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Friday, August 31, 2012

Money and the Banking System

But even paper money, abstract and ephemeral though it be, cannot be considered as the final stage of that “aenemia” which has characterized the development of money. Paper money is, after all, “cash”; it is a visible concrete currency. Now it is commonly known that most business transactions in the economically most developed countries are consummated not by the use of actual cash but by the transfer of bank deposits. The participants in such transactions maintain bank accounts against which they write checks. In disposing of their bank deposits in this way, they make use of a variety of money which is designated as credit money (bank money, check money, or demand deposits). In this, the dominant medium of exchange today, money has found its most abstract expression. Even the simple counter, as it were, has disappeared from the gaming tables of finance—people simply “keep track of the score.” If, under the general heading of “the banking system” we include both banks of issue and banks which handle demand deposits (commercial banks), it is evident that in the economically advanced countries the monetary system is intimately connected with the banking system. Thenceforth, money and credit constitute an inseparable entity.

We find, too, that the same sequence of credit expansion which is associated with the issuance of bank notes occurred in the case of demand deposits. Thus, to the extent to which demand deposits circulated as money, the banks felt themselves freed of the obligation of maintaining a 100 per cent cash reserve behind these deposits, despite the fact that they are debts of the bank subject to payment on demand (hence the name “demand deposit”). To provide the necessary minimum liquidity (the ability to meet expected demands for cash) it was deemed sufficient to maintain a supply of ready money equal to, let us say, 10 per cent of the total demand deposits oustanding. The banks could loan out the remaining 90 per cent and earn enough in the process to administer the deposits without charge or even to pay a small amount of interest on them. Hence-forth, the whole art of bank management consisted in effecting a daily compromise between the two opposed principles of liquidity and profitability, with the over-all goal being the maintenance of minimum liquidity and maximum profitability. Small errors of calculation could be corrected by recourse to the so-called “money market.” Thus, the whole system is truly “minutely adjusted to reflect the smallest increment in weight which it can just support.” We can now observe what an important bearing banking has on the entire monetary system. Prior to the development described above, only cash money circulated. Thenceforth, demand deposits circulated simultaneously with the greater part of the cash which gave rise to these same deposits. The circulation of demand deposits or check money was equivalent in short to the “creation” of an additional supply of money.

There is yet another angle from which we can observe how the modern banking system affects the
supply of money. A businessman, for instance, may establish a demand deposit (checking account) not only by depositing hard cash in the bank, but by getting the bank to extend him a loan for this purpose. Thus, by adhering to a proportion of 1 : 10 between cash reserves and outstanding demand deposits, with 90 per cent of the actual currency paid in being loaned out, the bank can, by granting cerdits, create new checking accounts (demand deposits) to an amount nine times greater than that which has been paid into it. It is clear in this case that the bank, following the same procedure as a bank of issue, grants credits not out of preceding savings, but from additional resources obtained by the creation of credit. To what extent is a bank capable of creating credit? This depends upon the bank’s liquidity requirements, that is, upon the amount of the reserve which the bank must maintain to meet the demands for the conversion of check money into actual cash. This preoccupation with the maintenance of liquidity, which no bank can safely ignore, more or less effectively limits the bank’s power to create credit. The liquidity requirements of banks fluctuate with the degree of confidence placed in banks, with the amount of the payments made to those who are outside the circle of the bank’s regular clients (payrolls, small payments to retail merchants, farmers, etc.), and with the turnover of individual bank accounts. But more significantly, the fluctuations to which bank liquidity is subject—and pro tanto the fluctuations to which the total supply of credit is subject—coincide to a very large extent with the cyclical fluctuations of prosperity and depression. In a period of expansion the economy’s supply of credit increases, while the banks’ liquidity is proportionately lowered (credit expansion); in a period of depression the banks seek greater liquidity and are forced, in the process, to contract credit (deflation).

It is of great importance that we thoroughly understand the above relationships, for without such understanding we cannot adequately comprehend the perils and the problems which currently beset our economic system. Hence, no effort should be spared in getting to the bottom of these relationships.8 One way of doing this is to imagine an economy where all payments are effected without the use of actual currency. Evidently, in such case, there would no longer be any limit to the power of the banks to create credit. The more widely extended is the system of transactions effected without cash, the greater becomes the power of the banks to “manufacture” credit. Yet again, we may compare a bank with the cloakroom of a theatre. In both cases we deposit something: in the bank, currency and in the cloakroom, our hats; in both cases in exchange for a receipt which authorizes us to reclaim what we have deposited. But while the cloakroom employees cannot count on the theatre-goer’s not presenting his receipt because he regards it as just as good as his headgear, the bank may safely assume that its clients will in fact consider their receipts (i.e., their right to claim their deposits) to be equally as good as their deposits. A bank is in consequence an institution which, finding it possible to hold less cash than it promises to pay and living on the difference, regularly promises more than it could actually pay should the worse come to the worst. Indeed, it is one of the essential features of a modern bank that alone it is unable to meet a simultaneous presentation for payment of all the debts owed by it (“run on the bank”).

When the whole banking system of a country is subject to a run, as in the United States in 1933, it is an event of very grave import. For then the whole ingenious system of immaterial money, founded on convention and on trust, suddenly crashes down and the desire of the public for solid cash erupts with elemental force. What then takes place is a sudden panic collapse of the credit edifice to some anterior stage of monetary evolution. In this headlong retrogression money may fall back past even the paper bank-note stage to full-value coins or, in more drastic cases, to unstamped pieces of the precious metals. In the ’30’s, a number of countries underwent such monetary crises and their effects are still being felt.
The so-called “creation of credit” by commercial banks is possible only because the circulation of short-term credit is equivalent to a circulation of money. To create credit, then, is to create money. This mysterious and seemingly sinister phenomenon may be better understood by once again comparing checks (or demand deposits) with bank notes and by recalling the historic discussion of the problems of bank note issuance. Two important facts emerge from such reflection: (1) bank notes can be printed ad hoc, as the occasion demands; (2) the commercial bank, with its power of creating credit, differs in this respect only in degree and not in kind from the note-issuing bank. No one, certainly, will gainsay the first point. For the truth of our second observation, we have only to recall that the transfer of a demand deposit from one person to another by means of a check, coupled with the confidence of the parties to such a transaction in the solvency of the bank, causes this deposit to circulate exactly as money.
Checking accounts may be regarded as money held on the bank’s books and awaiting withdrawal; checks and drafts drawn on these accounts are, therefore, simply means by which such book money is put into circulation. In the extent to which, in accordance with the law of great numbers, deposits and withdrawals offset each other, and to the extent, furthermore, that the circulation of demand deposits is confined to the banking system’s circle of customers, it is not required to maintain a 100 per cent reserve behind such deposits. On the contrary, a bank can, as we have seen, loan out a part of its deposited funds, even though such funds are callable by the bank’s depositors at any time. Bank notes and demand deposits are thus very similar to each other. Both have this in common, that they are circulating claims which the banks write against themselves and which they can create to an extent equal to some multiple of their cash reserves. The only difference between them is that the acceptability of demand deposits for purposes of general circulation is more limited than that of bank notes, but this is a difference of degree and not of kind.

Few will contest the fact that since bank notes are actual money and can be issued theoretically in unlimited amounts, there should be some kind of legal control over the note-issuing power. This is all the more necessary since in practically all countries bank notes are full legal tender even though they are no longer redeemable in specie. But it is interesting to recall that the power of banks to issue notes at will and thus to increase the supply of money was once just as controversial as is today the corresponding, if more limited power of the commercial banks to create credit.

To be sure, the issuance of bank notes has always been regarded as an undertaking fraught with risk to the community. The history of the note-issuing banks is a long and anguished one, dotted with ruined banks and—what is even more depressing—strewn with the memorials of wrecked monetary systems. “Never,” said the English economist Ricardo 150 years ago, “has a bank which had unlimited power to issue paper money not abused that power.” Thus the conviction grew that the issuing of bank notes should be subject to definite limitation. But where ought the limits to be placed? On this point there was a very heated argument one hundred years ago between two schools—the Currency School and the Banking School. Their differences, even after the lapse of a century, have lost none of their significance.

The opinion of the Banking School with respect to the phenomenon of credit creation may be summarized as follows: bank notes and demand deposits are similar inasmuch as both are phenomena pertaining to banking—hence the name “Banking School”—but neither exert any active influence on the monetary system. In the rigid view of this School, the monetary system will remain shipshape so long as bank notes enter circulation through banking operations alone, that is, through short-term credit transactions. In these circumstances, every legal barrier to the issuance of bank notes would be harmful while, conversely, unrestricted powers of issuance would be absolutely indispensable to maintaining elasticity of the supply of currency, and to adjusting this supply to the fluctuating needs of business. This adjustment would ensue automatically because demands for credit on the note-issuing banks would rise or fall as general economic activity rose or fell. Thus, the position of the note-issuing banks with respect to the increase or decrease of the volume of bank notes would be a completely passive one, since the volume of bank notes would depend on the money and credit needs of the business community and not on the volition of the note-issuing banks. A change in the volume of currency would be not the cause but only the effect of events occurring in the sphere of production, or of changes in the price level, or of cyclical changes, or of variations in the rates of foreign exchange, etc. Every attempt of the banks to alter the volume of currency above or below the requirements of business would fail; if too many notes were issued, the excess would flow back to the banks, while if not enough were issued, business would resort to other circulating instruments.

The Currency School, in contradistinction to the Banking School, considered bank notes to be a money phenomenon and not a credit phenomenon. It reasoned, therefore, that the issuance of bank notes should be just as jealously supervised as the issuance of any other kind of money. In opposition to the Banking School, it argued logically that the sum total of bank credits is not unaffected by the policy of the note-issuing bank which fixes the conditions of credit, particularly the rate of interest. The issuance of bank notes is to be considered like any other creation of money and there is nothing in the nature of the operation of the note-issuing bank which could prevent either an excessive creation of credit (credit inflation) or an insufficiency of credit (credit deflation). Hence, the issuance of bank notes requires strict legal supervision. But this much established, the Currency School forgot that demand deposits can be just as much a source of credit inflation or of credit deflation as bank notes. As a result, the adherents of this school suffered considerable disillusionment when the severe restrictions on the issuance of bank notes embodied in the famous English Bank Act of 1844 failed to solve the problems incident on credit creation; indeed, these restrictions on bank-note issues served to stimulate the growth of the demand deposit (check) system. The more rapid the increase in the last hundred years of the importance of demand deposits in business transactions, the clearer it has become that regulation of the note-issuing banks alone will not suffice to cope with the exceedingly difficult problems attendant on credit creation.
Control of the note-issuing banks must be supplemented by regulation of the demand-deposit system.
Though academic economists are now unanimously of the opinion that commercial banks can and do create credit, there is many a practical man of affairs who is inclined to view such “theories” with skepticism. There are still people in the banking world who hold that their own experience invalidates the creation of credit theory in toto. Such skepticism may be traced, in part, to exaggerated or incomplete descriptions of the process of credit creation. We must guard against overstating our case, for there are, of course, the limits to this process which were noted in an earlier part of this chapter. We also must take into account the optical illusion which causes the individual banker to view the aforementioned process in a radically different way than the economist who surveys the banking system as a whole. Thus the individual bank cannot continue indefinitely to make loans, for the cash reserve it must maintain clearly sets a limit to its loanable funds. If Bank A considers a reserve of 10 per cent adequate, then it can only loan out 90 per cent of its deposited cash. But the process of credit expansion is not therewith concluded because this 90 per cent will ordinarily become a primary deposit in Bank B which again loans out 90 per cent, etc. When the process is continued throughout the entire banking system it will be found that eventually nine times the original amount of cash deposited in the system will have been extended in loans (9/10 + 9/10 • 9/10 + 9/10 • 9/10 • 9/10 . . . . . . . 9/10n). We see that the “enigma of the banking system” (Philipps) consists in a given amount of cash becoming the basis for a towering edifice of credits and deposits, though this is clearly not the case with respect to the individual bank. Hence, by the very nature of the complicated process to which we have just alluded, it becomes impossible to distinguish between genuinely primary cash deposits and those derivative deposits that come into being through the creation of credit. Consequently, we can readily see why an individual banker will so vehemently deny the process of credit creation, a process that to us appears so self-evident. Such denial absolves the individual bank of the “guilt” (or at any rate of the responsibility) of creating additional credit. Now when we said that a bank must pay heed to its cash reserves, we said nothing more than that it must stay liquid. The degree of liquidity desired or required fixes the outer limits to a bank’s powers of credit creation, provided, of course, that actual currency is not completely displaced by demand deposits (check money) centralized in a single bank.

Two conclusions may be drawn from the foregoing analysis. First, that the global sum of a country’s demand deposits does not represent pure saving, but is in large part a consequence of the creation of bank credit. This is something which must never be lost sight of in considering any economic problem. The second conclusion is that money and credit constitute an entity, the complexities of which place a number of formidable difficulties in the path towards economic and monetary stability. A bank is no ordinary commercial enterprise. It is not just a cloakroom where we deposit our monetary property for safekeeping, or a kind of shop where one rents costumes for a masquerade, but an enterprise which exercises a profound influence on the circulation of money and thus on the entire economic process. Consequently, the thought never occurs even to the most intransigent European liberal to abandon the control of such an enterprise to itself. And so we repeat: he who does not understand the role of the banking system is incapable of understanding the operation of the modern economic system.

Economics of the Free Society

Thursday, August 30, 2012

From Cattle to Bank Notes

If we contemplate a collection of old coins, we can readily perceive some of those important features of a sound money about which we have been speaking. What first strikes us is the great variety of coins and of coin systems which appear to have existed in former times side by side within the frontiers of a single country. What a muddle of doubloons, continentals, florins, threepenny pieces, marks, ducats, and gold louis! We may rightly conclude that our ancestors’ patience must often have been tried with the continual counting and recounting made necessary by such a multiplicity of systems. Plainly, the elimination of such confusion by the establishment of a homogeneous monetary system must be numbered among the primary aims of monetary policy so soon as business activity has expanded beyond the rudimentary stage. Homogeneity of the monetary system is thus one of the principal requirements of a sound money: all monetary units within the same economic system should be exchangeable against one another at as stable and firm a ratio as possible. In spite of the antiquity which attaches to the discovery of the coin system, thousands of years of experimentation were required to develop the homogeneous monetary systems which, to our generation at any rate, seem so self-evident, and to put an end to the confusion in computation and, what was even more disagreeable, in prices. Actually, the homogeneity of national monetary systems is an accomplishment only of recent times. The close of the 19th and the beginning of the 20th centuries witnessed, moreover, the successful creation of international monetary homogeneity paralleling that existing on the national level, thanks to the gold standard which united all countries within the framework of one monetary system. The abandonment of the gold standard in our times means then, with regard to the postulate of monetary homogeneity, an unfortunate step backwards, for so far there has been discovered no other international monetary system. A special and thoroughly unhappy phase of the age-long struggle for national monetary homogeneity is represented in the attempts to combine the use of both gold and silver, in a fixed ratio, in one monetary system (bimetallism).4
The collection of coins we are contemplating tells us something else which is perhaps of even greater importance. Many of the silver coins will be seen to give off a suspicious reddish glint, indicating the presence of a strong alloy of copper. No great powers of imagination are needed to conjure up the coin debasements of past centuries (and the monetary depreciations which accompanied them); they are, in fact, the historical prototypes of the inflations of our own times. These experiences of the past make clear the importance of that other requirement of a sound money, stability of value, and the strenuous and repeated efforts required in the course of history to establish it. In this instance, too, the introduction of the gold standard in the nineteenth century was the factor most responsible for the establishment of money upon a solid base. Again, too, it is our own destructive age of wars and revolutions which is responsible for the sabotaging of this accomplishment. Once more, the maintenance of monetary stability has become an economic problem of the first magnitude.
There is one fact, however, which an examination of our coin collection does not reveal to us, but with which we have become intimately familiar as the result of our own painful experience. Though the people in whose pockets our collection of coins once jingled were plagued by a confusion of monetary systems and of coin debasements with a resulting lack of monetary homogeneity and stability, one thing was self-evident: their freedom to exchange their money against goods or against other kinds of money. Of course, there were instances in these earlier periods of where an unscrupulous ruler of the modern stamp such as King Philip the Fair of France would proclaim, as he did at the end of the thirteenth century during his struggle with the Papacy, an embargo on the export of money and letters of credit, thereby introducing what we term at the present time exchange control. But we have no record of Erasmus, Luther, or Goethe encountering any difficulties in exchanging their money on their respective journeys to Italy. Restrictions on freedom to exchange domestic money against foreign money are in fact an invention of our own time, and we have little reason to be proud of having made exchange control a normal procedure and therewith deprived money of that freedom which in the eyes of our forbears pertained to its very essence. Moreover, we find that in some countries even the freedom to exchange money against goods has been so restricted by rationing regulations that for the purchase of certain categories of goods money is worthless unless accompanied by a special permission to purchase. Out of such restrictions collectivist Russia has made a permanent system, a proof that in the collectivist economy money completely changes its role and in any case can no longer be equivalent to “coined freedom.”
If we keep in mind that the three most important postulates of a sound money are homogeneity, stability of value, and circulatory freedom, then we may regard the history of money as a history of the tribulations which it has endured: a history of debasements, of risky experiments, of repeated violations of these postulates. At the very least, valuable insights can be gained by reviewing the history of money from this angle. Another vantage point for the study of monetary evolution is found in the interesting fact that from earliest times to the present day, money has become progressively more abstract, more “aenemic.”
The cattle in which Homer counted out the value of Achilles’ shield was evidently a very concrete kind of money. Even in the age when men began to use specific weights of the precious metals as money, the purely material aspect of money was still of prime consideration. This primitive method of payment which consisted of weighing out amounts of the precious metals (“weight payment” according to G. F. Knapp) is memorialized in the fact that many contemporary words for money were originally nothing more than designations of weight, as in the obvious cases of the English “pound” and the Italian “lira,” but also in the cases of the German “mark” and the Yugosalv “dinar” (from the Latin “denarius”), among others. Nor did the evolution towards an even more complete dissociation of money from its purely material content end here. Those of us who have ever had to buy a railroad ticket at the last minute will appreciate the difficulties attendant upon the method of “payment by weight,” difficulties which disappeared after the tremendous forward step taken in antiquity—probably for the first time in Crete in the second millenary B.C., then later in Asia Minor—when unitary weights of the precious metals were introduced, embossed with an official stamp guaranteeing their weight and purity.
With the stamp of guarantee, there came into being a money which made it possible to make payments not by weighing, but simply by counting. The exchange value of this fully-valued money (currency) was still identical with its material value. But the next stage of development saw the issue of token money or subsidiary coin, that is, of under-valued monies whose material value represented only a fraction of their exchange value. This marks the further progress in the direction of monetary aenemia; and in fact in most civilized countries today, people know no other coins than these. These aenemic coins, however, are used only in transactions involving small sums; by far the greater part of payment transactions in all civilized countries is effected by means of money still more ephemeral in nature, viz., stamped pieces of paper.
In the beginning, paper money still had a certain material aspect, in the sense that it was a receipt for a deposited amount of precious metal. This early paper money, moreover, had a 100 per cent coverage and could always be converted into precious metal. It was, therefore, originally a circulating claim against the “bank” which had assumed the safekeeping of a quantity of the precious metals and issued in exchange therefor a receipt (bank note). The banks soon noticed the influence of the “law of great numbers” on their increasing volume of business: their deposits and withdrawals largely offset each other. And they noted the even more important fact that the bank notes began to circulate as money, supported by the confidence that people had in the possibility of redeeming them. Consequently, it did not appear necessary to cover the notes to the extent of 100 per cent. Even where full convertibility of the paper notes was maintained, a given ratio of reserves to liabilities was sufficient to enable the bank to meet the demands for redemption which could be expected in the ordinary course of business, a ratio which was later legally fixed in most countries, in one form or another. This meant, of course, that the bank of issue could put into circulation many more notes than the equivalent of its reserve in precious metal and could thus issue more promises of payment than it would have been able to meet if they had all been presented at once. Such additional bank notes got into circulation when the bank of issue used them to accord commercial credits, primarily in the form of purchases of promissory notes from which the interest was deducted in advance (discounting). By using these additional bank notes to furnish credit, the bank had succeeded in a bit of legerdemain which to this day many people fail to understand: it had furnished credits which did not arise from previous savings but from the issuance of additional bank notes (creation of credit).5
The bank notes thus put into circulation were born of a credit operation and hence represented a combination of the monetary system and the credit system. So long as the notes remained redeemable (full gold standard, gold circulation standard),6 they preserved a certain indirect connection with the concrete matter of money. But this connection became increasingly attenuated when redeemability was restricted to certain categories of payments (such as payments to foreign countries) and when the domestic circulation of gold coins was prohibited (gold bullion standard).7 The divorcement of bank notes from a precious metal was made complete with the abolition of redeemability in any form (paper standard). Before World War I, the full gold standard prevailed in the economically developed countries; subsequently, it was the gold bullion or gold exchange standard which became the dominant type. And today we find the paper standard, under various forms, almost everywhere in operation.

Economics of the Free Society

Wednesday, August 29, 2012


“The sole fact that credit is today the normal and proper expression of value and of exchange has introduced an element of extreme instability into all contemporary economic systems. Modern economic systems appear to be balanced on a knife’s edge as it were; the tiniest excess or deficiency of national credit can tip the balance in one direction or the other. This system is minutely adjusted, so to speak, to reflect the smallest increment in weight which it can just support, and that is why it is so extremely sensitive.”

What Is Money?
We have already established that money is a device which is indispensable to an economic system founded on exchange and on an intensive division of labor. Consequently, any investigation of the modern economic process remains incomplete without a special chapter on money. It is, moreover, certain that we shall be unable to understand the operation of our economic system so long as we do not have a clear apprehension of the peculiar qualities of money. It is in the deepening of our knowledge of these qualities that economics has made its most notable advances in recent years.1 We can go even further and say that the history of peoples and of civilizations cannot be fully understood if attention is not given to the important role which money has played in history, and in the development of the way of life of different epochs.2
We do not know when money first appeared in human history. Very probably, it was not invented in the same manner as the electric light bulb or the typewriter. What most likely happened is that one day, many thousands of years ago, people suddenly became conscious of the fact that money existed. Only one thing we can say with certainty: to be really money, money must have had to fulfill, thousands of years ago as today, the essential condition of being generally exchangeable and acceptable as a means of payment. We can understand, therefore, why the earliest form which money took was some particularly desirable commodity which could, if need be, serve for real satisfaction. Early money was constituted at times of bars of iron, at times of strips of cloth or of leather, and most often of cattle, proof of which we find in the fossil remains of language, in the Latin word “pecunia” and in the English “fee” which corresponds to the German “Vieh” (= cattle). Eventually, the precious metals, for many and obvious reasons, attained preeminence as money. Thence begins the history, open to our investigation, of money and currency.
We are already familiar with the economic revolution which followed the introduction of exchange based on money. Exchange was henceforth separated into two acts: the act of “selling” one’s own commodity against the receipt of a sum of money, and the act of “buying” another’s commodity by surrendering a sum of money. We can see that each of these two acts is an act of exchange: exchange of commodity against money, and exchange of money against commodity. In place of the original exchange of commodity against commodity, we now have the concatenation: commodity—money—commodity. Simultaneously, money made possible the participation of more than two persons in the act of exchange. The end result of the process of exchange in a money economy is, of course, an exchange of commodities against commodities, but in contrast to the economy of exchange in kind, this result is obtained in an indirect way by a detour passing through several individuals who make use of a general medium of exchange.
If we term a “good” every object or service to which we attach value, then money too is a “good.” Nevertheless, it is a good of a very special kind. We value an ordinary good because it is capable, in some way, of ultimately satisfying a want. In the act of satisfying a want, it renders up its economic soul, so to speak; it achieves the purpose of its existence. In a word, every other good but money serves for “real” satisfaction. From the raw material to the packaged product, chocolate goes through numerous stages and passes through many hands, but its final inglorious destiny is to be eaten. It is not so with money. If commodities providing real satisfaction are by essence and destination mortal, money is essentially immortal because it is not used for real satisfaction but for “circulatory” satisfaction. In other words, we do not derive satisfaction from money by eating it, but by spending it and by making it circulate, intact, from hand to hand. This does not mean that money, insofar as it is constituted of some material substance, may not also furnish real satisfaction. People can collect coins, melt them, or hang them on a watch chain. A man can paper his walls with bank notes, if he is willing to allow himself this extravagance. But money in these cases at once ceases to be money. It becomes a simple commodity, just one more addition to the strongly mixed company of chocolate bars, sugar buns, and phonograph records. It is essential to the concept of money that it circulate, and in a direction opposite to the (finite) circulation of ordinary goods. Whereas chocolate bars, phonograph records, etc. are always leaving the stream of goods in order to be consumed, it is the essential characteristic of money that it remain in circulation as money.
Money accomplishes its mission by enabling us to widthdraw from the huge store of the economy’s goods those which we desire. Ordinarily, we obtain this right by contributing, on our side, to this same store of goods. Money has thus been compared to an admission ticket providing access to the “social product,” that is, to the current stock of goods and services. Money may be compared, if we wish, to a “promissory note” on the social product. Such comparisons are permissible on the condition that we do not forget that money implies neither a qualitative nor a quantitative determination of a right to the commodities, nor any juridical claim on the store of commodities. The determination of the if, the what, and the how much is always subordinated to the market and to the formation of prices, in such a way that the “right” to something is narrowed to a simple possibility. From the purely juridical point of view, money should be defined only as “a final means of liquidating debts,” providing that it has been imbued by law with the quality of being “legal tender for all debts, public and private.” Such money confers on him who is obliged to pay (the debtor), vis-à-vis him who is entitled to receive payment (the creditor), the right to an acceptance which frees him from his debt.3
But if we employ—with this reservation—the comparison of money to a promissory note, we can see at once that it is possible to imagine a money which is incapable of furnishing any real satisfaction and which is thus without material value. But this lack will not negate the functions of money as a general medium of exchange provided that it retains the essential quality of “general acceptability” (F. von Wieser). The lack of a material content offering the possibility of real satisfaction does not exclude the possibility of a circulatory satisfaction, and if we value money according to what we can buy with the monetary unit, money without material value of its own possesses “value” just as well as money with material value. The value of money in the former case reflects the value of the goods which we can buy with the monetary unit; it does not flow from the value of the money material, but arises from the function of money which is to circulate and to be exchanged against commodities. Money in this context has a functional value and not a material value. The belief that it is the very essence of money to be incarnated in a piece of precious metal (metallism) is therewith refuted. The question of what will circulate as money is ultimately determined by the confidence of the people in the possibility of returning money to circulation. This confidence can be strengthened in two ways: either by endowing money with its own material value (coin), or by making it legal tender (nonredeemable paper money of fixed par value). As a general rule, it is necessary to educate the population to accept paper money which is nonredeemable and without material value. In the eastern provinces of Turkey, for example, it was still recently almost impossible to compel the peasants to accept the government’s (then stable) paper money. A Turkish official related to the author that while on an inspection trip, he had succeeded in getting a village wagoner to accept paper money rather than gold only by using his fists (admittedly, a somewhat crude illustration of the concept of fixed par value!). In our case, fisticuffs have been replaced by war which has so accustomed us to the use of paper money that we can scarcely recall a time when paper money was redeemable in gold. Indeed, we find it hard to imagine that our fathers could take their bank notes to the banks and obtain pieces of gold as naturally and as easily as postage stamps. Plainly, then, the connection of money with a precious material is not essential, though this does not exclude the fact that such connection may be very desirable. Normally, there is no need of making theatre tickets out of candy, unless it is feared that the management will sell more tickets than there are places, in which case we can console ourselves a little with the tickets made of candy.
In the case of inconvertible paper money, we see with special clarity the nature of money as a simple but indispensable auxiliary to economic activity, a kind of poker chip as it were. From the point of view of economics, money is a way-station, an item in the national ledger which disappears in the final accounting and which does not itself constitute an integral part of a nation’s wealth. A nation does not become richer or poorer because its supply of money increases or diminishes, but only when the supply of goods of which it disposes grows greater or smaller. If the supply of money in a country increases or diminishes while the supply goods remains the same, it follows that the supply of goods which can be purchased by the monetary unit will become smaller in the first case (inflation) and greater in the second (deflation). If the bank notes of a private individual are destroyed in a fire, his loss, which may be very great, does not necessarily represent a loss for the national economy, apart from the negligible value of the paper and the costs of printing. Indeed, the sum of which this unlucky individual is deprived actually benefits the rest of the population, for the purchasing power of all the other bank notes increases by the fraction corresponding to the amount of the burned bank notes. What has taken place is a sort of miniature deflation.
Pursuing this notion still farther, we see that however we use our money, our conduct will exercise an influence on the whole of the national economy. If we spend it, the way in which we spend it affects, in the fraction corresponding to the amount spent, the way in which goods are produced. If we do not spend it, we can either put it in a bank and thereby give to others the possibility of buying raw materials and machines, or we can pile it up in the cupboard at home. In the latter case, the purchasing power of the money becomes inactive to the profit of all the other members of the payment community who can now buy more cheaply. Whatever we do, we can never escape the responsibility which is imposed on us by the possession of money.
Money is one of those objects whose essence can be explained only in terms of their functions. Thus, the essence of money resides in its function of being a general medium of exchange. Of critical importance, in this connection, is how the broad masses of the citizens will react in a period, say, of hyper-inflation when once they become fully aware that money is no longer “functioning” as it should. Money is so indispensable to the modern economy that where the state-issued currency is rendered worthless, the country’s ongoing trade and business activities, even where they are at a low level, will of themselves bring into existence a substitute means of calculation. Such ersatz money may take the form of stable foreign monies as in the inflationary period following World War I when the dollar, the guilder, etc., supplanted the worthless local currencies in many countries. Or it may take the more unusual form of some scarce commodity such as the cigarettes which did yeoman service in those European countries which were devastated by World War II.
Only money makes possible the satisfaction of the complex pattern of consumer desires by causing the highly differentiated structure of production to shift continuously in response to such consumer desires. Only money makes possible rational economic calculation in that it provides a device for comparing production and consumption, profits and costs, and, as we have already seen, reduces all economic quantities to a common denominator. “Money alone is the absolute good: not merely because it satisfies a want in concreto but because it satisfies want as such, in abstracto” (Schopenhauer). It is, as Dostoievsky once expressed it, “coined freedom.” Finally, money has supplied the foundations for our modern credit system, without which the contemporary economy would be unthinkable. But it can furnish these manifold services only so long as it remains a general medium of exchange and meets the requirements of a “healthy” money.
When we consider somewhat more closely those services which money renders in virtue of its quality of being a general medium of exchange, our attention is drawn especially to the aforementioned attribute of money which enables us to compare all the objects of exchange with one another in such a way that we can express their value as a multiple of the common monetary unit. This is what is meant when we say that one of money’s functions is to be a general measure of value. However, we cannot regard this function of money as being equally important and equally necessary as its function of being a general medium of exchange. It is more accurate to say that because money in its concrete form is a general medium of exchange, the exchange value of marketable goods will inevitably be expressed in units of money. Money as a general medium of exchange consists of the concrete dollar notes or checks which I use to buy goods. Money as a measure of value, on the other hand, is the dollar as an abstract unit of account.
Closely connected with the exchange function of money is another of its functions, that of being a general means of payment. Every money payment need not involve an exchange transaction; payment of taxes, of penalties, of damages, gifts of money and many other examples show that money can also function as a means of unilateral value transfer. But this again is possible only because it is a general medium of exchange.
A further consequence of the exchange function of money is its ability to be an intermediary in capital transactions, i.e., its quality of making possible the emergence of debtor-creditor relationships and the transfer of the ownership of capital from person to person or group to group.
Finally, money’s function as a medium of exchange renders it an appropriate means of capital saving and capital movement. Or to express this idea somewhat differently, money becomes a vehicle of value through time and space (von Mises). Actually, money nowadays—except in periods of distress—no longer serves in any significant degree as a means of capital saving, since the average person is apt to put what is not mere working capital or simple cash reserves into investments which will yield a profit, or he turns over his savings to a bank to administer. It is as a vehicle of capital movement that money has retained a larger measure of significance.
In general, all monetary functions are exercised in a given country at a given time by one and the same monetary system. Indeed, its capacity for assuming all of its functions may be regarded as one of the criteria of a healthy money. It may happen, however, that the different functions are accomplished by different kinds of money. Such a process of division of functions was very well illustrated during the German inflation following World War I. The more worthless the mark became, the more of its functions it had to abandon. The first of its functions which the mark was to surrender was that of being a means of capital saving and capital movement; subsequently, it had to forego its function as go-between in capital transactions. Only an uncommon lack of economic insight could have induced anyone in the year 1923, at the height of the German inflation, to hoard mark bank notes or to buy mark securities. Next to go overboard was its function as a measure of value as more and more people turned to calculation in gold or used the “index” and the multiplier. The government itself was compelled in the end to collect its taxes in “gold marks.” Thus was the mark increasingly restricted to being merely a means of exchange and of payment. It was just about to lose even these last functions when the successful stabilization of the mark was accomplished in November 1923.

Economics of the Free Society

Tuesday, August 28, 2012

The Dangers and the Limits of the Division of Labor

It is well known that too intensive a division of labor can result in the atrophy of certain of our vital functions. There are several reasons for this. To begin with, the greatest part of our waking hours is spent on the job which yields us our daily bread. To be compelled to pass these hours in the performance of one narrowly confined operation is to cause the atrophy not only of certain muscles of the body, but of faculties of the mind and spirit as well. The highly specialized man is robbed of the chance to experience the fulness of his own personality; he becomes stunted. The country youth who comes from an unspecialized milieu will quickly adapt himself to city life. Indeed, it is a popular maxim that the “small town boy” makes good in the big city. On the other hand, the specialized industrial worker who goes to the country is, more often than not, a failure. Modern man does less and less by himself for himself. Canned foods replace those that were once prepared at home; ready-made clothes are substituted for those formerly made by mother or wife; the phonograph, the radio, and now television drive out the music once made around the family piano; football “fans” crowd gigantic stadia to experience on the vicarious level thrills that were once procured by genuine participation. And this vicarious way of life is extended even to letting others manufacture our thoughts and our opinions through the instruments of the press, the radio, and the movies. If credence be given to information emanating from certain cities that the demand for illegitimate children for adoption exceeds the supply, then we have reached the point where people even have their children made by others. Thus, as it encroaches on new fields of human activity, the division of labor leads increasingly to mechanization, to monotonous uniformity, to social and spiritual centralization, to the assembly-line production of human beings, to depersonalization, to collectivization—in a word, to complete meaninglessness which may one day generate a terrible revolt of the masses thus victimized. If there were not at this time evidence of encouraging countermovements, if the birth rate had not already begun to decline, thus freeing us from the principal mechanism of this development, we might easily imagine that we were moving full tilt towards the dreadful termite state of which Aldous Huxley has given us such a shocking glimpse in his Brave New World.
The dangers of an intensive division of labor lie not only in the fact that specialized work causes the impairment, through lack of use, of important human faculties, but also in the fact that it reduces the human content of the specialized work itself. Thus, we have the worker in a modern mass-production plant going through the same monotonous motions day after day to make some part of whose end use he may be only dimly or not at all aware, an object which in any case is being made for total strangers in whom he has not the slightest interest, nor they in him. This may kill the joy of work and the pride of craftsmanship. There is a tendency, moreover, for quality to worsen when it is performed for anonymous third parties, with advertising making up in aggressiveness what the goods lack in quality. But lest we exaggerate these evils, it is well to remember that we are speaking here only of dangers and tendencies. It is not true that specialized work is always more monotonous than non-specialized work, particularly since the progress of technology (automation) has made it possible to turn over to the machine, in large part, precisely those motions which are most monotonous. We would be equally in error if we were to believe that genuine enjoyment of work, meaningful work content, professional pride, and quality performance are necessarily denied to the highly specialized worker. Much can be done to restore real meaning to the work of the specialist by the right kind of plant organization and by awakening in him the professional pride of the craftsman in work well done. The problems of excessive specialization are primarily problems of large industrial establishments, so that the forces opposing industrial concentration (and the strength of these has been too often underestimated) may be expected to mitigate the evils here described.10
But much more immediate and obvious than the moral-cultural dangers we have mentioned are those which arise from the mutual dependence of one individual upon another which the method of specialization requires. The denser and the more complex the division of labor, the more difficult it will be to achieve harmonious coordination and the more widespread will be the reverberations of every disturbance of this complicated process. A simple example will serve to illustrate what this means.
Let us assume that a collection has been taken up for the construction of military aircraft, and let us see what effects this action will have upon a country’s economy. The action begins with the contribution of money by different people and it ends with the construction of planes of metal and wood for the use of the state for whom the collection was originally taken up. The question we must ask is: How are all those goods and services which the citizens, by virtue of their contributions, must forego, changed into aeroplanes? The case would be simple enough if all of the things which the donors renounce could be immediately used in the construction of aeroplanes; no change would then occur in the country’s economy beyond the substitution of one group of buyers (the state) for another (the donors). But this is a marginal case which we may exclude from our inquiry. Ordinarily, the donors are required to forego the consumption of quite different things than wood and metal.
In Turkey, some years ago, just such a collection as we have been describing was taken up. The population was urged to forego during the Kurban-Bayram (the Mohammedan spring festival) the feasts of mutton traditional on this occasion for the benefit of the national subscription for the construction of military aircraft. But why give up mutton? The Turkish government could no more make airplanes out of sheep than governments in Christian countries could make them out of Christmas trees or Easter eggs.
We can, at this point, glimpse the complications which a collection taken up for the construction of airplanes will involve. Let us suppose that the amount of my subscription compels me to give up a bouquet of flowers, or a taxi ride, or an evening at the theatre. The result of my sacrifice is to upset in some degree the markets which counted on my purchases. The bouquet wilts in the flower shop, the taxi driver awaits me in vain, my seat in the theatre stays empty. Each of the enterprises concerned sees its profits decline as the result of my abstentions. And these losses entail still further losses since the florist, the taxi owner, and the proprietor of the theatre will have to forego certain planned expenditures of their own in view of their diminished receipts. In all these cases, acts of consumption are foregone without others appearing to take their place. Moreover, the sacrifice which I impose on myself is multiplied throughout the economy until at last, by series of devious detours, production is adapted to the change in the flow of purchasing power. Disturbances of this kind affect, in the first instance, goods and services which cannot be used in alternative ways. We speak of such goods and services as having a “specific” character. The effects of such disturbances may be more clearly visualized if we compare the entire process of production to the biological process which goes on in a tree. As the sap mounts in the tree and penetrates to the very ends of the leaves, so production, as it advances from raw material to finished manufacture, removes farther and farther from goods with numerous alternative uses to direct itself towards the creation of goods having a more and more specific character. The cut flowers offered for sale represent, literally and figuratively, the “leaves” for which there is no alternative use. These “leaves” must wilt, unconsumed, if there occurs a change in the flow of purchasing power such as we have described. A rearrangement of production which will be adapted to the change in patterns of demand will take place ultimately, but such rearrangement requires time and inevitably entails some economic loss.
The problem we have just analyzed can be called the general problem of economic transfer, of which the much discussed “transfer problem” of Germany in connection with its World War I reparations payments represents a special case. It arises wherever there are changes in the flow of purchasing power regardless of the causes of such changes. Changes in taste and fashion, in the tax and expenditure policies of the state, in the velocity of circulation of money, fluctuations in harvests or in savings and investments, migrations, the rise and fall of population, inflation and deflation, the vicissitudes of foreign trade, technological progress, wars and revolutions—each of these can be the source of progressive disturbances in the structure of the division of labor. The more suddenly these changes occur, the greater is the amplitude and the severity of the disturbances they provoke.
There are a number of such changes, however, which it would be counter to the general interest to resist. Thus, if the consumers decide to spend less for alcohol and more for sport, if the urban population turns from rye bread to white bread, or from bread in general to vegetables, fruit, eggs, meat and cheese, or from automobiles to boats, it would be hardly proper for us to oppose these changes in demand in the interest of the producers of alcohol, of rye, of wheat, and of automobiles who are affected by these changes. For this would be favoring private interests against the general interest in defiance of the elementary economic truth that we produce in order to consume, and not consume in order to produce. We would evidence a like disregard for the general interest if we opposed changes in the flow of purchasing power and in the structure of production resulting from the introduction of cheaper methods of obtaining one or another good or service. Such a cheapening of production can take place in two ways which are basically similar in principle and in effect: by progress in technology and organization and by foreign trade. To take deliberate measures to destroy that which lightens our eternal struggle against scarcity, to dismantle the machines which can produce more cheaply than the old methods, to bar imports—all of this would doubtless be in the interest of the producers directly affected. But then it would also be in the interest of doctors to make the manufacture of cheap and efficacious remedies illegal, and in the interest of living authors to ban the publication of cheap editions of their dead confrères and to agitate against the translation of foreign writers.
In the last-named cases, we mean to direct attention to the attempts made in the interest of certain producers to oppose the lessening of the scarcity of goods which the general interest demands. But we can go a step further and consider the efforts, camouflaged usually in pseudo-economic theories, to increase the scarcity of commodities in the selfish interest of the producers and to have it believed that such increases in scarcity are advantageous in terms of general economic welfare. The hoodlum who has broken all the windows in the block may not have been hired by the local glazier for this job, but that he has acted in the interest of this glazier is just as certain as that he has grossly injured the general interest. An amusing variation on this same theme is the case of the East Prussian farmer who, many years ago, recommended with a straight face that German vegetable production be transferred to the maximum extent possible to Eastern Prussia, first, because the harsh climate of this area would necessitate the building of greenhouses, thus encouraging the iron, glass, and coal industries and secondly, because the higher costs of transport to German centers of consumption would stimulate the railroad and, indirectly, the coal industries. On the same reasoning, it would be possible to draw up a much longer list of promising developments that would follow the transfer of the whole of world agriculture to the spacious ice fields in the vicinity of the North Pole. Needless to add, this Prussian farmer’s proposal was accompanied by a demand for a drastic increase in the German tariff on vegetable imports.
The proposal of our Prussian farmer was not the gesture of a clown but simply a particularly flagrant example of the kind of thinking which is encountered daily under multiple guises and which is one of the most influential undercurrents in the economic policies of every modern state. For this reason, the author has been somewhat reluctant to tell, even in jest, such an anecdote as the preceding. The uninstructed might have taken the Prussian farmer at his word! The instances in which the efforts of private interests to maintain or increase scarcity have been applauded as acts beneficial to the general interest are certainly numerous enough to justify such concern.
Plainly, it is in the interest of the individual producer to maintain or even increase the scarcity of the goods or services he supplies. But since the whole purpose of a rational human economy is to lessen scarcity, we have here an irreconciliable antagonism between individual and general welfare, between the interest of the individual and the interest of the commonweal. This is a perversity which in a self-sufficient, exchangeless economy would appear completely absurd. It is something which is peculiar to an economy based on the division of labor; indeed, it is legitimate to describe such an economy as marred by a latent and persistent disharmony between the private interests of the producers and the general welfare. It is no exaggeration to say that this disharmony is one of the gravest defects from which our free society suffers.
But what is of still more concern than this disharmony is the growing ease with which the special interests of the producers customarily prevail over the general interest. The reasons for this are, in large part, psychological in origin. Thanks to the division of labor, each one of us in our role as producers is desirous of keeping our goods and services as rare, and therefore as expensive as possible in relation to other goods. By the same token, in our role of consumer, each of us is desirous of having abundance and cheapness prevail in all categories of goods other than those which we ourselves happen to produce. But since the consumer’s interest is spread over innumerable goods, the judgment of each man in economic matters is determined more by his position as producer than by his position as consumer. The concentration of producer interests in a given case will normally permit these interests to enjoy easy victories over the divided consumer interests. Thus, though the interests of the consumers taken as a whole are greater and more encompassing than the opposed interests of the producers in question, the latter will be easily able to override the dispersed and hence ineffectual power of the consumers. The producers’ task is made all the easier by the use of pseudo-economic theories which lull consumers into accepting their own impotence as a normal and beneficial state of affairs.
There is another important fact, closely connected with that just mentioned, which explains the ability of producers to exploit consumers. In our economic system, the general interest is secured by the mechanism of competition. In recent decades, however, increasing success has attended efforts to discredit competition as something egoistic and inimical to an integrated society. The result has been a substantial weakening of the psychological supports of competition. And the attackers of competition have been all the more successful to the extent that they have managed to identify it as “liberal” (in the European sense), thereby stamping it as an object meriting general contempt. Such attacks conveniently ignore the fact that it is the liberal economic philosophy* which recognizes the latent disharmony between consumer and producer and which sees in competition the means of mitigating this disharmony and thus of safeguarding the consumers’ interests. Piquantly enough, the enemies of competition answer this argument by saying that it was liberalism, after all, which developed the doctrine of the harmony of economic interests. Thus we find the real advocates of disharmony engaging with high glee in the task of obstructing those who seek to mitigate the evil by ridiculing them as the naive adherents of outworn doctrines of “harmony.” But our economic system can remain viable only if this disharmony is redressed by effective and continuous competition. Of course, we cannot overlook the fact that competition occasionally entails costly shifts in the structure of production which must be weighed against its long run benefits to the whole community. These considerations must, at all events, underlie any constructive economic policy, i.e., one which aims at minimizing the losses and inconveniences caused by such shifts in production and at mitigating the personal hardships involved without hindering the adjustment itself.
The extreme sensitivity of a society founded on a highly developed division of labor means that a disturbance in one sector of the economy (as illustrated by our innocuous miniature example of the collection for aeroplanes) will be transmitted, avalanche-style, through the whole of the system. A proper awareness of this sensitivity helps us understand more fully those disquieting phenomena known as “boom” and “bust,” or the cyclical alternation of prosperity and depression. A study of cyclical movements must properly begin with the recognition that in a mechanism as complicated and differentiated as that of the modern economic system a degree of friction among the moving parts cannot be avoided. It is inevitable that the different parts of this most complex machine will mesh with each other sometimes better, sometimes worse. We can understand now—and when we have become familiar with the sources of monetary disturbances and the especial complications connected with the production of capital goods we shall understand even better—how the friction among the moving parts of the economic machine may become so great as to result in the total breakdown known as a depression. Remembering our miniature Turkish example, we can also understand why “overproduction” may be found, paradoxically, side by side with increasing poverty and why a depression can lead to unemployment and “excess capacity.” Where the structure of production and the flow of purchasing power significantly diverge, the economy suffers from a glut of cut flowers, passengerless taxis, unoccupied theatre seats, and of other and even more important kinds of “unused capacity”: superabundance in the midst of poverty.
The paradoxical character of a Western depression becomes even more apparent when we consider the effects of a depression on the undifferentiated economy of a country like China. For the Chinese peasant of the pre-Communist era, content with the subsistence that could can be eked out on the land, “hard times” occurred when the pressure of rising population caused the average peasant holding to shrink. The obvious remedy, in such case, was to work the available land harder and longer. The Chinese peasant would have been unable to comprehend the Western phenomenon of unemployment. He would have taken it as a joke in rather bad taste to be told that there are countries where at times a job may become an envied privilege, begged for like bread, where those who hold two jobs are hatefully labeled “moonlighters.” Such things he would have held to be grotesque and irrational and we must admit that he is not far wrong. These periodic absurdities are nevertheless the price we must pay for the extraordinary productivity of a highly refined division of labor. The greater the refinement of the division of labor, the less is the economic system able to resist internal and external disturbances but conversely, the greater is its productivity. To ensure a state of equilibrium that would be proof against all disturbance, we would have to return to the primitive and impoverished conditions of a Robinson Crusoe-type economy. If this alternative repels, then we must accept the present economic system with its sensitivity and its instability.
This is the dilemma on which we are driven. But as a matter of fact we are no longer free to choose. The die is cast. For the growth of productivity which accompanied the extensive and intensive development of the division of labor is now claimed as a birthright by the new millions of individuals who owe their very existence to it. We cannot go back, we cannot cause a contraction in the division of labor without putting in peril the lives of numberless millions of human beings and thereby the very existence of our social order. This is the fact, as brutal as it is prosaic, which explodes the fond reveries of economic romanticists and autarkists. It is a fact, moreover, which should lead us to view with anxiety the continuation of the present rate of population growth and to hail its diminishment with a feeling of relief. The contemporary instability of the economies of all advanced countries indicates that our industrial civilization with its ever more extreme division of labor may be approaching some sort of limit in this respect. Moreover, when the political consequences of mass civilization are taken into account, it is patent that the psycho-moral fundaments of our society have become increasingly inadequate in respect to the existing degree of division of labor.
In the space of one unique century, mankind has simply attempted too much at once. Too much emphasis cannot be placed on the fact that the chief cause of our present difficulties must be sought not in the kind of economic system we have, but in a division of labor which has been carried to an unhealthy extreme. A socialist economy, compelled as it would be to preserve the present degree of division of labor, would change nothing in this respect. We shall have occasion later in a special section (Chapter VIII) to study these matters in detail.

Economics of the Free Society

Monday, August 27, 2012

The Division of Labor and the Number of Men (the Population Problem)

The relationship between the division of labor and population movements, which we have just touched upon, is so important that it merits closer investigation. This relationship is a reciprocal one: the extension of the division of labor increases productivity, thereby augmenting the capacity of the economy to absorb population in-creases. But the converse is equally true: an increase in population permits, in turn, the attainment of a greater degree of division of labor. As Adam Smith has shown in a celebrated passage of his Wealth of Nations (Book I, Chapter 3), this reciprocal relationship is clear from the fact that the division of labor is inevitably limited by the extent of the market (law of the extent of the market). The division of labor is limited, that is to say, by the number of possible purchasers of the goods produced, a high degree of specialization becoming profitable only where output levels can be high. One of the factors that most affects the extent of the market—though obviously not the only one—7 is the size of the population. Is a continual increase in population therefore desirable?
It is useful here to recall that the nineteenth century, which is associated with the greatest population increase in history, was ushered in with a doctrine which expected from population growth only misery, want, and famine. This was the pessimistic theory of Robert Malthus (1766-1836). Since Malthus uttered his cry of alarm, more than a century has elapsed, and in this period many events have occurred which put his doctrine in an entirely different light. The populations of the industrial countries have multiplied many times over and yet the average standard of living in these countries has risen to an extraordinary degree. Simultaneously, the agricultural production of the world has increased in many countries to an extent where there is more concern about the problems of overproduction than of insufficiency. Concurrently, in one country after another techniques which permit the separation of sexuality and procreation have been ever more widely disseminated. Old mores have succumbed to new attitudes until the practice of birth control has become increasingly a simple matter of habit. The result has been a sharp decline in the birth rates of almost all the countries within the orbit of Western civilization.
At the same time, however, other occurrences caused populations in the civilized world to increase sharply in absolute terms. The gigantic strides in recent times of hygiene, medicine, and standards of living offset falling birth rates by declines in death rates. The decline in death rates occurred, first, among the youngest age groups. While in former centuries perhaps two of every ten children survived the hazards of infancy, it became possible in the nineteenth century to keep them all alive. Now if this development is not immediately redressed by an equally lower birthrate, there inevitably results a sharp vertical increase in population. This is precisely what happened in the civilized world of the nineteenth century and which is still happening in the young countries of the Western world and in the so-called underdeveloped countries. The extraordinary population growth of the nineteenth and twentieth centuries is thus the result not of a rise in the birth rate, but of a decline in the death rate in conjunction with a continuing high birth rate. Two historical developments overlapped each other: the newly discovered hygienic techniques caused a rapid decline in the death rate while the birth rate, influenced still by deeply rooted traditional mores, continued to hold to the old high levels. This is a thoroughly natural phenomenon, for though the death rate can be lowered by external and collective measures, a fall in the birth rate is a long term process, growing out of slow changes in people’s attitudes. To express the point in more drastic terms: the chlorination of the communal water supply will result in an immediate and rapid decline in the death rate, but it will not reduce the birth rate.
Those countries which are now coming under the influence of Western civilization are experiencing just what the older nations experienced in the nineteenth century. The death rate declines at once and sharply, whereas the birth rate does not follow this decline until much later; as a result, population spurts up like a string bean after the rain. Sooner or later, there will occur a moment when the birth rate in such countries is “Westernized” and adjusts to the lowered death rate. The headlong increase in population in such case slows and may ultimately cease altogether. Most Western countries have come rather close to the final stages of this evolution of which they were the inaugurators. How very risky it is, however, to project a given trend dogmatically into the future, particularly where population movements are concerned, is shown by the example of the United States and France in which birth rates recently have risen to a remarkable degree. But there is little concern today over this phenomenon, in contrast to the fears of Malthus and his time. On the contrary, for contemporary Western statesmen, it is declines in birthrates which are the greatest source of worry.
The several reasons for this curious change in attitude can be examined here only briefly. The emphasis given to the national interest, for instance, is considerably greater today than in Malthus’ time. We tend to be concerned lest the birth rate in our own country fall below that of other countries. In addition, we have learned to pay more heed than formerly to the unfavorable consequences of a falling birth rate. There are a variety of motives, of course, which underlie conscious restriction of family size and their moral content will be found to be decidedly uneven. There is no doubt that the small family is quite often the result of deliberate selfishness which, if widely practiced, can weaken the moral fiber of a whole people, not to speak of the religious objections thereto. Here we have the genesis of a tragic situation wherein the modern rationalist spirit, under whose aegis the startling decline in the death rate took place, may overreach itself and in its fall drag down both the birth rate and the moral health of the nation. Clearly, the birth rate must be adapted to the exigencies of a diminished death rate if social and economic catastrophe is to be averted. But if free rein is given to the forces able to bring about an equilibrium of births and deaths, namely, to rationalist thought, the decline in the birth rate may get out of hand.
In the final analysis, of course, declines in the death rate will encounter natural limits set by the present state of medical knowledge in the advanced countries. The birth rate, on the other hand, can theoretically fall to zero. Hence, it is conceivable that an overlapping of population movements such as we have described above could again take place, but in an inverse sense this time (stable or slightly rising death rate plus rapidly falling birth rate), resulting in an absolute diminution of population.
A further circumstance which has caused the decline in the birth rate to be regarded in an unfavorable light is its differential character. The experiences of all countries show that birth rate declines begin at the apex of the social pyramid, with the well-to-do and educated classes having one child or no children, whereas the poorer members of society typically beget numerous offspring. Indeed, more often than not, it is the drunkards and the feeble-minded who have the most children. The unfortunate aspect of such a differential decline in the birth rate is that parents who would normally transmit to their children exceptional gifts of heredity and who have the material means of providing them with a good education are not reproducing themselves. Clearly, the qualitative and eugenic aspects of population movements must be taken into consideration as well as the merely quantitative aspects. But these matters, about which there is much discussion at present, require a breadth of treatment which our present inquiry does not permit.
The main reason why the present decline in the birth rate is regarded differently than it would have been in Malthus’ time must be sought in the domain of economics. The fact is that the enormous population increases of the nineteenth century have not resulted in an impoverishment of the masses; the catastrophe foretold by Malthus has not taken place. On the contrary, the population explosion has been accompanied by striking increases in the average standard of living. It is to be observed, however, that the population increases of the nineteenth century took place under special conditions which are not likely to recur. The same historic forces which resulted in a lowering of the death rate and thus in an explosive increase in population—viz., the scientific spirit, the belief in “progress,” the breaking of the fetters of tradition—all these led to industrialization, to world trade, to the colonization of new rich lands of vast extent. England and Germany, and the other countries for which Malthus predicted overpopulation, solved the problem of feeding their additional millions by superimposing on the agrarian foundation of the national economy an industrial second floor. Concurrently, huge surpluses of foodstuffs were being produced in the new overseas territories, in great part by people who had in the course of the nineteenth century emigrated from the Old World.
But these are unique developments which are not likely to be repeated. The globe in the interim has been fully preempted and mankind no longer has at its disposal a second valley of the Mississippi or a second Argentina. Consequently, those countries which are only now experiencing the vertical upsurge in population which the industrial nations of Europe experienced in the nineteenth century are finding the population problem ever more difficult to solve. This is true of countries such as Italy and Japan, whereas Russia is in the fortunate position, as a result of its enormous territorial acquisitions in the nineteenth century (not to speak of its more recent gains), of being assured of an almost inexhaustible supply of room for further population increases.
To return to Malthus: the population increases which he predicted would be fraught with the direst consequences for mankind have, in fact, taken place, and at a rate which would have been inconceivable in his day. But the catastrophe which he foretold has failed to materialize. Later, as the nineteenth century merged into the twentieth, Malthus’ first prophecy was proved false: the rate of population increase fell sharply. Do any of Malthus’ pessimistic theories still have validity?
To judge Malthusianism fairly, we should distinguish in it two parts: prophecy and analysis. Prophetic Malthusianism had argued that an ineluctable law of nature will cause population to increase unrestrainedly to the limits of the available food supply. Subsequent developments proved this prediction to be completely false. Population growth is not subject to any unyielding natural law; it is a phenomenon of the civilized world and hence an extremely complex phenomenon resulting from the combination of a wide variety of factors. The failure of these prophecies to come true does not, however, constitute a refutation of analytic Malthusianism. This is concerned simply with determining whether a given population increase should be judged as good or evil. It is this question alone which possesses interest for us today.8
But the question in this form is too vague to admit of an unambiguous reply. The answer depends on the aspect from which population growth is viewed. He who is concerned primarily with the size of the country’s military establishment will answer differently than the pacifist; he who considers the emergence of cities with millions of inhabitants as evidence of the progress of civilization will answer differently than the lover of solitude who views the rise of the masses as a development inimical to civilization. A final answer to the question of whether population increases are good or bad is thus dependent on one’s value judgments and is outside the competence of strictly scientific inquiry. The economist must content himself with the more restricted but still very important task of studying the effects of population increases on the material welfare of individuals. But even this limited inquiry is itself so difficult and so complex that space does not permit us to pursue it in any but the broadest outlines.
The invariable answer made to those who are skeptical of the supposed material benefits of population increases is that since each man is born not only with a mouth but with a pair of arms, population growth increases not only consumption but production. Each human being, so runs the argument, creates his own additional economic room and, indeed, enlarges it since population growth permits of a greater degree of division of labor. According to this optimistic theory, population growth will result not in a lessening but in an increase in the average standard of living. Is this widely held opinion solidly established in fact?
That population growth allows of the attainment of a greater degree of division of labor is a fact on which we agreed at the beginning of this chapter. But this is no proof of the truth of the optimist population theory and for three reasons. First, population growth is, as we have seen, not the only condition required for an enlargement of the market. Secondly, the division of labor cannot be extended indefinitely without encountering dangers and difficulties (which we shall presently specify) which set effective limits to the process. The division of labor, moreover, cannot exist on an extended scale in the absence of those extra-economic conditions of whose importance the present world situation has made us painfully aware. A fateful nexus of cause and effect brings it to pass that precisely those internal and external political tensions caused by population growth contribute to the undermining of the foundations upon which an intensive division of labor rests. As the historical experiences of the most heavily populated countries show, these tensions soon lead to radicalism in internal and external policy. It is unfortunate but true that our mass civilization has served to enfeeble rather than strengthen the fundaments of order and security which an intensive division of labor requires.
At the very least, it must be conceded, we have no guarantee that population growth of itself will assure the maintenance of the extra-economic conditions necessary to an intensive division of labor in as automatic a fashion as it assures the existence of the necessary economic factor, to wit, the extension of the market. It is an enviable brand of optimism which, in the face of these reflections and in the face of the difficulties the world is currently experiencing, can continue to view with unconcern further population increases. But such optimism becomes a veritable enigma after examination of a third point. The productivity-increasing effect yielded by an intensification of the division of labor, which in turn results from an increase in population, is in direct conflict with an opposite productivity-diminishing effect caused by the increasing scarcity of the factors of production (land, natural resources, capital) relative to the increasing population. The growing population intensifies competition for these factors, raises their costs, and thus diminishes their yield, relatively speaking. Which one of these conflicting tendencies will prevail cannot be determined in advance; but obviously, the answer will be decisive in judging whether a given population increase will increase or diminish economic welfare.
Let us once again review these complex and exceedingly important considerations. Let us note, first, that it is not the total production of a country with which we are here concerned; for then countries such as China or India with their fabulous resources and enormous national incomes would be the richest countries and not the poorest. What is decisive, rather, is the amount of production per caput of the population. If we call this amount the social share (total production divided by total population), we may pose the following decisive question: what is the effect of population growth on the social share of production? Does it increase or diminish it? The answer to this question, however, depends upon whether the increase in production which follows population growth develops proportionately, over-proportionately, or under-proportionately to such population growth. In the first case (if we ignore certain incidental influences on production such as inventions, etc.), the social share remains the same despite the increasing population; in the second case, it increases, and in the third, it diminishes. To put the matter in more familiar terms, the increase of population in the first case leaves the average standard of living unaffected; in the second case it raises it, and in the third case, it lowers the standard. It is obvious that it cannot be determined in advance which of the three cases will occur, all three being possible in principle.
If we disregard the—for our purposes—uninteresting case in which the increase in production is proportional to the increase in population, there remain the possibilities of an over-proportional or an under-proportional production increase. If population growth brings in its train an over-proportional increase in production, we have a case of underpopulation because a population increase would now be to the economic advantage of the nation. If, on the other hand, population growth is accompanied by an under-proportional production increase, we are faced with overpopulation because continued population growth is no longer economically desirable. At some point between the condition of underpopulation and the subsequent condition of overpopulation is found the optimum population. When a country has reached the point of optimum population, it is placed before the necessity of opting for either an increase in the standard of living or an increase in population. One excludes the other. As population continues to grow, this optimum point must be reached, sooner or later, in every country; and it must be considered as exceeded when the social share of production is smaller than it would have been with a smaller population, other things being equal.
The foregoing considerations should serve to correct a number of misconceptions, for example, the belief that technical progress and the bringing of new lands under cultivation will continue indefinitely to furnish the wherewithal for additional millions of human beings. No one denies, of course, that the possibilities of increasing production are still very great. But this is completely irrelevant to the problem we are here analyzing. The question of prime interest is whether mankind would not be better off if these increases in production were not always accompanied by population increases. Why is it necessary that every enlargement of economic room which is achieved by the labors and the ingenuity of the existing population be immediately filled by millions of new individuals instead of serving to increase the well-being of those now on earth?
The point of significance here is that it is not legitimate to regard an increase in the social share of production as proof of the absence of an overpopulation problem. For the increase in the social share might have been still greater if the population had not increased. Such would be the case where the increase in production, which caused the increase in the social share, were the result not of a population increase but of technological and organizational innovations. By itself, a rise in the average standard of living does not, therefore, exclude the possibility that a country may be suffering from overpopulation in the sense here defined. The rise in the living standards of many European countries during the past fifty years is no proof that these countries had not already passed the optimum population point. What follows will help to clarify this relationship.
The sudden rise in living standards during the past one hundred years ought not be allowed to conceal the fact that this rise has not been as great as we might have expected considering the extraordinary increase in the productivity of the economic system in this period. There is a certain disproportion here which demands explanation. This is the disproportion between “progress and poverty,” a phenomenon which has perennially engaged the attention of socialists of every shade of belief and which has prompted them to seek its cause in alleged basic defects of our economic system. An inveterate complaint of such persons is that under our economic system “economics” destroys what “technology” gains. It is not surprising to find that it is the technicians who tend to entertain this opinion and to regard economists with the same indignation and condescension that military men are wont to display towards diplomats. We have not the space to examine the multitude of misconceptions upon which this attitude of the socialists and the technicians is based. Did space permit, we could make a number of points calculated to enlighten the technicians, in particular, for example, that 100 per cent efficiency is no more to be expected from the economic system than from the most perfect motor. One thing, in any case, is certain: the lag of standards of living behind technological progress and increases in productivity cannot be explained by the fact that a part of what was properly owing to the people of the fruits of such progress has been withheld in favor of a few rich capitalists. This theory, abandoned today by almost all serious socialists, is refuted by a simple calculation which shows how little the average income of the population would increase if recourse were had to a rigorously equal distribution of the existing wealth, even under the much too favorable assumption that total production would not suffer from such action. How then can the apparent contradiction be explained? The only explanation which remains is that technological progress has served mainly to facilitate the existence on earth of a larger number of people instead of serving to increase the living standards of the existing population. It appears that the “disproportions” engendered by capitalism are in large part explained by the fact that this economic system had to spread its immense creative force for well-being in two directions at once: (1) to increase average standards of living and (2) simultaneously to give a foothold in life to huge numbers of newcomers. It is evident that the dilemma of having to choose between an “increase in population” and an “increase in the standard of living” is not a dilemma of yesteryear alone. It is one which at present confronts such countries as Japan, India, and Egypt in particularly acute form.
It would take us too far afield to expatiate here on the qualifications, and they are many, which must be brought to the theory of optimum population. To forestall misunderstanding, it must be emphasized that the theory is concerned only with the purely material and individual consequences of population growth.9 Thus, even when a country has passed the economic optimum of population, an increase in population may still be deemed desirable for non-economic reasons. But within this wide range of possibilities, it is useful to have a clear idea about the alternatives which exist and to weigh these against each other.
There are, in sum, three possibilities. The first is to brake the rate of population increase by increasing the death rate. This method, obviously, cannot be part of a conscious demographic policy, although there are those who believe that the modern paraphernalia of hygiene, inoculation, and medical care with which we are surrounded from the cradle to the grave have their disadvantages. For these techniques conflict with the selection of the fittest individuals and thus weaken our natural forces of resistance to, for example, epidemics still unknown. That such epidemics, conjoined with the atom bomb and bacillus warfare, might make short shrift of our modern mass civilization is a possibility. But no one seriously entertains the idea that we can consciously decide to increase the number of deaths. Thus, if we wish to restrain population increases, we shall have to reestablish an equilibrium between births and deaths, not by increasing the death rate, but by lowering the birth rate, a method which is already in wide use in many countries. That this is a method attended with considerable risks and disadvantages has already been noted. Among these disadvantages must be included the fact that a decline in the birth rate causes a shift in the age structure of the population in favor of the aged, a development which cannot be regarded as good in all circumstances. The full significance of these dangers and disadvantages becomes apparent when we recall the alternatives which are open to us.
A conscious increase in the death rate is, as we have seen, out of the question. There remain only the alternatives of braking population increases by lowering the birth rate, or of perpetuating the disequilibrium between births and deaths by allowing population to increase unrestrainedly. Let us reflect on exactly what this latter course would mean. It would mean that an increase in world population which issued from a special set of causes and may be considered, in virtue of its extraordinary tempo and extent, a phenomenon unique in history, would suddenly be regarded as the normal experience of the human race. Every thinking person must reject this view and admit that, sooner or later, it will become necessary to restrain such population increases as we have witnessed in recent times and to reestablish the rate of growth which is sanctioned by history. So why not sooner than later? A cogent argument for present action is the fact that we are compelled, under modern conditions, to pay a double price for continued population growth: in the form of a very probable decline in average standards of living, and in the form of a certain increase in the rigidity and instability of our economic system as the result of a division of labor which is becoming ever more extreme. It is this last effect of which we must now speak.

Economics of the Free Society