Economics of the Free Society

“La majestueuse égalite des lois, qui interdit au riche comme au pauvre de coucher sous les ponts, de mendier dans les rues et de voler du pain.”

ANATOLE FRANCE, Le Lys Rouge, VII

1. The Distribution of Income

As he analyzes the mechanism of our economic system, the economist finds himself lapsing easily into the language of GHQ communiqués—those cold, impersonal descriptions of military operations which leave it to the reader to picture the sum of human resolves, deeds, and sufferings that lie behind the bare words. We speak facilely, for example, of the purchasing power of money, although we know quite well that money does not enter the market by itself but that it gets there because individual human beings, at once deliberate, weak, and passionate, have spent it. Similarly, we have spoken of the demand for a good almost as if it were a physical quantum, in the certain expectation that the reader would remain at every instance aware of the abbreviated form of expression which we here employed. As a matter of fact, the demand for a good is made up of the demands of all individuals who, with reference to a specific price, decide to employ a specific part of their income for the said good. These individual portions of demand, moreover, vary greatly in amount, not only because of differences in taste but also because of the inequality of incomes.

Before entering upon a scientific study of the distribution of income, it remains for us to note the following possible types of income formation: 1. The extra-economic formation of income, so designated because income accrues to the recipient irrespective of whether he performs a corresponding service in exchange, i.e., it has no connection with the process of production, be it obtained through violence or fraud, or through governmental charities (welfare and relief payments, gifts, and that “distribution according to need” which doctrinaire Communists would establish for the whole of society). 2. The economic distribution of income, which arises from the participation of each individual in the economic process, i.e., from the sale of goods and services of all kinds. In this fashion is formed that type of income referred to previously (p. 120) as original income. Although the extra-economic formation of income is frequently encountered in our economic system, it is the economic formation of income which predominates and upon which the attention of economists is concentrated.

2. Income Distribution—A Problem of Price Formation

Once it has been recognized that the problem of distribution is identical with the problem of price, it can no longer be doubted that the distribution of income is an integral part of the entire economic process and that it is subject to the same laws as the other parts of this process. Equally little doubt can be entertained about the essential role played by the price-forming process among the factors of production (into which the distribution of income can be resolved). Where it is desired to ensure the orderly progress of economic life, this process can be ignored neither by our economic system nor by a socialist one. That wages in one country stand at such and such a level, that rents, interest, and profits are of such and such an amount—this is hardly to be ascribed to chance. Rather, these situations are the result of specific economic data. Every attempt to alter such data by force will produce disorder in the economic system which, in turn, will engender still greater counter-forces. That the prices of the factors of production stand at any given moment at a certain level is an essential condition of economic equilibrium, in our system as in any other. He who wishes to change these prices—and what economist would not wish to see rewards to the human factor of production at as high a level as possible-is certainly free to attempt to do so. But instead of trying to acquire the facile reputation of a “social-minded” man by vague demands for a “just wage,” by railing against “interest slavery” and “profiteering,” by emotional outpourings over “gluttonous landlords,” and real estate “speculators,” and instead of shoving aside as “liberalistic” the objections of those who understand something of these matters, one would serve his country better by applying himself to an unprejudiced study of the complex interrelationships of the economy. The insights thus acquired would enable him to discover what the basic factors are upon which it is necessary to act in order to be able to alter the existing distribution successfully, i.e., without provoking a costly disturbance of equilibrium. This is a difficult, thankless, and self-denying task, but one which a genuine social sense and a genuine patriotism oblige us to undertake.

Is it impossible, then, to forcibly raise wages by lowering the return to capital? It is certainly not impossible, but every attempt of this sort leads to a situation which shortly becomes untenable and results in serious disadvantages to the wage receivers themselves. It must be emphasized at the outset that those who promise great things from a transfer of income to the working class are the victims of an optical illusion. Large incomes attract much attention, but most people forget that given the small number of such incomes no particular benefits to the huge number of small income receivers could be expected to result from an equal distribution of the wealth. There would be all the less likelihood of such benefits—and this is the decisive consideration—inasmuch as a forcible transfer of this kind would lead to serious disturbances whose effects would be ultimately borne by the working class. Among the principal disturbances of such a wage policy would be a critical reduction of the economy’s supply of capital and a slowing down of investment activity with its consequent effects on employment opportunities. Capital earnings (interest and dividends) go normally to individuals who spend only a small part of them and return the major share to production as fresh capital. It is very doubtful whether this income, once in the hands of workers, would be saved and invested in the same proportion as previously. To this must be added the fact that a collapse of the securities market, which is to be expected from such a policy, would seriously damage one of the most sensitive and at the same time one of the least understood elements in the complicated apparatus which sees to it that the economy is supplied with sufficient capital and that this capital is rationally allocated. Indeed, a policy of this kind would have a depressing effect on the entire economy and from the interaction of these various causes and effects, depression and unemployment could be expected all along the line. That regard for the economy’s capital requirements and for its investment activity obliges us to set limits to the extent to which wages can be increased, is not a devilish peculiarity of our economic system but—and this is true even of a socialist state—a necessity based on fact. In any case, we have not yet had any information to the effect that the Russian government has fixed wages so high that no surplus funds remain in its hands, nor that this government counts on voluntary savings of the workers for its supply of capital.

Let us take another instance of what happens when wages are increased to a degree which is not justified by the market situation. An arbitrary raising of prices on the labor market will (just as similar arbitrary price rises on other markets) render a part of the “merchandise” unsaleable, i.e., will cause unemployment. If the unemployed are not supported by the state, they will bring their total weight to bear on the wage level (via competition) until an equilibrium situation is again achieved. If, on the other hand, the unemployed are taken care of by the state, their pressure on the wage level will be deflected for the most part. But at the same time there will result such an extreme gap as between the abnormally high wages of those who are employed and the bitter poverty of those condemned to unemployment (not to mention the worsened situation of the tax-paying groups) that we cannot speak of an improvement in the situation of the working class as a whole, but only of an improvement in the situation of one stratum of workers at the expense of the others.

Or let us take another case in which the interest rate is forcibly lowered. Thorny questions of monetary theory are involved here, and the fabric of interrelationships is even more complicated than that which we observed in connection with our previous example of a forcible alteration of wages. Nevertheless, in this case as in the preceding, there can exist no doubt as to the essential outcome. Here, too, there are likely to be after-effects by which the economic system avenges itself when violence is done to it. In the first place, a reduction in, or even a complete abolition of interest by state decree would probably cause those engaged in capital transactions to find ways of circumventing the control of the state or of the community. In devious ways, an illegal interest rate will establish itself, a rate which will not only correspond to the actual ratio of supply to demand on the capital market but one which will be increased by an amount necessary to meet the costs of more complicated transactions, including an indemnity to cover the extra risks run in transgressing the law. But if we posit the rather unlikely situation where the maximum rate of interest decreed by the state is really enforced, we will find that sooner or later an untenable situation will develop on the capital market. As in every instance where a policy of ceiling prices is enforced, a disproportion between supply and demand will develop. In consequence, the state will be forced to take a further step, viz., to ration the available supplies of credit. This means that the state itself will now take over the functions which hitherto had been exercised by the free formation of interest. Can we assume that it will do the job in a satisfactory manner?

Next to wages, rent, and interest, there is still another large and important category of income which can be fitted only with difficulty into the framework of our previous considerations. Let us take the case of an entrepreneur who has entered on his books the costs of the various factors of production, employed under the following headings: wages to the workers, rent to the owner of the land (or to himself as the case may be), interest on capital (also to himself should he have contributed the capital), and a normal rate of compensation for his own services (entrepreneur’s wage). Assume now that our entrepreneur has been able to dispose of his output in such a way that a surplus income remains to him after he has paid for all of the above “costs” of doing business. This surplus we call entrepreneur’s profit, i.e., profit in the narrow and proper meaning of the word. To be sure, this income also arises from the process of price formation since the prices of the saleable output and of the factors of production are the resultants of this process. But it is distinguished from the previously considered types of income in that it represents merely a differential gain and not the market-determined price accruing from the sale of a “service” as it is usually understood. The difficult task of a theory of entrepreneur’s profit is to explain on general grounds the origin of such pure profit, whereby the hardly less frequent case of entrepreneur’s loss (negative pure profit) must also be taken into consideration. Such a theory will also have to answer the question as to whether entrepreneur’s profit fulfills a specific positive function within our economic system or whether it is a simple case of enrichment unrelated to any particular function.

The masses see only the successful man of business and have but a meager understanding of how such a success is achieved. Equally vague is their knowledge of the silent and pitiless process of elimination which—provided always that competition exists—is carried on among entrepreneurs, a process to which those are sacrificed who are weighed in the scales of the market and found wanting. Thus, the entrepreneur appears in a genuinely competitive market economy as a sort of trustee whom the community has placed in charge of its means of production. Comparing the costs of his services with those of a bureaucratic state-controlled economy, our entrepreneur may be regarded as a very inexpensive public servant, one who really assumes risks, while the politician is apt to be answerable only to God and history. Such a risk-assuming entrepreneur, who disdains the comfortable crutches both of state subventions and of monopoly, should be protected against attacks of a vulgar anticapitalism. From all that we know at present, it is certain that in Communist Russia the differences in income between the economically favored and the workers are far greater than in the capitalist countries, although the population is consoled, from one five-year plan to another, with the promise of a final redemption in which there will be a notable change for the better in its condition. Again, the cliché of the “two hundred families” who are supposed to be secretly exerting an irresponsible control over the free economy’s destiny is, when applied to the entrepreneurs we have described above, thoroughly out of place. The difference between the market economy and the collectivist economy rests precisely in the fact that in the first case economic decisions are distributed among very many “families” which, in turn, are bound by the supreme authority of the market, i.e., in the last analysis by the votes of the consumers. In the collectivist state, on the other hand, these decisions devolve upon a single family—assuming that the dictator has one—against which there is no appeal. These statements are valid, of course, only on the supposition that the entrepreneur does not himself become confused and fall into the defeatism of seeking his salvation under the sheltering roof of monopoly or of the state, forgetting that in so doing he destroys himself.

3. Should Interest and Rent be Abolished?

We have seen that the principal categories of income—wages, interest, rent, and profits—are to be regarded as the prices of the factors of production to which each corresponds, that these prices are determined by the economic process as a whole, and that they cannot be arbitrarily changed without causing a more or less radical dislocation of all economic relationships. Although it has already been made clear that this in no way precludes a successful change in price relationships in favor of wages (viz., by acting on the original factors), there are many to whom our findings will be a cause of extreme irritation. They reject the idea that interest and rent, for example, should be placed on the same footing with wages, and argue instead that these highly unjust forms of nonfunctional income should be summarily abolished. Are they not right? And if such abolition is not possible within the framework of our economic system, is this not reason enough to make an end once for all of this system and its execrable “laws” about which economists make such a great to-do?

To add some light to all this heat, it will be useful to distinguish once again between the personal and the functional distribution of income. In truth, we must sharply distinguish between the one fact that rent and interest are paid at all, and the other that they are paid to individuals in such unequal amounts. If the distribution of property were more equal than it is today and if, in consequence, the masses were to receive a larger share of the income accruing from the ownership of land and capital, the attitude of the average person towards rent and interest would probably be much less hostile. We have here, then, two different questions to answer. Let us for the moment confine our attention to the first: whether interest and rent are justified at all, regardless of to whom and in what amounts they are paid. In answering this question we can under no circumstances ignore the fact that rent and interest are not meaningless sources of enrichment but institutions which have a specific significance and function. Although we have already discussed the functions of interest in the preceding paragraph, the point seems to be important enough to justify a fuller and more general explanation. Such an explanation should, above all, secure recognition of the fact that behind rent and interest is concealed a complex of relationships, knowledge of which is just as important in a socialist as in a “capitalist” state.

We know that interest and rent are nothing else than the prices which are paid for the services of the corresponding factors of production. These factors of production are available, however, only in limited quantities, while the demand for them may be measured on a scale which extends to infinity. The formation of prices, which leads in this instance to the phenomena of rent and interest, is thus only a special case (although a very important one) of the general principle of equilibrium which, as we saw previously (pp. 26ff., 33ff.), rules our economic system.

The same is true of rent, whose existence is predicated on the necessity of making demand for land conform to the degree of need in each case, and of equating this need with the limited supplies available. Rent fulfills in our economic system a function which must be fulfilled in every economic system, viz., the introduction of reasonable order into the allocation of the limited supply of land. A very vivid appreciation of this function of rent may be had by observing the countryside from the vantage point of an airplane. The division of the land into residential and farm areas, forests and meadows, railroads and highways, the silhouettes of the cities with the skyscrapers in the center and the villas in the outskirts—all this is, fundamentally, the work of rent which through a series of gradations in its amount causes one piece of land to be used for this purpose and another for that purpose. Just as interest—to express this idea in more drastic form—ensures that subways will not be built in every country town, so rent acts to prevent the planting of potatoes in Regent Street or on Fifth Avenue. Rent is a warning, as it were, that land of a given quality or in a given location is scarce, and that therefore it should be entrusted only to those who are able and willing to make the best and most profitable use of it. The general regulatory principle which rules the whole of our economic system comes here, as elsewhere, into full play. That land is reckoned among the production costs of every economic good (since a price in the form of rent must be paid for its use) is an expression of the truth that the use of a piece of land for one purpose precludes its use for another purpose. In consequence, we see that rent differs in no wise from other cost elements.

4. Changing the Distribution of Income

Even the adversaries of our economic system do not, as a rule, deny that the services which it renders in the sphere of production are deserving of considerable respect. A number of them were not even dissuaded by the economic crisis of the thirties from holding that in this regard our economic system is very much superior to a communist one. Only because it is so unjust, they say, should it be done away with. To criticisms of this sort one must resolutely affirm that it is thoroughly possible, and even necessary, to bring about changes in distribution so long as such action does not result in the destruction of the high achievements of our economic system in the realm of production. To accomplish this purpose, three courses of action are available: 1) an “organic” change in the functional distribution of income; 2) a change in the personal distribution of income; 3) the use of extra-economic means to offset a change in the distribution of income.

We have already established that for a change in the functional distribution of income, it is not required to employ force, but rather to effect an “organic” change by acting on the original factors. To describe these factors in detail would require a whole book, the reading of which would not be easy since it would be necessary to treat of the very thorny questions connected with the theories of wages, interest, and rent. What must here be stressed is only the most essential consideration, viz., that both theory and experience point to productivity as being the final determining cause of the average level of wages in a country. All the differences in national living standards—between the United States and Europe, between Sweden and the countries in the Danube basin—can be traced back to this single factor. Everything which increases the productivity of labor, increases wages. Of decisive importance is the fact that the productivity of labor is greater, the larger are the quantities of capital and of land with which the labor factor of production can be combined. This depends, in turn, on the quantitative ratios of the three factors of production to one another, a circumstance whose importance has already been made clear to us (pp. 133 ff.). We can doubly understand now why the level of wages is high in a country where the labor factor of production is scarce in relation to capital and land. Because labor is scarce, a higher price must be paid for it, and because it is combined with a greater quantity of capital and land, its productivity is increased. This much established, it can be easily demonstrated that both points are reducible to the same common denominator. Of especial importance in this connection is the quantitative relationship between the productive factors of labor and capital, a fact corroborated by the classical theory of wages (wages fund theory), if not in its premises, nevertheless in its conclusions. At the same time, the truth is once again borne in upon us that an unrestricted increase of population will almost certainly cause a change in the distribution of income to the detriment of the wage income of the masses. A waste of capital caused by unproductive government expenditures has, in the long run, an identical effect.

Last but not least, we must make mention of the role played by foreign trade. The more completely a country participates in the international division of labor, thereby making the most rational use of its factors of production, the more favorable are the terms of trade which it can obtain on international markets. The less restricted a country is in buying foreign goods where they are cheapest and in selling its own where they are dearest, the higher will be the wage level of that country. This is a factor which plays an especially big role today in the surprising prosperity of certain small countries such as Switzerland and the Scandinavian countries.

We have thus arrived at a strange but suggestive result. It turns out that the functional distribution of income is the more prejudicial to wage income the poorer—i.e., the more unproductive, the more “proletarian,” and capital-poor—a country is. On the other hand, the greater a country’s average wealth, the more equitable will be its distribution of wage and property incomes. There is some truth to Uncle Bräsig’s famous thesis in Fritz Reuters Ut mine Stromtid “that poverty comes from being poor.”1 We can see from the foregoing that it is possible to formulate a policy of raising the national level of wages which will have a real chance of success. Such a policy will consist of the following: increasing capital wealth (by means, if need be, of capital imports and a rational organization of credit), allocation of the factors of production to their most productive uses, intelligent participation in the international division of labor, exploitation of technological and organizational progress, restrained increases in population, a reasonable economic policy in all fields, peace, security, confidence and order—such are the bases of national prosperity.

A change in the functional distribution of income in favor of wages will result at the same time in a more equal distribution of personal income since it will give to the masses of wage receivers the increasing possibility of obtaining—via wealth formation—income from the ownership of property of all kinds. The consequence will be a “de-proletarianization” which ought to be close to the hearts of those who need no propertyless masses for the fulfillment of their political ambitions. This process can be assisted by a number of direct measures, above all by an economic policy which sees to it that the equalizing effects of the competitive principle are not frustrated by manipulations which lead to an undeserved enrichment of the few at the expense of the many. An antimonopoly policy is thus always a good income policy, as is also the suppression of abuses born of the competitive struggle. Other measures that would help to reduce excessive concentration of wealth are housing programs, encouragement of independent farming, easing the difficulties encountered in progressing from one social class to another, attention to the credit needs of small industries, and numerous other measures.

As a last resort, there is available the extra-economic correction of the distribution of income. This consists in the state awaiting the results of the economic distribution of income as they are crystallized in the market processes, and then correcting these results by taxing the rich and spending for the poor. As a matter of fact, a considerable portion of the public finances is devoted to such rectification, supplemented by the efforts of private welfare groups. Obviously, there are certain limits here which may not be overstepped if paralyzing effects on the process of production are to be avoided. It is, of course, clear that the state can go much further in employing such corrective measures the smaller are its expenditures for other purposes.

______________

2 “Armut kommt von der ‘Poverteh.’ ”

• 1* “Armut kommt von der ‘Poverteh.’ ”
• 2We have thus arrived at a strange but suggestive result. It turns out that the functional distribution of income is the more prejudicial to wage income the poorer—i.e., the more unproductive, the more “proletarian,” and capital-poor—a country is. On the other hand, the greater a country’s average wealth, the more equitable will be its distribution of wage and property incomes. There is some truth to Uncle Bräsig’s famous thesis in Fritz Reuters Ut mine Stromtid “that poverty comes from being poor.”* We can see from the foregoing that it is possible to formulate a policy of raising the national level of wages which will have a real chance of success. Such a policy will consist of the following: increasing capital wealth (by means, if need be, of capital imports and a rational organization of credit), allocation of the factors of production to their most productive uses, intelligent participation in the international division of labor, exploitation of technological and organizational progress, restrained increases in population, a reasonable economic policy in all fields, peace, security, confidence and order—such are the bases of national prosperity.