Keynes’ Theory of the Business Cycle as Measured Against the 2008 Recession


In this post I will explore Keynes’ theory of the business cycle. He discusses his views in Chapter 22 of the General Theory and I think they hold up pretty well today. At the beginning of the chapter he notes that the business cycle — so-called, because it is not really a “cycle” at all despite what Keynes says in the chapter — is a highly complex phenomenon and that we can only really glean some very general features of it.

Keynes opens with a very clear quote on what he thinks to be the key determinate:

The Trade Cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated. and often aggravated by associated changes in the other significant short-period variables of the economic system.

Recall that the marginal efficiency of capital (MEC) is basically the expected profitability that investors think they will receive on their investments measured against the present cost of these investments. The key component in the MEC is, of course, investor expectations. Keynes is clear on this and distinguishes himself from those who claim that a rise in the rate of interest is the cause of the crisis. He writes:

Now, we have been accustomed in explaining the “crisis” to lay stress on the rising tendency of the rate of interest under the influence of the increased demand for money both for trade and speculative purposes. At times this factor may certainly play an aggravating and, occasionally perhaps, an initiating part. But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.

This is extremely perceptive and, I think, entirely correct. A rise in the rate of interest will typically precipitate a recession. In the US, for example, it is well-known that when the short-term rate of interest rises above the long-term rate of interest (i.e. when the yield curve is inverted) there will likely be a recession. (This is probably not, however, the case in other countries).

But the actual cause of the crisis is, as Keynes says, a collapse in the MEC. Consider the case of the 2008 recession. This recession was initiated by a fall in house prices which led to a fall in housing construction. Below is the number of housing starts plotted against the interest rate.

housing starts interest rateNow Keynes would argue that the causal chain went as follows: interest rates began to rise => the MEC of investors began to fall => eventually the MEC reached a threshold point at which investors stopped building houses. A recession ensued.

This is extremely important because the alternative interpretation is that the interest rate reached a point that it choked off credit demand for new housing. But this is not empirically valid. Take a look at the following chart plotting the same variables in the 1990s.

housing starts interest rate 2

In this period we see interest rates rise continuously — and, what is more, from a higher base — and yet housing continues to rise in lockstep. Clearly there is no mechanical relationship between housing starts and the interest rate. So, Keynes’ interpretation bears out: for some reason — and we shall not get into it here because it is very complicated — but for some reason in 2006 the interest rate rises triggered a collapse of the MEC among home-builders.

What happens next? Keynes says that liquidity preference shoots up quickly after the MEC collapses, the economy enters recession and the capital markets get nervous. He writes:

The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse in the marginal efficiency of capital, particularly in the case of those types of capital which have been contributing most to the previous phase of heavy new investment. Liquidity-preference, except those manifestations of it which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.

The effects of this are actually more difficult to perceive today than they were in Keynes’ time. Today central banks will step in and quickly flood the capital markets with liquidity when liquidity preference rises. Nevertheless, in extreme cases — such as a liquidity trap proper when the central bank loses control of interest rates — we will indeed see liquidity preference rise and interest rates on risky assets shoot up. This is precisely the case in 2008. Here is a graph showing interest rates on interbank loans shoot up vis-a-vis highly liquid treasury bills (which are money substitutes).

TED Spread 2008Keynes is quick to emphasise that monetary policy alone will ease interest rates and this may help recovery, but it will not actually provoke the recovery. He writes:

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But, in fact, this is not usually the case; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.

Again, if we turn to the data from the 2008 slump this will prove the case beyond a shadow of a doubt. The following graph maps gross private investment, the unemployment rate and the central bank interest rate.

impotent monetary policy

Meanwhile in the background the government deficit opened up massively and Congress passed a massive stimulus plan. After this investment picked up — very slowly — and unemployment started to fall — again, slowly. Because the stimulus spending did not plug the investment gap after six years we are still not back where we were in 2008 in terms of employment and investment has just about clawed back its losses.

Some will point to previous recessions where the interest rate was lowered and investment shot up as proof that monetary alone might be sufficient to steer the economy. I would say to them: take a look at the government budget balance. In all the post-war recessions the budget balance opened up — usually through the automatic stabilisers — and it was this that propped up demand. In absence of this some of these recessions would likely have become depressions.

Keynes is aware that the Austrians might pick up on his theory and then add their own ideologically motivated analyses of what constitutes ‘good’ and ‘bad’ investments. He makes clear something that I have tried to emphasise in a paper that I will be publishing shortly: we cannot say that the private sector will allocate resources effectively if left alone because they are subject to irrational swings of mood and do not engage in rational calculations as the marginalists (and Austrians) assume.

It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent. in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

The final point we should bring out is the policy implications of this. Keynes favours that the central bank holds down the rate of interest and the government maintains full employment throughout the cycle. He writes:

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

I think that this is overly simplistic but certainly on the right track. We can hold down the general rate of interest so that money is cheap but then have the central bank exercise control particular rates of interest in markets prone to speculative bubbles by using Tom Palley’s ABRR proposal. In this scheme the central bank controls overactive investment markets but does not really hold responsibility for ensuring that economic growth be maintained continuously. That is the role of fiscal policy.

Personally I think that democracies are seriously flawed and politicians generally stupid and short-sighted. For this reason I would recommend building institutions that automatically open up the fiscal deficit in times of unemployment. Many welfare state institutions do exactly that — and we have these institutions, not politicians, to thank for ensuring that we have not entered a serious depression between 1980 and today. My favourite of such institutions is the Job Guarantee program developed and supported by Abba Lerner, Hyman Minsky and the Modern Monetary Theorists. But I recognise that this should be an open debate.


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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17 Responses to Keynes’ Theory of the Business Cycle as Measured Against the 2008 Recession

  1. NeilW says:

    “but then have the central bank exercise control particular rates of interest in markets prone to speculative bubbles”

    For me there is rather too much faith in rates of interest being the driver and I just don’t see that. It’s somewhat more complicated than that. The world is not a bunch of bonds, based around a discounted cash flow, nor can it be equated as such.

    The issues in the US housing market were fundamentally fraudulent behaviour which led, essentially, to a whole bunch of assets decaying instantly in value which leads to a run to cash while the dust settled. It was a Ponzi collapse – Minsky style.

    At that point it is hardly surprising that construction people hung up their hats. They knew there would be no demand until the loan system was sorted out.

    The limitations in the General Theory are noted here on Lars blog:

    For me the limitation on loans shouldn’t be targeted at the ‘price of money’, which should just be held low. Driving a system indirectly leads to uncertain distribution outcomes and just ends up messy. Too clever for its own good.

    Limitations should be targeted at the ‘creditworthy’ borrower’ bit of the equation. Regulated banks should only issue loans (i.e. create money) for specific concrete purposes which the state wishes to support – preferably uncollateralised so that banks actually have to assess cash flows and won’t create asset spirals. Any use of the money outside of those bounds would make the debt unenforceable.

    Everything else then has to fight in the market for equity/commercial debt.

    Park it and limit bank lending to concrete things. Force banks to assess cash flows. A nice and simple monetary framework, with fiscal auto-stabilisers picking up the slack.

  2. Dantey says:

    “Personally I think that democracies are seriously flawed..”
    Hmm… Could you please elaborate on that? Would be an interesting read.

    • Well, to put it briefly and bluntly: most of the key decisions made in democracies are not really undertaken by voters. Rather they are made by the legislature. And the legislature are bound by relatively short-run incentives — i.e. the incentive to get elected in the next cycle. This means that in modern democracies structural reform is often, outside of full-scale war, impossible. If you contrast this with totalitarian/authoritarian regimes it is clear that the latter are simply better at tackling widespread social problems. This does not mean, of course, that I support authoritarianism or totalitarianism. I think it is better to live in a flawed democracy then to support tyranny to fix social problems. But I think the facts, frankly, speak for themselves. In this regard I am very pessimistic that Western capitalist democracies can truly overcome the economic problems they now face. And I think that the best we can hope for are some bandages to cover up certain wounds.

      • Dantey says:

        Hmm… Thanks for the reply. I think this is worth a blog post to know the framework, thought process and how you came to this conclusion.
        This reminds me of one of Slavoj Zizek’s comments that if one looks around the world, capitalism seems to be working properly mostly in authoritarian regimes like the UAE, Singapore,etc. I think Peter Thiel also mentioned that he thinks capitalism and democracy are now incompatible. I wonder which one do we need to replace?

  3. LK says:

    Wonderful post, which I learned a lot from.

    “Keynes is aware that the Austrians might pick up on his theory and then add their own ideologically motivated analyses of what constitutes ‘good’ and ‘bad’ investments. He makes clear something that I have tried to emphasise in a paper that I will be publishing shortly: we cannot say that the private sector will allocate resources effectively if left alone because they are subject to irrational swings of mood and do not engage in rational calculations as the marginalists (and Austrians) assume.”

    And not to mention

    (1) the classic Austrian business cycle theory collapses once it is shown that the unique Wicksellian natural rate of interest cannot be defined outside a one commodity world, right?

    (2) And if (a) interest rates do not provide the necessary inter-temporal coordination of real saving and investment, (b) the loanable funds model is wrong, and (c) lowering monetary interest rates does not reliably stimulate new demand for investment credit anyway when the investment decision is made under subjective expectations and swings in the general state of confidence drive it, the whole ABCT is utterly bankrupt.
    If we add to this the fact that most fluctuations in investment, employment and output are caused by capacity utilisation decisions and the need to liquidate/accumulate inventory, how can anyone believe this Austrian B.S.?

    • Broadly agreed.

      (1) This is true. It’s the Capital Controversies point. But I don’t like this criticism. It is too abstract and theoretical. Its the type of criticism that ideologues LIKE because they can engage with it in their own highly abstract way. See: Bob Murphy.

      The problem here is that this is an extremely important practical issue and applied economists know it. Last week I had a meeting with the former Chairman of the Financial Services Authority. He basically ran the whole financial sector in London until last year. I saw a talk by him and he was discussing the natural rate and the EMH and so on and so I got in contact and we had a meeting. I gave him the paper that I will be publishing soon and we had a long discussion.

      It all instantly clicked with him. I showed him that the natural rate of interest theory that backs up the whole interest rate targeting ideology assumed the EMH as a transmission mechanism from the central bank interest rate to the other interest rates. And I pointed out that the MEC was the key to the whole puzzle. He is an avid reader of Keynes but he had not been able to piece this together until then. He said that he is completely re-evaluating his presentation in light of this.

      What this shows is two things. First of all, the natural rate theory IS guiding policymakers. I discovered this while I was doing my Masters. Secondly, if you take a non-abstract, practical line on the issue you can show the policymakers the flaws in the theory and why they cannot use it for policy. This is why I think you say in (2) is a far better way to approach this issue.

      • NeilW says:

        So are you seeing MEC as a function of those who are looking to invest in terms of their feelings on uncertainty (i.e. the famous animal spirits)? So one day they are all bright and breezy and then something changes in the air and they start to become less so. Does that tie into the Minsky Moment idea – where people delude themselves (to the extent of borrowing excessively) until they suddenly don’t and start to demand a greater safety margin.

      • Mark says:

        I’m sure that many academic economists believe in the Wicksellian theory of interest rates, but I got the impression that professional economists (who worked at a bank or a central bank) understand that in practice, monetary policy transmits into the economy by different, somewhat unreliable channels. When officials in the Fed were asked what QE is trying to achieve, the answer went along the lines of “wealth effect” and “portfolio rebalancing”, not a stimulus to investment.

        The Economist did a nice piece on this issue:
        They recognize that there are many interest rates in the economy and that movements in the Fed’s policy rate may have different effects on every one of them.

  4. Hugo Evans says:

    Dear Mr Pilkington, I’m not an economist, but nor am I an austrian or ‘goldbug’, so may evade your full scorn. Is it fair to say: Relating the MEC to the yield curve inversion phenomenon for which you give a link: The yield curve is the market forecast for the future bank rate, so if the bank raises its rate but the market does not think this is sustainable the curve inverts. No one wants to go for a walk on the yellow brick road. Maybe because they looked out of the window and saw the profit warning clouds signalling a fall in MEC. As the rain starts falling the bank rate falls with it. Therefore, switching analogies, the monetarist string is just about stiff enough to get some push, but when the bank pushes too hard the curve inverts as the string flops?

    From a psychological perspective the whole thing is like kids pretending to believe in Father Christmas because that’s what they believe their parents want them think and they don’t want to disappoint them. But there comes a point (never explicitly discussed in the family) when we all tacitly agree to abandon the physics of letters to the north pole and fat men in chimneys. If so then the monetarist expectations channel actually runs from the market to the central bank MPC. All they need to know is that we don’t think they are bad parents, we will still love them, even without a natural rate of interest. Just so long as they remember the tangerine.

  5. An investment’s Internal Rate of Return is independent of the current interest rate. Investment projects across a depressed economy may all have low IRRs despite low interest rates.

    If a project’s IRR is lower than the cost of capital (a function of the interest rate) then the investment should not take place. However, it’s a bit daft to believe that investment is principally a function of the interest rate. IRRs can be very low even in a low interest rate economy. Low IRRs may exist for a variety of reasons, some of which may stem indirectly from a high interest rate, some of which may not.

    Is this not what Keynes was driving at – that investment is more a function of animal spirits than it is of interest rates? Just as saving is more a function of income than it of the interest rate?

  6. Pingback: Keynes’ Theory of the Business Cycle as Measured Against the 2008 Recession by pilkingtonphil (26th Sept 2014) | Lies, Liars, Beatniks & Hippies: Economics

  7. Mark says:

    “We can hold down the general rate of interest so that money is cheap but then have the central bank exercise control particular rates of interest in markets prone to speculative bubbles by using Tom Palley’s ABRR proposal.”

    The usual objections to this kind of policy are:
    1. The central bank can’t reliably recognize bubbles (until they pop).
    2. Popping a bubble may cause a crisis in itself.
    3. Financial institutions are so sophisticated nowadays that they will find ways to bypass the new requirements. Jeremy Stein, former Fed governor, said that “higher interest rates engineered by the Fed “gets in all of the cracks” that might be missed by supervision and regulation”.
    4. Such measures would have large political and possibly distributional implications, while monetary policy proper is neutral and is not distortionary*. For instance, consider the possible effects on the housing market, which is a huge political and social issue in the US. As Helmut Schlesinger said, it is not popular to take measures when the market participants feel they are getting richer and richer every day (I guess this ties with your view on democracies).

    I don’t necessarily agree with these objections, I just wanted to point them out. A lot of opinions on the subject are given here:

    Click to access TIE_F09_AssetPriceSymp.pdf

    * I do not believe that monetary policy is neutral and apolitical, but it seems like a lot of people do.

  8. Chapter 22 deserves more attention than it has attracted. Kudos to you for highlighting it.

    Keynes uses the framework developed at chapters 11 and 12 as well as his theory of business cycle theory developed on his early writings of 1912 and on Treatise of Money:
    ““After a crisis there is probably too little fixed capital; hence large profits for what there is; hence the creation of more fixed capital with the expectation of equal profits; hence creation of too much fixed capital” (Keynes papers UA/6/21/12)
    “I find myself in strong sympathy with the school of writers— Tugan-Baranovski, Hull, Spiethoff and Schumpeter—of which Tugan-Baranovski was the first and most original, and especially with the form which the theory takes in the works of Tugan-Baranovski himself…..”
    (Keynes, 1930, vol. 2, p. 100-101)
    Putting aside the flaws of the MEC (eg defining capital as a “thing” instead of social relation) Keynes provides some genuine insights. It seems to me that he sketches a business cycle theory based on investments determined by the long term profitability. A statement that had already been made by Marx (and other classical economists) as well.
    It is actually possible that Keynes thought of falling profitability as an already accomplished fact.
    Even though they have many differences (eg normal vs below normal capacity utilization , expectations vs general rate of profit, etc) the main concept is the same. Also, I do believe that their theories (at least regarding profitability) complement each other.

    PS Your vision on institutions should be a very interesting open debate indeed.

    • Confidence Fairy Nonsense says:

      “Chapter 22 deserves more attention than it has attracted.”

      No, it doesn’t. It is not the centerpiece of the General Theory which is not about explaining why booms and busts exist but about why economists might be stuck in a PERMANENT underemployment equilibrium and what we can do to get out of it. All this dynamic stuff is an afterthought but not the centerpiece of the GT.
      I don’t think that it is not a coincidence that Post Keynesians focus just like right-wingers on expectations. The lunatic fringes of the discipline wait for the confidence fairy.

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