Chapter 11—Money and Its Purchasing Power
(continued)
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Chapter 11—Money
and Its Purchasing Power (continued)
15.
Business Fluctuations
In the real world, there will be continual changes in the pattern of
economic activity, changes resulting from shifts in the tastes and
demands of consumers, in resources available, technological knowledge,
etc. That prices and outputs fluctuate, therefore, is to be expected,
and absence of fluctuation would be unusual. Particular prices and
outputs will change under the impact of shifts in demand and production
conditions; the general level of production will change
according to individual time preferences. Prices will all tend to move
in the same direction, instead of shifting in different directions for
different goods, whenever there is a change in the money relation. Only
a change in the supply of or demand for money will transmit its
impulses throughout the entire monetary economy and impel prices in a
similar direction, albeit at varying rates of speed. General price
fluctuations can be understood only by analyzing the money
relation.
Yet simple fluctuations and changes do not suffice to explain that
terrible phenomenon so marked in the last century and a
half—the “business cycle.” The business
cycle has had certain definite features which reveal themselves time
and again. First, there is a boom period, when prices and productive
activity expand. There is a greater boom in the heavy
capital-goods and higher-order industries—such as industrial
raw materials, machine goods, and construction, and in the
markets for titles to these goods, such as the stock market and real
estate. Then, suddenly, without warning, there is a
“crash.” A financial panic with runs on banks
ensues, prices fall very sharply, and there is a sudden piling up of
unsold inventory, and particularly a revelation of great
excess capacity in the higher-order capital-goods industries. A painful
period of liquidation and bankruptcy follows, accompanied by
heavy unemployment, until recovery to normal conditions gradually takes
place.
This is the empirical pattern of the modern business cycle. Historical
events can be explained by laws of praxeology, which isolate causal
connections. Some of these events can be explained by laws that we have
learned: a general price rise could result from an increase in the
supply of money or from a fall in demand, unemployment from insistence
on maintaining wage rates that have suddenly increased in real value, a
reduction in unemployment from a fall in real wage rates, etc.
But one thing cannot be explained by any economics of the free market.
And this is the crucial phenomenon of the crisis: Why is
there a sudden revelation of business error? Suddenly, all or
nearly all businessmen find that their investments and
estimates have been in error, that they cannot sell their products for
the prices which they had anticipated. This is the central problem of
the business cycle, and this is the problem which any adequate theory
of the cycle must explain.
No businessman in the real world is equipped with perfect foresight;
all make errors. But the free-market process precisely rewards those
businessmen who are equipped to make a minimum number of errors. Why
should there suddenly be a cluster of errors? Furthermore, why should
these errors particularly pervade the capital-goods industries?
Sometimes sharp changes, such as a sudden burst of hoarding or a sudden
raising of time preferences and hence a decrease in saving, may arrive
unanticipated, with a resulting crisis of error. But since the
eighteenth century there has been an almost regular pattern of
consistent clusters of error which always follow a boom and expansion
of money and prices. In the Middle Ages and down to the seventeenth and
eighteenth centuries, business crises rarely followed upon booms in
this manner. They took place suddenly, in the midst of normal activity,
and as the result of some obvious and identifiable external event.
Thus, Scott lists crises in sixteenth- and early seventeenth-century
England as irregular and caused by some obvious event: famine,
plague, seizures of goods in war, bad harvest, crises in the
cloth trade as a result of royal manipulations, seizure of bullion by
the King, etc.But in the late seventeenth,
eighteenth and nineteenth centuries, there developed the
aforementioned pattern of the business cycle, and it became
obvious that the crisis and ensuing depression could no longer
be attributed to some single external event or single act of government.
Since no one event could account for the crisis and depression,
observers began to theorize that there must be some deep-seated defect within
the free-market economy that causes these crises and cycles. The blame
must rest with the “capitalist system”
itself. Many ingenious theories have been put forward to
explain the business cycle as an outgrowth of the free-market economy,
but none of them has been able to explain the crucial point: the
cluster of errors after a boom. In fact, such an explanation can never
be found, since no such cluster could appear on the free market.
The nearest attempt at an explanation stressed general swings of
“overoptimism” and
“overpessimism” in the business community.
But put in such fashion, the theory looks very much like a deus
ex machina. Why should hardheaded businessmen, schooled in
trying to maximize their profits, suddenly fall victim to such
psychological swings? In fact, the crisis brings bankruptcies
regardless of the emotional state of particular entrepreneurs.
We shall see in chapter 12 that feelings of optimism do
play a role, but they are induced by certain
objective economic conditions. We must search for the objective reasons
that cause businessmen to become “overoptimistic.”
And they cannot be found on the free market.
The positive explanation
of the business cycle, therefore, will have to be postponed to the next
chapter.
16.
Schumpeter’s Theory of Business Cycles
Joseph Schumpeter’s business cycle theory is one of the very
few that attempts to integrate an explanation of the business cycle
with an analysis of the entire economic system. The theory was
presented in essence in his Theory of Economic Development,
published in 1912. This analysis formed the basis for the
“first approximation” of his more elaborate
doctrine, presented in the two-volume Business Cycles,
published in 1939.
The latter
volume, however, was a distinct retrogression from the former,
for it attempted to explain the business cycle by postulating three
superimposed cycles (each of which was explainable according to his
“first approximation”). Each of these cycles is
supposed to be roughly periodic in length. They are alleged by
Schumpeter to be the three-year “Kitchin” cycle;
the nine-year “Juglar”; and the very long (50-year)
“Kondratieff.” These cycles are conceived as
independent entities, combining in various ways to yield the aggregate
cyclical pattern.
Any such
“multicyclic” approach must be set down as a
mystical adoption of the fallacy of conceptual realism. There is no
reality or meaning to the allegedly independent sets of
“cycles.” The market is one interdependent unit,
and the more developed it is, the greater the interrelations among
market elements. It is therefore impossible for several or
numerous independent cycles to coexist as self-contained
units. It is precisely the characteristic of a business cycle
that it permeates all market activities.
Many theorists have assumed the existence of periodic
cycles, where the length of each successive cycle is uniform, even down
to the precise number of months. The quest for periodicity is a
chimerical hankering after the laws of physics; in human action there
are no quantitative constants. Praxeological laws can be only
qualitative in nature. Therefore, there will be no periodicity
in the length of business cycles.
It is best, then, to discard Schumpeter’s multicyclical
schema entirely and to consider his more interesting one-cycle
“approximation” (as presented in his
earlier book), which he attempts to derive from his general economic
analysis. Schumpeter begins his study with the economy in a state of
“circular flow” equilibrium, i.e., what amounts to
a picture of an evenly rotating economy. This is proper, since it is
only by hypothetically investigating the disturbances of an imaginary
state of equilibrium that we can mentally isolate the causal factors of
the business cycle. First, Schumpeter describes the ERE, where all
anticipations are fulfilled, every individual and economic
element is in equilibrium, profits and losses are zero—all
based on given values and resources. Then, asks Schumpeter, what can
impel changes in this setup? First, there are possible changes in
consumer tastes and demands. This is cavalierly dismissed by Schumpeter
as unimportant.There are possible changes in
population and therefore in the labor supply; but these are gradual,
and entrepreneurs can readily adapt to them. Third, there can
be new saving and investment. Wisely, Schumpeter sees that
changes in saving-investment rates imply no business cycle; new saving
will cause continuous growth. Sudden changes in the rate of saving,
when unanticipated by the market, can cause
dislocations, of course, as may any
sudden, unanticipated change. But there is nothing cyclic
or mysterious about these effects. Instead of concluding from
this survey, as he should have done, that there can
be no business cycle on the free market, Schumpeter turned to
a fourth element, which for him was the generator of all growth as well
as of business cycles—innovation
in productive techniques.
We have seen above that innovations cannot be considered the prime
mover of the economy, since innovations can work their effects only through
saving and investment and since there are always a great many
investments that could improve techniques within
the corpus of existing knowledge, but which are not made for lack of
adequate savings. This consideration alone is enough to invalidate
Schumpeter’s business-cycle theory.
A further consideration is that Schumpeter’s own theory
relies specifically for the financing of innovations on newly expanded
bank credit, on new money issued by the banks. Without delving
into Schumpeter’s theory of bank credit and its consequences,
it is clear that Schumpeter assumes a hampered market, for we have seen
that there could not be any monetary credit expansion on a
free market. Schumpeter therefore cannot establish a business-cycle
theory for a purely unhampered market.
Finally, Schumpeter’s explanation of innovations as the
trigger for the business cycle necessarily assumes that there is a
recurrent cluster of innovations that takes place
in each boom period. Why should there be such a cluster of innovations?
Why are innovations not more or less continuous, as we would
expect? Schumpeter cannot answer this question satisfactorily.
The fact that a bold few begin innovating and that they are followed by
imitators does not yield a cluster, for this process could be
continuous, with new innovators arriving on the scene. Schumpeter
offers two explanations for the slackening of innovatory activity
toward the end of the boom (a slackening essential to his theory). On
the one hand, the release of new products yielded by the new
investments creates difficulties for old producers and leads
to a period of uncertainty and need for “rest.” In
contrast, in equilibrium periods, the risk of failure and uncertainty
is less than in other periods. But here Schumpeter mistakes the
auxiliary construction of the ERE for the real world. There is never
in existence any actual period of certainty; all periods are
uncertain, and there is no reason why increased production
should cause more uncertainty to develop or any vague needs
for rest. Entrepreneurs are always seeking profit-making opportunities,
and there is no reason for any periods of
“waiting” or of “gathering the
harvest” to develop suddenly in the economic system.
Schumpeter’s second explanation is that innovations cluster
in only one or a few industries and that these innovation
opportunities are therefore limited. After a while they become
exhausted, and the cluster of innovations ceases. This is
obviously related to the Hansen stagnation thesis, in the sense that
there are alleged to be a certain limited number of
“investment opportunities”—here
innovation opportunities—at any time, and that once these are
exhausted there is temporarily no further room for investments or
innovations. The whole concept of
“opportunity” in this connection, however,
is meaningless. There is no limit on “opportunity”
as long as wants remain unfulfilled. The only other limit on investment
or innovation is saved capital available to embark on the projects. But
this has nothing to do with vaguely available opportunities which
become “exhausted”; the existence of saved capital
is a continuing factor. As for innovations, there is no reason
why innovations cannot be continuous or take place in many
industries, or why the innovatory pace has to slacken.
As Kuznets has shown, a cluster of innovation must assume a cluster of
entrepreneurial ability as well, and this is clearly
unwarranted. Clemence and Doody, Schumpeterian disciples,
countered that entrepreneurial ability is
exhausted in the act of founding a new firm.
But to view
entrepreneurship as simply the founding of new firms is completely
invalid. Entrepreneurship is not just the founding of new firms, it is
not merely innovation; it is adjustment: adjustment
to the uncertain, changing conditions of the future.
This adjustment takes
place, perforce, all the time and is not exhausted in any single act of
investment.
We must conclude that Schumpeter’s praiseworthy attempt to
derive a business cycle theory from general economic analysis is a
failure. Schumpeter almost hit on the right explanation when he stated
that the only other explanation that could be found for the business
cycle would be a cluster of errors by
entrepreneurs, and he saw no reason, no objective cause, why
there should be such a cluster of errors. That is perfectly
true—for the free, unhampered market!
17.
Further Fallacies of the Keynesian System
In the text above, we saw that even if the Keynesian functions
were correct and social expenditures fell below income above a certain
point and vice versa, this would have no
unfortunate consequences for the economy. The level of
national money income, and consequently of hoarding, is an imaginary
bogey. In this section, we shall pursue our analysis of the
Keynesian system and demonstrate further grave fallacies
within the system itself. In other words, we shall see that
the consumption function and investment are not ultimate
determinants of social income (whereas above we demonstrated
that it makes no particular difference if they are or not).
A.
Interest and Investment
Investment, though the dynamic and volatile factor in the Keynesian
system, is also the Keynesian stepchild. Keynesians have differed on
the causal determinants of investment. Originally, Keynes
determined it by the interest rate as compared with the marginal
efficiency of capital, or prospect for net return. The interest rate is
supposed to be determined by the money relation; we have seen
that this idea is fallacious. Actually, the equilibrium net
rate of return is the interest rate, the natural
rate to which the bond rate conforms. Rather than changes in the
interest rate causing changes in investment, as we
have seen before, changes in time preference are reflected in
changes in consumption-investment decisions. Changes in the
interest rate and in investment are two sides of a coin, both
determined by individual valuations and time preferences.
The error of calling the interest rate the cause of investment changes,
and itself determined by the money relation, is also adopted by such
“critics” of the Keynesian system as Pigou, who
asserts that falling prices will release enough cash to lower the
interest rate, stimulate investment, and thus finally restore full
employment.
Modern Keynesians have tended to abandon the intricacies of the
relation between interest and investment and simply declare themselves
agnostic on the factors determining investment. They rest their case on
an alleged determination of consumption.
B.
The “Consumption Function”
If Keynesians are unsure about investment, they have, until very
recently, been very emphatic about consumption. Investment is a
volatile, uncertain expenditure. Aggregate consumption, on the other
hand, is a passive, stable “function” of
immediately previous social income. Total net expenditures determining
and equaling total net income in a period (gross expenditures between
stages of production are unfortunately removed from
discussion) consist of investment and consumption.
Furthermore, consumption always behaves so that below a certain income
level consumption will be higher than income, and above that level
consumption will be lower. Figure 82 depicts the relations among
consumption, investment, expenditure, and social income.
The relation between income and expenditure is the same as shown in
Figure 78. Now we see why the Keynesians assume the expenditure curve
to have a smaller slope than income. Consumption
is supposed to have the identical slope as expenditures; for investment
is unrelated to income, as the determinants are unknown. Hence,
investment is depicted as having no functional relation to income and
is represented as a constant gap between the expenditure and
consumption lines.
The stability of the passive consumption function, as contrasted with
the volatility of active investment, is a keystone of the Keynesian
system. This assumption is replete with so many grave errors that it is
necessary to take them up one at a time.
(a) How do the Keynesians justify the assumption of
a stable consumption function with the shape as shown above? One route
was through “budget
studies”—cross-sectional studies of the
relation between family income and expenditure by income
groups in a given year. Budget studies such as that of the National
Resources Committee in the mid-1930’s yielded
similar “consumption functions” with
dishoardings increasing below a certain point, and hoardings above it
(i.e., income below expenditures below a certain point, and
expenditures below income above it).
This is supposed to intimate that those doing the
“dissaving,” i.e., the dishoarding, are poor people
below the subsistence level who incur deficits by borrowing. But how
long is this supposed to go on? How can there be a continuous deficit?
Who would continue to lend these people the money? It is more
reasonable to suppose that the dishoarders are decumulating
their previously accumulated capital, i.e., that they are wealthy
people whose businesses suffered losses during that year.
(b) Aside from the fact that budget studies are
misinterpreted, there are graver fallacies involved. For the curve
given by the budget study has no relation whatever to the Keynesian
consumption function! The former, at best, gives a cross
section of the relation between classes of family
expenditure and income for one year; the Keynesian consumption function
attempts to establish a relation between total
social income and total social consumption for any
given year, holding true over a hypothetical range of social incomes.
At best, one entire budget curve can be summed up to yield only one
point on the Keynesian consumption function. Budget
studies, therefore, can in no way confirm the Keynesian assumptions.
(c) Another very popular device to confirm the
consumption function reached the peak of its popularity during World
War II. This was historical-statistical correlation of national income
and consumption for a definite period of time, usually the
1930’s. This correlation equation was then assumed to be the
“stable” consumption function. Errors in this
procedure were numerous. In the first place, even assuming such a
stable relation, it would only be an historical
conclusion, not a theoretical law. In physics, an
experimentally determined law may be assumed to be constant
for other identical situations; in human action, historical situations
are never the same, and therefore there are no quantitative
constants! Conditions and valuations could change at any time, and the
“stable” relationship altered. There is here no
proof of a stable consumption function. The dismal record of forecasts
(such as those of postwar unemployment) made on this assumption should
not have been surprising.
Moreover, a stable relation was not even established. Income was
correlated with consumption and with investment. Since
consumption is a much larger magnitude than (net) investment,
no wonder that its percentage deviations around the
regression equation were smaller! Furthermore, income is here
being correlated with 80–90 percent of itself;
naturally, the “stability” is tremendous. If income
were correlated with saving, of similar magnitude
as investment, there would be no greater stability in the
income-saving function than in the
“income-investment function.”
Thirdly, the consumption function is necessarily an ex ante
relation; it is supposed to tell how much consumers will
decide to spend given a certain total income. Historical statistics, on
the other hand, record only ex post data, which
give a completely different story. For any given period of
time, for example, hoarding and dishoarding cannot
be recorded ex post. In fact, ex post,
on double-entry accounting records, total social income is always equal
to total social expenditures. Yet, in the dynamic, ex ante,
sense, it is precisely the divergence between total
social income and total social expenditures (hoarding or dishoarding)
that plays the crucial role in the Keynesian theory. But these
divergences can never be revealed, as Keynesians believe, by study of ex
post data. Ex post, in fact, saving
always equals investment, and social expenditure always equals
social income, so that the ex post expenditure line
coincides with the income line.
(d) Actually, the whole idea of stable consumption
functions has now been discredited, although many Keynesians do not
fully realize this fact.
In fact, Keynesians
themselves have admitted that, in the long run, the
consumption function is not stable, since total consumption rises as
income rises; and that in the short run it is not
stable, since it is affected by all sorts of changing factors.
But if it is not stable in the short run and not stable in the long
run, what kind of stability does it have? Of what use is it? We have
seen that the only really important runs are the immediate and
the long-run, which shows the direction in which the immediate is
tending. There is no use for some sort of separate
“intermediate” situation.
(e) it is instructive to turn now to the reasons
that Keynes himself, in contrast to his followers, gave for
assuming his stable consumption function. It is a confused
exposition indeed.The “propensity
to consume” out of given income, according to Keynes, is
determined by two sets of factors, “objective” and
“subjective.” It seems clear, however, that these
are purely subjective decisions, so that there can
be no separate objective determinants. In
classifying subjective factors, Keynes makes the mistake of
subsuming hoarding and investing motivations under categories of
separate “causes”: precaution, foresight,
improvement, etc. Actually, as we have seen, the demand for money is
ultimately determined by each individual for all sorts of reasons, but
all tied up with uncertainty; motives for investment are to
maintain and increase future standards of living. By a sleight of hand
completely unsupported by facts or argument Keynes simply
assumes all these subjective factors to be given in the short run,
although he admits that they will change in the long run. (If
they change in the long run, how can his system yield an equilibrium
position?) He simply reduces the subjective motives to current economic
organization, customs, standards of living, etc., and assumes
them to be given.
The “objective
factors” (which in reality are subjective, such as
time-preference changes, expectations, etc.) can admittedly cause
short-run changes in the consumption function (such as windfall changes
in capital values). Expectations of future changes in income
can affect an individual’s consumption, but Keynes simply
asserts without discussion that this factor “is likely to
average out for the community as a whole.” Time
preferences are discussed in a very confused way, with
interest rate and time preference assumed to be apart from and
influencing the propensity to consume. Here again, short-run
fluctuations are assumed to have little effect, and Keynes simply leaps
to the conclusion that the propensity to consume is, in the
short run, a “fairly” stable function.
(f) The failure of the consumption-function theory
is not only the failure of a specific theory. It is a profound
epistemological failure as well. For the concept of a consumption
function has no place in economics at all. Economics is praxeological,
i.e., its propositions are absolutely true given the existence of the
axioms—the basic axiom being the existence of human action
itself. Economics, therefore, is not and cannot be
“empirical” in the positivist sense, i.e., it
cannot establish some sort of empirical hypothesis which could or could
not be true, and at best is only true approximately. Quantitative,
empirico-historical “laws” are worthless in
economics, since they may only be coincidences of complex facts, and
not isolable, repeatable laws which will hold true in the future. The
idea of the consumption function is not only wrong on many counts; it
is irrelevant to economics.
Furthermore, the very term “function” is
inappropriate in a study of human action. Function implies a
quantitative, determined relationship, whereas no such
quantitative determinism exists. People act and can change their
actions at any time; no causal, constant, external determinants of
action can exist. The term “function” is
appropriate only to the unmotivated, repeatable motion of
inorganic matter.
In conclusion, there is no reason whatever to assume that at some
point, expenditures will be below income, while at lower points it will
be above income. Economics does not and cannot know
what ex ante expenditure will ever be in relation
to income; at any point, it could be equal, or there could be
net hoarding or dishoarding. The ultimate decisions are made
by the individuals and are not determinable by science. There
is, therefore, no stable expenditure function whatever.
C.
The Multiplier
The once highly esteemed “multiplier” has now
happily faded in popularity, as economists have begun to realize that
it is simply the obverse of the stable consumption function.
However, the complete absurdity of the multiplier has not yet
been fully appreciated. The theory of the “investment
multiplier” runs somewhat as follows:
Social Income = Consumption +
Investment
Consumption is a stable function of income, as revealed by statistical
correlation, etc. Let us say, for the sake of simplicity, that
Consumption will always be .80 (Income).
In that case,
Income
= .80 (Income) + Investment.
.20 (Income) = Investment; or
Income = 5 (Investment).
The “5” is the “investment
multiplier.” It is then obvious that all we need to increase
social money income by a desired amount is to increase investment by 1/5
of that amount; and the multiplier magic will do the rest. The
early “pump primers” believed in approaching this
goal through stimulating private investment; later Keynesians realized
that if investment is an “active” volatile
factor, government spending is no less active and more
certain, so that government spending must be relied upon to
provide the needed multiplier effect. Creating new money would
be most effective, since the government would then be sure not to
reduce private funds. Hence the basis for calling all government
spending “investment”: it is
“investment” because it is not tied passively to
income.
The following is offered as a far more potent
“multiplier,” on Keynesian grounds even more potent
and effective than the investment multiplier, and on
Keynesian grounds there can be no objection to it. It is a reductio
ad absurdum, but it is not simply a parody, for it
is in keeping with the Keynesian method.
Social Income = Income of (insert name of any person, say the reader) +
Income of everyone else.
Let us use symbols:
Social
income = Y
Income of the Reader = R
Income of everyone else = V
We find that V is a completely stable function of Y.
Plot the two on coordinates, and we find historical one-to-one
correspondence between them. It is a tremendously stable
function, far more stable than the “consumption
function.” On the other hand, plot R
against Y. Here we find, instead of perfect
correlation, only the remotest of connections between the fluctuating
income of the reader of these lines and the social income. Therefore,
this reader’s income is the active, volatile, uncertain
element in the social income, while everyone else’s income is
passive, stable, determined by the social income.
Let us say the equation arrived at is:
V = .99999 Y
Then, Y = .99999 Y + R
.00001 Y = R
Y = 100,000 R
This is the reader’s own personal multiplier, a far more
powerful one than the investment multiplier. To increase
social income and thereby cure depression and unemployment, it
is only necessary for the government to print a certain number of
dollars and give them to the reader of these lines. The
reader’s spending will prime the pump of a 100,000-fold
increase in the national income.
18.
The Fallacy of the Acceleration Principle
The “acceleration principle” has been adopted by
some Keynesians as their explanation of investment, then to be
combined with the “multiplier” to yield
various mathematical “models” of the
business cycle. The acceleration principle antedates Keynesianism,
however, and may be considered on its own merits. It is almost always
used to explain the behavior of investment in the business cycle.
The essence of the acceleration principle may be summed up in the
following illustration:
Let us take a certain firm or industry, preferably a first-rank
producer of consumers’ goods. Assume that the firm
is producing an output of 100 units of a good during a certain period
of time and that 10 machines of a certain type are needed in this
production. If the period is a year, consumers demand and
purchase 100 units of output per year. The firm has a stock of 10
machines. Suppose that the average life of a machine is 10
years. In equilibrium, the firm buys one machine as replacement every
year (assuming it had bought a new machine every year to build up to
10).
Now suppose that there is
a 20-percent increase in the consumer demand for the
firm’s output. Consumers now wish to purchase 120 units of
output. Assuming a fixed ratio of capital investment to output, it is
now necessary for the firm to have 12 machines (maintaining the ratio
of one machine: 10 units of annual output). In order to have
the 12 machines, it must buy two additional machines this year. Add
this demand to its usual demand of one machine, and we see
that there has been a 200-percent increase in demand for the
machine. A 20-percent increase in demand for the product has caused a
200-percent increase in demand for the capital good. Hence,
say the proponents of the acceleration principle, an increase
in consumption demand in general causes an
enormously magnified increase in demand for capital goods. Or rather,
it causes a magnified increase in demand for
“fixed” capital goods, of high durability.
Obviously, capital goods lasting only one year would receive no
magnification effect. The essence of the acceleration principle is the
relationship between the increased demand and the low level of
replacement demand for a durable good. The more durable the good, the
greater the magnification and the greater, therefore, the acceleration
effect.
Now suppose that, in the next year, consumer demand for output
remains at 120 units. There has been no change in consumer demand from
the second year (when it changed from 100 to 120) to the third year.
And yet, the accelerationists point out, dire things are happening in
the demand for fixed capital. For now there is no longer any need for
firms to purchase any new machines beyond what is necessary
for replacement. Needed for replacement is still only one
machine per year. As a result, while there is zero change in demand for
consumers’ goods, there is a 200-percent decline
in demand for fixed capital. And the former is the cause of the latter.
In the long run, of course, the situation stabilizes into an
equilibrium with 120 units of output and one unit of replacement. But
in the short run there has been consequent upon a simple
increase of 20 percent in consumer demand, first a 200-percent increase
in the demand for fixed capital, and next a 200-percent decrease.
To the upholders of the acceleration principle, this illustration
provides the key to some of the main features of the business cycle:
the greater fluctuations of fixed capital-goods industries as compared
with consumers’ goods, and the mass of errors revealed by the
crisis in the investment goods industries. The acceleration
principle leaps boldly from the example of a single firm to a
discussion of aggregate consumption and aggregate investment. Everyone
knows, the advocates say, that consumption increases in a boom. This
increase in consumption accelerates and magnifies increases in
investment. Then, the rate of increase of consumption slows
down, and a decline is brought about in investment in fixed capital.
Furthermore, if consumption demand declines, then there is
“excess capacity” in fixed
capital—another feature of the depression.
The acceleration principle is rife with error. An important
fallacy at the heart of the principle has been uncovered by
Professor Hutt.
We have seen that consumer
demand increases by 20 percent; but why must two extra machines be
purchased in a year? What does the year
have to do with it? If we analyze the matter closely, we find that the
year is a purely arbitrary and irrelevant unit even within the terms of
the example itself. We might just as readily take a week
as the period of time. Then we would have to say that consumer demand
(which, after all, goes on continuously) increases 20 percent
over the first week, thereby necessitating a 200-percent increase in
demand for machines in the first week (or even an infinite
increase if the replacement does not precisely occur in the first
week), followed by a 200-percent (or infinite) decline in the next
week, and stability thereafter. A week is never used by the
accelerationists because the example would then be glaringly
inapplicable to real life, which does not see such enormous
fluctuations in the course of a couple of weeks. But
a week is no more arbitrary than a year. In fact, the only nonarbitrary
period to choose would be the life of the machine (e.g., 10 years).
Over a ten-year period, demand for machines had
previously been ten (in the previous decade), and in the current and
succeeding decades it will be 10 plus the extra two, i.e., 12.
In short, over the 10-year period the demand for machines will
increase precisely in the same proportion as the
demand for consumers’ goods—and there is no
magnification effect whatever.
Since businesses buy and produce over planned periods covering
the life of their equipment, there is no reason to assume that the
market will not plan production suitably and smoothly, without
the erratic fluctuations manufactured by the model of the acceleration
principle. There is, in fact, no validity in saying that increased
consumption requires increased production of
machines immediately; on the contrary, it is only increased
saving and investment in machines, at points of time chosen by
entrepreneurs strictly on the basis of expected profit, that permits
increased production of consumers’ goods in the
future.
Secondly, the acceleration principle makes a completely
unjustified leap from the single firm or industry to the whole
economy. A 20-percent increase in consumption demand at one
point must signify a 20-percent drop in consumption somewhere else. For
how can consumption demand in general increase? Consumption demand in
general can increase only through a shift from saving. But if saving
decreases, then there are less funds available for investment.
If there are less funds available for investment,
how can investment increase even more than
consumption? In fact, there are less funds
available for investment when consumption increases.
Consumption and investment compete for the use of funds.
Another important consideration is that the proof of the
acceleration principle is couched in physical
rather than monetary terms. Actually, consumption
demand, particularly aggregate consumption
demand, as well as demand for capital goods, cannot be expressed in
physical terms; it must be expressed in monetary terms, since
the demand for goods is the reverse of the supply
of money on the market for exchange. If consumer demand increases
either for one good or for all, it increases in monetary terms, thereby
raising prices of consumers’ goods. Yet we notice that there
has been no discussion whatever of prices or price relationships in the
acceleration principle. This neglect of price relationships is
sufficient by itself to invalidate the entire principle.
The acceleration principle
simply glides from a demonstration in physical
terms to a conclusion in monetary terms.
Furthermore, the acceleration principle assumes a constant
relationship between “fixed” capital and
output, ignoring substitutability, the possibility of a range
of output, the more or less intensive working of factors. It also
assumes that the new machines are produced practically
instantaneously, thus ignoring the requisite period of production.
In fact, the entire acceleration principle is a fallaciously
mechanistic one, assuming automatic reactions by entrepreneurs
to present data, thereby ignoring the most
important fact about entrepreneurship: that it is speculative,
that its essence is estimating the data of the uncertain
future. It therefore involves judgment of future conditions by
businessmen, and not simply blind reactions to past data. Successful
entrepreneurs are those who best forecast the future. Why
can’t the entrepreneurs foresee the supposed
slackening of demand and arrange their investments
accordingly? In fact, that is what they will do. If the
economist, armed with knowledge of the acceleration principle, thinks
that he will be able to operate more profitably than the generally
successful entrepreneur, why does he not become an
entrepreneur and reap the rewards of success himself? All theories of
the business cycle attempting to demonstrate general
entrepreneurial error on the free market founder on this
problem. They do not answer the crucial question: Why does a whole set
of men most able in judging the future suddenly lapse into forecasting
error?
A clue to the correct business cycle theory is contained in the fact
that buried somewhere in a footnote or minor clause of all business
cycle theories is the assumption that the money supply expands during
the boom, in particular through credit expansion by the banks. The fact
that this is a necessary condition in all the theories should lead us
to explore this factor further: perhaps it is a sufficient
condition as well. But, as we have seen above, there can be no bank
credit expansion on the free market, since this is equivalent
to the issue of fraudulent warehouse receipts. The positive discussion
of business cycle theory will have to be postponed to the next chapter,
since there can be no business cycle in the purely free market.
Business-cycle theorists have always claimed to be more
“realistic” than general economic
theorists. With the exceptions of Mises and Hayek (correctly) and
Schumpeter (fallaciously), none has tried to deduce his business cycle
theory from general economic analysis.
It should be clear that
this is required for a satisfactory explanation of the business cycle.
Some, in fact, have explicitly discarded economic analysis altogether
in their study of business cycles, while most writers use aggregative
“models” with no relation to a general economic
analysis of individual action. All of these commit the fallacy of
“conceptual realism”—i.e., of using
aggregative concepts and shuffling them at will, without relating them
to actual individual action, while believing that something is
being said about the real world. The business-cycle theorist
pores over sine curves, mathematical models, and curves of all types;
he shuffles equations and interactions and thinks that he is saying
something about the economic system or about human action. In
fact, he is not. The overwhelming bulk of current business
cycle theory is not economics at all, but meaningless manipulation of
mathematical equations and geometric diagrams.
Cited in Wesley C.
Mitchell, Business Cycles, the Problem and Its Setting
(New York: National Bureau of Economic Research, 1927), pp.
76–77.
See V. Lewis
Bassie:
The
whole psychological theory of the business cycle appears to be hardly
more than an inversion of the real causal sequence. Expectations more
nearly derive from objective conditions than produce them. . . . It is
not the wave of optimism that makes times good. Good times are almost
bound to bring a wave of optimism with them. On the other hand, when
the decline comes, it comes not because anyone loses
confidence, but because the basic economic forces are
changing. (V. Lewis Bassie, “Recent Development in Short-Term
Forecasting,” Studies in Income and Wealth,
XVII [Princeton, N.J.: National Bureau of Economic Research,
1955], 10–12)
Joseph A. Schumpeter, The
Theory of Economic Development (Cambridge: Harvard
University Press, 1936), and idem, Business
Cycles (New York: McGraw-Hill, 1939).
Warren and Pearson, as well as
Dewey and Dakin, conceive of the business cycle as made up of
superimposed, independent, periodic cycles from each field
of production activity. See George F. Warren and
Frank A. Pearson, Prices (New York: John Wiley and
Sons, 1933); E.R. Dewey and E.F. Dakin, Cycles: The Science
of Prediction (New York: Holt, 1949).
On the tendency to neglect the
consumer’s role in innovation, cf. Ernst W. Swanson,
“The Economic Stagnation Thesis, Once More,” The
Southern Economic Journal, January, 1956, pp.
287–304.
S.S. Kuznets,
“Schumpeter’s Business Cycles,”
American Economic Review, June, 1940, pp.
262–63; and Richard V. Clemence and Francis S. Doody, The
Schumpeterian System (Cambridge: Addison-Wesley Press, 1950),
pp. 52ff.
In so far as innovation is a
regularized business procedure of research and development, rents from
innovations will accrue to the research and development workers in
firms, rather than to entrepreneurial profits. Cf. Carolyn Shaw Solo,
“Innovation in the Capitalist Process: A Critique of the
Schumpeterian Theory,” Quarterly Journal of
Economics, August, 1951, pp. 417–28.
Some Keynesians account for
investment by the “acceleration principle” (see
below). The Hansen “stagnation”
thesis—that investment is determined by population
growth, the rate of technological improvement, etc.—seems
happily to be a thing of the past.
See Lindahl,
“On Keynes’ Economic System—Part
I,” p. 169n. Lindahl shows the difficulties of mixing an ex
post income line with ex ante consumption
and spending, as the Keynesians do. Lindahl also shows that the
expenditure and income lines coincide if the divergence between
expected and realized income affects income and not stocks. Yet it
cannot affect stocks, for, contrary to Keynesian assertion, there is no
such thing as hoarding or any other unexpected event leading
to “unintended increase in inventories.” An
increase in inventories is never unintended, since the seller has the
alternative of selling the good at the market price. The fact
that his inventory increases means that he has voluntarily invested
in larger inventory, hoping for a future price rise.
Summing up disillusionment with
the consumption function are two significant articles: Murray E.
Polakoff, “Some Critical Observations on the Major Keynesian
Building Blocks,” Southern Economic Journal,
October, 1954, pp. 141–51; and Leo Fishman,
“Consumer Expectations and the Consumption
Function,” ibid., January, 1954, pp.
243–51.
Keynes, General Theory,
pp. 89–112.
Ibid., pp.
109–10.
What is
“fairly” supposed to mean? How can a theoretical
law be based on “fair” stability? More stable than
other functions? What are the grounds for this assumption, particularly
as a law of human action? Ibid., pp.
89–96.
Actually, the form of the
Keynesian function is generally “linear,” e.g.,
Consumption = .80 (Income) + 20. The form given in the text simplifies
the exposition without, however, changing its essence.
Also see Hazlitt,
Failure of the “New Economics,”
pp. 135–55.
It is usually overlooked that this
replacement pattern, necessary to the acceleration principle, could
apply only to those firms or industries that had been growing in size
rapidly and continuously.
See his brilliant critique of the
acceleration principle in W.H. Hutt, Co-ordination and the
Price System (unpublished, but available from the Foundation
for Economic Education, Irvington-on-Hudson, N.Y., 1955), pp.
73–117.
Neglect of prices and price
relations is at the core of a great many economic fallacies.
See Mises,
Human Action, pp. 581f.; S.S. Kuznets,
“Relations between Capital Goods and Finished Products in the
Business Cycle” in Economic Essays in
Honor of Wesley Clair Mitchell (New York: Columbia University
Press, 1935), p. 228; and Hahn, Commonsense Economics,
pp. 139–43.
See the excellent critique by
Leland B. Yeager of the neostagnationist Keynesian versions of
“growth economics” of Harrod and Domar, which make
use of the acceleration principle. Yeager, “Some Questions on
Growth Economics,” pp. 53–63.
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