3. Criticism of Keynesian Economics

After our examination of monetarism, it seems appropriate to embark on a critical analysis of Keynesian theory. We have chosen this approach for two reasons. First, the “Keynesian revolution” erupted after old neoclassical monetarism (a mechanistic conception of the quantity theory of money, the lack of a capital theory, etc.) had gained a firm foothold. Second, nowadays Keynesian economics has undoubtedly been pushed into the background with respect to the Monetarist School. Despite these facts, we must emphasize that from the analytical viewpoint we adopt in our book, i.e., that of the Austrian School, monetarists and Keynesians use very similar approaches and methodologies. Like monetarists, Keynes held no capital theory to enable him to understand the division of economic processes into productive stages and the role time plays in such processes. Furthermore his macroeconomic theory of prices rests on such concepts as the general price level, the overall amount of money in circulation, and even the velocity of circulation of money.⁵⁰ Nevertheless certain significant peculiarities of Keynesian thought warrant discussion.

Before we begin, however, let us remember that Keynes possessed only a very limited knowledge of economics in general, and of the market processes of entrepreneurial coordination in particular. According to F.A. Hayek, Keynes's theoretical background was limited almost exclusively to the work of Alfred Marshall, and he was unable to understand economics books written in foreign languages (with the possible exception of those in French). Hayek wrote:

Keynes was not a highly trained or a very sophisticated economic theorist. He started from a rather elementary Marshallian economics and what had been achieved by Walras and Pareto, the Austrians and the Swedes was very much a closed book to him. I have reason to doubt whether he ever fully mastered the theory of international trade; I don't think he had ever thought systematically on the theory of capital, and even in the theory of the value of money his starting point—and later the object of his criticism— appears to have been a very simple, equation-of-exchangetype of the quantity theory rather than the much more sophisticated cash-balances approach of Alfred Marshall.⁵¹

Keynes himself admitted there were gaps in his training, especially with respect to his inferior ability to read German. When referring to Mises's works in his book, A Treatise on Money, Keynes had no choice but to confess that his poor knowledge of German had prevented him from grasping their content as fully as he would have liked. He went on to say:

In German I can only clearly understand what I know already!—so that new ideas are apt to be veiled from me by the difficulties of language.⁵²

SAY'S LAW OF MARKETS

John Maynard Keynes begins his book, The General Theory, by condemning Say's law as one of the fundamental principles upon which the classical analysis rests. Nonetheless Keynes overlooked the fact that the analysis carried out by Austrian School theorists (Mises and Hayek) had already revealed that processes of credit and monetary expansion ultimately distort the productive structure and create a situation in which the supply of capital goods and consumer goods and services no longer corresponds with economic agents’ demand for them. In other words a temporal maladjustment in the economic system results.⁵³ In fact the entire Austrian theory of the economic cycle merely explains why, under certain circumstances, and as a consequence of credit expansion, Say's law repetitively fails to hold true. The theory also accounts for the spontaneous reversion effects which, in the form of a crisis and the necessary recession or readjustment of the productive system, tend to cause the system to again become coordinated. Thus upon receiving from Keynes a copy of The General Theory, Hayek responded that although

I fully agree about the importance of the problem which you outline at the beginning, I cannot agree that it has always been as completely neglected as you suggest.⁵⁴

When members of the Austrian School developed the theory of capital, they shed light for the first time on the maladjustment process the productive structure often goes through. Hence the Austrians were the first to identify the microeconomic processes by which an increase in saving manifests itself in a lengthening and widening of the productive structure of capital goods. Therefore it is not surprising that the absence of an elaborate capital theory in Marshallian economics and Keynes's ignorance of Austrian contributions led Keynes to criticize all classical economists for assuming that “supply must always automatically create its own demand.” Indeed, according to Keynes, classical economists

are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption;... whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former.⁵⁵

Although this assertion may be justified with respect to the neoclassical economics of Keynes's time, it in no way applies to Austrian economics, if we consider the level of development Austrians had already reached with their theory of capital and cycles when The General Theory was published. Thus Keynes was mistaken when he called Hayek a neoclassical author.⁵⁶ Hayek came from a subjectivist tradition which differed sharply from Marshall's neoclassical background. Furthermore, aided by Mises's subjective theory of money, capital and cycles (a theory entirely compatible with the Austrian School), he had already closely analyzed the extent to which Say's law is temporally unsound and had studied the disruptive effect on the economic system of regular, creditrelated attacks.

KEYNES'S THREE ARGUMENTS ON CREDIT EXPANSION

Keynes conspicuously attempted to deny bank credit plays any role in disrupting the relationship between saving and investment. Indeed by the time Keynes published The General Theory, he had already debated enough with Hayek to identify Hayek's main argument: that credit expansion gives rise to a temporal, unsustainable separation between entrepreneurial investment and society's real, voluntary saving. If Hayek's thesis is correct, it deals a fatal blow to Keynes's theory. Thus it was crucial for Keynes to invalidate Hayek's argument. Nevertheless Keynes's reasoning on the issue of bank credit was too confused and faulty to refute Hayek's theory. Let us review his arguments one by one.

First, Keynes claims bank credit has no expansionary effect whatsoever on aggregate investment. He bases this assertion on the absurd accounting argument that the corresponding creditor and debtor positions cancel each other out:

We have, indeed, to adjust for the creation and discharge of debts (including changes in the quantity of credit or money); but since for the community as a whole the increase or decrease of the aggregate creditor position is always exactly equal to the increase or decrease of the aggregate debtor position, this complication also cancels out when we are dealing with aggregate investment.⁵⁷

Nonetheless a statement like this one cannot obscure the strong distorting influence credit expansion exerts on investment. It is indeed true that a person receiving a loan from a bank is the bank's debtor for the amount of the loan, and creditor for the amount of the deposit. However, as B.M. Anderson points out, the borrower's debt with the bank is not money, whereas his credit is a demand deposit account which clearly is money (or to be more precise, a perfect money substitute, as Mises maintains). Once the borrower decides to invest the loan funds in capital goods and in services offered by the factors of production, he uses the money (created ex nihilo by the bank) to increase investment, while no corresponding increase in voluntary saving takes place. He does so without altering the stability of his debt with the bank.⁵⁸

Second, Keynes, realizing the great weakness of his “accounting argument,” puts forward an even more preposterous one. He maintains that new loan funds the bank creates and grants its customers are not used to finance new investment above the level of voluntary saving, since the newly-created money borrowers receive could be used to purchase consumer goods instead. To the extent the new money is not used to purchase consumer goods and services, Keynes reasons, it is implicitly “saved” and thus when invested, its amount corresponds exactly to that of “genuine, prior” savings. This is how Keynes himself expresses this argument:

[T]he savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth.⁵⁹

Keynes clearly relies on the ex post facto equivalence between saving and investment to ward off the harmful effects credit expansion exerts on investment and the productive structure.⁶⁰ Nevertheless all saving requires discipline and the sacrifice of the prior consumption of goods and services, not merely the renunciation of the potential consumption afforded by new monetary units created ex nihilo. Otherwise any increase in the money supply via credit expansion would be tantamount to an “increase in saving,” which is sheer nonsense.⁶¹ Even if we concede for the sake of argument that all investment financed by new credit has been immediately and simultaneously “saved,” a problem still faces us. Once the new money reaches its final holders (workers and owners of capital goods and original means of production), if these people decide to spend all or part of it on consumer goods and services, the productive structure will automatically be revealed as too capital-intensive and recession will hit. For all his sophistry, Keynes cannot deny the obvious fact that artificial credit expansion does not guarantee economic agents will be compelled to save and invest more than they normally would.⁶² Furthermore it is paradoxical that Keynes should insist that voluntary saving does not guarantee more investment, while at the same time claiming all investment implies prior saving. If we admit that the agents who save and those who invest are different, and that a lack of coordination in their decisions may prevent equilibrium, then we must admit that such discoordination may exist not only on the side of voluntary saving (more voluntary saving without investment), but also on that of investment (more investment without prior saving). In the first case there is an increase in the demand for money. As we saw in the last chapter, such an increase provokes several overlapping effects: both those characteristic of all voluntary saving (changes in the relativeprice structure which lead to a lengthening of investment processes) and those due to a rise in the purchasing power of money.⁶³ In the second case (more investment without prior saving) an artificial structure of production is created. It is one which cannot be maintained indefinitely, since economic agents are not willing to save enough. It also accounts for the onset of crises and recessions following periods of credit expansion.

In his attempt to counteract the Austrian hypothesis on the harmful effects of credit expansion, Keynes puts forward a third and final argument. He alleges that credit expansion may ultimately be used to finance an increase in investment which would lead to a rise in income and therefore eventually also boost saving. Thus Keynes believes entrepreneurs cannot possibly invest loaned funds at a rate faster than that at which the public decides to increase savings. In Keynes's own words:

The notion that the creation of credit by the banking system allows investment to take place to which “no genuine saving” corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment. Moreover, except in conditions of full employment, there will be an increase of real income as well as of money-income. The public will exercise a “free choice” as to the proportion in which they divide their increase of income between saving and spending; and it is impossible that the intention of the entrepreneur who has borrowed in order to increase investment can become effective... at a faster rate than the public decide to increase their savings.⁶⁴

Keynes clearly states that it is impossible for the rate of investment to exceed the rate of saving. His claim is conditioned by his tautological belief that investment and saving are always equal, a concept which keeps him from appreciating the disruptive effect investment financed by newly-created loans exerts on the productive structure. Nonetheless if a rise in investment leads hypothetically to an increase in real income, we may still wonder whether or not such an increase in income could stimulate enough growth in saving to permanently sustain new investments initially financed by credit expansion.

We must remember that Hayek showed it to be practically impossible for the income growth which arises from investment financed by new credit expansion to provoke enough voluntary saving to sustain initial investment. Indeed if such investment is to be upheld by a subsequent rise in voluntary saving, economic agents will ultimately have to save absolutely all monetary income derived from the new investment. In other words when the portion of gross income shaded in Chart V-6 reaches the pockets of consumers, they will have to save all of it. (The shaded portion reflects the artificial lengthening and widening of the productive structure, modifications made possible by new loans the bank creates from nothing.) Obviously consumers will almost never save all such income, since they will spend at least part (and usually the largest part) of the new monetary income created by banks on consumer goods and services. In accordance with the theory presented in detail in the last two chapters, such spending will necessarily reverse the new investment processes of monetary origin, and the crisis and recession will hit. In Hayek's own words:

[S]o long as any part of the additional income thus created is spent on consumers’ goods (i.e. unless all of it is saved), the prices of consumers’ goods must rise permanently in relation to those of various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the relative prices of the various kinds of input and on the methods of production that will appear profitable.

Elsewhere in the same work Hayek concludes:

All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumers’ goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumers’ goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income [created by credit expansion], and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved.⁶⁵

KEYNESIAN ANALYSIS AS A PARTICULAR THEORY

As Austrian economists in general and Mises in particular demonstrated as early as 1928, in the specific event that idle resources and unemployment are widespread, entrepreneurs, relying on new loans, may continue to lengthen the productive structure without provoking the familiar reversion effects, until the moment one of the complementary factors in the production process becomes scarce.⁶⁶ At the very least, this fact shows Keynes's so-called general theory to be, in the best case, a particular theory, applicable only when the economy is in the deepest stages of a depression due to generalized idle capacity in all sectors.⁶⁷ However, as we saw in the last chapter, even under these conditions credit expansion will stimulate a widespread malinvestment of resources. This malinvestment will add to previous errors not yet liquidated owing to the institutional rigidity of the labor market and of the other productive resources. If holders of the new jobs created in these stages of acute depression begin to spend their earnings on consumer goods and services at a pace more rapid than that at which final consumer goods are arriving on the market (due to a relative shortage of some factor or to bottlenecks related to any of the complementary factors or resources of production), the familiar microeconomic processes which tend to reverse the initial expansionary effects of new bank-credit will be triggered. Under such conditions, it will be possible to create new jobs only if real wages fall, a phenomenon we observe when the price of consumer goods and services begins to rise faster than wages.⁶⁸

THE SO-CALLED MARGINAL EFFICIENCY OF CAPITAL

We find another indication that Keynes's is a specific theory, rather than a general one, in his definition of the “marginal efficiency of capital,” which he expresses as

that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price.⁶⁹

The most important error Keynes commits is to consider investment determined by the “marginal efficiency of capital” as defined above, viewing the offering price of the capital good as a given, an unchanging, constant amount, even when entrepreneurs’ profit outlook varies. Indeed Keynes, succumbing to the classical “objectivist” tradition passed down by Marshall, believes the offering price of capital goods does not fluctuate when entrepreneurs’ profit outlook improves or worsens. This belief is based on the implicit notion that such prices are ultimately determined by the historical cost of producing the capital good. Thus Keynes clings to a remnant of the old objective theory of value, according to which value is determined by cost. This doctrine, clearly on the decline in relation to the Austrian subjectivist conception, was partially revived by Marshall, at least regarding the supply side of price determination.⁷⁰

Hayek has conclusively demonstrated that the entire Keynesian doctrine of the “marginal efficiency of capital” as the determining factor in investment is acceptable only if we assume that there is absolutely no shortage of capital goods, and hence that any quantity can be acquired at a constant, set price. However, this would only be conceivable in a mythical economy in which no shortage ever occurs, or in a hypothetical economy in the deepest stages of an extraordinarily severe depression, and thus where an immense degree of excess capacity exists. In real life at least some of the complementary goods necessary to produce a capital good will always become relatively scarce at some point, and entrepreneurs, in keeping with their profit expectations, will increase the amount they are willing to pay for the good in question until the marginal efficiency or productivity of capital becomes equal to the interest rate. In other words, as Hayek indicates, competition among entrepreneurs will ultimately lead them to push up the cost or offering price of capital goods to the exact point where it coincides with the present value (the value discounted by the interest rate) of the marginal productivity of the equipment in question. Hence the “marginal efficiency of capital” will always tend to coincide with the interest rate.⁷¹ This is precisely the essence of the Austrian theory on the influence of the interest rate on the productive structure, a theory we covered in chapter 5. In fact we know that the interest rate is the price of present goods in terms of future goods, and that it tends to manifest itself throughout the productive structure in the accounting profit differential which arises between the different stages in the production process. To put it another way, the interest rate expresses itself in the difference between income and costs at each stage, and there is always an inexorable tendency for the profits at each stage to match the interest rate (that is, for the cost of production at each stage to equal the present value of the stage's marginal productivity).

KEYNES'S CRITICISM OF MISES AND HAYEK

In light of the above, the explicit criticism Keynes levels against Mises and Hayek on pages 192 and 193 of The General Theory is absurd. Keynes accuses Mises and Hayek of confusing the interest rate with the marginal efficiency of capital. As we know, the Austrians believe that the interest rate is determined independently by the value scales of time preference (the supply and demand of present goods in exchange for future goods), and that the marginal productivity or efficiency of capital merely affects the present value of capital goods. In the market, the price (cost) of a capital good tends to equal the value (discounted by the interest rate) of its future flow of rents, or the series of values corresponding to the marginal productivity of the capital equipment. The Austrians therefore consider that the marginal productivity of capital tends to follow the interest rate and not vice versa, and that only in equilibrium (which is never reached in real life) do the two become equal. Keynes's fundamental error lies in his failure to realize that the purchase price of capital goods will vary when expectations of the profit or productivity associated with them improve. This is how events unfold in real life, and Austrian economists have always taken this fact into account in their analysis. Hence when Keynes boldly claims Austrian economists “confuse” the interest rate with the marginal productivity of capital, he scandalously twists the facts.⁷²

CRITICISM OF THE KEYNESIAN MULTIPLIER

Keynes commits such errors because he lacks a capital theory to help him grasp how saving converts into investment through a series of microeconomic processes he overlooks entirely. Therefore it is not surprising that Keynes is simply incapable of understanding the Hayekian argument, and that, when referring to the schools of economic thought which, like the Austrian School, analyze the effects credit expansion exerts on the productive structure, he concludes: “I can make no sense at all of these schools of thought.”⁷³ Keynes's lack of an adequate theory of capital also explains his development of a mechanistic conception of the investment multiplier, which he defines as the reciprocal of one minus the marginal propensity to consume. Thus according to Keynes, the greater the marginal propensity to consume, the more an increase in investment will boost the national income. However the investment multiplier hinges on a purely mathematical argument which contradicts the most basic economic logic of capital theory. Indeed the multiplier indicates that any increase in credit expansion will cause a rise in real national income equal to the reciprocal of the marginal propensity to save (one minus the marginal propensity to consume). Hence according to Keynesian logic, the less people save, the more real income will grow. Nevertheless we know that the mathematical automatism which lies at the root of the multiplier concept bears no relation to the real processes at work in the productive structure. Credit expansion will stimulate investment that will drive up the price of the factors of production and bring about a subsequent, more-than-proportional increase in the price of consumer goods and services. Even if gross income in money terms rises as a result of the injection of new money created by the banking system, the multiplier, owing to its mechanical and macroeconomic nature, is inadequate to depict the disruptive microeconomic effects credit expansion always exerts on the productive structure. Consequently the multiplier masks the widespread malinvestment of resources which in the long run impoverishes society as a whole (rather than enriching it, as Keynes alleges). We agree with Gottfried Haberler when he concludes that the multiplier

turns out to be not an empirical statement which tells us something about the real world, but a purely analytical statement about the consistent use of an arbitrarily chosen terminology—a statement which does not explain anything about reality.... Mr. Keynes’ central theoretical idea about the relationships between the propensity to consume and the multiplier, which is destined to give shape and strength to those observations, turns out to be not an empirical statement which tells us something interesting about the real world, but a barren algebraic relation which no appeal to facts can either confirm or disprove.⁷⁴

Hayek, in his detailed critique of both volumes of Keynes's A Treatise on Money (1930), accuses Keynes of entirely ignoring the theory of capital and interest, particularly the work of Böhm-Bawerk and the other theorists of the Austrian School in this regard.⁷⁵ According to Hayek, Keynes's lack of knowledge in this area accounts for the fact that he overlooks the existence of different stages in the productive structure (as Clark had done and Knight later would) and that he ultimately fails to realize that the essential decision facing entrepreneurs is not whether to invest in consumer goods or in capital goods, but whether to invest in production processes which will yield consumer goods in the near future or in those which will yield them in a more distant future. Thus Keynes's notion of a productive structure comprised of only two stages (one of consumer goods and another of capital goods) and his failure to allow for the temporal aspect of the latter, nor for the consecutive stages which compose it, leads him into the trap of the “paradox of thrift,” the fallacious theoretical rationale which we explained in chapter 5.⁷⁶

Hence Keynesians hold no theory to explain why crises recur in a hampered market economy that suffers credit expansion (that is, one in which traditional legal principles are violated). Keynesians simply attribute crises to sudden halts in investment demand, interruptions caused by irrational behavior on the part of entrepreneurs or by an unexpected loss of confidence and optimism on the part of economic agents. Moreover Keynesians neglect to recognize in their analyses that crises are an endogenous consequence of the very credit expansion process which first feeds the boom. Unlike their fellow macroeconomists, the monetarists, Keynesians believe the results of monetary expansion policies to be relatively less effective and important than those of fiscal policy, and they advocate public spending as the means to directly increase effective demand. They fail to comprehend that such a policy further complicates the process by which the productive structure readjusts, and it worsens the outlook for the stages furthest from consumption. As a result of Keynesian “remedies,” entrepreneurs will surely encounter even greater difficulty in consistently financing these stages using voluntary savings. As to the likelihood that Keynesian policies could cure “secular” unemployment through the complete socialization of investment, the Austrian theorem on the impossibility of economic calculation under socialism is entirely applicable, as illustrated by the massive industrial malinvestment accumulated during the decades of government-directed investments in the former socialist economies of Eastern Europe.

Short-term unemployment can only be eliminated through “active” policies if workers and unions let themselves be deceived by the money illusion, and thus maintain nominal salaries constant in an inflationary atmosphere of soaring consumer prices. Experience has shown that the Keynesian remedy for unemployment (the reduction of real wages through increases in the general price level) has failed: workers have learned to demand raises which at least compensate them for decreases in the purchasing power of their money. Therefore the expansion of credit and effective demand, an action Keynesians supported, has gradually ceased to be a useful tool for generating employment. It has also entailed a cost: increasingly grave distortions of the productive structure. In fact a stage of deep depression combined with high inflation (stagflation) followed the crisis of the late seventies and was the empirical episode which most contributed to the invalidation of all Keynesian theory.⁷⁷

Hence we must concur with Hayek's statement that the doctrines of John Maynard Keynes take us

back to the pre-scientific stage of economics, when the whole working of the price mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices aroused interest.⁷⁸

In fact Keynesian remedies which consist of increasing effective demand and credit expansion do not begin to relieve unemployment. Instead they inevitably worsen it, as they result in a poor allocation of jobs and factors of production throughout a series of productive stages which consumers do not wish to maintain in the long run.⁷⁹

CRITICISM OF THE “ACCELERATOR” PRINCIPLE

Our theory on the impact of credit expansion on the structure of production rests on a capital theory we examined in detail in chapter 5. According to this theory, a healthy, permanent “lengthening” of the productive structure is contingent on a prior increase in saving. Therefore we must criticize the so-called “accelerator principle,” developed by the Keynesian School. Those who accept this principle assert that any increase in consumption leads to a more-than-proportional increase in investment, which is contrary to what our theory suggests.

In fact, according to the accelerator principle, a rise in the demand for consumer goods and services provokes an exaggerated upsurge in the demand for capital goods. The argument centers around the notion that a fixed relationship exists between the output of consumer goods and the number of machines necessary to produce them. Thus any rise in the demand for consumer goods and services causes a proportional increase in the number of machines necessary to produce them. When we compare this new number with that normally demanded to compensate for the customary depreciation of the machines, we see an upturn in the demand for capital goods which is far more than proportional to the rise in the demand for consumer goods and services.⁸⁰

We know that according to the accelerator principle, an increase in the demand for consumer goods and services brings about tremendously magnified growth in the demand for capital goods. However the principle also implies that if the demand for capital goods is to remain constant, the demand for consumer goods and services will have to continue to rise at a progressively increasing rate. This is due to the fact that a steady demand for consumer goods and services, i.e., a demand which does not increase, will provoke a marked contraction in the demand for equipment goods. The demand for these goods will return to the level necessary for replacements only. The accelerator principle clearly and perfectly fits the Keynesian prescriptions of an unlimited expansion of consumption and aggregate demand: indeed, the accelerator doctrine indicates that any rise in consumption causes a huge upsurge in investment, and that saving is of no importance! Thus the accelerator principle acts as a false substitute for the capital theory the Keynesian model lacks; it eases the theoretical conscience of Keynesians, and it reinforces their belief that voluntary saving is counterproductive and unnecessary for economic development (the “paradox of thrift”). Therefore it is particularly important that we thoroughly expose the errors and fallacies which form the basis of the principle.⁸¹

The theory based on the accelerator not only omits the most elementary principles of capital theory; it was also developed based on a mechanistic, automatic and fallacious conception of economics. Let us analyze each of the reasons behind this assertion.

First, the accelerator theory excludes the real functioning of the entrepreneurial market process and suggests that entrepreneurial activities are nothing more than a blind, automatic response to momentary impulses in the demand for consumer goods and services. However entrepreneurs are not robots, and their actions are not mechanical. On the contrary, entrepreneurs predict the course of events, and with the purpose of obtaining a profit, they act in light of what they believe may happen. Hence no transmitter mechanism automatically and instantaneously determines that growth in the demand for consumer goods and services will trigger an immediate, proportional increase in the demand for capital goods. Quite the opposite is true. In view of potential variations in the demand for consumer goods and services, entrepreneurs usually maintain a certain amount of idle capacity in the form of capital equipment. This idle capacity allows them to satisfy sudden increases in demand when they occur. The accelerator principle proves to be much less sound when, as in real life, companies keep some capital goods in reserve.

Therefore it is obvious that the accelerator principle would only be sound if capital goods were in full use, such that it would be impossible to raise the output of consumer goods at all without increasing the number of machines. Nevertheless, and second, the great fallacy of the accelerator principle is that it depends on the existence of fixed, unchanging proportions between capital goods, labor and the output of consumer goods and services. The accelerator principle fails to take into account that the same result in terms of consumer goods and services can be achieved using many different combinations of fixed capital, variable capital and especially, labor. The specific combination an entrepreneur may choose in any given case depends on the structure of relative prices. Hence, to assume fixed proportions exist between the output of consumer goods and services and the quantity of capital goods necessary to produce them is an error, and it contradicts the basic principles of the theory of prices in the factor market. Indeed, as we saw when we analyzed the “Ricardo Effect,” a drop in the relative price of labor will lead companies to produce consumer goods and services in a more labor-intensive manner, i.e., using fewer capital goods in relative terms. The reverse is also true: a rise in the relative cost of labor will trigger a relative increase in the use of capital goods. Because the accelerator principle rests on the assumption that fixed proportions exist between the factors of production, it totally excludes the role entrepreneurship, the price system and technological change play in market processes.

Furthermore, and third, even if, for the sake of argument, we suppose fixed ratios exist between consumption and capital equipment used, and we even assume there to be no idle capacity with respect to capital goods, we must ask ourselves the following question: How can the output of capital goods possibly rise in the absence of the saving necessary to finance such an investment? It is an insoluble logical contradiction to consider that an increase in the demand for consumer goods and services will automatically and instantaneously provoke a much-more-than-proportional rise in the output of capital goods, given that in the absence of excess capacity the production of these goods is contingent on growth in voluntary saving. Moreover such growth inevitably entails a momentary drop in the demand for consumer goods (which clearly contradicts the premise on which the accelerator theory is based). Therefore the accelerator theory contradicts the most fundamental principles of capital theory.

Fourth, it is important to realize that an investment in capital goods which is far more than proportional to the increase in the demand for consumer goods can only be financed if substantial credit expansion is initiated and sustained. In other words, the accelerator principle ultimately presupposes that the increase in credit expansion necessary to stimulate an enormously exaggerated investment in capital goods takes place. We are already familiar with the effects such credit expansion exerts on the productive structure and with the way in which the relative-price system invariably limits the expansion and forces a reversal that manifests itself in a crisis and recession.⁸²

Fifth, it is absurd to expect a rise in the demand for consumer goods and services to cause an instantaneous upsurge in the output of capital goods. We know that during the boom, which is financed by credit expansion, companies and industrial sectors devoted to the production of equipment and capital goods operate at maximum capacity. Orders pile up and companies are unable to satisfy the increased demand, except with very lengthy time lags and dramatic increases in the price of equipment goods. Therefore it is impossible to imagine that a rise in the output of capital goods could take place as soon as the accelerator principle presupposes.

Sixth, the accelerator theory rests on peculiar mechanistic reasoning by which an attempt is made to relate growth in the demand for consumer goods and services, measured in monetary terms, with a rise, in physical terms, in the demand for equipment and capital goods. Entrepreneurs never base their decisions on a comparison between monetary and physical magnitudes; instead they always compare estimated income and costs, measured strictly in monetary terms. To compare heterogeneous magnitudes is absurd and makes entrepreneurial economic calculation utterly impossible. Obviously, if the price of capital goods begins to increase, entrepreneurial decisions will not mechanically manifest themselves in “fixed proportions” of inputs. Instead entrepreneurs will carefully monitor the evolution of costs to determine the extent to which production will continue at the old proportions, or they will start using a higher proportion of alternative factors, specifically labor.⁸³

Seventh, William Hutt has shown that the entire accelerator theory rests on the choice of a purely arbitrary time period of analysis.⁸⁴ Indeed, why calculate the supposed relative increase in the demand for capital goods based on a one-year period? The shorter the time period chosen, the more “amplified” the supposed automatic rise in the demand for machines, an upsurge which results from any fixed ratio between the output of consumer goods and services and capital goods. However if we consider a longer time period, such as the estimated life of the machine, the marked oscillations which appear to arise from the accelerator principle disappear altogether. In addition, this long-term perspective is always the one considered by entrepreneurs. In order to be able to momentarily raise output if necessary in the future, they usually increase their demand for capital goods more than would be strictly necessary to produce a certain volume of consumer goods. Thus when we take into account society as a whole and entrepreneurial expectations, increases in the demand for equipment and machines in the stages closest to consumption are much more modest than the doctrine of the accelerator principle indicates. In short the accelerator principle rests on fallacious, mechanistic reasoning which excludes the most elementary principles of the market process, specifically the nature of entrepreneurship. The doctrine ignores the functioning and effects of the price system, the possibility of substituting certain inputs for others, the most essential aspects of capital theory and of the analysis of the productive structure, and finally, the microeconomic principles which govern the relationship between saving and the lengthening of the productive structure.⁸⁵