“Has the Fed Been a Failure?”

The Federal Reserve, America’s fatally conceited monetary central planner, is not terribly popular these days—which is cause for hope—and now we have a report card on the entire Fed era that strongly supports the view that we’d be better off without it. At the very least, as the authors suggest, the burden of proof is squarely on those who would retain the central bank.

The report card comes in the form of a working paper from the Cato Institute: “Has the Fed Been a Failure?” by George A. Selgin, William D. Lastrapes, and Lawrence H. White.
The authors state in their abstract:

As the one-hundredth anniversary of the 1913 Federal Reserve Act approaches, we assess whether the nation’s experiment with the Federal Reserve has been a success or a failure. Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

In light of the Fed’s defined mission—monetary support for economic growth, stable prices, maximum employment—the authors use the following criteria to assess its record: “the relative extent of pre- and post-Federal Reserve Act price level changes, pre- and post-Federal Reserve Act output fluctuations and business recessions, and pre- and post-Federal Reserve Act financial crises.” The Fed has done poorly on every count. No one familiar with the Mises-Hayek critique of central planning will be surprised. Central banking is not equivalent to comprehensive planning of the economy, but money is the most pervasive good and monetary engineers suffer the same insurmountable ignorance as any central planner.
I can only hit the paper’s highlights here.

Inflation

Selgin et al. pronounce the Fed a dismal failure in controlling inflation. “[F]ar from achieving long-run price stability, it has allowed the purchasing power of the U.S. dollar, which was hardly different on the eve of the Fed’s creation from what it had been at the time of the dollar’s establishment as the official U.S. monetary unit, to fall dramatically.”
The value of the dollar was essentially stable from the late eighteenth century to the second decade of the twentieth century! “A consumer basket selling for $100 in 1790,” they write, “cost only slightly more, at $108, than its (admittedly very rough) equivalent in 1913.”
And since that time? “[T]hereafter the price soared, reaching $2,422 in 2008. . . . [M]ost of the decline in the dollar’s purchasing power has taken place since 1970, when the gold standard no longer placed any limits on the Fed’s powers of monetary control.”
The dollar has lost 95 percent of its value since the Fed came into existence.

Deflation

The authors say that since the Great Depression the Fed has rid the economy of deflation (defined as falling prices), which was a feature of the late nineteenth-century economic landscape. Economists, including Fed chairman Ben Bernanke, generally deem deflation as something to be avoided at almost all costs, so they would give the Fed kudos in this respect. But Selgin et al. point out (as have others, such as Steven Horwitz, in the January/February 2010 Freeman) that what matters is not deflation per se but the kind of deflation:

Harmful deflation—the sort that goes hand-in-hand with depression—results from a contraction in overall spending or aggregate demand for goods in a world of sticky prices. As people try to rebuild their money balances they spend less of their income on goods. Slack demand gives rise to unsold inventories, discouraging production as it depresses equilibrium prices. Benign deflation, by contrast, is driven by improvements in aggregate supply—that is, by general reductions in unit production costs—which allow more goods to be produced from any given quantity of factor and which are therefore much more likely to be quickly and fully reflected in corresponding adjustments to actual (and not just equilibrium) prices.
Historically, benign deflation has been the far more common type.

During roughly the last quarter of the nineteenth century, prices in the United States declined 37 percent—1.2 percent a year on average. That’s what the Fed has saved us from, thank you very much.

Frequency and Duration of Recessions

Again, the pre-Fed record is better than the Fed’s performance. Drawing on the latest research, the authors conclude:

[A]lthough contractions were indeed somewhat more frequent before the Fed’s establishment than after World War II (though not, it bears noting, more frequent than in the full Federal Reserve sample period), they were also almost three months shorter on average, and no more severe. Recoveries were also faster, with an average time from trough to previous peak of 7.7 months, as compared to 10.6 months. Allowing for the recent, 18-month-long contraction further strengthens these conclusions.

Moreover, the Fed has violated traditional standards by bailing out insolvent banks. Selgin et al. reject the “too big to fail” doctrine, arguing that the fear-mongering about “systemic risk” is unsubstantiated. Bailing out the creditors of insolvent institutions, as the Fed did during the current financial crisis, has increased the future exposure of the public by reinforcing moral hazard—encouraging excessively risky behavior by creating the expectation of government rescue. In the process the Fed has gone from lender of last resort to allocator of capital—an ominous move toward central planning.
The authors do not endorse the pre-Fed system, which was heavily regulated by the national and state governments. Indeed, for most of American history interstate and intrastate branch banking was illegal, producing an industry of uncompetitive and undiversified banks.
Nor do they explore the free-banking alternative, though Selgin and White are well-known advocates of it. Instead they confine their analysis to various rules that would take away the Fed’s discretionary power over the money supply. These would be improvements but a far distant second to free banking.
The authors leave no doubt that “the Fed’s poor record calls for seriously contemplating a genuine change of regime.”

FOOD FROM THOUGHT

FOOD FROM THOUGHT -

  Charles W. Williams

  Important events in the exciting history of food have interesting, divergent, and often accidental beginnings.

  In 1856 a boy in Pittsburgh grew some extra horseradish in his mother’s garden. He borrowed a wheelbarrow, which he filled with bottles of ground horseradish and sold to local grocers. The boy was Henry Heinz; and from this first bottle of horseradish sauce grew the intricate world-wide business of the H. J. Heinz Company. Before 1900 that one variety had grown to 57, which today numbers close to 570 in this far-flung food empire.

  In 1904 Thomas Sullivan, a tea merchant, sent samples of his various blends of tea to a few of his customers packed in little, hand-sewn silk bags. To his amazement, orders began pouring in by the hundreds for his tea put up in bags. His customers had discovered that tea could be made quickly without muss or fuss by pouring boiling water over tea bags in cups. Thus, quite by accident, was the start of a million-dollar innovation in the sale of tea.

  In 1890 a salesman living in Johnstown, New York, while watching the time it took his wife to make some calf’s-foot jelly, decided that powdering gelatin would save a lot of time in the kitchen. Charles B. Knox put his idea into operation, hired salesmen to go into peoples’ homes to show how easily his gelatin could be dissolved in water and used. His wife worked out recipes for aspics and desserts to be given away with each package. This was the beginning of Knox Gelatine known today by every American housewife.

  Peter Cooper, the inventor of the ‘‘Tom Thumb” locomotives, also invented a process for mixing powdered gelatin, sugar, and fruit flavors. This was fifty years before it began to appear on grocers’ shelves as Jell-O. He was too early; merchandising methods had not been developed to convince housewives of the need for ready prepared foods. Just before the beginning of this century spectacular advertising for its day pointed out how many desserts could be prepared from this inexpensive, neat, clean package of Jell-O. Recipe booklets were distributed by the millions, as many as 15 million in one year, unheard of in that day. Another billion-dollar food business was launched.

  Count Rumford, born in Massachusetts, who later migrated to England, was a leading physicist of the nineteenth century. He built the first kitchen range designed for use in a prison in Munich. This proved so efficient and workable that many wealthy people commissioned Count Rumford to replace their open hearth type of cooking apparatus with these new contraptions in their manor kitchens. By 1850 many American manufacturers had adapted Rum-ford’s invention and were producing cast iron ranges in many sizes and shapes, lavishly decorated. From an experimental prison range, the modem stove industry was born.

  In 1914 a young scientist from Brooklyn, New York, named Clarence Birdseye joined a scientific expedition to Labrador. He was also an avid sportsman, so he lost no time. He cut a hole in the thick arctic ice to try his hand at fishing. The fish froze as soon as they Were exposed to the subfreezing air, often before he had them off the hook. To his surprise, the fish could be kept frozen for weeks and then defrosted and cooked like a fresh fish without any loss of texture or flavor. After returning to the United States, Birdseye made the same discovery while hunting caribou. The steaks from the quick-frozen caribou could later be broiled to a juicy, flavorsome rareness. Because of World War

  I, he had to drop many additional experiments in quick-freezing all kinds of food. After the war he went into the fishery business in Gloucester, Massachusetts, and experimented with fast freezing on the side. With a tremendous amount of good salesmanship, he raised money for the first quick-frozen food company. The first Birdseye package went on sale to the public in 1930. It would have been difficult to believe, at that time, that within a relatively few years almost every segment of our giant American food industry would be in quick freezing.

  In Boston in 1894 a boardinghouse keeper was criticized by a sailor in her rooming house because her puddings were lumpy. Insulted at first, she became interested when he explained that the South Sea island natives pounded tapioca to a smooth consistency and suggested that she experiment by running some through her coffee grinder. Sure enough from there on her puddings were as smooth as silk. Soon she was putting up her finely ground tapioca in bags and selling them to her neighbors. She chose a very magic name—“Minute Tapioca”—and soon found a big business on her hands. Many quickly prepared foods have since copied the word “minute,” but today a minute does not seem fast enough and has been replaced by “instant.”

  Many people believe Aunt Jemima to be a fictional name representing an old-fashioned Negro mammy. On the contrary, the name of this ever-popu-lar pancake mix was inspired by a real, live person. A widow who lost all her money and could no longer pay wages to the faithful old family cook worked out a formula with her real-life Aunt Jemima and managed to borrow enough money so they could jointly put their product on the market. The mix brought fame and fortune to the real Aunt Jemima and her former penniless mistress.

  Chiffon cake was billed in huge cake mix ads in the 1940’s as the “first really new cake in a hundred years.” Harry Baker was a professional baker and owned a pastry shop in Hollywood, California. For years celebrities had flocked to his store and raved about his cakes. Many cooks feel that their personal recipes should be very valuable to some big food manufacturer but are shocked to find that variations of nearly every recipe have already been tried in the research kitchens. Harry Baker was one of the lucky ones; he sold his recipes for many thousands of dollars to General Mills. The valuable secret of his chiffon cake was that instead of shortening he used salad oil.

  Going back many years to 1520, Cortez, the Spanish conqueror of Mexico, observed native Mayan Indians treating tough meat with the juice of the papaya, a common fruit in most tropical lands. He noted this in his writings about his conquest. Strangely enough, this find lay dormant until recent years, when the tenderizing element in papayas was turned into a powder, put up in jars ready to sprinkle on the surface of meat to make chuck and round steaks as tender as sirloin and porterhouse. From this long-forgotten idea came Adolph’s Meat Tenderizer, a necessity in many homes.

  In 1824 a German doctor living in Venezuela had a Spanish wife who had been sickly for years. Determined to cure her, he worked for over a year on a formula of herbs and spices until he invented a tonic that he claimed brought her back to health. Sailors stopping at the little port of Angostura found that this blend of herbs, spices, and the blossoms of the blue Gentian plant would cure seasickness. They spread the fame of Angostura bitters around the world, the process being speeded when they learned to add it to their ration of rum. When it became an essential part of a Manhattan cocktail, its place in our lives was further assured. Later, it was found to be an excellent addition in many food recipes, and today Angostura Bitters is found on almost everyone’s food shelf.

  Early traveling merchants from the city of Hamburg, Germany, learned from the Tartars in the Baltic Sea area how to scrape raw meat, season it with salt, pepper, and onion juice to make what is still called tartar steak. The people of Hamburg soon adopted the tartar steak. After many years some unknown Hamburg cook made patties out of the raw meat and broiled them brown on the outside and still pretty raw on the inside—a true hamburger. Today in the butcher shops of America, ground hamburger meat accounts for 30 per cent of all the beef sold to consumers.

  The Toll House was a country inn in Massachusetts noted for good food. In the early 1940’s Ruth Wakefield, who was then mistress of the inn, started serving a crisp little cookie studded with bits of chocolate. Miss Wakefield readily gave her customers the recipe, and all of a sudden, bars of semi-sweet chocolate began vanishing from the shelves of the stores in the area. It didn’t take long for the Nestle Company, and later Hershey, to smoke out the fact that everyone was making the cookie recipe from the Toll House; and soon they were selling millions of packages of chocolate bits specifically so people could make these wonderful cookies. Today it is America’s most popular cookie, available frozen, in ready-to-use cookie mixes, and already made in packages.

  The early Chinese found that seaweed dried and ground into a powder and added like salt to food had a magical effect on meats and vegetables—all their natural flavor was enhanced. That’s why Chinese food became so popular all over the world. Eventually our chemists discovered the flavor-enhancing element and called it glutamate. Today this product, monosodium glutamate, made from beet sugar waste, soy beans, or wheat, is a staple item in every market. It is known to American shoppers as Ac’cent.

  Gail Borden, the son of a frontiersman, went to London in 1852 to sell a dehydrated meat biscuit at the International Exposition being held in England. He used all his money trying to put over his idea and had to travel steerage to get home. He was appalled at the crowded, miserable conditions imposed on the immigrant families coming to America. During the trip several infants died in their mothers’ arms from milk from infected cows, which were carried on board most passenger vessels to furnish milk, cream, and butter for the passengers. Borden was sure there was a way to preserve milk for long voyages; but many before him had tried and failed, including Pasteur. After four years of intensive research, Borden perfected a process of condensing milk. In 1856 his patent was approved in Washington. After much work selling the idea to skeptics, the first canned milk was introduced to the American market and formed the cornerstone of the vast and diversified Borden Company.

  In Battle Creek, Michigan, Ellen Gould White had a dream one night in which she was told by the

  Lord that man should eat no meat, use no tobacco, tea, coffee, or alcoholic beverages. As a Seventh Day Adventist she established the “Health Reform Institute,” a sort of sanitarium, where her guests ate nuts disguised as meat and drank a cereal beverage. This beverage was the creation of one of her guests named Charles William Post, who was suffering from ulcers. He named his beverage Postum. Post also invented the first dry breakfast cereal, which he called “Elijah’s Manna.” He decided to go into business producing his inventions; but the name Elijah’s Manna ran into consumer resistance, so he changed it to “Grape Nuts.”

  In this same sanitarium was a surgeon named Dr. Harvey Kellogg, whose name along with Post’s was destined to be on millions of cereal packages every year. One of Dr. Kellogg’s patients had broken her false teeth on a piece of zwiebach, so he invented a paper-thin flake cereal from com. Breakfast cereals immediately became a rage, and at one time there were as many as forty different companies in Battle Creek competing for this new health food business. So began the vast cereal business of today.

  Margaret Rudkin was the wife of a stock broker and her son suffered from allergies. She made an old-fashioned loaf of bread from stone-milled whole wheat flour, hoping to build up her son’s health. The bread helped her son; so her doctor persuaded her to bake the bread for some of his patients, and soon she was in business. When this bread was introduced in the thirties, it competed at 25¢ against the spongy white variety selling at 10¢. Within 10 years, Maggie Rudkin’s Pepperidge Farm Bread was in demand all over the East Coast and other bakers were making similar loaves— another small beginning for a nationally-known company, Pepperidge Farms.

  One night Teddy Roosevelt, who had been visiting the home of President Andrew Jackson, stopped for dinner at the Maxwell House, a famous eating place nearby. Roosevelt, a great extrovert, was so delighted with the coffee that when he finished he replaced the cup in the saucer with a formal gesture and cried out heartily, “that was good to the last drop,” a phrase destined to make quite famous the coffee named after the Maxwell House.

  St. Louis, Missouri, was the site of two important developments in the realm of food. In 1904 an Englishman was tending a booth at the St. Louis International Exposition demonstrating the virtues of a hot cup of tea. This was an insurmountable task during the hot July days in the Mid-West. Our Englishman, Richard Blechynden, disparagingly wiped the perspiration from his face as he watched the crowds pass him by. Finally, in desperation, he threw some ice into the hot tea urn and the crowds began to swarm around his booth. The drink was a sensation, and iced tea quickly became one of America’s most popular thirst quenchers.

  Still in St. Louis, but back in 1890, a physician ground and pounded peanuts to provide an easily-digested form of protein for his patients. The result was peanut butter, which was quickly and rightly adopted by food faddists all over the country. Today it is a staple found in almost every American kitchen. It’s a rare mother who isn’t thankful for healthful peanut butter when nothing else seems to tempt her children’s appetites.

  So, with these ancedotes, one can see that almost every great food company or food idea had a small but fascinating beginning. Some came quite by accident, others from diligent perseverance, reflecting the drive and ingenuity of the human race—free enterprise among free men.

  Of all aspects of the free market economic system, the role of profit-making by individuals is the one most subject to controversy. An air of apology seems to permeate any discussion of profit-making, even among those who generally commend the market society.

WHY SPECULATORS?34.*

  Percy L. Greaves, Jr.

  Back in February, 1871, a group of free enterprisers found a way to help cotton growers adjust their production to market demand. They organized the New Orleans Cotton Exchange. There, for 93 years, cotton growers, wholesalers, manufacturers, and profit-seeking speculators could buy and sell cotton at free market prices for present and future delivery.

  The prices paid and offered were published in the press. No cotton grower or user was long in doubt about the state of the cotton market, present or future. For there is no better indicator of the state of a commodity market than the prices at which that commodity is bought and sold for various dates of delivery.

  The prices of the New Orleans Cotton Exchange were long a valuable guide for farmers and manufacturers alike. For farmers, they indicated how much land should be planted in cotton and how much in other crops. Through the growing season, future prices indicated how much time, care, and expense should be spent in tending crops. When future prices were high, no expense was spared to bring every possible ounce to market. When future prices were low, farmers were warned not to waste too much time and expense cultivating and picking that last possible ounce.

  For manufacturers and other cotton buyers, the Cotton Exchange quotations provided a base for estimating or determining their future raw material costs. This in turn helped them calculate the prices on which they bid for future business. On orders accepted for delivery over long periods of time, they could always make sure of their raw material costs by immediately buying contracts for delivery of cotton on the dates they would need it.

  Cotton Prices Controlled

  On July 9, 1964, the New Orleans Cotton Exchange closed its doors to trading in “cotton futures,” as contracts for future delivery are known. For years such sales have been fading away. With cotton prices more and more controlled by the government, neither farmers nor manufacturers need the information or insurance of a futures market.

  When demand for cotton drops off, the government advances the subsidized price to farmers and stores all unsold cotton. When demand for cotton rises, cotton pours out of government subsidized warehouses and sells at the government set price. Either way, the taxpayers lose. Until present laws change or break down, cotton prices will be set by the government, cotton acreage will be guided by bureaucrats, and valuable men, materials, and tax money will continue to be wasted in nonproductive enterprise.

  This situation reflects a complete lack of understanding of the rules of human behavior and the role of speculators in a free market society. It substitutes the wisdom of a few striving to stay in political power for the wisdom of those who spend their lives studying every facet of supply and demand before pledging their names and fortunes in support of their considered judgment.

  It is human nature for men to try to improve their future conditions. That is the aim of every conscious human action. Men make mistakes, but they always aim at success in providing a better future for themselves or their loved ones. Free market transactions are merely the attempts of men to improve their own situations by social actions which also improve the situation of others. Barring force, fraud, or human error, all voluntary market transactions must improve the situations of all participants.

  How Men Act

  Actually, there are only three basic principles of human action. Men can act as gamblers, scientists, or speculators. Few acts fall entirely within any one classification. For every human action is confronted by elements of future uncertainty, such as those that exist in life itself.

  Men act as gamblers when they know nothing in advance about the results except that some will win and others lose. There is nothing a man can know, study, learn, or experience that will help him to become a winner. When men gamble, the desired results depend upon pure chance. No skill whatsoever is involved.

  Men act as scientists when they know in advance the results their actions will produce. Scientists deal only with solvable problems where conditions can be controlled and where identical actions in identical situations will always produce identical results. Automation is a modem example of scientifically directed action. In all scientific action, the repetition of prescribed procedure will always produce the same results. So, the more that scientists know about the laws of nature, the more they can undertake with prior certainty as to the actual results.

  Men act as speculators when they have only partial knowledge and understanding of the results their actions are likely to produce. The more speculators know and understand, the better they can predict the future results of their actions. But they never can be certain of the actual results.

  Most speculations involve people and how they will react to given situations. Since we can never know with certainty the future reactions of others, every action which involves others is a speculative action. Thus, all voluntary actions, including market actions, are speculative.

  Why Men Specialize

  The best way to increase the probability that speculative actions will produce the desired results is to increase our knowledge and understanding of all pertinent data, including the thoughts and ideas that motivate the actions and reactions of others. This takes time, study, experience, and economic analysis.

  Men have found that the best way to gain more of the needed knowledge, experience, and understanding is for each one to select some limited area of human activity and then specialize in it. Out of this division-of-labor principle the whole market system has developed. In a market society, everyone specializes and then trades the products of his specialty for the products of other specialists, his partners in total social production.

  This system permits scientists to specialize in the automatic mass production of inanimate objects of wealth with certainty as to the physical results. However, men cannot plan or plot the market value of their products with scientific certainty. All such values are relative and speculative. They depend on the ever-changing ideas of buying men as to which of the many things offered for sale will give them the most satisfaction for the sums they have to spend.

  Specialization can and does help men engaged in marketing and other speculative social actions. It permits them to learn more about what they sell and also more about the needs and wants of those to whom they seek to sell. Thus they become wiser and more efficient speculators, wasting less time trying to sell the wrong things to the wrong people.

  Perfect results depend on the perfect prediction of future conditions. Because of human fallibility, this is rarely possible. However, better predictions and thus better results are often achievable. Greater specialization tends to reduce errors and help men achieve better results.

  Many men prefer the relative security of a reasonably assured steady income to the insecurity of a wholly speculative income—an income that may turn out to be very high, very low, or even a net loss. Such security-seeking people tend to become employees.

  Others prefer the lure and excitement of speculation. Such people are the investors, employers, business promoters, and professional speculators.

  They assume responsibility for the uncertainty of a business venture’s future success or failure. Their likelihood of success depends largely on their ability to predict the future wants of buyers.

  Better Foresight Pays

  In a mass production market economy, the function of prediction and speculation falls primarily on investors, business promoters, and specialists rather than on consumers. When producers seek to act as scientists only, creating wealth by relying on the known laws of the physical sciences, they must find others to undertake the predictions and speculations as to the future conditions of the market.

  Such specialists must estimate, at the time production starts, what consumer demand, competitive supplies, and other market conditions are likely to be at the time of sale. Such speculators then assume the responsibility that the planned production will meet the whims and wishes of consumers. Their income will depend on how correct their early predictions of future conditions prove to be.

  As the division of labor has progressed, men and firms have tried to reduce their predictive and speculative functions to limited areas in which they become specialists with a better understanding than most other men. They concentrate on making or marketing certain goods and, in doing so, pay little attention to the market conditions of other goods, including their raw materials which may come from far-away sources with which they are unfamiliar.

  Of course, the future prices they can get for their finished goods are in part dependent upon the ever-changing prices of the raw materials with which they are made. So, to protect themselves against future price fluctuations in their raw materials, businessmen sometimes engage in “hedging.” By “hedging,” they transfer the hazards resulting from the uncertainty of future prices to professional speculators in those products.

  How Hedging Works

  A good example of “hedging” is the case of the cotton shirt manufacturer. He is a specialist in making and selling shirts. He knows that the selling price of cotton shirts is largely dependent upon the price of raw cotton. He has little time to study the cotton-growing conditions around the world or the other prospective demands on the raw cotton supply. He is fully occupied with his own problems in the shirt business. However, he would like to avoid the consequences of unforeseen changes in the prices of raw cotton.

  Under free market conditions, he can hedge by contracting to sell at current prices raw cotton which he need not buy or deliver until the date he expects to sell the shirts he is making. Then, if the price for shirts has fallen, due to a drop in raw cotton prices, he would buy raw cotton at the lower price to meet his hedging contract. The profit on his raw cotton transaction would offset his loss on the shirts.

  On the other hand, if the prices of both raw cotton and cotton shirts have risen, the extra profits from his shirt sales will be offset by his losses on the hedging transaction in raw cotton. By hedging he can protect himself against all possible fluctuations in raw cotton prices which might affect the prices of the shirts he sells. He rids his mind of this worry so that he can concentrate on the details of the shirt business at which he is a specialist.

  The man who takes his hedge is usually a professional cotton speculator. He is a specialist who studies and interprets all the available data and conditions that are likely to affect future raw cotton prices. He trades in cotton a thousand times for every once or twice by the average cotton manufacturer. He knows how much has been planted in the many cotton-growing countries. He studies the rainfall and other weather conditions which may affect the size of the various crops. He keeps up-to-date on laws and proposed laws that may affect raw cotton prices. He follows the ups and downs in foreign exchange and transportation costs.

  He also keeps an eye open for changes in demand for each type of cotton. He has informed ideas about increased demands arising from new uses for cotton, as well as any decreases due to the substitution of synthetics. He watches developments in mass purchasing power, production, and consumption in faraway lands like India. In short, he learns all he can about anything that might affect the supply of, or demand for, cotton and thus bring about a change in future raw cotton prices.

  As a well-informed specialist, the speculator is much better able to predict future cotton prices than is the man who specializes in growing cotton or manufacturing cotton shirts. Competition among speculators trading on a commodity exchange forces them to share the benefits of their knowledge with their customers.

  Businessmen can protect themselves from some speculative losses by taking out insurance. However, customary insurance can only be bought for risks which are largely known or predictable. Losses from fire, death, theft, or transportation accidents are thus distributed over all those insured, instead of falling entirely on the ones who suffer a specific disaster. Future price changes do not fall in this category. They are the same for everyone. Only the well-informed specialist is equipped to speculate successfully and “insure” others against losses from price changes.

  In popular thinking, the speculator is a bold, bad man who makes money at the expense of others. Many people believe he gains his livelihood by luck, gambling, or inside manipulation. There are, of course, a few dishonest speculators who lie and cheat, as do some in all occupations, but the honest speculator is a serious specialist who serves mankind. He constantly strives to obtain a better understanding of future market conditions. He then places this better understanding at the service of all interested parties. Whenever his predictions are wrong, it is he who loses. When he is right, he and everyone who trades with him benefit. For if they did not expect to benefit, they would not trade with him.

  The service of a speculator is to smooth out some of the gaps between supply and demand and some of the extreme ups and downs in prices. He tries to buy when and where a commodity is plentiful and the price is low and to sell when and where the commodity is in short supply and the price is high. When he does this wisely and successfully, he tends to raise extremely low prices and reduce extremely high prices.

  Frequently, the speculator is the first to foresee a future scarcity. When he does, he buys while prices are still low. His buying bids up prices, and consumption is thus more quickly adjusted to future conditions than if no one had foreseen the approaching scarcity. A larger quantity is then stored for future use and serves to reduce the hardships when the shortage becomes evident to all.

  Since a price rise tends to encourage increased production, the sooner prices rise, the sooner new and additional production will be started and become available. So a successful speculator reduces both the time and the intensity of shortages as well as the hardships which always accompany shortages.

  Likewise, speculators are often the first to foresee an increase in future supplies. When they do, they hasten to sell contracts for future delivery. This in turn drives down future prices earlier than would otherwise be the case. This tends to discourage new production that could only be sold at a loss. It also gives manufacturers a better idea of what future prices will actually be. So, here again the speculator tends to smooth out production and consumption to the benefit of all concerned.

  A good example of how speculators serve society was provided in the coffee market a few years ago. A small newspaper item reported a sudden unexpected frost blight in Brazil. Speculators immediately realized that such a frost must have killed large numbers of coffee bushes. This meant much smaller future supplies for the United States. So the speculators promptly bought all the coffee they could below the price they thought would prevail when consumers became fully aware of the approaching shortage. This tended to raise coffee prices immediately.

  The effect of this was to reduce consumption and stretch some of the existing supply into the shortage period. It likewise alerted coffee growers in other areas to be more careful in their picking and handling of coffee so that there was less waste. Higher prices encouraged them to get to market every last bean, which at lower prices would not have been worth the trouble. Higher prices also speeded up the planting of new bushes. Since it takes five years for a new coffee bush to bear berries, the sooner new planting was undertaken the shorter the period of shortage.

  The speculators who first acted on this development served every coffee consumer. If these speculators had not driven up prices immediately, consumers would have continued drinking coffee at cheap prices for a time. Then, suddenly, they would have faced a still greater shortage and still higher prices than those that actually prevailed.

  By buying when coffee supplies were still relatively plentiful and selling later when the shortage was known to all, speculators helped to level out the available supply and reduce the extreme height to which prices would otherwise have risen. Speculators make money only when they serve society by better distributing a limited supply over a period of time in such a manner that it gives greater satisfaction to consumers. They thus permit other businessmen and consumers to proceed with greater safety and less speculation in their own actions.

  If a speculator buys a product thinking its price will rise and it later falls, he loses money for the simple reason that he has acted against the general welfare. He has sent out false indicators to producers and consumers alike. That happened just recently in the case of a large sugar importer. The firm bought large quantities of sugar when it was selling at 11¢ a pound. Its purchases were not hedged. In six months or so the price of sugar fell below 5¢ a pound and the importer was forced to file a petition under the National Bankruptcy Act.

  Hedging with a professional speculator would have prevented that loss. Of course, if the speculator had made no better estimate about future sugar prices than the importer did, it might have been the speculator who filed under the bankruptcy law. But as a rule, speculators are the specialists who are best informed on what future prices are likely to be.

  Fruits of Intervention

  When governments set prices, quotas, acreage limits, or other hampering restrictions on the honorable activities of men, they countermand the checks and balances that the free market places on supply and demand. The result is always surpluses and shortages: the former, where producers’ rewards are set too high; the latter, where they are set too low. Where there are surpluses of some things, there will always be shortages of others. For the men and materials subsidized to produce surpluses have been lured from producing those things which free market conditions would indicate that consumers prefer.

  Political interference with free market processes can only burden the taxpayer and weaken the human impulses of free men which tend to bring demand and supply into balance at the point which provides the greatest consumer satisfaction. With the passage of time, each such intervention can only make matters worse. Then, if people still believe the remedy for every economic ill is more intervention, political interventions will increase further until the police state is reached.

  In any such trend toward a police state, the speculators are among the first to be eliminated. They are the specialists who study world-wide markets in order to reduce the uncertainties that face all farmers and businessmen. Without the services of speculators, bottlenecks of production—a symptom of socialism—soon develop.

  Men and materials are then wasted in the production of surpluses. As a result there are ever-increasing shortages in the things people want most but can’t have because the means to produce them have been misdirected by government decree. The recent end to trading in cotton futures on the New Orleans Cotton Exchange is an omen that should make thoughtful men reflect on the road we are now traveling.

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PROFITS

PROFITS

  Hans F. Sennholz

  Although every businessman aims to earn a “profit,” he usually knows very little about the economic nature of his objective. He may even succeed in earning a profit, and yet be unable to explain this excess of proceeds that accrues to him after all expenses are paid.

  The same can be said about tax collectors who search for “profits” and aim to seize parts thereof for the state. And the accountants who reveal the “profits” by comparing the business revenue with the expenses. They all look at the totality of net income without any distinction of its various component parts.

  The economist who analyzes the economic nature of “profits” actually perceives three entirely different sources of income.

  Most proprietors and partners of small businesses who think they are reaping “profits” actually earn what economists call managerial remuneration. They are earning an income through their own managerial labor, supervising their employees, serving customers, working with salesmen, accountants, and auditors. Obviously, their services are very valuable in the labor market. They would earn a good salary if they were to work for the A & P or a 5 & 10¢ store. Therefore, that part of a businessman’s income that is earned through his own labor exertion is a kind of wage or salary, and as such, totally unrelated to economic profits.

  Most small businessmen with incomes up to $20,000 and $25,000 fall in this category. In the managerial labor market they would earn this income for services rendered to customers, for buying and selling, supervision of personnel, bookkeeping and accounting, and many other business activities.

  But the majority of American enterprises earn an income in excess of managerial remuneration. The economist who dissects this residium finds yet two other heterogeneous parts. By far the largest part, which is earned by the majority of American enterprises, is interest on the owners or stockholders invested capital. It accrues to the owner on account of the time-consuming nature of the production process.

  Interest

  Whoever refrains from spending his income and wealth and, instead, invests them in time-consuming production can expect a return. For without it no one would relinquish his savings to provide capital for production. Interest ultimately flows from human nature. Men of all ages and races value their present cash more highly than a claim payable in the future. Therefore, in order to induce an investor to relinquish his cash for production, which will yield its fruits in the future, a premium, called originary interest, must be paid. In other words, the businessman who invests in his own enterprise should hope to earn on his investment the same kind of income as the lender who extends a loan to a borrower.

  This basic interest return of some 4 per cent must accrue to business lest it withdraw its capital from production. As labor will leave an industry that pays low wages, so will capital shun an industry that does not yield a market return. If the government should tax it away or if labor unions should succeed in wresting this interest income from businessmen, production will necessarily contract and ultimately fall into deep depression. No additional capital will be placed at the disposal of an industry whose interest accrual is distributed to workers instead of owners. In fact, the liquid capital of that industry will even be withdrawn and turned to other employment where interest can still accrue. Capital consumption may even destroy what many generations before have built and accumulated.

  It is difficult to ascertain the precise rate of originary interest which businessmen earn on account of the time-consuming nature of production. For reasons of comparison we cannot even use the market rate of interest applicable to loan funds because the market rate itself is a gross rate consisting of originary interest, an entrepreneurial profit component that flows from the risks of the individual loan, and finally, a risk premium that flows from the dangers of monetary depreciation wherever inflation is practiced. But for reasons of simple illustration of the originary interest rate, we may use the rate the U.S. government must pay for the use of funds. If we assume that the lender of funds to the U.S. government bears no debtors risk and that inflation does not affect the loan value, we arrive at an interest rate that may constitute the originary rate, which is the rate businessmen should hope to earn as a basic interest return on their invested capital.

  Suppose your net worth of business, stated in present value, amounts to $100,000. Originary interest on that amount would come to $4,000 a year, which you would earn even in such riskless investments as U. S. Treasury bonds or savings banks deposits. As a basis for this interest calculation you would take the estimated present market value of your net worth, for only the present value of your assets, and not the arbitrary book value reflecting past valuations or tax considerations, is meaningful for individual motivation and action.

  A merchant with a business net worth of $100,000, spending long days in his shop serving customers, supervising his help, and otherwise managing the business may thus earn $4,000 interest and $20,000 managerial remuneration without actually reaping any profits.

  Pure Profits—Temporary Response to Changing Market Conditions

  Finally, there are enterprises that do earn pure profits. Through correct anticipation of future economic conditions, businessmen may earn what economists call entrepreneurial profits. For instance, through buying at a time when prices are low and selling when prices are higher, they may earn inventory profits. After interest allowance is made for the time of investment, stock market profits are pure profits. Of course, such profits are connected with risk on account of the uncertainty of the future. Instead of reaping profits, many businessmen suffer losses.

  Contrary to popular belief, pure profits are only short-lived. Whenever a change in demand, supply, fashion, or technology opens up an opportunity for pure profits, the early producer reaps high returns. But immediately he will be imitated by competitors and newcomers. They will produce the same good, render identical services, apply similar methods of production, and thus depress prices until the pure profit disappears. The first hoola-hoop manufacturer undoubtedly reaped pure profits. But as soon as dozens of competitors had retooled their factories the market was flooded with hoola-hoops. Prices dropped rapidly until the pure profits had vanished. When the American people suddenly discovered their need for compact cars, American Motors, who was the early manufacturer, temporarily earned pure profits. After General Motors, Chrysler, and Ford invaded the field, American Motors profits returned to the market rate of interest or even changed to losses.

  Pure profits are very elusive. But opportunities for profits will emerge as long as there are changes in demand, supply, fashion, population, technology, or even the weather. As all life is change, and economic adjustments need to be made continuously, opportunities for profits will arise again and again.

  And yet, in spite of the competitive forces that work incessantly in a free economy to wipe out pure profits, we may observe numerous enterprises that succeed in earning them over lengthy periods of time. The reason must be sought not only in the superior management of some enterprises in which gifted entrepreneurs direct the speculative aspects of business, but also in the different degrees of risk connected with the various industries.

  Industries that work with a minimum of risk in stable markets and with stagnant technology must expect to earn the lowest profits. When completely adjusted to consumer demand and without any anticipation of risk, pure profits would indeed be completely eliminated and only the originary interest return would remain. But as even a completely adjusted industry may face future risks, economic or political, and as the risk factor cannot be eliminated entirely from any productive investment, some remnant of pure profit is usually earned by the successful enterprises. This is the reason why even apparently riskless industries continue to earn a little more than the 4 per cent originary interest. The successful public utility, for instance, which may bear little investment risk, may earn 6 or 7 per cent, which consists of 4 per cent interest and 2 to 3 per cent pure profit. But the presence of risk also explains why some enterprises in the same industry only earn the interest return or even suffer loss.

  On the other hand, the successful enterprises that continuously face high degrees of risk tend to earn higher profits. For several years during the cold-war rearmament, the manufacture of aircraft and parts was exceptionally profitable. According to some statistics, a few aircraft manufacturers earned more than 20 per cent of net worth. Even if we bear in mind that corporate net worth is usually understated when compared with present values, and earnings ratios therefore are considerably overstated, we must admit that exceptionally high profits were earned by the most successful enterprises. In short, economic activity that involves a great deal of risk must yield exceptionally high profits to the successful enterprise in order to attract the necessary capital. It is obvious that the aircraft industry that continuously faces a great many imponderables, and often has suffered heavy losses, could not attract the needed capital if no more could be expected than a one per cent profit above the originary interest. Or, oil exploration and drilling which entail great financial risks would not be carried on without high rewards for success.

  Interference with Profits

  Taxation of these high rewards, or their arbitrary distribution to workers, would eliminate the incentive for risk-taking. Why should a man risk his capital in production if he can only suffer losses? In that case he would shun every productive investment, and search for riskless employment of his funds. The economy thus becomes rigid and inflexible, and unable to adjust to changes in demand, supply, and technology. Expansion and modernization are severely hampered. A confiscatory taxation of pure profits, maliciously called “excess profits,” destroys the vitality and dynamism of the market economy. (For an excellent discussion of profit and loss see Ludwig von Mises, Planning for Freedom, Libertarian Press, South Holland, 111.)

  And what are the effects of taxes levied on the 4 per cent basic interest return? As described above, interest is the payment for the use of capital over time. Without it capital cannot be invested and production must come to a standstill. When the government levies its confiscatory taxes on this basic income component, the market must fall into severe depression. In fact, the “multiplier” economists who usually apply their calculations to government spending would do much better calculating the depressive effects of this taxation. Let us assume, for instance, that the government imposes a tax of $1 billion on the interest return of business. At 4 per cent this interest constitutes the yield of $25 billion capital invested. And without this yield these $25 billion of business capital will be withdrawn from production, at least as far as it is liquid and can be withdrawn without heavy losses. For why should the owner keep his capital invested without a return?

  The Great Depression gave dramatic proof of the depressive effects of confiscatory corporate taxation. And today, we can observe similar stagnating effects whenever the Federal or state governments raise their basic levies on business, such as the social security taxes and unemployment taxes which fall on every business regardless of its profitability.

  And, finally, what are the economic effects of taxes that fall on the first-mentioned component, the managerial remuneration? Why should a merchant spend twelve to sixteen hours daily in his store if he cannot earn an income that is comparable with the salaries earned by other managers? If profit taxes encroach upon this income the independent businessman will be tempted to sell out to his big competitor and rather earn a salary as a branch manager than to face confiscatory profit taxes.

  In economic life it is rather difficult to ascertain the impact of profit taxation. The same tax in some cases may fall on pure profits, in others on basic interest, and yet others on managerial remuneration. The effects, therefore, do vary. In some cases the tax merely prevents risky undertakings, in others it causes depressive restrictions of production, and in yet others it may cause the liquidation of small and medium-sized enterprises.

  Addendum on Profit-Sharing

  For many people, profit-sharing is thought to provide the solution to our labor problems. It is said to hold the key to industrial peace and represent the ideal of industrial democracy. According to a Senate Committee Report, profit-sharing is “essential to the ultimate maintenance of the capitalistic system.” Even some businessmen praise it for giving employees a sense of partnership in the enterprise, raising worker morale, avoiding strikes, reducing turnover, increasing efficiency, and so on. In fact, profit-sharing is said to afford workers a stake in our capitalistic system.

  These people do not seem to realize that the market economy is a sharing system. Although hampered and mutilated, American business continues to deliver ever more and better goods. Wages continue to rise on account of improved technology and increased capital investments, not because we work ever harder and longer hours. Competition forces investors and businessmen to share the fruits of their investments with their customers through lower prices and with their workers through higher wages.

  But in popular terminology “profit-sharing” proposes to give the workers more than higher wages through competition in the labor market. It means an additional distribution of a businessman’s earnings to his employees. Some proposals depend on government or union coercion, others aim at voluntary sharing. Most sharing firms are rather small in size and employment.

  The economist who analyzes this supplementary sharing must ask a pointed question. Which part of the business surplus commonly called “profit” is to be divided between businessmen and workers? Is it the “managerial remuneration” which businessmen earn through their own managerial services? Why should independent businessmen yield their labor income while managers and supervisors in the service of large corporations continue to earn a market wage?

  Is it the “pure profit” which businessmen are urged to share? Only a small percentage of American enterprises actually earn pure profits. Now, are the fortunate workers who found employment in profitable enterprises to earn more than their fellow workers in average firms? Should an accountant who serves a brilliant stockbroker earn $100,000 per year while his equally competent fellow accountants labor at $5,000 or $6,000? What is to determine his remuneration? But, whatever the sharing plan should provide, it introduces a dubious wage principle: a man’s labor income is determined by the ability of his employer. I doubt that this is the matrix for human cooperation, the key to industrial peace. On the contrary, it would create new sources of conflict. Most workers who receive wages only would probably demand “equal pay” from their profitless employers, which would aggravate rather than alleviate the labor situation.

  Many people fail to realize that industry doesn’t have much profit to share. According to Claude Robinson’s excellent analysis, 45 per cent of all companies, on the average, are reporting no profits. The average annual earnings for all manufacturing companies amount to eight and six-tenth cents per dollar of investment. “If we allow five cents as a form of interest,” Robinson concludes, “the remaining three and six-tenths cents is left for entrepreneurial risk-taking. Should the three and six-tenths cents entrepreneurial fee be shared, it could at best mean an insignificant wage increase, and would surely decrease the willingness of owners to take the investment risks involved in providing better tools for workers. Sharing the entrepreneurial fee, therefore, would likely do the wage-earner more harm than good.” (Claude Robinson, Understanding Profits. Princeton, N. J.: D. Van Nostrand, 1961, p. 315.)

  Interest on Investment

  And finally, there is the “interest” which capitalists usually earn on their invested funds. But, a forced reduction of this basic yield not only prevents capital formation but also causes its withdrawal and consumption. Such profit-sharing on a large scale causes stagnation and depression as the economic history of the past thirty-five years has repeatedly demonstrated Improvements in labor productivity and standards of living largely depend on the increased use of capital. Saving is a fundamental prerequisite of economic progress. It is hard to understand how anyone who has human betterment at heart can urge us to reduce the award of saving by sharing it with those who did not earn it but propose to consume it.

  The friends of profit-sharing sometimes argue that if all companies would share their profits, labor productivity would rise greatly and everyone would benefit. But in this case, competition would again reduce prices and profits until there would be no excess profits to share. The benefits of rising productivity would thus accrue to consumers through lower prices and to workers through rising wages. Competition would not tolerate the existence of permanent profits to share. Therefore, profit-sharing can remain only a limited industrial practice.

  In many cases even this limited sharing is sailing under false colors. Where labor actually becomes more productive through greater effort and application, its market value rises accordingly. Competition among businessmen will cause wages to rise. A businessman who then proposes to share his profits with his workers may merely be using this means to pay higher market wages. But instead of making payments every Friday, he may hold off paying for six months or a year, and call this profit-sharing. It is my opinion that most of the seemingly successful profit-sharing plans merely constitute plans for delayed payment of that part of wages that is earned through special effort and application.

  In all such cases the workers would be well advised to insist on payment of higher wages rather than expose their earnings to the risks of business. Workers may even lose their delayed wages in case the business should lose money through poor management decisions.

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THE ELITE UNDER CAPITALISM

THE ELITE UNDER CAPITALISM

  Ludwig von Mises

  A long line of eminent authors, beginning with Adam Ferguson, tried to grasp the characteristic feature that distinguishes the modem capitalistic society, the market economy, from the older systems of the arrangement of social cooperation. They distinguished between warlike nations and commercial nations, between societies of a militant structure and those of individual freedom, between the society based on status and that based on contract. The appreciation of each of the two “ideal types” was, of course, different with the various authors. But they all agreed in establishing the contrast between the two types of social cooperation as well as in the cognition that no third principle of the arrangement of social affairs is thinkable and feasible.32.1 One may disagree with some of the characteristics that they ascribed to each of the two types, but one must admit that the classification as such makes us comprehend essential facts of history as well as of contemporary social conflicts.

  There are several reasons that prevent a full understanding of the significance of the distinction between these two types of society. There is in the first place the popular repugnance to assign to the inborn inequality of various individuals its due importance. There is furthermore the failure to realize the fundamental difference that exists between the meaning and the effects of private ownership of the means of production in the precapitalistic and in the capitalistic society. Finally, there is serious confusion brought about by the ambiguous employment of the term “economic power.”

  Inborn Inequality

  The doctrine that ascribed all differences between individuals to postnatal influences is untenable. The fact that human beings are born unequal in regard to physical and mental capacities is not denied by any reasonable man, certainly also not by pediatrists. Some individuals surpass their fellow men in health and vigor, in brain power and aptitude for various performances, in energy and resolution. Some people are better fit for the pursuit of earthly affairs, some less. From this point of view we may—without indulging in any judgment of value—distinguish between superior and inferior men. Karl Marx referred to “the inequality of individual endowment and therefore productive capacity (Leistungsfähigkeit) as natural privileges” and was fully aware of the fact that men “would not be different individuals if they were not unequal.”32.2

  In the precapitalistic ages the better endowed, the “superior” people, took advantage of their superiority by seizing power and enthralling the masses of weaker, i.e., “inferior” men. Victorious warriors appropriated to themselves all the land available for hunting and fishing, cattle raising and tilling. Nothing was left to the rest of the people than to serve the princes and their retinue. They were serfs and slaves, landless and penniless underlings.

  Such was by and large the state of affairs in most parts of the world in the ages in which the “heroes”32.3 were supreme and “commercialism” was absent. But then, in a process that, although again and again frustrated by a renascence of the spirit of violence, went on for centuries and is still going on, the spirit of business, i.e., of peaceful cooperation under the principle of the division of labor, undermined the mentality of the “good old days.” Capitalism—the market economy—radically transformed the economic and political organization of mankind.

  In the precapitalistic society the superior men knew no other method of utilizing their own superiority than to subdue the masses of inferior people. But under capitalism the more able and more gifted men can profit from their superiority only by serving to the best of their abilities the wishes and wants of the majority of less gifted men. In the market economy the consumers are supreme. They determine, by their buying or abstention from buying, what should be produced, by whom and how, of what quality and in what quantity. The entrepreneurs, capitalists, and landowners who fail to satisfy in the best possible and cheapest way the most urgent of the not yet satisfied wishes of the consumers are forced to go out of business and forfeit their preferred position. In business offices and in laboratories the keenest minds are busy fructifying the most complex achievements of scientific research for the production of ever better implements and gadgets for people who have no inkling of the scientific theories that make the fabrication of such things possible. The bigger an enterprise is, the more it is forced to adjust its production activities to the changing whims and fancies of the masses, its masters. The fundamental principle of capitalism is mass production to supply the masses. It is the patronage of the masses that makes enterprises grow into bigness. The common man is supreme in the market economy. He is the customer “who is always right.”

  In the political sphere representative government is the corollary of the supremacy of the consumers in the market. The officeholders depend on the voters in a way similar to that in which the entrepreneurs and investors depend on the consumers. The same historical process that substituted the capitalistic mode of production for precapitalistic methods substituted popular government— democracy—for royal absolutism and other forms of government by the few. And wherever the market economy is superseded by socialism, autocracy makes a comeback. It does not matter whether the socialist or communist despotism is camouflaged by the use of aliases such as “dictatorship of the proletariat” or “people’s democracy” or “Führer principle.” It always amounts to a subjection of the many to the few.

  It is hardly possible to misconstrue more improperly the state of affairs prevailing in the capitalistic society than by dubbing the capitalists and entrepreneurs a “ruling” class intent upon “exploiting” the masses of decent men. We do not have to raise the question how the men who under capitalism are businessmen would have tried to take advantage of their superior talents in any other thinkable organization of production activities. Under capitalism they are vying with one another in serving the masses of less gifted men. All their thoughts aim at perfecting the methods of supplying the consumers. Every year, every month, every week something unheard of before appears on the market and is very soon made accessible to the many. Precisely because they are producing for profit, the businessmen are producing for the use of the consumers.

  Confusion Concerning Property

  The second deficiency of the customary treatment of the problems of society’s economic organization is the confusion produced by the indiscriminate employment of juridical concepts, first of all the concept of private property.

  In the precapitalistic ages there prevailed by and large economic self-sufficiency, first of every household, later—with the gradual progress toward commercialism—of small regional units. The much greater part of all products did not reach the market. They were consumed without having been sold and bought. Under such conditions there was no essential difference between private ownership of producers’ goods and that of consumers’ goods. In each case property served the owner exclusively. To own something, whether a producers’ good or a consumers’ good, meant to have it for oneself alone and to deal with it for one’s own satisfaction.

  But it is different in the frame of a market economy. The owner of producer’s goods, the capitalist, can derive advantage from his ownership only by employing them for the best possible satisfaction of the wants of the consumers. In the market economy property in the means of production is acquired and preserved by serving the public and is lost if the public becomes dissatisfied with the way in which it is served. Private property of the material factors of production is a public mandate, as it were, which is withdrawn as soon as the consumers think that other people would employ the capital goods more efficiently for their, viz., the consumers’, benefit. By the instrumentality of the profit and loss system the capitalists are forced to deal with “their” property as if it were other peoples’ property entrusted to them under the obligation to utilize it for the best possible provision of the virtual beneficiaries, the consumers. This real meaning of private ownership of the material factors of production under capitalism could be ignored and misinterpreted because all people— economists, lawyers, and laymen—had been led astray by the fact that the legal concept of property as developed by the juridical practices and doctrines of precapitalistic ages has been retained unchanged or only slightly altered while its effective meaning has been radically transformed.32.4

  In the feudal society the economic situation of every individual was determined by the share allotted to him by the powers that be. The poor man was poor because little land or no land at all had been given to him. He could with good reason think—to say it openly would have been too dangerous—: I am poor because other people have more than a fair share. But in the frame of a capitalistic society the accumulation of additional capital by those who succeeded in utilizing their funds for the best possible provision of the consumers enriches not only the owners but all of the people, on the one hand by raising the marginal productivity of labor and thereby wages, and on the other hand by increasing the quantity of goods produced and brought to the market. The peoples of the economically backward countries are poorer than the Americans because their countries lack a sufficient number of successful capitalists and entrepreneurs.

  A tendency toward an improvement of the standard of living of the masses can prevail only when and where the accumulation of new capital outruns the increase in population figures.

  The formation of capital is a process performed with the cooperation of the consumers: only those entrepreneurs can earn surpluses whose activities satisfy best the public. And the utilization of the once accumulated capital is directed by the anticipation of the most urgent of the not yet fully satisfied wishes of the consumers. Thus capital comes into existence and is employed according to the wishes of the consumers.

  When in dealing with market phenomena we apply the term “power,” we must be fully aware of the fact that we are employing it with a connotation that is entirely different from the traditional connotation attached to it in dealing with issues of government and affairs of state.

  Governmental power is the faculty to beat into submission all those who would dare to disobey the orders issued by the authorities. Nobody would call government an entity that lacks this faculty. Every governmental action is backed by constables, prison guards, and executioners. However beneficial a governmental action may appear, it is ultimately made possible only by the government’s power to compel its subjects to do what many of them would not do if they were not threatened by the police and the penal courts. A government supported hospital serves charitable purposes. But the taxes collected that enable the authorities to spend money for the upkeep of the hospital are not paid voluntarily. The citizens pay taxes because not to pay them would bring them into prison and physical resistance to the revenue agents to the gallows.

  It is true that the majority of the people willy-nilly acquiesce in this state of affairs and, as David Hume put it, “resign their own sentiments and passions to those of their rulers.” They proceed in this way because they think that in the long run they serve better their own interests by being loyal to their government than by overturning it. But this does not alter the fact that governmental power means the exclusive faculty to frustrate any disobedience by the recourse to violence. As human nature is, the institution of government is an indispensable means to make civilized life possible. The alternative is anarchy and the law of the stronger. But the fact remains that government is the power to imprison and to kill.

  The concept of economic power as applied by the socialist authors means something entirely different. The fact to which it refers is the capacity to influence other peoples’ behavior by offering them something the acquisition of which they consider as more desirable than the avoidance of the sacrifice they have to make for it. In plain words: it means the invitation to enter into a bargain, an act of exchange. I will give you a if you give me b. There is no question of any compulsion nor of any threats. The buyer does not “rule” the seller and the seller does not “rule” the buyer.

  Of course, in the market economy everybody’s style of life is adjusted to the division of labor, and a return to self-sufficiency is out of the question. Everybody’s bare survival would be jeopardized if suddenly he would be forced to experience the autarky of ages gone by. But in the regular course of market transactions there is no danger of such a relapse into the conditions of the primeval household economy. A faint image of the effects of any disturbance in the usual course of market exchanges is provided when labor union violence, benevolently tolerated or even openly encouraged and aided by the government, stops the activities of vital branches of business.

  In the market economy every specialist—and there are no other people than specialists—depends on all other specialists. This mutuality is the characteristic feature of interpersonal relations under capitalism. The socialists ignore the fact of mutuality and speak of economic power. For example, as they see it, “the capacity to determine product” is one of the powers of the entrepreneur.32.5 One can hardly misconstrue more radically the essential features of the market economy. It is not business, but the consumers who ultimately determine what should be produced. It is a silly fable that nations go to war because there is a munitions industry and that people are getting drunk because the distillers have “economic power.” If one calls economic power the capacity to choose—or, as the socialists prefer to say, to “determine”—the product, one must establish the fact that this power is fully vested in the buyers and consumers.

  “Modem civilization, nearly all civilization,” said the great British economist, Edwin Cannan, “is based on the principle of making things pleasant for those who please the market and unpleasant for those who fail to do so.”32.6 The market, that means the buyers; the consumers, that means all of the people. To the contrary, under planning or socialism the goals of production are determined by the supreme planning authority; the individual gets what the authority thinks he ought to get. All this empty talk about the economic power of business aims at obliterating this fundamental distinction between freedom and bondage.

  The “Power” of the Employer

  People refer to economic power also in describing the internal conditions prevailing within the various enterprises. The owner of a private firm or the president of a corporation, it is said, enjoys within his outfit absolute power. He is free to indulge in his whims and fancies. All employees depend on his arbitrariness. They must stoop and obey or else face dismissal and starvation.

  Such observations, too, ascribe to the employer powers that are vested in the consumers. The requirement to outstrip its competitors by serving the public in the cheapest and best possible way enjoins upon every enterprise the necessity to employ the personnel best fitted for the performance of the various functions entrusted to them. The individual enterprise must try to outdo its competitors not only by the employment of the most suitable methods of production and the purchase of the best fitted materials, but also by hiring the right type of workers. It is true that the head of an enterprise has the faculty to give vent to his sympathies or antipathies. He is free to prefer an inferior man to a better man; he may fire a valuable assistant and in his place employ an incompetent and inefficient substitute. But all the faults he commits in this regard affect the profitability of his enterprise. He has to pay for them in full. It is the very supremacy of the market that penalizes such capricious behavior. The market forces the entrepreneurs to deal with every employee exclusively from the point of view of the services he renders to the satisfaction of the consumers.

  What curbs in all market transactions the temptation of indulging in malice and venom is precisely the costs involved in such behavior. The consumer is free to boycott for some reasons, popularly called noneconomic or irrational, the purveyor who would in the best and cheapest way satisfy his wants. But then he has to bear the consequences; he will either be less perfectly served or he will have to pay a higher price. Civil government enforces its commandments by recourse to violence or the threat of violence. The market does not need any recourse to violence because neglect of its rationality penalizes itself.

  The critics of capitalism fully acknowledge this fact in pointing out that for private enterprise nothing counts but the striving after profit. Profit can be made only by satisfying the consumers better or cheaper or better and cheaper than others do. The consumer has in his capacity as customer the right to be full of whim and fancies. The businessman qua producer has only one aim: to provide for the consumer. If one deplores the businessman’s unfeeling preoccupation with profit-seeking, one has to realize two things. First, that this attitude is prescribed to the entrepreneur by the consumers who are not prepared to accept any excuse for poor service. Secondly, that it is precisely this neglect of “the human angle” that prevents arbitrariness and partiality from affecting the employer-employ-ee nexus.

  To establish these facts does not amount either to a commendation or to a condemnation of the market economy or its political corollary, government by the people (representative government, democracy). Science is neutral with regard to any judgments of value. It neither approves nor condemns; it just describes and analyzes what is.

  Stressing the fact that under unhampered capitalism the consumers are supreme in determining the goals of production does not imply any opinion about the moral and intellectual capacities of these individuals. The individuals qua consumers as well as qua voters are mortal men liable to error and may very often choose what in the long run will harm them. Philosophers may be right in severely criticizing the conduct of their fellow citizens. But there is, in a free society, no other means to avoid the evils resulting from one’s fellows’ bad judgment than to induce them to alter their ways of life voluntarily. Where there is freedom, this is the task incumbent upon the elite.

  Men are unequal and the inherent inferiority of the many manifests itself also in the manner in which they enjoy the affluence capitalism bestows upon them. It would be a boon for mankind, say many authors, if the common man would spend less time and money for the satisfaction of vulgar appetites and more for higher and nobler gratifications. But should not the distinguished critics rather blame themselves than the masses? Why did they, whom fate and nature have blessed with moral and intellectual eminence, not better succeed in persuading the masses of inferior people to drop their vulgar tastes and habits? If something is wrong with the behavior of the many, the fault rests no more with the inferiority of the masses than with the inability or unwillingness of the elite to induce all other people to accept their own higher standards of value. The serious crisis of our civilization is caused not only by the shortcomings of the masses. It is no less the effect of a failure of the elite.

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WINDFALL PROFITS

WINDFALL PROFITS

  Robert G. Anderson

  Companies seem duty-bound to defend their latest financial reports. Any increase in profits is contrasted with earlier periods of losses or “inadequate” profits. The relative smallness of profits is demonstrated in terms of capital invested, annual sales, or total wages. Public relations departments tremble over reported company success and gear themselves for the inevitable onslaught such favorable reports will bring.

  Among the charges most feared is the accusation that the firm has reaped windfall profits. While “normal” profits might be tolerated, anything above so-called normalcy is invariably subject to public charges of exploitation. The implication subtly drawn is that windfall profits accrue as a result of someone else’s losses. While the public might overlook small injustices, large profits are simply intolerable.

  This massive assault on profit-making reflects a belief that profits are something extra, the elimination of which would result in a general improvement in human welfare, that profits are gained at the expense of others—“unearned” and “unjust.”

  This anti-profit mentality stems from a failure to understand the true nature and source of profits, the integral relationship existing between profits and losses, and their basic importance to the functioning of the market system. It is a failure to understand that an attack upon profits, even excess or windfall profits, is an attack upon the market system itself.

  Within the framework of a free market price system, profits show which producers have best satisfied the wants of consumers. Profits appear as the result of actions taken earlier by those producers most successful in anticipating and serving the demands of the consumer. Profits demonstrate how well a producer has employed scarce resources in the past toward the satisfaction of consumer wants. Profits are a record of experience, a reward for satisfactory service rendered.

  The process of profit-making, however, is not the same thing as the amount of profits recorded. Profits earned in the past serve as no specific guide for future productive activity, though the fact that they were earned may offer hope of future profits. Past profitable activity in a given form of production assures nothing about the future. Attempts to imitate activities that have been profitable have resulted in many business failures.

  The opportunity for profit-making stems from the changing values of consumers over time, and the reflection of these changing values on prices. The individual who foresees correctly these developing changes in market prices, and acts upon his foresight, will be the profit-maker.

  Adjusting to Change

  If man were omniscient, or if his values were to remain static, the concept of profit and loss would not exist. But fallibility and change are part of the human condition and necessarily affect man’s economic behavior.

  Today’s market prices are reflections of values previously held by consumers and of the production those values generated. The prices so established will be either too high or too low with respect to the market conditions of tomorrow, conditions which could only be known by knowing the future, which is impossible.

  The profit-maker, however, must attempt the impossible. The uncertainty of the future overrides all human action. The fact that future prices are uncertain does not dissuade the potential profit-maker from acting.

  It is this potential of profit-making that provides the entrepreneurs motivation and incentive for production. The entrepreneur identifies resources in today’s market that he believes will possess a higher market value tomorrow. If his foresight about the future values of the consumers is correct, a profit can be realized. The magnitude of the profit will depend upon the degree of change in future market prices and the entrepreneurial decision to act on his foresight.

  When the rise in prices is large, the entrepreneur holding the resources so affected will experience large profits. The identification of this development as excess or windfall profits has been grossly misleading. The fact that he did not anticipate the precise degree of change in prices is no basis for denying the owner of the resources his right to the gain.

  The concept of windfall profit merely observes that large gains can be realized from drastic changes in consumer evaluations and their resultant impact on market prices. The owner of the affected resources experiences a dramatic and sudden increase in the value of his property. But, if consumer evaluations change in the other direction, market prices can just as suddenly and dramatically fall, causing windfall losses to the owners of resources so affected.

  Windfall profits or losses simply emphasize the risk of productive activity resulting from the changing values of consumers. While the entrepreneur attempts to calculate future market conditions, he is not omniscient. An underestimate of future prices may yield him a higher profit than he had anticipated when he took productive action, but that same higher profit becomes the magnet for an influx of new competitive activity.

  A Reliable Guide

  With the profit and loss system as their guide, competing entrepreneurs decide how resources shall be directed for future consumption. Anticipated profitability attracts the productive capital of the entrepreneurs, but the ultimate profit is determined by the actions of the consumers. The entrepreneur’s astuteness in judging the consumer’s demands will decide whether profits or losses are to be realized by him in the future.

  A significant contributor to a smoothly functioning market is the much maligned speculator.

  As an entrepreneur, the speculator acts in anticipation of the changing values of consumers. His buying and selling of resources creates a more orderly market, reducing erratic fluctuations in prices, and thus holds down the magnitude and severity of gains and losses. Accurate foresight by the speculator mitigates the errors of resource pricing and the consequent large profits or losses brought on by changing consumer tastes.

  Once profits are understood to evolve from the actions of the consumers, it becomes pointless to speak of profits as being “fair,” “normal,” “excess,” or whatever.

  The decision on how to allocate existing resources into future use is made by entrepreneurs on the basis of their interpretation of the consumer’s actions in the market place of the future. Through a subsequent return of profits and losses to the entrepreneur, the consumer is constantly signaling entrepreneurs, as to how to direct scarce resources toward best satisfying consumer wants.

  This relationship between the entrepreneur and the consumer is much like that of a revocable trust. The trustee-entrepreneur allocates resources for the benefit of the trustor-consumer, a relationship perpetuated by profits and revoked by losses. Through the signal of these profits and losses the consumer steers the producer.

  The allure of profit-making is the catalyst for productive activity. Sparked by an entrepreneurial decision on the future state of the market, resources are continually being directed into hopefully productive use. The soundness of the original decision is reflected by profits or losses generated by the venture. Without some prospect that profits will substantiate the original decision, no productive activity would be undertaken. The problem of determining how resources should be allocated could not be resolved. There would be no response to the will of the consumer in the market. The market would be in a state of chaos.

  The Fundamental Issue Concerns Property Rights

  The real controversy over the concept of excess or windfall profits evolves over who should be the beneficiary of these subsequent unanticipated changes in market prices. The fundamental issue in this controversy is one of property rights. In a free market system the entrepreneur subjects his property to risk in a productive activity in the hope of generating a profit. If his judgment of the future demand of the consumers proves correct, his property increases in value, and he profits. The extent of his gain is thus determined by the consumer. In a market system of private ownership the gains would therefore accrue to the owner of the property.

  Similarly, the burden of windfall losses is borne by the entrepreneur. If he directs his property into productive activities later rejected by the consumer’s changing values, he is responsible for his erroneous decision. The sudden abstention from buying on the part of the consumers causes a fall in the value of his property and a loss to the entrepreneur. Within such a market system, the entrepreneur subjects his property to risk—to the gain or loss that accrues from the changing tastes of the consumer.

  The notion that windfall profits accrue at another’s expense or loss is patently false. They result from the same forces that bring windfall losses: changes in the values of consumers. Such windfalls result from future uncertainty, and should accrue to the owners who expose their property to the risks of production.

  Profits or Losses Stem from Changing Values of Consumers

  Once it is understood that profits and losses evolve from the changing values of consumers, it becomes obvious that abolishing windfall profits or windfall losses is impossible. Fallibility and change are a part of our nature, and both large errors and great changes are inevitable. To deny to the entrepreneur the gains or losses resulting from such error or change does not eliminate gains or losses; it eliminates entrepreneurs, disrupts the market, and ultimately leaves everyone under the dead hand of government control.

  As long as consumers continue to express their changing values in the market place, profits, anticipated or not, will continue to materialize. The only question is whether the gain in the value of the entrepreneur’s property should accrue to the owner or to someone else.

  When the government attempts to make itself the beneficiary of windfall profits, it can only disrupt the productive processes of the market. The natural adjustments in supply and demand that occur in the free market are hampered, and further disequilibrium develops. The consumer’s urgent signal for increased production, which is the essence of windfall profits, cannot be heard or acted upon by producers to whom the market is closed. The ultimate consequence must inevitably be even higher prices for the resources involved. Thus, the expropriation of windfall profits is not only counterproductive, but also denies the sovereignty of the consumer in the structuring of society.

  If the individual as consumer is to retain his personal liberty, if he is to remain the sovereign force in the structuring of society, he must be free to reflect fully his changing values in the market place. This requires that the profit and loss signal must remain unhampered. For that is the only signal to which entrepreneurs can reasonably respond.

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