Introduction
The section of The General Theory in which chapter 12 is located is titled “The Inducement to Invest” and chapter 12 is titled “Long-Term Expectation.” The objective of the chapter is to explain the nature or character of long-term expectation formation with respect to the profitability of new capital investment goods, and in so doing to explore the effects of long-term expectations on the behavior of capital investment.
The chapter thus deals with a crucial area of the interpretation of Keynes's theory about which there is considerable debate. It is an important debate because the determination of the stability or instability of equilibrium and the character of out-of-equilibrium processes in Keynes's theory depend critically on the character of long-term expectation formation, as does the existence of endogenous sources of instability. Does The General Theory argue that long-term expectations are exogenous or endogenous? If they are exogenous, where do they come from? If they are endogenous, are long-term expectations strongly or weakly sensitive to or even affected by recent outcomes? The more sensitive that long-term expectations are to recent economic outcomes, the more potentially unstable the economic system will be. Conversely, if long-term expectations do not respond to events in the recent past, it is more likely that equilibriums will be relatively stable and business cycles will have moderate amplitude.1For Keynes, as we have seen, answers to questions about the “laws of motion” of a capitalist economy require the specification of the historical and institutional characteristics of the economy under investigation in the time period under investigation. In other words, answers must be derived from the analysis of concrete capitalisms and not some abstract capitalism-in-general model. This is of special importance in chapter 12 because Keynes believed that the character of the long-term expectations that co-determines the level of capital investment had dramatically altered between the nineteenth century and the interwar years, especially in the USA.
Two institutional changes were particularly important in this regard. First, Keynes argued that, in the interwar era, the site of decision-making 240 The General Theory about capital investment in effect shifted from the investing corporation itself to the stock market. He argued that this change dramatically increased the elasticity of long-term expectations with respect to recent realizations, making the economy much more volatile. Second, he said that the stock market had become an "insane" "gambling casino" in the postwar period dominated by short-term speculators. The result of these two changes, Keynes concluded, was less investment and more volatile investment. "When the capital development of a country becomes a byproduct of the activities of a casino," he said, "the job is likely to be ill- done" (CW 7, p. 159).In order to achieve his objectives in this chapter, Keynes had to create a theory of the dynamics of the era's casino stock markets. Chapters 12, 13, 15, and 22 together constitute a theory of the inherent instability of lightly regulated financial markets that is the foundation of Keynes-Minsky models of financial volatility and financial fragility, the best models available to analyze today's global "casino" financial markets.
In this important chapter, Keynes analyzed the effect of fundamental or radical uncertainty on the capital investment decision of the firm. Fundamental uncertainty means that the probability distributions that describe future states of the economy are not knowable in the present because these states have yet to be determined in the present and will be influenced by decisions taken today and tomorrow by agents ignorant of the future. This assumption is a crucial underpinning of Keynes's revolutionary transformation of macro theory. It also led him to create a largely unrecognized transformation in micro theory or the theory of agent choice, a transformation discussed in Appendix 1.
We saw in the previous chapter how the assumption of fundamental uncertainty led to a theory of potentially unstable interest rates that were likely to rise in the face of any serious downturn in the real sector, worsening the problem. Chapter 12 applies Keynes's theory of agent choice under uncertainty to the determination of the mec or expected profit rate on investment, and thus to the determination of capital investment spending. The mec is defined in chapter 11 of The General Theory. It has to be a function of the expected future cash flows associated with a capital investment project because, under fundamental uncertainty, no one has certain knowledge of what these future cash flows will be at the time the investment decision is made.
I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price [or cost]... The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield.
(CW 7, pp. 135-136, emphasis in original)
Keynes tells us that investment projects should only be undertaken if their marginal efficiency or mec exceeds the long-term interest rate.