What Would Keynes Have Said About the Current Stagnation?


Readers may have noted some absence on the blog over the past few days. This is because I am currently writing a book which seems to be sapping all my writerly juices at the moment. I have about a third of it done and I expect to finish it in about two weeks. During that time I would imagine that my posts will be sporadic.

Anyway, as part of the research for one of the chapters I was reading Keynes’ Treatise on Money. The book, while fundamentally flawed due to its Wicksellian (perhaps even New Keynesian!) framework, has a lot of interesting material that the General Theory lacks (not least a theory of profits). It is also cast, as GLS Shackle never tired of noting, in an explicitly dynamic framework rather than the inferior comparative statics framework of the General Theory.

Anyway, in reading the book one of the Fundamental Equations caught my eye as being particularly relevant to the present moment. The Equation is the following and can be found on page 137:

Fundamental Equation

Where P is the price-level, W are wages, e is the productivity coefficient, I and S are investment and savings respectively and O is total output.

For Keynes this equation said that the price-level “is made up, therefore, of two terms, the first of which is the level of efficiency-earnings… and the second of which is positive, zero or negative, according as the cost of new investment exceeds, equals or falls short of the volume of current savings” (p136).

We can easily translate the early Wicksellian Keynes into the later Keynes of the General Theory by converting this equation into an equation laying out the components of effective demand rather than a price equation. We can do this simply by assuming that it is quantities rather than prices that may adjust due to a change in any of the terms.

Now, what does this tell us about our present moment. Well, in order to contemplate this take a look at this well-known graph for the US:


That chart maps out the ‘efficiency earnings’ variable of Keynes’ equation. And as we can see real wages in relation to productivity — i.e. Keynes’ ‘efficiency earnings’ — have been falling since the mid-1970s. In Keynes’ discussion in the Treatise on Money this would, ceteris paribus, entail a fall in the price-level. And if we read the equation in terms of quantity adjustments it would entail, again ceteris paribus, a fall in employment and output.

But then why hasn’t there been stagnation since the mid-1970s in the US. Well, if we take Keynes’ equation at face value then net investment must have been picking up the slack left by the fall-off in real wages. Keynes’ framework, however, ignore that the economy is open, has a government sector and that, crucially, money can be spent on final goods and services by a net change in debt. We can thus rewrite the equation as such:

Fundamental EquationMODIFIED

We have made some fairly substantial changes here that we should probably explain. For one, we have replaced the term O with the more conventional term Y. We have also added time periods to highlight the dynamic nature of Keynes’ system in the Treatise. This was particularly important because (obviously) now that we have converted the price equation into a quantity equation we have the variable for output (Y) on both sides. Thus we must distinguish between them to show that they refer to output in different periods and thus cannot “cancel each other out”. Finally, we have opened up the equation to include a government and a foreign sector and added a variable, Cd, which denotes debt-fueled consumption.

Now we can speculate that the fall in efficiency earnings was probably counteracted by some combination of government deficit spending and debt-based consumption. (Note we also have to account for the US trade deficits in this year which produce a further drag on national income; thus we must assume high private sector debt levels and high government deficits or some combination thereof). When we turn to the statistics we do indeed see something quite like this. First, here are the sectoral balances of this period:


As we can see, it was mainly large government deficits in this period that propped up demand. But at the same time we also see the household debt burden rise relative to GDP. Here is a graph:


So there you have it! With a bit of modification Keynes’ old Fundamental Equations can be used to provide quite a nice account of the current stagnation in the US, which is basically a result of households pulling back on their debt-fueled consumption spending (and the reaction of investment to this loss of effective demand).



About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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14 Responses to What Would Keynes Have Said About the Current Stagnation?

  1. In this equation where are earnings from international commerce exerted as monopoly on prime matters, priviledged commerce in all the world?

  2. philippe101 says:

    “The book, while fundamentally flawed due to its Wicksellian (perhaps even New Keynesian!) framework”

    So they aren’t such bastards after all?

  3. NeilW says:

    Isn’t this just Steve Keen’s point that Aggregate demand = Aggregate Supply plus the change in debt, which again is a dynamic point that static imbued people struggle with for some reason – probably because they can’t cope with the time lag and expectations issues that statement brings forth.

    “The cor­rect propo­si­tion is that, in a world in which the bank­ing sec­tor endoge­nously cre­ates new money by cre­at­ing new loans, aggre­gate demand in a given period is the sum of aggre­gate demand at the begin­ning of that period, plus the change in debt over the period mul­ti­plied by the veloc­ity of money.”

    “As is well known, con­trary to Mil­ton Friedman’s claims (Fried­man 1948; Fried­man 1959; Fried­man 1969; Fried­man and Schwartz 1963), the veloc­ity of money is not a constant”


    • No. Debt can be used to hold over insolvent companies or bid up asset prices. I just included debt that can be used in consumption. (Keynes spends about 1/6 of the book saying that people are not using proper price indices, actually…).

  4. philippe101 says:

    “As we can see, it was mainly large government deficits in this period that propped up demand. But at the same time we also see the household debt burden rise relative to GDP.”

    What about the role of private investment in propping up demand?

  5. philippe101 says:

    what’s your book about?

  6. GlassHammer says:

    “why hasn’t there been stagnation since the mid-1970s in the US”

    Is it possible that we simply delayed that stagnation through government deficits and debt-fueled consumption?

    Should we even view/frame our current problems as un-resolved problems from the past?

  7. Carlos says:

    It is impossible to understand what is going on at the moment without doing this kind of balance sheet analysis.

  8. aelmak says:

    Reblogged this on Political Economics Review Blog and commented:
    Stagflation: what Keynes could have said about it? from Fixing the Economists blog.

  9. Would it aid the analysis of the sectoral balances to divide the private sector balances into personal and corporate sectors? I assume it would make the additional personal debt/GDP chart redundant.

  10. Patrick Trombly says:

    (1) Total compensation has risen almost in line with productivity – it’s just that a rising percentage of total comp comprises non-wage comp, such as health insurance. This was pointed out by the Left in the Obamacare debates and by the Right in a few Heritage Foundation studies.
    (2) Debt increased because financial institutions (a) had a whole lot of Fed funny money to lend, and (b) make our loans based on three criteria that are thrown out of whack through expanded credit – (i) default history (which falls when the rates are cut for the same reason that shooting percentages would rise if David Stern lowered the nets to 9 feet high – resi mortgages through 2004 being a prime example), (ii) debt-to-income (when the rates are cut, the same income or property NOI supports more debt), and (iii) LTV (which supports more debt as property values are bid up).

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