October 24, 2015

Interest and profit

Comment on David Glasner on ‘Keynes on the Theory of Interest’


At the immediately preceding thread Keynes and Accounting Identities the rigorous formal proof has been given that Keynes’ elementary accounting identities are false.#1 From this follows, first of all, for economic policy that the familiar multiplier is formally defective. The correct employment multiplier is displayed on Wikimedia AXEC48 (2015a, eq. (15)).

The elementary Keynesian multiplier follows from the saving-equals-investment condition and the consumption function. Because I=S is provably false#2 it follows that the complementary story of the interest rate mechanism is false by logical implication. Because of this, a complete analytical reset is needed.

For good methodological reasons, one has to start — not from individual behavior but — from the institutional fact that an elementary production-consumption economy (no investment, no government, no foreign trade) consists of the banking sector, represented for a start by the central bank, and the production sector, represented for a start by a single firm. Now, there are two rates of interest — for overdrafts and deposits to begin with — and the difference between the two is a co-determinant of profit of the central bank, which produces, as the saying goes, money (= deposits) and credit (= overdrafts) out of nothing.

So, the interest rates on both sides of the central bank’s balance sheet and profit are closely intertwined. By consequence, if the profit theory is false the interest theory is false by logical implication. Now, it has been shown that Keynes’ profit theory is definitively false. Because of this, his theory of interest is unacceptable. An alternative is needed.

To make a long argument short: the relation of the rate of interest to product price, the so-called real interest rate, has to be derived for the most elementary case from the production conditions of the sub-sectors of the elementary monetary economy (2013, eq. (28)), see also (2011, eq. (30)) and (2011) and (2015b, Sec. 7).

Roughly speaking, in the most elementary case, the real rate of interest is objectively determined by the respective productivities in the consumption good sector and the banking sector. Needless to stress that things become a bit more complex as soon as different term structures on the asset and liability side and the financing of investment expenditures are taken into the picture.

As Keynes realized, there is no direct connection between saving/dissaving and “the” rate of interest. Roughly speaking, the households can accumulate their period savings on a zero-interest deposit account as long as they wish, no matter what the actual rate for overdrafts/loans is. Hence the intertemporal allocation of consumption expenditures (= period saving/dissaving) is — as a matter of principle — independent from the rate of interest. Because of this, Fisher’s subjective time preference approach cannot explain anything. Therefore, Keynes was right to ignore it.

It should be noted in passing that the stock of deposits/overdrafts is, in the most elementary case, the numerical integral of period saving/dissaving of the household sector. The two interest rates refer to the respective stocks and not to period saving/dissaving. The quantity of money is endogenously determined.

Take away: If profit theory is false, interest theory is false; this is the case with both Keynes’ and Fisher’s approach; I=S is always false and therefore cannot explain interest.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011a). The Emergence of Profit and Interest in the Monetary Circuit. SSRN Working Paper Series, 1973952: 1–22. URL
Kakarot-Handtke, E. (2011b). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL
Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL
Kakarot-Handtke, E. (2015a). Essentials of Constructive Heterodoxy: Employment. SSRN Working Paper Series, 2576867: 1–11. URL
Kakarot-Handtke, E. (2015b). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL

#1 Refers to End of confusion and Keynes and the logical brilliance of Bedlam.
#2 The axiomatically correct relationship is given on Wikimedia AXEC09