The Economics of Illusion

15. The Investment Gap1

Critics of Keynesian economic theory or policy do not usually stress its logical inconsistency. In their opinion what is wrong is that the underlying factual assumptions are unrealistic or, more specifically, correct only in very special cases. Their charge is similar to that of Keynes against classical theory: that its assumptions are in general not “those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.” 2

The miracles the Keynesian system works can be attributed to the data taken as dependent and independent variables and as fixed, plus certain assumptions concerning the shape of important functions, especially the consumption, money supply, and investment functions. Change these assumptions to what non-Keynesians consider more realistic terms and the classical or neoclassical theory reappears like an old picture when the layers of paint laid on by successive generations are removed.

In a certain sense the Keynesian factual assumptions were never correct; in another, they have been invalidated through changes of the last decade. It is not pure chance that “modern employment theory sheds little light” 3 on the practical problems of today, which are essentially problems of wage-price relationships and—at least for the time being—of overabundant, not of deficient demand. But with the lag peculiar to economics, publications based upon the Keynesian approach are more frequent than ever.4

In Chapter 11, “Wage Flexibility Upwards,” I tried to show that Keynes’ wage assumptions, so essential to his investment theory of employment, must be considered unrealistic and/or anachronistic. In Chapter 13, “Anachronism of the Liquidity Preference Concept,” I tried to do the same for the assumptions underlying the liquidity preference concept. In the present chapter I examine the assumptions underlying the so-called “investment gap approach,” especially those concerning the consumption and the investment-demand functions.

Anyone familiar with Keynes’ theory will agree that if these three cornerstones—the assumptions concerning the behavior of people in matters of wage demands, liquidity preference, and consumption—were removed, nothing would remain of his system except a formal construction inadequate to describe and explain reality. And the far-reaching conclusions for economic theory as well as policy derived by those who think along Keynesian lines would have to be revised in many respects.

THE BASIC DIFFERENCE BETWEEN THE CLASSICAL AND THE KEYNESIAN ATTITUDE

The investment gap approach is responsible for the emphasis modern theory lays upon consumption as the prerequisite for production. And it is responsible, too, for the attitude of our times, so favorable to spending and so unfavorable to saving—an attitude fundamentally different from the classical, which always deemed saving a virtue.

For the classical economists the problem of filling “the gap” 5 between saving and investment did not exist. Interest rates were supposed to keep saving and investment always in balance. Keynes, on the other hand, believes that increased savings are not necessarily absorbed by investment in the wake of falling interest rates. If they are not absorbed, the balancing of saving and investment takes place through a decline in saving in the wake of a decline in employment to what can be called a “poverty equilibrium”: “There must be sufficient unemployment to keep us so poor that our consumption falls short of our income by not more than the equivalent of the physical provision for future consumption which it pays to produce today.” 6 The result is that the economy remains “in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.” 7 Thus, if investment is not increased, expansion of employment is hindered unless consumption keeps pace with production. In short, saving regulates employment.

Keynes’ assumptions in this as in other important problems cannot help being unrealistic because, in trying to establish a “general” theory, he makes statements concerning the behavior of men in general, whether in short- or long-term situations, under dynamic or static conditions. His purpose is to overcome what he considers one of the weakest points in prevailing theory—the inconsistency between general and business-cycle theory. But men’s reactions to more income vary with circumstances; therefore a “combination theory” which attempts to cover all cases really covers none.

Dividing Keynes’ combination theory into its components and distinguishing short- and long-term equilibrium situations on the one hand and dynamic and static conditions on the other, we shall discuss in turn: “general” short-run equilibrium; cyclical movements; and long-run equilibrium.8

We shall try to prove that—

a. An investment gap approach is not applicable in the case of general short-term equilibrium because the consumption (or saving) function does not have the form Keynes assumed;

b. Cyclical depressions are neither induced nor aggravated by unabsorbable savings; something quite different, what we call “waiting,” is at work;

c. In long-term equilibrium an investment gap, while conceivable under special conditions, could at best explain a progressive decline in employment, never stagnation, i.e., a long-lasting low level of economic activity.

THE “PSYCHOLOGICAL LAW” AND ITS IMPLICATIONS WITHIN KEYNES’ SYSTEM

Keynes makes the relation between an increase in income and in consumption or saving the basis of his entire system. Calling it a “psychological law,” he gives it two forms: a stronger and a weaker.

In its weaker form the law states that when income increases, consumption also increases but somewhat less; i.e., marginal consumption never equals marginal income:

The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.9

In its stronger form the law states that marginal consumption not only never equals marginal income but that the “marginal propensity to consume falls off steadily as we approach full employment.” 10

Both statements are meant as “general” statements. They are supposed to apply to all sorts of increases in income, whether due to cyclical and other short-term changes or to improvements in productivity and other long-term changes. This is obvious if from nothing else than his remark: “We have short periods in view, as in the case of the so-called cyclical fluctuations of employment”;11 and by his further remark that the psychological law is valid “apart from short-period changes” 12 though not for “far-reaching social changes or . . . the slow effects of secular progress.” 13

What is the significance of the psychological law in Keynes’ system?

a. It serves to establish an unemployment equilibrium. Given a certain amount of investment and a consumption function that obeys the psychological law, employment is, so to speak, squeezed down by the lack of demand due to the deficiency of consumption (or increase in saving) that would follow higher employment: “the insufficiency of effective demand will inhibit the process of production.” 14 For if “entrepreneurs were to increase employment as a whole, their proceeds will necessarily fall short of their supply price.” 15 Therefore “the increased employment will prove unprofitable unless there is an increase in investment to fill the gap.” 16

To establish this employment equilibrium, the psychological law in its weaker form suffices.

b. It serves to explain at least in part why prosperity does not last. As income increases during prosperity, saving increases. If a demand deficit is to be prevented, the current rate of investment must rise. However, it becomes increasingly difficult to find new investment opportunities. This line of thinking places Keynes distinctly in the ranks of the oversaving or underinvestment business-cycle theorists. It is expressed in various passages of his General Theory, though (as we shall see) contradicted in others. It is given its most striking formulation when it is used to explain the crash of 1929:

It became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump.17

c. It serves to explain why allegedly modern economies must remain in a state of chronic underemployment in the long run: “to fill the gap between net income and consumption, presents a problem which is increasingly difficult as capital increases.” 18

For the second and third purposes, too, the psychological law in its weaker form suffices. If saving in the current production period is to be by only the slightest degree larger than in the preceding period, the rate of investment must rise; otherwise, income cannot increase. However, investment would obviously have to increase much more if the psychological law in its stronger form were valid. On the other hand, in the long run, an investment gap from the investment side could threaten even if there were no psychological law whatsoever. Even if saving, while remaining positive, does not increase at all, a continuous addition to the capital stock could in time lead to a saturation of the economy with capital and thus to a downward shift of the investment curve.

Our main problem remains, however: is there a “psychological law”? And if there is, can it have the effects attributed to it in Keynesian theory? The answer depends largely upon how the increase in income comes about:

a. Aggregate real income can increase if entrepreneurs engage former unemployed workers because, for instance, wage demands have been lowered. This is the case Keynes treats in his Chapter 19 (“Changes in Money-Wages”).19

b. Income can increase in the wake of and through the peculiar mechanism of the credit expansion characteristic of cyclical upswings.

c. Aggregate real income can increase by reason of the greater productivity of labor brought about either by technical progress or the use of more capital. This is essentially a long-run increase.

“GENERAL” SHORT-RUN EQUILIBRIUM: INCOME RISES WHEN EMPLOYMENT INCREASES AFTER WAGES HAVE BEEN REDUCED

Keynes’ presupposition in the case of short-run equilibrium is that a deflation threatening in the wake of higher employment would prevent any improvement in the rate of unemployment. But this need not be the case. Suppose wage demands are reduced 10 per cent, and aggregate income—through increased employment—is raised 20 per cent. If half of the 20 per cent is saved, prices will be deflated 10 per cent on the average. Thus the effect of the decline in the supply price of labor would be nullified and an increase in employment indeed prevented. However, if less than half is saved, employment would increase despite the deflation of the price level.

We shall not discuss here the possibility of a deflationary employment increase.20 Instead we will concentrate on the question whether an increase in employment can lead to deflation.

“In general,” people tend to use part of an increase in income to provide for the future. No psychological law is necessary to explain this behavior. Under modern conditions people, except the very poor, always devote part of their income to the future, if only in the form of life, old-age, or sickness insurance. Furthermore, it has often been verified empirically that the saving-income ratio is usually higher in rich than in poor families.

However, the increment to income from an increase in employment induced by lower wages—the case Keynes really has in mind in Chapter 19—cannot be called a “general” case. It is a very special case. Only if violence is done to the facts can the psychological law be considered to work here. It has in this special case never been verified statistically, and probably never can be. For most increases in employment are cyclical and not due to a spontaneous decline in wages; and when wages do decline spontaneously, the effects could hardly be separated from those of simultaneous cyclical developments.

Moreover, probability points against the working of the psychological law in this special case. For here the addition to the income of the community comes from the income of the former unemployed—according to Keynes: “not all the additional employment will be required to satisfy the needs of additional consumption.” 21 If any general rule on the behavior of the newly employed—formerly unemployed—can be established, it is that they probably spend all their earnings. And even if they saved, the saving would be of negligible significance. For all practical purposes the curve of spending and the curve of income coincide if the increase in aggregate income is due to new employment.

To state the contrary and to use the statement as a basis for a general theory of employment seems therefore entirely unrealistic.

Nor can it be assumed that the newly employed increase aggregate saving because they stop dissaving. Usually the unemployed live on the earnings of members of their family or on unemployment relief, which in turn is financed by taxes on the income of other members of the community, not on their capital.

But it might be objected: suppose the unemployed have been supported by public deficit spending, i.e., by spending the savings of the community. Then such dissaving would decline as unemployment declined. However, this objection would merely introduce governmental anti-depression measures into the argument. When governmental deficit spending stops, deflation may follow. But such deflation does not occur because people are inclined to save parts of their income in accordance with the psychological law. It occurs because the government ceases to spend the savings of the community.

It has furthermore been argued: if employment increases after wages have been reduced, the income of entrepreneurs increases, and of this new income a part will be saved. This is not the case Keynes had in mind when he established the relationship between increased income and saving. For, as a simple graph would show, such new income of entrepreneurs does not mean an additional income to the community. It merely means that the distribution of income has been altered. Profits have increased at the expense of wages. Such redistribution of income might of course lead to more aggregate saving, but it need not.

Under present conditions saving would probably even decline, not increase because income would be shifted from lower to higher tax brackets. This may be otherwise, but never so generally and so automatically that it warrants the establishment of a law according to which increase of employment through wage lowering must lead to deflation via increase in saving. But even if aggregate saving would increase: to assume that the deflation threatened by the saving of the relatively few entrepreneurs could nullify the effect of the preceding deflation of the wages of the working masses—except under very peculiar circumstances—betrays a lack of sense of proportion.

The whole Keynesian “formal analysis” suffers furthermore from the inconsistency that it takes into account the effect of wage lowering and employment increase on saving but not on investment decisions, which are not in the slightest less probable. Every businessman expects in fact—and not without reason—that in an otherwise neutral atmosphere wage lowering leads to an inflationary boom via increased investment rather than to a deflationary depression via increased saving. For the newly employed workers have to be equipped with tools and machines and—very often forgotten—have to be paid, which fact alone creates a new demand for credits. If therefore the news would spread that the unions had lowered their wage demands, a boom on the stock market and not a slump would develop. This is one of the chief reasons why Keynesianism appears so very unrealistic to businessmen. The theorist will object that an equilibrium analysis must take into consideration all reasonable reactions, not just one. By failing to do so one can indeed demonstrate the possibility of equilibria that are most amazing to classical thinking. But they are no real equilibria in any correct sense of the word, not even short-term equilibria, but at best transitory situations.

What then limits employment if not a deflationary pressure from an investment gap? In “general” or “formal” analysis the answer can only be the answer of the classical economists: employment is dependent solely upon the wage level and the marginal productivity of labor.

A DIGRESSION: PRICES AND EMPLOYMENT IN AN ECONOMY WITH A PERFECTLY ELASTIC MONEY SUPPLY

Of course the problem remains whether an increase in employment will not be hindered by a scarcity of funds to meet the bigger payroll, especially when the demand for labor is very elastic, so that a slight decline in wage rates leads to a big increase in employment. Formerly, this impediment to employment was extensively discussed in connection with the “neutral money” problem. However, if meeting a bigger payroll, and thereby an increase in employment, is hindered by an undersupply of money, the reason is clearly not an excess but rather a deficit of investible funds. Furthermore, the problem would not be how to pay for the products of the newly employed, but how to pay their wages. Obviously, this problem does not exist as long as the supply of money is almost perfectly elastic at a very low interest rate level. As this is written (March 1948), the trouble is that entrepreneurs, if their credit is good, can obtain all the additional money they need for bigger payrolls at practically the same low interest cost—not that they cannot obtain it.

Parenthetically it may be added: the quantity of money plays, as is well known, an important role in Keynes’ system as an independent variable. It is held responsible for certain changes in investment and employment. If the money-supply curve remains unchanged as the result of deliberate government policy, the quantity of money of course ceases to be an independent variable. And if the supply curve has become not only stable but also almost horizontal, the supply of money being almost perfectly elastic, the quantity of money can hardly be considered useful any longer as a fixed datum in any equilibrium analysis.

Indeed, the problem now is not how to meet payrolls inflated by full employment, but how to prevent payrolls—and the price level—from inflating indefinitely. What then puts a ceiling on prices and wages when money is not scarce? What keeps them from skyrocketing? It is sometimes argued that wages and prices cannot rise indefinitely because the purchasing power to buy the products at higher than prevailing prices would be lacking. The flaw in this argument is that high wages create in the aggregate sufficient purchasing power to absorb at least the price increases due to them.

Now, if no wage increase need ever lead to the situation so feared by Keynes—where the proceeds from production fall short of the outlays—why do entrepreneurs not grant every demand for an increase in wages? A “circular analysis,” reckoning with a limited money supply, can give no answer after the money supply has become perfectly elastic. Obviously, it would also be a vicious circle to assume that the prices entrepreneurs expect for their products act as a ceiling on wage increases. For the prices themselves are a function of the demand created by the wage increases. The answer can be given only by “chain analysis,” according to which entrepreneurs reckon with the price pattern of the past, which they consider stable as long as optimistic or pessimistic expectations do not suggest markups or markdowns.

Our assumptions concerning the elasticity of the money supply may not seem entirely warranted. In fact, there are signs that the prevailing easy-money policy cannot be maintained indefinitely. It nevertheless seems more useful to base an analysis on a state of affairs in which the money supply is perfectly elastic than to continue to assume that the economy will constantly be disturbed by a scarcity of money.22

CYCLICAL MOVEMENTS

A. Can increases in saving due to rising income (shifts along the income curve) lead to depression?

Undoubtedly during cyclical upswings saving increases, not only absolutely, not only proportionately to the increase in income, but even more than proportionately. However, there seems no proof and not even a probability that “the marginal propensity to consume falls off steadily as we approach full employment.” 23 Saving is apparently greatest at the beginning and the middle of an upswing.

The special case of high saving during cyclical upswings evidently impressed Keynes so much that he felt impelled to formulate his general psychological law. In fact, everything he says about income and saving fits this case, the case of “prosperity saving,” as we should like to call it.24 But is prosperity saving due to an increase in income by reason of higher employment? It may be conceded that over a longer period the newly employed too begin to save. Yet if Keynes is right, wages tend to lag behind prices during a boom. According to the psychological law, however, declining real wages would mean decreased saving. On the average, saving would scarcely increase.

The windfall profits that accrue during an inflationary boom offer a better explanation. Unless taxes are too progressive, the savings of profiteers overcompensate the decline in the savings of the victims of inflation. Such savings have correctly been called “secondary” or “induced” savings.25

The paramount reason for “prosperity saving,” however, seems to be that the monetary expansion is not recognized as such at the beginning or even in the middle of an upswing, by either buyers or sellers. People are not prepared to compete for the goods on hand by bidding prices up. Buyers prefer to wait in the hope that goods will soon be plentiful at the old prices. On the other hand, sellers do not mark up their prices because they hope they will be able to replace their inventories at the old price. In other words, at the beginning of an upswing and far into prosperity a sort of voluntary rationing and price-ceiling system prevails. Although goods are available in only limited amounts, their prices are not raised. In wartime this system is enforced by laws and regulations. It is in large degree responsible for the huge amounts of “war savings.” What happens during a war boom in this respect is nothing but a replica of an ordinary boom on a gigantic scale.

So the increase in saving during an upswing has nothing to do with the stickiness of spending habits, i.e., with the reluctance of people to spend all their increased income on current consumption. It has to do with the stickiness of price expectations. Prosperity saving is, in other words, caused essentially by inflation that is not recognized as such. One might therefore call it “inflationary saving.”

But whatever its origin, prosperity saving can never explain how a boom can end for lack of sufficient investment opportunities; certainly not, if one subscribes to Keynes’ general statements about the relations between investment, income, and saving.26 According to these the increase in saving during an upswing is due to increased income, which in turn is due to increased investment typical of prosperity. What is really the consequence of investment can never be the cause of a deficiency in it. Investment is always sufficient to absorb the saving it creates. And because investment financed by credit expansion brings on inflation which in turn leads to saving, such saving is not a deflationary force but a force that at best can dampen the inflationary force of investment financed by additional credit.

Thus the form of a curve showing the propensity to consume at various income levels during an upswing is relevant only for the degree of the inflation caused by the increased investment. If the propensity to consume is high, investment will have strong inflationary effects. If the propensity to consume is low and therefore saving is high, the effects of investment will be less inflationary. But the form of the consumption function can never be of any importance for the capacity of investment to absorb saving. Abundance of saving cannot explain the deficit in investment at the beginning of a depression. Even in the last minute of the boom saving is absorbed by the very investment that brought it into existence.

Under one condition alone could investment create saving it could not absorb: if the increased income led to a decrease in consumption. In this case investment would be impossible, because a resulting saving would not only hinder inflation but cause deflation. Such a form of consumption curve, however, is highly improbable.

The situation prevailing at the end of an upswing shows in fact that saving, increasing during and by reason of the upswing, has nothing at all to do with terminating it. For until the downward shift in investment and consumption causing the turn really sets in, the situation is characterized by inflation and/or high interest rates; there is neither deflation nor an abundance of new saving such as a “wealthy community in full employment would be disposed to set aside.” 27 In any case, the turning cannot be caused by savings increased by “shifts along the curve.” Nor is, incidentally, the turning from depression to recovery caused by such shifts along the curve. Depression ends not because savings decrease during the downswing in the wake of decreasing income, but because from incomes no longer decreasing a greater portion is spent: after an exhaustion of inventories, a change in the psychological situation or—familiar to every stock market speculator—a growth of cash balances in relation to the price level.

In conceding that the form of the consumption function is relevant for the inflationary effects of new investment, we do not wish to imply that the consumption function, though perhaps stable in the long run, remains stable during the cyclical upswing and that it is determinable in advance—an assumption underlying the so-called multiplier concept. To what degree money is spent or saved during an upswing, and what forces are at work at every stage, is just the question business-cycle theorists try to solve. To this end they analyze the dynamic process of the upswing and the resulting changes in profit expectations. The “multiplier” concept, however, is either a truism—in stating that money not saved is spent until it is finally saved; or it is a petitio principii—in implying that a constant portion is saved or spent. The problem is: how big will the various portions be? What will happen during a certain period after the government has spent a billion dollars on public works? What will be the various consumption quotas? The answer can never be given in advance. For the function of production and consumption is never stable over time in a dynamic world. They depend on innumerable data responsible for the successive reinvestment and consumption decisions of the individuals. Therefore the multiplier which seemingly gives the answer as to the effects of governmental or other investments on future income and employment, in reality only reformulates the question.

B. Can spontaneous increases in saving or decreases in investment (shifts of the curves) lead to depression?

1. Increases in saving.

In the main parts of his General Theory Keynes considers an increase in saving induced by an increase in income as the cause of subnormal activity. On the other hand, he seems to think that cyclical depressions are due to a spontaneous increase in saving and/or a spontaneous decrease in investment. The reason he gives for the 1929 crash in the passage quoted28 could be interpreted in this way.

An increase in saving proper cannot, however, lead to anything resembling the typical pattern of crises and depressions, except in very special cases:

a. If an increase in saving (in the usual sense of the word) were causative, the boom would peter out, not end suddenly.

b. During a crisis and in the first phases of a depression, interest rates rise. Investment demand, especially for financing unsalable inventories, is high. There is no “oversaving”; rather there is “undersaving,” as certain business-cycle theorists contend. Deflation is brought on not by an oversupply of investible funds, but by “liquidity preference,” i.e., a curtailment of the supply of funds from the “money side.” Incidentally, such a deflation will, as I tried to show in Chapter 13, hardly occur in the future because of the institutional changes of the last decade.

c. Some time after the break, a new sort of deflation develops—the so-called “self-deflation” accompanied by low interest rates. But this self-deflation is not brought about by an increase in saving in the usual sense of the word. For:

If more is saved—investment schedules remaining the same—interest rates will fall, uncovering new investment opportunities. This fall will not be hindered by the disappearance of money into hoards 29 or into central banks—provided the discount rates are not kept “unnaturally” high, which would of course represent an independent cause of deflation. Not until interest rates have reached zero (or what creditors consider a minimum rate to compensate the inconvenience and risk of lending) can deflation ensue. But a reduction to such a level is highly improbable unless something else happens to depress interest rates.

2. Decrease in investment.

In the well-known passage in Chapter 22 (“Notes on the Trade Cycle”) Keynes attributes the depression to a breakdown of “optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also.” 30

Here Keynes is clearly an adherent of the old oversaving underinvestment—via overinvestment—theories. For, according to these theories, during prosperity so much capital equipment is built up that finally all investment opportunities are exhausted, the investment curve shifts downwards and deflation and depression ensue.

Keynes, as far as I can see, added nothing to this approach, as presented, for instance, by Spiethoff. So what neoclassic monetary theorists, especially the Wicksellians, objected to still stands. Acknowledging that shifts in the propensity to invest may occur from time to time they considered the elasticity of money supply or the fact that interest rates were alternately too low and too high in comparison to the “natural” rate as the ultimate reason for fluctuations in investment and thus for inflation and deflation.31 A downward shift of investment following a former upward shift would in fact—under the assumption of “neutral” money—lead only to a lower interest rate, not to deflation; for new investment opportunities would be uncovered through the “neutralizing” downward shift of the supply schedule for investible funds.

3. Simultaneous decrease in consumption and investment.

Whether an autonomous decrease in investment brought about by earlier overinvestment would have provided the sufficient or even necessary condition to bring about depressions of the type known until now can, however, be doubted. I personally think that another sort of decrease in investment has been far more important in originating crises and depressions, namely, the decrease in investment happening simultaneously and as a consequence of a decrease in consumption.

The statement that depressions are brought about by simultaneous decreases in consumption and investment is quite in line with Keynes’ ideas, as expressed in another passage of his “Notes on the Trade Cycle” (Chapter 22). Here he attributes lack of demand to simultaneous declines in the propensity to consume and to invest. Not quite consistently with his general approach, he considers the breakdown of consumer demand to be “induced” by a breakdown in demand by investors rather than the other way around: “Unfortunately a serious fall in the marginal productivity of capital also tends to affect adversely the propensity to consume.” 32 But wherever the movement starts, at a cyclical peak the propensity to consume is supposed to diminish, the propensity to save to increase.

Keynes states furthermore that “overinvestment” has two meanings:

It may refer to investments which are destined to disappoint the expectations which prompted them or for which there is no use in conditions of severe unemployment, or it may indicate a state of affairs where every kind of capital-goods is so abundant that there is no new investment which is expected, even in conditions of full employment, to earn in the course of its life more than its replacement cost.

And he concludes: “Overinvestment” in the second sense of the word is not “a normal characteristic of the boom.” 33

People may be “overbought,” but never “overinvested.” It seems advisable to make this basic difference between overbuying and overinvesting quite clear.

Obviously the yield on capital can increase for two reasons:

i. The marginal utility of capital increases because of technological progress;

ii. Prices rise during the production period or—in the case of speculative investment in inventories—during the period of speculation.

Now it may be that during the upswing investment turns out to have been temporarily “accelerated” because people have been enabled by elasticity of money supply to cluster their investments in the present instead of spreading them evenly over time.34 But, as explained above, such temporary “overinvestment” need lead subsequently only to low interest rates, not to a demand deficit, and surely not to a deficit that appears suddenly.

So expectations concerning the second alternative must be at work. Observation proves indeed that demand for investment has never subsided only because entrepreneurs became skeptical about the technical profitability of capital. It subsided because entrepreneurs became skeptical, too, about the demand for their products. To this extent, not a general pessimism about the yield of investments, but a very special pessimism, namely, about consumer demand, was at the root of the reluctance to invest. In any event, depression is not essentially due to too much investment. In fact, during a depression one invests in order to apply more capital to a unit of labor so as to reduce costs. Genuine overinvestment is not “a normal characteristic of a boom.” Nor is, consequently, genuine oversaving: savings increasing from slow changes of consumption habits are always absorbed in an economy in which there is no “overinvestment.”

This is sometimes denied because during a depression the prices of capital goods fall more than those of consumer goods. Likewise, stocks drop sharply under the impact of lower earnings and perhaps higher interest rates. But only the prices of capital goods frozen into a certain, hitherto optimum, combination with labor decline more than proportionately. If a factory is built to employ 10,000 workers, it obviously cannot be run at a profit if only 5,000 work. However, the prices of capital goods not already frozen in certain combinations with labor and produced currently do not decline overproportionately; and the entrepreneur who has the courage to build a plant during a depression does not have to pay any more on the average than if he bought consumer goods. Existing underutilized equipment, in contrast, is marked down to the price at which the earnings, low because of “false combinations,” are capitalized at the prevailing interest rate.

4. Saving vs. Waiting.

In crises and depressions consumption and derived investment decline. But is the decline in consumption really saving? We think it is not and that it should be clearly distinguished from genuine saving. The indiscriminate use of the term is at least partly responsible for the fact that Keynes and, even more, his followers attribute the end of prosperity to “saving.” The decline in spending for consumption that occurs in crises and depressions should therefore be called by a special name, for instance, “waiting” (although in earlier literature “waiting” is sometimes used synonymously with saving). And the increase in spending that happens during a boom and is induced by the expectation of higher prices should be called “hurrying.” That Keynes should treat “saving” and “waiting” as one and the same phenomenon, namely, as a deficient propensity to consume, is only natural. In a timeless analysis, which is not concerned with the sequence and causality of events, a reduction in consumption must appear to be of the same nature whether due to a desire to provide for the future, as in the case of genuine saving, or to hope or fear of price declines as in the case of “waiting.” For while waiting, like saving, certainly reflects a declining propensity to consume, its concomitants, and consequently its causes, effects, and the remedies for it, are totally different. Before Keynes the two phenomena were clearly distinguished, and “waiting” was called “buyers’ resistance” or “buyers’ crisis” (the latter in German Absatzstockung or Absatzkrise) and, in line with common usage, never identified with saving. A return to this pre-Keynesian distinction seems warranted because saving and waiting differ in several ways:35

i. In motive. One saves out of prudence; one waits only because one hopes for or fears lower prices.

ii. In duration. Saving ends with the emergency for which one has saved; hence it may never end.

iii. In character. Waiting is a purely cyclical phenomenon. It happens at the end of a boom and during the downswing. It has its counterpart on the upswing in what may be called “hurrying.” Waiting and hurrying do not happen in lieu of, but interplay with, saving and dissaving in certain phases of the cycle. At times, for instance at the height of a boom, hurrying may reduce or even overcompensate the demand-restricting power of increasing saving; at other times, for instance in a crisis, waiting may reduce or over-compensate the demand-stimulating power of declining saving. This interplay of hurrying and saving on the one side, and waiting and dissaving on the other, could, incidentally, probably be verified statistically: waiting and hurrying would manifest themselves chiefly in fluctuations in the velocity of money; genuine saving would be reflected chiefly in an increase of savings accounts and certain securities.

iv. In the policies they may require. Waiting may have to be discouraged as harmful; saving may have to be encouraged as beneficial. This, by the way, would have been the attitude of neoclassical theorists. The modern attitude, in contrast, seems to be inimical to both, for it advocates a redistribution of income that tends to discourage not only waiting but also genuine saving.36

There remains of course the question why the consumption curve suddenly shifts downwards. It is the duty of business-cycle theorists to show the causes of the shift. After a lifetime of practical experience I personally, although not denying the importance of an autonomous decline in investment from which the movement may start, am inclined to attribute great importance to the simple fact of overbuying or overspeculation in the widest sense: during a boom people expect ever higher prices. But as at a certain moment there are no new layers of buyers on whom speculators can unload, prices stop rising. Now the speculators try to sell, but as the suddenly increased supply of goods is too large for normal demand, prices fall. Soon everyone postpones even normal purchases. Prices decline further, leading people to expect still lower prices. These facts were described over and over again by business-cycle theorists in the nineteenth century in order to explain depressions and crises. On them in this century A. C. Pigou built his famous theory of Industrial Fluctuations.37

If our “waiting theory of depression” is correct, the following conclusions are warranted:

i. One should not worry about overinvestment—i.e., lack of opportunities for investment in crises or depressions. Entrepreneurs hesitate to produce because they fear losses no matter whether they produce in a more or a less “capitalistic” way. Such losses could be incurred in an economy that uses little capital as well as in a highly capitalistic economy. Cyclical depressions therefore cannot be attributed to an investment gap despite the somewhat confusing fact that interest rates drop sharply in the later phases of a depression. They fall not because of oversaving and underinvestment, but because people “wait” simultaneously to consume and to invest. The money they do not spend accumulates in the banks. The banks in turn lend on the money market, giving it the appearance of extreme easiness.

ii. The statement that “the remedy for a boom is not a higher rate of interest but a lower rate of interest” 38 cannot be correct. Investment declines not because interest rates are high in view of the marginal productivity of capital, but because people no longer expect higher prices. To reduce interest rates would therefore be entirely inappropriate. Low interest rates, far from opening new investment opportunities in a technical sense, would merely encourage the use of credit for speculation on higher prices. They would only prolong the boom and prepare the way for an even more severe decline.

iii. Keynesians who hold saving to be a vice and spending a virtue oversimplify the problems involved. While a Sudden increase in genuine saving during a depression might accentuate the noxious effects of waiting, a thrifty economy is superior to a spendthrift economy because it assures a higher living standard, provided that in the long run there are no impediments to the flow of savings into investment. And while in a depression the income of lower brackets is obviously spent more freely than that of higher, wage increases, as advocated for instance by unions, remain the worst method of supporting demand. For whereas demand can be supported by many other means, wage increases unavoidably raise costs, thus leading to structural unemployment.

LONG-RUN EQUILIBRIUM

Keynes believes in the possibility of an investment gap also in the long run. This is evident from the passages already quoted 39 and from his remarks about the responsibility of the state “for directly organizing investment” in the future.40 These remarks laid the foundation for the theory of the maturity and stagnation of our economy and of the inevitability of state capitalism.

The assumptions underlying Keynes’ statements have not been verified statistically; indeed, considerable evidence of their incorrectness seems to be accumulating.

1. How large have savings averaged over a long period?

The great significance many writers attribute to the long-run effects of saving induces the feeling that they have somewhat lost their sense of proportion. One gets the impression that people work only in order to accumulate wealth. In reality investment-additions to capital stock—plays in the long run a rather small role in keeping an economy going. According to Simon Kuznets, only 6 to 7 per cent of national income went to net capital formation in 1919-1938.41 Obviously it is much easier to find new investment opportunities for such a small percentage than for higher percentage of national income.

There also seems to be no proof that in the long run the saving-income ratio rises with income. This ratio has been constant as far as the secular trend, not the cycle, is concerned.42 What may be correct for the case of an individual moving into a higher bracket seems to be quite wrong in—and should not be confounded with—the case of a whole community getting richer over time.

Nevertheless, the absolute amount of saving undoubtedly increases when real income increases, as it has always done in the long run. Furthermore, with the simple passage of time capital accumulates even though the net increment to savings and investments during any one period may be very small.

2. Has there been a tendency toward an investment gap in the long run?

If saving and investment tend to get out of balance, deflation must ensue. No proof can be found that on the average the secular trend has been toward deflation. At some times, the propensity to invest has been stronger than the propensity to save; at other times, weaker. But the trend has always been toward a relative strengthening of the propensity to invest and toward inflation.

Keynes attributes the alleged trend toward deflation partly to hoarding. But, as has been shown frequently, and recently by me,43 “liquidity preference” cannot curtail the supply of loanable funds in the long run.

Keynes offers an additional argument for the statement that “to fill the gap between net income and consumption, presents a problem which is increasingly difficult.” 44 One might call it the “capital disinvestment” argument. Its premises are that consumption is “satisfied partly by objects produced currently and partly by objects produced previously, i.e., by disinvestment.” 45 “Now all capital investment is destined to result, sooner or later, in capital disinvestment.” 46 Therefore “new capital investment can only take place in excess of current capital disinvestment if future expenditure on consumption is expected to increase.” 47 In this connection Keynes recalls The Fable of the Bees: “The gay of tomorrow are absolutely indispensable to provide a raison d’être for the grave of today.” 48 The conclusion is correct but the premises are untenable. There is no reason why in the long run and in the aggregate, capital should ever be disinvested. As a matter of fact, economic progress has been achieved mainly by successive additions to capital stock. Only during severe depressions, if at all, has disinvestment taken place. So the picture of an economy suffocating in its own fat because capital goods, transformed into consumer goods, constantly press on the markets for the latter, is based upon a factual error. The sole problem is to provide demand for consumer goods coming from current production, not from disinvestment. Whether the increased productivity resulting from capital accumulation leads to an oversupply of goods is of course another problem. But in the long run it is not a problem at all because living standards tend to keep up with productivity.

The long-run investment argument has been presented by economists during history every time a cyclical depression lasted longer than was expected. It might well be that we shall not hear about it for quite a long time.

3. A long-term analysis with long-term assumptions.

The chief objections to Keynes’ “Chronic underinvestment” theory is, however, that it is a long-run analysis based upon short-run assumptions—a fault arising from his endeavor to construct a “combination theory.”

In the last analysis, underinvestment could threaten in the long run only if the demand price for capital fell to zero or to a point below which creditors were willing to lend. According to the “stagnation” school, this is supposed to happen because the saturation of the economy with capital exhausts investment opportunities and causes the investment curve to shift downward as time goes on.

Now suppose there were really a lack of opportunities. Could and would it inevitably cause an interruption in the flow of savings into investments? To assume this would assume that the productivity of capital is a fixed schedule, depending only upon the quantity of capital; in reality it is a function, too, of the amount of labor supplied at various wage rates. The newly employed labor-becoming profitable through reductions in wages, provided demand for labor is not too inelastic—will need new capital equipment. And this resulting increase in the demand for capital will be greater than the reduction in the demand for capital by enterprises with a strong capital structure. As Keynes mentions as a possibility, a reduction of money wages “will increase the marginal efficiency of capital” and “the change will be favourable to investment.” 49

So the insufficient marginal productivity of capital can threaten a secular investment gap under two assumptions only:

i. that wages are fixed;

ii. that unutilized capital equipment is so ample that demand for capital would not be stimulated by lower wages.

These two assumptions are indeed introduced by Keynes in his short-term analysis, where they might be tenable and realistic under certain conditions. In long-term analysis, into which they are taken over indiscriminately, they seem entirely out of place.

Obviously, stable wages cannot be presupposed outside cycle analysis, at least under conditions of perfect competition. If the labor market is competitive, unemployment tends to reduce wages. Only labor monopolies could keep wages—and unemployment-high.

Equally, demand for capital cannot be considered fixed, because higher employment necessitates more capital equipment unless one can rely on unused capacity. When an economy emerges from depression, one can indeed rely on such unused capacity. But in the long run there cannot be anything like unused capacity. Labor and capital must be assumed to be combined in the optimal way so that every increase in employment entails an addition to capital equipment.

Hence one can never speak of an absolute absence of investment opportunities as long as there is voluntary unemployment, unless the demand for new capital in case of increased employment is extremely inelastic. Outside of this very special and improbable case, underinvestment—nonabsorption of savings—need never occur. If there is nevertheless unemployment, it is not because demand for capital is too low but because labor is too costly. It is caused by a strike, so to speak, of labor, not of investors.

This, by the way, is quite in line with the Keynesian idea that a slackening of population growth reduces the demand for capital. Obviously the effect must be the same whether the supply of labor is restricted by a decline in population or by the unwillingness of some to work at wage rates that would insure full employment.

4. The remaining case.

In one case, however, the nonabsorption of potential savings is at least theoretically possible: if everyone is employed at the beginning of a production period, a reduction in wages cannot lead to the absorption of either more workers or more capital. Therefore a very low demand for investment could produce deflation and unemployment.

But does this mean that a lack of investment opportunities can explain chronic depression and unemployment? Unemployment can be of two kinds. If it is brought about by low demand for products and deflation ensues, it is involuntary unemployment in Keynes’ sense. If it is brought about by the high cost of labor, it is voluntary. Only the first kind can in any way be connected with an “investment gap.” But there is no a priori presumption that this kind is present in cases of chronic depression. Unemployment is not synonymous with underinvestment, and not every unemployment can be charged to lack of investment, as so many do nowadays.

But even the “involuntary” unemployment brought about by deflation cannot explain a protracted stagnation. For involuntary unemployment is essentially short-run; it cannot last forever. If the quantity of money decreases by reason of deflation, wages must adjust themselves to the new, reduced quantity of money, just as they adjust themselves to inflation.

So while immediately after deflationary pressure has started, unemployment can be considered to be due to deflation, after a certain time the responsibility shifts. Long-run unemployment must be considered to be due to high wages. Nor could it be argued that a new investment gap would threaten if wages were reduced. For, as we have shown above, the employment of the former unemployed does not lead to such a gap. Nor in the long run would a reduction in wages provoke fear of a renewed deflation, as Keynes seems to think; 50 not even if all entrepreneurs were Keynesians. In non-Keynesians a reduction of wages inspires hope for higher prices through higher investment, anyway.

Of course if saving (ex ante) exceeded investment not once but in consecutive production periods, wages would never get adjusted. Wage declines would always lag behind deflation, causing genuine involuntary unemployment. But this would be a dynamic process with all the characteristics of a cyclical depression, not stagnation, which the investment gap is supposed to explain. Cyclical depression can, however, be explained much more realistically by the “waiting” approach. Static or stabilized unemployment is never a “low demand” unemployment, caused by entrepreneurs’ fear that “the proceeds realized from the increased output will disappoint” them because the “proceeds will necessarily fall short of their supply price.” 51 It is always high-cost unemployment.

Confused by Keynes’ timeless and isolated analysis, many economists do not recognize sufficiently the essential difference between the two kinds of unemployment. Businessmen, on the contrary, know very well whether they are curtailing production because demand is low or because costs are rising. Curtailment for the former reason can lead to progressive deflation and involuntary unemployment. Curtailment of production when prices do not decline but remain at a low level for a long time—in other words, when there is a true long-term equilibrium—has nothing whatever to do with low demand. In this case there is only one reason for low employment as well as low investment: a wage level that is too high.

This statement, which is identical with the classical employment theory, must be qualified in only one respect. Wages can seem too high not only absolutely but also in relation to the general conditions under which production is carried on. Insecurity concerning continuity of production—a threat of strikes, for instance—can be as serious a deterrent to employment as exaggerated wage demands. What is of theoretical importance is that such facts are not, in the last analysis, impediments to investment. They menace profits not on the use of more units of capital per unit of labor, but on the use of more units of labor per unit of capital.

There is no theoretical justification for discouraging saving and encouraging spending—as distinct from cyclical “hurrying” and waiting. Keynes is wrong in denying that “a decrease in spending will tend to lower the rate of interest” and increase investment.52 He is also wrong in assuming that spending determines “the aggregate volume of employment.” 53 And it is theoretically confusing and must lead to disastrous practical consequences if “a decreased readiness to spend” is regarded “as a factor which will, ceteris paribus, diminish employment” rather than “a factor which will, ceteris paribus, increase investment.” 54

In the general case—outside cyclical disturbances—Say’s law is valid. Money is always spent on either consumption or investment. Therefore national income does not depend on “marginal productivity of capital, the propensity to consume, liquidity preference, and the amount of money,” as Keynesians believe. In fact, I think that such a statement will appear very awkward in a not too distant future. Especially the idea that the amount of money determines national income may again be considered what it really is: a serious relapse to preclassical economies and a rationalization of inflationary policies.

National income, identical with production, depends—as common sense suggests—on the amount of labor it pays to employ. This fundamental fact should be the basis of every modern employment theory as it was the basis of the classical theory. The proposition that in general the flow of money is interrupted by saving and the economy more or less permanently threatened by deflation can only lead to paradoxical conclusions.

 

 

55 Appeared first in Schweizerische Zeitschrift für Volkswirtschaft und Statistik, 1948.

56 Keynes, The General Theory, p. 3.

57 Sumner H. Slichter, Review of Economic Statistics, 1947, p. 140.

58 That Keynesianism and its success are due to a certain historical constellation becomes clear when one reads reactions from outside the Anglo-American deflation-fearing realm. We quote at random: “An entire world separates us from the conceptions of modern economics which, influenced by Keynes, considers that full employment is threatened mainly by the lag of investment behind saving. How far this theory is valid for the English economy is not for us to decide. As far as present German conditions are concerned, it sounds like a bad joke.” (Translated from Der Wirtschafts-Spiegel, Wiesbaden, Oct. 1, 1947, p. 365.)

59 Keynes, op. cit., p. 98.

60 Ibid., p. 105.

61 Ibid., p. 249.

62 See my Volkswirtschaftliche Theorie des Bankkredits, 3d ed. In the first two editions I sought to give a “general” theory of the effects of credit expansion; in the third edition I differentiated sharply between static and dynamic situations.

63 Keynes, op. cit., p. 96.

64 Ibid., p. 127.

65 Ibid., p. 97.

66 Ibid., p. 97.

67 Ibid., p. 109.

68 Ibid., p. 31.

69 Ibid., p. 261.

70 Ibid., p. 98.

71 Ibid., p. 100.

72 Ibid., p. 105.

73 Ibid., pp. 261 ff.

74 For the opposite phenomenon, “inflationary employment recession,” see Chapter 11, p. 132.

75 Keynes, op. cit., p. 97 (italics mine).

76 See Chapter 13, “Anachronism of the Liquidity Preference Concept.”

77 Keynes, op. cit., p. 127.

78 I drew attention to “prosperity saving” in the third edition of my Volkswirtschaftliche Theorie des Bankkredits. A Statistical verification was attempted in my “Zur Frage des volkswirtschaftlichen Erkenntnisinhalts der Bankbilanzziffern,” in Vierteljahreshefte zur Konjunkturforschung, I, 1926, Erg.-Heft 4; reprinted in Geld und Kredit. Neue Folge, Tübingen, 1929.

79 Fritz Machlup, Review of Economic Statistics, 1943, pp. 26-39.

80 Keynes, op. cit., p. 184.

81 Ibid., p. 100.

82 Ibid., p. 100.

83 In Chapter 13 I have tried to show that, under present conditions, demand for money to hoard is not stimulated by a reduction in interest rates.

84 Keynes, op. cit., p. 315.

85 Concerning the so-called “acceleration principle,” cf. footnote 34, p. 164.

86 Keynes, op. cit., p. 319.

87 Ibid., p. 321.

88 As Wicksellians would put it.

89 Cf. Chapter 8, “Is Saving a Virtue or a Sin?”, p. 100.

90 The interplay of “waiting” and “saving” during the German inflation was examined in “Zur Frage des sogenannten Vertrauens in die Währung,” Archiv für Sozialwissenschaft und Sozialpolitik, Band 52 (1924), pp. 289 ff.

91 The inadequacy of the Keynesian short-run equilibrium theory to explain business cycles has been at least implicitly acknowledged by those of his followers who have tried to “dynamize” his system—e.g., Harrod, Samuelson, Kalecki, Smithies, and Metzler. In building up such macrodynamic models, the liquidity preference concept has not played any role, but the consumption function has been retained and a number of additional assumptions have been introduced. These cannot be discussed here in detail. As far as I can see, none of these models can explain the sudden break characteristic of a crisis. They could at best explain a slow structural decline.

92 Keynes, op. cit., p. 322.

93 Ibid., pp. 97 and 109.

94 Ibid., p. 164.

95 National Income: A Summary of Findings (National Bureau of Economic Research, 1946), p. 18.

96 Arthur F. Burns, Stepping Stones Towards the Future (National Bureau of Economic Research, 27th Annual Report, 1947), p. 13.

97 See Chapter 13.

98 Keynes, p. 105.

99 Ibid.

100 Ibid., p. 106.

101 Ibid., p. 263.

102 Ibid., p. 263.

103 Ibid., p. 261.

104 Ibid., p. 185.

105 Ibid.

• 1* Appeared first in The Banking and Law Journal, July 1943.
• 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.
• 28Ibid., p. 100.
• 29I 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.
• 30For 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.
• 31Accordingly, in the third edition of my Volkswirtschaftliche Theorie des Bankkredits, the Interest Theory of Unemployment was developed as a cyclical theory.
• 32A Select Collection of Scarce and Valuable Tracts and Other Publications on Paper Currency and Banking, ed. by J. R. McCulloch, 1862.
• 33See Chapter 6, p. 62.
• 34See the corresponding remark by D. McC. Wright in “The Future of Keynesian Economics,” in American Economic Review, vol. 35, no. 2 (June 1945), p. 299.
• 35Abba P. Lerner, “Functional Finance and the Federal Debt,” in Social Research, vol. 10, February, 1943, p. 39.
• 36Kenneth E. Boulding, The Economics of Peace, New York, 1945, p. 215.
• 37W. H. Beveridge, in his Full Employment in a Free Society, London, 1944, demands strict control of the labor supply. This is probably nothing but the tacit acknowledgment of the changes in the labor supply we have described. Yet the restoration of a free labor market remains as an alternative—and a desirable one, at least as long as we wish to live in a truly free economy, rather than in Beveridge’s pseudo-free economy.
• 38Keynes, op. cit., p. 322.
• 39Ibid., pp. 97 and 109.
• 40Ibid., p. 164.
• 41National Income: A Summary of Findings (National Bureau of Economic Research, 1946), p. 18.
• 42Arthur F. Burns, Stepping Stones Towards the Future (National Bureau of Economic Research, 27th Annual Report, 1947), p. 13.
• 43See Chapter 13.
• 44Keynes, p. 105.
• 45Keynes, p. 105.
• 46Ibid.
• 47Ibid.
• 48Ibid., p. 106.
• 49Ibid., p. 263.
• 50Ibid., p. 263.
• 51Ibid., p. 261.
• 52Ibid., p. 185.
• 53Ibid.
• 54Ibid.
• 55  2. Should a Government Debt, Internally Held, Be Called a Debt at All?*
• 56I 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.
• 57When 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.
• 58These 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.
• 59In 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.
• 60In 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.
• 61In 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.
• 62But 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.
• 63The 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.
• 64At 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.
• 65Since 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):
• 66Hitler’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.
• 67Hitler’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.
• 68As 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.
• 69As 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.
• 70It 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.
• 71Another 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.
• 72Still 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.
• 73The 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.”
• 74Nevertheless, 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.
• 75In 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.
• 76In 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.
• 77Finally, 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.
• 78From 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.
• 79Elasticity 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.
• 80When 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.
• 81Our 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.
• 82In the main parts of his General Theory Keynes considers an increase in saving induced by an increase in income as the cause of subnormal activity. On the other hand, he seems to think that cyclical depressions are due to a spontaneous increase in saving and/or a spontaneous decrease in investment. The reason he gives for the 1929 crash in the passage quoted could be interpreted in this way.
• 83Consequently, 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.
• 84Now 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.
• 85To 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.
• 86The 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.
• 87It is not necessary to decide whether an analysis in terms of effective demand alone was justified ten years ago. Today, an analysis in terms of effective demand that is not supplemented by analysis in terms of effective supply, especially of labor, is not justified in any circumstances. It seems both illogical and certain to lead to false conclusions if one indulges (as is so often done) in elaborate estimates of employment at various levels of effective demand, from private or public spending, without making the corresponding estimates of the employment that is created by the same effective demand at various wage levels.
• 88It is not necessary to decide whether an analysis in terms of effective demand alone was justified ten years ago. Today, an analysis in terms of effective demand that is not supplemented by analysis in terms of effective supply, especially of labor, is not justified in any circumstances. It seems both illogical and certain to lead to false conclusions if one indulges (as is so often done) in elaborate estimates of employment at various levels of effective demand, from private or public spending, without making the corresponding estimates of the employment that is created by the same effective demand at various wage levels.
• 89A second matter for consideration is that the devices to combat unemployment known as “government deficit spending,” “compensatory spending,” or “functional finance” are clearly an outgrowth of the idea that in the general case more investment leads to more employment. If our analysis is correct, this will be true only under special conditions. Thus, before applying government spending one has to study carefully to what extent the wage situation has caused the unemployment, and whether and to what extent wages can be held inflexible in an upward direction. Unless this is done, government spending, apart from all fiscal difficulties, will only lead to price inflation. The indiscriminate creation of purchasing power every time private demand slows down for whatever reason or whenever full employment is not achieved, as advocated by the proponents of “functional finance,” is indeed “like almost every important discovery . . . extremely simple.” It is, in fact, not only extremely simple but also an extreme oversimplification of very complicated problems. And if another proponent of “functional finance” wishes to “persuade people that inflation is impossible as long as there is serious unemployment, for under those circumstances a rise in money demands leads to a rise in output and employment, not to a rise in prices,” we should like to take the opposite position: people—economists and laymen alike—should be persuaded that even with serious unemployment the rise in money demand may, under today’s conditions, lead to a rise in prices rather than to a rise in output or employment. The widely held belief in an a priori parallelism of investment and employment is not justified.
• 90A second matter for consideration is that the devices to combat unemployment known as “government deficit spending,” “compensatory spending,” or “functional finance” are clearly an outgrowth of the idea that in the general case more investment leads to more employment. If our analysis is correct, this will be true only under special conditions. Thus, before applying government spending one has to study carefully to what extent the wage situation has caused the unemployment, and whether and to what extent wages can be held inflexible in an upward direction. Unless this is done, government spending, apart from all fiscal difficulties, will only lead to price inflation. The indiscriminate creation of purchasing power every time private demand slows down for whatever reason or whenever full employment is not achieved, as advocated by the proponents of “functional finance,” is indeed “like almost every important discovery . . . extremely simple.” It is, in fact, not only extremely simple but also an extreme oversimplification of very complicated problems. And if another proponent of “functional finance” wishes to “persuade people that inflation is impossible as long as there is serious unemployment, for under those circumstances a rise in money demands leads to a rise in output and employment, not to a rise in prices,” we should like to take the opposite position: people—economists and laymen alike—should be persuaded that even with serious unemployment the rise in money demand may, under today’s conditions, lead to a rise in prices rather than to a rise in output or employment. The widely held belief in an a priori parallelism of investment and employment is not justified.
• 91A second matter for consideration is that the devices to combat unemployment known as “government deficit spending,” “compensatory spending,” or “functional finance” are clearly an outgrowth of the idea that in the general case more investment leads to more employment. If our analysis is correct, this will be true only under special conditions. Thus, before applying government spending one has to study carefully to what extent the wage situation has caused the unemployment, and whether and to what extent wages can be held inflexible in an upward direction. Unless this is done, government spending, apart from all fiscal difficulties, will only lead to price inflation. The indiscriminate creation of purchasing power every time private demand slows down for whatever reason or whenever full employment is not achieved, as advocated by the proponents of “functional finance,” is indeed “like almost every important discovery . . . extremely simple.” It is, in fact, not only extremely simple but also an extreme oversimplification of very complicated problems. And if another proponent of “functional finance” wishes to “persuade people that inflation is impossible as long as there is serious unemployment, for under those circumstances a rise in money demands leads to a rise in output and employment, not to a rise in prices,” we should like to take the opposite position: people—economists and laymen alike—should be persuaded that even with serious unemployment the rise in money demand may, under today’s conditions, lead to a rise in prices rather than to a rise in output or employment. The widely held belief in an a priori parallelism of investment and employment is not justified.
• 92ii. The statement that “the remedy for a boom is not a higher rate of interest but a lower rate of interest” cannot be correct. Investment declines not because interest rates are high in view of the marginal productivity of capital, but because people no longer expect higher prices. To reduce interest rates would therefore be entirely inappropriate. Low interest rates, far from opening new investment opportunities in a technical sense, would merely encourage the use of credit for speculation on higher prices. They would only prolong the boom and prepare the way for an even more severe decline.
• 93Keynes believes in the possibility of an investment gap also in the long run. This is evident from the passages already quoted and from his remarks about the responsibility of the state “for directly organizing investment” in the future. These remarks laid the foundation for the theory of the maturity and stagnation of our economy and of the inevitability of state capitalism.
• 94Keynes believes in the possibility of an investment gap also in the long run. This is evident from the passages already quoted and from his remarks about the responsibility of the state “for directly organizing investment” in the future. These remarks laid the foundation for the theory of the maturity and stagnation of our economy and of the inevitability of state capitalism.
• 95The great significance many writers attribute to the long-run effects of saving induces the feeling that they have somewhat lost their sense of proportion. One gets the impression that people work only in order to accumulate wealth. In reality investment-additions to capital stock—plays in the long run a rather small role in keeping an economy going. According to Simon Kuznets, only 6 to 7 per cent of national income went to net capital formation in 1919-1938. Obviously it is much easier to find new investment opportunities for such a small percentage than for higher percentage of national income.
• 96There also seems to be no proof that in the long run the saving-income ratio rises with income. This ratio has been constant as far as the secular trend, not the cycle, is concerned. What may be correct for the case of an individual moving into a higher bracket seems to be quite wrong in—and should not be confounded with—the case of a whole community getting richer over time.
• 97Keynes attributes the alleged trend toward deflation partly to hoarding. But, as has been shown frequently, and recently by me, “liquidity preference” cannot curtail the supply of loanable funds in the long run.
• 98Keynes offers an additional argument for the statement that “to fill the gap between net income and consumption, presents a problem which is increasingly difficult.” One might call it the “capital disinvestment” argument. Its premises are that consumption is “satisfied partly by objects produced currently and partly by objects produced previously, i.e., by disinvestment.” “Now all capital investment is destined to result, sooner or later, in capital disinvestment.” Therefore “new capital investment can only take place in excess of current capital disinvestment if future expenditure on consumption is expected to increase.” In this connection Keynes recalls The Fable of the Bees: “The gay of tomorrow are absolutely indispensable to provide a raison d’être for the grave of today.” The conclusion is correct but the premises are untenable. There is no reason why in the long run and in the aggregate, capital should ever be disinvested. As a matter of fact, economic progress has been achieved mainly by successive additions to capital stock. Only during severe depressions, if at all, has disinvestment taken place. So the picture of an economy suffocating in its own fat because capital goods, transformed into consumer goods, constantly press on the markets for the latter, is based upon a factual error. The sole problem is to provide demand for consumer goods coming from current production, not from disinvestment. Whether the increased productivity resulting from capital accumulation leads to an oversupply of goods is of course another problem. But in the long run it is not a problem at all because living standards tend to keep up with productivity.
• 99Keynes offers an additional argument for the statement that “to fill the gap between net income and consumption, presents a problem which is increasingly difficult.” One might call it the “capital disinvestment” argument. Its premises are that consumption is “satisfied partly by objects produced currently and partly by objects produced previously, i.e., by disinvestment.” “Now all capital investment is destined to result, sooner or later, in capital disinvestment.” Therefore “new capital investment can only take place in excess of current capital disinvestment if future expenditure on consumption is expected to increase.” In this connection Keynes recalls The Fable of the Bees: “The gay of tomorrow are absolutely indispensable to provide a raison d’être for the grave of today.” The conclusion is correct but the premises are untenable. There is no reason why in the long run and in the aggregate, capital should ever be disinvested. As a matter of fact, economic progress has been achieved mainly by successive additions to capital stock. Only during severe depressions, if at all, has disinvestment taken place. So the picture of an economy suffocating in its own fat because capital goods, transformed into consumer goods, constantly press on the markets for the latter, is based upon a factual error. The sole problem is to provide demand for consumer goods coming from current production, not from disinvestment. Whether the increased productivity resulting from capital accumulation leads to an oversupply of goods is of course another problem. But in the long run it is not a problem at all because living standards tend to keep up with productivity.
• 100Keynes offers an additional argument for the statement that “to fill the gap between net income and consumption, presents a problem which is increasingly difficult.” One might call it the “capital disinvestment” argument. Its premises are that consumption is “satisfied partly by objects produced currently and partly by objects produced previously, i.e., by disinvestment.” “Now all capital investment is destined to result, sooner or later, in capital disinvestment.” Therefore “new capital investment can only take place in excess of current capital disinvestment if future expenditure on consumption is expected to increase.” In this connection Keynes recalls The Fable of the Bees: “The gay of tomorrow are absolutely indispensable to provide a raison d’être for the grave of today.” The conclusion is correct but the premises are untenable. There is no reason why in the long run and in the aggregate, capital should ever be disinvested. As a matter of fact, economic progress has been achieved mainly by successive additions to capital stock. Only during severe depressions, if at all, has disinvestment taken place. So the picture of an economy suffocating in its own fat because capital goods, transformed into consumer goods, constantly press on the markets for the latter, is based upon a factual error. The sole problem is to provide demand for consumer goods coming from current production, not from disinvestment. Whether the increased productivity resulting from capital accumulation leads to an oversupply of goods is of course another problem. But in the long run it is not a problem at all because living standards tend to keep up with productivity.
• 101Now suppose there were really a lack of opportunities. Could and would it inevitably cause an interruption in the flow of savings into investments? To assume this would assume that the productivity of capital is a fixed schedule, depending only upon the quantity of capital; in reality it is a function, too, of the amount of labor supplied at various wage rates. The newly employed labor-becoming profitable through reductions in wages, provided demand for labor is not too inelastic—will need new capital equipment. And this resulting increase in the demand for capital will be greater than the reduction in the demand for capital by enterprises with a strong capital structure. As Keynes mentions as a possibility, a reduction of money wages “will increase the marginal efficiency of capital” and “the change will be favourable to investment.”
• 102So while immediately after deflationary pressure has started, unemployment can be considered to be due to deflation, after a certain time the responsibility shifts. Long-run unemployment must be considered to be due to high wages. Nor could it be argued that a new investment gap would threaten if wages were reduced. For, as we have shown above, the employment of the former unemployed does not lead to such a gap. Nor in the long run would a reduction in wages provoke fear of a renewed deflation, as Keynes seems to think; not even if all entrepreneurs were Keynesians. In non-Keynesians a reduction of wages inspires hope for higher prices through higher investment, anyway.
• 103Of course if saving (ex ante) exceeded investment not once but in consecutive production periods, wages would never get adjusted. Wage declines would always lag behind deflation, causing genuine involuntary unemployment. But this would be a dynamic process with all the characteristics of a cyclical depression, not stagnation, which the investment gap is supposed to explain. Cyclical depression can, however, be explained much more realistically by the “waiting” approach. Static or stabilized unemployment is never a “low demand” unemployment, caused by entrepreneurs’ fear that “the proceeds realized from the increased output will disappoint” them because the “proceeds will necessarily fall short of their supply price.” It is always high-cost unemployment.
• 104There is no theoretical justification for discouraging saving and encouraging spending—as distinct from cyclical “hurrying” and waiting. Keynes is wrong in denying that “a decrease in spending will tend to lower the rate of interest” and increase investment. He is also wrong in assuming that spending determines “the aggregate volume of employment.” And it is theoretically confusing and must lead to disastrous practical consequences if “a decreased readiness to spend” is regarded “as a factor which will, ceteris paribus, diminish employment” rather than “a factor which will, ceteris paribus, increase investment.”
• 105There is no theoretical justification for discouraging saving and encouraging spending—as distinct from cyclical “hurrying” and waiting. Keynes is wrong in denying that “a decrease in spending will tend to lower the rate of interest” and increase investment. He is also wrong in assuming that spending determines “the aggregate volume of employment.” And it is theoretically confusing and must lead to disastrous practical consequences if “a decreased readiness to spend” is regarded “as a factor which will, ceteris paribus, diminish employment” rather than “a factor which will, ceteris paribus, increase investment.”