Chapter VI THE ROLE OF EXPECTATIONS

Chapter 5 of the General Theory, “Expectation as Determining Output and Employment,” is in the main both sensible and realistic.

Keynes begins by pointing out what ought to be obvious:

All production is for the purpose of ultimately satisfying a consumer. Time usually elapses, however—and sometimes much time—between the incurring of costs by the producer (with the consumer in view) and the purchase of the output by the ultimate consumer. Meanwhile the entrepreneur... has to form the best expectations he can... and he has no choice but to be guided by these expectations, if he is to produce at all by the processes which occupy time (p. 46).

Keynes then goes on to distinguish “short-term” expectations, concerned with current production, from “long-term” expectations, concerned with additions to capital equipment. After introducing many needless elaborations and complications, he concludes:

An uninterrupted process of transition... to a new long-period position can be complicated in detail. But the actual course of events is more complicated still. For the state of expectation is liable to constant change, a new expectation being superimposed long before the previous change has fully worked itself out.... (p. 50).

There would be little need to devote much attention to this chapter if Keynes’s admirers and disciples had not made so much ado about it. “Expectations,” writes Alvin H. Hansen (commonly regarded as Keynes’s leading American disciple), “play a role in all Keynes’s basic functional relations.” ¹ The British economist, J. R. Hicks, hails this as a new and vitally significant element: “Once the missing element—anticipation—is added, equilibrium analysis can be used, not only in the remote stationary conditions to which many economists have found themselves driven back, but even in the real world, even in the real world in ‘disequilibrium.’” ²

Such a statement makes a reader rub his eyes in incredulity. It may be true that it has only recently become fashionable for academic economists to lay a great deal of emphasis on “expectations”—under that specific name. But most economists since Adam Smith’s day have taken them into account, if only by implication. No one could ever have written about the fluctuations in the stock market, or in the price of wheat or corn or cotton, without doing so, at least implicitly, in terms of the expectations of speculators, investors, and the business community. And most writers on the business cycle have recognized the role that changes of expectations play in booms, panics, and depressions.

It was the practice of the older writers to introduce this element under the names of “optimism” and “pessimism,” or “confidence” and “lack of confidence.” Thus, to cite only a single example, Wesley C. Mitchell, as early as 1913, wrote:

Virtually all business problems involve elements that are not precisely known, but must be approximately estimated even for the present, and forecast still more roughly for the future. Probabilities take the place of certainties, both among the data upon which reasoning proceeds and among the conclusions at which it arrives. This fact gives hopeful or despondent moods a large share in shaping business decisions.³

Even if academic economists had entirely neglected the role of expectations in economic changes, every speculator, investor, and businessman must from time immemorial have been aware of the central role that expectations play. Every sophisticated speculator knows that the level of prices on the stock market reflects the composite expectations of the speculative, investment, and business communities. His own purchases or short sales are in effect a wager that his own expectations about future security prices are better than the composite current expectations against which he bets. Every investor and businessman is inescapably in part a speculator. The businessman not only has to calculate what consumers will be willing to pay for his product when it is ready for the market; he also has to guess correctly whether they are going to want that product at all.

The chief criticism to be made of Keynes’s treatment of expectations (in Chapter 5) is not that it gives them too much emphasis, but too little. For that chapter is concerned with the effect of expectations merely on output and employment. Keynes should have recognized also that expectations are embodied and reflected in every price—including the price of the raw materials that the individual businessman has to buy, and the wage-rates that he has to pay.

One further observation, however, must be made on Chapter 5 of the General Theory. Throughout it Keynes makes the tacit (but never explicit) assumption that there is nearly always substantial unemployment. He assumes that when new workers are demanded in the capital equipment industries, for example, they are always added to the total volume of employment. They are apparently drawn out of some unspecified army of unemployed. Keynes never considers the possibility that the new capital-goods workers might have to be recruited from existing consumer-goods workers. He never considers what the effect of this competion for workers might be on raising wage-rates rather than merely increasing the volume of employment. Wage-rates are tacitly assumed to remain unchanged.

The limitations and nature of Keynes’s assumptions, in short, make his theory of employment at best a special theory, not a general theory, as his title boasts.

¹A Guide to Keynes, (New York: McGraw-Hill, 1953), p. 53.

² “Mr. Keynes’ Theory of Unemployment,” Economic Journal, June, 1936, p. 240.

³Business Cycles and Their Causes, (University of California Press, 1941 edition), p. 5.