III. The Significance of Analysis in Real Terms

CHAPTER III THE SIGNIFICANCE OF ANALYSIS IN REAL TERMS THE analysis of the relations between the production plans of different entrepreneurs must necessarily proceed in what is known as "real terms". If we assume - as we must if we are to investigate the com-I I EqulJlbr um analys s patibility of the different plans - that the is analysis In roal entrepreneurs make definite and detailed terms plans for fairly long periods, there is indeed little room for money in the picture at all, except as " mere counters" which stand for definite quantities of particular com modities. In fact, so long as we assume entrepreneurs to decide every detail in advance in the certain expectation that they will be able to adhere to all their plans, the need for holding money almost vanishes. For in the actual world money is largely held because the decision as to when to buy or to pay for something is deliberately postponed; and this is contrary to our assumptions.

But' even to the extent to which money would still be held under these conditions (because of the discontinuity of transactions and the cost or inconvenience of investing it for the short periods until it was needed) it would cease to playa significant role. For money would enter into the plans, not in the quasi-independent character of com mand over things in general (that is as something which confers on its holders the chance of taking advantage of unforeseen opportunities), but only as a transitory item representing the definite quantities of commodities for the purchase of which the particular amounts of money are held. The existence of such a condition in which all that would be relevant to the plans made by the public would 29 30 Introductory PT. I be the concrete quantities of goods which they expected to get in exchange for money, but not the quantities of money itself, is often silently assumed, usually illegitimately. On our assumptions such a conThe Introduction of money Into equUlb-dition would actually exist. We should dum analysis would therefore gain nothing if we were to intro-cause unnecessary and Irrelevant com-duce quantities of money as separate magni plicatlons tudes into this type of analysis in place of the quantities of commodities for which the money would stand. Such a procedure would merely entail a very considerable and unnecessary complication of the argu ment. Particular money prices stand in a determinate relationship to quantities of goods which will be produced or sold at these prices only on the assumption that all other prices are given. In principle any particular money price for a commodity may correspond to the production or sale of any quantity of that commodity, according as the prices of other commodities vary. There are no such definite relationships b'etween prices in money terms and quantity of goods, as there are between the real ratios of exchange and such quantities. The introduction of money at this stage would therefore merely have the effect of introducing an additional variable which is irrelevant for our purpose and would make it more difficult to see the relationships, between quantities of commodities and real ratios of exchange, in which we are here interested.

Economists have often felt the need for some such analysis in real terms, and in fact a considerable part of classical economics, explicitly or implicitly, makes use of this idea. Its exact meaning and significance have, however, scarcely ever been made clear. Recently the concept of " neutral money " 1 has been widely used in this connection. While this has at least the advantage of 1 The present author must plead guilty of some responsibility for the popularity of this concept and even for the incautious way in which attempts have occasionally been made to use it as a practical ideal of monetary policy. But while for this second purpose it is clearly not of much help, it still appears to me as a useful concept to describe a CR. III Analysis in Real Terms 31 drawing attention to the existence of a problem, it is in itself, of course, nothing more than a new name for an old problem and does not provide us with a solution. It makes it clear that we cannot, as has often D efeets of traditional been done, treat money as non-existent so attempts to" abstract long as its value remains stable, and that from money"

it is erroneous to assume that if its value remains stable it exerts no influence on the formation of prices. Neither do the special constructions which certain economists have used to meet this difficulty really solve the problem. The best known of these is Walras' "numeraire". According to definition the" numeraire ", which may be any of the commodities, serves merely as a unit of account; but it is not actually used as a medium of exchange and con sequently there will be no additional demand for it to hold it as money. All that the introduction of this concept does is to solve the difficulty of the mathematical econ omist in expressing all the different ratios of exchange in one common unit. It contributes nothing to the explanation of how the triangular and multi-angular exchange transactions, which arc necessary to bring about equilibrium, can be effected without the use of one or more media of exchange which are demanded and held merely for the purpose of exchanging them against other commodities.

The crux of the matter is that where analysis aims directly at a causal explanation of the economic process as it proceeds in time, the use of the conception of a money~ less exchange economy is misplaced. It is Real term analysis Is If t d· t t d' legitimate only wltbln se -con ra lC ory 0 IS cuss a process equilibrIum eonstruewhich admittedly could not take place Uon without money, and at the same time to assume that money is absent or has no effect. In the case of our ideal position of equilibrium, which we construct as a guide to real theoretical problem: the conditions under which it would be con· ceivable that in a monetary economy prices would behave as they are supposed to behave in equilibrium analysis.

32 Introductory PT. I interpretation, and in which all parts are assumed to be perfectly matched, the case is different. Here analysis in real terms is not only in place, but is almost essential. Since at each point money is in the strictest sense only an intermediary between definite quantities of certain goods, all the essential relations in this system are rela tions between goods (rates of substitution between certain quantities of goods determined by the total quantities of these goods). Or, in other words, it will be true of this system - what has sometimes been asserted to be true in the real world - that the total supply of goods and the total demand for goods must be identical. (This so-called " Law of Markets" of J. B. Say is indeed one of the first formulations of the modern concept of equilibrium.) It would, however, be a mistake to believe that, since these relationships will exist only in a purely fictitious state of equilibrium, it is mere waste of time to work Analysis In real terms it out. The fact that in the real world not useless relations between money prices, and not real ratios of exchange, directly determine human action, does not make these real ratios uninteresting. Relations between money prices in themselves tell us little, unless we know what prices are appropriate to the existing real structure of productive equipment, or what price rela tionships are required to enable people to go on with the plans they have made. Nor is it sufficient, as is some times supposed, to know whether the prices of finished products exceed or fall short of a given money cost of production as represented by the prices of a particular combination of productive resources. Whether this or some other combination of resources will be used in the manufacture of the product will itself depend on prices.

The costs of production of a particular good do not there fore move in exact conformity with prices of any par ticular collection of resources, but are also affected by changes in the technique of production made profitable by changes in the relative prices of the different resources.

OR. ill Analysis in Real Terms 33 In the real world production is so obviously dependent in the first instance on concrete money prices that the suggestion that it "ultimately"· depends on some real relationships which lie behind these money Usual argument In . . d b dl h h I h· defence of real term prICes, IS un OU te y, as t e woe IstOry analysIs unsatlsfacof economics shows, in sharp contrast with tory the conclusions that are first suggested by experience. It is therefore necessary to justify our procedure some what more fully than by merely repeating the mostly metaphorical phrases which are commonly used in its defence. That there are "underlying real forces which tend to reassert themselves, although they may be temporarily hidden by the monetary surface", or that the real relationships which" ultimately" determine the relations between prices show a certain resiliency and are more permanent than the temporary distortion caused by money, or that the real determinants are more funda mental or basic in the sense that they win be restored when the monetary disturbances have disappeared, is all approximately true; but it hardly p],"oves or explains the significance of these real factors.

It is undeniably true that in the absence of continu ous progressive monetary changes, and with given tastes and a given distribution of incomes, the relations between the prices of different commodities will be Instability and seH uniquely determined by the quantities of revenlng character o( h d ·· t B t th·· t monetary changes t ese goo s III eXIS ence. U IS IS no the whole story, because these quantities can themselves be changed by monetary influences. The decisive fact, however, is that the effect on prices of these changes in quantities brought about by monetary influences will be in exactly the opposite direction from the direct effect on prices of these same monetary changes. We may suppose, for instance, that, at the point where a net addition to the total money stream makes its first impact on the commodity markets, there will result an increase first of. the prices and then the output of the commodities affected.

4 34 . Introductory PT. I The effect of this increase in output will be that, as soon as the additions to the money stream cease, the prices of these commodities will fall relatively to the prices of all other commodities and will reach a lower level than prevailed before the monetary change. Monetary changes have this effect in common with all merely temporary changes which are not recognised as such. But they have it in a particularly high degree. This is so not only because by their very nature they cannot continue indefinitely, but more especially because a change in the volume of the money stream which takes place at one point of the economic system works round and is bound to cause further changes in all other prices. Monetary changes are therefore in a peculiar sense self-reversing and the position created by them is inherently unstable. For sooner or later any deviation from the equilibrium position - as determined by the real quantities - will cause a swing of the pendulum in the opposite direction. 1 Unfortunately the significance of these real factors cannot be fully demonstrated without a systematic analysis of the operation of the monetary factors which A i ti r th we propose largely to disregard in this n llustra on 0 e dlflerentetIectsofreal study. But an illustration may be given and monetary changes b £. b . fl h . Y re errIng rle y to t e maIn problem in connection with which this question is con tinually cropping up. This problem relates to the possible differences between the prospective profitability of a given investment according to whether the investor has to use real resources which he owns or borrows, or whether he can obtain those resources by borrowing money for the purpose. There can be no doubt that under certain circumstances the possibility of borrowing money will make investments profitable which would never appear attractive if the investors could only use such resources as they owned or could borrow in natura. The reason 1 cr. in this connection the discussion in my M onetary Nationalism and InternationallS'tability, pp. 31 et 8eq.

CH. III Analysis in Real Terms 35 for this, now very familiar, is that the amounts of money offered on the loan market are capable of changing quite independently of the supply of real resources 'available for investment purposes. l In point of fact, monetary changes facilitate invest ments and cause resources to be put to uses which are not in accordance with a state of equilibrium between the demand for and the supply of real resources. This does not, of course, mean to say that monetary factors may not change the composition of the real quantities in existence. On the contrary. By affecting the uses to which the availa,ble resources are put, they will inevitably bring about a change in the real structure of production. But the point is that this new, changed, material structure of production will require for its maintena.nce a new set of price-relationships, namely those which the initial mone tary change temporarily created or led people to expect, but which this monetary change cannot perpetuate.

Most additions to, or deductions from, the money stream will not stay where they have first appeared; they have the inherent tendency to reverse 2 the changes in price relationships which they have caused. But the significance of the further changes in relative prices which will be brought about by the monetary change will have to be judged in relation to the price structure appropriate to the changed organisation of production. 1 Much confusion has been caused in this connection by the assump. tion sometimes made that there could be a real capital market without money on which there would be some determinate in natura rate of interest. In fact there would not and could not be one rate of interest without money, and the effect of the limitation placed on the possible amount of waiting by the scarcity of the stock of nonpermanent resources would make itself felt exclusively via the changes in relative prices of the different kinds of commodities.

2 Of course this does not mean that the position which would have existed without the monetary disturbance will-or even can - ever be fully restored. The losses and redistributions of incomec caused by the misdirection of production will naturally have a permanent effect - but an effect in a direction opposite to the impact effect of the monetary change.

36 Introductory PT. I We cannot judge the effect of any change in money prices without a knowledge of the system of prices which is appropriate to the existing structure of production. Certain conditions 01 There is thus a task which is logically prior liability can be stated t th t d f th t h'· In real terms and In 0 e s u y 0 e mone ary mec anlsm. real terms ~nly the task of analysing the principle on which particular systems of quantities of goods and particular systems of prices (or real ratios of exchange) are co ordinated. This is what the so-called analysis in real terms attempts. Like equilibrium analysis in general its aim is not to give a direct explanation of any real phenomena, but to analyse in isolation a set of relation ships which are relevant for the explanation of actual events. In other words: there are conditions of stability of the economic system which not only can be described more simply if we neglect the monetary factor, but which, although they can be changed by monetary in fluences, exist independently of them, These conditions are at any moment determined by the technical structure of the material equipment in existence and by the tastes of the people.

In the particular case we have to study the amount of abstraction involved in disregarding money is especially great. We are setting out to investigate problems of capital Analysis In real terms and at the same time the possibility oflendInvolves abstraction· db' N h" f Irom lending and Ing an orroWlng money, ow t IS IS 0 borrowlll! 01 money course a phenomenon with which the problems of capital and interest are so closely connected in real life that it may appear futile to talk about capital at all without taking money-lending into account. But that this appears so only goes to show that in our minds the terms capital and interest are so closely connected with monetary phenomena that it would perhaps have been better if they had never been used by economists in connection with the real phenomena which,though somehow connected with the monetary phenomena, would exist even in a money less capitalist society. It has, however, become so firmly CR. III Analysis in Real Terms 37 established a usage to apply the same terms to the under lying real phenomena as were first applied to their monetary manifestations that it would be difficult, at this stage, to introduce new terms for them.

In one respect, indeed, this tradition has recently been seriously challenged. In his last work 1 Mr. Keynes has placed very strong emphasis on the desirability of con fining the term "rate of interest" to the Use 01 the term rate at which money can be borrowed. .. rate 01 interest" in • • this study And qUlteapart from the fact that hIS use of the term would be more in cOIIformity with its meaning in ordinary life, there can be no doubt that it is only in this form that interest appears as a price actually quoted in the market and directly entering into the calculations of entrepreneurs. The real or commodity rates of interest, which have played such a prominent role in traditional economic theory, are in comparison merely secondary or constructed magnitudes which, besides, vary according to the commodity in terms of which we compute them. These considerations probably make it advisable, in all investigations dealing with monetary phenomena, to restrict the term interest, as Mr. Keynes suggests, to the money rate, and to introduce some other term for the "real rates". This objection, however, does not apply, or at least not as strongly, so long as we confine ourselves to the real aspects of the problem. Here the danger of confusion does not arise, and it has seemed on the whole expedient to use the term interest here in the sense in which it has become customary to use it in pure economics, that is as referring to real percentage rates of return.

In what sense and to what extent it is justified under the assumptions made here to speak of one uniform rate of return can be shown only as the investigation proceeds. But in order that the term rate of interest which we pro pose to use in this connection should not mislead, it is 1 Cf. Keynes, 1936.

38 Introductory PT. I necessary at this stage to explain at least a little more fully what will be designated by this term. It has already been mentioned that the rate of interest in these conditions is not a price of any particular thing. It is an element in the relations between the various prices of different commodities, a ratio between the prices of the factors of production and the expected prices of their products, which stands in a certain relationship to the time interval between the purchase of the factors and the sale of the product. The problem of the rate of interest in the sense in which it will be discussed in this book is therefore the problem why there is such a difference between the prices of the factors and the prices of the products and what determines the size of this difference. It would perhaps be more correct if we referred to this difference between cost and prices as profits rather than interest. But as it has become customary - particularly since B6hm Bawerk, to whom this particular statement of the problem of interest is due - to refer to this difference in equilibrium analysis as the rate of interest, and as the term rate of profit is now generally reserved for such "abnormal" differ ences as will arise only under dynamic conditions, it will probably cause less confusion if in equilibrium analysis we retain this established although somewhat unfortunate term.

That these differences between costs and prices which pervade - and are expres'led in - the whole system of relative prices will in equilibrium stand in a definite relationship to each other which can be expressed, in some sense, as a uniform time rate is, strictly speaking, a fact which should not be assumed at the beginning of this investigation but forms one of its results. But as in this respect we are only going over ground which has often been covered in a similar manner, there can be no harm in anticipating this result, with which every reader will be familiar, and in occasion ally speaking of a rate of interest in this sense before CR. HI Analysis in Real Terms 39 we have shown why there should be a tendency to adjust all the various price differences to a common standard. If this methodological discussion is not to grow to disproportionate length, we must leave it with this rather cursory discussion of the relation between analysis in real terms and analysis in monetary terms. LlmltaUons 01 analy A more systematic and exhaustive treat-sis in real terms ment would be impossible without explicit consideration of the role money does actually play; and this is just what we want to avoid here. What has been said is merely an attempt to indicate certain consequences which follow from the treatment of the problem of capital as part of general equilibrium analysis.

There is only one more point which should be stressed in conclusion of this discussion. The fact that almost this entire volume is devoted to the equilibrium or " real" aspects of our problem must not be taken to mean that we attach excessive importance to these aspects. The idea is rather to emphasise the width of the gulf which separates this exercise in economic logic from any attempt directly to explain the processes of the real world. It would have been easy enough to expand this exposi tion with occasional disquisitions about the significance of the considerations advanced here in a scheme of causal explanation of the real economic process. The author has on the whole tried to resist this temptation as far as possible and to keep strictly within the limits explained in this and the preceding chapter. The application of the results of equilibrium analysis to the real world means a transition to an altogether different plane of argument and requires a very careful restatement of the assump tions on which it proceeds. It is impossible to do this by occasional remarks without running the risk of illegiti mately turning analytic propositions into assertions about causation. It seems much better frankly to recognise the limits of what can be achieved with the method here 40 Introductory PT. 1 employed, and to reserve the task of applying the results to causal explanation for separate investigation. Some suggestions concerning the treatment of these further problems which will arise in a money economy will be found in Part IV of the present study.