Keynes on secular stagnation in 1937

Keynes received a letter three months after The General Theory was published in which the writer said that he could not find a fully adequate defense of the secular stagnation thesis in the book.

inadequate in not formulating the difference between diminishing m.e. [mec] in one line (when investment in other lines is kept con­stant) and diminishing m.e. in all lines when investment in all lines is extending. I see no reason to suppose that in the latter case m.e. (long period) will decline all that steeply.

(CW 29, p. 212)

The writer believed that an endless creation of "technological progress" and "conscious entrepreneur planning" created unlimited profitable investment opportunities that made it possible to have "almost indefinite growth" (CW 29, p. 212).

Keynes could have defended himself by repeating and perhaps providing additional support for his argument that endless system­transforming technical change was nowhere to be seen in the mid-1930s UK, nor had it made an appearance in the decade-plus that preceded it. He could have repeated his standard list of all the structural, behav­ioral, and institutional impediments to a return to rapid growth.^[IV] But, surprisingly, he did neither of these things. Instead, he acknowledged that his defense of secular stagnation in the book was not fully adequate. In fact, he appears to bend over backwards to accept the writer 's cri­tique. Keynes suggests that his arguments in support of secular stagna­tion were half-hearted - a mere "obiter dictum," rather than an adequate defense.

an obiter dictum. I may very well be wrong, but I should like to make an attempt to justify more adequately the way in which I feel about the matter.

(CW 29, p. 213)

We know that Keynes's efforts to support the stagnation thesis were anything but just "thrown out." As we have seen, he devoted a substantial part of the book to its defense.

Nevertheless, it is probably true that Keynes understood that the arguments about stagnation in the book left many readers unconvinced of its validity and that he could - and should - improve upon them. This led him to undertake a different kind of defense of the stagnation thesis in an important lecture he gave to the Eugenics Society in February 1937 titled "Some Economic Consequences of a Declining Population." It is referred to in the literature as the Galton Lecture. Keynes was a Director of the Society, which included a wide swath of Britain's intellectual and political elite among its members, from 1937 to 1944.

In his lecture, Keynes presented a macroeconomic-empirical argument in defense of the existence of secular stagnation in the current era, some­thing he had not to my knowledge done before. He opened his essay with a warning - reminiscent of arguments he made in chapter 12 - that though the future is unknowable, people have an inherent psychological need to fool themselves into thinking that they can forecast the future with some degree of accuracy.

The future never resembles the present - as we all know... We do not know what the future holds. Nevertheless, as living and moving beings, we are forced to act. Peace and comfort of mind require that we should hide from ourselves how little we foresee. Yet we must be guided by some hypothesis. We tend, therefore, to substitute for the knowledge which is unattainable certain conventions, the chief of which is to assume, contrary to all likelihood, that the future will resemble the past.

(CW 14, p. 124)

Keynes ridiculed the classical school as an extreme example of this ten­dency to assume people have true knowledge of the future.² It asserted that agents can estimate the probability distributions of all possible future

Upon further reflection 203 outcomes associated with every possible alternative current choice. Note that this implies that the future is already determined and there­fore unaffected by agent choice in the present - no "micro-foundations" of macroeconomic outcomes here.

In this way a mythical system of probable knowledge was employed to reduce the future to the same calculable status as the present. No [real person] has ever acted on this theory. But even today I believe our thought is sometimes influenced by such pseudo-rationalistic principles.

(CW 14, p. 124)

However, he said, "the most outstanding example of a case where we in fact have a considerable power of seeing into the future is the prospective trend of population" because of the existence of detailed population statistics. He argued that there is near-certain knowledge that the rate of population growth has declined sharply and will continue to be low for a long time.

We know much more securely than we know almost any other social or economic factor relating to the future that, in the place of a steady and indeed steeply rising level of population which we have experienced for a great number of decades, we shall be faced in a very short time with a stationary or a declining level... [I]t is virtually certain that the change-over, compared with what we have been used to, will be substantial. because of the long but definite time lag in the effects of vital statistics.

(CW 14, p. 125)

Keynes then introduced a macro demand-for-capital-goods relation or function. "The demand for capital depends, of course, on three factors: on population, on the standard of life, and on capital technique" (CW 14, p.

Keynes did not formalize this function in his lecture, but it can be represented, I believe, without significant distortion to the logic of his argument as the identity K^d = f(N, Y/N, K/Y),³ where K is capital stock, N is population, Y is national income, Y/N represents the "standard of life," and K/Y is an index of the "capital technique" Keynes referred to as the "period of production."

Keynes, as always, stressed the crucial impact of population growth on the demand for capital goods. "In assessing the causes of the enor­mous increase in capital during the nineteenth century and since, too little emphasis, I think, has been given to the influence of an increasing popula­tion as distinct from other influences" (CW 14, p. 126). (The data show that the population of Britain did grow very rapidly in this period.) He warned

that "a changeover from an increasing to a declining population may be very dangerous."⁴

Keynes stated that the demand for capital goods will, ceteris paribus, "increase more or less in proportion to population [N], and the progress of invention may be relied on to raise the standard of life [Y/N]" (CW 14, p. 125). But the effect of invention on "the period of production [K/Y] depends on the type of invention which is characteristic of the age" (CW 14, p. 126). He defined the period of production as "the amount of capital employed to produce a unit of output" (CW 14, p. 127). The longer the "period of production" represented by K/Y, the greater the demand for capital stimulated by any increase in AD.

He then observed that technical change in the nineteenth century was capital-augmenting - it increased K/Y - and thereby increased the demand for capital goods. But it had become either neutral or, more likely, capital-reducing in the interwar period.

It may have been true of the nineteenth century that improvements in transport, standards of housing and public services [such as public utilities]...

(CW 14, p. 127)

Moreover, "as the result of our experience as to the rapidity of change in tastes and technique, our preference is decidedly toward those types of capital goods which are not too durable." Finally, "as we get richer, our consumption tends to be directed toward those articles of consump­tion, particularly the services of other people," which are also not durable (CW 14, p. 127). He concludes that, if anything, K/Y is likely to fall in the current era: "apart from changes in the interest rate, [K/Y] may be tending to diminish."

Now, if the number of consumers is falling off and we cannot rely on any significant technical lengthening of the period of production, the demand for a net increase of capital good is thrown back into being wholly dependent on an improvement in the average level of con­sumption or on a fall in the rate of interest.

(CW 14, p. 127)

Recall that Keynes did not expect the mpc and multiplier to increase and believed that the long-term interest rate was unlikely to fall much further under current policy institutions and practices.

At this point in the lecture, Keynes used long-term time series data to support his hypothesis that the rate of capital investment is likely, under

Upon further reflection 205 current institutional arrangements, to continue to be far too low to move the British economy to sustained full employment. He presents data on the change in the four variables in the demand for capital equation - K, N, Y/N, and K/Y - over the period 1860-1913, warning the reader that, with the exception of the estimate of population growth, the available data are "very rough," so that any conclusions drawn from the data should "be regarded only as broad pointers to what is going on" (CW 14, p.

Keynes estimated that the capital stock rose by 170 percent over the period; population grew by 50 percent; the standard of life (Y/N) increased by 60 percent; and the capital-intensity of production (K/Y) increased by just 10 percent (CW 14, p. 128). He drew a number of important conclusions from these data. The first is that the high rate of capital accumulation that drove the tremendous growth in per capita income and productivity in that era was caused to a substantial degree by a rapid rise in population at home and abroad.

It follows that a stationary population with the same improvement in the standard of life and the same lengthening of the period of pro­duction would have required an increase in the stock of capital of only a little more than half of the increase which actually occurred. Moreover, whilst nearly half of the home investment was required by the increase in population, probably a substantially higher proportion of the foreign investment of that period was attributable to that cause. (CW 14, p. 128)

What, then, Keynes asked, are the implications for macroeconomic per­formance in the current era of a seismic demographic shift toward a sta­tionary or slowly growing population?

He starts his answer with the guess that changes in family size, average incomes, taxation rates, and institutional and social change "may have raised the proportion of the national income which tends to be saved in conditions of full employment" (CW 14, p. 129). Saving at full employ­ment must be equaled by capital investment at full employment or else full employment is unattainable and unsustainable. Taking account of the lack of precision in estimates of future economic conditions on the propensity to save, Keynes estimates that national savings at full employ­ment will "lie somewhere between 8 per cent and 15 per cent of income each year" (CW 14, p. 129). Given his calculation of the current size of the capital stock, he estimates that "new investment at a rate of somewhere between 8 per cent and 15 per cent of a year's income means a cumulative increment in the stock of capital of somewhere between 2 per cent and 4 percent per annum" (CW 14, p. 129).

If we assume no large change in the rate of interest and no change in existing institutions and policies, then in order to ensure full employment "we shall have to discover a demand for net [of depreciation] additions to our

stock of capital amounting to somewhere between 2 per cent and 4 percent annually. And this will have to continue year after year indefinitely" (CW 14, pp. 129-130, emphasis added). Selecting the lower bound of 2 percent to make his argument as persuasive as possible - if his secular stagna­tion thesis is supported at 2 percent, it will be overwhelmingly supported at 4 percent - Keynes showed that, in the absence of qualitative institu­tional change of the kind he supported, the likely rate of growth of the capital stock will be much too low to be compatible with sustained full employment.

Keynes reminds his audience that his data from 1850-1913 show that the demand for new capital in that era of high growth came primarily from two sources, each of about equal strength: the rapid growth of the population and the effect of innovations that increase labor and capital productivity and thus permit a higher standard of life (Y/N). Looking for­ward, Keynes assumes no growth in population in the foreseeable future, as well as no growth in K/Y. He projects that the average rate of growth of Y/N over the past 100 years will continue into the future at "somewhat less than 1 per cent per annum cumulatively" (CW 14, p. 130).⁵ Given that savings at full employment are expected be at least 2 percent of the cap­ital stock annually and as much as 4 percent, and that investment will be at most 1 percent of the capital stock annually, the large to massive gap between savings and investment at full employment will ensure the continuance of sustained high unemployment and secular stagnation.

The validity of Keynes's empirical support for his stagnation thesis was, of course, contingent on the assumption that there would be no unfore­seen qualitative future changes in Britain's economic institutions and structures in the next few decades and that no future system-transforming innovations were on the horizon. The facts of the economic transform­ation caused by the planned economies of WWII and of the creation of a massive increase in the economic role of governments in the social demo­cratic welfare/warfare states that were created in the USA and UK after­wards therefore do not undermine the validity of Keynes's conditional prediction. Absent the buildup to and prosecution of the war and all of the unforeseeable economic and political changes that followed, no one knows what the trajectory of European and North American economies would have been or what the ultimate results of the then-ongoing dan­gerous process of social and political unrest would be.

Keynes concluded his talk by drawing conclusions about necessary changes in Britain's economic system similar to those he drew in the exit to chapter 24 in The General Theory discussed in Chapter 20 of this book. Bear in mind that his audience was quite familiar with the policy debate triggered by the recent publication of The General Theory; they knew that Keynes was a liberal socialist because he had said this in public on many occasions, and they knew that his preferred policies centered around public control of most large-scale capital investment.

Upon further reflection 207

The first conclusion deals with the need for immediate reforms within the current political economy of Britain. He argues that if those who dom­inate economic policy in Britain, especially the powerful rentier class, refuse to take effective reforms to sharply raise the propensity to consume and sharply lower interest rates, investment will remain in the doldrums and the investment multiplier will remain low. This will condemn Britain to perpetually high unemployment. Chronic joblessness and meager living standards for the majority will eventually create a political revolt that will end "civil peace" and eventually destroy the current "form of society."

With a stationary population we shall, I argue, be absolutely dependent for the maintenance of prosperity and civil peace on policies of increasing consumption [and the multiplier] by a more equal distribution of income and of forcing down the rate of interest so as to make profitable a substantial change in the period of production [K/Y]... Yet there will be many social and political forces to oppose the necessary change. We must foresee what is before us and move to meet it half-way. If capitalist society rejects a more equal distribution of incomes and the forces of banking and finance succeed in maintaining the rate of interest some­where near the figure which ruled on average during the nineteenth century (which was, by the way a little lower than the rate of interest which rules today), then a chronic tendency towards the underemploy­ment of resources must in the end sap and destroy that form of society.

(CW 14, p. 132, emphasis added)

The second conclusion supports the peaceful revolution to achieve Liberal Socialism that Keynes had been calling for throughout the interwar years, based on state control or guidance of the lion's share of large-scale capital investment and the perpetually low interest rates made possible by the "euthanasia" of the rentier class discussed in chapter 24 of The General Theory. This is the "evolution in our attitude toward [capital] accumula­tion" referred to by Keynes. The position taken here is fully consistent with the policy views in The General Theory.

But if, on the other hand, persuaded and guided by the spirit of the age and such enlightenment as there is, it permits - as I believe it may - a gradual evolution of our attitude toward [capital] accumula­tion, so that it shall be appropriate in the circumstances of a stationary or declining population, we shall be able, perhaps, to get the best of both worlds - to maintain the liberties and independence of our pre­sent system, whilst its more signal faults [such as rentier influence on policy] gradually suffer euthanasia as the diminishing importance of capital accumulation and the rewards to it fall into their proper pos­ition in the social scheme.

(CW 7, pp. 132-133)

Keynes ended his lecture with an upbeat message. If the country would take the steps necessary to see that capital investment equaled full­employment saving in an economy with a stable population, people could achieve a rising standard of living along with full employment.

But a stationary or slowly declining population may, if we exercise the necessary strength and wisdom, enable us to raise the standard of life to what it should be, whilst retaining those parts of our trad­itional scheme of life which we value the more now that we see what happens to those who lose them.

(CW 14, p. 133)