I. The Debate, 1931–1971: Sudha Shenoy

I. The Debate, 1931–19711

By Sudha Shenoy

The roots of current economic ideas and of those guiding wages policy lie in the 1930s, in discussion inspired by the publication of the General Theory. Though Keynes’s ideas diverged significantly from the theoretical structure of Pigou and Marshall, with which he was most familiar, ‘Keynesian’ ways of thinking had been fairly widespread in Britain and the USA before the General Theory appeared in 1936.2 Keynes provided a theoretical foundation for these new ways of thinking.

Since the publication of the General Theory there has been an extensive elaboration of the theoretical system outlined in or generally associated with it, together with a further development of an alternative system of concepts called the Classical system. This was close to a mirror-image of the Keynesian system,3 in the main relationships (e.g., between the quantity of money and total expenditure, between interest, saving and investment, between the wage level and the level of employment, and so on). But whereas the Keynesian system was couched wholly in terms of aggregates, the so-called ‘Classical’ system contained what may be termed a price dimension: the changes in the price ‘level’ associated with changes in the total money stock were held by the Classical system to imply equi-proportional changes in all prices, and variations in the price level in turn were associated with changes in the level of economic activity. In a sense the Keynesian approach may be regarded as a logical extension and elaboration of this rather crudely aggregative element in the ‘Classical’ system.

Challenge to Keynes

The doctrines generally accepted among English economists contemporaneous with Keynes were challenged, in fundamental respects, by an alternative analysis, developed on the Continent, and propounded in Britain by Professor Hayek. But by the 1940s, the Keynesian approach was almost universally adopted by economists. Initially, many appeared to believe that the ‘macro’ problems of unemployment and depression were solved and that few other major economic problems would emerge. The only problem remaining, it seemed, was the methods required to ensure ‘full’ employment.

‘Now that the principle of adequate effective demand is so firmly established,’ declared Professor Arthur Smithies, ‘economists should devote particular attention to defining the responsibilities of the state.’4

The British White Paper on Employment Policy in 1944 and the full employment commitment in the UN Charter reflected this belief, as did the 1946 Employment Act in the USA.5

A few dissenting voices warned of trouble ahead. Professor Jacob Viner observed of a report to the Economic and Social Council of the United Nations, National and International Measures for Full Employment, prepared by a group of distinguished economists (J.M. Clark, A. Smithies, N. Kaldor, P. Uri and E.R. Walker):

The sixty-four dollar question with respect to the relations between unemployment and full employment policy is what to do if a policy to guarantee full employment leads to chronic upward pressure on money wages through the operation of collective bargaining. The authors take a good look at the question—and run away.

Effective demand to provide employment was the ‘key concept’ in recommendations which Professor Viner rated as ‘much more Keynesian than was the final Keynes himself . . .’6

Shortly after the General Theory appeared, Professor W.H. Hutt argued that it was a specific for inflation.7

Even Keynes had doubts, a few years after the General Theory. In his essay How to Pay for the War (London: Macmillan, 1940) he warned the trade unions of the ‘futility’ of demanding an increase in money rates of wages to compensate for every increase in the cost of living. To prevent inflation, he insisted,

Some means must be found for withdrawing purchasing power from the market; or prices must rise until the available goods are selling at figures which absorb the increased quantity of expenditure—in other words the method of inflation.

And in a discussion of financing war expenditure:

. . . a demand on the part of the trade unions for an increase in money rates of wages to compensate for every increase in his cost of living is futile, and greatly to the disadvantage of the working class. Like the dog in the fable, they lose the substance in grasping at the shadow. It is true that the better organised might benefit at the expense of other consumers. But except as an effort at group selfishness, as a means of hustling someone else out of the queue, it is a mug’s game . . .

The Approach to an Incomes Policy

Over the following 25-odd years, the early Keynesian theory was further elaborated and refined and a highly sophisticated series of macro-economic models developed. The 1950s more especially saw the discovery of ‘cost inflation’, in which a rise in wages pushed up the cost level. As prices were determined by costs, and, in crucial sectors of the economy, were ‘administered’ on the cost-plus-mark-up practice, prices rose to protect profit margins. But since wages were also incomes the cost and price increases had no deflationary effect, as effective demand rose simultaneously.8 In these circumstances a contractionary monetary/fiscal policy would be deflationary: it would lead to socially intolerable levels of unemployment and excess capacity; an alternative measure, directed specifically at rising costs, would have to be devised. If price stability and full employment could both be achieved by keeping wage increases within the limits set by rises in productivity, this implied an ‘incomes policy’. Further investigation into the implications for the price- and wage-level of linking sectoral wage increases with productivity strengthened the case for a nationally-determined ‘wages policy’ covering both relative wage-rates and the general wage level. If wages rose in the sectors where productivity was rising, the result would be a rise in demand for the outputs of other sectors, resulting in a rise in their prices.9

Economic policy in the UK and the USA, from 1950 on, reflected the adoption of these views; there was a gradual shift from exhortations, guidelines and pay pauses to more direct attempts to influence and control wages.10

That such direct control of wages and prices would be needed to forestall the ‘vicious wage-price spiral’11 resulting from full employment had been forecast by Lord Beveridge as early as 1944.

By the late 1960s and early 1970s more economists came to favour an incomes policy, some reluctantly (Robbins, Meade, Paish, Brittan, Morgan),12 others enthusiastically (Balogh, Streeten, Opie).13

Lord Robbins’s case is particularly interesting. In the early 1950s he analysed clearly the inflationary implications of the full employment policy contemplated by Beveridge: it gave union leaders a virtual guarantee that

whatever [wage] rates they succeeded in getting, unemployment would not be permitted to emerge.14

It would give them a continuous incentive to push wages beyond increases in productivity, setting off a ‘vicious spiral’ of ‘more inflation’. This, in turn, might force governments to act directly on wage rates.

The present determination of wages by bargain between employer and employed would be suspended. Wage-fixing by the state would take its place.

He believed, however, that this alternative would be rejected ‘on the ground that in the end its efficient operation would prove to be incompatible with the continuation of political democracy. . . .’15 Seventeen years later he argued16 for an incomes policy as temporary ‘shocktactics’, to afford a ‘breathing space’ in which fundamental monetary-fiscal reforms might be ‘advanced and understood’.

Despairing of the good sense of union leaders, he sought to bring pressure on them indirectly, suggesting that businessmen be restrained from granting inflationary wage increases by restrictions on aggregate demand, even to the point of precipitating bankruptcies, thus preventing the payment of higher wages that would simply be recouped by higher prices. A suggested alternative or parallel measure would be to tax inflationary wage increases granted by firms. He hoped that union leaders’ expectations of automatic increases in wages would thereby be frustrated. (A similar view is taken by Professors E. Victor Morgan, F.W. Paish, and Sidney Weintraub.)17

An alternative type of incomes policy was proposed by Mr. Samuel Brittan.18 The government would control the level to which wage rates would be permitted to rise while allowing employers short of labour to offer higher rates, but without pretending to determine relative wage rates on the basis of social justice. Such a policy, he said, must be treated as a supplement to monetary and fiscal policies that provide sufficient demand to prevent unemployment, but prevent the emergence of excess demand. He suggested as a stop-gap a temporary price and wage freeze until these policies are implemented.

Two possible implications of this suggestion may be considered. First, if such a brake on wage increases is to be more than advice, unions must be willing to accept the guidance of the incomes authority—implying a permanent watchdog role for the authority (or at least an existence parallel to that of the unions-as-wage-fixers). If the unions refuse to cooperate presumably the authority will have to take over their wage-fixing function . . .

Secondly, in common with other recommendations for incomes policies, this proposal would perpetuate a given structure of relative wage rates since all the rates to which it applied would be allowed to rise only by a given percentage (save in ‘labour scarcity’). This relative wage structure today reflects not so much the allocative forces of the market19 but the relative power or ‘pushfulness’ of the different unions. Can we assume that they would be content to retain indefinitely whatever relative positions they had achieved at the moment the incomes policy came into existence?

‘Micro’ Dimensions Acknowledged

The common thread running through these discussions is the alleviation of specific wage-rate maladjustments. They have moved some distance from the aggregative analysis. The ‘macro’ problem of adequate demand management has, it now appears, a ‘micro’ dimension: that of establishing (or obtaining) an ‘appropriate’ scale of prices. In other words, from the viewpoint of practical policy, the ‘macro’ problem of a persistent upward push (or pull) on the price ‘level’ is now seen to have ‘micro’ roots, in the specific ‘pricing’ methods used by specific groups of workers. ‘Macro’ measures acting on aggregate expenditure may have allowed us hitherto to ignore this basic micro discoordination,20 but events seemingly have brought the issue forward unavoidably. ‘Macro’ measures, it would appear, may offset micro problems but are no substitute for appropriate micro solutions.

The significance of coordination at the micro-level appears here, in the light of a third type of analysis, which Professor Hayek developed, on foundations laid by the ‘Austrians’: Menger, Wieser and Böhm-Bawerk, culminating in the works of Mises. Hayek concentrated on an analysis of the structure of relative prices and their interrelations. He did not adopt the framework of a general equilibrium system, nor treat price changes as elements in a ‘dynamic’ shift between two general equilibria. He regarded prices rather as empirical reflectors of specific circumstances and price changes as an interrelated series of changes in these ‘signals’, which produced a gradual adaptation in the entire price structure (and hence in the outputs of different commodities and services) to the constant, unpredictable changes in the real world. Pricing, in short, is seen as a continuous information-collecting and disseminating process, but it is the institutional framework that determines both the extent to which, and the degree of success with which, prices are enabled to perform this potential signalling or allocative function.

This ‘Austrian’ analysis constitutes a substantial break with Classical economic theory from Adam Smith to J.S. Mill. It differs also both from the doctrines of the English economists after Mill and from the theoretical preoccupations of the Lausanne School with the conditions of general equilibrium.21

Is There a Price ‘Level’?

In his first English work, the four lectures published as Prices and Production,22 Hayek questioned the concept of a price ‘level’—i.e., a relationship between the total money stock and the total volume of production, variations in this ‘level’ being associated with variations in aggregate output. He argued that such a concept failed to show that there were specific influences of changes in the stream of money expenditure on the structure of relative prices, and hence on the structure of production.23 These price and output changes, he maintained, occurred irrespective of changes in the price level. Hayek’s analysis implied that if ‘the’ price ‘level’ is held ‘stable’ by offsetting monetary measures, under conditions where the relative price changes would result in a falling price ‘level’, the real dislocations would be the same as if prices were made to rise by monetary measures, if otherwise they might have remained ‘stable.’ In either case, the outcome is a painful correction of the preceding real misdirection, i.e., a ‘depression’.

During the 1920s, the widespread theoretical and policy influence of the ‘stabilisationists’ meant that considerations of the kind sketched by Professor Hayek were not incorporated into either theoretical or policy analysis; consequently, the price ‘level’ ‘stability’ of the period was read as implying a lack of maladjustment in the underlying price structure. (This is an extremely oversimplified summary of a complex historical situation, the specific conditions of which were not uniform in all countries.)

Theoretically and practically, it may be argued that in conditions of ‘depression’ there is little choice save to augment the level of monetary expenditure to the highest possible degree. Hayekian analysis, while readily conceding that depressionary symptoms may thus be overlaid, would argue that the problems are then transformed into those arising out of a situation where every reappearance of recessionary symptoms has to be met by ever larger increases of monetary expenditure, eventually issuing in the ‘stag-flationist’ dilemma.

This is not necessarily to say that the specific policies pursued in the 1920s and 1930s, or the economic and monetary framework of the time, represented an approximation to the Hayekian ideal. Hayek has said with regard to the period 1927–32:

. . . up to 1927, I should, indeed, have expected that because, during the preceding boom period, prices did not rise—but rather tended to fall—the subsequent depression would be very mild. But, as is well known, in that year an entirely unprecedented action was taken by the American monetary authorities, which makes it impossible to compare the effects of the boom on the subsequent depression with any previous experience. The authorities succeeded by means of an easy money policy, inaugurated as soon as the symptoms of an impending reaction were noticed, in prolonging the boom for two years beyond what would otherwise have been its natural end. And when the crisis finally occurred, for almost two more years deliberate attempts were made to prevent, by all conceivable means, the normal process of liquidation. It seems to me that these facts have had a far greater influence on the character of the depression than the developments up to 1927, which, from all we know, might instead have led to a comparatively mild depression in and after 1927.24

Shortly after the publication of the first edition of Prices and Production, Professor Hayek published (in Economica) the first part of a long, substantive review of Keynes’s Treatise on Money.25 This provoked a reply from Keynes, followed by a rejoinder, before the publication of the second part of the review. Hayek criticised Keynes for his neglect of the real structure of production, arguing that Keynes’s predilection for concentrating on the immediate and purely monetary phenomena accompanying changes in money expenditure, together with his penchant for aggregative macro concepts (total profits, total investment), had led him into contradictory or untenable conclusions. Keynes apparently held that if there were no entrepreneurial profits or losses in the aggregate, total output would be held constant. Hayek replied that if profits in the ‘lower’ stages of production (nearer consumption) were exactly counterbalanced by losses in the ‘higher’ stages, there would be a contraction in the capital structure and a fall in output and employment—even though there were no aggregate profits or losses.

In his reply, Keynes failed to take up the numerous substantial criticisms made by Hayek. The main point of interest is his explicit statement that ‘. . . in my view, saving and investment . . . can get out of gear . . . there being no automatic mechanism in the economic system . . . to keep the two rates equal’. Hayek’s reply to this was based on his analysis of the relative price-structure:

Mr. Keynes’s assertion that there is no automatic mechanism in the economic system to keep the rate of saving and the rate of investing equal . . . might with equal justification be extended to the more general contention that there is no automatic mechanism in the economic system to adapt production to any other shift in demand.

Further Implications of Hayekian Analysis

There are further implications of the Hayekian approach:

(a) If the current level of output and employment is made to depend on inflation, a slowing-down in the pace of inflation will produce recessionary symptoms. Moreover, as the economy becomes adjusted to a particular rate of inflation, the rate must itself be continuously increased if symptoms of a depression are to be avoided: to inflate is to have ‘a tiger by the tail’.

(b) To limit price or wage-rate increases by an incomes policy is to freeze a particular set of price and wage-rate interrelationships while underlying circumstances of supply and demand are continually changing. This is like the ‘stability’ of a set of defective gauges perpetually pointing to the same set of readings. It reinforces other institutional factors preventing the specific changes in relative prices and wage rates necessary to the maintenance of ‘full’ employment. Or, to put this same point from a different angle, if ‘full’ employment is to be maintained at union-determined wage rates (which are inflexible downwards), all other prices and wage rates must be adjusted to them: other prices and wage rates must be set at, or reach, levels consistent with this objective. Even if union-determined wage rates were held down to a maximum percentage increase, it still does not follow that the same percentage increase, or a lesser increase, in all other prices and wage rates would suffice to achieve ‘full’ employment. This is why it may be necessary for incomes to rise faster than output, even to secure that increase in output.26

(c) The major objection to an incomes policy approach is that it merely freezes a given array of prices and wage rates. It does nothing to bring about coordination or to introduce coordinative institutions into the labour sector. So long as the discoordinative potential of such non-market institutions as unions is not tackled, the problem will recur again and again. There may be no substitute for a very painful reshaping of institutions or other means of bringing within the ambit of the pricing system wage rates made impervious to market forces.27 The alternative is a permanent incomes policy: an all-round fixing of wage rates and prices, i.e., an effectively centrally-controlled economy (with all its problems), although we may, as it were, ‘back into’ this situation unintentionally. This is to say nothing about whether it is desirable politically.28

_______________

29 I should like to thank Dr. C.A. Blyth and Professors P.P. Streeten, L. Lachmann and I.M. Kirzner for reading this introductory essay and for their helpful comments. They do not necessarily share my interpretations.—S.R.S.

30Cf. Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford: Oxford University Press, 1968); Keynes and the Classics, Occasional Paper 30 (London: IEA, 1969); T.W. Hutchison, Economics and Economic Policy in Britain, 1946–66 (London: Allen and Unwin, 1968); H. Stein, The Fiscal Revolution in America (Chicago: University of Chicago Press, 1969).

31Cf. E.E. Hagen, ‘The Classical Theory of Output and Employment’, in M.G. Mueller (ed.), Readings in Macroeconomics (New York: Holt, Rinehart and Winston, 1966); H.G. Johnson, ‘Monetary Theory and Keynesian Economies’ in Money, Trade and Economic Growth (London: Allen & Unwin, 1962); ‘Introduction’ in R.J. Ball and Peter Doyle (eds.), Inflation (Baltimore: Penguin Books, 1969).

32Professor A. Smithies, in the American Economic Review (June 1945): 367. The symposium on employment policy, American Economic Review (May 1946), is also relevant.

33The Congress declared it was

. . . the continuing policy and responsibility of the Federal Government to use all practicable means . . . to coordinate and utilize all its plans, functions and resources for the purpose of creating and maintaining . . . conditions under which there will be afforded useful employment for those able, willing and seeking work. . . . (Quoted in Robert Lekachman, The Age of Keynes , p. 144)

34‘Full Employment at Whatever Cost?’, Quarterly Journal of Economics (August 1950). Earlier Professor Viner said:

. . . it is a matter of serious concern whether under modern conditions, even in a socialist country if it adheres to democratic political procedures, employment can always be maintained at a high level without recourse to inflation, overt or disguised, or if maintained whether it will not itself induce an inflationary wage spiral through the operation of collective bargaining . . .

Reviewing the General Theory in Quarterly Journal of Economics, 1936–37, he said:

In a world organised in accordance with Keynes’s specifications, there would be a constant race between the printing press and the business agents of the trade unions with the problem of unemployment largely solved if the printing press could maintain a constant lead . . .

35Economists and the Public (London: Jonathan Cape, 1936). Professor Hutt published a brief analysis of the central issues in his Theory of Idle Resources (London: Jonathan Cape, 1939); his earlier work on the Theory of Collective Bargaining (1930; new edition, Glencoe, Ill.: The Free Press, 1954; 2nd British edition published as The Theory of Collective Bargaining 1930–1975G, Hobart Paperback No. 8 ) analysed the position of the Classical economists on the relation between unions and wage determination.

There is also a collection of extracts from reviews and other early writings critical of the General Theory, edited by Henry Hazlitt: The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960).

36F. Machlup, ‘Another view of cost push and demand pull inflation’, Review of Economics and Statistics (1960).

37P.P. Streeten, ‘Wages, prices and productivity’, Kyklos (1962).

38D.J. Robertson, ‘Guideposts and Norms: Contrasts in US and UK Wage Policy’, Three Banks Review (December 1966) ; D.C. Smith, ‘Income Policy’, in R.E. Caves and Associates (eds.), Britain’s Economic Prospects (London: Allen & Unwin, 1968).

39W.H. Beveridge, Full Employment in a Free Society (London: Allen and Unwin, 1944, pp. 198–201, esp. p. 201: ‘Adoption by the State of a price policy is a natural and probably an inevitable consequence of a full employment policy’.

40Lord Robbins, ‘Inflation: The Position Now’, Financial Times, 23 June, 1971; J.E. Meade, Wages and Prices in a Mixed Economy, Occasional Paper 35 (London: IEA for Wincott Foundation, 1971); F.W. Paish, Rise and Fall of Incomes Policy, Hobart Paper 47 (London: IEA, second edition, 1971); S. Brittan, Government and the Market Economy, Hobart Paperback 2 (London: IEA, 1971); E. Victor Morgan, ‘Is Inflation Inevitable?’, Economic Journal (March 1966).

41T. Balogh, Labour and Inflation, Fabian Tract 403 (Fabian Society, 1970); Streeten, ‘Wages, prices and productivity’; R.G. Opie, ‘Inflation’ in P.D. Henderson (ed.), Economic Growth in Britain (London: Weidenfeld & Nicolson, 1966).

42Robbins, ‘Full Employment as an Objective’, in The Economist in the Twentieth Century (London: Macmillan, 1954); italics in original.

43Robbins, Inflation’, pp. 35–36.

44Financial Times, 23 June, 1971.

45Morgan, ‘Is Inflation Inevitable’, p. 14; Paish, Rise and Fall of Incomes Policy, Postscript; S. Weintraub, ‘An Incomes Policy to Stop Inflation’, Lloyds Bank Review (January 1971).

46Brittan, Government and the Market Economy, pp. 48–56.

47Professor W.B. Reddaway (‘Wage Flexibility and the Distribution of Labour’, Lloyds Bank Review [April 1959]) has suggested, on empirical investigations, that relative wage-rate movements have little allocative significance today: labour reallocation among industries and firms is achieved by changes in job offers. Given union-determined wage-rate structure, this is perhaps to be expected; but it is not incompatible with the basic proposition that prices are capable of performing allocative functions—if the institutional framework is designed to this end.

Professor Reddaway has argued elsewhere (‘Rising Prices Forever?’, Lloyds Bank Review [July 1966]) that rising prices are here to stay indefinitely. While advocating institutional restraints on price and wage increases, he recommends measures to raise productivity, arguing that, given such ‘assured’ increases in real income, even fairly high rates of price increase may be tolerated—the few hyperinflations in history being special cases. To live with inflations of the Latin American type, as he seems to contemplate (p. 15), would imply not only very substantial changes in British economic institutions (which he might have made explicit); it would also imply the acquiescence or political impotence of groups whose incomes remained static or failed to rise as fast as prices.

48Suggestions that wage increases be linked to productivity are clearly attempts to offer some coordinative criterion, in this discoordinated situation.

49F.A. Hayek, ‘Economics and Knowledge’, ‘The Use of Knowledge in Society’ and the three chapters on ‘Socialist Calculation’ in Individualism and Economic Order(London: Routledge, 1948).

50Routledge and Kegan Paul, 1931 and 1933. A scheme which confines itself to contrasting ‘the “Classical” model’ (i.e., the conceptual framework used by the English economists contemporary with Keynes) and ‘the Keynesian (and/or post-Keynesian) model’ may therefore be incomplete. H.G. Johnson, ‘Monetary Theory and Keynesian Economies’; ‘Introduction’, in Ball and Doyle (eds.); and the ‘Introduction’ to R.W. Clower (ed.), Monetary Theory (Harmondsworth, U.K.: Penguin Books, 1969) are instances of such schemes.

51Professor Clower’s stricture that ‘at no stage in pre-Keynesian economics was any serious attempt made to build peculiarly monetary assumptions into the micro-foundations of economic analysis’ (Monetary Theory, p. 19) is not accurate.

52Prices and Production (London: Routledge, 2nd ed., 1935), pp. 161–62.

53‘Reflections on the Pure Theory of Money of Mr. J.M. Keynes’, Economica (August 1931 and February 1932); J.M. Keynes, ‘The Pure Theory of Money—A Reply to Dr. Hayek’; F.A. Hayek, ‘A Rejoinder to Mr. Keynes’, Economica (November 1931).

54Incomes policy advocates implicitly assume that ‘full employment’ relative price and wage interrelationships once established can be maintained indefinitely; their implicit ‘model’ is that of a rigid real structure of outputs and prices on which a varying monetary stream impinges (see esp. Meade, Wages and Prices in a Mixed Economy, pp. 11–12; Morgan, ‘Monetary Theory and Keynesian Economies’; Brittan, Government and the Market Economy. Hayek has characterised such a mode of thinking as belonging essentially to the naïve early stages of economic thought (Pure Theory of Capital, pp. 409–10; also see Economica [August 1931]: 273).

But if prices and wages are inflexible downwards, the ‘full employment’ level of expenditure may itself continually shift upwards, since the appropriate price changes can only be made by continually ‘jacking up’ the entire structure.

55A similar view was put by Professors William Fellner and Friedrich Lutz in W. Fellner et al., The Problem of Rising Prices (Organisation of European Economic Cooperation, 1961).

56This stress on the labour side need not imply that established firms (in the Western economies or elsewhere) are never at present protected against actual or potential competition and against actual or potential losses, either by the institutional framework or by economic policy. The Hayekian approach implies that no incomes and assets—whether business or other—be protected against losses. (F.A. Hayek, “Free” Enterprise and Competitive Order’ in Individualism and Economic Order , and ‘The Modern Corporation in a Democratic Society . . .’ in Studies in Philosophy, Politics and Economics ).

1* I should like to thank Dr. C.A. Blyth and Professors P.P. Streeten, L. Lachmann and I.M. Kirzner for reading this introductory essay and for their helpful comments. They do not necessarily share my interpretations.—S.R.S.
2Charles Gascom, “The Current Recession: How Bad Is It?” Federal Reserve Bank of St. Louis Economic Synopses 4 (January 8, 2009): 2, available at http://research.stlouisfed.org/publications/es/09/ES0904.pdf.
3It should be briefly noted that this was the same cheap money policy that ignited and stoked the unsustainable real estate boom in the first place. Thus from December 1999 through December 2005, the Fed increased the money supply as measured by MZM by about $2.5 trillion, or 57 percent, which works out to an uncompounded annual rate of 9.5 percent. During the same time period another Fed monetary aggregate, M2, registered an increase of $2 trillion, or about 44 percent, which yields an uncompounded annual rate of 7.3 percent. This massive monetary inflation was naturally accompanied by a precipitous decline in interest rates, with the target Fed Funds rate plunging from 6.5 percent in late 2000 to 1.0 percent in mid-2003 and being pegged at that level for nearly a year and then remaining below 3.0 percent for almost another year. Mortgages rates followed this sharp downward movement, with the rate on 30-year conventional fixed mortgages dropping 3 percentage points, from 8.52 percent in mid-2000 to 5.58 percent in mid-2005. But this understates the looseness in the home loan markets generated by the monetary inflation, which also induced the development of a remarkable laxity in credit standards. The statistics in this footnote and in the associated paragraph in the text are based on data from The Federal Reserve Bank of St. Louis Economic Research available at http://research.stlouisfed.org/).
4The Pure Theory of Capital (London: Routledge and Kegan Paul, 1953), p. 409; p. 29 in this volume.
5Professor T.W. Hutchison, Markets and the Franchise, Occasional Paper 10 (London: IEA, 1966).
6The Times, 4 January, 1975.
7Economists and the Public (London: Jonathan Cape, 1936). Professor Hutt published a brief analysis of the central issues in his Theory of Idle Resources (London: Jonathan Cape, 1939); his earlier work on the Theory of Collective Bargaining (1930; new edition, Glencoe, Ill.: The Free Press, 1954; 2nd British edition published as The Theory of Collective Bargaining 1930–1975G, Hobart Paperback No. 8 ) analysed the position of the Classical economists on the relation between unions and wage determination.
8F. Machlup, ‘Another view of cost push and demand pull inflation’, Review of Economics and Statistics (1960).
9P.P. Streeten, ‘Wages, prices and productivity’, Kyklos (1962).
10D.J. Robertson, ‘Guideposts and Norms: Contrasts in US and UK Wage Policy’, Three Banks Review (December 1966) ; D.C. Smith, ‘Income Policy’, in R.E. Caves and Associates (eds.), Britain’s Economic Prospects (London: Allen & Unwin, 1968).
11W.H. Beveridge, Full Employment in a Free Society (London: Allen and Unwin, 1944, pp. 198–201, esp. p. 201: ‘Adoption by the State of a price policy is a natural and probably an inevitable consequence of a full employment policy’.
12Lord Robbins, ‘Inflation: The Position Now’, Financial Times, 23 June, 1971; J.E. Meade, Wages and Prices in a Mixed Economy, Occasional Paper 35 (London: IEA for Wincott Foundation, 1971); F.W. Paish, Rise and Fall of Incomes Policy, Hobart Paper 47 (London: IEA, second edition, 1971); S. Brittan, Government and the Market Economy, Hobart Paperback 2 (London: IEA, 1971); E. Victor Morgan, ‘Is Inflation Inevitable?’, Economic Journal (March 1966).
13T. Balogh, Labour and Inflation, Fabian Tract 403 (Fabian Society, 1970); Streeten, ‘Wages, prices and productivity’; R.G. Opie, ‘Inflation’ in P.D. Henderson (ed.), Economic Growth in Britain (London: Weidenfeld & Nicolson, 1966).
14Robbins, ‘Full Employment as an Objective’, in The Economist in the Twentieth Century (London: Macmillan, 1954); italics in original.
15Robbins, Inflation’, pp. 35–36.
16Financial Times, 23 June, 1971.
17Morgan, ‘Is Inflation Inevitable’, p. 14; Paish, Rise and Fall of Incomes Policy, Postscript; S. Weintraub, ‘An Incomes Policy to Stop Inflation’, Lloyds Bank Review (January 1971).
18Brittan, Government and the Market Economy, pp. 48–56.
19Professor W.B. Reddaway (‘Wage Flexibility and the Distribution of Labour’, Lloyds Bank Review [April 1959]) has suggested, on empirical investigations, that relative wage-rate movements have little allocative significance today: labour reallocation among industries and firms is achieved by changes in job offers. Given union-determined wage-rate structure, this is perhaps to be expected; but it is not incompatible with the basic proposition that prices are capable of performing allocative functions—if the institutional framework is designed to this end.
20Suggestions that wage increases be linked to productivity are clearly attempts to offer some coordinative criterion, in this discoordinated situation.
21F.A. Hayek, ‘Economics and Knowledge’, ‘The Use of Knowledge in Society’ and the three chapters on ‘Socialist Calculation’ in Individualism and Economic Order(London: Routledge, 1948).
22Routledge and Kegan Paul, 1931 and 1933. A scheme which confines itself to contrasting ‘the “Classical” model’ (i.e., the conceptual framework used by the English economists contemporary with Keynes) and ‘the Keynesian (and/or post-Keynesian) model’ may therefore be incomplete. H.G. Johnson, ‘Monetary Theory and Keynesian Economies’; ‘Introduction’, in Ball and Doyle (eds.); and the ‘Introduction’ to R.W. Clower (ed.), Monetary Theory (Harmondsworth, U.K.: Penguin Books, 1969) are instances of such schemes.
23Professor Clower’s stricture that ‘at no stage in pre-Keynesian economics was any serious attempt made to build peculiarly monetary assumptions into the micro-foundations of economic analysis’ (Monetary Theory, p. 19) is not accurate.
24Prices and Production (London: Routledge, 2nd ed., 1935), pp. 161–62.
25‘Reflections on the Pure Theory of Money of Mr. J.M. Keynes’, Economica (August 1931 and February 1932); J.M. Keynes, ‘The Pure Theory of Money—A Reply to Dr. Hayek’; F.A. Hayek, ‘A Rejoinder to Mr. Keynes’, Economica (November 1931).
26Incomes policy advocates implicitly assume that ‘full employment’ relative price and wage interrelationships once established can be maintained indefinitely; their implicit ‘model’ is that of a rigid real structure of outputs and prices on which a varying monetary stream impinges (see esp. Meade, Wages and Prices in a Mixed Economy, pp. 11–12; Morgan, ‘Monetary Theory and Keynesian Economies’; Brittan, Government and the Market Economy. Hayek has characterised such a mode of thinking as belonging essentially to the naïve early stages of economic thought (Pure Theory of Capital, pp. 409–10; also see Economica [August 1931]: 273).
27A similar view was put by Professors William Fellner and Friedrich Lutz in W. Fellner et al., The Problem of Rising Prices (Organisation of European Economic Cooperation, 1961).
28This stress on the labour side need not imply that established firms (in the Western economies or elsewhere) are never at present protected against actual or potential competition and against actual or potential losses, either by the institutional framework or by economic policy. The Hayekian approach implies that no incomes and assets—whether business or other—be protected against losses. (F.A. Hayek, “Free” Enterprise and Competitive Order’ in Individualism and Economic Order , and ‘The Modern Corporation in a Democratic Society . . .’ in Studies in Philosophy, Politics and Economics ).
29I. The Debate, 1931–1971*
30The publication of the new edition of this classic could not have come at a better time, moreover. For it is not merely an outstanding contribution to intellectual history, but also a tract for our times. The U.S. has been mired in an officially-recognized recession for more than a year now with no end in sight. Our current downturn is fast becoming the lengthiest and most severe of the post-World War II era. Entering its fourteenth month, it has already surpassed the average length of the last six recessions and is rapidly approaching the postwar record of sixteen months. The net decline in employment of 2.6 million recorded for 2008 represents the greatest absolute decline in the number of jobs since 1945. With over a half-million workers losing their jobs in December 2008 alone, the unemployment rate unexpectedly spiked from 6.8 percent in November 2008 to 7.2 percent, the highest level in sixteen years. The 4.78 million Americans now claiming unemployment insurance is the highest since 1967, when this statistic began to be recorded and represents the highest proportion of the work force since 1983. Adding to the dismal employment picture, the average work week for the month plummeted to 33.3 hours, the lowest level since 1964, while part-time jobs shot up by 700,000, or nearly 10 percent, from the previous month, indicating that many part-time workers counted as officially employed were either previously terminated from full-time jobs or reduced from full-time to part-time employment by their current employers. Other indicators of the severity of recession besides employment reveal that the current recession has been deeper than the average recession, including industrial production, real income, and retail sales. As one Fed economist concluded, “Main recession indicators tend to support the claim that this recession could be the most severe in the past 40 years.”
31Indeed the dread word “depression” is now being used by some economists and media pundits to portray our current difficulties, conjuring up the specter of the prolonged mass unemployment amidst idle industrial capacity and unsold piles of raw materials that marked the 1930s. For most recognized experts and opinion leaders, how we got into our current difficulties is now a moot question. Everyone is clamoring for a way out. A massive government bailout involving $700 billion to purchase risky assets and to subsidize troubled financial service and domestic automobile firms has proven spectacularly ineffective in reversing or even slowing the contraction of the economy, although it has led to a staggering projected federal budget deficit of $1.2 trillion for the current fiscal year. Accompanying this deluge of red ink is highly inflationary growth in the official Fed monetary aggregates, with MZM shooting up by 10.1 percent and M2 by 7.6 percent year-over-year as of November 2008. Driving this monetary inflation has been the Fed’s expansion of the adjusted monetary base by 76 percent over the same period, which has reduced the target Fed Funds rate from 5.25 percent in mid-2007 to less than .25 percent by the end of 2008.
32I cannot help regarding the increasing concentration on short-run effects—which in this context amounts to the same thing as a concentration on purely monetary factors—not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilization. To the understanding of the forces which determine the day-to-day changes of business, the economist has probably little to contribute that the man of affairs does not know better. It used, however, to be regarded as the duty and the privilege of the economist to study and to stress the long-run effects which are apt to be hidden to the untrained eye, and to leave the concern about the more immediate effects to the practical man, who in any event would see only the latter and nothing else.
33The purpose of the Hobart Paperbacks is to discuss, in the spirit of what was once called ‘political economy,’ the influences which affect the translation of economic ideas into practical policy and the economics of government activity. In the first Paperback Professor W.H. Hutt examined the notion that some ideas are not adopted because they are considered to be ‘politically impossible.’ In the second Mr. Samuel Brittan analysed the consistency of British Government economic policy since June 1970. In the third Mr. W.R. Lewis analysed the conflict between ideas and policy in the aspirations of the Treaty of Rome and the performance of its interpreters at Brussels.
34As Professor Friedrich Hayek has argued ever since his pre-war disputes with Keynes, the price of maintaining full employment by more and more inflationary public finance is not only accelerating inflation but also a progressive diversion of economic resources into activities favoured by or dependent on inflation. If inflation is to be checked, that structural distortion has to be reversed, which must be painful.
35Shortly after the General Theory appeared, Professor W.H. Hutt argued that it was a specific for inflation.
36Over the following 25-odd years, the early Keynesian theory was further elaborated and refined and a highly sophisticated series of macro-economic models developed. The 1950s more especially saw the discovery of ‘cost inflation’, in which a rise in wages pushed up the cost level. As prices were determined by costs, and, in crucial sectors of the economy, were ‘administered’ on the cost-plus-mark-up practice, prices rose to protect profit margins. But since wages were also incomes the cost and price increases had no deflationary effect, as effective demand rose simultaneously. In these circumstances a contractionary monetary/fiscal policy would be deflationary: it would lead to socially intolerable levels of unemployment and excess capacity; an alternative measure, directed specifically at rising costs, would have to be devised. If price stability and full employment could both be achieved by keeping wage increases within the limits set by rises in productivity, this implied an ‘incomes policy’. Further investigation into the implications for the price- and wage-level of linking sectoral wage increases with productivity strengthened the case for a nationally-determined ‘wages policy’ covering both relative wage-rates and the general wage level. If wages rose in the sectors where productivity was rising, the result would be a rise in demand for the outputs of other sectors, resulting in a rise in their prices.
37Over the following 25-odd years, the early Keynesian theory was further elaborated and refined and a highly sophisticated series of macro-economic models developed. The 1950s more especially saw the discovery of ‘cost inflation’, in which a rise in wages pushed up the cost level. As prices were determined by costs, and, in crucial sectors of the economy, were ‘administered’ on the cost-plus-mark-up practice, prices rose to protect profit margins. But since wages were also incomes the cost and price increases had no deflationary effect, as effective demand rose simultaneously. In these circumstances a contractionary monetary/fiscal policy would be deflationary: it would lead to socially intolerable levels of unemployment and excess capacity; an alternative measure, directed specifically at rising costs, would have to be devised. If price stability and full employment could both be achieved by keeping wage increases within the limits set by rises in productivity, this implied an ‘incomes policy’. Further investigation into the implications for the price- and wage-level of linking sectoral wage increases with productivity strengthened the case for a nationally-determined ‘wages policy’ covering both relative wage-rates and the general wage level. If wages rose in the sectors where productivity was rising, the result would be a rise in demand for the outputs of other sectors, resulting in a rise in their prices.
38Economic policy in the UK and the USA, from 1950 on, reflected the adoption of these views; there was a gradual shift from exhortations, guidelines and pay pauses to more direct attempts to influence and control wages.
39That such direct control of wages and prices would be needed to forestall the ‘vicious wage-price spiral’ resulting from full employment had been forecast by Lord Beveridge as early as 1944.
40By the late 1960s and early 1970s more economists came to favour an incomes policy, some reluctantly (Robbins, Meade, Paish, Brittan, Morgan), others enthusiastically (Balogh, Streeten, Opie).
41By the late 1960s and early 1970s more economists came to favour an incomes policy, some reluctantly (Robbins, Meade, Paish, Brittan, Morgan), others enthusiastically (Balogh, Streeten, Opie).
42whatever [wage] rates they succeeded in getting, unemployment would not be permitted to emerge.
43He believed, however, that this alternative would be rejected ‘on the ground that in the end its efficient operation would prove to be incompatible with the continuation of political democracy. . . .’ Seventeen years later he argued for an incomes policy as temporary ‘shocktactics’, to afford a ‘breathing space’ in which fundamental monetary-fiscal reforms might be ‘advanced and understood’.
44He believed, however, that this alternative would be rejected ‘on the ground that in the end its efficient operation would prove to be incompatible with the continuation of political democracy. . . .’ Seventeen years later he argued for an incomes policy as temporary ‘shocktactics’, to afford a ‘breathing space’ in which fundamental monetary-fiscal reforms might be ‘advanced and understood’.
45Despairing of the good sense of union leaders, he sought to bring pressure on them indirectly, suggesting that businessmen be restrained from granting inflationary wage increases by restrictions on aggregate demand, even to the point of precipitating bankruptcies, thus preventing the payment of higher wages that would simply be recouped by higher prices. A suggested alternative or parallel measure would be to tax inflationary wage increases granted by firms. He hoped that union leaders’ expectations of automatic increases in wages would thereby be frustrated. (A similar view is taken by Professors E. Victor Morgan, F.W. Paish, and Sidney Weintraub.)
46An alternative type of incomes policy was proposed by Mr. Samuel Brittan. The government would control the level to which wage rates would be permitted to rise while allowing employers short of labour to offer higher rates, but without pretending to determine relative wage rates on the basis of social justice. Such a policy, he said, must be treated as a supplement to monetary and fiscal policies that provide sufficient demand to prevent unemployment, but prevent the emergence of excess demand. He suggested as a stop-gap a temporary price and wage freeze until these policies are implemented.
47Secondly, in common with other recommendations for incomes policies, this proposal would perpetuate a given structure of relative wage rates since all the rates to which it applied would be allowed to rise only by a given percentage (save in ‘labour scarcity’). This relative wage structure today reflects not so much the allocative forces of the market but the relative power or ‘pushfulness’ of the different unions. Can we assume that they would be content to retain indefinitely whatever relative positions they had achieved at the moment the incomes policy came into existence?
48The common thread running through these discussions is the alleviation of specific wage-rate maladjustments. They have moved some distance from the aggregative analysis. The ‘macro’ problem of adequate demand management has, it now appears, a ‘micro’ dimension: that of establishing (or obtaining) an ‘appropriate’ scale of prices. In other words, from the viewpoint of practical policy, the ‘macro’ problem of a persistent upward push (or pull) on the price ‘level’ is now seen to have ‘micro’ roots, in the specific ‘pricing’ methods used by specific groups of workers. ‘Macro’ measures acting on aggregate expenditure may have allowed us hitherto to ignore this basic micro discoordination, but events seemingly have brought the issue forward unavoidably. ‘Macro’ measures, it would appear, may offset micro problems but are no substitute for appropriate micro solutions.
49This ‘Austrian’ analysis constitutes a substantial break with Classical economic theory from Adam Smith to J.S. Mill. It differs also both from the doctrines of the English economists after Mill and from the theoretical preoccupations of the Lausanne School with the conditions of general equilibrium.
50In his first English work, the four lectures published as Prices and Production, Hayek questioned the concept of a price ‘level’—i.e., a relationship between the total money stock and the total volume of production, variations in this ‘level’ being associated with variations in aggregate output. He argued that such a concept failed to show that there were specific influences of changes in the stream of money expenditure on the structure of relative prices, and hence on the structure of production. These price and output changes, he maintained, occurred irrespective of changes in the price level. Hayek’s analysis implied that if ‘the’ price ‘level’ is held ‘stable’ by offsetting monetary measures, under conditions where the relative price changes would result in a falling price ‘level’, the real dislocations would be the same as if prices were made to rise by monetary measures, if otherwise they might have remained ‘stable.’ In either case, the outcome is a painful correction of the preceding real misdirection, i.e., a ‘depression’.
51In his first English work, the four lectures published as Prices and Production, Hayek questioned the concept of a price ‘level’—i.e., a relationship between the total money stock and the total volume of production, variations in this ‘level’ being associated with variations in aggregate output. He argued that such a concept failed to show that there were specific influences of changes in the stream of money expenditure on the structure of relative prices, and hence on the structure of production. These price and output changes, he maintained, occurred irrespective of changes in the price level. Hayek’s analysis implied that if ‘the’ price ‘level’ is held ‘stable’ by offsetting monetary measures, under conditions where the relative price changes would result in a falling price ‘level’, the real dislocations would be the same as if prices were made to rise by monetary measures, if otherwise they might have remained ‘stable.’ In either case, the outcome is a painful correction of the preceding real misdirection, i.e., a ‘depression’.
52. . . up to 1927, I should, indeed, have expected that because, during the preceding boom period, prices did not rise—but rather tended to fall—the subsequent depression would be very mild. But, as is well known, in that year an entirely unprecedented action was taken by the American monetary authorities, which makes it impossible to compare the effects of the boom on the subsequent depression with any previous experience. The authorities succeeded by means of an easy money policy, inaugurated as soon as the symptoms of an impending reaction were noticed, in prolonging the boom for two years beyond what would otherwise have been its natural end. And when the crisis finally occurred, for almost two more years deliberate attempts were made to prevent, by all conceivable means, the normal process of liquidation. It seems to me that these facts have had a far greater influence on the character of the depression than the developments up to 1927, which, from all we know, might instead have led to a comparatively mild depression in and after 1927.
53Shortly after the publication of the first edition of Prices and Production, Professor Hayek published (in Economica) the first part of a long, substantive review of Keynes’s Treatise on Money. This provoked a reply from Keynes, followed by a rejoinder, before the publication of the second part of the review. Hayek criticised Keynes for his neglect of the real structure of production, arguing that Keynes’s predilection for concentrating on the immediate and purely monetary phenomena accompanying changes in money expenditure, together with his penchant for aggregative macro concepts (total profits, total investment), had led him into contradictory or untenable conclusions. Keynes apparently held that if there were no entrepreneurial profits or losses in the aggregate, total output would be held constant. Hayek replied that if profits in the ‘lower’ stages of production (nearer consumption) were exactly counterbalanced by losses in the ‘higher’ stages, there would be a contraction in the capital structure and a fall in output and employment—even though there were no aggregate profits or losses.
54(b) To limit price or wage-rate increases by an incomes policy is to freeze a particular set of price and wage-rate interrelationships while underlying circumstances of supply and demand are continually changing. This is like the ‘stability’ of a set of defective gauges perpetually pointing to the same set of readings. It reinforces other institutional factors preventing the specific changes in relative prices and wage rates necessary to the maintenance of ‘full’ employment. Or, to put this same point from a different angle, if ‘full’ employment is to be maintained at union-determined wage rates (which are inflexible downwards), all other prices and wage rates must be adjusted to them: other prices and wage rates must be set at, or reach, levels consistent with this objective. Even if union-determined wage rates were held down to a maximum percentage increase, it still does not follow that the same percentage increase, or a lesser increase, in all other prices and wage rates would suffice to achieve ‘full’ employment. This is why it may be necessary for incomes to rise faster than output, even to secure that increase in output.
55(c) The major objection to an incomes policy approach is that it merely freezes a given array of prices and wage rates. It does nothing to bring about coordination or to introduce coordinative institutions into the labour sector. So long as the discoordinative potential of such non-market institutions as unions is not tackled, the problem will recur again and again. There may be no substitute for a very painful reshaping of institutions or other means of bringing within the ambit of the pricing system wage rates made impervious to market forces. The alternative is a permanent incomes policy: an all-round fixing of wage rates and prices, i.e., an effectively centrally-controlled economy (with all its problems), although we may, as it were, ‘back into’ this situation unintentionally. This is to say nothing about whether it is desirable politically.
56(c) The major objection to an incomes policy approach is that it merely freezes a given array of prices and wage rates. It does nothing to bring about coordination or to introduce coordinative institutions into the labour sector. So long as the discoordinative potential of such non-market institutions as unions is not tackled, the problem will recur again and again. There may be no substitute for a very painful reshaping of institutions or other means of bringing within the ambit of the pricing system wage rates made impervious to market forces. The alternative is a permanent incomes policy: an all-round fixing of wage rates and prices, i.e., an effectively centrally-controlled economy (with all its problems), although we may, as it were, ‘back into’ this situation unintentionally. This is to say nothing about whether it is desirable politically.

A Tiger by the Tail