Levy Economics Institute of Bard College

Levy Economics
Institute
of Bard College
Policy Note
2011 / 4

WAS KEYNES’S MONETARY POLICY,

À OUTRANCE IN THE TREATISE,
A FORERUNNER OF ZIRP AND QE?
DID HE CHANGE HIS MIND IN THE
GENERAL THEORY?
 

Introduction. Keynes’s Challenge: ZIRP and QE

At the end of 1930, as the 1929 US stock market crash was starting to have an impact on the real
economy in the form of falling commodity prices, falling output, and rising unemployment, John
Maynard Keynes, in the concluding chapters of his Treatise on Money, launched a challenge to
monetary authorities to take “deliberate and vigorous action” to reduce interest rates and reverse
the crisis. He argues that until “extraordinary,” “unorthodox” monetary policy action “has been
taken along such lines as these and has failed, need we, in the light of the argument of this trea-
tise, admit that the banking system can not, on this occasion, control the rate of investment, and,
therefore, the level of prices” (Keynes 1930a, 387).1 The “unorthodox” policies that Keynes recom-
mends are a nearly perfect description of the Japanese central bank’s experiment with a zero inter-
est rate policy (ZIRP) in the 1990s and the Federal Reserve’s experiment with ZIRP, accompanied by
quantitative easing (QE1 and QE2), during the recent crisis. These experiments may be considered

Senior Scholar   is director of the Institute’s Monetary Policy and Financial Structure program, and a professor at Tallinn
Technical University. This paper was originally presented at “Whither the Capitalist World? Dialogue in ‘Keynes’s Spirits,’” 7th International
Keynes Conference at Sophia (IKCS), Sophia University, Tokyo, Japan, March 1–2, 2011.

The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discus-
sion on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the author.

Copyright © 2011 Levy Economics Institute of Bard College

a response to Keynes’s challenge, and to provide a clear test of The Treatise and the Alternative Determination
his belief in the power of monetary policy to counter financial of Prices
crisis. That response would appear to be a clear No. Keynes’s position is built on the explanation of price determi-
nation that he had attempted to provide as an alternative to the
traditional quantity theory. His approach was based on the for-
The Objectives of Monetary Policy mulation of “fundamental equations” for the prices of what he
In the penultimate chapter of volume 2 of the Treatise, Keynes called “available” and “non-available” output: “We have claimed
raises the question of the ability of the monetary authority to to prove in this treatise that the price level of output depends on
influence the price level: “I reach at last the crux of the whole the level of money incomes relatively to efficiency, on the vol-
matter. We have endeavoured to analyse and to classify the mul- ume of investment (measured in cost of production) relatively
tifarious factors which determine the price level and the means to saving, and on the ‘bearish’ or ‘bullish’ sentiment of capital-
by which the central bank in a closed system, or the aggregate ists relatively to the supply of savings deposits available in the
behaviour of central banks throughout the world, can influence banking system. We have claimed, further, that the banking sys-
and dominate the behaviour of the banking and monetary sys- tem can control the supply of savings deposits, and hence the
tem as a whole. But when all is said and done, does it lie within third factor; that it can by the terms of credit influence to any
the power of a central bank in actual practice to pursue a pol- required extent the volume of investment, and hence the second
icy which will have the effect of fixing the value of money at any factor; and that the indirect effects of its influence on the vol-
prescribed level?” (339). ume of investment determine the money offers which entrepre-
Keynes confronts this question in the context of setting the neurs make to the factors of production, and hence the first
central bank the legal “duty of preserving the purchasing power factor. But we have not claimed that the banking system can
of money within narrow limits” (ibid.). While he indicates that produce any of these effects instantaneously; or that it can be
he had formerly been favorably disposed to such a proposition, expected always to foresee the operation of non-monetary fac-
he notes that the “reasonable doubts expressed by persons of tors in time to take measures in advance to counteract their
great experience” (345) had tested his resolve. He refers in par- influence on prices; or that it can avoid violent fluctuations in
ticular to committee hearings held in the United States on the the prices of different classes of commodities relatively to one
issue of whether the Federal Reserve Act should be amended “to another; or that a central bank, which is a member of an inter-
lay upon the Federal Reserve Board the duty of using all the national system, can preserve domestic stability irrespective of
powers at its disposal to ‘promote a stable price level for com- the behavior of other central banks” (345–46).
modities in general’” (340). In particular, the hearings raised In simple terms, Keynes argued that prices would be deter-
the question of how international conditions impact commod- mined by unit labor costs (efficiency wages) and the pressure of
ity prices, and thus domestic prices, and the difficulty of using demand (caused by a divergence of savings from investment).
monetary policy to counter declining prices in a depression. The focus of recovery policy should thus be to increase invest-
Despite his doubts, Keynes nonetheless answers his own ment in order to drive up the demand for output, absorbing
question in the affirmative, urging central bankers to adopt excess production and encouraging entrepreneurs to again
extraordinary, unorthodox measures in an attempt to counter expand employment and production. Keynes points out that
the deepening recession. His proposals are virtually identical to his approach is substantially different from that of the quantity
the measures that were taken by the Bank of Japan in counter- theorists, in that there is no direct impact of money on prices.
ing the collapse of asset prices in the 1990s and the policies Indeed, he notes the opposition that they might raise against his
adopted by the Federal Reserve in response to the financial approach: that it would generate inflation rather than recovery
crash of 2007–08. of output.
Keynes’s conclusions regarding the limitations of the bank-
ing system’s ability to control the price level include:

4 Policy Note, 2011/4 2

• It is much easier to preserve stability than to restore it economist Winfield William Riefler (1930), who drew on statis-
quickly. tical studies by the Federal Reserve Board to show that ”’all the
important movements in short-term rates from 1919 to 1928
• Nonmonetary causes of instability may sometimes
were reflected in bond yields. Minor fluctuations in short-term
arise so suddenly that it is impossible to counteract
rates were also frequently reflected in bond yields, even in the
them in time.
years 1921 and 1926’”(quoted in ibid.). Riefler observes that,
• Strong social or political forces may cause sponta- “‘the surprising fact is not that bond yields are relatively stable
neous changes in the money rates of efficiency wages, in comparison with short-term rates, but rather that they have
and thus the control of the price level may pass beyond reflected fluctuations in short-term rates so strikingly and to
the power of the banking system. such a considerable extent’” (ibid., 355–56).2
Keynes then outlines the reasons why these results shouldn’t
• If the country adheres to an international standard
be surprising:
that is itself unstable, it is, of course, impossible to pre-
serve the stability of the domestic price level. Thus,
(a) If the running yield on bonds is greater than the
even if the banking system is strong enough to pre-
rate payable in short-term loans, a profit is obtainable
serve the stability of the price level, it does not follow
by borrowing short in order to carry long-term secu-
that it is strong enough both to alter the price level and
rities, so long as the latter do not actually fall in value
to establish equilibrium at the new level without long
during the currency of the loan. . . .
delays and frictions.
(b) There are a number of financial institutions . . .
“In short,” says Keynes, “I should attribute to the banking which vary from time to time the proportionate divi-
system much greater power to preserve investment equilibrium sion of their assets between long-term and short-term
than to force the prevailing rate of money incomes away from securities respectively. Where short-term yields are
the existing level or from the level produced by spontaneous high, the safety and liquidity of short-term securities
changes, to a new and changed level imposed by conditions appear extremely attractive. But when short-term
abroad or by arbitrary decree at home” (352). yields are very low, not only does this attraction disap-
pear, but another motive enters in, namely, a fear lest
the institution may be unable to maintain its estab-
Short-Term and Long-Term Rates of Interest lished level of income, any serious falling off in which
A major difficulty that Keynes recognizes in his reasoning is would be injurious to its reputation. A point comes,
that “the main direct influence of the banking system is over the therefore, when they hasten to move into long-dated
short-term rate of interest. But when it is a question of control- securities; the movement itself sends up the price of
ling the rate of investment, not in working capital but in fixed the latter; and this movement seems to confirm the
capital, it is the long-term rate of interest which chiefly matters. wisdom of those who were recommending the policy
How can we be sure that the long-term rate of interest will of the changeover. Thus, unless there is a serious rea-
respond to the wishes of the currency authority which will be son in the minds of the majority of those controlling
exerting its direct influence, as it must, mainly on the short- funds for positively fearing long-term securities at
term rate?” (ibid.). their existing price level, this price will tend to rise a
But he does not consider this a real problem, since “experi- little, and the initial small price will tend to become a
ence shows that, as a rule, the influence of the short-term rate bigger one through its increasing the general anxiety
of interest on the long-term rate is much greater than anyone amongst those who cannot afford to see their income
who argued on the above lines would have expected. We shall from running yield suffer a serious fall, lest they miss
find, moreover, that there are some sound reasons, based on the the bus. (357–58)
technical character of the market, why it is not unnatural that
this should be so” (353). Keynes cites the work of the American

Levy Economics Institute of Bard College 3

 In addition to these “technical reasons,” Keynes raises an Short-Term Money: Quantity Is as Important
issue that would take on greater importance in the General as Price
Theory: the predominant impact of short-term realizations on Having established the importance of the short term in formu-
long-term expectations. “In truth,” he writes, “we know almost lating long-term expectations, and thus the possibility that
nothing about the more remote future. . . . The value of a com- short-term interest rates could be used to influence long-term
pany’s shares, and even of its bonds, will be found to be sensi- capital investment decisions, Keynes goes on to admit, “I do not
tive to a degree, which a rational observer from outside might believe . . . that the volume of investment either in working cap-
consider quite absurd, to short-period fluctuations in its known ital or in liquid capital is sensitive to changes in the short-term
or anticipated profits. . . . rate of interest by itself and unless these changes create an
“Nor need we be surprised. The ignorance of even the best- expectation of changes in prices. Fluctuations in the volume of
informed investor about the more remote future is much investment in working and liquid capital play a large part, of
greater than his knowledge, and he cannot but be influenced to course, in the accentuation of booms and depressions; but I
a degree which would seem wildly disproportionate to anyone doubt if they can be either caused or avoided merely by changes
who really knew the future, by the little which he knows for cer- of bank rate. They generally represent a belated response to
tain, or almost for certain, about the recent past and the near changes in the price level which have been brought about by an
future, and be forced to seek a clue mainly here to trends fur- unbalanced volume of investment in fixed capital. . . .
ther ahead. But if this is true of the best informed, the vast “Such effects as can be produced directly on the willingness
majority . . . know almost nothing whatever about what they are to invest in working in liquid capital are attributable, I think,
doing. They do not possess even the rudiments of what is rather to the greater or less degree in which the fringe of ‘unsat-
required for a valid judgment, and are the prey of hopes and isfied’ borrowers . . . is satisfied than to the cheapness or dear-
fears easily aroused by transient events and as easily dispelled. ness of money in itself.
This is one of the odd characteristics of the capitalist system “On the other hand, the direct effects of cheap money
under which we live, which, when we are dealing with the real operating through changes, even small ones, in the bond mar-
world, is not to be overlooked. ket . . . on the volume of new investment is probably of more
“But there is also a further reason why it may often profit importance. Willingness to invest more or less in manufactur-
the wisest to anticipate mob psychology rather than the real ing plant is not likely to be very sensitive to small changes in
trend of events, and to ape reason proleptically. For the value of bond rate” (364).
a security is determined, not by the terms on which one could
expect to purchase the whole block of the outstanding interest,
but by the small fringe which is the subject of actual dealing; Extraordinary Measures: ZIRP and QE
just as current new investment is only a small fringe on the edge But Keynes goes on: “So far we have been dealing with the nor-
of the totality of existing investments. Now this fringe is largely mal and orthodox methods by which a central bank can use its
dealt in by professional financiers—speculators you may call powers for easing (or stiffening) the credit situation to stimu-
them—who have no intention of holding the securities long late (or retard) the rate of new investment. If these measures are
enough for the influence of distant events to have its effect; applied in the right degree and at the right time, I doubt
their object is to re-sell to the mob after a few weeks or at most whether it would often be necessary to go beyond them or to
a few months. It is natural, therefore, that they should be influ- apply the extraordinary methods next to be considered. It is
enced by the cost of borrowing, and still more by their expecta- only, that is to say, if the milder remedies have not been applied
tions on the basis of past experience of the trend of mob in time, so that conditions of acute slump or boom have been
psychology. Thus, so long as the crowd can be relied on to act in allowed to develop, that more extreme measures will have to
a certain way, even if it be misguided, it will be to the advantage be invoked and that doubts may be reasonably entertained
of the better-informed professional to act in the same way—a whether even these more extreme measures will be wholly
short period ahead” (359–61). efficacious.

Policy Note, 2011/4 4

 “These extraordinary methods are, in fact, no more than an ceeds liquid at a very low rate of interest. If (e.g.) the long-term
intensification of the normal procedure of open-market operations rate is 3 per cent per annum above the short-term rate, this
[emphasis added]. I do not know of any case in which the means that the mathematical expectation for bond prices in the
method of open-market operations has been carried out à out- minds of such persons is for a fall of 3 per cent per annum; and
rance. Central banks have always been too nervous hitherto— at that and at a time when bond prices are in fact rising and the
partly, perhaps under the influence of crude versions of the central bank is accentuating the cheapness of money, there is
quantity theory—of taking measures which would have the not likely to be a large volume of such selling—unless the price
effect of causing the total volume of bank money to depart of bonds has been driven to a level which is generally believed
widely from its normal value, whether in excess or in defect. But to be quite excessive from the long-period point of view, a con-
this attitude of mind neglects, I think, the part which the ‘bull- tingency and a limiting factor to the consideration of which we
ishness’ or ‘bearishness’ of the public plays in the demand for will return shortly. If the effect of such measures is to raise the
bank money; it forgets the financial circulation in its concern price of ‘equities’ (e.g., ordinary shares) more than the price of
for the industrial circulation, and overlooks the statistical fact bonds, no harm in a time of slump will result from this; for
that the former may be quite as large as the latter and much investment can be stimulated by its being unusually easy to
more capable of sharp variation. . . . On such occasions the cen- raise resources by the sale of ordinary shares as well as by high
tral bank should carry its open-market operations to the point bond prices. Moreover, a very excessive price for equities is not
of satisfying to saturation the desire of the public to hold sav- likely to occur at a time of depression and business losses.
ings deposits, or of exhausting the supply of such deposits in “Thus I see small reason to doubt that the central bank can
the contrary case. produce a large effect on the cost of raising new resources for
“The risk of bringing to bear too rapidly and severely on long-term investment, if it is prepared to persist with its open-
the industrial circulation, when it is the financial circulation market policy far enough. What, however, are in practice the fac-
which is being aimed at, is greater, I think in the case of a con- tors limiting the degree in which it can push such a policy home?
traction of credit than in the case of an expansion. But, on the “There is, first of all, the question of the sufficiency of its
other hand, it is less likely to be necessary to resort to extreme ‘ammunition,’ i.e., of its power to go on buying or selling in ade-
measures to check a boom than to check a slump. . . . quate quantity securities of the suitable kind. The lack of suit-
“My remedy in the event of the obstinate persistence of the able ammunition is more likely to hamper a central bank when
slump would consist, therefore, in the purchase of securities by it is seeking to contract the volume of bank money than when
the central bank until the long-term market rate of interest has it is seeking to expand it, since its stock of securities at the com-
been brought down to the limiting point, which we shall have mencement of its contraction policy is necessarily limited. But
to admit a few paragraphs further on. It should not be beyond it also operates, in a sense, against an expansionist policy, since
the power of a central bank (international complications apart) a central bank is generally limited in the type of securities
to bring down the long-term market-rate of interest to any fig- which it purchases, so that, if it continues such purchases
ure at which it is itself prepared to buy long-term securities. For beyond a certain point, it may create an entirely artificial posi-
the bearishness of the capitalist public is never very obstinate, tion in them relatively to other securities. It is to provide against
and when the rate of interest on savings deposits is next door to the contingency of insufficient ammunition for the carrying on
nothing the saturation point can fairly soon be reached. If the of open-market operations à outrance that I have suggested . . .
central bank supplies the member banks with more funds than that the central bank should have power to vary within limits
they can lend at short term, in the first place the short-term rate the reserve requirements of its member banks” (369–72).
of interest will decline towards zero, and in the second place the Keynes then notes that if the central bank may be purchas-
member banks will soon begin, if only to maintain their prof- ing securities at rates “far beyond what it considers to be the long-
its, to second the efforts of the central bank by themselves buy- term norm . . . this will mean that these purchases, when in due
ing securities. This means that the price of bonds will rise until course they have to be reversed by sales at a later date, may show
there are many persons to be found who, as they see the prices a serious financial loss. . . .
of long-term bonds rising, prefer to sell them and hold the pro-

Levy Economics Institute of Bard College 5

 “We might perhaps expect the central bank, as representing rate, was accurate. In addition, we have experienced the recov-
the public interest, to be ready to run the risks of the future ery of stock prices that Keynes expected.
prospects when private interest reckons these risks to be unusu- What has not been borne out is the expected impact on the
ally high. But the choice may conceivably lie between assuming rate of investment. Businesses have indeed increased their bor-
the burden of a prospective loss, allowing the slump to con- rowing, and the spread between corporate junk bonds has fallen
tinue, and socialistic action, by which some official body steps to near-historic lows as companies seek to borrow at historically
into the shoes which the feet of the entrepreneurs are too cold low interest rates. However, these funds are not being used to
to occupy.3 finance new investment. Similarly, banks have accumulated
“I would repeat, however, that these extreme situations are record levels of reserves in their deposit accounts at the Fed,
not likely to arise except as a result of some previous mistake earning the short-term interest rate, which is nearly zero. Thus,
which has prevented the slumping tendency from being reme- the policy has been successful in influencing the interest rate in
died at an earlier stage before so complete a lack of confidence the way Keynes predicted, but it has not had the impact on
had sapped the spirits and the energies of enterprise” (373). investment that he outlined in the Treatise.
“A partial recovery, therefore, is to be anticipated merely
through the elapse of time and without the application of pur-
poseful remedies. But if my diagnosis is correct, we cannot hope A Shift of Position in the General Theory?
for a complete or lasting recovery until there has been a very Keynes maintained his belief in the efficacy of monetary policy
great fall in the long-term market rate of interest throughout at least until September 1932, when he writes in the Economic
the world towards something nearer pre-war levels. Failing this, Journal, “A reduction of the long-term rate of interest to a low
there will be a steady pressure towards profit deflation and a level is probably the most necessary of all measures if we are to
sagging price level” (384). Thus, Keynes concludes, without escape from the slump and secure a lasting revival of enter-
extraordinary policies, “the thing will never cure itself by the prise” (Keynes 1932, 415). However, his position changed with
lack of borrowers forcing down the rate; for it absorbs just as his development of the General Theory.
much savings to finance losses as to finance investment” (ibid.). Keynes tells his readers that one of the basic differences
“The remedy should come, I suggest, from a general recogni- between it and the earlier book is the separation of the analysis
tion that the rate of investment need not be beyond our control, of investment in financial assets and capital assets through the
if we are prepared to use our banking systems to effect a proper separation of their determinants via liquidity preference and
adjustment of the market rate of interest. It might be sufficient the marginal efficiency of capital. While the Treatise made a dis-
merely to produce a general belief in the long continuance of a tinction between industrial and financial circulation, the prices
very low rate of short-term interest. The change, once it has of both assets and liabilities were treated in a single fundamen-
begun, will feed on itself ” (386). tal price equation and financed by the financial circulation.
It would appear that the Bank of Japan, by introducing a In his new analysis in the General Theory, Keynes states that
zero interest rate policy, experimented with Keynes’s recom- “current investment will depend . . . on what we shall call the
mendation that interest rates be set as low as possible, and that inducement to invest; and the inducement to invest will be
the Federal Reserve, through its program of quantitative lend- found to depend on the relation between the schedule of the
ing, has followed his recommendation in full by purchasing marginal efficiency of capital and the complex of rates of inter-
long-term securities to bring down the long-term rate of inter- est on loans of various maturities and risks” (Keynes 1936, 27).
est and satiate the desire to hold deposits. Keynes notes that “The schedule of the marginal efficiency of capital may be said to
these policies are not at all different from normal open-market govern the terms on which loanable funds are demanded for the
policies, and that the central bank possesses the power to set any purpose of new investment; whilst the rate of interest governs the
interest rate, short or long, at any level it desires. It also appears terms on which funds are being currently supplied” (165).
as if Keynes’s expectation that the public would become willing Another novel feature of the General Theory is its emphasis
buyers of government securities upon a sharp reduction in on the conditions of a monetary economy as “one in which
short rates, thereby aiding the policy of lowering the long-term changing views about the future are capable of influencing the

Policy Note, 2011/4 6

quantity of employment and not merely its direction” (ibid., instinct; whilst he who has it must pay to this propensity the
vii). In particular, Keynes notes that the major determinant of appropriate toll. Furthermore, an investor who proposes to
the rate of interest will be “largely governed by the prevailing ignore near-term market fluctuations needs greater resources
view as to what its value is expected to be” (203), while “the for safety and must not operate on so large a scale, if at all, with
schedule of the marginal efficiency of capital is of fundamental borrowed money—a further reason for the higher return from
importance because it is mainly through this factor (much the pastime to a given stock of intelligence and resources.
more than through the rate of interest) that the expectation of Finally it is the long-term investor, he who most promotes the
the future influences the present”(145). public interest, who will in practice come in for most criticism,
Echoing his views in the Treatise, he writes: “It would be wherever investment funds are managed by committees or
foolish, in forming our expectations, to attach great weight to boards or banks. For it is in the essence of his behaviour that he
matters which are very uncertain. It is reasonable, therefore, to should be eccentric, unconventional and rash in the eyes of
be guided to a considerable degree by the facts about which we average opinion. If he is successful, that will only confirm the
feel somewhat confident, even though they may be less deci- general belief in his rashness; and if in the short run he is
sively relevant to the issue than other facts about which our unsuccessful, which is very likely, he will not receive much
knowledge is vague and scanty. For this reason the facts of the mercy. Worldly wisdom teaches that it is better for reputation to
existing situation enter, in a sense disproportionately, into the fail conventionally than to succeed unconventionally” (157).
formation of our long-term expectations; our usual practice As a result, Keynes modifies his prior belief in the positive
being to take the existing situation and to project it into the impact of lower interest rates on the rate of investment. For
future, modified only to the extent that we have more or less example, “an expectation of a future fall in the rate of interest
definite reasons for expecting a change. will have the effect of lowering the schedule of the marginal effi-
“The state of long-term expectation, upon which our deci- ciency of capital; since it means that the output from equip-
sions are based, does not solely depend, therefore, on the most ment produced to-day will have to compete during part of its
probable forecast we can make. It also depends on the confidence life with the output from equipment which is content with a
with which we make this forecast—on how highly we rate the lower return. This expectation will have no great depressing
likelihood of our best forecast turning out quite wrong. If we effect, since the expectations, which are held concerning the
expect large changes but are very uncertain as to what precise complex of rates of interest for various terms which will rule in
form these changes will take, then our confidence will be weak. the future, will be partially reflected in the complex of rates of
“The state of confidence . . . is a matter to which practical interest which rule to-day. Nevertheless there may be some
men always pay the closest and most anxious attention” because depressing effect, since the output from equipment produced
of “its important influence on the schedule of the marginal effi- to-day, which will emerge towards the end of the life of this
ciency of capital. There are not two separate factors affecting equipment, may have to compete with the output of much
the rate of investment, namely, the schedule of the marginal younger equipment which is content with a lower return because
efficiency of capital and the state of confidence. The state of of the lower rate of interest which rules for periods subsequent to
confidence is relevant because it is one of the major factors the end of the life of equipment produced to-day” (143).
determining the former” (148–49). Thus, “there is no clear evi- Keynes also modifies his position on the ability of the cen-
dence from experience that the investment policy which is tral bank to influence the lending practices of financial institu-
socially advantageous coincides with that which is most prof- tions through a reduction in interest rates: “So far we have had
itable. It needs more intelligence to defeat the forces of time and chiefly in mind the state of confidence of the speculator or
our ignorance of the future than to beat the gun. Moreover, life speculative investor himself and may have seemed to be tacitly
is not long enough;—human nature desires quick results, there assuming that, if he himself is satisfied with the prospects, he has
is a peculiar zest in making money quickly, and remoter gains unlimited command over money at the market rate of interest.
are discounted by the average man at a very high rate. The game This is, of course, not the case. Thus we must also take account
of professional investment is intolerably boring and overexact- of the other facet of the state of confidence, namely, the confi-
ing to anyone who is entirely exempt from the gambling dence of the lending institutions towards those who seek to

Levy Economics Institute of Bard College 7

borrow from them, sometimes described as the state of credit. disturbing effect on confidence; so a moderate reduction in
A collapse in the price of equities, which has had disastrous money-wages may prove inadequate, whilst an immoderate
reactions on the marginal efficiency of capital, may have been reduction might shatter confidence even if it were practicable.
due to the weakening either of speculative confidence or of the “There is, therefore, no ground for the belief that a flexible
state of credit. But whereas the weakening of either is enough to wage policy is capable of maintaining a state of continuous full
cause a collapse, recovery requires the revival of both. For whilst employment;—any more than for the belief that an open-market
the weakening of credit is sufficient to bring about a collapse, its monetary policy is capable, unaided, of achieving this result.
strengthening, though a necessary condition of recovery, is not The economic system cannot be made self-adjusting along
a sufficient condition” (158). these lines” (267).
Further, Keynes argues that there may be difficulty in Although Keynes continues to maintain that the “short-
pushing interest rates down to extremely low levels: “We have term rate of interest is easily controlled by the monetary
seen . . . that uncertainty as to the future course of the rate of inter- authority, both because it is not difficult to produce a convic-
est is the sole intelligible explanation of the type of liquidity- tion that its policy will not greatly change in the very near
preference . . . which leads to the holding of cash. . . . It follows future, and also because the possible loss is small compared
that . . . what matters is not the absolute level of r [rate of inter- with the running yield (unless it is approaching vanishing
est] but the degree of its divergence from what is considered a point),” he also observes that “the long-term rate may be more
fairly safe level of r, having regard to those calculations of prob- recalcitrant when once it has fallen to a level which, on the basis
ability which are being relied on. . . . Every fall in r reduces the of past experience and present expectations of future monetary
market rate relatively to the ‘safe’ rate and therefore increases policy, is considered ‘unsafe’ by representative opinion. For
the risk of illiquidity; and, in the second place, every fall in r example, in a country linked to an international gold standard,
reduces the current earnings from illiquidity, which are avail- a rate of interest lower than prevails elsewhere will be viewed
able as a sort of insurance premium to offset the risk of loss on with a justifiable lack of confidence; yet a domestic rate of inter-
capital account, by an amount equal to the difference between est dragged up to a parity with the highest rate (highest after
the squares of the old rate of interest and the new. For example, allowing for risk) prevailing in any country belonging to the
if the rate of interest on a long-term debt is 4 per cent, it is international system may be much higher than is consistent
preferable to sacrifice liquidity unless on a balance of probabil- with domestic full employment” (203).
ities it is feared that the long-term rate of interest may rise faster Thus, the influence of capital’s marginal efficiency on the
than by 4 per cent of itself per annum, i.e. by an amount greater rate of investment (independent of the rate of interest) and
than 0.16 per cent per annum. If, however, the rate of interest is liquidity preference as the (independent) determinant of the
already as low as 2 per cent, the running yield will only offset a rate of interest leads Keynes to modify his Treatise analysis of
rise in it of as little as 0.04 per cent per annum. This, indeed, is the impact of “extraordinary” monetary policy on the long-
perhaps the chief obstacle to a fall in the rate of interest to a very term rate of interest: “A monetary policy which strikes public
low level [emphasis added]. Unless reasons are believed to exist opinion as being experimental in character or easily liable to
why future experience will be very different from past experi- change may fail in its objective of greatly reducing the long-
ence, a long-term rate of interest of (say) 2 per cent leaves more term rate of interest, because M2 [speculative funds] may tend
to fear than to hope, and offers, at the same time, a running to increase almost without limit in response to a reduction of r
yield which is only sufficient to offset a very small measure of below a certain figure. The same policy, on the other hand, may
fear” (201–02). prove easily successful if it appeals to public opinion as being
Keynes also notes that the classical theory proposed an reasonable and practicable and in the public interest, rooted in
alternative method of lowering the rate of interest, by “reducing strong conviction, and promoted by an authority unlikely to be
wages, whilst leaving the quantity of money unchanged. . . . Just superseded”(ibid.).
as a moderate increase in the quantity of money may exert an In the General Theory, Keynes, “after giving full weight to
inadequate influence over the long-term rate of interest, whilst the importance of the influence of short-period changes in the
an immoderate increase may offset its other advantages by its state of long-term expectation as distinct from changes in the

Policy Note, 2011/4 8

rate of interest,” further modifies his belief in the efficacy of 2. Keynes does not, however, report Riefler’s caveat that this is
monetary policy to influence the rate of investment, noting that more the result of the impact on the stock of existing long-
“we are still entitled to return to the latter [i.e., the rate of inter- terms bonds than on the prices of newly issued long-term
est] as exercising, at any rate, in normal circumstances, a great, securities; see Riefler 1930, 123.
though not a decisive, influence on the rate of investment. Only 3. In Keynes 1932, he notes that “in the United States the fear
experience, however, can show how far management of the rate of the Member Banks lest they should be unable to cover
of interest is capable of continuously stimulating the appropri- their expenses” may have provided “an obstacle to the
ate volume of investment” (164). He then goes on to state: “For adoption of a wholehearted cheap money policy”
my own part I am now somewhat sceptical of the success of a (421–22).
merely monetary policy directed towards influencing the rate of
interest. I expect to see the State, which is in a position to calcu-
late the marginal efficiency of capital-goods on long views and References
on the basis of the general social advantage, taking an ever Keynes, J. M. 1930a. A Treatise on Money, Vol. II: The Applied
greater responsibility for directly organising investment; since it Theory of Money. London: Macmillan.
seems likely that the fluctuations in the market estimation of ———. 1930b. ”Monetary Policy Alone Will Not End
the marginal efficiency of different types of capital, calculated Depression.” The Nation, May 10.
on the principles I have described above, will be too great to be ______. 1932. “A Note on the Long-Term Rate of Interest in
offset by any practicable changes in the rate of interest” (ibid.). Relation to the Conversion Scheme.” The Economic
While Keynes can be considered the true father of the Journal 42, no. 167 (September): 415–23
unorthodox monetary policies introduced by the Bank of Japan ———. 1936. The General Theory of Employment, Interest and
and the Federal Reserve, these policies also meet the test of their Money. London: Macmillan.
efficacy that Keynes called for. They suggest that Keynes’s Riefler, W. W. 1930. Money Rates and Money Markets in the
Treatise optimism was misplaced, and that his more nuanced United States. New York and London: Harper & Brothers.
position in the General Theory was more appropriate; in partic-
ular, his emphasis on the need to provide an external source of
demand through government expenditure. Finally, in compari-
son with the current period, Keynes did not take into account
the impact of capital loss on the inducement to invest and the
propensity to consume, factors that in all likelihood would have
led him to place even greater emphasis on the role of govern-
ment spending in bringing about recovery.

Notes
1. Keynes had expressed this view as early as May 1930, in an
article in the Nation that reflects the conclusions of the
Treatise: “The fact is—a fact not yet recognized by the great
public—that we are now in the depths of a very severe
international slump, a slump which will take its place in
history amongst the most acute ever experienced. It will
require not merely passive movements of bank rates to lift
us out of a depression of this order, but a very active and
determined policy” (Keynes 1930b, n.p.).

Levy Economics Institute of Bard College 9