 I want to link what I did in the last three lectures, especially the last couple of lectures, which is the theory of competition, of real competition. I want to link it to the theory of macro-dynamics. And I want to show you that it provides an absolutely natural foundation for Keynes' theory of effective demand. So in order to do that, I have to talk about a little bit what I did and then show you the connection to Keynes. I focused last time on the mobility of capital across sectors. Remember if there's a higher profit rate in this side of the room than that, then capital will flow more rapidly. Not that it flows from one to the other. It's always flowing because the system is growing. But it'll flow more rapidly where the profit rate is higher and less rapidly where it's lower. And that means the supply will rise relative to demand. It'll always be relative to demand because if it doesn't rise relative to demand, then the profit rate will keep up. So it'll accelerate until it overtakes demand, brings the profit rate down here because it brings down prices. And here, decelerate relative to demand and the prices will rise and the profit rates will rise. And I tried to show you that this process leads to equalization of rates of return on new investment, which is a key thing because it's the investment that moves. When you say capital, you don't mean old machines get up and walk across the street, which you mean is new machines are built more rapidly in the regulating conditions of production in the sector where the profit rates are higher. That leads to this turbulent equalization of profit rates. Now, and in this case, it's important to understand that there is a difference between the expectation of the individual capitalist and the outcome. In the book, I talk about the fact that when profit rates are higher in a particular industry, this is a survey in the Harvard Business Review, where the profit rates are higher, they just find that capital enters. By capital, I don't mean firms necessarily. The growth rate expands because either the firms already there figure, well, the profit rates are higher, this is a good place to put my money where you get profits, you have more capital, you want to put the capital somewhere to get more profits. So that's a good place. Others seeing that that's a good place will enter and the article mentions that most of them fail. Some of them succeed spectacularly, but many of them succeed automatically and the others fail. Now, that tells you that there is a gap between the expectation of profitability and the outcome. But it doesn't mean that the outcome and expectation are unlinked. It means that they are linked in a way in which the mistaken expectations are disciplined by the outcome. And this is something that Soros calls the hysteria of reflexivity. The relation between expected profit rates and actual profit rates is by the adjustment of both because expectations can cause a boom and can cause profitability to rise and at some point fall as labor markets tighten, but the expectations always have to be about the real. They are not expectations in the sense of just anything you think of, they're evaluations. They're evaluations made about the prospective outcomes and they are then judged in the light of the actual outcomes. Now, if you happen to get a job in business as an economist, you might be asked to make these judgments and I assure you that they will not say to you, oh, don't worry, you were wrong in the long run, we're all dead, that won't work, you'll be dead in the short run because they're paying you to make these judgments and they pay you more if you do it correctly and if you don't do it correctly, if you do it badly, they get rid of you. This does not mean rational expectations. This means expectations are disciplined by the outcome. It doesn't follow that what they expected to get is what they got. Does everybody understand the difference between the two? And this is very important because this is, I would argue, what Keynes is really saying when he says, well, the effective demand, firms are motivated by effective demand, but of course they never know whether the expected demand is actually going to get and there's what he calls a higgling of the market, the higgling going up and down as they adjust. Now, this for me is fundamental because it tells us that there is a relation between expectations and actuals and that a relation involves over-shooting, over-enthusiasm, I mean that's very clear. If a bunch of capitals flow into an industry and most of them don't get what they expect, some of them get more than they expect others don't, then that tells you that expectations are generally falsified. But it doesn't follow that they were wrong in the sense that they didn't know what they were doing. They can't necessarily capture all the interactions and the better ones are the ones who are better at guessing. Soros himself says that what he does is the reason he's successful is that he understands this process, he understands its inherent in all kinds of economic patterns and what he tries to do is ride the wave up the bubble and the bubble is because the expectations are higher than the fundamentals and he knows that and he wants to ride it up and when they get far enough away it collapses and what he wants to do is get out before. When I was, well I can't say when I was a kid but I remember when I was younger road runner cartoons and you remember road runner cartoons and if you have kids who have probably spent some time watching these things you know that when road runners are being pursued by Coyote usually they are approaching a cliff and the Coyote is chasing him and suddenly the road runner takes a U-turn the Coyote goes over the edge and the road runner whistles to him he stops but he doesn't fall. He stops and he looks around and he's going where's the road and the road runner goes and then the Coyote falls that's reflexive adjustment of expectations to the reality of gravity. Now what's important in this adjustment process is the rate of return on investment not the rate of return on average capital because if I'm coming into your industry because your profit rate is higher I'm not going to go to the old machines or the old technology I'm going to go to the best reproducible technology reproducible is a big aspect of that and that's what I call regulating conditions of production and that really comes from Ricardo it's not a new idea, it's in Marx also in Volume 3 and these obscure little things that he illustrations no one pays any attention to because they are looking for quotes about class struggle and exploitation and they're not that much interested in the theory of rent but that actually is fundamental because it makes the distinction between the average rate and the rate of return on new investment so then that leads to the idea that investment or at least the rate of growth of investment, rate of growth of capital investment relative to the capital stock is determined by the expected rate of return now I said you know capital is always growing so what happens when the rate of return is higher and the rate of growth rate accelerates so it's the rate of growth of capital that responds to this difference and it's going to accelerate where the difference is high and decelerate where it's low but it's not only the difference between two rates of return it's the difference between the rate of return and the interest rate too so it's actually the difference between the net rate of return because after all you don't have to go into either industry if the rate of return in both industries is expected to be below the interest rate then you stay you keep your capital in liquid form you don't go in because after all you can leave it in the bank and take it out when you need it so holding cash is not a sign of a mistake it's a sign that your expectation of profitability doesn't justify the use of that cash and there are a lot of talk discussions now cash held of abroad and all that we were having this discussion with Krugman at lunch so if it's true that expectations determine the outcomes immediate outcomes but expectations themselves regulated by the actual output then you have an argument that links expectations to the fundamentals the fundamentals in this case being the profit rate when we know what determines the profit rate it's a relationship between wages and productivity and technology and all of that that's the strength of the classical argument Smith, Ricardo, Mark, Srapa, whatever now when we come to Keynes so we end up therefore with the following notice you can't read red and we don't have black so that is a problem no black so let me just oh great thank you thank you very much that way I can do more than the color but I don't need any black it's okay I think and so in Marx we have something like the rate of growth of capital which is simply defined as investment over capital so it's normalized investment is a function of the expected rate of profit minus the interest rate and this is explicitly the argument in Marx when he's talking about business cycles he calls this difference the expected profit rate of enterprise now it's a nice phrase profit rate of enterprise because it says this is the rate of return that's due to taking the risk of investing your money not it's not a risk premium it's a return to your doing active investment rather than passive investment and leaving it in the bank now when we come to Keynes so this is Marx in Keynes we get an argument very similar to this what Keynes says investment is a function of the rate of return minus and this expected rate of return is what he calls the marginal efficiency of capital to see the argument is extremely similar except there are two things which are crucially different in Keynes one is that Keynes never really tells us any link between this and the actual profit rate and his argument is well I'm dealing with the short run and the short run this is expectations are very influential this is correct I mean all those firms entering those industries in the short run they were based on expectations and those expectations are animal spirits literally in the sense of Keynes but in Keynes he was never disciplined by the outcome and one could argue that Keynes did this because he was concentrating on the short run because that was where his attack on neoclassical economics was concentrated so he never really deals with that the other possibility of course is that Keynes died young I mean people forget this point it is important he was not even 60 I think he was 57 or 58 or something you could google it and find out but he was very young and under the condition and under the stress of all setting up after the war and trying to have Bretton Woods and all the policies and stuff that he was involved in he was told repeatedly you have to slow down and he said yeah I'll do it soon soon and he had a second heart attack and he died so if he had gone back to that question perhaps he would have linked it back because he knew very well how businesses operate so it was not a question that could hang but the problem is afterwards the Keynesian literature split along two lines one line said that the marginal efficiency of capital is linked to the actual profit rate I'm going to say that's Garniani's line though there are other Keynesians who said that and the other is a marginal efficiency of capital is psychological psychological or conventional now the first one clearly links back to the classical tradition Garniani is coming from the classical tradition himself from Srafa one of Srafa's most famous students and he certainly understood that the determination of the profit rate depends on wages and technology class struggle and all of that Joan Robinson is the other one here and at least at one point in her argument she argues that you can't link this and this was a very interesting debate you might look up about the two sides but for us what's relevant is that I would argue that this is an unfinished aspect of Keynes and so if you do close it back to the actual profit rate then you get a very different story and that's the story I want to try to explain to you actually explains Keynesian policies in the post war period including most recently in Brazil and Argentina I want to therefore now begin the sort of elements of the classical Keynesian I'm not sure exactly what to call this classical Keynesian political economy classical Keynesian economics I don't want to call it classical Keynesian synthesis because that's what the neoclassicals call their argument and I can't call it the third way because of Tony Blair so it these are sort of problem of how you specify this but there's some characteristic elements one, the expected rate of return is linked I'm going to use this symbol for linked to the actual rate of return in a reflexive sense now the second point is very important in Keynes the interest rate is dependent on liquidity preference there's a whole reason why Keynes chose the interest rate liquidity preference that is money demand versus money supply and therefore that is psychological it's subjective it depends on how much you want to hold your money and Keynes talks about all of that and that's not necessarily wrong by the way but what's interesting in the way that Keynes poses the problem the demand for money is something that comes only from personal subjective things it's very neoclassical and the interest rate is determined by the demand and supply for money I would argue that it's very clear in the classical tradition that the interest rate is the price of finance and supplied by banks and that's a very different conception because if the interest rate is the price of finance supplied by banks then like every other price since banks are businesses and they're motivated by profit every other like every other price this is going to have a price of production a price which is determined by profit rate equalization and I go through some extended discussion of different theories of interest rates going back to Smith and Ricardo and Hicks and classical theory liquidity preference all kinds of other subjective theories which I urge you to take a look at in the chapter on finance but my main point for this thing is that that it implies that there is a normal interest rate just like there is a normal price which is dependent on the cost unit cost of banks plus a profit rate times the capital intensity of banks this is unit cost in money capital intensity in money so the interest rate is a rate of return which is a magnitude which depends on cost and profitability normal profitability the actual interest rate is not equal to the normal rate that's what profit rate equalization brings about just like actual prices are not equal to prices of production they're regulated by precisely these movements of equalization of profit rate but this has an important implication that the interest rate therefore depends on the price level because these variables which are nominal will therefore rise the interest rate will rise with the price level the normal interest rate will rise with the price level because as prices rise the costs will rise costs are nominal terms now one way to simply express this is to divide everything by multiply by price here and divide these by price capital cost and this is in the input output sense and this is the price level and you can see that the interest rate will depend on the price level I'm going to come back to it I do have the algebra here very good question so in a bank banks have costs tellers, machines used to be more people now it's mostly machines but they have buildings, they have paper they have their plant and equipment and their reserves because just as wholesalers have their inventory banks have their inventory and their inventory is their cash reserves the reserves they need to keep the bank going so when you actually measure and I do this in the book you can measure the profit rate on banks by keeping track of that information and you see the profit rate is actually surprisingly not very different because if banks are making a lot of money then people move from manufacturing to banks capital doesn't care where it lands, it cares how profitable it is and so that has an immediate implication that the nominal interest rate will be linked to the price level this is known as Gibson's paradox but it's actually something earlier called Tuck's Law Thomas Tuck did his work on improvement of price and this was something well known to Marx because Tuck was one of the things Marx comments on the puzzles in Tuck Tuck went out to study the quantity theory money, he believed in the quantity theory money so he tracked a huge amount of gold coming out of California as it moved across from west coast to east coast from east coast to Europe and the question he was asking is wherever the gold landed why did that happen here? I don't want to log in let me see where I am goes this right? yeah so Tuck among the things Tuck discovered was that prices do not rise according in proportion to quantity in other words that the quantity theory money was falsified but the other thing he found was that the interest rate rises at the price level that is relevant modern economics calls this Gibson's paradox and it's a paradox because if you believe in Fisher's hypothesis that the interest rate is equal to some intrinsic return minus the inflation rate that is a real rate the interest rate minus the inflation rate is the real rate of interest is equal to some time preference structure parameter rise or fall with the inflation rate and so this is known as Fisher's hypothesis always wrong it doesn't work empirically but it doesn't matter every textbook has it anyway because it's convenient and Keynes knew this very well so when Keynes sees Gibson's study he says well this is the link between the interest rate and the price level is the best known empirical law of economics best known empirical law of economics and so obviously it's true but then he doesn't come back to it so he doesn't explain it himself okay so the third point is that in the I always do this in the classical in the neoclassical tradition I'm sorry in the classical tradition the argument is that capacity utilization will be linked to normal capacity utilization now what does that mean normal capacity it's an argument comes in Harrod especially is the point of your utilization curve capacity I mean your cost curve which has the lowest unit cost because Harrod says firms are driven by the fact that if they can have lower cost they can beat out each other that's very interesting because that's the same argument as in the classical tradition that firms are driven to lower cost because lower cost gives you a possibility of setting a lower price which means beating your competitor and so the point in your cost curve which is the lowest point is your normal capacity utilization now that is in actual cost curves which I discuss in the book unit cost curve looks like this this is shift one shift two and shift three these are the costs that would operate I'm sorry this is scale output and this is average cost these are the costs that you would get from the scale of output and there's a physical limit to the output and that's usually called engineering capacity but economic capacity is in the vicinity of the lowest cost average cost not the maximum physical output because why would you take it to the maximum physical output if your costs are higher so this is not that different from the neoclassical idea of the minimum cost curve like the neoclassical one and therefore marginal costs spike when you go from one to the other and you can't use marginal cost equals price as the optimal point that goes through that in the book but I also show that actual cost curves such as in general motors manufacturing and all that are shaped like this yeah why during the crisis did we see the price levels rising and the interest rates very good point I'm going to come to that tomorrow because I'm talking here about the competitive interest rate and we know perfectly well that what happened in the late 1970s early 1980s as the government began to intervene to lower the interest rate and I'm going to link that think about this for a moment if for some reason profitability is falling and we're going to see that it was falling a lot in that period up to about 1980 then it got stabilized those graphs before you know the profit rate stabilized it fell and then stabilized so they managed to keep this profit rate which was falling and make it stabilized by making wages fall relative to productivity so the old raising the rate of exploitation but that only made it stable what they also did is lower the interest rate tremendously and that caused a boom and I'm going to use that tomorrow to explain why there was a boom in the time of a falling rate of profit they stabilized the profit but that wouldn't be enough to cause a boom it would prevent the sort of decline what caused the boom or good part of the boom was the tremendous lowering of the interest rate went from about 15% down to close to zero now that has a limit obvious reasons so they've used up that limit and then the question is what happens next where do they go one answer is you go abroad the profit rate can be raised by going to where labor is cheaper it's just where labor is cheaper it's where you can keep labor cheaper so the tremendous incentive to invest in regimes that can keep labor from asking more and that's all over Asia and will be certainly all over Africa so this is not the social, institutional and political context of this is very important to understand that's why this is not this is political economy really that I'm talking about is the same the interest rate I'm a capitalist and also I'm owner of a bank and also I can invest in other sectors the interest rate that I face is the same that everybody else if I'm the owner of a bank I can borrow money at the same rate I lend everybody else money unless I'm cheating so what a bank does is lend you money that's the interest rate that's relevant so conversely when you put the money in a bank they give you a rate of return so the question is the difference between the interest rate you get for leaving your money in a bank which is really the proper rate here because it's your passive return and the profit rate that you make and if you're the owner of a bank you have the same calculation I mean it's the money that you get if you didn't use your money versus the money you get if you did use it and may lose it that's the difference banks are not owners of banks are not like except in the movies nice people who live in a small town their predatory capital is like everybody else their job is to make the most with what they have and so there is actually for them the same logic absolutely the same logic exactly I'm not sure I answered your question the money that the bank have as deposits have an alternative use relative to our investment bankers okay good point but let's not confuse the money the bank has deposits it can't use it has to keep a certain amount to pay you back when you come in and say oh I need to buy a house or whatever or I need to buy a car without lending on the other hand that money is the base for its lending and as a borrower the bank is no different than any other borrower I mean if you're a banker and you want to use a loan to expand a bank and the same criterion as you would give a loan to a business person whether you can make more profit that way or give it to them so there's no difference there think of banks as taking in your money at one door in the front of the bank and then giving your money out at the back of the bank and when you're at the back of the bank everybody lines up the same yes there's corruption we know all that but in fact it's amazing how the criterion is the same with their money with their loans their deposits on the other hand they have to pay you back if you happen to walk in the door and of course we know that deposits provide the foundation for loans we know this when you discover for instance that somebody robs a bank we're always very interested where the cowboys would come in and rob a bank and what interesting thing about robbing a bank is the cause of the bank to collapse because when you rob a bank you discover that the money that you put in there in fact generally speaking the money in a bank the money you put in is not there it's been lent out and what they do is they keep the minimum possible to keep you happy when you come in the door based on their guests but if there's a panic a bank run banks collapse for a simple reason because your money is actually not there and they can't get it back then a panic or a run Argentina had this very clearly in 1980s 2000s there's no money no bank has your money it has your money statistically but not all of you can get it at the same time John Kenneth Galbraith's book called Money when it came and where it went or something like that wonderful book this is Jamie Galbraith's father John Kenneth Galbraith and it's a great book because he writes with that wit and style that makes it fun to read about money not normally the most exciting subject but he makes it really entertaining and one of the things he says is one of the astonishing things that you learn about banks is that your money is not there actually okay third point so this capacity utilization issue Harrod Keynesians had make the argument that output is a function of investment over the savings propensity that's a multiplier everybody know that part this is equilibrium output and it'll be investment divided by the savings propensity Harrod says well that doesn't make any sense because investment is adding to the stock of capital which means that the stock of capital is rising which means that capacity which I'm going to call normal output is rising so if investment is taken as given in the short run then capacity utilization must be falling is that point clear because it's an old argument about the Keynesian statics thing you cannot have a Keynesian static argument it's stock flow inconsistent because it implies that you're adding a stock adding to the stock of capital but your output is dependent only on the flow of investment so it's not changing so any given level of investment will create a given level of output will cause a capacity utilization to fall towards zero and Harrod says well you think about that reverse the problem what is the level of investment that's consistent with the increase of the stock of capital in the famous warranted path and it's easy I'm going to skip it here because it's in the book but you can easily show that there is one level of investment that will give you the growth of capacity and the growth of output that must be a growing level of investment obviously investment must be growing for output to be growing but investment is causing capital to grow so there is one growth path which makes both consistent and that's a warranted path now Harrod was never able to explain the stability of that warranted path Harrod actually didn't have any real mathematics like many people in the Cambridge tradition he'd had trouble with algebra simple algebra John Robinson was even more so she really had trouble with simple algebra doesn't mean she was brilliant but that just had not part of her training so he always had trouble with this and people didn't actually were not able to do this but it's easy to show that Harrod was actually solved by Hicks verbally in his book on growth and I sort of formalize that in the book and I show you that there's a general way to formalize this in which the warranted path so to speak is stable that is to say when you go above it which means that your growth rate is such that capacity utilization is above normal then investment will grow more rapidly it will accelerate and that will bring your capacity utilization you would expect fluctuations around normal capacity utilization and that's pretty much implicit in the classical argument that what determines all of these things is the point of normal output that defines the profit rate the interest rate and so on and the adjustments of capital versus output come about in an endogenous way but because when you increase investment you increase output too which will increase capital so it's not that these are two separate things okay I'm covering a lot of ground here I apologize for that but I want to give you the big picture before I run out of time so that's point number three now point number four I've already done which is that the rate of growth of capital is dependent on the expected rate of return on investment minus the interest rate but we know that the expected rate of return is linked to the actual rate of return so we can write this as another function I'm going to call it H and it's very convenient because then it's a function of the normal profit rate which we know how to deal with it's normal profit rate depends on wages and technology it's Strafas and Marx's and Ricardo's profit rate and normal capacity utilization so it's going to be here the normal interest rate which is based on equalization of profit rates in a turbulent and reflexive manner and this is everything is a way to capture the fluctuations of demand and supply that is excess demand and all the fluctuations of the economy towards demand and supply the fluctuations of output and capacity and injections of purchasing power and these are the injections that are so central to Keynes Keynes focuses on the injections but doesn't deal with the capacity utilization problem again one could argue that if he lived he might have dealt with that problem post Keynesian theory cannot I'm going to come back to that if I have time I will not deal with that assumes that capacity utilization is always different than normal capacity because the logic of its argument requires that but these three fluctuations this is demand and supply fluctuating around here this is output and capacity fluctuating around here and this is not necessarily a zero mean fluctuation because I can pump up the economy by deficit spending creating new purchasing power now when I say new purchasing power it's important to understand it's not the same thing as deficit spending in the book I discuss the differences too but if the government prints money and spends it that's an injection of purchasing power if banks create credit that's an injection of purchasing power the differences in bank credit you have to pay it back so an injection of purchasing power through the bank is a leakage of purchasing power when you pay it back so that those two cancel out over time and therefore bank injections only count as net injections if they are growing over time again that's kind of obvious and when you measure net injections what you do you take the newly created loans and subtract from it the payment back so that you have net injections of purchasing power and these are variables that you can calculate the IMFF data on this you can calculate that there's also injections that come from foreigners if there's a big increase in demand for your exports without your imports rising then your trade surplus rises that's a net injection of purchasing power that's part of the Keynesian story already so we can track empirically we can measure the injections of purchasing power and this variable is therefore not a zero mean variable if these two fluctuate around other than their differences zero mean but this can be a pumping up and in the book I actually show you that if you measure the injections of purchasing power and you can do it by adding them up and saying per person what has happened you can see in the post war period a steady rise per person in the amount of newly created purchasing power that has some implications remember those graphs of inflation rate and all that the post war period is really quite striking that way ok and the fifth point there's actually six I think but fifth point is that the savings rate is endogenous now I want to explain what I mean by that the savings rate is endogenous Keynesian economics when it's doing the multiplier story typically says this is a multiplier output depends on investment and the savings rate you know the multiplier sequence I won't go through that with you but the savings rate is taken as constant so here how does a multiplier sequence work there you are at a particular level of output and investment at a particular level so you have an output consistent with that consistent with the multiplier and equilibrium output now the multiplier goes the investment goes up the multiplier causes output to go up because when the investment goes up Keynes assuming that it's financed by new credit so he's assuming that it's an injection of purchasing power and he's quite explicit about that he's assuming when he wrote the general theory he didn't actually realize that Kolecki does the same thing investment goes up you get out and then people said to him Lord Keynes why is this why is it true that when investment rises savings can only rise by creating more output why couldn't savings rise by having people save more and he goes no well I'm assuming constant savings rate and then they go well how can you spend therefore more how can investment rise if your savings rate doesn't go up and he said oh you're right I meant to say that I'm assuming that all of investment is financed by bank credit new bank credit in other words investment a change in investment is an injection of purchasing power now it makes sense then if I inject purchasing power then I have more output if I have a fixed savings rate but more output than the total amount of saving rises and little by little that total amount of savings catches up to the investment that's the multiplier the sequence of the multiplier that you famously see everywhere but that's predicated on the idea that investment is financed entirely by bank credit now when you put it that way that's astonishing it's astonishing because in the classical tradition the general assumption the first level assumption is exactly the opposite which is the investment goes up firms will save more go look at volume two of capital chapter chapter what the scheme to reproduction and here marks has an example of simple reproduction that is a society where investment is zero net investment is zero that you keep making the same gross investment so it's static society then he says well how do we get to growth suppose that capitalist decide to grow then they're going to invest but in order to invest because he's abstracting for bank credit they have to save more of their money so they have to consume less and they save more but now and he shows a numerical example of an extraordinary one two sector model going from zero growth rate with a transition to a balanced growth path if you follow through the numbers on that but that's quite striking is that there there is no multiplier and I remember when I first ran it I'm going thinking wait a minute why is there no multiplier and then it occurred to me well it's because if I raise investment and I raise the savings rates so that the existing level of output gives me the new savings then there's no reason for multiplier the multiplier comes from an injection of purchasing power and that comes from the assumption that the savings rate is constant now so Keynes justifies that the savings comes from households and all that but again that's completely wrong if you track business savings rate which is called retained earnings and you compare it to investment you find that business savings rate and investment move together why is that because otherwise firms would have to pay someone to borrow the money and it's easier to do it from inside if you can so on the aggregate internal funds provide somewhere between 97 and 103% of business investment you can I show you the data in the United States you can look it up it's in the flow of funds so how strange is it that if this is a fact that economics assumes that firms borrow all the money and that is because in neoclassical economics businesses don't exist as active agents they're just simply maximizing their profit so they don't save the implicit assumption in neoclassical models is that all of business output is handed over as wages and profits to households and then households save and the business borrow back and that doesn't make any sense Keynesians fall into that same trap so very important to understand that the savings rate is actually linked to investment now what do I mean by linked how is it linked doesn't mean that every time investment rises firms entirely funded from savings all you need to say is that if they raise investment above the current level of savings then the savings rate will have to go up to meet some of that and that's all you need that their rate of retained earnings will rise if there's a gap between their current investment plan and their current savings coming to them as stocks and bonds and all of that and that means the savings rate of businesses is partially endogenous well it turns out that that is sufficient doesn't matter of households respond to this so they are incentives where they do it's sufficient to make the savings rate endogenous that means that when investment when growth takes place the savings rate also responds to the gap I call the finance gap and so these elements I think there's one more but these elements broadly define the classical tradition and you notice that they're different this is different from the Keynesian one because of the link to real profitability this is different from the Keynesian one because the price interest rate is determined by competition not by liquidity preference and by the way let me just make that point liquidity preference is right it's about money demand and supply but certainly you have preferences about borrowing and lending there's no question about that but if those preferences lead to a profit rate for banks higher than others then you can build banks and bring that interest rate the profit rate of banks down and it does it by lowering the interest rate because that's where they get their profit and so the flow of capital will override your preference structure the same thing with the stock market everybody has different ideas about the stock market I like to think of myself as having finance people like George Soros because when he's going on the way up I'm going on the way down but those preference structures get overridden by the mobility of capital so yes they're all true safe havens and preferences for your retirement but if that leads to a profit rate difference then a set of capital will appear to override if it's high or same thing of it's low so it isn't that these preferences are wrong they're just not determining what is determining is arbitrage the process of equalization of profit rates I saw a hand, sorry so this fact that most of the financing actually comes from the retail earnings of the parents right does that fact go to for instance the 19th century or the 19th century for instance the US in fact I don't say most of the financing I just say and I said it quickly I apologize because I'm racing the necessary to tell this story is that the savings rate of businesses will rise somewhat in response to the gap between their current level of savings and their planned investment so it doesn't actually matter how much that's a more concrete issue depends on other factors taxes, local issues of banking and regulation and all of that but that's all it requires but in practice in the United States you have to invest you can track it and in some cases it actually goes higher than that why is that? because they have retained earnings but they don't have any incentive structure so they end up holding cash because they've made all they have the retained earnings and they're not going to throw them away by making an investment where the climate is bad so typically after 2007 their retained earnings continued but there was no incentive for investment so they just had a lot of liquidity you can go to earlier bank stories so this week and definitely otherwise they have to pay someone money to invest, they have to borrow it yeah I just want to clarify something about the thing you just said about liquidity you're saying that if bank capital is more profitable capital goes into there therefore lower the interest rate sort of injecting more money in the system, is that what you're saying or did I misunderstand that? I'm not sure I followed that you were sort of saying that maybe I missed the point you made about the liquidity reference if you could repeat that maybe then I'd be clear let me say that again and you can ask me specifically where Keynes is faced with actually a problem when he's doing his theory and that problem is according to neoclassical theory, demand and supply are equated through the interest rate now Keynes wants to say that demand regulates supply directly so excess demand he doesn't need so to speak the interest rate argument but he has to get rid of it also and the interest rate argument is specifically that savings adapts to finance by moving the interest rate up and down so you can consider savings is loanable funds investment as demand for loanable funds, supply of loanable funds interest rate is the price it's going to make the supply and demand equal which means that savings is equal to investment by the interest rate which is no multiplier then it's the interest rate that's the price variable of that and he wants to say no that's not true so he wants another theory of the interest rate and he settles on liquidity preference from my point of view what's wrong with both theories so it would be like my saying the price of corn depends on the desire of corn for people to buy corn and the supply of corn which is true in the short run but it's not true in the classical sense because if that demand and supply mixture causes corn profit rates to be higher than elsewhere bang comes the arbitrage part and that overrides all of these are there but the arbitrages are basically all of these gaps that's their job and capital comes in and overrides that so that's why the classical economists don't spend time on the subjective determination because they understand that this process leads to an objective one and all of the subjective ones are important, they do talk about Smith talks about it, Mark talks about it they cause bubbles and booms and crises but this underlying dynamic is very fundamental to first explore and that's very important and we don't deny all this determination it's just that it's a part of the process of determining the profit rate differential and then bang out of nowhere comes more capital or leaves, they run away too they can go to liquidity, they don't have to go somewhere else they can just go and set a bank vault for a while okay, yeah this framework is interesting to think in developing banks they work supposedly it's a policy that suicide rate to foster investment is certain sectors but if capital moves to those sectors when you artificially pop up their profit rate a policy that is meant to be like to a longer policy it cannot work in the longer well, I want to reserve that because I want to tell the story of the dynamic here what happens if you interrupt the dynamic it's a more concrete issue I'd like to reserve that for tomorrow because I'm going to be talking about that so I'm going to be talking about interrupting the dynamic let's say of determining the interest rate I certainly can do it in New York City I happened for a while to live for 10, 15 years to live in a rent stabilized apartment building now the rent stabilized was something where the state intervened the local thing to prevent the price from going to the market with that intervention until I left and moved to Brooklyn and there I came in and they didn't have that and my rents went up like 20% every year until I had to leave that particular place, a wonderful place but they kept raising the rent because the demand was rising faster than the supply in those areas in Brooklyn you can't build new houses so the supply is fixed and the price rises so you can intervene of course but then you have to ask what consequences follow from that intervention and I want to reserve that if you remind me tomorrow I'll have more time tomorrow instead of this week to talk about that so I want to have enough time to sort of lay out the framework so that you don't think that this is all let me just tell you the punchline because I'm going to come back to it in more detail tomorrow and link it to the crisis the punchline is the following if you have an injection of purchasing power which is a stimulus run by the government, it doesn't have to be discovery of gold in California was a huge stimulus so it's not a state sponsored stimulus but an increase of demand for exports is a stimulus not necessarily run by the state but let's take the big one the injections of purchasing power coming from state finance injections deficit finance injections that pumps up the economy and I'm going to show you formally, algebraically and formally how that works but let me just tell you the story it pumps up output and employment, not very surprising if I give everybody more money you will spend it and if you spend it you'll have all the multiplier effects that Keynes talked about with the flexible exchange savings rate and all that and output will rise as output rises in the short run employment rises employment rises, unemployment falls because the labor supply doesn't react very rapidly to all of that so unemployment falls as unemployment falls the reserve army of labor the pool of unemployed shrinks as it shrinks real wages start to rise faster than productivity or they slow down in their fall relative productivity in other words real wages rise whether they rise faster than productivity depends on more concrete things you remember yesterday I showed you that or maybe the day before the classical wage curve the rate of change in the wage share versus unemployment and what I showed you was that actually there is such a curve which is derived in the book theoretically but it also has a very nice picture which is that if you plot in the United States here what I call unemployment intensity which is just adjusted for duration of unemployment and here I have the rate of change in the wage share and the wage share is just wage rate relative to real wage relative to productivity right so we can write this as real wage relative to real output per worker and what you get starting in 1949 you get a curve that looks like this and then here 1982 and you know what happens then the curve kind of breaks up and you get a new curve and this break up is exactly at the point of attack on labor unions welfare state all of that so what you do what Reagan actually does is shift the relation down what does that mean shift it down to a particular level of unemployment let's say this is 6% then on the old curve the rate of increase of the wage share would be up here and the line of the zero line was here wages would be rising faster than productivity and the new curve if you move the unemployment rate this way wages would be falling relative to productivity they'd be rising more slowly than productivity but perhaps not as much as they were before in other words the slow down is reduced and by shifting the curve you make it obviously much more feasible for capital because labor is weakened and a given level of unemployment has less of an impact on the wage productivity relation than it does before you can easily translate this into a rate of surplus value thing I mean you can see that relationship so you have to keep in mind then this possibility you pump up the economy and as soon as you pump up you keep it pumping that should remind me to stop in 10 minutes you pump up the economy you create output rising, employment rising, unemployment falling the reserve army shrinking then you're going to be moving in this direction now that could mean the rate of change of wages relative to productivity is less negative that is wages are growing relative to lower than productivity but not as much as before or if you are up here they're now growing faster than productivity more rapidly they're accelerating relative to productivity if you do that then you have an impact on the profit rate and that depends on whether here or here, both of these from the point of your profit rate is going to raise lower it relative to its trend but its trend might be rising and this could be lowering that trend or it might be falling and this could be making it worse so you need to be more concrete but if this continues at some point profitability is impacted and if profitability is impacted then the growth rate of capital is impacted and if the growth rate of capital is impacted the growth rate of output is impacted which means output slows down then unemployment comes back and this I would argue is exactly what you find in the post-war period in the 1970s the famous stagflation Keynesians come in pump up the economy unemployment goes down they're really happy wage share goes up everybody is happy golden age of labour but the profit rate is declining steadily in the whole thing and this is making it worse and at some point that sets off a reaction which reverses the whole thing so you can see already that contained here is a problem of the limits to stimulus and you can see the other side the interest rate you can see that if the interest rate is determined by profitability then it can be shown that the gap between the interest rate and the profit rate will actually go down if the wage share goes up so you have a problem not as bad the interest rate goes down the profit rate goes down but the difference between the two goes down so you will have a problem even at the level of the normal rate of profit of enterprise now if this is so then it helps explain something that we observe and I want to end there I didn't get to my formal presentation but I just want to tell you a story when Keynes was trying to figure out another theory he was troubled deeply troubled by the fact that in Europe in the 1920s after World War I there was mass unemployment and misery and not to mention communism spreading and after the Russian Revolution capitalism never worked look at you people you don't have jobs we have jobs for everybody in the Soviet Union so that kind of pressure was there and Keynes was thinking how could we solve this and one of his proposals was he says it's half joking but he does say it he says why don't you have the finance ministers of every country drop money from an airplane so if people will pick it up and they'll spend it and you'll get a multiplier and another one he says you bury money in deep mines and then capitalists will pay people to dig it up and people will have jobs and the capitalists will get the return and all that so that's the germ of the idea that effective demand can stimulate output and employment and from this idea comes the notion that you can stimulate it and something interesting happens the first country to apply this is Hitler's Germany Hitler's finance minister Shach creates deficit spending and Hitler is able in one year to eliminate massive unemployment in Germany which had crushed the previous government leading to hyperinflation they were printing money and all that Hitler was able to change it in one year and he says his finance minister says if I remember for anything nothing else it should be this that I eliminated unemployment that's Hitler's number two massive rise in output employment deficit spending money everybody was urged to save their money and give it to the government so the government could spend it so all consumption was reduced savings was increased and that savings was monetized and spent by the government instead of going into finance it went into output employment so you got an injection of purchasing power that injection of purchasing power led to a tremendous rise in employment and output the war machine was extremely efficient and good and output rose and deficits rose and didn't have any problem with inflation no slowdown so that's the beginning of my graph 1947 1949 they're coming off that so it seemed that you had these two great instances of Keynesian effective Keynesian policy the problem is that the same Keynesians were now in charge of the economy in the 1950s and they applied the same policies and they worked in the beginning so you had the pumping up I showed you on the Vietnam war if you remember Vietnam war deficit stimulus moved you up the curve so Vietnam war deficit starts in 65 it moves you back up this curve which of course means the rate of change of the wage share positive increase is rising but then after the deficit the war financing winds down you come back so you are in this region of wage is rising faster than productivity and Keynesians don't see any problem with that because expectations determine the profit rate and they don't their theory of interest rate is liquidity preference so there's no problem except for the fact that capitalism had a problem because as they did this in the 70s and 70s inflation unemployment went down the reserve army the unemployment rate went down the labor market got tighter wages were rising faster than productivity profitability was falling and growth started to slow down as growth started to slow down they had what they called stagnation growth slowing down but they were pumping even more so what you're getting is more and more inflation and I'm going to develop that here but the relation between the growth rate and the profit rate is a key to the theory of inflation but basically if your growth rate is going down and you're pumping the economy more you're going to get inflation so that was the explanation of stagnation now we can jump ahead to say Brazil recently to successive Lula governments post Keynesian economists in charge they by the way studied at the new school and they did what the theory said would work which is to pump up the economy give money from the top to the bottom which increase consumption spending because people consume more poorer people than rich people they created means of financing output in employment and for five or six years that pumped up the economy and then it began to die out the growth rate began to fall and inflation and they couldn't explain it now Argentina also but I don't have the data on Argentina yet but the point is that you have five instances, six instances and they partition in a nice way in Hitler's time prices were not allowed to rise and you didn't mess around with Hitler he said prices are not rising they didn't rise wages were not allowed to rise relative to productivity under Hitler and the profit rate under Hitler rose sharply so that there was no limit from the real economy feedback to the stimulus in World War II they did the same thing you were not allowed to raise prices because it would be war profiteering and the penalties were severe, you were also not allowed to raise wages because that would be again fighting against the interests of the nation and you were urged to work as hard as possible as Hitler did too so productivity rose wages were rising slowly or not at all profitability was rising and so the limit to the stimulus was stopped and was stopped through policy but of course the question is whether you can do that forever now I do have to go so I'm going to argue I'm going to pick this up next time explanation incorporates the Keynesian story has a theory of inflation but also most importantly has a theory of the limits to stimulus the limits to the kind of intervention of the state and that's something to keep in mind I'll pick this up next time