The "Greatest Age" in context

Keynes called it the "marginal efficiency of capital", but Keynes makes my head spin. So does the Wikipedia page. For the moment, I'll just call it the expected rate of return. Expected, because you figure it before you even make the investment. Rate of return because you want to know if it looks like a good investment.

More accurately -- the "featured snippet" nails it -- the marginal efficiency of capital is the rate of return expected on a new capital asset over its lifetime.

I'm thinking now, the "efficiency" of capital is the rate of return you get. You consider the "marginal" efficiency because you are focused not on all the capital that exists, but on the new capital asset you may decide to invest in. Just the new one. Evidently, that's what "marginal" means.

The expected rate of return on new investment has to be higher than the rate of interest you are getting on your money in the bank. If the expected rate of return is less than the rate of interest, you are better off leaving your money where it is, collecting interest. So then you decide not to make the investment, and the pace of investment slows.

Or, if you plan to fund the investment by borrowing, the rate of return you expect to get has to be more than the rate of interest you'll have to pay on the borrowed money. If not, you will lose money by investing. So again then, you decide not to make the investment, and the pace of investment slows.

Using the abbreviation "MEC" for the technical term "marginal efficiency of capital", the Wikipedia page offers a summary of what I'm trying to say:

The MEC needs to be higher than the rate of interest for investment to take place.

Remember when the economy went bad, back in 2007-08? The Fed lowered interest rates as far as they could go. Among other things, they wanted to make the rate of interest lower than the "MEC", to boost the economy by stimulating investment.

During the "greatest age" of investment,  the rate of return  the "MEC" was high relative to the rate of interest. That's what made it the greatest age. 

Near the end of chapter 21 of the General Theory, Keynes listed several factors which contributed to making the MEC unusually high in the nineteenth century:

During the nineteenth century, the growth of population and of invention, the opening-up of new lands, the state of confidence and the frequency of war over the average of (say) each decade seem to have been sufficient, taken in conjunction with the propensity to consume, to establish a schedule of the marginal efficiency of capital which allowed a reasonably satisfactory average level of employment to be compatible with a rate of interest high enough to be psychologically acceptable to wealth-owners.

That's all one sentence. The MEC was high in the 19th century. In his next sentence, Keynes points out that interest rates were low in the 19th century:

There is evidence that for a period of almost one hundred and fifty years the long-run typical rate of interest in the leading financial centres was about 5 pet cent., and the gilt-edged rate between 3 and 3 1/2 per cent.; and that these rates of interest were modest enough to encourage a rate of investment consistent with an average of employment which was not intolerably low.

"Modest," he says, interest rates were "modest" in the 19th century. Low, relative to earlier times. Paul Schmelzing's graph shows a trend of decline in interest rates since the 1300s, confirming the view that interest rates were relatively low in the 19th.

In two sentences, Keynes tells us that in the 19th century, interest rates were unusually low and the MEC was unusually high at the same time. These factors combined to create an unusually strong "inducement to invest", he said, making the 19th century "the greatest age of the inducement to investment". Thus the title of today's essay.

Historians sometimes refer to "the long nineteenth century". We can do that here, if you are troubled by Keynes cramming "almost one hundred and fifty years" into the 19th.

 

What made the Greatest Age special?

Keynes opens the General Theory by explaining the significance of the words "general theory" in the title of the book. His intent: "to contrast the character of my arguments and conclusions with those of the classical theory", he says, "... upon which I was brought up":

I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case...

As I read it, Keynes is not saying the classical theory is wrong. He says it is right, but it only applies sometimes. It only applies when the conditions are right. It only applies to the 19th century.

In recent times, you may have heard that Keynesian economics explained the good economy that followed the Second World War, but it could not explain the severe inflation of the 1970s. Well, that story appears to have been modeled after a story Keynes had in mind when he was writing the General Theory: classical economics could explain the good economy of the 19th century, but it could not explain the severe unemployment of the Great Depression.

I love that kind of ironic twist.

We have already noted several factors identified by Keynes, which contributed to the strong inducement to invest during the long 19th century. I want to go back now to that first Keynes quote, where he listed the factors that made the 19th century unique:

1. the growth of population 
2. and of invention, 
3. the opening-up of new lands, 
4. the state of confidence 
5. the frequency of war [and] 
6. the propensity to consume ...

Let that sit a moment, while I take you back to Carroll Quigley's The Evolution of Civilizations, which came up more than once in my "July 2021" posts. On page 146 Quigley lists his "seven stages" of civilization. On page 149 he lists the four types of expansion that occur in the "expansion" stage:

1. increased production of goods, eventually reflected in rising standards of living;
2. increase in population of the society, generally because of a declining death rate;
3. an increase in the geographic extent of the civilization, for this is a period of exploration and colonization; and
4. an increase in knowledge.

Keynes's factor "1" (population growth) is Quigley's "b". Keynes's "2" (invention) goes with Quigley's "d" (an increase in knowledge). Keynes's factor "3" (territorial expansion) is Quigley's "c". And Quigley's "a" (increased production) is the reason Keynes mentions the 19th century in the first place. The lists are similar. The features described by Keynes and those described by Quigley are very much the same. Both describe a favorable investment environment.

Second, the timing matches up. On page 145, Quigley identifies three periods of expansion in Western civilization:

the first about 970-1270, the second about 1420-1650, and the third about 1725-1929.

The third period is just over 200 years in length. That's a bit long, even for a long 19th century. However, the nineteenth century is entirely contained within Quigley's third period. So is Keynes's "greatest age".

James R. Crotty uses World War I as the point of transition from 19th to 20th century capitalism in Keynes's work. Keynes does the same in his 1936 book. For example:

• He refers to the "post-war experiences of Great Britain and the United States" to describe problems arising from an inadequate inducement to invest (see the fascinating chapter 16, section iii -- but read it slowly).
  
• In a powerful paragraph (chapter 2, section vi) Keynes points out a flaw in the argument of "Post-war economists". 

Taking the first year of World War I (1914) as the last of the "almost one hundred and fifty years" of the Greatest Age, that Age would have started soon after 1764, around the time Adam Smith started writing The Wealth of Nations.

The "greatest age" dates may vary somewhat, depending on the source. Even Crotty at one point refers not to World War I but to 1920 as "the line of demarcation". At this later date, though, the period of almost 150 years which constitutes for Keynes the "greatest age" of investment is still entirely contained within Quigley's "Stage of Expansion". 

As for the differences of timing, remember that Keynes and Quigley were not measuring the same thing. Keynes's dates are based on interest rates, with an eye on investment. Quigley's are based the expansion of civilization. They are definitely related, investment and the expansion of civilization, but don't expect a glove-like fit. Anyway, as Quigley says (page 128): "it should be remembered that the dates given for historical periods are only approximate."

 

Third, as Wikipedia summarizes the view of Keynes, "unemployment arises whenever entrepreneurs' incentive to invest fails to keep pace with society's propensity to save". Quigley (pages 140-141) makes a similar argument, saying "our modern economic system cannot produce and consume what it produces unless it also invests" because "savings reduce the flow of purchasing power". Both writers point to the same process as the cause of the trouble: Saving interferes with economic progress unless investment spending adequately compensates.

In sum, Keynes and Quigley agree on three points:

• The economic process: for growth to occur, investment must sufficiently offset saving.
• The timing: The "greatest age" of Keynes occurs entirely within Quigley's third expansion of Western civilization.
• The economic environment: Keynes and Quigley describe similar factors that made that time unique.

This is no coincidence. Keynes was fully aware of the connection between civilization and the economy.