Loyola University College of Business Administration Intermediate Macroeconomic Analysis Economics 206 - Section 001

Instructor: Dr. Barnett Semester: Spring, 2016 Class meetings: Mondays, and Wednesdays, 8:00 a.m. to 9:15 a.m. Room: 112 Miller Hall Office: 319 Miller Hall. Office hours: Office hours: Mondays and Wednesdays, 1:00 p.m. – 3:00 p.m.; Tuesdays, 8:00 a.m. - 10:00 a.m.; and, by appointment. Phone nos.: Office: 864-7950; E-mail: [email protected]

Course prerequisites: Principles of Macroeconomics (ECON B101)

N.B. This is a reading intensive, lecture/discussion class. Students are encouraged to ask questions.

Catalog description: This course considers various theories concerning the functioning of the macroeconomy: Classical, Keynesian and the Neoclassical Synthesis, Monetarism, Supply-Side, Post Keynesian, and Austrian. Rational Expectations, Real Business Cycles and Dynamic Stochastic General Equilibrium, and New Keynesianism will also be considered

Course purpose: It is not inaccurate to say that macroeconomic theory is in a state of disarray. Unlike the period from the time of the General Theory, in the mid-1930s, until the early 1970s, when there was “an” orthodox view based on the conventional Keynesian model,1 today no consensus exists. Rather, a number of competing theories coexist. The purpose of this course is to examine these theories in more depth than is the case in the principles of macroeconomics course, and to consider the policy implications of each. Thus we shall be analyzing, comparing, and contrasting the following theories and hypotheses: the Pre-Keynesian/Classical, orthodox Keynesian, Neoclassical Synthesis, Monetarist, Supply-Side, Post Keynesian, including Minsky’s Financial Instability, Fisher’s Debt-Deflation, and the Austrian Business Cycle theories, as well as Rational Expectations, Real Business Cycles and Dynamic Stochastic General Equilibrium, and New Keynesianism theories. However, despite the fact that that there is no agreement as to which is the best theory, given the current state of the economy, and the policy-makers clear reliance on Keynesian in its most crude form, regardless of the modern variant of macroeconomic theory to which they might claim allegiance, short shrift will be paid to Rational Expectations, Real Business Cycles and Dynamic Stochastic General Equilibrium, and New Keynesianism theories.

1 As we shall see, there are those who think that standard or orthodox Keynesianism is not true Keynesianism, in the sense of what Keynes himself really meant. 1

Course Learning Objectives Students completing this course successfully will: 1) be able to explain Pre-Keynesian/Classical theory and its implications for governmental policies; 2) be able to explain the Keynesian theory and its implications for governmental policies; 3) be able to explain the Neoclassical Synthesis and its implications for governmental policies; 4) be able to explain the Monetarist theory and its implications for governmental policies; 5) be able to explain the Supply-Side theory and its implications for governmental policies; 7) be able to explain the Post Keynesian theory, including Minsky’s Financial Instability Hypothesis, and its implications for governmental policies; 9) be able to explain Fisher’s Debt-Deflation Theory; 10) be able to explain the Austrian Business Cycle theory and its implications for governmental policies; and, 11) be able to explain the major flaws in Rational Expectations, Real Business Cycles and Dynamic Stochastic General Equilibrium, and New Keynesianism theories.

This is a reading intensive, lecture/discussion class. Students are encouraged to ask questions.

Text: Snowden, B., and H. R. Vane. 2005. Modern Guide to Macroeconomics: Its Origins, Development and Current State., Edward Elgar. Ebeling, R., ed. 1996. The Austrian Theory of the Trade Cycle and Other Essays. (Ludwig von Mises Institute.) Referred to in the schedule as ATTC.

NB: Some important readings are attached.

Grading: There will be two examinations. It is my normal practice to weight, on an individual basis, the exam with the more favorable outcome 60% and the exam with the less favorable outcome 40%.. I reserve the right to adjust your final grade upward or downward by one letter grade based upon your classroom performance. The grading scale is: A>89≥A->86≥B+ >82≥B>79≥B->76≥C+>72≥C>69≥C->66≥D+>62≥D>59≥F.

Attendance: You will be held responsible for all lecture material and class discussions as well as all of the reading assignments. Therefore, although there is no formal attendance requirement, you are strongly urged to attend all class meetings.

Communications: All Loyola email correspondence will be directed to students’ Loyola email address only. You are responsible for any communications addressed to your Loyola email account.

Academic Integrity Statement: I consider honesty and integrity to be of the utmost importance and presume that my students do also, and thus that each and every one of you is a person of integrity. Therefore, I have one simple rule: you are to do your own work. I will not tolerate academic dishonesty in any way, shape, or form. The penalty in my class for cheating, no matter how minor the infraction might appear to be, is an F for the course. If you have any doubt

2

whatsoever as to whether a particular course of action or inaction would constitute academic dishonesty, you should consult me immediately.

Electronic Devices: Absolutely no electronic devices of any type are allowed during exams. If you use one during an exam you will receive an F for the course.

Disabilities: If you have a disability and wish to receive accommodations, please contact Sarah Mead Smith, Director of Disability Services at 504-865-2990. If you wish to receive test accommodations (e.g., extended test time), you will need to give the course instructor an official Accommodation Form from Disability Services. The Office of Disability Services is located in Marquette Hall 112.

Emergency Statement: At times, ordinary university operations are interrupted as a result of tropical storms, hurricanes, or other emergencies that require evacuation or suspension of on-campus activities. To prepare for such emergencies, all students will do the following during the first week of classes: 1. Practice signing on for each course through Blackboard. 2. Provide regular and alternative e-mail address and phone contact information to each instructor. In the event of an interruption to our course due to the result of an emergency requiring an evacuation or suspension of campus activities, students will: 3. Pack textbooks, assignments, syllabi and any other needed materials for each course ad bring during an evacuation/suspension 4. Keep up with course work during the evacuation/suspension as specified on course syllabi and on-line Blackboard courses. 5. Complete any reading and/or writing assignments given by professors before emergency began. Assuming a power source is available.... 6. Log on to university Web site within 48 hours of an evacuation/suspension. 7. Monitor the main university site (www.loyno.edu) for general information. 8. Log on to each course through Blackboard or e-mail within 48 hours of an evacuation/suspension to receive further information regarding contacting course instructors for assignments, etc. 9. Complete Blackboard and/or other online assignments posted by professors (students are required to turn in assignments on time during the evacuation/suspension period and once the university campus has reopened.) 10. Contact professors during an evacuation/suspension (or as soon as classes resume on campus) to explain any emergency circumstances that may have prevented them from completing expected work.

Further information about student responsibilities in emergencies is available on the Academic Affairs web site: http://academicaffairs.loyno.edu/students-emergency-responsibilities

3

All dates, except that of the final exam, are approximate. Dates Material Readings (classes) Jan. 20 (1) Introduction Text Ch. 1 & Preliminary Materials section of the Readings Jan. 25-Feb. 3 (4) Keynes and the Old Classical School Text Ch. 2 & Classicals section of the Readings Feb. 15-24 (4) Keynes & the Orthodox Keynesian School Text Ch. 3 & the Keynes section of the Readings Feb. 29-Mar. 2 (2) The Orthodox Monetarist School Text Ch. 4 and section of Readings on Friedman Mar. 7-9 (2) The Supply-Side School Hailstones, T. 1962. A Guide to Supply-Side Economics. Robert F. Dame. & Fink, R.H. 1982. Supply- side Economics. Alethia Books. Chapters 1,3,5,7,& 9 (These books are on reserve.) Mar. 14 (1) First Exam Mar. 9 (3) Mar. 16-30 (2) The New Classical I School and the Real Business Text Ch. 5-6 Cycle School Apr. 4 (1) The New Keynesian School Text Ch. 7 Apr. 6-13 (3) The Post Keynesian School, Minsky’s Financial Text Ch. 8 + sections of Instability Hypothesis, & Fisher’s Debt-Deflation Readings on Minsky and Theory. Fisher Apr. 18-May 11 (8) The Austrian School Text Ch. 9 & The Austrian Theory of the Trade Cycle and other essays MAY 16 FINAL EXAM (9:00 a.m.-11:00 p.m.) All dates, except that of the final exam, are approximate.

4

PRELIMINARY MATERIALS

“Refresher” Mankiw, N. G. 1990. “A Quick Refresher Course in Macroeconomics.” Journal of Economic Literature. 28(4): 1645-1660. Read papes 1645-1648. http://scholar.harvard.edu/mankiw/files/Quick_Refresher.pdf

Various Economists on the State of Macroeconomics

Stiglitz, Jonathan M. Orszag and Peter R. Orszag (2002): Implications of the New Fannie Mae and Freddie Mac Risk-based Capital Standard http://www.pierrelemieux.org/stiglitzrisk.pdf

Bernanke (2002): http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Solow (2003): Dumb and Dumber in Macroeconomics. http://www2.gsb.columbia.edu/faculty/jstiglitz/festschrift/Papers/Stig-Solow.pdf

Bernanke (2004): The Great Moderation. http://www.federalreserve.gov/boarddocs/speeches/2004/20040220/default.htm

Mankiw (2006): The Economist as Scientist and Engineer. http://www.economics.harvard.edu/files/faculty/40_Macroeconomist_as_Scientist.pdf

Chari and Kehoe (2006): Modern Macroeconomics in Practice: How Theory Is Shaping Policy. http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.20.4.3

Chari and Kehoe (2007): The Heterogeneous State of Modern Macroeconomics: Reply to Solow. http://www.minneapolisfed.org/research/sr/sr399.pdf

Solow (2008): The State of Macroeconomics. http://www.jstor.org/stable/pdfplus/27648233.pdf?acceptTC=true

Arestis (2009): New Consensus Macroeconomics: A Critical Appraisal. http://www.landecon.cam.ac.uk/research/reuag/ccepp/publications/WP05-09.pdf

Blanchard (2009): The State of Macro. http://www.webpages.ttu.edu/pesummer/ECO%205381/readings/Blanchard-ARE-2009.pdf

Stiglitz (2012): The Book of Jobs http://www.vanityfair.com/politics/2012/01/stiglitz-depression-201201?currentPage=all

1

Higgs, Robert. 1998. “Official Economic Statistics: The Emperor’s Clothes Are Dirty.” The Independent Review. 3 (1): 147-153.

Economists have been grousing a good deal lately about the deteriorating quality of basic economic statistics—official data on prices, incomes, employment, productivity, and poverty, among other things—and about the lack of government funding to remedy the problem. (The first eight articles in the Winter 1998 issue of the Journal of Economic Perspectives deal with various aspects of this issue.) On its face, the complaint seems reasonable and practical.

But I wonder. Having used official economic statistics from time to time for some thirty- five years, I would miss them if they were to disappear. Yet, however put out I might be as an economic analyst, I suspect that the world would be a happier place had these figures never been created. Certainly the statistics are often inaccurate or otherwise flawed, and hence misleading. An even more serious consideration, however, is that the official statistics help to provide rationales for pernicious policy making.

Poorly Defined, Imprecise, and Invidious

Because they are ill defined conceptually, many official economic statistics fail to capture what they purport to measure. Figures on “poverty,” for instance, are notorious in this regard. Is poverty an absolute or a relative condition? If the latter, what is the proper standard of comparison? Obviously, the living conditions of many Americans below the “poverty line” must seem affluent to billions of submerged denizens of the Third World. Apart from international comparisons, many Americans now classified as poor would have seemed well-to-do in the eyes of, say, their grandparents. Above a certain absolute income, “poverty” becomes less a definite condition than a staging area from which armies of redistributionists launch their attacks on higher-income people.

Aside from the conceptual questions, the mere measurement of personal income as currently defined poses nearly insurmountable difficulties. For example, among those in “poverty,” illegal (hence unreported) incomes loom large—earnings from drug dealing, prostitution, gambling enterprises, and everyday theft. If the poor have only the income they report to the Internal Revenue Service or the Bureau of the Census, how do they come by the automobiles, televisions, jewelry, and other visible adornments of their homes and persons? Of course, the poor are scarcely the only class concealing real income, whether honestly or illicitly acquired. The wealthy support an entire stratum of professional attendants—lawyers, accountants, financial gurus—whose sole mission in economic affairs is to remove income from the gaze of the tax collector. Small business people notoriously accept payments “under the table,” and hosts of carpenters, painters, electricians, plumbers, and gardeners, not to mention the nannies, earn income that is wholly or partly unreported.

In one of the most important and unjustly neglected economics books of the past fifty years, Oskar Morgenstern warned, “We must carefully distinguish between what we think we know and what we really do and can know” (On the Accuracy of Economic Observations, 2d ed. [Princeton: Princeton University Press, 1963], vii). Yet all too often economists avert their eyes,

2

plowing blithely ahead with exquisitely sophisticated econometric analyses of virtually meaningless or inaccurately measured variables. As Michael J. Boskin attests, “Both the economics and statistics professions have become more theoretical and spend less time on the practical issues of sampling, data collection, quality of data, and providing professional rewards in terms of standing in the profession for those who show great skill in finding, developing, or improving data” (“Some Thoughts on Improving Economic Statistics to Make Them More Relevant in the Information Age,” prepared for the Joint Economic Committee, Office of the Vice Chairman, United States Congress, October 1997, 5).

One hesitates, then, to blame lay persons for reacting to the drumbeat of media reports of a widening distribution of income during recent decades in the United States. Is this “growing inequality” not a fact? Who really knows? But whether in some purely arithmetic sense it is or not, it would never have been made the basis for public policy proposals to “correct” the situation if statisticians had not constructed “the distribution of income” in the first place. It is hard to imagine another statistical artifact better calculated to feed the fires of envy and political rapacity. Such information is unnecessary for the conduct of a just government but well-nigh indispensable for the operation of a predatory one. (Here I stand by my previous statement, “Is More Economic Equality Better?” Intercollegiate Review 16 [Spring/Summer 1981]: 99–102.)

Nourishing the Mercantilists

In an uncertain world, one thing is sure: every month, without fail, the press will prominently report the latest official figures for the U.S. international “trade deficit.” Even in a relatively intelligent recent article (Peter Passell, “The Fear Is Gone, Not the Danger,” New York Times, March 1, 1998), the graph is labeled “That Pesky Trade Deficit.” Of course, the very term “deficit” has a negative connotation, suggesting a shortfall of some, presumably regrettable, kind. Clearly the journalists, along with the proverbial man in the street, regard the trade deficit as a Bad Thing. Often they highlight some ominous bilateral trade imbalance, especially the perennial trade deficit of the United States with Japan. No doubt it dampens one’s spirits to be told repeatedly that the nation is being “flooded” by imports, that it is “awash” in cheap foreign goods.

Yet anyone who stops to consider how someone might keep track of all the goods and services being exchanged across America’s borders must develop some fundamental doubts. Upon being informed that the trade deficit is X, one might ask: How do they know? Of course, the Customs Service generates mountains of data on international trade, but surely many transactions escape the agency’s surveillance—for instance, the sizable commerce in illegal drugs, estimated at $400 billion per year worldwide, in which the United States looms large as a net importer (Mark J. Porubcansky, “U.N.: Drug Dealing Is 8% of All Trade,” Seattle Times, June 26, 1997). Nor are illicit drugs the only products covertly imported or exported.

Morgenstern aptly warned against the unreliability of the international trade data when he wrote, Any one who has ever sat through meetings (as the author has) in which final balance of payment figures for most invisible items were put together, can only marvel at the naiveté with which these products of fantasy, policy, and imagination, combined with figures

3

diligently arrived at, are gravely used in subsequent publications. . . . Writers on all phases of foreign trade will have to assume the burden of proof that the figures on commodity movements are good enough to warrant the manipulation and the reasoning to which they are customarily subject. (On the Accuracy, 180)

Morgenstern was writing decades ago, but the deficiencies to which he called attention have persisted. According to Boskin’s recent assessment, “the trade statistics have serious flaws” and “it is becoming more and more difficult to measure trade accurately” (“Some Thoughts,” 9).

Actually, the compilers of the international trade statistics confess their inability to identify all the relevant transactions or to measure correctly the ones they do identify. Because every exchange has two sides, the overall balance of payments must necessarily balance. But in practice it never does, and the Commerce Department reconciles the two sides of the account by inserting a fudge factor called “statistical discrepancy” (formerly “errors and unrecorded transactions”). In 1996, for example, this amounted to minus $46.9 billion, equivalent to 32 percent of that year’s deficit on current account. (The current account includes investment income and transfers as well as sales of goods and services. For the data, see U.S. Council of Economic Advisers, Annual Report for 1998 [Washington, D.C.: U.S. Government Printing Office, 1998], 399.) The statistical discrepancy varies widely from year to year. For instance, in 1992 it was negative $43.6 billion, in 1993 positive $5.6 billion. In view of the violent fluctuations of this fudge factor, how much confidence can one place in the “fact” that between 1992 and 1993 the deficit on current account increased by $34.4 billion (398–99)? Perhaps, despite all the hand-wringing occasioned by the increase of the measured current-account deficit in 1993, the true deficit did not increase at all. And considering the inaccuracy of even the annual data, the monthly reports featured in the press deserve no credence whatsoever.

If balance-of-trade data merely served as one more excuse for econometricians to waste their time, the data would be relatively innocuous. Unfortunately, by virtue of their routine and widespread dissemination by the news media, these figures play an important role in the politics of rent-seeking. As Paul Heyne has written (“Do Trade Deficits Matter?” Cato Journal 3 [Winter 1983–84]: 705–16), allegations of a trade deficit provide political arguments that can be used by people who want protection from foreign competitors or subsidies for their efforts to sell abroad. For the existence of a trade deficit implies that the ratio of imports to exports must eventually decline, since no deficit can continue forever. So we might as well get on with it now: Fund the Export-Import Bank, restrict imports from nations that interfere with our exports, slap penalties on foreign firms that are “dumping” in our markets, and face up in general to the fact that free trade is good trade only if it is fair trade. (711)

Anyone who pays attention to the news will recognize the refrain. As Heyne observes, “the declaration of a trade deficit amounts in practice to a kind of declaration of martial law. What is most dangerous about such a declaration is that it gives government officials a license to subordinate the rule of law and respect for established rights to considerations of political advantage” (715). Far better for both justice and economic prosperity if the international trade

4

statistics had never been collected. They have been and continue to be major means to the thoroughly mischievous ends of pandering politicians and their rent-seeking supporters.

Defining Government Spending as Productive

William Petty (1623–1687), an Englishman who practiced “the art of political arithmetic,” has been called “the first econometrician” and identified as “the author of the first known national income estimates” (Phyllis Deane, “Petty, William,” in International Encyclopedia of the Social Sciences, vol. 12, edited by David L. Sills [New York: Macmillan and The Free Press, 1968], 67). It would have been a boon to honest humanity had “political arithmetic” stuck as the name for economic statistics of the sort now assembled in the official national income and product accounts. This designation would have alerted one and all to the political purposes lurking beneath the construction of such figures.

Consider, for instance, how the statisticians arrive at the amount of gross domestic product: add the values at market prices of all newly produced, domestic, final goods and services purchased by consumers, investors, and governments, then throw in net exports. So accustomed are we to this setup that no one pauses to ask, Why make government purchases a separate category? And if we include government services, how can we value them at market prices, inasmuch as they are generally provided without charge and financed by taxation? Nowadays not even many economists know that prior to World War II the inclusion of a government category in the national income and product accounts was a hotly debated issue. Now, however, as Ellen O’Brien has written, “it is rare that someone suggests that the current treatment of the government product in national income is flawed and it is nearly inconceivable that it would be suggested that a government product doesn’t belong at all” (“How the ‘G’ Got into the GNP,” in Perspectives on the History of Economic Thought, vol. 10, Method, Competition, Conflict and Measurement in the Twentieth Century, edited by Karen I. Vaughn [Aldershot, Eng.: Elgar, 1994], 247).

As O’Brien notes, “the treatment of the government sector put in place in 1947 (which has remained standard practice in the US since that date) was initiated by estimators in order to assess the impact of the tremendous increase in war expenditures on the economy” during World War II. The “theoretical debates from the pre-war period continued through 1947 and were never fully resolved” (242). Simon Kuznets, the principal architect of the early national income accounts in the United States, played David in this David-and-Goliath struggle, but ultimately he could not prevail against the vastly superior resources of the U.S. Department of Commerce, and he retreated from the field of battle. (See, however, the rearguard action he mounted in his Capital in the American Economy [Princeton: Princeton University Press, 1961], 465–84).

In reviewing this dispute, O’Brien puts her finger on a critically important but scarcely appreciated consideration: It seems as if the government bureaucrats were determined to emphasize the importance of government’s role in the economy by enlarging the share of government expenditure in the national income. While this official change was motivated by the great increase in 5

government expenditures caused by the war, the underlying explanation must relate to the Commerce estimators’ philosophy of the proper role of government in the economy. (252)

It is easy to see how postwar Keynesian doctrine and policy making meshed with a system of national accounts in which all government purchases of goods and services—the services of government employees being valued at whatever the employees happen to be paid— count equally with private purchases of only final goods and services in the market, where consumers and investors demonstrate their valuations by spending their own money.

Among the many repercussions of adopting the official national income and product accounts was the perpetuation of the myth of “wartime prosperity” during World War II, along with the crackpot theories of “military Keynesianism” that the myth fostered. Eliminate the government component, which was almost entirely devoted to purchasing munitions and paying the personnel of the bloated, mainly conscripted armed forces, and you are left with national product data indicative of wartime recession (Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economic History 52 [March 1992]: 41–60). Later, especially in the 1950s, the official accounts gave rise to a distorted picture of the business cycle (Robert Higgs, “The Cold War Economy: Opportunity Costs, Ideology, and the Politics of Crisis,” Explorations in Economic History 31 [July 1994]: 283–312, esp. 297–98).

For more than half a century the official national income and product accounts have served as the map used by policy warriors to plan their assaults on Fine-Tune Mountain. (For this indictment, the annual reports of the Council of Economic Advisers contain incontestable evidence, as do successive generations of macroeconomics textbooks, written as though intended to serve as cookbooks for policy makers.) If the macroeconomic warriors failed to capture the hill, perhaps the blame belongs to their tactics or weaponry as well as to their faulty map. But lacking that map, they might have been more reluctant to sally forth, and hence the American economy might have been spared the ravages of these pretentious idiot savants.

To Conclude

That economists have passively accepted economic statistics designed and constructed by government bureaucrats ranks among the more shameful aspects of their professional conduct in the twentieth century. One wonders, who was using whom? In the post–World War II era, this intermingling of an ever more intrusive government and an economics profession dedicated to instructing the intruders achieved solid institutionalization. It is now the status quo, with every prospect of remaining so. But the economic statistics joining the two sides of this symbiosis are often ill defined, inaccurate, and productive of mischief when used in policy making.

Morgenstern considered it necessary that worthless statistics be completely and mercilessly rejected on the ground that it is usually better to say nothing than to give wrong information which—quite apart from its practical, political abuse—in turn misleads hosts of later investigators who are

6

not always able to check the quality of the data processed by earlier investigators. (On the Accuracy, 55)

(For a similar warning, see Boskin, “Some Thoughts,” 20.) The advice remains sound, however little it has been or will be heeded. Economics would progress faster if economists asked more hard questions before admitting official data into their analyses. On a wider front, where the interests of the general public come into play, economic statistics might be put to an even more stringent test. Suppose we were to pose seriously the question asked rhetorically by journalist Peter Passell in his discussion of international trade statistics (“The Fear Is Gone”). “The transactions are voluntary and generally take place between consenting adults,” Passell observed. “So why is it anyone’s business but theirs?” Why indeed?

A just government, one that confines itself to protecting the citizens’ rights to life, liberty, and property, has no need for figures on the distribution of personal income; no need for data on international trade and finance; no need for national income and product accounts. None of these statistics can assist in the defense of the citizens’ just rights. Such figures belong to “political arithmetic.” They are raw materials for rent-seekers and government officials who would make government an engine of predation and a destroyer of just rights.

Private Business Net Investment Remains in a Deep Ditch By Robert Higgs http://www.independent.org/blog/index.php?p=9385 Sunday February 20, 2011 at 12:26:44 PM PST

If any one thing estimated in the Commerce Department’s National Income and Product Accounts may be described as the engine of economic growth, private domestic business net investment is that thing. This variable has such tremendous importance because, if accurately gauged, it tells us better than any other measure how many resources are being devoted to building up the private business capital stock and improving it by innovation. An economy that has anemic private business net investment almost certainly will falter soon, if it is not doing so already.

Notice that every aspect of this awkwardly named variable is critical.

• First, it has to do with private investment, not so-called government investment. The latter, which looms fairly large in the official accounts, ought never to have been labeled as investment, because it comes about not as a result of wealth-seeking motives and rational economic calculation, but as a result of political motives, calculations, and actions that often clash with the creation of real wealth, rather than contributing to it.

• Second, we are looking here at business investment, excluding what the Bureau of Economic Analysis calls private “household and institutions” investment, which has somewhat murky underlying objectives, determinants, and consequences.

• Third, we are examining net, rather than gross, investment. The latter includes a large element of expenditure aimed merely at compensating for the wear and tear and obsolescence of the

7 existing stock of private business capital. For example, even at the most recent peak for gross private domestic business investment, in the third quarter of 2007, it was running at $1,661 billion (annual rate), whereas net private domestic business investment was only $463 billion (annual rate), or about 28 percent of the total. (The investment data cited in this article are taken from Table 5.1, Saving and Investment by Sector, in the National Income and Product Accounts, accessed 02/16/11.)

It is obviously important that businesses compensate for ongoing depreciation of their existing stock of capital goods, which includes structures, tools and equipment, software, and inventories. But unless firms do more than make up for depreciation, they do not expand their productive capacity except to the extent that they can embed improved technology in their replacements for worn-out or obsolete capital goods. In general, economic growth requires net investment, and more rapid economic growth requires a greater rate of net investment.

With that essential idea in mind, let us examine what has happened recently to private domestic business net investment, which I will henceforth call simply net private investment. Such investment reached its recent cyclical peak in the third quarter of 2007, at $463 billion (annual rate). It then fell steadily for the next four quarters, reaching $336 billion in the third quarter of 2008. At that point, it plunged steeply, falling to only $159 billion, or by 53 percent, in the fourth quarter of 2008.

Although the financial-market panic that had flared up in late September 2008 began to subside early in 2009, net private investment continued to fall, becoming negative (-$53 billion, annual rate) in the first quarter of 2009 and even more negative in the second quarter (-$119 billion). Although some improvement began in the third quarter of 2009, net private investment remained negative during the third and fourth quarters. For the entire year 2009, the amount of net private investment amounted to a large negative amount (-$69 billion). So, in other words, the value of the private business capital stock fell by that amount. Hardly by coincidence, real GDP also fell substantially in 2009, by 2.6 percent.

In 2010, net private investment increased smartly for three quarters, reaching an annual rate of $270 billion in the third quarter, then contracted sharply – by almost 47 percent – to $144 billion in the fourth quarter. For the entire year, the amount of private net investment was $177 billion. Whether the collapse in the final quarter of 2010 will turn out to have been a fluke or the beginning of a longer-term decline, we shall have to wait to see.

According to the National Bureau of Economic Research, the most recent business-cycle peak occurred in December 2007, and the trough was reached in June 2009. As we have seen, net private investment peaked slightly sooner, in the third quarter of 2007. So, we are now more than three years past the economy’s overall peak and some 20 months past its trough, yet net private investment in the most recent quarter was running at only 31 percent of the annual rate at its previous peak.

Private net investment is currently running far below the rate required to sustain a rapid rate of economic growth. Real consumer spending, in contrast, peaked in the fourth quarter of 2007, fell only slightly (about 2.5 percent) to the second quarter of 2009, and by the fourth quarter of 2010 exceeded its previous quarterly peak (by almost 1 percent). Despite the wailing

8 and gnashing of teeth among Keynesian economists and politicians with regard to allegedly inadequate consumption, a collapse of consumption is not to blame for the economy’s anemic recovery to date. However, looking elsewhere for the cause, we find that the economy’s true engine of growth – private business net investment – continues to sputter, running in the most recent quarter at less than a third of its previous peak rate and, for the entire year 2010, at only 40 percent of its rate for the entire year 2007.

Unless net private investment recovers more rapidly, the overall economy’s recovery is sure to remain slow, at best, certainly too slow to bring down significantly the high unemployment rate that has been stuck for a long time between 9 percent and 10 percent (and would be substantially greater if we took into account the millions who have left the labor force recently because they did not believe they could find a job even if they searched for one). As matters now stand, real stagnation is a likely prospect and, given the Fed’s massive ongoing purchases of Treasury debt and the stupendous amount of excess reserves in the commercial banks’ accounts at the Fed, stagflation also seems to be a credible expectation.

Investors continue to view the future with major misgivings, owing to the unsettled condition of the government’s future actions with regard to health care, financial regulations, energy regulations, taxation, and other matters that have serious implications for business costs and the security of private property rights in business capital and its returns. Although ObamaCare and the Dodd-Frank bill have already been enacted, these massive statutes leave scores of important details awaiting determination by administrative agencies and courts whose actions will be fiercely contested at every step. Future tax rates also remain up for grabs in Congress.

Nor are the investment-paralyzing uncertainties confined to the United States. Europe in particular continues to wrestle with the aftermath of the malinvestments and other distortions wrought in its asset markets and financial institutions during the boom of 2002-2006, and several countries teeter on the brink of sovereign default. Given the close linkages of national markets in today’s world, U.S. companies will feel a great impact from any new crises in Europe – something else to worry about as they contemplate the desirability of increasing their investment spending.

Of course, the major trading countries and their governments may ultimately find a way to muddle through. They have eventually weathered major storms in the past. Yet, however the world’s economy moves in the longer term, the immediate prospect for investors in the U.S. economy remains troubled, at best. A substantial, rapid recovery of private business net investment must await the clearing of these clouds. Until such a recovery does occur, however, overall economic prospects must remain rather gloomy for the near and medium terms. 2 Comment(s) 1. Thanks for this excellent post, Bob.

Just one point. You claim that “growth requires net investment, and more rapid economic growth requires a greater rate of net investment”. I wonder whether this claim, as well as other parts of your note, overlook key microeconomic and disaggregated aspects of the nature of investment and the capital structure. After all, the variable you are considering

9

is a macro-aggregate, and the more of it doesn’t necessarily imply the better the economy is going. I don’t think it takes into account the possibility of malinvestments. Nevertheless, I’ve understood your point, and I agree with it.

Ángel Martín | Feb 20, 2011 | Reply

2. Angel,

You make a good point, with which I agree entirely. Like many economists, I get into the habit of taking the ceteris paribus condition for granted in stating economic relationships. It is best, however, to state this condition explicitly in order to allay misunderstandings.

As you suggest, if government or central bank policies are changing the extent to which resources are being misallocated via malinvestments and other uneconomic actions, then it may well be that more aggregate net investment will not produce more rapid economic growth. In a full-fledged analysis, such possibilities would need to be considered fully.

10

CLASSICALS

Hume from On Money … Accordingly we find, that, in every kingdom, into which money begins to flow in greater abundance than formerly, every thing takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for, if we consider only the influence which a greater abundance of coin has in the kingdom itself, by heightening the price of Commodities, and obliging every one to pay a greater number of these little yellow or white pieces for every thing he purchases. And as to foreign trade, it appears, that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.

To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry. When any quantity of money is imported into a nation, it is not at first dispersed into many hands; but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver for goods which they sent to CADIZ. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment from such good paymasters. If workmen become scarce, the manufacturer gives higher wages, but at first requires an encrease of labour; and this is willingly submitted to by the artisan, who can now eat and drink better, to compensate his additional toil and fatigue. He carries his money to market, where he, finds every thing at the same price as formerly, but returns with greater quantity and of better kinds, for the use of his family. The farmer and gardener, finding, that all their commodities are taken off, apply themselves with alacrity to the raising more; and at the same time can afford to take better and more cloths from their tradesmen, whose price is the same as formerly, and their industry only whetted by so much new gain. It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour.

And that the specie may encrease to a considerable pitch, before it have this latter effect, appears, amongst other instances, from the frequent operations of the FRENCH king on the money; where it was always found, that the augmenting of the numerary value did not produce a proportional rise of the prices, at least for some time. In the last year of LOUIS XIV, money was raised three- sevenths, but prices augmented only one. Corn in FRANCE is now sold at the same price, or for the same number of livres, it was in 1683; though silver was then at 30 livres the mark, and is now at 50. Not to mention the great addition of gold and silver, which may have come into that kingdom since the former period.

11

From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of astate, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for every thing in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.

Mill Essays on Some Unsettled Questions in Political Economy

Nothing is more true than that it is produce which constitutes the market for produce, and that every increase of production, if distributed without miscalculation among all kinds of produce in the proportion which private interest would dictate, creates, or rather constitutes, its own demand [italics added]. – J. S. Mill, Essays on Some Unsettled Questions in Political Economy 1948 [1844]: 73.

Wicksell: Lectures on Political Economy. Volume II: Note on Trade Cycles and Crises.

The above views, so far as they relate to price movements in " good " and " bad " times, are connected with a view of the nature and causes of trade cycles which I have not had the opportunity of developing further since I put it forward in a lecture to the Norwegian Statsokonomiska Forening (Economic Club), published in Statsokonomisk Tidshrift, 1907. The lecture does not claim to give a definitive explanation of the puzzling phenomena of the trade cycle, but does point out a necessary and hitherto often neglected clue to a full explanation. Moreover my view closely agrees with that of Professor Spiethoff. Its main feature is that it ascribes trade cycles to real causes independent of movements in commodity price, so that the latter become of only secondary importance, although in real life they nevertheless play an important and even a dominating part in the development of crises.

Since rising prices almost always accompany prosperous times and falling prices times of depression, it is natural—though in my opinion wrong—to regard such a rise in prices as the cause of good times, and falling prices as the cause of depressions, just as according to Clement Juglar—who may well be right here— the cause of crises, or rather the crises themselves, consist

12

of the sudden cessation of the rise in commodity prices. A consistent statement of this point of view is contained, for example, in Sombart's well-known assertion that, historically, prosperous times are always associated with increased gold production. That such a general rise in prices, or rather a rise caused in such a way, may act as an incentive to increased business activity and thus to conversion on a large scale of liquid capital into fixed capital, which, as all agree, is the outstanding characteristic of good times, need not be disputed. But if the formation of the real capital which is then absolutely essential is only based on the rise in prices itself, i.e. is due to diminished consumption on the part of those persons or classes of society with fixed money incomes, then the increased prosperity could scarcely be very great or enduring. Moreover, the constant parallelism between largely increasing gold production and boom periods which advocates of this view have observed is disputed, and in my opinion rightly, by others, for example by Spiethoff.

Still less can we accept the view first put forward by Tugan Baronowski, and later adopted by Lescure (in his work on crises) according to which both a rise in prices in good times and a fall in prices during and after a crisis have no relation to the currency system and are caused exclusively by the phenomena of production and of the market. Thus, for example, in this view increased production and the resulting increase in the supply of certain kinds of goods, especially of those for which the demand is not very elastic, such as foodstuffs, would lead to a heavy fall in the prices of such goods, and since sellers would then obtain smaller amounts of money with which to demand other goods, the fall in prices would extend to these also and depression and crisis would result (surproduction generalisee in contrast to surproduetion generate, formerly the commonest theoretical explanation of crises, but now mostly abandoned).

Clearly the fact is here overlooked that the purchasing power which on this assumption would be reduced in the case of the sellers of the former goods would be increased to a corresponding degree in the case of the buyers. If the latter only have to offer a smaller part of their income in order to satisfy their needs for the goods or classes of goods in question, then they have a correspondingly greater amount left for their demand for other goods, and it is not impossible that these other goods— quite contrary to the theory—would rise in price and thereby perhaps compensate for the fall in price of the cheapened goods. On the whole it is vain here, as in the general theory of prices, to explain any particular movement without regard to the one thing which constitutes a basis of comparison in all price-formation, namely money and its substitutes, or the means of hastening its velocity of circulation, credit. In pure theory we are at liberty to invent any measure of prices we please. Let us suppose, for example, that instead of 0*4 grammes of gold, as in Sweden, we select as our unit of money value one kg. of pig-iron. Then, since of all commodities pig-iron usually shows the most violent fluctuations in price before and after a crisis, the choice of this measure of value would mean that the prices of all goods (except pig-iron, which would remain constant) would fall in good times and rise in the subsequent depression. That price movements in fact occur in the opposite direction can only be explained by the choice of the measure of prices—gold, and not pig-iron. Yet the difference does not consist in the fact that gold as a commodity, i.e. in industrial use, is less in demand in good than in bad times —the opposite is certainly true—but in the fact that its quality as a commodity remains in an indifferent relation to the other factors influencing its value. The utility of gold in its technical employment is, unlike that of pig-iron, at any rate during the short periods here

13

under consideration, of too little importance to be able to offer any resistance to the changes in its exchange value which are caused by an acceleration or retardation of the velocity of circulation of minted gold or by the expansion or contraction of credit.

It is true, of course, that the last-mentioned factor is of some influence between individuals, apart from any measures taken by the banks. The general tone of confidence produced by a boom no doubt has the effect of considerably expanding the volume of claims and debts on ordinary current account between merchants—and vice versa in times of depression— but in the main and especially nowadays it is probably the banks who by their discounting of bills and other credit facilities regulate the amount of circulating medium. And after what we have said above we may take it for granted that that which primarily determines the extent to which this bank credit is taken must be its price, its relative price, the bank rate, in relation to the yield or expected yield of capital employed in production and turnover.

Our conclusion is therefore that the changes in the purchasing power of money caused by credit are under existing conditions certainly ultimately bound up with industrial fluctuations and undoubtedly affect them, especially in causing crises, though we need not assume any necessary connection between the phenomena.

The principal and sufficient cause of cyclical fluctuations should rather be sought in the fact that in its very nature technical or commercial advance cannot maintain the same even progress as does, in our days, the increase in needs—especially owing to the organic phenomenon of increase of population—but is sometimes precipitate, sometimes delayed. It is natural and at the same time economically justifiable that in the former case people seek to exploit the favourable situation as quickly as possible, and since the new discoveries, inventions, and other improvements nearly always require various kinds of preparatory work for their realization, there occurs the conversion of large masses of liquid into fixed capital which is an inevitable preliminary to every boom and indeed is probably the only fully characteristic sign, or at any rate one which cannot conceivably be absent.

If, again, these technical improvements are already in operation and no others are available, or at any rate none which have been sufficiently tested or promise a profit in excess of the margin of risk attaching to all new enterprises, there will come a period of depression; people will not venture to the capital which is now being accumulated in such a fixed form, but will retain it as far as possible in a liquid, available form. It is not difficult to understand that in the former case such goods (raw materials) as serve in the construction of fixed capital —bricks, timber, iron, etc.—would be in great demand and rise in price, and that in a period of depression they would be in slight demand and fall in price. But this rise or fall in price should under ordinary conditions be accompanied by a movement in the opposite direction of the price of other goods, so that the average level of prices would remain unchanged. This would probably be the case if the banks at the beginning of a boom raised their interest rates sufficiently and on the other hand finally lowered them at the beginning of a depression. In that case presumably the real element of the crisis would be eliminated and what remained would be merely an even fluctuation between periods in which the newly formed capital would assume, and, economically speaking, should assume, other forms, of which we shall now speak, but which have been almost completely

14

ignored in all previous theories of the trade cycle. Since the demand for new capital in an upward swing of the trade cycle is frequently much too great to be satisfied by contemporaneous saving, even if it is stimulated by a higher rate of interest, and since, on the other hand, in bad times this demand is practically nil, though saving does not nevertheless entirely cease, the rise in rates of interest and commodity prices in good times and their fall in bad times would presumably be much more severe than now, if it were not that the replenishment and depletion of stocks in all branches of production producing durable goods, acted as a regulator or " parachute ". When demand falls, manufacturers, unless they wish to dismiss their workers or work half-time, have no alternative but to work for stock, and usually they do so, since wages have generally fallen and the rise in prices which they expect to occur later on will more than cover the loss of keeping goods in stock even for several years. (In some years the price of bricks has varied from 25 to 40 Kr. per 1,000. If rent and warehousing are estimated at 10 per cent per annum for the whole output—which is an exaggeration—then the holding of stocks for even five years would be economically possible, if the higher price were assured at the end of the period.) The accumulation of stocks is probably the most important form of fresh capital accumulation in bad times. In subsequent good times the largely increased demand for raw materials and finished goods for production and consumption is largely satisfied from these stocks, both directly and by exchange for the products of other countries. Clearly, working for stock would be much facilitated if the banks offered sufficient cheap credit. Manufacturers would then not need to wait for a fall in wages or in the prices of raw materials, but even a moderate fall in the prices of their own products would, in combination with low loan rates, make it profitable for them to increase .their stocks in order to reduce them after some years by selling at normal prices. Earlier theory has in my opinion turned the whole matter as it were upside down in so far as it assumes that stocks are increased in good times and are depleted in bad times (the so-called theory of over- production). It is not easy to understand whence the surplus in the former case or the shortage in the latter case should come. In point of fact consumption increases in good times and much labour and land is withdrawn from the production of present commodities. Nor can we understand why practical business men should habitually choose such a topsy-turvy procedure as to complete their stocks when costs of production are high in order to sell them when prices are low. Not even the assumption of widespread unemployment (or short time) in depressions suffices as an explanation, for, quite apart from the fact that this argument is exaggerated, unemployment itself implies greatly reduced consumption. Unfortunately here also we lack the detailed commercial statistics which alone can finally solve this problem. Yet from inquiry among business men I have learned that it is just in periods of depression that they are forced to work for stock, and that they can never do so in good times, since they are then often not in a position fully to meet the demand for their goods. And this appears probable a priori. If we ask when a manufacturer may reasonably describe loans as good and take steps to expand his output, the answer must be when the demand for his goods begins to exceed his production capacity. But that is the moment at which his stocks, which he had previously enlarged, begin to be depleted, that is, mathematically, when they have reached their maximum, and not their minimum dimensions. An apparent argument against this is the heavy fall in prices which usually accompanies a crisis, but the cause of this need not be sought in the accumulation of stocks. No manufacturer is disposed to sell his wares at a slump price just because his warehouses are full. But if he is refused credit and if he is compelled to obtain ready cash, then he will be compelled to dispose of his goods at any price at all, whether his stocks be large or small.

15

In the absence of comprehensive statistics, however, we must content ourselves with a weighing of arguments. Spiethoff (in his discussions in the transactions of the Vereinfur Sozialpolitik, 1903) mentions as a well-known fact that in bad times manufacturers' stock rooms are filled from floor to ceiling. Herkner (in the article " Krisen " in the Handworterbuch der Staatswissenschaften,3rd ed.) disputes this fact by reference to Esslen and Merovich. Esslen's work, however, gives no information on this point and Merovich's work is still, so far as I know, unpublished. How little this important point has hitherto been considered may be seen from the fact that the comprehensive questionnaire which the Verein fur Sozialpolitik at one time sent out, and which is the foundation of the inquiry into the crisis of 1900, did not contain any question as to the magnitude of stocks.

16

KEYNES

Foreword to the German Edition/Vorwort Zur Deutschen Ausgabe

Alfred Marshall, on whose Principles of Economics the education of all contemporary English economists has been based, took particular pains to call special attention to the relationship of his thought to that of Ricardo. His work consisted for the most part in stuffing the law of limited use [Grenznutzen] and the law of substitution into the Ricardo tradition, and his theory of production and of consumption as a whole—contrary to his theory of producing and distributing a given production—has never been laid open. I am not certain whether he himself ever perceived the need for such a theory. but his immediate successors and disciples surely have abandoned it and evidently never perceived its absence. I was educated in this atmosphere. I have taught these doctrines myself and it was only in the course of the last decade that I became aware of their inadequacy. In my own thought and development, this book, therefore, presents a reaction, a transition and a disengagement from the classical English (or orthodox) tradition. How I have stressed this and the points in which I deviate from the recognized doctrine has been regarded by certain circles in England as extremely controversial. But how could someone educated in English economic orthodoxy, who was even once a priest of that faith, avoid some controversial emphasis, if he becomes a protestant for the first time? I can, however, imagine that all this may concern the German readers somewhat differently. The orthodox tradition which reigned in the England of the 19th century never had such a strong influence on German thought. In Germany there have always been important schools of economics which strongly questioned the adequacy of classical theory for the analysis of contemporary events. The Manchester School as well as Marxism, have, after all, stemmed from Ricardo—a conclusion that need cause surprise only when superficially considered. But in Germany there has always been a majority of opinion which adhered neither to one school nor the other. However, it can hardly be contended that this school of thought ever established a theoretical counter-structure, nor did it ever attempt to do this. It has been skeptical and realistic, satisfied with historical and empirical methods and results which reject a formal analysis. The most important unorthodox discussion on the theoretical level has been that of Wicksell. His books (until recently not available in English) were available in the German language; one of his most important was in fact written in German. His successors, however, were mainly Swedes and Austrians; the latter linked his ideas in with a substantially Austrian theory, and thus in reality actually brought them back to the classical tradition. Germany thus has—in contrast to her custom in most fields of science—contented herself for a whole century without a dominant and generally recognized formal theory of economics. I may, therefore, perhaps expect to meet with less resistance on the part of German readers than from English, when I submit to them a theory of employment and production as a whole which deviates in important particulars from the orthodox tradition. But could I hope to overcome the economic agnosticism of Germany? Could I convince German economists that methods of formal analysis constitute an important contribution to the interpretation of contemporary events and to the shaping of contemporary policy? It is, after all, a feature of German character to find satisfaction in a theory. How hungry and thirsty German economists must feel having lived all these years without one! It is certainly worthwhile for me to make the effort. And if I can

17

contribute a single morsel to a full meal prepared by German economists, particularly adjusted to German conditions, I will be satisfied. For I must confess that much in the following book has been mainly set forth and illustrated in relation to conditions in the Anglo-Saxon countries. The theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory. Since it is based on fewer hypotheses than the orthodox theory, it can accommodate itself all the easier to a wider field of varying conditions. Although I have, after all, worked it out with a view to the conditions prevailing in the Anglo-Saxon countries where a large degree of laissez-faire still prevails, nevertheless it remains applicable to situations in which state management is more pronounced. For the theory of psychological laws which bring consumption and saving into relationship with each other, the influence of loan expenditures on prices, and real wages, the role played by the rate of interest—all these basic ideas also remain under such conditions necessary parts of our plan of thought. I would like to take this opportunity to thank my translator, Mr. Waeger, for his excellent effort (I hope that his vocabulary at the end of this book will prove useful beyond its immediate purpose), as well as my publishers, Messrs. Duncker & Humblot, whose enterprising spirit ever since the days sixteen years ago when they published my Economic Consequences of the Peace has made it possible for me to maintain my contact with German readers. 7 September 1936 J.M.KEYNES

J.M. Keyne's Famous Foreword to the 1936 German Edition of the General Theory Introduction by James J. Martin

Historians write about economics with a fearful and trembling hand, but economists brashly and cheerfully tackle historical enterprises as if they enjoyed some special commissioned prerogative. What follows this brief introductory material is not an expository essay but a document for all to examine, economists, historians, and the general reader alike. It may be of some embarrassment to both Keynesian and anti-Keynesian partisans, to both those who have never known of this subject and those who have known of it but who have been inhibited by psychic pressures, ranging all the way from an exaggerated sense of delicacy to intellectual cowardice, from ever saying anything about it. One can read whole reams of economic literature written by both fervent followers of John Maynard Keynes and his attackers as well and never know that there was a German language edition of his profoundly influential General Theory late in 1936, for which Keynes wrote a special foreword addressed solely to German readers. By that time the National Socialist regime of Adolf Hitler was four months short of four years in power in Germany. Even the perfumed and sanctified Life of John Maynard Keynes by R.H. Harrod, a book going on to almost 700 pages, never even faintly alludes to the fact that Keynes had a German publisher, nor that the General Theory appeared in Hitler Germany a few months after it was published by Macmillan in England in 1936. (Keynes's foreword to the English edition was dated December 13, 1935.) Perhaps it would have thrown readers offstride for Harrod to discuss such a matter since his book

18

was published in the heat of the immediate post-World War Two years, appearing in 1951. But incongruous and ill-fitting matters such as this are almost always left out of romantic and poetic essays passing as biography. Two prestigious English economic periodicals, the Economic Journal and The Economist,, with meticulous coverage of European and world economic affairs, failed to make any reference to a German edition when they reviewed Keynes's tour de force, nor did subsequent issues in the immediately following years, as far as I have been able to determine. In recent years only Henry Hazlitt has called attention to this important matter. Some economic scribblers hostile to Keynes want too much to attack him personally as if he created the modern state, but appear to be most hesitant about challenging the state themselves. Keynes did not create the modern state. He found it the way it is, and, obviously, from the context of his German foreword, prepared a scheme or system to work within its confines; the greater and more total the state employment of his General Theory, the better. The core of Keynes is found in two consecutive sentences in the German foreword: "The theory of aggregate production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory." We are deep in an age of scriptural exegetics devoted to Keynes and a plethora of what-Keynes- really-meant glosses akin to the tidal wave of similar print which deluged us on Marx in the 1930's. But it ought to be interesting to see what kind of sinuous evasion must be employed to discount the very clear testament involved in this declaration by the Master. The main purpose for this publication is to make it available to students of all persuasions and to general readers who might have an interest in original documentation, for a change. The original German text is included to aid those who wish to make a careful examination of their own.

Samuelson on Keynes’ General Theory Econometrica 1946. 14(3): 190.

Herein lies the secret of the General Theory. It is a badly written book, poorly organized; any layman who, beguiled by the author's previous reputation, bought the book was .cheated of his 5 shillings. It is not well suited for classroom use. It is arrogant, bad-tempered, polemical, and not overly-generous in its acknowledgments. It abounds in mares' nests and confusions: involuntary unemployment, wage units, the equality of savings and investment, the timing of the multiplier, interactions of marginal efficiency upon the rate of interest, forced savings, own rates of interest, and many others. In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding its relations to its predecessors. Flashes of insight and intuition intersperse tedious algebra. An awkward defini tion suddenly gives way to an unforgettable cadenza. When it finally is mastered, we find its analysis to be obvious and at the same time new. In short, it is a work of genius.

Keynes on Creating Wealth and Employment

19

Pyramid-building, earthquakes, even wars may serve to increase wealth, If the education of our statesmen on the principles of classical economics stands in the way of anything better. […] If the Treasury were to fill old bottles with banknotes, burry them at suitable depths in disused coal-mines which are then filled yup to the surface with town rubbish, and leave it to[private enterprise on well-tiered principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note bearing territory, there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. Keynes, GT, 129.

Full Quote − GT 128-131.

When involuntary unemployment exists, the marginal disutility of labour is necessarily less than the utility of the marginal product. Indeed it may be much less. For a man who has been long unemployed some measure of labour, instead of involving disutility, may have a positive utility. If this is accepted, the above reasoning shows how “wasteful” loan expenditure[8] may nevertheless enrich the community on balance. Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.

It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly “wasteful” forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict “business” principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

The analogy between this expedient and the goldmines of the real world is complete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available, our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value and importance to civilisation. just as wars

20

have been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining is the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance; and each of these activities has played its part in progress-failing something better. To mention a detail, the tendency in slumps for the price of gold to rise in terms of labour and materials aids eventual recovery, because it increases the depth at which gold-digging pays and lowers the minimum grade of ore which is payable.

In addition to the probable effect of increased supplies of gold on the rate of interest, gold-mining is for two reasons a highly practical form of investment, if we are precluded from increasing employment by means which at the same time increase our stock of useful wealth. In the first place, owing to the gambling attractions which it offers it is carried on without too close a regard to the ruling rate of interest. In the second place the result, namely, the increased stock of gold, does not, as in other cases, have the effect of diminishing its marginal utility. Since the value of a house depends on its utility, every house which is built serves to diminish the prospective rents obtainable from further house-building and therefore lessens the attraction of further similar investment unless the rate of interest is falling part passu. But the fruits of gold-mining do not suffer from this disadvantage, and a check can only come through a rise of the wage-unit in terms of gold, which is not likely to occur unless and until employment is substantially better. Moreover, there is no subsequent reverse effect on account of provision for user and supplementary costs, as in the case of less durable forms of wealth.

Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth, in that it possessed two activities, namely, pyramid-building as well as the search for the precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance. The Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York. Thus we are so sensible, have schooled ourselves to so close a semblance of prudent financiers, taking careful thought before we add to the “financial” burdens of posterity by building them houses to live in, that we have no such easy escape from the sufferings of unemployment. We have to accept them as an inevitable result of applying to the conduct of the State the maxims which are best calculated to “enrich” an individual by enabling him to pile up claims to enjoyment which he does not intend to exercise at any definite time. K’s GT 128-131

Keynes on Saving Amidst the welter of divergent usages of terms, it is agreeable to discover one fixed point. So far as I know, everyone is agreed that saving means the excess of income over expenditure on consumption. Thus any doubts about the meaning of saving must arise from doubts about the meaning either of income or of consumption. Income we have defined above. Expenditure on consumption during any period must mean the value of goods sold to consumers during that period, which throws us back to the question of what is meant by a consumer- purchaser. Any reasonable definition of the line between consumer- purchasers and investor-purchasers will serve us equally well, provided that it is consistently applied. Such problem as there is, e.g. whether it is right to regard the purchase of a motor- car as a consumer-purchase and the purchase of a house as an investor- purchase, has been

21 frequently discussed and I have nothing material to add to the discussion. The criterion must obviously correspond to where we draw the line between the consumer and the entrepreneur. Thus when we have defined A1 as the value of what one entrepreneur has purchased from another, we have implicitly settled the question. It follows that expenditure on consumption can be unambiguously defined as Σ(A - A1 ), where ΣA is the total sales made during the period and ΣA1 is the total sales made by one entrepreneur to another. In what follows it will be convenient, as a rule, to omit Σ and write A for the aggregate sales of all kinds, A1 for the aggregate sales from one entrepreneur to another and U for the aggregate user costs of the entrepreneurs.

Having now defined both income and consumption, the definition of saving, which is the excess of income over consumption, naturally follows. Since income is equal to A - U and consumption is equal to A - A1 , it follows that saving is equal to A1 - U. Similarly, we have net saving for the excess of net income over consumption, equal to A1 - U - V.

Our definition of income also leads at once to the definition of current investment. For we must mean by this the current addition to the value of the

capital equipment which has resulted from the productive activity of the period. This is, clearly, equal to what we have just defined as saving. For it is that part of the income of the period which has not passed into consumption. We have seen above that as the result of the production of any period entrepreneurs end up with having sold finished output having a value A and with a capital equipment which has suffered a deterioration measured by U (or an improvement measured by -U where U is negative) as a result of having produced and parted with A1 after allowing for purchases 1 from other entrepreneurs. During the same period finished output having a value A - A1 will have passed into consumption. The excess of A - U over A - A1 , namely A1 - U, is the addition to capital equipment as a result of the productive activities of the period and is, therefore, the investment of the period. Similarly A1 - U - V, which is the net addition to capital equipment, after allowing for normal impairment in the value of capital apart from its being used and apart from windfall changes in the value of the equipment chargeable to capital account, is the net investment of the period.

Whilst, therefore, the amount of saving is an outcome of the collective behaviour of individual consumers and the amount of investment of the collective behaviour of individual entrepreneurs, these two amounts are necessarily equal, since each of them is equal to the excess of income over consumption. Moreover, this conclusion in no way depends on any subtleties or peculiarities in the definition of income given above. Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumption — all of which is conformable both to common sense and to the traditional usage of the great majority of economists — the equality of saving and investment necessarily follows. In short—

22

Income = value of output = consumption + investment. Saving = income consumption. Therefore saving = investment.

Thus any set of definitions which satisfy the above conditions leads to the same conclusion. It is only by denying the validity of one or other of them that the conclusion can avoided.

The equivalence between the quantity of saving and the quantity of investment emerges from the bilateral character of the transactions between the producer on the one hand and, on the other hand, the consumer or the purchaser of capital equipment. GT 61-63

Keynes on Involuntary Unemployment:

“Men are involuntarily unemployed if, in the event of a small rise in the price of wage- goods relatively to the money-wage, both the aggregate supply of labor willing to work for the current money-wage and the aggregate demand for it [labor] at that wage would be greater than the existing volume of employment. - J. M. Keynes, The General Theory of Employment, Interest, and Money, 1936.

Keynes on Money:

“In attributing, therefore, a peculiar significance to the money-rate of interest, we have been tacitly assuming that the kind of money to which we are accustomed has some special characteristics which lead to its own-rate of interest in terms of itself as standard being more reluctant to fall as output as increases than the own-rates of interest of any other assets in terms of themselves. Is this assumption justified? Reflection shows, I think, that the following peculiarities, which commonly characterize money as we know it, are capable of justifying it. To the extent that the established standard of value has these peculiarities, the summary statement, that it is the money-rate of interest which is the significant rate of interest, will hold good. (i) The first characteristic which tends toward the above conclusion is the fact that money has, both in the long and in the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority; - elasticity of production2 meaning in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour it will command. Money, that is to say cannot be readily produced; - labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in

2 See Chapter 20. 23

the case of a gold -standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed of a country of which gold-mining is the major industry.

[…]

(ii) Obviously, however, the above condition is satisfied not only by money, but by all pure rent-factors, the production of which is entirely inelastic. A second condition, therefore, is required to distinguish money from other rent elements.

The second differentia of money is that it has an elasticity of substitution equal, or nearly equal, to zero; which means that as the exchange value of money rises there is no tendency to substitute some other factor for it; - except, perhaps, to some trifling extent, where the money commodity is also used in manufacture or the arts. This follows from the peculiarity of money that its utility is solely derived from its exchange value, so that the two rise and fall pari passu, with the result that as the exchange value of money rises there is no motive or tendency, as in the case of rent-factors, to substitute some other for it.

Thus, not only is it impossible to turn more labour on to producing money when its labour- price rises, but money is a bottomless sink for purchasing power, when the demand for it increases, since there is no value for it at which demand is diverted - as in the case of other rent-factors - so as to slop over into a demand for other things.” - J. M. Keynes, The General Theory of Employment, Interest, and Money, 1936.

John Maynard Keynes The General Theory of Employment, Interest and Money

Book VI

Short Notes Suggested by the General Theory

Chapter 22. Notes on the Trade Cycle

SINCE we claim to have shown in the preceding chapters what determines the volume of employment at any time, it follows, if we are right, that our theory must be capable of explaining the phenomena of the Trade Cycle.

If we examine the details of any actual instance of the Trade Cycle, we shall find that it is highly complex and that every element in our analysis will be required for its complete explanation. In particular we shall. find that fluctuations in the propensity to consume, in the state of liquidity-preference, and in the marginal 24 efficiency of capital have all played a part. But I suggest that the essential character of the Trade Cycle, and, especially, the regularity of time- sequence and of duration which justifies us in calling it a cycle, is mainly due to the way in which the marginal efficiency of capital fluctuates. The Trade Cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated. and often aggravated by associated changes in the other significant short-period variables of the economic system. To develop this thesis would occupy a book rather than a chapter, and would require a close examination of facts. But the following short notes will be sufficient to indicate the line of investigation which our preceding theory suggests.

I By a cyclical movement we mean that as the system progresses in, e.g., the upward direction, the forces propelling it upwards at first gather force and have a cumulative effect on one another but gradually lose their strength until at a certain point they tend to be replaced by forces operating in the opposite direction; which in turn gather force for a time and accentuate one another, until they too, having reached their maximum development, wane and give place to their opposite. We do not, however, merely mean by a cyclical movement that upward and downward tendencies, once started, do not persist for ever in the same direction but are ultimately reversed. We mean also that there is some recognisable degree of regularity in the time sequence and duration of the upward and downward movements.

There is, however, another characteristic of what we call the Trade Cycle which our explanation must cover if it is to be adequate; namely, the phenomenon of the crisis — the fact that the substitution of a downward for an upward tendency often takes place suddenly and violently, whereas there is, as a rule, no such sharp turning-point when an upward is substituted for a downward tendency.

Any fluctuation in investment not offset by a corresponding change in the propensity to consume will, of course, result in a fluctuation in employment. Since, therefore, the volume of investment is subject to highly complex influences, it is highly improbable that all fluctuations either in investment itself or in the marginal efficiency of capital will be of a cyclical character. One special case, in particular, namely, that which is associated with agricultural fluctuations, will be separately considered in a later section of this chapter. I suggest, however, that there are certain definite reasons why, in the case of a typical industrial trade cycle in the nineteenth-century environment, fluctuations in the marginal efficiency of capital should have had cyclical characteristics. These reasons are by no means unfamiliar either in themselves or as explanations of the trade cycle. My only purpose here is to link them up with the preceding theory.

II

25

I can best introduce what I have to say by beginning with the later stages of the boom and the onset of the “crisis”.

We have seen above that the marginal efficiency of capital[1] depends, not only on the existing abundance or scarcity of capital-goods and the current cost of production of capital-goods, but also on current expectations as to the future yield of capital-goods. In the case of durable assets it is, therefore, natural and reasonable that expectations of the future should play a dominant part in determining the scale on which new investment is deemed advisable. But, as we have seen, the basis for such expectations is very precarious. Being based on shifting and unreliable evidence, they are subject to sudden and violent changes.

Now, we have been accustomed in explaining the “crisis” to lay stress on the rising tendency of the rate of interest under the influence of the increased demand for money both for trade and speculative purposes. At times this factor may certainly play an aggravating and, occasionally perhaps, an initiating part. But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.

The later stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also. It is of the nature of organised investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.[2] Moreover, the dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity-preference — and hence a rise in the rate of interest. Thus the fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But 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

26 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; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. 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 in the trade cycle, of the fact that an interval of time of a particular order of magnitude must usually elapse before recovery begins, is to be sought in the influences which govern the recovery of the marginal efficiency of capital. There are reasons, given firstly by the length of life of durable assets in relation to the normal rate of growth in a given epoch, and secondly, by the carrying-costs of surplus stocks, why the duration of the downward movement should have an order of magnitude which is not fortuitous, which does not fluctuate between, say, one year this time and ten years next time, but which shows some regularity of habit between, let us say, three and five years.

Let us recur to what happens at the crisis. 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 concerning the reliability of the prospective yield, perhaps because the current yield shows signs of failing off, as the stock of newly produced durable goods steadily increases. If current costs of production are thought to be higher than they will be later on, that will be a further reason for a fall in the marginal efficiency of capital. 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 in a given epoch. If the characteristics of the epoch shift, the standard time- interval will change. If, for example, we pass from a period of increasing population into one of declining population, the characteristic phase of the cycle will be lengthened. But we have in the above a substantial reason why the duration of the slump should have a definite relationship to the length of life of durable assets and to the normal rate of growth in a given epoch.

The second stable time-factor is due to the carrying-costs of surplus stocks which force their absorption within a certain period, neither very short nor very 27 long. The sudden cessation of new investment after the crisis will probably lead to an accumulation of surplus stocks of unfinished goods. The carrying-costs of these stocks will seldom be less than 10 per cent. per annum. Thus the fall in their price needs to be sufficient to bring about a restriction which provides for their absorption within a period of, say, three to five years at the outside. Now the 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; and, once the recession has begun, this exerts a strong cumulative influence in the downward direction. In the earliest phase of a typical slump there will probably be an investment in increasing stocks which helps to offset disinvestment in working-capital; in the next phase there may be a short period of disinvestment both in stocks and in working-capital; after the lowest point has been passed there is likely to be a further disinvestment in stocks which partially offsets reinvestment in working-capital; and, finally, after the recovery is well on its way, both factors will be simultaneously favourable to investment. It is against this background that the additional and superimposed effects of fluctuations of investment in durable goods must be examined. When a decline in this type of investment has set a cyclical fluctuation in motion there will be little encouragement to a recovery in such investment until the cycle has [3] partly run its course.

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. Now, on the class who take an active interest in their Stock Exchange investments, especially if they are employing, borrowed funds, this naturally exerts a very depressing influence. These people are, perhaps, even more influenced in their readiness to spend by rises and falls in the value of their investments than by the state of their income. With a “stock- minded” public, as in the United States to-day, a rising stock-market may be an almost essential condition of a satisfactory propensity to consume; and this circumstance, generally overlooked until lately, obviously serves to aggravate still further the depressing effect of a decline in the marginal efficiency of capital.

When once the recovery has been started, the manner in which it feeds on itself and cumulates is obvious. But during the downward phase, when both fixed capital and stocks of materials are for the time being redundant and working- capital is being reduced, the schedule of 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. Thus with markets organised and influenced as they are at present, the market estimation of the marginal efficiency of capital may suffer such enormously wide fluctuations 28 that it cannot be sufficiently offset by corresponding fluctuations in the rate of interest. Moreover, the corresponding movements in the stock-market may, as we have seen above, depress the propensity to consume just when it is most needed. 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.

III

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.[4] Moreover, even if over-investment in this sense was a normal characteristic of the boom, the remedy would not lie in clapping on a high rate of interest which would probably deter some useful investments and might further diminish the propensity to consume, but in taking drastic steps, by redistributing incomes or otherwise, to stimulate the propensity to consume.

According to my analysis, however, it is only in the former sense that the boom can be said to be characterised by over-investment. The situation, which I am indicating as typical, 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;

29

— which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. 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![5] 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.

The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expectation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact deterrent. A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive.

Except during the war, I doubt if we have any recent experience of a boom so strong that it led to full employment. In the United States employment was very satisfactory in 1928-29 on normal standards; but I have seen no evidence of a shortage of labour, except, perhaps, in the case of a few groups of highly specialised workers. Some “bottle-necks” were reached, but output as a whole was still capable of further expansion. Nor was there over-investment in the sense that the standard and equipment of housing was so high that everyone, assuming full employment, had all he wanted at a rate which would no more than cover the replacement cost, without any allowance for interest, over the life of the house; and that transport, public services and agricultural improvement had been carried to a point where further additions could not reasonably be expected to yield even their replacement cost. Quite the contrary. It would be absurd to assert of the United States in 1929 the existence of over-investment in the strict sense. The true state of affairs was of a different character. New investment during the previous five years had been, indeed, on so enormous a scale in the aggregate that the prospective yield of further additions was, coolly considered, falling rapidly.

30

Correct foresight would have brought down the marginal efficiency of capital to an unprecedentedly low figure; so that the “boom” could not have continued on a sound basis except with a very low long-term rate of interest, and an avoidance of misdirected investment in the particular directions which were in danger of being over-exploited. In fact, the rate of interest was high enough to deter new investment except in those particular directions which were under the influence of speculative excitement and, therefore, in special danger of being over-exploited; and a rate of interest, high enough to overcome the speculative excitement, would have checked, at the same time, every kind of reasonable new investment. Thus an increase in the rate of interest, as a remedy for the state of affairs arising out of a prolonged period of abnormally heavy new investment, belongs to the species of remedy which cures the disease by killing the patient.

It is, indeed, very possible that the prolongation of approximately full employment over a period of years would be associated in countries so wealthy as Great Britain or the United States with a volume of new investment, assuming the existing propensity to consume, so great that it would eventually lead to a state of full investment in the sense that an aggregate gross yield in excess of replacement cost could no longer be expected on a reasonable calculation from a further increment of durable goods of any type whatever. Moreover, this situation might be reached comparatively soon — say within twenty-five years or less. I must not be taken to deny this, because I assert that a state of full investment in the strict sense has never yet occurred, not even momentarily.

Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it.

IV

It may be convenient at this point to say a word about the important schools of thought which maintain, from various points of view, that the chronic tendency of contemporary societies to under-employment is to be traced to under- consumption; — that is to say, to social practices and to a distribution of wealth which result in a propensity to consume which is unduly low.

In existing conditions — or, at least, in the conditions which existed until lately

— where the volume of investment is unplanned and uncontrolled, subject to the vagaries of the marginal efficiency of capital as determined by the private judgment of individuals ignorant or speculative, and to a long-term rate of interest 31 which seldom or never falls below a conventional level, these schools of thought are, as guides to practical policy, undoubtedly in the right. For in such conditions there is no other means of raising the average level of employment to a more satisfactory level. If it is impracticable materially to increase investment, obviously there is no means of securing a higher level of employment except by increasing consumption.

Practically I only differ from these schools of thought in thinking that they may lay a little too much emphasis on increased consumption at a time when there is still much social advantage to be obtained from increased investment. Theoretically, however, they are open to the criticism of neglecting the fact that there are two ways to expand output. Even if we were to decide that it would be better to increase capital more slowly and to concentrate effort on increasing consumption, we must decide this with open eyes, after well considering the alternative. I am myself impressed by the great social advantages of increasing the stock of capital until it ceases to be scarce. But this is a practical judgment, not a theoretical imperative.

Moreover, I should readily concede that the wisest course is to advance on both fronts at once. Whilst aiming at a socially controlled rate of investment with a view to a progressive decline in the marginal efficiency of capital, I should support at the same time all sorts of policies for increasing the propensity to consume. For it is unlikely that full employment can be maintained, whatever we may do about investment, with the existing propensity to consume. There is room, therefore, for both policies to operate together; — to promote investment and, at the same time, to promote consumption, not merely to the level which with the existing propensity to consume would correspond to the increased investment, but to a higher level still.

If — to take round figures for the purpose of illustration — the average level of output of to-day is 15 per cent. below what it would be with continuous full employment, and if 10 per cent. of this output represents net investment and go per cent. of it consumption — if, furthermore, net investment would have to rise 50 per cent. in order to secure full employment with the existing propensity to consume, so that with full employment output would rise from 100 to 115, consumption from go to 100 and net investment from 10 to 15: — then we might aim, perhaps, at so modifying the propensity to consume that with full employment consumption would rise from go to 103 and net investment from 10 to 12.

V

Another school of thought finds the solution of the trade cycle, not in increasing either consumption or investment, but in diminishing the supply of 32 labour seeking employment; i.e. by redistributing the existing volume of employment without increasing employment or output.

This seems to me to be a premature policy — much more clearly so than the plan of increasing consumption. A point comes where every individual weighs the advantages of increased leisure against increased income. But at present the evidence is, I think, strong that the great majority of individuals would prefer increased income to increased leisure; and I see no sufficient reason for compelling those who would prefer more income to enjoy more leisure.

VI

It may appear extraordinary that a school of thought should exist which finds the solution for the trade cycle in checking the boom in its early stages by a higher rate of interest. The only line of argument, along which any justification for this policy can be discovered, is that put forward by Mr. D. H. Robertson, who assumes, in effect, that full employment is an impracticable ideal and that the best that we can hope for is a level of employment much more stable than at present and averaging, perhaps, a little higher.

If we rule out major changes of policy affecting either the control of investment or the propensity to consume, and assume, broadly speaking, a continuance of the existing state of affairs, it is, I think, arguable that a more advantageous average state of expectation might result from a banking policy which always nipped in the bud an incipient boom by a rate of interest high enough to deter even the most misguided optimists. The disappointment of expectation, characteristic of the slump, may lead to so much loss and waste that the average level of useful investment might be higher if a deterrent is applied. It is difficult to be sure whether or not this is correct on its own assumptions; it is a matter for practical judgment where detailed evidence is wanting. It may be that it overlooks the social advantage which accrues from the increased consumption which attends even on investment which proves to have been totally misdirected, so that even such investment may be more beneficial than no investment at all. Nevertheless, the most enlightened monetary control might find itself in difficulties, faced with a boom of the 1929 type in America, and armed with no other weapons than those possessed at that time by the Federal Reserve System; and none of the alternatives within its power might make much difference to the result. However this may be, such an outlook seems to me to be dangerously and unnecessarily defeatist. It recommends, or at least assumes, for permanent acceptance too much that is defective in our existing economic scheme.

The austere view, which would employ a high rate of interest to check at once any tendency in the level of employment to rise appreciably above the average of, 33 say, the previous decade, is, however, more usually supported by arguments which have no foundation at all apart from confusion of mind. It flows, in some cases, from the belief that in a boom investment tends to outrun saving, and that a higher rate of interest will restore equilibrium by checking investment on the one hand and stimulating savings on the other. This implies that saving and investment can be unequal, and has, therefore, no meaning until these terms have been defined in some special sense. Or it is sometimes suggested that the increased saving which accompanies increased investment is undesirable and unjust because it is, as a rule, also associated with rising prices. But if this were so, any upward change in the existing level of output and employment is to be deprecated. For the rise in prices is not essentially due to the increase in investment; — it is due to the fact that in the short period supply price usually increases with increasing output, on account either of the physical fact of diminishing return or of the tendency of the cost-unit to rise in terms of money when output increases. If the conditions were those of constant supply-price, there would, of course, be no rise of prices; yet, all the same, increased saving would accompany increased investment. It is the increased output which produces the increased saving; and the rise of prices is, merely a by-product of the increased output, which will occur equally if there is no increased saving but, instead, an increased propensity to consume. No one has a legitimate vested interest in being able to buy at prices which are only low because output is low.

Or, again, the evil is supposed to creep in if the increased investment has been promoted by a fall in the rate of interest engineered by an increase in the quantity of money. Yet there is no special virtue in the pre-existing rate of interest, and the new money is not “forced” on anyone; — it is created in order to satisfy the increased liquidity-preference which corresponds to the lower rate of interest or the increased volume of transactions, and it is held by those individuals who prefer to hold money rather than to lend it at the lower rate of interest. Or, once more, it is suggested that a boom is characterised by “capital consumption”, which presumably means negative net investment, i.e. by an excessive propensity to consume. Unless the phenomena of the trade cycle have been confused with those of a flight from the currency such as occurred during the post-war European currency collapses, the evidence is wholly to the contrary. Moreover, even if it were so, a reduction in the rate of interest would be a more plausible remedy than a rise in the rate of interest for conditions of under-investment. I can make no sense at all of these schools of thought; except, perhaps, by supplying a tacit assumption that aggregate output is incapable of change. But a theory which assumes constant output is obviously not very serviceable for explaining the trade cycle.

VII

In the earlier studies of the trade cycle, notably by Jevons, an explanation was found in agricultural fluctuations due to the seasons, rather than in the phenomena of industry. In the light of the above theory this appears as an extremely plausible 34 approach to the problem. For even to-day fluctuation in the stocks of agricultural products as between one year and another is one of the largest individual items amongst the causes of changes in the rate of current investment; whilst at the time when Jevons wrote — and more particularly over the period to which most of his statistics applied — this factor must have far outweighed all others.

Jevons’s theory, that the trade cycle was primarily due to the fluctuations in the bounty of the harvest, can be re-stated as follows. When an exceptionally large harvest is gathered in, an important addition is usually made to the quantity carried over into later years. The proceeds of this addition are added to the current incomes of the farmers and are treated by them as income; whereas the increased carry-over involves no drain on the income-expenditure of other sections of the community but is financed out of savings. That is to say, the addition to the carry- over is an addition to current investment. This conclusion is not invalidated even if prices fall sharply. Similarly when there is a poor harvest, the carry-over is drawn upon for current consumption, so that a corresponding part of the income- expenditure of the consumers creates no current income for the farmers. That is to say, what is taken from the carry-over involves a corresponding reduction in current investment. Thus, if investment in other directions is taken to be constant, the difference in aggregate investment between a year in which there is a substantial addition to the carry-over and a year in which there is a substantial subtraction from it may be large; and in a community where agriculture is the predominant industry it will be overwhelmingly large compared with any other usual cause of investment fluctuations. Thus it is natural that we should find the upward turning-point to be marked by bountiful harvests and the downward turning-point by deficient harvests. The further theory, that there are physical causes for a regular cycle of good and bad harvests, is, of course, a different matter with which we are not concerned here.

More recently, the theory has been advanced that it is bad harvests, not good harvests, which are good for trade, either because bad harvests make the population ready to work for a smaller real reward or because the resulting redistribution of purchasing-power is held to be favourable to consumption. Needless to say, it is not these theories which I have in mind in the above description of harvest phenomena as an explanation of the trade cycle.

The agricultural causes of fluctuation are, however, much less important in the modern world for two reasons. In the first place agricultural output is a much smaller proportion of total output. And in the second place the development of a world market for most agricultural products, drawing upon both hemispheres, leads to an averaging out of the effects of good and bad seasons, the percentage fluctuation in the amount of the world harvest being far less than the percentage fluctuations in the harvests of individual countries. But in old days, when a country was mainly dependent on its own harvest, it is difficult to see any

35 possible cause of fluctuations in investment, except war, which was in any way comparable in magnitude with changes in the carry-over of agricultural products.

Even to-day it is important to pay close attention to the part played by changes in the stocks of raw materials, both agricultural and mineral, in the determination of the rate of current investment. I should attribute the slow rate of recovery from a slump, after the turning-point has been reached, mainly to the deflationary effect of the reduction of redundant stocks to a normal level. At first the accumulation of stocks, which occurs after the boom has broken, moderates the rate of the collapse; but we have to pay for this relief later on in the damping- down of the subsequent rate of recovery. Sometimes, indeed, the reduction of stocks may have to be virtually completed before any measurable degree of recovery can be detected. For a rate of investment in other directions, which is sufficient to produce an upward movement when there is no current disinvestment in stocks to set off against it, may be quite inadequate so long as such disinvestment is still proceeding.

We have seen, I think, a signal example of this in the earlier phases of America’s “New Deal”. When President Roosevelt’s substantial loan expenditure began, stocks of all kinds — and particularly of agricultural products — still stood at a very high level. The “New Deal” partly consisted in a strenuous attempt to reduce these stocks — by curtailment of current output and in all sorts of ways. The reduction of stocks to a normal level was a necessary process — a phase which had to be endured. But so long as it lasted, namely, about two years, it constituted a substantial offset to the loan expenditure which was being incurred in other directions. Only when it had been completed was the way prepared for substantial recovery.

Recent American experience has also afforded good examples of the part played by fluctuations in the stocks of finished and unfinished goods — “inventories” as it is becoming usual to call them — in causing the minor oscillations within the main movement of the Trade Cycle. Manufacturers, setting industry in motion to provide for a scale of consumption which is expected to prevail some months later, are apt to make minor miscalculations, generally in the direction of running a little ahead of the facts. When they discover their mistake they have to contract for a short time to a level below that of current consumption so as to allow for the absorption of the excess inventories; and the difference of pace between running a little ahead and dropping back again has proved sufficient in its effect on the current rate of investment to display itself quite clearly against the background of the excellently complete statistics now available in the United States.

Author’s Footnotes

36

1. It is often convenient in contexts where there is no room for misunderstanding to write “the marginal efficiency of capital”, where “the schedule of the marginal efficiency of capital” is meant.

2. I have shown above (Chapter 12) that, although the private investor is seldom himself directly responsible for new investment, nevertheless the entrepreneurs, who are directly responsible, will find it financially advantageous, and often unavoidable, to fall in with the ideas of the market, even though they themselves are better instructed.

3. Some part of the discussion in my Treatise on Money, Book IV, bears upon the above.

4. On certain assumptions, however, as to the distribution of the propensity to consume through time, investment which yielded a negative return might be advantageous in the sense that, for the community as a whole, it would maximise satisfaction.

5. See below (p. 327) for some arguments which can be urged on the other side. For, if we are precluded from making large changes in our present methods, I should agree that to raise the rate of interest during a boom may be, in conceivable circumstances, the lesser evil. Contents | Chapter 23 | Keynes Archive

The General Theory of Employment, Interest and Money Chapter 23. Notes on Mercantilism, The Usury Laws, Stamped Money and Theories of Under-Consumption I

For some two hundred years both economic theorists and practical men did not doubt that there is a peculiar advantage to a country in a favourable balance of trade, and grave danger in an unfavourable balance, particularly if it results in an efflux of the precious metals. But for the past one hundred years there has been a remarkable divergence of opinion. The majority of statesmen and practical men in most countries, and nearly half of them even in Great Britain, the home of the opposite view, have remained faithful to the ancient doctrine; whereas almost all economic theorists have held that anxiety concerning such matters is absolutely groundless except on a very short view, since the mechanism of foreign trade is self-adjusting and attempts to interfere with it are not only futile, but greatly impoverish those who practise them because they forfeit the advantages of the international division of labour. It will be convenient, in accordance with tradition, to designate the older opinion as Mercantilism and the newer as Free

37

Trade, though these terms, since each of them has both a broader and a narrower signification, must be interpreted with reference to the context.

Generally speaking, modern economists have maintained not merely that there is, as a rule, a balance of gain from the international division of labour sufficient to outweigh such advantages as mercantilist practice can fairly claim, but that the mercantilist argument is based, from start to finish, on an intellectual confusion.

Marshall,[1] for example, although his references to Mercantilism are not altogether unsympathetic, had no regard for their central theory as such and does not even mention those elements of truth in their contentions which I shall examine below.[2] In the same way, the theoretical concessions which free-trade economists have been ready to make in contemporary controversies, relating, for example, to the encouragement of infant industries or to the improvement of the terms of trade, are not concerned with the real substance of the mercantilist case. During the fiscal controversy of the first quarter of the present century I do not remember that any concession was ever allowed by economists to the claim that Protection might increase domestic employment. It will be fairest, perhaps, to quote, as an example, what I wrote myself. So lately as 1923, as a faithful pupil of the classical school who did not at that time doubt what he had been taught and entertained on this matter no reserves at all, I wrote: “If there is one thing that Protection can not do, it is to cure Unemployment. ... There are some arguments for Protection, based upon its securing possible but improbable advantages, to which there is no simple answer. But the claim to cure Unemployment involves

the Protectionist fallacy in its grossest and crudest form.”[3] As for earlier mercantilist theory, no intelligible account was available; and we were brought up to believe that it was little better than nonsense. So absolutely overwhelming and complete has been the domination of the classical school.

II

Let me first state in my own terms what now seems to me to be the element of scientific truth in mercantilist doctrine. We will then compare this with the actual arguments of the mercantilists. It should be understood that the advantages claimed are avowedly national advantages and are unlikely to benefit the world as a whole.

When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment. Given the social and political environment and the national characteristics which determine the propensity to consume, the well-being of a progressive state essentially depends, for the reasons we have already explained, on the sufficiency of such inducements. They may be found either in home investment or in foreign

38 investment (including in the latter the accumulation of the precious metals), which, between them, make up aggregate investment. In conditions in which the quantity of aggregate investment is determined by the profit motive alone, the opportunities for home investment will be governed, in the long run, by the domestic rate of interest; whilst the volume of foreign investment is necessarily determined by the size of the favourable balance of trade. Thus, in a society where there is no question of direct investment under the aegis of public authority, the economic objects, with which it is reasonable for the government to be preoccupied, are the domestic rate of interest and the balance of foreign trade.

Now, if the wage-unit is somewhat stable and not liable to spontaneous changes of significant magnitude (a condition which is almost always satisfied), if the state of liquidity-preference is somewhat stable, taken as an average of its short-period fluctuations, and if banking conventions are also stable, the rate of interest will tend to be governed by the quantity of the precious metals, measured in terms of the wage-unit, available to satisfy the community’s desire for liquidity. At the same time, in an age in which substantial foreign loans and the outright ownership of wealth located abroad are scarcely practicable, increases and decreases in the quantity of the precious metals will largely depend on whether the balance of trade is favourable or unfavourable.

Thus, as it happens, a preoccupation on the part of the authorities with a favourable balance of trade served both purposes; and was, furthermore, the only available means of promoting them. At a time when the authorities had no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade were the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of the precious metals was their only indirect means of reducing the domestic rate of interest and so increasing the inducement to home investment.

There are, however, two limitations on the success of this policy which must not be overlooked. If the domestic rate of interest falls so low that the volume of investment is sufficiently stimulated to raise employment to a level which breaks through some of the critical points at which the wage-unit rises, the increase in the domestic level of costs will begin to react unfavourably on the balance of foreign trade, so that the effort to increase the latter will have overreached and defeated itself. Again, if the domestic rate of interest falls so low relatively to rates of interest elsewhere as to stimulate a volume of foreign lending which is disproportionate to the favourable balance, there may ensue an efflux of the precious metals sufficient to reverse the advantages previously obtained. The risk of one or other of these limitations becoming operative is increased in the case of a country which is large and internationally important by the fact that, in conditions where the current output of the precious metals from the mines is on a relatively small scale, an influx of money into one country means an efflux from 39 another; so that the adverse effects of rising costs and falling rates of interest at home may be accentuated (if the mercantilist policy is pushed too far) by falling costs and rising rates of interest abroad.

The economic history of Spain in the latter part of the fifteenth and in the sixteenth centuries provides an example of a country whose foreign trade was destroyed by the effect on the wage-unit of an excessive abundance of the precious metals. Great Britain in the pre-war years of the twentieth century provides an example of a country in which the excessive facilities for foreign lending and the purchase of properties abroad frequently stood in the way of the decline in the domestic rate of interest which was required to ensure full employment at home. The history of India at all times has provided an example of a country impoverished by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth.

Nevertheless, if we contemplate a society with a somewhat stable wage-unit, with national characteristics which determine the propensity to consume and the preference for liquidity, and with a monetary system which rigidly links the quantity of money to the stock of the precious metals, it will be essential for the maintenance of prosperity that the authorities should pay close attention to the state of the balance of trade. For a favourable balance, provided it is not too large, will prove extremely stimulating; whilst an unfavourable balance may soon produce a state of persistent depression.

It does not follow from this that the maximum degree of restriction of imports will promote the maximum favourable balance of trade. The earlier mercantilists laid great emphasis on this and were often to be found opposing trade restrictions because on a long view they were liable to operate adversely to a favourable balance. It is, indeed, arguable that in the special circumstances of mid- nineteenth-century Great Britain an almost complete freedom of trade was the policy most conducive to the development of a favourable balance. Contemporary experience of trade restrictions in post-war Europe offers manifold examples of ill-conceived impediments on freedom which, designed to improve the favourable balance, had in fact a contrary tendency.

For this and other reasons the reader must not reach a premature conclusion as to the practical policy to which our argument leads up. There are strong presumptions of a general character against trade restrictions unless they can be justified on special grounds. The advantages of the international division of labour are real and substantial, even though the classical school greatly overstressed them. The fact that the advantage which our own country gains from a favourable balance is liable to involve an equal disadvantage to some other country (a point to which the mercantilists were fully alive) means not only that great moderation is necessary, so that a country secures for itself no larger a share of 40 the stock of the precious metals than is fair and reasonable, but also that an immoderate policy may lead to a senseless international competition for a favourable balance which injures all alike.[4] And finally, a policy of trade restrictions is a treacherous instrument even for the attainment of its ostensible object, since private interest, administrative incompetence and the intrinsic difficulty of the task may divert it into producing results directly opposite to those intended.

Thus, the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire doctrine upon which I was brought up and which for many years I taught;— against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time. For we, the faculty of economists, prove to have been guilty of presumptuous error in treating as a puerile obsession what for centuries has been a prime object of practical statecraft.

Under the influence of this faulty theory the City of London gradually devised the most dangerous technique for the maintenance of equilibrium which can possibly be imagined, namely, the technique of bank rate coupled with a rigid parity of the foreign exchanges. For this meant that the objective of maintaining a domestic rate of interest consistent with full employment was wholly ruled out. Since, in practice, it is impossible to neglect the balance of payments, a means of controlling it was evolved which, instead of protecting the domestic rate of interest, sacrificed it to the operation of blind forces. Recently, practical bankers in London have learnt much, and one can almost hope that in Great Britain the technique of bank rate will never be used again to protect the foreign balance in conditions in which it is likely to cause unemployment at home.

Regarded as the theory of the individual firm and of the distribution of the product resulting from the employment of a given quantity of resources, the classical theory has made a contribution to economic thinking which cannot be impugned. It is impossible to think clearly on the subject without this theory as a part of one’s apparatus of thought. I must not be supposed to question this in calling attention to their neglect of what was valuable in their predecessors. Nevertheless, as a contribution to statecraft, which is concerned with the economic system as whole and with securing the optimum employment of the system’s entire resources, the methods of the early pioneers of economic thinking in the sixteenth and seventeenth centuries may have attained to fragments of practical wisdom which the unrealistic abstractions of Ricardo first forgot and then obliterated. There was wisdom in their intense preoccupation with keeping down the rate of interest by means of usury laws (to which we will return later in this chapter), by maintaining the domestic stock of money and by discouraging rises in the wage-unit; and in their readiness in the last resort to restore the stock of money by devaluation, if it had become plainly deficient through an 41 unavoidable foreign drain, a rise in the wage-unit[5], or any other cause.

III

The early pioneers of economic thinking may have hit upon their maxims of practical wisdom without having had much cognisance of the underlying theoretical grounds. Let us, therefore, examine briefly the reasons they gave as well as what they recommended. This is made easy by reference to Professor Heckscher’s great work on Mercantilism, in which the essential characteristics of economic thought over a period of two centuries are made available for the first time to the general economic reader. The quotations which follow are mainly [6] taken from his pages.

(1) Mercantilist thought never supposed that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level. On the contrary they were emphatic that an unduly high rate of interest was the main obstacle to the growth of wealth; and they were even aware that the rate of interest depended on liquidity-preference and the quantity of money. They were concerned both with diminishing liquidity-preference and with increasing the quantity of money, and several of them made it clear that their preoccupation with increasing the quantity of money was due to their desire to diminish the rate of interest. Professor Heckscher sums up this aspect of their theory as follows:

The position of the more perspicacious mercantilists was in this respect, as in many others, perfectly clear within certain limits. For them, money was — to use the terminology of to-day — a factor of production, on the same footing as land, sometimes

regarded as “artificial” wealth as distinct from the “natural” wealth; interest on capital was the payment for the renting of money similar to rent for land. In so far as mercantilists sought to discover objective reasons for the height of the rate of interest — and they did so more and more during this period — they found such reasons in the total quantity of money. From the abundant material available, only the most typical examples will be selected, so as to demonstrate first and foremost how lasting this notion was, how deep-rooted and independent of practical considerations.

Both of the protagonists in the struggle over monetary policy and the East India trade in the early 1620’s in England were in entire agreement on this point. Gerard Malynes stated, giving detailed reason for his assertion, that “Plenty of money decreaseth usury in price or rate” (Lex Mercatoria and Maintenance of Free Trade,

42

1622). His truculent and rather unscrupulous adversary, Edward Misselden, replied that “The remedy for Usury may be plenty of money” (Free Trade or the Meanes to make Trade Florish, same year). Of the leading writers of half a century later, Child, the omnipotent leader of the East India Company and its most skilful advocate, discussed (1668) the question of how far the legal maximum rate of interest, which he emphatically demanded, would result in drawing “the money” of the Dutch away from England. He found a remedy for this dreaded disadvantage in the easier transference of bills of debt, if these were used as currency, for this, he said, “will certainly supply the defect of at least one- half of all the ready money we have in use in the nation”. Petty, the other writer, who was entirely unaffected by the clash of interests, was in agreement with the rest when he explained the “natural” fall in the rate of interest from 10 per cent to 6 per cent by the increase in the amount of money (Political Arithmetick, 1676), and advised lending at interest as an appropriate remedy for a country with too much “Coin” (Quantulumcunque concerning Money, 1682).

This reasoning, naturally enough, was by no means confined to England. Several years later (1701 and 1706), for example, French merchants and statesmen complained of the prevailing scarcity of coin (disette des espèces) as the cause of the high interest rates, and they were anxious to lower the rate of usury by increasing the [7] circulation of money.

The great Locke was, perhaps, the first to express in abstract terms the relationship between the rate of interest and the quantity of money in his controversy with Petty.[8] He was opposing Petty’s proposal of a maximum rate of interest on the ground that it was as impracticable as to fix a maximum rent for land, since “the natural Value of Money, as it is apt to yield such an yearly Income by Interest, depends on the whole quantity of the then passing Money of the Kingdom, in proportion to the whole Trade of the Kingdom (i.e. the general Vent of all the commodities)”.[9] Locke explains that Money has two values: (1) its value in use which is given by the rate of interest “and in this it has the Nature of Land, the Income of one being called Rent, of the other, Use[10]”, and (2) its value in exchange “and in this it has the Nature of a Commodity”, its value in exchange “depending only on the Plenty or Scarcity of Money in proportion to the Plenty or Scarcity of those things and not on what Interest shall be”. Thus Locke was the parent of twin quantity theories. In the first place he held that the rate of interest depended on the proportion of the quantity of money (allowing for the velocity of circulation) to the total value of trade. In the second place he held that the value of money in exchange depended on the proportion of the quantity of money to the total volume of goods in the market. But — standing with one foot 43 in the mercantilist world and with one foot in the classical world[11] — he was confused concerning the relation between these two proportions, and he overlooked altogether the possibility of fluctuations in liquidity-preference. He was, however, eager to explain that a reduction in the rate of interest has no direct effect on the price-level and affects prices “only as the Change of Interest in Trade conduces to the bringing in or carrying out Money or Commodity, and so in time varying their Proportion here in England from what it was before”, i.e. if the reduction in the rate of interest leads to the export of cash or an increase in [12] output. But he never, I think, proceeds to a genuine synthesis.

How easily the mercantilist mind distinguished between the rate of interest and the marginal efficiency of capital is illustrated by a passage (printed in 1621) which Locke quotes from A Letter to a Friend concerning Usury: “High Interest decays Trade. The advantage from Interest is greater than the Profit from Trade, which makes the rich Merchants give over, and put out their Stock to Interest, and the lesser Merchants Break.” Fortrey (England’s Interest and Improvement, 1663) affords another example of the stress laid on a low rate of interest as a means of increasing wealth.

The mercantilists did not overlook the point that, if an excessive liquidity- preference were to withdraw the influx of precious metals into hoards, the advantage to the rate of interest would be lost. In some cases (e.g. Mun) the object of enhancing the power of the State led them, nevertheless, to advocate the accumulation of state treasure. But others frankly opposed this policy:

Schrötter, for instance, employed the usual mercantilist arguments in drawing a lurid picture of how the circulation in the country would be robbed of all its money through a greatly increasing state treasury ... he, too, drew a perfectly logical parallel between the accumulation of treasure by the monasteries and the export surplus of precious metals, which, to him, was indeed the worst possible

thing which he could think of. Davenant explained the extreme poverty of many Eastern nations — who were believed to have more gold and silver than any other countries in the world — by the fact that treasure “is suffered to stagnate in the Princes’ Coffers”. ... If hoarding by the state was considered, at best, a doubtful boon, and often a great danger, it goes without saying that private hoarding was to be shunned like the pest. It was one of the tendencies against which innumerable mercantilist writers thundered, and I do not think it would be possible to find a single [13] dissentient voice.

(2) The mercantilists were aware of the fallacy of cheapness and the danger that excessive competition may turn the terms of trade against a country. Thus Malynes wrote in his Lex Mercatoria (1622): “Strive not to undersell others to the 44 hurt of the Commonwealth, under colour to increase trade: for trade doth not increase when commodities are good cheap, because the cheapness proceedeth of the small request and scarcity of money, which maketh things cheap: so that the contrary augmenteth trade, when there is plenty of money, and commodities become dearer being in request”.[14] Professor Heckscher sums up as follows this strand in mercantilist thought:

In the course of a century and a half the standpoint was formulated again and again in this way, that a country with relatively less money than other countries must “sell cheap and buy dear...”

Even in the original edition of the Discourse of the Common Weal, that is in the middle of the 16th century, this attitude was already manifested. Hales said, in fact, “And yet if strangers should be content to take but our wares for theirs, what should let them to advance the price of other things (meaning: among others, such as we buy from them), though ours were good cheap unto them? And then shall we be still losers, and they at the winning hand with us, while they sell dear and yet buy ours good cheap, and consequently enrich themselves and impoverish us. Yet had I rather advance our wares in price, as they advance theirs, as we now do; though some be losers thereby, and yet not so many as should be the other way.” On this point he had the Unqualified approval of his editor several decades later (1581). In the 17th century, this attitude recurred again without any fundamental change in significance. Thus, Malynes believed this unfortunate position to be the result of what he dreaded above all things, i.e. a foreign under-valuation of the English exchange.... The same conception then recurred continually. In his Verbum Sapienti (written 1665, published 1691), Petty believed that the violent efforts to increase the quantity of money could only cease “when we have certainly more money than any of our Neighbour States

(though never so little), both in Arithmetical and Geometrical proportion”. During the period between the writing and the publication of this work, Coke declared, “If our Treasure were more than our Neighbouring Nations, I did not care whether we [15] had one fifth part of the Treasure we now have” (1675).

(3) The mercantilists were the originals of “the fear of goods” and the scarcity of money as causes of unemployment which the classicals were to denounce two centuries later as an absurdity:

One of the earliest instances of the application of the Unemployment argument as a reason for the prohibition of

45

imports is to be found in Florence in the year 1426.... The English legislation on the matter goes back to at least 1455 .... An almost contemporary French decree of 1466, forming the basis of the silk industry of Lyons, later to become so famous, was less interesting in so far as it was not actually directed against foreign goods. But it, too, mentioned the possibility of giving work to tens of thousands of unemployed men and women. It is seen how very much this argument was in the air at the time...

The first great discussion of this matter, as of nearly all social and economic problems, occurred in England in the middle of the 16th century or rather earlier, during the reigns of Henry VIII and Edward VI. In this connection we cannot but mention a series of writings, written apparently at the latest in the 1530’s, two of which at any rate are believed to have been by Clement Armstrong.... He formulates it, for example, in the following terms: “By reason of great abundance of strange merchandises and wares brought yearly into England hath not only caused scarcity of money, but hath destroyed all handicrafts, whereby great number of common people should have works to get money to pay for their meat and drink, which of very necessity must live idly and beg and steal”

The best instance to my knowledge of a typically mercantilist discussion of a state of affairs of this kind is the debates in the English House of Commons concerning the scarcity of money, which occurred in 1621, when a serious depression had set in, particularly in the cloth export. The conditions were described very clearly by one of the most influential members of parliament, Sir Edwin Sandys. He stated that the farmer and the artificer had to suffer almost everywhere; that looms were standing idle for want of money in the country, and that peasants were forced to repudiate their contracts, “not (thanks be to God) for want of fruits of the earth, but for want of money”. The situation led to detailed

enquiries into where the money could have got to, the want of which was felt so bitterly. Numerous attacks were directed against all persons who were supposed to have contributed either to an export (export surplus) of precious metals, or to their disappearance on account of corresponding activities within the [17] country.

Mercantilists were conscious that their policy, as Professor Heckscher puts it, “killed two birds with one stone”. “On the one hand the country was rid of an unwelcome surplus of goods, which was believed to result in unemployment,

46 while on the other the total stock of money in the country was increased”[18] with the resulting advantages of a fall in the rate of interest.

It is impossible to study the notions to which the mercantilists were led by their actual experiences, without perceiving that there has been a chronic tendency throughout human history for the propensity to save to be stronger than the inducement to invest. The weakness of the inducement to invest has been at all times the key to the economic problem. To-day the explanation of the weakness of this inducement may chiefly lie in the extent of existing accumulations; whereas, formerly, risks and hazards of all kinds may have played a larger part. But the result is the same. The desire of the individual to augment his personal wealth by abstaining from consumption has usually been stronger than the inducement to the entrepreneur to augment the national wealth by employing labour on the construction of durable assets.

(4) The mercantilists were under no illusions as to the nationalistic character of their policies and their tendency to promote war. It was national advantage and [19] relative strength at which they were admittedly aiming.

We may criticise them for the apparent indifference with which they accepted this inevitable consequence of an international monetary system. But intellectually their realism is much preferable to the confused thinking of contemporary advocates of an international fixed gold standard and laissez-faire in international lending, who believe that it is precisely these policies which will best promote peace.

For in an economy subject to money contracts and customs more or less fixed over an appreciable period of time, where the quantity of the domestic circulation and the domestic rate of interest are primarily determined by the balance of payments, as they were in Great Britain before the war, there is no orthodox means open to the authorities for countering unemployment at home except by struggling for an export surplus and an import of the monetary metal at the expense of their neighbours. Never in history was there a method devised of such efficacy for setting each country’s advantage at variance with its neighbours’ as the international gold (or, formerly, silver) standard. For it made domestic prosperity directly dependent on a competitive pursuit of markets and a competitive appetite for the precious metals. When by happy accident the new supplies of gold and silver were comparatively abundant, the struggle might be somewhat abated. But with the growth of wealth and the diminishing marginal propensity to consume, it has tended to become increasingly internecine. The part played by orthodox economists, whose common sense has been insufficient to check their faulty logic, has been disastrous to the latest act. For when in their blind struggle for an escape, some countries have thrown off the obligations which had previously rendered impossible an autonomous rate of interest, these

47 economists have taught that a restoration of the former shackles is a necessary first step to a general recovery.

In truth the opposite holds good. It is the policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment programme directed to an optimum level of domestic employment which is twice blessed in the sense that it helps ourselves and our neighbours at the same time. And it is the simultaneous pursuit of these policies by all countries together which is capable of restoring economic health and strength internationally, whether we measure it by the level of domestic employment or by the volume of international [20] trade.

IV

The mercantilists perceived the existence of the problem without being able to push their analysis to the point of solving it. But the classical school ignored the problem, as a consequence of introducing into their premisses conditions which involved its non-existence; with the result of creating a cleavage between the conclusions of economic theory and those of common sense. The extraordinary achievement of the classical theory was to overcome the beliefs of the “natural man” and, at the same time, to be wrong. As Professor Heckscher expresses it:

If, then, the underlying attitude towards money and the material from which money was created did not alter in the period between the Crusades and the 18th century, it follows that we are dealing with deep-rooted notions. Perhaps the same notions have persisted even beyond the 500 years included in that period, even though not nearly to the same degree as the “fear of goods”. ... With the exception of the period of laissez-faire, no age has been free from these ideas. It was only the unique intellectual tenacity of laissez- faire that for a time overcame the beliefs of the “natural man” on [21] this point.

It required the unqualified faith of doctrinaire laissez-faire to wipe out the “fear of goods” ... [which] is the most natural attitude of the “natural man” in a money economy. Free Trade denied the existence of factors which appeared to be obvious, and was doomed to be discredited in the eyes of the man in the street as

soon as laissez-faire could no longer hold the minds of men [22] enchained in its ideology.

I remember Bonar Law’s mingled rage and perplexity in face of the economists, because they were denying what was obvious. He was deeply troubled for an explanation. One recurs to the analogy between the sway of the

48 classical school of economic theory and that of certain religions. For it is a far greater exercise of the potency of an idea to exorcise the obvious than to introduce into men’s common notions the recondite and the remote.

V

There remains an allied, but distinct, matter where for centuries, indeed for several millenniums, enlightened opinion held for certain and obvious a doctrine which the classical school has repudiated as childish, but which deserves rehabilitation and honour. I mean the doctrine that the rate of interest is not self- adjusting at a level best suited to the social advantage but constantly tends to rise too high, so that a wise Government is concerned to curb it by statute and custom and even by invoking the sanctions of the moral law.

Provisions against usury are amongst the most ancient economic practices of which we have record. The destruction of the inducement to invest by an excessive liquidity-preference was the outstanding evil, the prime impediment to the growth of wealth, in the ancient and medieval worlds. And naturally so, since certain of the risks and hazards of economic life diminish the marginal efficiency of capital whilst others serve to increase the preference for liquidity. In a world, therefore, which no one reckoned to be safe, it was almost inevitable that the rate of interest, unless it was curbed by every instrument at the disposal of society, would rise too high to permit of an adequate inducement to invest.

I was brought up to believe that the attitude of the Medieval Church to the rate of interest was inherently absurd, and that the subtle discussions aimed at distinguishing the return on money-loans from the return to active investment were merely Jesuitical attempts to find a practical escape from a foolish theory. But I now read these discussions as an honest intellectual effort to keep separate what the classical theory has inextricably confused together, namely, the rate of interest and the marginal efficiency of capital. For it now seems clear that the disquisitions of the schoolmen were directed towards the elucidation of a formula which should allow the schedule of the marginal efficiency of capital to be high, whilst using rule and custom and the moral law to keep down the rate of interest.

Even Adam Smith was extremely moderate in his attitude to the usury laws. For he was well aware that individual savings may be absorbed either by investment or by debts, and that there is no security that they will find an outlet in the former. Furthermore, he favoured a low rate of interest as increasing the chance of savings finding their outlet in new investment rather than in debts; and for this reason, in a passage for which he was severely taken to task by Bentham,[23] he defended a moderate application of the usury laws.[24] Moreover, Bentham’s criticisms were mainly on the ground that Adam Smith’s Scotch caution was too severe on “projectors” and that a maximum rate of interest would 49 leave too little margin for the reward of legitimate and socially advisable risks. For Bentham understood by projectors “all such persons, as, in the pursuit of wealth, or even of any other object, endeavour, by the assistance of wealth, to strike into any channel of invention ... upon all such persons as, in the line of any of their pursuits, aim at anything that can be called improvement. ... It falls, in short, upon every application of the human powers, in which ingenuity stands in need of wealth for its assistance.” Of course Bentham is right in protesting against laws which stand in the way of taking legitimate risks. “A prudent man”, Bentham continues, “will not, in these circumstances, pick out the good projects [25] from the bad, for he will not meddle with projects at all.”

It may be doubted, perhaps, whether the above is just what Adam Smith intended by his term. Or is it that we are hearing in Bentham (though writing in March 1787 from “Crichoff in White Russia”) the voice of nineteenth-century England speaking to the eighteenth? For nothing short of the exuberance of the greatest age of the inducement to investment could have made it possible to lose sight of the theoretical possibility of its insufficiency.

VI

It is convenient to mention at this point the strange, unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight and who only just failed to reach down to the essence of the matter. In the post-war years his devotees bombarded me with copies of his works; yet, owing to certain palpable defects in the argument, I entirely failed to discover their merit. As is often the case with imperfectly analysed intuitions, their significance only became apparent after I had reached my own conclusions in my own way. Meanwhile, like other academic economists, I treated his profoundly original strivings as being no better than those of a crank. Since few of the readers of this book are likely to be well acquainted with the significance of Gesell, I will give to him what would be otherwise a disproportionate space.

Gesell was a successful German[26] merchant in Buenos Aires who was led to the study of monetary problems by the crisis of the late ’eighties, which was especially violent in the Argentine, his first work, Die Reformation im Münzwesen als Brücke zum socialen Staat, being published in Buenos Aires in 1891. His fundamental ideas on money were published in Buenos Aires in the same year under the title Nervus rerum, and many books and pamphlets followed until he retired to Switzerland in 1906 as a man of some means, able to devote the last decades of his life to the two most delightful occupations open to those who do not have to earn their living, authorship and experimental farming.

The first section of his standard work was published in 1906 at Les Hauts Geneveys, Switzerland, under the title Die Verwirklichung des Rechtes auf dem vollen Arbeitsertrag, and the second section in 1911 at Berlin under the title Die

50 neue Lehre vom Zins. The two together were published in Berlin and in Switzerland during the war (1916) and reached a sixth edition during his lifetime under the title Die natürliche Wirtschaftsordnung durch Freiland und Freigeld, the English version (translated by Mr. Philip Pye) being called The Natural Economic Order. In April 1919 Gesell joined the short-lived Soviet cabinet of Bavaria as their Minister of Finance, being subsequently tried by court-martial. The last decade of his life was spent in Berlin and Switzerland and devoted to propaganda. Gesell, drawing to himself the semi-religious fervour which had formerly centred round Henry George, became the revered prophet of a cult with many thousand disciples throughout the world. The first international convention of the Swiss and German Freiland-Freigeld Bund and similar organisations from many countries was held in Basle in 1923. Since his death in 1930 much of the peculiar type of fervour which doctrines such as his are capable of exciting has been diverted to other (in my opinion less eminent) prophets. Dr. Büchi is the leader of the movement in England, but its literature seems to be distributed from San Antonio, Texas, its main strength lying to-day in the United States, where Professor Irving Fisher, alone amongst academic economists, has recognised its significance.

In spite of the prophetic trappings with which his devotees have decorated him, Gesell’s main book is written in cool, scientific language; though it is suffused throughout by a more passionate, a more emotional devotion to social justice than some think decent in a scientist. The part which derives from Henry George,[27] though doubtless an important source of the movement’s strength, is of altogether secondary interest. The purpose of the book as a whole may be described as the establishment of an anti-Marxian socialism, a reaction against laissez-faire built on theoretical foundations totally unlike those of Marx in being based on a repudiation instead of on an acceptance of the classical hypotheses, and on an unfettering of competition instead of its abolition. I believe that the future will learn more from the spirit of Gesell than from that of Marx. The preface to The Natural Economic Order will indicate to the reader, if he will refer to it, the moral quality of Gesell. The answer to Marxism is, I think, to be found along the lines of this preface.

Gesell’s specific contribution to the theory of money and interest is as follows. In the first place, he distinguishes clearly between the rate of interest and the marginal efficiency of capital, and he argues that it is the rate of interest which sets a limit to the rate of growth of real capital. Next, he points out that the rate of interest is a purely monetary phenomenon and that the peculiarity of money, from which flows the significance of the money rate of interest, lies in the fact that its ownership as a means of storing wealth involves the holder in negligible carrying charges, and that forms of wealth, such as stocks of commodities which do involve carrying charges, in fact yield a return because of the standard set by money. He cites the comparative stability of the rate of interest throughout the ages as evidence that it cannot depend on purely physical characters, inasmuch as 51 the variation of the latter from one epoch to another must have been incalculably greater than the observed changes in the rate of interest; i.e. (in my terminology) the rate of interest, which depends on constant psychological characters, has remained stable, whilst the widely fluctuating characters, which primarily determine the schedule of the marginal efficiency of capital, have determined not the rate of interest but the rate at which the (more or less) given rate of interest allows the stock of real capital to grow.

But there is a great defect in Gesell’s theory. He shows how it is only the existence of a rate of money interest which allows a yield to be obtained from lending out stocks of commodities. His dialogue between Robinson Crusoe and a stranger[28] is a most excellent economic parable — as good as anything of the kind that has been written — to demonstrate this point. But, having given the reason why the money-rate of interest unlike most commodity rates of interest cannot be negative, he altogether overlooks the need of an explanation why the money-rate of interest is positive, and he fails to explain why the money-rate of interest is not governed (as the classical school maintains) by the standard set by the yield on productive capital. This is because the notion of liquidity-preference had escaped him. He has constructed only half a theory of the rate of interest.

The incompleteness of his theory is doubtless the explanation of his work having suffered neglect at the hands of the academic world. Nevertheless he had carried his theory far enough to lead him to a practical recommendation, which may carry with it the essence of what is needed, though it is not feasible in the form in which he proposed it. He argues that the growth of real capital is held back by the money-rate of interest, and that if this brake were removed the growth of real capital would be, in the modern world, so rapid that a zero money- rate of interest would probably be justified, not indeed forthwith, but within a comparatively short period of time. Thus the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of “stamped” money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher. According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure. According to my theory it should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per month, equivalent to 5.4 per cent. per annum. This would be too high in existing conditions, but the correct figure, which would have to be changed from time to time, could only be reached by trial and error.

52

The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; — though under Gesell’s system this possibility would have been eliminated by land nationalisation.

VII

The theories which we have examined above are directed, in substance, to the constituent of effective demand which depends on the sufficiency of the inducement to invest. It is no new thing, however, to ascribe the evils of unemployment to the insufficiency of the other constituent, namely, the insufficiency of the propensity to consume. But this alternative explanation of the economic evils of the day — equally unpopular with the classical economists — played a much smaller part in sixteenth- and seventeenth-century thinking and has only gathered force in comparatively recent times.

Though complaints of under-consumption were a very subsidiary aspect of mercantilist thought, Professor Heckscher quotes a number of examples of what he calls “the deep-rooted belief in the utility of luxury and the evil of thrift. Thrift, in fact, was regarded as the cause of unemployment, and for two reasons: in the first place, because real income was believed to diminish by the amount of money which did not enter into exchange, and secondly, because saving was believed to withdraw money from circulation."[29] In 1598 Laffemas (Les Trésors et richesses pour mettre l'Estat en Splendeur) denounced the objectors to the use of French silks on the ground that all purchasers of French luxury goods created a livelihood for the poor, whereas the miser caused them to die in distress.[30] In 1662 Petty justified “entertainments, magnificent shews, triumphal arches, etc.”, on the ground that their costs flowed back into the pockets of brewers, bakers, tailors, shoemakers and so forth. Fortrey justified “excess of apparel”. Von Schrötter (1686) deprecated sumptuary regulations and declared that he would wish that display in clothing and the like were even greater. Barbon (1690) wrote that “Prodigality is a vice that is prejudicial to the Man, but not to trade. ... Covetousness is a Vice, prejudicial both to Man and Trade.” [31] In 1695 Cary argued that if everybody spent more, all would obtain larger incomes “and might [32] then live more plentifully”.

53

But it was by Bernard Mandeville’s Fable of the Bees that Barbon’s opinion was mainly popularised, a book convicted as a nuisance by the grand jury of Middlesex in 1723, which stands out in the history of the moral sciences for its scandalous reputation. Only one man is recorded as having spoken a good word for it, namely Dr. Johnson, who declared that it did not puzzle him, but “opened his eyes into real life very much”. The nature of the book’s wickedness can be best conveyed by Leslie Stephen’s summary in the Dictionary of National Biography:

Mandeville gave great offence by this book, in which a cynical system of morality was made attractive by ingenious paradoxes. ... His doctrine that prosperity was increased by expenditure rather than by saving fell in with many current economic fallacies not yet extinct.[33] Assuming with the ascetics that human desires were essentially evil and therefore produced “private vices” and assuming with the common view that wealth was a “public benefit”, he easily showed that all civilisation implied the development of vicious propensities....

The text of the Fable of the Bees is an allegorical poem — “The Grumbling Hive, or Knaves turned honest”, in which is set forth the appalling plight of a prosperous community in which all the citizens suddenly take it into their heads to abandon luxurious living, and the State to cut down armaments, in the interests of Saving:

No Honour now could be content, To live and owe for what was spent, Liv’ries in Broker’s shops are hung; They part with Coaches for a song; Sell stately Horses by whole sets; And Country-Houses to pay debts. Vain cost is shunn’d as moral Fraud; They have no Forces kept Abroad; Laugh at th’ Esteem of Foreigners, And empty Glory got by Wars; They fight, but for their Country’s sake, When Right or Liberty’s at Stake.

The haughty Chloe

Contracts th’ expensive Bill of Fare, And wears her strong Suit a whole Year. And what is the result? —

Now mind the glorious Hive, and see

54

How Honesty and Trade agree: The Shew is gone, it thins apace; And looks with quite another Face, For ’twas not only they that went, By whom vast sums were yearly spent; But Multitudes that lived on them, Were daily forc’d to do the same. In vain to other Trades they’d fly; All were o’er-stocked accordingly. The price of Land and Houses falls; Mirac’lous Palaces whose Walls, Like those of Thebes, were rais’d by Play, Are to be let ... The Building Trade is quite destroy’d, Artificers are not employ’d; No limner for his Art is fam’d, Stone-cutters, Carvers are not nam’d. So “The Moral” is: are Virtue can’t make Nations live In Splendour. They that would revive A Golden Age, must be as free, For Acorns as for Honesty.

Two extracts from the commentary which follows the allegory will show that the above was not without a theoretical basis:

As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an [34] error.

On the contrary, Mandeville concludes:

The great art to make a nation happy, and what we call flourishing, consists in giving everybody an opportunity of being employed; which to compass, let a Government’s first care be to promote as great a variety of Manufactures, Arts and Handicrafts as human wit can invent; and the second to encourage Agriculture and Fishery in all their branches, that the whole Earth may be

55

forced to exert itself as well as Man. It is from this Policy and not from the trifling regulations of Lavishness and Frugality that the greatness and felicity of Nations must be expected; for let the value of Gold and Silver rise or fall, the enjoyment of all Societies will ever depend upon the Fruits of the Earth and the Labour of the People; both which joined together are a more certain, a more inexhaustible and a more real Treasure than the Gold of Brazil or the Silver of Potosi.

No wonder that such wicked sentiments called down the opprobrium of two centuries of moralists and economists who felt much more virtuous in possession of their austere doctrine that no sound remedy was discoverable except in the utmost of thrift and economy both by the individual and by the state. Petty’s “entertainments, magnificent shews, triumphal arches, etc.” gave place to the penny-wisdom of Gladstonian finance and to a state system which “could not afford” hospitals, open spaces, noble buildings, even the preservation of its ancient monuments, far less the splendours of music and the drama, all of which were consigned to the private charity or magnanimity of improvident individuals.

The doctrine did not reappear in respectable circles for another century, until in the later phase of Malthus the notion of the insufficiency of effective demand takes a definite place as a scientific explanation of unemployment. Since I have already dealt with this somewhat fully in my essay on Malthus,[35] it will be sufficient if I repeat here one or two characteristic passages which I have already quoted in my essay:

We see in almost every part of the world vast powers of production which are not put into action, and I explain this phenomenon by saying that from the want of a proper distribution of the actual produce adequate motives are not furnished to continued production. ... I distinctly maintain that an attempt to accumulate very rapidly, which necessarily implies a considerable diminution of unproductive consumption, by greatly impairing the usual motives to production must prematurely check the progress of wealth. ... But if it be true that an attempt to accumulate very rapidly will occasion such a division between labour and profits as almost to destroy both the motive and the power of future accumulation and consequently the power of maintaining and employing an increasing population, must it not be acknowledged that such an attempt to accumulate, or that saving too much, may [36] be really prejudicial to a country?

The question is whether this stagnation of capital, and subsequent stagnation in the demand for labour arising from increased production without an adequate proportion of unproductive consumption on the part of the landlords and capitalists, could 56

take place without prejudice to the country, without occasioning a less degree both of happiness and wealth than would have occurred if the unproductive consumption of the landlords and capitalists had been so proportioned to the natural surplus of the society as to have continued uninterrupted the motives to production, and prevented first an unnatural demand for labour and then a necessary and sudden diminution of such demand. But if this be so, how can it be said with truth that parsimony, though it may be prejudicial to the producers, cannot be prejudicial to the state; or that an increase of unproductive consumption among landlords and capitalists may not sometimes be the proper remedy [37] for a state of things in which the motives to production fails?

Adam Smith has stated that capitals are increased by parsimony, that every frugal man is a public benefactor, and that the increase of wealth depends upon the balance of produce above consumption. That these propositions are true to a great extent is perfectly unquestionable. ... But it is quite obvious that they are not true to an indefinite extent, and that the principles of saving, pushed to excess, would destroy the motive to production. If every person were satisfied with the simplest food, the poorest clothing and the meanest houses, it is certain that no other sort of food, clothing, and lodging would be in existence. ... The two extremes are obvious; and it follows that there must be some intermediate point, though the resources of political economy may not be able to ascertain it, where, taking into consideration both the power to produce and the will to consume, the encouragement to the [38] increase of wealth is the greatest.

Of all the opinions advanced by able and ingenious men, which I have ever met with, the opinion of M. Say, which states that: un product consommé ou détruit est un débouché fermé (I. i. ch. 15), appears to me to be the most directly opposed to just theory, and the most uniformly contradicted by experience. Yet it directly follows from the new doctrine, that commodities are to be considered only in their relation to each other, — not to the consumers. What, I would ask, would become of the demand for commodities, if all consumption except bread and water were suspended for the next half-year? What an accumulation of commodities! Quels débouchés! What a prodigious market would [39] this event occasion!

Ricardo, however, was stone-deaf to what Malthus was saying. The last echo of the controversy is to be found in John Stuart Mill’s discussion of his Wages- Fund

57

Theory, [40] which in his own mind played a vital part in his rejection of the later phase of Malthus, amidst the discussions of which he had, of course, been brought up. Mill’s successors rejected his Wages-Fund Theory but overlooked the fact that Mill’s refutation of Malthus depended on it. Their method was to dismiss the problem from the corpus of Economics not by solving it but by not mentioning it. It altogether disappeared from controversy. Mr. Cairncross, searching recently for traces of it amongst the minor Victorians, [41] has found even less, perhaps, than might have been expected. [42] Theories of under- consumption hibernated until the appearance in 1889 of The Physiology of Industry, by J. A. Hobson and A. F. Mummery, the first and most significant of many volumes in which for nearly fifty years Mr. Hobson has flung himself with unflagging, but almost unavailing, ardour and courage against the ranks of orthodoxy. Though it is so completely forgotten to-day, the publication of this [43] book marks, in a sense, an epoch in economic thought.

The Physiology of Industry was written in collaboration with A. F. Mummery. [44] Mr. Hobson has told how the book came to be written as follows:

It was not until the middle ’eighties that my economic heterodoxy began to take shape. Though the Henry George campaign against land values and the early agitation of various socialist groups against the visible oppression of the working classes, coupled with the revelations of the two Booths regarding the poverty of London, made a deep impression on my feelings, they did not destroy my faith in Political Economy. That came from what may be called an accidental contact. While teaching at a school in Exeter I came into personal relations with a business man named Mummery, known then and afterwards as a great mountaineer who had discovered another way up the Matterhorn and who, in 1895, was killed in an attempt to climb the famous Himalayan mountain Nanga Parbat. My intercourse with him, I need hardly say did not lie on this physical plane. But he was a mental climber as well, with a natural eye for a path of his own finding and a sublime disregard of intellectual authority. This man entangled me in a controversy about excessive saving, which he regarded as responsible for the under-employment of capital and labour in periods of bad trade. For a long time I sought to counter his arguments by the use of the orthodox economic weapons. But at length he convinced me and I went in with him to elaborate the over-saving argument in a book entitled The Physiology of Industry, which was published in 1889. This was the first open step in my heretical career, and I did not in the least realise its momentous consequences. For just at that time I had given up my scholastic post and was opening a new line of work as University Extension Lecturer in Economics and Literature. The first shock 58

came in a refusal of the London Extension Board to allow me to offer courses of Political Economy. This was due, I learned, to the intervention of an Economic Professor who had read my book and

considered it as equivalent in rationality to an attempt to prove the flatness of the earth. How could there be any limit to the amount of useful saving when every item of saving went to increase the capital structure and the fund for paying wages? Sound economists could not fail to view with horror an argument which sought to check the source of all industrial progress.[45] Another interesting personal experience helped to bring home to me the sense of my iniquity. Though prevented from lecturing on economics in London, I had been allowed by the greater liberality of the Oxford University Extension Movement to address audiences in the Provinces, confining myself to practical issues relating to working-class life. Now it happened at this time that the Charity Organisation Society was planning a lecture campaign upon economic subjects and invited me to prepare a course. I had expressed a willingness to undertake this new lecture work, when suddenly, without explanation, the invitation was withdrawn. Even then I hardly realised that in appearing to question the virtue of unlimited thrift I had committed the unpardonable sin.

In this early work Mr. Hobson with his collaborator expressed himself with more direct reference to the classical economics (in which he had been brought up) than in his later writings; and for this reason, as well as because it is the first expression of his theory, I will quote from it to show how significant and well- founded were the authors’ criticisms and intuitions. They point out in their preface as follows the nature of the conclusions which they attack:

Saving enriches and spending impoverishes the community along with the individual, and it may be generally defined as an assertion that the effective love of money is the root of all economic good. Not merely does it enrich the thrifty individual himself, but it raises wages, gives work to the unemployed, and scatters blessings on every side. From the daily papers to the latest economic treatise, from the pulpit to the House of Commons, this conclusion is reiterated and re-stated till it appears positively impious to question it. Yet the educated world, supported by the majority of economic thinkers, up to the publication of Ricardo’s work strenuously denied this doctrine, and its ultimate acceptance was exclusively due to their inability to meet the now exploded wages-fund doctrine. That the conclusion should have survived the argument on which it logically stood, can be explained on no other hypothesis than the commanding authority of the great men who asserted it. Economic critics have ventured to attack the 59

theory in detail, but they have shrunk appalled from touching its main conclusions. Our purpose is to show that these conclusions are not tenable, that an undue exercise of the habit of saving is possible, and that such undue exercise impoverishes the

Community, throws labourers out of work, drives down wages, and spreads that gloom and prostration through the commercial world which is known as Depression in Trade. ...

The object of production is to provide “utilities and conveniences” for consumers, and the process is a continuous one from the first handling of the raw material to the moment when it is finally consumed as a utility or a convenience. The only use of Capital being to aid the production of these utilities and conveniences, the total used will necessarily vary with the total of utilities and conveniences daily or weekly consumed. Now saving, while it increases the existing aggregate of Capital, simultaneously reduces the quantity of utilities and conveniences consumed; any undue exercise of this habit must, therefore, cause an accumulation of Capital in excess of that which is required for use, and this excess will exist in the form of general over- [46] production.

In the last sentence of this passage there appears the root of Hobson’s mistake, namely, his supposing that it is a case of excessive saving causing the actual accumulation of capital in excess of what is required, which is, in fact, a secondary evil which only occurs through mistakes of foresight; whereas the primary evil is a propensity to save in conditions of full employment more than the equivalent of the capital which is required, thus preventing full employment except when there is a mistake of foresight. A page or two later, however, he puts one half of the matter, as it seems to me, with absolute precision, though still overlooking the possible role of changes in the rate of interest and in the state of business confidence, factors which he presumably takes as given:

We are thus brought to the conclusion that the basis on which all economic teaching since Adam Smith has stood, viz. that the quantity annually produced is determined by the aggregates of Natural Agents, Capital, and Labour available, is erroneous, and that, on the contrary, the quantity produced, while it can never exceed the limits imposed by these aggregates, may be, and actually is, reduced far below this maximum by the check that undue saving and the consequent accumulation of over-supply exerts on production; i.e. that in the normal state of modern industrial Communities, consumption limits production and not [47] production consumption.

60

Finally he notices the bearing of his theory on the validity of the orthodox Free Trade arguments:

We also note that the charge of commercial imbecility, so freely launched by orthodox economists against our American cousins

and other Protectionist Communities, can no longer be maintained by any of the Free Trade arguments hitherto adduced, since all these are based on the assumption that over-supply is [48] impossible.

The subsequent argument is, admittedly, incomplete. But it is the first explicit statement of the fact that capital is brought into existence not by the propensity to save but in response to the demand resulting from actual and prospective consumption. The following portmanteau quotation indicates the line of thought:

It should be clear that the capital of a community cannot be advantageously increased without a subsequent increase in consumption of commodities. ... Every increase in saving and in capital requires, in order to be effectual, a corresponding increase in immediately future consumption.[49] ... And when we say future consumption, we do not refer to a future of ten, twenty, or fifty years hence, but to a future that is but little removed he present. ... If increased thrift or caution induces people to save more in the present, they must consent to consume more in the future.[50] ... No more capital can economically exist at any point in the productive process than is required to furnish commodities for the current rate of consumption.[51] ... It is clear that my thrift in no wise affects the total economic thrift of the community, but only determines whether a particular portion of the total thrift shall have been exercised by myself or by somebody else. We shall show how the thrift of one part of the community has power to force another part to live beyond their income.[52] ... Most modern economists deny that consumption could by any possibility be insufficient. Can we find any economic force at work which might incite a community to this excess, and if there be any such forces are there not efficient checks provided by the mechanism of commerce? It will be shown, firstly, that in every highly organised industrial society there is constantly at work a force which naturally operates to induce excess of thrift; secondly, that the checks alleged to be provided by the mechanism of commerce are either wholly inoperative [53] or are inadequate to prevent grave commercial evil. ... The brief answer which Ricardo gave to the contentions of Malthus and Chalmers seems to have been accepted as sufficient by most later economists. “Productions are always bought by

61

productions or by services; money is only the medium by which the exchange is effected. Hence the increased production being always accompanied by a correspondingly increased ability to get and consume, there is no possibility of Overproduction” (Ricardo, [54] Prin. of Pol. Econ. p. 362).

Hobson and Mummery were aware that interest was nothing whatever except payment for the use of money.[55] They also knew well enough that their opponents would claim that there would be “such a fall in the rate of interest (or profit) as will act as a check upon Saving, and restore the proper relation between production and consumption”.[56] They point out in reply that “if a fall of Profit is to induce people to save less, it must operate in one of two ways, either by inducing them to spend more or by inducing them to produce less”.[57] As regards the former they argue that when profits fall the aggregate income of the community is reduced, and “we cannot suppose that when the average rate of incomes is falling, individuals will be induced to increase their rate of consumption by the fact that the premium upon thrift is correspondingly diminished”; whilst as for the second alternative, “it is so far from being our intention to deny that a fall of profit, due to over-supply, will check production, that the admission of the operation of this check forms the very centre of our argument”.[58] Nevertheless, their theory failed of completeness, essentially on account of their having no independent theory of the rate of interest; with the result that Mr. Hobson laid too much emphasis (especially in his later books) on under-consumption leading to over-investment, in the sense of unprofitable investment, instead of explaining that a relatively weak propensity to consume helps to cause unemployment by requiring and not receiving the accompaniment of a compensating volume of new investment, which, even if it may sometimes occur temporarily through errors of optimism, is in general prevented from happening at all by the prospective profit falling below the standard set by the rate of interest.

Since the war there has been a spate of heretical theories of under- consumption, of which those of Major Douglas are the most famous. The strength of Major Douglas’s advocacy has, of course, largely depended on orthodoxy having no valid reply to much of his destructive criticism. On the other hand, the detail of his diagnosis, in particular the so-called A + B theorem, includes much mere mystification. If Major Douglas had limited his B-items to the financial provisions made by entrepreneurs to which no current expenditure on replacements and renewals corresponds, he would be nearer the truth. But even in that case it is necessary to allow for the possibility of these provisions being offset by new investment in other directions as well as by increased expenditure on consumption. Major Douglas is entitled to claim, as against some of his orthodox adversaries, that he at least has not been wholly oblivious of the outstanding problem of our economic system. Yet he has scarcely established an equal claim to rank — a private, perhaps, but not a major in the brave army of heretics — with Mandeville, Malthus, Gesell and Hobson, who, following their 62 intuitions, have preferred to see the truth obscurely and imperfectly rather than to maintain error, reached indeed with clearness and consistency and by easy logic, but on hypotheses inappropriate to the facts.

Author’s Footnotes

1. Vide his Industry and Trade, Appendix D; Money, Credit and Commerce, p. 130; and Principles of Economics, Appendix I.

2. His view of them is well summed up in a footnote to the first edition of his Principles, p. 51: “Much study has been given both in England and Germany to medieval opinions as to the relation of money to national wealth. On the whole they are to be regarded as confused through want of a clear understanding of the functions of money, rather than as wrong in consequence of a deliberate assumption that the increase in the net wealth of a nation can be effected only by an increase of the stores of the precious metals in her.”

3. The Nation and the Athenaeum, November 24, 1923.

4. The remedy of an elastic wage-unit, so that a depression is met by a reduction of wages, is liable, for the same reason, to be a means of benefiting ourselves at the expense of our neighbours.

5. Experience since the age of Solon at least, and probably, if we had the statistics, for many centuries before that, indicates what a knowledge of human nature would lead us to expect, namely, that there is a steady tendency for the wage-unit to rise over long periods of time and that it can be reduced only amidst the decay and dissolution of economic society. Thus, apart altogether from progress and increasing population, a gradually increasing stock of money has proved imperative.

6. They are the more suitable for my purpose because Prof. Heckscher is himself an adherent, on the whole, of the classical theory and much less sympathetic to the mercantilist theories than I am. Thus there is no risk that his choice of quotations has been biased in any way by a desire to illustrate their wisdom.

7. Heckscher, Mercantilism, vol. ii. pp. 200, 201, very slightly abridged.

8. Some Considerations of the Consequences of the Lowering of Interest and Raising the Value of Money, 1692, but written some years previously.

9. He adds: “not barely on the quantity of money but the quickness of its circulation”.

63

10. “Use” being, of course, old-fashioned English for “interest”.

11. Hume a little later had a foot and a half in the classical world. For Hume began the practice amongst economists of stressing the importance of the equilibrium position as compared with the ever-shifting transition towards it, though he was still enough of a mercantilist not to overlook the fact that it is in the transition that we actually have our being: “It is only in this interval or intermediate situation, between the acquisition of money and a rise of prices, that the increasing quantity of gold and silver is favourable to industry. ... It is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still increasing; because by that means he keeps alive a spirit of industry in the nation, and increases the state of labour in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money but is on the increasing trend.” (Essay On Money, 1752).

12. It illustrates the completeness with which the mercantilist view, that interest means interest on money (the view which is, as it now seems to me, indubitably correct), has dropt out, that Prof. Heckscher, as a good classical economist, sums up his account of Locke’s theory with the comment — “Locke’s argument would be irrefutable ... if interest really were synonymous with the price for the loan of money; as this is not so, it is entirely irrelevant” (op. cit. vol. ii. p. 204).

13. Heckscher, op. cit. vol. ii. pp. 210, 21I.

14. Heckscher, op. cit. vol. ii. p. 228.

15. Heckscher, op. cit. vol. ii. p. 235.

16. Heckscher, op. cit. vol. ii. p. 122.

17. Heckscher, op. cit. vol. ii. P. 223.

18. Heckscher, op. cit. vol. ii. p. 178.

19. “Within the state, mercantilism pursued thoroughgoing dynamic ends. But the important thing is that this was bound up with a static conception of the total economic resources in the world; for this it was that created that fundamental disharmony which sustained the endless commercial wars.... This was the tragedy of mercantilism. Both the Middle Ages with their universal static ideal and laissez-faire with its universal dynamic ideal avoided this consequence” (Heckscher, op. cit. vol. ii. pp. 25, 26).

64

20. The consistent appreciation of this truth by the International Labour Office, first under Albert Thomas and subsequently under Mr. H. B. Butler, has stood out conspicuously amongst the pronouncements of the numerous post-war international bodies.

21. Heckscher, op. cit. vol. ii. pp. 176-7.

22. Op. cit. vol. ii. p. 335.

23. In his Letter to Adam Smith appended to his Defence of Usury.

24. Wealth of Nations, Book II, chap. 4.

25. Having started to quote Bentham in this context, I must remind the reader of his finest passage: “The career of art, the great road which receives the footsteps of projectors, may be considered as a vast, and perhaps un-bounded, plain, bestrewed with gulphs, such as Curtius was swallowed up in. Each requires a human victim to fall into it ere it can close, but when it once closes, it closes to open no more, and so much of the path is safe to those who follow.”

26. Born near the Luxembourg frontier of a German father and a French mother.

27. Gesell differed from George in recommending the payment of compensation when the land is nationalised.

28. The Natural Economic Order, pp. 297 et seq.

29. Heckscher, op. cit. vol. ii. p. 208.

30. Op. cit. vol. ii. p. 290.

31. Op. cit. vol. ii. p. 209.

32. Op. cit. vol. ii. p. 291.

33. In his History of English Thought in the Eighteenth Century Stephen wrote (p. 297) in speaking of “the fallacy made celebrated by Mandeville” that ..the complete confutation of it lies in the doctrine — so rarely understood that its complete apprehension is, perhaps, the best test of an economist — that demand for commodities is not demand for labour”.

34. Compare Adam Smith, the forerunner of the classical school, who wrote, “What is prudence in the conduct of every private family can scarce be folly in 65 that of a great Kingdom” — probably with reference to the above passage from Mandeville.

35. Essays in Biography, pp. 139-47.

36. A letter from Malthus to Ricardo, dated July 7, 1821.

37. A letter from Malthus to Ricardo, dated July 16, 1822.

38. Preface to Malthus’s Principles of Political Economy, pp. 8, 9.

39. Malthus’s Principles of Political Economy, p. 363, footnote.

40. J. S. Mill, Political Economy, Book I. chapter v. Them is a most important and penetrating discussion of this aspect of Mill’s theory in Mummery and Hobson’s Physiology of Industry? pp. 38 et seq., and, in particular, of his doctrine (which Marshall, in his very unsatisfactory discussion of the Wages-Fund Theory, endeavoured to explain away) that “a demand for commodities is not a demand for labour”.

41. “The Victorians and Investment”, Economic History, 1936.

42. Fullarton’s tract On the Regulation of Currencies (1844) is the most interesting of his references.

43. J. M. Robertson’s The Fallacy of Saving, published in 1892, supported the heresy of Mummery and Hobson. But it is not a book of much value or significance, being entirety lacking in the penetrating intuitions of The Physiology of Industry.

44. In an address called “Confessions of an Economic Heretic”, delivered before the London Ethical Society at Conway Hall on Sunday, July 14, 1935. I reproduce it here by Mr. Hobson’s permission.

45. Hobson had written disrespectfully in The Physiology of Industry, p. 26: “Thrift is the source of national wealth, and the more thrifty a nation is the more wealthy it becomes. Such is the common teaching of almost all economists; many of them assume a tone of ethical dignity as they plead the infinite value of thrift; this note alone in all their dreary song has caught the favour of the public ear.”

46. Hobson and Mummery, Physiology of Industry, pp. iii-v.

47. Hobson and Mummery, Physiology of Industry, p. vi.

66

48. Op. cit. p. ix.

49. Op. cit. p. 27

50. Op. cit. pp. 50, 51

51. Op. cit. p. 69

52. Op. cit. p. 113

53. Op. cit. p. 100

54. Op. cit. p. 101

55. Op. cit. p. 79 56. Op. cit. p. 117.

57. Op. cit. P. 130. 58. Hobson and Mummery, Physiology of Industry, p. 131.

The General Theory of Employment, Interest and Money Chapter 24.

Concluding Notes on the Social Philosophy towards Which the General Theory Might Lead

I The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes. The bearing of the foregoing theory on the first of these is obvious. But there are also two important respects in which it is relevant to the second.

Since the end of the nineteenth century significant progress towards the removal of very great disparities of wealth and income has been achieved through the instrument of direct taxation — income tax and surtax and death duties — especially in Great Britain. Many people would wish to see this process carried much further, but they are deterred by two considerations; partly by the fear of making skilful evasions too much worth while and also of diminishing unduly the motive towards risk-taking, but mainly, I think, by the belief that the growth of capital depends upon the strength of the motive towards individual saving and that for a large proportion of this growth we are dependent on the savings of the rich out of their superfluity. Our argument does not affect the first of these considerations. But it may considerably modify our attitude towards the second. For we have seen that, up to the point where full employment prevails, the growth of capital depends not at all on a low propensity to consume but is, on the contrary, held back by it; and only in conditions of full employment is a low propensity to consume conducive to the

67 growth of capital. Moreover, experience suggests that in existing conditions saving by institutions and through sinking funds is more than adequate, and that measures for the redistribution of incomes in a way likely to raise the propensity to consume may prove positively favourable to the growth of capital.

The existing confusion of the public mind on the matter is well illustrated by the very common belief that the death duties are responsible for a reduction in the capital wealth of the country. Assuming that the State applies the proceeds of these duties to its ordinary outgoings so that taxes on incomes and consumption are correspondingly reduced or avoided, it is, of course, true that a fiscal policy of heavy death duties has the effect of increasing the community’s propensity to consume. But inasmuch as an increase in the habitual propensity to consume will in general (i.e. except in conditions of full employment) serve to increase at the same time the inducement to invest, the inference commonly drawn is the exact opposite of the truth.

Thus our argument leads towards the conclusion that in contemporary conditions the growth of wealth, so far from being dependent on the abstinence of the rich, as is commonly supposed, is more likely to be impeded by it. One of the chief social justifications of great inequality of wealth is, therefore, removed. I am not saying that there are no other reasons,unaffected by our theory, capable of justifying some measure of inequality in some circumstances. But it does dispose of the most important of the reasons why hitherto we have thought it prudent to move carefully. This particularly affects our attitude towards death duties: for there are certain justifications for inequality of incomes which do not apply equally to inequality of inheritances.

For my own part, I believe that there is social and psychological justification for significant inequalities of incomes and wealth, but not for such large disparities as exist today. There are valuable human activities which require the motive of money-making and the environment of private wealth-ownership for their full fruition. Moreover, dangerous human proclivities can be canalised into comparatively harmless channels by the existence of opportunities for money-making and private wealth, which, if they cannot be satisfied in this way, may find their outlet in cruelty, the reckless pursuit of personal power and authority, and other forms of self-aggrandisement. It is better that a man should tyrannise over his bank balance than over his fellow-citizens; and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative. But it is not necessary for the stimulation of these activities and the satisfaction of these proclivities that the game should be played for such high stakes as at present. Much lower stakes will serve the purpose equally well, as soon as the players are accustomed to them. The task of transmuting human nature must not be confused with the task of managing it. Though in the ideal commonwealth men may have been taught or inspired or bred to take no interest in the stakes, it may still be wise and prudent statesmanship to allow the game to be played, subject to rules and limitations, so long as the average man, or even a significant section of the community, is in fact strongly addicted to the money-making passion.

II

There is, however, a second, much more fundamental inference from our argument which has a bearing on the future of inequalities of wealth; namely, our theory of the rate of interest. The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save. But we have shown that the extent of effective saving 68

is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment. Thus it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of capital at which there is full employment.

There can be no doubt that this criterion will lead to a much lower rate of interest than has ruled hitherto; and, so far as one can guess at the schedules of the marginal efficiency of capital corresponding to increasing amounts of capital, the rate of interest is likely to fall steadily, if it should be practicable to maintain conditions of more or less continuous full employment unless, indeed, there is an excessive change in the aggregate propensity to consume (including the State).

I feel sure that the demand for capital is strictly limited in the sense that it would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure. This would not mean that the use of capital instruments would cost almost nothing, but only that the return from them would have to cover little more than their exhaustion by wastage and obsolescence together with some margin to cover risk and the exercise of skill and judgment. In short, the aggregate return from durable goods in the course of their life would, as in the case of short-lived goods, just cover their labour costs of production plus an allowance for risk and the costs of skill and supervision.

Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce.

I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are

69

certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward.

At the same time we must recognise that only experience can show how far the common will, embodied in the policy of the State, ought to be directed to increasing and supplementing the inducement to invest; and how far it is safe to stimulate the average propensity to consume, without foregoing our aim of depriving capital of its scarcity-value within one or two generations. It may turn out that the propensity to consume will be so easily strengthened by the effects of a falling rate of interest, that full employment can be reached with a rate of accumulation little greater than at present. In this event a scheme for the higher taxation of large incomes and inheritances might be open to the objection that it would lead to full employment with a rate of accumulation which was reduced considerably below the current level. I must not

70

be supposed to deny the possibility, or even the probability, of this outcome. For in such matters it is rash to predict how the average man will react to a changed environment. If, however, it should prove easy to secure an approximation to full employment with a rate of accumulation not much greater than at present, an outstanding problem will at least have been solved. And it would remain for separate decision on what scale and by what means it is right and reasonable to call on the living generation to restrict their consumption, so as to establish in course of time, a state of full investment for their successors.

III

In some other respects the foregoing theory is moderately conservative in its implications. For whilst it indicates the vital importance of establishing certain central controls in matters which are now left in the main to individual initiative, there are wide fields of activity which are unaffected. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society.

Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. If we suppose the volume of output to be given, i.e. to be determined by forces outside the classical scheme of thought, then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them. Again, if we have dealt otherwise with the problem of thrift, there is no objection to be raised against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition respectively. Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before. To put the point concretely, I see no reason to suppose that the existing system seriously misemploys the factors of production which are in use. There are, of course, errors of foresight; but these would not be avoided by centralising decisions. When 9,000,000 men are employed out of 71

10,000,000 willing and able to work, there is no evidence that the labour of these 9,000,000 men is misdirected. The complaint against the present system is not that these 9,000,000 men ought to be employed on different tasks, but that tasks should be available for the remaining 1,000,000 men. It is in determining the volume, not the direction, of actual employment that the existing system has broken down.

Thus I agree with Gesell that the result of filling in the gaps in the classical theory is not to dispose of the ‘Manchester System’, but to indicate the nature of the environment which the free play of economic forces requires if it is to realise the full potentialities of production. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government. Furthermore, the modern classical theory has itself called attention to various conditions in which the free play of economic forces may need to be curbed or guided. But there will still remain a wide field for the exercise of private initiative and responsibility. Within this field the traditional advantages of individualism will still hold good.

Let us stop for a moment to remind ourselves what these advantages are. They are partly advantages of efficiency — the advantages of decentralisation and of the play of self-interest. The advantage to efficiency of the decentralisation of decisions and of individual responsibility is even greater, perhaps, than the nineteenth century supposed; and the reaction against the appeal to self-interest may have gone too far. But, above all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty in the sense that, compared with any other system, it greatly widens the field for the exercise of personal choice. It is also the best safeguard of the variety of life, which emerges precisely from this extended field of personal choice, and the loss of which is the greatest of all the losses of the homogeneous or totalitarian state. For this variety preserves the traditions which embody the most secure and successful choices of former generations; it colours the present with the diversification of its fancy; and, being the handmaid of experiment as well as of tradition and of fancy, it is the most powerful instrument to better the future.

Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism. I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him. The game of hazard which he plays is furnished with many zeros, so that the players as a whole will lose if they have the energy and hope to deal all the cards. Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough.

The authoritarian state systems of today seem to solve the problem of unemployment at the expense of efficiency and of freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated and in 72

my opinion, inevitably associated with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.

IV

I have mentioned in passing that the new system might be more favourable to peace than the old has been. It is worth while to repeat and emphasise that aspect.

War has several causes. Dictators and others such, to whom war offers, in expectation at least, a pleasurable excitement, find it easy to work on the natural bellicosity of their peoples. But, over and above this, facilitating their task of fanning the popular flame, are the economic causes of war, namely, the pressure of population and the competitive struggle for markets. It is the second factor, which probably played a predominant part in the nineteenth century, and might again, that is germane to this discussion.

I have pointed out in the preceding chapter that, under the system of domestic laissez- faire and an international gold standard such as was orthodox in the latter half of the nineteenth century, there was no means open to a government whereby to mitigate economic distress at home except through the competitive struggle for markets. For all measures helpful to a state of chronic or intermittent under-employment were ruled out, except measures to improve the balance of trade on income account.

Thus, whilst economists were accustomed to applaud the prevailing international system as furnishing the fruits of the international division of labour and harmonising at the same time the interests of different nations, there lay concealed a less benign influence; and those statesmen were moved by common sense and a correct apprehension of the true course of events, who believed that if a rich, old country were to neglect the struggle for markets its prosperity would droop and fail. But if nations can learn to provide themselves with full employment by their domestic policy (and, we must add, if they can also attain equilibrium in the trend of their population), there need be no important economic forces calculated to set the interest of one country against that of its neighbours. There would still be room for the international division of labour and for international lending in appropriate conditions. But there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbour, not because this was necessary to enable it to pay for what it wished to purchase, but with the express object of upsetting the equilibrium of payments so as to develop a balance of trade in its own favour. International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbor which is worsted in the struggle, but a willing and unimpeded exchange of goods and services in conditions of mutual advantage. V Is the fulfilment of these ideas a visionary hope? Have they insufficient roots in the motives which govern the evolution of political society? Are the interests which they will thwart stronger and more obvious than those which they will serve?

I do not attempt an answer in this place. It would need a volume of a different character from this one to indicate even in outline the practical measures in which they might be gradually 73 clothed. But if the ideas are correct — an hypothesis on which the author himself must necessarily base what he writes — it would be a mistake, I predict, to dispute their potency over a period of time. At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

74

Monetarism

Friedman’s Plucking Model

THE "PLUCKING MODEL" OF BUSINESS FLUCTUATIONS REVISITED

Milton Friedman

Working Papers in Economics E-88-48

The Hoover Institution Stanford University December, 1988

75

The views expressed in this paper are solely those of the author and do not necessarily reflect the views of the staff, officers, or Board of Overseers of the Hoover Institution.

76

Hoover Institution Working Paper No. E-88-48 December 1988

THE "PLUCKING MODEL" OF BUSINESS FLUCTUATIONS REVISITED

Abstract

Some twenty-five years ago, I suggested a model of business fluctuations that stresses occasional events producing contractions and subsequent revivals rather than a self-generating cyclical process. Evidence for the past quarter­ century, like evidence presented earlier for a longer period, supports the view that the model is a useful way to interpret business fluctuations and has suf­ ficiently important implications to justify further empirical work for both the United States and other countries.

Milton Friedman Senior Research Fellow Hoover Institution ( 415) 723-0580

THE "PLUCKING MODEL" OF BUSINESS FLUCTUATIONS REVISITED

Milton Friedman Senior Research Fellow Hoover Institution

77

The recent surge of renewed interest in business cycles in general, and of real business cycles in particular, brought to mind a "plucking model" of business fluctuations that I suggested some twenty-five years ago

1 but that has since sunk into complete oblivion. I was led to the model in the course of investigating the direction of influence between money and income. Did the common cyclical fluctuations in money and income reflect primarily the influence of money on income or of income on money? One of

the five kinds of evidence that I examined was the "serial correlation of 2 amplitudes of cycle phases."

As I wrote, "Is the magnitude of an expansion related systematically to the magnitude of the succeeding contraction? Does a boom tend on the average to be followed by a large contraction? A mild expansion, by a mild contraction?" To find out, I calculated rank difference correlations be- tween measures of the amplitudes of expansions and successive contractions in three different series for the period 1879 to 1961. The three series were rate of change of the stock of money, a physical index of general business, and clearing-debits as an indicator of dollar value change in general business.

Similarly, I asked the same question, except starting with a contrac- tion in the given series and correlating its amplitude with the amplitude of the succeeding expansion.

The results were striking. For all three series the correlation was

78

Friedman 2 trivial between the amplitude of an expansion and the amplitude of the sue- ceeding contraction. On the other hand, for both the rate of change of the money stock, and the physical index of general business, the correlation was high and statistically significant between the amplitude of a contraction and the amplitude of the succeeding expansion. For clearing-debits, this correlation too was low.

I concluded, "There appears to be no systematic connection between the size of an expansion and of the succeeding contraction, whether size is measured by physical volume or by dollar value." On the other hand, a

"large contraction in output tends to be followed on the average by a large business expansion; a mild contraction, by a mild expansion," though that is not so for the dollar value of the expansion and contraction.

I went on,

"This phenomenon, if it should be confirmed by a fuller analysis of data for the United States and other countries, would have important implications for the analysis of business cycles in general, not solely for our monetary studies. For one thing, it would cast grave doubt on those theories that see as the source of a deep depression the excesses 4 of the prior expansion [the Mises cycle theory is a clear example].[ ]

For another, it would raise serious questions about both the analytical models, in terms of which most of us have come to approach the analysis of cycles, and the statistical methods we use to analyze them. "Our analytical models generally involve a conception of a self­

generating cycle, in which each phase gives rise to the next, and which may be kept going by a sequence of random shocks, each giving rise to a series of damped perturbations. The corresponding physical analogy is of an electrical network in which responses are described by sine waves. The asymmetric serial correlation pattern suggests that this analogy may

be misleading, that a better one is what can be termed a plucking model. Consider an elastic string stretched taut between two points on the underside of a rigid horizontal board and glued lightly to the board.

2

Friedman 3

Let the string be plucked at a number of points chosen more or less at random with a force that varies at random, and then held down at the lowest point reached. The result will be to produce a succession of apparent cycles in the string whose amplitudes depend on the force used in plucking the string. The cycles are symmetrical about their troughs; each contraction is of the same amplitude as the succeeding expansion. But there is no necessary connection between the amplitude of an expan­ sion and the amplitude of the succeeding contraction. Correlations be­ tween the amplitudes of successive phases would be asymmetric in the same way the [observed] correlations ... are. Expansions would be uncorre­ lated with succeeding contractions, but contractions would be correlated with succeeding expansions. Up to this point, the peaks in the series would all be at the same level. To complete the analogy, we can suppose the board to be tilted to allow for trend and the underside of the board to be irregular to generate variability in the peaks, which would also introduce something less than perfect correlation between the size of contractions and subsequent expansions. "In this analogy, the irregular underside of the rigid board corre­ sponds to the upper limit to output set by the available resources and methods of organizing them. Output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. Given institutional rigidities in prices, the contraction takes in considerable measure the form of a decline in output. Since there is no physical limit to the decline short of zero output, the size of the decline in output can vary widely. When subsequent recovery sets in, it tends to return output to the ceiling; it cannot go beyond, so there is an upper limit to output and the amplitude of the expansion tends to be correlated with the amplitude of the contraction. "For series on prices and money values, the situation is different. The very rigidity in prices invoked to explain the decline in output may mean that the declines in prices vary less in size than the declines in output. More important, there is no physical ceiling, so that there is nothing on this level of analysis to prevent the string from being plucked up as well as down. These differences make it plausible that the

asymmetric correlation would be much less marked in money-value series

3

4 Friedman than in output and perhaps entirely absent in price series. This is so for the [observed] correlations.... The same conclusion is suggested also by graphic inspection of a wide variety of physical-volume and price series. A symmetric pattern of downward pluckings can be clearly seen in many of the physical-volume series; such a pattern is much less clear in the price series; and, in some price series, symmetric upward pluckings seem about as numerous. "The contrast between the physical-volume and dollar-value or price

series can be put somewhat differently. The indicated pattern in

physical-volume series is readily understandable regardless of the reason for the cyclical fluctuations in the series -- of the source of the pluckings, as it were. A similar pattern in value or price series would have to be explained by some similar pattern or asymmetry in the source of the cyclical fluctuations, some factor that prevents upward plucking

from being as important as downward plucking....

"The simplest interpretation of [the correlation as a whole] is that the pattern for business is a reflection of the pattern for money. In terms of our analogy, every now and then the money string is plucked downward. That produces, after some lag, a downward movement in economic activity related in magnitude to the downward movement in money. The money string then rebounds, and that in turn produces, after some lag, an upward movement in economic activity, again related in magnitude to the upward movement in money. Since the downward and subsequent upward move­ ments in money are correlated in amplitude with one another, so are down­ ward and subsequent upward movements in economic activity. Since the upward and subsequent downward movements in money are not correlated in amplitude, neither are the upward and subsequent downward movements in economic activity.... [O]ur historical studies have uncovered a number of episodes that correspond precisely to the notion of downward pluckings of the money string."

Clearly, however, the downward plucks need not be monetary. The OPEC oil crisis is a striking example of a non-monetary downward pluck that has occurred since the preceding paragraphs were written, and undoubtedly there are many others. Indeed, it has become fashionable in the recent business

4

Friedman 5 cycle literature to emphasize technological change as the chief source of disturbances. Such disturbances clearly may play a role, though I believe that the recent literature has exaggerated their importance relative to monetary disturbances.

In terms of the language that has become more common in recent years, the underside of the rigid board, "the ceiling of maximum feasible output," may well be approximated by a purely random walk, with all sorts of distur- bances producing perturbations in it, including the recently popular techno- logical disturbances.

Unfortunately, so far as I know, no one has explored whether the asymmetrical correlation pattern holds for other countries or for longer periods for the United States. We now have some twenty-five years of addi- tional data for the U.S. I have calculated a few correlations for this period like those for the earlier period for real and nominal GNP as mea- sures of physical and dollar-value fluctuations. However, these twenty- five years provide only five complete cycles, or five pairs of observations, or three degrees of freedom, which are too few on which to base any confident judgment. (My earlier analysis used 15 pairs or 13 degrees of freedom.)

Not surprisingly, none of the correlations was high enough to be statis- tically significant. However, they did not contradict the . 5 asymmetricalo corre1at n pattern.

Direct examination of the basic data provides much stronger evidence connected with the "plucking model." Figure 1 plots the natural logarithm of the level of real GNP from 1961 on. I have superimposed a hypothetical maximum feasible output simply by connecting the (log of the) 1971.1 peak with the (log of the) final observation for 1988.2. The series is consis- tent with an initial and three later downward major plucks. Most important, 5

Friedman 6

the peaks closely fit the hypothetical maximum, while no similar line could be drawn through the troughs.

This feature of the data is brought out more sharply in Figure 2

which plots year-to-year changes in real GNP. Compared with the average

level, the peaks of the series are relatively homogeneous, the troughs

extremely variable. I rather arbitrarily plotted the hypothetical maximum

year-to-year growth at 6 percent. Again the successive peaks seem pretty

much to bump that level, whereas no line could be drawn through the

troughs which would have that quality.

The contrast between Figure 2, for real GNP, and Figure 3, for

nominal GNP, is striking, illustrating very well the distinction I drew

earlier between real and nominal magnitudes. That is illustrated also by

Figure 4, for nominal M2. Nonetheless, comparison of Figure 4 with Figure 2

suggests that downward plucks in money generally correspond to downward

plucks in real output; and with Figure 3, that both downward and upward

plucks in money generally correspond to both downward and upward plucks in·

nominal income.

All in all, therefore, the evidence for the past quarter-century

supports the view that the "plucking model" is a useful way to interpret

business fluctuations, though in itself it does not explain the source of

the plucks. Further, the asymmetrical correlation pattern has

sufficiently important implications for the analysis of business cycles to

justify

further empirical work on testing its existence for other countries, as well

as exploring it further for the U.S. using the additional data that have

accumulated in recent decades. The additional U.S. data are not only for

the recent past but also for the whole period my earlier analysis covered,

and indeed, even for the pre-Civil War period.

6

7 Friedman

NOTES

1. Milton Friedman, "Monetary Studies of the National Bureau," The

National Bureau Enters Its 45th Year, 44th Annual Report, 1964, pp. 7-25, reprinted in Milton Friedman, The Optimum Quantity of Money and Other

Essays (Chicago: Aldine, 1969), chap. 12, pp. 261-84. The "plucking model" is suggested on p. 274.

2. The subtitle of Section D of Part III of the article (p. 271).

3. Ibid., Table 2, p. 272.

4. "The major qualification that must be attached to our result for this purpose is the definitions of the cycle and of expansion and contrac- tion phases on which it rests. Proponents of the view cited might well argue that what matters is the cumulative effect of several expansions, as we define them, and that the relevant concept of expansion is of a 'major' expansion or a phase of a long cycle."

5. For each series, I calculated correlations for both the total amplitude of the phase and the per quarter amplitude. The correlation coefficients, all based on five pairs of values, for 1960 to 1982, the latest reference turning point designated by the National Bureau as of this writing, are as follows:

======

Nominal GNP Real GNP

Total Per Qtr Total Per Qtr

Expansion and Succeeding -.04 .57 -.66 .37 Contraction

Contraction and Succeeding -.31 -.43 .45 .11 Expansion

7

Friedman 8

The results I refer to as "not contradictory" are the contrast between the one negative and one positive correlation for real GNP in the first line in the table, and the two positive coefficients in the second line.

8

FIGURE 1: NATURAL LOG OF REAL GNP AND HYPOTHETICAL MAXIMUM: QUARTERLY, 1961.1-1988.2

8.30

L 8.10 0 HYPOTHETICAL MAXIMUM G

7.90 R E A L 7.70

G N p 7.50

61.1 63.1 65.1 67. 1 69. 1 71 . 1 73. 1 75. 1 77. 1 79. 1 81 . 1 83.1 85.1 87 I

9

FIGURE 2: ACTUAL AND HYPOTHETICAL MAXIMUM RATE OF CHANGE OF REAL GNP FROM SAME QUARTER YEAR EARLIER: 1961.1-1988.2

10 p HVPOTHETICAL MAXIt1UM E R 8 c E N T C A H 4 G A E N G 2

AR E T 0 E

0 -2 AVERAGE F

-4 +H #+

61.1 63.1 65.1 67.1 69. 1 71. 1 73.1 75.1 77.1 79.1 81. 1 83.1 85.1 87.1

10

FIGURE 3: ACTUAL AND AVERAGE RATE OF CHANGE OF NOMINAL GNP FROM

SAME QUARTER YEAR EARLIER: 1961.1-1988.2

16 p E 14 R c E 12 N T C 10 A H G A 8 E N G 6 RA E T E 4

0 2 AVERAGE F

61 . 1 63.1 65.1 67.1 69. 1 71. 1 73.1 75.1 77.1 79.1 81.1 83.1 85.1 87.1

11

FIGURE 4: ACTUAL AND AVERAGE RATE OF CHANGE OF M2 FROM SAME QUARTER YEAR EARLIER: 1961.1-1988.2

14 p E R 12 c E N 10 T C A H 8 G A E N G 6 R E A T 4 E

2 0 AVERAGE F

61.1 63.1 65.1 67.1 69.1 71.1 73.1 75.1 77.1 79.1 81.1 83.1 85.1 87.1

...... N

12

13

Fisher

The Debt-Deflation Theory of Great Depressions Author(s): Irving Fisher Source: Econometrica, Vol. 1, No. 4 (Oct., 1933), pp. 337-357 Published by: The Econometric Society Stable URL: http://www.jstor.org/stable/1907327 Accessed: 07/01/2011 14:40

Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use.

Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=econosoc.

Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].

14

The Econometric Society is collaborating with JSTOR to digitize, preserve and extend access to Econometrica.

http://www.jstor.org

15

THE DEBT-DEFLATION THEORY OF GREAT DEPRESSIONS

BY IRVING FISHER INTRODUCTORY IN Booms and Depressions, I have developed, theoretically and sta­ tistically, what may be called a debt-deflation theory of great depres­ sions. In the preface, I stated that the results "seem largely new," I spoke thus cautiously because of my unfamiliarity with the vast literature on the subject. Since the book was published its special con­ clusions have been widely accepted and, so far as I know, no one has yet found them anticipated by previous writers, though several, in­ cluding myself, have zealously sought to find such anticipations. Two of the best-read authorities in this field assure me that those conclu­ sions are, in the words of one of them, "both new and important." Partly to specify what some of these special conclusions are which are believed to be new and partly to fit them into the conclusions of other students in this field, I am offering this paper as embodying, in brief, my present "creed" on the whole subject of so-called "cycle theory." My "creed" consists of 49 "articles" some of which are old and some new. I say"creed" because, for brevity, it is purposely ex­ pressed dogmatically and without proof. But it is not a creed in the sense that my faith in it does not rest on evidence and that I am not ready to modify it on presentation of new evidence. On the contrary, it is quite tentative. It may serve as a challenge to others and as raw material to help them work out a better product. Meanwhile the following is a list of my 49 tentative conclusions.

"CYCLE THEORY" IN GENERAL 1. The economic system contains innumerable variables-quantities of"goods" (physical wealth, property rights, and services), the prices of these goods, and their values (the quantities multiplied by the prices). Changes in any or all of this vast array of variables may be due to many causes. Only in imagination can all of these variables re­ main constant and be kept in equilibrium by the balanced forces of human desires, as manifested through "supply and demand." 2. Economic theory includes a study both of (a) such imaginary, ideal equilibrium-which may be stable or unstable-and (b) dis­ equilibrium. The former is economic statics; the latter, economic dy­ namics. So-called cycle theory is merely one part of the study of eco­ nomic dis-equilibrium. 3. The study of dis-equilibrium may proceed in either of two ways.

337

16

IRVING FISHER 338

We may take as our unit for study an actual historical case of great dis-equilibrium, such as, say, the panic of 1873; or we may take as our unit for study any constituent tendency, such as, say, deflation, and discover its general laws, relations to, and combinations with, other tendencies. The former study revolves around events, or facts; the latter, around tendencies. The former is primarily economic history; the latter is primarily economic science. Both sorts of studies are prop­ er and important. Each helps the other. The panic of 1873 can only be understood in the light of the various tendencies involved-defla­ tion and other; and deflation can only be understood in the light of the various historical manifestations-1873 and other. 4. The old and apparently still persistent notion of"the" business cycle, as a single, simple, self-generating cycle (analogous to that of a pendulum swinging under influence of the single force of gravity) and as actually realized historically in regularly recurring crises, is a myth. Instead of one force there are many forces. Specifically, instead of one cycle, there are many co-existing cycles, constantly aggravating or neutralizing each other, as well as co-existing with many non-cyclical forces. In other words, while a cycle, conceived as a fact, or historical event, is non-existent, there are always innumerable cycles, long and short, big and little, conceived as tendencies (as well as numerous non­ cyclical tendencies), any historical event being the resultant of all the tendencies then at work. Any one cycle, however perfect and like a sine curve it may tend to be, is sure to be interfered with by other tend­ encies. 5. The innumerable tendencies making mostly for economic dis-equi­ librium may roughly be classified under three groups: (a) growth or trend tendencies, which are steady; (b) haphazard disturbances, which are unsteady; (c) cyclical tendencies, which are unsteady but steadily repeated. 6. There are two sorts of cyclical tendencies. One is "forced" or im­ posed on the economic mechanism from outside. Such is the yearly rhythm; also the daily rhythm. Both the yearly and the daily rhythm are imposed on us by astronomical forces from outside the economic organization; and there may be others such as from sun spots or transits of Venus.Other examples of "forced'' cycles are the monthly and week­ ly rhythms imposed on us by custom and religion. The second sort of cyclical tendency is the "free" cycle, not forced from outside, but self-generating, operating analogously to a pen­ dulum or wave motion. 7. It is the "free" type of cycle which is apparently uppermost in the minds of most people when they talk of"the" business cycle. The yearly cycle, though it more nearly approaches a perfect cycle than

338

IRVING FISHER 339 any other, is seldom thought of as a cycle at all but referred to as "seasonal variation." 8. There may be equilibrium which, though stable, is so delicately poised that, after departure from it beyond certain limits, instability ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks. This simile probably applies when a debtor gets "broke,"or when the breaking of many debtors constitutes a "crash," after which there is no coming back to the original equilibrium. To take another simile, such a disaster is somewhat like the"capsizing" of a ship which, under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart further from it. 9. We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, to­ ward a stable equilibrium. In our classroom expositions of supply and demand curves, we very properly assume that if the price, say, of sugar is above the point at which supply and demand are equal, it tends to fall; and if below, to rise. 10. Under such assumptions, and taking account of"economic fric­ tion," which is always present, it follows that, unless some outside force intervenes, any "free" oscillations about equilibrium must tend progressively to grow smaller and smaller, just as a rocking chair set in motion tends to stop. That is, while "forced" cycles, such as season­ al, tend to continue unabated in amplitude, ordinary "free" cycles tend to cease, giving way to equilibrium. 11. But the exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium. For example, coffee in Brazil may be over-produced, that is, may be more than it would have been if the producers had known in ad­ vance that it could not have been sold at a profit. Or there may be a shortage in the cotton crop. Or factory, or commercial inventories may be under or over the equilibrium point. Theoretically there may be-in fact, at most times there must be­ over- or under-production, over- or under-consumption, over- or under­ spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave. 12. The important variables which may, and ordinarily do, stand

339

IRVING FISHER 340 above or below equilibrium are: (a) capital items, such as homes, fac­ tories, ships, productive capacity generally, inventories, gold, money, credits, and debts; (b) income items, such as real income, volume of trade, shares traded; (c) price items, such as prices of securities, com­ modities, interest. 13. There may even be a generaover-production and in either of two senses: (a) there may be, in general, at a particular point of time, over-large inventories or stocks on hand, or (b) there may be, in gen­ eral, during a particular period of time, an over-rapid flow of produc­ tion. The classical notion that over-production can only be relative as between different products is erroneous. Aside from the abundance or scarcity of particular products, relative to each other, production as a whole is relative to human desires and aversions, and can as a whole overshoot or undershoot the equilibrium mark. In fact, except for brief moments, there must always be some de­ gree of general over-production or general under-production and in both senses-stock and flow. 14. But, in practice, general over-production, as popularly imagined, has never, so far as I can discover, been a chief cause of great dis-equi­ librium. The reason, or a reason, for the common notion of over-pro­ duction is mistaking too little money for too much goods. 15. While any deviation from equilibrium of any economic variable theoretically may, and doubtless in practice does, set up some sort of oscillations, the important question is: Which of them have been suf­ ficiently great disturbers to afford any substantial explanation of the great booms and depressions of history? 16. I am not sufficiently familiar with the long detailed history of these disturbances, nor with the colossal literature concerning their al­ leged explanations, to have reached any definitive conclusions as to the relative importance of all the influences at work. I am eager to learn from others. 17. According to my present opinion, which is purely tentative, there is some grain of truth in most of the alleged explanations commonly offered, but this grain is often small. Any of them may suffice to ex­ plain small disturbances, but all of them put together have probably been inadequate to explain big disturbances. 18. In particular, as explanations of the so-called business cycle, or cycles, when these are really serious, I doubt the adequacy of over­ production, under-consumption, over-capacity, price-dislocation, mal­ adjustment between agricultural and industrial prices, over-confidence, over-investment, over-saving, over-spending, and the discrepancy be­ tween saving and investment. 19. I venture the opinion, subject to correction on submission of

340

IRVING FISHER 341 future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and de­ flation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price­ level disturbances. While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and de­ pressions, more important causes than all others put together. 20. Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant fac­ tors. Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its vic­ tims into debt. Another example is the mal-adjustment between agricultural and industrial prices, which can be shown to be a result of a change in the general price level. 21. Disturbances in these two factors-debt and the purchasing pow­ er of the monetary unit-will set up serious disturbances in all, or near­ ly all, other economic variables. On the other hand, if debt and de­ flation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33.

THE ROLES OF DEBT AND DEFLATION

22. No exhaustive list can be given of the secondary variables af­ fected by the two primary ones, debt and deflation; but they include especially seven, making in all at least nine variables, as follows:debts, circulating media, their velocity of circulation, price levels, net worths, profits, trade, business confidence, interest rates. 23. The chief interrelations between the nine chief factors may be de­ rived deductively, assuming, to start with, that general economic equi­ librium is disturbed by only the one factor of over-indebtedness, and, in particular, assuming that there is no other influence, whether ac­ cidental or designed, tending to affect the price level. 24. Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through

341

IRVING FISHER 342 the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circula­ tion. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bank­ ruptcies and (5) A like fall in profits, which in a"capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pes­ simism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest. Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way. 25. The above chain of causes, consisting of nine links, includes only a few of the interrelations between the nine factors. There are other demonstrable interrelations, both rational and empirical, and doubtless still others which cannot, yet, at least, be formulated at all.l There must also be many indirect relations involving variables not in­ cluded among the nine groups. 26. One of the most important of such interrelations (and probably too little stressed in my Booms and Depressions) is the direct effect of lessened money, deposits, and their velocity, in curtailing trade, as evidenced by the fact that trade has been revived locally by emergency money without any raising of the price level. 27. In actual chronology, the order of the nine events is somewhat different from the above "logical" order, and there are reactions and repeated effects. As stated in Appendix I of Booms and Depressions:

The following table of our nine factors, occurring and recurring (together with distress selling), gives a fairly typical, though still inadequate, picture of the

1 Many of these interrelations have been shown statistically, and by many writers. Some, which I have so shown and which fit in with the debt-deflation theory, are: that price-change, after a distributed lag, causes, or is followed by, corresponding fluctuations in the volume of trade , employment, bankruptcies, and rate of interest. The results as to price-change and unemployment are con­ tained in Charts II and III, pp. 352-3. See references at the end of this article; also footnote 2, page 345, regarding the charts.

342

IRVING FISHER 343 cross-currents of a depression in the approximate order in which it is believed they usually occur. (The first occurrence of each factor and its sub-divisions is indicated by italics. The figures in parenthesis show the sequence in the original exposition.)

I. (7) Mild Gloom and Shock to Confidence (8) Slightly Reduced Velocity of Circulation (1) Debt Liquidation II. (9) Money Interest on Safe Loans Falls (9) But Money Interest on Unsafe Loans Rises III. (2) Distress Selling (7) More Gloom (3) Fall in Security Prices (1) More Liquidation (3) Fall in Commodity Prices IV. (9) Real Interest Rises; REAL DEBTS INCREASE (7) More Pessimism and Distrust (1) More Liquidation (2) More Distress Selling (8) More Reduction in Velocity V. (2) More Distress Selling (2) Contraction of Deposit Currency (3) Further Dollar Enlargement VI. (4) Reduction in Net Worth (4) Increase in Bankruptcies (7) More Pessimism and Distrust (8) More Slowing in Velocity (1) More Liquidation VII. (5) Decrease in Profits (5) Increase in Losses (7) Increase in Pessimism (8) Slower Velocity (1) More Liquidation (6) Reduction in Volume of Stock Trading VIII. (6) Decrease in Construction (6) Reduction in Output (6) Reduction in Trade (6) Unemployment (7) More Pessimism IX. (8) Hoarding X. (8) Runs on Banks (8) Banks Curtailing Loans for Self-Protection (8) Banks Selling Investments (8) Bank Failures (7) Distrust Grows (8) More Hoarding (1) More Liquidation (2) More Distress Selling (3) Further Dollar Enlargement

343

IRVING FISHER 344

As has been stated, this order (or any order, for that matter) can be only ap­ proximate and subject to variations at different times and places. It represents my present guess as to how, if not too much interfered with, the nine factors selected for explicit study in this book are likely in most cases to fall in line. But, as has also been stated, the idea of a single-line succession is itself inade­ quate, for while Factor (1) acts on (2), for instance, it also acts directly on (7}, so that we really need a picture of subdividing streams or, better, an interacting network in which each factor may be pictured as influencing and being influenced by many or all of the others.

Paragraph 24 above gives a logical, and paragraph 27 a chronolog­ ical, order of the chief variables put out of joint in a depression when once started by over-indebtedness. 28. But it should be noted that, except for the first and last in the "logical" list, namely debt and interest on debts, all the fluctuations listed come about through a fall of prices. 29. When over-indebtedness stands alone, that is, does not lead to a fall of prices, in other words, when its tendency to do so is counter­ acted by inflationary forces (whether by accident or design), the re­ sulting "cycle" will be far milder and far more regular. 30. Likewise, when a deflation occurs from other than debt causes and without any great volume of debt, the resulting evils are much less. It is the combination of both-the debt disease coming first, then precipitating the dollar disease-which works the greatest havoc. 31. The two diseases act and react on each other. Pathologists are now discovering that a pair of diseases are sometimes worse than either or than the mere sum of both, so to speak. And we all know that a minor disease may lead to a major one. Just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation. 32. And, vice versa, deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liqui­ dation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great para­ dox which, I submit, is the chief secret of most, if not all, great de­ pressions: The more the debtors pa.y, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing. 33. But if the over-indebtedness is not sufficiently great to make liquidation thus defeat itself, the situation is different and simpler. It is then more analogous to stable equilibrium; the more the boat rocks the more it will tend to right itself. In that case, we have a truer example of a cycle. 34. In the "capsizing" type in particular, the worst of it is that real incomes are so rapidly and progressively reduced. Idle men and idle machines spell lessened production and lessened real income, the cen­ tral factor in all economic science. Incidentally this under-production occurs at the very time that there is the illusion of over-production. 35. In this rapid survey, I have not discussed what constitutes over­ indebtedness. Suffice it here to note that (a) over-indebtedness is al­ ways relative to other items, including national wealth and income and the gold supply, which last is specially important, as evidenced by the recent researches of Warren and Pearson; and (b) it is not a mere one-dimensional magnitude to be measured simply by the num­ ber of dollars owed. It must also take account of the distribution in time of the sums coming due. Debts due at once are more embarras­ sing than debts due years hence; and those payable at the option of the creditor, than those payable at the convenience of the debtor. Thus debt embarrassment is great for call loans and for early maturities. For practical purposes, we may roughly measure the total national debt embarrassment by taking the total sum currently due, say within the current year, including rent, taxes, interest, installments, sinking fund requirements, maturities and any other definite or rigid commit­ ments for payment on principal. ILLUSTRATED BY THE DEPRESSION OF 1929-33' 36. The depression out of which we are now (I trust) emerging is an example of a debt-deflation depression of the most serious sort. The 2 Note the charts, pp. 352-7: Chart I shows: (1) the price level (P) and (2) its percentage rate of rise or fall (P'). When the last named is lagged with the lag distributed according to a probability curve so that the various P"s overlap and cumulate we get P', as in Charts II and III. This P' is virtually a lagged average of the P"s. Charts II and III show: P' contrasted with employment (E). P' may be con­ sidered as what employment would be if controlled entirely by price-change. Chart IV shows the Swedish official (retail) weekly index number contrasted with the American weekly wholesale and monthly retail indexes.

344

IRVING FISHER 345 Chart V shows the estimated internal debt in the United States contrasted with the estimated total money value of wealth. The unshaded extensions of the bars upward show what the 1933 figures would be if enlarged 75 per cent to translate them into 1929 dollars (according to the index number of wholesale commodity prices). Chart VI shows estimated "fixed" annual charges (actually collected) con­ trasted with estimated national income. The unshaded extensions of the bars upward show what the 1932 figures would be if enlarged 56 per cent to translate them into 1929 dollars. Charts VII and VIII show the chief available statistics before and after March 4, 1933, grouped in the order indicated in Article 27 above. debts of 1929 were the greatest known, both nominally and really, up to that time. They were great enough not only to "rock the boat" but to start it capsizing. By March, 1933, liquidation had reduced the debts about 20 per cent, but had increased the dollar about 75 per cent, so that the real debt, that is the debt as measured in terms of commodities, was increased about 40 per cent [(100%-20%) X (100%+75%) = 140%]. Note Chart V. 37. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted­ ness must cease to grow greater and begin to grow less. Then comes re­ covery and a tendency for a new boom-depression sequence. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation. 38. On the other hand, if the foregoing analysis is correct, it is al­ ways economically possible to stop or prevent such a depression sim­ ply by reflating the price level up to the average level at which out­ standing debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged. That the price level is controllable is not only claimed by monetary theorists but has recently been evidenced by two great events: (1) Sweden has now for nearly two years maintained a stable price level, practically always within 2 per cent of the chosen par and usually within 1 per cent. Note Chart IV. (2) The fact that immediate rever­ sal of deflation is easily achieved by the use, or even the prospect of use, of appropriate instrumentalities has just been demonstrated by President Roosevelt. Note Charts VII and VIII. 39. Those who imagine that Roosevelt's avowed reflation is not the cause of our recovery but that we had "reached the bottom anyway" are very much mistaken. At any rate, they have given no evidence, so far as I have seen, that we had reached the bottom. And if they are right, my analysis must be woefully wrong. According to all the evi­ dence, under that analysis, debt and deflation, which had wrought havoc up to March 4, 1933, were then stronger than ever and, if let alone, would have wreaked greater wreckage than ever, after March 4. Had no "artificial respiration" been applied, we would soon have seen general bankruptcies of the mortgage guarantee companies, sav­ ings banks, life insurance companies, railways, municipalities, and states. By that time the Federal Government would probably have be-

345

IRVING FISHER 346 come unable to pay its bills without resort to the printing press, which would itself have been a very belated and unfortunate case of artifi­ cial respiration. If even then our rulers should still have insisted on "leaving recovery to nature" and should still have refused to inflate in any way, should vainly have tried to balance the budget and dis­ charge more government employees, to raise taxes, to float, or try to float, more loans, they would soon have ceased to be our rulers. For we would have insolvency of our national government itself, and prob­ ably some form of political revolution without waiting for the next legal election. The mid-west farmers had already begun to defy the law. 40. If all this is true, it would be as silly and immoral to "let nature take her course" as for a physician to neglect a case of pneumonia. It would also be a libel on economic science, which has its therapeutics as truly as medical science. 41. If reflation can now so easily and quickly reverse the deadly down-swing of deflation after nearly four years, when it was gathering increased momentum, it would have been still easier, and at any time, to have stopped it earlier. In fact, under President Hoover, recovery was apparently well started by the Federal Reserve open-market pur­ chases, which revived prices and business from May to September 1932. The efforts were not kept up and recovery was stopped by va­ rious circumstances, including the political "campaign of fear." It would have been still easier to have prevented the depressional­ most altogether. In fact, in my opinion, this would have been done had Governor Strong of the Federal Reserve Bank of New York lived, or had his policies been embraced by other banks and the Federal Re­ serve Board and pursued consistently after his death.3 In that case, there would have been nothing worse than the first crash. We would have had the debt disease, but not the dollar disease-the bad cold but not the pneumonia. 42. If the debt-deflation theory of great depressions is essentially correct, the question of controlling the price level assumes a new im­ portance; and those in the drivers' seats-the Federal Reserve Board and the Secretary of the Treasury, or, let us hope, a special stabili­ zation commission-will in future be held to a new accountability. 43. Price level control, or dollar control, would not be a panacea. Even with an ideally stable dollar, we would still be exposed to the

3 Eventually, however, in order to have avoided depression, the gold stand­ ard would have had to be abandoned or modified (by devaluation); for, with the gold standard as of 1929, the price levels at that time could not have been main­ tained indefinitely in the face of: (1) the "scramble for gold" due to the continued extension of the gold standard to include nation after nation; (2) the increasing volume of trade; and (3) the prospective insufficiency of the world gold supply.

346

IRVING FISHER 347 debt disease, to the technological-unemployment disease, to over-pro­ duction, price-dislocation, over-confidence, and many other minor dis­ eases. To find the proper therapy for these diseases will keep econo­ mists busy long after we have exterminated the dollar disease.

DEBT STARTERS 44. The over-indebtedness hitherto presupposed must have had its starters. It may be started by many causes, of which the most common appears to be new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest, such as through new in­ ventions, new industries, development of new resources, opening of new lands or new markets. Easy money is the great cause of over­ borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and tech­ nological improvements created wonderful investment opportunities, and so caused big debts. Other causes were the left-over war debts, domestic and foreign, public and private, the reconstruction loans to foreigners, and the low interest policy adopted to help England get back on the gold standard in 1925. Each case of over-indebtedness has its own starter or set of starters. The chief starters of the over-indebtedness leading up to the crisis of 1837 were connected with lucrative investment opportunities from de­ veloping the West and Southwest in real estate, cotton, canal building (led by the Erie Canal), steamboats, and turnpikes, opening up each side of the Appalachian Mountains to the other. For the over-indebt­ edness leading up to the crisis of 1873, the chief starters were the ex­ ploitation of railways and of western farms following the Homestead Act. The over-indebtedness leading up to the panic of 1893 was chief­ ly relative to the gold base which had become too small, because of the injection of too much silver. But the panic of 1893 seems to have had less of the debt ingredient than in most cases, though deflation played a leading r6le. The starter may, of course, be wholly or in part the pendulum-like back-swing or reaction in recovery from a preceding depression as com­ monly assumed by cycle theorists. This, of itself, would tend to leave the next depression smaller than the last. 45. When the starter consists of new opportunities to make unu­ sually profitable investments, the bubble of debt tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts. The only notable exception is a great war and even then chiefly because it leads after it is over to productive debts for reconstruction purposes. 46. This is quite different from the common naive opinions of how war results in depression. If the present interpretation is correct, the World War need never have led to a great depression. It is very true that much or most of the inflations could not have been helped because of the exigencies of governmental finance, but the subsequent undue deflations could probably have been avoided entirely. 47. The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of sell­ ing at a profit, and realizing a capital gain in the immediate future; (c)thevogue of reckless promotions,taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible. When it is too late the dupes discover scandals like the Hatry, Krueg­ er, and Insull scandals. At least one book has been written to prove that crises are due to frauds of clever promoters. But probably these frauds could never have become so great without the original starters of real opportunities to invest lucratively. There is probably always a very real basis for the "new era" psychology before it runs away with its victims. This was certainly the case before 1929. 48. In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many oc­ casional disturbances, are new opportunities to invest, especially be­ cause of new inventions; (3) these, with other causes, sometimes con­ spire to lead to a great volume of over-indebtedness; (4) this, in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counter­ acted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either via laissez faire (bank­ ruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place. 49. The general correctness of the above "debt-deflation theory of

347

IRVING FISHER 348 great depressions" is, I believe, evidenced by experience in the present and previous great depressions. Future studies by others will doubt­ less check up on this opinion. One way is to compare different coun­ tries simultaneously. If the "debt-deflation theory" is correct, the in­ fectiousness of depressions internationally is chiefly due to a common gold (or other) monetary standard and there should be found little tendency for a depression to pass from a deflating to an inflating, or stabilizing, country. SOME NEW FEATURES As stated at the outset, several features of the above analysis are, as far as I know, new. Some of these are too unimportant or self-evi­ dent to stress. The one (No. 32 above; also 36) which I do venture to stress most is the theory that when over-indebtedness is so great as to depress prices faster than liquidation, the mass effort to get out of debt sinks us more deeply into debt.4 I would also like to emphasize the whole logical articulation of the nine factors, of which debt and de­ flation are the two chief (Nos. 23, 24, and 28, above). I would call attention to new investment opportunities as the important "starter" of over-indebtedness (Nos. 44, 45). Finally, I would emphasize the im­ portant corollary, of the debt-deflation theory, that great depressions are curable and preventable through reflation and stabilization (Nos. 38-42). Yale University 4 This interaction between liquidation and deflation did not occur to me until 1931, although, with others, I had since 1909 been stressing the fact that deflation tended toward depression and inflation toward a boom. This debt-deflation theory was first stated in my lectures at Yale in 1931, and first stated publicly before the American Association for the Advancement of Science, on January 1, 1932. It is fully set forth in my Booms and Depressions, 1932, and some special features of my general views on cycle theory in "Business Cycles as Facts or Tendencies" in Economische Opstellen Aangeboden aan Prof. C. A. Verrijn Stuart, Haarlem, 1931. Certain sorts of disequilibrium are discussed in other writings. The role of the lag between real and nominal interest is dis­ cussed in The Purchasing Power of Money, Macmillan, New York, 1911; and more fully in The Theory of Interest, Macmillan, New York, 1930, as well as the effects of inequality of foresight. Some statistical verification will be found in "Our Unstable Dollar and the So-called Business Cycle," Journal of the Ameri­ can Statistical Association, June, 1925, pp. 179-202, and "The Relation of Em­ ployment to the Price Level" (address given before a section of the American Association for the Advancement of Science, Atlantic City, N.J., December 28, 1932, and later published in Stabilization of Employment, edited by Charles F. Roos, The Principia Press, Inc., Bloomingdale, Ind., 1933, pp. 152-159). See Charts I, II, III. Some statistical verification will be found in The Stock Market Crash and After, Macmillan, New York, 1930. A selected bibliography of the writings of others is given in Appendix III of Booms and Depressions, Adelphi Company, New York, 1932. This bibliography omitted Veblen's Theory of Business Enterprise, Charles Scribner's Sons, New York, 1904, Chapter vu of which, Professor Wesley C. Mitchell points out, probably comes nearest to the debt-deflation theory. Hawtrey's writings seem the next nearest. Professor Alvin H. Hansen informs me that Professor Paxson, of the American History Department of the University of Wisconsin, in a course on the History of the West some twenty years ago, stressed the debt factor and its relation to deflation. But, so far as I know, no one hitherto has pointed out how debt liquidation defeats itself via deflation nor several other features of the present "creed." If any clear-cut anticipation exists, it can never have been prominently set forth, for even the word "debt" is missing in the indexes of the treatises on the subject.

348

349

CHARTS The following eight charts are all on the "ratio scale" excepting Charts II, III, V, VI, and curve P' of Chart I. The particular ratio scale used is indicated in each case. It will be noted that in Charts VII and VIII all curves have a common ratio scale, as indicated by the inset at the right in both charts, except "Brokers' Loans" in Chart VII and "Failures Num­ bers," "Failures Liabilities," and "Shares Traded" in Chart VIII, which four curves have another, "reduced" i.e., smaller, common scale, as indicated by the inset at the left of Chart VIII. It will be further noted that "Money in Circulation," "Failures Numbers," and "Failures Liabilities" are inverted. The full details of how P' in Charts II and III is derived from P' in Chart I and also how P' in Chart I is derived from Pare given in "Our Unstable Dollar and the So-Called Business Cycle," Journal of the American Statistical Association, June, 1925.

349

MINSKY 350

Minsky’s Analysis of Financial Capitalism Bard Working Paper No. 277.

The late Hyman Minsky (1919–1996) was a leading authority on monetary theory and financial institutions. For much of Minsky’s career, mainstream economics paid little attention to the role of the financial system in macroeconomic theory. But in recent years, there has been an outpouring of new research, both theoretical and empirical, much of which validates his remarkable insights. Following is a digest of a paper* by Papadimitriou and Wray, that briefly outlines Minsky’s views on modern capitalist systems.

Capitalism's Many Stages Capitalism is constantly evolving. We can identify several distinct stages in its evolution going back to the early 1600s. Today, capitalism is quite different from what it was just 30 years ago, and it may now be in the process of evolving into a new stage through globalization. The one constant throughout is the profit-seeking motive in money terms that leads to continual innovation, especially in finance. Firms spend money to earn more money.

Financial institutions play a critical but delicate role, since they are themselves profit-seeking enterprises. They not only supply the funds, but may have a direct stake in the potential profits of the enterprise. Banks increase the money supply whenever they share the belief of the borrower that positions in assets or financed activity will generate sufficient cash flows. Money is thus created as a result of normal economic processes.

The Key Role of Firms A modern economy is ultimately dependent on the viability of its firms, all of which are owned by the household sector, and which provide the main source of household income as wages. The focus should therefore be on firms, not households, and on investment and its finance, not on consumption and saving out of household income flows. This is in sharp contrast to the exposition found in textbooks, which begins with households and their consumption versus saving decision, with thrift determining investment and therefore growth.

Two Price Model Minsky’s analysis involves two sets of prices. One set consists of the prices of current output -- consumption, investment, government, and export goods and services. The other set is the prices of assets-- capital assets used by firms in production and financial instruments that firms issue to gain control of fixed and working capital. The second set of prices is critical in determining how much investment will be undertaken. The two sets of prices reflect what happens in two different sets of markets, and thus will vary independently. This is in marked contrast to the single price system of the consumption versus investment model typically used in textbooks.

Spending on investment depends on the demand price of capital assets (what firms are willing to pay) relative to supply prices (what suppliers require to produce them). For capital assets to be produced and thus generate profits, demand prices must exceed supply prices by enough to cover the risks. The 350

resulting investment will then validate previous investment. Investment today determines whether investment351 yesterday was a good idea. But investment today depends on expectations about the future regarding demand and supply prices of investment goods. Whether there will be aggregate profits to distribute depends on aggregate capitalist spending.

The Role of Profits Capitalism involves the acquisition of expensive assets that usually necessitate financing of positions in those assets. A firm must have sufficient market power to assure lenders that it will earn enough to service its financial liabilities. Thus a goal of every firm is to gain market power in order to control its markup. The ability to set price is critical in determining who gets credit.

At the micro level, each firm must be able to obtain a markup over labor costs. However at the macro level there won’t be any profit unless there is spending in excess of aggregate wages in the consumption sector. Aggregate profit of firms is equal to the sum of investment plus consumption out of profits, plus the government’s deficit, plus the trade surplus, less saving out of wages.

In the simple case with no government deficit, no trade imbalance, and no saving out of wages, capitalist profit equals investment plus capitalist consumption. As long as the price is set high enough that workers cannot buy all the output, capitalists can get the rest so long as they spend. The amount of surplus available at the aggregate level depends on the aggregate markup. It is aggregate spending on investment that generates the profit, and validates the accumulated capital. Neither thriftiness nor technology has anything to do with capital accumulation.

Financial Positions of a Firm Minsky defines three financial positions of increasing fragility:

• Hedge finance: income flows are expected to meet financial obligations in every period.

• Speculative finance: the firm must roll over debt because income flows are expected to only cover interest costs.

• Ponzi finance: income flows won’t even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. Over a protracted period of good times, economies tend to move from a financial structure dominated by hedge financing to a structure with increasing speculative and Ponzi financing. The shift toward speculative positions occurs intentionally and more or less inevitably because of the way in which success in a boom enhances expectations. However the shift from speculative toward Ponzi finance is usually unintentional. Business Cycles Business cycles are endogenously generated, and are not due to shocks. In large part they are due to the interplay between the two price systems and the way the financial system naturally evolves toward fragility. Exogenous effects can precipitate a crisis, but only when the system has already evolved to a fragile position.

Conventional wisdom argues that the economy is naturally stable, with the invisible hand guiding the economy to equilibrium. Rather than treating institutions as contributing to stability, orthodoxy views them as barriers to achieving equilibrium. Minsky argues that institutions and interventions thwart the 351

inherent instability of financial capitalism by interrupting the endogenous process and restarting the economy352 under more favorable conditions.

System Instability As Minsky observed, capitalism is inherently unstable. As each crisis is successfully contained, it encourages greater speculation and risk taking in borrowing and lending. Financial innovation makes it easier to finance various schemes. To a large extent, borrowers and lenders operate on the basis of trial and error. If a behavior is rewarded, it will be repeated. Thus stable periods naturally lead to optimism, to booms, and to increasing fragility.

A financial crisis can lead to asset price deflation and repudiation of debt. A debt deflation, once started, is very difficult to stop. It may not end until balance sheets are largely purged of bad debts, at great loss in financial wealth to the creditors as well as the economy at large.

Big Government and Big Bank Before World War II, government spending was no more than 3% of GNP. Whenever the economy faltered, there was little countercyclical deficit spending to offset the loss in private spending. The era was marked by several depressions. Government has since grown to more than 20% of GNP. Its spending effectively sets ceilings and floors on prices of current output, helping to constrain the natural tendency of aggregate demand toward boom and bust cycles. It is notable that there has been no depression in the Big Government era.

Government deficits may not be sufficient to prevent a debt deflation. If one occurs on a large enough scale, asset prices can become so depressed that revenue from sales of assets does not permit servicing of debt. Defaults can spread and bring down more creditors. Minsky argues that the prevention of such a financial crisis is the primary purpose of the central bank and not, as orthodoxy assumes, control of the money supply or inflation. To reduce the moral hazard effects, any lender of last resort activity must be accompanied by Big Bank supervision of balance sheets. ------* Working Paper No. 277, Minsky's Analysis of Financial Capitalism, by Dimitri B. Papadimitriou and L. Randall Wray, of Jerome Levy Economics Institute, July 1999.

MINSKY'S ANALYSIS OF FINANCIAL CAPITALISM Dimitri B. Papadimitriou and L. Randall Wray The Jerome Levy Economics Institute Working Paper No. 275, July 1999

Hyman Minsky used to joke that there are as many varieties of capitalism as Heinz has pickles-- 57. (Minsky 1991) In this contribution, we will be analyzing one of them--the general form of post-war capitalism taken in the developed countries, which can be characterized as Financial Capitalism. Obviously, there are differences in the specific form that financial capitalism takes over the postwar period in each of these countries, as well as cross-country differences. However, Minsky's model is applicable to all of them, at least at a general level.

The term finance capital appears to come from Hilferding's 1910 book, which proclaimed a new stage of capitalism characterized by complex financial relations and domination of industry by finance. (Hilferding 1981) Importantly, Hilferding argued 352

353The most characteristic features of 'modern' capitalism are those processes of concentration which, on the one hand, 'eliminate free competition' through the formation of cartels and trusts, and on the other, bring bank and industrial capital into an ever more intimate relationship. Through this relationship...capital assumes the form of finance capital, its supreme and most abstract expression....The progress of industrial concentration has been accompanied by an increasing coalescence between bank and industrial capital. This makes it imperative to undertake a study of the processes of concentration and the direction of their development and particularly their culmination in cartels and trusts. The hopes for the 'regulation of production', and hence for the continuance of the capitalist system, to which the growth of monopolies has given rise...requires an analysis of crises and their causes. (Hilferding 1981, pp. 21-22)

While the details of Hilferding's analysis seem to be applicable to very particular institutional arrangements that existed in Europe around the turn of the century, in a general sort of way one could argue that Veblen, Keynes, Schumpeter and, later, Minsky were analyzing this new stage of capitalism. While Keynes placed less emphasis on economic concentration, market power played a significant role in the theories of Schumpeter, and especially in those developed by Veblen and Minsky. Veblen (1919a, 1919b), in particular, argued that modern crises could be attributed to the "sabotage of production" (or "conscientious withdrawal of efficiency") by the "captains of industry". As we will argue, in Minsky's approach modern capitalism requires expensive and long-lived capital assets, which in turn necessitate financing of positions in these assets as well as market power in order to gain access to financial markets. It is the relation between finance and investment that creates instability of the modern capitalist economy, and Minsky emphasized that market power, alone, proved to be insufficient to ensure revenue flows that are necessary to meet financial commitments.

According to Minsky, the two world wars and the intervening Great Depression represented something of a failure of Hilferding's finance capital stage: "Sixty years ago capitalism was a failed economic order..." (Minsky 1993, p. 2) He used to argue that even the cartelization of industry proved to be impotent in the face of pressures to cut prices, which in turn made it impossible to service debt issued to finance positions in capital assets. Thus, Veblen's "sabotage of production" failed to protect profits, leading to "fire sales" of assets and debt deflation. However, financial capitalism emerged from WWII with an array of new institutions that made it stronger than ever before. As we will argue, the two most important institutions were "big government" and "big (central) bank": "The capitalism that had a good run after the second world war was a big government interventionist economy with central banks that were less constrained than during the inter war years." (Minsky 1993 p. 19)

Of course, the economy continued to evolve, and Minsky argued that the postwar period could be subdivided into half a dozen stages--from paternalistic capitalism to money-manager capitalism. Generally, this evolution was from a more successful form of financial capitalism to a more problematic form: "While the capitalisms of the United States and Western Europe were truly successful societies during the first two and a half decades after the second world war, their performance over the last decade and a half falls short..." (Minsky 1993, p. 2) We will discuss Minsky's analysis of this evolution to the fragile form of capitalism that exists today.

CRISES

Minsky's analysis began with the recognition that the post-war capitalist economy is different: before the war, depressions were frequent events--occurring about every quarter century. Furthermore, a 353

financial crisis--sometimes a Fisher-type debt deflation--typically coincided with depression. After WWII, 354however, there were no depressions in the developed capitalist countries (with the possible exception of post-1990 Japan). Interestingly, in the US although there were recessions throughout the postwar period, there were no financial crises until 1966. (Minsky 1986, Wray 1999) After 1966, crises became increasingly frequent and more severe even as recessions became more severe and economic growth generally slowed. However, none of the downturns has thus far led to depression.

Minsky argued that financial capitalism is inherently unstable--thus, the Great Depression was not at all unusual--indeed, it should have been the expected outcome of the forces at work in the modern capitalist economy. He argued that institutions had to be developed that would constrain the natural instability of this sort of economic system. As discussed above, the modern corporation tried to develop institutions (for example, constraints on price competition) that would constrain the instability, but proved unable to do so in what Minsky called the small government economy. Thus, it was up to government to create adequate constraining institutions. And the two most important were Big Government and the Big Bank.

The problem with the pre-war economy was that the US government was too small--on the order of three percent of GNP. When the economy slowed, tax revenues would fall and some types of government spending might rise, generating a deficit that could act as an automatic stabilizer. However, given the small size of the government, the swings of its budget could not be large enough to offset swings of private spending. Thus, aggregate demand would fall, generating idle capital and labor and placing downward pressure on prices. Cartelization (and its consequent sabotage of production) represented an attempt to hold wages and prices steady, but this was never adequate to the task. Falling revenue would make it difficult to service debt and thereby add to pressures to leave the cartel and cut prices and costs.

However, in the postwar period, government grew significantly--typically to a third or even half of GNP. (In the US, the federal government's spending alone amounts to 20-25% of GNP.) With a government this large, budget swings could offset fluctuations of private spending and potentially stabilize income, employment, and output. Thus, the effects of countercyclical big government deficits in downturns and surpluses in booms would be big. Unlike orthodox Keynesians, Minsky emphasized the importance of government transfer payments and interest payments over direct government employment and production (quite small and actually declining in the US) or government spending on contracts (larger, but still declining in importance in the US). For Minsky, transfer payments did not simply "net out" but represented a large automatic stabilizer that caused the budget to swing between deficit and surplus. With a lag, interest payments on the debt rose as a result of tight money policy (which usually preceded recession) and as a result of a greater quantity of outstanding debt generated by government deficits in downturns.

According to Minsky the deficit of a big government will have three effects: (1) Income and employment effect. This is simply the "multiplier effect" of government spending, although as discussed above, Minsky included transfers and interest payments. (2) Cash flow effect. What Minsky meant is that government deficits maintain cash in-flows so that private debts can be serviced. Most importantly, deficits maintain profit flows to firms--as we'll see later. (3) Portfolio effect.

354

Government deficits mean that government debt is issued, which is a safe asset. This helps to 355stabilize the economy by providing safe assets for private portfolios, which can be "leveraged".

Orthodox Keynesians focused only on the first of these effects: they wanted to fine-tune economy through discretionary tax and spend policies, and emphasized the multiplier effects on income and employment. Orthodoxy ignored the other effects, or, even worse, got them wrong. For example, crowding-out theory completely misunderstands the impact of government bond sales--that is, what Minsky called the portfolio effect. As will be discussed below, Minsky rejected the ISLM-fixed money supply model which is used to demonstrate that deficits push up interest rates. Instead, he argued that an economy with a lot of government debt is more "robust"--thus, would probably face lower interest rates. Below, we will return to the "cash flow" effects of budget deficits--with particular attention given to the role that deficits play in maintaining profit flows.

Minsky argued that post-war recessions are unusual because government deficits place a floor on employment, personal income, and profit flows; in fact, in some recessions, personal income and profits actually continue to rise--thwarting the normal, cumulative, invisible hand processes that would lead to depression. Minsky argued that the first serious recession of the postwar period--the 1974-75--was contained by government deficits that maintained income flows. For example, "although unemployment rates went to 8.9 percent in May 1975, in no quarter during 1973-75 did disposable income decline..." mainly because transfer payments grew quickly. (1986, p. 25) Similarly, Wray (1989) showed that during the deep Reagan recession of the early 1980s, personal income grew in every quarter, with transfer payments accounting for 65% of the growth of personal income during the depths of the recession, in the third quarter of 1982.

While Minsky did not explicitly analyze changes to the US transfer "safety net", it is likely that cut-backs in the 1980s and 1990s reduced the effectiveness of deficits to place a floor on aggregate demand. On the other hand, Minsky did argue that changes to the tax system during the Reagan presidency had reduced the ability of the budget to constrain a boom in private demand (by moving toward surplus) since even at relatively rapid rates of economic growth, the budget remained in deficit. It was only during the 1990s--and mainly through spending cuts (although supplemented to some extent by tax revenues resulting from capital gains)--that the US federal government budget was changed such that robust growth would generate surpluses. It is possible that the shift of stance has been too great and that today Minsky might argue that it is now too difficult to generate a budget deficit in order to maintain profit and personal income as spending falls.

In any case, Minsky argued that the three effects of government deficits may not be sufficient to prevent crises. If one very large firm or bank defaults anyway, this can generate a debt deflation because of the way in which balance sheets are interlocking. In particular, if the default of a debtor imperils the ability of a creditor to service its own debt, the creditors may be forced to "make position by selling out position"--that is, to sell assets. If this occurs on a large enough scale, asset prices can become depressed so far that revenue from sales does not permit servicing of debt. Defaults can spread and bring down more creditors. Thus, a lender of last resort is needed to prevent failure of a big firm or bank that might lead to a snowball of other failures. The lender of last resort might directly purchase assets of questionable value and issue liabilities that are riskless, or it might simply lend (or promise to lend) to creditors in difficulty if they will not foreclose on debtors.

This is the Big Bank institutional constraint. It is generally undertaken by the central bank, although that is not absolutely necessary. For example the treasury or another governmental or quasi- 355

governmental organization (such as the FDIC in the US) can undertake lender of last resort activity (so long as 356it is backed by the "full faith and credit" of the government, which means in practice that its liabilities are redeemable for central government liabilities). What is important is that the intervention can provide reserves or "high powered money" as necessary and without limit--as Bagehot had argued. The lender of last resort is needed because the economy is naturally unstable. According to Minsky, this is the primary purpose of central bank, and not, as orthodoxy assumes, to control the money supply or inflation.

However, every lender of last resort intervention has side effects--it changes expectations of economic agents, so leads to innovation, taking the form of institutional change. The main side effect of such interventions--such as the recent Fed-arranged bailout of Long-Term Capital Management (a private hedge fund)--is that risky behavior is rewarded. When this is done, bad ideas do not result in losses, sending the wrong signals and increasing risks. This increases the potential for instability and makes the financial structure more fragile. To reduce the "moral hazard" effects, lender of last resort activity must be accompanied by Big Bank (again, not necessarily the central bank; in the US, supervision is undertaken by the FDIC and the Comptroller of the Currency, as well as by the Fed and by state bank supervisors) supervision of balance sheets. (Minsky 1992)

In sum, households, firms, and banks cause institutional change through innovations. These transform the financial and economic system from a robust one in which crisis is unlikely to a fragile one that is vulnerable to crisis. As Minsky used to say, stability is destabilizing. Even though the New Deal and postwar reforms erected institutions to constrain instability, these reforms changed behavior such that fragility increased. By the mid 1960s, this change became apparent, as evidenced by riskier assets, more debt relative to income flows, and lower liquidity--what Minsky called fragility. Then the crises began, each one halted by Big Government and Big Bank intervention--changing behavior so as to increase fragility.

MINSKY'S CRITIQUE OF ORTHODOXY

Note how different the view of Minsky presented above is from the one that underlies conventional wisdom, which argues that the economy is naturally stable, with the invisible hand guiding the economy to equilibrium. Shocks might temporarily move the economy away from equilibrium, but the forces that move us back to equilibrium are strong. Furthermore, rather than viewing institutions as contributing to stability, orthodoxy views institutions as barriers to achieving equilibrium. In contrast, Minsky's vision, insists that "institutions and interventions thwart the instability breeding dynamics that are natural to market economies by interrupting the endogenous process and 'starting' the economy again with non-market determined values as 'initial conditions'." (Minsky and Ferri, 1991, p. 4) Moreover, "To contain the evils that market systems can inflict, capitalist economies developed sets of institutions and authorities, which can be characterized as the equivalent of circuit breakers." (Minsky et al., 1994, p. 2)

Let us look briefly at Minsky's analysis of the dominant paradigm. Even what is called the Keynesian approach in the textbooks is really based on a flawed view of the way in which financial capitalism operates. First we will examine the assumptions that underlie the micro and macro models of the orthodox approach.

Assumptions Underlying the Orthodox Micro Model

356

The micro model that underlies the orthodox approach is based on a simple barter paradigm, with price as357 the parameter of behavioral equations. In it, the auctioneer announces a vector of prices and receives bids and continues until an equilibrium price vector is achieved. No trading occurs until the equilibrium price vector is achieved--that is, no "false trading" occurs. By design, the model is very "general"--with no money, virtually no institutions (as Kregel 1995 has argued, the model actually assumes a very particular market form--the auction market--but this is generally not recognized), no long-lived capital assets and no financed positions. Ironically, the things that are assumed away happen to be the most obvious features of the economy we actually live in. Thus, in a quite different sense, the model is very "restricted" because it excludes the institutions that make ours a modern, financial capitalist economy. With these restrictions, the free market is supposed to lead to an efficient allocation and a coherent equilibrium. As Minsky argued, however, demonstrating that an exchange economy based on barter can achieve equilibrium is not the same as demonstrating that a modern capitalist economy can do the same thing.

Furthermore, while the existence of equilibrium in such a model has been proven, it has not been shown that it is unique or stable. Minsky often cited the excellent book by Ingrao and Israel (1990), which argues that it is precisely the absence of institutional constraints that makes it impossible to demonstrate uniqueness and stability of equilibrium. Minsky took this as confirmation of his own belief that the "free market" would be unstable without the "ceilings and floors" provided by institutional constraints. Even though general equilibrium theory has been largely unsuccessful as a microeconomic approach, all mainstream theory at least implicitly refers to it as providing the micro foundations for the macro model. Let us turn to that macro model.

Assumptions Underlying the Orthodox Macro Model

The macro model adds an aggregate labor market and an aggregate production function (see Figure 1). The labor market "dominates" in the sense that flexible wages ensure full employment; given full employment, the production function determines aggregate output. Saving and investment in a loanable funds model determines the "real" interest rate, which simply determines the division of output between consumption today and consumption tomorrow (which is saving and investment). According to Minsky, there is no explanation of how an unemployment equilibrium could be achieved in this model. Involuntary unemployment must be explained as a result of irrational rigidities or fooling--which should be only short run phenomena. Thus, in the long run the economy must be at full employment equilibrium.

Features of the Orthodox Model

Minsky focused on four particular features of the orthodox approach that are quite different from his alternative, institutional approach: (1) the role of prices as signals; (2) the treatment of capital; (3) the role of saving; and (4) the role of money.

The role of prices in the neoclassical model: signals

In the perfectly competitive, neoclassical model, no economic agent can influence prices, thus each takes price as given (prices are parameters). Consumers maximize utility, subject to given prices and a budget constraint; firms maximize profit given prices of inputs and outputs, and given a production function. Then it can be shown that if all act as if the current price will always exist, the model can achieve a coherent result such that price equates quantity demanded and supplied. But what if 357

there is power to influence price? Or, if agents act on the basis of what they expect price to be--rather than taking358 price as a parameter? Then coherent results won't be achieved. According to Minsky, in the real world, some firms can influence price and expectations play a role: at the extreme, agents speculate on price. In fact, investment is always a function of expected price, not current price. So free markets can fail to achieve equilibrium.

Treatment of capital

Neoclassical theory cannot handle the existence of anything like the capital that exists in the real world, so it cannot handle investment that results in long-lived capital assets. Neoclassical capital is some physical thing that is instantly malleable. It produces some physical product and earns a real return based on its physical productivity. Marginal products are just technical relations and in the end, technical proficiency will triumph. According to modern finance theory, it makes absolutely no difference how positions in physical capital are taken--whether they are financed out of earnings, savings, sales of equity, or debt. Mistakes cannot be made--at least persistently. In the real world, in contrast, a capital asset is purchased today, based on expectations of future prices, and all positions are financed positions. Exactly how the position was financed does make a difference. A purchase of capital today will not be validated until the future--by future income flows. Present income flows validate past investment decisions and if current flows are less than what was expected at the time the investments were made, then past decisions will not be validated. This implies that contracted financial commitments may not be met, which has an effect on expectations about the future, and so affects current investment, which affects current income. This leads to an incoherent result: the feedback from falling investment makes things worse--moving the system further from equilibrium as positions are not validated--causing investment to fall further. The feedback effect, then, generates persistent "mistakes" because, in retrospect, past investment decisions turn out to have been based on incorrect expectations about the future.

The role of saving

All orthodox models of the long run are essentially saving-driven. In these models, thrift is good because more saving leads to more investment which leads to more growth. While Minsky rejected the orthodox long-run growth models, he focused his attention on a critique of the neoclassical short run model. In this model, saving and investment determine the interest rate, therefore, determine the split between consumption and investment goods. If thrift rises, consumption falls but investment rises to maintain full employment so that an increase of thrift will not cause unemployment.

Minsky (1986) offered three main critiques of this loanable funds approach. First, the orthodox model ignores the impact of falling consumption on investment. Since in the neoclassical model, a decision not to consume today is a decision to consume tomorrow, firms can go ahead and invest even as sales fall today. In the real world, a decision to not consume today does not represent a decision to consume tomorrow--or ever. Second, orthodoxy ignores inherited financial obligations. When consumption falls and sales fall, some firms would not be able to meet obligations--leading to defaults, cuts of spending, and falling incomes. Falling incomes can force household bankruptcies as well, and further curtailment of consumer spending. In other words, incoherent results are obtained if nominal financial obligations exist. Finally, orthodoxy makes the interest rate a function only of real variables-- money plays no role. This is another aspect of the real-nominal dichotomy rejected by Minsky. Let us turn to Minsky's critique of the way in which orthodoxy treats money.

358

The role of money: The quantity theory 359 Hahn nicely summarized the current state of orthodox monetary theory as follows: "The most serious challenge that the existence of money poses is this: the best developed model of the economy cannot find room for it. The best developed model is, of course, the Arrow Debreu version of Walrasian general equilibrium." (Hahn 1983, p. 1) In the orthodox model, money is added as an after thought, as fiat or helicopter money to facilitate transactions and thereby reduce costs entailed in barter exchange. Since there is no uncertainty, only a fool would hold money because it earns no interest--liquidity has no value in the orthodox model. In the long-run, money must be neutral--determining only nominal prices-- although it might be nonneutral in the short-run (with some disagreement among factions--old style monetarism versus rational expectations augmented new classical monetarism). As mentioned above, the theory ignores financial institutions and financed positions in assets. In conclusion, the orthodox model is based on a barter paradigm, with real or relative prices as parameters. As Friedman put it, although money and other institutions complicate the analysis, all the important characteristics of a modern capitalist economy are supposed to be contained in the simple model of the barter economy. But in the real world, in the financial capitalist world, money is the key institution. It is endogenous, created during normal economic processes. Access to money gives power--not just purchasing power, but market power. In the capitalist economy, production is always undertaken with money to get more money. There never was an economy based on barter exchange, outside of trivial prisoner of war cases, and money did not arise as a cost-minimizing medium of exchange. Indeed, most likely money evolved out of imposition of taxes--long before there were private markets. (Wray 1998) The medium of exchange function of money derives from its unit of account function, and in all modern economies, it is the state that determines what will function as the unit of account. In any case, money is the key link between present and future, a one-way time machine, that allows capitalists to buy now, produce, and pay later. Minsky emphasized that most importantly, it is created in the process of financing positions in assets. Banks increase the money supply whenever they share the belief of the borrower that positions in assets or financed activity will generate sufficient cash flows. If the future turns out to be worse than expected, it may be impossible to meet commitments. So money and nominal financial commitments matter.

THE ALTERNATIVE MODEL

We are now ready to turn to the main features of the alternative model advanced by Minsky. Our plan for the rest of this paper is to first examine in detail Minsky's view of the roles of prices in the modern financial capitalist economy. We next turn to his analysis of instability that is inherent to this sort of system. This will lead us to his exposition of the "financial theory of investment and investment theory of the cycle". We will then conclude with a summary of the main features of his alternative approach.

What Do Prices Do?

In the neoclassical model, only real or relative prices matter as they allocate scarce resources among unlimited wants. Any scarce resource will have a positive price that is competitively established to ration its use. In Minsky's alternative approach, all financial commitments are in nominal terms and all income flows are in nominal terms. It matters whether an economic unit's nominal inflow is greater than its nominal outflow. Money cannot be neutral in this sort of world. This view is similar to the "monetary theory of production" advanced by Marx, Veblen, and Keynes, however, Minsky's analysis focuses in greater detail upon modern financial relations. In the real world, nominal prices are

359

administered, in large part to gain control over nominal inflows, while relative prices are just a residual that is mainly360 nondiscretionary.

If one thinks about the problem faced by the colonial governor who wants to move surplus resources to his command, one obtains some idea of the purpose of prices in the modern world. (See Wray 1998, Chapter 3.) The governor would impose a monetary head tax on the population--say, 100 pounds per year. The population would then ask what could be done to obtain the 100 pounds. The governor would put prices on resources--a pound for an hour of labor, a half pound for a bushel of corn, and so on. The tax created a demand for money while the prices paid by the governor determined how many surplus resources would be moved. Now, the modern corporation cannot impose head taxes, and unlike the colonial governor, it really does not care about moving real resources around. It operates in a thoroughly monetized economy, it is a money-in, money-out operation, and it wants to ensure that a surplus in money terms is left after paying all operating costs and costs of servicing its financial commitments. Let us look at the purpose of prices in the financial capitalist economy.

Minsky (1986, Chapter 7) argued that prices have five functions (and note he didn't necessarily mean to imply that these are behavioral functions). An adequate or proper price would: (1) ensure a surplus is generated, (2) ensure that at least some of the surplus goes to owners of capital, (3) ensure the market (or demand) price of capital assets is consistent with current production costs (or supply price), (4) ensure obligations on business debts can be fulfilled, and (5) ensure resources are directed toward the investment sector, that is, to allow accumulation of capital. Each of these is important enough to warrant further examination.

Prices ensure a surplus is generated

The price at the aggregate level must be set high enough above labor costs to make sure workers cannot buy everything--leaving a surplus. This leads to an aggregate markup theory of pricing in which price is set at the macro level as labor costs plus a markup. The price of consumption goods must be set high enough above wages in that sector so that some consumption goods will be left for workers in other sectors. This allows some workers to be put in the investment sector (and government and trade sectors) to produce the surplus (goods and services) that workers cannot buy.

Prices ensure profits go to capitalists

At the micro level, each capitalist must be able to obtain a markup over labor costs. Market power helps at the micro level to ensure the individual capitalist can obtain a markup. But at the macro level, there won't be any profits to distribute unless there is spending in excess of the wage bill in the consumption sector. The aggregate, macro, price level determines the aggregate potential surplus to be divided among all the firms in society; the capitals compete at the micro level for profit flows. What generates this aggregate surplus to be realized by firms at the micro level? As the Kalecki-Levy equation shows, the aggregate amount of profits is identically equal to the sum of investment plus consumption out of profits plus the government's deficit and the trade surplus, less saving out of wages. (See Figure 2.) In the simplest model (no government deficit, balanced trade, and no saving out of wages), profits equal investment plus capitalist consumption: "Capitalists get what they spend", according to the Kalecki-Levy way of looking at profits. Again, as long as the price is set high enough that workers cannot buy all the output, capitalists can get the rest so long as they spend.

Prices ensure demand prices are consistent with supply prices so that capital assets are produced 360

361Capitalists get what they spend; but what determines their spending? Consumption out of profits is negligible--capitalists don't exist to consume. What is important is investment. Spending on investment depends on the demand price of capital assets (the price one is willing to pay to purchase them) relative to supply prices (the price at which suppliers are willing to produce them). We will go into this in detail shortly. If the demand price is below the supply price, no investment is forthcoming, which means there is no generation of profit (in the simple model). Thus, it is necessary for demand prices to exceed supply prices so that capital assets are produced, which then generates profits, and this validates previous investment. In the simple model, investment today determines whether investment yesterday was a good idea, but investment today depends on expectations about the future, which are incorporated into demand prices, and the relation of these to supply prices. Minsky liked to say that investment won't occur today unless it is expected to occur tomorrow because unless investment occurs in the future there will not be any profits (again, in the simple model).

Prices ensure firms can fulfill debt obligations

Clearly, prices at the individual firm level must be set sufficiently high as a markup over labor costs to ensure that the firm can service its debt. As we have seen, market share is a major determinant of the ability to set price at a level at which a share of the aggregate profit is obtained. However, whether there will be any aggregate profits to distribute depends on aggregate capitalist spending.

Prices ensure resources go to investment so that capital is accumulated

At the individual level, market share is important to maintain a sufficient markup--the source of profits at the micro level. Normally, a firm cannot even obtain finance unless it has market power. Each firm tries to set a price high enough to cover all expected costs and to provide a margin of safety. The bigger the margin of safety, the more willing banks are to lend. To put it very simply, the goal of every firm is to get market power so that it will have control over its markup so that it can get loans. Thus, the ability to set and maintain price is critical at the micro level to obtain loans and to service them. Schumpeter (1949, p. 70) argued that credit is the means by which capitalists ensure they can divert the allocation of resources to the investment sector. (See Wray 1994) Market power and the ability to set price is critical in determining who gets credit, but the amount of surplus available at the aggregate level depends on the aggregate markup. This, in turn, depends on capitalist spending, mainly on investment, although it is supplemented by government deficit spending and trade surpluses in the expanded model. In other words, market power and even technological efficiency only affect the distribution of profits, but not the aggregate amount. It is the aggregate spending on investment that generates the profits that validate the accumulated capital. Neither "thriftiness" nor even technology have anything directly to do with capital accumulation.

In this sort of world, with ability to affect price, and with expected price rather than actual price as the critical parameter, there is no reason to believe that equilibrium exists and even less to believe that it would be stable. Next we turn to Minsky's analysis of instability.

Natural Instability

When a "small government" economy is not at full employment, this causes wages and prices to fall. According to Patinkin, this increases aggregate (real) demand and moves the system back to full employment. (See Minsky 1986, pp. 133-138.) However, Minsky argued that in the real world, falling 361

prices make it impossible for debtors to meet commitments; this generates asset price deflation and repudiation362 of debt. According to Minsky, the economy will not turn around until the financial system is "simplified", or, a good portion of private debt is wiped out such that most positions in assets that remain are those that were not debt-financed--that is, equity positions. This is essentially what happened during the Great Depression. Alternatively, when this "small government" economy is at full employment, aggregate demand, investment and profits are high so that projects are successful on average. Success breads greater risk taking; borrowing and lending take place on smaller margins of safety; financial innovations make it easier to finance various schemes. This leads to a speculative boom as capital gains are generated and spending on assets booms. Over time, the financial structure becomes weak as increasingly risky financial positions are taken. Eventually, someone defaults and the whole financial system comes crashing down.

One might ask: if the economy is so unstable, why doesn't debt deflation or a runaway speculative boom occur anymore? Minsky argued that it is the ceilings and floors that have constrained the inherent instability. (Minsky and Ferri 1991) The Big Government has set ceilings and floors on prices of current output, helping to constrain the natural tendency of aggregate demand toward boom/bust cycle, while the Big Bank has put into place ceilings and floors on asset prices and, more specifically, prices of capital assets, helping to curb financial system instability. Minsky would thus argue that the economy is still inherently unstable, but is constrained within ceilings and floors. The endogenous instability of our system stems primarily from the interaction of finance and investment. Minsky characterized his approach as a "financial theory of investment and an investment theory of the cycle". Let us turn to his financial instability hypothesis--a hypothesis that follows from his approach to investment finance--and a detailed look at the evolution process in which the economy is transformed from one in which crisis is unlikely to one in which crisis becomes probable.

Financial instability hypothesis

We begin with Minsky's analysis of what he called the two price systems. His exposition is an alternative to the typical treatment presented in textbooks, which distinguishes between two primary components of aggregate demand, consumption and investment, but then posits a single aggregate "price level". In Minsky's view, this conflates two very different kinds of prices, or, really, systems of prices. Further, the two price systems analysis is a better way to analyze the financial capitalist economy than is the consumption/investment approach of the orthodox textbooks.

First, there is the price system for current output, which includes consumption, investment, government, and export goods and services. Prices of current output are essentially set as a markup over labor costs. Of course, market power allows the individual firm to set price at a greater markup. At the micro level, the markup distributes profits among firms, with market power leading to a greater share of profit flows. At the macro level, the markup delineates the aggregate amount of profit to be distributed among firms, which is realized only when spending on investment, plus capitalist consumption, plus the government deficit, plus the trade surplus and less worker saving is sufficient.

Second, there is the asset price system. Most importantly for Minsky's analysis, this includes the price of capital assets--which is critical to the determination of the amount of investment that will be undertaken, which, in turn, is a critical determinant of the amount of aggregate profit to be realized and distributed. The quantity of investment depends on the relation between the demand price and supply price of capital assets.

362

Figure 3 presents a simplified version of Minsky's investment model. The supply price, depicted as Pi has363 two main components: purchase price (as discussed above) plus financing costs. The purchase price comes from the price system for current output, because capital assets are part of current output; thus, this price is determined as a markup over labor cost. (Since some consumption goods and services are also financed, these would include finance costs in their supply price--but Minsky's model presented in Figure 3 applies directly to investment purchases only.) Of course, the alternative to newly produced capital assets is existing second-hand capital, however, in practice, capital assets are generally firm- specific and custom produced on order, thus, prices in second-hand markets are not usually an important source of competitive pressure. The purchase price can be thought of as a horizontal line, with the price independent of the quantity of investment, although it is possible that beyond some point it could be upward sloping due to bottlenecks. In addition to purchase price, unless capital assets are purchased wholly out of retained earnings, supply prices must also include finance costs--this is the primary reason for the kink in the Pi curve. Finance costs include explicit costs (interest rate and fees) and implicit costs (increased supervision by lenders). These tend to rise with the quantity of investment because lenders perceive greater risk associated with larger loans--what Keynes had called lender's risk. Lenders must take into account the balance sheet of the borrower (which is leveraging capital, net worth, and prospective income flows) as well as their own balance sheets. Informal rules of thumb are applied to maintain what is believed to be an adequate margin of safety. In short, the main component of Pi comes from the current output price system, however, because capital assets are typically financed, finance costs are also a significant portion of supply price.

The supply price must be weighed against the demand price--which mainly comes out of the asset price system. This is the price one is willing to pay for an asset, including capital. The main determinant of demand price is expected profit. However, expected profits are in the future and are uncertain, so are discounted before they can be compared with supply price. If the capital asset will have to be at least partially externally financed, the demand price must include a margin to compensate for what Keynes called borrower's risk. This is the main reason that the Pk curve is kinked--the greater the quantity of external finance required, the greater the perceived borrower's risk because of higher payment commitments. Expectations will affect the position of the curve--it will be higher with more optimism-- while the more fragile the financial structure or the more indebted the firm, the lower the curve.

For investment to occur, the demand price must exceed supply price. Innovations, changes of rules of thumb, changes of quantity of liquidity, and changes of perceived lender's and borrower's risk, will all shift the curves. There is no fixed rule about how liquid a portfolio should be, nor are there fixed rules about margins of safety. To a large extent, borrowers and lenders operate on the basis of trial and error; if a behavior is rewarded, it will be repeated. Thus, stable periods naturally lead optimism, to booms and to increasing fragility. If, however, government prevents any crises from becoming deflations, then riskier behavior is encouraged and financial positions evolve from robust to fragile.

Minsky used three terms to describe possible financial positions:

1. Hedge: income flows are expected to meet balance sheet outflows in every period. 2. Speculative: the firm must roll over debt because income flows are expected to only cover interest costs. 3. Ponzi: income flows won't even cover interest costs, so the firm must issue new liabilities at the end of each period to capitalize interest (or must sell-off assets).

363

Note that hedge positions are relatively immune to monetary policy--unless interest rates rise tremendously364 it is unlikely that interest costs will exceed income flows--while rising interest rates can turn a speculative position into a Ponzi position. Similarly, falling income flows can push a speculative position into a Ponzi position. According to Minsky,

It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system...[O]ver a protracted period of good times economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is a large weight to units engaged in speculative and Ponzi finance. (Minsky 1992, pp. 7-8)

The shift toward speculative positions, or fragility, occurs intentionally (and more-or-less inevitably because of the way in which expectations are affected by success in a boom), while the shift from speculative toward Ponzi finance is mainly unintentional.

Minsky's analysis typically began with the early post-war period, following the Great Depression that "simplified" balance sheets. The postwar economy thus commenced with hedge positions and conservative strategies. Over time, as the economy performed well, success bred innovations and revisions of rules of thumb, which allowed margins of safety to fall. The weight of speculative finance increased in the economy as a whole. As the expansion proceeded, one of two events could push some units to Ponzi positions that could precipitate a crisis: Either interest rates could rise or income flows could fail to meet expectations. Interest rates could begin to rise either "endogenously" as lenders began to build in larger "lender's risk" out of fear that balance sheets and become over-extended, or "exogenously" as the central bank began to fear inflation and thus instituted tight money policy. Alternatively, some borrowers might find income flows less than expected, leading to "belt-tightening" spending reductions that would cause income flows of others to fall below expectations. Of course, rising interest payments could also cause spending to decline (some spending is interest-elastic, and as interest rates rise the cost of servicing debt rises and can cause other spending to fall) which lowers income flows.

Thus, over the course of an expansion, the economy moves from hedge to speculative to Ponzi finance. Minsky argued that this is a necessary precondition for an unstable financial system. As income flows fall and as lenders cut-off lending to Ponzi units, economic units try to make position by selling out position. This generates falling asset prices and a Fisher-type debt deflation process. After a debt deflation, the system starts again with a robust financial system, leading to another boom and then to another crisis. However, postwar Big Government sustains profits, and Big Bank intervention prevents debt deflation and its purging effect, thus, the instability is constrained even as behavior changes in such a way as to increase the system's fragility.

Summary: Components of The Alternative Model

Let us summarize the key features of Minsky's alternative model of the financial capitalist economy.

The focus should be on firms, not on households, and on investment and its finance, not on consumption and saving out of household income flows.

364

This stands in sharp contrast to the exposition found in textbooks, which begin with households and their365 consumption/saving decision, and with thrift determining investment and therefore growth. Minsky's firms have market power--it is impossible to conceive of a perfectly competitive form of financial capitalism given the cost of modern capital equipment--which necessitates huge financial positions that must be validated. Only firms with substantial market power can give the necessary assurance that they will service such positions. The focus on financing of investment leads in turn to Minsky's two price approach--an alternative to the consumption/investment approach of textbooks (which presumes a single price system).

Cycles are endogenously generated, and are not due to shocks.

In large part, the cyclical behavior has to do with the interplay between the two price systems and the way the financial system evolves endogenously and toward fragility through time. While it is true that an exogenous event (failure of an important firm or bank, or imposition of tight money policy) can precipitate crisis, these events would not generate crises unless the system had evolved to a fragile position.

Agents in the model have a model of the model and the agents know the economy is naturally unstable.

This is why uncertainty plays a role in their decisions, why they must have contingency plans, why they build in margins of safety, and why liquidity matters. The world is uncertain--but in a very particular way. Minsky always argued that most of the uncertainty is over the validity of the model held by the agents. In other words, the problem is not that the sun might not come up tomorrow, or even that the stock market might crash. Rather, it is that we all operate on the basis of a particular view as to how the economy works, but we believe our understanding could be flawed. So Minsky always credited Rational Expectations theory with the recognition that agents have a model of the model; but he criticized it for what he called the heroic assumption that the agents have the correct model.

If government always intervenes to prevent deflation, it lowers the value of liquidity and margins of safety so that fragile balance sheets are accepted.

That is, agents change their model to include government intervention, so their behavior changes. Again, Rational Expectations was correct in criticizing the bastard Keynesian model of the textbooks which presumed that the fine-tuning government could intervene without inducing economic agents to change their behavior.

Money is endogenously supplied, and bankers live in the same expectational environment as everyone else.

If the value of liquidity is lowered, this increases the willingness of "lenders" to also reduce their own liquidity as they finance leveraged positions. In fact, bank money is leveraged money--it leverages high powered money, what Minsky called the "fundamental hierarchical property of our money and banking system." (Minsky 1986 p. 231)

The financial instability hypothesis is pessimistic: financial capitalism is fundamentally flawed because each success at crisis containment leads to further risk taking.

365

This fundamental flaw, in turn, results from the necessity of complex financial arrangements that must exist366 in an economy in which capital assets are expensive.

Big Government is necessary and countercyclical deficits are necessary to put a floor on aggregate demand and thus on current output prices. The Big Bank is necessary and lender of last resort intervention is necessary to put a floor on asset prices to prevent debt deflation.

But the other side of the coin is that regulations and supervision are needed and they must continually evolve so they stay only a step behind innovations. A variety of institutions are needed to constrain the inherent instability--they don't all have to come from government, but many must.

CONCLUSION

Minsky's analysis always concerned "modern" capitalism, a capitalism that could be called financial capitalism because of the important role played by financial arrangements in this sort of economy. Private ownership of expensive and long-lived capital assets normally necessitates access to external sources of finance. While modern corporations might have relied on equity finance of capital purchases, in practice this is not a significant source of funds. Instead, corporations have relied on a combination of retained earnings and debt issues. As Minsky argued, the problem is that debt entails a commitment to make nominal payments in the future. This, in turn, necessitates market power because a firm that cannot administer its prices cannot provide the necessary assurance that it will be able to service its debt. The "process of concentration" already recognized by Hilferding after the turn of the century, as well as the cartelization and "sabotage of production" noticed by Veblen a decade later represented the private sector's attempt to control price in order to protect profits and the ability to service debt. This failed spectacularly in the Great Depression, leading to the development of stronger institutional constraints. The New Deal and postwar reforms worked exceedingly well to constrain the natural instabilities of financial capitalism for several decades. However, successful containment of instability led to the evolution of fragile financial structures and to renewed financial crisis. The problem as Minsky saw it, is that the institutional reforms have not evolved to keep pace with innovations that make it more likely that "it" (another debt deflation) might happen again.

366

Figure 1: The NeoClassical Model 367

Figure 2: The Kalecki-Levy Equation

367

368

368

ENDNOTES 369 1. Minsky did not believe the Fed can control the money supply or even reserves even if it tried. He did believe the central bank can affect interest rates (most directly, the fed funds rate), but this would then affect private lending and private borrowing (thus, private expansion of the money supply) only indirectly and only at a critical phase of the business cycle--when what he termed "speculative positions" dominate. (See the discussion below.) 2. One could certainly argue that the propensity to runaway speculative boom has increased in the last two decades--a point recognized by Minsky, as we will discuss below. One could point to the savings and loan fiasco in the US during the 1980s, to the mid-1990s Asian "tiger" financial crisis, and to the late 1990s US stock market boom as examples of speculative excesses.

REFERENCES Hahn, F. 1983. Money and Inflation, Cambridge, Mass.: MIT Press.

Hilferding, R. 1981. Finance Capital: A study of the latest phase of capitalist development, London, Boston, and Henley: Routledge&Kegan Paul.

Ingrao, B., and Israel, G. 1990. The Invisible Hand: Economic equilibrium in the history of science, Cambridge, Mass.: MIT Press.

Kregel, J.A. 1995. "Neoclassical Price Theory, Institutions, and the Evolution of Securities Market Organisation", Economic Journal (March): 459-70.

Levy, S Jay, and David A. Levy. 1983. Profits and the Future of American Society, New York: Harper&Row.

Minsky, H.P. 1986. Stabilizing an Unstable Economy, New Haven, Conn.: Yale University Press. ------.

1991. "The Transition to a Market Economy", Working Paper no. 66, Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute, November. ------.

1992. "The Financial Instability Hypothesis", Working Paper no. 74, Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute, May. ------.

1993. "Finance and Stability: The Limits of Capitalism", Working Paper no. 93, Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute, May.

Minsky, H.P., Delli Gatti, D., and Gallegati, M. 1994. "Financial Institutions, Economic Policy and the Dynamic Behavior of the Economy", Working Paper no. 126, Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute, October.

Minsky, H.P., and Ferri, P. 1991. "Market Processes and Thwarting Systems", Working Paper no. 64, Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute.

Schumpeter, J.A. 1949. The Theory of Economic Development: An inquiry into profits, capital, credit, interest and the business cycle, Cambridge Mass.: Harvard University Press.

369

Veblen, T. 1919a. On the Nature and Uses of Sabotage, New York: Oriole Chapbooks. ------. 370 1919b. The Industrial System and the Captains of Industry, New York: Oriole Chapbooks.

Wray, L.R. 1989. "Government Deficits, Investment, Saving, and Growth", Journal of Economic Issues, 23, 4 (December): 977-1002. ------.

1994. "Government Deficits, Liquidity Preference, and Schumpeterian Innovation", Economies et Societes 9 (January/February): 39-59. ------.

1998. Understanding Modern Money: The key to full employment and price stability, Cheltenham: Edward Elgar. ------.

1999. "The 1966 Financial Crisis: A case of Minskian instability?", Working Paper no. 262, Annandale- on-Hudson, N.Y.: The Jerome Levy Economics Institute, January.

370

Theorie des Geldes und der Umlaufsmittel. by Ludwig von Mises; Geld und Kapital. by Friedrich371 Bendixen Review by: J. M. Keynes The Economic Journal, Vol. 24, No. 95 (Sep., 1914), pp. 417-419 Published by: Wiley-Blackwell for the Royal Economic Society Stable URL: http://www.jstor.org/stable/2222004 Accessed: 26/11/2012 15:18 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Wiley-Blackwell and Royal Economic Society are collaborating with JSTOR to digitize, preserve and extend access to The Economic Journal. http://www.jstor.org This content downloaded by the authorized user from 192.168.52.61 on Mon, 26 Nov 2012 15:18:10 PM All use subject to JSTOR Terms and Conditions

1914] MISES: THEORIE DES GEI,DES 417

Theorie des Geldes und der Umlaufsmittel. By LuDWIG VON MrsES. (Munich: Duncker and Humblot, 1912. Pp. xi+ 476. M. 10.) Geld und Kapital. By FRIEDRICH BENDIXEN. ( Leipzig : Duncker and Humblot, 1912. Pp. 187. M. 4.50.)

DR. VON MrsEs' treatise is the work of an acute and cul­ tivated mind. But it is critical rather than constructive, dialectical and not original. The author avoids all the usual pitfalls, but he avoids them by pointing them out and turning back rather than by surmounting them. Dr. Mises strikes an outside reader as being the very highly educated pupil of a school, once of great eminence, but now losing its vitality. There is no "lift" in his book; but, on the other hand, an easy or tired acquiescence in the veils which obscure the light rather than a rending away of them. One closes the book, therefore, with a feeling of disappointment that an author so intelligent, so candid, and so widely read should, after all, help one so little to a clear and constructive understanding of the fundamentals of his subject. When this much has been said, the book is not to be denied considerable merits. Its lucid common sense has the quality, to be found so much more often in Austrian than in German authors, of the best French writing. The field covered is wide. The first book deals with the meaning, place, and function of money; the second with the value of money, the problem of measuring it, and the social con­ sequences of variations in it; and the third with the relation of bank-money, of notes, and of discount policy to the theory of money. With the exception of the section on the value of money, where Dr. von Mises is too easily satisfied with mere criticism of imperfect theories, there is a great deal on every one of these topics very well worth reading. Perhaps the third book is, on the whole, the best. The treatment throughout is primarily theoretical, and quite without striving after actualite. The book is "enlightened" in the highest degree possible. The second of the two books under review is a collection of brief essays, many of them reprinted from Bank-Archiv, by a director of the H ypothekenbank of Hamburg. If the book had come from the pen of an English bank director it would have been little short of a prodigy. But the relation between knowledge and practice is ordered differently in Germany. The first seven essays deal with the theory of money, and are chiefly intended to

371

This content downloaded by the authori;r.cd user rrom 192. 1 68.52.61 on Mon, 26 Nov 201 2 1 5: 1 8: 1 0 PM All use subject to JSTOR Tcmt s and Conditions

372 418 THE ECONOMIC JOURNAL (SEPT.

popularise the ideas of G. F. Knapp, of whom Dr. Bendixen is evidently a devoted disciple and admirer. When he reminds us that Knapp thinks nothing of writing such things as that "der aus pantopolischen Ursachen gestorte Wechselkurs nicht nur durch Hylolepsie und Hylophantismus sondern auch auf exodromischen Wege reguliert werden konne," even those who have had a classical (as well as a German) education will be grateful for a simpler pen. It was Lotz, I think, who calculated that Knapp introduces in Die staatliche Theorie des Geldes some­ thing like seventy new technical terms, without explaining the meaning of any of them. It is perhaps partly for this reason that followers of Knapp show a distinct tendency to regard him at least as much in the light of a prophet as in that of an economist. Indeed, there may be some positive value in such a style; for there are few exercises better calculated tQ stimulate one's own ideas than a close and patient study of a work in which the words can only be understood by ref erence to the context, and the context only by reference to the words. There can be no complaint, however, against Dr. Bendixen on the score of obscurity. With him all is clear and simple, and his only fault is to exaggerate somewhat the novelty and import­ ance of his master's ideas. The old "metallist " view of money is superstitious, and Dr. Bendixen trounces it with the vigour of a convert. Money is the creation of the State ; it is not true to say that gold is international currency, for international con­ tracts are never made in terms of gold, but always in terms of some national monetary unit ; there is no essential or important distinction between notes and metallic money ; money is the measure of value, but to regard it as having value itself is a relic of the view that the value of money is regulated by the value of the substance of which it is made, and is like confusing a theatre ticket with the performance. With the exception of the last, the only true interpretation of which is purely dialectical, these ideas are undoubtedly of the right complexion. It is probably true that the old "metallist" view and the theories of regulation of note issue based on it do greatly stand in the way of currency reform, whether we are thinking of economy and elasticity or of a change in the standard; and a gospel which can be made the basis of a crusade on these lines is likely to be very useful to the world, whatever its crudities or terminology. The rest of Dr. Bendixen's book is devoted to banking topics, and chiefly to the Reichsbank. While admitting that the element of private capital in the Reicbsbank has been valuable in pre-

This content downloaded by the authorized user from 192.168.52.61 on Mon, 26 Nov 201 2 15:18:10 PM All use subject to JSTOR Tenus and Conditions 1914] INNESWHAT IS MONEY'? 419

venting the institution from being used in the interests of the most powerful party in the State, and while allowing that the Con­ servatives wish the State to buy out the shareholders mainly in the hope that their party may then be able to direct the bank's policy in agrarian interests, he thinks that a constitution which leads to the bank's being run to a considerable extent with a view to profit has grave disadvantages. Neither the State nor the share­ holders should derive from the bank varying profits which may tempt either party to subordinate policy to gain. The wide use of a cheque and clearing-house system, to take one instance, will never be developed in Germany, according to Dr. Bendixen, so long as the Reichsbank's profits are partly dependent on a main­ tenance of the existing state of affairs. As a banker of Hamburg, where the cheque or "giro" system is almost as fully developed as in England, Dr. Bendixen naturally regards the rest of Ger­ many as grossly backward and uncivilised in this respect. On numerous other points of recent banking policy in Germany Dr. Bendixen makes penetrating criticisms. Amongst these may be mentioned his exposure of the foolishness of the half-hearted attempts which have been made to discourage the investment of German capital abroad, and of the futility of the Reichsbank's attempts to ease off the pressure on its resources at quarter days by refusing to lend to the market for very short periods. I have described Dr. von Mises' book as "enlightened." If a

372

corresponding epithet is to be applied to Dr. von Bendixen's book, I should describe it as "emancipated "- which,373 within the sphere of what is liberal and intelligent , is at the opposite pole. Dr. von Bendixen is without the cultivated subtlety of Dr. von Mises, but his practical wisdom is of a high order. Hamburg's mind is not so clever as Vienna's, but more comes of it. J. M. KEYNES

373

Supplemental Reading List 374 JEP = Journal of Economic Perspectives JEL = Journal of Economic Literature Articles in the JEL are more advanced than articles in the JEP. The JEP and JLE are in the stacks.

Classical Economics T. W. Sowell, Say’s Law, Princeton U. Press, 1972. T. W. Sowell, Classical Economics Reconsidered, Princeton U. Press, 1974.

Monetarism R. J. Gordon, ed., Milton Friedman’s Monetary Framework, U. of Chicago Press, 1974.

Supply-side Analysis R.H. Fink, Supply-side Economics, Alethia Books, 1982. (Chapters 2, 4, 6, & 8) V. A. Canto et al., Foundations of Supply-Side Economics, Academic Press, 1983.

New Classical Theory K. D. Hoover, Two Types of Monetarism, JEL, v. XXII, no. 1, March 1984.

Real Business Cycles C. I. Plosser, Understanding Real Business Cycles, JEP, v. 3, no.3, Summer 1989. N. G. Mankiw, Real Business Cycles: A New Keynesian Perspective, JEP, v.3, no.3. Summer 1989. G. W. Stadler, Real Business Cycles, JEL, v. XXXII, no. 4, December 1994.

New Keynesianism N. G. Mankiw, Symposium on Keynesian Economics Today, JEP, v.7, no.1. Winter 1993. D. Romer, The New Keynesian Synthesis, JEP, v.7, no.1. Winter 1993. B. Greenwald and D. Stiglitz, New and Old Keynesians, JEP, v.7, no.1. Winter 1993. J. Tobin, Price Flexibility and Output Stability: An Old Keynesian View, JEP, v.7, no.1. Winter 1993. R. G. King, Will the New Keynesian Macroeconomics Resurrect the IS-LM Model? JEP, v.7, no.1. Winter 1993. R. J. Gordon, What is New-Keynesian Economics? JEL, v. XXVIII, no. 3, September 1990.

Post Keynesian Theory P. Davidson, Controversies in Post Keynesian Economics, Edward Elgar, 1991. P. Davidson, Post Keynesian Macroeconomic Theory, Edward Elgar, 1994. P. Davidson, The Keynes Solution, Palgrave Macmillan, 2009.

Fisherian Debt-Deflation Theory I. Fisher, The Debt-Deflation Theory of Great Depressions, Econometrica 1(4): 337-357. 2010 [1933]. I. Fisher Booms and Depressions: Some First Principles; Adelphi. 2010 [1932] I. Fisher, 100% Money and the Public Debt, Economic Forum, ,April-June, 1936, 406-420.

Minsky’s Financial Instability Hypothesis H. Minsky, Stabilizing and Unstable Economy, McGraw-Hill 2008 [1986]. H. Minsky, Can “It” Happen Again? E. Sharpe. 1982.

Austrian Theory R. W. Garrison, Time and Money: The Universals of Macroeconomic Theorizing, Journal of Macroeconomics, v. 6, no. 2, Spring 1984.

R. W. Garrison. 2001. Time and Money: The Macroeconomics of Capital Structure. Routledge. 374

(I know 375that the title is identical to that of another reading by the same author, but the subtitle and, of course, the content, though related, is different.)

375