It’s the Marginal Efficiency of Capital, Stupid!

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John Maynard Keynes

Greetings, and best wishes to all on Memorial Day, 2012.  It was a lovely day in Albany, New York, as the predicted rain never arrived.  I spent most of today (now yesterday) on my project, my devotion to which has prevented me from blogging as much as I would like to. You see, I’m writing a book on inequality.  Inequality, and John Maynard Keynes.  I’ve been in better physical condition, and I’m not as young as I used to be, but I’m putting in ten-hour days when I can, because it’s important, and I need to get this work finished before too long.

I took a badly needed break, as it turns out, just at half-time of game one of the Celtics-Heat series.  Waiting for the second half to begin, I switched over to the Bill Maher show.  He was just introducing his panel.  Low and behold, he had both Paul Krugman and Arthur Laffer on his show this week, and I thought, holy cow!  After I watched their first exchange of comments, I turned off the TV and retired to my computer, to send my followers (those of you who may still be with me) this short note.

I thought you might like to see a picture of a man who, beyond a shadow of doubt in my mind, is rolling over in his grave.  I know it’s not possible, that it’s just an expression; but I simply can’t avoid the conclusion that John Maynard Keynes is really rolling over in his grave.

In the above photo, I imagine that the book he’s holding is his own groundbreaking The General Theory of Employment, Interest, and Money.  And I imagine him asking, as I saw Milton Friedman ask Jamie Johnson in his documentary film The One Percent, “Have you read my book?!”  Whatever Keynes was thinking when that portrait was taken, he looks irritated and disappointed today.  I can see it in his eyes.

Bill Maher started off the discussion asking a question something like this: “If economics is a science, isn’t there just one right answer?”   Paul Krugman responded that, yes, there is only one right answer, and he has it. Krugman proceeded to explain (to muted applause) that we’re in a depression. Consumer spending is stifled, businesses won’t respond with investments and jobs, and in order to stimulate the economy, our government is going to have to provide the needed spending. Arthur Laffer proceeded to respond that yes, indeed, we are in a depression, and yet the best way to get through it is to cut taxes on businesses and rich people, thus stimulating investment and the creation of more jobs.

In the relative silence of that exchange, I turned off the TV, forgetting all about the Celtics-Heat game, and returned to my computer.  I was thinking, with great dismay, how would any viewer be able to understand which one of those two was right, if they didn’t already know? Frankly, that seems next to impossible, which is why a man like Mitt Romney can run so strongly on just the kind of austerity proposal Laffer advances. (Yes, Virginia, if you cut back taxes even more, you will have to finance those tax cuts, and with today’s huge level of national debt, that will require more spending cuts.)  So, if Krugman is correct — and he is — then people just don’t get it, at least not yet in enough numbers to save our country from a continuously worsening depression and ultimate catastrophe.

You know, I hate feeling like the guy in the robe with the long white beard standing on a street corner holding a sign that says “The End Is Near.”  But when I hear conversations like the Krugman-Laffer exchange, between two of the leading lights of the diametrically competing  views of how the economy works, I do not feel encouraged. (Yes, only one of those views can be correct: Laffer, as I have been explaining on this blog for well over a year now, is dead wrong.)

Keynes’ 1935 book was written by an economist for other economists, in the formal stilted prose that was, no doubt, common in his day.  Still, Keynes asserted, most of what he was explaining should be regarded as “obvious.”  Now, I don’t know how he could have allowed himself to say that: He was a brilliant man, and yet it took him more than five years to work everything out. But maybe, with the internet to help him gather everything together, he could have done it far more quickly.

The point is, he did figure most of it out, and to our advantage.  It helps to understand something about economics, but for those of us who do Keynes’ book might turn out after all to be a bit more informative about his theories than even professors like Paul Samuelson, Campbell McConnell, or Gardner Ackley were in their second-hand accounts of Keynes’ work.  When you read Keynes, you learn his reasoning process.

Frankly, I doubt if Laffer has even read The General Theory.  Why would he?  I’m sure he’s heard second-hand what Keynes said, and it doesn’t support his supply-side, “trickle-down” Chicago-School fantasy, which he still clings to after 30 years of continuing disproof.  So why would he bother?  Arthur Laffer likely has no intention of ever considering changing his mind, which of course makes me wonder how much he even cares about this depression he agrees we’re in.

Well, I have this little tidbit for you, Mr. Laffer:  It’s the marginal efficiency of capital that determines when and if businesses will invest.  Not incentives through tax breaks, and not lower interest rates. (Only a change in the real interest rate, which reflects only a narrow band of liquidity preference, could do that; but mostly changes in the interest rate reflect changing inflation expectations which are also reflected in the expectations of the future return on investment, i.e., the marginal efficiency of capital.)

As Krugman points out in his recently released book, End This Depression Now!, the depressed U.S. economy is in a “liquidity trap,” since even with interest rates all the way down near zero, businesses still aren’t enticed to chase many rainbows in the scorched air of depression.   As I’m sure you must be aware, Mr. Laffer, when businesses won’t invest in new production at a zero interest rate, it’s because they don’t expect to beat a zero return.  They don’t expect to make any money.   So why should we cut their taxes more?  Is it because they feel that, if they don’t expect to profit from potential investments, we should allow them instead to increase their after-tax incomes at the expense of other taxpayers?

What is the “marginal efficiency of capital,” you ask?  That’s the expected return on a potential investment over its expected useful life.  If the present value of that return exceeds the present value of expected interest payments over that time frame, plus a factor reflecting the additional riskiness of the investment itself, then the firm will invest.  I used this concept during my many years of rate regulation, targeting utility rates at levels sufficiently high to allow firms a reasonable opportunity to earn their “cost of capital” — that is, their marginal efficiency of capital.

In his monumental work, Keynes meticulously showed how the classical theory of economics had confused cause and effect, reversing the specification of some dependent and independent variables.  This caused the classical theory to predict “feast” when the economy was producing “famine”:

For the economic principle, on which the practical advice of economists has been almost invariably based, has assumed, in effect, that cet. par.,* a decrease in spending will tend to lower the rate of interest and an increase in investment to raise it.  But if what these two quantities determine is, not the rate of interest, but the aggregate volume of employment, then our outlook on the mechanism of the economic system will be profoundly changed.

A decreased readiness to spend will be looked on in quite a different light if, instead of being regarded as a factor which will, cet. par., increase investment, it is seen as a factor which will, cet. par., diminish employment. (The General Theory, Harcourt 1991, pp. 184-185.)  

So that’s where we’re at, Mr. Laffer: Based on outmoded thinking that Keynes corrected 80 years ago, you and your ideological buddies continue to fantasize (or ask us to fantasize) that actions Keynes showed simply reduce employment will somehow, as once erroneously believed, stimulate investment and jobs.  You press this argument without even pausing to wonder why it hasn’t happened yet or, indeed, why we’re in this depression in the first place, in circumstances in which interest rates have already been reduced to the max and the economy still shows virtually no signs (despite Obama’s Herculean efforts to create private-sector jobs) of pulling back from the brink of Great Depression #2.

It would help a lot, too, if Paul Krugman would rethink his recent tentative position that the growing inequality of wealth and incomes may be mainly a “political” problem.  That seems to give aid and comfort to the Laffer camp, especially since all they want to do is lower rich people’s taxes, and the proposal in his book doesn’t include or even discuss the pros and cons of increasing their taxes.

If nothing else, all that wealth and income continuing to rise to the top can’t make it easier for those losing their shares of wealth and income to increase their aggregate demand.  If nothing else, it will be easier to stimulate the economy if, instead of just borrowing more money, the federal government also took in more tax revenues from the wealthiest Americans and their corporations, the very folks who at their current high level of liquidity preference would rather hold their trillions of dollars of tax savings as cash than do much of anything else with it, at least here at home.

Debates like the one you just had with Arthur Laffer, Mr. Krugman, entirely ignore the economic implications of inequality, and suffer for it.  I suspect that Keynes would be asking us right about now, among other things, whether we think the conditions he specified for a business cycle that would keep returning to equilibrium, instead of spinning out of control into catastrophe (The General Theory, Harcourt 1991, pp. 250-251), currently exist in today’s economy.

That is, if he weren’t so busy rolling over in his grave.

JMH – 5/29/2012


*Ceteris paribus means “all else equal.”

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4 Responses to It’s the Marginal Efficiency of Capital, Stupid!

  1. vorfahrt says:

    I like it simple (not to deride your efforts but this says it all):
    “As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth … to provide men with buying power. … Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. … The other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”
    Marriner Stoddard Eccles

  2. vorfahrt says:

    Even more from Marriner – he was a real genius although I have only heard of him very recently:
    It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.

  3. Pingback: Falling Off the Inequality Cliff |

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