General Theory Study Guide: Book 1, Chapter 2, Sections I and II

To start off Chapter 2 of “The General Theory of Employment, Interest, and Money”, Keynes makes a keen observation of the economics profession.  That there is a tendency to talk more about how an economy distributes its wealth, and not how to produce more wealth as well as what determines the employment of the available resources.  He attributes this to be because classic political economists believe that the answer is so simple and obvious it is barely worth mentioning.   However, since Keynes is planning on refuting much of it, he’ll prove that he understands the “classical” position by restating it.  In Section 1,  Keynes restates the classical position on several economic items, including: What determines wages, the “types” of unemployment, and how to reduce unemployment.  In section II, Keynes starts to refute some of these by implying that there is the possibility that there is another type of unemployment.

Section 1 is just a restatement of the “classical” view of wages and unemployment. Keynes uses Professor Pigou‘s writings as representative of the mainstream understanding of economics.  The reason is that Pigou was, at the time, the head of the world renown school of economics at University of Cambridge.  He studied under Alfred Marshall.  I would probably compare Pigou to Larry Summers or Greg Mankiw.  A well-known, influential economist who mostly adheres to conventional wisdom.

The classical view of wages is the typical supply vs. demand curve, like the one below, that we’re all used to seeing.  The value of the worker to the company sets the demand line.  The willingness of workers to give up their time sets the supply line.

Simple Supply and Demand Curve of Labor

The classic postulate allows for only two types of unemployment.  The first is “frictional” That’s a fancy way of saying someone is literally “between” jobs for various reasons.  For instance, was just laid-off and is looking for another job.  The other type is ‘voluntary’ unemployment.  And I purposely use quotes around voluntary.  This is unemployment where a person or persons either doesn’t want a job, or is holding out for more pay.

From this, Keynes lists the 4 logical ways to increase employment according to the Classic economists:(I’m paraphrasing)

A)  Better policies to make “frictional” unemployment end quicker.

B)  Make workers more willing to give up their time(to eliminate so-called “voluntary” unemployment)

C) Make workers more productive so that companies are willing to hire more at the current wage

D) All Labor becomes cheaper as compared to everything else a company(or “firm”) needs to make its products

Before going to Section two let’s look at the two categories of unemployment the classic economists recognize vs. those that we recognize today.  Today, economists recognize “frictional” unemployment, just like pre-Keynes’s classic economists.  Today, we also recognize “structural” unemployment.  Since structural unemployment just means workers don’t have the skills or knowledge to do the jobs that are available, we could categorize that as long-term frictional unemployment that the classics recognize.  That means the only point of contention between classics and today is Voluntary and “Cyclical”.    “Voluntary” unemployment isn’t even considered a “type” of unemployment these days.  The other category we have today, “cyclical” is what Keynes is introducing to the world.  It is appropriate that these are the types that the others don’t recognize.  Because, in section II, Keynes will introduce what people will one day call “cyclical” unemployment.  However, what we call cyclical unemployment today, classical economists would call “voluntary”.

Section II

In this section, Keynes is calling “Bullshit!” on the classical theory as he describes in section I.  the mainstream view of the time was that if unemployed workers would just quit being so obstinate and agree to a decrease in wages, then they could get a job and end mass unemployment.  Therefore, mainstream economists believed that massive “cyclical” unemployment was really just a type of ‘voluntary unemployment’.  Keynes takes 2 issues with this.  The first issue is covered in this section and is only a minor issue.  The second issue is the “fundamental” issue and will be described in this book.

To start off explaining his first issue, Keynes again demonstrates his understanding of classic economics.  In classic economics, economists always assume that the money(or dollar) wages workers agree to are always the same as the REAL wage(i.e. adjusted for inflation) that they would work for.  Logically, if a worker would quit if an employer cut his salary by 10%, then a worker would also quit if prices of products rose 10%.  This seems logical because in both scenario’s workers are getting 10% less stuff in the end.  Classical economists agree with this logic.

Keynes points out that this doesn’t happen in the real world.  Workers will not resist short term REAL wage cuts that come in the form of rising prices, but do resist short term dollar cuts in wages.  As Keynes puts it, “whether logical or illogical, experience shows that this is how labor in fact behaves.”  Keynes claims that the  Classical economists actually acknowledge that a short term drop in REAL wages won’t lead to workers quitting – but they assume that. since it’s a short term thing, it isn’t a significant departure from their theory. Keynes disagrees. If dollar-wages aren’t solely dependent on REAL wages then the whole classical theory of employment falls apart.

The second issue is the more fundamental issue to Keynes. Wage workers have no way to lower their own REAL wages as a group, they have only the ability to redistribute REAL wages.  Here is what I think Keynes is getting at:  An individual can always agree to lower his or her own wages to get a job.  However, that act alone will not increase employment, instead what will happen is that someone else becomes unemployed.  If labor as a group lowers it’s REAL wages as a group, the number of workers won’t increase, instead, the income will only be redistributed to non-labor input.  He doesn’t say what that input is, but I assume he means capital and land.  Explaining how and why this all happens is the purpose of this book.

Happy B-day to 2 Misunderstood Men: Adam Smith & J.M. Keynes

It is a fun fact that both the “founder” of economics, Adam Smith, and “founder” of macro economics, John Maynard Keynes, share the same birthday.  It is a not so fun fact that both men and their theories are so misunderstood by, not just the general public, but by other economists as well.  I realize I’m a day late on wishing them a happy birthday, but I’d like to give them both a belated present:  Clearing up some common misconceptions of their work.

Adam Smith was a compassionate person who cared greatly about morality, the well-being of humanity, and the poor.  Before publishing his famous economic Treatise, The Wealth of Nations, he published The Theory of Moral Sentiments.  A book that starts out with (bold emphasis mine)

How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it… a matter of fact too obvious to require any instances to prove it

Smith was certainly no “let the poor fend for themselves or die” Ayn Rand disciple.  Despite this, the right wing in this country attempts to portray Smith as their mascot.  Even to the point of naming right-wing institutes after him.  So let’s take a look at some of his views that would get him drummed right out of the republican party, tea party, and the general conservative movement.

Adam Smith recognized “the rich” taking advantage of the poor.  This excerpt is from From Book I, chapter 11 of the Wealth of Nations. (bold emphasis mine)

Rent, considered as the price paid for the use of land, is naturally the highest which the tenant can afford to pay in the actual circumstances of the land. In adjusting the terms of the lease, the landlord endeavours to leave him no greater share of the produce than what is sufficient to keep up the stock from which he furnishes the seed, pays the labour, and purchases and maintains the cattle and other instruments of husbandry, together with the ordinary profits of farming stock in the neighbourhood. This is evidently the smallest share with which the tenant can content himself, without being a loser, and the landlord seldom means to leave him any more.

In his day, Smith didn’t use the term ‘the rich’ or the ‘1%’ to describe wealthy people living off of the working class.  In his day they were called land lords and he didn’t particularly care for them.  In this day and age he’d be accused of “envy” and “class warfare”.  The excerpt above is just one of many that paints a negative view of landlords.

One last thing on Adam Smith.  If you were to claim Adam Smith’s principles of taxation as your own, your right-wing friends and relatives would label you a socialist. It’s really that first principle that would get smith labeled a socialist and thrown out of the tea party. From Book 5, Chapter 2, part 2. (bold emphasis mine)

1. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state…

2. The tax which each individual is bound to pay, ought to be certain and not arbitrary…

3.  Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it…

4. Every tax ought to be so contrived, as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state…

I’m not saying Smith would be a liberal or a democrat if he were alive today.  But I am saying he’d be a lot closer to one than he would be to modern conservatives.

Now let’s move on to Keynes.  John Maynard Keynes was a pro-capitalist, anti-communist British economist.  His biggest contribution to economics was a coherent theory showing that when it comes to analyzing a modern economy, money matters.  Up to that point, many thought that one could apply the principles of a barter economy to a monetary economy.

The common perception is that Keynes’s big contribution to economics was that “demand creates its own supply” as opposed to “Say’s law” which stated “supply creates its own demand”.  If that was the only thrust of his argument, people wouldn’t still be talking about him.  Economists had been making that argument since the time Say made his law.  It was the underlying theory behind his conclusion that made him famous.  Keynes arrived at his  “demand creates its own supply” conclusion based on his analysis of money and it’s effect.  There was a reason his major book was called “The General Theory of Employment, Interest, and Money” not “The General Theory of Employment, Interest, and demand“.  There was a reason that the prequel to “The General Theory” was called “A treatise on Money” and not “A Treatise on aggregate demand“.  If you still don’t believe me, read this excerpt from the Preface to “The General Theory”.

When I began to write my Treatise on Money I was still moving along the traditional lines of regarding the influence of money as something so to speak separate from the general theory of supply and demand. When I finished it, I had made some progress towards pushing monetary theory back to becoming a theory of output as a whole.


This book, on the other hand, has evolved into what is primarily a study of the forces which determine changes in the scale of output and employment as a whole; and, whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary detail falls into the background. A monetary economy, we shall find, is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction.

There is something else about Keynes.  He shows that, because of money, the state must play a role in the economy to maintain full employment.  This has spawned two common misconceptions:  One is that conservatives demonize Keynes as the second-coming of Karl Marx.  The other is that in a recession, the government should spend money all willy-nilly until the recession is over.

For the first misconception, Keynes seemed ready for the attack.  In the last chapter of “The General Theory” he states several times he is no socialist and does not advocate it.

But beyond this, no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community.


To put the point concretely, I see no reason to suppose that the existing system seriously misemploys the factors of production which are in use.  There are, of course, errors of foresight; but these would not be avoided by centralizing decisions.


But there will still remain a wide field of the exercise of private initiative and responsibility.  Within this field the traditional advantages of individualism will still hold good.

Finally, if your only understanding of Keynes is, “use government stimulus to get out of recessions”, you haven’t fully understood him.  Keynes made clear that in a monetary economy, there is chronic under-consumption and under-utilization of resources.  Even during expansions there is a need for “social investment” (though not necessarily as much).  If the government can always guarantee full employment levels of spending, the private sector will respond by making their own investments and thereby cut the amount government needs to make.  There’s much more to Keynes than just his conclusion of demand management.  But they’ll have to wait as this post is too long already.  They’ll have to wait until next year.

Reading The General Theory

As much as I’ve talked about economics on this blog, I’ve never actually read Keynes’s entire Magnum Opus, “The General Theory of Employment, Interest, and Money”.  Sure, I’ve read parts of it here and there, but never all the way through as written.  Normally, I’d feel ridiculous about talking about a subject without reading one of the most famous books on the subject.  But apparently, most “real” economists haven’t done so either and some even actively advocate against reading it.

So, I started reading “The General Theory” and very quickly learned new things and other things that I wanted to find more information about.  That’s when I discovered there are no free, online study guides for The General Theory that are pro-Keyensreality (the one I found was written by a very hostile austrian enthusiast).  So, I’ve decided to start one.  What qualifies me to do this?  Absolutely nothing but a curious intellect and a blog.  But, the way I figure it, until a more qualified person offers the same thing , I’ve got a monopoly on this niche.

So, what I’m going to do is read a selection.  Then I’ll blog about what I read.  In the title, I’ll put what section I’m talking about.  I’ll point out things that I think are correct, things that I think are wrong, things I found insightful or interesting, and things that I found difficult to understand.  I’ll then try to justify why and put in the correct information or summary.  I expect that I may occasionally change my mind or find new information and will have to update a post.  If it’s a small change I’ll edit the post.  If it’s a big change I might just rewrite it and note that the older section is deprecated.

I’ll also be creating a new page, The General Theory Study Guide, that puts the readings in order so that future readers can easily find the different sections.  I have no idea how long this will take, but it won’t be finished unless I start it.  Hopefully, somebody will eventually find this helpful.  For those who are curious, this is the edition I’ll be reading on the eBook reader device of my choosing.

CATO’s Cheap Shot at Keynes

The CATO institute is the foremost libertarian political organization.  I like their blog because even though it’s ideological, it’s non-partisan.  Meaning they will criticize both political parties and criticize both depending on what their advocating.  That being said, in a recent post they took some cheap shots to try and disprove Keynesian economic theory.

Wikipedia gives a good summation of Keynesian economic theory:

Keynesian economics (pronounced /ˈkeɪnziən/, also called Keynesianism and Keynesian theory) is a macroeconomic theory based on the ideas of 20th century British economist John Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle

Economists who accept this theory usually advocate that when the economy is doing good – as indicated by rising inflation- the government should reduce spending and pay off past deficits, but when the economy is bad – as indicated by high unemployment – our government should increase spending in spite of any deficits that may occur.  The key part of the theory is that in a typical business cycle unemployment and inflation are indirectly related.  As one rises, the other should fall.

It is with this part of the theory that CATO tries to “disprove” in a post called Does High Unemployment Make Inflation Impossible?

If this “slack theory” of inflation makes you too sanguine about future inflation, recall that it is the same theory that predicted stagflation would be impossible in 1973–75 and 1979–81. Figures from The Economist, August 21, raise some doubts.  The latest unemployment rate in Argentina is 8.3%, but CPI inflation over the past year was 12.2%. Unemployment in Venezuela is 8.2%, but inflation is 13.3%. Unemployment in Egypt is 9.1%, but inflation is 10.7%.  Unemployment in India is 10.7%, but inflation is 13.7%.  Unemployment in Turkey is 11%, but inflation is 7.6%.   Wasn’t high unemployment supposed to make high inflation impossible

My first problem with this is that Keynes never said High Unemployment makes inflation impossible, so I think CATO setup a straw man argument.

My second problem is the 2 examples used to point out when the united states had both high inflation and high unemployment.    Both of them were caused by a giant oil shock(1973 and 1979).  No macroeconomic theory can fix or prevent a sudden scarcity of a natural resource that is integral to an economy.  Of course it’s going to wreck it.  Those 2 cases weren’t caused by a typical business cycle and had a clear cause.

Third, and finally, CATO tries to disprove their straw man argument by listing off countries that have fairly high unemployment and inflation.  The problem with this is that typical inflation and unemployment is different for every country.  It varies based on natural wealth of the country, their various policies and laws, and levels of corruption.  Therefore comparing one country to another isn’t useful.  You have to compare trends within the country.

Let’s take a look at Egypt.  According to the CIA, unemployment in Egypt was 9.4%, but inflation was 11.8% in 2009, but in 2008 unemployment was 8.7% and inflation was 18.3%.  So when CATO says that inflation in Egypt is 10.7% you can see that 10.7% is a low inflation rate… for EgyptTurkey‘s numbers play out similarly to Egypt’s.   Inflation was 10.4% in 2008, and went down to 6.3% in 2009.  At the same time, unemployment, as Keynesian economists predict, went up from 11.2% to 14.1%.  I went through all of the countries listed, and India was the only country whose inflationunemployment didn’t act in perfect accordance of Keynesian economics.  However, in India’s case, it’s GDP grew at the same rate both years suggesting that something else was going on because GDP growth and employment rate almost always rise and fall together.

In the end, India and the two oil shocks of the 1970s does disprove the straw man argument that CATO setup.  It is possible to have high unemployment and high inflation, however I think that’s a long ways from disproving what Keynes actually theorized.