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Keynes and Keynesian theories of profit

Due to his activities at the British Treasury and at the University of Cambridge, John Maynard Keynes became one of the leading economists of the 20th century. The first part of this chapter aims to highlight the major features of the theory of profit developed by the British economist. Although his concept of profit evolved over his professional life, Keynes always conceived profit as the motor driving productive activities. ‘[F]or enterprise to be active, [. ..] [t]here must be an expectation of profit; and it must be possible for enterprises to obtain command of sufficient resources to put their projects into execution’ (1930b [1971]: 133). Profit is one of the central themes of Keynes’s scientific research. As shall be observed in the second part of the chapter, the contributions of Keynes gave rise to different economic traditions since 1936. Interestingly enough, still at present, economic theory lacks a general consensus on the nature of profit.

Before starting our assessment of profits in A Treatise on Money and in The General Theory of Employment, Interest and Money, the most influential books written by Keynes, it must be observed that in A Tract on Monetary Reform, published in 1923, years before A Treatise, Keynes was already concerned with the problem of profit. In particular, it is worth noting that in the Tract (1923), Keynes analyzes profit by sub-dividing the society of his time into social classes. In A Treatise, and then in The General Theory, Keynes was somewhat vague in this respect. One might argue, controversially enough, that Keynes was more prone to provide his readers with an analysis of incomes rather than of social classes.

The Treatise was published in 1930, and The General Theory dates back to 1936. In A Treatise, Keynes wrote about ‘normal’ and ‘windfall’ profits. Normal profits, which correspond to the remuneration of the entrepreneur, are included into income, whereas windfall profits are excluded from it. Windfall profits, the central theme of A Treatise, are barely mentioned in The General Theory, where special attention is paid instead to normal profits.

A number of scholars have written about Keynes’s contributions and legacy: notable examples are, for instance, Moggridge (1971-83, 1992),

Eatwell and Milgate (1983, 2011), Skidelsky (2003,2009), Pasinetti (2007), and Davenport-Hines (2015). At present time, one among the major experts in Keynes’s works is Robert W. Dimand. A former doctoral scholar of Nobel Prize recipient James Tobin, Dimand wrote extensively, in particular, on the making of Keynes’s theory, focusing on the years between 1930, when A Treatise was published, and 1936, the publication year of The General Theory. See, for instance, Dimand’s 1988 book (based on Dimand 1983), in which the author deals, among other topics, with the concepts of profit and quasi-rents. Keynes’s analysis of quasi-rents was surely influenced by Marshall’s theory and is a stepping-off point when studying Keynes’s works. Nevertheless, in the following assessment, they shall be left aside, consistently with the aim of exclusively dealing with the concept of profit.

At first, they were windfalls

In A Treatise (1930a [1971]), Keynes used at least three expressions to refer to the concept of income: ‘the community’s money income’, ‘the earnings of the factors of production’, and ‘the cost of production’. In that book, income is made up of wages, the ‘normal remuneration of entrepreneurs’, ‘interest on capital’, and ‘[r]egular monopoly gains, rents and the like’ (1930a [1971]: 111). Suppose interest, gains, rents, and the like to be null. This supposition is dictated by sole reasons of exposition. Interest, gains, and the like, though fascinating topics, are in fact beyond the scope of this chapter.

The concept of profit, in A Treatise, is strictly tied to the definition of income. In 1930, indeed, Keynes wrote about two kinds of profit. The ‘normal remuneration of entrepreneurs’ corresponds to the type of profit defined as ‘normal’, and it is included in the definition of income. Windfall profit, instead, is excluded from it. It must be observed that the very existence of profit, with particular reference to windfalls, is a controversial issue that creates much confusion for the reader of A Treatise. This topic is intimately linked to output price levels, a matter of great interest to Keynes in 1930. In fact, as Kahn (1984: 65) mentioned, Keynes was more concerned with price levels rather than with output and employment levels. Indeed, Keynes himself, in the memorandum of a letter to Ralph Hawtrey (November 28, 1930), wrote that in A Treatise he was ‘primarily concerned with what governs prices' (quoted in Kahn, 1984: 108).

Although Keynes dealt with this topic in A Treatise, the concept of windfalls can be understood from the reading of a document to be found in Keynes’s collected writings, edited by Donald Moggridge (1971—89). Such a document casts some light on the matter. On November 21, 1929, the Committee on Finance and Industry met for the first time. Also known as the Macmillan Committee, named after its chairman Hugh Pattison Macmillan, it was designated by the British government so as to find out the causes of the economic and financial crisis of the late 1930s (for instance, see Stamp 1931; Moggridge 1992). Between November 1929 and the end of May 1931, the Committee met one hundred times. Keynes was among the most active members of the Committee, together with Reginald McKenna, Theodore E. Gregory, Robert H. Brand, and Ernest Bevin. The proceedings of these meetings echo Keynes’s ideas in his Treatise on Money, published for the first time in October 1930 (see Moggridge, 1971-89: 38, Vol. 20). In fact, as emerges from the transcripts of the Committee meetings, chaired by the Rt Hon. Lord Macmillan (see Moggridge 1971—89: 38-93, Vol. 20), Keynes had a very precise two-fold conception of profit at that time.

The first category of profit corresponds to the remuneration of entrepreneurs. The other category of profit was defined, instead, as ‘windfall’; it was considered of inflationary origin and was excluded from income. Keynes is quite clear: national income is equal to the sum of total wages, inclusive of the normal profits of entrepreneurs, and exclusive of windfall profits. Keynes wrote:

I should explain that I use ‘wages’ in a very wide sense, to cover what economists call ‘remuneration of the factors of production’. Whether it is business men’s efforts, or capital, or whatever it is, the ‘remuneration of the factors of production’ is very often convenient, though not quite accurate, to cover by the term ‘wages’. [. . .] Including profits [. . .]; in the sense of the normal reward that a business man receives - not including windfalls.

(Keynes in Moggridge, 1971-89: 45, Vol. 20)

To explain his theory of windfall profits, Keynes used an example he had developed together with the members of the Cambridge Circus. Importantly, the members of the Circus were Keynes’s closest friends: Richard F. Kahn, James Meade, Austin Robinson, Joan Robinson, and Piero Sraffa. The group advised Keynes in the years following the publication of A Treatise, when Keynes began to develop his General Theory. This example is also to be found in Chapter 12 of A Treatise (‘A further elucidation of the distinction between savings and investment’). Keynes hypothesized the existence of a society that owns banana plantations, on which it works. The members of this society consume bananas and save part of their income: family savings are used to finance the production cost of new investment in extending the plantations. Thus, there is equality between savings and investment, inasmuch as society’s savings correspond exactly to the cost of new investment. Subsequently, Keynes supposed that individuals save more than before, and that, for various reasons, investment levels do not increase accordingly. Keynes believed that, given that bananas rot quickly, entrepreneurs shall sell them at a lower price, since, it should be remembered, savings have increased. The reduction in the price of bananas shall be proportional to the increase in savings. Because the price of bananas has fallen and wages remain unchanged, *[w]hat will happen is that you have just as many bananas consumed as before, but the entrepreneurs will lose an amount equal to the new savings of those people who have saved’ (Keynes in Moggridge, 1971-89: 77, Vol. 20). Due to the increase in savings, individuals have obtained the same quantity of bananas as before, at a lower price. Therefore, the wealth of the society has not increased. ‘The continuance of this will cause entrepreneurs to [. . .] reduce wages, and if they cannot reduce wages they will try to protect themselves by putting their employees out of work’ (Keynes in Moggridge, 1971-89: 77, Vol. 20). To deal with this problem, Keynes believed that the use of savings in new investments can restore the equilibrium of savings and investment. ‘[Tjhere is no cure for the reduction of wages and unemployment, except universal starvation, the cartel, the calling off of the thrift campaign for these or other reasons, or the finding of some new outlet for investment’ (Keynes in Moggridge, 1971-89: 78, Vol. 20). Moreover, bank intervention can lead to an excess of investment over savings. This could cause inflation and the birth of windfall profits. If banks are successful in their purpose, for example, through variations in the bank rate,

you have an inflation. If people are able to borrow more [than] the equivalent of saving, prices rise above costs of production and the entrepreneur makes windfall profits and the extra investment that is created becomes the property of the entrepreneur. Owing to the rise of prices the consumer finds his money income worth less than he anticipated, the profiteer makes the profit and the extra quantity of goods represented by the extra investment [. . .] belongs to the profiteer.

(Keynes in Moggridge, 1971-89: 80, Vol. 20)

Keynes wrote more on this in Chapter 16 of A Treatise (‘A classification of the causes of a disequilibrium of purchasing power’), in which he once more turned his attention to the ‘parable’ of banana plantations. There he wrote that in the ‘state of equilibrium in which the price level corresponds to the cost of production, profits are zero’. In that case, it consequently emerges that ‘the cost of investment is equal to that of saving’ (Keynes 1930a [1971]: 231).

Keynes wrote that ‘profits [. . .] having once come into existence become [. . .] the mainspring of change in the existing economic system’ (1930a [1971]: 126). Yet, possibly the most important aspect of A Treatise is the careful attention Keynes paid to a particular category of profit that can be defined pathological. In fact, according to Keynes, windfall profits must be nil if the economy is to be in equilibrium. In Chapter 11 (‘The conditions of equilibrium’) Keynes kept writing about windfall profits and economic equilibrium, a concept inherited by Keynes from his neoclassical mentors (the influence of Alfred Marshall and Arthur C. Pigou on Keynes as an economist cannot be denied, at least until 1930, the year in which A Treatise was published). In fact, in the following passage from A Treatise, Keynes wrote:

since the profits (Q) are the difference between the value of current output and E, its cost of production, we have Q = I-S so that entrepreneurs make a profit or a loss according as the money value of current investment exceeds or falls short of current savings. Thus we have profits = value of output - cost of production = value of investment -savings; profits being the balancing figure not only between cost of production and value of output, but also between savings and the value of net investment, both in terms of money. [...] Now equilibrium requires that [. ..] Q should all be zero.

(1930a [1971]: 136)

Therefore, as Keynes himself stated, a prerequisite for a monetary economy to be in equilibrium is that ‘aggregate profits are zero’ (1930a [1971]: 137). Whenever windfall profits are positive, there will be a disequilibrium caused by the excess of investment over savings: the ‘disparity between investment and saving sets up a disequilibrium in the rate of profit’ (Keynes 1930a [1971]: 138). ‘We may have a rise or fall of [. . .] the total profits above or below zero, due to an inequality between saving and the value of investment. We shall call this profit inflation (or deflation)' (Keynes 1930a [1971]: 140).

Following a famous passage in A Treatise, windfall profits are repeatedly renewed over time. The excerpt contains the examples of the ‘widow’s cruse’, in the case of profits, or the ‘Danaid’s jar’, in the case of losses. As explained by Kahn (1984: 106), the widow’s cruse refers to the widow whose tears can never be depleted, in the Holy Bible, I Kings XVII, and, among the members of the Circus, it was firstly discussed by Austin Robinson (1977: 34). The ‘Danaid’s jar’ refers instead to ancient Greece. As Kahn (1984: 106) puts it, ‘[i]n Greek legend, Argos, founded by Danaus, suffered every summer from a drought. In the lower world the fifty daughters of Danaus (the Danaids) had to carry water in broken vases’. Keynes wrote:

If entrepreneurs choose to spend a portion of their profits on consumption [. . .], the effect is to increase the profit on the sale of liquid consumption goods by an amount exactly equal to the amount of profits which have been thus expended. [...] Thus profits, as a source of capital increment for entrepreneurs, are a widow’s cruse which remains undepleted however much of them may be devoted to riotous living.

(1930a [1971]: 125)

According to Keynes, windfall profits are spent infinite times and yet constantly restored. Profits spent in the purchase of consumer-goods appear to replenish company deposits to an equal amount. This would take place time and time again. The deeper reason behind this phenomenon is a controversial subject in economic theory. The most famous criticism of this passage of A Treatise originates from the Cambridge Circus. As Kahn recalls (1984:

  • 106) , ‘[t]he most important issue discussed by the Circus was what Austin Robinson called the ‘“widow’s cruse” fallacy’ and the “Danaid jar” fallacy’. The main criticism concerned Keynes’s hypothesis that the level of consumption-goods was fixed. As Kahn recalls (1984: 107), Keynes never explained why he had chosen a fixed level of consumption-goods and, above all, he never explained how it might be possible to subdivide the total output, O, ‘between R, the sales of consumption-goods, and C, the output of capital-goods plus the increment of working capital and stocks’ (Kahn 1984:
  • 107) . The influence of the Circus was enormous and can be felt, for instance, in Keynes’s new research into the determinants of output levels, an interest already evident in his Harris Foundation lectures in June 1931 (see Kahn 1984: 110; Moggridge 1973: 79, Vol. 20). In this context, Keynes showed a reduced interest in the determination of price levels, which, instead, had been an important line of inquiry in A Treatise.

Also, it has to be noted that Keynes’s ideas were highly criticized by Friedrich Hayek. In particular, Hayek (e.g., 1931, 1932) stirred a heated debate with Keynes (1931) about the ideas that permeate A Treatise. Referring to windfall profits, Hayek was harsh. Indeed, he described windfalls as ‘a stumbling-block to most readers’ (Hayek 1931: 273), while adding: ‘I have no fundamental objection to this somewhat irritating distinction’ (Hayek 1931: 273). One of the main critiques the Austrian economist advanced against Keynes regarded profit. Hayek in fact did not agree with Keynes’s explanation of profit:

I cannot agree with his explanation of why profits arise, nor with his implication that only changes in ‘total profits’ in his sense can lead to an expansion or curtailment of output. For profits in his view are considered as a ‘purely monetary phenomenon’ [. . .]. The cause of the emergence of those profits [. . .] is [. . .] simply and solely spontaneous changes in the quantity and direction of the flow of money.

(Hayek 1931:273)

To the eyes of Hayek, the theory of investment developed in A Treatise laid on weak foundations:

I pass now to the central and most obscure theme of the book, the description and explanation of the processes of investment. It seems to me that most of the difficulties which arise here are a consequence of the peculiar method of approach adopted by Mr. Keynes, who, from the outset, analyses complex dynamic processes without laying the necessary foundations by adequate static analysis of the fundamental process.

(Hayek 1931:277-8).

Moved by the passionate debates about his 1930 work, Keynes himself rejected the theory of profit and investment as developed in A Treatise and started formulating a new one. It took six years for Keynes to be able to publish another book, in 1936. Keynes’s new purpose was

to deal with difficult questions of theory, and only in the second place with the applications of this theory to practice. For if orthodox economics is at fault, the error is to be found not in the superstructure [...], but in a lack of clearness and of generality in the premises.

(1936: v)

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