THE DETERMINATION OF INVESTMENT
In the neo-classical tradition, as we have seen, decisions to save and to invest were interpreted as determined by the same influence: the rate of interest. It could thus be argued that the economic system, by its nature, would tend to produce an automatic equilibrium between saving and investment.
Keynes shattered the symmetry of this argument by severing the link between saving and the rate of interest. Decisions to save and to invest, he maintained, were largely independent of one another and often undertaken by different groups of people for quite different reasons.If the rate of interest now largely dropped out of the account of saving it still retained an
important place in investment analysis. On this point Keynes accepted much of the neoclassical approach. His argument presupposed that the volume of private investment would be governed largely by two considerations - the cost of borrowing and the anticipated rate of return. If expected net yields exceeded the cost of capital (i.e. the rate of interest) then capital expenditures would be worthwhile; on the other hand, should the rate of interest exceed expected rates of return, spending on plant, equipment, and inventories would not be undertaken.
This element of continuity between the Keynesian and neo-classical systems should not, however, conceal an important difference in their interpretations of the expected rate of return on investment (in Keynes's terminology, the marginal efficiency of capital). At first glance it might appear that Keynes worked with a concept closely allied to the neo-classical notion of the marginal productivity of capital. In part, he had this relationship in mind; as the capital stock grew (other things being equal), he expected that returns to the additional units would tend to fall. But his concept also embraced another matter relevant to the analysis of investment decisions - the expectations of entrepreneurs.
Keynes insisted that 'the most important confusion concerning the meaning and significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield'. 10Throughout his work Keynes assigned much more weight to the influence of psychological factors on the economic process than had his neo-classical predecessors. Just as expectations were crucial to his discussion of liquidity preference, so also did they lie at the core of his investment analysis. On this basis Keynes could assert that investment expenditures might not be undertaken even when conventional calculations of returns indicated them to be profitable. This might occur if entrepreneurial expectations were bearish. Fears of capital loss might then deter outlays which, on paper, appeared to be attractive.
It will be recalled that neo-classical writers commented on the waves of optimism and pessimism within the business community in their discussions of cyclical fluctuations. These disturbances, of course, were always assumed to be confined within narrow limits. No cases of extreme and stubborn unemployment had then been experienced and there was little reason to attach major importance to psychological considerations. Keynes saw the problem quite differently. Once he had established that the equilibrium level of income was subject to a wide range of variation it was possible to argue that entrepreneurial temperament was both volatile and highly important to the behaviour of the economy. Indeed the marginal efficiency of capital was so much a matter of expectations that the shifting moods of the business community might easily swamp the rate of interest's influence on investment expenditure.
This phenomenon highlighted one of the central policy concerns of Keynesian analysis. High levels of income were likely to generate savings in substantial volume. If full employment was to be achieved, investment expenditure on a scale sufficient to match a full-employment level of saving would be necessary.
There was little basis for confidence, however, that investment spending in the amounts required for full employment would be undertaken on private initiative. As capital accumulated, the marginal rate of return would be expected todecline unless the offsets provided by technological progress were forceful. Moreover, it could not safely be assumed that substantial increases in investment could be induced by monetary measures designed to lower the costs of borrowing. In the circumstances of a depression, bearish entrepreneurial expectations might neutralize the effects of reductions in interest rates. An active monetary policy to push interest rates down was still desirable. But it was important to recognize the limitations of this procedure. Should the situation of the liquidity trap be approximated, monetary measures would be incapable of reducing interest rates.
In short, conventional techniques of economic policy were insufficient to remedy the deficiency of aggregate demand. A more active role for government as a spender was called for if prosperity was to be restored. Keynes maintained:
Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.
For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him.11
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