Common Sense Economics
Appendix II. The Economic Situation in the United States
Since about the middle of 1953 production in the United States has been receding; unemployment has been rising and has reached quite substantial proportions in some places and in some industries. In some circles of entrepreneurs, but above all in circles of trade unions, the future is regarded with apprehension. A number of theoreticians of standing, including the Australian economist Colin Clark, forecast a further very severe deterioration of the situation. On the other hand, the government and the majority of economists assert that the situation will very soon improve, that it is in fact improving already. In their opinion, what is happening is just an adjustment, especially an adjustment of excess inventories.
There is no doubt that it is, for the economic and political fate not only of the United States but also of Europe, of the highest importance who will prove to be right in this controversy.
I have described developments of the monetary sphere until the end of 1952 in my article “Prosperity by Inflation.”2 What developments have taken place in the meantime?
The Reactions of Economists and Politicians
It will be remembered that long before 1953 the question was strongly discussed in the United States as to whether the credit expansion which was then obtaining should be curtailed, or whether its further advance should be tolerated. Two diametrically opposite opinions were put forward. The one demanding curtailment can be described as the Conservative Neo-classic. The other, which considered a further expansion as permissible or unobjectionable, can be described as the Keynesian New Dealistic. For both opinions are in fact nothing else but the expression of those opposing conceptions of economic life which, during the past two decades, have put a stamp on all economic and political discussions in almost every sphere.
Conservative neo-classical economists diagnosed the situation as a clear case of highly inflationary prosperity. They compared the situation with that of 1927, when by an energetic credit restriction the development of the super-boom of 1927-29, and thus the great crisis, should have been prevented. Therefore they now demanded, too, the braking of the boom through higher interest rates and other means of credit restrictions.
This demand of the conservative economists was the logical consequence of their ideas about the business cycle and the methods for its stabilization. For neo-classical economists the business cycle is basically nothing else but an intertemporal maldistribution of aggregate demand. In contrast to the so-called stagnation theoreticians, who believe that the demand for credit can in the long run vanish through lack of investment opportunities, these economists are of the opinion that short-term phenomena are at stake. What is too little invested during the depression is too much invested during the boom. They contend that by preventing an excess investment during the preceding boom the investment deficit of the following depression can be avoided. By making the supply of credit more expensive, the exaggeration of the prosperity phase of the cycle, and thus the following depression, could and should be prevented. This is the method of fighting the depression by fighting the preceding boom. One can describe it also as a method of stabilizing the cycle at the average level. In principle it works, in the case of recession, with the means of cancellation of the preceding increase of interest rates. It considers this—provided that the preceding boom has been braked by raising the interest rate—as necessary and sufficient to increase, by stimulating the use of credit, the aggregate demand of the economy and restore full employment. Governmental deficit spending is rejected as unnecessary and damaging in principle.
Keynesian New Dealistic economists, in spite of many reservations, do not recognize the necessity of braking the boom before it begins to collapse by itself. They speak of stabilizing the cycle at the level of highest employment. They know, it is true, that one day the demand must dwindle and the reaction set in. But many rely for fighting it on planned governmental interventions, especially deficit spending, or, as it is sometimes called, the policy of functional finance. This is indeed the position which before 1953 was taken by New Dealistic economists like Hansen, Harris, and, above all, by the leaders of trade unions who denounced every possible increase in the cost of credit as a wicked interference in the full employment policy and an unwarranted gift of advantages to the capitalist class.
One can describe the method of business cycle stabilization demanded by the Keynesians also as the method of stabilizing the cycle at its highest possible level.
The Dream of all Laymen
To stabilize the boom at its highest level, or to prolong it in all eternity, is the dream of all laymen. My friends and I have in the period prior to 1953 pointed out that this dream is Utopian and have fought the easy money policy which would lead to the exaggeration of the boom. Our reasons were the following. During prosperity a development sets in which the French characterize by the slogan la hausse amène la hausse. The entrepreneurs try to expand their production because their profits rise under the influence of the inflationary demand. They use additional credits or loans which the banks again grant “inflationary.” The new money increases the demand, prices and profits rise further. A vicious circle upward is released. But the moment comes when the expectation of the continuation of the boom no longer gives a new stimulus to expand production. Now there are no new layers of entrepreneurs or speculators who, by use of additional credits, could carry the boom further. Now all enterprises have to be liquidated and all speculative positions have to be dissolved which were profitable only under inflation, i.e. with rising demand or prices. The boom is followed by depression and this depression cannot be fought with the classical method of lowering the interest rate. For, contrary to the case in which the cycle was braked at an average level, in the case of the stabilization of the cycle at the highest level there is no more potential credit demand which has been left unsatisfied, because the interest rate was too high, and which can be satisfied after it has been lowered. In any case, lowering of the interest rate cannot be applied for the simple reason that these rates have already reached their lows.
Functional Finance
All this does not disturb those who believe in the possibility of missing an eternal boom. According to them, the government which can disregard profitability of its investments, has the right and the obligation to replace the failing demand of the private economy as soon as the boom recedes. As long as effective demand can be held at its previous level by governmental deficit spending, full employment is considered as guaranteed.
This application of governmental finance policy is called functional finance and praised as a new invention. One can say that in so far as it is correct it is not new, and in so far as it is new it is not correct. The idea of concentrating governmental expenditures in times of depression in order to mitigate the fluctuations of the cycle is an old one. The idea that such concentration guarantees full employment is, however, incorrect. It is based on an over-simplification of the problem. If the State compensates the failing demand of the private sector of the economy, immediately, and not only after liquidation of the boom, it not only has to spend extraordinarily high amounts but the spending has also to be repeated permanently. For a part of the amounts spent by the government trickles away by the building up of savings and has to be replaced by new governmental expenditures. Permanent deficit of the State, however, means permanently increasing governmental debts. What permanently increasing government debts mean for the financial situation of the State and the currency need not be further explained, especially after the results of the Nazi experiment have been recognized. A permanently increasing intervention of the State must, incidentally, also lead to a displacement of the private sector of the economy by the governmental sector, and by doing so to total socialization.
In all this we have not considered that under the prevailing political conditions there exists the further danger that wages are pushed upward during the depression in order to strengthen the purchasing power of the masses. To compensate for the cost increase which follows, it is not sufficient to re-establish the old price level—the inflation has to be pushed so far that the price level even goes up. A race between prices and wages develops which, in the long run, must be even more catastrophic for governmental finances and currency.
Republican Credit Policy I
One of the chief objections of the Republicans to the Democratic economic policy was concerned with the permanent easy money policy of the New Dealers, which, it was argued, robbed the dollar of 50 per cent of its purchasing power since 1939. The leading Republicans, so far as they are concerned with economic policy, adhered unconditionally to the neo-classical conservative view described above, according to which the inflation should be curtailed immediately by an energetic increase in the cost of the credit supply.
In accordance with this opinion the Republican administration, when it came to power in January 1953, allowed the interest rate to rise in such a way that the yield of the so-called A.A.A. bonds went up by the middle of the year from 3 to 31/2 per cent—a very substantial increase in view of the former stability and low level of the yields.
As far as the braking of the inflation is concerned, the measure was a full success. Contrary to the opinion of most of the New Dealistic economists, according to whom raising of the interest rate has no effect in preventing inflation—an argument by which they had resisted every raising of the interest rate—the effect was strong and spontaneous. The money circulation which had increased markedly for years, increased only negligibly. The same applied to demand deposits. Total investments and loans, it is true, still increased during the year 1953 by about $6 billion, but this increase was evidently no longer financed by inflation. The general price level remained for the first time entirely stable.
Depression of Production without Deflation
Not so satisfactory, and for many quite unexpected, was the effect on production and employment. When in the middle of 1953 the anti-inflationary effect of the interest rate policy materialized, production began to decline. The index of production fell from about 138 to about 122 by March 1954. Unemployment, which until then had been negligible, increased by about 3 million. Only this March (1954) has the movement seemed to have reached its low point and perhaps even to have turned upward.
These developments are almost uniformly described as cyclical in character and called, according to the mood of the observer, adjustment, recession, or depression; and diagnosed as a consequence of the deflation induced by the Republicans’ monetary policy. The Democrats try to profit by what has happened. New Dealistic Keynesian economists, especially Professor Harris, demand the return of a policy of extreme cheap money which allegedly has brought so many years of magnificent prosperity.
This diagnosis seems to misjudge the situation entirely. The figures of the developments in the monetary sphere that have just been mentioned clearly show that inflation was indeed curtailed—although perhaps not completely—but that there is no question of deflation. This easily recognizable fact seems to have entirely escaped all observers, with only one exception as far as I know—all others speaking always only of deflation. However, what has been deflated are production and employment; prices have remained entirely constant and money circulation pretty much so, and total loans and investments by banks have even gone up substantially. What had set in was an employment depression without a money deflation or, better, no depression at all—at least not a cyclical one.
There is in my opinion only one explanation for these phenomena, i.e. that the prevailing unemployment is of a stabilized or structural character such as develops when wages increase too quickly compared with prices. Unemployment was the result of the monetary situation only in so far as the progress of inflation was prevented for the first time for many years. A similar unemployment had been observed in Germany in the years 1926 to 1929. At that time unemployment increased substantially, whereas the inflationary boom progressed until 1929. Then, just as today, the reason can only have been that wages increased correspondingly more than prices and productivity. Then, just as today, labor which had become too expensive was replaced by relatively cheap capital investments.
If this diagnosis is correct, then the prevailing unemployment only confirms the year-long fears and warnings of conservative economists who regarded the permanent raising of the wage level with concern. They contended that the high wages were made only partly tolerable by higher productivity, but for the greater part only by inflation. The moment inflation would end unemployment would appear, if wages were not reduced in time, or at least prevented from rising further. However, wages have in fact steadily continued their steep rise which began in 1949, as becomes clearly evident by a look at the curve of hourly wages which in 1953 showed the same upward angle as in previous years.
The Dilemma of the Republicans
What was to be done in view of this development in the realm of production and unemployment?
Again minds were divided. Conservative economists, wishing to prevent the resumption of inflation by all means, believed the only possible way of reducing unemployment was through an adjustment of costs to the price and demand level which now showed no signs of further inflation. They demanded—in an Utopian fashion perhaps—the reduction of wages to the level prevailing at the beginning of 1953, or at least their stabilization at the level of the moment, so that an increase of productivity would be able to absorb the wage rises which had taken place until then.
Keynesian New Dealistic economists demanded, as already mentioned, the immediate return to a policy of permanent easy money, and thus, consciously or unconsciously, to further inflation. They demanded, therefore, the adjustment of the price and money level to the cost level, instead of conversely the adjustment of the latter to the former. This demand was only the consequent expression of the Keynesian employment theory, or, as I would say, mythology. For Keynesians do not consider employment, as neo-classical economists do, essentially a function of the propensity of the people to work but of the so-called effective monetary demand for products. In order to increase or maintain employment, an increase of the monetary demand is considered necessary and sufficient. In reality, an increase of the demand is by no means necessary. Full employment can also be attained by adequate regulation of the labor supply. Nor is the increase of the demand sufficient: even a strong inflation does not produce an increase of employment if wages go up with prices.
Republican Credit Policy II
The decision of the Republicans in this dilemma is known. From the middle of the year 1953 the administration again followed a conscious easy-money policy which has lowered the yields of A.A.A. bonds below the level prevailing at the beginning of 1953, with the characteristic result—very much reminiscent of the year 1927—of an extraordinarily strong upward movement of the stock market. The decision was rationalized with the argument that the lowering of the interest rate is meant to prevent a real deflation which could perhaps develop. So far as this is the aim, the new credit policy can be approved. But I am afraid that, within these limits, it will prove to be insufficient to absorb the prevailing unemployment. The new policy, if it wants to succeed, must not exhaust itself in preventing deflation, but must have inflationary effects. In so far as the Republicans allow the development of a further inflation, or even consciously create it, they act contrary to their own pre-election program. But it is perhaps too much to demand that they remain faithful to it. The population is through the Keynesian economists educated in the belief that unemployment is always the result of a failing demand for labor and never the result of a too expensive supply, so that not the wages but the monetary policy must be responsible. In democracies, however, the opinions of the masses are decisive. Consequently, the Republicans could obviously banish the evil spirit of inflation which the Democrats called in only at the price of their own election defeat.
Will the Inflation Catch?
Quite another, by no means self-evident, question is, of course, whether by lowering the interest rate one will succeed in revitalizing an inflationary boom which has been interrupted by a raising of the interest rate. The question is identical with the question of the future course of the business cycle in the United States. To answer it means forecasting the future course of the cycle.
Unfortunately I have now to disappoint severely all those who hope to receive from me an objectively founded, and not only a purely subjective, reply. For the question can never be objectively answered. We have to face the regrettable fact that we are in general, and particularly at this moment, not able to make scientific forecasts about further developments. Even now (spring 1954), when the recession is one year old, the uncertainty is not less than it was. The slight improvement of the last weeks could just as well be the beginning of a new upswing as a secondary upward reaction in a primarily still downward movement.
Reasons Suggesting a New Upswing
I can, therefore, only express the opinion to which my own business cycle feeling leans. I think that the government will succeed in starting the inflationary credit expansion anew, and that under its influence unemployment will decrease substantially.3 But my opinion is, as I want to stress again, purely subjective and possibly quite erroneous. Nevertheless I may, perhaps, mention the reasons with which I rationalize my feeling.
(1) The end of the inflationary boom in the middle of 1953 did not coincide by chance with the height of the interest rate but was caused by the high interest rate. Although, in my opinion, all sins were committed which can be committed in matters of business cycle stabilization, it still was a stabilization somewhat at the average level of the cycle, as described above, and not at its highest level. Historically viewed we were still in the year 1927, not in the year 1929.
(2) Never until now have deep depressions set in at the moment when they were expected. Depressions come, so to speak, out of the clear skies. Now the average of the entrepreneurs in the United States have expected the coming of a depression for many years, and particularly since 1951. Therefore, the so-called business-cycle consciousness has, by its dampening effect on the credit demand, compensated—at least partly—for the mistakes of the governmental credit supply policy; with the result that heavy exaggeration of the boom, and, thus, the danger of a deep depression no longer correctible through interest rate lowering, have been avoided.
(3) All the characteristic features of a genuine cyclical turn were absent. The usual credit demand of a crisis, with its strongly rising interest rate, was not observed. Employment did not fall off suddenly and commodity prices did not recede at all. The slow decline of employment and production which could be observed was in contrast to the sudden interruption of production and dismissal of workers regularly observable at the beginning of a typical depression resulting from financial difficulties.
No Boom Will Last Eternally
This optimism concerning the course of the cycle is, to put it quite clearly, no optimism for a very long period. Nor would I like it to be thought that I approve of absorbing unemployment by methods coming very near to the New Dealist Keynesians. In this realm the principle of “Time is won, all is won” is not a good one, and the Keynesian sentence “In the long run, we are all dead” is valid only for individuals and not for economies and nations.
The path which is now followed will not be eternally successful. Once all the reserves of the boom—of an objective and psychological nature—are exhausted, a depression will set in which it will be possible to mitigate only by the strongest governmental intervention. How much time will pass until then I do not wish to forecast even approximately. Only those who believe they can predict the unpredictable will think they are able to do so.
