Chapter XX EMPLOYMENT, MONEY, AND PRICES

1. An Unproved “Functional” Relationship

I hope I have not said it too often, but as we advance in the General Theory, the confusions and fallacies become progressively denser, and crowd up to a point where the task of disentangling the traffic snarl begins to look utterly hopeless.

This is not surprising. In Chapters 20 and 21, for example, which we shall now consider together, “Keynes applied to the theory of money and prices,” as one Keynesian has put it, “the tools of analysis which he had developed earlier” in the book. But as these “tools of analysis,” as we have seen, nearly all consisted of faulty and confused concepts, a discussion of their supposed interaction merely compounds the confusion. As we have already analyzed these basic confusions, I need not repeat the analysis, though it may be necessary to remind the reader from time to time of these basic confusions in calling attention to the additional and derived confusions that arise when these fallacious concepts are made the basis of further reasoning concerning their alleged interrelationships.

The substance of Chapter 20, “The Employment Function,” need not detain us long. It is an effort to work out a series of mathematical equations concerning “the employment function.” Keynes offers an alleged “definition” of “the employment function” on page 280, but what he really gives us is, as in other cases, an equation without a definition. He does tell us, however, that the object of the employment function [is] to relate the amount of the effective demand, measured in terms of the wage-unit, directed to a given firm or industry or to industry as a whole with the amount of employment, the supply price of the output of which will compare to that amount of effective demand (p. 280).

The reader may make whatever he can of this; but a few hints will probably economize his time and mental effort. The first thing he can do is to put aside the phrase “measured in terms of the wage-unit.” Though Keynes defined the “wage-unit” as a “quantity of employment” (p. 41), his explanation showed that he really defined it as meaning merely a quantity of money paid to persons employed. In fact, it seems to mean merely the average national hourly wage-rate at any moment as measured in shillings or dollars.

But in accordance with the philosophic principle of Occam’s razor, that entities should not be multiplied unnecessarily, it is better to think in any given context either of the number of man-hours worked, or the number of men employed, or total wage payments, and to omit the merely confusing hybrid concept of “wage-units.” If these mean nothing more than the average national hourly wage-rate, and if this is, say, $2, then it is easy to convert total wage payments into total man-hours worked, or vice versa, if we know one sum or the other. Then we shall at least know whether what we are talking about is total man-hours worked, or average hourly wage-rates in dollars, or total wage payments in dollars—and we shall be at least one step nearer to clarity of thought.

When a few other such simplifications have been made, we shall find that all Keynes is talking about is the relation of “effective demand” (another confused conception—“the aggregate income [or proceeds] which the entrepreneurs expect to receive” [p. 55]) to the amount of employment. But without analyzing this further, what reason is there to suppose that this relationship is a “functional” relationship at all—that there is any such thing as “the employment function”? Keynes never condescends to offer any statistical evidence that any such “function” exists (or, for that matter, that any of his other “functions” exist), and certainly he does not offer any plausible deductive proof that it exists. We touch here upon an economic error that long antedates Keynes. It can be traced back as far as Cournot (1838) and was revived in its modern form chiefly by Jevons (in 1871); it is the basis today of a huge literature of “mathematical economics.” When an empiric or presumptive relationship seems to exist between one economic “quantity” and another, so that one seems to vary proportionately, or increasingly, decreasingly, or inversely, with another, some economists have fallen into the habit of calling the first a “function” of the second. This suggests a mathematical analogy; and perhaps little harm is done as long as it is treated merely as an analogy, as a figure of speech. It is unobjectionable to say, for example, that, other things remaining unchanged, the demand for a commodity (in the sense of the amount bought) seems to vary almost as if this demand were a decreasing function of the price of the commodity. But the moment we put this in the form of a mathematical expression—the moment, we write, for example:

D = f(P)

or use some similar notation to stand for such a relationship, we are in danger of making an illicit leap. We have assumed in our formula that this mathematical relationship exists. We can of course assume such a relationship by hypothesis, but this can never yield anything better than a hypothetical conclusion. We no more prove that a relationship exists by expressing it in a mathematical equation than by expressing the same assumption in words. We are merely more in danger of deceiving ourselves, because we have made our assumption precise, though it may be precisely wrong.

Let us remind ourselves, for example, of exactly what a “function” is. Once more I take the definition: “If a variable y is related to a variable x in such a way that each assignment of a value to x definitely determines one or more values of y, then y is called a FUNCTION of x.” ¹ (My italics.)

That a given value of x, in any assigned meaning, definitely determines one or more values of y, is something that we must prove to be true, not something that we make true simply because we have assumed it.

Section I of Chapter 20 on “The Employment Function” consists of a set of equations concerning this alleged function. Keynes assumes that the functional relationship exists, but never attempts to prove it. There is, in fact, no good reason whatever to assume that any functional relationship exists between “effective demand” and the volume of employment. Everything depends, in fact, upon the interrelationships of wage-rates, prices, and the money supply. No matter how low total monetary demand falls, full employment could exist at the appropriate relationship of wage-rates to prices. No matter how high total monetary demand is pushed, unemployment will exist if an unworkable relationship exists between wage-rates and prices.

But even Keynes does not seem to take his mathematical explorations very seriously. At the beginning of Section I he remarks in a footnote: “Those who (rightly) dislike algebra will lose little by omitting the first section of this chapter” (p. 280).

2. General Value Theory vs. Monetary Theory

As all the other major questions raised by Chapter 20 are also raised by Chapter 21 on “The Theory of Prices,” we may proceed to the latter forthwith.

Keynes opens this chapter with a long paragraph that is worth quoting in full:

So long as economists are concerned with what is called the Theory of Value, they have been accustomed to teach that prices are governed by the conditions of supply and demand; and, in particular, changes in marginal cost and the elasticity of short-period supply have played a prominent part. But when they pass in volume II, or more often in a separate treatise, to the Theory of Money and Prices, we hear no more of these homely but intelligible concepts and move into a world where prices are governed by the quantity of money, by its income-velocity, by the velocity of circulation relatively to the volume of transactions, by hoarding, by forced saving, by inflation and deflation et hoc genus omne; and little or no attempt is made to relate these vaguer phrases to our former notions of the elasticities of supply and demand. If we reflect on what we are being taught and try to rationalize it, in the simpler discussions it seems that the elasticity of supply must have become zero and demand proportional to the quantity of money; whilst in the more sophisticated we are lost in a haze where nothing is clear and everything is possible. We have all of us become used to finding ourselves on the one side of the moon and sometimes on the other, without knowing what route or journey connects them, related, apparently, after the fashion of our waking and our dreaming lives (p. 292).

This satire would have had considerably more point if it had been made a generation earlier. It sounds, indeed, suspiciously like a sly allusion to Keynes’s own teacher, Alfred Marshall. But at the time it appeared, in 1936, it no longer applied, at least to the pioneers of economic thought. Knut Wicksell’s Lectures on Political Economy, in two volumes (Vol. I: General Theory, Vol. II: Money) appeared in an English edition in 1934 and 1935. They had existed in German since 1901 and 1906. These lectures made giant strides toward a reconciliation and unification of “value” theory and monetary theory. Ludwig von Mises’ Theorie des Geldes und der Umlaufsmittel, which carried this unification even further, appeared in its first German edition as early as 1912, and in its second in 1924; it had been translated into English as The Theory of Money and Credit in 1934. In America, Benjamin M. Anderson’s The Value ofMoney, which appeared first in 1917, was in large part a protest against the tradition and practice of putting general economic theory and monetary theory in separate compartments. Anderson’s book had appeared in a second edition in 1936.

Was Keynes aware of all this? If so, why did he ignore it all in the paragraph just quoted? One dislikes to write of him, as Wicksell wrote of Gustav Cassel, that he ignored those who had anticipated him because he desired “at all costs to be esteemed an original and even path-breaking theorist.” ² But one must choose between this explanation or the explanation of sheer ignorance. And Keynes (even in the General Theory) makes references (though largely disparaging) to the work of both Wicksell and Mises.

But perhaps the dichotomy between general value theory and monetary theory was never quite as sharp as Keynes’s satiric portrait assumes. Scientific progress in all fields is made by isolating a problem; by studying the effect of one force or factor at a time. In the physical sciences this is done through the method of hypothesis tested by experiment. In the social sciences experiment in any meaningful scientific sense is impossible,³ and the method of isolating hypotheses must be the chief reliance. Keynes himself admits this in Chapter 20:

The object of our analysis is... to provide ourselves with an organized and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interaction of the factors amongst themselves (p. 297).

This was the method originated by the classical economists, and specifically by Keynes’s bête noire, Ricardo. They abstracted, among other things, from money, in order to simplify and make manageable the problem of value. In a perhaps unfortunate phrase of Mill’s, they tried to “look behind the monetary veil.” Their mistake was not in doing this, but in later forgetting that they had abstracted from money, and that their conclusions were therefore oversimplified and more hypothetical than realistic. And when they reintroduced money, or discussed monetary problems, they made the further mistake of forgetting what they had learned when they had abstracted from money. They failed, in short, to put the two sets of problems together; or rather, their solutions were merely pasted together, not unified. “Monetary economists” and “general economists” worked within separate frames of reference, and both lost by the separation.

Curiously enough, Keynes does much the same thing. His own effort at unification of monetary theory and general value theory, as well as of “static” and “dynamic” theory, is unsuccessful. It is unsuccessful because of a number of specific errors, some of them astonishing.

Keynes’s general method, in Chapter 20, of introducing a number of simplifying assumptions in the theory of value and money and prices and then reintroducing “the possible complications which will in fact influence events” is correct in principle. But he is unsuccessful in result because some of his simplifications and complications are the wrong simplifications and complications, and because some of his fundamental concepts are either misleading or false.

In discussing money, for example, he tells us in italics: “The importance of money essentially flows from its being a link between the present and the future” (p. 293). And again: “Money in its significant attributes is, above all, a subtle device for linking the present to the future” (p. 294).

Now I should say, on the contrary, that the importance of money flows essentially from its being a medium of exchange, and that its most significant attribute is that it functions as the medium of exchange. In performing this function, it is true, money does, incidentally, serve as a “link” between present and future; but so do all sorts of other things. Money is far from unique in this respect. It may be doubted whether, in economic life, it serves even as the chief link between the present and the future. That honor should preferably be reserved for the rate of interest (which is not, Keynes’s theories notwithstanding, a purely monetary phenomenon). Another link between the present and the future is the system of “forward” and “future” prices on the organized exchanges. All prices, in fact, even present prices of securities and commodities, are links between the present and the future, because they embody and reflect the anticipations of buyers and sellers respecting the future.

It is true that such prices happen to be expressed in terms of money; but they would anticipate the future just as much if they were expressed in terms of each other—if the price of wheat were expressed in terms of cotton or of cotton in terms of wheat. Of course, prices expressed in terms of money also reflect anticipations regarding the future value of the monetary unit itself. But money, as such, has no unique quality in reflecting anticipations regarding the future. It is, in fact, men’s anticipations regarding the future, and not the particular material terms in which these anticipations are expressed, that constitute the real “link” between the present and the future. Men constantly act with an eye on the future; and their actions and valuations express their anticipations regarding that future.

¹ Gerald E. Moore, Algebra (New York: Barnes & Noble, 1951), p. 50.

² Knut Wicksell, Lectures on Political Economy, (London: George Routledge, 1934), I, 220.

³ Cf. John Stuart Mill, A System of Logic, Vol. II, Book VI, Chap. VII, Sect. 2, for an illuminating discussion that is far from being out of date.