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Monetary Central Planning and the State, Part 19: Savings, Investment, and Interest and Keynesian Economics


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In the 1939 forward for the French edition of The General Theory of Employment, Interest and Money, John Maynard Keynes said that in writing this book, he had broken out of the prevailing economic orthodoxy “and was reacting strongly against it, that I was breaking its chains and gaining my freedom.”

The freedom that Keynes wanted to gain was from the laws of economics, the logic of human choice, and the relationships between savings, investment, and interest. For Keynes, spending out of income was determined by his “psychological law” of people’s “propensity to consume” out of any given level of income. This was dependent on various cultural, racial, class, and religious habits of mind that changed only very slowly. One thing that Keynes was certain did not significantly influence people’s willingness to consume was a change in the rate of interest; a rise or a fall in the rate of interest had no significant effect on people’s willingness to save or spend more or less out of income earned.

What did the rate of interest influence? According to Keynes: people’s willingness or “propensity” to hoard money. Given the propensity to consume out of income, the amount of income saved could either be invested in interest-earning securities or bonds or be held as an idle cash balance. All that the rate of interest influenced was the relative attractiveness of holding bonds or cash. No matter how low the rate of interest might go, individuals would not consume more; their consumption was determined by the “psychological law.” They would merely continue to hold their savings in idle cash.

In Keynes’s system, the rate of interest also had no appreciable effect on the willingness to invest. People’s willingness to invest was based on their estimates of the likely future profitability from a possible investment relative to the rate of interest to be paid to borrow the sums needed to undertake the production project. But in Keynes’s view, there is no way to precisely determine what the future holds in store or what the prospective return from an investment is really likely to be. Since we all must try to make some estimate of the probable results from present actions undertaken towards a radically uncertain future, Keynes believed that people fall back on “conventional wisdom.” That is, we model our beliefs about the future on the basis of what we think the majority of other people think at any point in time. “Being based on so flimsy a foundation,” Keynes argued, “it is subject to sudden and violent changes…. New fears and hopes will, without warning, take charge of human conduct.” Being based on nothing but what each thinks the other person believes, investor expectations about investment possibilities and profitabilities are open to dramatic and unpredictable fluctuations that are far more important in influencing investment demand than any changes in the rate of interest, Keynes insisted.

The great demon in the Keynesian system, therefore, was the propensity to save some portion of any additional income earned rather than to consume it all. Savings diminished spending in the economy; diminished consumption spending decreased expected revenues from sales; lowered sales expectations made businessmen want to cut back production; lowered production meant fewer jobs; fewer jobs decreased total income earned in the economy; a decline in total income created a further falling off in consumer spending; and this additional falling off in consumer spending set the process of economic contraction in motion once again. If only everything that was earned was consumed, Keynes argued, full employment and high production would be ensured.

In explaining the fundamental error in Keynes’s conception of the evils of savings, I can do no better than to quote the insightful response given by the German free-market economist H. Albert Hahn from his 1946 article “Is Saving a Virtue or a Sin?”:

“According to the classical [economic] concept of the problem of savings … the interests of the individual and of the community are in full harmony. He who saves serves his own as well as the nation’s welfare.

“He improves his own welfare because savings implies the transfer of means of consumption from the present, where his earnings are ample, to the future where his earnings may become scarce through old age and sickness. Furthermore, savings will increase his means through the interest he receives.

“The nation as a whole, on the other hand, benefits from savings since these savings are paid into a bank or some other reservoir of money from which an employer may borrow for productive purposes, for instance to buy machinery. This means a change in the direction of productive activity.

“Through saving, production is diverted from goods for immediate consumption to goods which cannot themselves be consumed but with which consumer goods can be produced. Production is diverted, as one puts it, from a direct to a roundabout way of production. The roundabout way of production has the advantage of greater productivity. The high productivity of the more capitalistic production methods has further favorable effects. Because [of this greater productivity] employers can — and by competition are forced to — pay interest on the capital borrowed, to raise wages, and lower costs. The standard of living of the nation rises.

“This process is renewed over and over again, because increased savings permit primitive direct methods of production requiring small amounts of capital to be replaced by roundabout indirect methods requiring large amounts of capital.”

But doesn’t the falling off in consumption from the act of savings reduce the demand for goods and thus decrease the profitability from production? Why would businessmen undertake new and time-consuming investment projects to increase production capacity in the future when demand for consumer goods shows itself to be less in the present?

The answer to this Keynesian argument, as we saw, was given by the Austrian economist Eugen von Böhm-Bawerk 35 years before Keynes wrote The General Theory. (See “Monetary Central Planning and the State, Part VIII: The Austrian Theory of Capital and Interest,” Freedom Daily, August 1997.) In a 1901 essay entitled “The Function of Savings,” Böhm-Bawerk had pointed out that the error in such an argument arises from the failure to remember that what people do in an act of savings is to defer present consumption, not to plan to forgo consumption permanently. Income-earners shift a portion of their demand for goods from the present to the future, at which point they plan to utilize what they have saved and additionally earned as interest-income for some alternative desired consumption purposes.

The savings set aside frees resources and labor to be applied in those different, roundabout productive ways, so there can be produced greater and improved quantities of goods that will be demanded when those times in the future arrive. The task of the entrepreneur is to anticipate the direction and timing of future consumer demand as well as the prices those future consumers might be willing to pay for goods to be offered in certain quantities and qualities. The market rewards those entrepreneurs who more correctly anticipate future market conditions with earned profits and punishes the less competent entrepreneurs with no profits or even losses.

The market system of profit and loss through competition for the use of resources and the selling of products assures a greater rationality to investment decision-making than suggested by Keynes’s references to “animal spirits” and “conventional wisdom.” In the market economy, control over the investment decision-making process is always tending to be shifted into those entrepreneurial hands that, in the system of division of labor, demonstrate the most competent ability to direct production into the avenues most consistent with the present and future patterns of consumer demand.

The market interest rates are meant to bring into balance the individual plans of savers with the individual plans of borrowers and investors. They serve the same function as all other prices in the market: to coordinate the activities of multitudes of people for purposes of mutual benefit through opportunities for gains from trade. Changes in the market rates of interest potentially modify people’s consumption, savings, and investment decisions just as any other change in a price may modify the amount of a good consumers find attractive to buy and sellers find attractive to offer for sale.

In a developed market, with numerous consumers and producers, there always tend to be people for whom any change in price will represent their individual threshold point at which they will modify their buying and selling. Each of us has these threshold points; this is what economists call “marginal decision-making.” Some incremental change in a price will result in some incremental increase or decrease in the amount of a good some people are willing to purchase or sell.

By arguing that some mystical “psychological law” results in people’s consuming a certain amount of their income independent of changes in the rate of interest, Keynes was rejecting the fundamental logic of human action and choice upon which all economic understanding is based. The rate of interest not only influences the attractiveness, at the margin, of investing in bonds and securities versus holding a portion of one’s income as a cash balance. The interest income to be earned from savings is also the cost of not consuming. And as with any other price, if the rate of interest rises or falls, some people will find it less or more attractive to consume. It is the logic of these changes in people’s willingness to consume or save in the face of a change in the rate of interest that ensures that the supplies and demands for consumer goods, savings, and investment projects of particular types and durations are kept in balance.

It was this logic of human choice and the rationality of market relationships between savings, investment, and interest that Keynes said he was “reacting strongly against” and from which he wanted to gain his “freedom.”

Part 1 | Part 2 | Part 3 | Part 4 | Part 5 | Part 6 | Part 7 | Part 8 | Part 9 | Part 10 | Part 11 | Part 12 | Part 13 | Part 14 | Part 15 | Part 16 | Part 17 | Part 18 | Part 19 | Part 20 | Part 21 | Part 22 | Part 23 | Part 24 | Part 25 | Part 26 | Part 27 | Part 28 | Part 29 | Part 30 | Part 31 | Part 32 | Part 33 | Part 34 | Part 35 | Part 36 | Part 37 | Part 38 | Part 39 | Part 40 | Table of Contents

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    Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).