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The Hampered Market Economy

2. The Thesis of Schmalenbach

Considering the dismal intellectual poverty and sterility of nearly all books and papers defending interventionism, we must take notice of an attempt by Schmalenbach to prove the inevitability of the “hampered economy.”

Schmalenbach starts from the assumption that the capital intensity of industry is growing continuously. This leads to the inference that fixed costs become ever more significant while proportional costs lose in significance.

The fact that an ever larger share of production costs is fixed causes the old era of a free economy to draw to a close, and a new era of a hampered econ­omy to begin. It is a characteristic of proportional costs that they occur with every item produced, with every ton delivered. ... When prices fall below pro­duction costs, production is curtailed with corre­sponding savings in proportional costs. But if the lion’s share of production costs consists of fixed costs, a production cutback does not reduce costs correspondingly. When prices then decline it is rather futile to offset their fall through production cutbacks. It is cheaper to continue production with average costs. Of course, the business now suffers a loss which, however, is smaller than it would be in the case of production cutbacks with nearly undi­minished costs. The modern economy with its high fixed costs thus has been deprived of the remedy that automatically coordinates production and consump­tion, and thereby restores the economic equilibrium. The economy lacks the ability to adjust production to consumption because to a large extent proportional costs have become rigid.6

This shifting of production costs within the enterprise “al­most alone” is “guiding us from the old economic order to the new one.” “The old great era of the nineteenth century, the epoch of free enterprise, was possible only when pro­duction costs generally were proportional in nature. It ceased to be possible when the proportion of fixed costs be­came ever more significant.” Since the growth of fixed costs has not yet stopped and will probably continue for a long time, it is obviously hopeless to count on a return of the free economy.7

Schmalenbach at first offers proof for the relative rise in fixed costs with the remark that the continuous growth of enterprise size “is necessarily connected with an expansion, even a relative expansion, of the department that is heading the whole organization.”8 I doubt that. The superiority of a larger enterprise consists, among other things, in manage­rial costs lower than those of smaller enterprises. The same is true for the commercial departments, especially the sales organizations.

Of course, Schmalenbach is completely correct when he emphasizes that the costs of management and many other general costs cannot be reduced substantially when the en­terprise works only at one-half or one-fourth of its capacity. But as management costs decline with the growth of the en­terprise, calculated per unit of output, they are less signifi­cant in this age of big business and giant enterprises than formerly in the age of smaller operations.

But Schmalenbach’s emphasis is not here; it lies on the rise in capital intensity. He believes that he can simply con­clude from the continuous formation of new capital and progressive application of machines and equipment—which is undoubtedly true in a capitalist economy—that the ratio of fixed costs will rise. But he must prove first that this is actually the case for the whole economy, not just for indi­vidual enterprises. In fact, continuing capital formation leads to a decline in the marginal productivity of capital and an increase in that of labor. The share that goes to capital de­clines, and that of labor rises. Schmalenbach did not con­sider this, which negates the very premise of his thesis.9

But let us also ignore this shortcoming and examine Schmalenbach’s doctrine itself. Let us raise the question of whether a relative rise in fixed costs can actually precipitate entrepreneurial behavior that deprives the economy of its ability to adjust production to demand.

Let us look at an enterprise that either from the start or be­cause of a changed situation does not come up to its earlier expectations. When it was built its founders hoped that the investment capital not only would be amortized and would yield the going rate of interest but, in addition, would pay a profit. Now it has turned out differently. The product price has fallen so much that it covers only a part of produc­tion costs—even without allowance for the costs of interest and amortization. A cutback in output cannot bring relief; it cannot make the enterprise profitable. The less it pro­duces, the higher will be the production costs per unit of output and the greater the losses from the sale of each unit (pursuant to our assumption that the fixed costs are very high relative to proportional costs, disregarding even the costs of interest and amortization). There is only one way out of the difficulty: to shut down entirely; only then can further losses be avoided. Of course the situation may not always be so simple. There is hope, perhaps, that the prod­uct price will rise again. In the meantime, production is con­tinued because the disadvantages of the shutdown are thought to be greater than the operating losses during the bad time. Until recently most unprofitable railroads were in this situation because automobiles and airplanes entered the competition. They counted upon an increase in traffic, hoping to earn profits some day. But if such special condi­tions do not exist, production is shut down. Enterprises la­boring under less favorable conditions disappear, which establishes the equilibrium between production and de­mand.

Schmalenbach’s error lies in his belief that the cutback in production, necessitated by the decline in prices, must take place through a proportionate cutback of all existing opera­tions. He forgets that there is yet another way, namely, the complete shutdown of all plants working under unfavorable conditions because they can no longer stand the competi­tion of plants producing at lower costs. This is true espe­cially in industries producing raw materials and staples. In finishing industries, where individual plants usually manu­facture various items for which production and market con­ditions may vary, a cutback may be ordered, limiting output to the more profitable items.

This is the situation in a free economy unhampered by government intervention. Therefore, it is utterly erroneous to maintain that a rise in fixed costs denies our economy the ability to adjust production to demand.

It is true that if government interferes with this adjust­ment process through the imposition of protective tariffs of appropriate size a new possibility arises for producers: they can form a cartel in order to reap monopolistic gains through reductions in output. Obviously, the formation of cartels does not result from some development in the free economy, but is rather the consequence of the government interven­tion, i.e., the tariff. In the case of coal and brick, the trans­portation costs, which are so high relative to product value, may, under certain conditions and without government in­tervention, lead to the formation of cartels with limited local effectiveness. A few metals are found in so few places that even in a free economy the producers may attempt to form a world cartel. But it cannot be said too often that all other cartels owe their existence not to a tendency in a free econ­omy, but to intervention. International cartels generally can be formed only because important production and con­sumption areas are sheltered from the world market by tariff barriers.

The formation of cartels has nothing to do with the ratio of fixed to proportional costs. The fact that the cartel forma­tion in the finishing industries is proceeding more slowly than in staple industries is not due to the slower rise in fixed costs, as Schmalenbach believes, but to the complex manu­facture of goods nearer to consumption, which is too intri­cate for cartel agreements. Furthermore, it is due to the dis­persal of production over numerous enterprises that are more vulnerable to competition by outsiders.

The fixed costs, according to Schmalenbach, prod an en­terprise to embark upon expansion in spite of lacking de­mand. There are facilities in each plant that are used very little; even at full plant operation they are working with de­gressive costs. To utilize these facilities better the plant is enlarged. “Thus whole industries are expanding their capac­ities without justification by a rise in demand.”10 We read­ily admit that this is the case in contemporary Europe with its interventionistic policies, and especially in highly inter­ventionistic Germany. Production is expanded without con­sideration of the market, but rather in view of the redistri­bution of cartel quotas and similar considerations. Again, this is a consequence of interventionism, not a factor giv­ing rise to it.

Even Schmalenbach, whose thinking is oriented eco­nomically in contrast to that of other observers, could not es­cape the error that generally characterizes German economic literature. It is erroneous to view developments in Europe, and particularly in Germany under the influence of highly protective tariffs, as the result of free market forces. It cannot be emphasized too often and too emphatically that the Ger­man iron, coal, and potash industries are operating under the impact of tariff protection, and, in the case of coal and potash, also under other government intervention, and these are forcing the formation of syndicates. Therefore, to draw conclusions for the free economy from what is happening in those industries is completely incorrect. The “permanent inefficiency” so sharply criticized by Schmal­enbach,11is no inefficiency of the free economy, but in­efficiency of the hampered economy. The “new eco­nomic order” is the product of interventionism.

Schmalenbach is convinced that in the not-too-distant fu­ture we must reach a state of affairs in which the monopolis­tic organizations will receive their monopolistic power from the state, and the state will superintend “the performance of the duties incumbent on the monopoly.”12Surely, if for any reason we reject the return to a free economy, this con­clusion completely agrees with that to which every eco­nomic analysis of the problems of interventionism must lead. Interventionism as an economic system is unsuitable and illogical. Once this is recognized it leaves us with the choice between lifting all restrictions, or expanding them to a system in which government directs all business decisions—in which the state determines what to produce and how, under what conditions, and to whom the products must be sold. This is a system of socialism in which private property at best survives in name only.

A discussion of the economy of a socialistic community does not belong with this analysis. I have dealt with it in an­other place.13

  • 6. Schmalenbach, “Die Betriebswirtschaftslehre an der Schwelle der neuen Wirt­schaftsverfassung” [The doctrines of business administration at the dawn of a new economic constitution] in Zeitschrift für Handelswissenschaftljche Forschung [Journal for trade research], 22nd year, 1928, p. 244 et seq.
  • 7. Ibid., p. 242 et seq.
  • 8. Ibid., p. 243.
  • 9. See Adolf Weber, Das Ende des Kapitalismus [The end of capitalism], Munich, 1929, p. 19.
  • 10. Schmalenbach, op. cit., p. 245.
  • 11. Ibid., p. 247.
  • 12. Ibid., p. 249, et seq.
  • 13. See Mises, Die Gemeinwirtschaft, Jena, 1922, p. 94 et seq. [English-language edition: Socialism (London: Jonathan Cape, 1936), p. 111 et seq.]
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