Keynes On The Stages of Development of The Capitalist Economy Crotty

Keynes on the Stages of Development of the Capitalist Economy: The Institutional Foundation
of Keynes's Methodology
Author(s): James R. Crotty
Source: Journal of Economic Issues, Vol. 24, No. 3 (Sep., 1990), pp. 761-780
Published by: Association for Evolutionary Economics
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JeIJOURNALOF ECONOMICISSUES
Vol. XXIV No. 3 September1990
Keynes on the Stages of Development of the

Capitalist Economy: The Institutional Foundation
of Keynes's Methodology
James R. Crotty
MosteconomistsassumethatKeynes'stheoryof the capitalistmac-

roeconomyis adequatelyrepresented by the standardset of "Keynes-
ian" aggregatedsupplyand demandcurves.The generallyaccepted
interpretationof The GeneralTheory,pioneeredand popularizedby
PaulSamuelson,suggeststhatthe consumption,marginalefficiencyof
capital,liquiditypreference,andlaborsupplyfunctionsconstitutethe
scientificcoreof thebook;thecomments,observationsandasidesthat
surroundthiscore,it is assumed,havelittlescientificvalue.Thesecore
behavioralequationsof mainstreamKeynesianismare derivedfrom
the optimizingdecisionsof typicalneoclassicaleconomicagentswho
arefullyspecifiedthroughtheirendowmentbundlesandpreference or-
derings.Indeed,the fact that modem Keynesiantheoryis logically
foundedon such starklydefined,isolatedagentsis the reasonit is
grantedscientificstatus.
Thisessayis concernedwiththe followingimportantimplicationof
the standardinterpretation of Keynes'stheory.If mainstreamKeynes-
ian theoryis indeedan adequatereflectionof Keynes'sapproachto
macroeconomic analysis,thenhis theorymustbe ahistoricalandinsti-
Theauthoris Professorof Economicsat the Universityof Massachusetts,Amherstcam-

pus. He would like to thank Randall Bausor, Don Goldstein,Jon Goldstein, Craig
Freedman,Ilene Grabel,Martha Olney, Douglas Vickers,Sam Bowles, and especially
CarolHeimfor helpfulcriticismand suggestions.
761

762 JamesR. Crotty
tutionallynonspecific,and The GeneralTheorymust be a model of

capitalism-in-general, equallyapplicablein all times and in all places
wherethecapitalistsystemdominateseconomicactivity.I argueto the
contrarythatsucha characterization of Keynes'stheoryis profoundly
mistaken.Thecentralthesisof thisarticleis thatKeynes'stheoryis-as
it oughtto be-institutionallyspecificand historicallycontingent.In
TheGeneralTheoryandelsewhereKeynesmadeevidenthis beliefthat
no all-purpose, abstractmacromodelcanadquatelycap-
institutionally
turetheprocessesandoutcomesof distinctphasesorstagesof capitalist
development: qualitativechangein institutions,in classstructureor in
agent constitutionor motivationrequiresa qualitativelydistinctver-
sion of his theory.'
If Keynes'smacrotheoryis indeedhistoricallycontingent,then he
shouldhavedevelopeddifferentversionsof his theoryto describeand
analyzeinstitutionallydistincthistoricalstagesof capitalism.I argue
that Keynesprovidedthe outlinesof a theoryof the evolutionof two
distinctstagesof capitalistdevelopment(andanticipatedthetransition
towarda third)in whicheachstageis assumedto possessuniqueinsti-
tutionsandagentpracticesthatdifferentiate its processesandoutcomes
fromtheother.Specifically, Keynesarguesthatnineteenth-century cap-
italismdifferedin institutionaland classstructureas well as in agent
behaviorpatternsfrompostWorldWarI capitalism.Becauseof these
institutionaldifferences,nineteenth-century capitalismexhibitedim-
pressiveeconomicgrowthandstability,whereastwentieth-century cap-
italism was prone to stagnation-depression as well as to bouts of
extremeinstabillity.
Clearly,thesesetsof profoundlydifferentoutcomescannotbe com-
fortablygeneratedby a singleKeynesiantheoryof somethingcalled
competitive-capitalism-in-the-abstract.This beingthe case,the ques-
tionnaturallyarisesas to preciselywhatTheGeneralTheoryis a theory
of, andin whatsenseit is general.
In the sectionsto followI addressthis questionandexplainandde-
fendthe propositionthatKeynes'stheoryis institutionally andhistor-
icallycontingent.
Keynes'sMethodologyand The GeneralTheory

The institutionalfoundationof Keynes'smethodologycan be seen
most clearlyif we understand
his macrotheory
to be the integrationof
two distinctlevelsof analysis-a relativelyabstractlevel (whichwe label
LevelI) and a moreinstitutionally
concretelevel (LevelII). Keynes's

TheInstitutional
Foundationof Keynes'sMethodology 763
Level I analysis would then incorporatethe definingcharacteristicsof

the capitalisteconomyas well as those assumptionsrequiredto con-
structthe skeletalpropertiesof the supplyand demandschedulesof
textbookKeynesianism (butnot theirpositionorpatternof movement
throughtime).A LevelII analysisaddsto the theorythe assumptions
thatspecifytheconcreteinstitutions,classes,andagentmotivationspe-
culiarto eachparticular stageof economicdevelopmentanddevelops
the theoreticaland behavioralimplicationsof this institutionalas-
sumptionset.2
Standingalone,Keynes'sLevelI analysisis incapableof generating
the characteristic pattemsof outcomesassociatedwith a particular
stageof developmentor of explainingwhydistinctstagesexhibitcon-
trastingpatternsbecauseLevel I theoryhas underdeveloped institu-
tionalandbehavioralconcreteness. Conversely,withoutthe guidance
anddirectionof Keynes'sLevelI analysis,a uniquelyKeynesianLevel
II theoryof anyspecificstageis not possible.LevelI conceptsandcate-
goriesare designedto guide the institutionalresearchthat informs
LevelII theory:theytell the theoristwhichinstitutionsandwhichbe-
haviorpatternsto study.3
Lookedat fromthis perspective,TheGeneralTheorycanbe saidto
be generalbecauseit containsKeynes'sLevelI analysisof thecapitalist
macroeconomy at the mostabstractlevel.Butits concreteobjectof in-
vestigationis the institutionallyspecificformof capitalismfoundin
Britain(orthe UnitedStates)in the interwarperiod.Thus,neitherthe
theoreticalnor the policyconclusionsof The GeneralTheoryare di-
rectlyapplicableto earlierto laterstagesof development.
The "general" analyticallevel of The GeneralTheoryincorporates
manyof the ideastypicallyassociatedwithKeynesianeconomics.For
example,it includesthe attackon the classicalthesisthat wageand
priceflexibilityguarantee market-clearingin competitivecapitalism,as
well as the thesisthatthe behaviorof aggregate demandis the key to
macrodynamics. Keynes'sargumentsthat consumptionand savings
patternsarecomplexlydeterminedbutrelativelystablein theshort-to-
intermediaterun,andthatinvestmentis the activeelement(andcon-
sumptionthe passiveelement)in capitalistmacrodynamics aremade
primarilyat LevelI. Indeed,the mainconclusionof LevelI theoryis
thatthe key to understanding the characteristic
behaviorof the econ-
omy in any particularstageis a concretetheoreticalanalysisof three
clustersof institutionsandagentpracticesthatdeterminethe behavior
of capitalaccumulationin that stage:(1) the strengthand stabilityof
the desireof enterprises to accumulatephysicalcapital(financingcon-

764 James R. Crotty
siderationsaside);(2)theproportionof incomesaved;and(3)thechar-
acterof the relationbetweenthe entrepreneurial classandthe classof
saversandwealth-holders.
Sincemuchof TheGeneralTheoryis devotedto a LevelII analysis
of interwarcapitalism,a briefreviewof Keynes'sspecificationof the
institutionsandbehaviorsthatmoldedthepatternof capitalaccumula-
tion in the 1920sand 1930swillhelpclarifymajordifferences between
Keynes'stheoriesof the macrodynamics of nineteenth-andtwentieth-
centurycapitalism.
In TheGeneralTheoryKeynesdiscussedtwo relatedproblemswith
investmentdemandin the modernera.First,he argued,investmentis
potentiallyextremelyunstable.Second,investmenthas a tendencyto
stagnateat a levelwellbelowfull-employment savings.
The stagnationist perspectiveis easiestto dealwith.Keynesargued
that risinghouseholdwealthand the satiationof basicconsumption
needswouldgeneratea highaveragepropensityto save. Investment
spending,on the otherhand,wouldbe helddownby the assumedlow
consumptiongrowthrate,a relativelycompletedinfrastructure, theab-
senceof significanttechnicalchange(it playedno rolein TheGeneral
Theory),a stablepopulation(whichimplieda secularrisein capitalper
worker),anda not insignificant lowerboundon interestrates.In addi-
tion, the potentialinstabilityof investmentwould,by makinginvest-
mentrisky,lowerthe incentiveto invest.
Keynes'svision of an extremelyunstablemoderncapitalismhas
morecomplexroots.His theoryof investmentinstabilityfocusedon
the behaviorof enterprisemanagersandwealthyrentiersandstressed
the separationof ownershipfrommanagement.Enterprisemanagers
have to constructa "marginal efficiencyof capital"or MECschedule
thatassociatesanexpectedmarginalrateof profitwitheachprospective
level of investment.As expectedlong-termprofitmaximizers,manag-
ers shouldundertakeeverypotentialinvestmentprojectwhoseMEC
exceedthe appropriate risk-adjusted cost of financialcapital.
Rentiersin turnmustdecideuponthe compositionof theirportfo-
lios, a decisionthatturnsuponboththeirattitudestowardriskversus
returnandtherisk-return characteristicstheyassociatein theirexpecta-
tionswithdifferentfinancialassets.Changesin eitherrentierattitudes
or expectationswill changethe cost of capital.
Becauseof this particularinstitutionalstructureof the investment
decision,Keynesrootedhis theoryof theinstabilityof moderncapital-
ism in theunknowability of thefuture.4Thefundamental determinants
of both the MECscheduleand the long-terminterestratearethe ex-

The InstitutionalFoundationof Keynes'sMethodology 765
pectationsof entrepreneursandrentiersaboutprospectivefutureyields
on realandfinancialassets,the degreeof confidencetheyplacein the
reliabilityof theirexpectations,and theirattitudestowardrisk. The
centraltenetof Keynes'stheoryof instabilityis thatthesefuturereturns
are in principleknowable;they cannotbe adequatelyrepresentedby
stable subjectiveprobabilitydistributions."The outstandingfact"
aboutthe investmentdecision,Keyneswrotein TheGeneralTheory:
is the extremeprecariousnessof the basis of knowledgeon which our es-
timatesof prospectiveyield have to be made.Ourknowledgeof the factors
which governthe yield of an investmentsome yearshence is usuallyvery
slight and often negligible. [It]... amounts to little and sometimes to
nothing [Keynes 1964, pp. 149-50].
In otherwords,Keynesplacedthe two classesof agentsresponsible

fortheinvestmentdecisionin thefollowingirreducibleepistemological
dilemma.They mustmake investmentand portfolioselectiondeci-
sions,forthesedecisionsarecrucialto theirreproductionas economic
agents,yetit is impossibleforthemto obtaintheinformationrequired
to makethesedecisionsin a safe,"rational" manner.Keynesput this
conundrumrathernicely:"Aboutthesemattersthereis no scientific
basison whichto formanycalculableprobability whatever.Wesimply
do not know.Nevertheless,the necessityfor actionand for decision
compelsus as practicalmen to overlookthis awkwardfact"[Keynes
1937,p. 214].
To "saveourfacesas rationaleconomicmen"in this contradictory
situation,Keynesnoted, we act-at least in noncrisisperiods-as if the
informationavailableto us wasin factan adequatebasison whichto
makerealandfinancialinvestmentdecisions.Specifically,we pretend
thatthe pastandpresentarea moreadequateguideto the futurethan
theycanpossiblybe andmakeourselvesbelievethat,thoughindivid-
ualjudgmentsaboutthe futureareworthless,the collectiveand"con-
ventional"judgmentof the business communityis much better
informed. Unfortunately,
a practicaltheory of the futurebased on these ... principleshas certain
markedcharacteristics.In particular,being based on so flimsy a founda-
tion, it is subjectto suddenand violent changes... At all times the vague
panic fearsand equallyvague and unreasonedhopes are not reallylulled,
and lie but a little way below the surface[Keynes 1937, p. 215].
Given these core institutionsand practicesof moderncapitalism,the

assumptionthat the futureis unknowableconstitutesan adequatefoun-

766 JamesR.Crotty
dationfor a theoryof instability.But in the absenceof additionalin-

stitutionaldetail, the degreeof instabilityassociatedwith modem
capitalismwouldhavebeenlimitedby Keynes'sbeliefthatBritishen-
trepreneurs wereknowledgeable professionals who habituallyadopted
a long-termperspectiveand tended,unlessconvincedotherwise,to
providetheirfirmswith the capitalrequiredto surviveand prosper
overthe longhaul.
*ButKeynesremovedeven this modestlimitationon the instability
of modemcapitalismby arguing,especiallyin Chapter12of The Gen-
eral Theory,thatentrepreneurs areforcedto substitutethe stockmar-
ket'smorevolatile,short-term assessmentof the expectedprofitability
of capitalexpansion,implicitin the priceof the firm'sshares,fortheir
ownmoresoberandlonger-term MECcalculations.5 He stated,forex-
ample,that investmentis "governedby the averageexpectationof
thosewhodealon theStockExchange as revealedin thepriceof shares,
ratherthanby the genuineexpectationsof the professionalentrepre-
neur"[Keynes1964,p. 151].
SinceKeynespicturedtwentieth-century rentiersas notoriouslyfick-
le andshort-sighted, thedegreeof instabilityassociatedin The General
Theorywiththeunknowability of thefutureis potentiallysevere.Vola-
tile rentier
expectationswill, fromtime to time, violentlyunhingein-
vestmentdemand.With "no strongroots to hold [them]steady,"
Keynesargued,theexpectational determinants of investmentwillfluc-
tuatesubstantially in the faceof "wavesof optimisticand pessimistic
sentiment,whichareunreasoning and yet in a senselegitimatewhere
no solidbasisexistsforrationalcalculation" [Keynes1964,p. 154].
This,in brief,is Keynes'stheoryof the instabilityof interwarcapi-
talism.6MycentralthesisimpliesthatKeynesdidnot intendthisto be
a theoryof the instabilityof capitalismin generalor in everystageof
development.I turnnowto his LevelII analysisof nineteenth-century
capitalismto providesupportforthis thesis.
Pre-WorldWarI Britain:Keynes'sFirstStageof Capitalist

Development
Note firstthatKeynesclearlydistinguishedtwo historicalstagesof
capitalistdevelopment:pre-World WarI or "nineteenth-century"cap-
italism(whichI labelStageOne),andpost-WorldWarI or modernor
twentieth-centurycapitalism(whichI labelStageTwo).He arguedthat
these stageshad qualitativelydifferenteconomicoutcomesbecause
they hadqualitativelydistinctinstitutionsandagentpractices.
In a numberof writings,Keynesassertedthatwhilefreedomof trade

and of capitalflows broughtpeaceand prosperityin the nineteenthcen-

tury,the same internationalsystem producedimperialism,war,and de-
pressionin the twentiethcentury(a point to which I return).In a similar
vein, Keynes often observedthat Britain'sdomestic nineteenth-century
capitalismwas characterizedby reasonablysteadygrowth,price stabil-
ity, adequateemployment and risingliving standards,all producedby
a strongand relativelysteadypace of capitalaccumulation.In The Gen-
eral TheoryKeynes made the point as follows. "Duringthe nineteenth
century,"there existed:
a scheduleof the marginalefficiencyof capitalwhich alloweda reasonably
satisfactoryaveragelevel of employmentto be compatiblewith a rate of
interest high enough to be psychologicallyacceptableto wealth-owners.
Thereis evidence that for a period of almost one hundredand fiftyyears
... ratesof interestweremodest enoughto encouragea rateof investment
consistent with a rate of employment which was not intolerably low
[Keynes 1964, pp. 307-8].
Laterin the book he commented on "theexuberanceof the greatestage

of the inducement to invest" in nineteenth-centuryEngland [Keynes
1964, p. 353]. And in the Economic Consequencesof the Peace he ar-
gued that before World War I, "Europewas so organizedsocially and
economicallyas to securethe maximum of capitalaccumulation[with]
some continuous improvement in the daily conditions of life of the
mass of the population"[Keynes 1920, p. 18].
Second, note Keynes's belief in the need for a theorythat could ex-
plain the evolution of qualitativelydistinct stages of economic devel-
opment. He aligned himself with Commons's view that economic
theory had to reflectthe existence of "threeepochs, three economic or-
ders, upon the third of which we are entering."The first,accordingto
Keynes, was a precapitalist"Eraof Scarcitywith a maximum of com-
munistic, feudalisticor governmentalcoercion,"which was dominant
through the sixteenth century and survived to some degree into the
eighteenthcentury.Then came the "Eraof Abundance"with "themaxi-
mization of individual liberty, the minimum of coercive control
throughgovernment,and individualbargaining.... [In]the nineteenth
centurythis epoch culminatedgloriouslyin the victories of laissez-faire
and historic liberalism"[Keynes 1963, p. 334].
But, Keynes continued, we are now passingthrougha period of tur-
bulence into a new stage of capitalism, an "Era of Stabilization"in
which societal or governmentalcontrols will replacelaissez-faire.The
coming era will requirea "transitionfrom economic anarchyto a re-
gime which deliberatelyaims at controlling and directing economic

768 JamesR. Crotty
forces in the interests of social justice and social stability" [Keynes

1963, p. 335].
Having established Keynes's belief in the qualitative differencein
performance between nineteenth- and twentieth-centurycapitalism
and in the need for a theory of stages of capitalist development to ex-
plain these differences,I ask: What is Keynes'sexplanationof whythe
stabilityand growthof nineteenth-centurylaissez-fairewas replacedby
the instabilityand stagnationof the interwaryears?
My interpretationof Keynes'smethod suggeststhat the Level I anal-
ysis of The General Theoryis the guide to the constructionof the in-
stitutionally concrete Level II models used to theoreticallycompare
and contrastthe two stages. Keynes's Level I model suggeststhat the
Level II theory should focus on the three clusters of institutions and
practices that determine the characterof capital accumulationin the
period. I examine Keynes's view of Stage One capitalismwith respect
to each in turn.
The agent motivation and behavior that characterizedthe decision
to accumulatecapitalin the Level II analysis of The GeneralTheoryis
not applicableto Stage One, Keynes tells us. Stage One entrepreneurs
were not nervous managers unsure of whether the accumulation of
physical capital or of liquid financial assets would best satisfy the
whimsical desires of their stockholders.In Chapter 12, Keynes con-
trastedthe investment-determiningprocess of this period with that of
modern capitalism.
In formertimes,whenenterprises
weremainlyownedby thosewho un-
dertookthem or by their friendsand associates,investmentdependedon
a sufficientsupplyof individualsof sanguinetemperamentand con-
structiveimpulseswhoembarked on businessas a wayof life,notrelying
on a precisecalculationof prospective profit.The affairwas partlya lot-
tery... Butevenaftertheeventno onewouldknowwhethertheaverage
resultsin termsof thesumsinvestedhadexceeded,equaledorfallenshort
of the prevailingrateof interest.... Decisionsto investin privatebusi-
ness of the old-fashionedtype were,however,decisionslargelyirrev-
ocable,not onlyforthe communityas whole,butalsoforthe individual
[Keynes1964,p. 150,emphasisadded].
Thus, Keynes saw the Stage One entrepreneurinvesting not as the

result of a carefulmonetarycost-benefitanalysisbut ratheras a way of
life, plowingbackhis profits(and the savingsof his family and business
associates)without much regardto whetherthe expected rate of profit
exceeded some interest rate. This characterizationof the "heroic"
nineteenth-centuryentrepreneur-"the active and constructive ele-

ment in the whole of capitalistsociety... he of all men and classes

most respectable,praiseworthy and necessary"[Keynes1963,pp. 87,
94]-was centralto his understanding of whyStageOnewas"thegreat-
est ageof the inducementto invest."
Not only was the desireto accumulatecapitalstrongin StageOne,
the propensityto save was highas well.Savingsweremorethanade-
quateto financebothdomesticandforeigninvestmentat low interest
rates.Thehighsavingsratewasin turncreatedby twohistoricallyspe-
cific aspectsof nineteenth-century
Britishclass structure:a very un-
equaldistributionof incomethatfunneleda disproportionate income
shareto theemergingstrataof industrialistsandmerchants, to thepro-
fessions,andto the landedaristocracy, and a highpropensityto save
amongthe upperclasses.
BeforeWorldWarI, Keynestellsus:
Society was so framed as to throw a great part of the increasedincome
into the controlof the class least likely to consume it. The new rich of the
nineteenthcenturywere not broughtup to large expenditures,and pre-
ferredthe power which investment gave them to the pleasuresof imme-
diate consumption. In fact, it was precisely the inequality of the
distributionof wealth which made possible those vast accumulationsof
fixed wealth and of capital improvementswhich distinguishedthat age
from all others [Keynes 1920, p. 18].
He wenton to argue(in 1920,at thelineof demarcation betweenStages

OneandTwo)thatthisclassstructure, withits particularclassmotiva-
tionsandbehavioralconventions,wastransitory."Iseekonlyto point
out thatthe principleof accumulationbasedon inequality... depend-
ed on unstablepsychologicalconditions,whichit may be impossible
to recreate"[Keynes1920,p. 21].
Finally,I turnto Keynes'scharacterization of the relationbetween
the saving and investing classes. He identified two different saver-
investor relations. The first referredto the owner-managedfirms dis-
cussed in the "in former times" quote cited above. Capital
accumulationin such firms was financedthroughretainedprofits and
the savingsof close friendsand business associates.Here, in sharpcon-
trast with the Level II analysis of The General Theory,saving and in-
vestment was done by the same people motivated by the same
objective-the growthof the enterprise.
The second relationinvolved the emergenceof the Victorianrentier
class. The key behavioralcharacteristicof this class, in Keynes'sview,
was that it invested primarily in bonds and preferredstock-not in
equity-and that it sought long-term income rather than short-term

770 James R. Crotty
capital gains. Though the rentierclass did purchasefinancialassets is-

sued by domestic enterprisesin the latterpart of StageOne, the money
was providedon a long-term,non-ownershipbasis. In contrastto mod-
em capitalism, there was no separation of ownershipfrom control in
Stage One. In Keynes'swords:
Thus theregrewup in the nineteenthcenturya large,powerful,and greatly
respectedclass of persons,well-to-doindividuallyand very wealthyin the
aggregate,who owned neitherbuildings,nor land, nor business, nor pre-
cious metals,but titles to an annualincome in legaltendermoney. In par-
ticular, that peculiar creation and pride of the nineteenth century, the
savingsof the middleclass,hadbeen mainlythus embarked[Keynes1963,
p. 90].
With nineteenth-centuryrentierstreatingtheir investments as rela-

tively illiquid assets, capital accumulationduring the period was not
burdenedby the unstable liquidity preferenceschedule of Stage Two.
The cost of financialcapitalwas on averagelow and stable. Keynes ar-
gued that there was a harmony of interest between the rentierand en-
trepreneurialclassesthat is in starkcontrastwith the domination of the
entrepreneurby the fickle rentier pictured in the Level II analysis of
The GeneralTheory.He describedthis relation as follows:
Contractsto receive fixed sums of money at futuredates ... must have

existed as long as money has been lent and borrowed.... But duringthe
nineteenthcenturythey developed a new and increasedimportance,and
had, by the beginningof the twentieth,divided the propertiedclassesinto
two groups-the "businessmen"and the "investors"-with partlydiver-
gent interests....
By this system the active business class could call to the aid of their
enterprisesnot only theirown wealthbut the savingsof the whole commu-
nity;and the professionaland propertiedclasses,on the otherhand,could
find an employment for their resources,which involved them in little
trouble,no responsibility,and (it was believed) small risk.
Europewithan ex-
yearsthesystemworkedthroughout
Fora hundred
traordinarysuccess and facilitatedthe growth of wealth on an unprece-
dented scale. To save and invest became at once the duty and the delight
of a largeclass. The savings were seldom drawnon....
The atmospherethus createdwell harmonizedthe demandsof expand-
ing business... with the growthof a comfortablenon-businessclass....
Investments spread and multiplied, until, for the middle classes of the
world, the gilt-edgedbond came to typify all that was most permanent
and secure[Keynes 1963, pp. 83-85, emphasisadded].
Keynes'stheoreticalmessage here is clear. A large rentierclass that

holds its wealth in the form of long-termbonds almost "as a way of

life" and an entrepreneurialclass that both owns and controls business

enterprisescan, if institutionalconditionsareright,coexist in harmony,
generating secular growth and stability for the community. Though
Stage One had some of the same institutional and class categoriesas
The General Theory,its concrete Level II structurewas qualitatively
different.As a result, it had neither the processesnor the outcomes of
Stage Two.
Keynes'sEmpiricalAssumptionsand the HistoricalRecord:A Digression

Since this essay is about Keynes's methodology ratherthan his cre-
dentials as an economic historian,the accuracyof his characterization
of the institutions and agent practicesof the nineteenthcenturyis not
directlyrelevantto its main thesis. Nonetheless, since the issue is per-
tinent to an assessment of the usefulness of his method of analysis, a
brief look at the historicalrecordis warranted.'
I first evaluate Keynes's assertion that capital accumulation was
more a "way of life" and less the result of a carefulpresent-valuecal-
culation in StageOne. Considerthat the major supportsof nineteenth-
century capital accumulationin Britain were the construction of the
railroadsystem and the growth of the export market. They provided
the demand that drove the expansion of the core industriesof the in-
dustrialrevolution-capital goods, textiles, iron and steel, and mining.
It is not unreasonableto arguethat both sectorswerethemselvesdriven
by forcesand motives not adequatelycapturedby standardtheories of
profit maximization,includingthe one used by Keynes in The General
Theory.
Eric Hobsbawm,for example, has arguedthat the railroadboom:
turned a valuable innovation in transport into a major national pro-
grammeof capitalinvestment.... [M]uchof [the capital invested in rail-
roads] was rashly, stupidly, some of it insanely invested. Britons with
surpluses,encouragedby projectors,contractorsand otherswhose profits
weremadenot by runningrailroadsbut by planningor buildingthem were
undeterredby the extraordinaryswollen costs of railways.... Much of
this capital was attractedless by rational calculationsof profit and loss
than by the romantic appeal of technological revolution [Hobsbawm
1968, p. 113].
A similarargumentcan be made for the export market.Geopolitical

motivations associated with "nation-building"and colonialism were
obviously of considerablesignificancein sustainingexport demand.
Moreover, there is support for Keynes's characterizationof the

772 JamesR. Crotty
nineteenth-centuryowner-entrepreneur.First, until late in the century

most industrial enterprises did rely almost exclusively on retained
profits and the savings of people closely associated with the firm.
Through at least the mid-1870s the combination of strong market
growth,limited competitive pressureand a weak labor force generated
a profitrate more than high enough to financeinvestment.
Second, the growth of the family enterpriseand the economic and
social status of the family were inextricablyintertwined:capital accu-
mulation was, to some extent, a way of life. CharlesKindlebergerde-
scribed this period in British history as follows:
Capitalto start most enterprisescame from an individual, his family,
friends,neighbors,in very informalways.... Growthcame usuallyfrom
retainedprofits.Middle-classentrepreneursin small firmswere reluctant
to get involved with outside funds for fear that the family's ownership
might be diluted and even lost. The argumentbeing maximized in the
objectivefunction,to use economicjargon,was not profitbut family sur-
vival [Kindleberger1984, pp. 192-93].
After 1880 externalfunds becameimportantto the growthof domes-

tic industryfor the first time (though much less important than they
would become in StageTwo).8Technicalchangeand increasedecono-
mies of scale, along with marketingand distributiondemands and the
merger movement, necessitated larger plant and firm size even as
heightened competition, slower growth and a stronger labor force
squeezedinternalfunds.However,as Keynesstressed,long-termbonds
and preferredstock totally dominated public offerings.Ownershipand
managementremainedunited.
Turningto the saving side of the saving-investmentrelation,it seems
clear that Keynes's assumptions of a very unequal distributionof in-
come and wealth, a high savings rate and a relativelylow interestrate
are consistentwith the historicalrecord.Thereis a discussion of "capi-
tal glut" in most treatmentsof the period. His characterizationof the
rentier class seems reasonable as well. P. L. Cottrell notes that the
ratherscattereddata on financialmarketspriorto 1885 "depicta capi-
tal marketwhich was highlylocalizedand dependentmainly upon sub-
scriptions from three social groups, the unoccupied, trade and the
professions"[Cottrell1980, p. 95].
In the first half of the nineteenth century,governmentand railroad
bonds were the assets of choice-"the favorite of couples about to
marry,the last resortof Trustees... the cynosureof the old fashioned
school of investor"[Kindleberger1984, p. 201]. Then foreignloans, es-

pecially for railroadconstruction, became a rentier favorite. Finally,

towardthe end of the century,large-scaleissues of domestic industrial
and commercial bonds and preferenceshares became popular. They
were:
suited both to the "outside"investor and the managementgroupbehind
the public company. The investor gained by having a guaranteedreturn.
... [The] managementgroup of a converted company gained an advan-
tage becausethey could continue to control it in an unfetteredway [Cot-
trell 1980, p. 164].
With lengtheningmaturities,industrial"debenturescame to be ranked

alongsideother long dated or perpetualfixed stock such as Consols,but
especially colonial government bonds and domestic local authority
stock" in Victorianportfolios [Cottrell1980, p. 165].
Thus, the historical record suggeststhat the Stage One rentierclass
received a large share of British income and saved a large share of it.
Earlyon they financedinfrastructuraldevelopmentand the export sec-
tor and in so doing indirectlyfinancedthe growthof domestic industry.
Towardthe end of the era they directlyfinancedthat portion of capital
accumulation that could no longer be internally funded. They held
long-termdebt and preferredstock and they held it for the long term.
There was little separationof ownershipfrom controland capitalaccu-
mulation was not the by-productof a casino. Keynes's stylized facts
seem reasonablyconsistent with historicalscholarship.
TheTransition
fromStageOneto ModernCapitalism
Many factorscontributedto the collapse of the institutionalfounda-
tion of StageOne. Keynes stressedthose associatedwith the separation
of ownershipfrom control, the changein characterof the rentierclass,
and the domination of the entrepreneurialclass by rentiers.
In Keynes'sview, reasonableprice stability was a condition of exis-
tence of the Victorianrentierclass. "Amidstthe generalenjoyment of
ease and progress"in the nineteenth century,he observed "the extent
to which the system depended on the stability of the money to which
the investing classes had committed their fortuneswas generallyover-
looked; and an unquestioningconfidencewas apparentlyfelt that this
matter would look after itself' [Keynes 1963, p. 85]. "The remarkable
featureof this long period,"he continued,"wasthe relative stabilityof
the price level" [Keynes 1963, p. 88].
Of course, Keynes'sStageOne rentierclass could not have coexisted

774 JamesR. Crotty
with recurringbouts of severe inflation and the capital losses and low
real ratesof returnthat usuallyaccompanythem. The inflationthat was
triggeredby World War I and acceleratedin the social conflict of its
aftermathsounded the death knell of the Victorian rentier class, and
thus of Stage One capitalism as well. "Through-outthe Continent,"
Keynes wrote, "the pre-warsavings of the middle class, so far as they
were invested in bonds, mortgages,or bank deposits, have been largely
or entirelywiped out" [Keynes 1963, p. 91].
With long-termbond prices and real interest rates now unpredict-
able, with confidencein the securityof gilt-edgedbonds broken, with
the disappearanceof the class that lent their savings to corporations
long-termat low fixed interest rates, financialmarketshad to undergo
a profoundtransformation.
The new rentierclass constitutedafterWorldWarI was qualitatively
differentfrom the old one. Diminished inequality meant that the rich
were no longerable to personallyfinanceindustry.Small savers,whose
bank accounts had grown during the war, were increasinglydrawn to
postwar financial markets,both directly and throughthe growingin-
stitutionalizationof savings associated with investment trusts, insur-
ance companies and pension funds. Moreover, from World War I to
the 1929 crash, financialassets were increasinglypurchasedfor spec-
ulation rather than long-term income-"prices of shares were hope-
lessly inflated and based on grossly optimistic expected earnings"
[Thomas 1978, p. 28]-and were increasinglyfinanced by bank bor-
rowing ratherthan saving.
On the other side of the marketone observes that domestic industry
funded accumulationexternallyin a majorway for the firsttime. New
firms relied on capital marketsfor start-upfunds and old firmsfloated
stocks and bonds to finance expansion. "The day of the small unit is
over," Keynes noted, "partlyfor technical, even more for marketing
reasons"[Keynes 1981, p. 601]. By the late 1920sthe speculativeboom
providedsuch cheap accessto extemal funds that even well-established
and well-capitalizedfirms felt compelled to enter the market.The sit-
uation was describedin The Economistin these terms:
Beforethe war, the small industrialundertakingobtaineda largepropor-

tion of its financewithout making a generalappeal to the public. From
choice or necessity, industrialistsnow deem it worth their while, in the
periods when the marketis active, to turn family businesses into public
companieswith widelydiffusedshareholdings.The publicfor its own part
is preparedto buy and hold equities in the undertakingsabout which
shareholdersknow comparativelylittle and in whose managementthey
cannot hope to have any decisive influence[Thomas 1978, p. 25].

TheInstitutionalFoundationof Keynes'sMethodology 775
Thus, the institutionsand practicesthat Keynesdescribedin the

LevelII analysisof The GeneralTheoryhademergedto replacethose
of Stage One: not surprisingly,the macrodynamicpropertiesof
Keynes'smodelunderwentqualitativechangeas well.The accumula-
tion processwas now directlydependentuponfinancialmarketsthat
Keynesaccuratelydescribedas gamblingcasinos.The investmentde-
cisionof domesticindustrywasnowhostageto the whimsof an unsta-
ble, speculativerentierclass.Management wasnow separatefrombut
dependenton ownerswho "haveno specialknowledgeof the circum-
stances,either actual or prospective,of the businessin question"
[Keynes1964,p. 153].The"heroic"entrepreneurial classof StageOne
hadbeenstrippedof effectivecontrolof thepaceanddirectionof capi-
tal accumulation: it couldno longerinvest for the long run,moreor
less as 'a way of life."The Victorianrentierclasswas dead:"Invest-
mentbasedon genuinelong-termexpectationis so difficulttodayas to
be scarcelypracticable" [Keynes1964,p. 157].
The "harmony" betweenthe greatstrataof the nineteenth-century
capitalistclass was replacedby conflict,contradiction,and rentier
dominancein thetwentiethcentury.It is littlewonder,then,thatin the
last chapterof The General TheoryKeynescalledfor "theeuthanasia
of the rentierand,consequently,the cumulativeoppressivepowerof
the capitalistto exploitthe scarcity-value
of capital"[Keynes1964p.
376].9
Keynes'sStagesofDevelopmentTheoryand theInternationalEconomicSystem
Whilean extensiveanalysisof Keynes'sviews on the changesthat
occurredin the internationaleconomyin the twentiethcenturyis be-
yondthe scopeof this article,it wouldbe appropriate to commenton
the similaritybetweenKeynes'sstages-of-development approachto
boththe domesticandinternational economicsystems.
Throughthe early1920s,Keyneshad been an ardentsupporterof
freetrade,freecapitalflowsand laissez-fairepolicyas the foundation
for peaceand prosperityin the international
economy.Of course,the
factthatBritainhadbeenthe mainbeneficiary of the international di-
visionof laborin thenineteenthcenturyno doubtcoloredhis thinking
on this issue.The horrorsof WorldWarI stimulatedKeynesto com-
pletelyrethinkhis positionon international
economics.After1923he
becamea harshcriticof the free-tradesystem.
Keyneswrotevoluminouslyaboutinternational economicproblems,
butthebestexampleof his thinkingon thisparticular issueis his 1933
essay,"NationalSelf-Sufficiency."Theopeningparagraph of thisessay

776 JamesR. Crotty
stressed Keynes's unconditionalbelief in the free-tradedoctrine prior

to World War I and its aftermath."I was broughtup," he said, "like
most Englishmen,to respect free trade not only as an economic doc-
trine which a rational and instructedperson could not doubt, but al-
most as a part of moral law" [Keynes 1933, p. 755]. Indeed, he argued,
this doctrine was adequateto describe and analyze the processes and
outcomes of the StageOne internationaleconomic system:in his view
both economic growthand the cause of world peace were facilitatedby
free trade in the nineteenthcentury.
But the twentiethcenturywroughtdramaticchangesin the structure
of the internationaleconomy and thus in the effectsof free trade. The
following comment captureswell the totality of Keynes's rejection of
free trade doctrine.
The decadentinternationalbut individualisticcapitalism,in the hands of
which we found ourselves after the war, is not a success. It is not intel-
ligent, it is not beautiful,it is not just, it is not virtuous-and it doesn't
deliver the goods. In short, we dislike it, and we are beginningto despise
it [Keynes 1933, p. 761].
We turn firstto Keynes'sviews on the question of peace:

it does not now seem obvious that a greatconcentrationof nationaleffort
on the captureof foreign trade, that the penetrationof a country'seco-
nomic structureby the resourcesand influenceof foreigncapitalists,and
that a close dependenceof our own economic life on the fluctuatingeco-
nomic policies of foreigncountriesare safeguardsand assurancesof inter-
nationalpeace.It is easier,in the light of experienceand foresight,to argue
quite the contrary[Keynes 1933, p. 757].
Keynes's argumentabout the relation between free trade and pros-

perity was as follows. In the nineteenth-century,Britain was much
more economicallyadvancedthan most of the rest of the world. Under
such conditions, it made sense for Britainto export capital goods and
skilled labor and for the importing countries to borrow the money
needed to pay for these goods from the more-than-adequatesavings of
the British rentier class. In these circumstances"the advantagesof a
high degree of international specialization were very considerable"
[Keynes 1933, p. 759].
By StageTwo the situationhad changeddramatically.For one thing,
"the economic advantagesof the internationaldivision of labor today
are [not]at all comparablewith what they were"[Keynes 1933, p. 760].
More important,financialflows were no longerprimarilygeneratedby

the needto importspecificcapitalgoods:international financialflows

becameincreasingly speculative.Moneyflowedfromcapitalmarkets
all overthe globeto capitalmarketsall overthe globein searchof the
highestpossibleshort-term rewards.Andfinancialblocksfrompower-
fulcountriesbeganto seekcontrolovertheeconomiesof weakerones.
Keynesdid not hesitateto labelthis situationimperialism,and he
againidentifiedthe institutionalchangesleadingto the separationof
ownershipandcontrolof economiclifeas the mainsourceof theprob-
lem. Whenthe principleof the "divorcebetweenownershipand the
realresponsibilityof management" is:
appliedinternationally,it is, in times of stress,intolerable-I am irrespon-
sible towardwhat I own and those who operatewhat I own are irrespon-
sible towards me.... But experience is accumulatingthat remoteness
between ownershipand operationis an evil in the relation among men,
likely or certainin the long run to set up strainsand enmities which will
bring to naught the financial calculation [of international investors]
[Keynes 1933, pp. 757-58.].
Keynes ended this essay with a call for the radical restructuringof
Britain'sinternationaleconomic relations.In brief, he supportedstrict
state controls over the internationalmovement of goods and money.
The details of his proposalsneed not concern us here. The important
point for our purposes is that Keynes clearly identified two different
stages of development of the internationaleconomic system. And just
as clearly,Keynesbelievedthat no institutionallyabstracttheoryof
capitalistworldmarketswas adequateto describeor analyzethe pro-
cessesandoutcomesof bothstages.
Conclusion
The centralissues addressedin this article,strictlyspeaking,concern
the historyof economic thought.It is importantto note, however, that
they areequallyrelevantto currentdebatesover macrotheoryand mac-
ropolicy.Keyneswasrightandmainstream Keynesians(and"disequi-
librium"KeynesiansandWalrasians) wrongabouthowtheorycanbest
help us understandand influencethe processesand typicaloutcomes
of any historicallyspecificcapitalisteconomicsystem-includingour
own. The mainpolicyadvantageof a macrotheory, suchas Keynes's,
thatis groundedin the concreteinstitutionalstructureof the economy
is that it generatesa richerset of policy options than a theory such as
mainstreamKeynesianismthat is built on Walrasianagentsand an ab-

778 James R. Crotty
stractconceptof markets.Keynes'stheoryfacilitatesa consideration

of
institutionalchangeas an integralpart of thepolicydecision-making
process.'I
Thus,we shouldnot be surprisedthat Keynesdrewpolicyconclu-
sions fromhis historicallycontingent,institutionallybasedapproach
to theorythat are qualitativelydifferentfrom those associatedwith
mainstreamKeynesianism. His mostsignificant andcontroversial
reg-
ulatoryproposalscalledforsubstantialchanges in economic andpoliti-
cal institutionsandin agentpractices.He supportedpubliccontrolof
the investment process or the "socializationof investment"as well as
a substantial of income.Heproposeda newinternational
redistribution
financial system centered around his InternationalClearingUnion, a
system radicallydifferentfrom both the gold standardand the Bretton
Woods system. He arguedthat controlby governmentsover the move-
ment of goods and, especially, money across their borderswas a nec-
essary condition for stable full-employmentgrowth."'
Whether or not this particular set of institutional, regulatory
proposalswouldhelpus betterachieveourowneconomicandpolitical
objectivesis not the issuehere.Thepointis thatqualitatively different
theoreticalmethodologies producequalitativelydifferentexplanations
of importanteconomiceventsas well as qualitativelydifferentpolicy
proposalsfortheachievementof economicobjectives.Theimplicitde-
bateovermacroeconomic theorythatis the subjectof this articlehas
implicationsthatreachfarbeyondthe disciplineof the historyof eco-
nomicthought.We aremorelikelyto understand andcontrolthe dy-
namicsof the latetwentieth-century capitalismin whichwe live if we
take our lead fromKeynesratherthan fromPaul Samuelsonin this
debate.
Notes
1. Keynes'sbelief that abstractmathematicalmacromodelsareinherentlyin-

capableof capturingthe historicaland institutionalcontingencyof macro-
theory comes through stronglyin his criticism of Jan Tinbergen'searly
work. (See Keynes [1073, pp. 299-320]).
2. I do not mean to arguethat Keynes self-conciouslyutilizedtheformal dis-
tinctionbetweenthe analyticallevels discussedhere.I use this logicalparti-
tion solely to clarifymy own thesis that Keynes'smethodof analysisinfact
incorporatedboth generaland stage-specifictheoreticaland empiricalas-
sumptions.
3. By implicationat least, a Level I analysis also tells the theorist what not
to study. For example, in The GeneralTheoryKeynes shows no interest
in the human aspects of production (or the labor process) and de-

emphasizesthe significanceof the structure,organization,and attitudesof

the workingclass in determiningeconomic outcomes. The starkcontrast
between Keynes's Level I analysis and Marx's analysis of "capital-in-
general"is quite instructivein this regard.
4. The centralrole playedby the unknowabilityof the futurein Keynes'sthe-
ory of instabilityhas been stressedby G. L. S. Shackle,among others,and
is an importantcomponent of Post Keynesiananalysis.
5. For a richerdiscussionof Keynes'streatmentof manager-stockholder rela-
tions or of what is known as the principal-agentproblemin the theory of
the firm, see Crotty[1990].
6. In this discussion I have focused on Keynes's treatmentof those institu-
tions, agents, and practices that directly affect the investment decision.
However,the investment decision is not the only subjectthat receives an
institutionalanalysisin The GeneralTheory.Keynes'scritiqueof classical
labormarkettheoryand his reconstructionof the labor supplyfunctionin
Chapters2 and 19 depend cruciallyon the absence of nationalor central-
ized processof wage determinationon a numberof occasions.See, for ex-
ample, Keynes [1964, pp. 268, 269 and 333]). And Keynes discussed the
institutionalfoundationof the consumption-savingsdecision in Chapters
8, 9, and 10.
Paradoxically,Keynes'sdecision not to investigatethe institutionsand
practicesof the laborprocessbut ratherto acceptthe purelytechnicaland
abstractclassicaltheoryof capital-laborrelationscreatedone of the major
flaws or blindspotsin his theory.
7. Two caveatsshouldbe noted, however.First,to my knowledgeKeynesdid
not addressthe historicalquestions at issue here in depth and detail: his
historicalobservationsare quite sketchy.Second,he was not above select-
ing only those fragmentsof economic history that suited his theoretical
purpose.
8. This discussion of externalfinanceand the evolution of financialmarkets
relies heavily on Cottrell[1980] and Thomas [1978].
9. In the spirit of Keynes'sanalysis, one could arguethat at least two quali-
tative shifts in investor-saverrelationshave takenplace since The General
Theory was written. In the 1950s and 1960s, top managers of U.S.
Corporations-Keynes's entrepreneurs-werein controlof the investment
decision-makingprocess.Financialmarketswere relativelystable,real in-
terest rates were modest, and stockholders, bondholders and bankers
playedno majorrole in corporatepolicy-making.Entrepreneur-rentier re-
lations were characterizedby the "harmony"Keynes ascribedto them in
Stage One. Since the mid-1970s, however, financial markets have once
again become unstableand highly speculative.Meanwhile,in the face of
leveragedbuyouts,hostile takeovers,and risingdebt-equityratios, corpo-
rationmanagerscan no longermake the investmentdecisions they believe
to be in the long-runinterest of the enterprise:rather,they are forced to
bow to the whims of an increasinglyshort-horizonedstock market. See
Crotty [1990] for a discussion of the currentstate of entrepreneur-rentier
relations.
10. In this discussion of differencesamong economic theories I have focused
on the questionof institutionalconcreteness.However,this is certainlynot
the only thing that distinguishesKeynes from Samuelsonor, for that mat-

780 James R. Crotty
ter, from Marx.Thereare, in addition,centralquestionsconcerningwhich

institutionsand agentsto theorizeand how to theorize them.
11. See Crotty [1983] for a discussion of Keynes's proposalsfor institutional
reformin both the domestic and the internationalsectors.
References
Cottreel,P. L. 1980. IndustrialFinance 1830-1914: The Finance and Organi-

zation of EnglishManufacturingIndustry.New York:Methuen.
Crotty,James R. 1983. "On Keynes and CapitalFlight."Journalof Economic
Literature21 (March):59-65.
. 1990."Owner-Manager Conflictand FinancialTheoriesof Investment
Instability:A CriticalAssessment of Keynes, Tobin and Minsky."Journal
of Post KeynesianEconomics(Summer)(forthcoming).
Hobsbawm,EricJ. 1968. Industryand Empire.New York:PenguinBooks.
Keynes, John Maynard.1920. TheEconomic Consequencesof the Peace. New
York:Harcourt,Braceand Howe.
. 1933. "NationalSelf-Sufficiency."YaleReview22 (June):755-69.
. 1937. "The General Theory of Employment."QuarterlyJournal of
Economics51 (February):209-23.
. 1963.Essays in Persuasion.New York:W.W. Norton.
. 1964. The GeneralTheoryof Employment,Interestand Money. New
York:Harcourt,Braceand World.
. 1973. The Collected Writingsof John MaynardKeynes.Ed. Donald
Moggridge.Volume 14. TheGeneralTheoryandAfter:PartII. London:Mac-
millan.
. 1981. The Collected Writingsof John MaynardKeynes.Ed. Donald
Moggridge.Volume 19.Activities1922-1929: TheReturnto Goldand Indus-
trial Policy. London:Macmillan.
Kindleberger,CharlesP. 1984. A Financial History of WesternEurope.Lon-
don: GeorgeAllen and Unwin.
Thomas, W.A. 1978. The Finance of British Industry 1918-1976. London:
Methuen.


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