The Economics of Illusion

10. Mercantilism and Keynesianism1

Nothing is so instructive for the evaluation of scientific and political ideas as the history of those ideas. It teaches us that conceptions claiming novelty and originality have nearly always, during the course of history, been not only conceived but refuted. The knowledge of this history can therefore prevent scientific discussion from moving always in circles; it can prevent undertaking hopeless economic experiments for the testing of which the past has already paid; and finally it can deprive some scientific or political opinions of the appeal of paradoxicalness that make them seemingly irresistible to many people.

In the field of monetary theory and policy, history teaches us, further, that ideas about the role of money in the economy swing like a pendulum from one extreme to the other. Times when the power of monetary changes is overrated alternate with times when it is underrated. Times when a reasonable synthesis of opinion is achieved appear to be rare and brief.

There seems no doubt that in our time the pendulum has again swung strongly in the direction of an overestimation of the possibilities of influencing the economy from the money side. By the followers of the late J. M. Keynes, whose opinions prevail especially in this country, it is considered self-evident that by increasing purchasing power (or “effective demand”) employment can be increased and unemployment combated. It might therefore be appropriate to recall briefly the teachings of the school that has shown more enthusiasm for monetary manipulations than any other during history. We mean the teachings of the Mercantilists.

THE THEORIES OF THE MERCANTILISTS

The relationship of Keynesianism to Mercantilism of the sixteenth to the eighteenth centuries is well known. Keynes himself has pointed to it.2 He has said much in praise and in defense of mercantilistic theory and policy and against arguments presented by its classical critics.

The ideas of the Mercantilists contain—in this we have definitely to agree with Keynes—theoretical insights on money which are astonishing for those times. This is why the general prejudice against them is surely unjust. But can it be concluded from this, as Keynes seems to assume, that Mercantilism can be used in support of Keynes’ ideas, especially regarding the stimulation of business activity? We doubt it.

The main conclusion of the Mercantilists is—in Keynes’ formulation—that “a favourable balance [of payments in International trade], provided it is not too large, will prove extremely stimulating.”3 This stimulation happens, according to the Mercantilists, by a simple mechanism: the favorable balance of payments draws precious metal into the country. This increases the circulating purchasing power. This again means increased demand for labor and thus higher production.4 Such a mechanism can indeed work; however, as Keynes correctly remarks, only under the condition that “the increase in the domestic level of costs [does not] begin to react unfavourably on the balance of foreign trade”5 a condition which the Mercantilists fulfilled by “discouraging rises in the wage-unit.”6

If the Mercantilistic employment theory is thus based on the idea that increased purchasing power results in higher employment, provided wages remain fixed, they have indeed anticipated Keynesianism. For Keynes, too, holds the theory that increased demand leads to increased production; and his theory, too, is valid only if wages and costs are prevented from rising with and through the increasing demand.7

This condition was fulfilled in the times of the Mercantilists. Today it is all but fulfilled.8 Therefore the paradoxical situation arises that Keynesianism is indeed applicable for an analysis of Mercantilistic but not of modern economy; and that on the other hand Mercantilism cannot be used to support modern Keynesianism.

However, we do not want to examine further the factual conditions under which the Mercantilistic-Keynesian employment theory is valid. What we want to show is that this theory embraced in fact all essential features of modern “Effective Demand Analysis.” As far as I can see, the man who developed this analysis most conclusively is John Law who, although generally not counted among the Mercantilists proper, is undoubtedly to be considered the strongest and most interesting exponent of their ideas.

John Law was a man of fabulous ascent and terrible downfall. At the peak of his good fortune (1717-1720) he was master of billions but he died (1729 in Venice) in extreme poverty. Seldom has a man been more loved and admired and also more hated and despised. His relation to Mercantilism can be compared to the relation of Keynes to the New Deal: he was not the originator of the movement but he was the most able and mature formulator of its ideas. Law’s chief works9 are not the works of a crank, as has been maintained by Charles Rist10 and many other authors, but of an extremely ingenious thinker who reached conclusions amazing for his time.

Law by no means identifies abundance of money with abundance of goods, for which many Mercantilists have been correctly reproached. On the contrary, he states explicitly that money as such has no value through its use: “Money is not the value for which goods are exchanged but the value by which they are exchanged: the use of money is to buy goods, and silver while money is of no other use.”11 Money is not wealth but money creates wealth. For “National power and wealth . . . depend on trade and trade depends on money”12 “. . . nor can more people be set to work, without more money to circulate, so as to pay the wages of a greater number.”13

CREATION OF EMPLOYMENT THROUGH CREATION OF “EFFECTIVE DEMAND”

But how is it that according to Law money creates wealth? Law’s reply differs in form but not, so far as I can see, in essence from the reply that Keynes gave nearly two and a half centuries later. It is already a complete “analysis in terms of effective demand.” We quote the famous passages from Chapter 7 of Law’s Money and Trade:

Suppose an Island belonging to one man, the number of Tenants 100, each Tenant 10 in Family, in all 1000. By these the Island is labour’d, part to the Product of Corns, the Rest for Pasturage. Besides the Tenants and their Families, there are 300 Poor or Idle who live by Charity. There is no money; but Rents are paid in kind, and if one Tenant has more of one Product, and less of another than his Family has occasion for he barters with his Neighbour.14

One sees that there are 300 unemployed and 1000 farmers employed for only half the year. “For this reason,” continues Law, “ ’tis proposed to the Proprietor that if a Money were established to pay the Wages of Labour, the 300 Poor might be employed in manufacturing such Goods as before were exported in Product; and as the 1000 that labour the Ground were idle one half their Time, they might be employed so as their additional Labour would be equal to that of 500 more.”15

And he concludes: “But as this addition to the Money will employ the People that are now Idle, and those now employ’d to more Advantage, so the Product will be encreas’d, and manufacture advanced.”16

This is obviously the same idea that Keynes expresses in the words: “. . . it will be possible to increase employment by increasing expenditures in terms of money”17 and later “. . . as effective demand increases, employment increases.”18

But what is the deeper reason for the creation of employment by the creation of new money or demand? Keynes explains the mechanism very clearly by analyzing the reason for existing unemployment. If people are unemployed, it is because their wage demands are higher than the value of their product. If new money is created, the prices of the products increase in terms of money whereas wages remain stable.19 So new money transforms former unemployed into employed by reducing the reward of labor in comparison with the value of its product. Keynes himself, it is true, believes in the employment-creating power of an increase in the quantity of money only for the “general case” because only in the “general case” can wages be considered stable. His followers, however, have formulated the theory in an absolute form, forgetting the special Keynesian assumptions. For them, increase in purchasing power increases employment always until all unemployed are absorbed.

We have already mentioned that nowadays money wages can no longer be considered stable when an inflationary monetary policy tends to lower real wages. In the Mercantilistic period, however, the mechanism as described by Keynes could work, because the omnipotent State had absolute control over labor conditions: workers were forced to work wherever the government wanted, and wages were fixed—and at very low levels—by governmental authority. It is well known that, in case of need, workers were even driven by force into the factories, and a not unimportant part of labor supply was recruited from among the inmates of prisons and orphanages.20

CREATION OF PURCHASING POWER THROUGH CREATION OF NEW PAPER MONEY

If the increase of purchasing power means more employment, and more employment means more wealth, then the problem of increasing wealth is obviously the problem of increasing purchasing power. And here, at the question how the quantity of purchasing power (of money) can be increased, Law arrives at those statements and claims through which he gained, more than through everything else, the attention but also the execration of his contemporaries and later generations. He claims not only that bank notes or paper money should be created, but also—and this is the decisive part—that these should be created in any amount demanded and for which real estate could be given as security. If the authorities “. . . do not give out money when it is demanded, where good security is offer’d ’tis a hardship on the person who is refuted, and a loss to the country: for few if any borrow money to keep by them; and if employ’d it brings a profit to the nation, tho’ the employer loses.”21

Thus according to Law’s theory the size of the credit supply in a country is no longer dependent on the amounts which have been saved, or, incidentally, on the amounts of capital goods that are available. With paper money to be created ad libitum every credit demand can be met at the prevailing interest rate without any disadvantageous consequences. It was this theory that served as a theoretical justification, not only for the bank which he himself was to create later on, but also for the entire sympathetic attitude towards the creation of banks of deposit and banks of issue during the eighteenth and nineteenth centuries. It led to the idea that the founding of a bank, and especially of an issuing bank, is under all circumstances beneficial for every country; an idea that considerably later was formulated by Henry Dunning Macleod in the words: “A bank is a gold mine.”

It will be noted that Law’s opinions are, to a certain extent, more conservative than those of the modern proponents of the “easy-money policy.” His idea is that every demand for credit can be satisfied through creation of new money at the same interest rate—i.e., that the scarce supply need not be defended by rising interest rates. Modern easy-money policy as proposed by Keynes22 goes further in that it advocates lowering of interest rates below the prevailing level in order to incite new demand. Generally speaking, however, it is clear that John Law can be correctly considered the founder of the modern “easy-money policy.”

THE EXPERIENCE OF JOHN LAW’S BANK

As is well known, Law had full opportunity to try to create employment through creation of new purchasing power, and to create new purchasing power by the issuing of paper money. In 1717 he founded his famous Issuing Bank, which, at the end of 1719, created what was probably the greatest boom of all times with more employment than was desired. But the beginning of the year 1720 brought what was probably the biggest crash of all time.

The bank had created paper money without hindrance or inhibitions. Every demand was satisfied—the demand of the private economy, whose need for credits rose during the boom, as well as the demand of the government which financed its deficits through the help of the banks. The financing of the government’s deficit, incidentally, took place as the result of pressure from the government and very much against Law’s will. The creation of paper money led at first to an increasing discount of the bills in comparison with bullion, then to their repudiation: the public no longer accepted the paper money. And all this, though all the well-known techniques were applied with which governments, deteriorating their money, fight the citizen who wants to conserve his capital. The hoarding of bullion was suppressed, the use of coins allowed for small payments only. Export of bullion was punished. Wearing or importing diamonds and pearls was forbidden. Manufacture of silver objects was prohibited, and the paper money became legal tender in the entire country.23

It has been said that the débâcle occurred because Law was an inflationist—that is, he consciously aimed at the depreciation of money. Nothing is more false. He believed that he could create employment by creating money and that he would be able to cease the issuance of new money the moment full employment was reached. He was, therefore, not an “inflationist” but a “prosperity spender.” Like his modern successors, he believed that prosperity created through inflation could be stabilized at a high level. He overlooked the fact that the inflationary boom is followed either by deflationary reaction or by a runaway inflation—this latter in case an attempt is made to prolong the boom artificially. For the stimulus of inflation works only so long as costs have not adapted themselves to rising prices. Therefore, prices have to be raised ever anew by the creation of new money in order to provide the necessary stimulus for the maintenance of the boom. The ever-renewed issuance of new money, however, leads in the long run to the ruin of the currency. Law’s experiment, in any case, ended in severe economic depression, the bankruptcy of his bank, and the devaluation to zero of the paper money it had issued.

If a great financier dies at the peak of his power, it is said at his grave that he was a financial genius. If, like Law, he dies after the collapse of his creations, or if after his death it is discovered (as in the modern case of Ivar Kreuger) that he was bankrupt, people say that he was a ruthless speculator who ruined his contemporaries and his country. If Law’s “system” lives in the memory of posterity as the creation of a visionary, a swindler and a crook, it is because he died broke. But his theories would be objectionable even if by chance his bank had survived him for a certain length of time.

THE CRITICISM OF THE CLASSICISTS

Law’s theories are interesting not only because of their similarity to modern ideas. A knowledge of them is indispensable if one wants to do justice to the teachings of the great English Classicists in the field of monetary and general theory. It has become customary nowadays to think of the Classicists as a sort of antiquated and obsolete out-of-the-world people whose assumptions “happen not to be those of the economic society in which we actually live,” as Keynes24 charges. In reality their theories were based on the very practical experiences of their times, and if certain (though by no means all) of their views were one-sided, this is explainable by the fact that they represented the reaction to a very extreme swing of the pendulum to the unconservative side.

MORE MONEY LEADS TO HIGHER PRICES, NOT TO HIGHER EMPLOYMENT

What the Classicists set against the ideas of Law (whose name, by the way, they did not mention because they considered him unworthy of notice) was the “Quantity Theory of Money,” which they did not invent but which they reproduced and reformulated. In so doing they expressed the basic truth of monetary theory to which science will always return after excursions into the realm of fantasy, quackery, and the illusion that basic economic maladjustments can be corrected through monetary measures. The classical formulation of the quantity theory is found in the famous fourth paragraph of the twenty-seventh chapter of David Ricardo’s Political Economy: “A circulation can never be so abundant as to overflow; for by diminishing its value, in the same proportion you will increase its quantity, and by increasing its value diminish its quantity.”25

It is clear that within the framework of a quantity-theoretical attitude there is no room for the idea that employment can be increased by increasing purchasing power. If one creates additional money, prices and wages, but not employment, will increase. Employment will increase not when money increases but when capital—tools and the means of subsistence for the worker—increases. Adam Smith expresses this idea in the second chapter of the second book of The Wealth of Nations in the following way:

In order to put industry into motion, three things are requisite: materials to work upon, tools to work with, and the wages or recompense for the sake of which the work is done. Money is neither a material to work upon, nor a tool to work with; and though the wages of the workman are commonly paid to him in money, his real revenue, like that of all other men, consists, not in the money, but in the money’s worth; not in the metal pieces, but in what can be got for them.

The quantity of industry which any capital can employ, must, evidently, be equal to the number of workmen whom it can supply with materials, tools and a maintenance suitable to the nature of the work. Money may be requisite for purchasing the materials and tools of the work, as well as the maintenance of the workmen. But the quantity of industry which the whole capital can employ, is certainly not equal both to the money which it purchases, and to the materials, tools and maintenance, which are purchased with it; but only to one or other of those two values, and to the latter more properly than to the former.26

It follows that according to the Quantity Theorists an increase of purchasing power can never lead to an increase in employment. The increase in purchasing power leads to an increase in prices, and, because the workers need the same amount of means of subsistence, to a corresponding degree of wage increases. The increase of money exhausts itself and is absorbed by these price and wage increases. There is no money left for the employment of additional labor.

It is clear that this line of thought is exactly the contrary of Law’s. Whereas he believed that the additional money can be used profitably for the employment of workers hitherto unemployed, the Quantity Theorists contend that the additional money spent itself in increased nominal prices and wages. No wonder that in their system there was no room for what one calls today fluctuations of employment caused by fluctuations of “effective demand.”

LOANABLE FUNDS CANNOT BE INCREASED THROUGH CREATION OF ADDITIONAL MONEY

For the same reasons, the Classicists deny that it is possible to increase the amount of purchasing power loanable to entrepreneurs by the issuance of new paper money. They consequently deny, too, that it is possible to lower interest rates or to prevent their rising by increasing the quantity of money.

I do not dispute [says Ricardo in his famous essay, “The High Price of Bullion”27] that if the Bank were to bring a large additional sum of notes into the Market, and offer them on loan, but that they would for a time affect the rate of interest. The same effects would follow from the discovery of a hidden treasure of gold or silver coin. If the amount were large, the Bank, or the owner of the treasure, might not be able to lend the notes or the money at 4, nor perhaps above 3 per cent; but having done so, neither the notes, nor the money, would be retained unemployed by the borrowers; they would be sent into every Market, and would everywhere raise the prices of commodities, till they were absorbed in the general circulation. It is only during the interval of the issues of the Bank, and their effect on prices, that we should be sensible of an abundance of money; interest would during that interval be under its natural level; but as soon as the additional sum of notes or of money became absorbed in the general circulation, the rate of interest would be high and new loans would be demanded with as much eagerness as before the additional issues.

Only through increased savings can loanable funds be augmented and interest rates lowered.

To suppose that any increased issues of the Bank can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, or that a productive gold or silver mine can have such an effect, is to attribute a power to the circulating medium which it can never possess. Banks would, if this were possible, become powerful engines indeed.28. . . Profits can only be lowered by a competition of capitals not consisting of a circulating medium. As the increase of bank notes does not add to this species of capital, as it neither increases our exportable commodities, our machinery, or our raw materials, it cannot add to our profits nor lower interest.29

The reason is simply that the increase of currency increases prices. The power over machines, material, and labor that the entrepreneur acquires through the credits is only apparently but not actually enhanced. It is true that displacements and dislocations of the power to command production factors occur. The owner of the old money is expropriated in favor of the entrepreneur who is endowed with the new money. In a masterly way Ricardo depicts these consequences of an inflationary credit expansion:

But however abundant may be the quantity of money or of bank notes; though it may increase the nominal prices of commodities; though it may distribute the productive capital in different proportions; though the Bank, by increasing the quantity of their notes, may enable A to carry on part of the business formerly engrossed by B and C, nothing will be added to the real revenue and wealth of the country. B and C may be injured, and A and the Bank may be gainers, but they will gain exactly what B and C lose. There will be a violent and unjust transfer of property but no benefit whatever will be gained by the community.30

THE PENDULUM HAS AGAIN SWUNG BACKWARD

As we have mentioned at the beginning, periods that overrated the power of monetary changes have alternated with periods underrating this power.

The aim of science should be, in this as in every other field, to achieve a synthesis of divergent concepts. Such a synthesis was reached by David Hume in his Essay on Bank and Paper Money, 1752.31 He describes the strong effects of inflation on production during transitory periods and the ineffectiveness of purely monetary measures for longer periods. He recognizes the reason for this: inflation no longer works as soon as the various data of the economy have become adjusted to the increased quantity of money. Thus Hume avoids the overestimation of the Mercantilists as well as the underestimation of the Classicists.

People seem to learn only from their latest experience. Under the effects of the disastrous inflation, German monetary policy turned extremely deflationary in the early ’thirties. The consequence was such an increase of unemployment and such an uprooting of the entire social structure that the Nazi revolution was made possible.

The experience with deflation during the Great Depression in the Anglo-American countries, though less serious, was serious enough to imbue people with a terrible fear of a repetition of deflation and a great respect for reflationary measures. In the framework of this situation, Keynes’ book and its influence on his contemporaries can be understood. In this author’s opinion, the atmosphere which created this influence and which was so strongly enforced by it represents a swing of the pendulum away from the classic toward the pre-classic state of affairs—a swing that can only lead to deceptions. It is to be hoped that theory and policy will again revert to a reasonable synthesis of the divergent concepts.

 

 

32 Appeared first in the American Journal of Economics and Sociology, July 1947.

33 J. M. Keynes, General Theory of Employment, Interest, and Money, New York, 1936, p. 333 ff.: Notes on Mercantilism, the Usury Laws, Stamped Money and Theories of Under-consumption.

34 Keynes, op. cit., p. 338.

35 I can see no essential difference between this process and what is today called “the foreign trade multiplier,”

36 Keynes, op, cit., p. 336,

37 Ibid., p. 340,

38 Ibid., p. 289.

39 See Chapter 6, “Compensating Reactions to Compensatory Spending.”

40 John Law, Money and Trade Considered as a Proposal for Supplying the Nation with Money, Glasgow, 1760 (first published at Edinburgh, 1705); Mémoires sur les banques and Lettres sur les banques, 1717. Cf. Faire, ed., Economistes financiers du dix-huitième siècle, Paris, 1843.

41 Charles Rist, History of Monetary and Credit Theory, New York. First printed in English in 1940.

42 Law, Money and Trade . . . , p. 188.

43 Ibid., p. 110.

44 Ibid., p. 21.

45 Ibid., pp. 182-83.

46 Ibid., pp. 183-84.

47 Ibid., p. 198.

48 Keynes, op. cit., p. 284.

49 Ibid., p. 289.

50 Ibid., p. 284.

51 Handwörterbuch der Staatswissenschaft, “Merkantilismus,” 1925, Band VI, pp. 548-49.

52 John Law, op. cit., p. 168.

53 Keynes, op. cit., pp. 27-28.

54 Cf. Handwörterbuch der Staatswissenschaft, “John Law,” 1925, Band VI, p. 261 (3).

55 Keynes, op. cit., p. 3.

56 David Ricardo, Principles of Political Economy and Taxation, 2nd edition, London, 1819, p. 448.

57 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Vol. I, 8th edition, London, 1796, p. 440.

58 4th ed., London, 1811.

59 Ibid., pp. 35-36.

60 Ibid., p. 36.

61 Ibid., p. 37.

62 A Select Collection of Scarce and Valuable Tracts and Other Publications on Paper Currency and Banking, ed. by J. R. McCulloch, 1862.

• 1* I am grateful to Miss Hedwig Wachenheim for her collaboration in compiling the statistical data used in this chapter. It appeared first in Social Research, May 1944.
• 2Tübingen, 1st ed., 1920; 2d ed., 1924; 3d ed., 1930.
• 3Berlin, 1930; Tübingen, 1931. These articles, as well as those mentioned above, are available in the New York Public Library.
• 4A summary of this volume will appear in German in “Ordo,” Zeitschrift für Ordnung von Gesellschaft und Wirtschaft, 1949, and in French in Economie appliquée, Archives de l’Institut de Science Economique Appliquée.
• 5Remarks on my priority are to be found in Gottfried Haberler, Prosperity and Depression (1939), Wilhelm Lautenbach, “Zur Zinstheorie von John Maynard Keynes,” in Weltwirtschaftliches Archiv (Vol. 45, 1937), Heimann, History of Economic Doctrines (1945), and others.
• 6In my first criticism of The General Theory in 1936, mentioned above.
• 7Vol. 57, pp. 803 ff. (Tübingen, 1927).
• 8Claude William Guillebaud, The Economic Recovery of Germany, London, 1939, p. 21.
• 9On September 21, 1931, Great Britain suspended the gold standard, and on December 8, 1931, the Brüning government cut all income from interest, wages, social insurance, and relief, as well as prices; see Reichsgesetzblatt, 1931, I, p. 699.
• 10Guillebaud, op. cit., pp. 63-65.
• 11Reichskreditgesellschaft, Deutschlands Wirtschaftliche Lage in der Jahresmitte 1939, Berlin, 1939, p. 5.
• 12In a Reichstag address of September 1, 1939: Monatshefte für auswärtige Politik, 1939, p. 907.
• 13Banker (London), February 1937, p. 114; Fritz Lehmann and Hans Staudinger, “Germany’s Economic Mobilization for War,” National Industrial Conference Board, Conference Board Economic Record, New York, 1940, pp. 290-309.
• 14Banker, July 1938, p. 14; Guillebaud, op. cit., p. 63.
• 15Allen Thomas Bonnel, German Control over International Economic Relations, Urbana, 111., 1940, p. 118.
• 16Harris, op. cit., p. 38.
• 17Schacht in Frankfürter Zeitung, November 19, 1927.
• 18Young Plan Advisory Committee Report, Economist, Supplement, January 2, 1932, p. 5.
• 19The Problem of International Investment (cited above), p. 13.
• 20Statistisches Jahrbuch, 1938, p. 254.
• 21Ibid., 1938, p. 254.
• 22In the early days of the Nazi regime exports were promoted by giving the exporter as a subsidy the difference between the low market price paid in foreign exchange for the German bonds repurchased abroad and their nominal Reichsmark value. Blocked mark accounts were bought up by the “Golddiskont” bank at a heavy discount; the discount was also used to subsidize the exporter, as was the gain from the repurchase of the scrip certificates issued after June 1933 in part payment of interest on Germany’s long-term debt. In the middle of 1934, however, the issue of scrip was stopped and the buying of German bonds abroad through the Exportförderung was limited to cases in which payment did not become due until twelve months after the sale. From then on exports were subsidized from a fund (800 million marks in 1935 and 1,000 million in 1936) produced by a levy on the annual turnover. Throughout this period exports were subsidized also by the use of blocked marks (Banker, February 1937, p. 161).
• 23The German-Swiss dealings are a case in point. Although Germany owed money to Swiss citizens for the credits granted her from 1924 to 1930, Switzerland paid for the German coal deliveries of later years by putting the money at the disposal of German tourists traveling in Switzerland. Instead of seeing to it that her own nationals, who were Germany’s creditors, were paid out of the coal deliveries, Switzerland reciprocated by new services. Schacht cleverly used Switzerland’s biggest export industry, tourism.
• 24The Problem of International Investment (cited above), p. 238.
• 25Dr. H. Neisser in Social Research, August 1944, pages 369-381, has pointed out that my “position is surprisingly close to the position of certain Keynesians, who have argued . . . that the amount of saving necessary for expanding the current rate of output is always automatically created by increasing the current rate of investment.” He thinks that capital can be made by inflation only if a totalitarian government can tell the people “how much to save or how much to spend” and if “a certain historically obtained standard of living must be maintained for the major part of the population.” To this I would agree to a certain extent, but would raise the question whether a country urgently seeking capital abroad has not to lower rather than to raise “the historically obtained standard of living” by opposing instead of encouraging wage increases.
• 26Cf. Sumner H. Slichter, in Harris, op. cit.: “The fears which encourage the hoarding of cash may be partly fears of higher taxes, i.e., fears aroused by the deficit itself” (p. 250).
• 27There exists, in addition to the incorrectness of his factual assumptions, a methodological reason why Keynes’ theory cannot be considered a satisfactory analysis of a stable equilibrium but only of frictional maladjustments: in an equilibrium analysis it is inadmissible to assume that some of the data, the prices of goods, yield to inflation whereas the others, the wages, interests, profits remain rigid. Either everything or nothing must be considered as flexible. In the first case the quantity theory is valid; in the latter case we have a sort of regulated economy in which not economic but price- and wage-fixing laws reign over the market.
• 28I consider the refusal of the Brüning government to follow a reflationary policy in 1931 the most important cause of the victory of the Nazi party.
• 29For the distinction between structural and cyclical unemployment, cf. L. Albert Hahn, 1st Arbeitslosigkeit unvermeidlich?, Berlin, 1930. The reader will find in this booklet a summary of the views on unemployment expressed in Europe during a discussion which strikingly resembles the one going on at the present time in this country.
• 30Accordingly, in the third edition of my Volkswirtschaftliche Theorie des Bankkredits, the Interest Theory of Unemployment was developed as a cyclical theory.
• 31A Select Collection of Scarce and Valuable Tracts and Other Publications on Paper Currency and Banking, ed. by J. R. McCulloch, 1862.
• 32  4. Capital Is Made at Home*
• 33I have attempted to counter to the best of my ability the noxious extremes to which monetary policy and theory seem to swing, pendulum-like, as if subject to a historical law. My first publication, the Volkswirtschaftliche Theorie des Bankkredits, it is true, was an inflationary book in an inflationary time; it was understandable, however, as a reaction against the hyper-classicism of prevailing theory in which the effects on the economy of manipulation of money and credit were entirely ignored. It is, to my present way of thinking, a typical soft money book and I attribute its success mainly to the fact that any soft money book—any book that promises prosperity by the relatively easy means of monetary manipulations—is eagerly taken up by readers who have recently witnessed the beneficial effects of inflation in its first phases.
• 34When in 1929 practice and theory again became deflationary in most countries, and especially in Germany, my fight was directed against deflationism, particularly of the Bruening-Luther brand which, I was convinced, would undermine the economy to the breaking point. The Nazi revolution was, in my opinion, largely the inevitable result of the deflationary policy of the last pre-Hitler government. By lectures and articles in daily papers, notably the Frankfurter Zeitung, and in journals, I tried in vain to combat this policy. Of longer articles that were published separately, 1st Arbeitslosigkeit unvermeidlich? (Is Unemployment Unavoidable?) and Kredit und Krise (Credit and Crisis) may be mentioned. Like that of all similar endeavors, their effect was frustrated by the strongly anti-inflationary editorial attitude of the influential Frankfurter Zeitung and the Deutsche Volkswirt which, even after the pound sterling had been devaluated, saw in every monetary adjustment an attack on the value of the mark and persistently warned against what they called unzulässige Währungsexperimente (inadmissible currency experiments). As occurs all too frequently, the people, politicians, and economists had forgotten the past and were solely under the impression of the immediately preceding experience—the hyper-inflation of 1921-23.
• 35These articles are reprinted in this volume with only slight alterations—some omissions to prevent repetitions, and a few supplementary footnotes. I am conscious that today I would express many things differently and, above all, that somebody else, more familiar with the English language and the technique of expressing theoretical statements usual in this country could do better. However, in view of the almost entire lack of anti-Keynesian literature, I have felt obliged to surmount my inhibitions in order to relieve this situation to the best of my ability.
• 36In rejecting Keynesianism, I am in a peculiar position. Keynesianism is a sin of my youth, for as early as 1920 in my Volkswirtschaftliche Theorie des Bankkredits I presented what to me are the basic Keynesian statements. As I confessed later, “all that is wrong and exaggerated in Keynes I said much earlier and more clearly.” Unfortunately I cannot refer to an English translation of my book to prove my claim to priority to English readers. However, Howard S. Ellis gives a very good résumé of my theories in his German Monetary Theory (Harvard University Press, 1934). In order that the reader may judge for himself, and because I refer several times to my work in the following articles, the chapter of Ellis’s book summarizing my theory is reprinted in Appendix I. For the same reason, part of Gottfried Haberler’s extensive résumé and criticism of my book, which appeared in the Archiv für Sozialwissenschaft und Sozialpolitik, has been translated (Appendix II). Another reason for adding these two excerpts is that what the authors say, with full justification, against my theses can be said with the same justification against Keynes, but has not been.
• 37In rejecting Keynesianism, I am in a peculiar position. Keynesianism is a sin of my youth, for as early as 1920 in my Volkswirtschaftliche Theorie des Bankkredits I presented what to me are the basic Keynesian statements. As I confessed later, “all that is wrong and exaggerated in Keynes I said much earlier and more clearly.” Unfortunately I cannot refer to an English translation of my book to prove my claim to priority to English readers. However, Howard S. Ellis gives a very good résumé of my theories in his German Monetary Theory (Harvard University Press, 1934). In order that the reader may judge for himself, and because I refer several times to my work in the following articles, the chapter of Ellis’s book summarizing my theory is reprinted in Appendix I. For the same reason, part of Gottfried Haberler’s extensive résumé and criticism of my book, which appeared in the Archiv für Sozialwissenschaft und Sozialpolitik, has been translated (Appendix II). Another reason for adding these two excerpts is that what the authors say, with full justification, against my theses can be said with the same justification against Keynes, but has not been.
• 38In rejecting Keynesianism, I am in a peculiar position. Keynesianism is a sin of my youth, for as early as 1920 in my Volkswirtschaftliche Theorie des Bankkredits I presented what to me are the basic Keynesian statements. As I confessed later, “all that is wrong and exaggerated in Keynes I said much earlier and more clearly.” Unfortunately I cannot refer to an English translation of my book to prove my claim to priority to English readers. However, Howard S. Ellis gives a very good résumé of my theories in his German Monetary Theory (Harvard University Press, 1934). In order that the reader may judge for himself, and because I refer several times to my work in the following articles, the chapter of Ellis’s book summarizing my theory is reprinted in Appendix I. For the same reason, part of Gottfried Haberler’s extensive résumé and criticism of my book, which appeared in the Archiv für Sozialwissenschaft und Sozialpolitik, has been translated (Appendix II). Another reason for adding these two excerpts is that what the authors say, with full justification, against my theses can be said with the same justification against Keynes, but has not been.
• 39But the spring of 1931 represented the turning point. The Reichsbank lost nearly 2 billion marks in gold and foreign currency in the two months after the crash of the Austrian Kreditanstalt in May of that year. In a panic the German Government sent the president of the Reichsbank to the European money centers in quest of new credits of at least 400 million dollars. On July 9 Dr. Luther arrived in London, on the 10th he was in Paris, and on the 11th he flew home. On the 13th he went to Basle to attend a meeting of the governors of the central banks. The credit of 100 million dollars which had been granted the Reich in June for three weeks was extended for three months—for all practical purposes it was frozen anyhow—but a new credit grant was refused. The creditors were no longer willing to pour money into the bottomless German barrel. Germany was forced to act alone. On July 14 the government announced a bank holiday, and on the 15th centralized all foreign exchange dealings in the Reichsbank, which meant the first step toward full currency control. Germany was embarking upon a new policy: to live without importing capital.
• 40The world expected a new collapse. True, a heavy deflationary crisis shook Germany. But the deflation was not caused by capital withdrawals or by the lack of new capital influxes; it was government-made, to enable German exporters to compete with the British, who were being favored by the devaluation of the pound.
• 41At the beginning of September 1931 the first moratorium agreement for short-term credits was concluded. In June 1933 a partial transfer moratorium for the service of long-term loans was announced, followed by an almost total one in 1934. Nevertheless, until her war with the United States, Germany continuously repurchased her loans in foreign markets, where they were devalued by default. Thus she recovered from the 1931 crisis not only without capital imports but even while reducing her foreign debt.
• 42Since the turning point Germany has produced capital in tremendous amounts, for domestic investment as well as for exportation. The Hitler era before the war was one of intensive industrial reconstruction, in which Germany’s capacity for production in general, and for the production of war material in particular, was enormously expanded. During those six years from 1933 through 1938 the capital produced for domestic investment was as follows (in billions of marks):
• 43Hitler’s statement that Germany spent 90 billion marks on her armament from March 1933 to the outbreak of the war in 1939 is corroborated by estimates made in Great Britain and in this country. And the output of armament represented capital production, inasmuch as it withdrew goods and services from consumption.
• 44Hitler’s statement that Germany spent 90 billion marks on her armament from March 1933 to the outbreak of the war in 1939 is corroborated by estimates made in Great Britain and in this country. And the output of armament represented capital production, inasmuch as it withdrew goods and services from consumption.
• 45As for capital exports, Germany transferred, from the turning point in July 1931 to the outbreak of war in 1939, approximately 4.5 billion marks on her debt service; of this, it must be emphasized, approximately 3 billion was transferred during the pre-Hitler era. In addition, her foreign debt was reduced during these years by 14.3 billion marks, as shown in the table above. Of that amount 6 billion marks was accounted for by the depreciation of the creditor countries’ currencies, and only part of the remaining 8.3 billion represented actual repayments, for Germany was able, as shown in preceding table, to repurchase loans and marks in foreign hands well under par. Nevertheless, very substantial exports took place, and the capital exported was replaced by domestically created capital.
• 46As for capital exports, Germany transferred, from the turning point in July 1931 to the outbreak of war in 1939, approximately 4.5 billion marks on her debt service; of this, it must be emphasized, approximately 3 billion was transferred during the pre-Hitler era. In addition, her foreign debt was reduced during these years by 14.3 billion marks, as shown in the table above. Of that amount 6 billion marks was accounted for by the depreciation of the creditor countries’ currencies, and only part of the remaining 8.3 billion represented actual repayments, for Germany was able, as shown in preceding table, to repurchase loans and marks in foreign hands well under par. Nevertheless, very substantial exports took place, and the capital exported was replaced by domestically created capital.
• 47It is very difficult to estimate the creditors’ losses. As far as the moratorium credits are concerned, it is generally estimated that the creditors lost 15 per cent when they sold their accounts; this would mean a loss of approximately 825 million marks, since 5.5 billion marks in these accounts was disposed of by 1939. Estimates on the repatriation of the foreign bonds range from 400 to 700 million dollars. Up to 1934, when approximately 300 million dollars in these accounts had been repatriated, the foreign creditors had lost about one-half through sales below par; later their loss was much higher.
• 48Another explanation that has been put forward is that the loans were used not for production but for consumption purposes, such as the construction of “stadia, swimming pools, and ornamental buildings.” This is true only to a small extent, however, for most of the loans were granted to private industrial firms and public utilities. Furthermore, Germany’s productive capacity, whatever may be meant by that rather vague term, was increased sufficiently after 1923 to create a surplus production equivalent to the amount necessary for amortization and interest.
• 49Still another explanation, frequently encountered, is that the default was caused by the German debtors’ lack of liquidity; especially the German banks are accused of having borrowed short and lent long. After the bank holidays, however, and the subsequent moratorium agreements of 1931, all short-term loans became long, and interest and amortization payments were nevertheless suspended in 1933.
• 50The best of the usual explanations, and one that seems to be generally accepted nowadays, is that in regard to the loans of that period—in contrast to the big international loans of the nineteenth century—it was no longer possible to transfer the interest and amortization burden to the creditor countries. The argument is accurately summarized in the report of the Study Group of Members of the Royal Institute of International Affairs: “In the nineteenth century . . . the chief lending country, namely Great Britain, herself constituted a market with unlimited possibilities of expansion for the produce of the countries to which she lent; and her lending served to increase the output of precisely the commodities which she was ready to consume. But when the United States lent . . . there was only a somewhat weak presumption that Germany’s capacity to sell goods in world markets would thereby be increased, and virtually no presumption at all that the United States herself would be willing to increase her imports in proportion to the growth of her interest claims.”
• 51Nevertheless, events since 1933 and particularly during the last years before World War II, show that the reasoning of the Royal Institute report is only partly correct. Although the creditor countries, reluctant to accept more imports, rationed them and imposed high duties on them, they could not prevent their arrival from Germany; these measures merely made importation harder for the debtor, who was forced to subsidize his exports. In the matter of a country’s ability to make payments abroad, it should never be forgotten that, despite the widely held opinion, no country is predestined to have an active or passive trade balance. A small deflationary pressure on the price level, or a small inflationary rise in the price level, will, under certain conditions, suffice to reverse the trend of the trade balance. This is especially clear from the change in the German trade balance between 1927, the year of the largest capital import, and 1931, the year of the largest capital export. In 1927 it showed an import surplus of 3,427 million marks, and in 1931 an export surplus of 2,872 million, a difference of 6,299 million.
• 52In the first period the balance of trade became unfavorable and the acquisition of foreign exchange ceased, simply because Germany started on a policy of credit expansion to combat unemployment. During this credit expansion the exchange rate of the mark was not lowered, although it had previously risen substantially through the devaluation of other countries’ currencies. In these circumstances it was only natural—according to all rules of the purchasing-power parity theory, the classical theory of exchange-that the balance of trade became passive; it turned from an export surplus of 1,072 million marks in 1932 to an import surplus of 284 million in 1934. Thus from June 1934 the default on interest and amortization on long-term loans was inevitable.
• 53In addition, exports were fostered. The technique of the so-called Exportförderung (promotion of exports) changed as time went on, but the fundamental idea was always that through defaulting on her foreign loans Germany could depreciate her foreign bonds. Furthermore, by restricting the use of certain mark balances and securities held by people abroad (Auslandssperrmark, Effektensperrmark, Auswanderer sperrmark), she depreciated these assets too, and was thus able to repurchase them at a fraction of their face value. With the profits from this procedure her exports were subsidized and, in consequence, substantially increased.
• 54Finally, it should be remembered that in all countries the position of creditors, in comparison with that of industrialists, suffers from an inherent weakness. Industrialists will continue their export business even if the debts accumulated from former exports have not been paid. They would rather give away goods, if the gifts come out of the pockets of the bondholders, than turn down new business. That is why most countries are reluctant to use all possible means of collecting their external debts, so long as there is a chance of continuing exports to debtor nations.
• 55From 1924 to 1931 foreign loans poured into Germany in the huge amounts mentioned above. But whether they actually augmented Germany’s productive capacity is open to question. Her balance of payments raises some doubts. Of the net capital import of 17.3 billion marks from 1924 to 1930, only 2.4 billion was used to buy merchandise; the remainder was spent on the transfer of interest payments (2.7 billion marks), on reparations (10.1 billion) and for the import of gold and foreign currency (2.1 billion). Thus only a relatively small part of the gigantic capital influx was used for really productive purposes, and we may therefore conclude that only a small part was needed for such purposes.
• 56Elasticity of production was the strength of the European countries after the 1914-18 war. They have since acquired in addition elasticity of money and credit. With the abandonment of the gold standard, governments and central banks are no longer forced to restrict their credits in order to maintain the parity of their currency. There is no longer such a thing as need for the so-called external discount policy. Now there exists only the so-called internal discount policy, which is used to manipulate the business cycle and the capital and credit supply. The supply of credit can be raised and the interest rate lowered at will; the effect is merely a change in the distribution of income between debtors and creditors. The “slight inflation” that arises from such inflationary expansions of credit restricts current consumption, through raising the prices of goods, and directs economic activity toward the production of capital goods, as described above.
• 57When employment is created by means of governmental deficit spending, the day will come when people realize that the real rates of earnings have been reduced and they will demand higher rates. Labor will not be satisfied with the prevailing wage level, less capital will be offered at the prevailing interest rate, and less entrepreneurial activity at the prevailing profit rate. All supply price schedules will move upward. Which of these upward movements will be the strongest depends upon whether labor, capital, or entrepreneurial earnings are expected to be taxed most heavily. The consequences for the structure of the economy are well known; in any case, a further increase in employment will not be possible. And if the government tries to compensate for the compensating reactions by spending still more, again still higher taxes will be anticipated, and so on in a vicious spiral. All this will happen at the latest when the first taxes to meet the larger government obligations are to be levied.
• 58Our conclusion is that the case Lord Keynes regards as the “general case” is in reality a special case, valid only under special conditions and for a certain time. His theory is a special theory of employment for the case when the money illusion works.
• 59Consequently, monetary manipulations will be effective in shortening the transition period from a cyclical depression to recovery. Lowering interest rates below the prevailing market rates and governmental deficit spending are defensible, even advisable at this juncture. But all this is nothing more than the discount policy, open-market policy, and fiscal policy recommended as a means of mitigating cyclical movements, long before Keynes, by almost every monetary business-cycle theorist.
• 60Now there is no doubt that Keynes’ employment theory was conceived during and under the impression of such a cyclical prerecovery and recovery period. This alone can explain his factual assumptions which are typical for such periods but entirely atypical for other periods. On the other hand, Lord Keynes certainly does not intend his theory to be merely a theory of fluctuations in employment during business cycles; these are treated as a special case toward the end of his work. He deals with the establishment of stable equilibria with larger employment, as distinct from the increase of employment during the dynamic process of the cycle. He means his theory to be, chiefly, a theory of noncyclical and thus stabilized, or—to use the European expression—structural employment and unemployment; in short, a general theory. And it is just and only as a general (not as a business-cycle) theory that it is original, challenging, and different from the classical. And it is at this point that there arises a phenomenon that is tragic for economic theory and dangerous for practical economic policy: what is really a theory of cyclical unemployment is formulated as a theory of structural unemployment. And once formulated, it leads its own life, detached from its premises, and becomes the basis and justification for policies concerning situations for which it is not valid, such as unemployment caused by wages which are structurally too high.
• 61To this case Keynes’ scheme is not applicable. In other words, neither lowering interest rates nor government compensatory spending is effective when unemployment prevails at a price level that is neither boom-inflated nor depression-deflated. The reason is simply that in this case the illusion effect does not work for any length of time and that the reaction period is therefore very short.
• 62The aim of science should be, in this as in every other field, to achieve a synthesis of divergent concepts. Such a synthesis was reached by David Hume in his Essay on Bank and Paper Money, 1752. He describes the strong effects of inflation on production during transitory periods and the ineffectiveness of purely monetary measures for longer periods. He recognizes the reason for this: inflation no longer works as soon as the various data of the economy have become adjusted to the increased quantity of money. Thus Hume avoids the overestimation of the Mercantilists as well as the underestimation of the Classicists.