Chapter XII “THE MARGINAL EFFICIENCY OF CAPITAL”

1. Slippery Terms

We have had frequent occasion to note the ambiguities, inconsistencies, and contradictions that run through the General Theory; but in Chapter 11, “The Marginal Efficiency of Capital,” they reach an even higher level than in the chapters preceding.

We shall see, as we go on, that Keynes uses the phrase, “marginal efficiency of capital,” in so many different senses that it becomes at last impossible to keep track of them. Let us begin with his first formal definition:

The relation between the prospective yield of a capital asset and its supply price or replacement cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More precisely, 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. [My italics in this sentence.] This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.

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... (pp. 135-136).

Keynes then goes on to tell us that we can build up a “schedule” of the marginal efficiency of capital which we can call alternatively the investment demand-schedule, and that “the rate of investment will be pushed to the point on the investment demand-schedule where the marginal efficiency of capital in general is equal to the market rate of interest” (p. 136-137).

Keynes next asks how his own definition of capital is related to common usage. “The Marginal Productivity or Yield or Efficiency or Utility of Capital are familiar terms which we have all frequently used” (p. 137). (Just why does he adopt the vaguest of them?)

“It is not easy by searching the literature of economics,” Keynes goes on, “to find a clear statement of what economists have usually intended by these terms. There are at least three ambiguities to clear up” (pp. 137-138). It is amusing to find Keynes, that father of so many ambiguities, so persistently worried about the alleged ambiguities of others.

There is, to begin with, the ambiguity whether we are concerned with the increment of physical product per unit of time due to the employment of one more physical unit of capital, or with the increment of value due to the employment of one more value unit of capital. The former involves difficulties as to the definition of the physical unit of capital, which I believe to be both insoluble and unnecessary. It is, of course, possible to say that ten laborers will raise more wheat from a given area when they are in a position to make use of certain additional machines; but I know of no means of reducing this to an intelligible arithmetical ratio which does not bring in values (p. 138).

All this is entirely true. But it is strange coming from the coiner and adopter of “wage-units.” On Keynes’s own definition, as we have seen, these are measured in proportion to remuneration; they are therefore not “real” units or “employment” units, but units of money value. If, in offering the above illustration, Keynes had remembered that it is also possible to say that five skilled or efficient laborers will raise as much wheat from a given area as ten unskilled or inefficient laborers, he would also have seen that there is no intelligible way of measuring “wage-units” which does not bring in values. Why was Keynes so much more acute in detecting the ambiguities of other writers than in detecting his own?

2. Interest Rates Embody Expectations

We next come to what Keynes seems to consider his special contribution:

Finally, there is the distinction, the neglect of which has been the main cause of confusion and misunderstanding, between the increment of value obtainable by using an additional quantity of capital in the existing situation, and the series of increments which it is expected to obtain over the whole life of the additional capital asset.... This involves the whole question of the place of expectation in economic theory (p. 138).

[And again:] The most important confusion concerning the meaning and significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield (p. 141).

All this is true. And yet one of Keynes’s own principal errors in his discussion of the relation of the marginal efficiency of capital ¹ to interest rates is his failure or refusal to recognize that current interest rates are also determined in large part by expectations regarding the future. The comparison is analogous to that between the valuation of a share of stock and the valuation of a bond. When the long-term interest rate is 4 per cent, a high grade bond yielding $4 a year will sell at $100. At the same time a good stock currently paying a dividend of $5 a year may also sell at $100. It does not sell at more because the continuation of the dividend is less certain than the continuation of the interest on the bond, and more liable to fluctuation from year to year. But a stock currently paying a dividend of only $3 a year may sell at $100 because market opinion believes it highly probable that the stock will soon be paying more. The current price of both dividend-paying (or non-dividend-paying) stocks and interest-paying bonds is determined by expectations regarding the future. When the interest rate is 4 per cent, some bonds paying $4 a year will be selling much below $100, and yielding, say 5 or 5¹/₂ per cent interest on their capital value, because they embody greater risk than gilt-edge bonds.

(In the preceding paragraph I have used the phrase “the interest rate.” This is in accordance with the practice of Keynes and many other economists, who sometimes write of “the” interest rate and sometimes of “the complex [or constellation] of interest rates.” “The interest rate” is usually a simpler and more convenient phrase and concept provided it is not misused—that is, provided its arbitrary and over-simplified nature is constantly kept in mind. When I use the term, I shall be taken to mean something like “the current average annual percentage yield on AAA bonds maturing in twenty years or longer.” Even so, it is safer most of the time at least to make explicit whether one is talking of “the long-term interest rate” or “the short-term interest rate”—even though each of these phrases also refers to a whole complex of interest rates, and even though the line dividing “short-term” from “long-term” is an arbitrary one—“short-term” sometimes meaning, say, five years or less to maturity, sometimes one year or less to maturity.)

Because Keynes (usually) refuses to recognize that the interest rate as well as “the marginal efficiency of capital” is governed by expectations, he makes unjustified criticisms of other writers and builds up a false theory of his own. “The expectation of a fall in the value of money stimulates investment,” he declares, “and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital” (pp. 141-142). This is the equivalent of saying that inflation, and even more, the threat of further inflation, is good because it stimulates investment and employment.

And it is because it interferes with the foregoing theory that Keynes criticizes Irving Fisher’s “distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money” (p. 142).

It is difficult to make sense of this theory as stated, [declares Keynes] because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent (p. 142).

It is inexcusable, in the first place, for Keynes to write of Fisher’s statement of his theory that “it is not clear Whether the change in the value of money is or is not assumed to be foreseen.” Irving Fisher wrote clearly, for example, in The Theory of Interest (1930, p. 37): “The influence of such changes in the purchasing power of money on the money rate of interest will be different according to whether or not that change is foreseen.” The italics here are not mine but Fisher’s own. And the sentence is followed by paragraphs of further unequivocal explanation.

It is, moreover, not too difficult to escape from Keynes’s “dilemma.” The easiest way is to point to an undeniable and repeated fact of experience—that in the later stages of a hyper-inflation, when further inflation is generally expected, interest rates do begin to soar. This happened, for example, in the great inflation in Germany in 1923:

In the first phases of the inflation the rate of interest tended to rise in Germany, as always happens at a time of monetary depreciation. But for a long time the rise in interest rates was appreciably less than the rate of currency depreciation. Subsequently the rate of interest became more sensitive to the influence of the currency depreciation. As the depreciation became more rapid, the premium for the creditor’s risk was bound to increase, and consequently in the final phase of inflation the rate of interest was extremely high. At the beginning of November 1923 the rates for ‘call money’ rose as high as 30 per cent per day! ²

This situation will practically always be found in the later stages of a serious inflation. For example, as I write this, there is a serious inflation in Chile, and the commercial bank rate [according to International Financial Statistics (June, 1957), published by the International Monetary Fund] rose from 7.84 per cent in 1937 to 13.95 per cent in 1956.³

As I write this, also, the same phenomenon has occurred in England itself, and in large part, ironically, because of the cheap money policy that Keynes took such leadership in advocating. In June of 1957 the British Treasury 2¹/₂ per cent bonds, which had been issued in 1946, during the last phases of the cheap-money policy, could be bought at 50, or half the original purchase price. But while prime bonds in Britain were going begging in June of 1957 at heavy discounts, prices of corporate shares were being bid up to levels where, despite the risks they involved, their return to the investor was in many cases substantially lower than those available on gilt-edge bonds. As one leading London investment house explained:

Clearly, the main cause of the trouble lies in the barely checked progress of the creeping inflation.... The argument is, indeed, put forward that, since the pound has been depreciating in the past decade at an average rate of 4¾ per cent per annum, any investment likely to show a total net return on income and capital accounts over a given period of less than this amount is giving a negative yield and should be discarded.⁴

A similar development took place in the United States in July, 1957, and again in the summer and fall of 1958.

3. Effects of Expected Inflation

Now let us look at the theoretical explanation of this. It is true that in a period of inflation, and when further inflation is widely foreseen, prices of existing goods rise in anticipation. But prices of different goods rise in different degrees, determined by the nature of the commodity and the nature of its market. This year’s perishable foodstuffs, for example, reflect this year’s monetary inflation in their price; but they cannot reflect next year’s expected inflation because they cannot be held till next year; they must be consumed now. The same reasoning applies to current services of all kinds. A durable good with a two-year life can reflect less expected further inflation in its present price than a durable good with a five-year life, and that in turn can reflect less than a durable good with a still longer life. I do not mean to suggest that the reflection of further expected inflation in present prices is directly proportional to the life span of particular goods; this is only one of the factors involved. It is sufficient to note that expected further inflation is reflected in different degrees in the current price response of different goods.

Now when other conditions are such that they would bring about both a real and a money rate of interest of, say, 4 per cent, but when lenders generally believe that next year’s average price level (including both perishable and durable goods, in the proportions in which they are expected to be consumed) will be 3 per cent higher than this year’s price level (for the same goods “mix”), they will charge 7 per cent in order to get the real return of 4 per cent. And borrowers will pay this 7 per cent if they expect to use the borrowed funds for acquiring durable goods or investments that they believe will rise even more than 3 per cent in the year. (Or at more than that rate over a series of years corresponding to the period of the loan.)

Keynes constantly goes wrong, as we shall see, because he chronically thinks in terms of averages and aggregates that conceal the very causal relations he is trying to study. This aggregate, in-block, or lump thinking is the exact opposite of economic analysis. Its recent prevalence, largely under Keynes’s influence, represents a serious retrogression in economic thought.

Keynes even argues that the rate of interest cannot rise under the conditions he assumes, because if it did it would spoil his theory about the “stimulating” effect of the expectation of further inflation:

The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output—insofar as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, here would be no stimulating effect from the expectation of rising prices. For the stimulus to output depends on the marginal efficiency of a given stock of capital rising relatively to the rate of interest. (His italics, p. 143.)

Keynes’s admissions here are quite correct. “If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices.” But what is Keynes’s reason for supposing that the rate of interest will not rise with the marginal efficiency of capital? It lies in his assumption that “the marginal efficiency of capital” embodies expectations and that the rate of interest does not. The marginal efficiency of capital, by Keynes’s order, has entered the realm of “dynamic” economics, but the rate of interest, also by Keynes’s order, has been kept in the realm of “static” economics.

There is no warrant for his assumption. It does not correspond with the facts of economic life. If the marginal efficiency of capital embodies expectations, so do interest rates. To assume otherwise is to assume that entrepreneurs are influenced by their expectations but that lenders are not. Or it is to assume that entrepreneurs as a body can be expecting prices to rise while lenders as a body do not expect prices to rise. Or it is to assume that lenders are too stupid to know what borrowers know. If the borrowers wish to borrow more because they expect higher commodity prices, this means, in other words, that they expect to pay the lenders back in depreciated dollars. And, according to Keynes, the lenders will be perfectly agreeable to this. They will not demand a higher interest rate as an insurance premium against the depreciated dollars in which they expect to be repaid. They will not even ask a higher interest rate because the demand for their loanable funds has increased. In brief, the Keynesian assumption that the marginal efficiency of capital is influenced by expectations regarding the future, but that the rate of interest is not, rests on inconsistent premises.

The sad truth is that Keynes has no consistent assumptions regarding any of his major concepts or theses. The assumption of one sentence is as likely as not to be contradicted in the next. Thus on the very page from which the foregoing quotation is taken Keynes tells us that “the expectations, which are held concerning the complex of rates of interest for various terms which will rule in the future, will be partially reflected in the complex of rates of interest which rule today.” (My italics, p. 143.) Here is an admission that an expected rise in future interest rates will be reflected in present interest rates, but only “partially.” Yet as Keynes promises us that in his Chapter 22, “we shall show that the succession of Boom and Slump can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest” (p. 144), we shall wait till then to pursue our own analysis of this relationship.

4. Does Lending Double the Risk?

In Section IV of Chapter 11 Keynes finds it “important to distinguish” between “two types of risk” affecting the volume of investment “which have not commonly been distinguished.... The first is the entrepreneur’s or borrower’s risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes” (p. 144). (I may point out in passing that to the extent to which the risk is real, it arises out of the objective situation, and not out of the doubts in the entrepreneur’s own mind. These doubts may overestimate or underestimate the real risk involved, but do not determine it.)

But where a system of borrowing and lending exists [Keynes continues], by which I mean the granting of loans with a margin of real or personal security, a second type of risk is relevant which we may call the lender’s risk. This may be due either to moral hazard, i.e. voluntary default or... involuntary default due to the disappointment of expectation (p. 144).

A third source of risk might be added, namely, a possible adverse change in the value of the monetary standard which renders a money-loan to this extent less secure than a real asset; though all or most of this should be already reflected, and therefore absorbed, in the price of durable real assets. (My italics, p. 144.)

This sentence is significant because it admits, in the grudging phrase “or most,” that not all the risk to the lender of a possible rise in prices will necessarily be already reflected in the price of “durable real assets.” But this admission contradicts the inescapable “dilemma” that Keynes had presented only two pages previously to prove that the present money rate of interest could not be raised by lenders to protect themselves against an expected further inflation. Let us continue, however, with Keynes’s “two types of risk”:

Now the first type of risk is, in a sense, a real social cost... The second, however, is a pure addition to the cost of investment which would not exist if the borrower and lender were the same person. [My italics.] Moreover, it involves in part a duplication of a proportion of the entrepreneur’s risk, which is added twice to the pure rate of interest to give the minimum prospective yield which will induce the investment (pp. 144-145).

This is pure nonsense. The risk is not “duplicated”; it is not “added twice”; it is simply shared. To the extent that the entrepreneur assumes the risk the lender is relieved of it; the lender assumes a risk only to the extent that the entrepreneur fails to assume it. Suppose entrepreneur E borrows $10,000 from lender L to start a small business. Suppose the entrepreneur loses the whole $10,000. Then a total of $10,000 is lost, not $20,000. If the entrepreneur makes the whole loss good out of his own pocket, none of it falls on the lender. If the entrepreneur goes bankrupt, or leaves town, without repaying the lender a cent, then the lender takes a loss of $10,000. But the borrower E has lost nothing of his own; he has simply thrown away L’s $10,000. If the borrower is able to make good $6,000 of the loss out of his own resources, but is compelled to default on the rest, then $4,000 of the loss falls on the lender—not more. Would Keynes argue that fewer houses are built with the mortgage system than would be built without it, because mortgages “double the risk,” or constitute “a pure addition to the cost of investment”? It is the mortgage, on the contrary, that enables the builder or owner to build or own the house. The mortgagor, on his part, assumes that the market value of the house above the amount of the mortgage gives him additional security (beyond the good faith of the mortgagee, the other resources of the mortgagee, and the mortgagor’s legal recourse against the mortgagee) which removes or minimizes his own risk.

But if the objective “social” risk is clearly not increased “where a system of borrowing and lending exists,” perhaps, it may be said, Keynes was arguing that the subjective risk, the feeling of risk, is doubled or “added twice.” This too is an incredible and self-contradictory assumption. For the lender contents himself with a fixed rate of interest, and with the eventual return merely of the original amount (in dollar terms) of his capital investment, on the assumption that he is leaving the risk of loss as well as the prospect of gain to the borrower. Corporations have found that they can raise the maximum amount of capital by issuing a judicious mixture of common stock, preferred stock, debenture bonds, first mortgage bonds, etc., partly depending on market (and tax) conditions at the time of issue, but depending, also, on the diverse temperaments and purposes of the different investors to whom they are appealing. Those who are willing to assume the entrepreneurial risks in exchange for the entrepreneurial prospects of profit and capital gain become common stockholders. Those who wish to minimize their risks, and are content with a low but presumably dependable and regular interest rate, and the mere return of their dollar capital investment, will buy what they regard as “gilt-edge” bonds. They become technically the creditors of the stockholders in the same corporation.

To argue that such an arrangement increases or “duplicates” either the objective risk or the subjective sense of risk is as absurd as it would be to argue that the institution of fire insurance increases the risk, or sense of risk, of fire. It is precisely because the institution of insurance shares and diffuses risks that risks are more freely taken; that more houses are built and more investments made. And it is precisely “where a system of borrowing and lending exists” that investment increases enormously compared with what it would be where such a system did not exist.

I regret having taken so much space to point out this elementary error. I have done so only because it illustrates once more, and so clearly, the kind of perverse logic typical of the General Theory.

5. Confusions About “Statics” and “Dynamics”

Section V of Chapter 11 is less than a page in length, but none the less reveals the extraordinary arbitrariness of Keynes’s reasoning:

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 today and tomorrow. Even the rate of interest is, virtually, a current phenomenon; and if we reduce the marginal efficiency of capital to the same status, we cut ourselves off from taking any direct account of the influence of the future in our analysis of the existing equilibrium.

The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality (pp. 145-146).

Few passages even of Keynes are more arbitrary or confused. Boom and Slump, we were told on page 144, are to be “described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” But now we are to understand that whereas the marginal efficiency of capital is to be treated as a “dynamic” concept, the rate of interest is to be treated as a “static” concept. The rate of interest is a “current” phenomenon, but apparently the marginal efficiency of capital is not. The marginal efficiency of capital reflects expectations regarding the future, but the rate of interest “virtually” does not. And then even this contrast is partly repudiated. For in the passage just quoted, Keynes puts a footnote mark after the word “virtually,” and the footnote says: “Not completely; for its [the rate-of-interest’s] value partly reflects the uncertainty of the future. Moreover, the relations between rates of interest for different terms depends on expectations” (p. 145).

But this footnote gives away the point of the passage to which it refers. The truth is that both “static” and “dynamic” analysis are necessary in economics; that “static” analysis is a necessary preliminary to “dynamic” analysis; but that the one unforgivable sin is to confuse them in the same analysis.

One of the chief defects in Keynes’s analysis, not only in the passage quoted above but throughout the General Theory, is his failure to adhere to any fixed meanings for his terms. He plays particularly fast and loose, as we have seen already and shall see later, with his term “the marginal efficiency of capital.” The ambiguities and bad reasoning that he falls into could have been avoided by dropping this vague term completely, and substituting for it any one of half a dozen different terms, depending upon which was really appropriate to his meaning in a given context. A simpier and less vague term than “efficiency” in connection with capital is “yield.” (Keynes himself uses it as a synonym even in the passage quoted above.) Substituting this for greater clarity, we would then have several terms depending upon what we wished to say in a given context:

1. The current yield of a specific capital instrument.

2. The expected future yield of a specific capital instrument.

3. The current marginal yield of a type of capital equipment (like lathes).

4. The expected future marginal yield (over its life span, say) of a type of capital equipment.

5. The current marginal yield of capital (in general).

6. The expected future marginal yield of capital (in general).

If Keynes had consistently maintained even the distinction between terms and concepts 5 and 6 he would have avoided a host of errors. He could have done this, modifying his chosen vocabulary in only a slight degree, if instead of confusing both concepts under the common term “marginal efficiency of capital,” he had at least distinguished at all times between the current marginal efficiency of capital and the anticipated marginal efficiency of capital.

But if Keynes had been constantly careful to make such distinctions, he might not have written the General Theory at all; for the theory could not have been born without the confusions that gave rise to it.

¹ It is difficult to analyze Keynes’s theories without beginning with his own terminology and concepts. Some economists contend that there is no such thing as the “marginal efficiency (or productivity) of capital.” They admit that capital goods have marginal value but argue that capital value is derived from income value rather than the other way round. But this question will be postponed to later consideration.

² Constantino Bresciani-Turroni, The Economics of Inflation (London: Allen & Unwin, 1937), p. 360. (Italian edition, 1931.)

³ Unfortunately, as I have found, statistics giving the real lending rates of commercial banks are not easily available, and often require on-the-spot investigation in the country concerned. Official discount rates have become fictions or artifacts designed rather to conceal than to reveal the actual situation. Perhaps the comparative inaccessibility of the actual interest rates charged accounts for Keyne’s otherwise astonishing ignorance on this point.

⁴ Quoted by the First National City Bank of New York, in its monthly letter of August, 1957.