At any given time, a few Keynesian economists and Austrian economists can always be found arguing on the internet. Recently, Don Boudreaux of Cafe Hayek has clashed with Daniel Kuehn on Keynes’ “Marginal Efficiency of Capital”. This argument brings up the Keynesian view of the economic long term, making it more interesting than the usual ones.
I’m sorry, but I do believe that on matters of economics Keynes was indeed a simpleton. I offer here but one quotation, from page 220 of The General Theory, as evidence of Keynes’s simple-mindedness on matters of economics: “I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation.”
Keynes here argues that capital can be made non-scarce (and, as he puts it in the preceding paragraph, that one key to making it non-scarce is “that State action enters in as a balancing factor to provide that the growth of capital equipment shall be such as to approach saturation-point….”). These are the words of an economic simpleton ‚Äì a simpleton about the nature of capital, about the nature of scarcity and human wants, and about the nature of the state and “State action.”
Don Boudreaux is wrong.
I don’t know why these things even pass the smell test for people, but apparently they do. Does Keynes come across as a utopian? He doesn’t come across as a utopian because he’s not a utopian.
The marginal efficiency of capital is not the same thing as the marginal cost of capital or the marginal productivity of capital. Keynes defined the marginal efficiency of capital as the discount rate at which the price of capital was just equal to the present value of the stream of benefits proceeding from that capital. So the marginal efficiency of capital could be zero at a time when the marginal cost and the marginal benefit of capital were both very, very high (but equal). A high marginal cost and marginal benefit of capital, of course, means that capital is scarce. A lower marginal efficiency of capital is associated with more capital, to be sure – because a lower discount rate means more investment becomes viable, driving down the marginal benefit of capital. So certainly a more capital-rich future is part of the Keynesian vision. But “non-scarcity”? Of course not. He never says that anywhere, and the marginal efficiency of capital is not the marginal cost or the marginal productivity of capital. The point is this – since the level of investment is determined by the interest rate (through the marginal efficiency of capital – what investments are viable at what interest rates), capital owners commanded a return simply by virtue of the scarcity of capital (or – put another way – by virtue of artificially high interest rates). A low interest rate and potentially even a zero marginal efficiency of capital was Keynes’s way of separating out the rentier from the entrepreneur.
And in Keynes’s vision there were entrepreneurs. Why? Because capital is still scarce and the expertise of the entrepreneur was still needed.
Before Keynes the “Marginal Efficiency of Capital”, or MEC, wasn’t a common term. Keynes gave a definition of it in his “General Theory”, but he doesn’t just give one clear definition, as Hazlitt notes .
Keynes gives the following definition first. In this article I’ll use this definition as it seems the one preferred by Keynesians.
Over against the prospective yield of the investment we have the supply price of the capital-asset, meaning by this, not the market-price at which an asset of the type in question can actually be purchased in the market, but the price which would just induce a manufacturer newly to produce an additional unit of such assets, i.e. what is sometimes called its replacement cost . 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, 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. 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; 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.
This first thing to note is that the MEC is similar to accounting concepts used to compare the profitability of projects such as the internal rate of return and minimum acceptable rate of return. But, it isn’t the same. In any commercial calculation the starting point is the price that capital assets can be bought on the market, but the MEC doesn’t consider this. It deals in the “supply price”, which isn’t necessarily the prevailing market price.
It is simplest to discuss this initially without involving entrepreneurship…. Suppose I own a machine we’ll call the “very simple machine” (VSM) because anyone at all can operate it and maintain it. Suppose too that I bought my VSM at what Keynes calls the “supply price”. The VSM produces 1000 widgets per year and widgets sell for £100 each. The cost of my labour and inputs is £50 per widget, so I make £50 profit per widget and £50K per year. I expect my costs and the selling price will remain the same for the next 5 years and the VSM itself lasts for 5 years. Suppose that the VSM costs £220K. In this case if the interest rate is less than ~4.4% then according to my expectations of the future I will make more by buying the VSM and running it than I would from a bank account. But, if the rate of interest is greater than ~4.4% then I’ll be better off putting my £220K in a bank account and taking £50K per year. In this case the MEC for the VSM is 4.4%.
Let’s suppose that the interest rate is indeed less than 4.4%. The VSM is very simple, which means anyone can buy one and make widgets. We can suppose too that my expectations aren’t unusual — other market participants expect the same selling prices and costs as I do. In that case, others will buy VSMs and consequently they will rise in price. Since the profit opportunity is so clear here, the market price of VSMs will rise quickly to extinguish the difference between the rate of return from buying a VSM and the interest rate, Bohm-Bawerk emphasised this. But, Keynes’ MEC takes as it’s starting point the “supply price” which is “the price which would just induce a manufacturer newly to produce an additional unit of such assets”. So, if the market for widget producers becomes saturated quickly then this profits the manufacturers of VSMs instead. The price of a VSM may rise much higher than its manufacturing cost or its “supply price”. But, in this case the MEC remains high. The MEC only begins to fall if one of two things happen. Firstly, the price of inputs to the VSM manufacturers will eventually rise because of increased demand. Secondly, the price of widgets will fall because of increased supply. Keynes explicitly mentions both of these cases later. Since we are assuming that entrepreneurship isn’t an issue we must assume that building a company to manufacture the VSMs themselves is also simple, which means that market will quickly saturate too, just as the one for widgets did.
We can then think of the following situation: initially capital assets are scarce and the MEC is greater than the interest rate. Then the difference between the MEC and interest rate incentivizes producers of both investment goods and consumer goods. Output of both then rises and as it does so the MEC falls towards the interest rate.
In the quote, Boudreaux criticises Keynes’s supposition that over a long period the MEC will tend towards zero. Here is a fuller quote:
On such assumptions I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation; so that we should attain the conditions of a quasi-stationary community where change and progress would result only from changes in technique, taste, population and institutions, with the products of capital selling at a price proportioned to the labour, etc., embodied in them on just the same principles as govern the prices of consumption-goods into which capital-charges enter in an insignificant degree.
In the example above, if the interest rate is lower than the MEC of the VSMs then the market for widgets saturates and then so does the market for producing VSMs. This could then happen across all industries, but would that reduce the MEC to zero?
Here we must reach for the time-preference theory of interest. In my opinion the most defensible version of this theory is that time-preference defines a “floor” below which the interest rate can’t fall. As I understand it, this is Hayek’s interpretation in his paper “Time-Preference and Productivity: A Reconsideration” (reproduced here). In my example above I compared the interest from a bank account to the return on buying a VSM. In some ways this begs the question because it assumes that the owner of capital will invest. On the contrary, the owner of capital must be induced by the payment of interest to invest rather than consume. This means that the supply curve for capital slopes downwards like other supply curves.
It seems possible that that Keynes didn’t recognize that time-preference would determine interest rates if productivity did not. Hayek made that mistake in the first edition of “The Pure Theory of Capital”. He considered only productivity interest following Fisher and Knight. Hayek later reconsidered his position in the paper I mention above. But, even before that, Hayek’s view was that in hypothetical states of equilibrium internal rates of return and the interest rates could fall to zero and remain there, not that this was possible in the real world.
Since the supply of savings falls as interest rates fall does that mean that the supply of savings dries up if the interest rate is zero? Well, not necessarily, there a three reasons why it may not. Firstly, as Keynesians point out in their “liquidity trap” argument, it’s worth holding a money balance that earns 0% if you think that you will soon be able to invest it in something that earns more. We can agree with Keynesians about that without agreeing with the rest of the liquidity trap argument. However, this only deals with the short-run situation where the interest rate is 0% for a small period of time and it’s believed that it will rise soon. The more general question is if a situation can occur where the interest rate stays at 0% for a more extended period so we have to abandon that argument when considering the long term. The second issue is that banks supply services as well as paying interest. People put money in zero interest current accounts because doing so allows them to perform transactions more easily than they could with cash, and in most developed economies these services are free to the customer. So, there is a portion of the interest rate that is paid in services which the money interest rate doesn’t accurately represent. (For this reason most “0% interest rates” that have occurred during the crisis or in Japan have not really been 0%). Lastly, there is the issue of “intertemporal-substitution”. If all consumer goods lasted forever and could be stored for free then the interest rate could never fall to zero for a great length of time. That’s because if it did then any owners of capital could simply spend it all on consumer goods and store them. However, in the real world that may not be possible. It may be that a saver is interested in consuming services in the future, or can’t store consumer goods cheaply or at all. For that reason a saver may accept an interest rate that is zero or negative because it allows some capital to be transferred into the future that can’t be transferred there otherwise. So, even if interest rates did fall to 0%, there would be some supply of savings. I’m not convinced that this latter effect has much relevance outside exceptional situations such as war, extreme government or central bank behaviour. Though it does explain why people who have a high time-preference sometimes save.
Whether Keynes is wrong or not is a matter of interpretation. If all markets were saturated as I describe then the rate of interest may fall to a very low level, perhaps “approximately to zero”. If the economy is progressing and there is no expansion of the money supply beyond demand then prices will gradually fall with increasing productivity. In that case, even though the money rate of interest is zero, its real rate may be positive. It seems doubtful though that Keynes meant that, since he praises the beneficial effects of inflation elsewhere. I’m perhaps being too generous to Keynes here.
It may also be that what Keynes was thinking of here was something slightly different, not the MEC itself but the difference between the MEC and the rate of interest. This is an entirely different matter. At this point it’s useful to bring back entrepreneurship. We’ve assumed so far that machines and businesses are very simple and gathering expectations about them is very simple. In the real world they are far from simple, and for that reason competition doesn’t always work as quickly as I described above. A real business may require great skill to direct and may be very difficult to replicate. For this reason the internal rate of return of a business (and therefore the MEC of it’s assets) may remain above the interest rate for a long period of time. This is entrepreneurial profit and it’s necessary for economic progress.
But, an important issue for critics and supporters of capitalism is whether this is always entrepreneurial profit. It isn’t possible to answer that question concretely, but we can answer it more generally. In a particular environment we may have a market interest rate that is above the time-preference rate of the capital owning community. In that situation very few capital owners asks themselves “shall I invest what I earn tomorrow or consume it”. The interest rate is high enough that they concentrate on deciding what to invest their capital in. Of course, capital owners aren’t all the same, so we can only talk about generalities here. In this case I mean that the average time-preference (weighting each capital owner by the amount of capital they own) is far below the real market interest rate. It could be said that we have a “productivity interest” situation here. We can contrast that with the “time-preference interest” situation that prevails if capital is more plentiful and there are few business opportunities. In that case lending and borrowing occurs because different people have different time-preferences. In a hypothetical evenly-rotating economy (or general equilibrium), this is all that can happen since the definition of even rotation precludes entrepreneurship and increasing productivity. The difference between the two situations I describe is only a conceptual one; no direct empirical measurement of it can be possible because the rate of time-preference of individuals is a matter of psychology.
The MEC as Keynes defines it doesn’t really help us much with this differentiation. Keynes defines the MEC of capital in general as the greatest of the MECs of particular assets, but entrepreneurship makes this problematic. The greatest MEC will be that of a business with a unique product or production process which allows it to be exceptionally profitable and gives an exceptionally high internal rate of return. At any time or place this will apply. Giving “a generation” of Keynesian government policies as Keynes suggests can’t prevent it. Entrepreneurship always exists because new opportunities always exist. Any change in market relations creates new opportunities.
Keynes doesn’t specify any “who” in his definition of the MEC for an asset. If he means “any entrepreneur” then the previous paragraph applies. But if he means any capital owner, even someone with no knowledge of business, then things are different. Does the MEC make more sense in this case? We can suppose that an asset exists which is very easy to exploit and pays more than the interest rate. In that case the MEC for that opportunity will be high and will quickly fall as businesses and investors join in the rush to exploit it. At the beginning there will be “rentiers” who earn a quick profit without much risk* that profit will quickly disappear and it will disappear because of the market, not the government. But, as we observed above, the MEC isn’t the same as the internal rate of return because it involves the hypothetical “supply-price”. If the supplier of the asset is making a profit because the market selling price for the asset is above the minimum he would be prepared to sell it for, then the MEC remains above the interest rate even if the earnings of owners of the asset has fallen to the interest rate. However, in many situations the manufacturer of the asset will be making a profit from his or her earlier entrepreneurial decisions. So even this alternative from of the MEC would not fall to the interest rate or to zero. At least not in a real economy, and Keynes seems to be discussing a real economy, not a hypothetical case.
Is there any way that we can tell if we have “rentiers”? Personally, I can’t think of one, and certainly not one that’s measurable in practice. Keynes may not have been a utopian, but in this case, as in many others, his economic theories are careless.
 “Failure of the New Economics” p.156, Van Nostrand, 1959. This book is available in PDF from the Mises Institute, who also sell a new edition in print.
 Economica, February 1945. Reproduced as an Appendix in later editions of “The Pure Theory of Capital”.
* – Even in this case the opportunity must be spotted, which requires at least some alertness to entrepreneurial opportunities.