Those who advocate vast governmental expenditures and deficit financing after the war as the only means of getting full employment, separate production and purchasing power sharply. Purchasing power must be kept above production if production is to expand, in their view. If purchasing power falls off, production will fall off.
The prevailing view among economists, on the other hand, has long been that purchasing power grows out of production. The great producing countries are the great consuming countries. The twentieth century world consumes vastly more than the eighteenth century world because it produces vastly more. Supply of wheat gives rise to demand for automobiles, silks, shoes, cotton goods, and other things that the wheat producer wants. Supply of shoes gives rise to demand for wheat, for silks, for automobiles and for other things that the shoe producer wants. Supply and demand in the aggregate are thus not merely equal, but they are identical, since every commodity may be looked upon either as supply of its own kind or as demand for other things. But this doctrine is subject to the great qualification that the proportions must be right; that there must be equilibrium.
On the equilibrium theory occasional periods of readjustment are inevitable and are useful. An active boom almost inevitably generates disequilibria. The story in the present volume of the boom of 1919-1920 and the crisis of 1920-1921 gives a classical illustration. The period of readjustment may be relatively short and need not be severe, but a period of shakedown, a period in which overexpanded industries are contracted and opportunities made for underdeveloped industries to expand, a period in which prices and costs come into equilibrium, a period in which weak spots in the credit situation are cleaned up, a period in which excessive debts are liquidated-such periods we must have from time to time. The effort to prevent adjustment and liquidation by the pouring out of artificial purchasing power is, from the standpoint of the equilibrium doctrine, an utterly futile and wasteful and dangerous performance. Once a reequilibration is accomplished, moreover, the equilibrium doctrine would regard pouring out new artificial purchasing power as wholly unnecessary and further as dangerous, since it would tend to create new disequilibria.
The late Lord Keynes was the leading advocate of the purchasing power doctrine, and the leading opponent of the doctrine that supply creates its own demand. The present chapter is concerned with Keynes' attack on the doctrine that supply creates its own demand.
Keynes was a dangerously unsound thinker. 1 His influence in the Roosevelt Administration was very great. His .influence upon most of the economists in the employ of the Government is incredibly great. There has arisen a volume of theoretical literature regarding Keynes almost equal to that which has arisen around Karl Marx. 2 His followers are satisfied that he has destroyed the long accepted economic doctrine that aggregate supply and aggregate demand grow together. It seems necessary to analyze Keynes's argument with respect to this point.
Keynes Ignores the Essential Point in the Doctrine He Attacks. Keynes presents his argument in his 1'he General Theory o/Employment, Interest and Money, published in 1936. But he nowhere in the book takes account of the law of equilibrium among the industries, which has always been recognized as an essential part of the doctrine that supply creates its own demand. He takes as his target a seemingly crude statement from. J. S.· Mill's· Principles of Political Economy (Book III, chap. 14, par. 2) which follows:
"What constitutes the means of payment for commodities is simply commodities. Each person's nleans of paying for the productions of other people consist. of those which he himself possesses. All sellers are ine,vitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply: everybody would be able to· buy twice as much, because everyone would have twice as much to offer in exchange."
N ow this passage by itself does not present the essentials of the doctrine. If we doubled the productive power of the country, we should not double the supply of commodities in every market, and if we did, we should not clear the markets of the double supply in every market. If we doubled the supply in the salt market, for example, we should have an appalling glut of salt. The great increases would come in the items where demand is elastic. We should change very radically the proportions in which we produced commodities.
But it is unfair to Mill to take this brief passage out of its context and present it as if it represented the heart of the doctrine. If Keynes had quoted only the three sentences immediately following, he would have introduced us to the conception of balance and proportion and equilibrium which is the heart of the doctrine-a notion which Keynes nowhere considers in this book. Mill's next few lines, immediately following the passage torn from its context, quoted above, are as follows:
"It is probable, indeed, that there would now be a superfluity of certain things. Although the community would willingly double its aggregate consumption, it may already have as much as it desires of some commodities, and it may prefer to do more than double its consumption of others, or to exercise its increased purchasing power on some new thing. If so, the supply will adapt itself accordingly, and the values of things will continue to conform to their cost of production."
Keynes, furthermore, ignores entirely the rich, fine work done by such writers as J. B. Clark and the Austrian School, who elaborated the laws of proportionality and equilibrium.
The doctrine that supply creates its own demand, as presented by John Stuart Mill, assumes a proper equilibrium anlong the different kinds of production, assumes proper terms of exchange (i.e., price relationships) among different kinds of· products, assumes proper relations between prices and costs. And the doctrine expects competition and free markets to be the instrumentality by means of which these proportions and price relations will be brought about. The modern version of the doctrine would make explicit certain additional factors. There must be a proper balance in the international balance sheet. If foreign debts are excessive in relation to the volume of foreign trade, grave disorders can come. Moreover, the money and capital markets must be in a state of balance. When there is an excess of bank credit used as a substitute for savings, when bank credit goes in undue amounts into capital uses and speculative uses, impairing the liquidity of bank assets, or when the total volume of money and credit is expanded far beyond the growth of production and trade, disequilibria arise, and, above all, the quality of credit is impaired. Confidence may be suddenly shaken and a countermovement may set in.
With respect to all these points, automatic market forces tead to restore equilibrium in the absence of overwhelming governmental interference.
Keynes has nothing to say in·' his attack upon the doctrine that supply creates its own demand, in the volume referred to, with respect to these matters.
Incleed, far from considering the· intricacies of the .. interrelations of markets, prices and different kinds of production, Keynes prefers to look at things in block. He says:
"In dealing with the theory of employment I propose,. therefore, to make use of onlytwo fundamental units of quantity, namely, quantities of money-value and quantities of employment. The first of these is strictly homogeneous, and the secondcan be made .so. For, in so far as different grades and kinds of labor and salaried assistance enjoy a more or less fixed relative remuneration, the quantity of employment can be sufficiently defined for our purpose by taking an hour's employment of ordinary labor as our unit anti 'weightingan hour's employment of special labor in proportion /0 its remuneration; i.e., an hour ot· special labor remunerated at double ordlnar1rates wfll count as two units." •••
"It is mybelie£ that much unnecessary perplexity can be avoided if we limit ourselvesstrictly to the two units, money and labor, when we are dealing with the behavior of the economic system as a whole ••."
Procedure of this kind is empty and tells us nothing about economic life. How empty it' is becomes apparent' when we observe that· these two·· supposedly independent units of quantity, namely, "quantities of money value))· and "quantities of employment," are· both merely quantities .. of money value. If ten laborers working for $2 a day are dismissed and two laborers working for $10 a day are taken on, there is no change in the volume of employment, by Keynes's method of reckoning, as,is obvious from the italicized portiono£ the quotation above. His "quantity of employment" is not a quantity of employment. It is a quantity of money received by laborers who are employed.
Throughout Keynes's analysis he is working with aggregate,·. block concepts. He has an aggregate supply.funct~on' and an aggregate demand function. But nowhere is there any discussion of the interrelationships of the elements in these vast aggregates, or of elements in one aggregate with elements in another. Nowhere is there a recognition that different eletnents in the aggregate supply give rise to the demand for other elements in the aggregate supply. In Keynes's discussion, purchasing power and production are sharply sundered.
The Function of Prices.
It is part of the equilibrium doctrine that prices tend to equate supply and demand in various markets: commodities, labor, capital, and so on. If prices go down in particular markets this constitutes a signal for producers to produce less, and a signal for consumers to consume more. In the markets, on the other hand, where prices are rising we have a signal for producers to produce more,. for consumers to consume less, and a signal for men in fields where prices are less satisfactory to shift their labor and, to the extent that this is possible,· to shift their capital to the more productive field. Free prices, telling the truth about supply and demand, thus constitute the great· equilibrating factor.
The Function of the Rate of Interest.
Among these prices is the rate of interest. The traditional doctrine is that the rate of interest equates supply and demand in the capital market and equates·saving and investment. Interest is.looked upon as reward' for saving and as inducement to saving. The old doctrine which looked upon consumer's thrift as the primary source of capital is inadequate. It must be broadened to include producer's thrift, and especially corporate thrift, and direct. capitalization, as when the farmer uses his spare time in building fences and putting other improvements on his farm, or when the farmer lets his flocks and herds increase instead of selling off the whole of the annual increase, and so forth. It must include governmental thrift, as when government taxes to pay down public debt or when government taxes for capital purposes· instead of borrowing-historically very important! The doctrine needs a major qualification, moreover, with respect to tke use of bank credit for capital purposes.
Keynes's Attack on the Interest Ratc as Equilibrator.
It. is. with respect to the interest·· rate as the equilibrating factor that Keynes. has made his most vigorous assault upon prevailing views. Where economists generally have held that saving and avoiding unnecessary debt and paying off debt where possible are good things, Keynes. holds that they are bad things. He deprecates depreciation reserves for business corporations. He deprecates· amortization of· public debt by municipalities. He·· deprecates additions to· corporate surpluses out of earnings. His philosophy is responsible for the ill-fated undistributed profits tax which we adopted in 1936 and which we abandoned with a great sigh of relief, over the President's plaintive protest, in 1938.
Keynes gives two reasons for his rejection of prevailing ideas with respect to interest and savings, ~nd the equilibrating function of the rate of interest. The first will be found on pages 110 and I I I of his General Theory. He says:
"The influenciOf changes in the rate of interest on the amount actually saved is of paramount im o.rtance, but is in the oppOJite direction to that usually supposed. For even if the att action of the larger future income to be earned fronl a higher rate of interest has ,the effect of diminishing the propensity to consume, nevertheless we can be certa1o,n that a rise in the rate of interest Will. have the effect of reducing the amount act ally saved. For aggregate saving is governed by aggregate investment; a rise in he rate of interest (unless it is offset by a corresponding cnange in tne demand-sen dule for investment) [italics mine] will diminish investment; hence a rise in the rate of interest must have the effect of reducing incomes to a level at which savin is decreased in the same measure as investment. Since incomes will decrease by a reater absolute amount than investment, it is, indeed, true that, when the rate of in erest rises, the rate of consumption will decrease. But this does not mean that there will be a wider margin for saving. On the contrary, saving and spending will both decrease."
This is an extraord narily superficial argument. The whole case is given away by the parenthetical assage, " (unless it is offset by a corresponding change in the demand.lschedule for investment)." The usual cause of an increase in the rate of interest is a ri e in the demand-schedule for investment. Interest usually rises because of an inc eased demand for capital on the part of those who wish to increase their investents, of businesses which wish to expand, of speculators for the rise, of ho~e-builders, and so on. Usually, when the interest rate rises, it rises because 'nvestment is increasing, and the increased savings which rising interest rates nduce are promptly invested. Indeed, investment often precedes saving 10 in such a situation, through an expansion of bank credit, also induced by the rising rate of interest.
Keynes is assuming an uncaused rise in the rate of interest, and he has very little difficulty in disposing of this. But economic phenomena do not occur without causes.
Keynes's second argument against the prevailing doctrine will be found in his Chapter 14 (ibid.) called "The Classical Theory of the Rate of Interest." Here (with a diagram on page 180) he complains that the static theory of interest has not taken account of the possibility of changes in the level of income, or the possibility that the level of income is actually a function of the rate of investment.
Now it may be observed that Keynes is here introducing dynamic considerations into a static analysis. By this device one may equally destroy the law of supply and demand, the law of cost of production, the capitalization theory, or any other of the standard working tools of the static analysis. Thus the static law of supply and demand is that a decrease in price will lead to an increase in the amount demanded. But with a sudden, violent general fall in prices the tendency is for buyers to hold off and wait until they see where prices are going to settle.
The static economist has known all this almost from the beginning. He has been aware that he was making abstractions. He has protected himself in general by the well-known phrase, ((ceteris paribus" (other things equal), and the general level of income has been among those other things assumed to be unchanged. Moreover, the static economist has concerned himself with delicate marginal adjustments, and· with infinitesimal variations in the region of the margin, a device which Keynes is very glad to borrow from static economics in his conception of the "marginal propensity to consume" and in his initial conception of the "marginal efficiency of capital."
Rejecting the function of the interest rate as the equilibrator of saving and investment, Keynes is so impressed with the danger of thrift that he finally convinces himself in one of his major doctrines that no part of an increase in income which is not consumed is invested; that all of the unconsumed increase in income is hoarded. This major doctrine is the much-praised Keynesian "investment multiplier theory." If an investment is made it gives a certain amount of employment, but that is not the end of the story. Investment tends to multiply itself in subsequent stages of spending. The recipients of the proceeds of the investment spend at least part of it, and the recipients of their spending spend part of what they get, and so on. How many times does the original investment multiply itself? Keynes gives a definite mathematical answer in which his· investment· multiplier rests solely on what he calls "the marginal propensity to consume." The multiplier figure rests on the assumption that the subsequent spending consists entirely of purchases for consumption. None of the unconsumed increase in income is invested. If any of the recipients of the proceeds of the investment should add to their expenditures ,for consumption any investment at all, the mathematics of the Keynes multiplier would be upset, and the multiplier would, be increased. It is a source of satisfaction to find this view in agreement with that of Professor James W. Angell on this point.
The multiplier concept is an unfruitful notion. In times when the business cycle is moving upward, particularly in the early stages of revival, increased expenditure, whether for investment or consumption, tends to multiply itself many fold, as Wesley Mitchell 13 has shown.
In times of business reaction there may be very little multiplication. The soldiers' bonus payments by the Government under Mr. Hoover made no difference in the business, picture. On the other hand, the soldiers' bonus payments under Mr. Roosevelt in 1936, at a time when the business curve was moving upward sharply, appear to have intensified the movement.
The Relation of Savings to Investment.
The preoccupation with the varying relationship of saving to investment is superficial. Investment tends. to equal saving in a reasonably good business situation, when bank credit is not expanding. In a strong upward move, when bank credit is readily obtainable, investment tends to exceed saving because men borrow at the banks and because expanding bank credit facilitates the issue of new securities. Ina crisis and in the liquidation that follows a crisis, saving exceeds investment. Men and businessesare saving to pay down debts and especially to repay bank loans-a necessary preliminary to a subsequent revival of business. But the reasons for these changes in the relation of saving to investment are the all-important things. The relation of saving to investment is itself a very superficial thing. The reasons lie in the factors which govern the prospects of profits, including the price and cost equilibrium, the industrial equilibrium, and the quality of credit.
Keynes strives desperately to rule out bank credit as a factor in the relation of savings to investment. At one point he does it very simply indeed:
"We have, indeed, to adjust for the creation and discharge of debts (including changes in the quantity of credit or money); but since for the community as a whole the increase or decrease of the aggregate creditor position is always exactly equal to the increase or decrease of the aggregate debtor position, this complication also cancels out when we are dealing with aggregate investment."
But bank credit is not so easily canceled out as a factor in the volume of money available for investment. The borrower at the bank is, of course, both debtor to and creditor of the bank when he gets his loan. But his debt is an obligation which is not money, and his credit is a demand deposit, which is money. When he uses this money for investment, he is making an investment in addition to the investment which comes from savings.
On pages 8 I to 85 of the same book, Keynes engages in a very confused further argument on this point.
"It is supposed that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment,or, contrariwise, that the banking system can make it possible for investment to occur, to which no saving corresponds. But no one can save without acquiring an asset, whether it be cash or a debt or capitalgoods; and no one can acquire an asset which he did not previously possess, unless either an asset of equal value is newly produced or someone else parts with an asset of that value which he previously had. In the first alternative there is a corresponding new investment: in the second alternative someone else must be dissaving an equal sum. For his loss of wealth must be due to his consumption exceeding his income... "
But the assumption that a man who parts with an asset for cash is losing wealth, and that this must be due to his consumption exceeding his income, is purely gratuitous. The man who sells an asset for cash may hold his cash or he may reinvest it in something else. It is not "dis-saving" unless he spends it for current consumption, and he does not have to do that unless he wants to. Indeed on the next page (page 83) the man who holds the additional money corresponding to the new bank-credit is said to be saving. "Moreover the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bankcredit, unless he deliberately prefers to hold more money rather than some other form of wealth."
Keynes's confusion· here could be interpreted as due to his effort to carry out a puckish joke on the Keynesians. He had got them excited in his earlier writings about the relation between savings and investment. Then, in his General Theory, he propounds the doctrine that savings are always equal to investment. 15 This makes the theology harder for the devout follower to understand, and calls, moreover, for a miracle by which the disturbing factor of bank credit may be abolished. This miracle Keynes attempts in the pages cited above, with indifferent success.
One must here protest against the dangerous identification of bank expansIon with savings, which is part of the Keynesian doctrine. This, fallacy is discussed at length in the chapters dealing with the expansion of bank credit in the 1920'S and the discussion of the doctrine of oversaving in connection with the undistributed profits tax. This doctrine is particularly dangerous today, when we find our vast increase in money and bank deposits growing out of'war finance described as "savings," just because somebody happens to hold them at a given moment of time. On this doctrine, the greater the inflation, the greater the savings! The alleged excess of savings over investment in the period, 1924- 1929, was merely a failure to invest all of the rapidly expanding bank credit. All of the real savings of this period was invested, and far too much new bank credit in addition.
The Wage-rate as h'quilibrator of the Supply and Demand of Labor.
Keynes also tries to destroy the accepted doctrine regarding the rate of wages as the equilibrating factor between" the supply and demand, of labor: He attempts at various places to suggest' that a reduction in money wages "may be" ineffective in increasing the demand for labor (e.g., ibid., p. 13), but he nowhere, so far as I can find, positively states this. He does suggest (p. 264) that a fall in wages would mean a fall in prices, and' that this could lead to embarrassment and insolvency to entrepreneurs who' are heavily indebted, and to an increase in the real burden of the national debt. On this point it is sufficient to say that the fall in wages in a depression usually follows, and does not precede, the fall in prices, and that it is usually more'moderate than the fall in prices. It does not need to be so great as the fall in prices in order to bring about a reequilibration, since wages are only part of cost of production, and, since the efficiency of labor increases in such a situation.
Keynes accuses other economists of reasoning regarding the demand' schedule for labor on the basis of a single industry, and then, without substantial modification, making a simple extension of the argument, to industry, as, a whole (pp. 258-259). But this is merely additional evidence that he has ignored John Bates Clark's Distribution of TVealth, and the theory of costs of the Austrian School, for whom the law of costs, including wages, is merely the law of the leveling of values among the different industries. Moreover, the studies of Paul Douglas, dealing with the elasticity of the demand for labor as a whole, constitute a sufficient answer to Keynes on this point.. Douglas holds that the demand for labor is highly elastic; so much so that a I % decline in wages can mean a 3% or·4%increase in employment, when wages are held above the marginal product of labor.
But the practical issue does not usually relate to wages as a whole. The wages of nonunion labor, and especially agricultural labor, usually recede promptly and sometimes to extremes, in a depression. The issue usually relates to union wage scales hel-d so high in particular industries that employment falls off, very heavily in these industries, and that· the· industries constitute bottlenecks.
But Keynes does not come to. the theoretical conclusion that a reduction in money wages could not· bring about an increase in employment. He rather reaches the practical conclusion that this is not the best way to do- it. Instead, he would prefer in a closed economy, i.e., one without foreign trade, to make such readjustments as are necessary by manipulations of money, and for an open economy, i.e., one with large foreign trade, to accomplish it by letting the foreignexchangesfluctuate (p. 270).
The fact seems to be that Keynes entertains a settled prejudice against any reduction in money wages. He is opposed to flexibility downward' in wage scales. He has, however, no such prejudice against flexibility upward. On the contrary, in the Keynes plan for an International Clearing Union of' April 8, 1943, Keynes proposes, as a means of maintaining stability in foreign exchange rates, that a member state in the Clearing Union whose credit balance is increasing unduly, shall encourage. an increase in money rates of earnings. (meaning wages) .18. This would increase the cost of its goods in foreign trade, and consequently reduce its exports, and' consequently hold down its credit balance. But Keynes makes no corresponding demand on the country whose debit in the Clearing Union is increasing unduly that it should encourage a decrease in money rates of earnings.