Weekend Reading: John Maynard Keynes (1937): How to Avoid a Slump

I. The Problem of the Steady Level

It is clear that by painful degrees we have climbed out of the
slump. It is also clear that we are well advanced on the upward
slopes of prosperity I will not say 'of the boom', for 'boom'
is an opprobrious term, and what we are enjoying is desirable.
But many are already preoccupied with what is to come. It is
widely agreed that it is more important to avoid a descent into
another slump than to stimulate (subject to an important
qualification to be mentioned below) a still greater activity than
we have. This means that all of us���politicians, bankers,
industrialists, and economists���are faced with a scientific problem which we have never tried to solve before.

I emphasise that point. Not only have we never solved it; we
have never tried to. Not once. The booms and slumps of the
past have been neither courted nor contrived against. The action
of central banks has been hitherto an almost automatic response
to the unforeseen and undesigned impact of outside events. But
this time it is different. We have entirely freed ourselves���this
applies to every party and every quarter���from the philosop[hy
of the laissez-faire state. We have new means at our disposal
which we intend to use. Perhaps we know more. But chiefly it
is a general conviction that the stability of our institutions
absolutely requires a resolute attempt to apply what perhaps we
know to preventing the recurrence of another steep descent. I
should like to try, therefore, to reduce a complicated problem
to its essential elements.

It is natural to interject that it is premature to abate our efforts
to increase employment so long as the figures of unemployment
remain so large. In a sense this must be true. But I believe that
we are approaching, or have reached, the point where there is
not much advantage in applying a further general stimulus at
the centre. So long as surplus resources were widely diffused
between industries and localities it was no great matter at what
point in the economic structure the impulse of an increased
demand was applied. But the evidence grows that���for several
reasons into which there is no space to enter here���the economic
structure is unfortunately rigid, and that (for example) building
activity in the home counties is less effective than one might have
hoped in decreasing unemployment in the distressed areas. It
follows that the later stages of recovery require a different
technique. To remedy the condition of the distressed areas, ad hoc measures are necessary. The Jarrow marchers were, so to
speak, theoretically correct. The Government have been wrong
in their reluctance to accept the strenuous ad hoc measures
recommended by those in close touch with the problem.

Nevertheless a change of policy in the right direction seems to
be imminent. We are in more need today of a rightly distributed
demand than of a greater aggregate demand; and the Treasury
would be entitled to economise elsewhere to compensate for the
cost of special assistance to the distressed areas. If our
responsibility in this direction could be thus disposed of we
could concentrate with a clear mind on our central problem of
how to maintain a fairly steady level of sustained prosperity.

Why is it that good times have been so intermittent? The
explanation is not difficult. The public, especially when they are
prosperous, do not spend the whole of their incomes on current
consumption. It follows that the productive activities, from
which their incomes are derived, must not be devoted to
preparing for consumption in any greater proportion than that
in which the corresponding incomes will be spent on
consumption; since, if they are, the resulting goods cannot be sold at
a profit and production will have to be curtailed. If when
incomes are at a given level the public consume, let us say,
nine-tenths of their incomes, the productive efforts devoted to
consumption goods cannot be more than nine times the efforts
devoted to investment, if the results are to be sold without loss.

Thus it is an indispensable condition of a stable increased in
incomes that the production of investment goods (which must
be interpreted in a wide sense so as to include working capital;
and also relief works and armaments if they are paid for by
borrowing) should advance pari passu and in the right
proportion. Otherwise the proportion of income spent on consumption
will be less than the proportion of income earned by producing
consumption goods, which means that the receipts of the
producers of consumption goods will be less than their costs,
so that business losses and a curtailment of output will ensue.

 

Difficulty of 'planning': Now there are several reasons why the production of investment
goods tends to fluctuate widely, and it is these fluctuations which
cause the fluctuations, first of profits, then of general business
activity, and hence of national and world prosperity. The
sustained enjoyment of prosperity requires as its condition that
as near as possible the right proportion of the national resources,
neither too much nor too little, should be devoted to active
investment (interpreted, as I have indicated, in a wide sense).
The proportion will be just right if it is the same as the
proportion of their incomes which the community is disposed
to save when the national resources of equipment and labour
are being fully employed.

There is no reason to suppose that there is 'an invisible hand',
an automatic control in the economic system which ensures of
itself that the amount of active investment shall be continuously
of the right proportion. Yet it is also very difficult to ensure it
by our own design, by what is now called 'planning.' The best
we can hope to achieve is to use those kinds of investment which
it is relatively easy to plan as a make-weight, bringing them in
so as to preserve as much stability of aggregate investment as
we can manage at the right and appropriate level. Three years
ago it was important to use public policy to increase investment.
It may soon be equally important to retard certain types of
investment, so as to keep our most easily available ammunition
in hand for when it is more require.

The longer the recovery has lasted, the more difficult does
it become to maintain the stability of new investment. Some of
the investment which properly occurs during a recovery is, in
the nature of things, non-recurrent; for example, the increase
in working capital as output increases and the provision of
additional equipment to keep pace with the improvement of
consumption. Another part becomes less easy to sustain, not
because saturation point has been reached, but because with
each increase in our stock of wealth the profit to be expected
from a further increase declines. And, thirdly, the abnormal
profits obtainable, during a too rapid recovery of demand, from
equipment which is temporarily in short supply is likely to lead
to exaggerated expectations from certain types of new
investment, the disappointment of which will bring a subsequent
reaction. Experience shows that this is sure to occur if aggregate
investment is allowed to rise for a time above the normal proper
proportion. We can also add that the rise in stock exchange
values consequent on the recovery usually leads to a certain
amount of expenditure paid for, not out of current income, but
out of stock exchange profits, which will cease when values cease
to rise further. It is evident, therefore, what a ticklish business
it is to maintain stability. We have to be preparing the way for
an increase in sound investments of the second type which have
not yet reached saturation point, to take the place in due course
of the investment of the first type which is necessarily
non-current, while at the same time avoiding a temporary
overlap of investments of the first and second types liable to
increase aggregate investment to an excessive figure, which by
inflating profits will induce unsound investment of the third type
based on mistaken expectations.

Having made these general observations, let us examine the
opportunities for putting them into practice:

 

II. 'Dear' Money: The Right Time for Austerity

In one respect we are better placed than ever before. On
previous occasions a shortage of cash has nearly always played
a significant part in turning the boom into the slump. Prices and
wages are sure to rise somewhat with an increase in output. Nor
is there anything wrong in that; for it is to her sharply
distinguished from the so-called 'vicious spiral' which attended
the post-war currency inflations. But the higher incomes
resulting from increased output at a higher level of costs naturally
require more cash. Formerly there was seldom a sufficient
margin of cash which could be made available to finance the
higher incomes. Thus the resulting shortage of cash led to a rise
in the rate of interest, which, developing at a time when the
maintenance of investment was already becoming difficult for
other reasons, had a fatal influence on confidence and credit, and
decisively established the slump.

But this time there is no risk of a cash shortage in those
countries which still maintain a free economic system and are
enjoying a normal recovery. The currency devaluations, the
huge output of gold, and the newly-won elasticity of the foreign
exchanges have combined to give us the needed freedom of
action. We no longer rest under a compulsion to do what is
ruinous. Unfortunately there is a widely held belief that dear
money is a 'natural' consequence of recovery, and is, in such
circumstances, a 'healthy' feature.

Unquestionably in past experience dear money has accompanied
recovery; and has also heralded a slump. If we play with dear
money on the ground that it is 'healthy' or 'natural', then, I
have no doubt, the inevitable slump will ensue. We must avoid
it, therefore, as we would hell-fire. It is true that there is a phase
in every recovery when we need to go slow with postponable
investment of the recurrent type, lest, in conjunction with the
non-recurrent investment which necessarily attends a recovery,
it raises aggregate investment too high. But we must find other
means of achieving this than a higher rate of interest. For if we
allow the rate of interest to be affected, we cannot easily reverse
the trend. A low enough long-term rate of interest cannot be
achieved if we allow it to be believed that better terms will be
obtainable from time to time by those who keep their resources
liquid. The long-term rate of interest must be kept continuously
as near as possible to what we believe to be the long-term
optimum. It is not suitable to be used as a short-period weapon.

Moreover, when the recovery is reaching its peak of activity,
the phase of non-recurrent investment in increased working
capital and the like will be almost over; and we can be practically
certain that within a few weeks or months we shall require a
lower rate of interest to stimulate increased investment of the
recurrent type to fill the gap. Thus it is a fatal mistake to use
a high rate of interest as a means of damping down the boom.
It has been the occurrence of dear money hitherto which as
joined with other forces to make a slump inevitable.

If the stock exchange is unduly excited or if new issues of
a doubtful type are becoming too abundant, a higher rate of
interest will be useless except in so far as it affects adversely the
whole structure of confidence and credit. Moreover, alternative
methods are available. A hint to the banks to be cautious in allowing their names to appear on prospectuses, and to the
Committee of the Stock Exchange to exercise discrimination
in granting permissions to deal would be more efficacious. And
if necessary a temporary increase of a substantial amount in there
stamp on contract-notes (as distinguished from transfers) in
respect of transactions in ordinary shares would help to check
an undue speculative activity.

Nevertheless a phase of the recovery may be at hand when
it will be desirable to find other methods temporarily to damp
down aggregate demand, with a view to stabilizing subsequent
activity at as high a level as possible. There are three important
methods open to our authorities, all of which deserve to be
considered in the immediate future.

Boom control: Just as it was advisable for the Government to incur debt during
the slump, so for the same reasons it is now advisable that they
should incline to the opposite policy. Aggregate demand is
increased by loan expenditure and decreased when loans are
discharged out of taxation. In view of the high cost of the
armaments, which we cannot postpone, it would put too much
strain on our fiscal system actually to discharge debt, but the
Chancellor of the Exchequer should, I suggest, meet there main
part of the cost of armaments out of taxation, raising taxes and
withholding all reliefs for the present as something in hand for 1938 or 1939, or whenever there are signs of recession. The
boom, not the slump, is the right time for austerity at the
Treasury.

Just as it was advisable for local authorities to press on with
capital expenditure during the slump, so it is now advisable that
they should postpone whatever new enterprises can reasonably
be held back. I do not mean that they should abandon their plans
of improvement. On the contrary, they should have them fully
matured, available for quick release at the right moment. But
the boom, not the slump, is the right time for procrastination
at the Ministry of Health.

Just as it was advisable (from our own point of view) to check
imports and to take measures to improve the balance of trade
during the slump, so it is now advisable to shift in the opposite
direction and to welcome imports even though they result in an
adverse balance of trade. I should like to see a temporary rebate
on tariffs wherever this could be done without throwing British
resources out of employment. But, above all, it is desirable that
we should view with equanimity and without anxiety the
prospective worsening of our trade balance which is likely to
result from higher prices for raw materials and from our
armament expenditure and general trade activity, even though
this may put a temporary strain on the Exchange Equalisation
Fund. The recent decrease in the Bank of England's fiduciary
issue indicates that we have today a plethora of gold. It is
desirable, therefore, that the raw material countries should be
allowed to replenish their gold and sterling resources by sending
their goods to us; especially so in view of the difficulties which
would remain in the way of foreign lending on the old scale even
if the existing artificial obstacles were to be removed. This policy
is doubly desirable. First, because it will help to relieve a
temporarily inflated demand in the home market. But, secondly,
because a policy of allowing these countries to increase their
resources in 1937 provides the best prospect of their using these
resources to buy our goods and help our export industries at a
later date when an increased demand in our home market is just
what we shall be wanting.

These, I urge, are the methods which will best serve to
protect us from the excesses of the boom and, at the same time,
put us in good trim to ward off the cumulative dangers of the
slump when the reaction comes, as come it surely will. But we also need more positive measures to maintain a decent level of
continuous prosperity. In a third article we will conclude with
suggestions to this end.

 

III. OPPORTUNITIES

While we shall be prudent to take such steps as I have indicated
to prevent the present recovery from developing into a precarious
boom, I admit that I do not see much sign of this, except,
perhaps, in certain special directions. For the moment we have
the rearmament expenditure superimposed on the building
activity and on the large non-recurrent investment in working
capital and in renewals which are characteristic of a recovery as
such; and this is a situation which suggests caution.

But, on the other hand, our export industries remain, on the
whole, inactive; the peak of the non-recurrent investment in
increased working capital (which in the last two or three years
has been much larger per annum than the cost of rearmament
now is) may be behind us; sooner or later the building activity
will relax; and the cost of rearmament is neither permanent nor
large enough while it lasts to sustain prosperity by itself (in 1936
at least seven or eight times as much was spent on new building
as on rearmament). Thus our main preoccupation should be
concerned not so much with avoiding the perils of a somewhat
hypothetical boom as with advance precautions against that
sagging away of activity which, if it is allowed to cumulate after
the usual fashion, will once again develop into a slump. Too
much alarm about a hypothetical boom will be just the way to
make a slump inevitable. There is nothing wrong with the very
moderate prosperity we now enjoy. Our object must be to
stabilise it and to distribute it more widely, not to diminish it.

 

Positive precautions: Thus we need constructive preparations against the future.
Recent experience has shown us how long it takes to prepare
for useful investment; and what careful handling is necessary
to develop a psychological state in the investment market which
will accept a reduction in the long-term rate of intersest. Moreover,
it will be much easier to check a recession if we intervene at its
earliest stages. For, if it is allowed to develop, cumulative forces
of decline will be set in motion which it may prove almost
impossible to check until they have run their course. If we are
to be successful we must intervene with moderate measures of
expansion before the decline has become visible to the general
public. One factor only shall we have in our favor���namely,
the improvement in our export trade with the raw material
countries which I now anticipate with confidence at a date not
far distant. In other directions we shall be hard put to it, in my
opinion, to develop useful activities on an adequate scale. The
menace of the next slump, and what that would mean to our
institutions and traditions, if it comes, should be at our elbow,
urging us to new policies and boldness for mind.

Perhaps it is absurd to expect Englishmen to think things out
beforehand. But if it is not, there are various thoughts to think.

So far I have stressed the importance of investment. But the
maintenance of prosperity and of a stable economic life only
depends on increased investment if we take as unalterable the
existing distribution of purchasing power and the willingness of
those who enjoy purchasing power to use it for consumption.

The wealthier we get and the smaller, therefore, the profit to
be gained from adding to our capital goods, the more it is
incumbent on us to see that those who would benefit from
increasing their consumption���which is, after all, the sole
ultimate object of economic effort���have the power and the
opportunity to do so. Up to a point individual saving can allow
an advantageous way of postponing consumption. But beyond
that point it is for the community as a whole both an absurdity
and a disaster. The natural evolution should be towards a decent
level of consumption for every one; and, when that is high
enough, towards the occupation of our energies in the non-economic interests of our lives. Thus we need to be slowly
reconstructing our social system with these ends in view. This
is a large matter, not to be embarked upon here. But, in
particular and in detail, the relief of taxation, when the time
comes for that, will do most for the general welfare if it is so
directed as to increase the purchasing power of those who have
most need to consume more.

 

Planning investment: The capital requirements of home industry and manufacture
cannot possibly absorb more than a fraction of what this
country, with its present social structure and distribution of
wealth, chooses to save in years of general prosperity; while the
amount of our net foreign investment is limited by our exports
and our trade balance. Building and transport and public
utilities, which can use large amounts of capital, lie half way
between private and public control. They need, therefore, the
combined stimulus of public policy and a low rate of interest.

But a wise public policy to promote investment needs, as I have
said, long preparation. Now is the time to appoint a board of
public investment to prepare sound schemes against the time
that they are needed. If we wait until the crisis is upon us we
shall, of course, be too late. We ought to set up immediately an
authority whose business it is not to launch anything at present,
but to make sure that detailed plans are prepared. The railway
companies, the port and river authorities, the water, gas, and
electricity undertakings, the building contractors, the local
authorities, above all, perhaps, the London County Council and
the other great Corporations with congested population, should
be asked to investigate what projects could be usefully undertaken if capital were available at certain rates of interest���3.5 per cent, 3 per cent, 21 per cent, 2 per cent. The question of the
general advisability of the schemes and their order of preference
should be examined next. What is required at once are acts of
constructive imagination by our administrators, engineers, and
architects, to be followed by financial criticism, sifting, and more
detailed designing; so that some large and useful projects, at
least, can be launched at a few months' notice.

There can be no justification for a rate of interest which
impedes an adequate flow of new projects at a time when the
national resources for production are not fully employed. The
rate of interest must be reduced to the figure that the new
projects can afford. In special cases subsidies may be justified;
but in general it is the long-term rate of interest which should
come down to the figure which the marginal project can earn.

We have the power to achieve this. The Bank of England and the Treasury had a great success at the time of conversion
of the War Loan. But it is possible that they still underrate the
extent of their powers. With the existing control over the
exchanges which has revolutionised the technical position, and
with the vast resources at the disposal of the authorities through
the Bank of England, the Exchange Equalisation Fund, and
other funds under the control of the Treasury, it lies within
their power, by the exercise of the moderation, the gradualness,
and the discreet handling of the market of which they have
shown themselves to be masters, to make the long-term rate of
interest what they choose within reason. If we know what rate
of interest is required to make profitable a flow of new projects
at the proper pace, we have the power to make that rate prevail
in the market. A low rate of interest can only be harmful and
liable to cause an inflation if it is so low as to stimulate a flow
of new projects more than enough to absorb our available
resources.

Is there the slightest chance of a constructive or
a forethoughtful policy in contemporary England? Is it conceivable
that the Government should do anything in time? Why
shouldn't they?

#weekendreading