-sector and financial-sector firms to sus­tain capital investment spending in the boom in this chapter, the kernel of the idea is planted here and in chapter 19, as well as in his reports to British government while on his visits to the USA in early 1930s.

If the actual profit rate does fall well below the rate embedded in security prices, Keynes argued, investors' optimism and confidence will be shaken, causing a shift from a bull to a bear market. This will cause investment spending to decline, which will reduce AD. "The latter stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abun­dance and their rising costs of production and, probably, a rise in the rate of interest" (CW 7, p. 315). But a time must come when the forces that lower the rate of profit and raise the interest rate as the boom matures adversely affect expectations and confidence in financial markets. "The disillusion comes because doubts suddenly arise concerning the reliability of the prospective [or expected] yield, perhaps because the current yield shows signs of falling off, as the stock of newly produced durable goods steadily increases" (CW 7, p. 317). The boom may end with a financial and economic crisis rather than a smooth slowdown largely because of the dysfunctional character of financial markets.

It is in the nature of organized investment markets, under the influ­ence of purchasers largely [and unavoidably] ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets, that, when disillusion falls over an optimistic and over-bought market, it should fall with sudden and even catastrophic force.

(CW 7, pp. 315-316, emphasis added)

When the disillusion comes, this expectation [that investment will yield 6 per cent] is replaced by a contrary "error of pessimism," with the result that the investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent in conditions of full employment, in fact yield less than nothing.

(CW 7, pp. 321-322)

The outbreak of pessimism and the loss of confidence in the conventions that underlie expectation formation will also cast a pall over the bond market, a point Keynes also stressed in his 1937 defense of The General Theory in the QJE.

The dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp rise in liquidity preference and hence a rise in the interest rate. Thus the fact that a collapse in the marginal efficiency of capital tends to be associated with a subsequent rise in the interest rate may ser­iously aggravate the decline in investment.

(CW 7, p. 316)

This is an endogenously generated shift in the LM curve caused by a pre­ceding shift in the IS curve caused by the fall in the mec.³ Once a substan­tial collapse in the mec and therefore in capital investment has occurred, Keynes argued, it may be extremely difficult to restore prosperity. "It is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world" (CW 7, p. 317). If the financial system is over-leveraged and fragile before the mec falls, the reaction in financial markets may be severe.

Keynes went on to argue that the excesses of the late-1920s boom in the USA could not have been avoided by tightening monetary policy early in the boom, a policy supported by many economists at the time, except by killing the economic expansion altogether.

[The] remedy for the boom is not a higher rate of interest but a lower rate of interest. For that may enable the boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

(CW 7, p. 322)

But herein lies a problem for monetary theory and policy: an interest rate low enough to have generated the low unemployment rates of the late 1920s also fueled an unsustainable financial-market boom whose eventual crash brought the whole system down with it. You cannot perpetually sustain a capital investment boom via low interest rates without simultaneously fueling a financial market bubble. This circle could not be squared within the confines of the then-current policy regime. It is public investment supported by low interest rates and cap­ital controls, not monetary policy alone, which can facilitate a sustained high growth rate.

Keynes stated this position as follows:

The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expect­ation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact a deterrent. A boom is a situation in which over­optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive.

(CW 7, p. 322)

In other words, he argued, modern stock and bond markets are an impediment to the achievement and maintenance of full employment, and the Central Bank alone cannot resolve the problem. The solution, of course, is planned public investment in pursuit of sustained full employ­ment supported by a secularly low interest rate, capital controls, and managed trade.

Notes

1 Keynes argued in chapter 11 that the mec will fall as investment increases in the short run due to a declining marginal product of capital and rising unit costs in the industries that produce capital goods. In chapter 22, he said that the profit rate would hit its expansion low if and when the economy reached full employment.

2 This argument bears a resemblance to one that Marx made: the crisis comes not because the rate of profit falls, but because profit flows no longer adequately cover fixed costs such as rent and interest payments. "The rate of profit falls... The fixed charges - interest, rent, - which were based on the anticipation [expectation] of a constant rate of profit and exploitation of labour, remain the same and in part cannot be paid. Hence crisis. Crisis of labour and crisis of capital. This is therefore a disturbance in the reproduction process" (Crotty 2017, p. 101, emphasis in original).

3 We will return to the subject if endogenous shifts in the IS and LM curves in the next chapter.

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