Keynes’ General Theory, the ISLM and Roy Harrod’s ‘Dynamics’

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Too often discussions of the relationship between Keynes’ General Theory and the ISLM model focus on John Hicks’ 1937 paper ‘Mr. Keynes and the Classics‘. That paper appeared in the April edition of Econometrica, Volume 5, Issue 2. But Roy Harrod had already formulated the ISLM — in half-mathematical, half-verbal form — in the January edition of the same journal, Volume 5, Issue 1. I think that an appraisal of the relationship between the General Theory and the ISLM is far better done taking leave from Harrod’s paper ‘Mr. Keynes and Traditional Theory’ as it will allow us to clearly highlight the differences and why Harrod glossed over them.

In his paper Harrod claims that Keynes argues that investment is determined by equating the marginal productivity of capital with the rate of interest. He writes:

Harrod1

Of course, this is not in fact the case. Rather for Keynes investment is determined by the interest rate and the marginal efficiency of capital. The difference in the two concepts is absolutely key to understanding Keynesian economics proper. The marginal productivity of capital is a simple concept: it is the amount of output that is produced by an additional increment of capital. The standard theory says that investors will invest up to the point that the marginal productivity of capital is equal to the rate of interest. This makes sense on its own terms (that is, assuming perfectly rational, competitive etc. actors). If the rate of interest is, say, 2% and invested capital is throwing off profits of 3%, rational investors will step in and borrow at 2% to obtain the profits. Eventually the ‘spread’ between the two rates will become equalised.

Keynes’ theory of the marginal efficiency of capital is entirely different. In the General Theory he thinks this an important enough concept that he devotes an entire chapter to it in which he writes:

I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price… The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over… The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to-day and to-morrow… The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality. But the introduction of the concepts of user cost and of the marginal efficiency of capital, as defined above, will have the effect, I think, of bringing it back to reality, whilst reducing to a minimum the necessary degree of adaptation. (Emphasis Original)

The reader will appreciate the enormous difference here. Investment becomes wholly subject to expectations — what Keynes will elsewhere call ‘animal spirits’. He thinks that if this is not taken into account the theory of investment “imports into it a large element of unreality” and will thus, presumably, not be commensurate with the real world.

Harrod actually recognises this while he is expounding the ISLM view of Keynes’ work. But he then glosses over it.

Harrod2Harrod seems to recognise to some extent the difference here and praises Keynes’ incorporation of expectations. But he then moves to gloss over this difference. In order to do this he introduces an interesting trope: that of the ‘working economist’. The ‘working economist’ appears to be, for Harrod, the dupe or the idiot who cannot properly understand the nuances of high theory and needs some simplistic explanation such as the ISLM.

Harrod3“Oh, we clever economists know that the rate of investment is not really determined by the equalising of the rate of interest and the marginal productivity of capital,” Harrod says, “But there are lesser mortals out there who need a simple theory and we shall tell these folks that this is the actual theory.”

This seems a rather strange maneuver on Harrod’s part. It is clear that there are a lot of ‘working economists’ who do appear to require such constructions in that they insist on closed, deterministic models. But I would argue that they are just bad economists. I do not see why it is so problematic to tell students (or whoever) quite clearly that investment is determined through expectational formation. Those students who cannot get their heads around this and insist that they must ‘close’ the model and make investment ‘determined’ by the marginal productivity can simply pack up and take their bags elsewhere. If you can’t deal with this aspect you will not be good at applying economic theory to the real world and your pronouncements on the economy will be suspect. End of story.

But Harrod isn’t just fobbing off his ISLM on the dupes. There is another motive for glossing over what appears to be the most important component of Keynes’ theory of investment. Harrod does want to integrate expectations but he wants to do it in a way that he insists is different from Keynes. He writes:

Harrod4Harrod had been working on his ‘dynamic economics’ the whole time that Keynes had been working on his General Theory. There was thus a certain amount of rivalry between the two. So, Harrod thinks that expectations should only be brought in when dynamics are being discussed.

But this is just a miscommunication between the two men. Keynes is clearly interested in dynamics. That is why he writes that determining the rate of investment by equating the marginal productivity of capital and the rate of interest “has had the result of breaking the theoretical link between to-day and to-morrow”. What Harrod will try to develop in the ensuing years will be perfectly in keeping with what Keynes was doing. But Harrod felt the need to distinguish his work from Keynes’. That is why he suppressed the dynamic element in Keynes’ General Theory: so that he could claim that he was the first to introduce this aspect of economics. This is a narcissism of small differences if ever you may come across one.

Today, however, the men Harrod rather derogatorily called ‘working economists’ have won the day. Students are simply not taught the real-world truth: investment is determined by expectations about the future that are not subject to mathematical formalisation or reduction. One month after Harrod’s review appeared Keynes published a summary of his work in which he noted the danger inherent in the interpretation that Harrod was putting forward.

Keynes1Keynes clearly saw the modern development that Harrod’s ‘working economists’ would begin to use probability theorems to determine investment decisions. He saw that this was already somewhat implicit in the theory yet never expressed. But he also knew that this would only produce unrealistic rubbish.

How then are investment decisions determined. In his article Keynes gives us some pointers. He writes:

Keynes2Basically, people pretend ‘as if’ they know what is going on. But they do not and cannot. Keynes opened the way for work to be done on how people actually cope when faced with an uncertain future. GLS Shackle paved the way for work to be done in this area but it went largely ignored (except by a few obscure psychologists). Today, however, this black box has been opened once more by a team of researchers at University College London.

Using a mixture of empirical techniques, psychoanalytical theory and economic analysis these researchers have opened up a box that has been sealed for a very long time indeed. Their findings so far, some of which I believe are being taken quite seriously by the Bank of England, are extremely promising. Frankly, I think they might change the way that good economics is done. The ‘working economists’, however, will probably not be very happy about this at all.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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8 Responses to Keynes’ General Theory, the ISLM and Roy Harrod’s ‘Dynamics’

  1. NeilW says:

    “Investment becomes wholly subject to expectations — what Keynes will elsewhere call ‘animal spirits’.”

    I find it astonishing that this is even remotely controversial given the nature of entrepreneurial investment – where you quite literally have to ‘believe in the concept’ if you’re going to get it to go anywhere.

    Look at the development of Facebook for heaven’s sake. It was all about the expected valuation. Anybody who looked at the discount rate got kicked out for failing to ‘believe’ hard enough.

    • Its not so much shocking as it is self-serving. By making this assumption the ‘economists’ can build their GIGO models that give them the prestige their position requires.

      In the pursuit, however, of professional status, the academic economist must have something impressive to say which enables him to lay claim to a kind of knowledge which is out of reach of those immersed in the actual processes of business and government, and also of journalist commentators. This is where mathematics has proved such a boon and a blessing for the professional, or would-be professional, academic economist. ‘Objectively’, as a Marxist might have put it, an important function of mathematical economics is to mark off intellectual ‘turf’ from outsiders.

      — Terence Hutchison

      Mathematics can readily be used to silence most non-economists who pontificate on the subject. Economics is not the only field that uses
      mathematics as a barrier against criticism by the unwashed… Another way economists strive for status and self-respect is by using
      complicated theory even when discussing straightforward problems that could be resolved without it. It is something that only those with training in economics can do and, besides, it seems to justify the effort made in acquiring the theoretical tools of economics. Beyond this, it distinguishes economics from the other social sciences.

      –Thomas Mayer

  2. Enjoyed today’s post quite much, Philip. I wanted to comment on the mathematical slight of hand, and I see that it will build nicely with your quotes above.

    Harrod makes sly use of the very bland statement, y = f(x) by re-defining f(x) in the text to include Keynes “efficiency” after having used it to define “productivity” just above. So, Harrod morphs Keynes into his own theoretical architecture, like an intellectual Triffid. In this way, it seems to me, that Harrod enables the “working economist” to believe that he is being a Keynesian, when in fact he’s not. This looks a lot like subversion to me.

  3. Anon says:

    Students are simply not taught the real-world truth: investment is determined by expectations about the future that are not subject to mathematical formalisation or reduction.

    To paraphrase Indiana Jones: “Economics is the search for fact, not truth. If it’s truth you’re looking for, Dr. Tyree’s philosophy class is right down the hall.”

    It is boring to go over the same old nonsense, be it with neoclassical demand deniers or Post-Keynesian non-ergodicity nihilists but what can you do. You cannot postulate that investment is only determined by expectations (actually all the Keynesian models I know in which financial market imperfections are the source of the underemployment equilibrium work with expectations … but it is obviously not the only ingredient) and then refrain from saying anything but obscurantist nonsense about expectations.

    It is also simply wrong to pretend that the interdisciplinary literature is starting right now. Guys like Akerlof wrote papers that connected econ with psychology and sociology back in the eighties and nowadays behavioural finance is quite en vogue. You are knocking on the open door.

    The “working economists” took from the GE what matters most from a practical perspective, the insight that monetary policy alone cannot stabilize an economy, and leave the obscurantist nonsense to the philosophers. Central bankers and finance ministers need stuff to work with an not unscientific “oohh, we cannot say anything about those expecations”.

    And last but not least, from a Kaleckian political-strategical perspective focusing on expectations just serves the enemy. As Kalecki wrote about seventy years ago, business leaders want politicians to think that aggregate demand depends upon the expecations of big business and the lack of uncertainty. They don’t want technocrats that can actually simply stabilize demand via monetary and fiscal policy as unemployment keeps workers at bay (not just wage-wise, à la Marx reserve army of labour or Stiglitz’ efficiency wages, but also political-wise).

    • Yes, yes, I’m aware of the mainstream economists who are now picking up bits of heterodox economics and calling it their own. It’s depressing and is usually, as in the above comment, smattered with quasi-Marxist allusions to ‘the enemy’ showing that this ‘conversion’ is really all about politics. You might want to look a bit into history on this though. Keynes consulted Kalecki to lead the critique on econometrics in the late-30s. And the Kaleckians (the real ones) embrace uncertainty. The most prominent Kaleckian has just released a book with an extensive critique of econometric estimations. But from the rest of your comment I can see that you just came for the politics and didn’t stay for the debate.

      The expectations variable can be measured in a variety of ways. Tuckett and company are working with the Bank of England at the moment on a very interesting measure. Please don’t parade your ignorance of contemporary debates in the comments section here. Or, if you do insist on doing so, do it under your real name.

      • philippe101 says:

        “As Kalecki wrote about seventy years ago, business leaders want politicians to think that aggregate demand depends upon the expecations of big business and the lack of uncertainty. They don’t want technocrats that can actually simply stabilize demand via monetary and fiscal policy”

        Surely stabilizing demand via monetary and fiscal policy will also serve to stabilize business expectations about the future?

  4. Lincoln's economics says:

    As an engineer I’ve always felt Keynes got investment/interest wrong (perhaps I’ve misunderstood him?). Investment is not a function of interest rates, but of the state of technology in order to maximize productivity gains. Interest rates are common to all competitor making them null and void in the broad sense. An automobile manufacturer will invest in robots to stay competitive in the construction cost of a car, not an arbitrary interest rate that his competitor shares. Am I missing something?

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