John Maynard Keynes (1936):
The General Theory of Employment, Interest and Money, chapter 32: the essence of the situation is to be found, nevertheless, in the collapse in the marginal efficiency of capital, particularly in the case of those types of capital which have been contributing most to the previous phase of heavy new investment. Liquidity-preference, except those manifestations of it which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital. It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But, in fact, this is not usually the case…. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.
This brings me to my point. The explanation of the time-element… is to be sought in the influences which govern the recovery of the marginal efficiency of capital…. [T]he length of life of durable assets… the carrying-costs of surplus stocks… [explain why] the downward movement… does not fluctuate between, say, one year this time and ten years next time, but… between, let us say, three and five years….
So long as the boom was continuing, much of the new investment showed a not unsatisfactory current yield. The disillusion comes because doubts suddenly arise… because the current yield shows signs of failing off, as the stock of newly produced durable goods steadily increases…. Once doubt begins it spreads rapidly. Thus at the outset of the slump there is probably much capital of which the marginal efficiency has become negligible or even negative. But the interval of time, which will have to elapse before the shortage of capital through use, decay and obsolescence causes a sufficiently obvious scarcity to increase the marginal efficiency, may be a somewhat stable function of the average durability of capital…. The second stable time-factor is due to the carrying-costs of surplus stocks which force their absorption within a certain period…. The sudden cessation of new investment… lead[s] to an accumulation of surplus stocks of unfinished goods…. [T]he process of absorbing the stocks represents negative investment, which is a further deterrent to employment; and, when it is over, a manifest relief will be experienced. Moreover, the reduction in working capital, which is necessarily attendant on the decline in output on the downward phase, represents a further element of disinvestment, which may be large….
Unfortunately a serious fall in the marginal efficiency of capital also tends to affect adversely the propensity to consume. For it involves a severe decline in the market value of Stock Exchange equities….
When once the recovery has been started, the manner in which it feeds on itself and cumulates is obvious. But during the downward phase… the marginal efficiency of capital may fall so low that it can scarcely be corrected, so as to secure a satisfactory rate of new investment, by any practicable reduction in the rate of interest…. In conditions of laissez-faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far-reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.
The preceding analysis may appear to be in conformity with the view of those who hold that over-investment is the characteristic of the boom, that the avoidance of this over-investment is the only possible remedy for the ensuing slump, and that, whilst for the reasons given above the slump cannot be prevented by a low rate of interest, nevertheless the boom can be avoided by a high rate of interest. There is, indeed, force in the argument that a high rate of interest is much more effective against a boom than a low rate of interest against a slump.
To infer these conclusions from the above would, however, misinterpret my analysis; and would, according to my way of thinking, involve serious error. For the term over-investment is ambiguous. It may refer to investments which are destined to disappoint the expectations which prompted them or for which there is no use in conditions of severe unemployment, or it may indicate a state of affairs where every kind of capital-goods is so abundant that there is no new investment which is expected, even in conditions of full employment, to earn in the course of its life more than its replacement cost. It is only the latter state of affairs which is one of over-investment, strictly speaking, in the sense that any further investment would be a sheer waste of resources…. [I]t is only in the former sense that the boom can be said to be characterised by over-investment. The situation… is not one in which capital is so abundant that the community as a whole has no reasonable use for any more, but where investment is being made in conditions which are unstable and cannot endure, because it is prompted by expectations which are destined to disappointment.
It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom…. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent. in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.
Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom…