Hansen and Keynes

The downturn of 1937, when there was still massive unemployment and unused industrial capacity, challenged Hansen's perspective, for it made it clear that the Great Depression was no ordinary business cycle.¹ It had been particularly deep, but there were plenty of factors that could explain this whilst remaining within the framework of Hansen's existing theory of the business cycle: there had been an exceptionally dramatic expansion during the 1920s, an exceptionally deep financial crisis, and a terrible international situation.

Hansen's answer was that recovery after 1933 had been led by consump­tion, which meant that as soon as consumption stopped growing so rapidly, there would be—through the accelerator—a fall in investment, and this could cause a downturn. Though it was easy to identify the immediate cause of why consumption had fallen in 1937—the decision to build up the Social Security fund—this raised the question of why the recovery had been so ane­mic. Hansen's explanation, taking up the theory that investment opportuni­ties were crucial, was that the economy had entered a new era. Now that the American economy had matured, the pace of technological change was less and the population was growing more slowly. Both of these implied fewer opportunities for investment. Thus, unless action were taken, there would be long-term stagnation. There was need for what he called a “dual economy,” in which the government created investment opportunities for the private sector, stimulating growth. This involved management of both the American and the international economies.

This was the context in which Hansen, very slowly, took up Keynesian ideas.

This perspective explains Hansen’s response to the General Theory. In his first review (in June 1936), he offered a simple interpretation of Keynes’s the­ory: that wealthy communities save more, but because outlets for new invest­ment are limited, investment is low. Surplus savings do not get invested because the desire to hold money keeps interest rates low. Hansen concluded that Keynes’s new theory would fare no better than his previous one because it assumed a rigid economy. In contrast, the United States was “a progressive and flexible community [that] is always busily at work raising the marginal productivity of capital and the rate of investment.”² Thus, Hansen was not objecting to the logic of Keynes’s argument: he merely believed that a state of technological stagnation had not yet been reached.

Hansen’s second review (October 1936), written at much greater length for an audience of economists, engaged more seriously with the book and showed a much clearer understanding of Keynes’s arguments. However, though he found the book exciting and in places brilliant, the review did not mark a conversion.

The book under review is not a landmark in the sense that it lays a foundation for a “new economics.” It warns once again, in a provoca­tive manner, of the danger of reasoning based on assumptions which no longer fit the facts of economic life. Out of discussion and research will come bit by bit an improved theoretical apparatus (Keynes’s interest theory contains promising suggestions) and a more accurate appreciation of social psychology (the brilliant chapter on long-term expectation) and of the precise character of the economic environment in which humans act as individuals and in groups. The book is more a symptom of economic trends than a foundation stone upon which a science can be built.³

These conclusions reflect Hansen's eclectic, open-minded approach to eco­nomic theory, which led him to appreciate certain chapters in the book. However, there were many reasons why Keynes's theory could not provide a foundation on which a new theory could be built. There were technical problems with Keynes's theory (for example, his definitions of saving and investment were not helpful for analyzing a dynamic economy). Hansen was more open to the idea that there were monopolistic rigidities in the econ­omy, which would make Keynes's theory more relevant, but it was an open question whether these would be important in the long term. But, most important, Hansen attached great importance to the ability of technological advances to raise the productivity of capital:

In brief, it is not improbable that the continued workability of the sys­tem of private enterprise will be made possible, not by changes in pre­vailing economic institutions (such as those advocated by Keynes), but rather by the work of the inventor and the engineer. Just as technolog­ical progress has been mainly responsible for the great advance in real wages and in standards of living during the last century, so also it may well turn out that in the future we shall have to look to new outlets for profitable investment—new discoveries in technique, new ways of utilizing nature's resources, new products, and new industries—if we expect the prevailing economic system to survive.⁴

He saw Keynes as reverting to a pre-capitalist mercantilism, endorsing lei­sure and luxury consumption that was a long way from his own emphasis on capitalism's ability to create new investment opportunities by developing “new resources, new products and new industries.”⁵

The situation changed in April 1937, when Keynes published “Some Economic Consequences of a Declining Population” in the Eugenics Review, in which he argued that the rate of investment had fallen since 1913 because the growth rate of the population had fallen.