Chapter 21 of 26 · Capitalism: A Treatise on Economics by George Reisman
Chapter 18. Keynesianism: A Critique
CHAPTER 18
KEYNESIANISM: A CRITIQUE
In previous chapters, I have criticized various major aspects of Keynesianism, notably the Keynesian approach to aggregate economic accounting, its negative view of saving, and the multiplier doctrine in its various forms. 1 Very significantly, I have also shown that insofar as people might choose to hold accumulated savings in the form of cash rather than income-producing assets, the effect would be to raise the rate of return on the income producing assets, thereby automatically limiting any possible preference people might have for holding savings in the form of cash and rendering impossible the limitless rise in “liquidity preference”—viz., cash hoarding—alleged by the Keynesians to exist in response to too low a rate of profit. 2 Of course, I also showed how the determinants of the rate of profit, along with the enormous abundance of profitable investment opportunities for additional capital, preclude any actual need for people in modern conditions to attempt to accumulate a major portion of their savings in the form of cash in the first place. I demonstrated that the profitability of investment, and thus the superiority of investing rather than holding cash, is guaranteed by the very nature of the forces that determine the rate of profit, including the existence of veritable “springs” to profitability. 3
In addition, I showed that what leads to efforts to hold a greater portion of accumulated savings in the form of cash is not any lack of investment opportunities in the economic system as it is basically constituted, but undue increases in the quantity of money, which almost always take place, ironically enough, precisely in the conviction that spending needs to be stimulated. The result, I showed, is that cash holdings are driven down relative to the volume of spending and lending in the economic system— viz., business becomes illiquid—and the stage is thereby set for a financial contraction once the stimulus of the additional quantity of money comes to an end and the normal demand for money for holding reasserts itself. 4
My demonstration that the rate of interest is not the “price of money” and cannot be permanently reduced, let alone eliminated, by virtue of the increase in the quantity of money, can also be counted as a criticism of Keynesianism. 5 This is because Keynesianism ardently embraces this doctrine and makes it central to its views on “monetary policy.” 6
Up to now, I have dealt with Keynesianism either merely by implication or on the fly, so to speak. It is difficult to do otherwise, because conceptually Keynesianism is a form of amorphous sludge, oozing its way through any possible cracks or chinks in the intellectual armor of a capitalist economy and thereby undermining as far as possible the intellectual foundations of such an economy. Before turning full face to Keynesianism, it has been necessary to set right a number of major theoretical issues that are wider than Keynesianism. Yet, from time to time, I have felt morally obliged to deal explicitly with various Keynesian positions at the earliest opportunity, just as soon as my own theoretical position was in place.
Here I turn to an exposition of Keynesianism in its best organized, strongest form, preparatory to slaying the dragon one more time, with a critique of all of the doctrine’s remaining essential claims whether in the realm of economic theory or in the realm of economic policy.
This is the variant that goes under the name the IS-LM analysis.
I believe that my exposition of this analysis is far more compact and much clearer than those to be found in the very best of the Keynesian textbooks. At the same time, I am confident that any honest Keynesian will agree with the substance of my exposition. I consider the superiority of my exposition to be based on the fact that I have reversed the usual order of development of the doctrine. I begin with the Keynesian view of aggregate demand, whose significance can be understood immediately, and then proceed to explain the underlying doctrines on which it is based. The usual procedure is to devote chapter after chapter to subjects apparently leading nowhere, such as the “consumption and saving functions,” the various “multipliers,” the “marginal efficiency of capital schedule,” “liquidity preference,” and so on, and then at the very end pull all the elements together into the central argument concerning aggregate demand. By that time, as I will show, the reader has forgotten the essential questions and is no longer in a position to see that the wool is being pulled over his eyes. In contrast, my procedure keeps all of the elements in sharpest focus and never allows sight of the essential questions to be lost.
1. The Essential Claims of Keynesianism
Prior to the publication of Keynes’s book The General Theory of Employment, Interest, and Money in 1936, economists had accepted the proposition that unemployment can be eliminated by a fall in wage rates. 7 This was an intellectually uncomfortable position for most economists to be in, because its obvious implication is that, in order to prevent or eliminate unemployment, the government should abstain from interfering with the height of wage rates—i.e., should not enact prounion legislation, minimum-wage laws, or in any other way coerce or pressure employers into paying wages higher than those which a free market would establish.
This position, of course, was in direct conflict with the Marxian exploitation theory, which exerted a powerful influence probably over the majority even of the economics profession and certainly over the overwhelming majority of intellectuals in all other fields. For according to the exploitation theory, a free market in labor means subsistence wages, unbearably long hours of work, and inhuman working conditions. Thus, acceptance of the doctrine that a free market in labor can eliminate unemployment by means of a fall in wages placed economists in a position in which they appeared to be virtual enemies of mankind and in which virtually they alone stood in opposition to what was (and by many still is) regarded as the only possible path of social progress—namely, ever-growing government interference and ultimately, if not immediately, socialism.
In this intellectual environment, Keynes appeared on the scene. His entire system can be summarized in a single sentence: A free market in labor and fall in wage rates is incapable of eliminating unemployment; mass unemployment is an inescapable feature of a capitalist economic system in modern conditions. Thus, Keynesianism held, it is pointless to fight for a free market in labor. Because even if it were achieved, it would be to no avail. On the contrary, the only solution is “fiscal policy”—by which, in essence, is meant that the government must adopt a policy of budget deficits.
In this way, Keynes’s ideas filled what perhaps the majority of economists experienced as a vital need—it gave them a way out of conflict with the rest of the intellectual world and with a good portion of their own convictions. For if Keynes were right, economists need not oppose labor legislation. Indeed, they could join in the calls for expanded government intervention. This is because Keynes also gave them arguments designed to show that the more the government spends for any purpose—even for the least valuable programs imaginable, even for pyramid building—the more prosperous must the economic system become. 8
If one considers the implications of such ideas as that pyramid building and budget deficits are economically beneficial, it becomes obvious that Keynesianism is the enemy both of common sense and the love of liberty (viz., the freedom from excessive government, which excess is fostered by the policy of budget deficits). Keynesianism is also incompatible with such fundamental economic truths as the quantity theory of money. And, if it is not already apparent, we shall see, too, how it is actually nothing more than a species of consumptionism.
The incompatibility of Keynesianism with the quantity theory of money requires some comment. Keynesianism implies that even though the quantity of money remains the same, the volume of spending in the economic system falls without limit as wages and prices fall, and thus that no connection whatever exists between the quantity of money and volume of spending. It implies this because if spending does not fall in full proportion to the fall in wage rates and prices, thus totally obliterating the connection between the volume of spending and the quantity of money, the fall in wage rates and prices must result in larger quantities of goods and labor being sold, and thus, at some point, in the elimination of unemployment. If, as the quantity theory of money in fact implies, the volume of spending tends to remain unchanged in the face of a given quantity of money, then, of course, reductions in wage rates and prices must put an end to unemployment in short order. And, indeed, as we saw in the discussion
CRITIQUE OF KEYNESIANISM 865 of unemployment, there is actually good reason for believing that when wage rates and prices fall to their new equilibrium level following a financial contraction, total spending in the economic system will actually increase, since it first declines in part as the result of the postponement of investments precisely to that time. 9
The incompatibility of Keynesianism with so much of established sound economic doctrine and with the traditional Anglo-Saxon acceptance of the political philosophy of limited government, and, no less, its open flaunting of the absurd and paradoxical as newly discovered truths, deservedly aroused great opposition. Unfortunately, the critics were not able to answer the Keynesian sophistries decisively.
The reason was that in the two generations preceding the appearance of Keynes, much of the foundations of sound economics had quietly been lost, without anyone even being aware of the loss. The loss took place starting in the 1870s, in the abandonment of British classical economics in favor of the newer neoclassical economics. As explained in Chapter 11, the cause of this development was the fact that classical economics, with its labor theory of value, appeared to lay the groundwork for Marxism. Instead of eliminating the particular, localized errors of classical economics which did provide support for Marxism and then integrating the new doctrine of marginal utility propounded by neoclassical economics with the essential substance of classical economics that remained, virtually the whole theoretical body of knowledge constituted by classical economics was abandoned. What then remained were largely just out-of-context, memorized conclusions that in the absence of the necessary theoretical foundations could no longer be supported. Thus, when Keynes came along, it was only necessary for him to overturn such out-of-context, intellectually severed conclusions, not serious, living convictions. The state of underlying intellectual decay that had set in long before Keynes appeared is clearly indicated in a passage written by J. A. Hobson as far back as 1889, a passage which Keynes quotes approvingly:
Saving enriches and spending impoverishes the community along with the individual, and it may be generally defined as an assertion that the effective love of money is the root of all economic good. Not merely does it enrich the thrifty individual himself, but it raises wages, gives work to the unemployed, and scatters blessings on every side.
From the daily papers to the latest economic treatise, from the pulpit to the House of Commons, this conclusion is reiterated and restated till it appears positively impious to question it. Yet the educated world, supported by the majority of economic thinkers, up to the publication of Ricardo’s work strenuously denied this doctrine, and its ultimate acceptance was exclusively due to their inability to meet the now exploded wages-fund doctrine. That the conclusion should have survived the argument on which it logically stood, can be explained on no other hypothesis than the commanding authority of the great men who asserted it. Economic critics have ventured to attack the theory in detail, but they have shrunk appalled from touching its main conclusions. 10
The wages-fund doctrine referred to by Hobson, is, of course, the doctrine that holds—correctly—that the demand for labor is separate and distinct from the demand for consumers’ goods, and is made out of saving and productive expenditure, not consumption expenditure. As I showed in Chapter 14, it was never actually refuted. The essential criticism raised against it was merely that changes in wage rates might be accompanied by changes in total payrolls coming at the expense of other portions of productive expenditure or at the expense of net consumption. 11 I have already explained very well how to analyze such changes in total payrolls, namely, that little or nothing can be obtained at the expense of net consumption and that what can be obtained at the expense of other parts of productive expenditure is against the longrun interests of the wage earners. 12 The possible variation of total payrolls in no way affects the essential fact that wages are paid out of saving and productive expenditure and in real terms depend on the economic degree of capitalism and productivity of labor. The wages-fund doctrine was not overthrown; it was simply left undefended. It was left undefended because it was an integral part of classical economics, which had ceased to be seriously valued and studied. As I have shown, there was—and is—no justifiable basis for abandoning the doctrine.
What Hobson was absolutely correct in pointing out, however, and which is my reason for quoting him, is that the abandonment of the wages-fund doctrine, and other such essential doctrines of classical economics, did have the effect of withdrawing the foundation for conclusions that could otherwise not be supported.
Neo-Keynesianism
In response to some relatively mild criticism levied by a colleague of Keynes at Cambridge University, A. C. Pigou, Keynesianism was succeeded by “neo-Keynesianism.” According to this variant, which concedes the substance of Pigou’s criticism, a fall in wage rates might, conceivably, be capable of eliminating unemployment, but the fall would have to be enormously out of proportion to any additional employment achieved. The clear implication is that in the process virtually every debtor would be bankrupted, because the grossly disproportionate drop in wage rates and prices implies correspondingly large reductions in aggregate spending and revenues and thus in the ability to repay debts. For example, if to eliminate an unemployment rate of 10 percent, wage rates and prices had to fall by 90 percent, the volume of
spending in the economic system would equal one-tenth the price-and-wage level times ten-ninths the output and employment. Thus, total spending would be reduced to one ninth of its former height, or by 89 percent.
And, even if people were willing to allow such a thing to transpire, the further argument is ready at hand that a necessary condition of prices being able to fall would be the adoption of a radical antitrust policy, or a program of widespread nationalization of industry. These measures would allegedly be necessary to establish “price competition.” Big business, left to its own devices, it is held, is “oligopolistic” and practices “administered pricing”— i.e., won’t reduce prices. Thus, either it must be broken up into large numbers of small competitors, to approximate the conditions of “pure and perfect competition,” or the government must take it over and set prices. 13 Thus, neo-Keynesianism, no less than Keynesianism, holds that a free market is incompatible with full employment. The only difference is that while Keynesianism claims that a free market in labor cannot establish full employment, neo-Keynesianism claims that a free market in products cannot establish full employment, for the free market in products allegedly results in “oligopoly” and the refusal to cut prices. Thus, according to both variants, a free economy must be accompanied by mass unemployment.
Much of the substance of neo-Keynesianism is clearly stated by Joseph P. McKenna, a supporter of Keynes, in his relatively readable textbook Aggregate Economic Analysis:
Keynes’s conclusions were unacceptable to two groups.
The first group objected because his analysis made government intervention or continued depression the only two possible alternatives. Many members of this group opposed government intervention in principle and therefore rejected this choice as undesirable.
The second group, the supporters of classical analysis, opposed Keynes’s conclusions on logical rather than political grounds. To them, it seemed impossible that workers could not find jobs by cutting their wages sufficiently.
Among this group was A. C. Pigou, who discussed the question in his article “The Classical Stationary State.” He observed that price changes would alter the consumption function. . . . A decline in prices tends to raise the value of money assets and, therefore, to shift the consumption function upward. . . .
This result satisfied Pigou. He had proved that it was always possible to obtain full employment if wages and prices fell sufficiently. As a logical proposition this conclusion was almost indisputable, and Pigou claimed nothing more than logic. (Pigou himself made it clear though that, as matter of policy, he preferred to increase demand through fiscal policy.) Strangely enough, this result also satisfied the political opponents of Keynes, who could now blame unemployment on the unwillingness of workers to accept lower wages, for Pigou had shown that there exists some level of wages that would be compatible with full employment. The important practical question was an empirical one: Just how elastic is the aggregate demand curve? If the elasticity is very high, a modest change in price might produce the desired income level. If the elasticity is low, the price level that is compatible with full employment might require such a large change that the process of reaching it would be hopelessly disruptive. (Imagine what would happen if it were necessary to lower the price level to one-tenth its present level.)
The question of how much prices must change to produce a given level of income [viz., real income and employment] cannot be answered by any purely theoretical analysis.
Only statistical study, concerned with the size of consumer assets and debts and the effects of these upon consumption, could offer even a tentative hypothesis. The usual conclusion is that the aggregate demand curve is inelastic, so that very large changes in prices would be required for moderate changes in income. Nevertheless, the controversy is not yet settled, and further study continues. 14
The reason for such negative conclusions about the extent of the fall in wage rates and prices necessary to achieve full employment is that Pigou and the other neo-Keynesians are trapped in the Keynesian intellectual framework. The only mechanism they can imagine by which a fall in wage rates and prices can increase the quantity of goods and labor demanded is by virtue of its effect in increasing the buying power of the stock of money. Once in possession of a stock of money of larger real purchasing power, people will be willing to consume more, and this will create additional employment. Obviously the doctrine views an additional demand for consumers’ goods as equivalent to an additional demand for labor.
Actually, Pigou’s doctrine is even weaker than the Keynesians themselves recognize. For if the money of the economic system rests on a fractional reserve, and if it were the case that there must be some significant drop in total spending accompanying the fall in wage rates and prices, then there would be substantial business failures, which would result in substantial bank failures and in a reduction in the quantity of money. In such a case, the “Pigou effect” would be reduced to depending on the ability of a fall in wage rates and prices to raise the purchasing power not of a fixed stock of money (which would not be fixed, but falling) but of a much more limited fixed monetary base. 15
Obviously the answer to Keynes concerning the effect of a fall in wage rates must be far more powerful than the answer provided by Pigou. After I have set forth the essential elements of Keynes’s doctrine, I will provide such an answer.
In its most recent incarnation, neo-Keynesianism has
abandoned the claim that the problem is an inelastic aggregate demand curve, or, indeed, has anything fundamentally to do with a problem on the side of demand. It has given up the whole substance of the Keynesian position and retreated to the claim that wages and prices are somehow inflexible in the downward direction and that this inflexibility is what necessitates government intervention to alleviate unemployment—as though the inflexibility (and the periodic reductions in aggregate monetary demand that exacerbate it) were not itself the result of government intervention. In the most brazen misrepresentation of the views both of the classical economists and of Keynes, Samuelson and Nordhaus declare in the most recent edition of their textbook:
The basic difference between classical and Keynesian approaches can be found in differing views about the behavior of aggregate supply.[!] Keynesian economists believe that prices and wages adjust slowly, so any equilibrating forces may take many years or even decades to operate. The classical approach holds that prices and wages are flexible, so the economy moves to its longrun equilibrium very quickly. . . . While the classical economists were preaching that persistent unemployment was impossible, economists of the 1930s could hardly ignore the vast army of unemployed workers . . . . Keynes emphasized that because wages and prices are inflexible, there is no economic mechanism to restore full employment and ensure that the economy produces its potential. . . . In the Keynesian model, aggregate supply slopes upward, implying that output will increase with higher aggregate demand as long as there are unused resources. 16
Thus, what currently remains of the Keynesian position is merely an obstinate refusal to challenge the government intervention that is responsible for mass unemployment, and an insistence that the problem of unemployment be dealt with by means of still more government intervention.
In view of the virtually total intellectual capitulation of today’s neo-Keynesians, it may be asked why I believe it is necessary to engage in an extensive critique of Keynes’s actual doctrine when his supporters themselves have apparently abandoned it and proceed as though he never even held it. My reason is—precisely as the passages quoted above indicate—that the world abounds with prominent intellectuals who do not take ideas very seriously—who adopt them and then discard them on the basis of no more genuine intellectual conviction than stands behind a change in such fashions as the height of women’s hemlines or the width of men’s neckties. What has been casually discarded for the present can just as easily be picked up again in the future. My purpose in what follows is to provide intellectuals who do take ideas seriously with the means of quashing any possible future resurrection of Keynesianism.
2. The Unemployment-Equilibrium Doctrine and Its Basis: The IS Curve and Its Elements
The Keynesian doctrine that a free economy cannot escape from mass unemployment, that a fall in wage rates and prices is useless, because it is accompanied by a corresponding fall in the aggregate monetary demands for consumers’ goods and labor, is known as the doctrine of the unemployment equilibrium. This doctrine is a species of out-and-out consumptionism, as its diagrammatic exposition (provided by the Keynesian textbooks themselves) clearly demonstrates. For what is presented as the Keynesian aggregate demand curve in Figure 18–1 is nothing other than the very same aggregate demand curve we examined earlier, in Chapter 13, as representing the views of the consumptionists. 17 All that is different is the description of the horizontal axis as representing employment as well as output, and, following the customary, Keynesian practice, the use of the letter Y to denote output.
The presentation of the Keynesian aggregate demand curve DD as absolutely inelastic—as a vertical line—and the belief that as wage rates and prices fall, the aggregate monetary demands, i.e., the respective volumes of spending, fall in proportion, are mutual corollaries. If people are prepared to buy just so much in physical terms and no more, then any fall in the price of what they buy must be accompanied by a proportional fall in the overall amount of money they spend in buying it. By the same token, if as wage rates and prices fall, people reduce the amount of their monetary demand in proportion, then they are capable of buying no more at the lower wage rates and prices than they bought at the higher wage rates and prices.
The strictly limited quantity of output and employment that is depicted by DD is allegedly all that a free market is capable of absorbing in a given period of time, and thus all that it is allegedly capable of demanding. Just as in the case of consumptionism, unemployment supposedly results because (and exists to the degree that) the economic system is capable of producing more at the point of full employment than corresponds to the allegedly fixed aggregate quantity of goods and labor demanded. In the diagram, output at the point of full employment (denoted by Y f ) is indicated by the vertical line SS, which is drawn to the right of DD. In other words, Keynesianism in essence is really nothing more than the overproduction doctrine. It simply adds some peculiar twists and turns.
These twists and turns concern how Keynesianism arrives at the notion of a fixed aggregate quantity of goods and labor demanded. One route is the widely held belief, fostered by labor unions, that because a cut in
wage rates reduces the ability of the individual wage earner to spend money for consumers’ goods, it correspondingly reduces overall spending for consumers’ goods in the economic system. This is an elementary fallacy. It does not see that the reduction in wage rates makes possible the employment of correspondingly more wage earners, with the result that the total amount of spending—the monetary demand—for consumers’ goods does not fall. The basic result is the existence of the same amount of monetary demand both for labor and for consumers’ goods, but because wage rates and prices are lower, the same respective monetary demands employ more labor and buy more consumers’ goods. 18
Of course, the demand for labor and the wage earners’ demand for consumers’ goods are not the only relevant monetary demands in the economic system. There is also the demand for capital goods and the demand for consumers’ goods on the part of businessmen and capitalists, i.e., net consumption. It is entirely possible that under an invariable money, a fall in wage rates would be accompanied by some change in the demand for labor accompanied by an equal and opposite change in one of these other elements, especially in the demand for capital goods. But even if this entailed some fall in the aggregate monetary demand for labor, over and against this is the fact that in the context of the elimination of mass unemployment the fall in wage rates to their new equilibrium level almost certainly results in a rise in spending of virtually all kinds, including the demand for labor. This is because in a situation of mass unemployment the fall in wage rates brings out the investment expenditures which had been postponed, awaiting their fall. Thus, in actuality, the fall in wage rates to their new equilibrium is accompanied by a rise in the aggregate monetary demands for labor and for goods, both consumers’ goods and capital goods. 19
Despite the widespread impression to the contrary, the fallacy that lower wage rates are the cause of proportionately less spending, is not the major argument that Keynesianism advances in support of a vertical aggregate demand curve—that is, in support of the notion that the aggregate quantity demanded is fixed. The actual doctrine it relies on is the socalled IS curve and the relationships from which it is derived. An IS curve appears in Figure 18–2. 20
The IS curve is the relationship between the “marginal efficiency of capital” (viz., the rate of profit and interest), on the one side, and the volume of output and employment, on the other, for equilibria of investment and saving. (The meaning of this definition will become clearer as we proceed.) The IS curve purports to show that as output and employment expand, as measured along the horizontal axis, the rate of return on capital falls, as measured along the vertical axis. (Output is represented by Y and the rate of return is represented by r.) The Keynesians claim that at the point of full employment, namely Y f and its corresponding output, the rate of return would either be negative or, if not negative, at least unacceptably low—below 2 percent is the usual estimate of what is unacceptably low. 21 This alleged insufficiency of the rate of return that would exist if full employment were achieved is supposed to be the reason that full employment cannot exist, or if it did exist, could not be maintained.
Observe that in Figure 18–2 full employment and the output it results in are alleged to be accompanied by a rate of return on capital of zero. The specific assumption of a zero rate of return is not necessary. Any rate of return
Figure 18–1
The Keynesian Aggregate Demand Curve and the “Unemployment Equilibrium”
Price and Wage Level
D S
Fixed Aggre-Output at Full gate Quantity Employment
Demanded
0
D S
Y
Y 2% Y f Output/Employment
Figure 18–2
The IS Curve r%
IS
2% _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ LM
0 on capital of less than 2 percent is held to be unacceptably low. At any such rate of return, the Keynesians argue, businessmen and investors will prefer to hoard cash rather than to invest. Thus, if full employment requires any rate of return below 2 percent, the existence of full employment is allegedly impossible, at least as a lasting phenomenon. And this, according to the Keynesians, is exactly what it does require and is why its existence is allegedly impossible. Full employment cannot exist under the conditions of modern capitalism, say the Keynesians, because its existence requires a rate of return on capital below the minimum acceptable rate of 2 percent, the rate below which lending and investing allegedly simply do not pay. Whether full employment actually requires a rate of return of zero, 1 percent, 1 1 ⁄ 2 percent, or a negative rate of return, the rate is allegedly just too low to make investment worthwhile. And thus, if somehow full employment were achieved, say the Keynesians, savings would be hoarded rather than invested. The effect would be a drop in spending for output and labor and a reduction in output and employment below the fullemployment level. This would go on until sufficient movement had taken place up and to the left along the IS curve to raise the rate of return on capital back up to the 2 percent figure, the alleged minimum acceptable rate of return.
(In the preceding discussion, I have not dealt explicitly with the socalled LM curve. The relevant portion of it is present in the horizontal line representing the alleged minimum acceptable rate of return of 2 percent, and which is intersected by the IS curve in Figure 18–2. As wage rates and prices fall, according to the Keynesians, and less and less money is required in the form of
Y
Y f Output/Employment
“transactions balances” to provide the spending necessary to buy the same physical product at lower prices, funds allegedly pile up in “speculative balances.” At a rate of return of 2 percent, the potential accumulation of speculative balances is allegedly infinite. 22 )
Figure 18–3, which combines the IS curve of Figure 18–2 with the aggregate demand and supply curves of Figure 18–1, shows precisely how the IS curve is supposed to set the allegedly fixed limit of aggregate demand. 23 The horizontal axes of both diagrams are exactly the same. In the upper diagram, depicting the IS curve, output and employment are limited to the point marked Y 2% . This is because that is the volume of output and employment at which the rate of return on capital is 2 percent. Any greater volume of output and employment would allegedly require a rate of return below 2 percent, which is unacceptably low and which would induce the hoarding of savings and drive the volume of output and employment back down (viz., to the left) and the rate of return back up. Equilibrium would allegedly be reached only at the respective values of Y 2% for output and 2% for the rate of return. This is the situation with respect to the IS curve, in the upper diagram of Figure 18–3.
The vertical aggregate demand curve DD, in the lower diagram of Figure 18–3, is drawn precisely at the point where the volume of output and employment allegedly bring the rate of return on capital on the IS curve down to 2 percent. DD cannot be one iota to the right of where it is, say the Keynesians, because if it were, the rate of return on capital invested would be below the minimum acceptable rate of 2 percent on the IS curve shown in the upper diagram. Thus, say the Keynesians, the aggregate demand curve of Figure 18–3 cannot possibly move to
the right to coincide with the aggregate supply curve that level. This is supposed to be the reason why a fall in wage reflects output at the point of full employment. It cannot, rates and prices is unable to achieve full employment. it is argued, because, if it did, the rate of return on capital The underlying problem, allegedly, is that the physical would be zero, as shown by the IS curve in the upper output corresponding to full employment imposes an diagram, at the point of output corresponding to full unacceptably low rate of return on capital. The level of employment. Indeed, the aggregate demand curve alleg-wage rates and prices is thus held to be irrelevant. Em-edly cannot move so much as a hair’s breadth to the right ployment and output cannot get beyond where they are, without reducing the rate of return below the minimum no matter what happens to wage rates and prices, accord-acceptable level, as shown by the position of the rate of ing to the Keynesians, because if they did, the rate of return on the IS curve. return on capital would be lower than it is, which is
Thus the Keynesian argument is that full employment already the minimum acceptable rate. Thus, say the cannot exist, because if, somehow, it did, the rate of profit Keynesians, the only effect of a fall in wage rates and would be too low. Businessmen would then start to hoard, prices would be a reduction in the volume of spending and the hoarding would reduce output and employment for the same amount of goods and labor, not any increase until the rate of profit was raised back up to an acceptable in employment and output.
Figure 18–3
The IS Curve Sets the Limit to Aggregate Demand r%
IS
2% LM
Y
0
Y 2% Y f Output/Employment
Price and
Wage Level
D S
Fixed Aggregate Demand Output at Full
Employment
D S
Y
0
Y 2% Y f Output/Employment
Figure 18–4
The Derivation of the IS Curve
S
S
S = I
S f _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ S f _ _ _ _ _ _ _ _ _ _ _ _
S = – a + (1 – c) Y
_
S 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ S 1 _ _ _ _ _ _ _ _
S 0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ S 0 _ _ _ _
_ _ _ 0 _ _ _ Y
_ Y 0 Y 1 Y _ f
– a _ _ Saving Function _ _ _ _ _ r% _ _ _ _ _ _ _ _ _
r 0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
45˚ _ _ 0 _ _ _ I
I 0 I 1 _ I f
_ _ Saving = _ Investment _
_ _ _ r% _ _ _ _ _ _
_r 0 _ _ _ _ _
_ _ _ _ _ _ _ _ _ r 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ IS _ _ _ _ _ _ _ _ _ _ _ _ _ _r 1 _ _ _ _ _ _ _ _ _ _ _ _ MEC _ _ _ _
2% _ _ _ _ _ _ r f _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
0 _ _ _ Y
_ Y 0 Y 1 _ Y f
N _
_ IS Curve _
_
_
N f _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
N 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
N 0 _ _ _ _ _ _ _ _ _ _
0 _ _ Y
Y 0 Y 1 Y f
Production Function
_ _ _ _ _ _ _ _ _ 2% _ _ _ _ _ _
_ rf _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 0 I
I 0 I 1 I f
MEC Schedule
KEY:
S = Saving.
Y = National National Product. Income/Net
I = Net Investment.
MEC = Marginal Efficiency of Capital.
r = Rate of Return on Capital.
N= Volume of Employment.
Now some people may object to the Keynesian analysis that there is no good reason for picking 2 percent as the minimum acceptable rate of return—that employment and output should be able to expand so long as the rate of return on capital remains above zero, because earning any positive rate of return is better than earning none at all. This criticism, of course, could not meet the argument that the rate of return at full employment would have to be less than zero. Moreover, the Keynesians have various arguments in favor of taking 2 percent as the practical lower limit of acceptability for the rate of return. It would be possible to present and then refute these arguments. It would also be possible to show why full employment would be compatible even with a negative rate of return (because the prospect would still exist of any given individual employer earning a positive rate of return and thereby continuing to have a sufficiently strong motive for investing). Instead, however, I prefer to challenge the IS curve—the very notion that as employment and output expand, the rate of return on capital falls.
In order to accomplish this, it is necessary to explain the process by which the Keynesians derive the IS curve from various other real or imagined relationships. These relationships are: (1) the production function, (2) the saving function, (3) an equality of saving and investment, and (4) the marginal-efficiency-of-capital schedule. All of them, and the derivation of the IS curve from them, are shown in Figure 18–4 as a set of five interconnected diagrams. The production function appears in the diagram in the bottom-left portion of Figure 18–4; the saving function, in the diagram in the top-left portion; the equality of saving and investment, in the diagram in the top-right portion; the marginal efficiency of capital schedule, in the diagram in the center-right portion of the figure; and, finally, the IS curve, in the diagram in the center-left portion of the figure.
“Production function,” it should be recalled from Chapter 13, is simply the technical name given to the relationship between the volume of employment (labor performed) and the volume of output that results, given the state of technology and the supply of capital equipment. The labor performed is shown on the vertical axis, while the output produced is shown on the horizontal axis. This, of course, is a relationship that is in no way specific to Keynesian economics. 24 The use of the letter N, however, to measure the volume of employment is taken from the practice of the Keynesian textbooks.
The “saving function” is the Keynesian doctrine that a definite, determinate mathematical relationship exists between the level of income, on the one side, and the volume of saving out of income, on the other. In the diagram, saving is shown on the vertical axis and income on the horizontal axis. The saving function is the corollary of the more widely known Keynesian doctrine of the “consumption function,” according to which consumption spending is mathematically determined by the level of income. It is derived by subtracting the consumption function from income. Typically, it is presented as the algebraic formula
S = –a + (1–c)Y, where a is a given amount of consumption that occurs irrespective of the level of income, c is the “marginal propensity to consume,” viz., the extra consumption that take place out of additional income, and Y is national income/net national product. A minus sign appears before the constant a to indicate the amount of dissaving that would occur if income were zero. Since all income is either consumed or saved, and c is the marginal propensity of consume, 1-c is the “marginal propensity to save.”
It should be noted that there is more than a little equivocation in the way the symbol Y is used. When it appears in connection with the production function, it refers to physical output—to “real income.” When it appears in connection with saving, however, it becomes money income, out of which cash hoarding occurs. Please note in this connection that the horizontal axis of the production function and the saving function are presented as identical, and so is the horizontal axis of the IS curve. Y is the measure of all three.
The third diagram—the equilibria of saving and investment—in the upper-right portion of Figure 18–4, shows investment equal to saving at every point. The vertical axis of this diagram is identical with the vertical axis of the saving-function diagram. Thus it too represents saving. The equality of investment, which is shown on the horizontal axis, with saving, is accomplished by the drawing of a 45-degree line through the origin. Every point on this line represents an equal distance on both axes of the diagram, and thus represents an equality of saving and investment. The purpose of this diagram is to set the stage for showing why investment cannot in fact be equal to saving when saving is substantial. Its purpose is to ask what would happen if all that were saved at every level of real income were actually invested.
The answer to this last, and very critical question is supposedly supplied in the fourth diagram, the marginal-efficiency-of-capital schedule—mec schedule for short— in the center-right portion of Figure 18–4. Here, the horizontal, investment axis of the diagram above is repeated, while the rate of return on capital is shown on the vertical axis. It is claimed that the greater is the volume of net investment, the lower is the rate of return on capital. This is shown by the mec schedule sloping downward to the right, with the greater being the size of I, the
smaller being the size of r. (The reasons advanced in support of the mec doctrine will be presented shortly. For the moment, it can be taken at face value, simply in order to understand the derivation of the IS curve. It is important to note in this connection, that the vertical axis of the mec schedule and the vertical axis of the IS curve are also identical.)
Given the production function, the saving function, the equilibria of saving and investment, and the mec schedule, the derivation of the IS curve is not difficult. We can begin by picking a low level of employment. Let us take point N 0 on the vertical axis in the bottom-left diagram. Reading over to the production function, along the dashed line, we see that this implies a definite level of output (real income). Call that level of output Y 0 . Now we read up a dashed line, all the way to the saving function. There, we find that Y 0 output (income) implies S 0 of saving. Reading across, along the dashed line, to the investment-equals-saving diagram, we find that S 0 of saving requires I 0 of net investment, if the saving is not to be hoarded. Reading down now, along the dashed line to the mec schedule, we find that I 0 of net investment implies an r 0 rate of return. If we now connect the Y 0 output produced by the N 0 volume of employment, with the r 0 rate of return that results from the investment of the savings generated by that level of output (income), we have a point on the IS curve.
Down in the bottom-left diagram, let us pick a second, higher level of employment on the vertical axis, namely, the amount denoted by N 1 . Reading over to the production function, we see that this implies another definite level of output—a higher one. Call it Y 1 . Again, we read up along the dashed line to the saving function. There we find a second, higher level of saving. Call it S 1 . Reading across to the saving-equals-investment diagram, we find that S 1 of saving requires equivalent I 1 of investment, if the saving is not to be hoarded. Reading down to the mec schedule, we find that I 1 of investment implies a lower, r 1 rate of return. If we now connect the r 1 rate of return with the Y 1 level of output, we obtain a second point on the IS curve. This is a point of greater output and a lower rate of return. What is present here is that more employment means more output (real income), more saving, the need for more investment to prevent the hoarding of that saving, and a lower rate of return on investment, if that investment actually takes place.
Finally, let us pick a third, still higher level of employment on the vertical axis in the production-function diagram. Let us call it “full employment, and denote it by the letters N f . Once more reading over to the production function along a dashed line, we find that the higher level of employment goes with a higher level of output. Call this level of output Y f , the fullemployment level of output. Reading up along the dashed line to the saving function, we see that there is a higher level of saving corresponding to the fullemployment level of output. Call it S f , the fullemployment level of saving. Reading over to the saving-equals-investment diagram, we see that S f of saving, if it is not to be hoarded, requires the correspondingly larger amount I f of net investment. Reading down to the mec schedule, we see that I f of net investment is accompanied by a further reduction in the rate of return to rf, the full employment rate of return. The r f rate of return and the Y f level of output constitute a third point on the IS curve. Unfortunately, say the Keynesians, this rate of return is simply below the minimum acceptable rate of return of 2 percent, and so full employment cannot be achieved, or if somehow achieved, cannot be maintained.
A fall in wage rates and prices is held to be useless in achieving full employment because all of the above relationships are supposed to hold true in physical terms. N f of employment means Y f of output, means S f of saving, requiring I f of net investment, which causes too low a rate of return. These same physical relationships allegedly hold irrespective of the wage-and-price level. Specifically, at a lower wage-and-price level, it is held, no more physical investment is profitable (yields more than 2 percent) than before.
If, for example, initially there is 250 of investment at a 2 percent rate of return and, say, approximately 10 percent unemployment, a fall in wage rates and prices to 9 ⁄ 10 their initial level will not achieve full employment— indeed, it will supposedly not achieve any increase in employment at all. This is because investment will allegedly have to fall 10 percent to 225—that is, in full proportion to the fall in wage rates and prices. It is claimed that investment must fall in this way because all the investment that there is room for at a 2-percent-or-greater rate of return is, allegedly, that physical amount of investment—for example, so many steel mills, cement factories, bicycle shops, and so forth—which at the initial price-and-wage level requires 250 to purchase. At a price-and-wage level 9 ⁄ 10 as high, that physical amount of net investment requires only 225 to purchase. Net investment cannot remain at 250 in money, because then 250 of monetary net investment would be equivalent to approximately 278 of net investment at the initial price-and-wage level (viz., at 9 ⁄ 10 times the initial price-and-wage level, 250 would be equivalent in buying power to 10 ⁄ 9 times 250, which is 278). This greater physical amount of net investment would mean a rate of return below 2 percent. Thus, all that net investment can be at the 9 ⁄ 10 price-and-wage level is 225, because now 225 represents the alleged maximum physical quantity of net investment that is profitable.
In exactly the same way, if the wage-and-price level were to fall all the way to half, the monetary amount of net investment would supposedly have to fall in half—to 125 from 250. It allegedly could not remain at 250 or even at 225, because monetary amounts of net investment at those levels would now represent real, physical net investment equivalent to what 500 purchased at the initial price-and-wage level, or what 450 would purchase at 9 ⁄ 10 the initial price-and-wage level. Such volumes of net investment would allegedly thus result in a rate of return all the more below 2 percent. At a halved wage-and-price level, net investment cannot get beyond 125 in money, it is held, because that sum now represents the maximum physical amount of net investment that is profitable. 25
These results are shown in Figure 18–5. Below the horizontal axis in this figure are three different scales of measurement of net investment, each one corresponding to a different price-and-wage level, namely, the initial price-and-wage level, one that is 9 ⁄ 10 as high, and one that is only half as high. Because the same maximum physical amount of net investment is allegedly all that is profitable—namely, the amount that is profitable down to a rate of return of 2 percent and no lower—the effect is that each successive scale of measurement at lower prices and wages moves correspondingly to the right. Thus, the net
Figure investment that initially required 250 to purchase, successively requires only 225, and then only 125. Continued net investment in the amount of 250 at the 9 ⁄ 10 price-and-wage level, and then at the halved price-and-wage level, would allegedly result in rates of return on capital respectively equivalent to those produced by 278 and 500 of net investment at the initial price-and-wage level
Thus, despite the fall in wage rates and prices, the problem that allegedly remains is that there cannot be an outlet for saving in excess of the given physical amount of net investment that is profitable (i.e., that yields 2 percent or more). And thus there cannot be a real income (output) that results in any such greater level of saving, nor, finally, a volume of employment that would result in any such level of output. The volume of employment is thus allegedly limited to that amount that results in a level of output (real income) out of which saving is no greater than is consistent with the allegedly limited physical volume of profitable investment opportunities.
In other words, according to the Keynesians, there cannot lastingly be a level of employment, output, and real income greater than what produces the limited volume of saving that can be accommodated by the limited volume of profitable investment opportunities. If the volume of employment is greater than the one that pro—
18–5
The MEC Schedule r% 10
8
6
MEC 4
2
0
At initial p and w level: 50 100 150 200 At 9/10 p and w level: 45 90 135 180 At 1/2 p and w level: 25 50 75 100
I 2%
250 300 350 400 450 500 225 270 315 360 405 450 125 150 175 200 225 250
duces such a limited level of saving, then saving supposedly exceeds the limited profitable investment opportunities that exist, thereby driving the rate of return on capital below the minimum acceptable level. The alleged consequences are that hoarding results, spending drops, and sales revenues, employment, and output all decline. Their decline then represents a drop in real income. Out of the smaller real income, less saving occurs. The drop in employment, output, and real income must allegedly be great enough to reduce the volume of saving to the point where it no longer exceeds the allegedly limited profitable investment opportunities available.
In sum, full employment, or any employment beyond a fixed, given amount, cannot exist, or at least cannot be maintained, according to the Keynesians, because it would produce a physical volume of output out of which there would be a physical volume of saving requiring a physical volume of net investment that would put the rate of return below the minimum acceptable rate. In essence, the Keynesian argument is that full employment cannot exist in a free economy because if it did, the economic system would, in effect, choke on the allegedly excessive saving that would accompany full employment. Keynes himself states the essence of his position in the following words (where helpful, I insert my own clarifications in brackets):
Perhaps it will help to rebut the crude conclusion that a reduction in money-wages will increase employment “because it reduces the cost of production”, if we follow up the course of events on the hypothesis most favourable to this view, namely that at the outset entrepreneurs expect the reduction in money-wages to have this effect. It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will overlook at the outset the repercussions on the demand for his product and will act on the assumption that he will be able to sell at a profit a larger output than before. If, then, entrepreneurs generally act on this expectation, will they in fact succeed in increasing their profits? Only if the community’s marginal propensity to consume is equal to unity, so that there is no gap between the increment of income and the increment of consumption [i.e., there is no additional saving]; or if there is an increase in investment, corresponding to the gap between the increment of income and the increment of consumption, which will only occur if the schedule of marginal efficiencies of capital has increased relatively to the rate of interest [i.e., either the mec schedule must somehow move to the right, which there is allegedly no reason for its doing, or the rate of interest must fall, which it can’t do, if it is already at 2 percent]. Thus the proceeds realised from the increased output will disappoint the entrepreneurs and employment will fall back again to its previous figure, unless the marginal propensity to consume is equal to unity [i.e., there is no additional saving] or the reduction in money-wages has had the effect of increasing the schedule of marginal efficiencies of capital relatively to the rate of interest and hence the amount of investment [Keynes means, of course, increase the amount of investment that is profitable—i.e., yields 2 percent or more]. For if entrepreneurs offer employment on a scale which, if they could sell their output at the expected price, would provide the public with incomes out of which they would save more than the amount of current investment, entrepreneurs are bound to make a loss equal to the difference; and this will be the case absolutely irrespective of the level of money wages. 26
I have italicized the last sentence because if any single sentence of Keynes can express the theoretical substance
27 of his doctrine, that is the one.
The Grounds for the MEC Doctrine
It should be obvious that the two critical doctrines underlying the IS curve are the doctrines of the saving function and, above all, the declining mec schedule. According to the saving function, people insist on saving a significant portion of the additional real income corresponding to the additional output that results from additional employment. If they did not do so—if there were no additional savings requiring investment as employment increased, full employment might actually be achieved according to Keynes, as the passage quoted above makes clear. For the rate of return on capital would then not have to fall as employment increased. Thus, if only people were sufficiently profligate, they could be prosperous, says Keynes.
Fortunately, of course, people do wish to save. From the perspective of Keynesian economics, however, this creates the problem of having to prevent the resulting savings from being hoarded, because of the alleged decline in the rate of return on capital that results from their being invested.
It is now necessary to present the reasons Keynes and his followers advance in support of the declining mec doctrine—of the claim that as net investment increases, the rate of return on capital must fall. Keynes himself writes:
If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase . . . .
Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively,
the schedule of the marginal efficiency of capital. 28
When Keynes speaks of rising “supply prices” of capital assets as investment demand increases and causes pressure on the facilities for producing capital goods, what he has in mind is the notion that more net investment constitutes additional demand for capital assets and thus raises their prices. His further belief that increasing net investment results in declining yields to capital assets is based in part on the conviction that as more productive capacity is brought into existence, as the result of the net investment, the selling prices of products will fall because of their larger supply. In addition, the yields to capital assets will allegedly fall because of the operation of the law of diminishing returns: successive equal increments of net investment, even at constant purchase prices of capital assets, supposedly result in diminishing physical returns to the successive doses of capital assets purchased. 29
To express these ideas in terms of a simple example, we might imagine that initially the price of a machine that turns out widgets is $1,000 and that its use enables the same quantity of labor to produce 10 additional widgets every year, which have a selling price of $10 each. On the simplifying assumptions that this machine will last forever and that the cost of materials and fuel can be ignored, the implied rate of return is 10 percent per year: 10 additional widgets times $10, divided by $1,000. Now, however, there is a demand for two such machines. As a result, the purchase price rises above $1,000—say, to $1,050. In addition, the selling price of widgets will fall somewhat, because of their larger supply—say, to $9.50. Finally, because of diminishing returns, it may be possible to obtain only 9 additional widgets instead of 10 by virtue of the employment of the second machine. The operation of any one of these factors, it is held, reduces the rate of return. Their combined operation in this example must reduce the rate of return to not much more than 8 percent: $9.50 times 9 widgets, divided by $1,050. In these ways, more net investment is held to reduce the rate of return on capital. 30
The Keynesian Solution: “Fiscal Policy”
The Keynesian solution to the alleged unemployment equilibrium of capitalism is government budget deficits (euphemistically called “fiscal policy”). The purpose of the budget deficits is to absorb the excess saving that allegedly would otherwise take place at full employment. Figure 18–6 shows the nature of the gains the Keynesians believe government budget deficits achieve.
The diagram in Figure 18–6 is the same as that in the upper-right portion of Figure 18–4—that is, the saving-equals-investment diagram. But it shows investment as
Figure 18–6
Government Budget Deficits as an Outlet for Savings
S - d = I
S S = I
S f
S 1 d d
S 0
45˚
I
0 I 0 I 1 I f equal to saving minus the deficit, instead of saving in full. The deficit, according to the Keynesians, serves as an additional outlet for saving and thus reduces the amount flowing through to net investment. This is shown in the diagram by the drawing of a second 45-degree line, above the first one by a vertical distance equal to the amount of the deficit, which is represented by d on the vertical axis. This new 45-degree line is labeled S – d = I—saving minus the deficit equals net investment—in contrast to S = I, which is the label describing the first 45-degree line. Note that when saving equals the deficit, investment equals zero, as shown by the intersection of the new 45-degree line with the vertical axis at point d. Because both are 45-degree lines, the new line is not only above the original one by the amount of the deficit but also to the left of it by the amount of the deficit. This depicts the idea that every given amount of saving now requires an amount of investment that is less than itself by the amount of the deficit.
The crucial result is supposed to be that for any given level of employment, output, and saving, the amount of investment required to prevent hoarding is less than it otherwise would be by the amount of the deficit. Since there is less investment, the further crucial result is supposed to be that the rate of return on capital is now higher for any given level of employment, output, and saving. By the same token, it takes more employment, output and saving to achieve the same rate of return as previously. In other words, the effect of the deficit is supposedly to shift the IS curve up and to the right.
This result is confirmed by drawing the new saving—
Figure 18–7
How Budget Deficits Are Supposed to Promote Full Employment
S
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ S f
S = – a + (1 – c) Y
S 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_
_
_
S 0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
0 _ _ Y 0 Y 1
– a _ Saving Function _
_
_ _ r% _ _
S – d = I
S
S = I
_ S f + _ _ + _ _ + _ _ + _
_ _ _ _ _ _ _ _ S 1 _ _ _ _ _ _ _ + _
_ + _ _ + _ + _ _ + _ + _
_ _ _ _ _ _ _ _ _ S 0 d _ 45˚ + + _ _ + + _ _
_ Y f Y 0 _ I 0 + + _ _ I 1 + + _ I f I
_ _ Saving + = Investment + _ _ _
_ _ + _ + _ _ r% _ + _ + _ _ _ + _ + _ r 0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _r 0 _ _ + _ + _
_ _ + + + + +
_ IS _ ′
_ _ + _ + _ _ _ + _ + _
+ + _ + + + + + + + _ + + + + _ + _
_ _ _ MEC + _ r 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ IS _ _ _ _ _ _ _ _ _ _ _r 1 _ _ _ _ _ _ _ + _
2% _ _ _ _ _ _
_ _ _ + _ _ _ _ + _ _ _ _ + _
_ _ _ + + + + + 2% + _ _ _ + + + + + _ _ _ + + + + + _ _ _ r f _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _r f _ _ _ _ _ _ _ _ _ _ _ _ _ _
0
Y 0 Y 1
IS Curve
N
Y 0 I
Y f I 0 I 1 I f
MEC Schedule
_
_ KEY:
_
_
N f _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ S = Saving.
N 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _
N 0 _ _
0
Y 0 Y 1
Production Function
_
_ Y = National Income/Net _ National Product.
_
_ i = Net Investment.
_
_ MEC = Marginal Efficiency of Capital.
_
_ r = Rate of Return
_ on Capital.
_
Y
Y f N= Volume of
Employment.
d = the Deficit.
minus-the-deficit-equals-investment line in the upper-right diagram of Figure 18–4 and then examining the effect on the IS curve. Each N, Y, and S point will be found to go with a lower I and thus a higher r point. This is shown in Figure 18–7, which, in essence, substitutes Figure 18–6 for the upper-right diagram of Figure 18–4.
What the set of diagrams in Figure 18–7 purports to show is that, thanks to the government’s budget deficit, for any given volume of employment, output, real income, and saving, there is less investment and thus a higher rate of return on capital than before. Thus, there can be more employment, output, real income, and saving before the volume of investment becomes so large as to push the rate of return on capital to the minimum acceptable level of 2 percent. With a large enough deficit, argue the Keynesians, there can be full employment.
The whole process is described by the upward and rightward movement of the IS curve. Following along the dashed lines, notice how the same magnitudes of employment, N 0 , N 1 , and N f , continue to result in the same magnitudes of output (real income) and saving— namely, Y 0 , Y 1 , and Y f and S 0 , S 1 , and S f respectively. But now S 0 of saving requires less than I 0 of net investment; S 1 of saving now requires less than I 1 of net investment; and, what is supposedly critical, S f of saving now requires sufficiently less than the old I f volume of net investment that full employment can now take place at a rate of return above 2 percent. The new relationships to investment and the rate of return are indicated by lines composed of plus signs, which run downward from the saving-minus-the-deficit-equals-investment line to the mec schedule and then across, to the left, to the various values of Y resulting from the various values of N.
To describe matters verbally, one could say this: The alleged problem of capitalism, according to the Keynesians, is that full employment results in a volume of saving that the economic system cannot profitably invest. In effect, such saving is a destructive by-product of full employment under capitalism, and thus prevents the existence of full employment. It is a kind of toxic excrescence—a veritable boil on the economic body that interferes with its vital functioning. Fortunately, however, there is a doctor, and he has a cure for the problem. The doctor is the government, and the cure is a deficit in its budget. As Keynes has explained matters, the government doctor will lance the savings boil and allow its destructive juices to flow into the waiting pan of the government’s deficit rather than into private investment, where it would reduce the rate of return on capital to an intolerably low level.
A different, perhaps less distasteful analogy can be used. Capitalism, we might imagine, cannot have full employment because of the existence of a hard-drink function, rather than a saving function. As employment and real income rise, people feel themselves able to afford to drink more. At the point of full employment, they drink so much that they are physically hung over on the week ends to such an extent that they are incapable of work on Mondays. This too would represent a kind of “unemployment equilibrium.” Once again, a case might be made for the intervention of the good government doctor: it might siphon off people’s liquor money with the sale of soft drinks, 2 percent beer, or perhaps even methadone. Or, perhaps, it might work to divert their liquor money onto ecclesiastical collection plates, in effect, buying bonds issued in the name of heaven rather than in its name.
Innumerable analogies to the unemployment-equilibrium doctrine can be created on the basis of environmentalism. That doctrine, of course, holds that economic activity is replete with self-destructive by-products. 31 On the basis of it, one could easily invent all kinds of mathematical functions analogous to the “saving function.” Then all one would need to do is arbitrarily assert some fixed limit to the capacity of the world to cope with the particular by-product. On that basis, one could proceed to argue that employment and production must be limited to the point of not generating an amount of such by-product in excess of the alleged fixed limit. Indeed, this is precisely what the environmentalists are doing in the cases of carbon dioxide emissions and garbage disposal. Only instead of seeking to impose an unemployment equilibrium by forcibly holding down the volume of employment, they seek to impose limits on the productivity of labor and the volume of consumption. But just as with Keynesianism and its budget deficits, there is still an alleged need for the good government doctor (though not as often, because the environmentalists believe that human suffering is fundamentally inescapable and, indeed, desirable). In the case of the carbon dioxide emissions, it is sometimes argued that the alleged low-productivity-oflabor equilibrium might be overcome to some extent by virtue of government imposed tree-planting programs. These would play the same kind of role in the absorption of allegedly harmful carbon dioxide as government budget deficits are supposed to play in the absorption of allegedly harmful saving. The essential common element in Keynesianism and environmentalism is the belief that free individuals are engaged in essentially self-destructive activity that, if it can be remedied at all, can only be remedied by the coercive power of the state.
3. Critique of the IS-LM Analysis
The Declining-Marginal-Efficiency-of-Capital
Doctrine and the Fallacy of Context Dropping
The critique of the Keynesian IS-LM analysis can be concentrated on the declining-marginal-efficiency-of-capital doctrine. The Keynesians’ use of this doctrine is a prime example of a major logical fallacy identified by Ayn Rand, which she calls “context dropping.” 32 Context dropping is the fallacy of denying, forgetting, or otherwise contradicting the context that is explicitly or implicitly under discussion. An example of context dropping from outside the field of economics is the following. Imagine a group of aeronautical engineers who are working on the problem of how to increase the speed of an airplane. They know that other things being equal, the lighter the weight of the plane, the faster it will fly. If, to make the plane lighter, they concluded that its engines should be eliminated, they would be committing the fallacy of context dropping. For the context under discussion is the flight of a heavier-than-air machine, which is possible only by virtue of its possession of engines. Another example of context dropping would be an esoteric discussion of the effects of living or working on the tenth floor of a building, which discussion somehow managed to deny or otherwise contradict the existence of any one or more of the lower nine floors of the building or of its foundation.
The use of the declining-marginal-efficiency-of-capital doctrine is an example of context dropping, for the following reasons. The context under discussion is the question can a fall in wage rates and prices achieve full employment or can it not? This question is the context which must always be kept in mind. It is the context within which the declining-marginal-efficiency-of-capital doctrine is advanced, in order to show why a fall in wage rates and prices cannot achieve full employment. Yet, as will quickly be made apparent, every one of the three grounds advanced in support of the declining-marginal-efficiency-of-capital doctrine, and which were described in the previous section, flatly contradicts the context under discussion.
Once again, the context under discussion is the ability of lower wage rates and prices to achieve full employment. This context, of course, implies lower unit costs of production, for that is what lower wage rates achieve both directly and through bringing about lower prices of materials and machinery and capital goods in general. The achievement of full employment also implies the availability of more labor in production relative to the existing supply of capital goods. In a state of mass unemployment, the factories and machinery exist in virtually the same quantity as before the onset of the depression and the unemployment. But they are largely idle. The ratio of capital to labor employed is correspondingly high. As full employment is approached, and more and more workers return to the factories, the ratio of capital to labor correspondingly falls.
Now this whole context is contradicted by the use of the declining-marginal-efficiency-of-capital doctrine to show why a fall in wage rates and prices cannot achieve full employment.
The use of the declining-marginal-efficiency-of-capital doctrine enables the Keynesians to end up claiming that a fall in wage rates and prices cannot achieve full employment, precisely by dropping the context of a fall in wage rates and prices and rise in employment, and switching to an altogether different, indeed, opposite context, which could exist only if wages rates, production costs, and prices rose instead of fell. For the context to which the Keynesians deftly switch is one of a rise in the prices of capital assets, no fall in the costs of production but constant or, indeed, rising costs of production, and no increase in the quantity of labor employed relative to the supply of capital goods in existence, but, on the contrary, a further increase in the supply of capital goods relative to the supply of labor that is employed.
Recall that the first reason advanced in support of the falling marginal efficiency of capital was the claim that as more net investment took place to offset the additional saving accompanying the additional employment, the prices of capital assets would rise, in response to the increase in demand for capital assets allegedly constituted by the additional net investment. The actual fact is, of course, that in the context of the elimination of unemployment by means of a fall in wage rates and prices, the prices of capital assets would fall, not rise. Keynes and his followers thus totally contradict the context under discussion. They claim that a fall in wage rates and prices cannot achieve full employment, because if, instead of falling, as they necessarily would in these circumstances, the prices of capital assets rose, the rate of return on capital would be reduced.
Furthermore, it is curiously ironic that in arriving at their bizarre conclusion that the prices of capital assets would rise in the midst of a fall in wage rates and prices, the Keynesians commit precisely the fallacy that the arch-Keynesian Professor Samuelson is at such pains to warn new students of economics against. Namely, the fallacy of confusing the increase in the quantity of a good demanded that takes place in response to a lower price of the good, with an increase in the demand for the good. 33 Precisely this fallacy is what is present in the Keynesians’ belief that the rise in net investment that accompanies the fall in wage rates and prices and the
restoration of full employment, constitutes a rise in the demand for capital assets and thus acts to raise their prices. The fact is that the additional net investment presupposes and is in response to lower prices of capital assets, and can endure only so long as the prices of the capital assets are lower. It does not operate to raise those prices. And this is true even if one were to grant the legitimacy of conceiving of the additional net investment as representing an additional total expenditure of money for the capital assets. It would still be necessary to keep in mind that the larger expenditure of money was in response to lower prices and could endure only so long as the prices of capital assets remained lower. 34
Recall that the second reason advanced for the declining marginal efficiency of capital was the claim that more net investment means more capacity in place, which means lower selling prices of products, which, other things being equal, means a fall in profitability. Here the context dropping consists of forgetting that other things— namely, the costs of production—are not equal. Precisely a fall in wages and costs is what brings about the additional production and the decline in prices. Lower prices founded on lower costs of production do not reduce profitability or the socalled marginal efficiency of capital.
Again, the Keynesians contradict the context. They argue that a fall in wages, costs, and prices cannot achieve full employment because if all that occurred were the fall in selling prices and no fall in costs—indeed, a rise in costs because of the alleged rise in the prices of capital assets—the rate of return on capital would fall. This, of course, is totally absurd. It is absurd to argue against the ability of a fall in wage rates and costs of production to achieve full employment on the grounds that if there were no fall in costs of production but, somehow, only a fall in the prices of the products, full employment could not be achieved. This dropping and switching of context enables the Keynesians to fail to see that the lower selling prices of products are offset and in fact more than offset by a fall in costs of production, and thus that there is not only no fall in the rate of profit (the “marginal efficiency of capital”), but an actual rise in the rate of profit in consequence of the fall in wages and costs of production.
Finally, it should be recalled that the third reason advanced in support of the declining marginal efficiency of capital was the claim that diminishing returns would accompany the additional net investment that was required to offset the additional saving taking place as employment, output, and real income expanded. Now putting aside the actual irrelevance of the law of diminishing returns to the rate of profit, and assuming for the sake of argument that it did have a determining effect, the truth is that in the context of a fall in wage rates and prices and increase in the volume of employment and output, the physical returns to capital goods would increase rather than decrease. This is because as the economic system moves from mass unemployment to full employment, the supply of labor employed in production increases at a more rapid rate than the supply of capital goods. This is so because in the conditions of mass unemployment a substantial supply of capital goods previously used in production continues to exist in the form of idle machines and factories. Its existence relative to the diminished number of workers employed constitutes an unusually high ratio of capital to labor. As the workers come back into the factories and once again take up the use of these capital goods, the ratio of capital to labor sharply declines.
Such increase in the supply of capital goods as occurs as the result of additional employment, output, real income, and saving is a purely derivative phenomenon. The fundamental, primary phenomenon is the increase in the ratio of labor employed to capital goods, which implies increasing returns to capital goods, not decreasing returns. If ever there were a problem of too-low physical returns to capital goods, nothing could be a surer cure than the employment of more labor. Whatever problem might be imagined to exist, it would necessarily be less at the point of full employment than at the point of mass unemployment, or any unemployment.
As an illustration of this fact, imagine that in conditions of unemployment there are 12 units of capital goods and 3 workers employed, who produce a net output of 3 units of goods. The achievement of full employment means, let us assume, the employment of 4 workers who produce a net output of 4 units of goods. If fully one-half of the additional net output of 1 unit is saved, the ratio of capital goods to labor still falls dramatically—from 12 to 3 (i.e., 4:1), to 12.5 to 4 (i.e., to 3.125:1). And this principle continues to hold, even if it were the case that the longterm continuation of full employment and steady saving and net investment of a half a unit of net output per year ultimately resulted in a ratio of capital to labor of, say, 24 to 4 (i.e., 6 to 1) at the point of full employment. This is because in that case, with the same unemployment as before, the ratio of capital to labor would be 24 to 3 (i.e., 8 to 1). Thus, the movement from unemployment to full employment would still reduce the ratio of capital to labor and increase the physical returns to capital goods, not decrease them.
The procedure of the Keynesians, of course, is to forget the existence of the fundamental phenomenon, the increase in the supply of labor employed as the economic system goes from unemployment to full employment, and to focus on the secondary, derivative phenomenon, the increase in the supply of capital goods that results
from the saving out of the net output of the additional workers employed. In this way, the Keynesians proceed to assume that the ratio of capital goods to labor rises and the physical returns to capital goods fall, at the very time that exactly the opposite is true. Thus, the Keynesians end up claiming that full employment cannot take place on the grounds that if extra employment did not mean an increase in the ratio of labor to capital, but somehow the opposite, namely, an increase in the ratio of capital to labor, full employment could not exist—by virtue of the too-low rate of profit allegedly resulting from the relative overabundance of capital goods. In a word, the Keynesians end up denying that full employment can exist by confusing the effects of its existence with the effects of its nonexistence.
Indeed, the whole process by which the Keynesians reach the conclusion that a fall in wage rates and prices cannot achieve full employment is nothing more than a refusal to consider its actual existence. Instead of considering the existence of a fall in wage rates, costs, and prices and the employment of a larger number of workers, they choose to consider the totally different and opposite case of a rise in the prices of capital assets, of no fall in the costs of production but only in the selling prices of products, and of no increase in the supply of labor employed but only of an increase in the supply of capital goods that derives from that employment. Then, on the basis of their consideration of this totally opposite and thoroughly illegitimate case, in which down has literally become up—namely, a fall in the prices of capital assets has become a rise in the prices of capital assets—and in which effects have been divorced from their causes—that is, the fall in selling prices has been divorced from its cause, the fall in wage rates and costs, and the additional net investment and capital accumulation has been divorced from its cause, which is the employment of additional workers with the capital goods already in existence—they conclude that they have proven something about the case at hand. All they have actually proven is their own capacity for confusion, if not intellectual dishonesty. 35
The Marginal-Efficiency-of-Capital Doctrine and the Claim That the Rate of Profit Is Lower in the Recovery from a Depression Than in the Depression
There are further major criticisms which must be made of the Keynesian analysis in connection with the marginal-efficiency-of-capital doctrine. The Keynesian claim that a fall in wage rates and prices cannot achieve full employment, because at full employment the rate of return on capital would be too low, is a claim that the rate of return in the recovery from a depression is lower than it is in the depression.
What the Keynesians claim is that the economic system cannot recover from mass unemployment and depression because if somehow it did, the rate of return on capital would fall—which means that it would be lower in the recovery from the depression than it was in the depression. In effect, the Keynesians tell us that if we think the rate of profit is low now, in the conditions of mass unemployment and depression, we should wait and see what it will look like in the recovery. In the state of mass unemployment and depression, it is already at the minimum acceptable level (in the neighborhood of 2 percent) and at full employment it would have to be lower still, they say. Indeed, according to the Keynesians, if somehow the economic system did temporarily manage to recover and achieve full employment, it would immediately have to return to the conditions of mass unemployment and depression as the means of elevating the rate of profit—above the still lower level that is supposed to exist in the recovery. This is the actual meaning of the whole Keynesian argument for the unemployment equilibrium. If there is any doubt about this fact, the reader should look once again at the standard Keynesian diagrammatic relationships presented above in Figure 18–4 of this chapter and reread the extensive passage quoted from Keynes himself some paragraphs later, in which he claims to “rebut the crude conclusion that a reduction in money wages rates will increase employment.”
The Unemployment-Equilibrium Doctrine and the
Claim That Saving and Net Investment Are at
Their Maximum Possible Limits at the Very Time
They Are Actually Negative
An equally profound and closely related reversal of economic reality on the part of the Keynesian analysis is its belief that in a depression saving and net investment are at their maximum possible limits, and the problem is that full employment requires that they be carried still further. 36 This, of course, is the alleged proximate cause of the marginal efficiency of capital having to be pushed below its minimum acceptable level. The actual fact is, however, that far from being at their maximum limits, saving and net investment are extremely low or even negative in a depression. For example, in the Great Depression following 1929, corporate saving (undistributed corporate profits) was negative in every year from 1930 to 1936 and again in 1938; personal saving was negative in 1932 and 1933 and barely more than zero in 1934; net investment was negative in the years 1931 to 1935 and again in 1938. 37
There should be nothing surprising in these facts. They are logically implied in the very nature of a depression and mass unemployment. When people are out of
work, they must live off their savings. In a state of mass unemployment, the consumption of savings in this way is necessarily very considerable. At the same time, corporations are under pressure to continue to pay dividends to their stockholders, even though they are currently earning little or no profits. To pay dividends under such conditions, they must dip into their accumulated savings—their earned surplus accounts. Unincorporated businesses, of course, are under the same kind of pressure; they too must frequently continue to support their owners even though their current profits are insufficient to do so. In these ways, the current saving of those individuals and business firms who are still in a position to save out of income is more than offset, and saving in the economy as a whole becomes nonexistent or, indeed, becomes negative.
The fact that net investment becomes negative can be understood by direct inference, either from the fact that saving out of income becomes negative or from the fact that in a depression productive expenditure sharply declines, in particular productive expenditure for fixed assets, such as plant and equipment. A plunge in productive expenditure for fixed assets implies a fall in net investment, because at the same time depreciation charges hardly change at all, since they are based on a percentage of the productive expenditure for fixed assets made over a long period of prior years. Net investment in fixed assets actually becomes negative to the extent that current productive expenditure for fixed assets drops below depreciation charges. To that extent, the sum of the subtractions from the fixed asset accounts in the economic system exceeds the sum of the additions currently being made to those accounts, and thus the net change— the net investment—is negative. 38 Similarly, in a depression productive expenditure on account of inventory and work in progress plunges, while cost of goods sold, which reflects such productive expenditure made in prior periods, continues to hold up. To the extent that productive expenditure on account of inventory and work in progress drops below cost of goods sold in the economic system, the result is negative net investment in inventory and work in progress, because what is now signified is that the sum of the additions being made to these accounts correspondingly falls short of the sum of the subtractions. The reduction in the value of the inventory and work-in-progress accounts in the economic system is the extent of the negative net investment of this type. 39
The Marginal-Efficiency-of-Capital Doctrine’s Reversal of the Actual Relationship Between Net Investment and the Rate of Profit
We are now in a position to make what is perhaps the most decisive objection of all to the declining-marginal-efficiency-of-capital doctrine and the Keynesian analysis. And that is that our discussion of the determinants of the rate of profit has shown that the rate of profit and net investment are positively related. We have seen that net investment and profits move together virtually dollar for dollar, because while profits are the difference between sales revenue and costs, net investment is the difference between productive expenditure (which is almost equivalent to sales revenue) and those same costs. 40
Thus, the actual reason the rate of profit is so low or negative in a depression is the same as the reason net investment is so low or negative—namely, that productive expenditure has fallen, taking sales revenue with it, while costs, especially depreciation costs, fall only with a lag. By the same token, in the recovery from a depression net investment and the rate of profit both improve together. For every dollar by which productive expenditure rises relative to costs, creating net investment, sales revenues rise relative to those same costs, creating profits. Likewise, for every dollar by which costs fall relative to productive expenditure, also creating net investment, those same costs fall relative to sales revenues, creating profits. The mathematical implication of this virtual dollar-for-dollar equivalence between additional net investment and additional profits is that the rate of profit—the socalled marginal efficiency of capital—must actually rise with the rise in net investment, and not fall as the Keynesians maintain.
For example, if in the depths of a depression, aggregate profit in the economic system is 10, while total accumulated capital is 1,000, then the average rate of profit is a mere 1 percent. But if now net investment increases by, say, 50, then aggregate profit increases from 10 to 60. At the same time, of course, the total accumulated capital of the economic system rises to 1,050. The average capital outstanding over the period becomes 1,025—viz., the average of 1,000 and 1,050. However much it may come as a shock to the Keynesians, the unavoidable implication of these facts is that the average rate of profit rises from 1 percent to almost 6 percent! What happens mathematically is exactly the same sort of thing as happens to the season average of a baseball team that goes on a winning streak. In the case of the baseball team, its season average rises in the direction of 1,000. A thousand is its average over the course of its winning streak—its marginal average so to speak—and thus its season average rises accordingly. In the case of more net investment and equivalently more profit, the average rate of profit rises in the direction of a mathematical limit of 200 percent, for the additional net investment is accompanied by an equivalent addition to the amount of profit and by an addition only half as great to the average capital outstanding in the economic system.
As indicated, the rise in the rate of profit that must accompany more net investment in the recovery from a depression, has its counterpart in the fall in the rate of profit that accompanies the wiping out of net investment in the descent into a depression. In the latter case, the plunge in productive expenditure not only drives productive expenditure below costs, making net investment negative, but equivalently reduces sales revenues relative to the same costs. This drives profit in the economic system below net consumption. Profit comes to equal net consumption plus a negative net investment component.
In the light of the foregoing analysis, it is difficult to imagine a more erroneous conception of things than the Keynesian notion that the rate of profit is at a depression level because of too much net investment and that the further net investment that must accompany recovery from the depression will drive it still lower. The facts are that the rate of profit is low in a depression for the same reasons that net investment is low—to the point of being negative—and will rise with the rise in net investment. In other words, among the changes that would need to be made in the Keynesian analysis, if for some reason one had any wish to retain it, is a reversal of the slope of the socalled mec and IS curves in the context of recovery from a depression and the reestablishment of full employment. But since the Keynesian system is so thoroughly riddled with errors and contradictions, there is no point in attempting to modify it or retain it in any way. The Keynesian analysis is so wrong that it is beyond redemption. The one, fundamental change that is needed is its total abandonment.
The Contradiction Between the Marginal-Efficiency-of-Capital Doctrine and the Multiplier Doctrine
It is worth pointing out the existence of a major contradiction between the marginal-efficiency-of-capital doctrine and the multiplier doctrine. When they propound the marginal-efficiency-of-capital doctrine, the Keynesians claim that the effect of more net investment is a reduction in the rate of profit. Yet when they propound the multiplier doctrine, they claim that the effect of more net investment is a multiplied increase in aggregate demand. (In their absurdly narrow view of aggregate demand, of course, this means an increase in net national product, NNP, which is equal to the sum of net investment plus consumption, which in turn allegedly pay the national income.) The additional net investment, they tell us, brings about a diminishing series of additional consumption expenditures, which increases aggregate demand by a multiple of the initial increase in net investment. 41
Now surely, if there is an increase in aggregate demand, aggregate profit must rise. Even on the highly conservative assumption that aggregate profit maintained merely a fixed percentage relationship to “aggregate demand,” instead of bearing a higher percentage relationship, as a rising demand actually implies, the greater the increase in net investment, the greater would be the increase in the rate of profit.
If, for example, profits were assumed to constitute a steady 20 percent of the national income, which, historically, is not an unreasonable figure, a multiplier of two would mean an increment of profits 40 percent as large as the increment of net investment. A multiplier of three would mean an increment of profits 60 percent as large as the increment of net investment, and so on. Even with a multiplier of only two, the rate of profit on accumulated capital would certainly have to rise as net investment increased, for it is certainly below 40 percent to begin with and would move in the direction of 40 percent on the basis of additional net investment. (Indeed, allowing for the fact that the average capital outstanding grows by only half of the additional net investment, the rate of profit would rise toward 80 percent rather than 40 percent.)
The contradiction between the multiplier doctrine and the declining-marginal-efficiency-of-capital doctrine is actually much more acute than this example indicates. For I have shown that virtually all of the increase in national income that would accompany the rise in consumption spending that the multiplier is supposed to bring about, would be profit income. 42 Of course, I have also shown that the multiplier doctrine itself is totally fallacious. The fact that it totally contradicts the marginal-efficiency-of-capital doctrine, which, as shown, is also entirely fallacious, further adds to the indictment of the Keynesian analysis.
A Fall in Wage Rates as the Requirement for the
Restoration of Net Investment and Profitability
Along With Full Employment
Not only do net investment and the rate of profit improve together in the recovery from a depression, but precisely what is required for their improvement is a fall in wage rates. In the context of recovering from a depression, a fall in wage rates is necessary both for the restoration of productive expenditure and thus sales revenues, and for the write-down of the value of existing fixed assets and inventories, which operation reduces the costs deducted from productive expenditure and sales revenues. In both of these ways, a fall in wage rates increases net investment and profits. Thus, it not only brings about full employment, but restores net investment and profitability as well.
To elaborate, when wage rates fall to their new equilibrium level—a level corresponding to the reduced velocity of circulation of money and the reduced quantity
of money that follows the removal of the artificial monetary stimulus of the preceding boom—the costs of new investments are correspondingly reduced. In response, as I have repeatedly pointed out, investment expenditures which had been postponed, awaiting the necessary fall in wage rates and costs to the lower level, now take place, with the result that productive expenditure and thus sales revenues in the economic system are increased. At the same time, assets acquired in the previous boom at an artificially high level of costs, are written down to be competitive with the lower-cost investments that can now be made, as the result of the fall in wage rates. And this, of course, reduces the costs deducted from productive expenditure and sales revenues. In these ways, the fall in wage rates restores both net investment and profitability.
By the same token, as I have also pointed out before, the failure of wage rates to fall operates not only to prolong, but also to deepen the depression. To the extent that it causes the postponement of investment expenditures and the consequent wiping out of profitability, it adds to the inability of business firms to repay their debts. This, in turn, causes more bank failures, a further reduction in the quantity of money and velocity of circulation, and thus necessitates greater wage cuts to achieve full employment and recovery than would have been the case if the wage cuts had come quickly. 43
Wage Rates, Total Wage Payments, and the
Rate of Profit
The preceding discussion has shown that when unemployment exists a fall in wage rates operates to increase total productive expenditure. As part of this process, it is virtually certain that total wage payments increase, with the result that the fall in wage rates is actually accompanied by a more than proportionate increase in the quantity of labor demanded, and thus by a more than proportionate increase in the volume of employment. However, it should be realized that the improvement in business profitability will tend to be the greater the smaller is the portion of the additional productive expenditure that takes the form of wage payments. Indeed, business profitability would increase the most if the fall in wage rates were accompanied by an actual fall in total wage payments and a correspondingly greater increase in the demand for capital goods.
The reason for these conclusions is that wage payments tend to show up relatively quickly as costs deducted from sales revenues. In contrast, outlays for machinery and plant show up much more slowly as costs deducted from sales revenues. Thus, if a billion dollars, say, of wage payments were replaced with a billion dollars of spending for plant and equipment, total business profits might very well increase by almost the full billion dollars. This is because total business sales revenues would be unchanged: the demand for capital goods would rise by a billion dollars, while the wage earners’ demand for consumers’ goods would fall by a billion dollars. At the same time, depreciation cost, equal to a relatively small percentage of the billion dollars spent for the plant and equipment, would take the place of the much larger cost figure reflecting the payment of a billion dollars in wages. Thus, total profits in the economic system would rise—by virtue of aggregate sales revenues remaining whatever they were while aggregate costs deducted from sales revenues fell. Obviously the increase in net investment would also be correspondingly greater under these conditions. 44
This discussion should serve further to refute the popular Keynesian and labor-union doctrine that a fall in wage rates operates to intensify a depression by virtue of reducing total wage payments and thus consumer spending. The truth is that even if the effect of a fall in wage rates really were a reduction in total wage payments and consumer spending, the rate of profit would rise all the more, for all that this effect would really mean would be a shift of sales revenues from the sellers of consumers’ goods to the sellers of capital goods, and, at the same time, a reduction in aggregate costs.
Critique of the “Paradox-of-Thrift” Doctrine
Another popular Keynesian doctrine that calls for special attention is the alleged “paradox of thrift.” According to this doctrine, the more people attempt to save, the poorer they become. Instead of being a principal foundation of economic progress and prosperity, saving is made to appear as the cause of unemployment and poverty. Samuelson, a leading supporter of this doctrine, states it as follows:
In a multiplier model with unchanged investment, an upward shift in the savings function, reflecting an increase in thriftiness, will actually reduce income and output. How much? Output is reduced in a multiplied way until income falls low enough to bring people’s new desired saving again into equality with investment. Thus an attempt to save more may lead, instead, to a lower income and no more saving or investment.
Just when we have learned Poor Richard’s wisdom, along comes a new generation of financial wizards who claim that in depressed times the old virtues may be modern sins. 45
Now the paradox-of-thrift doctrine rests entirely on the central notion of the Keynesian analysis that there is room in the economic system for only a strictly limited amount of profitable investment. It is only on this basis that the attempt to save a larger proportion of income
CRITIQUE OF KEYNESIANISM 885 implies the necessity of a smaller amount of income. Thus, for example, if there were room in the economic system for only one unit of saving that could be profitably invested, and people sought to save only 1 percent of their income, their income could be 100 and still be consistent with the allegedly limited profitable opportunities for investment. If, however, they seek to save 20 percent of their income, then their income can be no more than a mere 5 and still be consistent with the allegedly limited profitable opportunities for investment.
It should be apparent that the paradox-of-thrift doctrine is utterly absurd. In the context to which it is meant to apply most strongly—namely, that of depression and mass unemployment—saving and investment, far from being at any kind of maximum limit, are extremely low or even negative, as we saw just a few pages ago. And, as we saw even more recently, it is precisely when saving and investment are restored, as the result of a fall in wage rates, unit costs of production, and prices, that the rate of profit is restored, along with full employment.
At all other times, as I have shown, there is room for far more profitable investment in the economic system than the power of saving can ever have the capacity to meet. One need only recall the enormous extent of the need for additional capital in its various forms, the extent of the need for savings to finance housing, and the fact that the downtown real estate of a single city all by itself provides an investment outlet for a virtually infinite amount of savings. At the same time, one should recall that the effect of a higher degree of capital intensiveness in the economic system is a more rapid rate of economic progress, including, as a by-product, a more rapid rate of increase in the quantity of commodity money and thus the corresponding addition of a positive monetary/net-investment component to the rate of return. 46 On the basis of these facts, it follows that in the absence of financial contraction caused by preceding inflation and credit expansion, the rate of return on capital can be assumed to be not only positive but sufficiently positive to make investment worthwhile for more savings and capital than people are capable of accumulating. And finally, as I have shown, to whatever extent people do or might for any reason decide to accumulate savings in the form of cash, that very fact operates further to raise the rate of return on capital. 47
The Keynesians’ preoccupation with the utterly fictitious problem of saving as a cause of poverty bears major responsibility for the very real problem of growing poverty as the result of a lack of saving. Based on their hostile economic analysis of saving, the Keynesians have brought about the enactment of correspondingly hostile government economic policies toward saving. The result has been economic stagnation and decline, whose nature and significance are captured in the words: the rust belt. Over a span of approximately two generations, the intellectual rot of Keynesianism has helped to bring about the physical rot of the industrial heartland of the United States. 48
Critique of the Saving Function
The errors of the Keynesian analysis in connection with saving include its very promulgation of the “saving function.” There is no such thing as saving being a mathematical function of income. Saving out of income continues to exist only because incomes continue to grow, as the result of an increase in the quantity of money. As I have shown, if the quantity of money stopped growing, saving out income would come to an end, once accumulated savings and capital reached a sufficient height relative to income. 49 Nor, as I have shown, is there any actual tendency for saving to constitute a rising share of income as income rises. The appearance of such a tendency is entirely the result of the fact that high incomes largely overlap with incomes that are saved heavily for different reasons, notably high incomes constituted by high rates of profit and high incomes that are considered transitory by their recipients. 50
In connection with saving as a continuing phenomenon, it should be recalled once more that the same cause that brings this about, namely, the continuing increase in the quantity of money and volume of spending in the economic system, adds correspondingly to the average rate of profit and interest. Indeed, most of the saving that goes on in the economic system takes place precisely out of this elevated rate of return on capital. 51 This fact, of course, adds still a further perspective on the errors of Keynesianism with respect to saving and its relationship to the rate of return.
Critique of the “Liquidity-Preference” Doctrine
The final aspect of the Keynesian analysis that must be considered is the “liquidity-preference” doctrine. Liquidity preference or, as Hazlitt aptly describes it, “cash preference,” is what is supposedly responsible for the existence of a minimum, irreducible rate of return below which lenders and investors will not lend or invest. 52 They will allegedly not lend or invest below a 2 percent rate of return because they would prefer to hold cash instead.
Now, on the basis of all that I have established concerning the rate of return, it is virtually certain that in the absence of inflation and credit expansion and the subsequent financial contraction that results, the rate of return would actually be substantially in excess of 2 percent. But even if it were not, and even if that fact resulted in a tendency toward holding savings in the form of cash, the very existence of that tendency would itself operate to
886 CAPITALISM raise the rate of return, as I showed in the last chapter. 53
In addition to this, it is also necessary to question the assumption that a 2 percent rate of return is the minimum at which people are willing to lend or invest. For if for some reason it did become necessary for the economic system to operate with a rate of return below 2 percent, there would be nothing to prevent it from doing so. 54
The Keynesians advance two arguments that attempt to show why 2 percent, or a rate not far from 2 percent, constitutes the practical lower limit to the rate of return lenders and investors will accept. In the words of Keynes himself:
We have assumed so far an institutional factor which prevents the rate of interest from being negative, in the shape of money which has negligible carrying costs. In fact, however, institutional and psychological factors are present which set a limit much above zero to the practicable decline in the rate of interest. In particular the costs of bringing borrowers and lenders together and uncertainty as to the future of the rate of interest . . . set a lower limit, which in the present circumstances may be as high as 2 or 2 1 ⁄ 2 per cent. on long term. 55
The uncertainty as to the future of the rate of interest that Keynes refers to is the fear that it may rise from its present level and thus create a capital loss for any investor who finds it necessary to sell his investment—for example, a longterm bondholder who buys a bond when interest rates are 2 percent, and must sell it when interest rates rise to 4 percent, and who thus suffers a capital loss. 56
Now neither of these arguments in fact supports the conclusion that people are unwilling to lend or invest below some arbitrary rate of return. At most, they support the conclusion that at lower rates of return, the demand for money for holding will be somewhat higher than at higher rates of return, and thus that the velocity of circulation of money will be somewhat lower and wage rates and prices will have to be somewhat lower in order to have full employment. The fact that there are costs of bringing lenders and borrowers together, and of otherwise investing, is always true. The existence of such costs merely requires that in order for lending and investing to be worthwhile, the size of the loan or investment, and the period of time for which it is made, be of some minimum.
For example, as we saw in Chapter 12, if the cost of making a given type of loan or investment were some minimum amount, such as $100, then at a 2 percent annual interest rate it would not pay to lend any sum smaller than $250,000 for a period as short as one week, because that would be the sum required to yield the minimum of $100 in just one week at that annual rate of interest. 57 But it would certainly pay to lend smaller sums for longer periods of time, such as $100,000, or even $50,000, for a year. And, in fact, when the pooling of small sums is allowed for, as is accomplished every day by such institutions as savings banks, the sums which it pays to lend and invest even at a rate of return as low as 2 percent, turn out to be far less than $50,000 and for periods far shorter than a year. Indeed, even at a 1 percent annual rate of return and need for a $100 minimum amount of interest, it would still pay to deposit a sum as small as $10,000 for a period as short as a year.
The argument about uncertainty concerning the future of the rate of interest does not fare any better. If the rate of return on capital is extremely low and people hesitate to lend or invest for fear that it will rise, then either they are right in expecting the rate of return to rise, or they are wrong. If they are right, then the rate of return rises, and the alleged problem of too low a rate of return simply disappears. If they are wrong, and the rate of return does not rise, then there is no actual reason to fear the rise and they can lend and invest at the low rate of return. Indeed, if we consider the phenomenon of a rise in the rate of return on capital as such, rather than merely a rise in the rate of interest on loans, and keep in mind that what brings it about in the circumstances of recovery from a depression—namely, a recovery of productive expenditure and sales revenues—then it becomes clear that people have good reason to go ahead and invest immediately if they expect the rate of return to rise. This is because if they invest as stockholders or other categories of equity owners, they will actually gain from the rise in the rate of return. And if they do not expect the rate of return to rise, then they have no good reason to abstain from investing out of any fear of securities prices falling.
The liquidity-preference doctrine represents a profoundly wrong explanation of the rate of interest. According to Keynes, the rate of interest is “the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. . . . It is the ‘price’ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash . . . .” 58 And, says Keynes, “If this explanation is correct, the quantity of money is the other factor, which, in conjunction with liquidity preference, determines the actual rate of interest in given circumstances.” 59
Thus, Keynes’s doctrine here is that the rate of interest is determined by the combination of “liquidity preference” and the quantity of money. And on this basis, he comes to the conclusion that if it is not already at its minimum acceptable level, the rate of interest can be reduced by the mere increase in the quantity of money, if not to zero, then at least to its minimum acceptable level. 60 And he further concludes that by means of reduc—
CRITIQUE OF KEYNESIANISM 887 ing the rate of interest in such conditions, namely, where it is not yet at its minimum acceptable level, the increase in the quantity of money will serve to make possible an expansion in employment and production, a result of which will be a reduction in the “marginal efficiency of capital”—i.e., the rate of profit. 61
Now the fact is that “liquidity preference” is not at all a determinant of the rate of interest, much less of the rate of profit. This is dramatically illustrated by conditions under rapid inflation, where the desire to hold money virtually disappears and the rate of interest, instead of approaching zero, as the liquidity-preference doctrine implies, rises to extremely high levels. By the same token, the less rapidly the supply of money increases and the correspondingly greater is the desire to hold money, the lower is the rate of interest, not the higher—again, in contradiction of what the liquidity-preference doctrine implies.
As we have seen, the rate of interest is governed by the rate of profit, not vice versa; and the more rapidly the quantity of money is increased, the higher tends to be the rate of profit and thus the higher tends to be the rate of interest. 62 The rise in prices that results from an increasing quantity of money also contributes to the rise in interest rates, in that it brings about increases in the demand for loanable funds to buy goods such as houses, land, and raw materials in the face of prospective higher prices for them. In the absence of higher interest rates, the purchase of such goods would become progressively more profitable, the more rapidly the quantity of money increased and prices rose. Interest rates must rise in the face of increases in the quantity of money, in order to limit the increase in demand for loanable funds that would otherwise result both from a higher rate of profit and, as far as they are present, rising commodity prices. As I have shown, because the increase in the quantity of money and consequent rise in spending increases the rate of profit and makes prices rise, it is impossible lastingly to reduce, let alone eliminate, the rate of interest by means of increasing the quantity of money. If carried out consistently, such an attempt would entail the continual acceleration of the increase in the quantity of money and thus the ultimate destruction of the monetary system. It would not eliminate or even lastingly hold down the rate of interest. 63
It should not be necessary to repeat here the critique I have made of the closely associated error of thinking of the rate of interest as the price of money, which Keynes does when he describes the rate of interest as “the ‘price’ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash . . . .” 64 Interest is not the price of money, but the difference between the money borrowed and the money repaid, which difference tends to be the greater the more rapidly the quantity of money increases between the time of borrowing and the time of repayment.
The critique of the liquidity-preference doctrine can be combined with a further critique of Keynes’s doctrines concerning consumption, saving, employment, and the rate of profit. We have seen that the problem of unemployment, according to Keynes, rests on the fact that people insist on saving. If they did not save, if they only consumed, the “multiplier” would allegedly be infinite, and full employment would exist.
It is instructive to examine Keynes’s doctrines precisely in conditions in which there would be no saving whatever—no net saving out of income and no gross saving out of sales revenues. Such conditions would be similar to those which characterized Adam Smith’s “early and rude state of society” and Marx’s “C–M–C” sequence, but go beyond them in that there would not even be saving in the form of cash holdings, because everyone would race to consume immediately. 65
In such conditions, not only would there be no saving, but also there would be no liquidity preference. In such conditions, according to Keynes, because there is no saving, employment must be full; and because there is no liquidity preference, the rate of interest and profit must be zero. Yet in fact, in such conditions, employment would be virtually zero and the rate of profit and interest would be infinite. This is because there would be no demand for labor in the production of products for sale, and while sales revenues would exist, there would be no productive expenditure and thus no costs to deduct from sales revenues, and there would be no capital. Thus, profits would equal the whole of sales revenues and, when divided by zero of capital invested, would yield an infinite rate of return. 66
4. The Economic Consequences of Keynesianism
As I have shown, the essential economic policy advocated by Keynesianism is government budget deficits, which are held to be necessary to prevent or combat mass unemployment. This is the essence of “fiscal policy.” Thus, it should be obvious that matters are misrepresented when fiscal policy is presented as some kind of neutral tool which now must be used to expand the economy, and now to slow it down. The underlying economic problem according to the Keynesians is mass unemployment, and that requires a continuously expansionary policy, which is believed to be budget deficits. At most, the Keynesians may be prepared to call for a reduction in the size of the deficit if the expansion in spending allegedly induced by it is greater than necessary
888 CAPITALISM to achieve full employment and is thus held to contribute to rising prices. In virtually no circumstances does the logic of their position permit them to call for budget surpluses.
The most effective method of achieving a budget deficit according to the Keynesians is by increasing government spending rather than by reducing taxes. This is because, as we have seen, the socalled government-spending multiplier is held to be one larger than the multiplier allegedly associated with a reduction in taxes and is therefore believed to be correspondingly more “stimulative.” 67
The increase in government spending is held to be truly wonderful. It is alleged to be not only costless but also the source of a substantial increase in real income over and above itself. It is held to be the means of absorbing the allegedly destructive additional savings that accompany full employment and thus of permitting people to benefit from all of the additional output that full employment brings over and above their additional saving. The savings the government takes allegedly costs people nothing because those savings supposedly could not even be formed in the absence of the government’s willingness to take them. And, say the Keynesians, people are then able to keep for themselves all that their additional employment produces over and above those additional savings. Thus, not only is there a free lunch for the government and its clients, but also, the Keynesians believe, the government’s willingness to enjoy its free lunch is the necessary basis for the producers being able to produce and enjoy most of their additional product. Thus Keynesianism is consumptionism par excellence. For no doctrine is more adept in claiming that parasitism is a source of actual enrichment to its victims.
As I have pointed out repeatedly, Keynesianism is the philosophy which holds that “pyramid-building, earthquakes, and even wars may serve to increase wealth.” 68 With this philosophy as a starting point, there is almost no program a government could adopt that would not represent a significant improvement in comparison, since it could almost certainly be designed so that at least some people would directly benefit from it. Public housing, public transportation, public education, socialized medicine, and so forth all compare favorably with pyramid building, earthquakes, and wars in terms of their ability to provide benefits to at least some people for some period of time.
The Growth in Government
An inevitable effect of the influence of such ideas is the increase in the size and scope of government activity. As James Mill observed in criticizing very similar ideas in the early nineteenth century:
Were the exhortations to consumption . . . addressed only to individuals, we might listen to them with a great deal of indifference; as we might trust with abundant confidence that the disposition in mankind to save and to better their condition would easily prevail over any speculative opinion, and be even little affected by its practical influence. When the same advice, however, is offered to government, the case is widely and awfully changed. Here the disposition is not to save but to expend. The tendency in national affairs to improve, by the disposition in individuals to save and to better their condition, here finds its chief counteraction. Here all the most obvious motives, the motives calculated to operate upon the greater part of mankind, urge to expence; and human wisdom has not yet devised adequate checks to confine within the just bounds this universal propensity. Let us consider then what are likely to be the consequences should this strong disposition become impelled, and precipitated by a prevailing sentiment among mankind. One of the most powerful restraints upon the prodigal inclinations of governments, is the condemnation with which expence, at least beyond the received ideas of propriety, is sure to be viewed by the people. But should this restraint be taken off, should the disposition of government to spend become heated by an opinion that it is right to spend, and should this be still farther inflamed by the assurance that it will by the people also be deemed right in their government to expend, no bounds would then be set to the consumption of the annual produce. Such a delusion could not certainly last long: but even its partial operation, and that but for a short time, might be productive of the most baneful consequences. 69
Just as James Mill anticipated, the success of the kind of ideas advocated by Keynes in gaining popular influence has indeed been followed by the most baneful consequences. Among them is an approximately fourfold increase in the relative size of government spending in the United States. Between 1929 and the present day, government spending has increased from approximately 11 percent of “national income” to approximately 40 percent. This has meant a corresponding decline in the freedom of the individual to spend his own income as he chooses and the imposition of a reign of fear of the tax authorities, as the measures taken by the government to obtain the growing percentage of income have become more and more severe. It has also meant a vast increase in the government’s interference in the daily lives of the people in countless other ways as well, which are financed with the government’s additional funds. And, of course, there have been other highly destructive consequences stemming from individuals’ loss of control over their incomes and the accompanying growth in government regulation, most notably, the undermining of capital accumulation and economic progress.
Budget Deficits, Inflation, and Deflation Although Keynesianism is, and must be, radically
opposed to the quantity theory of money, for the reasons explained at the beginning of this chapter, it nevertheless recognizes the need to couple its policy of budget deficits with an expansion in the quantity of money. This is because even though Keynesianism avows that what increases spending is the mere existence of budget deficits, the fact is that in the absence of substantial increases in the quantity of money, a policy of sustained largescale budget deficits would inevitably result in the government’s bankruptcy.
Bankruptcy would be the result because the government’s accumulated debt would continue to grow and the burden of servicing the debt would come to require more and more revenue. Increases in taxes would at most only delay the government’s bankruptcy. For they would reduce the country’s ability to produce and to compete internationally (as does, of course, the government’s absorption of savings when it borrows to finance its deficits). The government’s tax revenues would thus be unable to keep pace with its growing financial obligations caused by the deficits. The rate of interest the government had to pay on its debt would rise. Eventually the day would come when the government had to repay a portion of its debt and found itself unable to borrow the means of doing so. At that point, it would be bankrupt in the literal sense of the term.
The fact that in the absence of the ability to create money, a policy of budget deficits leads to a country’s economic and financial decline and the government’s bankruptcy, means that in such circumstances a policy of deficits is actually deflationary! This is the case under any kind of meaningful gold standard. Under a gold standard, a policy of deficits has the effect of reducing the supply of gold that circulates within a country’s borders. This is because in undermining capital accumulation in the country, the effect of the deficits is to reduce the country’s share of world commerce and thus the share of the world’s gold that it possesses. 70 Within the country, moreover, the threat of the government’s bankruptcy, and its attendant uncertainties, must lead to a greater demand for the holding of gold as opposed to productive expenditure and investment. Furthermore, insofar as the monetary system of the country may use government debt as an asset standing behind the issuance of fiduciary media, the quantity of money in the country is further threatened. For any threat to the solvency of the government in such circumstances is a threat to the solvency of the banks that hold its securities as an asset. Thus, under a meaningful gold standard, a policy of deficits could not achieve the Keynesian objective of expanding spending, but would sooner or later accomplish the exact opposite. 71
Although they never acknowledge the existence of conditions in which deficits would be deflationary, the
Keynesians nevertheless seem to know very well that such conditions would exist under any real gold standard. And thus, to a man, they are totally opposed to the gold standard, which they do everything possible to ridicule. They oppose the gold standard because they know that if the policy of deficits is in fact to succeed in increasing total spending, the deficits must largely be financed by an increase in the quantity of money and that the government must have the power to bring about this increase. A gold standard, on the other hand, deprives the government of this power. It makes the increase in the quantity of money depend on the increase in the supply of gold.
The Keynesians’ advocacy of a policy of budget deficits is an implicit advocacy of inflation. In addition, the Keynesians explicitly advocate inflation, in the form of credit expansion, insofar as they believe that it can succeed in reducing the rate of interest—that is, insofar as the rate of interest is not yet at its allegedly irreducible level of approximately 2 percent.
As Chapter 12 has shown, and as the next chapter will show more fully, the creation of money by the government, or with the encouragement of the government, is the essence of the inflation problem—inflation is the government’s creation, or sponsorship of the creation, of money at a rate more rapid than the increase in the supply of the precious metals. And Keynesianism bears primary responsibility for it in the countries of the Western world today and since the 1930s.
Keynesianism and Economic Destruction
Thus, in appraising the consequences of the Keynesian policies, it is necessary to charge them with all the destructive consequences of inflation. This includes rising prices and the impoverishment of everyone whose income or assets are contractually fixed in terms of a definite sum of money. It includes the arbitrary redistribution of wealth and income from creditors to debtors and from those who receive the new money relatively late to those who receive it relatively early. It includes— as does a policy of deficits without resort to inflation— the impairment of capital formation and thus of the rise in the productivity of labor and real wages. Indeed, if carried out on a large enough scale, capital decumulation and an actual fall in the productivity of labor and real wages are the result. 72
I have said that Keynesianism and its hostility to saving are responsible for the vast economic devastation conveyed in the words “the rust belt.” This devastation has occurred because under the influence of Keynesianism literally several trillion dollars of savings have been absorbed in government budget deficits—an amount of savings equal to the growth in the publicly held national debt in the years since the time of Keynes. 73 Over this
890 CAPITALISM period, confiscatory taxation applied to large personal incomes and to corporate profits, capital gains, and inheritances have prevented trillions more of savings from being made in the first place or, in the case of inheritance taxes, being kept. Such taxation has been strongly supported by Keynesianism, precisely because the taxes fall on saving. As we shall see, inflation too, like inheritance taxes, destroys savings already accumulated, and does so on a vast scale.
Thus factories, machinery, stocks of materials and supplies, power plants, railroads, bridges, tunnels, and homes that these savings and potential savings would have made possible have not come into existence because the necessary savings have been diverted into financing the government’s budget deficits, have been prevented from occurring in the first place, or have been prevented from being maintained. The result has been a sharp decline in the rate of economic progress in the United States, if not outright economic stagnation, and increasing difficulty in replacing existing capital assets when they wear out.
In connection with this last, under conditions even of modest increase in the overall supply of capital goods— let alone stagnation or outright capital decumulation— the very fact of the economic development of new areas, such as the U.S. Far West, implies the economic decline of older areas. This is the case because in such conditions additional capital for the one, or at least additional capital for the one over and above any modest increase in the total of capital, can be obtained only by failing to provide replacement capital for the other.
Ironically, as we shall see, a further consequence of the inflation inspired by Keynesianism is a wiping out of the real rate of return on capital and the creation of conditions in which people actually do find it necessary to hoard their savings—not, to be sure, in the form of depreciating paper money, but in the form of physical assets whose price can rise, above all, gold and silver. 74 Inflation ultimately destroys the private granting of credit calling for repayment in paper money, and makes impossible the writing of contracts of any kind which are stated in terms of a fixed sum of money. For a variety of reasons it has an inherent tendency to go on accelerating until the point is reached at which paper money ceases to be acceptable in commerce. At that point, if the government has prevented the development of a new money that the market would create in the form of gold and silver, inflation actually succeeds in the destruction of money altogether, and with it, of an indispensable foundation of a division-of-labor society. Along the way, inflation creates the potential for a major depression, which is actualized if the inflation is stopped, sharply slowed, or, indeed, even fails to accelerate sufficiently. 75
Finally, it must be kept in mind that inflation is responsible for the imposition of wage and price controls, which are enacted in misguided efforts to stop it. As I showed in Chapters 7 and 8, wage and price controls create economic chaos and culminate in a totalitarian socialist dictatorship and economic collapse.
Thus, Keynesianism and the policies it gives rise to have played a leading and essential role in causing the economic decline of the United States that has become visible over the last generation and which is likely to continue. Keynesianism is a consistent assault on the foundations of prosperity: it is antisaving, antigold, anti-balanced budgets, antilimited government. Ironically, what it is not anti is unemployment. It is not the solution for unemployment.
Why Keynesianism Is Not a FullEmployment Policy
The Keynesian policies of deficits and inflation are not only not necessary for the achievement of full employment, but do not achieve it. Indeed, deficits by themselves, apart from the creation of money, actually cause more unemployment, both because of their deflationary effects, explained above, and because in depriving business of capital funds, they reduce the ability of business to make productive expenditures and thus to pay wages. And, as I explained in Chapter 13, even when the deficits are combined with inflation of the money supply, much, most, or even all of the extra spending that takes place can be nullified by wage increases that are just as rapid or even more rapid, with the result that little or no additional employment is actually achieved. 76 Furthermore, as I also explained in Chapter 13, much of any additional employment that might be achieved is likely to be of little or no economic value to those whose production must pay for it, because of the inherent nature of the output of those reemployed in connection with government make-work projects. 77 Finally, the inflation and credit expansion Keynesianism leads to, and the artificial elevation of the velocity of circulation and stimulus to indebtedness that result, help to create a constant potential for renewed depression and mass unemployment.
As I have shown, what brought about full employment in World War II was not the Keynesian policies of deficits and inflation by themselves but their coupling with wage and price controls. It was this which finally established a relationship between wage rates and prices, on the one side, and the quantity of money and volume of spending, on the other, that enabled the volume of spending for goods and labor to buy all that was offered. 78 Of course, this same result could have been achieved by a free market in labor, without any of the loss of output (not to mention human life) that took place on the battlefields of
the war and without any of the shortages and economic chaos caused by wage and price controls. Thus, even when applied in combination with wage and price controls, Keynesianism should not be thought of as a fullemployment policy, but as the policy that succeeds in destroying the economic value of full employment.
Keynesianism Versus the Rate of Profit: “The Euthanasia of the Rentier” and “The Socialization of Investment”
Keynesianism’s concern with the alleged lowness of the rate of profit at the point of full employment turns out to be nothing but a shedding of crocodile tears. As I have said, the effect of its policies is to wipe out the real rate of return on capital and actually to cause the very hoarding of savings it claims to fear. To discover how Keynesianism accomplishes this, it is not necessary to wait until the discussion of inflation in the next chapter. The fact that the Keynesian policies reduce the real rate of return on capital is implied precisely in its attempt to neutralize current savings, either by absorbing them in budget deficits that will never be repaid or by seizing them outright through taxation. The savings that are taken away, by these or any other methods, for the most part come out of the rate of return. They are the result of saving specifically out of profit and interest incomes. Thus, taking them away is tantamount to taking away part of the rate of return itself. For taking away savings means, at the same time, taking away the profits and interest that are the source of the savings.
The Keynesian policies are dishonest. Even if the Keynesian analysis were correct, which it certainly is not, the question would have to be asked of why it does not consider trying to raise the effective rate of return by reducing taxes on profits and interest? Only after all taxes on profits and interest had been eliminated, would it be legitimate to talk of a problem of too low a rate of return in the economic system.
The fact is, that when all is said and done, it turns out that Keynesianism is really not concerned with any alleged insufficiency of the rate of return. That is merely a convoluted pretext for more government intervention. Its actual belief, expressed by Keynes in the final chapter of The General Theory, is that the rate of return is too high! If this is difficult to believe in view of the diminishing-marginal-efficiency-of-capital and unemployment-equilibrium doctrines, which are the core of his book and of the whole Keynesian analysis, consider the following passages, which are in Keynes’s own words. They begin with an implicit reference to the alleged paradox-of-thrift doctrine and with an expression of satisfaction that on the basis of that doctrine his analysis allegedly deprives great inequality of wealth of one of its “chief social justifications.”
Thus our argument leads towards the conclusion that in contemporary conditions the growth of wealth, so far from being dependent on the abstinence of the rich, as is commonly supposed, is more likely to be impeded by it. One of the chief social justifications of great inequality of wealth is, therefore, removed. I am not saying that there are no other reasons, unaffected by our theory, capable of justifying some measure of inequality in some circumstances. But it does dispose of the most important of the reasons why hitherto we have thought it prudent to move carefully. . . .
For my own part, I believe that there is social and psychological justification for significant inequalities of incomes and wealth, but not for such large disparities as exist to-day. . . . Much lower stakes will serve the purpose equally well, as soon as the players are accustomed to them. 79
On the next three pages Keynes goes on with his newly revealed theme that profits are actually too high under capitalism. He even adopts a style of language which sounds hardly distinguishable from Marxism:
I feel sure that the demand for capital is strictly limited in the sense that it would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure. . . .
Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. . . .
I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.
Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne [translation: and all of this genus] (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward. 80
In other words, Keynes sees the effect of his policies as that of accomplishing the just demands of Marxism— the expropriation of the “expropriators” and the redistribution of their allegedly excessive and ill-gotten wealth to the state and the population at large—but without the necessity of a violent revolution.
892 CAPITALISM
Not surprisingly he advocates the socialization of investment: “Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.” 81
The meaning of this last passage is that Keynes thinks it unlikely that an increase in the quantity of money (which is what he means by “banking policy”) will be sufficient by itself to drive the rate of return below 2 percent, and that investment by the government, which will be willing to invest at a rate of return below 2 percent, will be necessary. Keynes claims to believe that nothing momentous is involved in the socialization of investment, for he immediately adds the words: “But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community.” 82 These words in turn are quickly followed by the admission: “Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society.” 83 It should be obvious, of course, that since the total of all the capital that is accumulated is nothing but the summation of the investments of the preceding years, full socialism requires nothing more than the socialization of new investment plus the lapse of time. Nevertheless, incredibly, Keynes is touted as a man who saved capitalism.
Keynes’s views in the above passages are so confused that it may well be the case that he believed 2 percent was simultaneously an excessively high rate of return, providing unnecessarily high stakes to the “players,” and too low a rate of return. Or, when he complained of the rate of return being too high, he may simply have forgotten his arguments about the rate of return being too low, or perhaps he never took them very seriously in the first place. The following statement, taken from the middle of his book, appears to support this latter view:
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. 84
The inescapable implication of these words is that Keynes knows no actual example of the existence of an unemployment equilibrium and that his entire doctrine is purely in the realm of the hypothetical. For if the rate of interest is not actually at its alleged minimum acceptable level, Keynes has no grounds, even on his own terms, of asserting the existence of an unemployment equilibrium.
Thus, it appears that Keynes’s actual objections to capitalism may well have been based merely on the standard resentments against inequality and the alleged injustice of the existence of profit and interest, and that his doctrine was merely an added pretext for government intervention. The government must intervene because the rate of profit is too high, and, if that objection does not gain sufficient support, then because the rate of profit is too low, which is the argument of the body of Keynes’s analysis. In any case, the government must intervene and seize more power. Any argument that serves will do. And thus Keynesianism ends exactly where it began: a piece of flotsam and jetsam from the wreckage of critical thought that is carried along by the tide of irrationalism and anticapitalism.
Notes
1. See above, pp. 673–715 passim.
2. See above, pp. 837–838.
3. See above, pp. 725–736, 744–774, and 778–787. See also above, pp. 838–859.
4. See above, pp. 519–526.
5. See above, pp. 520–522.
6. See below, p. 889 and pp. 891–892. 7. The full reference to Keynes’s book is John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, 1936).
8. For evidence of Keynes’s belief in pyramid building, earthquakes, and wars as sources of prosperity, see the General Theory, pp. 129 and 131. Also, see above, p. 544. 9. See above, p. 590.
10. Quoted in Keynes, General Theory, pp. 366–367. 11. See above, pp. 664–665, the quotation from John Stuart
Mill, which presents the substance of the alleged overthrow of the wages-fund doctrine.
12. See above, p. 647 and pp. 650–653.
13. For a critique of the confusions concerning price competition and of the oligopoly and pure-and-perfect-competition doctrines, see above, pp. 425–437. It follows from that critique, indeed, from the whole of Chapter 10 and from the principles of price determination set forth throughout this book, that in a free market prices fall to whatever extent changes in the conditions of demand and supply and/or cost of production necessitate, and that it is only government intervention, that prevents the necessary price reductions.
14. Joseph P. McKenna, Aggregate Economic Analysis, 5th ed. (Hinsdale, Ill.: The Dryden Press, 1977), pp. 220–221, 223. 15. Concerning the deflationary potential of a fractional-reserve monetary system see above, pp. 513–514.
16. Paul Samuelson and William Nordhaus, Economics, 14th ed. (New York: McGraw Hill Book Company, 1992, pp. 464– 467. Italics supplied.
17. Cf. above, Fig. 13–1, on p. 545. Also cf. McKenna, p. 281, for a standard Keynesian textbook presentation of the diagram. 18. The fallaciousness of the union argument is recognized by Gardner Ackley in his Macroeconomic Theory (New York: The Macmillan Company, 1961), pp. 388–389.
19. Later in this chapter, I show that to the extent that in consequence of a fall in wage rates the demand for capital goods is increased at the expense of the demand for labor, the rate of profit would be correspondingly increased, and would be increased even if an actual decrease in the demand for labor and consumers’ goods resulted. See below, p. 884.
20. Cf. McKenna, p. 210. Also cf. Ackley, p. 369.
21. Cf. McKenna, p. 210.
22. See McKenna, pp. 216–220.
23. Cf. ibid., p. 219.
24. See above, Fig. 13–1, on p. 545.
25. Cf. McKenna, pp. 216–217.
26. Keynes, General Theory, pp. 261–262. Italics in the last sentence are supplied.
27. Another passage from Keynes that provides conclusive support for my exposition of his views is this one, which appears earlier in The General Theory: “. . . the position of equilibrium, under conditions of laissez-faire, will be one in which employment is low enough and the standard of living sufficiently miserable to bring savings to zero. . . . Assuming correct foresight, the equilibrium stock of capital . . . will, of course, be a smaller stock than would correspond to full employment of the available labour; for it will be the equipment which corresponds to that proportion of unemployment which ensures zero saving. Ibid., pp. 217–218.
28. Ibid., p. 136.
29. Cf. Ackley, pp. 465–466.
30. Ackley believes he advances a different basis for the alleged declining yields to net investment when he cites the factor of increasing capital intensiveness and the adoption of more roundabout methods of production in the sense used by Böhm-Bawerk. See Ackley, pp. 466–472. Actually, this factor is fully in the spirit of the law of diminishing returns. Indeed, the basis for claiming diminishing returns is precisely the increasing degree of capital intensiveness.
31. See above, pp. 76–91 passim.
32. See The Ayn Rand Lexicon, Harry Binswanger, ed. (New York: New American Library, 1986), pp. 104–105.
33. Cf. Paul Samuelson and William Nordhaus, Economics, 13th ed. (New York: McGraw Hill Book Company, 1989), pp. 66–67.
34. In reality, of course, it is an error to conceive of net investment as an actual expenditure. As we know, rather than being an expenditure, net investment is in fact the difference between productive expenditure, which is the actual expenditure present, and business costs, which are largely an accounting abstraction, based on the productive expenditures of previous accounting periods. On this point, see above, pp. 702–705. 35. This latter possibility should not be dismissed in view of the blatant absurdities the Keynesians have embraced, and which cannot be explained on the basis of any kind of intellectual confusion. Keynes’s endorsement of wars, earthquakes, and pyramid building as sources of prosperity are the leading example. See Keynes, General Theory, pp. 129–131.
36. The saving referred to is, of course, saving out of net income, i.e., net saving.
37. See U.S. Department of Commerce, Office of Business Economics, National Income 1954 Edition, A Supplement to the Survey of Current Business (Washington, D. C.: U.S. Government Printing Office, 1954). Data for saving appear on page 164 of this document; data for net investment are derived by subtracting capital consumption allowances, reported on page 164, from gross private domestic investment, which is reported on page 162.
38. See above, pp. 702–705.
39. See above, ibid.
40. Again, see above, ibid. See also above, pp. 723–725 and 744–750.
41. See, for example, the exposition of the multiplier in Samuelson, which was discussed above, on p. 690.
42. See above, pp. 707–708.
43. See above, pp. 589–590. See also Ludwig von Mises, Human Action, 3d ed. rev. (Chicago: Henry Regnery Co., 1966), pp. 568–569.
44. These conclusions are not significantly disturbed by the fact that a portion of the expenditure made on account of plant and equipment is itself in the form of wage payments—such as the payment of the wages of workers installing machinery and the wages of construction workers paid by firms that act as their own contractors. To the extent that cases of this kind exist, the reduction in total wage payments and the consumer spending it supports is less, and a portion of the reduction in aggregate costs is achieved by the fact that the new wage payments show up as depreciation cost over a long period of years rather than all at once.
45. Samuelson and Nordhaus, 13th ed., pp. 183–184.
46. On these points, see above, pp. 56–58, 744, and 838–856. 47. See above, pp. 837–838.
48. For elaboration, see below, pp. 889–890. See also below, pp. 930–937.
49. See above, pp. 758–759, 768–771, and 834–837.
50. See above, pp. 741–743.
51. See above, pp. 836–837.
52. See Henry Hazlitt, The Failure of the “New Economics” (New York: D. Van Nostrand & Co., 1959) p. 193.
53. See above, pp. 837–838.
54. While this might not be as easily established in the case of a negative or zero percent rate of return, the fact that as the rate of return approaches zero, land values approach infinity, implies all by itself that the rate of return must indeed always be positive at some significant level.
55. Keynes, General Theory, pp. 218–219.
56. Ibid., pp. 201–202.
57. See above, pp. 521–522.
58. Keynes, General Theory, p. 167.
59. Ibid., pp. 167–168.
60. Ibid., p. 171.
61. Indeed, insofar as the rate of interest is not yet at its minimum acceptable level and thus has room to fall, and insofar as a fall in wage rates and prices increases the buying power of
a given stock of money and can thus be likened in its effects to an increase in the quantity of money, Keynes is prepared to concede that a fall in wage rates and prices can increase the volume of employment. This alleged concession is known as the “Keynes effect.” See ibid., p. 261. See also McKenna, pp. 216–220.
62. Concerning the effect of increases in the quantity of money on the rate of profit, see above, pp. 762–774. For the connection to a higher rate of interest, see above, pp. 520–521.
63. Again, see above, pp. 520–521.
64. Keynes, General Theory, p. 167.
65. Concerning the views of Smith and Marx in this area, see above, pp. 475–480.
66. In 1959, I showed Henry Hazlitt an early, unpublished paper that presented some of my basic views on profit and interest and that concluded with these very points. Beginning with the third printing of The Failure of the “New Economics,” which appeared in the following year, he very graciously found space to describe these points and credit me for them. See, ibid., p. 196.
67. See above, pp. 712–715.
68. Keynes, General Theory, p. 129.
69. James Mill, Commerce Defended (London, 1808), chap. 7; reprinted in Selected Economic Writings of James Mill, ed. Donald Winch (Chicago: University of Chicago Press, 1966), p. 140.
70. Depending on the relative size of the country’s economy, the by-product of a decline in its ability to produce, or of any lesser rate of increase in its ability to produce, is probably also to reduce the rate of increase in the world’s overall supply of gold, which, of course, depends on the ability to increase production in general. This principle is operative even if the country itself does not possess gold mines. Gold mining outside the country will be negatively affected insofar as it depends directly or indirectly on what is produced within that country. 71. For a discussion of additional deflationary consequences of government budget deficits, see below, pp. 940–941.
72. For elaboration of all of these points, see below, pp. 925– 938.
73. A significant fraction of the national debt is held by the Federal Reserve System and the banking system, as opposed to the general public. The increase in this portion of the debt represents the creation of new and additional money rather than the diversion of savings. Any lessening of the diversion of savings that this fact may appear to represent, is dwarfed by the vastly larger sums siphoned off under the social security system from savings into government consumption. Furthermore, as I have said, the creation of hundreds of billions of dollars of new and additional money is the essence of the problem of inflation and the root of all of the destructive consequences for capital accumulation that result from inflation.
74. On these points, see below, pp. 930–938 and 951.
75. On these points, see below, pp. 937–940 and 942–950. 76. See above, pp. 591–592.
77. See above, pp. 591–594.
78. See above, p. 592.
79. Keynes, General Theory, pp. 373, 374.
80. Ibid., pp. 375–377. Italics supplied.
81. Ibid., p. 378.
82. Ibid.
83. Ibid.
84. Ibid., p. 207. Italics supplied.
Capitalism: A Treatise on Economics
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