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11. Money and Its Purchasing Power

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).78 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.79 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.80 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.81 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.82

  • 78. 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.
  • 79. 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.
  • 80. Neglect of prices and price relations is at the core of a great many economic fallacies.
  • 81. See Mises, Human Action, pp. 581 f.; 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.
  • 82. 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.