Employment, Liquidity, and the Fight Against the Quantity Theory of Money
Kahn is by no means the most widely known of the Cambridge economists, and if he is known it is mostly in association with the concept of the multiplier, which he presented in an article ‘The Relation of Home Investment to Unemployment’, published in the Economic Journal (Kahn 1931). Even less well known is how he contributed to the development of an approach which turned out to be pivotal in Keynes’s General Theory, namely the concept of the short period, which he presented in his Fellowship dissertation, and in an unpublished and unfinished book under the same name (Kahn 1932a).[1]
Kahn accepts Marshall’s distinction between the short period—when the productive capacity of the firm is constant both in terms of physical capital and organization of production—and the long period, defining the distinction as ‘one of Marshall’s most fruitful contributions’ (Kahn 1989: xiii). The distinction is not seen as grounded on logical foundations but as a matter of fact, that is, even if natura non facit saltus, there is a factual dichotomy between the life of fixed capital and the period of production, the former being considerably longer than the latter (Kahn 1932a: Chapter 2, page 2). The productive life of physical capital is not distributed along a continuum, but, as Kahn noted (1989: xiii): ‘As a general rule, the life of physical capital is illustrated either by the mayfly or by the elephant’.
Although the short-/long-period distinction has a factual basis, the actual length of the short period cannot be defined on the basis of technological considerations alone. These determine only the upper and lower boundaries of the interval in which the short period varies because fixed capital cannot remain constant for a period longer than its physical life or be substituted before the period of production comes to an end. Within this interval, the length of the ‘short period’ is determined by the expectations of entrepreneurs regarding demand conditions. Accordingly, depending upon whether entrepreneurs believe changes in demand to be transitory or permanent as compared with the level considered as ‘normal’, the decision on whether to modify plant or organization—typically long-period decisions—will or will not be taken.
The two aspects—the nature of the production process, which is characterized by changes that occur rapidly (such as output and employment) and others that occur only slowly (such as alterations in fixed plant) and expectations of changes in demand relative to the level perceived as normal— are combined to explain why in the short period productive capacity is not altered. This is so because a change in the conditions of demand is not perceived as permanent; in fact, the ‘ideal’ short period is defined as a situation where ‘any change that occurs is not expected to be permanent’ (Kahn 1932a: Chapter 2, page 10). The conditions prevailing in the economy—depression or boom—mould expectations of a return to normal conditions of demand and introduce an asymmetry in the length of the short period. In a boom, short-period equilibrium implies that expectations are such that increasing production, at higher costs, is preferred to building up capacity until the increase in demand is confidently perceived as ‘permanent’; the short period, however, can be very short and innovations are introduced rapidly. In a depression, short-period equilibrium implies expectations that demand will return to its normal level; in this case, the short period can last decades if the firm survives (at a loss) while its physical capital is decaying. Since what matters are expectations regarding the normal value of the level of demand, it follows that the short period need not be a ‘short’ time interval, nor is it a transitory state before the long-period forces work out their effects. It is, rather, a position which is maintained as long as the set of decisions, depending upon the expected level of demand, do not change. This attributes to short-period equilibrium a meaning showing a fairly evident analogy with the unemployment equilibrium of Keynes’s General Theory.
Turning to another major contribution by Kahn to Keynesian economics— the multiplier—its importance lies in providing the terms for analysis of the conditions that see an increase either in the level of prices or in the quantities (or a combination of the two) in aggregate, following an exogenous increase in demand (in the case presented in the 1931 article, public investments in road building). In a depression—as prevailed at the time—Kahn showed that the effect on quantity outweighs that on prices, so that an autonomous increase in demand could boost income and employment. The multiplier has a story of alternate acceptance and rejection in the 80 plus years of its existence. After a long period of neglect and suspicion by the majority of the economics profession, it has come back into favour.[2]
Kahn was very close to Keynes in the years preceding and following the publication of The General Theory. He played the leading role in orienting Keynes’s thought in certain significant aspects through discussion and debate during the period when The General Theory was taking shape. In particular, the influence of Gerald Shove and the collaboration with Joan Robinson during the writing of the Economics of Imperfect Competition (see below) persuaded Kahn of the need to recover, rather than discard, Marshall’s apparatus, against Sraffas criticism in his 1926 article.[3] The task—as Kahn saw it—was to transform certain concepts into precise analytical tools and apply them to Keynes’s new ideas to obtain logically coherent results. The framework Kahn provided—the aggregate demand and supply curves—arguably had the eventual effect of taking the presentation of The General Theory in directions that departed from Keynes’s approach in A Treatise on Money, and at any rate of restricting its scope, but it helped Keynes to finally shake off the ‘stranglehold’ of the quantity theory of money. Kahn always prided himself on ‘finally disposing of the idea that the price level is determined by the quantity of money’ (Patinkin and Leith 1977: 147).
After Keynes’s death, Kahn carried on his battle against the quantity theory to the end of his life. Opposed as he was to an approach to monetary policy which paid exclusive attention to the money stock, Kahn developed his own theory of money following lines which moved him slightly away from Keynes. In particular, Kahn was critical of Keynes’s representation of the demand for money as a smooth curve, which could be placed at the same level of importance as the consumption function or the marginal productivity of capital as a key component of the structure of the economic system (as it was in fact placed within the IS-LM framework). This was not the only source of dissatisfaction with The General Theory, as Kahn explained in ‘Unemployment as Seen by the Keynesians’, where he disapproved of the way Keynes defined involuntary unemployment, going so far as to say that the second chapter of The General Theory always left him ‘very cold’ (Kahn 1976a: 23) However, where Kahn distanced himself most from Keynes was in relation to the liquidity preference theory.
In his essay ‘Some Notes on Liquidity Preference’ (Kahn 1954),[4] Kahn defends Keynes’s analysis of the long-term rate of interest as depending on the expectations for future rates held with uncertainty, and puts forward his own views on the workings of the financial markets and the behaviour of investors. According to Kahn, in the financial markets there are two kinds of investors: those who hold definite expectations for the future of interest rates and those ‘who do not have a clue’ (ibid.: 241) whether the rate of interest is going to increase or decrease. The same division exists in the mind of the investor himself, who can reveal contradictory preferences and decide to hold money and securities at the same time, while rational behaviour (and expected utility theory) would imply a definite choice between the two. On the basis of this observed behaviour, Kahn argues that a finite elasticity of the demand for money relative to the rate of interest is associated not only with the heterogeneity of opinions held by the public divided between bulls and bears, but also with the lack of conviction individuals show in their own conjectures. It is as if bullish and bearish sentiments ‘operated inside each person’s mind, one being responsible for his holding securities and one for his holding money’ (ibid.: 247). This analysis implies the ‘unsuitability of thinking of a schedule of liquidity preference as though it could be represented by a well-defined curve or by a functional relationship expressed in mathematical terms or subject to econometric processes’ (ibid.: 250).
In terms of monetary policy, it follows that since the monetary authority would be facing a shifting schedule of liquidity preference, a given quantity of money cannot be taken as a policy target. As Kahn confirmed in his evidence to the Radcliffe Committee, the quantity of money necessary to bring about a fall in the rate of interest varies with the circumstances (Kahn I960: 742) and the state and responsiveness of the market: ‘If the market likes to help by altering its expectations.. .the authorities will not have to do so much. If the market proves very obstinate and does not believe that they are going to succeed in doing what they are trying to do, then they will have to do much more’ (ibid.: 743).
In the 1970s—when the tide was turning against the hegemony of Keynesian thought and the Western economies were hit by levels of inflation such as had never been reached in the post-war period—Kahn deployed all the defences he could muster against monetarism, which, to all intents and purposes, amounted to the restoration of a pre-Keynesian approach. In fact, when Margaret Thatcher became Prime Minister in 1979, for the first time since the war the British government ceased to proclaim the goal of full employment, for, according to the monetarist philosophy behind official policy, it was not an objective which the government could pursue directly with policies to support demand. What the Conservative administration aimed at was cuts in public spending, the tax burden and the economic demands of the public sector, and the restoration of market mechanisms. It was these mechanisms that were supposed to boost employment indirectly. In addition, the goal of reducing inflation was to be achieved through a decrease in the money supply growth rate, this being in sharp contrast with the incomes policy advocated by Kahn (1976b, c).
Even today, the all-time record of money growth expansion overseen by the Federal Reserve, the European Central Bank, and the Bank of Japan to fight the present downturn has proved Kahn’s arguments: markets have been flooded with liquidity, but rather than inflation we have witnessed a general deflation, in the absence—with the possible exception of the USA—of that expansionary fiscal policy which the multiplier argument suggested as the means to increase income and employment.
- [1] One draft is extant, with annotations and related material, amounting to roughly 300 pages (RFK/2/7.References beginning with RFK are to the documents preserved in the Richard Kahn Papers, King’sCollege Archive Centre, Cambridge University). Of the planned 11 chapters, according to the index,Chapters 1, 3, and 4 remained unwritten, while Chapters 7, 9, and 10 are seemingly unfinished. Thedraft was almost certainly written in the last quarter of 1932. We will refer to it as Kahn (1932a). Part ofChapter 7 merged into ‘Imperfect Competition and the Marginal Principle’, which was an article Kahnsubmitted to Frank Taussig in 1933 for publication in the Quarterly Journal of Economics and which, having been rejected, still remains unpublished in English (Marcuzzo and Rosselli 2008). We will refer to itas Kahn (1932b).
- [2] As recently noted: ‘In the 1950s and 1960s, when Keynesianism was in contrast at its height, the multiplier was generally assumed to be about 2. Then in the 1990s and 2000s, these estimates graduallydropped, leaving the consensus range about 0.5—0.7 by 2009’ (Davies 2012: 3), in contrast with thecurrent figures of 0.9—1.7 presented in the 2012 World Economic Outlook by the International MonetaryFund.
- [3] Sraffa (1926) produced a devastating critique of Marshall’s supply and demand apparatus for the analysisof competitive markets, showing that the assumption of increasing costs underlying the upward-slopingsupply curve was inconsistent with the assumption of partial equilibrium or was confined to the case ofan industry which employs the totality of a productive factor. However, at the time, Sraffa was not yetready to offer his alternative theory based on the surplus approach.
- [4] An excellent analysis of Kahn’s theory of liquidity preference can be found in Dardi (1994).
