17. Concluding Remarks: Keynesianism—Progress or Retrogression? KEYNESIANISM—AN INFLATION-DEFLATION THEORY OF EMPLOYMENT

In order to pass a general judgment on Keynesianism the term must be defined. This is not easy because Keynesianism has come to embrace many and varied ideas. For not only has Keynes himself made self-contradictory statements but his statements are often at variance with those of his followers, who again vary widely among themselves in their views. Therefore any general remark on Keynesianism will and can easily be met with the objection that one has misunderstood the master or picked out the views of the wrong disciples. It might nevertheless be possible to define it pretty distinctly by pointing to a certain basic approach common to all Keynesians, but totally uncommon to orthodox classical or neoclassical economists. This basic approach is best expressed in the formula that Keynesians themselves consider the essence of the new creed and which they repeat over and over again: “National income” (and/or employment) “depends upon the propensity to consume, the marginal efficiency of capital, the liquidity function and the amount of money. . . .” ¹

What is the meaning of this statement so amazing to classical economists who, of course, would expect the variables upon which employment depends to also include the wage level? Obviously these variables are meant to determine “effective demand” or, in monetary terms, the degree of inflation and deflation. And if they at the same time determine employment, we are faced with what is essentially an inflation-deflation theory of employment, and a one-sided one at that. For inflation and deflation are considered dependent solely upon investment and consumption. In reality, they are in the first instance dependent on future employment and thus inversely on the wage level. For what is spent on consumer or capital goods produced this week is the income of those employed in the next.

It is a peculiar picture of an economy from which this theory is abstracted. It is the picture of an economy in which output and employment are so tightly coupled with the amount of circulating money that they can only expand if the latter has been inflated. Moreover, because the new money is spent—after a short initial period—on output and prices, increases in employment and output are always more or less associated with price rises. And as the money inflation is supposed to be brought about by interest rate lowering or increase of efficiency of capital, the increased output is connected with an increase in investment. In the same way decreases in output and employment are coupled with money deflation, price declines and decrease of investment.

Compare with this the working of the economy as imagined by the neoclassicists. They knew that expansion and contraction of employment and output could be brought about in the way just described, and many of them thought that they were thus brought about in the course of the business cycle. But in general they considered changes in output and employment as independent of money inflation and deflation, from price inflation and deflation and from changes in investment. In their opinion, employment and output can increase without any increase in the amount of circulating money. This happens if wages are lowered within the framework of an inelastic money supply. Here an unchanged amount of money spends itself on a higher output, but on lower prices. And if the money supply is elastic, employment and output nevertheless can increase without price inflation provided wages are deflated. The increased amount of money spends itself solely on increased output. In both of these cases lower costs, especially wages, provide the increased profit margin for the employment of less efficient labor that in the Keynesian scheme is provided by price inflation. And, in both cases, output and employment increase also independently of any addition to investment and thus of changes in the capital structure of the economy.

AN ELEMENT OF IMPERFECT COMPETITION IN A SYSTEM OF PERFECT COMPETITION

In neoclassic economics, production can expand for all sorts of reasons in all sorts of ways. It can expand with prices rising, unchanged or even falling. It can expand with or without new investments. Everything depends on the absolute and relative costs of capital and labor. In Keynesian economics—as represented by the employment formula mentioned above—it can expand only through money inflation, price inflation and an increase in investment: it represents a very one-sided—a monistic—theory of employment.

What are the reasons for this one-sidedness? Why do Keynesian and classical economics differ so widely? I think the answer is easy. The absence of really universal perfect competition is responsible for the wonders of the Keynesian world. Through the assumption that wages are inflexible and unadjustable to the prevailing price situation, an important element of imperfect competition is introduced on one single market, namely, the labor market, in an alleged system of entirely free markets. In all other fields of the economy the market prices are supposed to be lowered under the impact of competition until supply and demand equalize. Every supplier of industrial products, of railroad traffic, of real estate, of commodities, is expected to lower the supply price of the goods he produces or the services he renders if he really wants to get rid of them. But such lowering of the price of labor is excluded by the assumption that labor will not tolerate the lowering of nominal, as distinct from real, wages. Once this assumption is made there is of course only one way to influence the size of employment and production: by inflation and deflation. And these in turn can never be induced by changes in wages. These consequences are indeed awkward. But they are quite plausible within a system in which on one important market, the labor market, supply prices are inflexible in nominal, but oddly not in real, terms. Here inflation is left as the only way out of an otherwise unadjustable situation.

KEYNES’ “CONCEPTUAL APPARATUS”

The aim of this volume has been twofold. First, to show that Keynes’ theory is one-sided, that an inflation-deflation theory of employment does not cover the “general cases.” Second, to prove that his inflation-deflation theory of employment suffers in itself from inherent weaknesses. Neither do shifts in liquidity preference, the propensity to consume or the marginal productivity of capital lead necessarily to inflations or deflations; nor do inflations and deflations in turn lead to fluctuations in employment, except if and as long as wages are rigid.

If this is correct the usefulness of Keynes’ so-called “conceptual apparatus” for the analysis of long-run, short-run and cyclical situations cannot be as great as is assumed nowadays even by “moderate Keynesians.” I myself consider it in fact as very slight. My conclusions can be summarized as follows:

Long-run equilibria do not exist in the real world. They are fictions designed to depict the structure of an economy after such adjustments have taken place as can reasonably be expected under the assumption of free competition. Of paramount importance among such adjustments are the downward shifts of supply prices of the productive factors, labor and capital, which enable them to join or rejoin the production process. A long-run equilibrium theory of employment has therefore to assume that wage demands of those still wanting to work are lowered until demand and supply equalize and “involuntary” unemployment disappears. Just as supply on commodity markets cannot remain unabsorbed it seems unwarranted to assume that on the labor market, in the long run, supply can outgrow demand. A long-run equilibrium in which supply and demand for labor does not come into balance because of wage rigidity is a contradiction in terms. It could not serve the purposes for which it is constructed.

For short-run situations—for which it is meant in the first place, but by no means exclusively—Keynes’ analysis suffers from the opposite defects. Short-term analysis is not concerned with fictions. It is meant as a tool to describe and explain reality. Reality is always dynamic. Periods of prosperity and depression alternate. Neutral static periods do not exist. Keynes’ theory is essentially static. It treats the short-term equilibrium as an isolated phenomenon and examines the results of shifts in one variable, for instance, of income, assuming that other functions such as consumption or investment are “fairly stable.” ² But in dynamic reality stable functions are practically nonexistent. Every single equilibrium is, so to speak, only a snapshot out of a chain of equilibria. Changes in one link of the chain set the stage for overall changes that happen in the next and modify the effect of the impulse. The sequence, interaction and causality of all these changes, not one single shift in an otherwise static world, have to be explained. Therefore only a chain or sequence analysis, as distinct from Keynes’ circular analysis, can be useful.

As an example of how misleading circular analysis turns out we may refer to the investment gap theorem so essential for Keynes’ whole system: production cannot, ceteris paribus, be increased, because according to the so-called “psychological law” some part of the increased income is not spent so that deflation threatens. Applying even the crudest form of chain analysis we see immediately that the increased current income meets the output of the preceding period, which of course does not increase retroactively. Therefore prices would go up or, at least, inventories would decrease. Either would create optimistic expectations for the prices to be obtained for current production. In other words, shifts in the price expectations would counteract the effect of the “psychological law” even if it existed.

If this is a realistic description of a short-run equilibrium in a changing world—and I believe that every cyclical recovery proves it is—then an increase in income leads, ceteris paribus, to inflation, not deflation. The cornerstone of Keynes’ really fantastic theory, according to which things must get worse just because they get better, is overthrown.

It is the aim of business cycle theory to explain why from time to time the economy moves away, periodically and rhythmically, from an equilibrium and why it tends to return to it only after a lag, and by a sudden sharp corrective reversal rather than by a slow adjustment process which might have no substantial effect on employment and production.

I cannot see that Keynes has added anything to previous endeavors to explain this riddle of the cycle. Nor do I think that his followers, in trying to “dynamize” his system, have added any new explanation. A huge literature and an immense display of ingenuity have achieved nothing but a distinct step backwards, for instance by blurring the difference between saving and “buyers’ resistance.” More confused than enriched, we will have to return repentantly to the answers of neoclassical monetary business cycle theorists. We may again decide whether we want to rely, for instance, on the importance of the clustering of investment demand (Professor Schumpeter), the errors in monetary policy (Wick-sell and his school), or on optimistic and pessimistic mass psychology (Professor Pigou), the last being my own choice.

KEYNESIANISM AND APPLIED ECONOMICS

Can Keynesianism be considered useful when applied to practical problems? Has it improved our ability for correct diagnosis and prognosis of economic evils? I think that the answer must be negative. In the Keynesian world costs are more or less fixed, whereas prices fluctuate and have a tendency toward deflation. But this is not the situation today. Since the end of the great depression, with only the interruption of the short crisis of 1937-38, things have been different and will perhaps stay that way for quite a while. The demand situation is no longer deflationary, nor can the cost situation be considered anything like stable. Demand is stabilized or even inflationary and wages move up, without their traditional lag, but sometimes even faster than prices. Clearly in such a situation the Keynesian “inflation-deflation theory of employment” cannot be helpful. The classical employment theory that connects employment with the productivity of labor and the real wage level seems to focus the attention much better on the really important variable.

But after this boom a depression will come again. Will the younger generation, brought up under the influence of Keynes’ ideas, be well equipped to diagnose the various reasons for the dwindling demand and the developing unemployment? I am afraid not. For Keynesianism has produced certain peculiarities in their thinking of which they themselves are hardly aware but by which they will be greatly handicapped. They originate in Keynes’ employment theory being a one-sided, monistic theory which distracts the attention from some factors while putting the spotlight on others.

One of these peculiarities is the preoccupation of economists exclusively with questions of demand. Like salesmen of Fuller brushes, everybody seems to be trembling for fear that demand is not sufficient. The consequences are twofold. First, unemployment is always considered caused by insufficient demand although, after all, stabilized or structural or, in Keynes’ words, “voluntary employment” is, or can also be, an important component of total unemployment in a depression. Second, it is forgotten that goods, in order to be sold, have to be produced plentifully and at low cost if the living standard of the nation is to be maintained or raised. In spite of the experience of the war and postwar period, economists seem not to be concerned about increasing production and employment by technical progress and greater use of capital, dependent on increased savings. I fear that a generation deluded by the belief that national income depends on spending for consumption and, even more grotesque, on the amount of circulating paper money, will have to learn the hard way that it can only be increased through work, thrift and technical progress.

A further peculiarity of contemporary economic thinking, again a consequence of Keynes’ monistic theory, is what one would call the “estimate craze”; the abundance of estimates of future national income. Underlying all these estimates is the belief that future demand can be calculated in advance within certain limits. The demand for investment purposes especially is supposed to be calculable according to what business or government is expected to spend on investments. But first demand is not only created by spending for investment, but also by spending for employment, the last not at all identical with the former. Demand on the market for dresses could, for instance, be increased if more housemaids were employed—a possibility ignored by a theory concentrating on the demand-creating power of investments. Secondly, investment itself is not only dependent on the productivity of capital but also of labor. If an enlarged labor force has to be equipped, more has to be spent on investments. Nor is the wage level alone decisive. A change in the political atmosphere, too, can radically influence the size of investments. And finally, a small change in price expectations can alter the amount spent on investment, and on consumption, too, so radically that a potentially deflationary situation turns inflationary and vice versa, with the result that all forecasts turn out to be wrong.

The “peculiarities” mentioned are responsible for another peculiarity of our times: the standard for evaluation of economists, so different from the past. Today somebody is considered a good economist who can express more or less hypothetical statements on functional relationships in mathematical formulas or graphs. Previously somebody was considered a good economist who could evaluate and forecast the relative strength of the forces making for shifts of data in the future. Judgment, experience and common sense were believed more important than a formal education relying on methods appropriate in natural sciences but hardly in economics. For these deal with human beings with unpredictable reactions and not with machines with predictable movements. The forecasts on postwar deflation demonstrate the results of a technical overstatic approach—forecasts which, incidentally, seem to have done no harm to the forecasters in their own minds, nor in the minds of the public.

As far as mathematics in economics is concerned, I quote what Keynes, certainly more competent in this matter than I, said in one of the few passages in his book with which I agree:

It is a great fault of symbolic pseudo-mathematical methods of formalising a system of economic analysis, . . . that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep “at the back of our heads” the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials “at the back” of several pages of algebra which assume that they all vanish. Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.³

FULL EMPLOYMENT POLICY

Nowhere does the difference between Keynesian and pre-Keynesian economics show up stronger than in the matter of full employment policy.

Classical-neoclassical economists had not the ambition to “maintain full employment.” Their idea was: every boom is followed by a depression during which the excesses of the boom have to be corrected and liquidated; the price level is bound to fall. Interference by interest rate manipulation or deficit spending can prevent the price level from falling too far below an “average” level, but never maintain it at boom level for any length of time. Costs, especially wages, have to adjust themselves to the new price level. Before this happens no real recovery is possible. Only an economy where costs have been adjusted to the new price level keeps going in a “natural way” without ever-renewed inflationary injections.

Keynes’ full employment policy is more ambitious. It does not aim at restoring but at maintaining full employment. But this ambition is somewhat involuntary. For in his system full employment cannot be restored through wage adjustments. It can only be maintained through price and demand support. Wages cannot be lowered in view of labor’s resistance to lowering of money wages and in view of a threatening “oversaving deflation” which would overcompensate the effects of lowering of wages. There is only one way out: inflation or reflation by manipulating the interest rate downward and by government spending. If a man is taking a bath and the water in the tub is shallow he must lower his body to be covered. If he does not lower himself the only other way to be covered is to run more water into the bathtub.

We have tried in this volume, especially in Chapter 6, “Compensating Reactions to Compensatory Spending,” to show that such “refilling of the bathtub” is practicable only in very special situations, for instance, during a depression, after the excesses of the previous boom are already well liquidated but never with a view to extending a dying boom. Otherwise, to go back to our metaphor, the water will soon flow out of the tub again or it may be impossible to cover the body at all. Therefore, not only must the opening of the faucets be well timed but also the body must already have been lowered quite a bit.

It is true that intervention can be too late and too weak. This was the mistake committed at the beginning of the thirties, at least in Europe. A deflationary monetary and fiscal policy was continued for much too long a period and reflationary measures, when finally introduced, were too timid.

Today the great danger lies in the opposite direction. Keynes himself has expressed the opinion that low interest rates are the means of prolonging a boom ⁴ and many of his followers think that government spending has to set in every time demand dwindles.⁵ This has created an atmosphere that may well force an intervention at too early a moment and on too large a scale. But I doubt its success. Before the boom is liquidated to a certain extent and the price and demand situation, created through over-speculation, revised downwards, everything spent will prove to have been poured into a barrel without a bottom. Nothing else will be achieved but a waste of valuable ammunition. A short-lived consumer-spending boom will soon collapse without having revived the economy to a natural life but after having endangered the credit and currency of the country. Whether one wants it or not, prices will go down in the next depression from their boom level, as they have always done in depressions, and the only question is at what level the price decline can and should be arrested. So, after all, wages will have to come down: the man in the bathtub will have to lower his body.

But will he do it? I must confess that I doubt it and this situation frightens me.

I have once already lived through a period in which wages should have been lowered but were not because of the arguments of the purchasing power theory. From 1927 on employment began to decrease in Germany at a time when demand was still holding up. Entrepreneurs held that unemployment was the result of a too rapid rise in wages and a subsequent replacement of labor by capital. Labor leaders rejected wage reduction in the face of steadily mounting unemployment. Their argument was, just as it is today, that high wages are necessary to maintain a high level of purchasing power. Indeed the reasons advanced at that time in dailies representing the views of labor were so identical with those of today in this country, that I sometimes have the feeling of living this period of my life over again.

As is well known, wage reductions were opposed in Germany for years by the trade unions. They even succeeded in obtaining substantial wage increases at a time when the depression was already clearly noticeable. Only later, at the bottom of the depression, they consented to extensive wage reductions, then entirely useless in view of the very deflationary price policy of the Brüning government.

In France the arguments of the purchasing power theory were officially accepted by Leon Blum and his government before the last war. Wages were at that time raised in an already clearly deflationary environment. This was, in my opinion, one of the chief reasons for the economic chaos which characterized the prewar Blum era.

But what was the position of economic science? One is entitled to state that at that time in Europe the purchasing power theory was considered fundamentally wrong by an overwhelming majority of scholars. The first to warn against its fallacies was the late Professor Gustav Cassel in an article which appeared in 1927 and which aroused great interest all over the world. This article, “Selbstkritik! Die Sinnlosigkeit der deutschen Arbeitslosenpolitik” (“Self-criticism! The Senselessness of the German Unemployment Policy”), explained how senseless it was to keep the wages of the employed high and to pay subsidies out of the income of the employed to the unemployed, instead of letting the whole population work at adjusted wage rates.⁶

But the warning was not confined to orthodox economists. Professor Emil Lederer, a member of the Unabhanige Socialdemokratische Partei, who surely cannot be suspected of having been inimical to labor, in his book Eine Untersuchung ueber die Armut der Nationen (An Enquiry into the Poverty of Nations), 1927, says with reference to the effect of economically non-adjusted wage rates: “A sharp decline of the economy will be the consequence. The unemployment allowances cannot be paid any longer and the artificially erected wage system must collapse inevitably. A valorization of labor, what this policy would mean . . . , is just not possible for the long run.”⁷

And as to scientific opinion outside Europe, I may be allowed to quote a few sentences of Professor Alvin Hansen, obviously written before he became a Hansenian:

“It is therefore not surprising that the theory should become widespread that higher wages are the cure for the restricted market and declining price level of the last decade. This theory is accepted, one might almost say, by nearly every one in the United States, not only by trade union leaders but also by leading business men, politicians, and journalistic economists. During the 1930 depression leaders of American public opinion in all walks of life were constantly urging that the surest basis for a revival of prosperity was a maintenance of wages or even an increase in wages. This state of affairs indicates a confusion of thought for which, it must be admitted, professional economists are in part to blame.” ⁸

“You cannot raise the general level of prices by the simple process of raising wages. And it is an amazing fact that professional American economists have not come forward to point out the fallacy that lurks here.” ⁹

“We shall not succeed in solving the depression through the soothing and agreeable device of inflation. We shall come out of it only through hard work, and readjustments that are painful. There is no other alternative.” ¹⁰

If the downward adjustment of wages was opposed in the last depression in spite of a warning by economic science, resistance against adjustments will hardly be weaker now that economists too adhere so overwhelmingly to purchasing power theory. In the last analysis Keynes wrote his General Theory in order to find a way out of a situation which seemed to him hopeless if attacked in a traditional way. He felt that wages must be lowered in and after a depression but he advised lowering them in real terms because it seemed no longer possible to lower them in money terms. He has, as I once said, transformed the evil of a rigid wage system into the virtue of an inflationary employment theory. But by doing this and conceding that wages are unadjustable downwards he has of course rendered them even less adjustable than they already were.

It is a well-known sociological phenomenon that theories, even basically incorrect, if once accepted, can turn into an independent power which leads to the effect to which the original facts as such would never have led—thus seemingly proving the correctness of the original theory. The classic example for such an effect of a theory is Karl Marx’ “Klassenkampf” conception (class struggle) which caused the development of class-consciousness rather than vice versa.

Perhaps we have to acquiesce in the fact that money wages have become unadjustable downwards and even have a tendency to increase during depressions—tragically not the least through the influence of a doctrine designed to protect the economy against such rigidities. But before acquiescing we should consider what an economy will look like which has again and again to be pulled out of a deflationary situation by government spending. Such an economy must necessarily undergo fundamental changes in its social structure. In the long run governmental deficit spending leads necessarily to a progressive socialization of enterprises. Taxation has, from a certain point on, to be increased in order that government spending does not ruin the currency and credit of the country. Through this more and more enterprises become unprofitable so that the government must again replace them in their function of providing employment.

It is beyond the topic of this volume to examine whether the development which leads from economic rigidities to ever more governmental spending and from there to Socialism, is inevitable. Undoubtedly other alternatives exist. One is to urge the regulation of the whole economic process by the government, based on the idea that it is better to have all factors fixed according to a unified and centralized plan than as a result of the struggle of different pressure groups. This is how a Fascist economy works.

The other possibility is to put the economic laws to work again and in that way to rebuild a free economy. I personally hope that this way is still open.

¹ Compare, for instance: Papers and Proceedings of the Sixtieth Annual Meeting of the American Economic Association, May 1948, page 272, and many other places.

²Cf. Keynes’ General Theory, p. 95.

³Ibid., pp. 297-98.

⁴ Compare the quotation on p. 205.

⁵ Compare the quotations on p. 137.

⁶ A summary of the response to this article in the scientific and political world in Germany can be found in my little booklet which appeared in 1930, 1st Arbeitslosigkeit unvermeidlich? (Is Unemployment Inevitable?).

⁷ I refer furthermore to a pamphlet, “Rentabilitaetskrise (Veroeffentlichungen des Vereins deutscher Maschinen Bauanstalten, 1930)” which demonstrated statistically the parallelism between rising wages and unemployment.

⁸ Alvin Harvey Hansen, Economic Stabilization in an Unbalanced World, New York, 1932, p. 279.

⁹Ibid., p. 279.

¹⁰Ibid., p. 378.