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Chapter 11—Money and Its Purchasing Power (continued)

F. Hoarding and the Keynesian System

(1)  Social Income, Expenditures, and Unemployment

     To the great bulk of writers “hoarding”—an increase in the demand for money—has appeared an unmitigated catastrophe. The very word “hoarding” is a most inappropriate one to use in economics, since it is laden with connotations of vicious anti­social action. But there is nothing at all antisocial about either “hoarding” or “dishoarding.” “Hoarding” is simply an increase in the demand for money, and the result of this change in val­uations is that people get what they desire, i.e., an increase in the real value of their cash balances and of the monetary unit.[11] Conversely, if the people desire a lowering of their real cash bal­ances or in the value of the monetary unit, they may accomplish this through “dishoarding.” No other significant economic rela­tion—real income, capital structure, etc.—need be changed at all. The process of hoarding and dishoarding, then, simply means that people want something, either an increase or a decrease in their real cash balances or in the real value of the monetary unit, and that they are able to obtain this result. What is wrong with that? We see here simply another manifestation of consumers’ or individuals’ “sovereignty” on the free market.

     Furthermore, there is no theoretical way of defining “hoard­ing” beyond a simple addition to one’s cash balance in a certain period of time. Yet most writers use the term in a normative fashion, implying that there is some vague standard below which a cash balance is legitimate and above which it is antisocial and vicious. But any quantitative limit set on the demand-for-money schedule would be completely arbitrary and unwarranted.

     One of the two major pillars of the Keynesian system (now happily beginning to wane after sweeping the economic world in the 1930’s and 1940’s) is the proclamation that savings become equal to investment only through the terrible route of a decline in social income. The (implicit) foundation of Keynesianism is the assertion that at a certain level of total social income, total social expenditures out of this income will be lower than in­come, the remainder going into hoards. This will lower total social income in the next period of time, since, as we have seen, total income in one “day” equals, and is determined by, total expenditures in the previous “day.”

     The Keynesian “consumption function” plays its part in es­tablishing an alleged law that there exists a certain level of total income, say A, above which expenditures will be less than income (net hoarding), and below which expenditures will be greater than income (net dishoarding). But the basic Keynesian worry is hoard­ing, when total income must decline. This situation may be di­agramed as in Figure 78.

     In this graph, money income is plotted on both the horizontal and the vertical axes. Hence, a 45-degree straight line between the axes is equal to social income.[12]To illustrate: A social income of 100 on the horizontal axis will correspond to, and equal, a social in­come of 100 on the vertical axis. The co-ordinates of these figures will meet at a point equidistant between the two axes. The Key­nesian law asserts social expenditures to be lower than social in­come above point A, and higher than social income below point A, so that A will be the equilibrium point for social income to equal expenditure. For if social income is higher than A, social expenditures will be lower than income, and income will there­fore tend to decline from one day to the next until the equi­librium point A is reached. If social income is lower than A, dishoarding will occur, expenditures will be higher than income, until finally A is reached again.

     Below, we shall investigate the validity of this alleged law and the “consumption function” on which it rests. But suppose that we now grant the validity of such a law; the only comment can be an impertinent: So what? What if there is a fall in the na­tional income? Since the fall need only be in money terms, and real income, real capital, etc., may remain the same, why any alarm? The only change is that the hoarders have accomplished their objective of increasing their real cash balances and increas­ing the real value of the monetary unit. It is true that the pic­ture is rather more complex for the transition process until equi­librium is reached, and this will be treated further below (al­though our final conclusion will be the same). But the Keynesian system attempts to establish the perniciousness of the equilibrium position, and this it cannot do.

     Therefore, the elaborate attempts of the Keynesians to demon­strate that free-market expenditures will be limited—that con­sumption is limited by the “function,” and investment by stag­nation of opportunities and “liquidity preference”—are futile. For even if they were correct (which they are not), the result would be pointless. There is nothing wrong with hoarding or dishoarding, or with “low” or “high” levels (whatever that may mean) of social money income.

     The Keynesian attempt to salvage meaning for their doctrine rests on one point and one point alone—the second major pillar of their system. This is the thesis that money social income and level of employment are correlated, and that the latter is a func­tion of the former. This assumes that a certain “full employment” level of social income exists below which there is correspondingly greater unemployment. This can be diagramed as in Figure 79.

     On the previous diagram is superimposed a vertical FF line, which represents the point of alleged “full-employment” social income. If the intersection A is below (to the left of) the FF line, then there is permanent unemployment corresponding to the dis­tance by which A falls short of that line.

     Keynesians have also attempted, with little success, to give meaning to an equilibrium position where A falls to the right of the FF line, identifying this with inflation. Inflation, as we shall see below, is a dynamic process, the essence of which is change. The Keynesian system centers around the equilibrium position and therefore is hardly well equipped to analyze an in­flationary situation.

     The nub of the Keynesian critique of the free market econ­omy, then, rests on the involuntary unemployment allegedly caused by too low a level of social expenditures and income. But how can this be, since we have previously explained that there can be no involuntary unemployment in a free market? The answer has become evident (and is admitted in the most intelligent of the Keynesian writings): The Keynesian “under­employment equilibrium” occurs only if money wage rates are rigid downward, i.e., if the supply curve of labor below “full employment” is infinitely elastic.[13] Thus, suppose there is a “hoarding” (an increased demand for money), and social income falls. The result is a fall in the monetary demand curves for la­bor factors, as well as in all other monetary demand curves. We would expect the general supply curve of labor factors to be ver­tical. Since only money wage rates are being changed while real wage rates (in terms of purchasing power) remain the same, there will be no shift in labor/leisure preferences, and the total stock of labor offered on the market will remain constant. At any rate, certainly no involuntary unemployment will arise.

     How then can the Keynesian case arise? How can the supply of labor remain horizontal at the old money wage rate? In only two ways: (1) if people voluntarily agree with the unions, which insist that no one be employed at lower than the old money wage rate. Since selling prices are falling, maintaining the old money wage rate is equivalent to demanding a higher real wage rate. We have seen above that the unions’ raising of real wage rates causes unemployment. But this unemployment is voluntary, since the workers acquiesce in the imposition of a higher minimum real wage rate, below which they will not undercut the union and accept employment. Or (2) unions or government coercively impose the minimum wage rate. But this is an example of a hampered market, not the free market to which we are confin­ing our analysis here.

     Situation (1) or (2) may be diagramed as in Figure 80.

     The original demand curve for labor is DD (for simplicity of exposition we assume as meaningful the concept of “demand for labor” in general). Total stock of labor in the society is 0F, or at least that is the stock put forward upon the market. Now an increase in the demand for money shifts all demand curves down­ward as all money prices fall. If wage rates are free to fall, the intersection point will move from H to C and nominal wage rates reduced accordingly, from FH to FC. There is still “full employment” at level 0F. Now suppose however, that a union sets a minimum money wage rate of 0B (or FH). Then the sup­ply-of-labor curve becomes BHG; horizontal up to FG and ver­tical from there on. The new demand curve D'D' will now in­tersect the supply of labor at point E instead of point C. Total amount of labor now employed is reduced to BE, and EH are now unemployed as a result of the union action.

     Keynes’ own exposition tended to run in terms of real rather than money magnitudes—real social income, real expenditures, etc.[14] Such an analysis obscures dynamic considerations, since transactions take place at least superficially in monetary terms on the market. However, the essential conclusion of our analysis remains unchanged if we pursue it directly in real terms. In­stead of falling, demand curves in real terms will now remain the same. This is true for the labor market as well. Instead of being depicted on a diagram as a horizontal line at existing wage rates, the effect of union action would have to be shown as a horizontally imposed increase in real wage rates (the result of keeping money wage rates constant while selling prices fall). The relevant diagram is shown in Figure 81. The facts depicted in this diagram are the same as in the previous diagram: unions caus­ing unemployment (EH) by insisting on an excessively high money (and therefore real) wage (0B).

     The sum and substance of the “Keynesian Revolution” was the thesis that there can be an unemployment equilibrium on the free market. As we have seen, the only sense in which this is true was known years before Keynes: that widespread union mainte­nance of excessively high wage rates will cause unemployment.

     Keynes believed that while other elements of the economic system, including prices, were set basically in real terms, workers bargained even ultimately only in terms of money wages—that unions insisted on minimum money wage rates downward, but would passively accept falling real wages in the form of rising prices, money wage rates remaining the same. The Keynesian prescription for eliminating unemployment therefore rests spe­cifically on the “money illusion”—that unions will impose mini­mum money wage rates, but are too stupid to impose minimum real wage rates per se. Unions, however, have learned about pur­chasing-power problems and the distinction between money and real rates; indeed, it hardly requires much reasoning ability to grasp this distinction.[15] Ironically, Keynes’ advocacy of inflation based on the “money illusion” rested on the historical experi­ence (which we shall treat more fully below) that, during an in­flation, selling prices rise faster than wage rates. Yet an economy in which unions impose minimum wage rates is precisely an econ­omy in which unions will be alive to any losses in their real, as well as their money, wages. Inflation, therefore, cannot be used as a means of duping unions into relieving unemployment.[16]Key­nesianism has been touted as at least a “practical” system. What­ever its theoretical defects, it is alleged to be fit for the modern world of unionism. Yet it is precisely in the modern world that Keynes’ doctrine is least appropriate or practical.[17]

     The Keynesians object that to allow rigid money wage rates to become flexible downward would further lower monetary de­mand for goods, and therefore monetary income. But this com­pletely confuses wage rates with aggregate payroll, or total in­come going to wages.[18] That the former falls does not mean that the latter falls. On the contrary, total income is, as we have seen, determined by total expenditures in the previous period of time. Lower wage rates will cause the hiring of those made unemployed by the old excessively high wage rates. The fact that labor is now cheaper relatively to land factors will cause investors to expend a greater proportion on labor vis-à-vis land than before. And the employment of unemployed labor increases production and there­fore aggregate real income. Furthermore, even if payrolls also de­cline, prices and wage rates can adjust—but this will be taken up in the next section on liquidity preference.

(2)  “Liquidity Preference”

     Those Keynesians who recognize the grave difficulties of their system fall back on one last string in their bow—“liquidity pref­erence.” Intelligent Keynesians will concede that involuntary un­employment is a “special” or rare case, and Lindahl goes even further to say that it could be only a short-run and not a long-run equilibrium phenomenon.[19] Neither Modigliani nor Lin­dahl, however, is thoroughgoing enough in his critique of the Keynesian system, particularly of the “liquidity preference” doc­trine.

     The Keynesian system, as is quite clear from the mathemati­cal portrayals of it given by its followers, suffers grievously from the mathematical-economic sin of “mutual determination.” The use of mathematical functions, which are reversible at will, is appropriate in physics, where we do not know the causes of the observed movements. Since we do not know the causes, any math­ematical law explaining or describing movements will be reversi­ble, and, as far as we are concerned, any of the variables in the function is just as much “cause” as another. In praxeology, the science of human action, however, we know the original cause—motivated action by individuals. This knowledge provides us with true axioms. From these axioms, true laws are deduced. They are deduced step by step in a logical, cause-and-effect relationship. Since first causes are known, their consequent effects are also known. Economics therefore traces unilinear cause-and-effect re­lations, not vague “mutually determining” relations.

     This methodological reminder is singularly applicable to the Keynesian theory of interest. For the Keynesians consider the rate of interest (a) as determining investment and (b) as being determined by the demand for money to hold “for speculative purposes” (liquidity preference). In practice, however, they treat the latter not as determining the rate of interest, but as being determined by it. The methodology of “mutual determination” has completely obscured this sleight of hand. Keynesians might object that all demand and supply curves are “mutually deter­mining” in their relation to price. But this facile assertion is not correct. Demand curves are determined by utility scales, and supply curves by speculation and the stock produced by given labor and land factors, which is ultimately governed by time prefer­ences.

     The Keynesians therefore treat the rate of interest, not as they believe they do—as determined by liquidity preference—but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system. Thus, Keynesian discussion of liquidity preference centers around “inducement to hold cash” as the rate of interest rises or falls. According to the theory of liquidity preference, a fall in the rate of interest in­creases the quantity of cash demanded for “speculative purposes” (liquidity preferences), and a rise in the rate of interest lowers liquidity preference.

     The first error in this concept is the arbitrary separation of the demand for money into two separate parts: a “transactions demand,” supposedly determined by the size of social income, and a “speculative demand,” determined by the rate of interest. We have seen that all sorts of influences impinge themselves on the demand for money. But they are only influences working through the value scales of individuals. And there is only one final de­mand for money, because each individual has only one value scale. There is no way by which we can split the demand up into two parts and speak of them as independent entities. Further­more, there are far more than two influences on demand. In the final analysis, the demand for money, like all utilities, cannot be reduced to simple determinants; it is the outcome of free, inde­pendent decisions on individual value scales. There is, therefore, no “transaction demand” uniquely determined by the size of in­come.

     The “speculative demand” is mysterious indeed. Modigliani explains this “liquidity preference” as follows:

we should expect that any fall in the rate of interest . . . would induce a growing number of potential investors to keep their assets in the form of money, rather than securities; that is to say, we should expect a fall in the rate of interest to increase the demand for money as an asset.[20]

This is subject to the criticism, as we have seen, that the rate of interest is here determining, and is not it­self explained by any cause. Furthermore, what does this state­ment mean? A fall in the rate of interest, according to the Keynes­ians, means that less interest is being earned from bonds, and therefore there is a greater inducement to hold cash. This is cor­rect (as long as we allow ourselves to think in terms of the in­terest rate as determining instead of being determined), but highly inadequate. For if a lower interest rate “induces” greater cash holdings, it also induces greater consumption, since consumption also becomes more attractive. In fact, one of the grave defects of the liquidity-preference approach is that the Keynesians never think in terms of three “margins” being decided at once. They think only in terms of two at a time. Hence, Modigliani: “Hav­ing made his consumption-saving plan, the individual has to make decisions concerning the assets he owns”; i.e., he then allocates them between money and securities.[21] In other words, people first decide between consumption and saving (in the sense of not con­suming); and then they decide between investing and hoarding these savings. But this is an absurdly artificial construction. Peo­ple decide on all three of their alternatives, weighing one against each of the others. To say that people first decide between consuming and not consuming and then choose between hoarding and investing is just as misleading as to say that people first choose how much to hoard and then decide between consumption and investment.[22]

     People, therefore, allocate their money among consumption, investment, and hoarding. The proportion between consumption and investment reflects individual time preferences. Consumption reflects desires for present goods, and investment reflects desires for future goods. An increase in the demand-for-money schedule does not affect the rate of interest if the proportion between consumption and investment (i.e., time preference) remains the same.

     The rate of interest, we must reiterate, is determined by time preferences, which also determine the proportions of consumption and investment. To think of the rate of interest as “inducing” more or less saving or hoarding is to misunderstand the problem completely.[23]

     Admitting, then, that time preference determines the proportions of consumption and investment and that the demand for money determines the proportion of income hoarded, does the demand for money play a role in determining the interest rate? The Keynesians assert that there is a relation between the rate of interest and a “speculative” demand for cash. Should the schedule of the latter rise, the former rises also. But this is not necessarily true. A greater proportion of funds hoarded can be drawn from three alternative sources: (a) from funds that formerly went into consumption, (b) from funds that went into investment, and (c) from a mixture of both that leaves the old consumption-investment proportion unchanged. Condition (a) will bring about a fall in the rate of interest; condition (b) a rise in the rate of interest, and condition (c) will leave the rate of interest unchanged. Thus hoarding may reflect either a rise, a fall, or no change in the rate of interest, depending on whether time preferences have concomitantly risen, fallen, or remained the same.

     The Keynesians contend that the speculative demand for cash depends upon and determines the rate of interest in this way: if people expect that the rate of interest will rise in the near future, then their liquidity preference increases to await this rise. This, however, can hardly be a part of a long-run equilibrium theory, such as Keynes is trying to establish. Speculation, by its very nature, disappears in the ERE, and hence no fundamental causal theory can be based upon it. Furthermore, what is an in­terest rate? One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production. The former, as we have seen, is only the reflection of the latter. A strong expectation of a rapid rise in interest rate means a strong expectation of an increase in the price spreads, or rate of net return. A fall in prices means that entrepreneurs generally ex­pect that factor prices will fall further in the near future than their selling prices. But it requires no Keynesian labyrinth to explain this phenomenon; all we are confronted with is a situa­tion in which entrepreneurs, expecting that factor prices will soon fall, cease investing and wait for this happy event so that their return will be greater. This is not “liquidity preference,” but speculation on price changes. It involves a modification of our previous discussion of the relation between prices and the de­mand for money, caused by a fact that we shall explore soon in detail, namely, that prices do not change equally and propor­tionately.

     The expectation of falling factor prices speeds up the move­ment toward equilibrium and hence toward the pure interest re­lation as determined by time preference.[24]

     If, for example, unions keep wage rates artificially high, “hoard­ing” will increase as unions keep wage rates ever higher than the equilibrium rate at which “full employment” can be maintained. This induced hoarding lowers the money demand for factors and increases unemployment still further, but only because of wage­-rate rigidity.[25]

     The final Keynesian bogey is that people may acquire an un­limited demand for money, so that hoards will indefinitely in­crease. This is termed an “infinite” liquidity preference. And this is the only case in which neo-Keynesians such as Modigliani be­lieve that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall in the price of securities. Translating this into more important “natural” terms, this would mean, as we have stated, not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consum­ing, whatever their expectations. Of necessity, therefore, the de­mand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding.[26]

     A demand for money to hold stems from the general uncer­tainty of the market. Keynesians, however, attribute liquidity preference, not to general uncertainty, but to the specific uncer­tainty of future bond prices. Surely this is a highly superficial and limiting view.

     In the first place, this cause of liquidity preference could oc­cur only on a highly imperfect securities market. As Lachmann pointed out years ago in a neglected article, Keynes’ causal pat­tern—“bearishness” causing “liquidity preference” (demand for cash) and high interest rates—could take place only in the ab­sence of an organized forward or futures market for securities. If such a market existed, both bears and bulls on the bond mar­ket

could express their expectations by forward transactions which do not require any cash. Where the market for securities is fully organized over time, the owner of 4% bonds who fears a rise in the rate of interest has no incentive to exchange them for cash, for he can always “hedge” by selling them forward.[27]

Bearishness would cause a fall in forward bond prices, followed immediately by a fall in spot prices. Thus, speculative bearish­ness would, of course, cause at least a temporary rise in the rate of interest, but accompanied by no increase in the demand for cash. Hence, any attempted connection between liquidity prefer­ence, or demand for cash, and the rate of interest, falls to the ground.

     The fact that such a securities market has not been organized indicates that traders are not nearly as worried about rising in­terest rates as Keynes believes. If they were and this fear loomed as an important phenomenon, then surely a futures market would have developed in securities.

     Furthermore, as we have seen, interest rates on loans are merely a reflection of price spreads, so that a prediction of higher in­terest rates really means the expectation of lower prices and, es­pecially, lower costs, resulting in a greater demand for money. And all speculation, on the free market, is self-correcting and speeds adjustment, rather than a cause of economic trouble.

G.  The Purchasing-Power and Terms-of-Trade Components in the Rate of Interest

     Many economists, beginning with Irving Fisher, have asserted that the market rate of interest, in addition to containing spe­cific entrepreneurial components superimposed on the pure rate of interest, also contains a “price” or a “purchasing-power com­ponent.” When the purchasing power of money is generally ex­pected to rise, the theory asserts that the market rate of interest falls correspondingly; when the PPM is expected to fall, the the­ory declares that the market rate of interest rises correspondingly.

     These economists erred by concentrating on the loan rate rather than on the natural rate (the rate of return). The reasoning be­hind this theory was as follows: If the purchasing power of money is expected to change, then the pure rate of interest (determined by time preference) will no longer be the same in “real terms.” Suppose that 100 gold ounces exchange for 105 gold ounces a year from now—i.e., that the rate of interest is 5 percent. Now, suddenly, let there be a general expectation that the purchasing power of money will increase. In that case, a lower amount to be returned, say 102 ounces, may yield 5 percent real interest in terms of purchasing power. A general expectation of a rise in purchas­ing power, therefore, will lower the market rate of interest at present, while a general expectation of a fall in purchasing power will raise the rate.[28]

     There is a fatal defect in this generally accepted line of rea­soning. Suppose, for example, that prices are generally expected to fall by 50 percent in the next year. Would someone lend 100 gold ounces to exchange for 53 ounces one year from now? Why not? This would certainly preserve the real interest rate at 5 percent. But then why should the would-be lenders not simply hold on to their money and double their real assets as a result of the price fall? And that is precisely what they would do; they certainly would not give money away, even though their real assets would be greater than before. Fisher simply shrugged off this point by saying that the purchasing-power premium could never make the interest rate negative. But this flaw vitiates the entire theory.

     The root of the difficulty consists in ignoring the natural rate of interest. Let us consider the interest rate in those terms. Then, suppose 100 ounces are paid for factors that will be transformed in one year into a product that sells for 105 gold ounces, for an interest gain of five and an interest return of 5 percent. Now a general expectation arises of a general halving of prices one year from now. The selling price of the product will be 53 ounces in a year’s time. What happens now? Will entrepreneurs buy factors for 100 and sell at 53 merely because their real interest rate is preserved? Certainly not. They will do so only if they do not at all anticipate the change in purchasing power. But to the extent that it is anticipated, they will hold money rather than buy fac­tors. This will immediately lower factor prices to their expected future levels, say from 100 to 50.

     What happens to the loan rate is analytically quite trivial. It is simply a reflection of the natural rate and depends on how the expectations and judgment of the people on the loan market compare with those on the stock and other markets. For the free economy, there is no point in separately analyzing the loan mar­ket. Analysis of the Fisher problem—the relation of the interest rate to price changes—should concentrate on the natural rate of interest. Discussion of the relation between price movements and the (natural) rate of interest should be divided into two parts: first, assuming “neutral money”—that all prices change equally and at the same time—and second, analyzing conditions where factor and product change at different rates. And these changes should first be analyzed without considering that they had been anticipated by people on the market.

     Suppose, first, that all prices change equally and at the same time. Instead of thinking in terms of 100 ounces borrowed on the loan market, let us consider the natural rate. An investor buys factors in period 1 and then sells the product, say in pe­riod 3. Time, as we have seen, is the essence of the production structure. All the processes take time, and capitalists pay money to owners of factors in advance of production and sale. Since fac­tors are bought before products are sold, what is the effect of a period of rising general prices (i.e., falling PPM)? The result is that the entrepreneur reaps an apparent extra profit. Suppose that he normally purchases original factors for 100 and then sells the product for 120 ounces two years later, for an interest return of 10 percent per annum. Now suppose that a decrease in the demand for money or an increase of money stock propels a general up­ward movement in prices and that all prices double in two years’ time. Then, just because of the passage of time, an entrepreneur who purchases factors for 100 now will sell for 240 ounces in two years’ time. Instead of a net return of 20 ounces, or 10 percent per annum, he reaps 140 ounces, or 70 percent per annum.

     It would seem that a rise in prices creates an inherent tend­ency for large-scale profits that are not simply individual rewards for more accurate forecasting. However, more careful analysis re­veals that this is not an extra profit at all. For the 240 ounces two years from now is roughly equivalent, in terms of purchas­ing power, to 120 ounces now. The real rate of net return, based on money’s services, is the same 10 percent as it has always been. It is clear that any lower net return would amount to a decline in real return. A return of a mere 120 ounces, for example, would amount to a drastic negative real return, for 100 ounces would then be invested for the equivalent gross return of only 60 ounces. It has often been shown that a period of rising prices misleads businessmen into thinking that their increased money profits are also real gains, whereas they only maintain real rates of return. Consider, for example, “replacement costs”—the prices which the businessmen will now have to pay for factors. The capitalist who earns 240 ounces on a 100-ounce investment neglects to his sor­row the fact that his factor bundle now costs 200 ounces instead of 100. Businessmen who under such circumstances treat their monetary profits as real profits and consume them soon find that they are really consuming their capital.

     The converse occurs in the case of falling prices. The capi­talist buys factors in period 1 and sells the product in period 3, when all-around prices are lower. If prices are to fall by a half in two years, an investment of 100, followed by a sale at 60, does not really involve the terrific loss that it appears to be. For the 60 return is equivalent in real terms, both in general­ized purchasing power and in replacement of factors, to 120 pre­vious ounces. His real rate of return remains the same. The con­sequence is that businessmen will be likely to overstate their losses in a period of price contraction. Perhaps this is one of the major reasons for the deep-seated belief of most businessmen that they always gain during a general price expansion and lose dur­ing a period of general contraction. This belief is purely illusory.

     In these examples, the natural interest rate on the market has contained a purchasing-power component, which corrects for real rates, positively in money terms during a general expansion, and negatively during a general contraction. The loan rate will be simply a reflection of what has been happening in the natural rate. So far, the discussion is similar to Fisher’s, except that these are the effects of actual, not anticipated, changes and the Fisher thesis cannot take account of the negative interest rate case. We have seen that rather than take a monetary loss, even though their real return will be the same, entrepreneurs will hold back their purchases of factors until factor prices fall immediately to their future low level. But this process of anticipatory price movement does not occur only in the extreme case of a prospective “nega­tive” return. It happens whenever a price change is anticipated. Thus, suppose all entrepreneurs generally anticipate that prices will double in two years. The fact of an anticipated rise will lead to an increase in the price level now and an approach immedi­ately toward a doubled price level. An anticipated fall will lead to an immediate fall in factor prices. If all changes were antici­pated by everyone, there would be no room for a purchasing-power component to develop. Prices would simply fall immedi­ately to their future level.

     The purchasing-power component, then, is not the reflection, as has been thought, of expectations of changes in purchasing power. It is the reflection of the change itself; indeed, if the change were completely anticipated, the purchasing power would change immediately, and there would be no room for a purchas­ing-power component in the rate of interest. As it is, partial an­ticipations speed up the adjustment of the PPM to the changed conditions.

     So far we have distinguished three components of the natural rate of interest (all reflected in the loan rate of interest). One is the pure rate of interest—the result of individual time prefer­ences, tending to be uniform throughout the economy. Second are the specific entrepreneurial rates of interest. These differ from firm to firm and so are not uniform. They are anticipated in ad­vance, and they are the rates that an investor will have to antici­pate receiving before he enters the field. A particularly “risky” venture, if successful at all, will therefore tend to earn more in net return than what is generally anticipated to be a “safe” ven­ture. The third component of the natural rate of interest is the purchasing-power component, correcting for general PPM changes because of the inevitable time lags in production. This will be positive in an expansion and negative in a contraction, but will be ephemeral. The more that changes in the PPM are anticipated, the less important will be the purchasing-power component and the more rapid will be the adjustment in the PPM itself.

     There is still a fourth component in the natural rate of in­terest. This exists to the extent that money changes are not neu­tral (and they never are). Sometimes product prices rise and fall faster than factor prices, sometimes they rise and fall more slowly, and sometimes their behavior is mixed, with some factor prices and some product prices rising more rapidly. Whenever there is a general divergence in rates of movement between the prices of the product and of original factors, a terms-of-trade component emerges in the natural rate of interest.

     Historically, it has often been the case that product prices rise more rapidly and fall more rapidly than the prices of original factors. In the former case, there is, during the period of transi­tion, a favorable change in the terms of trade to the general run of capitalists. For selling prices are increasing faster than the buy­ing prices of original factors. This will increase the general rate of return and constitute a general positive terms-of-trade com­ponent in the natural rate of interest. This, of course, will also tend to be reflected in the loan rate of interest. In the case of a contraction, a more sluggish fall in the prices of factors creates a general negative terms-of-trade component in the interest rate. The components are precisely the reverse whenever factor prices change more rapidly than product prices. Whenever there is no general change in the “terms of trade” to capitalist-entrepreneurs, no terms-of-trade component will appear in the interest rate.

     Changes in terms of trade discussed here are only those result­ing purely from differences in the speed of reaction to changing conditions. They do not include basic changes in the terms of trade resulting from changes in time preferences, such as we have discussed above.

     It is clear that all the interest-rate components aside from the pure rate—entrepreneurial, purchasing power, and terms of trade—are “dynamic” and the result of uncertainty. None of these com­ponents would exist in the ERE, and therefore the market in­terest rate in the ERE would equal the pure rate determined by time preferences alone. In the ERE the only net incomes would be a uniform pure interest return and wages to labor (ground land rents being capitalized into an interest return).

[11] See the excellent article by W.H. Hutt, “The Significance of Price Flexi­bility” in Hazlitt, Critics of Keynseian Economics, pp. 383–406.

[12]The term generally used is “national” income. However, in a free-market economy the nation will no more be an important economic boundary than the village or region. It is more convenient, then, to set aside re­gional problems for other analysis and to concentrate on aggregate social income; this is especially true since regions do not present a problem to economic theory until their governments begin intervening in the free market.

[13]Thus, see the revealing article by Franco Modigliani, “Liquidity Prefer­ence and the Theory of Interest and Money” in Hazlitt, Critics of Keynesian Economics, pp. 156–69. Also see the articles by Erik Lindahl, “On Keynes’ Economic System—Part I,” The Economic Record, May, 1954, pp. 19–32; November, 1954, pp. 159–71; and Wassily W. Leontief, “Postulates: Keynes’ General Theory and the Classicists” in S. Harris, ed., The New Economics (New York: Knopf, 1952), pp. 232–42. For an empirical critique of the assumed Keynesian correspondence between aggregate output and employment, see George W. Wilson, “The Relationship between Output and Employment,” Review of Economics and Statistics,  February, 1960, pp. 37–43.

[14]This is what Keynes’ discussion of “wage units” amounted to. Cf. Lindahl, “On Keynes’ Economic System—Part I,” p. 20.

[15]Cf. Lindahl, “On Keynes’ Economic System—Part I,” pp. 25, 159ff. Lindahl’s articles provide a good summary as well as a critique of the Keynesian system.

[16]Furthermore, inflation is, at best, an inefficient and distortive substitute for flexible wage rates. For inflation affects the entire economy and its prices, while particular wage rates will fall only to the extent necessary to “clear” the market for the particular labor factor. Thus, freely flexible wage rates will fall only in those fields necessary to eliminate unemployment in those particular areas. Cf. Henry Hazlitt, The Failure of the “New Economics” (Princeton, N.J.: D. Van Nostrand, 1959), pp. 278ff.

[17]Cf. L. Albert Hahn, The Economics of Illusion (New York: Squier Publishing Co., 1949), pp. 50ff., 166ff., and passim.

[18]Cf. Hutt, “Significance of Price Flexibility.”

[19]Cf. Lindahl’s critique of Lawrence Klein’s The Keynesian Revolution in “On Keynes’ Economic System—Part I,” p. 162. Also see Leontief, “Postulates: Keynes’ General Theory and the Classicists.”

[20]Modigliani, “Liquidity Preference and the Theory of Interest and Money,” pp. 139–40.

[21]Ibid., p. 137.

[22]See the critique of the Keynesian doctrine by Tjardus Greidanus, The Value of Money (2nd ed.; London: Staples Press, 1950), pp. 194–215, and of the liquidity-preference theory by D.H. Robertson, “Mr. Keynes and the Rate of Interest” in Readings in the Theory of Income Distribution, pp. 439–41. In contrast to Keynes’ famous phrase that the rate of interest is “the reward for parting with liquidity,” Greidanus points out that buying consumers’ goods (or even producers’ goods in Keynes’ sense of “interest”) sacrifices liquidity and yet earns no interest “reward.” Greidanus, Value of Money, p. 211. Also see Hazlitt, Failure of the “New Economics,” pp. 186ff.

[23]Mises, Human Action, pp. 529–30.

[24]Hutt concludes that equilibrium

is secured when all services and prod­ucts are so priced that they are (i) brought within the reach of people’s pockets (i.e., so that they are purchasable by existing money incomes) or (ii) brought into such a relation to predicted prices that no postpone­ment of expenditure on them is induced. For instance, the products and services used in the manufacture of investment goods must be so priced that anticipated future money incomes will be able to buy the services and depreciation of new equipment or replacement. (Hutt, “Significance of Price Flexibility,” p. 394)

[25]“Postponements (in purchases) arise because it is judged that a cut in costs (or other prices) is less than will eventually have to take place, or because the rate of fall of costs is insufficiently rapid.” Ibid., p. 395.

[26]As Hutt points out, if we can conceive of a situation of infinitely elastic liquidity preference (and no such situation has ever existed), then “we can conceive of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of re­sources persisting all the way.” Ibid., p. 398.

[27]L.M. Lachmann, “Uncertainty and Liquidity Preference,” Economica, August, 1937, p. 301.

[28]Irving Fisher, The Rate of Interest (New York, 1907), chap. v, xiv; idem, Purchasing Power of Money, pp. 56–59.

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